In this two-act tragedy, Greg Heaton chronicles the genesis of Hong Kong’s special purpose acquisition company (“SPAC”) regime. He explains what makes these investment vehicles destructively seductive for fundraisers but regularly ruinous for investors. Finally, he reviews SPACs’ recent Wall Street performance and, off-Broadway, the Hong Kong regime’s first 12-month season.
Prologue
The costs of a conventional initial public offering (“IPO”), principally underwriting fees, can amount to over 20% of the money raised. Some private companies, rather than taking the time and expense of going through the listing process themselves, essentially buy a listing off the shelf by merging with a listed shell company. The listing industry has developed various ways to do this – some legitimate, others fraudulent.
Last year, Hong Kong formalized the practice of shell manufacturing with the introduction of a SPAC regime, largely basing its provisions on current US market practice. Problematically, analyses of US markets show that SPAC mergers tend to significantly underperform typical IPOs, with the proportion of investors’ funds that are consumed by service providers being much higher even than in a conventional IPO. As a result, although service providers and fundraisers may profit handsomely, SPACs are a toxic product for retail and professional investors alike, often sparing only those who dump their holdings at the first opportunity.
Act I, Scene I: An ill-omened pedigree
Listed shells have plagued the Hong Kong stock exchange (“HKEX”) for decades, long before the vehicles were re-branded as SPACs. Shell manufacturing typically involves the listing of a company without any genuine intention of raising capital for existing operations. Usually, it is a relatively small business, such as a family-owned trading firm, with barely sufficient turnover (real or fabricated) to satisfy the minimum listing criteria. Controlling shareholders sell their shares after the IPO and expiry of a regulatory lock-up period, and the directors have a change of heart regarding the business plan disclosed in the prospectus. Sometimes, they sell the company’s business back to its original owners, who walk away with a profit, leaving a listed shell with no operations.
Shareholders of the shell can usually sell at a premium to book value. At best, this premium represents the opportunity for quick access to public capital markets without the inconvenience of jumping through the regulatory hoops of an IPO. At worst, the premium is speculative froth arising from illegal market activity. Listed companies with few assets tend to have low revenue and few shareholders. The shares are likely to have a low trading volume, making them especially vulnerable to market manipulation and price volatility. A classic “penny stock fraud” involves the quiet accumulation of such shares, then noisy promotion by boiler room brokers through spam emails and cold calls. New demand drives up the price, allowing scammers to sell their shares at a profit before the demand and price again collapses.
The directors of the shell company, having divested the original business, later buy another. That business thereby becomes a public company via a “backdoor listing”, circumventing the regulatory vetting of the usual listing process. Backdoor listings are susceptible to fraud. This is because directors of the listed shell can make an acquisition with relatively little disclosure and oversight. In an IPO, key information must be disclosed in a prospectus, and underwriters mitigate their risk by undertaking due diligence. Without this independent verification, it is easier for the business that is going public to falsify its earnings and inflate its stock price. The directors of the listed company acquiring that business might be misled by the falsification, indifferent to it, or complicit in it.
Previously, the Securities and Futures Commission (“SFC”) and HKEX tried clamping down on shell manufacturing and backdoor listings. They increased their scrutiny of suspicious listing applications, such as those with assets consisting substantially of cash, and threatened to suspend or de-list companies with insufficient business operations. With backdoor listings attracting unwelcome regulatory attention, however, the scions of at least two Hong Kong billionaires turned away from Hong Kong markets to list SPACs in the US instead. This development, two or three years ago, spurred Hong Kong authorities to rethink their regulatory approach.
Act I, Scene II: A peek behind the curtain
As investment vehicles without any existing business, SPACs are simply listed shell companies in a different costume. Many are launched by high-profile financiers, known as “founders”, “sponsors”, or “promoters”. After raising capital through an IPO, the SPAC swallows one or more private companies (“de-SPAC targets”), a process known as “de-SPACing”. Although sometimes referred to as an “acquisition”, the deal is usually structured as a reverse merger, in which shareholders and management of the target gain control of the SPAC. The merged “successor company” is listed, and the target thereby becomes publicly owned and traded.
