Bringing SPACs to India

SPAC, a novel shell company structure, may be useful but effective investor protection measures and education are key

American comedian Eddie Cantor once said, “It takes 20 years to become an overnight success.” Special Purpose Acquisition Companies (SPACs) have been in existence in the US about the same time, but issuances have shot up in recent times. There have been 294 SPAC listings and they have issued a cumulative $94 billion so far this year — higher than the 248 listings and $83 billion raised in the entire 2020. SPAC IPOs have accounted for over half of all US IPOs in 2020.

SPACs are publicly listed shell companies with finite lifespan (typically two years) within which the “sponsor” of the SPAC must find a private company with which to merge and thereby bring public.

The issuance proceeds are held in an interest-bearing escrow account till the sponsor locates a target for merger. The investors must vote on the merger, and can redeem their shares for a pro rata portion in the escrow account if they don’t like the deal. 
 

The popularity of SPACs has attracted the attention of regulators and stock exchanges across the world, including India, which are contemplating introducing the structure. But the popularity has also attracted scrutiny on the complexity of the structure and the governance issues arising from misalignment of incentives between the sponsors and investors. Let’s look at these issues from the perspective of a recent consultation paper.

Last month, the International Financial Services Centres Authority (IFSCA), India’s offshore financial centre regulator, published a consultation paper on SPACs. A SPAC can list on IFSC’s stock exchange only if it issues at least $50 million, and the sponsor holds at least 20 per cent of the post-issue capital.

In theory, mandating a minimum holding for a sponsor is good, since it implies commitment. But SPAC sponsors get their shares, called “promote”, essentially for free, and would gladly hold more than 20 per cent if allowed.

For investors, “promote” represents a dilution cost they incur for accessing the supposed deal-making skills of the sponsor.

Other requirements are standard, but occasionally need to account for SPAC-specific features. For example, the proposal talks about determining price through a book-building process. But SPACs have no assets to begin with, and hence no price discovery; like new fund offers (NFOs) of mutual funds, they are priced in round units of 10 or 1,000 per share.

However, the paper proposes good investor protection measures to boot, not found in other markets. In a typical US SPAC, investors need to approve the merger with a simple majority, but sponsors (who hold 20 per cent of the votes) also get to vote on the resolution, despite being interested parties with the most to lose if the resolution fails.

Secondly (and strangely), the structure also allows for investors to redeem, whether or not they vote for the resolution. The reasoning is that the deal must be allowed to succeed, and all SPAC investors (including redeeming investors) typically receive warrants, regardless of whether they redeem. This incentivises them to vote for the resolution and potentially realise the value of those warrants post-merger, even if they believe the deal is bad.

The proposals in IFSCA paper seek to remove these incentive problems by proposing a majority of minority (other than sponsor) vote for the merger approval, and allowing investors who vote against the resolution to redeem their shares, but they need to clarify that investors who vote “yes” or “not participated” in the resolution will not be allowed to redeem.  

Regulations don’t provide enough indication about the scale of misalignment between sponsor and investors. A prominent academic study of 47 SPACs that successfully merged between 2019 and 2020 showed that sponsors, on an average, made a whopping five times on their investments three months after the merger, and three times 12 months after, thanks to the nearly-free “promote” shares. For investors the corresponding figures were minus 3 per cent and minus 35 per cent, respectively. 

The SPACs boom has not only attracted the attention of high-quality sponsors like industry executives and private equity investors, but also all manner of celebrities, like sports stars, movie stars and politicians, hoping to make a quick buck. The resulting dry powder is driving up the valuations of target segments with promise but little profitability (or even revenues) in the near-term, from air-taxis, electric vehicles, and battery technologies. 

In this context, what should investors do? Investors must look for sponsors with a demonstrated track record of making profitable investments, rather than falling for charlatans peddling seductive stories. They must understand the effects of dilution on their returns. Finally, buying an SPAC that is trading at a premium pre-merger is the worst mistake an investor could make.

Will SPACs succeed in India? India has plenty of high-growth and profitable start-up companies — ideal targets for SPACs. But success also depends on availability of capital, and quality of the ecosystem, all of which takes time to mature. Should India allow SPACs? Given the issues we described and the possibility that uninformed investors might be taken for a ride, regulators must approach this cautiously, and holistically. They must not only focus on the investor protection measures, but also, along with the industry, focus on awareness and education, so that investors fully understand the risks of investing in SPACs. Isn’t that true for all investing? 

The writer is Director of Capital Markets Policy (India) at CFA Institute