Episode #263: Best Idea Show – Julian Klymochko, Accelerate Financial Technologies, “The Purpose, And What We’re Really Seeing The SPAC Emerge This Year For, Is To Truly Raise Growth Capital For Growth Businesses”
Guest: Julian Klymochko is founder and CEO of Accelerate Financial Technologies, a firm delivering institutional-caliber hedge fund and private equity ETFs ranging from absolute return strategies to private equity replication to arbitrage.
Date Recorded: 10/15/2020 | Run-Time: 53:39
Summary: In today’s episode we’re covering our guest’s best idea: SPAC arbitrage. It’s been a hot topic lately, and we dive into what the world of SPACs and SPAC arbitrage is all about. Julian offers a nice walk through of what a SPAC is and how the mechanics work. We cover what makes them such a unique vehicle for sponsors and investors alike, and get into the practical steps a SPAC must go through in the process of making business deals. We talk market dynamics, and chat about where the interesting arbitrage opportunities exist for investors.
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Interested in sponsoring an episode? Email Justin at email@example.com
Links from the Episode:
- 0:40 – Intro
- 1:37 – Welcome to our guest, Julian Klymochko
- 1:45 – The Meb Faber Show Podcast – Episode #231: Julian Klymochko, Accelerate Financial Technologies “The Democratization Of Alternatives, It’s Happening, But It’s Something That Does Not Happen Overnight”
- 2:55 – Defining SPACs
- 5:16 – Why are SPACs so popular right now
- 10:41 – Walking through a SPAC as an example
- 12:55 – Cost of going public via SPAC vs. IPO
- 18:14 – Where the first money comes from in funding a SPAC
- 19:32 – First 1-2 years of a SPAC
- 23:46 – What percentage of SPACs get a deal, and which deals have a positive surprise
- 30:03 – Options for shareholders if the deal doesn’t go through
- 33:17 – What makes SPACs so labor intensive
- 37:18 – Accelerate’s strategy (ARB in Canada)
- 39:21 – Literature Accelerate publishes on SPACS – Alpha Rank SPAC Monitor
- 41:17 – Could VC create conflicts of interest getting into SPACs
- 43:41 – Current opportunities in SPACs
- 50:33 – Capacity for Accelerate to invest in the SPAC market
- 52:04 – Best way to connect with Julian: accelerateshares.com, twitter @julianklymochko, Absolute Returns podcast
Transcript of Episode 263:
Welcome Message: Welcome to “The Meb Faber Show,” where the focus is on helping you grow and preserve your wealth. Join us as we discuss the craft of investing and uncover new and profitable ideas, all to help you grow wealthier and wiser. Better investing starts here.
Disclaimer: Meb Faber is the Co-Founder and Chief Investment Officer at Cambria Investment Management. Due to industry regulations, he will not discuss any of Cambria’s funds on this podcast. All opinions expressed by podcast participants are solely their own opinions and do not reflect the opinion of Cambria Investment Management or its affiliates. For more information, visit cambriainvestments.com.
Meb: Hello, friends. Today we have another installment in our Best Ideas series. Our guest was with us back in June for Episode 231 to talk about democratizing alternatives. He’s the founder and CEO of Accelerate Financial Technologies, a firm delivering institutional caliber ETFs ranging from absolute return strategies to private equity replication to arbitrage. In today’s episode, we’re covering our guest’s best idea, SPAC arbitrage. It’s been a hot topic lately, and we dive into what the world of SPACs and SPAC arbitrage is all about. What is a SPAC anyways? How do they work? We cover what makes them such a unique vehicle for sponsors and investors alike and get into the practical steps a SPAC must go through in the process of making business deals. We talk market dynamics and chat about where the interesting arb opportunities exist for investors. Please enjoy this special Best Ideas episode with Accelerate’s Julian Klymochko. Julian, welcome to the show.
Julian: Thank you, Meb. Glad to be here.
Meb: I should say “Welcome back.” We had you on not too long ago, Episode 231. Listeners, you should view this as sort of a two-part series. We got such a great response, decided to have you back on. That was a pretty broad discussion. I wanted to get a little deeper here today on a topic that’s near and dear to everyone’s heart, SPACs. So what’s your best idea right now?
Julian: Yeah, thanks, Meb, for having me back on the show. So my best idea in the current environment is a strategy we call SPAC arbitrage, which is something that probably most investors are unfamiliar with, but it’s very similar to, I call it merger arbitrage’s younger brother. It’s a similar type exposure with some unique differences. So we really like SPAC arbitrage just given the low risk, high upside opportunity. I like calling it equity upside with the risk profile of treasury security. So I’m excited to get into that trading strategy today.
Meb: It’s everyone’s sort of dream combination. You’re not one for hyperbole, but I did see you at some point referring to SPAC arb as almost the holy grail of investing. So, listeners, if you’re not salivating already, get ready to. So let’s take a step back. Everyone in the news is talking about SPACs. Every day you have Chamath and Ackman and others talking about these big, massive, multi-hundred million, billion-dollar sort of SPACs. What is a SPAC? Give us a broad overview, and then we’ll start to dive into this concept of arb.
