Some calamitous deals have highlighted the risks posed by special-purpose acquisition companies. This has prompted US and UK regulators to put these increasingly popular investment vehicles under the microscope
What’s a popular source of finance and one of the hottest ways for a business to go public, yet can also lead to a disastrous M&A deal? The answer is a special-purpose acquisition company (SPAC).
A private business that achieves a stock-market listing by being acquired by a SPAC – a publicly traded shell company designed specifically for the task – can sidestep several of the stricter regulatory checks that would apply if it were to go down the traditional IPO route.
Last year in the US, 248 SPACs obtained stock-market listings, raising $83.4bn (£60.1bn) in total. In the first six months of this year alone, there were 361 SPAC flotations, which raised $111.2bn.
The market was put on ice earlier this year under mounting scrutiny from the US Securities and Exchange Commission (SEC), which remains concerned that SPAC investments are causing an equity bubble. Despite this, activity seems to be heating up again. The three months to the end of June 2021 were a record-breaking second quarter for SPAC flotations worldwide. Deals worth $1.5tn were announced – up 13% from Q1, which had also been a record quarter.
The SPAC listing frenzy is expected to continue over the summer. But high levels of activity heighten the likelihood that riskier transactions will occur. Indeed, there have been some damaging SPAC deals recently. Two cases, both in the US, stand out.
Last September, Nikola, a manufacturer of electric lorries, was accused of deceiving investors by exaggerating the capabilities of its technology. The claims led to the founder’s resignation less than four months after a $3.3bn SPAC deal had enabled Nikola to start trading on the Nasdaq.
At another automotive startup, Lordstown Motors, accusations of inflated revenue projections in early 2021 led to the resignations of its CEO and CFO in June. Federal prosecutors are investigating the company, whose $1.6bn SPAC deal went through at the end of October 2020.
The share prices of both Nikola and Lordstown Motors have fallen sharply, bruising retail investors in particular. It’s clear from these cases why the SEC wants to subject SPACs to greater scrutiny, according to Kathleen Harris, managing partner at the London office of US law firm Arnold & Porter.
“There certainly are questions surrounding whether retail investors understand the risks of investing in SPACs,” she says. “Part of the attraction of a SPAC to investors is that they aren’t having to pick a new company to invest in or do the due diligence. Instead, they’re leaving those jobs to the SPAC’s team.”
This isn’t to say that the SPAC teams behind deals that go wrong are failing in their due diligence. But the nature of the SPAC structure means that their team members (known as sponsors) aren’t likely to lose out if that happens. It’s often their small investors who are disproportionately affected.
“Sponsors can still make a hefty profit even if a SPAC merges with a mediocre
company and its stock value then drops by 50%,” says Maxim Manturov, head of investment research at Freedom Finance Europe.
This arrangement incentivises SPAC teams to pursue several deals at once. Yet it’s vital that they don’t lose focus and/or select inappropriate acquisition targets.
Picking the right time to go public
SPAC targets are usually fast-growth companies or startups that have yet to make a profit. The prospect of granting equity to a SPAC for a large lump sum and a stock-market listing might be tempting for any founder, but choosing the right time to go public is critical. Payoneer offers a case in point. The global payments provider started trading on the Nasdaq on 28 June after completing a $3.3bn SPAC deal backed by veteran banking entrepreneur Betsy Cohen.
According to James Allum, vice-president and head of Payoneer’s business in Europe, the acceleration of ecommerce during the pandemic had created the “perfect conditions” for the firm to seek a listing. The company was on “an exceptional trajectory, but needed additional resources to grow at the required pace”, he says. A key advantage of the SPAC route is that it enables relatively quick listing, because SPAC acquisitions tend to outpace IPOs.
“Recent high-profile failures have given SPACs an undeservedly negative reputation,” Allum argues. “Used properly, they can play a vital role in fostering innovation.”
Regulation will ensure quality mergers
The number of flotations via the SPAC route may continue at a record rate, but a complex accounting rule change introduced by the SEC in April has had a negative effect on SPAC share prices. The regulator is also set to issue guidance on how acquisition targets are valued and revenues are projected.
SPACs are comparatively rare in the UK, but there could be a change to the City’s listing rules that would result in a wave of flotations. The current rules mean that investors in each SPAC are locked into their holdings while it’s conducting an acquisition, which can take several months, from identifying a target to completing the deal. But the Financial Conduct Authority is considering whether to grant more flexibility for SPAC shares to be traded without suspension during this process – which is what the SEC allows. Harris expects that, if this happens, SPACs will have to become more transparent and show that they have strong protections in place for investors to prevent disorderly share trading.
Regulators on both sides of the Atlantic will be hoping that investors become more aware of the risks of investing in SPACs, according to Manturov. There is, of course, no guarantee that any future SPAC transaction won’t be a dud, but disasters should be less likely to occur, he predicts.
“Increased attention from regulators will help to stabilise the SPAC market, reduce risk and warn investors against trading less suitable transactions,” Manturov says. “This, in turn, should prevent low-quality SPAC deals.”