Is It The End Of The Age of SPACs?

The promise of unrealized potential may not quite be the most powerful drug on Earth, but it’s in the conversation. What could be is always more intoxicating than “it is what it is; here’s a plan; let’s execute it”.

In sports, this manifests in the form of draft choices – lottery tickets on which fans can dream, each potentially a future superstar. In business, the endorphin rush comes from, if not the idea of the idea, then the initial planning, when every market is addressable, and the trajectory of success is bound only by the imagination.

It’s less frequent than day-to-day minutiae and the tireless grind required to keep an enterprise afloat is romanticized. The allure typically lies in being the “ideas person”, the one whose intellect and creativity spawns high-level meetings and, of course, attracts funding.

On more than one occasion, we’ve gotten together to talk about SPACs.

To give you a quick refresh, a SPAC – or special purpose acquisition company –is a shell company, that exists solely to acquire an existing company. These funds are raised via initial public offering (IPO), through the sale of “units” (common shares, plus warrants, which entitle holders to buy additional shares post-merger). Once an acquisition is completed – which typically must be done within a two-year window – the entities are merged, and the combined company continues to trade publicly, under the acquired company’s name.

Over the past two years, SPACs become a creative means by which shareholders in private companies take those companies public, more quickly and with far less financial and regulatory hassle than with a traditional IPO. The 248 SPAC IPOs of 2020 raised nearly half of all IPO proceeds (about $83 billion) and, in terms of both volume and proceeds, not only smashed the previous records set in 2019 but topped the totals of the previous five years, combined.

Five months into 2021, 325 SPAC IPOs (72% of all IPOs; more than 500 have filed to go public this year) have already raised more than $103 billion, or 62% of all proceeds). According to SPAC Analytics, 2021 has already accounted for almost 34% of SPAC IPOs and over 40% of proceeds. EVER.

If you look back, though, you’ll notice that this activity represents a slightly smaller portion of the overall pie than it did a few weeks ago. That’s not a coincidence.

Oh Yeah… We’ve Still Got To Do That!

Until very recently, sponsors were primarily incentivized to continue creating new SPACs, each promising to acquire solid, sustainable growth at a reasonable price. This, of course, also happens to be the part of the process in which brings in the money. That’s probably a coincidence.

As of April 15, the number of SPAC acquisitions in 2021 was on pace to blow past 2020’s record mark. This is a bit misleading, of course, as the hundreds of acquisition companies established over the past year-plus, in general, haven’t actually been doing much acquiring. Sure, that April 15 figure (39 announced acquisitions) was tracking well against 2020’s total of 79, but the fact is that (according to SPAC Analytics), of the 961 SPACs ever created, some 423 are in the market right now, seeking acquisitions.

So, why is it that so few deals are getting done? Is it a simple as some sort of aversion to trading the romance of the process – the launching of a company, fundraising, bargain-hunting – for well, running a business, day in, day out? While it’s undoubtedly more fun toasting over champagne and millennial-aged scotch… that’s probably not it.

So what gives?

“We’re From the Government and We’re Here to Help”

Firstly – and incredibly importantly – the Securities and Exchange Commission recently elected to chime in on SPACs – and not because they’re big fans of financial innovation. Guidance issued by the SEC in late March and throughout April called into question key assumptions made by the issuers of SPAC shares and warrants. On April 8, the SEC’s acting Director of Corporate Finance, John Coates, said, rather pointedly, that:

“The staff at the SEC are continuing to look carefully at filings and disclosures by SPACs and their private targets… Any simple claim about reduced liability exposure for SPAC participants is overstated at best, and potentially seriously misleading at worst… in some ways, liability risks for those involved are higher, not lower, than in conventional IPOs.”

This wasn’t the opening shot, though.

Safe Harbor?

(Hopefully) Without getting completely lost in the weeds… a 1995 law, the Private Securities Litigation Reform Act (PSLRA), included a “safe-harbor provision”, which was intended to curb frivolous investor lawsuits. The provision offers protection to companies issuing forward-looking statements regarding expected performance during a merger, as these standard statements are typically used to communicate the rationale and outlook for a merger to analysts and investors.