Julian: So let’s start at the basic. So what a SPAC is, it stands for Special-Purpose Acquisition Company, also known as a blank check company. Now they’ve been around for a very long time. It was a very niche market or even nichier, that it is. Now it’s only about $80 billion market. So for some context, that’s like half the size of bitcoin’s market cap or double the size of cannabis stocks. And so it is still a fairly small market. But the way these things work is they IPO, they go public on a stock market at generally $10 per unit, raising on average $200 million to $300 million. It could be as small as a $50-million IPO, or, as you indicated, Ackman’s SPAC raised a record $4 billion, which was just massive. And so they go public in unit form and these units are made up of a common share plus typically a fraction of a warrant just to incentivize mostly hedge fund managers to buy in the IPO liquidity providers, give some additional equity upside. And all a SPAC is, this blank check company, is it’s a pile of cash that they raise in the IPO, and then they go on their quest to find a private company to merge with and bring them public. And they generally only have a limited amount of time to do that, which is typically two years. And they’re not allowed to do anything with the cash that they raise aside from invest in short-term treasuries. There’s not much risk for them to go down. Like, we look at what we call the net asset value or the cash and treasury held. And they start at $10, slowly accrue interest. It’s not a lot these days, 15 basis points. But at the end of the two years, if they haven’t struck a deal, then they either liquidate and pay you your money back plus accrued interest, and that’s, like, a key dynamic, unless they have a deal, and then they merge, and you have this new public company.
Meb: So you’ve had some pretty famous names in the news, Virgin Galactic, Open Door, and others, and since we recorded, a continued explosion in number of SPACs. Talk to me a little bit about the dynamics, why that’s happening right now. And also I’d like to walk through, like, a typical SPAC sort of example as well. But why is everyone all of a sudden doing SPACs, and why is everyone all of a sudden interested?
Julian: That’s a great question, Meb. So it’s basically driven by two factors, one on the demand side and one on the supply side. So on the demand side, what we’ve seen in the markets over the past 20 years is steady decline in U.S. publicly-listed securities, a lot of M&A go private, things of that nature. And on the opposite side of the coin, we’ve seen the emergence of large pools of capital in the private space, whether they’re private equity, leveraged buyouts, venture capital, just a ton of capital flooding that side of things, where in the large early stage growth opportunities, take Uber for example, by the time it was public, all of its growth was behind them. They went public at, what, like, a $50 billion valuation or something crazy such that, post-IPO, the performance of the stock has not been great. It’s not like getting in on Apple or Microsoft, their stage of growth, which was far, far earlier. What we’re seeing up until, say, this year is a lot of these large private growth companies waiting until all the growth juice is squeezed out of them prior to going public. But with the success of certain SPACs, and I think that Virgin Galactic was probably one of the first to really spur this trend, and arguably DraftKings as well, where it was shown that these private companies that were still fairly early stage, they call them sort of late-stage venture capital Series D type, Series E round opportunities, where their pre-profitability or, in some cases, pre-revenue, where the previous theory was that, Oh, public market investors, they’re too short-term. They’re only concerned about the next quarter. They’re not going to support a company in which revenue is five years. Oh, however, we see Virgin Galactic go public and the stock just goes bananas. And it turns out there’s significant public investor demand, retail investor demand, for these late-stage type VC opportunities that they haven’t had access to because they were only for venture capital funds in the private market.
And so you’ve had this dynamic on the demand side, where there in fact is a lot of demand for early-stage growth opportunities, and public market investors really haven’t been able to have exposure to those in quite a while ever since the private funding market sort of crowded them out and these great growth opportunities decided to just stay in the private space for longer and longer. So that’s on the demand side. And concurrently, on the supply side, you’ve had a number of sponsors, private equity firms, hedge funds, venture capital firms, they’re always looking to raise assets in order to generate fees. Now the SPAC model has a certain component in terms of what’s known as a sponsor promotes or effectively free shares to the tune of upwards of 20% of the company. So you have this fairly large potential compensation available to the sponsor if they were to successfully execute a SPAC business combination when they launch one of these. So I consider it, on the supply side, the monetization of one’s reputation and network. And you mentioned a guy like Chamath, and in my opinion, I actually call him the SPAC master on our podcast because he’s been so successful. He launched three SPACs last week raising, accumulated $2.1 billion. And that represents upwards of like half a billion dollars of promote value in him and his partner’s jeans. And so if you can utilize your reputation and your network to first off raise the capital within a SPAC, and then secondly put together an attractive business combination with a private company, then it can be incredibly lucrative for the sponsors. So it’s really the combination of these two dynamics such that, you know, significant retail interest and even institutional interest in publicly-listed, late-stage VC type opportunities, and on the other side, sponsors such as alternative asset managers coming into the space for the promote or the free shareholders’ compensation.
Meb: I think you just hit the nail on the head with a lot of the interest from all sides. It’s kind of the perfect storm. You have sexy companies like DraftKings and Virgin Galactic and Open Door, you have VCs that want to get liquidity, you have markets at all-time highs, so you have investors clamoring for the new hot deal. And then on the promote side, you have arguably the most rewarding setup I can even think of. So let’s walk through an example just so we get the math right. Let’s say Chamath says, “I’m gonna do $1 billion SPAC, Jan. 1, 2021.” This will be IPOQ, which will probably be on at that point. So of that billion dollars, he’s got to put up, let’s call it what, $20 million, $30 million as far as just expenses to get this ball rolling, or is it that much or not that much?
