Investing in a company that has no assets and no product would seem, at first glance, to be a poor decision. But a paper by three professors at the Gabelli School of Business shows that initial public offerings of shares by firms that own no tangible and operating assets are not uncommon, can be entirely logical, and do often turn out to be profitable.
Known as special purpose acquisition companies or SPACs, these ventures are governed by the federal Securities and Exchange Commission’s blank-check regulation and have been around for a little more than a decade. One legal commentator has even described SPACs as black-market capitalism.
But is there a rational explanation behind a SPAC and a rational way to explain its unique features? Sris Chatterjee, N.K. “Chiddi” Chidambaran and Gautam Goswami wanted to find an answer. Their resulting paper provides a theoretical framework that explains many of SPACs’ features. It won the best paper award in December 2015 at the India Finance Conference, the premier gathering of its type in India.
Essentially, a SPAC is a company formed on the promise to buy an existing firm, usually one that is yet untargeted and private. The SPAC raises money through an IPO, and the cash is held in an escrow account that only can be tapped for the eventual purchase of the existing company and expenses related to that purchase.
Investors purchase stocks and warrants with their investment, and any acquisition must be approved by the investors. On the successful completion of the acquisition, the target firm becomes a publicly traded entity. The whole sequence provides an alternate process for a private firm to go public. The risk is more heavily weighted to the SPAC founder—who optimally makes an at-risk investment of his or her own—rather than the investor.
“It’s a very complex contract design between the two parties,” Goswami said.
Chatterjee added that he was “amazed” when he first heard of SPACs.
“I got curious and started to collect some data with the help of my graduate assistants, and eventually I discussed this with Gautam and Chiddi, who are interested in security design, and both of them were equally intrigued. So we started to work on why it is that these things happen,” Chatterjee said.
“In finance, if you don’t have any particular company in mind, it’s very difficult to ask an outside shareholder, who has no control, to give you money, but SPACs are actually successful and surviving,” Goswami added.
Between 15 and 20 percent of the total IPOs from 2003 onward have been SPACs, Goswami said.
Of the 216 documented SPACs, 121 completed an acquisition, five had announced an acquisition target, 14 were still looking for a target and 76 had been liquidated. When a SPAC is liquidated, the money remaining in escrow is returned to the investors. Not more than 5 percent of the investment can be kept for expenses, Chidambaran explained.
Chidambaran presented the research in the finance area’s seminar series and at the conference organized by the Gabelli School of Business to honor Professor Jim Lothian’s long stewardship as the editor of the Journal of International Money and Finance.
“We received many helpful comments and encouragement from several colleagues,” Chidambaran said.
“We are happy to have been able to show that the SPAC design follows rationally from accepted principles of economic behavior, and not black-market capitalism,” the professors said.
For a copy of the complete paper, e-mail: Chidambaran@fordham.edu