• Michalis Papachristodoulou

SPAC-frenzy: The investment trend making market regulation essential

One of the strongest investment trends in 2020 was the rise of Special Purpose Acquisition Companies (SPACs). Almost 250 SPACs were set up last year, more than the aggregate number of SPACs during the 7 years before that. While successful SPAC acquisitions have made the news, their risks have not received as much publicity. The inherent dangers of SPACs and the increase in retail investment have made regulatory intervention in this area essential for the protection of investors.


What are SPACs?


A SPAC is a company which is formed and then listed on a stock market for the sole purpose of acquiring another private company, the target. Once a SPAC is approved for listing, it will seek to raise finance through the sale of its shares on the stock market. It will then use the money it raises to purchase a target company.


SPACs are formed by sponsors, who may have an expertise in a particular industry, and will usually seek to capitalise on that expertise to invest in that particular sector. Sometimes the sponsors will already have a target in mind before the SPAC is listed, but they will keep that information secret from other investors, so that they can avoid the need to make extensive disclosures to the relevant stock market regulator. This means that those investing in a SPAC during its Initial Public Offering (IPO) will not know which company, or even which sector, the SPAC will eventually invest their money in.


The investors’ money will be protected until the acquisition is completed through the use of a trust fund. By placing the investors’ money in a trust fund, the investors can provide finance safely with the knowledge that their money will not be used for any other purpose other than to complete the acquisition. Most SPACs also have a specific time limit in which they must invest the finance they raise. If the time limit elapses without a deal being completed, the SPAC will return the investors’ money back to them.

A trust fund is a legal entity that holds money or other assets for the benefit of another person or group of persons. The persons running the trust fund cannot use the trust assets unless this is expressly allowed in the trust document. High-value trust funds are insured against malpractice, making them a safe haven for investors.

Why use them?


We have previously analysed the traditional path of a start-up towards its establishment on the stock market through an IPO. SPACs are an investment vehicle designed to make this process easier, quicker, and cheaper.


As the SPAC will have already gone through the IPO process prior to the acquisition, the acquisition's completion will essentially introduce the target company to a public market, without the need for it go through the arduous process of an IPO. The SPAC will have no commercial operations prior to the acquisition, making it easier to get approval for a listing in a stock market by reducing the paperwork and the scope of information that must be disclosed. The reduced administrative workload means that a SPAC brings the benefit of a faster route to the public markets.


The prospect of a SPAC buyout appeals to the owners of the target company, as going public increases the value of their shareholding and it allows them to cash out at a higher price than they could otherwise get. For sponsors, arranging a SPAC acquisition allows them to get a stake in a profitable private company which they would not be able to buy without the use of external finance. Bill Ackman, a hedge fund manager who has attained celebrity status within the finance sector, has been amongst the most vocal supporters of SPACs. His successful investment record in SPACs, such as the one that took Burger King public[1], has enhanced the popularity of this method of investment.


Whilst the number of SPACs skyrocketed during 2020, these SPACs were also, impressively, able to raise more funds on average than those of previous years. The 248 SPACs that reached the IPO stage in 2020 raised a total of $83.4bn. That is an average of $336mn per SPAC; a significant increase on the average of $230mn per SPAC that was raised in 2019[2]. The added funds give SPACs the financial ability to go after more high-profile targets, while also making it harder for the owners of a target company to refuse the SPAC’s offer. It is no surprise then that the largest SPAC ever occurred in 2020, with $4bn raised in the IPO of a SPAC sponsored by Bill Ackman.


As for investors, their returns usually come after the acquisition is completed, when the share price of the SPAC increases to reflect the value of the acquired target company. The top performing SPACs can see their share price rise by as much as 150% in the space of less than a year[3], illustrating the incentive for investors to get onboard of this new investment trend.


Calling for Regulation


As with any kind of investment, SPACs carry various risks along with their potential rewards. Investors hand their money to the sponsors without knowing what it will be used for, essentially requiring investors to take a leap of faith in the abilities of the sponsors to spot a suitable target and complete a successful acquisition. The use of a trust may give some protection for investors, but this will be of little consolation if the acquired target turns out to be less profitable or less valuable than originally predicted to be.


The rise in the number of SPACs has oversaturated the market, increasing the risks. With more SPACs entering the market in search for a suitable private company to take public, the competition between SPACs to find targets will only increase, pushing the valuations of potential targets upwards and forcing some SPACs to acquire less suitable targets. This will be to the detriment of investors, who already paid for their investment during the IPO and can’t request a refund of their money if a less appealing target has been announced.


The need to complete the acquisition within a set time only exacerbates the risks involved, as sponsors may rush through a deal without proper due diligence. The US Securities and Exchange Commission has highlighted this problem, putting a lot of emphasis on the potential conflicts of interests for sponsors. SPAC sponsors usually have different incentives from investors, as their reward may come at the point of the acquisition, rather than further down the line. Hence, a sponsor may prioritise the completion of a deal, even if there are apparent issues with the potential acquisition.


When SPACs were used almost exclusively by institutional investors and experienced individuals, there was little need for regulation. All the parties were aware of the risks and could take appropriate safeguards, whether that would be through legal advice, insurance, or a decision-making input. The rise in retail investment means this is no longer the case, raising the stakes and putting regulators on alert as they contemplate intervening.


The involvement of celebrities in SPACs has increased the interest of the public in them. Shaquille O’Neal recently founded his own SPAC, and such SPACs draw in more consumers with little to no experience in investments. Such investors will not be able to spot any potential conflicts of interest. Even if they do recognise the risks, their bargaining power is close to non-existent. They will not be able to employ any safeguards against the risks of a SPAC, either forcing them to accept the risks or alienating them from the stock market.


Looking Forward


The SPAC frenzy of 2020 has grown even stronger in 2021, with more SPACs being set up in the first 3 months of 2021 than the whole of 2020. The increased involvement of retail investors in stock markets has made regulatory intervention essential in this area, leading to a requirement for more disclosures, especially regarding the remuneration of the sponsors, which forms as the most probable first regulatory step. In the absence of regulation, it is only a matter of time until SPAC-related litigation is brought by dissatisfied investors, especially where the sponsors' disclosure was inadequate .


[1] Bloomberg - Ackman’s Pershing Square Makes $203 Million on Burger King [2] SPAC Research [3] Investopedia - Top Performing SPACs of 2020

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