The Complexity of SPACS (PART I)
Wall Street has a bad reputation for coming up with ways to hurt the lives of public investors. Public investors do not have the privileges of a private investor to afford a well-educated opinion on the value of a company. These privileges give such an advantage that the SEC has made the distinction very clear through the use of the term accredited investor. This protects the public investors from those who would take advantage of them, in theory anyway. The most notable recent collapse in public faith is the financial crisis of 2008 where billions were lost in money and the public paid for it through a government bailout. Not only was taxpayer money used to keep the perpetrators from going bankrupt but many who couldn’t afford the homes they bought faced a massive loan with no way of paying it. Clearly the SEC was too slow to act on their mission or even turned a blind eye. Our recent research on SPACs has led us to believe that the SEC is definitely incompetent enough to allow it to happen and has led to financial harm to not only ourselves but to the public as a whole who unknowingly invested in such a complex instrument cooked up by Wall Street.
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SPAC is the acronym for special purpose acquisition company and has some of the most complex moving parts that a public investor could buy. While not entirely new, they have increased in popularity in the last couple of years. SPACs are an alternative to traditional public offerings that is much quicker, has lower costs, and the SEC doesn’t give as many review comments. The only operation is a small team dedicated to finding a suitable company to merge with. Almost all the money raised during the initial offering of their units (comprised of stock and warrants) is placed in a trust account. This is where the heart of the complexity lies. Each shareholder is entitled to a pro rata portion of the trust account value upon executing their right to redemption excluding those restricted such as the founders. While this feature is not hard to understand it is not something public investors would routinely invest in. Brokers impose a fee for such redemptions so it would require either a large investment or the market to inefficiently price the stock for any returns to be made for a public investor. For those who can make such large investments hours must also know how to gather information on hundreds of potential SPAC candidates efficiently such as a web scraper or purchase the information from various websites. We would caution against using these websites because their updates can lag several days making them unreliable for large investments. The key points to be known about making a trade around this redemption feature are the events that lead to the trust account value being released and increased. The trust account value can be increased by the sponsor injecting more money when their self-imposed deadline for merger is about to be reached to extend the deadline. The amount to be injected and the deadline extension are different for each SPAC. No redemption is allowed during this time. SPACs also have the option to extend their deadline via shareholder vote which does allow redemption, but the catch is that the trust account value may not increase. This zero-coupon trade is relatively simple to understand but requires a hefty initial time and monetary investment to make it worthwhile.
Moving along the life cycle of a SPAC the next feature is the business combination. Once the S-4 or equivalent becomes effective a record date is set for those entitled to vote at the special meeting of shareholders. One of the biggest points of a conflict interest boldens itself here. The founders want the special meeting to go through because if it doesn’t their shares might expire worthless since they are not entitled to the trust account and indeed it stated in the prospectus that they will vote yes for the business combination. Those are playing the redemption angle have an incentive for it to go through because if it doesn’t they will see a lower yield on their “bond” since all redemptions are cancelled when the business combination falls through. As we established earlier many public investors will not being redeeming these shares due to the barrier of entry. Therefore, they must sell their shares on the open market before the special meeting. Here is the catch though, they may have been diligent enough to put the special meeting date on their calendar and record the date that is the last day for redemption (two days prior). What they might fail to understand is that settlement exists. Settlement not something most public investors come across because most of the time they buy and sell stocks in big name companies or choose allocations in their 401k. Therefore, when SM-2 rolls around the investor will find that the floor has already dropped and the stock they bought for 9.80 is trading at 8 dollars. Settlement enforces the fact that the last day for an investor to buy shares and redeem them is SM-4, since the shares must be settled. Not an intuitive concept since everything is done electronically and the shares show up instantly on the account.
Even less intuitive and transparent is how corporate action works with brokers. The short answer is that it varies. If an investor were to short shares on Tradestation or Interactive brokers on SM-4 in anticipation of the floor drop, they will find that the trade will not work out as expected. It is quite possible that you will borrow shares that have already been selected for redemption and will have to pay the amount owed to redeemer. Any so called “take no action shares” available will be allocated on a lottery basis.
In the next paper we will continue to discuss SPAC and how its structure create false incentives for company founders to manipulate the equity and derivative market to profiteering at the cost of the public invesotrs.