Breakingviews - The house always wins with SPACs

NEW YORK (Reuters Breakingviews) - Finance is like poker: If you don’t know who the sucker is, it’s you. That’s especially true of special-purpose acquisition companies, the Wall Street craze that only seems to gather pace.

Scott Blumstein's winning cards are displayed during the World Series of Poker Main Event in Las Vegas, Nevada, U.S., July 23, 2017. REUTERS/Steve Marcus

Take this week’s blockbuster SPAC deal. Churchill Capital Corp IV agreed a merger with electric-car upstart Lucid Motors, lining the latter up for a public listing at a stonking headline valuation of $24 billion. It’s an unusual but instructive example. The SPAC’s stock atypically galloped upward on rumors of the deal and fell once the facts were announced, already costing some investors money.

For SPACs in general, though, the main reason public shareholders end up as suckers isn’t a poor choice of target, but the dilution as free or cheap equity interests are bestowed upon early investors. A Stanford Law School-led working paper picks this apart for nearly 50 SPACs that completed mergers between January 2019 and June 2020. For their creators, sometimes investment firms and sometimes individuals, diluting other shareholders is the point.


A SPAC sponsor gets the biggest cut in the form of a so-called promote – free, or nearly free, shares, typically totaling 25% of the number sold in the vehicle’s initial public offering – once a merger is secured. In just under half the deals struck last year, according to an analysis by lawyers at Freshfields, sponsors gave up some of the shares they were due to receive, but only some.

To get that reward, the sponsor contributes the cost of getting a SPAC to the point of an IPO. That’s probably a few million dollars. When all those extra shares arrive, the result, three months after a merger, is an average sponsor return of nearly 400%, according to the Stanford team. A recent JPMorgan analysis put the mean sponsor return at an even more eye-popping 650%. No wonder people like Michael Klein, the ex-Citigroup banker behind Churchill, and investment groups such as Gores keep repeating the SPAC playbook.


Someone has to pay for the giveaway to sponsors, and it’s not the SPAC IPO investors.

These are mainly specialist hedge funds. When SPACs first raise money, what’s on offer is shares with warrants attached. There are also generous redemption terms, so when the cash shells find a deal, the initial investors can choose to get their money back. But they usually keep their warrants – which, like options, entitle them to buy shares at a certain price, becoming valuable if the underlying stock price goes up.

This means, according to the Stanford paper, that for essentially risk-free investments these early holders on average make a nearly 12% return. That’s not bad with, say, 10-year U.S. government bond yields running at around 1.5%. Those warrants are another source of dilution for later-arriving shareholders.


The yardstick for presenting most SPAC deals to investors is the typical $10 per share IPO price, and that’s central to the math in the Churchill-Lucid deal. Because that’s how much cash was originally put into the blank-check firm, it’s usually the benchmark for valuing the merged entity, too.

But in practice, the dilution from free shares and such means the SPAC actually contributes less than $10 per share of cash to Lucid. The Stanford researchers figure that, factoring in redemptions, the amount may on average be less than $7.

All this dilution at the SPAC level means there’s an incentive to target the biggest possible merger partner so that the blank-check vehicle has less weight: the Churchill SPAC represents only a fraction of Lucid’s overall valuation. Even so, the Stanford figures suggest the sponsor promote, warrants and rights for investors, plus IPO underwriting fees eat up 14% of the post-merger equity value in the typical case.

In the Lucid example, Churchill’s shares were trading at a much higher price by the time the deal was announced. So some investors might have acquired their shares in the SPAC not near the original IPO price of $10, but in the market for more than $60. On Thursday, they closed under $30.


There’s another cohort of investors who get their own special set of rewards in return for boosting the SPAC’s firepower at the time of a deal: the PIPE investors.

The acronym stands for private investment in public equity, and typically comes from institutions or investment funds. In Churchill’s Lucid deal for example, Saudi Arabia’s Public Investment Fund – already a Lucid backer – and funds managed by BlackRock and others signed up to provide $2.5 billion.

Usually that’s at the same $10 per share standard share price, but in Churchill’s case it was at $15, still reflecting a massive discount to the market price at the time. The bells and whistles attached to these PIPE deals aren’t always completely transparent, so a regular investor buying at the same price may not be getting the same deal.


All this boils down to a predictable outcome, according to the Stanford research: share prices after SPAC merger deals tend to fall. The sponsors’ returns are so large they won’t be much affected, even if they still own shares. The hedge-fund SPAC mafia is long gone. PIPE investors have collected on side deals or priority access, as favored early-birds do in hot IPOs. The owners of target companies, presumably, already secured valuations higher than their wildest dreams.

The suckers are left to deal with the dilution. Churchill’s stock price after it finally announced its Lucid deal is emblematic of the problem, even if it’s too early to know for sure what Lucid will turn out to be worth. Regular investors are the ones taking real risk. Latecomers to the pre-deal runup in Churchill’s price are, so far, the only losers.

Michael Klausner, the lead author of the Stanford study, said on a Freshfields podcast that calculating all the dilution for a single SPAC deal can take him hours. The U.S. market is all about disclosure, and SPACs could be much clearer about the scale of dilution rather than providing only a trail of data to follow. Regulators could demand that if they chose.

There are other ways outside investors’ interests could be better served. SPACs present forecasts, sometimes wildly optimistic, for their merger targets. An IPO candidate cannot, for legal reasons, do that. An electric flying-taxi startup, Joby Aviation, just took off with a $6.6 billion valuation in a SPAC deal. It doesn’t expect any sales until 2024, and that may be optimistic.

A company with no revenue and an unproven business model probably couldn’t go public through a regular IPO process, because investors would be likely to give it a wide berth or a miserly valuation. Thanks to SPACs, that sensible principle no longer applies. Until watchdogs intervene, the poker adage remains investors’ best defense.


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