A SPACtacular Investment Opportunity? Depends
The Bengal Bite
Last week and the week before, Parts I and II, we discussed the growth of SPACs, the incentives of the various parties, and some historical financial results. This week we write on where and when investors might want to keep an eye on SPACs for opportunities:
SPACs Trading Below $10: This should go without saying, but if a SPAC share is trading below $10 (the standard redemption value of a share), an investor could buy the share and just wait to redeem it for $10 to earn a relatively riskless profit. SPACs don’t often trade for much under $10, but when the market is disrupted significantly, there may be more opportunities to pick up free dollars in SPACs than in other sectors because of a factor many investors may not appreciate: how hedge funds employ leverage.
Retail investors can obtain margin, i.e. a loan collateralized by their stock portfolio from their brokerages to buy stock. The maximum margin for the initial buy is 50% per Regulation T established by the Federal Reserve Board - that is, an investor cannot borrow more than $5000 from the brokerage to purchase $10,000 worth of stock. Once the stock is purchased, the price of the stock fluctuates, and if it declines too much, another rule kicks in: maintenance margin, the minimum percentage of equity an investor is required to have in their holdings - 25% per FINRA rules, but brokerages often set higher requirements and many require 30-40% (generally non-negotiable).
If your account goes below the limit, you can suffer a margin call where the brokerage requires you to put more cash in your account, or sell your stock to bring the balance of debt/equity back into line. So, you could be forced by your brokerage to sell stocks at the worst possible moment - right as stocks are hitting their lows in a disrupted market.
Hedge funds follow the same basic rules as retail investors, with at least one major exception: they don’t have the 50% limit retail investors do, and they can negotiate maintenance margins with their prime brokers. Prime brokers, like Goldman Sachs, provide hedge funds with all sorts of services like research, trade execution, stock borrowing for shorting, etc., and one of the most critical, and profitable, is lending hedge funds money, often significantly more than the 50% limit put on retail investors.
What many retail investors don’t realize is that to a prime broker, a share of SPAC stock is basically considered cash - it is just a contractual right to get back $10 at some point in the future to them. And because it’s nearly as good as cash, prime brokers will often let hedge funds borrow 3-4x their SPAC holdings. But, if another Gamestop-type situation develops, prime brokers can quickly and brutally pull back the money they loaned, and force hedge funds to do something to avoid a margin call. Since finding new investors to put cash in during a big drawdown is usually not realistic, that means hedge funds get forced to sell something, and often they choose to take a loss on the SPAC share by selling $10 for $9 or less rather than take a bigger loss on other holdings.
These situations are rare, but they did occur in the last financial crisis, and similar situations have occurred fairly recently (e.g. in the market drawdown last year as lockdowns hit, certain relatively illiquid issues of major bank preferred stocks were sold down to very high yields likely due in part to forced selling to cover margin requirements). An unanticipated uptick in volatility, Reddit-led or otherwise, could create a similar opportunity in the future.
A Good Deal: Sometimes a SPAC’s qualifying transaction is a solid acquisition done at a good price which offers shareholders significant upside. DraftKings merged with a European betting technology company and a SPAC named Diamond Eagle Acquisition Corp. (you can’t make these names up) in April 2020. At the time the merger closed, a share of DraftKings stock was trading for about $20 - it’s currently at $76.
An especially interesting time to look at SPACs generally is one year or so later - after the excitement has worn off and maybe some skepticism of the business has set in, and after a lot of the mechanical selling by short term investors that were just parking cash in a SPAC has worked itself out. COVID has made it much more complicated to ferret out whether the stock of a public company borne from a SPAC transaction is trading down because of the pandemic or because it wasn’t as good a deal as advertised - but there may be significant rewards for investors that do.
Rumors: SPAC share prices can sometimes move before a QT is announced. Despite the best efforts of everyone, rumors of an impending transaction can leak. Sometimes the share prices of SPACs start to tremor and move up from their normal $10 price to maybe $11 without any press releases being issued, and a quick Twitter search could reveal rumors of an impending transaction.
In cases like this, a bet on the SPAC stock could be asymmetric - if you’re wrong you lost a vending machine Diet Coke per share since you still have the ability to redeem and get $10 back, but if you’re right the stock could go up significantly on the QT’s official announcement.
Caution is advised, however, as many rumors are closer to lies than the truth. And, as Mark Twain said: A lie can travel halfway around the world while the truth is putting on its shoes. This is itself a rumor - despite the thousands of internet citations and cute posters confidently emblazoned with this particular quotation citing Twain, the first-ever instance of him being credited with it was in 1919. Mark Twain passed away in 1910.
