The rise of the SPAC – Should we be worried?
Companies looking to list their shares on public stock exchanges used to have to conduct an Initial Public Offering (IPO) – not so now in the age of the ‘SPAC’. Special Purpose Acquisition Companies (SPACs) are listed shell companies, formed usually by private equity firms, who seek to use investors’ capital to acquire an unlisted company. The acquired company (i.e. the ‘target’) inherits the SPAC’s listed status without having to conduct an IPO. Crucially, the target company is undetermined at the time the SPAC is created – therefore investors will have no idea in which company they are eventually investing in! If they don’t agree with the proposed deal, however, they can as shareholders vote to reject it, and have their investment returned.
While shell companies are not exactly new, the volume of SPACs, particularly in U.K. and U.S. markets, has increased markedly over the last few years. Last month’s, high profile, $800m deal between the SPAC, Social Capital Hedosophia Holdings, and Sir Richard Branson’s Virgin Galactic, marks a new high for SPAC activity. But while this alternative route for companies going public can help to avoid the high costs associated with the traditional IPO, it also circumvents much of the regulation designed to protect investors. Moreover, SPACs are a lucrative business for the investment firms that establish them, structuring the vehicles in a way that handsomely rewards them for deal completion – not necessarily deal quality.
The rewards to the investing public, who provide capital to SPACs, frequently fall far short of those earned by their managers and the target company. For example, a study by Kolb and Tykvová (2016) reports that companies going public via a SPAC severely underperform on average in terms of investment returns, compared with traditional IPO firms, their industry, and the broader stock market. But why then do investors approve SPAC deals, instead of taking their money back? As part of a Bangor Business School research project, funded by the British Academy and Leverhulme Trust, we examine whether clues may be found in target companies’ financial accounts.
Incentives to engage in opportunistic earnings management – typically, to inflate profits reported in the accounts by using accounting tricks – have formed a part of academic and policy debates for decades. Techniques used to manage earnings are not illegal, although usually only financial experts can see through them. Unfortunately, the typical individual investor is frequently fooled. As firms ‘going public’ for the first time are required to establish a market for their shares, they have, historically, been amongst the worst offenders. While concerted regulatory and public scrutiny has reduced opportunities for earnings management by IPO firms in some markets, it is yet to be known whether this is part of the reason why the SPAC alternative has increased in prominence. In fact, very little is currently known about the general quality of reporting by SPAC targets.
Early indications from our BBS research project are that, at least in their largest market – the U.S. – SPAC targets display hallmarks of significant engagement in earnings management prior to their stock market floatation. If further substantiated, these early findings therefore indicate that we should indeed be worried about the rise of the SPAC, and that those charged with protecting the public interest should take note.
Dr Danial Hemmings and Professor Aziz Jaafar, Bangor Business School
Disclaimer: as our findings on financial reporting quality are based on statistical analyses, they apply to the average SPAC deal, not necessarily every one. We are by no means therefore implying that such techniques were employed in the case of Virgin Galactic – we refer to this deal only to highlight the scale and prominence of recent SPACs. Our findings cited in this blog post are from a BBS working paper, which has not yet been subjected to the peer-review process.
- Henderson, R. 2019. Virgin Galactic hits $2.3bn valuation in public launch. Financial Times [Online]. 28th October 2019. Available here.
- Kolb, J. and Tykvova, T., 2016. Going public via special purpose acquisition companies: Frogs do not turn into princes. Journal of Corporate Finance, 40, pp.80-96. Available here.
Publication date: 25 November 2019