The special sauce that’s flavored blank-check firms has become potential poison. It’s time to reform their financial incentives. 

Last month, Atlas Crest Investment Corp., a blank-check firm created by investment banker Ken Moelis, spectacularly lopped $1 billion off the enterprise value off its $2.7 billion deal with flying taxi company Archer Aviation. Several factors contributed to this reset, including an intellectual property dispute with a rival and the fact Archer has yet to finish developing a fully operational prototype or agree to certification requirements with regulators, according to this filing.

Notably Atlas also cited the general turbulence in the market for special purpose acquisitions companies, specifically how many SPACs are trading under the value of their cash holdings – typically $10 a share – and the increase in what are called redemptions. That is, more investors are asking for their money back rather than funding SPAC mergers. 

The two things are closely related. If SPAC shares fall below $10 it makes financial sense for shareholders to redeem their holdings for cash rather than fund the merger. Atlas Crest’s stock itself was languishing below $10 at the time, like the majority of SPACS that have announced but not yet completed deals. Cutting the deal value might help prevent significant redemptions by persuading stockholders they’re getting a better deal.

This redemption right was the secret sauce behind the boom in SPACs, which raise cash in an initial public offering before finding a promising private firm with which to combine. Investors’ ability to claw-back cash from a SPAC deal they don’t like made hedge funds feel comfortable seeding blank-check firms with billions of dollars of capital. In effect, the hedge funds can’t lose, providing they redeem in time.

Now that investor enthusiasm for blank-check firms has evaporated amid heightened regulatory attention and some high profile flops, the secret sauce has become a potential poison. According to Spacresearch.com data I analyzed, the median redemption rate for North American SPAC deals completed in July was almost 50%. In several recent deals, more than 90% of shares were redeemed. 

Redemptions deprive the target of cash to help fund development and expansion plans; they can also signal — perhaps unfairly — that shareholders aren’t excited about the merger, which is a poor way to start out as a public company. Post-merger trading involving such companies has often been especially volatile as there are fewer shares available. 

If redemptions continue to pile up, this will also undermine the notion that SPACs are a more predictable way of going public than a regular IPO. A target often has no idea how much money it’ll receive until the deal closes. Right now it’s often a lot less than it was hoping for.

The problem stems from a couple of unique aspects of SPACs. First, investors can vote in favor of a deal yet still demand their money back. So a deal can proceed even though a majority of stockholders aren’t prepared to financially support it.

Second, the risk-averse arbitrage hedge funds who buy SPAC shares at the time of the initial IPO often have no intention of funding it past merger completion — they either sell if the stock is above $10, or they redeem. It requires careful marketing of the deal to replace them with more long-term orientated stockholders. Many SPACs sponsors are flunking that test.

Some SPAC sponsors, such as Moelis’s Atlas Crest, are trying to get ahead of the problem by re-pricing richly valued deals with the aim of boosting the share price and limiting redemptions. The Archer Aviation deal has yet to close and because it continues to trade a fraction below $10, redemptions remain a risk.  Flying taxi rival Joby Aviation Inc. saw over 60% of SPAC shareholders redeem upon its merger with Reinvent Technology Partners earlier this month, representing more than $400 million in foregone cash.

A more enduring solution would be to tie more sponsor compensation to the the amount of cash they end up bringing to the deal, says Julian Klymochko, chief executive officer of Accelerate Financial Technologies Inc., which manages a SPAC-focused ETF. This would incentivize SPAC owners to strike more competitively-priced deals in the first place. “I imagine we’d see higher quality deals,” he says. 

It’s not always a disaster if all the expected money doesn’t come in. More mature companies that go public via a SPAC often aren’t looking for much additional money. Most blank-check firms also raise a separate pot of institutional money, known as a PIPE, which ensures at least some cash is delivered to the merged entity.  

Archer believes it can fund its development up till 2024 with $570 million, an amount covered by its $600 million PIPE. Joby still has $1.6 billion to play with, including a PIPE and existing cash.

But in cases when redemptions are high, the transaction expenses and dilution borne by the shareholders who do elect to participate in the deal are proportionately higher. Underwriting fees are typically 5.5% of the money the SPAC raises. However, these costs usually aren’t lowered to reflect the amount of cash that’s left in the SPAC’s bank account.

Inflated underwriting fees are one reason why hedge fund billionaire Bill Ackman suggests not raising any money at all until a target has been identified. Ackman calls this model a SPARC — a special purpose acquisition rights company. He also proposed providing regular SPAC shareholders a financial incentive to fund the merger rather than redeem. He was denied the opportunity to test all this out when the Securities and Exchange Commission raised objections to Pershing Square Tontine Holdings Ltd.’s recent attempt to buy a stake in Universal Music Group.

Though sponsors are increasingly having to offer concessions — for example, by linking some of their compensation to post-merger share price performance — there usually aren’t adjustments to their pay for failing to deliver the cash they promised. Typically they receive 20% of the blank check firm shares for free, meaning they can make money even when other shareholders don’t.

Hopefully, Atlas’s price cut will encourage others to reprice their own richly valued deals and curb the cash draining out of SPACs. Otherwise expect hedge funds to keep demanding their money back.

1. SPACs vary widely in how such information is disclosed. Good practice is to publish this with merger voting results, but instead it’s often buried in later financial filings. Investors need to know just how much of the SPAC’s cash has disappeared.
2. Voting against the deal is self-defeating because hedge funds would risk losing potentially valuable share warrants that SPACs hand out to persuade them to park their cash for up to two years. Previously,the vote and redemption right were connected, but that led to big problems getting deals approved.
3. Targets often specify a minimum level of cash must be delivered in the deal. Even when not met, the requirement is often waived by the target. Participants are probably reluctant to see a merger fail after months of work. See here for an interesting discussion of these waivers.
4. Typically 2% is paid to underwriters up front, which is covered by the sale of sponsor warrants, and another 3.5% on closing. See this paperby Michael Klausner and Michael Ohlrogge for a discussion of these and other costs