Understanding SPACs now: From increased regulatory scrutiny to cross-border de-SPACs

16 August 2021
SPACs, or special purpose acquisition companies, have profoundly affected the investment landscape over the last 18 months. Most followers of financial news know that SPACs, also called blank-cheque companies, raise money and look to acquire private operating companies.

SPAC-related trends and opinions are evolving quickly, however. And those same financial-news followers may not know if SPACs are now experiencing rapid growth or a slump; if they’re a viable alternative to traditional IPOs or an overly risky mechanism; if they’re almost exclusively a US phenomenon or if there’s significant activity in other markets; if regulators around the world are cracking down on SPACs or encouraging their use.

This article provides a summary of these concerns and outlines some important points that SPAC sponsors and their target companies should consider now.

The rise of SPACs as alternative to traditional IPOs

SPACs have been used for decades as an alternative to traditional IPOs. They are essentially public shell companies that raise money for the purpose of identifying and merging with private operating companies. The process offers a quick route to a stock market listing and fewer pre-IPO rules (such as those related to revenue trends and forecasts) compared to traditional IPOs. In addition to these benefits, the New York Times notes that SPAC mergers “allow retail investors to get exposure to young, innovative companies earlier than the more staid IPO process.”

The investment vehicle took off last year, and by December Goldman Sachs had proclaimed 2020 to be “the year of the SPAC.” SPACs raised $73 billion in proceeds, nearly five times the amount raised in 2019 and $6 billion more than traditional IPOs. In short, last year SPACs entered the financial mainstream.

SPAC activity has slowed so far this year. The slowdown was perhaps inevitable given that most commentators characterised 2020’s activity as a “frenzy.” Reuters attributes the recent decline in SPAC listings partly to investors growing “wary of the asset class and regulators [tightening] up scrutiny on blank-cheque companies.” An industry expert quoted in the article sees the decline as an understandable correction, observing that, “Investors are no longer buying into these vehicles indiscriminately unless they have a solid story and management team.”

Companies that have gone public through SPACs have also experienced a recent slump in share prices. The Financial Times reports that shares in these companies “have dropped by an average of two-fifths from their highs, as appetite for the once red-hot sector of the US stock market cools.”

Some regard the drops in activity and share prices as a consequence of SPACs’ inherent shortcomings. The LA Times explains that some financial professionals have long been trumpeting the risks of SPACs, including their problematic operating-company valuations and disclosures. The article warns that “[although] most mergers have so far held up, steep declines … underscore the risks and may force sponsors to do more thorough diligence.”

Despite recent declines and concerns, it’s worth remembering that there are over 400 US SPACs — with a potential aggregate deal value of $348 billion — still seeking mergers. In other words, the current SPAC slump could quickly turn into another frenzy. 

SPACs in the US, Europe and beyond

Most SPAC activity has been confined to US-based blank-cheque companies, US target operating companies and US stock exchanges. Pitchbook reports that from January to mid-May 2021, 293 companies worth a combined €15.8 billion had gone public in the US through a SPAC. Europe, by contrast, had 17 listings worth €2.2 billion.

The numbers from Europe, however, represent a significant rise in activity from the prior year, when there had been just one European SPAC deal. The rise is perhaps not surprising given the crowded US market and sheer number of US SPACs looking for deals — not to mention the combined $348 billion at their disposal. CNBC reports that many US SPACs have listed in New York with the express intention of targeting European companies, specifically tech firms.

US SPACs may face some resistance from certain European target companies. Some European start-ups, for example, told Reuters they are “steering clear of SPACs” because of the maturity of European start-ups relative to US counterparts, along with concerns about costs and regulations. Others interviewed were more optimistic about SPACs taking hold in Europe, in part because of disclosure-related rules. One expert predicted, “You will see a lot of [European] life science companies, a lot of electric vehicle companies and nascent technologies going public via a SPAC because you are allowed to talk about forecasts, because it’s an acquisition.”

In March, UK online car seller Cazoo Holdings agreed to go public on the New York Stock Exchange through a merger with a SPAC that valued the company at $7 billion. Cazoo founder Alex Chesterman told the Evening Standard, “The UK is an amazing place to build a business but the IPO process is challenging for companies investing in high growth. It is just better understood by investors in the US.”

As we observed in another article, Asia-based start-ups have few listing options outside China, so merging with a US-based SPAC is seen as attractive possibility while local regulators, in the words of the South China Morning Post, “become comfortable with SPAC listings in the region.” Until then, some significant Asian companies have been lured by US SPACs. Singapore-based Grab Holdings, a company similar to Uber, agreed in April to go public through a NASDAQ-listed SPAC, securing a record $39.6 billion valuation.

“Sponsors need to maintain high standards of due diligence when selecting and valuing target companies and making relevant disclosures — including keeping a sharp focus on governance — no matter where the targets are located,” says Navita Yadav, managing director and global head of capital markets at Vistra. “Those US SPAC sponsors who do look beyond their own borders for target companies must consider domicile implications as well, which can be complex. The SPAC entity’s domicile will typically affect other decisions, including stock-exchange choice and business structuring, while also affecting compliance and reporting obligations.”

