Loyola University Chicago School of Law, JD 2023
As Coronavirus (Covid-19) has slowed the global economy, business owners have been forced to adapt to volatile market conditions and use creativity to raise capital. Investors and financial industry professionals have turned their attention to Special Purpose Acquisition Companies (SPACs), which have already raised nearly $100 billion in 2021 compared to $83.4 billion during the previous year. A SPAC is a publicly-traded shell company formed by industry professionals such as institutional investors, private equity firms, and hedge funds. Then, SPAC sponsors will seek to complete a merger or acquisition with another private company, which enables the private company to become publicly traded and bypass the initial public offering (IPO) stage. SPACs usually are allowed two years from the IPO date to formalize an acquisition or return the funds to investors.
Why are companies choosing the SPAC route instead of an IPO?
While there are numerous reasons that a company may pursue a merger with a SPAC rather than a traditional IPO, the most common motives are market certainty and flexibility. Traditional IPOs typically lack market certainty, since determining the appropriate time to introduce a new stock to the market can be costly and time-consuming. A new publicly-traded company may be negatively impacted long-term simply due to a one-day market meltdown. Additionally, IPO pricing is challenging because setting the initial price too high or too low will inevitably lead to heightened volatility throughout the company’s first few months on Wall Street. On the other hand, SPACs enable target companies to negotiate share price with the sponsor beforehand so that it may be included in the merger agreement, which permits the parties to avoid risk and market uncertainty.
Not only do SPAC deals require half of the time it takes to complete an IPO, but SPACs promote flexibility and enable target companies to negotiate other terms of the transaction besides the initial share price. For instance, parties may negotiate the structure of the agreement including whether extra financing is necessary through a private investment in public equity (PIPE) as well as additional equity or debt.
Will regulatory concerns slow SPAC usage?
Regulatory expert and veteran banker Gary Gensler was recently named chairman of the Securities and Exchange Commission (SEC), which places Gensler in charge of the Biden Administration’s plan to intensify oversight of Wall Street. While the SEC has been relatively quiet on SPACs over the past year, the regulator recently announced that it may require some SPACs to reassess their financial results. The dilemma revolves around the inclusion of warrants in the financing of a SPAC, which typically provides some investors the right to buy additional shares at a predetermined price in the future. In other words, warrants serve to increase the value of a SPAC because the added feature enables early investors to gain more exposure to the SPAC after the share price has already inflated. For most SPACs, warrants are generally listed on the balance sheet as equity. However, warrants may need to be classified as liabilities in certain cases, which forces a SPAC to periodically adjust for changes in the warrants’ value.
The SEC’s warning has halted the IPO process for nearly 260 SPACs or blank-check companies as regulators begin to investigate the financial projections reported by firms that merge with SPACs. In essence, the SEC is concerned that overly optimistic projections may mislead investors in ways that a traditional IPO cannot. For instance, a company participating in a traditional IPO is typically not able to release future financial projections before shares begin trading, which prevents that firm from overselling the company’s value. Regulators are beginning to catch on, however, as fourteen federal lawsuits have been filed against blank-check companies in the first half of 2021 along with seven in 2020 and six in 2019. At least half of the claims allege that blank-check companies are overestimating the suitability and profitability of their products.
Besides misleading investors, the SEC intends to combat the lack of transparency that exists between investors and SPAC sponsors. Regulators are concerned with the time-pressure blank-check companies face before electing to merge. SPACs typically must conclude a merger within twenty-four months, which may encourage firms to complete a deal that negatively impacts investors. Furthermore, early investors in SPACs purchase their shares before the SPAC sponsor reveals potential target companies. Invested funds are returned to those who do not approve of the proposed merger; however, previous SPAC deals have resulted in fraud, which has prompted SPAC investors to call for heightened regulation. Even though SPAC issuance has recently slowed, investors continue to seek exposure to equity-related assets, which bodes well for the future of IPOs and SPACs.