SPACs – Who Really Wins and Loses?

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This past Friday, WeWork announced that it was going public via a SPAC. This is after a failed attempt by WeWork to go public in September 2019, via a traditional IPO. WeWork was forced to withdraw its 2019 IPO largely due to concerns regarding the company’s poor governance and high valuation. What has changed? There are several key differences between the company’s two attempts to go public. First, there are key differences between a SPAC and a traditional IPO. Second, certain aspects of the company have changed.

It’s helpful to start with an overview of SPACs, which stands for Special Purpose Acquisition Companies. The process of going public via a SPAC can be summarized as follows:

timeline of when an SPAC IPOs and when the SPAC buys a private company

Thus, first there is the SPAC IPO. This is essentially a shell company raising money from investors, with the promise to purchase some private company at a future date. The second phase is the acquisition of the private company, which occurs a maximum of 18 to 24 months after the SPAC IPO. Each of these events consists of several steps, which are described in detail at the end of this piece for the interested reader.

The first striking feature of SPACs is that they are extremely costly. Klausner, Ohlrogge and Ruan (2020) document that on average, the costs of going public through a SPAC equal 50.4% of proceeds. This compares to an analogous 28.4% in traditional IPOs (see Gahng, Ritter, and Zhang (2021).1

graph of costs divided by proceeds raised for SPACs and traditional IPOs

The second striking feature of SPACs relate to the extreme conflicts of interest between the various players. Consider the investors in SPACs. As described in step 5 above, investors can vote for the acquisition, then redeem their shares, and also keep their warrants. Through this combination of decisions, investors recuperate the full value of the share ($10 plus interest) and also keep the warrant; they effectively obtain the warrant ‘for free’. As described by Gahng et al, this is analogous to a convertible bond, with a very attractive return of 9.3% on average.

The third striking feature of SPACs relates to the performance after the acquisition of the private company. Because investors have incentives to approve mergers even if the mergers are value-destroying, it is perhaps not surprising that the post-acquisition performance is quite low. On average, Gahng et al (2021) find that the average returns are -15% per year over the one year following the acquisition and -18% per year over the three years following the acquisition.

timeline of when an SPAC IPOs and when the SPAC buys a private company

In sum, who gains and who loses in SPACs? The first part of the answer is that the investors in the SPAC IPO gain: they can purchase units (i.e., shares with warrants) in the IPO for $10, redeem their shares for the full $10 plus interest at the time of the acquisition (18 to 24 months after the IPO), and keep the warrant ‘for free’. The second part of the answer is that the shareholders after the acquisition typically lose, with returns of -15% to -18% per year. The losses of these investors stem from low-quality mergers combined with dilution that arises from IPO investors selling and sponsors obtaining 20% of shares.

What can we expect from the WeWork case? On average, prior evidence suggest that investors that hold shares after the acquisition are unlikely to gain. Although WeWork was unable to go public in a traditional IPO, it will now become publicly traded by merging with a SPAC. The key question is whether its governance has improved enough, and whether its valuation has decreased enough, to ensure a normal rate of return going forward. Time will tell, but based on the experience of past SPACs the outlook is not encouraging.

Detailed overview of SPACs:

First there is the SPAC IPO. This is essentially a shell company raising money from investors, with the promise to purchase some private company at a future date. The SPAC IPO consists of several steps:

  1. Each SPAC IPO has a sponsor, who is a sophisticated institutional investor such as a hedge fund, a company executive, or even a celebrity. With the assistance of an underwriting bank, the sponsor sells ‘units’ in the SPAC IPO to investors. These units almost always sell for $10, and they consist of one share of common stock plus a fraction of a warrant.2
  2. The sponsor retains 20% of all shares, as compensation. The sponsor does not pay for these shares.
  3. The sponsor purchases warrants. The money from these warrant sales are used to pay the SPAC IPO underwriter.
  4. The proceeds from the SPAC IPO are ultimately used to purchase a private company. The sponsor has 18 to 24 months to identify a private company to purchase (and they are not permitted to identify this private company prior to the SPAC IPO).

    The acquisition of the private company, which occurs a maximum of 18 to 24 months after the SPAC IPO, also consists of several steps:

  5. When the sponsor announces the private company that the SPAC will purchase, the SPAC investors have three choices to make. First, they vote whether to approve the acquisition. Second, they decide whether to redeem their shares or to keep them. If they redeem the shares, they receive the $10 purchase price plus interest for each share. Third, they decide whether to keep or sell their warrants. These decisions are all separate.

  6. The private company is purchased with proceeds from the SPAC IPO, net of any redemptions (as described in previous step).
  7. In many cases, the percent of shares that are redeemed is very high. In such cases, there is a PIPE to raise additional funds.3
  8. After the purchase of the private company is completed, the private company is now publicly traded, and the name of the SPAC is replaced with the name of the previously private company.

1 In addition to underwriter fees, these cost estimates also include the effects of dilution and money left on the table due to underpricing.
2 A warrant is a derivative security similar to a call option, which has a positive value if the underlying common stock increases above some threshold value and which is worth zero otherwise.
3 A PIPE is a private investment in public equity. Typically, PIPE investors represent institutional investors such as hedge funds.

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