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Water Tower Research

Water Tower Research is a leading equity research firm that provides research on micro, small and mid cap companies.

Water Tower Research was founded by Wall Street veterans after witnessing a fundamental shift in the investment research industry with the result being a declining knowledge base among investors, a lack of awareness and a shrinking pool of fundamental research being conducted on companies across the small-cap and micro-cap spectrum. The same issues are now increasingly occurring in the mid-cap space. This sea change within the investment community is impacting not only the companies themselves but also current shareholders and potential investors. With significantly less active sell-side sponsorship by Wall Street, a substantial information gap has developed between companies and various constituents in the financial community. The net result is fewer channels for insight and information to flow between companies and investors.

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KEY HIGHLIGHTS

A look back at 1Q22.&nbsp;The differences between the first quarter of 2022 and the corresponding quarter last year could hardly be starker. While last year’s quarter recorded the highest ever quarterly number of SPAC IPOs priced, 1Q22 saw the lowest number of IPO pricings since 2Q20. That has not prevented a growing oversupply of SPACs in the market. De-SPAC deal announcements have declined since peaking in 1Q21, while the ratio of SPACs searching for targets relative to live IBCs has climbed to almost ~6:1 versus the low of ~3:1 achieved at the end of 2Q21. Meanwhile the shift in sentiment over the past year has been reflected in the surge in redemption rates, with 1Q22 averaging 84% versus just 8% in the year-ago quarter.
Activity remains muted.&nbsp;2Q22 has started in subdued fashion and is continuing the trend of the past quarter, with only one IPO priced in the first six days of April. The backlog of pending SPAC IPOs, currently at 186, continues to fall, which is a positive given the circumstances. Notwithstanding four new deal announcements so far this month, there remain 608 SPACs still searching for targets, including one SPAC, MDH Acquisition Corp. (MDH) which this week cancelled its $959 million merger with digital vehicle protection plan platform Olive Ventures. It remains doubtful that April showers will bring May flowers to SPAC Land this year.
Tighter regulation is coming, but it may not be all bad.&nbsp;Concern about overly optimistic projections made by SPACs has merit with one comprehensive study showing that ~60% of de-SPACs miss their near-term forecasts. This topic is the key element that is being addressed by the SEC Commission’s new proposals unveiled last week. Our SPAC Talk Focus this week looks more closely at the proposals and how they could impact the future development of the SPAC market.

SPAC STATISTICS


SPAC/DE-SPAC RETURNS






SPAC TALK FOCUS
How the SEC’s proposals could impact SPAC Land—it's not all bad
Rose-colored perspectives and red flags
The SPAC cycle that began in 2020 is certainly different from all previous SPAC cycles, not only in terms of the sheer volume of SPACs that have come to market and subsequent de-SPACings, but also in terms of the quality of SPAC sponsors with reputable investor pedigree that have been participating. Yet, SPACs and their sponsors have generally not been able to shed their reputations of doubtful honesty. Indeed, the experience in the last two years is that initial business combinations entered into by SPACs with mostly early-stage private companies have proven to be, more often than not, long on hype and short on delivery, benefiting no one other than the SPAC sponsors and owners of the target company, but certainly not the public shareholders lured into the de-SPAC either pre-merger or post-merger by the hype. As Table 4 indicates, more than 80% of post-merger companies that de-SPACed since the start of 2021 are currently trading below their SPAC IPO prices, and about half of those are trading at greater than 50% of their SPAC IPO values. Against this backdrop, it is perhaps no surprise that the number of class-action lawsuits against SPAC IBCs have been mounting, with 56 to date. Forty-three, or about 75%, have been filed since the start of 2021, and 29, or about 50%, have been filed in the past three quarters (see&nbsp;here).