For investors, one of the purported benefits of SPACs is that they provide an opportunity to exploit a valuation arbitrage between private and public equity markets by participating in private equity-like investment. However, that benefit has usually proven illusory, with the structure of SPACs creating substantial costs, misaligned incentives between promoters and other shareholders and, ultimately, losses for investors who continue to hold shares after de-SPACing.
Theoretically, investigation and analysis by promoters should enable them to identify promising targets among private companies that might struggle to go public through a conventional IPO. An IPO may be problematic, for example, because the company’s business is unusual or complicated, making it difficult for the company and its underwriters to agree on an IPO price. Another potential advantage of SPACs is that, within basic regulatory parameters, there is great scope for customization of the commercial terms governing each structure. In practice, however, SPACs have proven resistant to commercial innovation and have become quite standardized.
For promoters, the irresistible attraction is that they acquire equity in the SPAC on far more favourable terms than investors in the IPO or subsequent investors on the open market. The standard arrangement is that promoters are issued 20% of the post-IPO shares for mere nominal consideration. For example, if IPO investors buy 80 million shares for $10 each, the promoters receive 20 million shares essentially for free, resulting in a total issue of 100 million shares with $8 underlying each of them. Those 20 million shares, referred to as “the promote”, are the promoters’ reward for their efforts and risking their capital to set up the SPAC and complete a de-SPAC transaction. Promoters may also receive earn-out rights, entitling them to additional free shares if the successor company achieves specified revenue, profit or share price targets.
In most cases, SPAC promoters cannot use any IPO proceeds to pay the costs of the IPO and of finding a de-SPAC target. Instead, promoters themselves fund the SPAC’s working capital. For example, a SPAC may use a loan facility from its promoters, and also sell “promoter warrants” for $1 each. Each warrant may entitle the promoters, one year after de-SPACing, to purchase one share for $11.50. Warrants are typically exercisable on a cashless basis, meaning the promoters, in this example, can surrender their warrants in exchange for shares of equivalent value to the amount by which the market price of the shares exceeds $11.50. Although used primarily as a mechanism to pay the SPAC’s expenses, rather than as compensation for the promoters, the warrants will yield a profit if the successor company’s share price exceeds the exercise price by more than $1.
IPO investors, meanwhile, are customarily issued free warrants alongside the shares, similarly entitling the warrant holder to purchase newly issued shares in the future at a certain price. This compensates IPO investors for using their cash, like underwriters, to help launch the SPAC.
A proposed SPAC merger can only proceed after receiving majority shareholder approval. Shareholders rarely withhold approval because their warrants become worthless if no merger is completed. If the promoters fail to finalize a merger within a predetermined period, usually two years, all shares (other than the promote) are redeemed at the IPO price plus interest. The SPAC’s net asset value – consisting chiefly of the IPO proceeds, until then held in trust – then falls to zero, so the promote and all debt of the company become worthless. Consequently, promoters have an overwhelming incentive to ensure de-SPACing occurs, even if the terms are unfavourable to other investors. Given the costs they incur versus the equity received, promoters can enjoy very fat returns. This is possible even if the SPAC acquires targets for more than they are worth and the successor company’s share price subsequently tumbles.
While promote shares are locked-up, other shareholders are entitled to cash out, at the IPO price plus interest, after a merger is announced and before it is completed. Consequently, until de-SPACing, IPO shareholders enjoy a capital-guaranteed investment with potentially attractive returns, plus a free “equity kicker” in the form of warrants. If shares are trading above the IPO price, these investors typically sell them. Otherwise they typically redeem them after the merger announcement. According to a study published in 2022 (Klausner, Ohlrogge and Ruan), the investors in SPAC IPOs in the US are predominantly hedge funds and “nearly all” of them sell their shares before de-SPACing. However, most retain their warrants until they become exercisable, usually 30 days after de-SPACing. The authors found that the warrants delivered average annualized returns from the IPO until de-SPACing of 11.6%. While this may be an attractive low-risk return, it is a potential trap for retail investors. If an investor misses a notice of redemption and fails to exercise the warrants, they become worthless. The inattentive or inexperienced investors’ loss is the other investors’ windfall.
