How hedge funds have navigated the recent SPACs sell-off

Compass in hand

Hedge funds may be better placed to withstand a future performance squeeze in SPACs than other investors, as the recent sell-off in the asset class shed light on vehicle structures and investor-sponsor alignment. 

Special Purpose Acquisition Companies, or SPACs, have been among the brightest investment prospects over the past year, with hedge funds in particular helping to fuel the boom.

But as the sector sharply corrected towards the end of February, with retail investors feeling the pinch, hedge funds appeared to have registered a more modest hit from such ‘blank-check’ investments, Lyxor Asset Management strategists said this week.

SPACs raise capital from investors, via IPOs, to buy shares in private companies, with a view to taking them public, typically through a merger with the publicly-traded SPAC. Shareholders can then retain or redeem their shares following a takeover; if no takeover targets are found within two years, the SPAC dissolves, with cash returned to investors.

As the sector has evolved, research reveals considerable dispersion across the performance of SPACs, with fortunes hinging on structure, quality of management, available pre-merger cash, and the quality of targeted companies, among other things, with shareholder dilution remaining a live risk.

In a market commentary, Lyxor said over-subscribed SPACs have allowed managers to pick and choose their initial shareholders, opting for strategic institutional partners over retail investors. Despite the late February market correction, hedge funds may not have been dented as badly as others, Lyxor strategists observed.

“While SPACs have become key contributors to their returns, hedge funds appear to have taken a more modest toll. They are generally highly diversified, more selective, and involved in primary markets,” said Jean-Baptiste Berthon, senior strategist, Philippe Ferreira, senior strategist, and Montassar Jamai, hedge fund analyst.

“Additionally, they strive to hedge their SPAC exposures. They used to favour protection from small cap indices exposures, but increasingly recourse to baskets of stocks with high retail holding, a way to protect against speculation.”

In contrast, retail investors typically step in later, and at higher prices, and “are usually less finicky regarding the subtleties around SPACs trading.”

The draw of investing in burgeoning private companies in hot sectors – such as technology, healthcare or consumer cyclicals – with strong equity upside potential and limited downside risk has led to a boom in SPACs, Lyxor noted, with a broad range of retail and institutional investors including hedge funds diving in.

Last summer, Bill Ackman’s Pershing Square Asset Management became the latest well-known hedge fund firm to step into the space with Pershing Square Tontine Holdings.

The sector’s momentum had until now been rapidly gathering pace, with around USD72 billion raised through 235 SPACs so far in 2021, according to media reports this week. That compares with USD78 billion reportedly generated through 244 SPACs throughout the whole of 2020.

Ackman’s Pershing Square Tontine Holdings SPAC reportedly slipped more than 3 per cent at one point during the late February correction.

Lyxor suggested the recent sell-off could hasten structural changes in SPACs, toward improved sponsor-investor alignment. “The correction has partially cleaned up excess valuation and might lead investors to be more careful.”