Special purpose acquisition companies, or SPACs, are one of the hottest trends on Wall Street at the moment. About 235 SPAC vehicles in the U.S. have raised $72 billion this past year, and it looks as if the volume of deals in 2021 is on track to surpass 2020's record-breaking $78 billion funding raised from 244 SPACs.
Until 2020, these vehicles had a relatively bad reputation. SPAC deals have a history of raising money from investors, paying too much for acquired companies and providing poor returns for investors, as the creators of these vehicles stand to lose money if they can't find an acquisition deal and are thus incentivized to get one done at any cost.
Only time will tell if the current flood of SPACs will be able to achieve better outcomes. However, one group of investors looks like it anticipates to benefit more than most from the current boom, and that's hedge funds.
Hedge funds buy SPACs
Hedge funds have been piling into SPACs recently. Seth Klarman (Trades, Portfolio)'s Baupost, for example, had been building some extensive SPAC holdings over the past year. At the end of 2020, the firm had positions in at least 10 different SPAC stocks, according to its 13F filing. Baupost also owned a selection of warrants in SPAC deals.
These warrants are unique to these investment vehicles. Backers such as hedge funds are allocated SPAC units at $10 apiece before the listing. These units split into shares and warrants shortly after the SPAC makes a successful acquision and starts trading. These warrants usually are only worth a fraction of a share, but they act as a sweetener for early backers of the SPAC. Following the merger of the company with an acquisition target, the warrant converts into a new stake in the business with a strike price of $11.50.
Hedge funds and other early backers have another advantage. When a SPAC unit is issued at $10 per share, the money raised is placed in a trust. If there's no deal, the money is returned to investors.
Put simply, the structure of SPACs means they're a bonanza for hedge funds. These firms and other wealthy backers can provide funding for the deal at $10, safe in the knowledge that if there's no merger, they'll get their money back.
What's more, they can sell their shares soon after the listing and hold on to the warrants. This could provide a huge payoff with minimal real risk for the funds and their investors. The only real danger for hedge funds here is that the stock price might tank soon after listing, which is unlikely in a bull market.
Klarman's SPAC holdings
Based on this asymmetric risk-reward ratio, it's no surprise Klarman and Baupost have built significant SPAC positions. Klarman likes to find investments where there's a low risk of a permanent capital impairment but a high chance of a big payoff. SPACs fit this bill perfectly.
But this does not mean these investments are suitable for individual investors. Hedge funds have unique advantages when it comes to backing these deals. They provide the funding in the first place and are awarded the warrants. Individual investors will likely have to come into the secondary market and buy a position. That may put them at a disadvantage.
Investors should never blindly follow hedge fund positions without doing their own research. This is even more relevant when it comes to special purpose acquisition vehicles.
Hedge funds are trying to make money for their investors with reduced risk. That may mean they sell the units after the issue and keep the warrants. It does not make much sense for individual investors to be buying those units when the hedge fund backers are selling. This is something to keep in mind.
Still, this does not mean that all SPACs will be bad investments. Some may go on to produce a good return. Others may not. It is important to keep the history of these vehicles in mind, and the fact that oftentimes their institutional investors are relying on the broader market to snap up overpriced shares so that they themselves can net a profit.
Disclosure: The author owns no share mentioned.
Read more here:
- Hedge Fund Buys and Sells: Notable Trends
- 2020: What I Learned in a Year of Crisis
- Looking Back Over a Year of Crisis: Reviewing Trades
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