Turmoil In SPAC Mergers
By Thomas Kirchner of Camelot Portfolios
SPACs generally underperform after their mergers.
Shorting SPACs over the merger date can lead to short squeezes, making arbitraging SPAC underperformance impossible.
This will likely persist as a permanent inefficiency in the market.
We have previously written about SPACs and overblown talk of a SPAC crash. While exuberance has since left the SPAC space, investors with excessively negative positioning in SPACs recently took losses. This shows that SPACs remain a niche where it pays to tread carefully.
De-SPAC short squeeze
As we wrote in April, SPACs tend to jump temporarily once a merger has been announced. Over the three months after a merger, they underperform the Russell 2000 by 12%. To put it more bluntly: many SPACs fall below the original $10 cash level after a merger.
This happens for several reasons: once the merger is done, the original shareholders are diluted by the shares given to the owners of the target company. These shares were often issued at inflated valuations, so that the overall per share value post-merger is lower than the $10 cash value of the acquirer. To make matters worse, SPAC holders have the right to redeem their shares for cash, which many of them do. The end result is that following the SPAC merger, the remaining shareholders find themselves with a business that is overvalued and has little of the original SPAC cash left. Not surprisingly, many shares fall below the $10 level.
It did not take long for investors to understand this dynamic. To profit from it, some investors short shares in a SPAC just before it completes the merger. Once completed, most SPAC shares soon fall below the $10 level, generating profits for the shorts.
Of course, there are no risk-free profits in finance, and recently, the risks embedded in this strategy have become apparent as shorts suffered heavy losses. This is due to another feature of SPACs. More precisely, the feature that makes SPACs today safer for investors than the predecessors of yore: the ability to redeem SPAC shares in the merger. SPAC investors who do not like the SPAC merger can redeem their shares for their pro rata share of IPO proceeds held in trust, plus interest. That is generally a little more than $10 per share. Recently, many shareholders have taken advantage of these features, as the business models of SPAC merger candidates are frequently deemed to be lacking.
These SPAC redemptions cause a problem for short sellers: if a shareholder who has lent their shares to a short seller requests a SPAC redemption, these shares are withdrawn and the short seller gets a buy-in notice. A quarter of all SPACs have had redemption rates of 80% or higher [i]. This has led to some spectacular short squeezes.
For example, Blue Water Acquisition Corporation, a SPAC that was targeting private companies in the biotech and life science space in the $80 to $300m deal range, completed its merger with Clarus Therapeutics on August 27. The day prior to closing, the stock traded up from a close of $10.33 to an intraday high of $31.24. Within days, it was back to the $10 range and closed on Friday at $7.66. Therefore, the thesis of short sellers was correct – post-merger, the SPAC would be worth substantially less than the amount of cash originally held in trust. However, as a result of the short squeeze, many shorts are likely to have lost money.
This episode illustrates not just problems that short sellers face in general – as anyone who has followed the GameStop saga is well aware – but also the intricacies and inefficiencies inherent in SPACs. Even though SPAC underperformance is a systematic issue, it cannot be arbitraged easily due to the limited availability of shares to short. Therefore, we expect this phenomenon to persist as a permanent inefficiency in the market.
[i] Kia Kokalitcheva: “SPACs fall out of favor” axios.com, April 21, 2021.
Thu, 09/09/2021 – 06:30