In December of 2001, Enron – an energy conglomerate with a market capitalization of $USD 70 Billion – went bust. Formerly one of the largest companies on the major US indices, and a darling for investors who saw the its approach as a transformative force in the energy sector, the variety of scandals that caused Enron’s demise range from the organizational culture failures of a systemically important business to the downright greed and unaccountability of an arrogant board. These were the human flaws of the business, but what allowed them to perpetuate was the availability of complex accounting and financing procedures which kept a lid on the fraud being committed at Enron.
A prime example of these procedures was Enron’s use of Special Purpose Vehicles (SPVs). An SPV is an off-balance sheet subsidiary created by the parent for the purpose of pursuing risky projects and managing debts in a way that isolates them from the financial performance of the parent company. In non-fraudulent cases, an SPV can serve as a reliable way of pursuing risky investments for a company through its status as a separate entity. Similarly, the SPV can serve as a way of appealing to investors by isolating investment opportunity from the parent company, masking potential credit risks which could increase the cost of debt, this benefit again stemming from the SPV’s status as a separate company.
In the case of Enron, the misuse of the SPV originates from stock transfers from the parent company for the purpose of hedging assets held by the SPVs. Although this strategy worked to quell investor’s concerns, when Enron’s stock began to tumble the guarantees that Enron had made towards the value of its SPVs in the form of stock quickly failed to support what was owed. Bankruptcy ensued. Essentially, the vehicles were used as a way of separating failing assets from the performance of the company which in turn, unhindered by these assets, was able to prop up the value of SPV’s by using their stock as a method of capitalization. As explained, this system was ultimately to the detriment of investors.
So, why are we talking about an accounting fraud perpetrated over 20 years ago. Well, the lessons learned can serve as a useful, if pessimistic, lens for analyzing a booming trend in finance today: the Special Purpose Acquisition Company (SPAC).
SPACs are commonly referred to as blank-cheque companies. As a category of SPV, the sole purpose of these entities is to raise capital for the IPO of a private company. This capital is used to acquire a target company in the private sector with intention merging with said company, becoming its vessel to public markets, with the SPAC now embodying the business it has acquired.
Let’s begin by looking at the benefits of this process. First, it has revolutionized the way in which private companies enter the public sphere via IPO. While a private company would normally have to endure severe regulatory scrutiny in the form of audits and disclosures, this burden is now shifted unto the SPAC. As you can assume, there is not much that a blank-cheque company has to disclose. To this end, SPACs are able to pool capital from retail and institutional investors alike without sentiment being affected to the same extent by the ricochet effect of analysts opinion on business models or financials, making them less volatile than the traditional IPO process.
This early funding greatly benefits the founders of the SPAC, but are investors rewarded for taking the risk of providing capital in a situation where they are less informed than the traditional IPO? In short, yes, SPAC investors are rewarded for their faith in a handful of ways. After the IPO of the blank-cheque company, investors are typically given warrants exercisable shortly after the acquisition of the target company and at a price allowing them to profit from the rise in share price expected after the SPAC-target merger. They are also offered protection in the form of a timeline the SPAC has to acquire a private company after it has achieved target funding, typically in the range of 18-24 months. Lastly, many SPACs offer investors some form of discretion over their choice of target, with the option to sell their shares back to the SPAC if they choose at a mark-up in return for the risk they had taken on by funding the SPAC in the first place. Many of these elements of SPAC deals were made in consequence of the reputation these vehicles had during the 1980s, making a habit out of leaving investors high and dry. Founders are also obliged to take a significant stake.
Now, it may seem like there is not a significant amount in common between the SPV’s employed by Enron and the SPAC as explained above. The diverse “special purposes” in which these companies can be employed makes it difficult to compare one case to the next. To analyze the risk in a way from which we can draw lessons from the Enron case, let us focus on the key separation of the shell company from the parent (Enron) or the target company (the use of SPACs).
In the case of Enron, this separation was used in a fraudulent way to hide the effect that failing assets, which were the target of SPVs, would have typically had on the balance sheet of Enron. In the initial dissociation between target companies and SPACs, this risk is mitigated by the large equity stake possessed in the SPAC by the founder; they want a target primed for sound performance in the public markets as much as their investors. But, what does this process incentivize for the target companies?
Enter Nikola. Nikola is private electric vehicle company that has taken on the challenge of developing zero-emission semi-trucks. The company went public via a SPAC reverse merger organized by VectoIQ Acquisition Corp in June, 2020 at a valuation of more than $3.3USD Billion. However, scrutiny quickly arose as to whether Nikola had been deceptive in how it portrayed the progress it had made toward developing a viable zero-emission truck that could scale to mass production and use. The extent to which Nikola accurately portrayed its progress is under dispute, but the claims against them lay out a web of potential deceptions ranging from inflated assets to the viability of their technology. These are all questions which should have been asked, and probably would have been resolved via the rigour of the traditional IPO process.
In this anecdote lies the risk of SPACs, particularly given current market conditions. As companies seek to go public at increasingly early stages of their growth, the SPAC presents an expedited process of acquiring funding without the vetting of a traditional IPO process, increasing the risk for imposters. Public companies are such because they have been audited or otherwise analyzed to a degree deemed sufficient for the public trust them; to finance them under the impression that they will generate, at the very least, secure returns at an acceptable level of risk. But when this trust is undermined, as in the case of Enron, the losses absorbed now tap into a much wider pool of investors whose risk profiles were certainly not equipped for what was, in fact, a much riskier investment than it appeared to be on paper.
In the first three quarter of 2020, 165 SPACs were listed. This is at a rate five times higher than 2015. In most cases, they have resulted in tremendous successes, such as the listings of Virgin Galactic and online gambling platform DraftKings, allowing them to reach market quickly and to capitalize on the hype surrounding their companies. However, investors should be wary of the red hot pace with which the SPAC has gained momentum as a method for bypassing traditional IPOs and the scrutiny involved. They must be vigilant of the risk that exists, as immortalized by the Enron scandal, when ownership schemes are devised for the sake of dividing risk and separating financial accountability from the concept of a company and its commercial operations. If not, than the exploitation that occurred as a result of the corporate governance failures at Enron could very much be at risk of repeating, undermining the credibility of the SPAC as an innovative and expedited entry point to the public markets and a secure investment opportunity.
Ben is a Commerce student minoring in Philosophy at Dalhousie University in his fourth year of study. He has held positions in public accounting, corporate finance, and financial risk management. Ben’s interests include business law and government policy. He is a goalkeeper on the Dalhousie Men’s Soccer Team.
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