One of the hottest topics across global asset management throughout the pandemic period has been the noticeable increase in special purpose acquisition companies, better known as SPACs. SPACs have existed in the United States since the early 2000s, but they have enjoyed a resurgence in popularity recently, and in spite of a slight cooling of SPAC launches they remain one of the most discussed trends across the market. Here we take a whistle-stop tour through the various aspects of the rise of the SPAC.
What is a SPAC?
A special purpose acquisition vehicle (SPAC) (also referred to as a ‘blank cheque company’) is a company with no trading operations which is instead established for the sole purpose of raising capital to finance the purchase of another company. SPACs normally list on an exchange and raise proceeds through an initial public offering (IPO) of its shares. The listed SPAC subsequently seeks to identify a target investment and execute a reverse takeover of the target, which is normally an unlisted private company.
Unique to SPACs is the fact they only identify the potential acquisition target after investors have already committed capital. SPACs offer investors an alternative to the traditional initial public offer process, which is usually underwritten by an investment bank and largely allocates shares to institutional investors. Since the SPAC is already listed it allows a company to go public through the reverse merger and allow a wider range of investors to participate in the transaction, particularly retail investors.
Normally SPACs have a window of between 18 and 24 months to identify a target company to acquire or else they engage with their shareholder to request more time or hand back the capital raised if unable to execute a transaction. In essence SPACs propose to take a company public quicker and cheaper than traditional IPO by cutting out some red tape and also purport to bring greater deal certainty through a mixture of the pre funding and reverse merger (De-SPAC) transaction, which means a listed entity already exists on exchange.
SPACs will also typically issue warrants to the SPAC sponsor and other investors exercisable after the completion of the acquisition transaction – this adds a certain element of deal complexity, particularly to retail investors who might be more familiar with trading listed equity shares.
A passing fad or here to stay?
As with any novel financial innovation, it’s hard to know if SPACs will endure or represent a point-in-time trend. However, the numbers in the past two or three years tell a story. In 2019, 59 SPACs hit the market. That number leapt to 248 SPACs launched in 2020. This SPAC renaissance began in the U.S. but, like many things before, SPACs are now in vogue elsewhere around the globe.
Beyond regulatory scrutiny, there are those in the market who feel that SPACs’ primary value proposition is merely to structure themselves to ease the governance and due diligence regime put around the IPO or traditional buy out. This “governance arbitrage” might mean that the appropriate transparency, due diligence rigor and even valuation modelling for SPACs might not be as complete as for traditional IPO or buy-out markets.
Its supporters remain vocal that SPACs remain a viable and more flexible alternative to the rigid traditional IPO process to take a private company public. They also cite the appetite and participation rates of retail investors as indicative that this is the type of early stage exposure many investors want to have exposure to.
What makes SPACs so popular?
The main attraction of SPACs is that the “reverse merger” mechanism avoids many of the costs and complications of the tradition IPO and listing processes. With less complexity, it is suggested that SPACs reduce both the time and costs of acquisitions and bringing private companies public. They are also credited with allowing increased participation in private company acquisitions which would normally be reserved for large institutions or other wealthy professional investors. They diversify the sources of funding for companies looking to go public away from large private equity or investment banks to allow for a wider range of retail investors to participate earlier in a company’s growth cycle. They are part of a general evident trend of increased democratization of private markets that is occurring globally.
From the company perspective, SPAC sponsorship purports to be a less risky method of going public than traditional IPOs. With liquidity in debt markets falling and equity market volatility increasing, IPO markets are less certain than perhaps they once were. Instead of relying on the sale of equity to the public, a SPAC creates an upfront cash reserve that is ringfenced in escrow.
This SPAC war chest can then only be used to buy a company per the terms set out when the SPAC is first founded. The wide terms contained in SPAC term sheets often allows them great freedom to target larger buyouts and/or cutting-edge companies that might have a hard time accessing funding in traditional markets with the prevailing market environment.
The popularity and rapid growth of SPACs, twinned with the fact that they often target retail investors to invest in more esoteric asset types, has resulted in regulators across the globe taking an interest.
What are regulators doing?
