In last month’s issue, Greg Heaton chronicled the genesis of Hong Kong’s Special Purpose Acquisition Company (“SPAC”) regime. Now, in Act II of this two-act tragedy, he reviews SPACs’ recent Wall Street performance and, off-Broadway, the Hong Kong regime’s first 12-month season.
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.” Eighteen months after going public, its share price has fallen a further 93%.
- Car sharing company Getaround Inc listed through a SPAC merger in December 2022. Its share price has fallen over 99%.
- 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 earlie 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 private investment in public equity (“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.
This article first appeared in the May 2023 issue of the Hong Kong Lawyer, the official journal of The Law Society of Hong Kong.
For further information, please contact:
Greg Heaton, Partner, Hauzen
gregheaton@hauzen.hk
