SPAC Sponsors Used to Win at Investors’ Expense. Now Both Are Losing.

SPAC mergers can be faster and garner less scrutiny than initial public offerings, making them an attractive way for risky companies, such as electric-vehicle startups, to go public. A star venture capitalist—the sponsor—invites investors to participate in the listing of an empty cash vehicle with the promise of finding a high-growth business to merge with. Those who don’t like a deal can demand a refund come the merger. Sponsors must return the money if they haven’t found a target within a deadline, which is often two years.

In recent years, many investors have accused sponsors of playing a rigged game and picking bad or overvalued targets, as their incentive is to close a merger at all costs. A recently updated paper by Minmo Gahng, Jay R. Ritter and Donghang Zhang shows that average one-year returns for SPAC shareholders who rolled their money into post-SPAC companies were a negative 11.3%. Meanwhile, sponsors—who get 25% of the shares for a nominal price, as well as warrants—made annual one-year returns of 113%, using data through March 2022.

But these returns came as the craze for “meme stocks” made takeovers easy: Between 2015 and 2020, three quarters of the capital committed by sponsors turned into company equity, according to SPAC Research. As everyone has now discovered, getting a deal approved becomes near-impossible when markets turn. Of the $5.8 billion raised this year and last, $5 billion has either already been liquidated or is in peril. The clock now is ticking even louder than usual because, from 2023, reimbursing investors will involve an extra tax.

For sponsors, liquidation means putting a match to between $6 million and $9 million—the cost of listing a SPAC. Also, many who happily closed inflated deals in 2020 and 2021 are now suffering, because they usually aren’t allowed to cash out for at least a year after completion. They initially appeared to benefit handsomely, but it is now clear this was in exchange for taking big risks.

Who did reap the gains, then? For one, the companies getting overvalued. Mostly, though, it was those investors who held shares between the SPAC’s listing and merger, who made annualized returns of 23.9% for little risk. As an earlier paper shows, virtually all initial SPAC investors, mostly hedge funds, leave by the time deals close.

“You basically need to re-raise all of the money at the time of the merger, so what’s the point of raising it initially?” said one of its authors, NYU School of Law Professor Michael Ohlrogge. “You subject sponsors to needless risk.”

Hedge funds get free warrants at the listing, which through last year gave them post-merger one-year returns of 72.2% on top of their existing share-price gains, diluting long-term shareholders. Many also have taken to buying undervalued SPACs and redeeming the shares for an easy buck.

SPACs could be reformed. London’s nascent market hopes to prove they can help forge long-term partnerships between sponsors and firms. Hedge-fund guru

Bill Ackman

is promoting a new type of vehicle designed for investors to opt in only after a target has been found. Some, such as RA Capital Management, suggest adapting IPOs to incorporate some of the advantages of SPACs, such as greater upfront share-price certainty.

As they are, however, SPACs only seem to serve speculators, not the venture capitalists talent-spotting entrepreneurs nor the long-term investors buying into companies. Perhaps the clock should run out on them for good.

Write to Jon Sindreu at jon.sindreu@wsj.com