In June last year, hedge fund manager Falcon Edge Capital told clients about an exciting new investment opportunity that had “virtually zero-risk”.
The New York-based firm was referring to special purpose acquisition companies, which have taken Wall Street by storm and become a favourite investment among hedge fund managers.
Spacs, Falcon Edge wrote to investors, have an “inherently investor-friendly structure” with little downside. “The key to the Spac structure is that investors can opt to receive all of their investment back,” it said.
Falcon Edge was not the only evangelist. Its letter outlined the reasons why some of the world’s most influential hedge funds have piled into Spacs, fuelling a boom that has proved lucrative for both their early investors and promoters. Among them are names such as Millennium Management, Baupost Group and Magnetar Capital.
Spacs raise money from investors through a public listing and use that cash to hunt for a private company to then take public. In the US, which accounts for the bulk of Spac activity, 235 vehicles have raised $72bn this year, according to Refinitiv. This is closing in on the record-breaking $78bn mustered by 244 Spacs last year.
Hedge funds can earn lucrative rewards, while facing little risk if the deal goes awry, because of the unique structure of Spacs.
Falcon Edge, which manages $4bn in assets, was up 43 per cent last year, according to a source with knowledge of its performance.
The key for such funds is to get in early. Similar to traditional public offerings, hedge funds are allocated Spac units at $10 a piece prior to the listing.
A unique quirk
There is little risk of losing the original investment because cash is put into a trust that invests in US treasuries and shareholders can ask for their money back at any point.
But the potential to make lofty returns come from a unique quirk in the Spac unit, which splits into shares and warrants shortly after the structure starts trading.
The warrant, typically worth only a fraction of a share, acts as a sweetener for early backers, who can redeem their investment or sell out at any point while keeping hold of the warrant.
When the Spac has merged with a target, the warrants convert to relatively inexpensive stakes in the new company at a strike price of $11.50. This gives early backers the ability to profit from a hot Spac merger even if they redeemed their original investment.
“It’s very attractive for hedge funds,” said Mitchell Presser, a corporate partner at law firm Morrison & Foerster. “They are viewing this as a relatively low-risk investment with equity upside.”
The anatomy of the trade allows hedge funds to shoulder almost no risk while keeping a key economic interest in the merged company essentially for free. Few firms decide to stick around after a deal has been announced, preferring to sell their stake at a profit or redeem.
In a study conducted by Michael Klausner of Stanford Law School and Michael Ohlrogge of New York University — where the two professors looked at a group of 47 Spacs that merged between January 2019 and June 2020 — 97 per cent of hedge funds sold their shares or redeemed before a deal was consummated.
“It’s the separation that created the trade,” said Klausner, who has called Spacs a “gold mine” for hedge funds.
Meanwhile, those who stay in for a stake in the merged company, which increasingly includes retail investors, bear the risks of both a potentially bad deal and significant dilution from the free warrants that have been handed out to early backers.
Before the Spac boom, the best hedge funds could expect was to redeem their cash with interest and hope for a good deal that would see the warrants become profitable.
But as demand for Spacs has ramped up, they are securing even better payouts by selling shares in the market at a premium. One recent example is Churchill Capital IV, the Spac set up by ex-Citigroup dealmaker Michael Klein.
Rumours that CCIV was close to striking a deal with electric car maker Lucid Motors had sent shares in the Spac up to close to $60. For early shareholders who bought in at $10, it represented a sixfold return on their investment.
But since the deal was confirmed last month, CCIV share price has fallen by more than half, to $26. Regardless, early backers and insiders on the deal were sitting on huge profits. The group included hedge funds, Klein and his sponsor group, and investors who had funded the transaction.
For retail investors that had bet on the Spac based on hype, it was a different story. They had paid a huge premium for a stock that had an underlying value of $10. Some were left with hefty paper losses.
The risk is that Spacs will become a victim of their own success. The flurry of launches has increased competition for good companies to take public. Shares in Spacs can start to trade at a discount if the vehicle is nearing the end of its two-year deadline to find a target company or if the market is flooded with new launches.
Spac prices started to move downwards in early March amid a flurry of new issuance and rising bond yields, drying up arbitrage opportunities for hedge funds. When shares in Spacs start to fall, investors have to become more selective about the sponsors they are backing, which reduces enthusiasm.
“The people that say it is no risk or free money for hedge funds don’t have the longer-term perspective,” said Kevin Russell, head of UBS Asset Management’s hedge fund unit O’Connor.
“Over the past nine months it may have looked like free money but some Spacs traded at a discount to trust value and, if you look at critical times in the space, they can trade at pretty significant discounts. So there is risk in owning it,” he added.
Writing to investors, Falcon Edge acknowledged the risks of a booming Spac market last June, saying they were at times seeing “too big a premium baked in given the uncertainty of the end of the target and management’s reputation.”
By January, Falcon Edge had jumped on the bandwagon: it launched its own Spac, Pioneer Merger Corp, raising more than $400m.