Judge SPACs on the skin in the game of their backers

THE US SPAC (special purpose acquisition company) market is cooling off fast amid heightened regulatory scrutiny and an increasingly discerning crowd. But poor-quality SPACs may yet become a mainstay, and investors should pay closer attention to avoid being burnt.

Sixty-one new SPACs raised nearly US$12 billion in the second quarter, data from CB Insights showed. The number of SPACs created was an 80 per cent drop from the 298 SPACs formed during the first quarter of 2021, but was more in line with historical issuances seen pre-SPAC attack. (see graph)

A SPAC is a listed shell whose sole purpose is finding a private company to buy. The SPAC raises money for such an acquisition by issuing shares, typically with attached warrants that can help to boost returns for initial investors.

The slowdown comes amid increased scrutiny of these vehicles. SPACs allow their target companies to bypass the onerous regulatory checks of an initial public offering (IPO).

In April, for instance, the United States Securities and Exchange Commission (SEC) suggested that warrants should be accounted for as liabilities rather than equity.

Some SPACs were left scrambling to meet the new regulations, and Steven Canner, a partner at law firm Baker McKenzie, said the SEC's announcement was "initially very unsettling to the market".

Speaking at an Asia SPAC Management Bootcamp conference on July 15, he said that the change was more of a matter of "book keeping" than material for SPACs. "At least until there's an initial business combination," he added.

But the SEC has also expressed concern that in a SPAC transaction, companies can paint wildly optimistic forecasts of future growth, earnings, and sales to secure higher valuations than they otherwise would in a traditional IPO.

There could thus be a further tightening of regulations around financial projections for these blank-cheque vehicles, industry players reckon.

Financial projections have helped companies with little or no earnings tell their story in a more forward-looking fashion.

When electric car maker Fisker announced last year that it will go public in a US$2.9 billion deal with a SPAC backed by equity giant Apollo Global Management, it projected US$10.6 billion in yearly sales and US$1 billion of free cash flow by 2024. Yet, Fisker would not begin production of its Ocean electric SUV until the end-2022.

Fisker gained as much as 19 per cent on its debut and ended its first day of trading up nearly 13 per cent.

Those days of exuberance may be behind us.

Kristin Zimmerman, managing director at Morgan Stanley, said institutional and accredited investors taking early positions ahead of a public listing typically demand a strong foundation.

"They are looking at companies that have a closer path to revenue and profitability, or at least a clear and tangible bridge for how you get there," she said at the Asia SPAC Management Bootcamp.

Retail enthusiasm for SPACs has waned too, sending shares in early favourites such as electric truckmaker Nikola and battery developer QuantumScape down by as much as 78 per cent from their previous highs.

Even in the face of the increased scrutiny from regulators and investors, however, the supply of SPACs can be expected to grow. That is because many players still stand to gain from an increase in SPAC listings.

Exchanges and investment banks win in the form of fees. And for sponsors, listing a SPAC can be incredibly lucrative. Also, the incentives for SPAC sponsors and promoters are not designed to create high quality investments.

JPMorgan in January analysed returns for different investors in SPAC. Sponsors on average earned a 648 per cent return. The gross return for the average buy-and-hold investor who bought in after the merger was 44 per cent.

Sponsors contribute a nominal sum to start a SPAC, but can typically get a 20 per cent stake in the merged company so long as they find a target company and complete a merger within the two years allocated.

In other words, founders looking to raise US$100 million for a SPAC would only need to put in about US$5 million. That initial investment becomes a 20 per cent post-IPO stake worth US$20 million upon merger.

This incentive structure may also push sponsors to close any deal they can, rather than get the right deal done at the right price.

There are more than 570 SPACs with some US$180 billion in cash currently seeking acquisitions, data service SPAC Research showed. Since SPACs typically buy companies three to five times their size, relying on outside investors for additional cash, that implies around US$900 billion in potential buying power.

Flush with cash, SPACs can encourage private companies to go public even if they are not ready.

For the target companies, too, a merger with a SPAC is attractive because the target gains access to a guaranteed amount of cash at an often-attractive valuation.

Many SPACs are eyeing companies in South-east Asia, on the back of Grab's US$40 billion deal with Brad Gerstner's Altimeter Growth Corp announced in April.

"It is very crowded out there. My view is that there aren't enough quality targets for these SPACs to deploy their capital," said Morgan Stanley's Ms Zimmerman.

"Since the height of the SPAC mania in February, the aperture for targets that fit the SPAC model has narrowed considerably."

The increased regulatory scrutiny and competition could still end up flushing out subpar SPACs, as sponsors try to differentiate themselves with terms that are friendlier to target companies and investors.

Altimeter's Grab SPAC for example, has a three-year lockup period for its sponsors. Bill Ackman - who is behind the US$4 billion SPAC Pershing Square Tontine Holdings - has said he will not receive any compensation until shareholders get a 20 per cent return.

"As that indigestion works through the system, conditions will improve," said Ms Zimmerman.

But true quality improvements could take a while, and it may even take a spectacular bust for some real change to take place.

Meanwhile, investors would do well to be even more discerning than before.

Market experts recommend sticking to bigger SPACs sponsored by the very best in their game.

SPACs raising US$100 million and below, for instance, will likely be too small to compete for the stronger targets.

And given how easy it is for SPACs to stack their boards with credible names, it is more important that investors look for sponsors with significant skin in the game while paying less attention to the purported industry experience of boards and management.

And when SPACs come to Singapore shores, investors will need to exercise the same cautions.

READ MORE:

• The specs of SPACs
• Investors need to stay alert to what SPACs can offer
• Grab's US$39.6b SPAC deal comes with bells and whistles
• SGX needs to take a long hard look at SPACs