Julian: Yeah, so it’s not free shares like many people accused. Certainly, these seed shares of this promote, they pay like a nominal sum like $25,000. But given that the SPAC can’t touch the trust value raised in the IPO, they do have significant expenses to run it over the two years and run it as a company in search of a target. And in order to fund it, they typically subscribe to sponsors due to private placement warrants. If the IPO is at $10, these warrants would be struck at $11.50. And on average that’s for roughly 3% of the IPO value. So say it’s a $1-billion SPAC IPO, the sponsor would be putting up $30 million in what we refer to as at-risk capital, whereas they don’t get a deal that goes to $0, or if they put together a deal and the stock doesn’t go above $11.50, then it’s also worthless. And so there is skin in the game there, but…
Meb: And where does the promote fee come in? Of that billion dollars, is it coming out of that? Does it get diluted on the upside? Like, how does that work?
Julian: Yeah, it’s additional dilution. So it’d be effectively $200 million of additional shares issued to the sponsor upon successful consummation of a business domination.
Meb: Man, that is some juicy business right there. Goodness.
Julian: Nice work if you can get it.
Meb: It’s funny, because you have a lot of the VCs kind of gnashing their teeth and pulling their hair out about direct listings versus IPO, and it seems like there’s benefits to kind of all the different models, and you can kind of flow chart if you wanna raise capital, if you don’t wanna raise capital. But on average, and also the SPAC has some different disclosure requirements, you can make forward-looking statements, typically, which you usually can’t… And by the way, you’re the SPAC king, so correct me if I’m… This is just my understanding.
Julian: Yeah. No, you got it.
Meb: But it seems, on average, a more expensive way to go public than an IPO. True or false?
Julian: Well, it depends. It can generally be either. And so if we review kind of the three ways of going public, there’s the direct listing, which is only suitable for these very large private companies that don’t need growth capital, where they just put their shares out on the public market and let it trade like Spotify or Slack. Then, you have traditional IPO, which, say, over the past 10, 20 years have more become exit opportunities for venture capital and private equity firms. So they weren’t necessarily raising growth capital as you would traditionally see if we go way back what an original IPO was. The purpose and what we’re really seeing the SPAC emerge this year for is to truly raise growth capital for growth businesses. So I indicated the classic winning SPAC deal is a Series D/E, late-stage venture capital type exposure, in which the company requires significant capital to fund its business plan. So what we’re seeing is, say, a SPAC raises $200 million. Typically, the value of the target that they’re looking at will be three to five times that. So say they’re combining with $1-billion company. And so upon that combination, they’ll have $200 million in cash from the SPAC to fund their growth. And typically, you’re not seeing exits from backers. Typically, they’re just rolling their equity into this pro forma entity. And in addition to that, what’s becoming really popular these days, involved in a business combination of a SPAC and a private company, is a pipe financing, which is private investment in public equity. And these are sizeable. So say you got the $200 million SPAC, the billion-dollar equity value of private company, you can see a pipe in the range of $100 million to even $500 million such that the amount of shares being issued, or the capital raised versus the size of the company, is basically unmatched in terms of any other capital raising side of it, and so, whereas SPACs are coming into play are actually funding large growth opportunities, which is different than what we’ve been seeing in the traditional public offering space. As I indicated, generally, we’re seeing that more so for exit opportunities and not funding growth businesses. So it’s an interesting dynamic.
The other things that you mentioned make it different, the forward guidance, and many of these companies are very early stage such that some of them aren’t gonna generate material revenue until 2025, 2027. So in order to tell that story, many of these are certainly story stocks where you got to have that long-term belief in space travel or electric vehicles and things of that nature, where they need to be guiding out to 2025, 2027, and making the comparisons on those revenue or EBITDA figures such that in a traditional IPO, there’s no way you can make those statements. And the other thing is timing. You can go public within three months utilizing a SPAC, which is significantly quicker than your traditional IPO. But once you add up all the fees, say, in our example, a $200 million SPAC, typically, the investment bank takes their 6% to 7%, which is sizeable, then you have the sponsor promote, which, I should mention, there’s this 20% promote. However, I think that’s fairly rare in maintaining that allocation. Typically, they’ll get scaled back in negotiations, especially with so many SPACs out there. I’m sure they’re just getting that grinded down. The other thing we’re seeing is many of those convert to more performance-based, where they divest perhaps when the stock goes above $12.50, $15, $20, etc., so the promote generally is smaller than initially thought. So the all-in cost, including if you have a massive pipe, then perhaps it could be cheaper, but if the promote stays large, then it could be more expensive. So it really depends on the deal whether, in fact, it is cheaper or more expensive. I’d probably tend to think it’s more expensive on average. However, it does have these other unique structures, which is why many earlier stage businesses are leaning towards going public via this route.
Meb: Do I recall that Ackman is the big daddy of ’em, A, it hasn’t found a target yet, but B, he doesn’t have a promote, or there’s some structure where he’s not getting the carry or something?
Julian: Correct, yeah. So he was…
Meb: Why is he doing that?
Julian: Who knows? Perhaps it’s a marketing thing. Obviously, Bill Ackman is an exceptional marketer. His strategy is more so to bet on the value of the pro forma company. And so all of his exposure is basically through warrants. It’s a leveraged bet, but, yeah, he did famously give up the promote, which is a interesting strategy. Thus far, we have not seen anyone sort of follow that sanctimonious route. They’re all in it for that juicy potential cut of the pro forma entity.
Meb: His intentions will be revealed with the fullness of time, perhaps.
Meb: Let’s go back to Chamath’s IPOQ, January 1, 2021. How does he raise the initial billion dollars? Is it hedge funds, pension funds? Is it wirehouses? Where is it all coming from?
