Aswath Damodaran
For decades, the process that companies in the United States have used to go public has followed a familiar script. The company files a prospectus, providing prospective investors with information about its business model and financials, and hires an investment banker or bankers to manage the issuance process. The bankers, in addition to doing a roadshow where they market the company to investors, also price the company for the offering, having tested out what investors are willing to pay, and guarantee that they will deliver that price, all in return for underwriting commissions.
During the last decade, as that process revealed its weaknesses, many have questioned whether the services provided by banks merited the fees that they earned. Some have argued that direct listings, where companies dispense with bankers, and go directly to the market, serve the needs of investors and issuing companies much better, but the constraints on direct listings have made them unsuitable or unacceptable alternatives for many private companies. In the last three years, SPACs (special purpose acquisition companies) have given traditional IPOs a run for their money, and in this post, I look at whether they offer a better way to go public or are more of a stop on the road to a better way to go public.
What is a SPAC?
The attention that SPACs have drawn over the last few months may make it seem like they are a new phenomenon, but they have been around for a long time, though not in the numbers or the scale that we have seen in this iteration. In fact, blank check companies had a brief boom in the late 1980s, before regulation restricted their use, largely in response to their abuse, especially in the context of “pump and dump” schemes related to penny stocks.
What is SPAC structure
To understand how the modern SPAC is different from the blank check companies of the 1980s, lets revisit the regulations written in 1990 to restrict their usage. To protect investors in these companies, the SEC devised a series of tests that need to be met related to the creation and management of blank check companies:
1. Restricted purpose: The company has to have the singular purpose of acquiring a business or entity. Thus, it cannot be used as a shell company that chooses to alter its business purpose after the acquisition.
2. Time constraints: The acquisition has to be completed within 18 months of the company being formed or return the cash to the its investors.Use of proceeds: The IPO proceeds, net of issuance costs, from the company going public have to be kept in an escrow account, invested in close to riskless investments, and returned if a deal is not consummated.
3. Shareholder approval: During the process of finding an acquisition target and accomplishing the acquisition, shareholder approval is required, first when the target company is identified, and later when the acquisition price and terms are agreed to. As a prelude to shareholder approval, they have to be provided with the financial information on the proposed target and the necessary information to make an informed judgment.
4. Opt out provisions: If shareholders in the company choose to redeem their shares, they are entitled to get their initial investment back, net of specified costs, but with interest earned.
While these restrictions were onerous enough to stop the blank check company movement in its tracks, special purpose acquisition companies (SPACs) eventually were created around these restrictions. A SPAC is initiated by a sponsor, a lead investor who brings or claims to bring special skills to the acquisition process, either because of an understanding of an industry in which they plan to find a target or because of deal making skills.
As sponsors, they receive a significant stake (~20%) in the SPAC (called a promote), contributing little or nothing to capital, and in addition to finding and negotiating the price for a target company, they sometimes provide more capital to the target company through PIPEs (private investment in public equity). The picture below summarizes the time line for a SPAC, and the role of the sponsor along the way:
(Image source: Aswath Damodaran’s blog)
Unlike the blank check companies of the 1980s, investors in SPACs get multiple layers of protection, both in terms of being able to approve or reject the choice of target companies and the terms of the deal, as well as being able to redeem their shares and receive their money back, with interest, if a deal is not done, or if they are dissatisfied with a proposed target/deal.
In a significant proportion of SPACs, the sponsors create an entity (a private or PIPE) to supply additional capital, with two reasons for the add on. The first is to provide additional capital, if needed, for the target company in the deal for its business needs. The second is to cover capital withdrawals from SPAC shareholders who choose to opt out and get their money back.
Going Public? The Choices
The process that a private company follows to go public, for the last few decades, has been built around bankers as intermediaries. List of reasons of why many venture capitalists and issuing companies have soured on the process:
(Image source: Aswath Damodaran’s blog)
While banker-led IPOs will not disappear, you can see why the search is on for alternatives. In my earlier post, I looked at direct listings, where the company dispenses with the banking services (setting an offering price and roadshows) and lets the market set the price on the offering date.
(Image source: Aswath Damodaran’s blog)
This process, by doing away with the banking intermediaries, is less costly but it still takes time and comes with constraints, especially in the context of raising capital from the offering to cover future business needs. It may also be difficult for low-profile private companies to list directly, when investors are reluctant to invest based upon a prospectus, without someone else doing the due diligence (asking questions of management, checking the financials).
The Rise of SPACs
As noted at the start of this post, the SEC regulations put into place in 1990 to restrict the use of blank check companies removed them from the market landscape for about a decade. It was not until 2003 that the modern SPAC was born, but its usage stayed limited until 2016. In fact, the real boom in SPACs has been in the last three years, with the pace picking up in the second half of 2020 and in 2021:
(Image source: Aswath Damodaran’s blog)
In 2020, SPACs accounted for more than half of all deals made, in terms of dollar value, and SPACs are running well ahead of that pace in 2021. Since there were no regulatory changes in 2020 that could explain the dramatic rise, the explanations for the surge have to lie in developments in the market and I would list four contributing factors:
1. Low interest rates: Investors in SPACs effectively give up use of their proceeds, while the sponsors look for a deal. In a world, where interest rates were higher, the opportunity cost of idle cash may have repelled some investors, but in a world where interest rates, even on long term investments, is close to zero, that is not the case.