United States: SEC
The U.S. is the birthplace and by a distance the largest SPAC market in the world. It also remains the most vibrant SPAC market in terms of retail participation and deal volumes. Initially, the Securities and Exchange Commission (SEC) remained circumspect but, this year, the size of the market and some high-profile instances have resulted in the SEC taking a more active role in SPAC assessments.
At the beginning of 2021, the SEC intervened in a SPAC deal involving Momentus (a space exploration company) and Stable Road SPAC. The investigation focused primarily on the stated revenue projections of Momentus, who claimed they would have more than $4 billion revenues in 2027 from space vehicle sales and other outer worldly streams, this despite negligible current revenues and the technology they proposed to sell not having been built yet.
Then, on July 13, the SEC announced a partially settled enforcement action against this SPAC, its sponsor, and a number of individuals including the CEO involved in the deal for misstatements in a registration statement and amendments concerning the target’s technology and business risks. This SEC action is notable because the allegations against the SPAC, its sponsor and its CEO are alleged negligent deficiency in their due diligence processes, which failed to highlight certain misrepresentations by the target and its former CEO.
This action has important implications for SPACs more broadly since it shows that the SEC are on the look out for appropriate levels of transparency and robust pre transaction due diligence protocols, like what would be expected from a traditional IPO deal or merger.
The SEC action might have a chilling effect on the SPAC market as the risk of misstatement or overly optimistic projections to investors is now very real. The SEC are urging sponsors who are hunting SPAC acquisition to slow down and ensure the appropriate level of attention to detail in their due diligence is conducted, and the risks as well as the benefits are adequately disclosed to potential investors and to the SEC on such transactions. The question that remains is whether the SEC will be compelled to go further and draft more specific SPAC laws in terms of disclosure requirements or more robust independent verification of financial projections.
ESMA addressed SPACs head on in July and their focus was very much on investor protection mechanisms in the form of prospectus disclosures. ESMA asked national competent authorities to ensure adequate review of SPAC prospectuses and also that the MIFID II product governance rules were met at all times in terms of eligibility and suitability criteria for the distribution of SPAC offerings to retail investors in particular.
ESMA also drew attention to the inherent complexity of a SPAC and the manner in which deals are structured as a mix of equity shares and warrants. They said levels of participation for retail investors might not be fully understood, so SPAC manufacturers and distributors must always consider whether retail investors should be included or excluded from their target market for MIFID II purposes.
If retail investors are included then the disclosure of the SPAC deal terms must be sufficient to allow for retail investors to understand a long list of risks including:
- Possible share dilution
- Funding structures
- Offer price transparency
- Information on related party transactions conflicts of interests
- Information about major shareholders.
United Kingdom: FCA
One of the policy areas that the post-Brexit UK has targeted is increasing listing activity on the London Stock Exchange generally. Within this overarching review, the FCA also consulted on proposals to change the UK Listing Rules to remove the requirement to suspend trading of a SPAC when it has identified a target company to acquire.
Interestingly, the UK listing rules were said to be explicitly unfavorable to SPACs and resulted in no UK SPAC vehicles raising more than $75 million being listed in the UK in 2020, while significant growth occurred elsewhere. A policy to attract this business was put in place by UK lawmakers. Published in July, these listing rule amendments came into effect on August 10, and apply so long as the SPAC meets certain investor-protection conditions including:
- A size threshold
- Proof of ringfenced cash for the acquisition held with an independent third party
- A strict time limit has been legally imposed for conclusion of the acquisition
- The board of directors and shareholders must also each approve the acquisition transaction.
The SPAC must also include a ‘redemption’ option allowing investors to exit a SPAC prior to any acquisition being completed, so investors are not “locked into” commitments to an investment that they do not wish to participate in. This commitment element might be challenging practically should many investors change their minds when advised of the ultimate target company acquisition.
The past couple of years have taught us not to speculate too much with certainty, but it does seem like SPACs continue to attract investor interest and there are sponsors who see them as a good way to take attractive private companies to the public markets quickly and efficiently.
There also appears to be a resilient retail distribution market keen to continue to invest in SPAC transactions.
If SPAC growth continues then it also follows that regulators will continue to keep an eye on them and possibly look to intervene specific to certain deals which harm investors by means of regulatory enforcement actions, or more broadly by framing SPAC specific rules at some point. What is certain is that rise of the SPAC doesn’t appear to be yielding and we will be discussing them for some time to come.
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