SPAC before the merger? Why some investors seek refuge from inflation and market volatility in this unlikely hiding place

Of all the places where sophisticated investors have been looking for protection against high inflation and big swings in financial markets over the past year, there is one surprise option: Special Purpose Acquisition Companies, or SPACs.

The number of new SPACs reaching the stage of issuing their own initial public offerings has dropped sharply: to 67 this year from 613 in 2021 and 248 in 2020, according to data from SPAC Research. That bear market has created a compelling case for some investors to cash in on the glut of SPACs that are nearing the end of their two-year lifespans and are still looking for a deal. One estimate puts the amount of arbitrage proceeds that can be realized from overfunded SPAC trusts at more than $4.3 billion, provided investors buy at or below a SPAC’s redeemable net asset value.

The SPAC boom may be over, but there’s a reason why blank check companies may still be a place to hide in 2022 while making at least a modest return: The keyword is arbitrage, or the ability to exploit different markets. One arbitrage play focuses on the pre-merger stage of SPAC: this is when the intact capital is in trust, earning interest on Treasury bills, with the option to bullish a rising SPAC share price when it becomes available. heralds an attractive merger. Another game takes place the moment SPAC shares are redeemed, either with a shareholder vote on a merger or liquidation of SPAC.

Amar Pandya, portfolio manager at Vancouver-based PenderFund Capital Management, expects the vast majority of SPACs to fail to find targets, forcing them to return initial income plus interest to investors.

What investors are craving right now is the prospect of any return, given the 2022 sell-off in stocks and bonds, wild volatility and growing fears of stagflation. During the 18 months to two years it might take to find a target and complete a merger, SPACs must keep the proceeds from their initial public offering in risk-free instruments — that is, Treasury bills — while accruing interest. This feature of the SPAC structure is designed to provide a safety net regardless of whether a target company is found, investors like the target, or the SPAC fails and is forced to liquidate.

In SPAC arbitrage, “whether the sponsor finds a target is not a critical element of the strategy,” said Mark Yusko, chief executive officer and chief investment officer at Morgan Creek Capital Management in Chapel Hill, North Carolina, which oversees about $ 2.2 billion. “All we care about is receiving our Treasury principal and interest from the trust and, over time, investing in a certain amount of SPAC where the collateral in the combined post-merger entity has some upside potential.”

“The fundamental case for why an investor would want arbitrage in their portfolio has absolutely improved,” Yusko told MarketWatch. “SPAC arbitrage is significantly safer than bonds or stocks.”

Morgan Creek and Exos Financial manage a $60 million SPAC arbitrage hedge fund called the SPAC+ fund, as an alternative to fixed income. The fund returned 18% during the first half of 2020 and 11% in 2021, according to fund materials posted on Morgan Creek’s website. Yield figures for this year have not been made public, but hovered around 2% through April, and the private hedge fund is not required to file a return with the Securities and Exchange Commission.

Morgan Creek and Exos launched a version of the ETF, or exchange-traded fund, called the Morgan Creek-Exos Active SPAC Arbitrage ETF CSH,
in February, opening the arbitrage strategy to retail investors.

SPACs first emerged in their current form in 2003, and have long used short-term US government securities as a safe place to park their pre-merger IPO proceeds. What is different now is that increased regulatory scrutiny coupled with the bursting of the SPAC bubble in 2021 has not dented the enthusiasm of some investors, who still view SPACs as a safer alternative to equities or fixed income. . This is the case even though Goldman Sachs Group Inc. GS,
and other large banks are withdrawing from the SPAC market amid a series of regulatory proposals. Critics have called SPACs a “scam.”

In a nutshell, SPACs are shell corporations listed on a stock exchange, for the sole purpose of acquiring or merging with a private company and taking it public.

“With volatile markets, rising inflation and rising interest rates, there hasn’t been much hiding in the market. SPAC arbitrage provides a unique, low-risk opportunity for investors to earn an attractive return.”

— Amar Pandya of PenderFund Capital Management

Since shares of SPACs trade at a discount to their cash in escrow, the potential upside to buyers, or arbitrage profit, is more than $4.3 billion as of Monday, according to Accelerate, a provider with Calgary-based alternative investment strategies for retail investors. Currently, the firm said, 98.2% of SPACs are trading at a discount to their net asset values, offering an average arbitrage yield of 4.8%.

“SPAC arbitrage is perhaps the highest risk-reward proposition in the market today,” says Julian Klymochko, CEO of Accelerate, which created the $40 million Accelerate Arbitrage Fund. The fund reported an annualized return of 7.4% for 2021 in its Canadian regulatory filing, and an annualized return of 16.9% from inception in 2020 through April 29 of this year in its most recent fact sheet.

Klymochko points to Digital World Acquisition Corp. DWAC,
the SPAC plans to take Trump Media & Technology Group public. All the investors who bought SPAC at $10 a share did so with “no downside,” he says. SPAC shares closed at $46.21 on Tuesday.

“Stocks or bonds don’t look too good, and investors are looking for alternatives — they’re looking for alternative asset classes that give them the opportunity to earn positive returns,” Klymochko told MarketWatch.

Given the more than 600 SPACs still looking for a target, the market is pricing in the possibility that more than 400 will end up being liquidated, according to Klymochko. And that’s fine for arbitrageurs, “since we still make money (as long as we’re buying below the NAV),” he said by email.

Data from SPAC Research shows that $162.1 billion tied to 602 SPACs in search of targets is held in trusts, most of it invested in the Treasury market.

To be sure, SPACs aren’t the only place investors hide: They’re also looking for cash, Treasury bills, CDs, money market funds, and I-Bonds. And SPAC arbitrage is not without risk. Those risks may include limited liquidity, the potential for trust account fraud, and the chances of reduced upside if an unwelcome takeover target is announced.

Read: ‘No place to hide?’ What’s next as stocks slide into a bear market amid stagflation fears?

Still, the perception of SPACs as a safe haven marks a change from the more common view that has prevailed in recent years as get-rich-quick vehicles for investors. Investors typically pay around $10 for a single SPAC unit in the SPAC IPO, which consists of one common share and a fraction of warrant. Warrants provide the option to buy more shares in the future, at a certain price.

PenderFund’s Pandya, which manages $2.4 billion, manages the $25 million Pender Alternative Arbitration Fund. PenderFund declined to discuss the arbitrage fund’s performance because it’s only been around for less than a year, but Morningstar’s profile showed a year-to-date return of minus 0.88% on Monday and a final return of 1.16%. since the launch of the fund in September. Seventy percent of the fund is invested in merger arbitrage, while the other 30% is invested directly in SPAC arbitrage, with a preference for SPACs nearing the end of their two-year lifespan.

Pandya said he sees a limit to how long the SPAC arbitrage strategy can last, estimating there are only three to four more quarters left before the SPAC market “finds its footing again” as the SPAC pool shrinks and more targets are available.

“With volatile markets, rising inflation and rising interest rates, there hasn’t been much hiding in the market,” Pandya said by phone. “SPAC arbitrage provides a unique, low-risk opportunity for investors to earn an attractive return.”

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