This Week's Bite:
- Blame Game: Investor misconceptions sometimes drive prices, and sometimes mainstream financial journalism subtly reinforces those misconceptions, even while giving readers accurate information. Like this CNBC article, which dives into the recent slump in cannabis stocks, and does not distinguish between US MSOs and Canadian LPs - which have very different prospects in our view on any kind of federal legalization, as we’ve written about before - thereby reflecting many investors pre-existing misconceptions and also reinforcing them. (CNBC)
- Major tobacco company invests in cannabis: Following a few years after Altria’s investment into Cronos Group, and Constellation Brand’s investment into Canopy Growth, British American Tobacco (NYSE:BTI) made a $175 million investment into Organigram Holdings Inc. (NASDAQ: OGI) this past week. Tobacco companies have been very careful with how active they are in the cannabis space generally given the historical baggage of cigarettes, but the BTI/OGI deal could portend more involvement, although BTI’s bet on cannabis is much smaller than Constellation or Altria’s, as the graph below shows. (Green Market Report)
Source: Bengal Capital Market Research
- They’re back! The now-infamous co-founders of embattled cannabis retailer, MedMen, Adam Bierman and Andrew Modlin, are back in the cannabis game, this time taking a lower-profile approach working for Santa Barbara’s vertically-integrated Coast Dispensary, co-owned by Colorado cannabis entrepreneur Josh Ginsberg, co-founder of Denver-based cannabis chain Native Roots. (Marijuana Business Daily)
- I reward loyalty with loyalty. New research from cannabis analytics firm Headset illustrates how loyalty programs do positively impact the shopping habits of dispensary customers. Consumers enrolled in loyalty-program baskets had more items per basket, higher item prices, and 13% larger than average spend at retailers overall. With 280E tax burdens that punish dispensaries for traditional advertising and marketing efforts by making them nondeductible expenses, loyalty programs are potentially one of the most cost-effective ways for retailers to increase sales. (Marijuana Business Daily)
- State of the Unions: Union organizing targeting US cannabis companies has been on an uptick during the pandemic. One of the silver linings of union involvement is political clout - unions will often flex considerable strength to protect industries when they feel their members’ interests are at stake. So, while labor costs could well be increased for cannabis companies, a longer-term benefit could be a union using its political clout to push for regulatory moats like limiting additional licenses. (Marijuana Business Daily)
- Viva Mexico: Mexico has passed a bill legalizing cannabis and setting up a framework for a cannabis market in the most populous country in Latin America, three years after a judicial ruling decriminalized it. (NY Times)
- Is it a bird, is it a plane? No, it’s bipartisanship: The Senate Caucus on International Narcotics Control, which is overseen by Sens. Dianne Feinstein (D-CA) and John Cornyn (R-TX) (neither allies of the legalization movement), released a rare bipartisan report highlighting cannabis legalization’s popularity and the strength of the industry. The report did reflect the Sens. hesitancy around legalization and potential issues such as impaired driving, but all in all, it is surprising to see even one of the most conservative panels in the Senate having to recognize that the writing is on the wall for cannabis legalization. (Marijuana Moment)
- Seth Rogan: has released his cannabis brand, Houseplant, in California. We wish him well but are more interested in the release of a Superbad sequel which continues the coming of age tale of Jonah Hill’s Seth, Michael Cera’s Evan, and Christopher Mintz-Plasse’s McLovin. (Medium)
SPACtacular Games, So-So Prizes?
from the bengal bite
SPACs in 2020 raised more money than they did over the entire preceding decade. Last week we covered the “what” of SPACs, and this week we look a bit deeper and try to get to the “why.” Why have these vehicles gotten so popular, and what are the motivations of everyone involved?Recall the basic SPAC pattern: A sponsor puts in a few million dollars to fund the costs of the IPO of a “blank check” company which has 24 months to search for a private company (the “Target”) which to buy/merge with (the “Qualifying Transaction” or “QT”), an experienced and credentialed management team (sometimes part of the sponsor, sometimes paired with the sponsor) that has a track record of success in a certain industry and want to repeat that success with another company, initial IPO investors invest in the SPAC IPO and get in at $10 share with a half warrant to buy another share at $11.50, the right to redeem out their stock for cash value ($10 plus interest) if they do not like the QT, and then investors who purchase the SPAC on the open market.