This skeptic exposed flaws in SPACs. The SEC listened.

A dismal outlook for SPACs recently got much worse.

In a batch of new rules unveiled this week, the SEC acted to guard against companies' unrealistic revenue growth projections—a practice that many target companies had taken beyond justifiable limits. A number of proposed changes would also make it easier to sue sponsors, target companies and underwriters of deals.

For Michael Klausner, a Stanford Law School professor and prominent critic of SPACs, the most important change will be to clarify dilution within blank-check deals. Through dogged research with co-authors Michael Ohlrogge and Emily Ruan, Klausner showed that SPAC investors—especially those who entered a deal later on–consistently weren't getting their money's worth, and that a complicated web of diluted shares obscured the true value of a company's stock.

The iconoclastic stance taken by Klausner and company, first published in the midst of the SPAC frenzy, was vindicated this week in the SEC's proposed rules. The Klausner team's paper, titled "A Sober Look at SPACs," was cited more than a dozen times throughout the agency's framework.

Even without the new rules, hundreds of SPACs that went public in recent years most likely would've been doomed for liquidation—forced to end their hunt for acquisition targets by returning money to shareholders.

During the most recent quarter, SPAC mergers were announced at a rate of about five per month, according to PitchBook data. Meanwhile, 339 blank-check companies that haven't yet executed a deal have less than a year to complete one, assuming the industry's two-year horizon standard.
   

We caught up with Klausner this week to hear what he thinks of the SEC's new rules, and where blank-check deals will go from here.

This interview has been edited and condensed for clarity.

PitchBook: Why do you think it took so long for the market to wake up to the reality of SPACs?

Klausner: That's the question that we have had from the very beginning—from our academic friends, from people in the markets. How could you be right and the market be wrong for so long?

I think that it's a mystery. The market gets things wrong over long periods of time every once in a while. The tech bubble and the financial crisis are good examples. The market's acceptance of SPACs is on a smaller scale but similarly inexplicable.

A good deal with a bad company is a good deal. A bad deal with a good company is a bad deal. It's not so much the nature of the companies that SPACs are bringing public. It's also the terms of the deal, or how much of the company they are getting for their investment. The problem with SPACs, in my view, isn't the companies they take public. It's that their deal is consistently a bad deal. They get too little for their shareholders. Michael Klausner
(Courtesy of Michael Klausner)

SPACs worked out better for certain shareholders like IPO or PIPE investors, who received special incentives. Meanwhile, the people who are trading these shares on an exchange may not realize that they're paying $1 for 80 cents.

That's right, although your 80 cents might be a little bit of an exaggeration. Maybe it's more like 60 cents. On the other hand, it looks to me like a lot of PIPE investors have lost a lot of money, unless they're getting side payments that we don't know about from sponsors.

Do you think the proposed rules as they're written now fix the problem with SPACs?

These are proposals asking for comments. They're not actual rules. I think that the issues they address and the general structure is good. The devil will be in the details.

In the end, what's going to be important is: Will they require SPACs at the time they merge to disclose clearly how much cash they will be investing in a target company?

To go back to your example, the sponsor has to say, "I'm going to take $6 or $8 of yours and I'm going to invest it in a target company." And you have the alternative of getting $10 back through redemption. But if you think we can take your $6 and turn it into something more than $10, go for it.

I don't think too many people take that deal. But I think it has to be disclosed very clearly. Hopefully, when the SEC fills in the details, it will address the problem with disclosing dilution.

I remember early in the SPAC craze trying to understand just how much dilution there was in certain deals. I could never work it out.

I've done a lot of dilution calculations. And I would tell you, now it would take me two or three hours to do it. When I wrote the paper, it was taking Emily and me eight hours. It's a very time-consuming and uncertain exercise for a shareholder to do. So why on earth shouldn't the SPAC do it for you? They've got it all there.

Do SPACs still have an advantage over IPOs? It looks like companies won't be able to issue future projections, but they may still benefit from the added deal certainty.

I would push back a little bit on that. Certainty, I think, is a little too strong—maybe more certainty. There's deal certainty, price certainty, and then there's financing certainty. Financing certainty, when you have high redemptions, it's not there. You have no idea how much you're going to collect as a target company. And then price certainty—you don't have that either. The amount of cash that a target is going to get per share is also dependent on redemptions. There could be deal certainty if there is a PIPE that is above the minimum cash requirement in the merger agreement. So you could get the certainty, but often there isn't deal certainty.

You mentioned SPAC dealmakers have made a lot of money at the expense of others. Do you think that there's egg on the face of these sponsors?

I don't know. I mean, it's really just a matter of the vulnerability to egg.

Some dealmakers are made of Teflon.

They surely knew that when they were investing their shareholders' money in a target company, they were investing far less than $10. Because they were taking a lot of that $10. And they were giving a lot of that $10 to IPO investors.

Now, did they believe they nonetheless could get a good deal for their shareholders? I suppose you'd have to ask them. It's not plausible that they could do that repeatedly. Why would targets agree to take $8 or $6 and provide much greater value?

I think they had to know that they were putting their shareholders behind the eight ball to start with. But they probably did think there was some chance some of the time that they would make some money for shareholders. They surely were going to make a lot of money for themselves regardless.

It feels like the SEC is a little bit late to the party here. If we assume the markets don't change much over the next year, the vast majority of SPACs that haven't merged are on course for liquidation. Are these rules just shooting a dead horse?

What's happened has happened, and it's unfortunate. I think there are a lot of people—sponsors, IPO investors, banks—that have made money at the expense of SPAC shareholders. They have collected enormous amounts of money in helping SPAC investors lose their money.

It takes time to propose and write regulations. So I can't be too critical of the SEC for not moving more quickly. I think that's just the nature of things.

That said, SPACs will continue. I think that there was a role for SPACs before the craze, and there could well be a role going forward. It could be that a better SPAC will be developed that could play a more important role than the early SPACs did.

Featured image photo by Brendan Smialowski/Getty Images, illustration by Joey Schaffer/PitchBook News

This article originally appeared on PitchBook News