SPACs are allowed to make dazzling projections without supporting data and retail investors may not be aware of some conflicts of interest that influence sponsors’ investment behavior.
Special purpose acquisition companies (SPACs) have exploded in popularity in the last 18 months, with 90% created in 2020 or 2021. A SPAC, also known as blank-check company, is a stock created by sponsors that raises money in an initial public offering with no underlying business. Typically, the SPAC must use its cash within two years to buy a private company (in a de-SPAC transaction), or refund the money to investors. Generally, investors don’t know what the acquisition target will be until the announcement.
The SPAC usually uses additional funds from a PIPE (private investment in public equity) to accomplish the de-SPAC. By starting the company this way, a SPAC purports to avoid the regulatory requirements of a traditional IPO.
Proponents of SPACs tout them as good for small-time retail investors, because of the relatively low cost to own shares (usually only $10) and the ability to divest of shares before the merger. However, there are a number of notable risks for investors.
SPACs have a looser regulatory environment than traditional IPOs. They can make projections that traditionally are “not commonly found in conventional IPO prospectuses.” This allows the sponsors, those who start the SPAC, to “sell the sizzle, not the steak”, because until the merger is announced, there is, in fact, no steak to sell.
Investors have little information to go on in assessing the SPAC. In particular, retail investors may not be aware of conflicts of interest that influence sponsors’ investment behavior. The SEC admitted as much when it provided guidance for SPAC disclosure:
The economic interests of the entity or management team … often differ from the economic interests of public shareholders which may lead to conflicts of interests as they evaluate and decide whether to recommend business combination transactions to shareholders.
Despite this guidance, SPAC sponsors have continued to target companies where they have apparently have a personal vested interest. SPAC are not prohibited from these self-interested transactions. They only have to tell investors, usually in a lengthy disclosure, that the SPAC capital might be used to buy one of their own companies.
A recent story featured in TechCrunch looked at the example of Reid Hoffman, a SPAC sponsor who is close to finalizing a merger deal with autonomous vehicle startup Aurora. But Hoffman’s venture firm, Greylock, began investing in Aurora in 2018, and he is on its board of directors. He could set the price for acquisition of Aurora by his SPAC at a level that would greatly enhance its value and therefore his bottom line.
SPAC proponent Chamath Palihapitiya, the “King of SPACs”, invested in insurance company Clover through his firm Social Capital before one of his SPACs merged with Clover last year. Since the merger, Clover has been the subject of an SEC investigation, an undisclosed Justice Department inquiry, and an accusation by short-seller Hindenburg Research of fraud, including kickbacks, misrepresentation and undisclosed third-party deals.
Nothing stops these ethically questionable investments because the SEC’s guidelines are suggestions, not law.
Investment banks that sponsor SPACs also have a potential conflict of interest. Some banking sponsors invest minimal amounts into a SPAC, but then also underwrite the launch of the IPO and serve as advisors for the deal to acquire an operating company. Often those fees are much larger than the bank’s investment as a sponsor, so the bank might have a much greater financial interest in completion of the merger deal than in the success of the SPAC itself. In March the SEC opened an inquiry into Wall Street banks, seeking information on how underwriters are managing the risks involved in their SPACs.
The SEC may be looking into the depth of due diligence SPACs perform before acquiring assets in the de-SPAC transaction, and whether huge payouts are fully disclosed to investors. The regulators may also be concerned about the heightened risk of insider trading between the initiation of the SPAC and when it announces its acquisition target.
Retail investors should be aware that SPAC sponsors who have a vested interest in the target company may be using the merger to shore up a failing venture, a risky investment strategy.
Retail investors also fare worse than the PIPE investors, who come in just before or after the merger is announced. The PIPE investors come in after they know the target, but still get to buy shares for $10, though they are often worth $15 or $20 right away. Ordinary investors can’t buy at the lower price this late in the game.
Waking From the Dream
Allison Herren Lee, the SEC’s current acting chair, said last October at the Practicing Law Institute’s SEC Speaks, “In the short term, a SPAC investment acts largely as a blank check, so it is critical that [there’s an understanding of] the material risks involved.” As Paul Munter, Acting Chief Accountant of the SEC, noted,
Whether a company enters the public markets through a merger with a SPAC, traditional IPO, or other process, the quality and reliability of financial reporting and the quality of audits on the financial statements provided to investors is vital to our efforts to protect investors and to the confidence of investors in our markets.
Over the past six months the SEC has signaled that SPACs will be subject to increased levels of scrutiny. One key area of focus has been on the disclosure of germane conflicts of interest from each SPAC participant: insiders like the sponsors and management team; the IPO’s public shareholders; and third parties like underwriters. These parties will need to avoid conflicts or scrupulously disclose them if they wish to avoid enforcement actions and liability.
Rajiv Shukla, chairman and CEO of SPAC Alpha Healthcare Acquisition Corp., believes the SEC will also likely require enhanced disclosures on other financial interests of sponsors over the lifecycle of the SPAC deal.
Retail investors who are interested in investing in a SPAC should do as much due diligence on the sponsors of the SPAC as they reasonably can. After all, since there is no underlying company, you really are just investing in the sponsors. If in the past, the sponsors have used SPAC funds to invest in target companies with financial ties to those sponsors, you may want to reconsider giving them your money.
Up next: SPAC Risks Part 2: Matchmaker, Matchmaker–Sponsor Advantage