The Future of SPACs: Reining in Sponsors and Raising Retail

Seok Jeong

 

With the rise of Special Purpose Acquisition Companies (“SPACs”) over the past two years, many commentators and academics have wondered how exactly SPACs will evolve as an investment vehicle.[1] One of their biggest concerns is that SPACs are inefficient investment vehicles that provide poor returns for shareholders. One study found that “[o]f the 2019-20 Merger Cohort that we studied, few SPACs have generated positive returns for their non-redeeming shareholders. The same is true of SPACs that went public in prior years and that have had longer to prove their value to the market.”[2] Another concluded that SPACs presented lucrative returns between the IPO and the deSPAC, the business combination of the SPAC, finding that for 151 SPAC IPOs between January 2010 and December 2018 the average annualized returns were 12.0%, with all 151 returns being positive.[3] However, they found that:

investor returns in the deSPAC period on the merged companies are mixed. For the 114 SPACs that completed a merger with an operating company from January 2012 – September 2020, weighting each deal equally, common share investors have lost money on average, while warrant investors have earned positive returns. The equally weighted average one-year return on the merged company shares has been -7.3%, underperforming the market by 20.9%.[4]

So, how can SPACs present better returns throughout their lifecycle for both institutional and retail investors? Some commentators have suggested lockup provisions for sponsors for the duration of any financial projections made during the SPAC lifecycle.[5] This is a plausible proposal that would encourage sponsors to put their money where their mouths are. Chamath Palihapitiya, a venture capitalist and a prominent repeat SPAC sponsor, has suggested that requiring sponsors to invest bigger stakes in their SPACs.[6] This makes certain sense in that it could incentivize better due diligence and research on the part of the sponsors. The market seems to be adapting, forcing some sponsors to agree to longer lockup periods.[7] Michael Klein, a sponsor in Lucid Motors, agreed to an 18-month lockup.[8]Another idea is to stagger the sponsors’ equity compensation and release the promote as certain performance-based milestones are reached.[9]

One academic believes that the future of SPACs lies in a market-based equilibrium.[10]

Just like with all innovations, it takes time for the market to learn what works and what doesn’t. Through research, we have identified some of the factors that are associated with better returns for SPAC shareholders: skin in the game by sponsors and longer lock-in periods; sponsors who have experience in private equity and venture capital (rather than celebrity sponsors); and contractual terms that protect dilution of shareholders’ ownership after the acquisition. As the market learns, I expect that there will be more SPACs with such characteristics that improve shareholder returns, and a lower number of SPACs overall.[11]

SPACs are here to stay, at least for the short-term, Kristin Zimmerman-Sorio, Head of SPAC M&A at Morgan Stanley, stated “[a]s it stands, there is still about $160 billion of SPAC capital across more than 550 SPACs waiting to be deployed within a limited timeframe. Given this dynamic, we anticipate a sustained level of de-SPAC activity over the next two years[.]”[12]

In this context, a lingering question is how retail investors will fare even as SPACs evolve and adapt to market and regulatory pressures. Better disclosure and marketing practices would provide retail investors with better information, but will that be enough? A study examined the “divestment rates” to measure the market exit rates of 13F shareholders, institutional investment managers with at least $100 million in assets under management, who held shares immediately prior to the merger announcement.[13] In 2019, “[t]he mean and median SPAC divestment rates are 90% and 98%, respectively. For the SPAC Mafia, divestment rates are even higher, with mean and median divestment rates of 97% and 100% respectively.”[14] Thus, retail investors are often left holding the bag after sophisticated investors exit the SPAC. One possible solution is to give retail investors “a final right of redemption after disclosure of redemptions by institutional investors[.]”[15] This would give retail investors a sense of how much confidence institutional investors have in the investment going forward, which could prevent this bait-and-switch at the close.

With misaligned incentives between promote-seeking sponsors and return-seeking retail investors, “the essential determinant for retail investors will be the motivations and reputation of the sponsor, but it is challenging to make those evaluations when they cannot free-ride on the decision-making of institutional investors who may back a SPAC for short-term profits with no confidence in the ability or intentions of the sponsor.”[16]

Of course, one could even question the wisdom of the continued existence of SPACs themselves. Investing in growth companies that have high potential is likely to have benefits across the economy. Ideally, SPACs would bring these early-stage companies to the public and give them access to funding to continue to grow and innovate. However, some believe that in the US “it is mainly companies with inherent defects, rightly excluded from traditional IPOs, that are finding their way on to the public markets.”[17] Many of these companies often have pending lawsuits, weak financials, and little to no revenue.[18]

 

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[1] Chris Kornelis, Where Will SPACs Be in Five Years?, Wall. St. J. (December 10, 2021), https://www.wsj.com/articles/where-spacs-future-11638301556.

[2] Michael Klausner and Michael Ohlrogge and Emily Ruan, A Sober Look at SPACs 54 (December 20, 2021). (Eur. Corp. Governance Institute – Finance Working Paper No. 746/2021), https://ssrn.com/abstract=3720919.

[3] Minmo Gahng and Jay Ritter and Donghang Zhang, SPACs 38 (January 29, 2021) (working paper) (on file at https://ssrn.com/abstract=3775847).

[4] Id. at 39.

[5] Andrew Sorkin, How to Fix SPACs: Keep Their Backers Locked In Longer, N.Y. Times (March 31, 2021), https://www.nytimes.com/2021/03/31/business/dealbook/spac-sponsors.htmll

[6] Id.

[7] Id.

[8] Id.

[9] G. Okutan Nilsson. Incentive Structure of Special Purpose Acquisition Companies. 19, Euro. Bus. Org. L. Rev. 253, 266 (2018).

[10] Kornelis, supra note 1.

[11] Id.

[12] 2022 M&A Outlook: Continued Strength After a Record Year, Morgan Stanley (January 14, 2022), https://www.morganstanley.com/ideas/mergers-and-acquisitions-outlook-2022-continued-strength-after-record.

[13] Klausner supra note 2, at 16.

[14] Id. at 17.

[15] Bobby Reddy, The SPACtacular Rise of the Special Purpose Acquisition Company: A Retail Investor’s Worst Nightmare 42. (Univ.of Cambridge Fac. of L. Research Paper No. 32/2021, October 1, 2021),

https://ssrn.com/abstract=3968983.

[16] Id., at 45.

[17] Id., at 43.

[18] Id.