In 2020, the U.S. stock market situation went through a series of unexpected twists and turns as Covid-19 shook the economy and the Federal Reserve poured record amounts of resources toward propping up stock prices and making borrowing easier for companies and consumers alike. This resulted in a bull market for stocks despite the worsening economic crisis, and the Fed plans to maintain its dovish policy even as the economy recovers, repeatedly stating that it will allow interest rates to "moderately surpass" 2% for "some time."
This has resulted in attractive yields being rather difficult to find outside of the large-cap mainstream equities that are benefitting from government support. All things considered, it is no surprise that yield-starved investors have increasingly turned their attention to companies that are going public for the first time – or that companies looking to go public are wanting to do so in a way that dodges regulatory scrutiny as much as possible.
Enter special purpose acquisition companies, or SPACs. These blank-check companies, which have no operations of their own, raise capital from investors for the purpose of making an as-yet-undecided acquisition. Upon a successful acquisition, the SPAC investors become the shareholders of the new company, and the company avoids the stricter regulatory scrutiny involved with the traditional initial public offering process.
However, after the SPAC craze that started in 2020 went into overdrive in the first quarter of 2021, the U.S. Securities and Exchanges Commission seems to be turning its attention on this newly popular investment vehicle, and new SPAC issuances have slowed in response. Given the possibility of SPACs seeing stricter regulation, could they retain their popularity, or will the craze fade once again in favor of traditional IPOs?
A brief intro to SPACs
For those who are not familiar with how SPACs work, things typically go like this: the founders of the group raise funds on the open market to bankroll an as-yet-unspecified acquisition. The founders typically (but not always) have a history of negotiating successful acquisitions. If enough investors sign on for the deal, the SPAC goes public in an IPO that is typically priced at around $10 per unit. Each unit normally consists of one stock plus one warrant that is exercisable at $11.50. The SPAC puts the money in a trust account and lets it accumulate interest until the founders manage to secure an acquisition deal.
Next, the founders present the idea to their shareholders, who can then vote whether they want to approve the deal or redeem their stock to get their $10 per unit back, plus any interest accumulated. If enough shareholders vote for the deal, then the acquisition goes through and the SPAC becomes a normal publicly traded company under the acquisition's name. If it fails, then all of the shareholders get their money back.
Despite the reputation that SPACs have gained in recent years as relatively "safe" investments, they have a poor record of providing returns. Of the 107 companies that went public via SPAC between 2015 and 2019, the average "return" was a loss of 1.4%. However, the guaranteed purchase price that a company gets when it agrees to a reverse-merger with an SPAC, combined with the relative freedom from regulatory scrutiny, have recently caused SPACs to explode in popularity, with 248 SPAC IPOs being recorded in 2020. The pace picked up even more in the first quarter of 2021 with nearly 300 SPAC IPOs.
Clashing interests
The SEC's newfound concerns with SPACs stem mainly from the dramatic difference between the skyrocketing growth that these vehicles typically promise investors versus the mediocre (often nonexistent) profits that they end up delivering.
"We have seen more and more evidence on the risk side of the equation for SPACs as we see studies showing that their performance for most investors doesn't match the hype," said outgoing Acting Chair Allison Herren Lee in a recent note.
The main problem with SPACs, and the reason for their lackluster shareholder returns, is that the interests of the SPAC managers and the company being acquired do not line up at all with the interests of the investors providing the capital. If the SPAC managers can't make an acquisition, the entire profit of their venture will be nothing. Thus, they are ultimately incentivized to make an acquisition at any cost, often over-paying in order to seal the deal, which means the SPAC's investors start out holding overvalued shares from the start.
"Concerns [with SPACs] include risks from fees, conflicts, and sponsor compensation, from celebrity sponsorship and the potential for retail participation drawn by baseless hype, and the sheer amount of capital pouring into the SPACs," wrote John Coates, acting director of the Division of Corporation Finance, in early April.