As pre-merger SPACs have neither a financial track record nor an actual business of which to speak, virtually all of their value is derived from the expectation of future success. The issue is that SPACs rely on this protection in making forward-looking statements about their deals. While they exist solely for the purpose of facilitating a “merger”, the SEC believes (in one man’s opinion, not unreasonably) that SPACs are more IPO than M&A, and are thus subject to stricter restrictions around forward-looking statements that apply to pre-IPO companies. Based on this, in late March, the SEC called into question whether the warrants accompanying common SPAC shares should be treated as equity – as they typically have been – or liabilities.

On April 12, the SEC preliminarily concluded that these warrants “should be classified as a liability measured at fair value, with changes in fair value each period reported in earnings”, and that treating them as equity and issuing forward-looking exposes shareholders to “greater risk, complexities, and challenges”, and the companies themselves to a measure of regulatory liability.

Should the SEC concluded that these warrants must be treated as liabilities, sponsors will no longer be able to simply affix a one-time, up-front value to them. Rather, they’ll need to hire third-party accountants and auditors, on a quarterly basis, to conduct valuations. Existing SPACs would be affected, too, as post-merger public companies would need to revise their treatment of the warrants.

Efforts to reach a resolution are ongoing, but the SEC has effectively put all new approvals on hold until that point, stating that they “will not declare any registration statements effective unless the warrant issue is addressed”.

The good news doesn’t end there. In that same April 12 statement, Coates said that:

“Even if the safe harbor applies, its procedural and substantive provisions do not protect against false or misleading statements made with actual knowledge that the statement was false or misleading. A company in possession of multiple sets of projections based on reasonable assumptions, reflecting different scenarios.. would be on shaky ground [to only disclose] favorable projections and omit disclosure of equally reliable but unfavorable projections.”

What Does This Actually Mean?

In short (too late, I know), there is a very real risk that SPACs, both new ones that are raising funds as well as those already in the market, will be forced to revise forecasts to reflect a future that includes not only opportunity and untapped potential but also less-rosy scenarios. This would obviously hinder new fundraising efforts, but also dent the balance sheets of existing SPACs.

For the sheer number of SPACs already in the market, the focus has theoretically already shifted from attracting new money to actually putting money to work. However, with valuations in the U.S. equities markets (and, consequently, those of privately-owned companies) at or near historical highs, it will mean forecasting a reality in which there simply aren’t many bargains to be had.

As it is in most corners of the markets, this is also the case in the restaurant/dining space, where, for all of the (justified, it must be said) existential terror of the past year, valuations of publicly traded companies have steadily risen each quarter.

In reality, acquisition targets in the restaurant industry have not actually come to rely on SPACs. In fact, of the highest-profile SPACs expected to be shopping for dining assets, three have completed deals, only two of which actually involved restaurants: Opes Acquisition Group’s acquisition of BurgerFi in June 2020 and Fast Acquisition Corp.’s mega-deal for the dining and gaming assets of Fertitta Entertainment.

Where to from here?

It’s too early to declare the SPAC party definitively over, but calls to turn the music down are tough to ignore.

Until a resolution with the SEC is reached, from the targets’ perspective the focus will once again shift to traditional strategic, PE, hedge funds, and venture capital suitors. Once some sort of resolution is inevitably reached, despite visions of “pent-up demand” unleashing a “flood of capital into markets”, and “billions and billions of dollars waiting to be invested”, the environment is likely to become more challenging, with valuations suppressed.

Unsurprisingly, those companies that employed strategies during COVID that allowed them to maintain, if not thrive – digital, drive-thru, a reimagined outdoor experience – will be the belles of the ball. Beyond that, rather than pay premium valuations on less favorable terms for existing companies that lagged in these areas, it’s likely that buyers will use their capital to acquire start-ups and small, growing companies that demonstrate an ability (or at least viable plan) to execute these strategies.

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