By Phil Mackintosh, Senior Economist, Nasdaq
We recently examined the unusually strong IPO market in 2020 that thrived in the midst of a pandemic. A large part of that strength was driven by a surge in Special Purpose Acquisition Companies (SPACs). Given their increased presence in equity markets, it’s important to look at what SPACs are, how they work and how they trade.
SPAC popularity rises in line with private equity growth
SPACs have been around since the 1990s. However, we see in Chart 1 that their popularity has increased over the past 10 years.
Chart 1: SPACs have grown as Private Equity dry powder has grown, with more than half of all IPOs in 2020 being SPACs, with a majority listing on Nasdaq
The growth of SPACs has coincided with the increased size of private equity markets. Both of which highlight how the market is evolving to provide investors with solutions to bridge growing private markets with traditional public markets; SPACs and direct listings are two such solutions.
What is a SPAC?
Let’s start with a definition. A SPAC is an investment vehicle that raises capital with the sole purpose of combining with a private company and bringing it public.
When the SPAC IPOs, the cash raised is put into a trust while the management or sponsor of the SPAC searches for acquisition targets. Typically, that results in a private company being brought to public markets via an acquisition.
Not all SPACs complete acquisitions, however. Generally, management has two years to find a target. If no acquisition is made in the allotted time, the trust is unwound and money is returned to investors, although there can be extensions.
Once a SPAC identifies an acquisition target, it will make an announcement and then work towards completing the business combination. Once the deal is complete, the SPAC will cease to exist, and the combined company will trade under a new ticker.
Chart 2: Simplified life cycle of a SPAC with average times at each stage
Consequently, SPACs represent a way for well-funded private companies to come to public markets. SPACs and direct listings are both ways for private investors to access public market pricing and liquidity, usually without the extensive roadshow that has become standard with IPOs.
Not only is the market evolving to accept more SPACs, but data also shows SPACs themselves seem to be maturing. In 2020, the average size of SPACs increased, and many of the larger SPACs are being run by established private equity investors such as TPG, Apollo, Fortress, and Oaktree to name a few. Hedge fund manager Bill Ackman’s SPAC, PSTH, raised $4 billion in its IPO last June.
Chart 3: As the SPAC market has grown and matured, larger SPACs have increased
How are SPAC shares structured?
Almost all SPACs are first listed at $10 per unit, and there are three distinct phases in the lifecycle of a SPAC:
- SPAC: Cash held in trust while the management looks for acquisition targets.
- Pre-acquisition: Once a target deal is announced, but before the acquisition is completed.
- Post-acquisition: Sometimes called “de-SPACing,” when the private company is acquired by the SPAC, and the SPAC becomes an operating and listed version of that company.
SPACs also have an unusual capital structure that may include a combination of:
- Units (which are common shares with attached warrants)
- Common Shares
- Warrants
- PIPEs (Private Investment in Public Equities)
Generally, the unit will consist of a common share and a fraction of a warrant. Typically, in the first phase of a SPACs lifecycle, investors can trade the units, or the common shares and warrants, separately. So holders may be given the right to either continue trading the unit or convert their unit into the equivalent amount of shares and warrants.
Investors typically keep the right to redeem their $10 common share right up until the final phase of the process.
However, because of that, sometimes the SPAC will need to offset capital withdrawals to complete an acquisition. That is done with a PIPE, where investment funds participate in a secondary fundraising right before an acquisition.
How do SPACs trade?
As the data in Chart 3 shows, most SPACs would qualify as small or microcap companies. However, during their first phase, they lack an operating business and have assets in a trust earning bond-like returns.
So how do they trade?
In our analysis, SPACs that completed the entire cycle from 2018 through 2020 (55 SPACs) show that trading patterns change over the lifespan of a SPAC, and each phase is distinctly different.
What we see in Chart 4 makes sense, too. A SPAC starts with a risk-return profile like that of a bond and transitions over time to an operating company. With each phase and phase shift, liquidity, volatility and returns change as you’d mostly expect.
- Phase 1: Most SPACs begin trading at $10 per share and trade similarly to a bond with low volatility and a constant $10 valuation. Liquidity is highest immediately after the SPAC IPOs.
- Phase 2: A SPAC’s volatility and volume spikes when the acquisition target is announced, as price discovery starts to occur and the risk/return profile increases. SPAC common shares begin to trade more like an equity. As warrants start to price in the potential upside, their leverage (as with all options) exaggerates the change in their volatility and spreads. In general, during the post-announcement phase, volume forms a U-shaped curve. That reflects the fact that most news occurs after the target announcement as the deal completion nears. Surprisingly, increased interest/volume does not equally translate into volatility. In fact, post-announcement prices remain stable until the final days prior to the completion of the business combination.
