How Funds Are Gaming the Blank-Check Companies By Tim Melvin RealMoney.com Contributor 5/20/2008 11:44 AM EDT

Last week, I briefly mentioned special purpose acquisition companies, or SPACs, and noted that some value investors were suing them to set up an arbitrage opportunity. What I did not realize is how widespread the practice had become.

As I went through the latest 13F-HR filings of some of my favorite value and activist investors, I discovered that an astonishing number of institutional investors were using these vehicles to earn extra returns in the current uncertain markets. In addition to Seth Klarman at Baupost Fund, distressed investor Angelo Gordon, activist Warren Lichtenstein at Steel Partners and Fir Tree Partners were among the largest players in the space.

To refresh your memory, a SPAC is a blank-check company established to buy a business or enter into some sort of business combination in a predetermined amount of time. The targets are unknown at the time of the offering, and you are betting on management's ability to find a good deal. The money that is raised is kept in a trust fund until a deal is completed. If you do not like the deal that the SPAC finds, you can vote against it and get back your money, less offering fees. To sweeten the deal, you get warrants to purchase additional stock along with the stock you purchased during initial public offering.

The inclusion of the warrants sets up the opportunity that attracted so many savvy investors. By buying the offering and selling the warrants at the first opportunity, they set up a risk-free trade. The cash from the warrants would lower the basis in the shares to less than the amount in the trust fund that would be returned if the investors voted against the deal, giving them a decent arbitrage profit no matter what happens.

Get In at the Start

As I started doing some additional reading on SPAC deals, a few things became obvious. First, after the IPO, the pricing of these deals is shockingly efficient. The shares tend to price at nearly the sum total of the trust fund minus the warrants. There is almost never a chance to buy at a discount after market. For most investors, the only way to play the SPAC game and have the arbitrage opportunity is to buy the initial public offering.

Fortunately, this is not as hard as getting into most IPOs. The underwriters are begging for retail investors to buy shares, and they usually have contingency fees based on the completion of the deal. The more retail investors they can get to buy the shares, the better their chance of cashing those fee checks someday.

But institutional investors have simply been voting against the proposed acquisitions and collecting the arbitrage gains. If more than 20% of the shares vote against a proposed deal, the deal is dead and all money is returned. In fact, if Baupost Partners, Fir Tree, the arbitrage firm Millennium Management or HBK partners (a firm run by the former head of Merrill Lynch's convertible arbitrage desk), or any combination of the four, wins more than 20% of a deal, the deal is pretty much dead.

So far, the large value and arbitrage firms are very content to step aside from market risk and take the fairly reliable arbitrage returns. So far, 14 offerings have been voted down, returning over $1.4 billion to investors. Several more are currently in the process of liquidation after getting a "no" vote.

Changing the Ground Rules

There are signs of change that bear watching. Angelo Gordon, a firm that has been an active buyer of SPACs, has decided to form one itself. In this deal, the firm will be offering only three-quarters of a warrant per share. This will reduce the opportunity for a fairly risk-free arbitrage trade and increase the potential for a deal to actually get done.

This could be an interesting development, as Angelo Gordon is in touch with a lot of distressed companies that may need to sell a profitable division to raise cash. I'll be tracking this one closely to see if shares trade at any sort of discount without the arbs present.

A Goldman Sachs offering, Liberty Lane Acquisition, is doing its deal with a half warrant for the same reason. There are also some deals in registration that use a 30% or higher shareholder vote threshold to increase the likelihood of a deal being completed.

In the meantime, several SPAC deals in the IPO pipeline will continue to offer a structure that gives investors the opportunity to set up the arbitrage trade.

Recent filings include:

• The William Morris talent agency, whose board will include the actor Ashton Kutcher.
• An offering from the management team at Medallion Financial (TAXI) , a taxi medallion finance company, that will focus on homeland security companies and will be called National Security Solutions.
• At least one offering focusing on Chinese acquisitions.

The key to success is to sell the warrants. This gives you a worry-free trade. When a deal is announced, it has been very simple to tell how to vote your shares. If the institutional shareholders like the deal, the price will pop on the announcement. If it doesn't, vote no and take the arbitrage profit.

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At the time of publication, Melvin had no position in stocks mentioned, although positions may change at any time.

Tim Melvin is a writer from Stevensville, Maryland, who spent 20 years a stockbroker, the last 15 as a Vice President of Investments with a regional firm in the Mid Atlantic area. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Melvin appreciates your feedback; click here to send him an email.

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