Some of the equity lost to redemptions before de-SPACing is offset with private investments in public equity (“PIPE”) by independent institutional investors. The promoters and the target undertake a promotional roadshow, much like a company going public through a conventional IPO. Although shares are typically issued to PIPE investors at a discount, the funds raised at this stage often exceed non-redeemed equity from the SPAC IPO. PIPE financing therefore can sharply reduce SPAC costs as a percentage of net cash delivered to the successor company.
Even with significant PIPE financing, the costs of the SPAC process are typically “more than twice as high” as a conventional IPO. The promote, earn-outs and warrants, which substantially dilute other shareholders’ share of the underlying cash, are the most eviscerating expense. Further costs include underwriting fees, typically charged at 5.5% of the IPO proceeds, without adjustment even if most of the shares are redeemed before de-SPACing. The underwriter and other service providers may also tap the SPAC for advisory fees. Redemptions then deplete the amount of underlying cash, thereby amplifying the costs for each remaining shareholder.
Klausner et al’s study of 47 de-SPAC transactions occurring from January 2019 to June 2020 found that the average net cash underlying each SPAC share (issued at $10) was just $4.10. This means that more than half of the value per share was dissipated through fees and other compensation.
Until a merger is announced, SPAC shares tend to trade at roughly their IPO price of $10, because the redemption right creates a price floor. A year after de-SPACing, however, most successor companies’ share prices have underperformed by an amount roughly comparable to the cash per share that has been extracted by service providers, “with the remaining value [on a market-adjusted basis] roughly equal to the net cash a SPAC contributes to a merger.” While SPACs might be dazzling upon first appearance, they typically bomb at the box office.
Act II, Scene I: SPACs bomb in America
SPACs were the hottest thing on Wall Street in 2020, a financial fad accounting for more than half of all US IPOs. Many SPACs included celebrities in their management teams, and investors were captivated. SPACs raised a record US$83 billion that year, and a further US$162 billion in 2021.
The hype soured with a succession of high profile failures. For example:
- Rapper Jay-Z became “chief visionary officer” of The Parent Company, “the largest, most socially responsible and culturally impactful cannabis company in California,” with a market capitalization over US$1 billion after a de-SPAC merger. Two years later, its share price has fallen 98%.
- Two decades ago when asked on TV about her alleged involvement in securities fraud, Martha Stewart famously replied, “I want to focus on my salad.” Now embracing a “secular shift to vegetable-based diets”, Stewart is a director of AppHarvest Inc – “an applied technology company that could integrate a wide range of systems for the common purpose of providing a much-needed resource” and that, at the end of the day, grows tomatoes in a greenhouse. It went public through a SPAC deal in 2021 with a valuation over US$1 billion. Its share price has fallen 99%.
- Basketballer Shaquille O’Neal was “special advisor” to the SPAC that took WeWork Inc public. The merger valued WeWork at about one fifth of its US$47 billion valuation preceding a failed IPO attempt two years earlier, when the company was panned as “a real estate arbitrage startup that thinks [it’s] disrupting consciousness by making secondary leases and giving out beer.” Twenty months after going public, its share price has fallen a further 98%.
- Car sharing company Getaround Inc listed through a SPAC merger in December 2022. Its share price has fallen 97%.
- When Donald Trump’s media company announced a merger with Digital World Acquisition Corp, the SPAC’s share price jumped from $10 to $175, giving the proposed successor company an implied market valuation over US$19 billion. It then emerged that the parties signed a “letter of intent” less than three weeks after the SPAC’s IPO, raising suspicions they had secretly discussed the merger months earlier. While the SPAC shares are now trading around $13, the possibility of fraud charges could further dampen investors’ enthusiasm.
Overall in 2021, while the S&P 500 rallied 27%, a share price index of de-SPACed companies (DESPACTR) tumbled 45%. In 2022, DESPACTR fell another 71%.
