SPAC Arbitrage

Without a doubt, the trade of 2020 (aside from TSLA calls) was SPAC arbitrage. Given that SPACs, or special purpose acquisition vehicles, are starting to contend with IPO’s as the most popular method of going public, and that SPAC arbitrage is becoming more and more popular, I think it’d be useful to dive into what is SPAC arbitrage and why the opportunity exists.

First, a prerequisite is an understanding of what SPACs are and why they are becoming a thing. For that, I wrote about this a few months back. It might be a good idea to start there. I’m only going to cover the technical details of SPACs and SPAC arbitrage here.

There are five parties that are integral to the SPAC eco-system. They are the SPAC founder (sponsor), the company looking to go public (company), investment banks (banks), hedge funds, and Robinhood traders. Okay that last part is mostly a joke, the fifth party we will call “investors”.

A SPAC sponsor initiates the process by, with help of the banks, selling shares of their newfound SPAC to hedge funds in an IPO. The sponsor’s goal is to raise funds to go and find a private company to acquire/merge with, bringing that private company public. Any institutional investor can submit a bid for these SPAC shares, but it ends up mostly being hedge funds for reasons we will get to. The sponsor takes the proceeds from the IPO and puts them into a trust account where they are invested in risk-free short-term US treasury bills.

In return, hedge funds receive shares worth $10 (usually) that is fully backed by treasuries, but also receive a warrant. This warrant is kind of like a call option, giving the owner the right to purchase shares of the company for $11.50 (usually) in the event the SPAC is successful in merging with a private company. This is where the arbitrage magic happens. They receive the warrant for free, but the warrant always has a value worth more than $0.

Let me explain. Let’s pretend that the SPAC sponsor acquires a very speculative company (not uncommon in SPAC-land!). Let’s say that this company has a 99% chance of failing (share price going to $0), but also has a 1% chance of unbelievable success with share price increasing ~10x to $111.50. If you own a warrant which gives you the right to buy 1 share of the company, the value of that warrant is $1. Here’s the math: (99% x $0) + (1% x ($111.50 — $11.50)) = $1. Does that make sense? Options aren’t priced based on what the average result is; they are priced based on what all the potential outcomes are. Since there is always a probability that the SPAC sponsor acquires a company whose shares become worth more than $11.50 (or whatever the warrant’s strike price is), the warrants will always have some sort of value!

A key detail of these warrants is that they “break off” the SPAC share 50-some days after the SPAC IPO. This means that the warrants start trading individually, so hedge funds are able to sell their warrant. The warrant that they received for free! That’s where most of the SPAC magic comes from. As long as you have access to SPAC issuance, you can get free money.

There is another element of SPAC arbitrage which is also (relatively) risk-free. If a sponsor is successful in finding and acquiring a company, SPAC owners are given the option to convert their SPAC shares into A) shares of the company, or B) get their $10 back, plus whatever interest the t-bills earned. Hedge funds are always going to choose option B. They do not own SPACs because they want an interest in a company. They are in it for free money.

This is important because SPACS usually trade around their trust value ($10 plus accrued interest), but not always! Sometimes you can buy them for $9.90 or less. If a hedge fund finds a SPAC trading on the market for $9.90, and they know that they can trade it for >$10 once the SPAC acquires a company or the SPAC expires, they can make a free 1%+. That’s not exactly appealing, but if you lever it a few times, it will provide a pretty healthy, risk-free return. It also gives the hedge fund upside optionality, in case the SPAC announces an acquisition with a Bitcoin mining company and a bunch of Robinhood traders, er, investors bid it up to $15.

This is the other leg of the SPAC arbitrage trade, but it only really works if SPACs are trading less than trust value. Historically they have typically traded for less than trust value, but recently they are selling at premium, likely due to their growing popularity.

That is SPAC arbitrage in a nutshell.

The question you should be asking yourself is, “why does this arbitrage exist?” If someone is making risk-free money, someone else must be losing it. Money can’t be printed out of thin air (unless you’re the Fed). Let’s review who the five parties are and what they stand to benefit (or lose).

First, there’s the SPAC sponsor. The reasons sponsors pony up money to pay the banks to help IPO their SPAC is because they receive shares of the company for free if they successfully acquire a company (usually 20% issuance). They receive nothing if there is no deal, so they have a huge incentive to get a deal done, even if it’s not accretive to investors. The sponsor’s ACB on their potential shares is $0. SPAC sponsors are unquestionably a winner here, as long as they get a deal done.

Investment banks are basically always the winner of IPO’s and M&A’s so no need to go into detail. They always win.

Hedge funds, as we’ve seen, are massive winners here. They do have to put up capital to get an allocation of SPACs at IPO or buy them in the open market at a discount. That said, this capital is not really at risk. The only real risk is if the hedge fund is a forced seller due to too much leverage and too little liquidity in the market. Other than that, this is a pretty great trade. Hedge funds are a huge winner here.

Investors in SPACs have not faired so well. While there are exceptions, if history is a guide, SPACs are an absolutely terrible investment. Research from Harvard published late-2020 show that the 12 month return for a SPAC post-acquisition is a mean of -34.9% and a median of -65.3%! This honestly makes sense when you think about the incentives: SPAC sponsors just want to get a deal done, even if the pay double what the company is worth, as they only get paid if a deal is done. They basically have a call option on 20% of the outstanding shares with a strike price of $0, contingent on them getting a deal done. Why wouldn’t they overpay!?

The last party is the private company and this one is the most complicated. There are great reasons for companies to choose to go public with a SPAC (certainty of price, speed, explicit banking fees, etc.). The big issue with going public via a SPAC is the dilution of shares (because of sponsor issuance and potential exercising of warrants). This cost is not as tangible or as certain as explicit banking fees, but recent research show that these costs could be quite high. The same research paper I referenced above estimates that total SPAC fees (including dilution) were a median of 14.1%, with 25th percentile being 10% and 75th percentile being 21%. That’s a lot, but perhaps the companies believe it’s worth it given the benefits mentioned above. Or maybe they just don’t do the math.

There are some key risks that we are watching which could affect the appeal of the SPAC arb trade. They include increasing competition, evolution of SPAC terms, SPAC prices, SPAC redemption, and others. As mentioned, prices of SPACs in the secondary market are a little higher than usual right now, so many SPAC arb managers are lowering leverage in response.

Regardless, it doesn’t appear that SPACs are going anywhere anytime soon, which leaves lots of opportunities for those with access and expertise.