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ANALYSIS: SPACs—And the Next Trendy Innovation Going Mainstream

Jan. 24, 2022, 10:00 AM

Upstart SPAC IPOs finished a record-breaking year that saw them outnumber traditional IPOs for the first time ever. This astonishing accomplishment was propelled by the pandemic and sustained, at least in part, by the regulatory arbitrage of how SPACs operate. That structure confers advantages, particularly at the M&A stage.

What might be the next big thing in finance? Building on blockchain and cryptocurrencies, decentralized finance (DeFi) is looking to have its moment. But investors in DeFi could benefit from some regulatory oversight in the future—just as SPAC founders are now reaping the rewards of regulation initiated years ago to address the worst abuses associated with such blank check companies, with potentially more to come sooner rather than later.

SPACs Reach the Top of the IPO Mountain

SPACs were once on the fringes of finance. Remember back in the early 1990s, when SPACs were merely blank check companies without trust accounts to protect investor funds? Fraud was rife, and there was a strong stigma attached to the practice. Companies seeking financing generally avoided them unless they were out of better finance options.

Since the start of the Covid-19 pandemic, SPAC IPOs have become accepted by many retail and institutional investors as legitimate investment vehicles, much like a music genre that was once considered alternative and novel before becoming part of the pop culture mainstream.

As a percentage of annual IPOs on U.S. exchanges, SPACs have enjoyed enormous growth. In 2018, SPAC IPOs represented 16.8% of all IPOs. That figure rose to 23.6% in 2019, then to 49.2%, achieving near-parity with traditional IPOs in 2020. In 2021, SPAC IPOs were 56% of all initial public offerings, the first time traditional IPOs have not reigned supreme.

The money raised by SPAC IPOs has been nearly as impressive. SPACs raised nearly $163 billion in 2021, or about 48% of all IPO capital raised. In 2018, SPACs raised a far more modest $10.7 billion, or about 16% of all IPO capital raised.

Grab and Go Down? Deal Falls 21% Amid SPAC Boom

Grab, Southeast Asia’s largest ride-hailing and delivery company, went public in November via a reverse merger with public SPAC Altimeter Growth Corp., completing a $40 billion special purpose acquisition company deal, the largest in history.

Although hardly any investors redeemed their shares to opt out of the merger deal—a sign of very strong support—shares in the combined company fell 21% in its debut. The company isn’t yet profitable and the pandemic has suppressed ride-hailing activity, with the highly transmissible omicron variant adding to investor concerns. Nevertheless, this SPAC deal represents a significant milestone for the once-disfavored financial product.

DeFi: The Next Regulatory Frontier?

The next step in the evolution of finance appears to be a part of the digital asset revolution.

Like SPACs in their early, tumultuous years, which have since benefited enormously from the escrow or trust account requirement of Securities Act Rule 419, appropriate regulation needs to follow digital asset innovation for the good of both investors and for the industry’s future. Blank check companies virtually disappeared for years after their name got dragged through the mud underneath terrible headlines.

Revamped as special purpose acquisition companies, they still present some issues for investors and regulators. But the improvements made to SPACs and their investor protections paved the way for their current success.

Digital assets, whether cryptocurrencies or non-fungible tokens, and technologies that make use of blockchain and digital assets, such as DeFi and the metaverse, would likely put their long-term health on a more secure footing if there were more regulation and oversight to protect investors and encourage future investment.

The financial crisis of 2008 was the impetus for the creation of Bitcoin in 2009, the world’s first cryptocurrency that rose up independently of any country or central bank. Since then, cryptocurrencies have proliferated as digital assets have increasingly become accepted and adopted. However, so have frauds and outright thefts.

Crypto and DeFi cheerleaders claim they seek to democratize finance by opening up opportunities for ordinary investors not available in the current financial system. Those opportunities are made possible by removing middlemen from transactions, including big banks. That decentralization and removal of traditional financial institutions reduces costs and improves offerings for investors. Crypto lenders tend to offer APY in the double digits, unlike bank savings accounts, which pay nearly nothing at all.

Customers can use the crypto assets they’ve transferred to their DeFi account as collateral to very quickly secure a loan via their phone’s dapp (or decentralized app)—all without wrangling with a bank loan application. Crypto lending has obvious appeal.

At present, public digital ledgers, also known as blockchains, provide transparency in transactions. But there is no transparency mandated for parties to DeFi transactions. Customers don’t know the reputations of their counterparty lender, and the smart contracts (programs that automatically execute when certain pre-established conditions are met) that effect these transactions cannot anticipate every eventuality, potentially leaving customers without recourse if things go bad.

There is also no regulation of the DeFi industry (save for the SEC and some state attorneys general sending firms cease-and-desist letters or letters inquiring into possible unregistered securities violations); no oversight of its actors, like there are for banks and securities broker-dealers; no insurance for deposits (which get stolen by hackers with some regularity) or other customer protections; and no adequate requirements for disclosure of risks to investors. Some DeFi firms—like crypto exchange BitMart, after hackers stole $150 million in customer cryptocurrencies—pledge to make investors whole with their own funds after security breaches, but those promises may take time or go unfulfilled.

SEC Chair Gary Gensler would like crypto investors to enjoy protections similar to those afforded investors who trade stocks or other assets. Crypto exchanges, which are the focus of an effort by Gensler to regulate cryptocurrencies, have already begun going public in the U.S.

Coinbase was the first major crypto exchange to go public in the U.S., providing significant validation to burgeoning digital assets. Gensler wants these exchanges to register with the SEC. To date, DeFi companies have steered clear of becoming publicly registered in the U.S. The lone exception appears to be Canadian firm DeFi Technologies, which has registered as a foreign issuer. The company focuses on serving Canadian customers.

DeFi companies have grown in the past two years at rates that put SPACs to shame. From relative obscurity in early 2020, the value of assets used in decentralized finance grew to $100 billion in October 2021. In November, industry tracker CoinGecko put the overall DeFi market value at more than $170 billion, up from $22 billion in January.

Regulators have taken notice and are beginning to push the industry to register its products, disclose the risks, and better protect customers. Indeed, the Biden Administration announced on Friday that it expects to release an initial government-wide strategy for digital assets as soon as next month.

As Gensler noted in a speech in August, it is only after bringing innovations inside the appropriate regulatory regimes, consistent with public policy goals, that new technologies have a chance at broader adoption.

Bloomberg Law subscribers can find related content on our Equity Offerings Deal Analytics resource and on our Securities Practice Center resource.

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