From a structural perspective, turning a company public via a SPAC is an alternative. Indeed, compared to a traditional IPO, a SPAC operation is a two-tiered process. After raising capital through a common IPO, the SPAC merges with the target in the so-called “de-SPAC” transaction. Beyond being an alternative, a SPAC is regularly viewed as benefiting from a different legal regime. For instance, in the US, the business combination (de-SPAC transaction) has been, several times, regulated under merger laws to the detriment of securities law.
From the investor’s point of view, a SPAC is also a substitute option. First of all, the investment window is much wider: in addition to buying shares once the business combination has been finalized, investors have also the possibility to invest during the initial IPO of the SPAC. Also, they are entitled to select the asset they want to invest in. When the SPAC turns public, the target issues units, composed of a share and a fractional or entire warrant. After a certain period of time, the share and the warrant can be traded separately. As a result, investors are given the opportunity to either buy a unit, a share, or a warrant. Finally, the regulatory obligations are slightly different from one mechanism to the other. Among others, SPACs are, for instance, protected with a “safe harbor”. Such a safe harbor enables the SPAC to include some financial perspectives on the target’s business in its prospectus without fearing any legal vulnerability if such statements are wrong. Some companies are inclined to list via a SPAC because they can come and provide optimistic financial forecasts and secure higher valuations.
Nonetheless, even if SPACs propose an alternative path, structurally speaking, they both serve the same objective: taking a company public. As such, comparing the performances of companies that have gone public through a conventional IPO and a SPAC IPO is the only way to ensure that a SPAC is a convincing option. On that point, several studies have stated the underperformance of SPACs (Kolb, 2017). In addition, it turns out that SPACs are usually higher in debt, smaller in size, and deal with lower growth opportunities (Datar, 2012).
Consequently, in its traditional form, SPACs appear as a poor substitute. Starting from that point, some observers have tried to highlight the intrinsic features and characteristics that may explain those disappointing levels. Rather than coming from a specific attribute, it looks like a combination of different factors. Among others, a misalignment between stakeholders is regularly pointed out. We can distinguish three main SPAC stakeholders: the sponsors, the underwriters, and the common investors. An asymmetrical relationship exists between the sponsors and the investors. Sponsors are the initiators of the SPAC and are compensated by receiving 20% of the post-IPO shares outstanding. Even if they are considered the initiators, they remain investors. Consequently, their interests should be similar to common investors’ interests. The problem is that, in practice, common investors and sponsors are not aligned. Because of their initial promote (i.e., 20% of post-IPO equity), sponsors might still benefit from a declining post-IPO share value. That’s part of the reason why sponsors and investors are not in sync. Typically, sponsors are asked to invest additional money concomitantly. They often buy shares or warrants via a parallel investment vehicle, demonstrating their commitment and, thus, increasing their “skin in the game”. However, this additional commitment has the perverse effect of putting pressure on sponsors to find a target no matter what it costs. Compared to common investors, sponsors are investing non refundable money, meaning that they will definitely lose their money in case either they are unable to find a target or have not been able to perform the merger respecting the period of 24 months.
It results in sponsors being less diligent in their review of targets. Also, the redemption right might degrade the relationship existing between sponsors and investors. Prior to the de-SPAC transaction, the buyer (the SPAC) must collect and receive approval from its shareholders. The shareholders that do not approve the deal are able to “redeem” their shares in proportion to the proceeds collected from the IPO. On one hand, the redemption right creates uncertainty on the amount the blank-check company will be able to eventually raise. More importantly, on the other hand, investors that ask for redeeming their shares can keep their warrants. Some investors are entering the deal pre-IPO without any ambition or interest in the business combination itself. In reality, they see the IPO of the SPAC as a speculative investment and are only looking for a guaranteed return. By the way, given this arbitrage opportunity, SPACs have long been a popular investment tool for hedge funds: investing early in the SPAC, they redeemed their initial investment while still benefiting from holding a warrant. Because of the above-mentioned SPACs’ characteristics and the accelerating number of SPACs, SPACs have turned into even less virtuous investments. SPACs being under a strict timeline, sponsors refusing to lose the capital “at risk”, coupled with their growing number result inevitably in the decay of selected targets. Given that more and more money is to be deployed and those sponsors will necessarily benefit from consuming the business combination, they set their sights on companies that would have not been considered under other circumstances. Nevertheless, evolutions have emerged to rub out the imperfections aforementioned. SPACs were compelled to evolve structurally. A range of transformations and progress has arisen.