2. High stock prices: It is no coincidence that the explosion in SPACs has come about while markets have been booming, and especially so for high-growth companies. There are two benefits that SPACs derive, as a consequence. The first is that the opt out clauses that SPAC investors possess to return their shares and ask for their money back are less likely to be triggered in up than down markets. The second is that investors tend to be sloppier and more willing to outsource their analysis and decision making, when markets are rising than when they are falling.
3. Where pricing rules: Not only have markets been rising steeply for most of the last three years, but they have also been centered on the pricing game, where mood and momentum rule the roost, rather the value game, where fundamentals are key drivers. Since getting the timing right is key in the pricing game, it is not surprising that investors are attracted to SPACs, which at least in theory, are better positioned to take advantage of shifts in mood and momentum.
4. And celebrities move markets: Markets have always had their sages and gurus, who move markets with their views and perspectives, but until recently these market movers were either investors with long track records of success (Warren Buffett is the iconic example) or perceived rule-changing powers (Fed chairmen, Presidents).
No matter which measure of returns you look at, and over almost every time period, investors in SPAC-merged companies lose money. It is true that repeat sponsors do better than first-time SPAC sponsors, at least in the near term (three months), but the magic fades quickly thereafter. Finally, the median returns are much worse than the average, because of a few outsized winners, and that may explain part of the allure, is that these winner stories get told and retold to attach new investors.
If there is a cautionary note in these findings, it is for investors who invest in SPAC-merged companies, after the deal is consummated, since it looks like for many of these companies, prices peak on the day of the deal, and wear down in the months after, partly because the hype fades and partly because SPAC warrant conversions continue, upping share count and the dilution drag on value per share.
The bottom line is that SPACs, at least as constructed now, are games loaded in favor of the sponsors. There are some SPAC investors who are canny players at this game, usually cashing out at the time the deal is announced and using warrants to augment their returns, but those SPAC investors who stay on as shareholders in the merged company find themselves holding a loser’s hand. Finally, while there are issuing companies that may be able to go public because of SPACs and collect higher proceeds, the dilution inherent in the process acts as an anchor dragging and holding down stock prices in the aftermarket.
While there are some who are pushing for the SEC to ban or constrain SPACs, the problem, as I see it, is not that there is insufficient regulation, but that investors in SPACs who are sometimes too trusting of and too generous to big name sponsors, and too lazy to do their own homework. In fact, there is a path to redemption for SPACs and it will require the following changes:
1. Reduce the sponsor subsidy: The sponsor subsidy in most SPACs creates a hole that is too deep for investors to dig out of, even if the SPAC merger goes smoothly and is at the right price, since there isn’t enough surplus in this process to cover a 20% dilution or more.
2. Align SPAC sponsor and SPAC investor interests: There are too many places where sponsor and shareholder interests diverge in the SPAC structure. Since sponsors get to keep their subsidy only if the deal goes through, there is an incentive now to push deals through, even if it is not in the best interests of shareholders, and then dressing it up enough to get it approved.
3. Level the playing field on disclosures/capital: You cannot have two sets of rules on forecasts and business stories, a tighter one for traditional IPOs and a loose one for SPAC IPOs. Rather than tighten the rules on what SPACs can spin as stories, I would suggest loosening the rules for traditional IPOs. To the response that this could create misleading disclosure, I would suggest trusting investors to make their own judgments. To be honest, I would take three pages of pie-in-the-sky forecasts from a company going public, and decide what to believe and what not to, than twenty pages of mind numbing and utterly useless risk warnings (which you get in every prospectus today). On the fairness front, I also think that the restrictions on capital raising for companies that go the direct listing route are also outmoded, and may need to be removed or eased. Given that it has the fewest encumbrances and intermediaries, without this handicap, the direct listing approach to going public may very well beat out both the banker-based and SPAC IPO approaches.
4. Reduce deal underwriting costs: I am having a difficult time understanding why the deal fees on a SPAC deal are as high as they are (5-6%), especially if the sponsors are being compensated for finding the right target and negotiating the best price. Who is being paid these deal fees, and what exactly are the services that are being provided in return?
Conclusion
As markets change, both in terms of investor mix and information sharing, it is not surprising that corporate finance and investing practices, that were accepted as the status quo until recently, have come under scrutiny. The banker-centric IPO process has had a good run, but it is showing its age, and it is good that alternative approaches are emerging.
The problems for these alternatives is that going public, no matter which approach you use, is much easier when you are in a hot market, as we are in right now. That said, IPO markets though go through cold periods, where investor reception turns frigid and the number of public offerings drops off, and it is then that the weaknesses and failures of approaches become most visible. Neither direct listings nor SPACs have gone through that trial by fire yet, but if history is a guide, it will come sooner, rather than later.
The author is Professor of Finance at the Stern School of Business at NYU. He teaches classes in corporate finance and valuation, primarily to MBAs. 
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