Regulators respond to SPACs

On 31 March, the US Securities and Exchange Commission responded to last year’s SPAC frenzy by releasing two public statements, both concerned with protecting investors. One addresses “certain accounting, financial reporting and governance issues that should be carefully considered before a private operating company undertakes a business combination with a … SPAC.” Among other considerations, the statement points out that after the merger, or de-SPAC, the combined company must fulfil certain listing standards. These include specific corporate governance requirements such as those related to: a majority independent board of directors; an independent audit committee consisting of directors with specialised experience; a code of conduct for directors, officers and employees; and more.

The SEC’s other 31 March statement also addresses companies merging with SPACs, and outlines financial reporting and auditing considerations. It reminds us that the SEC is “always keenly focused on protecting investors,” and that ensuring quality financial reporting is paramount in that effort. The statement emphasises that operating companies must grasp that, while SPACs may offer a quicker route to markets, it is “essential that target companies have a comprehensive plan in place to address the resulting demands of becoming a public company on an accelerated timeline.”

The SEC statements echo an article published by the Harvard Law School Forum on Corporate Governance in 2018, two years before the SPAC frenzy. That article observes that while the SPAC IPO process can be done in a couple of months (more quickly than a traditional IPO), “the de-SPAC transaction involves many of the same requirements as would be applicable to an IPO of the target business, including audited financial statements and other disclosure items which may not otherwise be applicable if the target business were acquired by a public operating company.” In other words, while SPACs may offer a quicker route to market, the operating company and SPAC must have their financial houses in order when the de-SPAC occurs.

There are serious consequences for ignoring these and other requirements and standards. In the first quarter of 2021, eight companies that merged with SPACs were sued by investors for among other things hiding “weaknesses” before the de-SPAC. The SEC itself has also taken action recently, for example by bringing fraud charges against the founder of Nikola Corporation, a truck-maker start-up that went public through a SPAC in 2020. The SEC alleges that, prior to the de-SPAC, the founder used social media and other means to mislead investors about the efficacy of his products. Just two weeks earlier, the SEC had charged another target company — along with the SPAC and its sponsor — for making similarly misleading claims.

The SEC is not the only major financial regulator to issue post-frenzy warnings about SPACs. The European Securities and Markets Authority published investor protection guidance on 15 July, noting the recent rise of SPAC activity in EU capital markets. ESMA guidance says that “SPAC transactions may not be appropriate investments for all investors due to risks relating to dilution, conflicts of interests in relation to sponsors’ incentives and the uncertainty as to the identification and evaluation of the target company.” The guidance emphasises the importance of applicable governance rules and says that ESMA will “continue to monitor SPAC activity” to protect investors.

Significantly, at the same time that US and EU watchdogs are issuing warnings and (in the case of the US) charges related to SPACs, UK regulators are changing related rules to encourage SPACs. European SPACs have so far been concentrated in Amsterdam, in part because the UK’s rules have largely prevented investors from influencing acquisitions and don’t permit investors to retrieve their money after the target company has been chosen.

On 27 July, the UK’s Financial Conduct Authority published changes to its SPACs rules, which have a 10 August effective date. The FCA statement indicates that the final rules “aim to provide more flexibility to larger SPACs, provided they embed certain features that promote investor protection and the smooth operation of our markets.” The new rules include a “redemption” option to allow investors to exit (i.e. get their money back) prior to the acquisition and a requirement for shareholder approval before a proposed acquisition.

Other regulators are considering similar rules changes to ensure their own markets can accommodate SPACs in the face of their continued popularity, particularly on US stock exchanges. In Asia, over 30 SPACs have been established so far this year — after only 17 were formed in all of 2020 — and are looking to go public in the US. In response, Singapore and Hong Kong authorities are looking to change listing rules to allow SPACs on their own exchanges.

Considerations for sponsors and operating companies

SPAC sponsors, and operating companies considering going public through a SPAC, must be aware that regulatory scrutiny of SPACs is increasing. As with any company, SPACs and their potential targets must understand and follow rule changes that pertain to them. The rules in question will of course tend to protect investors. Even the UK’s recent rule changes — which were designed to encourage SPAC listings in Europe’s largest financial centre — were couched in the language of investor protection.

So while SPACs are widely regarded as a quick and easy means of going public, they in no way eliminate the obligation to follow rules governing public companies. These rules relate to corporate governance, accounting and financial reporting, and more. In short, target companies must be ready for the compliance rigors that come with operating a public company. And SPAC sponsors must focus on these concerns when performing due diligence prior to merging. Accurate and thorough due diligence can be particularly difficult in this area, since SPACs typically have two years to acquire a company and there is often pressure to get deals done.

Given that many SPAC targets are start-ups or scaling companies that lack mature controls and corporate governance, the experience and guidance provided by the SPAC sponsors themselves are likely to become even more critical to investors. For this reason, sponsors should strongly consider what long-term commitments they can provide to operating companies to achieve the growth objectives and high levels of governance required for public status. “Sponsors need to determine how to best guarantee the success of the merged company to deliver on the growth plans investors have bought into,” says Debbie Farman, head of advisory UK and global co-lead advisory at Vistra. “Getting the Board composition right is critical to success. Many SPAC sponsors are top private equity firms or highly reputable CEOs with public company experience, so remaining committed to the target company will go a long way to addressing concerns over sponsor incentives and long-term SPAC performance.”