- Phase 3: Trading around the completion of the business combination date tends to be quite volatile, with average daily high/low volatility reaching more than 10% in the first week of trading as a new operating company. That’s similar to the volatility IPOs experience on listing and likely reflects the range of different investor views of the private company’s business model and future earnings.
Chart 4: Volatility (vertical axis) and volume (line thickness) at each phase of the SPAC shows changes as new information enters the market and at SPAC lifecycle progresses
Note that liquidity is shown by the thickness of the lines, and the data shows that liquidity is present when price discovery is greatest during phase changes and once the SPAC starts to trade as an operating company.
Spreads are also important to investors, as they add to trading costs.
SPACs are initially thinly-traded securities, so consistent with other microcap stocks, they see substantially wider quoted spreads when there is low investor interest. If we look instead at effective spreads, we see they are lower and much more consistent. Effective spread is also a more relevant metric for investors, as it represents actual cost on each trade, similar to how retail computes execution costs.
Despite the fluctuations in volatility and volume across phases, effective spreads remain low and constant throughout the lifecycle, with the exception of units, which are typically unbundled into common stock and warrants anyway. This suggests that market makers are able to predict demand and provide liquidity to SPACs when it is needed. It also suggests that investors should avoid market orders unless they can see a competitive quote.
Units are traded only in the first few days and weeks following the IPO. Once units become redeemable for common shares or warrants, there is not much incentive for them to be traded on an exchange. Units are easily redeemable by any broker for free or a small fee, depending on the broker.
Chart 5: Effective spreads in cents are reasonably constant at each phase of the SPAC (with the exception of units, which are typically converted to shares and warrants)
How do SPACs perform?
The big question for investors (and private company entrepreneurs) is: How do SPACs perform?
The short answer is: it varies (as we also find with IPOs).
To try and answer this question, we looked at the performance of SPACs that held IPOs after 2018 and successfully completed an acquisition between 2019 and 2020.
We see that SPACs’ average performance is reasonably stable for those who held all SPACs throughout the life cycle. Six months after converting to an operating company, average returns are around 20%, which increased out to 12 months. That would seem to indicate that most recent deals are accretive to SPAC shareholders, who participate in the upside from bringing private companies to public markets.
However, we are aware that older studies tend to find much lower returns. The change could be due to many factors, including the maturing of SPAC operators, types of targets now considering the SPAC path, or the impact of recent very low interest rates. We also see in Chart 6 that, as expected from Chart 4, returns are bond-like in Phase 1 and increase as the SPAC moves closer to becoming an operating company.
Chart 6: Average and median performance of SPACs since 2019
Averages only tell part of the story. In fact, over the same period, the median SPAC return (yellow line) is negative, highlighting the benefits of diversification or picking your SPACs carefully. This is supported by a recent study that found that SPACs with experienced sponsors produced positive post-completion returns.
Looking at the range of SPAC returns in our data in Chart 7 shows that:
- Few SPACs post strongly positive or negative returns during Phase 1.
- Once the target is announced, and until completion, SPAC upside and downside returns increase.
- After conversion to an operating company, the return profile stabilizes. Although there are fewer winners, the average outperformance more than offsets the average of those SPAC shares with unrealized losses.
Chart 7: The ranges of SPAC performance over each of the three lifecycle phases
SPACs vs. IPOs?
The question of whether a SPAC or an IPO is better is somewhat subjective. For issuers, IPOs typically offer access to more new capital, but on average, issuers don’t benefit from the liquidity premium or “IPO pop” that shares receive after they start publicly trading.
SPACs can save issuers some of the investment banking fees, but they also pay the SPAC sponsor a significant return.
For investors, our data above does not adjust for market returns once the SPAC converts to an operating company. If we did, it would show that once the SPAC is converted, returns are roughly in line with the market. That’s in contrast to typical IPOs, where we recently showed an average IPO premium is around 14% on its first day of trading. Last year, at least, outperformance continued over the full year too. However, issuers could argue that same lack of alpha means issuers get a “fairer” price than an IPO might offer.
One of the documented concerns with SPACs for investors is the way the redeemable share and warrant work, especially when the data confirms that many SPACs underperform once the merger is complete. A recent paper on SPACs showed that because of the “free options” embedded in the SPAC structure, during the transition, short-term holders of SPACs may benefit at the cost of long-term holders.
What does this all mean?
SPACs are a suddenly popular and relatively new way to invest in emerging companies. The structure represents an alternative way for issuers to join public markets. They also represent a way for investors to own exposure to private companies as they convert to public companies.
Data shows that although SPACs are thinly traded in the first phase of their life, effective spreads are consistent for those trading with discretion, and liquidity improves each time the SPAC enters a new phase of its lifecycle, allowing new information to be priced in.
As with all investments, the public needs to do their research. Returns vary, sometimes significantly. But this data seems to show that SPACs are a bridge between private markets, which are accessible only to accredited investors, and the IPO typically required to enter public markets.
