What's already been a highly unusual year for the financial markets became even stranger on Wednesday, February 24th as Silver Run Acquisition Corp (SRAQU) began trading on the NASDAQ. Notably, Silver Run's IPO is only the fifth in 2016, raising $450 million in gross proceeds – the largest year-to-date. More interestingly, the company has no operations.
No, you didn't read that incorrectly: Silver Run has no operations. Silver Run is a unique type of investment vehicle called a special purpose acquisition company (SPAC), known colloquially as a blank check company. In contrast to a traditional private equity fund, SPACs hold the proceeds of their IPO in trust, giving them up to two years to propose and approve an acquisition, generally in a specific sector. At the time of a SPAC’s IPO, the company doesn’t yet have a specific target, and if an acquisition isn’t proposed and approved within the allotted timeframe, the shareholders’ investment is returned from the trust.
In spite of the ambiguity of SPACs at the time of IPO, SPACs have, at times, constituted significant portions of the overall IPO market since their advent in 2003 (in 2007, 24% of IPOs were SPACs.) These vehicles are typically founded by high profile business leaders and financiers, which gives them a star quality that perhaps explains some of their attractiveness to investors. Silver Run is no exception to this theory: the firm is led by Mark Papa, the renowned energy executive who led the 1999 separation of EOG Resources from its ill-fated parent, Enron. Fittingly, Silver Run’s mandate is to make an investment in a distressed energy target.
But why structure an investment as a SPAC instead of a traditional private equity fund? From the perspective of investors, the high management fees and carry charged by private equity funds can significantly depress net returns. In contrast, SPAC founders aren’t rewarded until an acquisition is made, at which point they own a stake in the target company proportional to their ownership in the SPAC (generally 20%). What’s more, because SPACs are publicly traded, the investment is highly liquid, especially compared to private equity funds that have long investing and distribution time horizons. What might be the most compelling advantage of a SPAC is that investors have the option to vote against any potential acquisition and liquidate their investment in the trust, creating the possibility of a zero-risk exit.
However, the empirical performance of SPAC investing is baffling. Because the shares are publicly traded, the market clearly indicates whether or not a proposed acquisition is value-additive or value-destructive immediately before the acquisition vote. If the stock price of the SPAC is below the liquidation value of a share from the trust before an acquisition vote, the market is indicating that the proposed deal would be value-destructive. It would seem rational at such a point to vote against the proposed acquisition and liquidate, but this behavior isn’t reflected in the history of SPACs.
Jenkinson & Sousa studied a set of 43 SPACs that had voted to execute an acquisition by June 2008. Of those 43 that agreed to the proposed acquisition, 23 were trading below the liquidation value of the shares the day before the acquisition decision date. This reveals dissonance between the market and those voting on the potential acquisition. (The study goes on to show that a portfolio that liquidates “bad SPACs” and sells “good SPACs” the day before the acquisition decision date generates an average IRR of 13.0%.)
What explains this counterintuitive phenomenon? The crux of the explanation is that the shares of the SPAC are publicly traded and that the founders are only rewarded if an acquisition is executed. In the days leading up to an acquisition vote, the founders can vet the shareholders as to how they plan to vote and buy the shares of those who plan to vote against the deal. This allows the founders to gain a significant foothold in the vote.
It’s a classic tale of misaligned incentives, but investors can still avoid unnecessary losses by simply listening to the market and liquidating their investment if the liquidation value is greater than the share price. To date, the legacy of special purpose acquisition companies is a mixed but incomplete story. So-called “sophisticated investors” demonstrate the propensity to be surprisingly dull by dismissing clear market indicators, resulting in significant losses. For SPAC founders, the path to payday is clear: acquire!