On Dec. 9, Securities and Exchange Commission Chair Gary Gensler made prepared remarks to the Healthy Markets Association about the unfairness of SPAC rules.
Specifically, Gensler is concerned that investors aren’t getting the same amount and quality of information with special purpose acquisition companies (SPACs) as they do with traditional initial public offerings (IPOs).
Why is that?
There are plenty of opinions out there. Gensler’s got his own concerns.
“Currently, I believe the investing public may not be getting like protections between traditional IPOs and SPACs,” Gensler stated. “Further, are we mitigating the information asymmetries, fraud, and conflicts as best we can?”
Frankly, whatever stage you’re at in the SPAC IPO process, his words are the most important. Moreover, they’re the ones that will carry actual weight as this investment vehicle evolves over the next few years.
If you’re a retail investor considering one of these beasts, I think it’s essential that you understand some of the reasons SPAC rules need to be rewritten. Here are seven of my own:
- The target search is too long
- The proposed business is too vague
- The inducement for waiting up to 24 months is too little
- PIPE investors get a big advantage
- SPAC sponsors don’t have enough skin in the game
- Warrants need to be offered with a 1:1 ratio
- Parties to merger announcements need to be held more accountable for information disclosed
SPAC Rules to Be Rewritten: The Target Company Search Is Too Long
One of the central tenets of the SPAC process is the time given for a sponsor to find a target company, reach an agreement with that business on the terms of a merger, and announce a combination.
As the SEC Chair mentions in his remarks noted in the introduction, the length of the target company search can be as long as 24 months. However, there are examples of SPACs who’ve gone with 18-month target searches.
One such example is FTAC Emerald Acquisition Corp. (NASDAQ:EMLDU). It raised $220 million on Dec. 15. EMLDU is one of the many SPACs sponsored by Betsy Cohen, the founder and former CEO of The Bancorp (NASDAQ:TBBK). It can stretch out to 21 months if it has a letter of intent or other binding agreement.
In fact, according to Bloomberg, more SPACs are opting for the shorter period of 18 months rather than opting for the full 24 months.
“‘Pricing IPOs is difficult with so many in the market,’ said Nicholas Skibo, a managing partner at Gritstone Asset Management, which invests in SPACs. ‘So you either have to be a world-class sponsor or you have to provide an incentive,’” Bloomberg reported in August.
Frankly, if I were the SEC Chair, I would make 12 months the maximum amount of time for the consummation of a deal. Either that or I would require SPACs to pay through the nose for an 18-24 month search.
The Proposed Business Is Too Vague
If you’re at all familiar with the boilerplate language in the SPAC prospectus, you know that it provides a tremendous amount of wiggle room for the sponsors.
Here’s the blurb from page 91 of the FTAC Emerald Acquisition Corp. prospectus:
“We currently intend to concentrate our efforts on identifying companies in the Target Sectors that power transformation and innovation.
“Our expertise lends itself well to pursuing platforms related to the Target Sectors, but we are not required to complete our initial business combination with a business in these industries and, as a result, we may pursue a business combination outside of these industries.”
The prospectus identifies the target sectors: clean/renewable energy, water sustainability, agricultural technology, shared economy software and next-generation mobility.
But again, it could just as easily spend 18 months looking for these types of businesses and then turn around and announce it was merging with an apparel manufacturer. Sure, investors could turn the deal down, but only after holding on to their cash for 18 months at minuscule interest rates.
When you invest in a traditional IPO, you know precisely what you are investing in. The quality of the business might be debatable, but you aren’t left in the dark when it comes to the ultimate target.
Ideally, I would like to see a rule instituted that acquired businesses must show some form of profitability, whether GAAP, Non-GAAP, annual, or quarterly. However, this type of rule would slow down interest on the part of sponsors.
That’s a good thing.
SPAC Rules to Be Rewritten: The Inducement for Waiting Up to 24 Months Is Too Little
Of all the SPAC rules, the trust account is probably one of the most debatable issues when considering the pros and cons of investing in one.
Schroeders’ Head of Research and Analytics, Duncan Lamont, discussed the pros, cons, and incentives of SPACs in March.
“Because investors in a SPAC IPO have the option to redeem their shares for what they paid for them plus interest, they essentially have a money back guarantee,” Lamont wrote on the company’s Insights blog. “In addition, they have a warrant, which may turn out to be worth a lot if the SPAC is a success. The warrant is akin to a risk-free bet on the success of the SPAC.”
Lamont’s comments cut to the core of this subject.
The pro is that investors can get their money back plus interest. The con is that the interest rate — a current 52-week Treasury bill pays 0.39% — makes the opportunity cost ridiculously high. The incentive is the portion of a warrant that comes with the SPAC units. You get to keep that even if you redeem your shares.
However, you can make the argument that if the merger target is a great business, you’re forging substantially more by redeeming your shares.
So, Betsy Cohen’s SPAC units sold for $10. It gave investors one share of Class A common stock and one-half of one redeemable warrant, which can be exercised to buy a second share of Class A common stock for $11.50.
My suggestion is that the number of warrants given increase as time passes. So, in the first six months held, you might get one-third of a whole warrant. Then, in the next six months, a half of an entire warrant. And so on.
The incentive to hold for 24 months is only there for the sponsor.
