In Act I of a two-act tragedy, Greg Heaton chronicles the genesis of Hong Kong’s Special Purpose Acquisition Company (“SPAC”) regime, then recounts the features that make SPACs destructively seductive for fundraisers but regularly ruinous for investors.
The costs of a conventional initial public offering (“IPO”), principally underwriting fees, can amount to over 20% of the money raised. Some private companies, rather than taking the time and expense of going through the listing process themselves, essentially buy a listing off the shelf by merging with a listed shell company. The listing industry has developed various ways to do this – some legitimate, others fraudulent.
Last year, Hong Kong formalized the practice of shell manufacturing with the introduction of a SPAC regime, largely basing its provisions on current US market practice. Problematically, analyses of US markets show that SPAC mergers tend to significantly underperform typical IPOs, with the proportion of investors’ funds that are consumed by service providers being much higher even than in a conventional IPO. As a result, although service providers and fundraisers may profit handsomely, SPACs are a toxic product for retail and professional investors alike, often sparing only those who dump their holdings at the first opportunity.
Act I, Scene I: An ill-omened prologue
Listed shells have plagued the Hong Kong stock exchange (“HKEX”) for decades, long before the vehicles were re-branded as SPACs. Shell manufacturing typically involves the listing of a company without any genuine intention of raising capital for existing operations. Usually it is a relatively small business, such as a family-owned trading firm, with barely sufficient turnover (real or fabricated) to satisfy the minimum listing criteria. Controlling shareholders sell their shares after the IPO and expiry of a regulatory lock-up period, and the directors have a change of heart regarding the business plan disclosed in the prospectus. Sometimes, they sell the company’s business back to its original owners, who walk away with a profit, leaving a listed shell with no operations.
Shareholders of the shell can usually sell at a premium to book value. At best, this premium represents the opportunity for quick access to public capital markets without the inconvenience of jumping through the regulatory hoops of an IPO. At worst, the premium is speculative froth arising from illegal market activity. Listed companies with few assets tend to have low revenue and few shareholders. The shares are likely to have a low trading volume, making them especially vulnerable to market manipulation and price volatility. A classic “penny stock fraud” involves the quiet accumulation of such shares, then noisy promotion by boiler room brokers through spam emails and cold calls. New demand drives up the price, allowing scammers to sell their shares at a profit before the demand and price again collapses.
The directors of the shell company, having divested the original business, later buy another. That business thereby becomes a public company via a “backdoor listing”, circumventing the regulatory vetting of the usual listing process. Backdoor listings are susceptible to fraud. This is because directors of the listed shell can make an acquisition with relatively little disclosure and oversight. In an IPO, key information must be disclosed in a prospectus, and underwriters mitigate their risk by undertaking due diligence. Without this independent verification, it is easier for the business that is going public to falsify its earnings and inflate its stock price. The directors of the listed company acquiring that business might be misled by the falsification, indifferent to it, or complicit in it.
Previously, the Securities and Futures Commission (“SFC”) and HKEX tried clamping down on shell manufacturing and backdoor listings. They increased their scrutiny of suspicious listing applications, such as those with assets consisting substantially of cash, and threatened to suspend or de-list companies with insufficient business operations. With backdoor listings attracting unwelcome regulatory attention however, the scions of at least two Hong Kong billionaires turned away from Hong Kong markets to list SPACs in the US instead. This development, two or three years ago, spurred Hong Kong authorities to rethink their regulatory approach.
Act I, Scene II: A peek behind the curtain
As investment vehicles without any existing business, SPACs are simply listed shell companies in a different costume. Many are launched by high-profile financiers, known as “founders”, “sponsors”, or “promoters”. After raising capital through an IPO, the SPAC swallows one or more private companies (“de-SPAC targets”), a process known as “de-SPACing”. Although sometimes referred to as an “acquisition”, the deal is usually structured as a reverse merger, in which shareholders and management of the target gain control of the SPAC. The merged “successor company” is listed, and the target thereby becomes publicly owned and traded.
For investors, one of the purported benefits of SPACs is that they provide an opportunity to exploit a valuation arbitrage between private and public equity markets by participating in private equity-like investment. However, that benefit has usually proven illusory, with the structure of SPACs creating substantial costs, misaligned incentives between promoters and other shareholders and, ultimately, losses for investors who continue to hold shares after de-SPACing.
Theoretically, investigation and analysis by promoters should enable them to identify promising targets among private companies that might struggle to go public through a conventional IPO. An IPO may be problematic, for example, because the company’s business is unusual or complicated, making it difficult for the company and its underwriters to agree on an IPO price. Another potential advantage of SPACs is that, within basic regulatory parameters, there is great scope for customization of the commercial terms governing each structure. In practice, however, SPACs have proven resistant to commercial innovation and have become quite standardized.