Julian: So that’s rapidly changing for the longest time, and I initially started following the market probably seven, eight years ago, I built my first SPAC arbitrage model, and there were less intensities, very small market, and it was completely dominated by hedge funds due to this arbitrage. And so the traditional route is that hedge funds would buy the IPO. Basically, it’s liquidity providers and put it on back sponsor to give them the upside of the arbitrage. But now you’re seeing different players come into the space just due to the increase in visibility and the increase in popularity. And not only that, but the quality of sponsor has really gone up significantly such that now you have Apollo, TPG, Social Capital, Christian Square, etc., etc., all these sort of tier-one hedge funds VC firms and private equity shops such that they can attract new pools of capital in the IPO. And so that’s rapidly changing, but it’s still a place that’s quite dominated by arbitrage hedge funds.
Meb: So let’s walk through, you could use a historical or theoretical kind of typical situation for a SPAC, we could say the Chamath one or you could use one historically just kind of give an idea of how this plays out. But kind of walk us through what a traditional one to two-year period is with one of these sort of investments. People subscribe billion dollars, then what?
Julian: So we can look at DraftKings as an example, which actually started out its life as the special purpose acquisition company known as Diamond Eagle Acquisition, ticker was DEAC, IPO’d at $10 per unit in early 2019. And the interesting thing that happens in SPAC land is generally after 52 days the units can be split into its contingent parts, the shares and the warrants, they start trading separately, which is an interesting dynamic in and of itself. But once that happens, you can generally, say, the units are trading at $10, they’ll split, and the shares will be trading at $9.70, and the warrants will be 30 cents in value. So the way that it works is there’s $10 in cash in that SPAC, plus it will accrue interest over time, basically yield the same as treasuries if you subscribe to the IPO. But if you’re looking to arbitrage and buy it at a discount, once it splits, you’re getting the return of treasury yields plus that discount. So if you buy it at $9.70, that’s a 3% gross return worst case scenario over the next two years, plus treasury yields, which before this spring were kind of in the 1.5% to 2% range. So that was an all-in, basically very low risk, I consider it no-risk return, as long as you can hold it until maturity of earning that. So that’s a fairly attractive return in an era of extremely low, basically zero interest rates. So there’s this straight cash arbitrage such that you either have liquidation, if they don’t find a deal, or, and this is a key aspect of the SPAC arbitrage trade, is, say, they announce a deal, and generally three months later they’ll stage a shareholder vote. Now it’s not the vote that’s the important thing, but what they do offer two days prior to the vote is the redemption option. You always have this option to redeem your shares for what’s in the trust account, which is the IPO price $10, plus the accrued interest of treasury yields over time. So it’s a really interesting potential arbitrage.
I call it heads we win, tails we win big. Because, in the heads we win scenario, you buy at $9.70 and, say, interesting accrues and now it’s worth $10.20 a year and a half, two years later, then you earn a low, single-digit, annualized, kind of low-volatility arbitrage return. But where the true juice and the strategy comes from is what I call upside optionality, when a deal is announced and the market becomes enamoured with the transaction. Specifically, on this SPAC that we’re discussing, Diamond Eagle, we go look at the trading in early 2020 or late 2019, they did announce a business combination with DraftKings. And so the stock slowly ticked up. But if you look at the share price before, one year ago, it’s still at around $9.90 so you can buy it at a discount to net as a value. And then this month it went above $60, for sure. And over the deal cycle, like, prior to this vote, it went to as high as $17, which is a 70% premium over now. So in the base case of this, you’re looking at say, like, a 2% to 3% return, nothing to write home about, but decent for the worst case scenario. However, where my favourite part of the strategy and obviously why many arbitrages are into this type of thing is that when a positive deal is announced such as DraftKings, the share price upside can be exceptional, where your 3% expected return now turns into 50%, 70%, 100%, where some of them are trading into the $20 to $30 range and that upside optionality can be pretty exceptional.
Meb: Give me a ballpark estimate, if you have one, and I imagine this changes over time, but kind of two questions is what percentage of SPACs actually get consummated with a deal? Is it, like, half? Is it, like, 98%? And then second is what percentage of deals, once announced, have a positive surprise, and what percentage have a negative surprise?
Julian: That’s a good question.
Meb: The first one is what percent is actually find the deal?
Julian: This one obviously changes depending on the market dynamics. If we went into a bear market and… It really depends on one thing and one thing only. Is the price of the stock above its net asset value? So you got to remember, these things are largely held by hedge funds that, when the vote rolls around, they’re not long-term investors. If the share price is above net asset value, then they’ll sell out for that. If it’s below, then they’ll redeem and get their money back and earn that baseline return. So that’s the ultimate determinant of success in a deal. There’s some things that sponsors can do to mitigate that risk, because if too many investors redeem, and they don’t have any cash left, then they’ll just scrap the deal and liquidate or perhaps look for a new one. However, these concurrent pipe financing mitigate that redemption risk, which is why you’re seeing more high quality sponsors with those deal structures inclusive of SPACs just to reduce that redemption risk. If I look at our model here, this year we’ve seen about 95% of SPACs be successful. Twenty-one of the last 22 have actually successfully consummated the deal, and now they’re trading as these new companies in the market. But historically, it’s much lower than that. I think the hit rate was below 50% back when you had lower quality sponsors. So it really depends on which era you’re talking about and which point in time. So that’s important to note, because one thing to consider…
Meb: And as far as once the deal is announced, is a pop typical, or is it sometimes they’ll, like, go down by, like, half? Does that ever happen?
