SPAC-ulation?

Investors are always seeking potential. The more specific, the better. And special purpose acquisition companies—better known as SPACs—deliver.

Potential, that is.

As they raise money to acquire or merge with an existing private firm, these “blank check companies” often issue long-term forecasts projecting the financial performance of their targets.

But SPAC projections tend to be overly optimistic, according to new research co-authored by Elizabeth Blankespoor, an associate professor of accounting and Marguerite Reimers Endowed Faculty Fellow at the University of Washington Foster School of Business.

From 2000 through 2021, just more than a third of SPACs with observable outcomes actually met or beat their projections, the study found. And SPAC projections were three times larger, on average, than the actual revenue growth of comparable public firms.

“Whether it’s due to more legal freedoms or investor expectations, overly optimistic projections have arisen in the SPAC environment,” says Blankespoor. “And if investors are not savvy enough to realize this, then there is a potential for decisions made on imperfect information.”

Rise of SPACs

SPACs are shell corporations, listed on a stock exchange, which are formed for the sole purpose of buying or merging with a private business. They are, in essence, a way to take private companies public without the time, expense and regulatory challenges associated with a traditional initial public offering (IPO).

“An IPO is a company looking for money,” explains Blankespoor. “A SPAC is money looking for a company.”

Lately, SPACs have meant big money. Though they have existed quietly for decades, SPAC activity has exploded in the past few years. For context, SPACs raised just $0.1 billion and accounted for 0.3% of IPOs in 2010. In 2020, SPACs raised over $75 billion and accounted for 55% of all IPOs. And they raised a combined $100 billion in the first six months of 2021 alone.

The boom has drawn SPAC sponsorship by notable investment companies, private equity firms and a cavalcade of celebrities, from Martha Stewart to Jay-Z to Leonardo DiCaprio to Serena Williams. Perhaps the highest-profile SPAC of all is Digital World Acquisition Corp., which raised $875 million toward its October merger with former President Donald Trump’s nascent social media venture.

While SPAC sponsors and entrepreneurs are drawn to this simplified way to raise capital and go public, investors like the chance to get in on the ground floor of promising new companies—with plenty of room to grow.

SPAC sponsors give them every reason to feel bullish. With only two years to make a deal in which they have an outsize stake, they often issue long-range financial forecasts to drum up investment in their target firms.

These forecasts can appear too good to be true. Are they?

Unrealistic projections

To find out, Blankespoor partnered with co-authors Bradley Hendricks of the University of North Carolina and Gregory Miller and DJ Stockbridge of the University of Michigan.

The researchers examined the financial projections and performance of SPACs launched between 2000 and 2021. They found:

• Long-term forecasting – 80% of firms projected financial performance over four years, on average; about a quarter of these projections extended more than five years in the future—an eternity for most public firms.
• Unrealistic optimism – 65% of SPAC deals with observable post-merger revenue failed to meet or beat projections. The longer-range the forecast, the worse the record of meeting projections.
• Projections > benchmark performance – SPAC projections were approximately three times larger, on average, than the actual revenue growth of comparable public firms (with even greater disparities for long-term projections).
• Disappearing forecasts – after successfully “de-SPACing”—completing a merger or acquisition—the resulting public companies reduced their use of projections to the mean of other public companies (which typically forecast no further than the next quarter).

Investor: be wary

Blankespoor says that these findings do not, on their own, cast special purpose acquisition companies in shadow.

“We’re not saying that SPACs are bad,” she says. “It’s just a different but legitimate mechanism for raising money—and it’s good to have different options in the capital markets.”

But not if they are delivering inaccurate information to investors. She stresses that incentives inherent in the structure of SPACs—a ticking clock to buy and a disproportionate stake in target companies—may move sponsors to communicate overly confident forecasts.

Future research will quantify the market effects of this imperfect—and potentially inaccurate—information coming from SPACs. “What we’re saying,” Blankespoor says, “is you are right to be concerned.”

So is the Securities and Exchange Commission (SEC), which is working quickly to regulate SPACs and ensure that investors have the most accurate information on which to make decisions.

Blankespoor expects to see, at a minimum, new rules mandating the disclosure of risk inherent in long-term forecasting, or perhaps a forecast conveying a more realistic range of potential outcomes.

She adds that the market may already have caught on to the study’s findings. While investment in SPACs saw massive growth from 2019 to 2021, the pace is already starting to slow. “Perhaps investors are saying, ‘Wait a minute, maybe this is too optimistic,’ ” says Blankespoor.