For promoters, the irresistible attraction is that they acquire equity in the SPAC on far more favourable terms than investors in the IPO or subsequent investors on the open market. The standard arrangement is that promoters are issued 20% of the post-IPO shares for mere nominal consideration. For example, if IPO investors buy 80 million shares for $10 each, the promoters receive 20 million shares essentially for free, resulting in a total issue of 100 million shares with $8 underlying each of them. Those 20 million shares, referred to as “the promote”, are the promoters’ reward for their efforts and risking their capital to set up the SPAC and complete a de-SPAC transaction. Promoters may also receive earn-out rights, entitling them to additional free shares if the successor company achieves specified revenue, profit or share price targets.
In most cases, SPAC promoters cannot use any IPO proceeds to pay the costs of the IPO and of finding a de-SPAC target. Instead, promoters themselves fund the SPAC’s working capital. For example, a SPAC may use a loan facility from its promoters, and also sell “promoter warrants” for $1 each. Each warrant may entitle the promoters, one year after de-SPACing, to purchase one share for $11.50. Warrants are typically exercisable on a cashless basis, meaning the promoters, in this example, can surrender their warrants in exchange for shares of equivalent value to the amount by which the market price of the shares exceeds $11.50. Although used primarily as a mechanism to pay the SPAC’s expenses, rather than as compensation for the promoters, the warrants will yield a profit if the successor company’s share price exceeds the exercise price by more than $1.
IPO investors, meanwhile, are customarily issued free warrants alongside the shares, similarly entitling the warrant holder to purchase newly issued shares in the future at a certain price. This compensates IPO investors for using their cash, like underwriters, to help launch the SPAC.
A proposed SPAC merger can only proceed after receiving majority shareholder approval. Shareholders rarely withhold approval because their warrants become worthless if no merger is completed. If the promoters fail to finalize a merger within a predetermined period, usually two years, all shares (other than the promote) are redeemed at the IPO price plus interest. The SPAC’s net asset value – consisting chiefly of the IPO proceeds, until then held in trust – then falls to zero, so the promote and all debt of the company become worthless. Consequently, promoters have an overwhelming incentive to ensure de-SPACing occurs, even if the terms are unfavourable to other investors. Given the costs they incur versus the equity received, promoters can enjoy very fat returns. This is possible even if the SPAC acquires targets for more than they are worth and the successor company’s share price subsequently tumbles.
While promote shares are locked-up, other shareholders are entitled to cash out, at the IPO price plus interest, after a merger is announced and before it is completed. Consequently, until de-SPACing, IPO shareholders enjoy a capital-guaranteed investment with potentially attractive returns, plus a free “equity kicker” in the form of warrants. If shares are trading above the IPO price, these investors typically sell them. Otherwise they typically redeem them after the merger announcement. According to a study published in 2022 (Klausner, Ohlrogge and Ruan), the investors in SPAC IPOs in the US are predominantly hedge funds and “nearly all” of them sell their shares before de-SPACing. However, most retain their warrants until they become exercisable, usually 30 days after de-SPACing. The authors found that the warrants delivered average annualized returns from the IPO until de-SPACing of 11.6%. While this may be an attractive low-risk return, it is a potential trap for retail investors. If an investor misses a notice of redemption and fails to exercise the warrants, they become worthless. The inattentive or inexperienced investors’ loss is the other investors’ windfall.
Some of the equity lost to redemptions before de-SPACing is offset with private investments in public equity (“PIPE”) by independent institutional investors. The promoters and the target undertake a promotional roadshow, much like a company going public through a conventional IPO. Although shares are typically issued to PIPE investors at a discount, the funds raised at this stage often exceed non-redeemed equity from the SPAC IPO. PIPE financing therefore can sharply reduce SPAC costs as a percentage of net cash delivered to the successor company.
Even with significant PIPE financing, the costs of the SPAC process are typically “more than twice as high” as a conventional IPO. The promote, earn-outs and warrants, which substantially dilute other shareholders’ share of the underlying cash, are the most eviscerating expense. Further costs include underwriting fees, typically charged at 5.5% of the IPO proceeds, without adjustment even if most of the shares are redeemed before de-SPACing. The underwriter and other service providers may also tap the SPAC for advisory fees. Redemptions then deplete the amount of underlying cash, thereby amplifying the costs for each remaining shareholder.
Klausner et al’s study of 47 de-SPAC transactions occurring from January 2019 to June 2020 found that the average net cash underlying each SPAC share (issued at $10) was just $4.10. This means that more than half of the value per share was dissipated through fees and other compensation.
Until a merger is announced, SPAC shares tend to trade at roughly their IPO price of $10, because the redemption right creates a price floor. A year after de-SPACing, however, most successor companies’ share prices have underperformed by an amount roughly comparable to the cash per share that has been extracted by service providers, “with the remaining value [on a market-adjusted basis] roughly equal to the net cash a SPAC contributes to a merger.”
While SPACs might be dazzling upon first appearance, they typically bomb at the box office. In next month’s issue, the author reviews SPACs’ recent Wall Street performance and, off-Broadway, the Hong Kong regime’s first 12-month season.
This article first appeared in the April 2023 issue of Hong Kong Lawyer, the official journal of The Law Society of Hong Kong.