Many of these lawsuits accuse the defendants of making materially false and/or misleading statements. A common allegation in these class-action lawsuits is that “positive statements about the Company’s business, operations, and prospects were materially misleading and/or lacked a reasonable basis,” which specifically refer to the often overly optimistic projections presented by SPACs when announcing IBCs. SPACs On announcement of an IBC, the majority (80%) of were found to present projections for four years ahead on average, with approximately one quarter of recent projections extending more than five years. A recent study conducted jointly by the business schools of the University of Washington, University of Michigan, and the University of North Carolina at Chapel Hill, in examining SPAC mergers between 2004 and 2021 and referencing the sample of SPAC mergers (152) with observable post-merger revenue, found that only 35% of IBCs met or beat their projections. This proportion declines for forecasts that are further out. However, the record of nearer term (one year ahead) forecasts leaves a lot to be desired with 58% of the sample missing forecasts and 18% by 25% and more.

The study also compares SPAC projected revenue growth to benchmark samples of IPO firms and matched firms, demonstrating that the SPAC projections are approximately three times larger on average than benchmark firms’ actual revenue growth, with even greater differences for long-term projections. After the merger, firms tended to reduce their use of projections, providing them at statistically similar rates as benchmark firms. Overall, the study concluded that evidence supported concerns that the SPAC merger includes highly optimistic projections. Indeed, we have seen many near-term projection downgrades once the de-SPACing has occurred.
The SEC riposte rewrites the rule book on SPACs
In May 2021, the SEC indicated that it was considering heightened scrutiny of projections in de-SPAC transactions. On March 30, 2022, the SEC released its eagerly awaited proposals to address the concern of overly optimistic projections and other key concerns related to the public interest concerning SPACs. The proposed new rules can be reviewed in full&nbsp;here&nbsp;(Warning: it is a 372-page document). But, in the interests of brevity, and for those who cannot spare the time to wade through this door stopper of a document, let us summarize the key proposals.
De-SPAC Transaction Financial Projections:&nbsp;The proposed new rules would require additional specific disclosures in a de-SPAC transaction with respect to projected financial information, including disclosure of the party that prepared the projections, the purpose for which they were prepared, all material bases and assumptions underlying the projections, any factors that may impact such assumptions, and whether the target company’s management has affirmed the projections to the SPAC. Additionally, projections based on historical measures and operating history would need to be presented with equal or greater prominence as counterparts not based on financial results or operating history.
Related to the use of forward-looking statements including financial projections, and arguably the most significant amendment proposed to the status quo, is the potential elimination of the Private Securities Litigation Reform Act (PSLRA) Safe Harbor from de-SPAC transactions. Should PSLRA Safe Harbor become unavailable for forward-looking statements for filings by SPACs, SPAC sponsors would need to take into consideration the consequent potential liability exposure when deciding whether and to what extent to use projections in connection with de-SPAC and PIPE transactions. However, this is the one proposal, if approved, that does create a conundrum and might ultimately prove counterproductive. Excluding SPACs from the safe harbor liability protections of the PSLRA would threaten to reduce investor information and deal transparency leading to increased litigation with respect to the information that is provided by potentially driving SPACs to use less comprehensive projections or even consider discontinuing the practice of presenting financial projections altogether.
It should be noted that disclosure of financial projections is not expressly required by the federal securities laws, although there are assorted reasons why they are frequently used in de-SPAC transactions. For instance, they may be used to comply with state or foreign corporate law regarding a board’s decision to approve a business combination transaction or as the basis for the agreed consideration for the target company or because projections provide existing and potential investors visibility into the target’s future financial growth, which may be especially attractive to companies that will not be profitable for a few years. Companies going down the traditional IPO route do not typically include financial projections in a registration statement and related prospectus for an IPO because of the liability risks associated with such disclosures. The use of projections for de-SPAC transactions is by virtue of their consideration as merger transactions. The ability to use projections to market de-SPAC transactions has been considered a competitive advantage relative to going public via a traditional IPO process.
Additional New Disclosure Requirements:&nbsp;The new proposals require additional disclosures on SPAC sponsors, their affiliates, and any other SPAC promoters. These disclosures include:

