Craig Coben is a former senior investment banker at Bank of America, where he served most recently as co-head of global capital markets for the Asia-Pacific region.
Last year may have been an annus horribilis for the IPO market, but it was an annus calamitosas for special purpose acquisition companies, or Spacs.
Spacs are blank-cheque vehicles designed as a backdoor way for a private company to list on the stock exchange without going through the expense and uncertainty of an initial public offering. But things have gone pear-shaped.
For one thing, investors have suffered bone-crushing losses, as companies merging with Spacs (inelegantly known as a “de-Spac transaction”) have vastly underperformed the stock market. The AXS De-Spac ETF fell almost 75 per cent in 2022. Several companies have missed their forecasts, restated their financials and even gone bankrupt. SPACs have in some cases incubated a unicorn-to-penny stock lifecycle — with companies having to launch reverse splits to avoid delisting.
Meanwhile, some Spac sponsors — who typically contribute 3-7 per cent of the listing proceeds upfront to cover underwriting and operating costs — have lost their entire investment because they haven’t been able to conclude a deal. Spacs typically have to be liquidated if they can’t complete a merger within 18-24 months, and when presented with a business combination, most Spac shareholders are now redeeming their shares to get their money back with interest. The average loss for Spac founders from liquidation has been around $9mn.
To make matters worse, sponsors incurred $750mn in losses last month alone, as they rushed to wind up Spacs before year-end, believing that a new 1 per cent federal excise tax on stock buybacks would apply to liquidations of US-domiciled Spacs starting in 2023. A whopping 85 Spacs were liquidated in December 12, only for the Department of Treasury to say at the very end of the month that the levy wouldn’t apply to liquidations after all. These sponsors acted in (understandable) haste and will now repent at leisure.
And finally, as often happens when people lose a lot of money, lawsuits and investigations are in the offing. Aggrieved investors claim that Spac founders had a conflict of interest in pushing through a merger, and as a result skimped on due diligence, inflated forecasts and failed to disclose important business risks. Naturally, the SEC is revving its enforcement engines.
The cycle of loss, regret and recrimination arises in part due to the same factors that have buffeted financial markets more generally, such as central bank tightening, higher inflation and economic slowdowns. Companies that de-Spac’d are often in high-growth segments, and these have suffered disproportionately in the market downdraft.
However, many of the problems also stem from the way in which the Spac structure embeds a potential misalignment of interests between Spac sponsors and their shareholders. This in turn created a vulnerability that the gloomy market environment is mercilessly exposing.
Sponsors make their money from what is called the “promote” in the form of shares and warrants usually representing 20 per cent of the Spac. But they receive that promote only if they lock down a merger. Otherwise, after (typically) 24 months the Spac is liquidated, investor money is returned with interest, and the sponsors are out of pocket. The sponsors face the choice: either push through a merger (even a suboptimal one) or lose millions of dollars of paid-in capital.
This merge-or-lose dilemma creates a significant potential conflict of interest, even if the shareholder right to redeem is an important protection. Some sponsors care about their reputation and prefer to swallow the loss over pushing a bad deal, but for others there is arguably an incentive to rush due diligence, underplay the risks, and overpay. Around 300 Spacs with $700bn in trust have deadlines to invest in the first half of 2023, and the temptation is to throw a “Hail Mary” pass and hope to score a deal in time.
And the issue goes beyond just the potential conflict. As a 2022 paper in the Yale Journal on Regulation explains, the promote, the underwriting expenses (normally 2 per cent upfront and 3.5 per cent post-merger), and the dilution from warrants and redemptions all combine to create a sizeable gap between the market cap of the Spac at $10 per share and its intrinsic cash value. Just last week the Delaware Chancery Court upheld the legal sufficiency of a complaint alleging that the Spac in question had less than $6 per share in cash to contribute to a merger.
The question, then, is: how can the merger of an operating company and a cash shell create enough additional value to bridge this gap?
One way is for Spac sponsors to deliver some kind of synergy. In some cases sponsors may claim, Liam Neeson-style, to have a “particular set of skills, skills [they] have acquired over a very long career,” and so their ongoing involvement might generate enough value to compensate for the dilution cost embedded in the Spac. But the rapid collapse in de-Spac share prices suggests that such value-adding is more often an article of faith than empirical reality.
Another way to make the numbers work is to talk up the target and its prospects and find new buyers, thereby lifting the share price. Spacss have had a key legal advantage over an IPO to facilitate the marketing: because the deal involves a merger, the company could publish forecasts under the SEC safe-harbour rules. In effect, the more lenient Spac rules gave aggressive sponsors a licence to hype.
With the economics so dependent on promotion, the Spac structure created fertile ground for embellishment and puffery, which has in turn built a growing pipeline of lawsuits. Last spring, the SEC proposed new rules to remove these legal differences between a Spac and an IPO, and the rules are expected to be adopted.
But the litigation horse bolted long before this stable door will have been shut. Last year saw a sizeable increase in the number of lawsuits filed over de-Spac transactions, and 2023 promises a busy litigation calendar. In the meantime, courts are not giving Spac founders the benefit of the doubt, ruling that if the conflicts were significant enough, they would judge deals by their “entire fairness”, instead of deferring to the “business judgment” of the sponsors.
And the likely tsunami of SEC enforcement action has only just begun to build. Already, several cases have been filed alleging due diligence failures by Spac management, and many more are under investigation. Last September the SEC charged a major bioscience hedge fund with advising its clients to invest in Spacs in which its principals had a financial interest.
Spacs had developed as a way for smaller companies to go public when the IPO market was otherwise unavailable or difficult to access. But as they exploded in popularity, Spacs evolved from a useful niche product to a widely-used but problematic pathway for taking a company public.
Investors and sponsors have been caught in the blast radius of the Spac explosion, and courts and regulators will be overseeing the clean-up.