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E-MailFangzhou Lu is Assistant Professor of Finance at the University of Hong Kong Business School. This post is based on a recent paper authored by Mr. Lu; Chen Lin, Stelux Professor in Finance at the University of Hong Kong Business School; Roni Michaely, Professor of Finance at the University of Hong Kong Business School; and Shihua Qin, Research Postgraduate Student at the University of Hong Kong Business School.
Special purpose acquisition companies (SPACs)—the shell companies whose sole purpose is to identify a private firm to merge with—have become an increasingly important channel for firms to raise money. In 2020, for instance, in the U.S. alone, 248 SPAC IPOS raised $83.4 billion, much more than that raised by traditional IPOs. However, SPACs are also known for underperforming after the acquisition. Since the identity of the merged firm is not known prior to the IPO, and there is little other advance information, investors must place their trust in SPAC sponsors. And here, our research shows there are discernible factors that can indicate the relative success of a SPAC.
SPAC sponsors are more important than in traditional IPOs because, similar to the role of VC’s general partners, investors give them a “blank check” and rely on them to invest it wisely later. The sponsors are also subject to few checks and balances, and a large part of their compensation is not tied to long-term performance, hence increasing the likelihood of less successful deals. All this means that the credentials, reputation, and quality of SPAC sponsors, which we measure using their network centrality, can be essential to a SPAC IPO’s eventual success. Network centrality measures how connected managers are, the extent to which they can exert influence in a social network, and the ability to obtain information. Finally, high network centrality signals to investors that the sponsors have some recognition of success and are regarded as trustworthy by others. These features make network centrality a good proxy for the reputation, experience, and quality of SPACs sponsors. Our research shows that the strength and extent of sponsors’ network connections in the private equity and venture capital industries is a major predictor of their performance. Sponsors with high network centrality are associated with better IPO fundraising, better acquisition targets, and better long-run stock returns, as well as the significantly higher operational performance of the target firm post-merger.
We use data from 390 SPACs that had their IPOs between 2003 and June 2020, including information on sponsors’ work experience and network connections in relation to private equities (PEs) and venture capitals (VCs). Our decision to focus on PE/VC network centrality to indicate sponsor quality was based on prior evidence that having strong networks of social and professional relationships is important when picking and sourcing good merger targets. We predict that better networks also lead to easier access to more potential funding during IPOs, as well as better access to institutional investors (or PIPE, for private investment in public equity), which is usually needed for a business combination to be successfully completed.
We find that fund-raising was significantly enhanced by sponsors with high PE/VC network centrality over those with low centrality. A one standard deviation increase in centrality translated into a $44.67 million increase in IPO proceeds and a $53.87 million increase in PIPE investors. These results are substantial given the average IPO in our sample had proceeds totaling $198 million, and the average PIPE investment was $79 million.
Well-connected sponsors were also able to more quickly identify target firms to merge with, taking 10% less time to complete the business combination (18 months relative to an average of 20 months). High network centrality also leads to greater transparency: those SPACs revealed more information about their acquisition target, based on the word count of their Form S-4 filings. A one standard increase in network centrality was associated with a 12% increase in the quantity of information disclosed. Considering the general paucity of information on SPAC IPOs, this is something that investors should welcome as more information can potentially lead to greater business combination success and operational performance. In fact, this is what we discover in further investigations. A one standard deviation in network centrality led to a 3.7% greater probability that the merger and acquisition would succeed. Most importantly, it was also associated with better long-term performance: revenue was 15.2% higher before the merge, and Tobin’s Q was 17.4% higher after the merge. And a one standard deviation increase in PE network centrality leads to a 2.1% higher post-merger monthly Fama-French three-factor alpha during the 2-year period after the business combination. These evidences support the notion that sponsors with higher network centrality are better at sourcing and picking target firms to work with, and they also to some extent have a positive impact on the firms after the merger.
One implication of our result is that regulators might want to consider implementing some pre-requisite qualifications of SPAC sponsors, and put some restrictions on how they are being compensated. By improving the quality of SPAC sponsors and limiting the dilution structure, SPACs can possibly become a viable channel for firms to go public. Given SPACs’ poor long term performance, implementing these policy recommendations is also likely to reduce SPACs overall underperformance and better protect investors when they invest in these instruments.
The complete paper is available for download here.
