August 14, 2013
Davidoff on SPACs
Posted by Usha Rodrigues

DealProfessor Steven Davidoff wrote a piece on SPACs yesterday that seemed unduly harsh to me.  Admittedly I have a something of a soft spot for this odd duck entity, having written two papers about it (here and here).

Steven's main beef is that SPACs are good for their promoters and for hedge funds that invest in them, but maybe not for the average Joe.  Let's examine those claims.

Silver Eagle Acquisition Corp.'s recent $325 million IPO is the launching point for the piece.  Steven takes SPAC promoters to task for claiming, like their private equity cousins,

up to 20 percent of the equity mostly for finding the target company. The fee is similar to that of a private equity firm, as is the idea of picking a company, but a SPAC is not as safe or rewarding as private equity. SPAC investors take all of the risk in one company instead of a portfolio of companies held by a private equity firm.

As we show, however, the recent trend in SPACs has been to condition some of the 20% equity promoters receive on certain performance targets.  In that respect Silver Eagle seems to be at the low end, with an "earnout" of 5% of the total equity contingent upon the stock reaching levels of $12.50 and $15.00.  Many recent SPACs tie up considerably more (or all) of the promoter's equity.

Next Steven offers a little history: "In the 1980s, they were rife with fraud, and briefly disappeared from Wall Street in the wake of stricter federal regulation. But, like zombies, they reappeared in the mid-2000s. Before the credit crisis, these vehicles accounted for nearly 25 percent of all I.P.O.’s."

Steven paints with too broad brush.  The 1980s were a time of bad hair, legwarmers, peerless teen movies, and blank check companies that indeed operated sketchily at best.  But the SPAC was an invention of the 90s that strove to differentiate itself by offering two notable features: 1) it gave shareholders and up or down vote on any proposed acquisition, and 2) a trust account that kept shareholders' money safe.  The promoters couldn't access the money unless and until the vote had occurred, and even if the acquisition was approved, they could elect to redeem their shares and get (most of) their cash back.  Indeed, even if a majority of shareholders voted for the acquisition, if a lower threshold (say 25%) of the shareholders redeemed their shares, then the acquisition would fail.  This supermajority veto set up unintended consequences that the form had to evolve to deal with, but the point is, SPACs have mechanisms in place to rein in the promoters.

SPACs only have 2-3 years to make an acquisition; otherwise they have to liquidate and return their cash to shareholders. Steven is absolutely right that this sets up the incentive for poor 11th hour acquisition choices.  But SPACs' trust account offers unique downside protection that makes it hard to compare them with a typical stock.  For example, Steven calls one SPAC's 6% return unspectacular, which is true.  But that return was on a stock that promised to redeem the $10 shares for $9.97. A 6% return on a stock where the most you're guaranteed to lose is 3 cents might not be a bad deal, all things considered.

In sum, SPACs are good for promoters, but if shareholders don't like the acquisition the promoters propose, they can exit.  And the trust account may offer a safe haven attractive enough to compensate for reduced return. 

Over the years people have asked me what I think of SPACs as an investment, and I confess I'm still not sure.  They fascinate me as in example of creative contract design that evolved quickly as the market changed. But I haven't invested any of my own money in SPACs.  Then again, I'm a pretty boring, index fund investor, so you can't extrapolate too much from that!


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