Julian: Yeah, it’s interesting. It all depends where the share price was trading. And so if it’s one of these ones that no one really cares about, and the share price is still at or below NAV, it can pop pretty significantly. We have seen some tremendous ones. If we look for example at Kensington Capital Acquisition, ticker KCAC, they just IPO’d in June at $10 per share, one common share, half a warrant per unit. Early September they announced a EV battery deal with a company called QuantumScape, very futuristic, definitely a story stock. If we look at the common shares now, they’re trading roughly $14.50, so 45% premium to NAV. Then, on a unit basis, which includes warrants, it’s $16 and change. So the warrants can be a key driver of the upside optionality, specifically as a unit arbitrage so you can buy the units at a discount and the deal just sucks. Say the price is 5 cents below NAV, everyone redeems but it still gets consummated because they have enough cash or they have this pipe financing. Those warrants can still be worth a lot of money. I was analyzing a recent deal, which was Churchill Capital’s merger with MultiPlan, which is basically just like a private equity deal. It was not well received. It actually traded at a discount to its NAV, so they did suffer significant redemptions. However, they did go on and become MultiPlan as a publicly listed company. Even if you bought it and then redeemed the shares, those warrants do have substantial value that led to, like, a baseline return of 7% annualized just because they provided that upside. Now in terms of number that are providing a good pop and what sort of magnitude that could be, I think, typically, it’s in…the good ones are in the 20% to 50% range. The very good ones can be above 100% in terms of the premium to mid asset value. And in terms of the ones that go above 100%, I’d say that’s kind of 1% in 25%.
And the ones that have the sort of 20% to 50% gains, those are more popular, probably a quarter of them. And those are the market just doesn’t care perhaps about half of them will be duds. And so that’s something to keep in mind, changing all the time, depending on the market as well. And, yes, a good question is on deal announcement, which way would the shares hit? And so really depends on where the SPAC price was prior to that announcement. If it’s one that the sponsor perhaps didn’t have a great marketing ability or a gold-plated reputation on the market, and it’s trading at below NAV, then you typically could see a very good pop on the first day. On the opposite side of that, take for example someone like to Chamath who has done six SPACs, and his recent ones all traded at massive premiums to NAV in the market. It’s interesting because on one of the transactions that he just announced, and this was for, was it IPOC? Yeah. So he announced a deal with Clover Health. And his SPAC IPOC, which is Social Capital Hedosophia III was trading at a 27% premium to its net asset value pre-deal. And when they announced the deal, it actually dropped double digits. Now it’s only trading at $10.50, i.e., a 5% premium. So pre-deal speculators paid too much for that one, and they’re down by over 20% just based on paying too much. And the way that we execute our…we stick with, like, a pretty airtight arbitrary strategy, where we’re always paying at or below NAV where we’re not going to suffer that downside. So it certainly takes expertise and substantial modeling such that you know at each point in time where the net asset value is to make sure you’re not paying too much and to confirm that you will be guaranteed this baseline IRR that’s relatively attractive.
Meb: If you’re thinking about this, the listeners, it seems like the main risk, just like with M&A, the main risk being the deal doesn’t happen. It feels like, and you can correct me, the main risk in this strategy is, even if you’re smart and you invest at a discount to NAV, the deal gets announced, and the stock trades down. Let’s say it’s now at 8 bucks, for whatever reason, people just hate the acquisition. It’s really expensive or whatnot. What are the shareholder options there? What percentage of time does the vote not go through? I imagine it’s pretty small, but you can correct me. And then do you have the ability to opt out and still get redeemed at NAV, or is that’s not a choice? Once the deal is announced and people vote for it, you’re kind of stuck. How does it work?
Julian: Exactly. So after the vote, the deal will close within a day or two, and it will be trading under its new ticker. And I see people make this mistake. It’s a day before the vote, and the share tanks, they’re like, “What’s going on?” Like, well, you missed the redemption date, and now it’s trading as the post-SPAC equity, which I consider like a completely different asset class because it doesn’t incorporate that redemption optionality, which is basically like an embedded put in the stock. So if the put option disappears, it can go into freefall. I saw a recently-closed SPAC deal that’s trading at, like, $2 just because that was a fairly poorly received deal, had a bunch of redemptions, then it ends up highly leveraged. However, if we’re talking about…
Meb: So just to be clear, you can opt out. It’s not all for one, one for all? If it’s like $1-billion SPAC, and you’re like, “I hate this idea,” you can still redeem in NAV if you want out or that’s not the case?
Julian: Correct. Before the vote. Yeah, you can redeem. And I definitely advise investors considering to redeem to look at SEC filings, calculate what the trust value is. Typically, they disclose it in the proxy. And then compare that to the share price. Because if the NAV is $10.20 and it’s trading at $10.30, you’re just better off selling it in the market, because this redemption process can be onerous for certain brokerage firms, and it can cost some money. And I think some brokerage firms may charge an investor 50 bucks or something just to affect that. But in terms of pre-deal, you generally don’t see them trade down that much just because arbitrages tend to keep them fairly close to the NAV. Because in a normal environment, no one’s going to let a stock go down to a 20% discount, because that’s amazing. Basically, free money. However, in a 2008, 2009 type scenario, where it’s a massive liquidity crunch, hedge funds are getting redemptions, they did trade down pretty significantly. We do run a SPAC index. And over the first quarter, where we had the quickest bear market in history, then index peak to trough went down about 6%. And back then, if you look at my tweets from kind of March, April era, I was tweeting a SPAC of the day, where I was highlighting just the great sort of risk-free arbitrage returns in the sort of 5% to 10% annualized range, which, unfortunately, aren’t there these days, but it’s still a fairly interesting environment for the strategy.
