In the past year or so, a new way of bringing private firms to the stock market has become all the rage on Wall Street. It involves—acronym alert—SPACs, short for “special purpose acquisition companies.” The upsurge in SPACs currently has no parallel in the City, owing to regulatory restrictions. Now there are moves afoot to allow London to follow suit. But this is one American financial innovation that Britain can usefully do without.
SPACs have turned on its head the usual process of launching a private company on the stock market in the United States. Traditionally, that has occurred through an initial public offering (IPO), which critics say is cumbersome and expensive. Instead, a SPAC raises money, also through an IPO, with the sole intention of finding a promising private business that it can take over, generally within two years. It must not identify any such acquisition target at the time of the IPO, but it can specify an industrial sector. The funds that it raises are parked in a trust account. As and when a deal is reached, the SPAC turns from a shell company into an actual business.
SPACs have been around for decades, but were for a long time no more than a sideshow in bringing private companies to the equity markets. All that has now changed. As recently as 2019, the funds raised by SPACs in the US amounted to over $13bn, or 19 per cent of the total raised through IPOs, according to SPACanalytics. Last year that vaulted to $83bn, worth 46 per cent of all IPO proceeds. In the first three months of 2021, that has leapt again to $97bn, equivalent to 69 per cent of total proceeds.
The lift-off in SPACs has been boosted by some high-profile ventures, such as the one enabling Richard Branson’s Virgin Galactic to go public in 2019. They appear to offer something for everyone at a time when advances in technology are creating the opportunity for start-ups to gatecrash markets long dominated by older firms. For brash new private enterprises, SPACs provide a nimbler and more secure way to the stock market than a traditional IPO. For the investors in them, they offer a chance to get in on the action ahead of the crowd, thanks to the expertise of the sponsors—the management teams—that create them.
Are SPACs really such a good thing, worth encouraging in London? To find out whether that is the case, you have to delve into what public investors get when they back a typical American SPAC. The standard price they pay is $10 per unit, each comprising one share and a fraction of a warrant. The warrants confer the right to buy a number of additional shares after the acquisition at a pre-determined price, generally of $11.50 per share. When the SPAC selects its merger target, investors unhappy with the choice can redeem their shares, in which case they get their money back. If they exercise that redemption right, they still retain their warrants.
For the original investors who do redeem their shares, SPACs are an attractive proposition. They get the same return that they could expect if they themselves put their spare cash in a safe place. However, through their warrants they can also benefit if the combined company turns out to be a success.
But for public investors who stay the course, the position is very different. Their initial investment is whittled away in three ways. At the conclusion of the IPO, a fifth of the total equity in the SPAC belongs to its sponsors in return for a nominal sum of money (usually $25,000). The investors that remain also have to contribute to the underwriting fee for the SPAC’s own IPO, most of which is deferred until it merges with the target firm. And, if the combined company wins favour and its share price goes up, the gains have to be shared with the investors who got out at the merger but retained the warrants.
Each of these three claims dilutes the worth of a $10 share invested at the start. A recent study by American law professors Michael Klausner and Michael Ohlrogge together with Emily Ruan focused mainly on SPACs that merged with their target business between January 2019 and June 2020. They showed that for a typical such SPAC, overall dilution leaves cash of only $6.67 per share by the time of the merger. This helps to explain why they found disappointing returns for not just this specific group of SPACs but also earlier ones. With so much money in effect drained out of the original proceeds, the shares start off with a heavy handicap.
At the very least, the American experience with SPACs suggests that Britain should be cautious about fostering them. But, following the damage inflicted on the City by Brexit, the government wants to show that it can do something to promote rather than undermine London’s standing as a financial centre. To that end, in November Chancellor Rishi Sunak asked Jonathan Hill, a former European Commissioner in charge of financial services, to review the rules that apply to companies listing on the stock market.
Despite acknowledging “a number of reservations being expressed about SPACs,” one of Hill’s recommendations when his report was published in early March was to facilitate them. The Financial Conduct Authority is dutifully following up by consulting on proposals that will remove a crucial regulatory obstacle in London, the suspension of trading in SPACs at the point of disclosing their acquisition target, while providing some further protection for investors in them.
The rushed initiative is ill-considered. Hill’s hastily conducted review lacked analytical rigour and glossed over the case against SPACs. The move is also badly timed. Sudden surges in a particular financial activity are often a warning sign. The financial crisis of 2008 would have been less traumatic for Britain if supervisors had been less tolerant of some of the more questionable practices that had burgeoned in London owing to light-touch regulation. Far from seeking to participate in what has become a frenzy, the City should steer well clear of SPACs.
