DealLawyers.com Blog

In the SEC’s recent rulemaking relating to SPACs, the new requirements were crafted to address concerns about conflicts of interest and perceived shortcomings in disclosures associated with SPAC transactions — both SPAC IPOs and de-SPACs. This recent post on the HLS blog from professors at UC San Diego and the University of Minnesota challenges the belief that requiring additional disclosure will protect less sophisticated investors. They opine, in the SPAC market, that “overconfidence” is its weakness:

Specifically, investors may be overconfident about their ability to process interim information (e.g. in the form of disclosures around the merger announcement) when they initially buy the units. This overconfidence leads them to overvalue the optionality embedded in their right to redeem shares. With overconfident investors, the sponsor can overprice the units relative to what rational investors, who correctly anticipate their likelihood of processing information in the future, are willing to pay. In equilibrium, overconfident investors overpay for the units and are unlikely to redeem, which earns them negative returns on average. Rational investors, by contrast, redeem optimally and receive excess returns.

Thus, the SPAC contract trades off dilution costs due to redemptions and the benefits derived from overpricing. When sufficiently many investors are overconfident, the SPAC structure leads to overinvestment. Intuitively, investors overvaluing the units lowers the sponsor’s cost of capital, since it allows the sponsor to raise funds cheaply. This, in turn, may make it profitable to finance relatively low-value targets.

They say “more stringent disclosure rules at the time of the merger” may actually “result in lower returns for unsophisticated investors but higher returns for more sophisticated investors, particularly when information is challenging to process.” Instead, they argue that access to SPAC transactions should be “based on measures of financial sophistication, such as allowing only accredited investors to buy units” and that “limiting or eliminating warrants as part of the initial unit issuance can reduce overpricing.”  Presumably, time will tell whether the SEC’s final rules address some of the criticisms of the SPAC market.

– Meredith Ervine