How can SPACs and hedge fund managers work together?

Sometimes called ‘blank check companies’, special purpose acquisition companies (SPACs) have been around for decades but have risen in popularity over the past few years as a viable alternative to the traditional initial public offering (IPO) route of going public, gaining traction as a result of market volatility. In fact, as of 2020, SPACs made up about 50% of the U.S. IPO market.

Hedge funds are the dominant buyers of SPAC IPO shares and warrants, but what exactly is their role in the trade? And what are the main risks, benefits and management strategies utilised during the investment.

Which hedge funds invest in SPACs?

SPAC IPO investors are usually savvy hedge funds. However, investors in SPACs can also include any entity from private equity fundsto the general public. As we’ve seen a huge rise in the growth of SPACs in recent years, it’s becoming increasingly crucial that hedge fund managers take notice of what this means.

Do hedge funds buy SPACs?

Yes. The unique structure of SPACs generates interest from hedge funds because the acquisitions provide an investment vehicle that offers profit with limited risk.

How do hedge funds make money from SPACs?

Here are how hedge funds make money from SPACs:

1. Hedge funds invest in a SPAC at $10 a piece, which is held in a pooled account along with investments from other parties.
2. For each $10, hedge funds are given a unit which includes one share of the company and one quarter of a warrant that allows them to buy another share at a higher price in the future.
3. Within two years, the SPAC must find a company to merge with. If they don’t, the initial investment is returned to the hedge fund plus interest. If they do, hedge funds receive shares and warrants in the new merged company.
4. At this point, the hedge fund is faced with two options: redeem the investment and sell the warrant as soon as possible, or wait until the merger announcement to exercise the warrant.

These strategies only work if there are other investors that believe the SPAC will find a viable merger and prove to be a worthwhile long-term investment. If every investor used the same strategies as hedge funds do, the trust would empty and the entire trade would come to an end.

Benefits

One key benefit of hedge fund investments in SPACs is that their involvement is relatively low-risk whilst maintaining equity upside. The nature of the trade means hedge funds experience very little threat but can keep an economic interest in the merged company for a very low fee.

Following the announcement of the merger, firms can choose to either sell their stake for a profit or redeem. Alternatively, if no merger is announced they can earn a risk-free return providing the SPAC units they acquired were at a discounted rate compared to the offer price.

Risks

The risk of a hedge fund losing the original SPAC investment is considered to be low because cash is put into a trust that invests in US treasury securities, shareholders can also request their investment back at any time.

However, this is not to say it is an entirely risk-free investment. Hedge funds that retain their stake in the merged company put themselves at risk of consequences from potentially bad deals and severe dilution from the free warrants offered to early investors.

Furthermore, there is speculation that SPACs will become a victim of their own success. The drastic increase in launches has led to a rise in competition for good companies to take public, and SPAC shares can be offered at a discount if the two-year mark is approaching and no announcement of an acquisition has been made, or if the market becomes saturated with too many new launches.

SPAC Investment Risk Management

In terms of risk management strategies for investing in SPACs, hedge fund managers must:

• Be prepared to think long-term. It will be no less than two years before any profit is seen and if the SPAC is unable to find a suitable merger company, there may not be one at all.
• Understand that you are investing blind. SPACs are a type of blank check company, which means they are set up without specific targets in mind. This means you could be investing without a specific idea of what the returns will be.
• Understand that due diligence is less stringent than with traditional IPOs. Unlike a typical IPO, SPACs are subject to a strict two-year deadline to find an acquisition, which limits the time available for comprehensive due diligence and routine scrutiny.

What is a hedge fund’s role with SPACs?

As explained throughout this article, hedge funds invest in SPACS because they present a limited-risk opportunity to generate substantial profits.

Beyond simply providing investment, hedge funds play a number of advantages as SPAC investors. One such advantage is credibility. Investment from a prominent hedge fund can distribute confidence amongst other potential IPO investors, and indicate that there is already institutional acceptance.

As well as this, in some cases, hedge funds will make an additional commitment to funding a portion of a private investment in public equity (PIPE) at the time of the merger, as part of their sponsor capital investment. For SPACs, this is a huge benefit and can provide significant support in the PIPE process.

Furthermore, hedge fund investors will often offer SPACs soft dollar commitments for analyst coverage, if they have analysts that focus on the SPAC’s target sector.

As a trusted, market leading prime broker, IG Prime can provide tailored solutions to give your hedge fund the edge in every potential investment.