SPAC bear presents arbitrage opportunity
Potential inflation hedge
Despite equity market volatility, record inflation, rising rates and a geopolitical crisis, M&A activity shows no signs of slowing with over $740 billion of global deal activity in the first two months 2022, the second highest total in history. The tech sector continues to lead deal activity with over $187 billion of deal volume in the sector, up 24% from last year.1
The Russian invasion of Ukraine has driven volatility in equity and bond markets, but the risk from rising geopolitical tensions is low for North American-based merger deals. This is due to the general low exposure of North American corporations to that region of the world and also because the conditions that support a robust merger arbitrage environment remain present. Deal activity is still elevated, with the end of February seeing a wave of merger deals announced. Spreads remain wide, with the expected spreads for the 20 largest all-cash mergers in the U.S. well in excess of 1000 basis points (bps)2 and success rates for merger deals remaining high with several mergers, including larger deals, subject to significant regulatory scrutiny being approved in the past month.
SPAC bear creates opportunity
The bear market in Special Purpose Acquisition Companies (SPACs), created as a result of the oversupply of nearly 600 SPACs searching for a limited pool of deals and under the pressure of approaching maturity, is creating a compelling low-risk investment opportunity for SPAC arbitrage. The popularity of SPACs took off in the back-half of 2020 and continued into the first quarter of 2021, with hundreds of SPACs raising billions of dollars. With a typical maturity of two years, we are about to enter a period where we believe the vast majority of SPACs are likely to be unsuccessful in finding a target and maturing, and many will be required to return their trust value to shareholders.
Even if a SPAC is successful in finding a target, SPAC holders can elect to redeem back trust value with the added benefit of a shorter holding period and higher IRR. The capital raised by SPACs is held in trust and invested in short-term U.S. Treasury Bills, widely considered the safest asset in the world, so buying a SPAC trading at a discount to trust value is like buying a Treasury Bill at a discount.
For investors searching for capital preservation and yield who have concerns about the negative impact on bond prices from rising rates, we view that the opportunity in SPAC arbitrage represents a compelling alternative.
At the end of February, SPACs searching for targets were trading at a discount to trust, which provides a yield-to-maturity in excess of 2.9%,3 a higher yield with a shorter duration than that of an investment grade bond index.4 This opportunity may be short-lived and transitory, but we are going to “make hay while the sun shines.”
With geopolitical tensions from the invasion of Ukraine resulting in equity market volatility, sanctions against Russia causing a spike in an already inflationary environment, and with central banks proceeding with a rate hike cycle, investors are facing an increasingly difficult market to navigate. The Bank of Canada’s 25 basis point rate increase with indications that more hikes are to be expected, along with the Federal Reserve Board’s 25 basis point hike earlier this month, signal the start of a tightening cycle that may be difficult to pause given higher inflationary expectations.
In environments such as this, we view the low correlation, low volatility, and absolute return-focused nature of merger arbitrage as a compelling investment strategy to allocate to within a portfolio. As merger arbitrage is among a limited number of investment strategies positively correlated to interest rates, the strategy could be a hedge to higher inflation as central banks employ monetary tightening.
We view that the short duration and wide spreads at hand for arbitrage make it an effective alternative to fixed-income allocations and a hedge against rising rates. We also believe the opportunity set for the strategy is ideally positioned with favourable conditions for both merger arbitrage and SPAC arbitrage.
4. Source: Bloomberg Global Aggregate Bond Index
Amar Pandya, CFA, is Portfolio Manager of the Pender Alternative Arbitrage Fund and the Pender Special Situations Fund at PenderFund Capital Management. This article is adapted from commentary that originally appeared in Pender Commentaries. Used with permission.
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