Additionally, a company that is acquired by a SPAC has every reason to hype itself as much as possible in order to negotiate a favorable acquisition price and get the SPAC's shareholders to agree to the deal. Such companies may often feel comfortable making unsupported predictions on their future revenue based on the assumption that they are not under as much scrutiny as they would be during a traditional IPO. Compared to traditional IPOs, whose registration statements almost never include revenue projections, SPACs are far more likely to do so. On this topic, Coates wrote:
"I would like to focus on legal liability that attaches to disclosures in the de-SPAC transaction. Some – but far from all – practitioners and commentators have claimed that an advantage of SPACs over traditional IPOs is lesser securities law liability exposure for targets and the public company itself. They sometimes specifically point to the Private Securities Litigation Reform Act (PSLRA) safe harbor for forward-looking statements, and suggest or assert that the safe harbor applies in the context of de-SPAC transactions but not in conventional IPOs. This, such observers assert, is the reason that sponsors, targets, and others involved in a de-SPAC feel comfortable presenting projections and other valuation material of a kind that is not commonly found in conventional IPO prospectuses."
Increasing regulatory attention
After the SEC's relative quietness in regards to SPACs during 2020, in which it mainly focused simply on making shareholders aware of the risks associated with the clash of interests between SPAC managers and shareholders, the regulator's rhetoric on the topic has become more pointed in recent months.
Coates called into question whether PSLRA safe harbor provision for forward-looking statements applies to de-SPAC mergers, pointing "towards a conclusion that the PSLRA should not be available for any unknown private company introducing itself to the public markets." Given that many SPACs have relied on the PSLRA as their crutch to avoid regulatory scrutiny, these statements may signal that the SPAC block party could come to an end soon.
In another April statement, the SEC's Division of Corporation Finance and the Office of the Chief Accountant issued a statement regarding accounting for warrants issued by SPACs, in which they asserted that some warrants should be classified as liabilities rather than equities or assets because the warrants were not indexed to the issuer's stock. According to the statement, a tender offer provision, which is included as a term the warrants issued by many SPACs, required warrants to be treated as liabilities. The statement even went a step further by cautioning that registrants and their auditors should review any potential errors in accounting for warrants and take corrective measures if necessary.
Although the above statements were issued as part of the staff's reviews and do not necessarily indicate that the SEC will take steps to ensure compliance with the views contained within, they do indicate that the SEC is viewing the SPAC market with increased skepticism, and that it could take regulatory action in the future if it believes such action is necessary.
Conclusion
The possibility of increased regulatory scrutiny on SPACs may have slowed down the flood of these vehicles, but that does not necessarily mean the SPAC frenzy will come to an end. While the statements issued by the SEC have many going back to revisit their accounting policies and ensure they can feasibly back up their revenue projections, increased regulation might not necessarily make SPACs less attractive than conventional IPOs for many companies.
If it was only less regulation that appealed to companies over traditional IPOs, then it seems unlikely that SPACs would have only recently seen a spike in popularity. Even if the SEC does crack down on SPAC liability issues, some companies looking to go public might still prefer the guaranteed purchase price of this type of vehicle in an uncertain market. This is especially true for companies that pose a high risk in terms of investment, such as biotechs, which could go on to create a blockbuster drug end up falling flat and never developing a profitable product.
One other important factor to consider is the timing of the SPAC boom. It's no coincidence that it began around the same time as the Covid-19 pandemic and the resulting economic crisis. Regardless of whether or not the SEC steps in with increased regulations, when we consider that increased economic risks helped make SPACs more attractive than traditional IPOs, it seems safe to assume that the number of SPACs might decrease again as the economy improves.
Read more here:
- Intel's 1st-Quarter Earnings Beat Expectations as Company Works Toward Revival
- Chipotle: Spotlight on Digital as Online Orders Surpass In-Store Sales
- Lithia Motors Posts Record-Setting Quarter
Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.