SPACs’ popularity has contributed to their decline. This is because they compete with each other in the hunt for target companies, while under pressure to de-SPAC before deadlines otherwise requiring money be returned to investors. Deals get riskier or more expensive as promoters get desperate. A surge of lawsuits has emerged from the wreckage, with investors and regulators suing SPAC promoters, directors and advisers for allegedly making misleading disclosures, failing to vet deals properly, or committing fraud.
Act II, Scene II: Hong Kong arrives late to the festival
On HKEX in 2021, the amount of money raised in IPOs shrank 18% from the previous year. In contrast, global IPO fundraising jumped 87%, having enjoyed a major boost from another record year of SPAC listings in New York. With the progeny of Hong Kong’s four (plus) big families eager to join the SPAC stampede, the Hong Kong government wished to help them do it at home. In March 2021, Financial Secretary Paul Chan cued SFC and HKEX to explore new listing regimes, including SPACs. The regulators obliged, in December that year publishing consultation conclusions and announcing that SPAC listing applications would be welcomed from the following month.
Standard features of SPACs that developed as a matter of market practice in the US were in Hong Kong codified in listing rules, with the addition of some convoluted and apparently arbitrary restrictions. For one thing, only professional investors may subscribe, and at least 75% of shares must be subscribed by institutions. Retail investors can buy the company’s shares on HKEX only after it has de-SPACed. HKEX concluded SPACs are not suitable for retail investors because, “As a SPAC is a cash shell without any operations, the price of its securities is much more likely, relative to an operating company, to be driven by speculation and rumour.” This assertion was contradicted by another, in HKEX’s consultation paper, that “Prior to a De-SPAC Transaction, the volatility in the share prices of most US listed SPACs is similar to that of a bond, with low volatility at a constant valuation around their IPO share price.”
Although SPAC share prices sometimes increase (like an “IPO pop”) on the announcement or completion of a de-SPAC transaction, prices typically start deflating immediately thereafter – the very time retail investors will be allowed in. The floor of around $10 disappears, and subsequent issues of free or discounted shares from earn-outs and warrants exert downward price pressure. In other words, Hong Kong regulators have decided to reserve a potentially lucrative risk-free asset class exclusively for professional investors, while allowing retail investors the opportunity to pay higher prices, without downside protection, in the secondary market after de-SPACing.
Another dubious requirement is that SPACs in Hong Kong must have a net asset value of at least HK$1 billion upon listing. This is intended “to ensure high quality Successor Companies are listed.” Without any evidence of correlation between size and quality (HKEX’s consultation referred only to “high quality” promoters), by whatever metric that might be measured, it was a weak justification. Coupling a small SPAC with a big PIPE decreases the severity of a SPAC’s dilution, with a lower proportion of the total amount being pocketed by promoters and underwriters. So the minimum SPAC IPO requirement is likely detrimental to SPAC investors.
While the US has no regulatory requirement for PIPE investment, Hong Kong rules stipulate that PIPE must amount to at least 25% of the target’s value, declining to a minimum of 7.5% for targets over HK$7 billion. On application, HKEX may permit a lower percentage for targets over HK$10 billion. At least half of the PIPE must come from at least three institutional investors with assets under management of at least HK$8 billion. Although these appear to be arbitrary arithmetic criteria with no empirical justification, the implication is that regulators consider these to be the thresholds necessary for ensuring that PIPE investors perform sufficient due diligence on target companies. Regulators hope PIPE will provide a price validation mechanism, preventing SPAC promoters from shortchanging the other SPAC shareholders by acquiring targets at an excessive valuation.
Hong Kong has a further regulatory overlay to the due diligence process, requiring every listing applicant to engage at least one licensed IPO sponsor. Under the new SPAC regime, that requirement applies both to the SPAC and later to its successor company. The intention is that successor companies’ sponsors will perform due diligence on target companies “to the same extent as is performed for an IPO”.
