Prior to combination, investors in blank-check firms must be mindful of potential pitfalls
Interest in SPACs exploded into the stratosphere last year, resulting in a boom in blank-check IPOs. But many of the mergers have yet to prove successful, and after some objects of high-profile SPAC acquisitions were exposed as fraudulent, U.S. regulators have tightened the rules, resulting in a cooling of the market.
While the bloom is certainly off the rose now with SPACs, they still hold a certain appeal to many companies looking to go public, including the ability to go public more quickly and with less regulatory or investor scrutiny. But from an investor perspective, blank-check companies that have yet to acquire a target represent certain unique risks.
In a new blog post, analysts from MSCI described how they analyzed constituents of the MSCI USA Investable Market Index (IMI) that had an IPO between January 1, 2018 and December 31, 2020. Of those 265 companies, just 23 began trading due to SPAC combinations.
“We found that post-combination, investors in former SPACs faced broadly similar governance risks, with similar levels of board independence and other key governance measures, as investors in conventional U.S. IPO companies,” the authors said.
However, the story is different for investors in SPACs prior to combination. One potential tripwire, the authors said, stems from how SPAC sponsors who provide the initial seed capital get founder shares, known as the “promote”, which are typically equal to 20% of the SPAC’s post-IPO equity.
“The promote gives the sponsor some huge advantages which can result in dilution of other investors’ shares and can create other misalignments of interests,” they said. “For example, the sponsor has a strong incentive to actually complete an acquisition, even absent an optimal target.”
Offerings of initial security offerings include stock shares plus warrants, which can be converted later into shares, can be tempting to some investors. However, the authors noted that warrants can be crafted in any number of ways: they may represent whole or fractional shares, for example, or redemptions can be set to occur at the IPO or just prior to the combination, creating another potential misalignment of interests across different groups of investors.
“Further, the need to raise additional capital to complete the combination can be addressed via a number of complex arrangements, including the use of private investment in public equity agreements (PIPES),” they added, noting how such arrangements can dilute investors’ equity further.
And while valuations in conventional IPOs are investor-driven, SPAC valuations are almost completely at the discretion of the sponsors, giving investors very limited control.
“While we found little to differentiate between SPACs post-combination and conventional IPO companies in terms of their governance risk, the same cannot be said for the SPACs on which the former were built,” the MSCI analysts said.