Meb: Give it time. I imagine a lot of these new SPAC shareholders will figure it out and give a lot of opportunity for arbs like you. So, simple question. It sounds…”too good to be true is the wrong word.” But if you have a thoughtful approach, listeners say, “Okay, why wouldn’t I just buy a basket of SPACs that have IPO’d or subscribe to the IPO,” but let’s say you’re a traditional investor. So once they launch, as long as I say, “I’m gonna buy them under 10 bucks, or whatever it may be, some sort of rule that you’re not going to be buying the Chamath one at $15 or something before the announcement, but maybe you cap it whatever it may be, hold them ’till the announcement, and either opt out or sell. Why wouldn’t everyone be doing this?
Julian: Yeah, it’s a good question, and it is a fairly labor-intensive strategy, like many arbitrage strategies are. So it’s more suitable for kind of, like, a full-time team that’s monitoring and trading in the market. Historically, we have seen, a firm like ours, we do subscribe to IPOs, and historically, we have seen them trade above the IPO price right out of the bat so it’s not necessary that you can get them at a nice discount to NAV. However, with the massive flood of SPACs lately, we’re finding that like upwards of 70% are actually trading below their IPO price on a unit basis. So that’s pretty good value there just because we’ve had so much issuance and not have commensurate increase in SPAC arbitrage capital sort of keeping those in line. But in order to run the process…The tricky thing is you never know which is going to be the next Diamond Peak DraftKings deal. Like I said, probably half of them are duds, where you got to redeem and get your money back, which can be a process in and of itself. A quarter of them are decent and maybe 5% are the huge winners. So you really need to have a super diversified portfolio. Like, in our fund, we own upwards of 80 at the moment. And with 80 of these, and a ton of corporate actions happening, whether it’s splitting your units for common shares and warrants, which you have to do at some time, trading these things, redeeming, voting, monitoring, all the specific dates, it can be quite the process and certainly labor intensive. So, certainly, if someone likes that type of strategy, they can do it themselves, but just note that it’s going to take many hours per day of work. It’s not something that you can just say, “Just buy a bunch, and that’s it.”
The other thing to consider is I think many investors’ perhaps lack the patience, which is why there’s this opportunity. Many don’t have the ability to buy something and say, “I may make money on this in 18 or 24 months.” So that’s another reason why I think this opportunity exists is that we put together a portfolio of, say, 80, 100 SPAC opportunities of different vintages so we make sure to diversify. Like, we own one that I believe was issued in December of 2017. Everything from that and everything in between up to ones issued this month. And typically, what you see is the older vintage is announcing deals. So you always want to, or the way that we execute is we’re always cycling capital, the old ones into the new ones. So it is fairly labor-intensive, but a great strategy that is, I think, retail-dominated at least in the secondary market, and there’s a ton of inefficiencies. It’s perhaps the only market that I know of that generally has no sell side coverage and there is a few buy side specialists, but it’s not flooded with super, super smart investors keeping it efficiently traded.
Meb: Like many strategies, I put this under the frustration arb or pain-in-the-ass arb, where, clearly, there’s some there there, but if you don’t monitor it and you muck up even a couple trades, it can have a pretty big, outsized outcome and the headache of dealing with it. So this must feel a little bit like Christmas for you. I’ve been watching you on Twitter and some of these comments. I’ve always been interested in a way to participate. You’ve alluded to your fund a little bit. What’s the ticker? What’s the name? And what’s the general strategy? I think we got a little bit of an idea, but maybe flush out kind of the approach overall?
Julian: Yeah. So it’s called the Accelerated Arbitrage Fund, ticker ARB, up in Canada. Note that there’s a different ARB in the U.S. that does, I believe, merger arbitrage, so they’re different. And so what we do is SPAC arbitrage and merger arbitrage. The goal of the strategy is to produce consistent returns and pay out a good yield to investors, so we do pay at a quarterly distribution to investors and really pitching it as perhaps a fixed income alternative such that you can generate a good amount of yield that’s consistent and not giving exposure to duration risk. So it’s a strategy that can do well in a rising rate environment, if and when we ever have that. And the other thing that we do consider is the balance between SPAC arbitrage and merger arbitrage. Six months ago, we were probably 30% SPACs, 70% M&A. But ever since the corona pandemic, M&A has really dipped down in activity, so there’s not a ton to do there. But SPACs have really exploded, where you’ve had four back-to-back-to-back-to-back months of $10 billion issuance, so $40 billion raised in SPACs since basically June early summer, which is just massive, because the biggest year for SPAC issuance was 2019 prior to this year, where it was, like, well below $20 billion. So we cracked that easily. So a ton going on in SPACs such that our arb fund now holds about 70% SPAC. So it’s really kind of the only SPAC-focused ETF in the market. And where we differ is we’re just really focused on that arbitrage opportunity. We’re not kind of speculating and buying ones way above NAV. We’re really trying to provide that baseline return and that low risk nature of the arbitrage opportunity.
Meb: Well, and you also, thoughtfully so, publish a lot of literature. We’ll link to it in the show notes, some of your articles recently, and also a table of a bunch of the SPACs. What’s the name of the table?
