Breakingviews - Guest view: SPAC secret sauce could turn sour

U.S. one dollar banknotes are seen in front of displayed stock graph in this illustration taken February 8, 2021. REUTERS/Dado Ruvic/Illustration

NEW YORK (Reuters) - What will be the long-term impact of market enthusiasm for special-purpose acquisition companies? The immediate effect is an overwhelming number of so-called de-SPAC transactions – meaning sales to U.S.-listed SPACs of every kind of privately-held entity imaginable, ranging from startups across the globe to divisions being carved out from multinational corporations. But once all these entities are publicly traded on exchanges, what can we expect? One possibility is a wave of shareholder activism.

Many of the businesses going public through sales to SPACs are in the early stages of their development, have management teams that are not seasoned at navigating investor relations, and are valued at historically high multiples of their last-12-month metrics. That sounds like all the necessary ingredients for volatility. But the most significant challenge these newly public companies may face arises from what is arguably the secret sauce of the current market enthusiasm in the United States for de-SPAC transactions: the public disclosure of a full set of optimistic, internal forecasts.

What happens in practice is a target company shows an “upside” case of internal projections to the SPAC. Then the SPAC discloses this upside case when soliciting its stockholders to vote in favor of the de-SPAC transaction. By contrast, the only internal projections shared in a traditional initial public offering are the guidance provided before the IPO to selected analysts to help them build their financial models. These are carefully curated conservative or “haircut” cases designed to give management teams leeway in the coming years, and they are not circulated beyond the pre-IPO analyst group.

The origin of the differing approaches to disclosure of projections in IPOs and de-SPACs is twofold. First is the presence of liability-averse underwriters in IPOs but not de-SPACs. Second is the availability in de-SPACs – but not IPOs – of a special so-called safe harbor from liability for statements about the future.

Investor groups, such as the Consumer Federation of America, are now petitioning the House Financial Services Committee to eliminate this safe harbor protection for de-SPACs and to hold investment banks liable for inaccuracies in internal forecasts that their SPAC clients disclose when soliciting stockholder support for a de-SPAC. For the time being, however, we expect the disclosure of long-term, internal projections to remain a standard feature in de-SPAC transactions. Indeed, in one recent de-SPAC, investors sued to have the projections disclosed more prominently.

The unintended consequence of riding this wave of optimistic forecasts may be an onslaught of shareholder activism over the next few years. Whenever these companies fail to meet their anticipated trajectories, the activists’ line of attack will be, “Surely, if only the company would have had more hedge fund representatives in the boardroom to direct strategy, then the promised forecasts would have been met.” Statements along these lines are not necessarily fair because the SPACs are not disclosing their forecasts as guidance or promises. Indeed, they come with a litany of disclaimers. But that won’t stop the activists, and newly public companies via de-SPAC will need to be ready.

One way to prepare is for the company going public via de-SPAC to implement a robust set of protections against shareholder-agitators. The strongest is a dual-class capital structure where founders or another defined group of investors with a long-term approach receive supervoting shares – similar to what is done in many technology sector IPOs. Not all potential investors like that kind of governance, but it does give company founders the time and space to make their business ideas come to fruition.

In many de-SPAC transactions, the parties iron out the governance structure of the newly public company quickly and fail to take account of such risks. This is understandable: The excitement of being able to go from being privately held to the virtual certainty of making it to the public markets with the mere execution of a de-SPAC agreement is enough to sideline any concerns about what lies ahead. But if their forecasts don’t come to pass, they may regret not having paid more attention to building the right governance structure.

Andrea Merediz Basham, Ethan Klingsberg and Paul Tiger are corporate lawyers at Freshfields in New York who have a number of clients that have gone public through de-SPAC transactions over the last several months.


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