As well as one or more IPO sponsors, each Hong Kong SPAC will almost inevitably have one or more SFC-licensed firms among its promoters. For one thing, some of the functions undertaken by promoters might constitute regulated activity. HKEX’s consultation conclusions dodged this issue, merely reminding promoters to consider whether there are any licensing implications. Also, listing rules now impose an eligibility or suitability test on promoters, in that HKEX “must be satisfied as to the character, experience and integrity of all SPAC Promoters and that each is capable of meeting a standard of competence commensurate with its position.” The intention is to exert tighter regulatory control over promoters than in the US, where endorsements by celebrities became so common that the Securities and Exchange Commission issued an alert cautioning investors not to make decisions based solely on celebrity involvement.
Supposedly, HKEX adopts a “holistic approach” in conducting the suitability assessment, taking into account “all relevant circumstances”. These include a listing rule that at least one of the SPAC’s promoters must be a firm licensed by SFC to provide corporate finance advice or asset management services. HKEX says promoters may seek a waiver of the requirement, for example on the basis that they have equivalent overseas accreditation. However, this guidance is inconsistent with listing rules requiring that the SPAC’s board include at least two SFC-licensed individuals, at least one of whom must be a director representing the SFC-licensed promoter. In view of the inconsistency (in which the rules should take precedence over the guidance), and the fact that SFC licensees are subject to SFC disciplinary proceedings (meaning they can easily be held accountable for perceived breaches of standards), it seems unlikely that regulatory authorities will readily allow the waiver. Consequently, in practice, suitability assessment will likely be left largely to SFC’s Licensing Department, which performs the task formulaically based on granular criteria (solvency, regulatory history, qualifications and years of experience) set out in its Guidelines on Competence.
HKEX’s first SPAC – Hong Kong’s off-Broadway SPAC premiere – listed on 17 March 2022, by which time the SPAC mania in America had already long turned rotten. Hong Kong’s stricter suitability requirements for promoters notwithstanding, the first SPACs to file listing applications were peppered with local personalities better known for their wealth or their political connections than their asset management experience. They included Kenneth Lau (hereditary legislator and Heung Yee Kuk chief) and his sisters; Norman Chan (former head of the Monetary Authority); Katherine Tsang (sister of Hong Kong’s second chief executive); and Li Ning (Olympic medalist).
Despite an initial flurry of applications, only five SPACs have listed, none raised more than the minimum HK$1 billion, and none have announced a de-SPAC transaction. The SPAC regime has failed to arrest the decline in equity fundraising on HKEX, with total IPO funds raised in 2022 plunging a further 68% from the previous year.
Denouement
Regulators in Hong Kong historically have seen prevention, suspension and delisting of shell companies as one way to improve market quality. So it is ironic that, with the introduction of a SPAC regime, they have now formalized the practice of shell manufacturing. In a further irony, seemingly to protect society’s grassroots from the more rapacious urges of the monied class, retail investors are excluded from this asset class altogether. They will be permitted to buy only after the shell becomes an operating company – precisely the moment that the smart money knows it’s time to sell.
While a honeypot to some celebrities, tycoons and their professional advisors, SPACs have by and large been disastrous for everybody else. A preponderance of failed SPACs in America suggests it is a deeply flawed structure. There is nothing yet to indicate that the experience in Hong Kong will be much brighter.
A version of this article first appeared in the April and May 2023 issues of the Hong Kong Lawyer, the official journal of The Law Society of Hong Kong.
Greg is a partner of Hauzen LLP in Hong Kong. Admitted as a solicitor of the High Court of Hong Kong and a legal practitioner of the Supreme Court of New South Wales, Greg was formerly a partner of another Hong Kong law firm, advising on asset management, securities regulation, and contentious regulatory matters, and director of an international consultancy firm, providing regulatory advice and project-based consultancy services to Hong Kong and global financial services firms.
In addition, he was formerly a senior director of the Securities and Futures Commission (SFC), where he played a key role in the oversight of SFC-licensed intermediaries and the development of regulatory policy. He was head of the Licensing Department at the SFC and a member of the Board of the Financial Dispute Resolution Centre, the body responsible for the arbitration and mediation of disputes between financial institutions and their clients.