Our latest blog takes an updated look at SPACs and their potential risks as the market comes under heavy scrutiny from US regulators
What are SPACs and how do they work?
Special Purpose Acquisition Companies or SPACs are shell companies formed with the sole purpose of raising money to acquire a company that already exists. A SPAC does not have any commercial operations and exists only for the purpose of creating an IPO (initial public offering) to raise capital. The funds raised through this process are then used to purchase an actual company. SPACs are also sometimes referred to as ‘blank cheque companies’. SPACs can only run for a maximum of two years before they must purchase the target company or return the funds to investors.
What are the risks?
There are risks to investing in SPACs and critics say they take advantage of less-sophisticated retail investors. Some suggest less-experienced investors are being bilked by the system and misled by celebrity endorsements and opaque investment strategies, as very little is revealed to investors about the company being targeted for acquisition.
The Great SPAC Crash: what is happening?
In the final few weeks of 2022, the so-called Great SPAC Crash was in full swing as at least 80 SPACs held shareholder meetings with investors looking to cash-out (according to Bloomberg.)
One of the drivers behind investors looking to divest was a potential new excise levy being proposed by lawmakers in the US. Part of President Joe Biden’s Inflation Reduction Act looks to place a 1% levy on stock repurchases and buybacks – which could inadvertently impact SPACs investments.
Other potential reasons for the spike in SPACs liquidations include high interest rates, rising inflation and falling share prices, plus disappointing returns on many recent SPAC-funded acquisitions and increased regulatory scrutiny from the US Securities and Exchange Commission (SEC).
The sheer volume of SPACs materialising in recent years has raised red flags, as has the way they are being marketed, the level of returns that retail investors can expect because of the way SPACs are structured and marketed, and the overall lack of transparency for investors. Parallels have even been drawn with collateralised debt obligations (CDOs), collateralised mortgage obligations (CMOs) and related products that triggered the Global Financial Crisis of 2008.
Have SPACs lost their lustre?
According to data from EY, SPAC deals went from a record 613 in 2021 to just a fraction of that number in 2022. SPACs became popular because they allowed a company to go public much more quickly than if they did so via a traditional IPO and with far less red tape. However, In March 2022, the SEC approved proposals for new rules around the use of SPACs as IPO alternatives. SEC Chairman Gary Gensler said the proposals would “strengthen disclosure, marketing standards and gatekeeper and issuer obligations by market participants in SPACs, helping ensure that investors in these vehicles get protections similar to those when investing in traditional IPOs.”
A hotbed for fraud?
Hundreds of investigations have been launched by the SEC into potential fraud via SPACs. On 3rd January 2023, Cooper Morgenthau, the former chief executive of two SPACs, African Gold Acquisition Corp and Strategic Metals Acquisition Corp, pled guilty to embezzling more than US$5m via a fraudulent SPACs scheme. US Attorney Damian Williams said: “Cooper Morgenthau…has admitted that he breached the trust that he owed to his public and private investors, stealing millions of dollars from them to trade meme stocks and cryptocurrencies. This Office remains committed to rooting out fraud in the SPAC market and to protecting Main Street investors from abuses on Wall Street.”
A report by the Financial Times suggests significant compliance weaknesses are likely to emerge as SPACs publish their annual financial reports. “The failures of internal controls and poor bookkeeping practices, disclosed in quarterly reports over the past month, add more evidence for critics of special purpose acquisition companies, who say the trend has resulted in a large number of immature and potentially risky new listings,” it says.
According to Investment research company, Bedrock AI, almost half of the financial filings by de-SPACs (a de-SPAC is the term used for the process that takes place when a SPAC purchases or merges with its target company) contained an admission of ineffective internal controls (49%), compared with just 20% of traditional US public companies.
“The boom of the SPAC market was fueled thanks to the low interest rate environment which forced investors to redirect to higher risk investments,” says EY. According to the EY Global IPO Trends Report, Q2 2022, the number of SPACs going public dropped by 80% compared to the previous year. Up until October 2022, SPAC IPOs attracted about US$11.8bn in gross proceeds, which was down 88% year-on-year.
Europe was later to the SPACs party, with a slower uptake than the US. However, it has still witnessed a significant drop in activity, with US$1.8 billion in the first half of 2022, down from US$5.11 billion at the same point in the previous year.
More from RiskBusiness on SPACs:
SPACs: What are they and why are they a potential source of non-financial risk?