SPACs have certainly presented a well-lighted pathway for hundreds of companies to reach the public markets this past year or so. In testimony before a House subcommittee in May, SEC Chair Gary Gensler observed that we are "witnessing an unprecedented surge" in SPACs: so far in 2021, the SEC has received 700 S-1 SPAC filings, and 300 of these "blank-check IPOs" have been completed so far this year, compared to just 13 in all of 2016. Most recently, SPACs have been the target of extensive criticism, both from the SEC and outside commentators. However, in this DealBook column in the NYT, In Defense of SPACs, the Deal Professor suggests that the animus underlying much of this criticism is misguided; these "complex takeover vehicles serve an important purpose that's worth protecting," he contends. What is that purpose? As has long been lamented, the lane for smaller, earlier-stage companies to go public has substantially narrowed over a number of years. SPACs, he contends, have not just offered an alternative pathway to public company status—they have "single-handedly revived" the IPO market for these smaller, younger—and yes, sometimes riskier—companies to go public.
The critics have voiced a number of criticisms of SPAC transactions. For example, Gensler has contended that SPACs raise policy questions regarding appropriate disclosure, investor protection and whether retail investors are bearing the brunt of dilution and too much of the cost burden (see this PubCo post). Commentators have complained of excessively rosy projections and meaningless merger votes (see this PubCo post). SEC staff have contended that SPACs may not be entitled to the liability safe harbor of the PSLRA (see this PubCo post), issued guidance about problematic accounting for SPAC warrants (see this PubCo post) and questioned whether the private operating company targets of de-SPAC transactions are even fully prepared to be public companies (see this PubCo post).
But the Deal Professor has a different take. As he frames it, while there may be some issues that should be addressed, SPACs "have single-handedly revived the market for initial public offerings, taking small companies public by the dozens....And since these cash shells...often target emerging tech companies, that market has returned to its glory years. Why, then," he asks, "are regulators trying to kill it?"
This recent regulatory scrutiny of SPACs, which has of late led to a steep decline in the number of SPAC IPOs, he says, has "been triggered by hand-wringing over whether they are too risky for retail investors." As the Deal Professor reminds us, he warned about the "perils" of SPACs way back in 2008. In the current surge, he says, some SPAC companies have done well, while other have "flamed out."
More broadly, however, the SPAC "has brought back the I.P.O. market for innovative, smaller companies. Despite the recent slowdown, there have been more than 330 SPAC I.P.O.s this year, raising just over $100 billion." In the late 1990s, he observes, the heyday of the middle-market boutique investment banks, the four leading boutiques "cumulatively underwrote about 130 I.P.O.s a year at the time." But, after the dot-com bubble burst and SOX "ushered in reforms to reduce broker conflicts, the small I.P.O. all but disappeared.... Since then, there has been a much slower pace of I.P.O.s, almost all bigger companies." (See the author's study of this subject.) Although the JOBS Act made it easier to go public, he notes, the drought in IPOs of smaller, earlier-stage companies continued, and "the goal of giving public investors earlier access to innovative start-ups has proved elusive."
SideBar
At a June 2017 meeting of the SEC's Investor Advisory Committee, panelists reported that the characteristics of IPOs were different in 2017 compared to 1996. In 2017, according to one panelist, the average size of an IPO was $192M compared with only $62M in the earlier period. There was also a significant extension of the timeframe to IPO. One panelist observed that, in the past, the typical time to IPO was six to seven years, whereas, in 2017, the timeframe was closer to ten to eleven years. As a result, he contended, more appreciation in value tended to accrue to private holders and less to public investors as companies go public at much higher valuations and do not experience post-IPO stock price growth at the same multiples as in the past. As examples, the panelist compared two highly successful companies, one that went public two decades ago and now has a market cap a thousand times its IPO valuation, almost all of which accrued to the public investors, and another which, 15 years later, had an enormous valuation upon going public, all of which accrued to its private investors, but now has a market cap only four times bigger. (See this PubCo post.)
In remarks delivered in May 2017, then-SEC Commissioner Michael Piwowar observed that the "substantial drop in the number of IPOs in the United States is primarily driven by the disappearance of small IPOs. In the 1980s and 1990s, IPOs with proceeds of less than $30 million constituted approximately 60 percent and 30 percent, respectively, of all IPOs. In fact, some of the most iconic and innovative U.S. companies... entered the public market as small IPOs. This trend reversed in the 2000s. IPOs with proceeds less than $30 million accounted for only 10 percent of all IPOs in the period 2000-2015. By comparison, large IPOs have increased from 13 percent in the 1990s to approximately 45 percent of all IPOs since then." (See this PubCo post.)
In testimony in October 2017 before the Senate Committee on Banking, Housing and Urban Affairs, then-SEC Chair Jay Clayton expressed concern regarding the decline in the number of public companies: "fewer companies are choosing to go public in their growth phase or at all and, consequently and significantly, there are fewer investment opportunities for Main Street investors. It is clear to me that our public capital markets are relatively less attractive to growing businesses than in the past." Who bears the cost of this problematic trend? In Clayton's view, it is Mr. and Ms. 401(k), who now have "fewer opportunities...to invest directly in high quality companies. To be clear, it is not fewer opportunities to invest in IPOs themselves that troubles me. But without IPOs of growing companies, we have a shrinking and generally more mature portfolio of public companies. This is a significant concern. A shrinking proportion of public companies, particularly smaller and medium-sized companies, has costs beyond investment choices, including that there will be less publicly available information about the operations and performance of companies that are important to our economy."