Julian: Yeah, we call it our AlphaRank SPAC monitor. So AlphaRank is just a lot of the alternative data that we utilize to run our alternative ETFs. We publish that for investors just so people know what we’re doing. Hedge fund world is always opaque and highly secretive. I kind of feel like I’m a magician giving away all the best tricks, because I tell investors exactly how it’s done at the risk of the inefficiencies being competed away. But at the end of the day, we just really haven’t seen that as of this moment. Just because I said, you mentioned this, pain-in-the-ass nature of it, it’s not an easy thing to do. It requires significant amount of work. I’ve read basically every SEC filing that comes out on the SPAC. There’s now, like, over 200 of them. So there’s definitely a ton of work, and you can’t really do it as a part-timer.
Meb: I’m a big fan of this increased transition of hedge-fund-like strategies into public liquid vehicles when they can be. There’s obviously things like CAT bonds. You can’t really put into an ETF. But this is one that I love, and it’s always been the purview of private funds like you yourself have been running for a long time. But giving broad investors, not just individuals but also advisors, access to this, I think you’re gonna see a ton of interest. From all the conversations I’m having with investors about what in the world do you do with bonds now, and in the U.S., being a higher yielding bond market, but certainly in the rest of the world, where many bonds are trading at zero and negative, to have something like this that has somewhat of a mixed, hybrid sort of characteristics, where it has the sort of bond traditional floor with a potential upside. Let’s talk about…you’ve seen some trends. There’s been some announcements from vision fund, from VCs starting to do SPACs. Is this gonna start to get into some weird conflicts of interest? I could have a scenario where a venture capital does a SPAC just to take one of their companies public. I don’t know if they would double dip if they do the promote. Who knows what Masa Son is doing, Masayoshi Son. Any thoughts in general?
Julian: That is certainly a concern regarding conflicts of interests, where you have a lot of kind of VC firms, private equity firms potentially double dipping. And there’s a lot of disclosure, but at the end of the day I think the market is decent at figuring these things out. If we look back at the attempted WeWork IPO, I think the market digested that and served as like a good sheriff. And as more and more posts back equities start trading…I always think of the best sheriff in the market being short sellers. And so if short sellers start to sniff out something that is wrong or raises red flags, especially with the democratization of information on services such as Twitter, where a ton of super smart investors are gathered and information tends to spread very very quickly, and I think the opportunity to pull a fast one on investors these days really isn’t there like it used to be, where you’re having these super intelligent financial analysts and capital market sleuths figure these things out and sort of mitigate that risk. But as in anything, you can see some hijinks happening like we almost saw on the WeWork IPO, which could have been a huge loser.
Meb: And the greatest disinfectant, which is just the internet. The funny thing is these blank check companies have been around since the times of the South Sea bubble 300 years ago. And then SPAC, kind of in the ’80s, like you mentioned, there’s a little more kind of bad behavior, and the SEC started passing rules and cleaned it up a bunch. And you’ve seen it come full circle in the last 20 years. But it’s good to see that I think the players like Chamath are honest at least and then seem to be a high quality of companies that are coming out. Although you’re starting to see a few kind of weird deals. I’ve seen a few lately, where I kind of scratch my set and say, “Huh, that’s an interesting pivot and or evaluation. Okay.” Are there any currently, to the extent you can talk about positions, I don’t know if you can, but what’s the lay of the land here in fall time 2020? Are there a lot of opportunities trading below NAV? Is it things you track, a yield composite? I know. What’s things look like?
Julian: Somewhat middle of the ground. And I really differentiate between pre-deal SPACs and post-deal SPACs, because there have been studies that show post-deal SPAC’s performance isn’t the greatest. There’s significant underperformance, especially on a median basis. It’s interesting. I crunched the numbers on the last 20 post-deal SPACs. They had average share price performance of -19%, but positive 13% on a median basis. So somewhat of a Pareto distribution in terms of post-deal SPAC. Share price performance where you have the odd, huge winner like a DraftKings or Nikola or something of that nature, but a lot of losers more analogous to a venture capital type exposure. But where we see the market currently, I think it’s fairly attractive. For a while, the average yield was negative, but now it’s ticked up back to positive, which just means if you bought them all, then you have a decent chance of earning a positive return, whereas we just focus on the ones trading at a discount. There are a number of ones yielding in the 2% to 4% annualized range to liquidation with no upside optionality priced in. So I like to compare those two like a “safe merger arbitrage” spread if we make that comparison to say the recently announced Morgan Stanley Eaton Vance deal, which, last time I checked, was trading kind of 2.5% annualized in which you have deal risk. A SPAC arbitrage where it’s basically holding treasuries at 3% is perhaps more attractive on a relative basis compared to a safe merger arbitrage transaction.
And the other aspect is massive flood of supply. This month, halfway through October, we’re already at $10 billion in SPAC issuance, which is tying July for the most of all time in terms of months. And July included Ackman’s $4 billion raise. And so the market has been absolutely flooded, but arbitragers like us, other hedge funds, certainly haven’t seen $10 billion in inflows. And so you’re seeing a lot of these IPOs break price, where you can buy instead of subscribing at $10 and then saying trade up to $10.20, $10.30, you’re now seeing IPO subscribers get run over with the truck and the SPAC trades down to $9.90, $9.85. So, certainly, do-it-yourself investors, I think it’s a good idea to be looking at a lot of these recent issues, specifically on the first day, because there’s a lot of volume, and they have been trading down. Unless there’s someone like Chamath, who, credit to him, he issued $2.1 billion of SPACs this month into an already very very flooded market. And for some context, $2.1 billion was about 3% of the entire market cap. And all of them traded up to premiums between 3% and 7% on the first day, whereas you look at 70% of the other recently issued SPACs and they’re trading down to a discount upon new issuance. So that’s one impression.
