A special purpose acquisition company (SPAC), also known as a “blank check” company, raises financing via an initial public offering to merge with a private target and take it public. Although SPAC deals are hugely popular, their performance is mixed. Thanks to HKUST’s Martin Szydlowski and a co-researcher, investors now have much-needed guidance for investing in SPACs and policymakers have a benchmark for developing related interventions.

“The recent popularity of SPACs is puzzling,” say the authors, “given the complexity of these transactions and their mixed performance across different investor classes.” To find out why long-term investors continue to buy and hold shares in SPACs despite earning negative returns on average, they propose a theoretical model of SPAC deals that highlights the potential to exploit investors’ overconfidence.

“Consistent with empirical evidence,” the researchers report, “the model predicts different returns for short-term and long-term investors and overall underperformance.” It suggests that SPAC sponsors derive returns from overconfident investors who expect to redeem their shares at the right time but do not in fact do so, causing them to overpay and allowing sponsors to finance deals that hurt long-term investors.

As well as explaining previously documented practices, the authors’ model yields several new predictions. For example, smaller SPAC transactions are associated with more unsophisticated investors, higher overpricing, and lower returns for buy-and-hold investors. In addition, SPAC transactions with riskier targets are linked with more rights per unit and more negative buy-and-hold returns.

“We also are able to characterize the impact of potential policy interventions,” the authors add. “While some policy interventions (e.g., eliminating redemption rights, limiting investor access, and restricting warrants) improve returns for unsophisticated investors, others (e.g., increased disclosure) can be counterproductive.” These findings will benefit long-term investors, who are most vulnerable to overconfidence traps in SPAC deals, and policymakers developing interventions to protect them.