Imagine you’re an investor putting money into an initial public offering. How much of what you’re contributing might you expect to be absorbed in fees and expenses?
In the US, it’s about 5-7 per cent of the proceeds. Quite a bite out of your investment.
But that’s just one way to buy into a newly quoted venture. How about putting your cash into a vehicle without knowing precisely what it will do with it? Known as special purpose acquisition companies, or Spacs, these “blank cheque” ventures are all the rage in the US. As of late November, there had been 182 Spac IPOs raising almost $70bn. That compares with 59 last year and just 46 in 2018.
Spacs, when they’ve been funded, have two years to find something to spend their money on. If they cannot, they can be liquidated. In the meantime, investors’ cash sits in an escrow fund.
Fans of the structure — of which there are plenty right now — claim they serve a useful purpose, teasing out decent companies that might not otherwise list. Selling to a Spac is less intrusive than the IPO process, with fewer disclosure requirements. At first glance, Spacs also look quite a bargain in cost terms. Fees are on the low side of the IPO range, at 5.5 per cent, and are funded by the Spac’s promoters (which could be some Wall Street bigshot, or well-known business tycoon) until a deal is found.
The snag with Spacs — as with so much of modern finance — comes when a merger deal is finally struck. It’s only then that you start to realise how much these ventures really cost.
A recent paper by two US academics, Michael Klausner and Michael Ohlrogge, examines all of the costs embedded in the structure. Some are more obvious, such as the so-called “promote”, which entitles the sponsor to free equity equivalent to 25 per cent of the IPO cash contributed, or 20 per cent of the enlarged equity. This vests only when a deal is done.
Others are more subtle, such as the right that IPO investors have to redeem their stock at par plus interest if they do not like the eventual deal. Many Spac investors routinely do this — largely because it’s quite a sound strategy. You get your money back while hanging on to the warrants and free rights to extra shares you received at the IPO as compensation for your involvement.
In the 47 Spacs the authors studied, they estimated that, on average, 58 per cent of shares were cashed in, with redeemers making just-above-market annual returns of 11.6 per cent.
The flip side of all this generosity, of course, is that it’s paid for by those that stick around. Redemptions drain the cash out of the Spac, while the sponsor’s stock swamps their claim on that which remains. Meanwhile, the warrants and free share rights retained by redeemers add further to the dilution. Messrs Klausner and Ohlrogge have calculated the total cost of all this friction for the median Spac. They estimate that for every dollar of cash delivered to the target when a Spac merges, a staggering 50 cents has been gobbled up in this way.
All of which means that sponsors must do amazing deals to earn back all that dilution. Most do not. Average returns for Spacs in the 12 months post-merger are minus 34.9 per cent, Mr Klausner and Mr Ohlrogge report. That’s not only feeble; it’s disastrously worse than for those that redeemed.
None of this is surprising when you consider the misalignment of interest baked into the structure. Because they get free equity, sponsors can benefit even when other investors are under water. “The sponsor has an incentive to enter into a losing deal for Spac investors if its alternative is to liquidate,” Messrs Klausner and Ohlrogge write.
A few billionaire promoters, such as hedge fund boss Bill Ackman, have pushed fairer deals but they are a small minority.
Spacs may seem novel. But there is very little new under the sun in finance. They can trace their ancestry back to the giant investment trusts of the 1920s described so memorably by John Kenneth Galbraith in his book on the Wall Street crash of 1929. Or even that artefact of the South Sea Bubble, the company “for an undertaking which shall in due time be revealed”.
The 1920s investment trusts similarly depended on the alchemical skills of their sponsors. There was a great willingness to “pay for the genius of the professional financier”, Galbraith wrote.
Such trust rarely pays off in the long run. “Large amounts of money under management and high fees spell eventual performance disappointment,” warned the late investor Barton Biggs. Those tempted by Spacs should remember that they are structured to underperform.