Study: The Need For Regulation Of Private Equity: Evidence From De-Spac Transactions (DOI: 10.2139/ssrn.5386505)
Investors suffer significant losses when they buy into "blank check" companies that acquire private companies in order to take them public-underscoring the need for more regulations on private equity as the Trump administration works to relax standards and expose retirement funds to greater risks.
The University of Michigan's Nejat Seyhun, says the whole environment is "akin to appointing the fox to guard the chicken coop."
The research, forthcoming in the Iowa Law Review, co-authored by Seyhun and Cindy Schipani, professors at U-M's Ross School of Business, finds these investors lose about 45% of their investment within two years of the transactions. The researchers say the trend has worsened over time.
Their concerns are compounded by a federal appeals court ruling last year thwarting attempts by the Securities and Exchange Commission to bring greater transparency to the private funds industry. In addition, President Donald Trump signed an executive order earlier this month further opening pension funds' access to private equity markets and making small, retail investors even more exposed to private equity as standards are loosened.
Schipani and Seyhun, who co-authored the study with Sureyya Burcu Avci, adjunct lecturer at Vanderbilt University, sought to determine whether investors were getting a fair deal in these private investments in public equity. They were able to examine the performance because PIPE returns are publicly available.
Further, the researchers found firms using PIPE financing experienced immediate, large and negative abnormal returns. A little over a year following the transactions they studied, abnormal returns reached over 50% (an abnormal return is the difference between the actual return of a security and the expected return).
Given high levels of business and financial risks, conflicts of interest, costs and a lack of transparency, the researchers say private investments are not suitable for small retail investors or even many accredited individual investors. These investors, Schipani says, are financing transactions without the benefit of full and fair disclosures.
However, these investments are finding their way into retail investors' portfolios through mutual funds, pension funds, 401(k) plans and other retirement vehicles. As of this year, rules allowed mutual funds to invest up to 15% of their assets in private funds without requiring accreditation from individual investors.
These "shell" or "blank check" companies, known as Special Purpose Acquisition Companies, emerged in the 1990s as an alternative for private companies to raise public funds without going through a traditional initial public offering. The process of a SPAC acquiring a private company and going public by virtue of the merger is known as a "de-SPAC" transaction.
Private companies went public at unprecedented rates in the early part of the decade because "SPACs offered enticing return-on-investment promises," the researchers say in the study. However, their popularity declined due to being bad investments and the result of controversies surrounding limited disclosures concerning shareholder redemption rights and other concerns.
SPACs, they add, historically evaded standard stock distribution disclosure requirements and anti-fraud provisions. That allowed sponsors to "shoehorn shareholders into bad investments."
Despite the decline since the SPAC boom, they still play an increasing role in U.S. securities markets.
Among several recommendations, the researchers urge Congress to empower the SEC to regulate private funds and their advisers. At minimum, the SEC should be authorized to reinstate disclosure rules as originally envisioned.
Seyhun says the research exposes clear risks associated with the failed attempt to bring any transparency or accountability to the industry, coupled with Trump's executive order opening private equity investments "for grandpa's and grandma's retirement savings."
"The private equity industry, which is high cost, risky, opaque and rife with massive conflicts-yet at the same time massively profitable for its sponsors-is now salivating over $44 trillion retirement savings," he said. "In our paper, we show the dangers of an unregulated private equity juggernaut getting access to unsophisticated retail investors' savings."
Short of regulation, Schipani says, investors in private equity should insist on disclosures of conflicts of interest and compensation arrangements.
"They should demand to know where their money is going," she said.
