Security Issuance, Institutional Investors and Quid Pro Quo: Insights from SPACs 

By | January 27, 2023

Why is it So Costly to Go Public? 

The average first-day returns to investors of initial public offerings (“IPOs”) in the U.S. is 19%. These returns are even higher elsewhere, such as in China. For reference, the S&P 500 index gains only a few basis points a day on average. While a large one-day return is desirable to IPO investors, it means becoming a publicly listed company is costly for private businesses. An alternative to IPO is for the business to merge with an existing special purpose acquisition company (“SPAC”). SPACs are publicly listed shell entities that sell shares to public investors and use those funds to merge with a private business and, in the process, take the private business public. In our dataset, between Jan 2010 and Dec 2021, 271 private companies used SPACs to become publicly listed companies, and 146 are in the process of becoming one. Some of these companies are well-known, e.g., Virgin Orbit, WeWork, and Lucid Motors, while others are less so, e.g., P3 Health Partners and Bowlero. However, the average first-day returns after the merger for a SPAC at 34.85% is even higher than the returns for a traditional IPO. 

So, it is natural to ask why so much money is left on the table (“MLOT”). In other words, what determines these high returns for investors? If the issuers (businesses that want to become publicly listed firms) pay for these high returns, why do they not raise the price of their newly issued shares? Or are these costs unavoidable? Answering questions like these is important as they help us better understand the workings of financial markets and inform regulatory policies. The extant IPO literature has proposed two competing explanations for high first-day returns, but they are both based on agency and informational frictions in the financial markets. 

The first explanation articulated in an important research paper by Jay Ritter and Ivo Welch is the agency friction between the sellers/issuers and the underwriters. During an IPO, shares are sold through an underwriter, who acts as an intermediary between buyers (investors) and sellers. However, the underwriter may not always act in the seller’s fiduciary interest. A typical IPO buyer is an institutional investor with whom the underwriter expects to work on a different IPO in the future. In contrast, a typical IPO seller delists or is acquired before ever doing a secondary equity issuance. So, an underwriter typically has repeated interactions with the same investors but most likely has a one-off interaction with the sellers. In such a setting, the underwriters have incentives to manage future relationships, which may tilt their favoritism toward the buyers rather than sellers. Specifically, underwriters may sell the newly issued shares too cheaply, hoping to profit in other future transactions with institutional buyers. Thus, the high first-day return is due to the quid pro quo relationship between these two parties. The IPO literature frets that this favoritism is of first-order importance and suggests the need for regulators to detect and prevent quid pro quo transactions. 

The second competing explanation is that there is information asymmetry between firms and investors or among investors about the value of the company that wants to go public. As is well-known, informational frictions depress the share prices and, in extreme cases, even cause the market to unravel and fail altogether, as shown in a celebrated paper by Sanford J. Grossman and Nobel prize winner Joseph E. Stiglitz. In another important research paper, Benveniste and Spindt argue that it behooves the underwriters to structure the IPO process in a way that manages informational frictions. One concern for institutional investors is that their private information about the company’s value may “leak” to counterparties without proper compensation. Much of this information leakage is likely to occur informally in a ‘road show’ before the formal sale, in which underwriters pitch the firm to institutional investors. During these negotiations or discussions, a skilled underwriter can credibly learn the extent of demand for the shares. So, these investors must be paid for their information. 

To reward the investors for revealing their favorable information, the underwriter allocates shares at a discounted price relative to the share price after incorporating the information revealed during the negotiation process. Thus, according to this theory, the high first-day return is simply the price of accessing proprietary information held by investors. Furthermore, the underwriters are already performing their tasks, so the laissez-faire system is efficient. However, these competing explanations are not mutually exclusive. They have different policy implications, so it is important to empirically determine how much of these first-day returns are due to agency frictions and how much is due to informational frictions. The previous IPO literature emphasizes the difficulty in separately identifying these two channels. For instance, both frictions imply lower share prices and therefore are observationally equivalent, so we need additional information to tease apart these two effects. 

SPACs Offer an Ideal Institutional Environment to Study This Problem 

In our research paper, we revisit this question in the context of SPACs. Unlike the previous IPO literature, we make progress because the SPAC process offers four research design advantages over traditional IPOs. First, it divides the process of going public into two distinct phases with potentially different frictions. In the initial stage, the sponsor of the SPAC raises capital from investors. The SPAC starts as a shell company without an operating business, which limits the amount of information asymmetry possible between investors compared to a traditional IPO. The next phase consists of a “business combination” in which the SPAC acquires a private firm. Second, during the business combination phase, SPACs publicly report the allocations to each institutional investor. These investors are also known as “PIPE” (an acronym for private investment in public equity). In a traditional IPO, allocations are never publicly reported. We can use these reports to measure the investment return history for every sponsor-PIPE pair and, in the process, create an in-sample measure of the “relationship” between a sponsor and a PIPE investor based on their track records. Third, SPACs are publicly traded firms. Consequently, we observe the effect of all major events (e.g., securing investment from PIPE investors and identifying a target) on share prices. Fourth, the quid pro quo channel is easier to observe in SPACs than in traditional IPOs. Unlike the investment banks in traditional IPOs, SPAC sponsors typically do not operate in other lines of business (e.g., trading and wealth management). Therefore, they must earn any quid pro quo from investors from future SPACs, some of which we observe in our dataset.  

