HKUST Business Review

attract overconfident investors, who overpay for SPAC shares and in turn, on average, end up realizing losses. The sponsor of a SPAC deal is incentivized to close a deal even if doing so is not beneficial for investors, since their large equity stake can only be sold when an acquisition is completed. Early-stage institutional players tend to act rationally, and as a result, they often sell their shares before the merger goes through. But a significant fraction of investors are retail investors: everyday people who might be lured in by hype, a celebrity sponsor, or a compelling story about a “moonshot” target. These investors tend to hold onto their shares for too long, even if the acquisition is unlikely to be profitable. In my paper, my coauthor and I argue that this behavior is due to a specific form of overconfidence: The redemption right leads investors to think, “If the deal is bad, I’ll be savvy enough to get out.” The warrants seem to only offer extra upside. Yet, when the time comes to make a decision, these investors often fail to act. They are swayed by optimistic projections, they don’t fully grasp how their shares are being diluted, or they just don’t pay close enough attention to dense merger documents to recognize when they would benefit from jumping ship. Instead, they hold on, waiting for a payout that is unlikely to materialize. This dynamic results in a transfer of profits from retail investors to SPAC sponsors and institutional investors. Overconfident investors essentially overvalue the warrants and redemption options that they are unlikely to use, making them willing to pay more per share than the “fair” rational value. This direct subsidy flows to the sponsor, to the target company (which may get a higher valuation than it deserves), and to the sophisticated investors who profit from redeeming their shares or exercising their warrants. In the near term, this means that a few sponsors and institutional investors benefit at the cost of a larger group of less-sophisticated investors. But in the longer term, it also drives market distortions which lead to overinvestment in SPACs and many unprofitable acquisitions. Short-Term Divergence in Returns By exploiting their redemption options and the overvaluation of warrants, institutional SPAC investors consistently earn positive, low risk returns. Unsophisticated buy-and-hold investors, on the other hand, are left holding diluted shares in companies whose prices were inflated by their own initial overconfidence. When the hype fades and the reality of the business sets in, the share price tends to fall, leading to negative returns. Long-Term Market Distortions Beyond the losses sustained by unsophisticated investors, SPACs also end up distorting markets by funding riskier, “moonshot” projects like pre- revenue electric vehicle companies or conceptual tech platforms. This is because SPACs aren’t subject to the same rigorous disclosure requirements as companies pursuing traditional IPOs, meaning that they can present extremely optimistic projections that draw in overconfident investors. As a result, objectively unprofitable projects end up getting funded instead of ones that are more likely to succeed long-term. The subsidy of overconfident investors means that these acquisitions are likely to pay off for the sponsor and the target, even if they lose money for long- term public shareholders. Conversely, a solid but “boring” company may not attract investment from SPACs because its lack of volatility makes using redemption rights and warrants unattractive. The SPAC Lifecycle SPAC Offering Search for Target Exit Sponsor forms SPAC, raises funds via IPO. Investors receive units (stock + warrant) SPAC seeks target company to merge with, negotiates deal, secures PIPE financing and obtains shareholder approval If merger closes, private company becomes public. Otherwise, SPAC liquidates. 35 HKUST Business Review