SPAC Shell Games Will Keep Hiding The Ball

By Breakingviews

As blank-check deals go, it hardly could have been much worse than Better (BETR). The online mortgage lender led by Vishal Garg unveiled plans in May 2021 to go public at a nearly $8 billion valuation by way of a special purpose acquisition company, exuberantly telling investors it expected to generate some $5 billion of revenue in 2023. It won’t come anywhere close, with a top line of only about $50 million in the first half of the year.

Better Home & Finance has been a notable casualty of the sharp rise in interest rates, but one thing that differentiates SPACs is the explicitly touted forecasts falling colossally short. With a market capitalization of just $120 million after its SoftBank-backed SPAC merger finally closed in August, Better is a prime example of the excessive hype that became a hallmark of such transactions.

Although appetite for SPACs has cooled, there has been no comprehensive reckoning for the value destroyed. Worse, many of the design flaws that allowed the mania to occur are unresolved.

Like so many other overly bullish presentations in the shell company game, Better’s featured charts with multiple upward-right-pointing arrows, a humongous market up for grabs and a flywheel of virtuously compounding growth opportunities. It’s more or less how another 216 companies backed into public markets in 2021, according to SPAC Research.

Of those, Breakingviews found that 126 deals included revenue outlooks that could be compared to what analysts expect from those companies today. Based on their original pitch decks, the targets projected combined sales of $97 billion for this year. They’re on track to miss the mark by more than 40%, delivering only about $55 billion, according to recent forecasts compiled by LSEG.

(Click here for an interactive version of the graphic.)

These pronounced holes flow directly into value. The electric vehicle industry, for one, was a serial SPAC user whose exuberance sputtered badly. Polestar Automotive (PSNY, PSNYW), once worth almost $30 billion, clocks in at just $6 billion today. Add rivals Lucid (LCID) and Faraday Future Intelligent Electric (FFIE), and the trio is set to under-deliver on its combined 2023 revenue estimates by $12 billion.

No industry was spared, however. Online car vendor Cazoo (CZOO), valued at $7 billion at the start of its SPAC journey, handed the keys to creditors last month, while office-sharing provider WeWork (WE) recently warned that its survival prospects were shaky. BuzzFeed (BZFD) is trending toward about $350 million of revenue this year, a far cry from the $830 million the digital media company envisioned earlier.

Part of the problem is that SPACs don’t go through the rigorous process of an initial public offering. Dressing them up as acquisitions of private firms by listed shell companies enables the participants to play by looser rules. In a conventional sale of new stock, prospective market debutants only make financial projections behind closed doors to professional fund managers. Blank-check deals provided them to a wider group of potential investors.

To some participants, the principle of buyer beware suffices. “Everyone should be an adult and understand that investing in a company’s initial listing is risky,” said Joel Rubinstein, a partner at law firm White & Case, which has advised on more than 150 SPACs and 70 related acquisitions. “The notion that people get hypnotized by the projections and can’t evaluate them along with detailed information about the company is a bit much.”

It’s a valid point, but the structures themselves are also flawed. SPAC investors buy shares in the empty vessel before its sponsor and takeover target agree on a valuation. Both have financial incentives to push up prices. The managers get a bundle of free stock, while the target secures cash and access to a public currency. Although shareholders get a vote, included warrants also motivate them to proceed. They receive a little extra value just for signing up to a deal and a bit more if the shares rise after trading. However well-intentioned it may have been for regulators to encourage disclosure of forecasts to mom-and-pop investors, the decision glossed over important components of such deals.

The Securities and Exchange Commission has filed scattered charges where it found wrongdoing. They include an $18 million penalty against Digital World Acquisition (DWAC), a SPAC that agreed to buy the company behind former U.S. President Donald Trump’s social network, for “making material misrepresentations” as part of its proposed merger in 2021. Just last week, the agency accused Spruce Power (SPRU), formerly known as XL Fleet, of being deceptive with its estimates.

Yet, neither the SEC nor any ambitious prosecutor has made an example of SPACs with a sweeping case, as has occurred in previous securities scandals. Even dogged plaintiffs’ attorneys have demurred. The number of SPAC-related lawsuits seeking class action status dwindled to just five this year through June 15, according to insurance broker Woodruff Sawyer.

Not every SPAC deal disappointed. Of the 2021 crop analyzed by Breakingviews, 19, or 15%, are on pace to hit or exceed their top line targets. The group includes ticket seller Vivid Seats (SEAT), bowling alley operator Bowlero (BOWL) and fashion brand Ermenegildo Zegna (ZGN). Meanwhile, many speculative biotechnology firms and others omitted forecasts entirely.

(Click here for an interactive version of the graphic.)

The popularity of SPACs, which accounted for more than half of all IPOs in 2020 and 2021 while raising more than $240 billion, prompted the SEC under Chair Gary Gensler to issue a 372-page set of guidelines and additional investor protections similar to ones provided in an IPO. They include requirements to spell out assumptions behind financial projections. Moreover, stripping SPACs of certain legal safeguards would make it easier for investors to win in court when alleging that growth forecasts were misleading.

The ideas, floated in March 2022, are credited with causing a chilling effect on SPACs, but they also coincided with monetary tightening which sparked a broader downturn in stock markets and reduced the zeal for investing in unproven companies. Eighteen months later, the SEC has yet to enact the rules, which have been questioned by powerful law firms, including White & Case and Kirkland & Ellis. Gensler indicated last week that its proposal might be adjusted or possibly go unadopted.

Even if implemented, asymmetric incentives will remain. SPAC managers, who are often sophisticated private equity or hedge fund bosses, can secure big payoffs by completing a transaction regardless of how the shares subsequently trade. There are disclosures, but often the information is dense, and what’s missing is just how a transaction’s terms were decided. This leaves shareholders unable to fully assess the quality of a deal.

Without a broader crackdown, new SPAC iterations are bound to arise. It’s possible they will be regarded more skeptically, but such structures have marched on for decades. Investors deserve better, not Better.

Context News

The U.S. Securities and Exchange Commission in March 2022 proposed new rules to govern transactions involving special purpose acquisition companies, or SPACs, which are used to take private firms onto public markets as an alternative to a traditional initial public offering. The comment period closed on June 13, 2022. The SEC typically takes between 12 and 24 months from the time a rule is first proposed until it is enacted so that staff members can “consider possible adjustments to the proposals and whether it’s appropriate to move forward to a final adoption,” Chair Gary Gensler told the House Committee on Financial Services on Sept. 27.

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