Print
E-MailSnehal Banerjee is an Associate Professor at the University of California, San Diego Rady School of Management, and Martin Szydlowski is an Assistant Professor at the University of Minnesota Carlson School of Management. This post is based on their article forthcoming in the Journal of Financial Economics. Related research from the Program on Corporate Governance includes SPAC Law and Myths (discussed on the Forum here) by John C. Coates, IV.
Special Purpose Acquisition Companies (SPACs), a form of blank check company, raise funds in an initial public offering (IPOs) with the aim of merging with a private target and facilitating its public listing. In the IPO, the SPAC sells units, which consist of redeemable shares and derivative securities like warrants or rights. Investors have the option to redeem their shares at the initial issue price before the merger, and they can keep and trade rights and warrants even after redemption.
In 2021, the U.S. witnessed an exceptional boom in SPAC deals, with 613 IPOs raising over $161 billion. This constituted 63% of total IPOs and around 48% of total IPO proceeds. However, despite this surge, SPAC investors face a mixed performance. As Ghang et al. (2023) document, buy-and-hold investors realize negative post-merger returns while those who redeem their shares optimally at the time of the merger realize significant excess returns. Additionally, Klausner and Ohlrogge (2022) show that due to redemptions, for every $10 raised at the IPO, the median SPAC only holds $6.67 in cash for each outstanding share at the time of the merger, leading to significant dilution.
A Model Based on Investor Overconfidence
The popularity of SPAC transactions and their underperformance raise several questions. Why do sponsors choose this financing method despite the dilution it gives rise to? Why do long-term investors buy and hold shares in SPACs despite earning negative returns? Common rationales that seek to explain the popularity of SPACs, such as lower disclosure requirements and the use of warrants and rights to attract long-term investors, do not fully explain these puzzles.
Our model suggests that redeemable shares and warrants can be used to exploit investor overconfidence. Specifically, investors may be overconfident about their ability to process interim information (e.g. in the form of disclosures around the merger announcement) when they initially buy the units. This overconfidence leads them to overvalue the optionality embedded in their right to redeem shares. With overconfident investors, the sponsor can overprice the units relative to what rational investors, who correctly anticipate their likelihood of processing information in the future, are willing to pay. In equilibrium, overconfident investors overpay for the units and are unlikely to redeem, which earns them negative returns on average. Rational investors, by contrast, redeem optimally and receive excess returns. Thus, the SPAC contract trades off dilution costs due to redemptions and the benefits derived from overpricing. When sufficiently many investors are overconfident, the SPAC structure leads to overinvestment. Intuitively, investors overvaluing the units lowers the sponsor’s cost of capital, since it allows the sponsor to raise funds cheaply. This, in turn, may make it profitable to finance relatively low-value targets.
The model aligns well with empirical observations: buy-and-hold investors experience negative returns, investors redeeming optimally earn positive excess returns, and higher redemptions predict lower returns. The SPAC’s targets are often relatively risky firms with fewer tangible assets, and SPACs are more profitable when more investors are overconfident.
Our model also suggests a rationale for the recent surge in SPACs. The expected payoff to the sponsor from a SPAC increases with investor overconfidence and the availability of funding. The years 2019 and 2020 saw a sharp increase in retail investor participation in financial markets and relatively high demand for investments. More recently, funding has become scarcer. In these conditions, our model predicts that IPOs will dominate SPACs.
Regulatory Implications
The surge in SPAC deals has drawn regulatory scrutiny, prompting calls for changes to disclosure requirements and enhanced investor protection. Our model serves as a benchmark for policy analysis:
- Restricting Investor Access: A proposal by the House Financial Services Committee aimed to restrict access to SPAC transactions based on measures of financial sophistication, such as allowing only accredited investors to buy units. In our model, restricting access for relatively unsophisticated investors increases returns for both buy-and-hold investors and decreases returns short-term investors, thus mitigating the return differences.
- Restricting Warrants: Our model suggests that bundling warrants with redeemable shares exacerbates the distortionary effect of investor overconfidence. Limiting or eliminating warrants as part of the initial unit issuance can reduce overpricing, potentially leading to higher returns for buy-and-hold investors.
- Mandatory Disclosure: Perhaps surprisingly, an increase in mandatory disclosure (e.g. via more stringent disclosure rules at the time of the merger), may result in lower returns for unsophisticated investors but higher returns for more sophisticated investors, particularly when information is challenging to process. Intuitively, when investors are overconfident about their ability to process information, they overvalue the right to redeem shares. For such investors, improving the quality of interim information may lead them to overvalue the redemption rights even more, leading to lower returns.
Conclusion
Our model highlights investor overconfidence as a driver of the recent popularity of SPACs. The unique features of SPACs, such as redeemable shares and the bundling of shares and warrants, may lead investors to overvalue the SPAC units, which generates the observed negative returns and artificially lowers a SPAC’s cost of capital.
Our analysis suggests that restricting access to sophisticated / accredited investors and unbundling warrants and rights from the equity issuance would mitigate the negative implications for retail investors. Similarly, policy interventions that lead investors to be more attentive to the specifics of SPAC transactions (e.g., the anticipated dilution due to redemption) are likely to improve retail investor welfare. On the other hand, mandating more information disclosure, especially when this information is not transparent to all investors, may be counterproductive. The complete paper is available for download here.
