Last year was a record one for special-purpose acquisition company (SPAC) IPOs. But that record was broken in just the first quarter of 2021, with 298 SPAC IPOs raking in $87 billion. But the days of easy money in the SPAC game may be behind us as hundreds of SPACs are in the hunt for “unicorn” companies that can absorb the average of over $300 million that they hold in trust. Tellingly, in the second quarter of this year, only 46 SPAC IPOs have priced, raising $8.8 billion.
After many pre-announcement SPACs enjoyed massive runs in January and February 2021, valuations came crashing back to earth. According to Renaissance Capital, the average SPAC IPO returned less than 1% this year, versus a 17.3% return for non-SPAC U.S. IPOs. That is how the SPAC market is supposed to work, with pre-announcement deals trading essentially at the value of cash held in trust.
After the merger announcement, SPAC deals should trade at a premium to trust if investors believe that the asset is worth more than the cash for which they could redeem their shares. Conversely, the shares will trade at a discount if investors perceive the deal as a loser and holders are waiting out the clock to redeem.
With the vast volume of SPAC mergers that will be coming to market over the next two years, SPAC sponsor teams and target management should be on notice: The bar has been raised. Regulators are casting a jaundiced eye at every deal announcement and S-4 filing. Private investment in public equity (PiPE) investors are much more selective in funding deals and asking for more onerous terms. And short-sellers are circling in the waters of over-hyped de-SPACs, waiting to attack.
SEC Short-Circuits Filings
The Securities and Exchange Commission has expressed a range of concerns about the potential for SPAC insiders to take advantage of poorly informed retail investors and issued a series of bulletins and investor alerts, most recently on May 25. It detailed concerns including:
- Investors may not understand the basics of how SPACs work and, therefore, may make irrational choices with no relation to valuation or capital structure.
- SPAC sponsors may have an incentive to merge with companies unlikely to generate positive returns post-merger as the clock runs out on their deals.
- The sheer volume of funded SPACs may lead to a shortage of viable targets of sufficient scale to absorb the capital these SPAC teams have raised or cause SPACs to overpay for the limited number of viable targets.
The SEC essentially succeeded in shutting down the SPAC IPO market for several months when the SEC Acting Chief Accountant, Paul Munter, adopted the novel accounting theory that many warrants issued by SPACs should be treated as liabilities, rather than equity, in a public statement on April 12. As a result, the SEC required public SPACs to employ mark-to-market accounting on these warrants, restate all their interim financial statements, and in some cases disclose that they were subject to potential delisting. While the non-cash charges associated with these restatements are a non-event for most investors, the action threw sand into the gears of an already overtaxed professional services machine working with SPACs.
Proposals to strip SPACs of the safe harbor for forward-looking statements afforded to mergers by operating companies under U.S. securities laws represent a much more severe threat to the viability of the SPAC program. On April 8, John Coates, acting director of the SEC’s corporate finance division, issued a public statement questioning whether the safe harbor was available to SPAC merger transactions. He also clarified that the SEC would be stepping up its scrutiny of all projections and valuations provided to public investors.
“A company in possession of multiple sets of projections that are based on reasonable assumptions, reflecting different scenarios of how the company’s future may unfold, would be on shaky ground if it only disclosed favorable projections and omitted disclosure of equally reliable but unfavorable projections, regardless of the liability framework later used by courts to assess the disclosures,” Coates said.
Companies can expect their projections to be much more carefully scrubbed by sponsors and PIPE funds and draw probing comments from SEC examiners to understand the assumptions behind them and assess whether they are reasonable.
Charlie Munger famously said, “Show me the incentives, and I will show you the outcome.”
The SEC’s quandary is trying to solve a problem of incentives with a toolkit consisting exclusively of disclosure and enforcement actions. Disclosure is, frankly, ineffective in addressing misalignment of incentives since the investors most likely to be fleeced frankly do not read the disclosures. Enforcement is, by definition, an after-the-fact solution of trying to put the yolks back in the broken eggs.
With SPACs, three groups have economic incentives that may diverge from those of public market investors.
First, SPAC sponsors have a very low, if not de minimis, cost basis in their 20% promote shares and cheap warrants. From the sponsor’s perspective, almost any deal is better than no deal. In the case of no merger, the sponsor team loses their initial investment, and they have wasted the two years invested in hunting for a target. On the other hand, sponsors can still book a hefty profit if the SPAC merges with a mediocre company and the stock trades off by 25% or 50%.
Second, target management may face pressure to provide the market with unrealistic projections to attract PIPE investors in the first instance and then promote the deal in the public markets once announced. We have seen over the past year several cases in which projections and backlog figures provided by SPAC targets ranged from abusive to outright fraudulent.
