[Gitika and Yashvardhan are students at NALSAR University of Law, Hyderabad.]
Special Purpose Acquisition Companies (SPACs) have recently emerged as an extremely popular means of investment having raised record amounts of money to take private companies public. As of June, 330 SPACs have already raised $105 billion in 2021. Indian companies such as ReNew Power, Yatra[dot]com, and Videocon D2H have also entered into massive deals with American SPACs.
In this context, regulators across the globe have undertaken to assess the viability of allowing SPACs within their jurisdictions. For instance, the Financial Conduct Authority (FCA) in England has recently released a consultation paper outlining its intention to permit SPACs. Similarly, the Australian Securities Exchange (ASX) has also seriously considered its viability. In India, the Securities and Exchange Board of India (SEBI) has recently formed a committee of experts to examine the feasibility of SPACs. In this article, the authors argue that the essential elements of the SPAC structures make them unviable in India.
The Essential Elements of SPACs
SPACs are described as “blank-cheque companies” since they do not have any commercial operations of their own. Instead, they are typically formed to raise funds through Initial Public Offerings (IPOs), which in turn finances an acquisition or merger with an unidentified target company. Post-completion, the SPAC reflects the identity of the target company. Consequently, the target company automatically becomes a listed company, thus avoiding the tedious IPO process.
Investors, at the time of offering, park funds into an empty vehicle with no identified targets or company track record. Owing to this leap of faith, certain aspects are essential to the SPAC structure. First, the shares of the SPAC are issued at a standard price, as the company has no pre-existing track record to justify price setting. Second, SPACs must identify and merge with a target company within a set time frame. For instance, the Securities Exchange Commission in the United States (SEC) prescribes two years. This ensures investor funds are not indefinitely parked in the vehicle and can be returned upon a failure to merge. Third, any investment in the SPAC is complemented with a right to “redeem”. At the time of merger, all investors have a right to redeem the entire value of their investment and exit the SPAC. This right typically exists irrespective of the manner in which the investor votes in relation to the prospective merger.
Regardless of the specific regulations that SPACs are subjected to, these essential aspects remain integral. FCA’s consultation paper has also affirmed that these features must be integrated to operationalise SPACs. However, these aspects attract significant downfalls and are particularly harmful in the Indian context.
Individual Investors and SPACs
The functioning of SPACs has proven inherently disadvantageous to individual non-institutional investors in two prominent ways.
Unequal distribution of risk
As the number of SPACs increase rapidly, most find themselves in a race against time to identify target companies within the stipulated timeframe. In the United States, there are presently more than 180 SPACs attempting to identify a ‘merging partner’. In fact, sponsors do not have a strong history of delivering deals altogether. Of the 313 SPAC IPOs since the start of 2015 to October 2020, only 93 companies have gone public.
Importantly, if the sponsor cannot deliver the deal, they must bear all the legal and underwriting costs. This incentivises sponsors to prioritise the identification of a target, over their duty to identify strong profitable companies. Consequently, SPACs partake in increasingly dubious deals to ensure that they identify targets in time. For instance, the SPAC, Landcadia Holdings II recently merged with Golden Nugget Online Gaming. However, the transaction had a significant conflict of interest, since the sponsor was also the owner of the target company and subsequently reduced his debt through the transaction.
Finally, even if bona fide, the deals rarely become profitable. According to a working paper published by the European Corporate Governance Institute (Working Paper), SPACs’ median returns are a loss of 12.3%. There are already signs of fatigue in the market, with several SPACs trading below their standard price. It is even predicted that the bubble is due to burst soon.
While the risk prima facie affects all investors equally, the brunt of the losses is actually faced by individual investors. While hedge funds continue to have a significant hold on SPACs, the Working Paper found that 97% of hedge fund investments are sold even before the target merger can take place. They simply trade these shares in the short-term to take advantage of the bubble. Hedge funds have made a consistent profit of around 20% from the SPACs, despite the companies themselves being unprofitable. Therefore, the entire effective risk is finally borne by those individual investors, who do not have the expertise to identify opportune moments to exit, or have the resources to independently monitor proposed deals.
Unexpected dilution of capital
Individual investors often bear unexpected dilution costs, leading to a reduction in the value of their investment. Dilution refers to the reduction of a shareholder’s equity positions through the issuance of new shares or increase in costs. This leads to a decrease in the total value of investment. The two primary hidden causes are the sponsor’s promote and the underwriting fees.
The promote refers to the compensation received by sponsors for covering the IPO costs. It is usually done by taking a block of shares equivalent to 25% of the IPO proceeds. This significantly dilutes the face value of the shares, as these shares do not require capital input. Importantly, its impact is exaggerated by larger shareholder redemptions, or any adjustments in the promote during the merger.
Dilution may also be a product of the underwriting fees. Typically, SPACs spend about 5.5% of IPO proceeds towards underwriting fees. However, as the Working Paper notes, 3.5% is conditioned upon the merger and is paid after the merger has taken place. Consequently, as large majority of SPAC shares are redeemed at the time of merger, the proportionate cost of underwriting increases significantly for the remaining shareholders. The 3.5% fees payable on the entire IPO proceeds becomes exorbitant in comparison to the capital that is finally retained.
Sponsor’s returns are so large through the promote, that the success of the target company in the long-run is insignificant to them. Similarly, the hedge funds that often create the initial excitement around these companies also sell their shares early-on. Therefore, only individual investors stay invested in the companies for long enough to bear the risk of these dilution costs, which they may not have foreseen at the time of investment.
Unsuitable to the Indian Context
Whether the SPAC structure is appropriate, must be ascertained in light of the particular context of each jurisdiction. For instance, while FCA has been quick to float potential changes to accommodate SPACs, ASX has been more cautious in its approach owing to its past experience. In India, potential harm to individual investors is exacerbated, making it incompatible with the country’s regulatory regime.
In India, SEBI has consistently afforded higher protection to individual investors recognising that they may not possess the requisite sophistication to trade in risky instruments. For instance, it explicitly prohibited individual investors from trading in the potentially risky Additional Tier – 1 instruments on account of a lack of a technical know-how. This was done on the belief that they could not be expected to understand the full-import of potential risks. SEBI even released a consultation paper on the concept of ‘Accredited Investors’, noting that the large majority of Indian individual investors cannot grasp all risks associated with their investments.
Such beliefs also dictate the protections provided by SEBI at every juncture. For instance, Regulation 30 of the SEBI Issue of Capital and Disclosure Requirements Regulations 2018 specifically protects individual investors against price discrimination. Similar protections are not afforded to the institutional investors, recognising the disparity in the Indian context. It is therefore apparent that the regulatory framework in the country is framed in a manner that recognises the lack of sophistication of individual investors.
As discussed previously, the nature of SPACs requires investors to possess the expertise to identify opportune moments to exit. Additionally, it requires significant sophistication as one must be able to independently verify risks associated with their transaction. To accommodate such a system, it is imperative that the individual investors have the requisite know-how to navigate through it. SEBI has continually recognised that this cannot be expected of individual investors, and there is little factual data to justify a significant change from this stance.
In conclusion, even though the non-recognition of SPACs may result in other Indian companies entering foreign markets through the vehicle, SEBI should avoid the temptation to hop on the SPAC bandwagon. A move in the opposite direction is likely to jeopardise the cautious investor-first model adopted by SEBI. As the SPAC bubble continues to show signs of fatigue, SEBI must prioritise individual investor protection over an attempt to capitalise on a potential bubble.