Premium Investors Provide Value-Relevant Information 

We identify the presence of two types of PIPE investors, “premium” and “non-premium” investors, to capture the differences in their business models. Who are these premium investors, and how are they different from the rest? Our working assumption is that only large investors produce value-relevant information. Accordingly, we classify an investor as a premium investor if it is in the 95th percentile for the number of SPAC deals in our sample and the total investments (in dollars). Twenty-seven large investors satisfy these cutoffs and are termed premium investors. This set includes familiar names like Blackrock, Fidelity, and UBS. Fidelity, for example, participated in 48 deals, contributing over three billion dollars. We classify the remaining 907 PIPE investors as non-premium investors. 

We find evidence that supports the hypothesis that premium investors produce value-relevant information about the target companies. In contrast, non-premium investors are “relational investors” who engage in quid pro quo arrangements with the sponsors. Interestingly, but perhaps not surprisingly, we find that whenever premium investors participate in SPAC deals, the public investors are more likely to ratify mergers, and there is a large positive business combination announcement effect on stock prices. More specifically, our estimates suggest that if we take a SPAC with an average rate at which initial public investors withdraw their money—the redemption rate—and average announcement-day returns and increase the probability of participation of premium investors by one standard deviation, the redemption rate decreases by more than 12%, and the announcement-day return increases by more than 62%. Thus, premium investors have significant positive effects on SPACs. It is “as if” premium investors certify merger deals. In contrast, the non-premium investors do not have the certification effect. 

Non-Premium Investors Enable More Targets to Go Public 

However, creating and registering SPACs and finding a target falls on the sponsors. In our sample, we find that the sponsors invest $8.2 million on average in this. Thus, they are the intermediaries between target companies (sellers) and the PIPE investors (buyers) and profit only if their SPACs successfully merge within two years. Otherwise, the SPAC is liquidated, their securities expire worthless, and they lose their investment. Thus, sponsors stand to benefit from participation by PIPE investors. As we mentioned, one way for the sponsors to encourage PIPE participation is to offer them discounted shares in strong deals in exchange for an implicit promise to help in (future) weaker deals. 

Under that arrangement, quid pro quo involves transfers from high-quality targets to (in part) low-quality targets by allowing potentially marginal targets to go public. In turn, quid pro quo arrangements may serve as “insurance” for targets to go public, even when there is uncertainty about the value of their business. In other words, a marginal target can benefit from the quid pro quo arrangement because it may otherwise not be able to go public (at least via the SPAC route). It is important to note that this value-adding feature of quid pro quo in SPACs differentiates it from its value-destroying feature previously identified in traditional IPOs. Although we do not observe discussions between sponsors and investors and do not observe any quid pro quo arrangements, we can test if our data are consistent with quid pro quo. In particular, quid pro quo suggests three predictions that can be tested in the data. 

First, for any sponsor and PIPE investor, MLOT should exhibit mean reversion. In other words, if the investor earned more than the average from the same sponsor’s last SPAC deal, it should earn less on the current deal. Second, if the current deal is weak, the sponsor allocates disproportionately more shares to those investors who earned high returns from the said sponsor in the past. Third, all else equal, a SPAC led by a sponsor with accumulated relationships (goodwill) with investors is more likely to succeed and less likely to be liquidated. 

These predictions have no analog in the information production paradigm: investors who did well in the past receive new signals of the current deal’s quality and are under no obligation to support future weak deals. If anything, the MLOTs of the premium investors should exhibit positive dependence. We find evidence consistent with all three predictions, but only for non-premium investors. Premium investors do not satisfy any of these predictions, which is consistent with their business model being information production and getting paid as such. Specifically, we find that non-premium investors profit less in the current deal when they have high returns on past deals. One dollar above average MLOT in the last deal leads to a 54-cent below average MLOT from the current deal. We document both legs of the relationship: the sponsor builds a relationship and subsequently draws it down for tepid deals. A sponsor is three times more likely to use a relationship non-premium investor than a new one. Indeed, when the deal is weaker, the sponsor is less likely to allocate shares to non-premium investors who have not previously worked with the sponsor, and vice versa. In contrast, a strong relationship with premium investors does not help reduce the liquidation risk. 

What We Have Learned and Yet to Learn 

Thus, we find that both agency- and information- frictions lead to higher first-day returns for the SPACs. As a new insight, we establish that not all investors are alike. In particular, the so-called premium investors produce value-relevant information and help SPACs merge with stronger businesses. In contrast, the non-premium investors engage in quid pro quo arrangements with the intermediaries and, in the process, enable weaker firms to go public. Because both types of investors perform their tasks and are rewarded accordingly in the financial markets, our study suggests that the laissez-faire system is efficient. This research is the first step in studying security issuance in the context of SPACs, as we have sidestepped several important questions. As discussed above, stronger businesses cross-subsidize weaker ones in SPAC. So, it is important to measure the value created. Second, during the first two years of the COVID-19 pandemic, SPACs were the preferred option for many private businesses to go public. Understanding when and why a company prefers SPAC to the traditional IPO would be interesting. We leave these and related policy questions for future research.  


Gaurab Aryal is an Associate Professor of Economics at Washington University in St. Louis. 

Zhaohui Chen is an Associate Professor of Commerce at the University of Virginia McIntire School of Commerce. 

Yuchi Yao is a Ph.D. student at the University of Rochester Simon Business School. 

Chris Yung is an Associate Professor of Commerce at the University of Virginia McIntire School of Commerce. 

 This post was adapted from their paper, “Security Issuance, Institutional Investors and Quid Pro Quo: Insights from SPACs,” available on SSRN and arXiv. 

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