Christopher Raby, BridgeTower Media Newswires
As yields on short-term, high quality securities fell to paltry levels over the last few years, investors scrambled to find safe, yield-generating investments for their portfolios. Keeping yields attractive typically required an investor to either extend duration or move down in credit quality. One such investment, which we have been using in clients' portfolios for years now, does neither: SPACs, or Special Purpose Acquisition Companies.
SPACs emerged as popular investment vehicles in the 1990s. Formed during an Initial Public Offering (IPO), a SPAC essentially consists of a blank check, written by investors to a management team for the sole purpose of effecting an acquisition in a specific period of time. During the IPO, a SPAC is typically sold as unit and proceeds are deposited to a trust account. Each unit costs $10 and consists of a varying combination of common shares, warrants and rights. Further, management teams might contribute additional money to the trust account to incentivize investors to purchase the IPO.
The value of a SPAC unit package often runs inversely to investor's perception of the management team's prospective success in selecting an accretive acquisition candidate. Experienced management teams with a history of accretive acquisitions often sell units that have minimal explicit value whereas weaker management teams must pack their units with value in order to successfully sell them. For example, experienced management teams often sell units consisting of one common share, 1/3 of a warrant and $10 cash in trust. A weaker management team might offer a unit consisting of one common share, one warrant and a starting trust value of $10.10 - all sold to the public for $10. For the purposes of our clients' portfolios, we seek SPACs offered by weaker management teams because they offer more explicit value.
The cash received from the IPO (and management) is deposited into a trust account until an acquisition candidate is found. In the interim, the trust is held in cash and short-term government securities - earning interest. Only common shareholders have a claim to the cash held in the trust account. That claim can only be made under certain conditions - typically when the SPAC has found an acquisition target or upon SPAC liquidation. Additionally, the trust is held at a custodian independent of the SPAC management team and is monitored by a third-party trust company, making the value of the trust account extremely safe. These investor protections are in place regardless of the strength of the SPAC's management team. Simply put, the SPAC essentially becomes a measurable, interest-bearing pool of cash and short-term government securities as the management team searches for an acquisition candidate.
Following the IPO, each unit will subsequently split into the unit's individual, tradable components. Continuing the weaker-management example from earlier, the unit that sold for $10 might now be split into a common share selling for $9.70 and a warrant selling for $0.30. At this point, SPACs offer myriad risk/return combinations to an investor. Investors only interested in the warrants will sell the common shares - and that's the point where we become SPAC investors in our clients' portfolios.
To see the value of SPAC common shares, let's assume our SPAC has an 18-month life and earns 1% on the trust during that life. The SPAC with a current trust value of $10.10 will then have a terminal trust value of $10.25. Since common shareholders are the only ones with a claim trust value, the common shares trading at $9.70 are trading at a $0.40 discount to the trust value, implying a "yield to current trust" of 2.73%. Taken to SPAC termination, the common shares trading at $9.70 are trading at a $0.55 discount to the terminal trust value, implying a "yield to liquidation" of 3.75%. For comparison's sake, an 18-month Treasury note currently trades with a yield of just 2.58%.
In our clients' portfolios, we hold a basket of SPACs, similar to a laddered bond portfolio. Each SPAC has different fundamental characteristics, but all were purchased at significant discounts to the value held in trust. The workout of a SPAC investment can happen at any point during the SPAC's life. When buying a SPAC at a discount to the value of the trust, we're anticipating one of three scenarios:
The first scenario occurs when the SPAC is unable to effect a transaction and liquidates, causing the cash to be returned to common shareholders. This is our base, worst-case scenario, generating about a 3-4% annualized return over an approximate 12- to 24-month holding period.
The second and third scenarios occur when a SPAC finds an acquisition target. Because SPAC common shares are freely traded, SPAC common can trade at discount or premium to the value of the trust account. If the acquisition target is poorly received, shares will continue to trade below trust value. At that point, we'll exercise our right to demand our shares be redeemed for our pro-rata share of the trust account. When this scenario occurs, we close the discount to cash quicker than if a SPAC liquidates, but at lower trust value. However, this scenario tends to slightly outperform the first, base-case scenario on an annualized return basis.
Lastly, the third scenario is when a SPAC finds an acquisition target and the transaction is well received by the market. The shares of the SPAC trade above the value of cash in the trust, and we simply sell into the market. We not only close the discount to cash quickly, but also earn an extra return above cash in trust. This case produces annualized returns above the first two scenarios.
At no time do our clients truly experience owning the "operating company" that would result from a completed SPAC transaction - which would introduce significant risk and is definitely not suitable for our clients' portfolios. By purchasing SPACs at a discount to trust prior to merger transactions, we're essentially buying cash and short-term Treasuries at a discount. We're using them in the most exceedingly conservative way possible while producing outsized returns. SPACs continue to be one of our best ideas on the short end of the yield curve.
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Christopher Raby, CFA, is a senior. taxable fixed income portfolio manager for Karpus Investment Management, a local independent, registered investment advisor managing assets for individuals, corporations, non-profits and trustees. Offices are located at 183 Sully's Trail, Pittsford, NY 14534, (585) 586-4680.
Published: Fri, Sep 07, 2018
