these two have no idea what they're about to walk into
down here to have a good time they figure why not give poker a try
after all how different can it be from the home games they've played their whole lives
all the luck in the world isn't going to change things for these guys there's an
old saying amongst gamblers if you sit in on a poker game and you don't see a sucker
get up from the table you are the sucker this rule applies quite often in the world of finance
too now if there's an investment structure where three types of investor are involved and two of
them have access to a risk-free profit opportunity it's possibly reasonable to think that the third
is the source of their profits so what is this structure and who are the winners and who are the
losers well the structure is of course the hottest investment product of the last 12 months the spec
and i'm hoping that you the viewer are not the sucker at this poker table spike promoters are so
busy banging out new products right now that they don't even bother to come up with names for them
anymore earlier this month a spack named two was announced it's spelled with a lowercase t the goal
is to raise 200 million dollars and take a company public the name's hardly creative but i suppose
it's easier to remember than x a e a dash 12 but i'm getting off topic so what are spacks well i
covered this in more detail in an earlier video and i'll include a link to that but spike stands
for special purpose acquisition company and spikes basically raise cash through an ipo they then
invest that cash in risk-free bonds and have up to two years to search for a private company to buy
buying the company has the effect of taking that company public when a spec proposes a merger spec
shareholders have an option to redeem their shares rather than participate in the merger if they do
this they get back their full investment plus some interest if a spike fails to complete a merger in
the two-year period it sells off the bonds and returns the capital to its shareholders with
interest so why is this a scandal in the making well it reminds me an awful lot of the mutual fund
timing scandal from 2003 and interestingly enough some of the same people are even involved today
the way these deals are structured means that the spax sponsor and some hedge fund investors
who get in and out quickly can profit at the expense of the long-term investors
who are being pitched these deals as a poor man's private equity investment let's think
about it if the sponsor and some hedge funds are making risk-free profits in this structure who is
shielding them from the risk and taking the losses maybe you don't want poor man's private equity
the biggest winner in this structure is of course the spac promoter or sponsor they organize this
back find the target company to take public and then take 20 percent of the shares as a fee
which they called the promote they often put in as little as 25 000 of their own money now of course
they could put in more but why would they want to it's a no-lose deal for sponsors the incentive is
to do any deal it doesn't matter if it's a good deal or not but once it's done they get to own
one-fifth or more of the company even if you end up with one-fifth of a company like nicola
you just sell it right away and move on the only reason the sponsor cares at all about doing a good
deal is that if the deal looks like a success they then get to raise more capital and do it again
chamat palihapitiya has become one of the most prolific spac founders with six listed
vehicles and three deals done so far he's filed to launch seven more spacs this year with the sec
some of the biggest hedge funds have piled into this trade too big names in the space include
millennium management baupost group archegos and magnetar capital according to the financial times
these funds can earn high returns with almost no risk of losses if the deal goes wrong
due to the unique structure of spikes so how does it work well the trick to spec arbitrage
is to get in early early investors who are usually hedge funds and not the retail investors who get
in later are usually allocated spac units at ten dollars a piece prior to it being listed
at this point it's pretty safe as the money you put in is invested in bonds and as long as you get
out before the merger the money is still there once the merger happens the sponsor then takes
off with 20 of the shares so you obviously want out before that happens unit holders
are allowed to ask for their money back plus interest at any point up until the merger occurs
typically for each share you get a warrant which is a bit like a call option but it causes equity
dilution and it allows you to buy a quarter of a share at 11.50 usually the early investors can
split the spike units into shares and warrants shortly after the structure starts trading
if they return the shares prior to the merger they get their ten dollars back and crucially
they get to keep these warrants the warrant which is worth only a fraction of a share is a sweetener
for early backers who can redeem their investment or sell out at any point while keeping hold of the
warrant when the spec 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 spark merger even if they redeemed their original investment well in advance of the deal
now this might not sound like much of a return but because the pre-merger spike can be redeemed for
ten dollars and costs ten dollars hedge funds can usually borrow money and lever up this investment
significantly getting a pretty good return out of it it's a low risk investment with equity upside
few hedge funds stick around after a deal has been announced preferring to sell their
stake at a profit or redeem in an academic study conducted by klausner and all rogue
where they analyzed a group of 47 spikes that merged between january 2019 and june 2020 97
of hedge funds sold their shares or redeemed before a deal was consummated it's this separation
that creates the trade opportunity 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
there are a few ways hedge funds can win in these deals should the sponsor announce a deal that the
market likes the shares might rally above ten dollars and the hedge fund can then simply just
sell them in the market for a profit their initial ten dollars having never really been at risk
they have a potential for profit but not much of a risk of loss if the share price doesn't pop they
can just cash in their shares before the merger get the ten dollars back plus interest and hold
on to the warrants if the deal's eventually a success the warrants earn them a profit
a good recent example is churchill capital four once again catchy name when rumors spread the
cciv was close to striking a deal with electric car maker lucid motors which i think is just
tesla spelled backwards the spec traded up to almost 60 dollars shareholders who bought
in at 10 and were backstopped at that level could exit with a 600 return on investment
when the deal was finally confirmed last month cciv fell by more than half to 26 dollars
retail investors who had piled in based on electric car hype paid a huge premium for a
stock that had an underlying value of ten dollars now why would a sponsor give such
an attractive deal to an investor who has no intention of ever being there for the merger
well as i mentioned earlier the sponsor gets 20 of the shares let's imagine that there's a spec that
has 100 shares 80 shares are sold to the public and 20 shares go to the sponsor if half of the
spike's 80 public shares are redeemed before the ipo the sponsor's 20 share promote will equal 50
of the remaining 40 publicly owned shares so the sponsor wins the hedge fund wins
and the end investors lose but as meatloaf would point out two out of three ain't bad
the academic study that i mentioned earlier which i've linked to in the description shows that
spac shares tend to drop by one-third of their value or more within a year following the merger
this suggests that investors who stay invested in spax on average take a financial hit although spax
issue shares for roughly ten dollars and value their shares at ten dollars when the merger occurs
as of the time of a merger the median spike holds cash of only 6.67
per share according to that study so a spec typically sells shares to one set of investors
in its ipo typically hedge funds and another set of investors when it comes time to merge
a more retail investor base nearly all pre-merger shareholders exit at the time of the merger either
by redeeming their shares or by selling them on in the market in effect a spac pays ipo investors
generously to get this back up and running so that other investors can later buy shares
once a target has been selected to bring public just to be clear i'm not saying that the hedge
funds are the villains in this story they've been offered a low risk trade and they've taken it the
spike sponsors on the other hand are pitching a structure that destroys value for retail investors
but makes the sponsors and hedge fund investors rich more and more these deals are being rushed
to market right now before the boom ends you don't actually have to be a hedge fund to do this trade
anyone can but as a retail investor you might not be able to lever it up as much as a hedge fund
can of course the problem here is that if everyone involved did the same thing and followed the
optimal strategy the money would all come in be invested in bonds and then when a deal was
announced everyone would pull out ending the deal making the warrants worthless for this arbitrage
to work there must be a sucker at the poker table if you found this video helpful do hit the like
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bye
you