The misalignment between sponsors and investors is mainly due to dilution. Dilution consists of the reduction of the shareholder’s ownership percentage. The first source of dilution results from the equity promote. Such a promote, consisting of 25% of the SPAC’s IPO proceeds (for free, as those shares are not given in exchange for something else), is a means for pre-IPO investors to compensate themselves. Secondly, common investors who buy units receive, in addition to shares, warrants. Even if we are here in the context of a SPAC, a warrant works the same as it would the usual way. At the time of the investment, the units are typically sold at a price of $10, with the warrant having an exercise price of $11,50. Consequently, in the case of a stock price higher than $11,50 (let’s take $12,00 as an example), the holders will exercise their warrants. Then, the company will issue additional shares at a price inferior to the market price, which creates a dilutive effect. Moreover, till now, we were working in a best-case scenario: our analysis assumed that there was no redemption. In case we assume that half of the common investors decide to redeem their shares (a common redemption rate), we will have severe implications on the ownership. Last but not least, usually, to supplement the cash that has been redeemed, SPACs are consolidated with third-party investments (“PIPE” investments). In order to attract newcomers, SPACs’ directors are tempted to offer financial terms that are more beneficial than the ones that have initially been discussed for early investors. As so, the redemption right creates a two-tiered dilution.
Beyond impacting the ownership of the different stakeholders, we note several other implications coming from dilution.
Before all, dilution affects the price per share. Once again, let’s consider a brief example: a company collects $1,000 from IPO proceeds (100 shares with every single share having a value of $10). When we add the equity promote, the number of shares increases to 125. As a result, the price per share is no longer equal to $10.00 but rather $8.00 ($1,000/125).
In parallel, dilution will also influence the investment strategies of the shareholders. Sponsors, unlike common investors, do not benefit from any redemption right for the so-called “at risk capital”. Thus, in case the SPAC does not consume its business combination within the given timeframe, that money will be definitely lost by the sponsors. On the other hand, we also remark that they benefit from “free” shares at the expense of common investors. In some cases, sponsors and investors may have contradictory interests. Let’s distinguish two different cases. In the first one, the business combination is successful and the operation creates value. As a result, the performances following the de-SPAC transaction are higher than the performances observed before it. Put differently, the post-merger SPAC returns are positive and both sponsors and investors benefit from the situation (although not in the same proportions). Let’s now consider the scenario in which the post-merger SPAC returns are negative. The situation is much more conflictual. Indeed, sponsors risk losing their initial investment if they do not find a target and finalize a business combination. Plus, given they have obtained “free” shares, they will benefit even if the post-merger company does not perform well. From the common investors’ point of view, the situation is different. They have an interest in keeping their shares only if the post-merger performances are positive. Otherwise, in case of a deal resulting in low performances, they would prefer to opt for redeeming their shares, or for the SPAC to be liquidated. In a nutshell, sponsors would favor a value-destroying operation over a no-deal situation, which runs counter to the common investors’ interests. As a result, the sponsor promote constitutes a sort of cushion that prevents sponsors from potential losses.
In the previous sections, we have explained the importance of the redemption rate. Some have underlined the correlation between the redemption rate and post-merger stock performances (Klausner, 2021). More importantly, we do consider that the redemption rate is also a proxy to estimate the misalignment between common investors and sponsors. Throughout recent years, the average redemption rate has kept increasing. At the same time, a corollary has also been the growing prevalence of de-SPAC PIPE financing. A PIPE is a Private Investment in Public Equity. A PIPE consists of selling securities of a public entity to selected investors. In the context of a SPAC, PIPE financing arises at the time of the de-SPAC transaction, to beef up or cover a high redemption rate. PIPEs secure the transaction by sustaining the minimum cash conditions to avoid the liquidation of the SPAC. This additional financing source enables SPACs to seek larger targets. Recent figures have shown that the frequency and size of those complementary financing have increased over the last couple of years. For instance, in 2020, a $2.6 billion PIPE transaction was announced: that figure doubles up the previous record set in 2019. Some observers have also underlined that amounts raised through PIPEs tend to be superior compared to the IPO proceeds. PIPEs have several advantages. They unleash additional financing to fill up the minimum cash conditions. That is also a way for existing investors to reiterate their confidence in the vehicle by topping up their commitment. More importantly, we think that PIPE financing has a critical upside compared to the proceeds collected from the IPO, it can raise money without any promote. As a result, a target might be more attracted by a SPAC with a lower IPO proceeds amount and higher PIPEs compared to higher earnings from an IPO with a smaller PIPE financing. As a result, PIPE financing crystallizes conflicts between the different investors: in addition to being a way to restate their confidence, such a fallback solution is also a means to limit the impact of the promote, id est of the initial investors towards the common ones.