Third, investment banks defer a hefty portion of their fees until the merger closes but get paid even if most SPAC shares redeem for cash. That provides them with a clear incentive to push through a low-quality deal rather than have the deal fail to close and miss out on a big chunk of their fees.
Sponsors — who are being compensated for their ability to source, diligence, and counsel an outstanding target company — should be subject to lockups to common shares and warrant shares.
Some reasonably straightforward solutions could better align the interests of these players with those of public shareholders. While outside of the remit of the SEC, they could be commercially negotiated to create a more equitable sharing of the potential spoils from investing in a high-growth, disruptive company.
Sponsors — who are being compensated for their ability to source, diligence, and counsel an outstanding target company — should be subject to lockups to common shares and warrant shares. These could be time-based, with limitations coming off in tranches during the first three years the company is public. Or they could be price-based, where shares become free-trading when specific price targets are achieved. The latter’s advantage is that the resulting selling may tend to cool unstainable investor enthusiasm and reduce volatility in the stock. The recently announced merger between Khosla Ventures and Valo Health featured a 12-month lockup, as one example. A shorter partial lockup for PIPE funds may also be appropriate, similar to venture capitalists in an IPO. This moderates selling pressure in the first two quarters after the de-SPAC and enables an orderly trading market to emerge.
Sponsors and underwriters that source a deal where shareholders approve the merger but the vast majority of cash in trust redeems should be subject to some form of pro-rata ratchet based on the permanent capital that is raised and not the “headline number” that usually assumes the full conversion of trust funds into common shares. Placing sponsors and underwriters at risk would create incentives to source better deals, negotiate valuations with some potential upside for public investors, and effectively market the deal to long-biased institutions.
The worst-case for public shareholders is when an underprepared company stumbles on its critical milestones out of the gate, and sponsors and PIPE investors are raining stock down on the market in a race to get out. Conversely, that is a dream scenario for a short seller, which is why SPAC mergers have become such a happy hunting ground for Hindenburg Research, Muddy Waters, Wolfpack, and others.
Upgrading Merger Disclosures
The tremendous competitive advantage the SPACs enjoy over traditional IPOs is time-to-market. Once the parties reach a definitive agreement, a SPAC merger can be closed in as little as three months, compared with nine to twelve months for an IPO.
But the short timeframe should not be viewed as a license to give due diligence and disclosure short shrift. SPACs provide sponsors with the opportunity to generate significant personal wealth precisely because of their supposedly superior industry insights and relationships and ability to do deep due diligence to pick industry disruptors that will rise to the top of the pack.
Both sponsors and target management have the responsibility to disclose all information relevant to an investor’s decision to invest in that company. Too often, SPAC disclosure documents have been viewed solely from the marketing lens, and sponsors have been tempted to engage in highly promotional language more closely resembling a penny stock promotion than an IPO.
Now that the SEC is carefully scrutinizing every filing and directors’ and officers’ insurance carriers are placing exclusions into coverage, SPAC teams need to raise disclosure quality in an S-4 to match a traditional IPO S-1 registration statement.
Protection from Shorts
High quality is the best protection from becoming the next target of a short-seller campaign that can permanently damage a public company. Carson Block of Muddy Waters Research recently said the firm looks for two things in a juicy SPAC target. First, “lies of commission,” where companies provide information to the market that just ain’t so. Second, “lies of omission” where there is information that investors would undoubtedly consider material — about flaws in the product, the background of management, soured customer relationships, emerging competitors — that is swept under the rug and not disclosed.
As these hundreds of SPAC mergers come out of the de-SPAC process, management can expect shorts to evaluate every deal as a short candidate. Therefore, beyond accurate disclosure, companies need to be fully prepared for life as a public company with robust governance practices, mature internal controls, and excellent investor communications capabilities.
The Promise Realized
The SPAC vehicle promises to make public markets more democratic. SPACs potentially provide ordinary investors access to hyper-growth, disruptive companies that otherwise would be the exclusive preserve of venture and private equity funds and their well-heeled limited partners.
It has also enabled companies to provide long-range forecasts on how they expect their business to develop and generate economic returns. Such direct disclosure is fundamentally more transparent than the “whisper game” of IPOs where sell-side analyst constructs forecasts based on private conversations with management that they share in turn with favored institutional clients.
SPACs have nearly single-handedly revived the pace of public company formation in the United States after decades of decline. However, supposed market participants don’t work together to implement market-based solutions that address some of the flaws and abuses. In that case, there is a high probability of the SEC or Congress stepping in with onerous regulations that throttle vibrant markets. By raising the bar for market practices, SPAC participants can ensure that this golden goose continues to lay for decades to come.