A House Financial Services subcommittee examined the impact of the recent boom of Special Purpose Acquisition Companies (SPACs) on capital formation and investor protection. The virtual hearing, "Going Public: SPACs, Direct Listings, Public Offerings, and the Need for Investor Protections", was held May 24, 2021.
SPAC boom. Rep. Maxine Waters (D-Cal), chair of the House Financial Services Committee, said in an opening statement that in 2020, the amount of money raised in SPAC transactions skyrocketed 462 percent over the previous year.
According to Rep. Brad Sherman (D-Cal), chair of the Subcommittee on Investor Protection, Entrepreneurship and Capital Markets, the $132 billion per year amount raised in all IPOs is probably the most important segment of all securities transactions, though dwarfed by the $2.1 trillion issued yearly in corporate bonds and $312 billion in stock offerings by public companies. This is because these are the companies that will drive growth in the future. And of this $132 billion in IPOs, currently about half are traditional IPOs and half are SPACs.
Fairness and investor protection. Waters said she has "deep concerns" about SPAC transactions because they are marked by a lack of transparency and accountability, and appear to be structured to ensure that Wall Street insiders receive huge profits at the expense of retail investors.
In looking at IPOs, Sherman said three elements must be considered. The first is how companies are treated because the goal is to get capital to companies so they can expand. About 7 percent goes to underwriting fees in a traditional IPO versus about 11 percent in a SPAC transaction. Companies are also concerned about underpricing. When there is a substantial bump in price several days after the IPO, that money is not going to the company.
The second element is investor protection, said Sherman. In a traditional IPO, a company going public for the first time has strict liability for projections it makes about the future. A SPAC has a lower level of liability, said Sherman, though he added parenthetically that there is uncertainty on this point, also stating that Congress needs to clarify SPAC liability and whether it should be the same liability as for traditional IPOs. The committee memo noted that SPAC sponsors have some protection from liability for overly optimistic projections as a result of the safe harbor for "forward looking statements" under the Private Securities Litigation Reform Act (PSLRA). A draft bill under consideration would exclude SPACs from the safe harbor provision.
Another investor protection issue, according to Sherman, is that while 70 percent of SPAC investors take their money out before the transaction goes forward, those who choose to remain see their investments diluted with PIPEs. According to the committee memo, a recent study found that despite being valued at $10 a share, as of the time of a merger, the median SPAC holds cash of only $6.67 per share, and that SPAC shares tend to drop by one third of their value or more within a year following a merger.
Finally, there is the element of opportunity to invest in the IPO since most stock prices do go up shortly following the IPO. First, who gets to invest in IPOs, and are retail investors missing out? Second, do we have in effect a system of bribery? An underwriter can go to someone with a fiduciary duty, for example the CFO of a big corporation or the trustee of a large charitable foundation, and give them for their own account the chance to buy a $30 stock for $20. Then they go back a month later and do business, not with the individual they have enriched, but with the company or charitable trust they control.
Sophisticated investor winners vs. retail investor losers. According to Stephen Deane, senior director of legislative and regulatory outreach at the CFA Institute, there are two distinct sets of investors in SPACs and they see starkly different outcomes. On the one hand, there are big, sophisticated investors such as hedge funds that invest at the IPO stage. These investors tend to exit when the SPAC announces a merger and gain lucrative profits along with the SPAC sponsors. On the other hand, there are individual investors who buy in the public market, often at the time of the merger announcement, and often hold their shares in the post-merger period. Individual investors tend to see poor returns, said Deane.
According to Deane, studies point to three particular features of SPACs that explain this strikingly divergent record of returns: dilution, misaligned incentives, and an uneven regulatory playing field that permits forward-looking statements at the time of the merger. While it is possible that a strong company can overcome the handicap of dilution and reward its investors, in practice most SPACs have been unable to overcome these hurdles. Moreover, the lack of safe harbor for forward-looking statements for traditional IPOs creates an uneven playing field. While this may seem like an arcane legal point, the frenzy surrounding SPACs over the past year or so shows how important these investor protections are in the real world, said Deane.
Flexibility and competition in capital formation. Rep. Bill Huizenga (R-Mich), the subcommittee’s ranking member, said the strength of U.S. capital markets is vital to long-term growth, but regulatory burdens are hindering the ability of small businesses to thrive and compete globally. 80 percent of company financing comes from investors, not from banks. In 2016, the number of IPOs hit a 40-year low, though last year’s spike broke the disturbing trend, said Huizenga.
According to Huizenga, the high cost of going public is caused by paying bankers, lawyers, and auditors to prepare the lengthy registration statement. It is estimated that the cost of regulatory compliance in a traditional IPO is $2.5 million dollars, with an average annual compliance cost of $1.5 million after that.
These costs contribute to a trend of staying private, said Huizenga, adding that currently there are 242 "unicorns", startups with a valuation of $1 billion or more.
"That’s called a herd of unicorns," said Huizenga. "Those aren’t unicorns."
A decline in IPOs hurts average investors due to lack of investment options, said Huizenga. Although U.S. IPOs declined until last year, foreign IPOs are growing, specifically China. Last year China produced over one-third of global IPOs, reporting 536 out of 1,363 IPOs across all global markets. Experts predict greater IPO activity to come under China’s current five-year plan, and all of this contributes to economic growth. China's annual GDP growth is approximately 6.2 percent, and in 2020 was the only economy to achieve positive economic growth.
Given the decline in U.S. IPOs and economic challenges from China, the Financial Services Committee needs to focus on reforming regulatory frameworks to help U.S. companies achieve capital formation and make U.S. markets more attractive, said Huizenga. Because of this, it is important to preserve various paths for companies to pursue going public.
Is the boom cooling off? Scott Kupor, managing partner at Andreessen Horowitz, noted that while there has been an incredible spike in SPAC issuances over the past couple of years, the SPAC new issue volume dropped to 13 deals in April 2021, a decline of roughly 90% from the March 2021 volume.
Kupor sees a number of factors contributing to the sudden decline:
- SEC warnings to issuers about potential accounting restatements stemming from option grants issued to promoters;
- SEC warnings to retail investors to be cautious about "celebrity-endorsed" SPAC offerings;
- Overall volatility in the public equity markets and, in particular, contraction in trading multiples for high-growth stocks;
- Delays caused by backlogs and thus longer SEC reviews of de-SPAC offering documents, resulting in existing holders of SPAC shares having less capital to invest in new issuances; and
- Overall poor after-market performance of de-SPAC’d entities.