The Wall Street Journal recently reported that at least 25 SPACs (special purpose acquisition companies) have concerns about their financial future. This represents more than 10% of the SPACs that went public between 2020 and 2021. SPAC investors had hoped to earn outsized returns.

A SPAC is a listed shell corporation that exists expressly to acquire startups and/or merge with an existing operating company. An operating company can be acquired by a publicly traded SPAC and become a listed company in lieu of executing its own IPO. SPACs typically have 18-24 months to identify and complete a merger with a target company. If an acquisition is not consummated prior to an outside date, the SPAC dissolves and returns the proceeds back to the investors.

SPACs are about twice as risky as more traditional companies that have gone through initial public offerings. The WSJ stated, “A high percentage of SPACS have missed their forecasts. Many companies, particularly startups with little revenue, quickly found that their projections were harder to attain than they said.”

We need to be attentive when a company’s auditor issues a warning when there is “substantial doubt” about a company’s ability to stay afloat over the next 12 months. Analysts Minmo Gahng and Jay Ritter of the University of Florida reported that shares of companies that listed through SPACs in 2021 were down an average of 59.5% as of May 23, 2022.

SPACs and the SEC: The need for change

In late 2021, SEC Chairman Gary Gensler suggested that the regulations involving SPACS might need to change. Modifications could include the following:

  1. How SPACs are marketed;
  2. What must SPACs disclose;
  3. Make the SPAC regulatory environment more closely aligned with IPO regulations.

Issuers found SPACs attractive for the following reasons:

  1. Looser regulations than IPOs, allowing startups to entice investors with projections of revenue and profits;
  2. Provide companies access to capital when market volatility and other conditions limit liquidity;
  3. Expedite the timeline to become a public company.

Michael Dambra, associate professor of accounting at the University of Buffalo, wrote a paper entitled “Should SPAC Forecasts be Sacked?” His paper points out that it is unclear whether forward-looking statements are beneficial or harmful to investors. Dambra questioned the integrity of the forecasts of SPACs. He wrote, “SPACs provide private firms an alternative route to going public that permits disclosure of forward-looking information without facing an increase in litigation risk.”

Dambra expressed the following reservations:

  1. The lack of historical performance may increase investor reliance on forward-looking statements.
  2. SPAC sponsors’ compensation is tied to the completion of the acquisition.
  3. SPAC sponsors are incentivized to provide optimistic, forward-looking information to ensure that the acquisition shareholder vote does not fail. That is, SPAC shareholders must approve the acquisition by majority vote. If the SPAC’s public shareholders vote against the transaction, they can elect to redeem their shares.

The challenges facing SPACs

Dambra did point out a benefit of SPACs. He wrote, “Forward-looking information may help shareholders make decisions about a proposed de-SPAC merger more capably and confidently, especially given that many private targets have limited historical information.”

For the past several years, investors benefitted from trillions in stimulus money, declining interest rates and record highs in the stock market. This positive scenario has changed. The challenges facing SPACs is part of the broader challenges facing the U.S. capital markets. Through Memorial Day, the Dow Jones Industrial Average is down -8.6%, the Nasdaq Composite is down -22.6% and the S&P 500 Index is down -12.8%.  We have been on a roller coaster ride for the past two years, experiencing the longest extended period of high volatility since the 2008 financial crisis. Investors face uncertainties from high inflation, the Russia-Ukraine conflict, rising interest rates, the end of quantitative easing and midterm elections.

Originally published in the Sarasota Herald-Tribune