Meb: And why is that? Why would they trade down? Who’s selling those at that point, or is it just not really a float or a market? What’s the reasoning?
Julian: Too much supply. And one interesting dynamic is, from someone who subscribes to IPOs a few months ago, we’re getting maybe, like, 10% allocations, and they’re trading up quite a bit. So as an IPO subscriber, if you’re only getting 10%, then you’re maybe like, “Okay, I actually want a 100,000 shares, but I’ll put in for 500,000, and hope to get my 100,000.” But as pricing starts to get weaker post-IPO, people start scaling that back such that now you’re getting full allocations, and the people that oversubscribe they’re like, “Oh, crap, I have 400,000 too many shares because I didn’t think I’d get a full allocation.” The market has changed, and there’s somewhat of a buyer’s strike, and you’re not seeing the post-issuance support because there’s just so much supply out there. Why buy this one at $9.95 if I can buy this other one at $9.90 just because of the potential return is greater. And like I indicated, I don’t think there’s a great correlation between sponsor quality and arbitrage return. Because, typically, with a high profile sponsors, say, like at Social Capital, those generally trade at large premiums, so a lot of that is baked in. And the other thing to consider is, we did discuss post-SPAC equity performance, a lot of the alpha is in the pre-deal era in which they outperform their [inaudible 00:48:33] by Goldman Sachs. They did do a study such that there was significant performance and pre-deal SPACs. And then, on the other hand, you do have post-SPAC equities that tend to underperform. So there are some other interesting opportunities on SPACs with greater vintages. But one thing that I noticed, and I’m not sure if this has ever been discussed, so perhaps some exclusive content here for your listeners, Meb, is that there’s this dynamic where you can subscribe to unit IPO. And these days you can buy them at a discount, where a unit is common shares and warrants. And after 52 days, these can split into common shares and their warrants.
And the interesting thing about that split is, typically, accompanied with that is this value lift on a unit basis. Because for the common share side, say they trade down to $9.70, which is an attractive return for cash IRR type arbitragers, where they look at the discounts and be like, “Okay, this is easy money.” Then, on the warrant side, you have speculators who come in who just want that levered exposure to SPAC warrants, and you have these two different contingents of buyers buying these separate securities, which the end result pushes up the unit price. So this interesting analysis that I’m working on that looks at unit discounts pre-split early on in their life and then unit premiums later on in their life, where there’s this inherent to value uplift after they split, you have different buying pushing it from a discount to a premium. So it’s an interesting, what I call, alternative yield, where it’s not your traditional, Oh, I buy a bond, it pays me 3%. I guess that’s a junk bond these days or a “high-yield bond.” But you can get this alternative yield through capital gains, buying us back at a discount, and then 6 months later, 12 months later, it’s trading up to, say, a 5% premium on a unit basis just due to this biodynamics.
Meb: I think you’ll be very successful with this. It’s a cool strategy. What’s capacity? Can you put $100 million to work, $1 billion, $10 billion, $100 billion? Where does it start to get a little constrained?
Julian: Yeah, it really depends on the environment. Like I said, past four months, we’ve seen $10 billion of issuance. So I could easily put $500 million to work in this market. But I always worry about what happens if there’s no SPACs issued for a long time. I doubt that’s gonna happen, but this market, I do consider it frothy. I don’t think we’ll be continuing at this space, say, six months from now. However, in the near term, say, over the next two three months, I still expect a significant amount of issuance. We do monitor new S-1 filings at the sec, and S-1s are prospectuses for new issuance. And we’re just seeing a ton of those. So a lot of groups putting together new SPACs, sometimes three to four per day, and significant new IPO issuance. We expect more than 100 SPACs to be outstanding by year-end and wouldn’t be surprised to see this market get to over $100 billion in the near term. But, certainly, investors should be cognizant of the fact that we could be in a bit of a frothy market. Not sure if I’d consider it a bubble, because you can still see attractive valuations with respect to net asset value. You can generate positive returns. So I think there’s still juice to be squeezed with it. And with the massive flood of supply, I think that investors can still put in a large amount of capital because the opportunity is still there.
Meb: Fun. Julian, this has been super educational. Where do people go? We’ll add links to the show notes of course, but where do people go if they wanna read your articles, keep up to date with your Alpha tables and everything else? Where do they find you?
Julian: So we publish all that on our website, accelerateshares.com. Alternatively, if you just Google search SPAC arbitrage, like, I think everything that pops up is probably written by me. Check me out on Twitter. I publish all our research through Twitter as well. That’s @JulianKlymochko. It’s my handle. And then on our podcast, “Absolute Return Podcast,” we’re always talking about SPAC deals, M&A deals, and things of that nature, and so really just providing weekly commentary on how that market is developing. And it’s a crazy market in that it seems to be different week over week. Like, we had earlier this month, Social Capital issued $2.1 billion of SPACs. And month-to-date in October, it’s just been absolutely gangbusters. So it’s a market that is changing dramatically, and we expect it to continue to do so in the near term. So, super exciting.
Meb: Awesome. Julian, thanks so much for joining us today.
Julian: Yeah, thank you, Meb. Always happy to be here.
Meb: Podcast listeners, we’ll post show notes to today’s conversation at mebfaber.com/podcast. If you love the show, if you hate it, shoot us firstname.lastname@example.org. We love to read the reviews. Please review us on iTunes, and subscribe to the show anywhere good podcasts are found. My current favourite is Breaker thanks for listening, friends, and good investing.