Quick Thoughts on SPACs and Misaligned Incentives
Buy the rumor, sell the news
Today’s entry is a quick summary of SPACs and misaligned incentives.
First, a brief bit of background: SPACs, which are increasingly popular in 2020 as a method for getting privately held technology companies to become publicly traded entities, have been around for more than 30 years. And for a majority of those 30 years, they have had a bad reputation that has made institutional investors stay away from them.
Let’s review how SPACs work:
A group of sponsors creates a SPAC.
Those sponsors and other parties commit a certain amount of capital, to be held in trust, which capital is to be used primarily for the acquisition of a privately held company that wants to reverse-merger itself into the public markets.
Upon acquisition of the target company, the SPAC’s equity gets converted into new stock.
The sponsors can either hold that stock or sell it. They are usually also given warrants, which can be converted into the post-acquisition stock.
SPACs have a window during which they have to find a suitable acquisition, which window is usually two years.
After two years, if the SPAC has not consummated an acquisition, it will dissolve, and the trust will disburse the cash according to each investor’s pro rata share of the SPAC equity, less administrative costs.
We can quickly see that this creates all manner of misaligned incentives between the SPAC sponsors, the company to be acquired, and retail investors. Let’s examine some of these misaligned incentives:
As the two year window closes, SPACs have an incentive to do any deal, just to get one done.
Once a deal is done, if the sponsors believe it to be a poor quality deal, they can dump their shares on an unsuspecting public, and pocket a nice profit.
Further, if the acquired company turns around, the sponsors still have warrants which can be converted into equity.
Given these various misaligned incentives, we can see why SPACs have been associated with fraud and underperformance.
Those who advocate their use in the present would do well to keep these misaligned incentives in mind and structure their SPACs accordingly.