The experience, material roles and responsibilities, and compensation of these parties, as well as an organizational chart that shows the relationship among the SPAC, the SPAC sponsor, and the SPAC sponsor’s affiliates.
Disclosures pertaining to the SPAC’s timeframe to complete a de-SPAC transaction, redemption rights, the compensation of the SPAC sponsor, conflicts of interest, dilution (including a simplified tabular disclosure incorporating a range of potential redemption levels) and, in a de-SPAC registration statement, a statement regarding the fairness of the de-SPAC transaction and related financing transactions.
Potential material sources of additional dilution that non-redeeming SPAC shareholders may experience at different phases of the SPAC lifecycle by electing not to redeem their shares in connection with de-SPAC transaction.
A description of any actual or potential material conflicts of interest between the SPAC sponsor, its affiliates, or the SPAC’s directors and officers, on the one hand, and the unaffiliated security holders, on the other. The SEC document considers different types of conflict but highlights one notable example where the potential conflict of interest stems from the contingent nature of the sponsor's compensation, whereby the sponsor and its affiliates have significant financial incentives to pursue a business combination transaction even though the transaction could result in lower returns for public shareholders than liquidation of the SPAC or an alternative transaction.

While the new proposals do not add a requirement that SPACs obtain a fairness opinion on a pending de-SPAC transaction, they do require an affirmative statement in a de-SPAC registration statement as to whether the SPAC reasonably believes that the de-SPAC transaction and any related financing transaction are fair or unfair to public investors and whether the SPAC has received any outside opinion or appraisal relating to the fairness of such a transaction. There is also a new requirement that the SPAC and the target company co-register the de-SPAC registration statement.
Underwriter Liability:&nbsp;Investment banks involved with de-SPAC transactions do not typically conduct the same level of due diligence as they would for a traditional IPO. The SEC’s new proposal would effectively expand statutory underwriter liability would increase the underwriter’s due-diligence obligations in the case of de-SPAC transactions. This might have the effect of either discouraging investment banks from taking on new de-SPAC transaction engagements given the heightened risks presented or raise the costs associated with de-SPAC transactions as underwriters demand higher fees to compensate for the additional work. In a traditional IPO, the underwriters typically receive a discount of around 6% to 7% of the gross proceeds, which is paid at the closing of the IPO. Today, in a SPAC transaction, the underwriters will typically receive a discount of 5.5% of the gross proceeds, but only 2% of the discount is paid at the closing of the IPO. The balance of the discount is deposited in the SPAC’s trust account and is deferred and payable to the underwriters at the closing of the IBC. If a business combination is not consummated, the deferred 3.5% is not paid to the underwriters, but is instead used with the rest of the funds in the SPAC’s trust account to redeem the public shares. The SEC announcement has already had some impact, with Citigroup, last year’s leading SPAC bookrunner, reported to have temporarily paused IPOs of new US SPACs until more clarity on the potential legal risks posed by recently proposed rules is forthcoming.
The bottom line
The proposed rules will be open for public comment until May 31, 2022 or the date that is 30 days after their official publication in the Federal Register. Following the public comment period, the SEC staff will consider appropriate revisions to the proposed rules before proposing final rules that will be subject to a subsequent vote by the SEC Commissioners who had voted 3-1 in favor of the draft proposals. According to at least one law firm, Sidley Austin, a considerable number of comments is anticipated, as well as likely legal challenges to the final rules, making it unlikely that any final rules would be adopted prior to 4Q22. Other law firms, such as Sullivan &amp; Cromwell, expect that after considering public comments, the SEC will proceed expeditiously to adopt the final rules and anticipate that comments will note the importance of providing for a transition period, which might encourage another burst of de-SPAC deal announcements ahead of the adoption of the final proposals. However, with more than 600 SPACs still searching for targets, the adoption of the proposed rules could result in far more liquidations than we have seen to date. Only four SPACs have been liquidated
