In the summer of 2019, Chamath Palihapitiya, a billionaire venture capital investor, announced that his public shell company would merge with Richard Branson’s spaceflight business, Virgin Galactic.
It was early in what has become a Wall Street phenomenon: using a special purpose acquisition company like his — known as a SPAC or blank-check firm — to take a private business public, bypassing the typical initial public offering process.
With his usual bravado, Palihapitiya compared Virgin Galactic to Tesla on the day of the deal’s announcement and forecast that it would reach “profitability in mid-2021 and should achieve real scale by ’22.” The company published an illustrated presentation for investors with financial projections out to 2023.
Palihapitiya sold the deal to public investors — many of whom were mesmerized by his words and the future of space travel — in part by investing $100 million of his own money into the business, a demonstration of his commitment to the future of the company.
Yet this past month, without warning to all those investors who had followed him into the stock, he sold those shares.
“I hated to do it but my balance sheet shrank by almost $2B this week,” he wrote on Twitter.
He maintains a significant stake in Virgin Galactic through his holding company’s “sponsor” stake, which is the equity that a SPAC’s founders receive in exchange for putting the deal together and making a small investment.
The sale illustrated an uncomfortable truth about the SPACs that are transforming the financial world: Investors and celebrities who put their names behind the next big headline-grabbing merger can exit long before any of those projections are ever realized or, in many cases, missed. (Virgin Galactic’s flight timetable has slipped, forcing it to revise its forecasts.)
“It’s an unbelievable ruse,” said Michael Klausner, a Stanford Law School professor whose research has found that investments by the public in SPACs, after a merger, have vastly underperformed traditional IPOs on average over the past decade, while sponsors have made a 400% return.
Palihapitiya’s commitment to his SPAC deals is actually far greater than the commitments most of his peers make; he agreed to lock in his sponsor stake of Virgin Galactic for the first two years of the deal (which expires in November) and invested his own money at the outset.
But in a review of hundreds of deals, many sponsors of SPACs appear to be planning to rush for the exits from the outset, and they rarely invest much of their own money in the first place.
Most of the hundreds of deals contain language that restricts sponsors from selling shares for only a year from the day the deal is completed, and many include a trapdoor. SPACs typically price their shares at $10 in an IPO. After a SPAC merges with another company, if its shares trade over $12 for more than 20 days in a 30-day period, the lockup provision disappears, and sponsors are free to sell whenever they want. (The argument for this provision is that sponsors has done their job if the stock trades 20% higher.)
To Palihapitiya’s credit, many of the lockup arrangements on his SPAC deals require him to hold on to at least 50% of his sponsor stake until the share price hits $15.
The ability of sponsors to build agreements that suggest they do not intend to be long-term investors is just one example of what some critics say is the misalignment of interests — often not understood by retail investors — between the various investor classes in SPAC deals.
Perhaps there is a fix: What if sponsors were required to hold their shares, including any investments they made at the time of a deal, for the full duration of the financial projections that helped sell the merger?
In other words, if a company makes financial projections for five years ahead, the sponsor is restricted from selling for five years. If the projections are for only one year, the sponsor must hold the stock for only one year. This rule would align sponsors’ interests directly with what they are selling to the public — a future vision of the company.
Financial projections are a particularly unusual feature of SPACs. When a company goes public through an IPO, the law limits it from making meaningful financial projections, so investors must rely on the company’s past performance to judge how much its stock is worth. The intent, in part, is to help protect small investors from being swindled with pie-in-the-sky forecasts.
But because going public via a SPAC is technically a merger, companies are free to make financial prognostications. And they do — lots of them — because most SPACs merge with early-stage companies that have no profits and, in some cases, no revenue, either. The entire selling point to investors is not what the company plans to do in 12 months but what it may do many years in the future.
Lynn Turner, a former chief accountant for the Securities and Exchange Commission, called the proposed fix “an excellent idea.” Because sponsors are the ones advertising “Here’s what we’re going to do in this time period,” he said, “they should be locked into that.”
Palihapitiya was less enthusiastic.
“This isn’t a very good idea,” he said. “Why would a sponsor agree to a five-year lockup when management wouldn’t, nor would other investors, including PIPE investors?” (At the time of the deal, institutional investors are often invited to buy shares with favorable terms through what is called a private investment in public equity, or PIPE.)
That is true. Management can typically sell shares after a short restricted period. But, as Turner pointed out, isn’t it the sponsor that is selling the deal to the public?
“What if management lied?” Palihapitiya argued. “Should the sponsor now be on the hook for bad behavior of management?” He said there were “too many corner cases where this fails.”
Palihapitiya said he had a better idea: “Make a sponsor invest at least as much as 10% of the deal size,” which is far more than most sponsors do. “The more they invest, the more they would need to scrutinize the projections,” he said. “This has always been the only meaningful way to align sponsors, management and investors.”
In some ways, the market is already forcing some sponsors to agree to longer lockups. Michael Klein, a former banker who has become a serial SPAC deal-maker, recently agreed to keep his stake in Lucid Motors, a high-flying electric vehicle maker, for at least 18 months as a way to seal the deal.
And with more and more SPACs losing their shine — most SPACs that went public in recent weeks are now trading below their offering price — investors may demand more from sponsors, perhaps even before regulators do.
But, in the end, investors should not have to ask sponsors to commit to their own deals.
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