Editor’s Note: This blog series is presented in four parts. ((See generally, Christian Jorgensen, SPAC: An Introduction to the Special Purpose Acquisition Company (Part I of IV), MBELR Online (Nov. 13, 2016), http://mbelr.org/spac-an-introduction-to-the-special-purpose-acquisition-company-part-i-of-iv/; Christian Jorgensen, SPAC: The History of the Form, from Penny Stocks and Blank Check Offerings (Part II of IV), MBELR Online (Nov. 13, 2016), http://mbelr.org/spac-the-history-of-the-form-from-penny-stocks-and-blank-check-offerings-part-ii-of-iv/; Christian Jorgensen, SPAC: The Mechanics of a Special Purpose Acquisition Company (Part III of IV), MBELR Online (Feb. 8, 2017), http://mbelr.org/spac-the-mechanics-of-a-special-purpose-acquisition-company-part-iii-of-iv/.)) In this fourth edition, the author presents an analysis of the reality of SPAC performance, and its causes.
Given the potential advantages to parties involved in a SPAC transaction, it becomes necessary to consider whether these advantages translate into an actual benefit in the real world. In order to do this, SPACs’ historical performance must be considered. On analysis, this historical performance makes it clear that the SPAC structure is not as advantageous as it first appears. As a class, SPAC performance has been poor, a result of the incentives the structure creates when actually utilized.
The Reality of SPAC Performance
Unfortunately, the success of the SPAC form is too often gauged by the prevalence of its use in the marketplace. This post suggests, however, that success is better interpreted by viewing the actual returns of SPACs in the real world. From an academic perspective the resurgence of the SPAC structure (discussed in Part II of this series) can be – and has been – explained by a number of factors: the forms perseverance over the early reputation of blank check companies, ((Derek Heyman, From Blank Check to SPAC: The Regulator’s Response to the Market, and the Market’s Response to the Regulation, 2 Entrepreneurial Bus. L. J. 531, 549 (2007).)) by their ability to provide investors with unique investment opportunities, ((Daniel S. Reimer, Special Purpose Acquisition Companies: Spic and Span, or Blank Check Redux?, 85 Wash. U. L. Rev. 931, 966 (2007).)) or by an increased quality of offerings within the SPAC marketplace. ((Tim Castelli, Not Guilty by Association: Why the Taint of their “Blank Check” Predecessors Should Not Stunt The Growth of Modern Special Purpose Acquisition Companies, 50 B.C. L. Rev. 237, 274 (2009).)) Although these factors explain why SPACs have resurged, they fail to take into account the reality of SPAC performance, and in turn to consider whether this form should have resurged at all. Far from reflecting the great conceptual benefits that this form of reverse merger might offer, what little academic study has been conducted on SPACs suggests that the average investor should, at the least, be wary of investing in this type of entity.
The poor performance of SPACs is an outcome which has caught the attention of at least a few market observers. ((See Andrew Ross Sorkin, $300 Million to Burn, With a Catch, N.Y. Times (Feb. 12, 2008), http://www.nytimes.com/2008/02/12/business/12sorkin.html?_r=2&scp=2&sq=Andrew+Ross+Sorkin&st=nyt&oref=slogin&.)) One recent study on the outcome of SPACs has found that in the period after an acquisition is completed, these companies earned negative raw returns of 1.9% per month, or negative 20.6% per year, over a sample period from August 2003 to June 2008. ((Stefan M. Lewellen, SPAC as an Asset Class 17 (Mar. 24, 2009) (unpublished manuscript), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1284999.)) This finding was consistent with an earlier study, which found that the median annualized abnormal return to shareholders (return above that available in the broader market as a whole) from the date of the SPAC’s acquisition, until at least sixty days following, was negative 17% ((Vijay Jog & Chengye Sun, Blank Check IPOs: A Home Run for Management 13 (Aug. 2007) (unpublished manuscript), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1018242.)) Yet another study, from 2003, shows that investors who agreed to the acquisitions suffered average cumulative returns of negative 55% after one year. ((Tim Jenkinson & Miguel Sousa, Why SPAC Investors Should Listen to the Market 12 (Feb. 12, 2009) (unpublished manuscript), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1331383.))