Concerns that adoption of the proposed rule changes will reduce the advantages of going public through a de-SPAC rather than a traditional IPO may be legitimate. However, we do not expect the proposed tighter regulations to shutter the SPAC market as some have suggested. These rules change little with respect to one major advantage SPACs have over traditional IPOs, that is the potential to cement key strategic partnerships with SPAC sponsors to the benefit of the development of the target company. The de-SPACing process has another advantage in that it can also provide the target company with the ability to negotiate its valuation face-to-face with a single counterparty, whereas valuations for traditional IPOs are set by underwriters and there is a book-building process with institutional investors through a roadshow, with changing investor sentiments and market conditions often influencing pricing.
As the experience of the past year demonstrates with de-SPAC valuations plummeting, there are clearly things that have to be fixed in the de-SPACing process. While there may be questions about some of the proposals put forward by the SEC commission, overall, we think the measures proposed by the SEC Commission should work to the benefit of the SPAC asset class by raising the bar in terms of the quality of assets being targeted for de-SPACing, even if it means a lower volume of SPACs coming to the market than we have seen in the past two years.
DISCLOSURES
Water Tower Research (“WTR”) is a professional publisher of investment research reports on public companies and, to a lesser extent, private firms (“the Companies”). WTR provides investor-focused content and digital distribution strategies designed to help companies communicate with investors.  WTR is not a registered investment adviser or a broker/dealer nor does WTR provide investment banking services. WTR operates as an exempt investment adviser under the so called “publishers’ exemption” from the definition of investment adviser under Section 202(a)(11) of the Investment Advisers Act of 1940. WTR does not provide investment ratings / recommendations or price targets on the companies it reports on. Readers are advised that the research reports are published and provided solely for informational purposes and should not be construed as an offer to sell or the solicitation of an offer to buy securities or the rendering of investment advice. The information provided in this report should not be construed in any manner whatsoever as personalized advice. All users and readers of WTR’s reports are cautioned to consult their own independent financial, tax and legal advisors prior to purchasing or selling securities.  Robert Sassoon, who is the writer of this report, covers the Emerging Growth &amp; Special Situations sector for WTR. Mr. Sassoon and members of his household have no personal or business-related relationship to the subject company other than providing digital content and any ancillary services WTR may offer.  Unless otherwise indicated, WTR intends to provide continuing coverage of the covered companies. WTR will notify its readers through website postings or other appropriate means if WTR determines to terminate coverage of any of the companies covered.  In certain instances, including this report, WTR will write research covering non-clients. Readers should assume that WTR may seek to turn these non-paying companies into paying clients. Likewise, WTR may seek to transform these non-clients into paying clients of it or of its affiliate, which provides services such as presenting at sponsored investor conferences, distributing press releases, advising on investor relations and broader corporate communications and public relations strategies as well as performing certain other related services (“Ancillary Services”). The companies that WTR covers in our research are not required to purchase or use Ancillary Services of WTR or an affiliate might offer to clients.  The manner of WTR’s potential research compensation and Ancillary Services to covered companies raise actual and perceived conflicts of interest. WTR is committed to manage those conflicts to protect its reputation and the objectivity of employees/analysts by adhering to strictly written compliance guidelines.  The views and analyses included in our research reports are based on current public information that we consider to be reliable, but no representation or warranty, expressed or implied, is made as to their accuracy, completeness, timeliness, or correctness. Neither we nor our analysts, directors, officers, employees, representatives, independent contractors or agents shall be liable for any omissions, errors or inaccuracies, regardless of cause, foreseeability or the lack of timeliness of, or any delay or interruptions in the transmission of our reports to content users. This lack of liability extends to direct, indirect, incidental, exemplary, compensatory, punitive, special or consequential damages, costs, expenses, legal fees, losses, lost income, lost profit or opportunity costs.  All investment information contained herein should be independently verified by the reader or user of this report. For additional information, all readers of this report are encouraged to visit WTR’s website www.watertowerresearch.com.

SPAC Talk: Removing Those Rose-Colored Glasses