SPACs Under Attack
The writing has been on Wall Street for a while, but the inevitable appears to have happened. Special-purpose acquisition companies (SPACs)—“blank-check” companies that merge with private companies in order to go public without the scrutiny of a traditional initial public offering (IPO)—were potentially laid low in April by the Securities and Exchange Commission (SEC), which issued accounting guidance that changes the way SPAC warrants are classified in the financial statements.
In layman’s terms, a warrant can give early SPAC investors the opportunity to buy additional shares in the future at a preset price. So if the SPAC stock rises, exercising these warrants can mean huge returns. This new guidance doesn’t really change a SPAC’s overall economics, but it does introduce some mumbo-jumbo (a technical accounting term) and signal that the SEC is looking to tap the brakes on the SPAC free-for-all.
There were a record number of SPAC IPOs in March 2021—109 in total. But the craze, which set records in four consecutive months, has clearly hit a wall, tumbling to only 10 scheduled SPACs in April.
Whenever there's a drastic change in trends, it takes awhile for the dust to settle. But it’s clear that SPACs are currently radioactive, and the SEC’s guidance may have ramifications for companies that already went public via SPACs. There’s a lot to unpack about the "Great UnSPACking," so let’s get started.
What a difference a month makes
A decade ago, SPACs were a rarity. They may return to that state a decade from now, but it is worth investigating how we got here.
A SPAC allows investors to create a shell company to raise money via an IPO, with the main goal of acquiring another private company. The SPAC acts like a cocoon that absorbs a private company, only to have it burst forth as a publicly traded butterfly. Proponents of SPACs point to a cheaper cost (in theory…see warrant discussion above) and a shorter time to go public while bypassing some of the traditional IPO scrutiny.
Still, they languished as edge cases for decades until a merging of politics, business, and opportunity in 2019 got the SPAC snowball rolling down the hill. Billionaire businessman Sir Richard Branson turned away from the Saudi Arabian government to fund his space-venture company Virgin Galactic and instead merged with a SPAC, starting a trend that lured companies like DraftKings, Opendoor, and Nikola Motor to go the SPAC route. Celebrities from Shaquille O’Neal to Alex Rodriguez stepped into the spotlight to become SPAC sponsors.
SPACs gained critical mass and headlines in 2020, when more than 250 were launched, raising $83 billion. That trend became a wave in the first quarter of 2021 with five SPACs created every working day in January. By March, more than 300 SPACs had been created, breaking the previous year’s record in just 90 days.
Then the snowball fell off a cliff.
Between a rock and the SEC
Before 2019, SPACs were regarded with some trepidation, as a back door means for unworthy businesses that couldn’t handle the bright lights of an IPO. The SEC has apparently not changed that view despite the boom.
In December 2020, the Commission issued guidance for investors to take care with SPACs. On March 10, 2021, it put out an alert that basically said that just because celebrities are involved in a SPAC does not make them inherently trustworthy (shocker!). On March 31, it released two statements: one regarding the financial reporting and auditing considerations for companies merging with SPACs, and another about accounting, financial reporting, and governance issues. Just in case the financial world misunderstood, last week’s guidance was the latest in a long line of SPAC-weary messages.
Time will tell if the SEC’s guidance on warrants will fundamentally slow the SPAC roll, and one could reasonably ask if that train was already headed to the station, considering that the momentum was already grinding to a halt even before the change on warrants. Headlines and money figures of the type SPACs garnered in 2020 create a frenzy of activity but the market has a way of adjusting to what seems too good to be true. Eight electric-vehicle firms went public via SPACs in 2020 and five of them promise to go from earning no revenues to $10 billion in less than five years. Perhaps, but, as the Economist points out, not even Google pulled off that trick.
Trends come and go all the time (remember the Macarena?), and from Dutch tulips to housing, investors know it is the nature of bubbles to burst. If the SPACarena has indeed flamed out, what comes next could have huge ramifications for businesses that already went public via SPAC.
Juice, meet the squeeze
When it comes to accounting matters like these, it’s definitely shades of gray rather than black and white. It’s important to note that everything the SEC has released thus far is interpretations of existing accounting standards. But when you’re the regulator who oversees the accounting standard setter, your interpretation is really the only one that matters. Moreover, if the Commission uncovers abuse of these interpretations, SEC comment letters may quickly become enforcement actions. (In plain English: Enforcement actions = U.S. Department of Justice = people who can send you to jail.)
Again, the guidance on warrants probably does not change the overall economics of a SPAC transaction, but it will clearly cause some understandable apprehension and short-term pain, forcing suddenly SPAC’d companies to potentially restate previously issued financials and recalculate the value of warrants each quarter (the previously mentioned mumbo-jumbo). And that’s before the inevitable pressure on external auditors to issue opinions with the SEC guidance ringing in their ears. In other words, the SEC has likely undone some of the expected benefits of SPAC transactions in the first place, and that most certainly wasn’t by accident.
Will SPAC mergers go away for good with traditional IPOs reclaiming their perch as the preferred way to go public? Probably not—at least not yet. There’s still a lot of legitimate opportunity hanging in SPAC cocoons that will make their way to the public market, and rightly so.
Notwithstanding, the SEC’s shot across the bow should be a warning to SPAC sponsors (I’ll take that off my 2021 resolutions), and aspiring SPAC targets (note to my 11-year-old daughter’s lemonade stand) that SPAC riff-raff is starting to get noticed and addressed. While we wait to find out just how wide the impact of the SPACaggedon may be, accounting teams, who will bear the brunt of these changes, need to be prepared for anything and armed with the right tools and platforms for their complex work.
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