PIPE investors get a big advantage
The private investment in public equity (PIPE) has become an essential part of the SPAC process. Rarely, if ever, do you see a combination without significant PIPE backing.
The SEC Chair discussed the advantage PIPEs have in the disclosure section of his Dec. 9 remarks:
“PIPE investors may gain access to information the public hasn’t seen yet, at different times, and can buy discounted shares based upon that information. That’s among other benefits,” he said. “What’s more, retail investors may not be getting adequate information about how their shares can be diluted throughout the various stages of a SPAC.”
In May, Lazard Asset Management analysts Dmitri Batsev and Jason Katz discussed PIPEs and their involvement in the de-SPAC process stating, “The de-SPAC process affords ample opportunity for just such analysis through a PIPE, which allows select investors the opportunity to scrutinize and buy into a proposed deal before the market is even aware of its existence.”
So, theoretically, SPAC shares are trading at $15, a deal gets announced, and the shares jump to $25; the PIPE gets in for $10, or 60% off the current price.
That’s too sweet a deal for the information advantage institutions already get. The process is unfair to regular investors. But it’s beyond my pay grade to figure out how this one gets fixed.
SPAC Rules to Be Rewritten: SPAC sponsors don’t have enough skin in the game
I think it’s fair to say that since the reemergence of SPAC IPOs in 2019, there’s been a tremendous focus on the financial gift sponsors give themselves when establishing these vehicles.
When Bill Ackman launched his SPAC in July 2020, founder shares were one of his primary targets. These are the shares founders of SPACs issue to themselves for a nominal amount, which is often $25,000. This gives them control of up to 20% of the total shares outstanding post-IPO.
“SPACs are a compensation scheme, like people used to say about hedge funds, but it’s even worse,” Ackman told Institutional Investor. “In a hedge fund, you get 15 to 20 percent of the profit,” he says, in reference to the incentive fees hedge funds earn on the gains in their portfolio. “Here you get 20 percent of the company.”
He says that a $25,000 investment by a founder becomes $100 million when the SPAC raises $400 million in its IPO. It’s called the “promote” by industry insiders. And it’s insidious.
It’s so insidious, in fact, that the House Financial Services Committee, as recently as October, was working on legislation prohibiting financial advisors from recommending SPACs that give sponsors more than 5% of a SPAC’s equity.
I suggest legislators make 5% the ceiling for founders’ shares. Then, if you want to buy more of the SPAC, let your pocketbook talk.
Warrants Need to Be Offered With a 1:1 Ratio
I’m confident this one will never happen primarily because if the ratio gets too high, more investors will redeem their shares, as I discussed earlier, solely to get the equity kicker. If so, it will become a major vehicle for investors looking to park money in the short term.
However, a solution could be to adjust the exercise price to an amount lower than $11.50.
Using EMLDU as an example, to own three shares of its stock in the future, you would have had to buy two units for $20. The two half warrants that came with the units would be used to buy a third share at $11.50, so your total outlay is $31.50, or $10.50 a share.
So, in this case, you would buy one EMLDU unit for $10. This would give you one whole warrant to buy another share for $11, putting the total outlay at $21, equivalent to what you’re currently paying for two shares.
Now, maybe I’m missing something, but this would also reduce the number of warrants issued and outstanding, cutting down speculation on the price of the warrants while making it easier for regular investors to decide whether to buy the units or not.
SPAC Rules to Be Rewritten: Parties to Merger Announcements Need to Be Held More Accountable for Information Disclosed
Of all the rules that need to be rewritten, this really should be at the top of the list. But, unfortunately, some SPACs have been so egregious in their misleading claims, the SEC has had to step in and fine them.
“‘As the order finds, Nikola is responsible both for Milton’s allegedly misleading statements and for other alleged deceptions, all of which falsely portrayed the true state of the company’s business and technology,’ CNN Business reported Gurbir Grewal, director of the SEC’s Division of Enforcement said. ‘This misconduct — and the harm it inflicted on retail investors — merits the strong remedies today’s settlement provides.’”
Another example of potentially misleading investors could ultimately be found with former President Trump’s media merger with Digital World Acquisition Corp. (NASDAQ:DWAC).
Matthew Tuttle is CEO of Tuttle Capital Management. His firm currently manages or sub-advises 10 ETFs, including The SPAC and New Issue ETF (NASDAQ:SPCX). So he knows a thing or two about these investments.
CNN Business reported some of Tuttle’s comments about DWAC:
“‘This is now the meme stock of all meme stocks,’ said Tuttle, whose firm issues ETFs, including several that focus on the SPAC market. ‘Take all of the buzz going around about AMC and GameStop in January and February and multiply it by a million, and that’s what this is.’”
I’ve got a lot of problems with the DWAC merger.
However, my biggest concern is the lack of detail about the investors putting money into the SPAC’s $1 billion PIPE. At the very least, investors should be given a list of the companies involved in all PIPEs, not just DWAC’s.
The lack of transparency is damning.
On the date of publication, Will Ashworth did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
Will Ashworth has written about investments full-time since 2008. Publications where he’s appeared include InvestorPlace, The Motley Fool Canada, Investopedia, Kiplinger, and several others in both the U.S. and Canada. He particularly enjoys creating model portfolios that stand the test of time. He lives in Halifax, Nova Scotia.