Anecdotally, there have also been prominent individual failures within the SPAC market. For example, Chardan 2008 China Acquisition Corporation (Chardan 2008) was founded to acquire a Chinese company seeking access to U.S. capital markets. ((Press Release, Nasdaq, Nasdaq Announces Listing of Chardan 2008 China Acquisition Corp. (Aug. 15, 2008), http://ir.nasdaq.com/releasedetail.cfm?releaseid=328387.)) Nonetheless, when facing its impending deadline for finding an acquisition target, the company changed course and acquired the Florida mortgage processing company DAL Group, LLC ((Press Release, PR Newswire, Chardan 2008 Announces Its acquisition (Dec. 14, 2009), http://www.prnewswire.com/news-releases/chardan-2008-announces-its-acquisition-79212487.html.)) That enterprise was subsequently caught in the “robo-signing” scandal, and forced into bankruptcy. ((Steven Davidoff Solomon, A Thriving Financial Product, Despite a Record of Failure, N.Y. Times Dealbook (Aug. 13, 2013), http://dealbook.nytimes.com/2013/08/13/a-thriving-financial-product-despite-a-record-of-failure/.)) Another high profile example is Endeavor Acquisition, which acquired a 41% stake in American Apparel in 2007, only three days before the SPAC was due to liquidate ((Id.)). Unfortunately, by October 6, 2015, trading in American Apparel stock had been suspended, and delisting proceedings for the company were formally commenced ((Press Release, PR Newswire, NYSE MKT Suspends Trading in American Apparel’s Common Stock and Commences Delisting Proceedings (Oct. 6, 2015), http://www.prnewswire.com/news-releases/nyse-mkt-suspends-trading-in-american-apparels-common-stock-and-commences-delisting-proceedings-300154666.html.)). Finally, yet another high profile implosion occurred when a SPAC (sponsored by the legendary football coach Lou Holtz and former Vice President Dan Quayle) invested $625 million in a Chinese water bottler. Ultimately that company was sold for next to nothing in 2011. ((Steven Davidoff Solomon, A Thriving Financial Product, Despite a Record of Failure, N.Y. Times Dealbook (Aug. 13, 2013), http://dealbook.nytimes.com/2013/08/13/a-thriving-financial-product-despite-a-record-of-failure/.))
All of this is not to say that all SPAC enterprises have been failures. Indeed, the fast-food chain Burger King used the SPAC method of reverse merger to reenter public markets in 2012, ((Annie Gasparro, Burger King Returns to Public Market on NYSE, Wall St. J. (June 20, 2012), http://www.wsj.com/articles/SB10001424052702304898704577478421173743002.)) that company’s share price rose from an initial price of around $14.50 to over $32 per share before the company merged with Canada-based Tim Horton’s. ((Compare Candice Choi, Burger King stock returns to NYSE, gains 3.7%, USA Today (June 20, 2012), http://usatoday30.usatoday.com/money/industries/food/story/2012-06-20/burger-king-stock/55704212/1, with Euna Rocha & Solarina Ho, Investors cheer Burger King-Tim Hortons ‘combo deal’, Reuters (Aug. 25, 2014), http://www.reuters.com/article/us-burger-kg-wld-tim-hortons-mergers-idUSKBN0GP00R20140825.)) It does appear, however, that successes like Burger King’s are an exception rather than the rule. ((See Liz Hoffman, Spacs Polish Tarnished Image with 2012 Successes, Law360 (Jan. 7, 2013), http://www.law360.com/articles/405086/spacs-polish-tarnished-image-with-2012-successes (“Today, about 21 percent of SPACs that have completed a merger are trading above their debut price, according to financial adviser MorganJoseph TriArtisan LLC. That’s not great, but it’s a marked improvement from this time last year, when just 12 percent were.”).))
These small glimpses into the SPAC market, and the specific examples of disastrous results, should raise red flags in the minds of investors. Despite the advantages the SPAC structure allows, the results of its actual use suggest that when the market forces of the real world are actually present, the downside often overwhelms the advantages that one would expect to result in positive performance.
