SPACs: Insider IPOs

Usha R. Rodrigues is M.E. Kilpatrick Professor of Law at the University of Georgia School of Law, and Michael Stegemoller is Harriette L. and Walter G. Lacy, Jr., Chair of Banking and Finance at Baylor University Hankamer School of Business. This post is based on their recent paper.

A special purpose acquisition company (SPAC) is an organizational form that allows a group of managers to raise cash via an initial public offering (IPO) in order to acquire a privately held firm. The SPAC organizers hold the cash raised from the IPO in a trust account, invested in government-backed securities. The acquisition, termed the “de-SPAC,” must occur within a limited time, or else the SPAC shareholders get their money back by redeeming their shares. Indeed, SPAC shareholders can redeem their shares—i.e., claim their money back from the trust account—in two circumstances: 1) if the managers successfully locate a target; or 2) if the SPAC reaches the end of its limited life having failed to negotiate a merger. SPACs thus theoretically offer benefits to both their shareholders and the private targets they acquire. The SPAC’s public shareholders get the first crack at owning a newly public operating company—a chance usually reserved for those lucky enough to have been allocated shares in an IPO—with no downside risk if the transaction falls through or if they simply decide they don’t like the look of the target. SPACs also purportedly offer the private firm—the target—capital raising and access to the liquidity of the public markets via a mechanism cheaper, faster, and less painful than a traditional IPO.

In our new paper, SPACs: Insider IPOs, we report hand-collected empirical data from initial and final prospectuses of all SPACs that filed an initial prospectus from 2010 to 2018. This window of time allows each SPAC from this period to play out the entirety of the contractual search period, with the most recent deals concluding in 2020 and 2021. Our findings conclude that SPACs are illiquid and do not demonstrate the sophistication expected of publicly traded firms, as measured by the periodic filings (10Ks and 10Qs) that the law requires. They fail to follow through on the representations they make to investors in their offering documents. More troubling still, the SPAC process does not vet private companies for the public markets as rigorously as a traditional IPO. We explain the structural reasons for these failings: a handful of players dominate the SPAC and de-SPAC process, and they are incentivized to push through any and all deals, regardless of quality. They are, in effect, “insider IPOs.” We advocate for a simple measure of reuniting voting and economic rights as a means to address both the trading and vetting shortcomings of SPAC’s current incarnation.

In terms of liquidity, our evidence shows that SPACs are, on average, thinly traded. In fact, on average, there is no trading of SPAC shares at all in a third of the thirty days leading up to the announcement of an acquisition. That is, not a single share of these companies changes hands for an average of 11 days out of thirty—even though these are supposedly publicly traded companies. The NYSE and NASDAQ repeatedly asked the SEC to reduce the minimum number of shareholders required in order to maintain a listing—a scant 300 for a standard publicly traded operating company—down to 150 or even to 1. SPACs are thinly held and rarely traded—offering particular peril for the retail investor. SPAC liquidity is abysmal.

The danger to the retail investor is of a peculiar kind, however. Academic research has shown that large institutional investors, such as hedge funds, dominate SPAC IPOs. This select group have no incentive to trade because there is no downside risk to owning the shares, given the redemption right. Logically, they will only sell if the shares are valued above the protective floor the redemption right provides. When the SPAC trades above the redemption price, that is when the retail investors can buy SPAC shares—when they are by definition more exposed to downside risk. They buy in to SPACs precisely because the IPO investors have gotten out while the getting is good. Thus, one harm SPACs pose is to the relatively few retail investors who buy those shares.

The second harm is more broad: the current de-SPAC process risks flooding the public markets with unsophisticated companies not ready for prime time. More than half of SPACs in our sample (59%) are unable to fulfill the self-imposed timelines disclosed in the IPO prospectus for acquiring a firm. For example, a SPAC may promise investors that it will take no more than 18 months to locate a target, only to get to month 17 and ask for an extension. And another one. And another one. We have already discussed that, although SPACs are publicly traded, they often fail to fulfill the basic disclosure requirements of publicly traded companies. SPACs that extend their initial term exhibit a particular inability to satisfy continued listing rules. This failure is all the more notable because SPACs are empty vehicles, piles of cash that have very little to disclose in the first place.

Crucially, the vetting process associated with the SPAC’s acquisition is less rigorous than that of a traditional IPO. This reduction in rigor stems from the shift in the role of the investment bank, the chief private gatekeeper in a traditional IPO. Section 11 of the Securities Act of 1933 assigns the banks strict liability in the IPO for any material misstatements or omissions. Since the de-SPAC is not an IPO, it does not carry the same burden of liability. For example, disclosures around the de-SPAC can feature the type of forward-looking information that is verboten in a traditional IPO. We argue that the removal of an important check on the momentum to take the firm public, coupled with the fact that every major player in the SPAC is incentivized to find a target and take it public, provides SPAC participants a comparative disincentive to provide the certification, vetting, and second-guessing observed of banks in a traditional IPO.

While our early work detailed the rise of the SPAC form, our current work recounts how the vetting process was weakened by removing a hurdle that had originally curbed acquisitions. This hurdle was tied to the redemption of shares: in earlier SPACs, if enough shareholders redeemed their shares, then the merger would not occur (because the trust account was depleted of money to fund the acquisition). SPACs did away with this requirement, and private investments in public equity (PIPEs) stepped in to fill the funding breach. Now, while a majority of SPAC shareholders must approve any proposed merger, SPAC shareholders are free to vote for the proposed merger while simultaneously heading for the exit. In effect, they can say, “Yes, we think the SPAC should acquire this company… but we don’t want any part of it. Give us back our money.” Our data show that, indeed, in over half of SPACs, a majority of shares are redeemed—even though a majority of shareholders vote in favor of the deal. Further, we find a negative correlation between firm performance and redemption levels: the more shareholders redeem their shares and leave the firm, the worse the performance of the newly public company in the first ten days of trading.

We argue that the decoupling of cash-flow rights and control rights is a species of empty voting, and we advocate for reuniting voting power with economic interest. This re-coupling ensures that at least some stakeholders with skin in the game believe the acquisition is valuable. The reform avoids the empty voting practices that currently predominate in SPACs and, according to our results, destroy value. Moreover, such a reform has the attraction of addressing both the liquidity and vetting concerns we describe: the vote can serve as a type of filtering mechanism to protect the market from bad deals and help ensure liquidity in post-acquisition SPACs.

The complete paper is available for download here.

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