Despite current exuberance, the signs don't augur well for "blank cheque" companies.

"Be fearful when others are greedy," wrote Warren Buffett in his annual letter to Berkshire Hathaway's shareholders. "And greedy only when others are fearful." Buffett'due south advice was meant for investors who try to time the market place – a strategy that is a crapshoot at all-time – only it could exist just equally prescient for the financial frenzy of the moment: special purpose acquisition companies.

SPACs are shell companies that heighten coin in an initial public offering, typically attracting retail investors at US$x a share, before finding private firms to merge with within a two-yr borderline. Those firms that merge with SPACs thus become public without going through the paperwork and scrutiny entailed in a conventional IPO. SPACs have been around for years merely exploded in popularity final year among the global market place exuberance, when 248 of them raised US$83 billion – six times the amount raised in 2019 and nearly equally much as IPOs.

This year the phenomenon has but burned hotter. Past the stop of Feb no fewer than 188 SPACs had gone public, amassing a total of United states of america$sixty billion. Famous founders or, in the jargon, "sponsors" ranging from billionaire hedge fund manager Bill Ackman, business magnate Richard Branson to football game star Colin Kaepernick have merely added to the allure of the so-called "bare cheque" companies, especially to retail investors who are oft shut out of IPOs past more than heavyweight players. But history – if not Buffett's counsel – should requite break to would-be SPAC investors, as my recent paper shows.

Blast from the by

With its modus operandi of an IPO done backwards , SPAC is a blazon of reverse merger, the subject of my paper, which was recently featured in the Harvard Business organisation Review . In a classic reverse merger, a private visitor hunts for a listed empty beat on whose dorsum it could quickly become public without the fuss of an IPO. The controversial practise has existed for decades, mostly on the margins of financial markets. The nigh recent wave of RMs began in the mid-2000s and peaked in 2010 – before crashing in 2011.

Conventional wisdom, as INSEAD professors Vibha Gaba, Henrich Greve and I documented in a paper, is that when more people adopt a not-controversial exercise, it will become increasingly widespread due to growing awareness and legitimacy. To understand how controversial practices propagate, Edward Zajac, Peggy Lee and I studied the boom-to-bosom of reverse mergers. We institute that, predictably, increasing adoption of RMs additional sensation and, in turn, aid spread the practice further.

However, the very aforementioned sensation also sparked and fuelled concern amid third parties – media, investors and regulators. The controversial practice then became increasingly seen as a threat to existing institutionalised practices. That, plus the entry of low-status adopters, somewhen stymied contrary mergers and caused them to wane. Like factors have at present converged in the froth of SPACs.

Too popular for its own good

We theorised that the popularity of a controversial practice has two opposing effects on its diffusion trajectory: a straight, positive result due to increasing awareness among potential adopters of the practice and its potential desirability; and an indirect, negative effect stemming from greater third-political party concern and scepticism.

These ii effects are exactly what nosotros constitute in our assay of the RM boom during the 2000s in the United States. We nerveless data on reverse mergers' diffusion, market place responses and firm characteristics, including market value, earnings, total avails and debt and exchange listing betwixt 2001 and 2012.

We likewise studied how the media evaluated contrary mergers. Of the 267 articles published from the time catamenia, 148 were neutral, 113 were negative and only six were positive. Finally, we gathered share cost information to examine how stock markets valued reverse mergers.

Our analysis shows that, initially, as reverse mergers grew in number, the practice attracted even more adherents. Information technology as well drew scrutiny from the media and investors. Their scepticism intensified equally the proportion of RM transactions involving firms with relatively low reputations and lacklustre market reception increased. This became a negative screw which discouraged firms with good reputations from adopting the practice.

More trouble was to come up. Both the Securities and Exchange Commission'southward 2005 disclosure rules for RMs and its 2011 warning to investors about investing in RMs amid an influx of Chinese players – a miracle studied in another of my recent papers – fanned negative market reactions.

In essence, investors, regulators and the media fed off one another'southward cues and evaluations. Negative media coverage weighed on stock market valuation and the subsequent diffusion of opposite mergers. By 2010, when RM activity peaked, 70 percent of media articles spoke of the practice in a negative tone. Cumulative returns on investment in RM firms neared -45 percent. The following yr, in 2011, RM activity plunged by 35 percentage.

Peak SPAC?

The SPACs nail has all the ingredients of the RM bubble: fast proliferation of a controversial financial innovation, poor-quality players, bad publicity and regulatory business.

Scepticism has largely been fuelled by high-profile failures like Nikola, the discredited electric truck maker whose stock is trading at a fraction of the acme reached soon after its merger with a SPAC last June. Poor shareholder returns from SPACs on the whole haven't helped. According to a written report published final year past advisory firm Renaissance Capital, of the 313 SPACs formed since 2015, 93 had completed mergers and taken a company public. Just these delivered an average loss of 9.6 pct and a median render of -29.1 percent, compared to the average return of 47.ane percent for traditional IPOs since 2015.

No surprise and so that media coverage of SPACs is often negative and cautionary. "SPACs are oven-set deals yous should get out on the shelf"warned aFinancial Times headline in Dec. Even David Solomon, chief executive of SPAC underwriter Goldman Sachs, hascautioned that the boom is not "sustainable in the medium term." The SEC signalled its business organization in September, when then-chairman Jay Clayton said the regulator was watching SPACs closely to ensure their shareholders "are getting the same rigorous disclosure that you go in connection with bringing an IPO to market."

More than 300 SPACs demand to secure private firms to merge with this year or face liquidation, with the coin they raised returned to investors. SPAC founders, who typically take a twenty per centum equity stake in the target company, thus have a strong imperative to shut deals — evenat the expense of shareholder value . SPACs may well end up in a negative screw of poor quality/bad press/tighter regulation. That should brand any investor agape.

Ivana Naumovska is an Assistant Professor of Entrepreneurship and Family Enterprise at INSEAD. Her inquiry examines the diffusion of practices and the consequences of corporate fraud, with a focus on financial markets.

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