The past year on the capital markets has produced a scenario that not even the best screenwriter could have created. At the beginning it looked as though the outbreak of the coronavirus pandemic and the subsequent market collapse would mean a very rocky period for the global economy, but the storm quickly died down, in a sharp turn from negative sentiment to elation. The financial markets enjoyed a renewed flow of cash, in part thanks to supporting measures by central banks, causing leading market indices to break records one after another.
In this positive atmosphere, a rush of flotations of companies began in various sectors, but chiefly in technology, which crowned 2020 as a record year for IPOs. That is, until 2021 came along. If we thought that last year was a hot year for flotations, it now looks as though it was just a promo for what was to come.
This year's unprecedented wave of IPOs can also, perhaps mainly, be attributed to the trend that has gained momentum enabling privately held companies that seek to become public to merge with a SPAC (special purpose acquisition company). This is an expedited procedure that saves the company being floated the whole traditional IPO track, which includes abiding by extensive regulations, publication of a public prospectus, a road show for financial institutions, and more.
A SPAC is a public company with no business activity that raises money from investors with the aim of acquiring a company within a specified period of time, usually two years. If this does not happen, the money must be repaid to the investors, and any acquisition is subject to their approval.
This is where the problem lies. As mentioned, a SPAC has a deadline for carrying out an acquisition, and so the promoters, who usually receive very fat fees, may be driven to complete the process within the time allotted under any circumstances. This means that the SPAC promoters may court target companies that are not at the right stage in their life-cycles for a flotation, and may not yet have matured from the point of view of management, standards, finalization of the product, and so forth. Both sides may nevertheless want a flotation, and the result is liable to be unfortunate, with the cost of the acquired company's failure to perform and develop falling on the SPAC investors.
This is just one of a set of problems affecting one of the riskiest trends of the past few years. Inflated valuations, pushing prices up, and publication of over-optimistic forecasts by some of the merged companies, are clearly in the interests of the SPAC promoters.
Red lights are already flashing
These risks have not escaped the notice of the Israel Securities Authority (ISA), which realized that a tidal wave of SPAC-format flotations was soon liable to flood the local market. The Authority formulated a more restrictive mechanism than the one operated by the US Securities and Exchange Commission (SEC). For example, besides a two-year time limit for finding a target company, the ISA model stipulates that the acquired business must be worth at least 80% of the amount of money raised.
The minimum amount to be raised will be NIS 400 million, with the promoter investing at least NIS 40 million; financial institutions must participate to the level of at least 70% of the offering; the promoter will not be allowed to take a loan for the purposes of the offering or to mortgage the shares received; the promoter's shares will be vested until a business is acquired and partially vested for six months after that; and the promoter will not receive compensation until a business is acquired, with a ceiling on success fees of 10% of the capital.
Despite these restrictions, it is doubtful whether this is what is needed to halt the sweeping trend. If we look at the numbers behind the SPAC offerings in the US, we can obtain some indication of the power of the hype in this area. From 59 SPAC offerings totaling $13.5 billion in 2019, the numbers shot up to 248 offerings totaling $80 billion in 2020. That record was broken even before we reached the halfway point in the current year, with over 300 SPAC offerings so far.
These numbers should disturb everyone, especially the regulators, and cause concern that new bubbles are being created. This could explain the warning recently issued by the SEC against over-optimistic forecasts by some of the companies that enter into SPAC mergers.
The exceptionally large wave of flotations may reflect emergence from the coronavirus crisis, the renewed flourishing of the economy and a return to accelerating economic activity, but it is possible that this is not the case. The SPAC merger trend raises the question whether a considerable proportion of the companies is riding the positive momentum and exploiting the unusual opportunity to be floated quickly at low cost, to gain access to a pipeline of cheap finance, and, above all, to obtain exaggerated valuations unjustified by business performance. The warning lights are already flashing, and now is the time for the regulators to demonstrate that they are able to halt, or at least slow, one of the most dangerous trends of recent years.
The writer is the CEO and founder of Karni Family Office
Published by Globes, Israel business news - en.globes.co.il - on June 6, 2021
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