When asked by Senator Elizabeth Warren whether it wasn't better for investors that more money was being invested in more mature companies, Clayton responded that it was better for investors to be able to invest at earlier stages and to ride the growth curve up rather than to invest in more mature companies. He was concerned that there was more private money taking advantage of the growth curve and that these private investors were profiting more than the later public investors. Warren had a different view. She said that the data showed that investing in fewer bigger IPOs was better for investors. Investors were pouring more money into IPOs now, and the current crop of IPO companies tended to have more revenue and to perform better in the long run than in the past, she said, which should actually benefit Mr. & Mrs. 401(k). He may fear, she suggested, that something is wrong with the market as a result of the rules and regulations, but, in her view, IPO companies now were more stable and that, ultimately, that was better for investors. The SEC's mission, she said, was to watch out for investors. (See this PubCo post.)
Now, the Deal Professor observes, the SPAC surge is "bringing many smaller companies to market." While SPACs can "run into trouble...when they make an acquisition[, a] bigger problem is if shareholders who invest in SPACs after acquisitions are getting a particularly bad deal, which some research suggests. Are they?" he asks, in effect seeming to question whether declines are attributable less to the potential impact of the structural differences between the two IPO pathways and more to the "inherent risk" of the companies: "SPACs are bringing riskier companies to market. Stock Market 101 suggests that with more risk come more reward and more failures." Whether investors should be exposed to these sorts of companies is certainly a judgment call, he argues, reminding us that, as discussed in the SideBar above, just a few years ago, the big worry was depriving retail investors of the opportunity to benefit from investments in IPOs of early-stage companies. "Now that the SPAC solves this problem," he contends, "regulators are backpedaling."
SideBar
The article to which the Deal Professor refers, A Sober Look at SPACs, found
"that costs built into the SPAC structure are subtle, opaque, and far higher than has been previously recognized. Although SPACs raise $10 per share from investors in their IPOs, by the time the median SPAC merges with a target, it holds just $6.67 in cash for each outstanding share. We find, first, that for a large majority of SPACs, post-merger share prices fall, and second, that these price drops are highly correlated with the extent of dilution, or cash shortfall, in a SPAC. This implies that SPAC investors are bearing the cost of the dilution built into the SPAC structure, and in effect subsidizing the companies they bring public. We question whether this is a sustainable situation."
SPACs may continue to evolve to address some shortcomings, the Deal Professor says, but in the meantime, there are improvements that should be implemented: for example, "[m]ore disclosure should be required about the compensation that SPAC sponsors receive." And the Deal Professor acknowledges, as many of the critics contend, "some SPACs are too aggressive or make companies public too soon or with faulty (or even fraudulent) business plans. But the same can happen with traditional I.P.O.s. That is not a reason to kill the only thing that has revived the market for I.P.O.s of small and emerging growth companies in 20 years."
SideBar
In an interview on CNBC with Andrew Ross Sorkin conducted in September 2020, Clayton indicated that he viewed the emergence of SPACs as healthy to the extent that they created competition by providing a different way to distribute shares to the public. Importantly, however, they need to provide good disclosure, particularly with regard to the incentives and motivations of those involved. At that time, he said, the SEC was particularly focused on the compensation and incentives that go to the sponsors of the SPAC. (SPAC sponsors typically receive a portion of the SPAC's equity to provide compensation and incentives for their work in creating the SPAC, soliciting investors, identifying acquisition targets and, sometimes, assisting the surviving public company to meet its corporate objectives and goals post-merger.) For example, how much equity do they have initially? How much do they receive at the time of the acquisition transaction? The SEC wants to be sure that the investors understand the incentives involved and that, at the time of the investor vote on the acquisition transaction, the disclosure to investors is as rigorous as in an IPO.
Sorkin commented that it can be especially difficult to understand the SPAC compensation schemes. How did Clayton envision that it should look? Should there be full hypothetical examples provided showing the SPAC sponsor's compensation? Clayton responded that, if hypotheticals are necessary to explain the compensation and incentives, then the SPAC should provide them. Again he emphasized that the public needs to understand the motivations both at the point of initial distribution of the SPAC into the market and also when the acquisition transaction takes place with the operating company. The SEC can't dictate what the compensation structures should be, but it can require that they be fully disclosed. (See this PubCo post.)
Similarly, a fundamental message of CF Disclosure Guidance: Topic No. 11, issued in December 2020, is to be on the alert for potential conflicts of interest—particularly the potentially competing or different economic interests (including compensation) of the SPAC sponsors, directors, officers and affiliates on the one hand and the public shareholders on the other—and be sure to provide clear disclosure about them. For example, conflicts may arise as sponsors, directors, officers and affiliates evaluate and decide whether to recommend a de-SPAC transaction to shareholders and as they negotiate the acquisition. In contrast to a traditional IPO, where the securities offered are valued through market-based price discovery, in a de-SPAC transaction, "these individuals are solely responsible for deciding how to value the private operating company and how much the SPAC will pay for it." (See this PubCo post.)
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