SPACs and Capital Structure Arbitrage
The late Paul Volcker famously said that the only innovation of true economic value coming out of the financial services industry was the ATM or the automated teller machine. But that doesn’t mean Wall Street isn’t innovative – it is just that the innovations (read CDOs, CLOs, etc) more often bring the economy down than otherwise. The flavour of the season of course is SPACs. Every private banker worth his salt has to begin a conversation with her client with SPACs these days. Whilst SPACs aren’t particularly new, they are a rage currently. So, who better to decipher the miracle of SPACs than the gurus of finance who taught us. Prof Jayanth Varma of IIMA, also known for his contribution to financial regulation and policy making, helps decode the underlying essence of SPACs in this beautiful short read. Prof Varma crunches the arbitrage down to capital structure and in effect the misnomers that a SPAC’s equity and warrants are.
“As I kept thinking about the SPAC structure, it occurred to me that at the heart of it is a capital structure arbitrage by smart investors at the cost of naive investors. The capital structure of the SPAC prior to its merger consists of shares and warrants. However, in economic terms, the share is actually a bond because at the time of the merger, the shareholders are allowed to redeem and get back their investment with interest. It is the warrant that is the true equity. If the share were treated as equity, it would have a lot of option value arising from the possibility that the SPAC might find a good merger candidate, and the greater the volatility, the greater the option value. A part of the upside (option value) would rest with the warrants. But if the shares are really bonds, then all the option value resides in the warrants which are the true equity. Naive investors are perhaps misled by the terminology, and think of the share as equity rather than a bond; hence, they ascribe a significant part of the option value to the shares. Based on this perception, they perhaps sell the detachable warrants too cheap, and hold on to the equity.
From the perspective of capital structure arbitrage, this is a simple mispricing of volatility between the two instruments. Volatility is underpriced in the warrants because only a part of the asset volatility is ascribed to it. At the same time, volatility is overpriced in the shares since a lot of volatility (that rightfully belongs to the warrant) is wrongly ascribed to the share. One way for smart investors in SPACs to exploit this disconnect is to sell (or redeem) the share and hold onto the warrant, while naive investors hold on to the share and possibly sell the warrant.
Capital structure arbitrage suggests a different (smarter?) way to do this trade. If at bottom, the SPAC conundrum is a mispricing of the same asset volatility in two markets, then capital structure arbitrage would seek to buy volatility where it is cheap and sell it where it is expensive. In other words, buy warrants (cheap volatility) and sell straddles on the share (expensive volatility). At least some smart investors seem to be doing this. A recent post on Seeking Alpha mentions all three elements of the capital structure arbitrage trade: (a) sell puts on the share, (b) write calls on the share and (c) buy warrants. But because the post treats each as a standalone trade (possibly applied to different SPACs), it does not see them as a single capital structure arbitrage. Or perhaps, finance professors like me tend to see capital structure arbitrage everywhere.”