The Causes of Underperformance
The structure of the SPAC vehicle does present a number of inherent downsides. In fact, when framed slightly differently, many of the advantages to the form can actually act as a detriment to SPAC performance under real market conditions. Perhaps the greatest single cause of such underperformance are the incentives the form creates for managers, investors, and the acquisition targets.
First, investors in SPACs have an incentive to accept whatever acquisition management puts forward. At the outset the opportunity cost of investing in the SPAC is non-negligible. The funds which investors contribute to SPACs at their IPO can be tied up for up to thirty-six months. ((See NASDAQ Stock Market Rules (CCH) Rule 5101-2 (Dec. 23, 2010) (Listing of Companies whose Business Plan is to Complete One or More Acquisitions); NYSE MKT Company Guide (CCH) § 119 (Jan. 21, 2011) (Listing of Companies whose Business Plan is to Complete One or More Acquisitions).)) Thus, investors give up the opportunity to invest that money more profitably elsewhere. Additionally, because not all of the funds raised in the IPO are placed in the escrow account, the investors have already taken a haircut on day one: their investment is immediately devalued by their pro rata share of the IPO set aside for SPAC operations. ((David N. Feldman, Reverse Mergers: Taking a Company Public Without an IPO 190 (2006).)) For an investor, there is a strong incentive to both make up for their opportunity cost, and to avoid recognizing this loss. Although they retain the right of rescission, the cost of exercising it is to accept these losses. Thus, investors have an incentive to roll the dice on whatever acquisition the SPAC manager proposes.
For managers, the incentive is to make any deal they can before the SPAC is forced to liquidate. The managers will only see a return on their founder’s shares if they are able to convert them into shares of an actual operating company. If the managers are able to complete a merger they can then sell their shares on the open market. If they fail to do so, the shares become worthless. Investors should be concerned that given the great potential upside to the SPAC managers, and the relatively short time frame they have to make a deal, mangers will try to push through any deal at all. ((See id.)) Chardan 2008 is a prime example of this.
There are also concerns for investors in what type of company the SPAC will be able to acquire. If a company is healthy and growing, there are incentives to pursue the traditional IPO. That choice would allow the company to see the benefit of post-IPO support from underwriters in the form of market making, and the added marketing benefits which come along with having a stock that that is heavily followed by research analysts. ((Id at 29.)) If this set of private companies represents the best among them, then the set left over to be acquired through a reverse merger of any kind are less attractive.
There are also downsides to the SPAC structure which originate with the warrants granted to investors, the ownership interest of SPAC managers, and the extra dilution these cause to owners of the acquired company. The warrants owned by SPAC investors create an “overhang” of potential shares, which will come into existence after completion of a deal, and which will dilute the ownership interest of the acquired company’s shareholders even more than they would be under a normal acquisition at the same price. This is the case even in spite of the additional funds brought to the deal by the warrant’s exercise, due to the warrant’s strike price being below the price of shares on the open market. ((Feldman, supra note 19, at 193.))
Another disadvantage pertaining to the SPAC’s takeover exists with reference to the 20% of the SPAC entity given to managers. If the acquisition target does not believe the management team will stay on, or otherwise benefit the company, it is less inclined to sell itself in the face of this further dilution of ownership. ((Id.)) In sum, the acquisition target has the incentive not to sell unless it is able to recognize a high premium, in order to make up for the dilution from warrants and SPAC manager’s ownership interest. Paying a high premium is exactly what the SPAC investors should want to avoid.
In conclusion, once the real world returns of SPACs are taken into account, the form looses much of its appeal. As a group, SPACs have underperformed, and individually, many have ended in disaster. The causes of this stem from the structure of the SPAC itself, and the incentives it creates for managers, investors, and acquisition targets.
Latest posts by Christian Jorgensen (see all)
- SPAC: The Mechanics of a Special Purpose Acquisition Company (Part IV of IV) - March 12, 2017
- SPAC: The Mechanics of a Special Purpose Acquisition Company (Part III of IV) - February 8, 2017
- SPAC: The History of the Form, from Penny Stocks and Blank Check Offerings (Part II of IV) - November 13, 2016