In 2020, special purpose acquisition companies went from a niche capital markets maneuver to being in the mainstream of popular culture, garnering the attention of the media, retail investors, celebrities and regulators—while raising approximately $75 billion through nearly 250 initial public offerings. The pace has increased rapidly in 2021, with about 300 IPOs raising $90 billion in the first quarter.
Given the benefits they provide to private equity sponsors, there are good reasons for SPACs’ sudden popularity. In comparison to traditional IPOs, SPACs offer a more streamlined and faster IPO process, lower financial transaction costs, greater control over deal terms, the management expertise of the sponsors and less uncertainty in pricing due to their simplified price discovery process. SPACs also provide sponsors with a permanent capital vehicle, access to different targets than might otherwise be available due to restrictive fund covenants and greater access to capital through retail investors and liquidity options that are not always available to a traditional private equity portfolio company and private equity funds, allowing for the pursuit of larger targets. Finally, SPACs generally require fewer disclosures to investors at the time of the IPO as compared to the typical disclosure package required in case of a listing of existing operating companies (and pre-commitment disclosure for private equity fund offerings).
Despite these attractions, SPAC sponsors should proceed with some caution. Here is a list of key considerations for any private equity sponsor evaluating a SPAC:
In the face of the vehicle’s proliferation, the SEC has begun to provide formal and informal direction on the potential regulatory risks of SPAC offerings and transactions, some of which raise acute issues for private equity fund managers looking to sponsor a SPAC. The SEC, for example, has: (i) provided educational materials to investors looking to invest in SPACs; (ii) cautioned investors against making investment decisions with respect to SPACs solely based on celebrity involvement; (iii) provided guidance for sponsors relating to disclosure obligations; (iv) hosted meetings and spoken publicly on SPACs, raising awareness of issues and inviting further feedback, especially as to how to further investor protections; (v) questioned whether the statutory safe harbor for forward-looking statements would apply to projections used in proxy statements for de-SPAC transactions; and (vi) explicitly cautioned SPAC sponsors on conflicts of interest and disclosure issues, stating its view that such warrants should be accounted for as liabilities, not equity.
SPACs: Key Regulatory Considerations for Private Equity Sponsors
In addition, the SEC has explicitly cautioned SPAC sponsors on conflicts of interest and disclosure issues and, in early April, the SEC brought the SPAC market to a standstill by publicly challenging the accepted accounting treatment for certain types of warrants issued by SPACs. Further slowing the SPAC market, the SEC orally advised SPAC issuers that it will apply its procedural policies rigidly in the registration statement review process. With the recent change in leadership at the SEC, further scrutiny may be ahead.
Conflicts of Interest. SPAC sponsors may have divergent financial incentives from public shareholders of the SPAC. These conflicts can arise in numerous places, including capital and payment structures in the SPAC itself, timing commitments to close a deal within the contractual investment window or repay investors, and competing fiduciary obligations where the sponsor has positions in other financial vehicles or separate business dealings and interests in the target company.
There have been attempts to solve this problem by using a more tailored structure. For example, in July 2020, Pershing Square decided not to take the typical 20 percent sponsor promote and instead to “keep skin in the game” by investing in warrants at market value that included significant transferability and exercise limitations. In addition, many recent acquisitions involve the restructuring of some or all sponsor-promote shares to vest only if the post-closing company’s stock performs above certain levels.
Disclosures. The participation by retail investors presents particular risks, as retail investors may not appreciate the implications and the risks of the SPAC structure and sponsor economics. Sponsors therefore should avoid recycling generic SPAC disclosures and instead ensure that disclosures are tailored to their specific SPAC and are consistent with SEC guidance. Another area where tailored disclosure is appropriate is the level of future expense and financing needs that a particular SPAC will incur.
For example, SPACs may be subject to different levels of fees and costs, some of which may not be known with precision at the time of the IPO (such as costs relating to potential redemptions and PIPE financing).
In addition to the foregoing concerns, which apply to all SPAC sponsors, private fund SPAC sponsors have particular considerations arising from obligations to private fund clients and any other investment advisory clients:
Allocation. A SPAC target company may be an appropriate investment for a manager’s existing funds, creating potential allocation conflicts. For example, a fund’s governing documents may require that the manager (who is affiliated with the SPAC sponsor) offer the deal with the target company to its fund as a portfolio company acquisition.
Conflicted transactions. Similarly, conflicted transactions may occur where the SPAC sponsor seeks to have the SPAC acquire a target company in which one of the fund manager’s funds has an interest. The precise degree of conflict this poses is determined by the fund’s organizing documents, as are the protocols to be followed in instances where conflicted transactions are contemplated.
Successor fund restrictions. A SPAC may be considered a “successor fund” under fund organizational documents, in which case the sponsor may be restricted in raising capital for the SPAC until after a certain amount of capital from existing funds has been invested or committed.
Key person time and attention requirements. Fund managers must be aware of obligations imposed upon them by fund documents or firm policies regarding the time and attention that must be dedicated to managing a certain fund. This issue is particularly acute where these requirements oblige key persons to devote time to specific funds or strategies, rather than being applicable on a firm-wide or platform-wide basis.
Local offering restrictions. Depending on where a SPAC is set up and offered and how it is organized it may be subject to additional regulatory and marketing restrictions. For example, if offered to investors in Europe, it could in some cases be considered an alternative investment fund within the meaning of the European AIFM Directive triggering a whole set of regulatory requirements.
Developing Litigation Trends
Looming upswing in litigation. Assuming that historic trends continue, the substantial increase in SPAC-related investment activity would indicate a commensurate increase in litigation arising out of alleged SPAC transaction shortcomings, including purported incomplete or misleading disclosures and/or conflicts of interest. The exponential increase in SPAC formations, however, is likely to lead to an even steeper exponential increase in related litigation as some targets will be weaker candidates, more likely to falter after the de-SPAC process concludes, drawing increased scrutiny from both regulators and the plaintiffs’ bar.
SPAC-specific litigation vulnerability. Time-limited contractual investment obligations leave SPAC sponsors particularly vulnerable to strike suits in which plaintiffs seek to enjoin the merger, often by way of demanding increased disclosures, in the immediate lead-up to a shareholder vote on the transaction. Sponsors with SPACs nearing the end of their investment windows may be forced to capitulate or face terminating the SPAC and repaying investors.
[See “What Do SPAC Federal Securities Lawsuits Look Like So Far?” Above the Law, April 6, 2021 (“Above the Law: Federal Securities Lawsuits”), available here.]
Bi-modal litigation timing trends. SPAC-related litigation to date suggests an emerging trend, that the risk of litigation is not equally likely over the life of the SPAC, but rather increases at two junctures: (i) close to the merger completion date, usually around four months after the merger announcement, often over disclosure or conflicts issues; and (ii) around eight months after the merger’s announcement, over stock performance issues only apparent after the merger’s completion.
[See “SPAC Plaintiffs Are Filing Early—But Not Too Early” BloombergLaw, April 22, 2021 (“Bloomberg: Filing Early”), available here.]
The regulatory and litigation concerns discussed above exist in the context of a market that suddenly feels less friendly to SPACs than it did earlier in 2021. The pace of new SPAC listings has slackened and existing SPACs are finding deals harder to consummate, thanks in part to a drop-off in available PIPE financing. With hundreds of SPACs in the market still pursuing transactions, sponsors have all the more reason to exercise caution.