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Guest view: SPAC investors face six key risks

4 minute read

3D printed percentage symbols are seen in front of dollar banknotes in this illustration taken May 25, 2020. REUTERS/Dado Ruvic/Illustration

CHICAGO, May 13 (Reuters) - Special purpose acquisition companies – or SPACs, as they are more commonly known – are having a moment. The investment vehicles raised $83.4 billion in the first quarter, more than all of 2020, and almost three times the amount traditional initial public offerings raised during the same period, according to industry tracker SPAC Research. With a bevy of high-profile sponsors, including tennis great Serena Williams, basketball star Stephen Curry, and hedge fund giants like Pershing Square, they have wedged their way into Wall Street vernacular quickly and heavily.

However, lack of oversight and scrutiny creates opportunity for fraud and heightened risk for investors. The U.S. Securities and Exchange Commission is sounding the alarm. But long-term sustainability of the SPAC market will rely on creating a comprehensive risk management framework – and clear regulatory guidelines – with stronger controls and safeguards, that ensure companies going public via SPACs have the same scrutiny as companies going public via traditional IPO. Until that happens, SPAC investors face six main risks.

INADEQUATE MANAGEMENT DUE DILIGENCE

In a typical IPO, comprehensive due diligence is routinely performed on the company going public. However, this takes time, and in the case of SPACs, the founders, or sponsors as they are often called, are typically up against a two-year deadline to find an acquisition. So this step is often overlooked. Investors may find themselves with executives or new board members whose backgrounds would not pass muster in a traditional IPO, and when the time comes, the founders of those blank check companies might be rushing to buy firms that aren’t suited for public markets.

INACCURATE FINANCIAL REPORTING

Due diligence often uncovers lapses in financial reporting. Given the time constraints under which SPACs operate, many managers of newly listed blank check firms focus on identifying companies that are open to a quick transaction rather than the suitability of the target for the public market.

Since the acquired companies are almost always private, their historical financial statements do not have the same requirements as a public company. These statements are not reviewed by the SEC until after the acquisition occurs, unlike a traditional IPO, which goes through a rigorous vetting process with the SEC.

MATERIAL MISSTATEMENTS AND OMISSIONS

A private company that goes public through a SPAC faces less scrutiny around its operations, too, which can lead to both false statements slipping into regulatory filings and key omissions that may have otherwise changed an investor’s perspective. Forward-looking statements are common, too. Until recently these statements did not receive the same scrutiny as a traditional IPO registration statement, given the acquiring company was already public.

UNPROVEN OPERATIONS

Typically, companies seeking to go public have markers for maturity: $100 million (or more) in revenue, a management team with a proven track record of success, controls and procedures that tighten record-keeping, and the divestiture of non-performing assets to improve financial health. But with the race and competition to find acquisitions, SPACs are seeking more companies at earlier stages.

This provides the opportunity for public investors to back riskier, early stage companies. The Financial Industry Regulatory Authority notes the speed of the SPAC process “may attract ‘hot’ sectors or business models that may be only short-term fads instead of viable long-term businesses.”

INADEQUATE CONTROLS

Because an acquired company does not face close scrutiny and is often in an earlier stage of development, its controls may not be adequate. Less experienced finance and accounting personnel may not establish and maintain effective disclosure processes and controls over financial reporting. Lapses open the door for inaccurate financial reporting, fraudulent payments, and even cyber fraud. Investors are still harmed as a result of inexperience and accidents caused by human error.

CONFLICTS OF INTEREST

The potential for conflicts abounds in SPACs. Sponsors, officers, and directors may not work exclusively on behalf of the SPAC and may have fiduciary obligations to other entities that compete for the SPAC’s business. Original SPAC investors may benefit from strategies that put themselves in conflict with acquisition targets. The process of buying a company, known as a de-SPAC transaction, relies heavily on advisers and sponsors who are incentivized to buy any company rather than a good one.

Given their heavily discounted interest in the SPAC’s common stock, a sponsor might benefit at the expense of a shareholder. FINRA warns that “underwriters and SPAC sponsors may possess material, non-public information regarding potential SPAC acquisition targets and trade around that knowledge.”

CONTEXT NEWS

- Lisa Silverman is a senior managing director at K2 Integrity, based in Chicago. She has conducted high-stakes, multinational investigations for a variety of clients for more than 20 years.

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