Practitioners have been compelled to consider new structures in order to cope with the growing claims from common investors. New practices related to sponsor commitment, sponsor promote and warrants have gradually emerged.
In its initial form, the sponsors only commit at-risk capital, and at the time of the IPO benefit from free shares. This situation has been considered highly favorable to them and common investors have asked for an additional commitment. As a result, a common practice is for the sponsors and affiliates to commit and buy a significant amount of the SPAC’s units. Even if this percentage is specific to every SPAC, usually we see this additional “skin in the game” from pre-IPO investors to be as high as 25% of the total proceeds of the IPO. This additional purchase of shares or warrants is commonly structured through a private placement. Such an investment is a sign of confidence from sponsors, and a way to demonstrate they work in the best interest of all investors. To our mind, having additional skin in the game is more like a band-aid than a genuine solution. In order to better align common investors and sponsors, the very basic features of a SPAC need to be changed and modified. Even if regulators have, little by little, made some recent development and proposed rules, tangible solutions have emerged from practitioners.
Firstly, a way of harmonization is to reduce the sponsor promote. Typically, the sponsor promote is about 20% of the post-IPO shares outstanding and some SPACs have lowered it to smaller portions. That is a means to reduce dilution on one side and ensure that all shareholders’ incentives are in line. For instance, Ajax I, a blank check company formed by hedge fund manager Daniel Och reduced its sponsor promote to 10%. Also, some SPACs propose to have reduced sponsor promotes with the possibility to increase over time given certain thresholds. Those thresholds are, in most cases, based on share prices’ performances. Consequently, the sponsor promote might be limited to 12% and increase to 15% or 20% in case the initial $10.00 price per share reaches $12.5 or $15.0. This structure has been formalized as a so-called “Stakeholder Aligned Initial Listing” (SAIL) SPAC: sponsors get additional shares in case of a post-merger capital appreciation. Those complementary shares are referred to as “alignment shares”.
Such a strategy enables the common investors to avoid suffering from an outright dilution and adopt a win-win approach: sponsors are incentivized to support the target during the post-business combination period. This structure is relatively close to another form designated as a CAPS (Capital that Aligns Partner with a Sponsor) structure. This mechanism allows sponsors to receive 5% upright and then might acquire the remaining part in case the stock average price appreciates. The above-mentioned strategies get closer to the “earnout structure”. Similarly, in an earnout structure, the 20% usual equity promote is not issued: part of it is still to be collected based on the performances of the post-merger company. If the defined thresholds are not met, the additional shares are not issued which limits the promote amount and dilution.
Potential sources of disequilibrium are also warrants and redemption right. In order to prevent redemption and limit this risk-free opportunity, some mechanisms have been rolled out. Gradually, we have observed the emergence of “contingent warrants”. The principle is as follows: instead of issuing the entire entitled number of warrants at the time of the IPO, part of it (commonly half of it) is delivered on the condition that the investor does not redeem its shares. It means that if the investor is entitled to half a warrant for the purchase of a share, a quarter will be obtained when the SPAC gets listed and the remaining 1/4 will be collected at the announcement of the business combination by the non-redeeming investors. Lastly, to cast off, purely and solely, such an investment strategy, a growing number of SPACs have started to go public without issuing any warrants.
We reiterate that SPACs in their current forms are unsatisfactory alternatives to IPOs. Nevertheless, some adjustments are to go mainstream and might clearly reinforce the efficiency of the structure. In any case, we do believe that SPACs are here to stay. The next question to be answered is whether practitioners will be able to overcome the existing flaws, or if the regulator will have to intervene in order to protect common investors.
References
J. Kolb & T. Tykvova (2017), “Going Public via Special Purpose Acquisition Companies: Frogs do not Turn into Princes”, Journal of Corporate Finance.
V. Datar, U. Ince & E. Emm (2012), “Going Public through the Back Door: A Comparative Analysis of SPACs and IPOs”, Banking and Finance review.
M. Klausner, M. Ohlrogge & E. Ruan (2021), “A Sober Loot at SPACs”, ECGI.
