By focusing on their fixed income nature rather than their high-flying risk-reward characteristics, pre-merger SPACs may be one of the safest assets in a portfolio.
SPACs (special purpose acquisition companies) have a reputation for being high-risk, get-rich-quick schemes that never seem to pay off for investors. It’s not wholly unwarranted, though.
While some post-merger SPACs, which are nothing more than speculative small/mid-cap corporations resulting from a SPAC merger, may meet that description, it’s only half of the tale.
Pre-merger SPACs get much less attention, but they, in my view, provide the most appealing and asymmetric risk-reward opportunity in today’s fixed income market by enabling investors to profit from SPACs’ fixed income nature rather than their high-flying risk-reward characteristics. Given the risks and consequences of increasing rates, as well as high valuations and narrow spreads, advisers should welcome rather than dread pre-merger SPACs as they prepare their clients’ portfolios for 2022.
To begin, a SPAC is a corporation with no commercial activities that was founded expressly to earn money via an IPO in order to buy or combine with a private firm and take it public.
To do so, a group of sponsors seeks to generate funds by selling “units” to investors, which are typically worth $10 apiece. One common stock plus a part of a warrant and/or right are included in each unit. The money earned in the initial public offering is retained in a trust account and is usually invested in US Treasury bonds until the trust funds are required to support the corporate merger.
Sponsors typically have 12 to 24 months from the moment they IPO to discover and purchase their target business. If no firm is found in that period, the SPAC is liquidated, and the trust account profits are dispersed to SPAC common stock stockholders. If the sponsors identify and approve a transaction, shareholders may participate by getting stock in the new firm (a post-merger SPAC), or they can opt to redeem their shares in cash from the trust account if they aren’t so pleased about the deal or simply want their money back.
When examining the lifetime of a SPAC, there are two components to consider: SPACs are divided into two types: pre-merger fixed income instruments and post-merger 100% stocks. Because they have a defined liquidation date (similar to a bond’s maturity date), pre-merger SPACs should be considered fixed income instruments. Shareholders are either fully or overcollateralized by a trust account that is typically invested in Treasuries, and like some bonds, pre-merger SPACs shareholders have the right to redeem and put their shares back to the sponsor for cash from the trust account.
To profit from the pre-merger SPAC opportunity, a customer invests only in pre-merger SPACs trading at trust value or a discount to trust value (equivalent to a bond’s par value), with no intention of proceeding with the transaction. Rather of speculating on the future of the newly merged firm, an investor redeems their shares for cash in the trust account when a SPAC announces a merger, regardless of how appealing the SPAC’s plan may seem. In addition, if the market responds positively to an announced agreement and the SPAC’s price increases, the investor may always sell on the open market to realize their profit.
Because SPAC shareholders have a full redemption right to their part of the trust account, which is generally invested in U.S. Treasuries, pre-merger SPACs have much lower downside risks and provide possible equity upside to shareholders.
SPACs might be a high-risk, high-reward investment, but they don’t have to be. When managed properly, pre-merger SPACs may be one of the safest assets in a client’s portfolio. Where else in today’s fixed income environment can clients invest in a security with low sensitivity to interest rates or credit risk, is backed by a trust account, offers investors a put feature/full redemption right for their share of trust account cash, and allows them to participate in potential equity upside?
CrossingBridge Advisors, an investment management business focusing in ultra-short and low-duration strategies, including special purpose acquisition firms, employs John Conner as the director of strategic alliances.