August 15, 2012
SPACs: The Finance Article (Part 1)
Posted by Usha Rodrigues

Faithful Glommers know that I've been thinking and writing about SPACs for a while now.  For those who don't remember, SPACs (short for special purpose acquisition corporations) are essentially one-shot private equity funds, where the managers raise a pile of money via IPO and then park it in a trust account. They then have 3ish years to search for a target, at which point shareholders get some sort of say on whether they want the acquisition to occur.  If no deal occurs or if they veto it, they get back their share of the trust account (an average of 96.4 cents on the dollar in our sample).  Mike Stegemoller and I studied a sample of SPACs from 2003-11.  Our first piece, Special Purpose Acquisition Corporations: A Public View of Private Equity, forthcoming in the Delaware Journal of Corporate Law, traced the evolution of the form from a contract design perspective.

We recently posted our second piece, What All-Cash Companies Tell Us About IPOs and Acquisitions, on SSRN.  It's a more finance piece, intended for a peer-reviewed journal, so I thought I'd use a few posts to translate our findings for the law crowd.  Plus you can draw more conclusions and make bigger claims in a blog post than in a finance article, and that's always fun. 

So SPACs are interesting in and of themselves, but that's our first paper.  This one is about using SPACS as a tool to see how two major events of a firm's life--the IPO and making an acquisition--work.  The cool thing about SPACs is that they're essentially a pile of cash, with all the extraneous "noise" (capital structure, industry-specific characteristics, heterogeneous goals, etc.) that typically plague empirical studies stripped away.  Because of SPACs' cookie-cutter nature, we can make more definitive conclusions about the mechanics of these events.  As a preview, we have 3 main findings, regarding IPO underpricing, underwriter gross spreads, and acquisition announcement returns.  I'll devote a post to each, beginning today with underpricing. 

I've already blogged about underpricing in the context of the Carlyle IPO.  For those not familiar with this phenomenon, Facebook and Carlyle notwithstanding, most IPOs are underpriced by the investment banks that sell them to the general public.  In other words, those wizards at Goldman or Citigroup or Morgan Stanley (ahem!) spend months evaluating what price the public market for the company's stock will bear, price it accordingly, and yet by the close of the first day of trading the stock price generally rises, sometimes substantially. 

So what gives?  The company is leaving money on the table by offering the shares to IPO buyers at a bargain, and letting those buyers enjoy the runup in stock price.  As I wrote in May:

There are 2 dominant stories for IPO underpricing, one sinister and one innocent.  Both hinge on the fact that in an IPO investment banks act as intermediaries, buying the company's shares at a discount and then turning around and selling them to the public.  The sinister story blames greedy investment bankers that strong-arm companies into asking too little for their shares so that the bankers can curry favor with their clients.  The innocent one chalks underpricing up to information asymmetry: it's hard to gauge the true price of a stock that hasn't been traded, and uninformed investors will shy away from the market entirely unless they can be enticed in with the prospect of a sure thing.  (Steven Davidoff has a characteristically incisive review of all the underpricing theories here).

A variant of the first explanation is that managers may willingly underprice in order to get favorable analyst coverage from the banks down the road.  With SPACs we have a case where the information asymmetries should be almost precisely zero.  Meaning I don't have a degree in finance, but even I can probably value an offering of 100,000 shares that will raise $50,000,000 for a shell company.  And SPAC managers generally exit after the acquisition, so they don't have the incentive to retain investment banker goodwill that the operating company managers do. So we predict that SPAC IPOs will not be underpriced.  And (drum roll, please)...

They're not.  Well, they are a little bit (0.9%), as compared with 11.8% from 2001-09 for conventional firms (Gao, Ritter, and Zhu (2011).  What little underpricing we find relates to the rank of the lead underwriter.  Lower ranked underwriters underprice their SPAC offerings more than do higher rank underwriters.  It may be that higher risk SPACs select lower-reputed underwriters.  Or it may be that, regardless of the underlying quality of the SPAC, lower ranked underwriters have to price their product to sell to convince investors to buy, in a way that the Goldmans of the world do not. 

Either way, the small amount of underpricing might lead one to conclude that our findings support the innocent story (information asymmetry), rather than the sinister one (greedy banks).  However, sinister proponents could argue that the greedy banks underprice IPOs for the average firm, they just can't get away with it in the transparent world of SPAC valuation. That's a limitation of using a sui generis beast like the SPAC to study underpricing. 

Luckily, SPACs' idiosyncratic nature actually makes our findings on the underwriter spread and acquisitions more compelling.  Tune in soon for more on those topics...or if you simply can't wait, read about them here.

 Update: Post 2 is here.

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