Hedge funds have found their latest arbitrage opportunity in SPACs, the once-trendy investment beaten down last fall as the fast money set liquidated their holdings, but the window of opportunity could be closing.

Special Purpose Acquisition Companies, or SPACs, are companies whose managers raise funds for an acquisition of an indeterminate private company. SPAC shares, which are priced anywhere from $6 to $10 apiece and whose funds are held in cash-like securities such as Treasury bonds and money-market funds, saw a sharp dislocation in their prices and yields since the fall.

As hedge-fund investors demanded their money back, arbitrage funds and others that used SPACs as a cash-like hedge were forced to liquidate holdings, driving prices into the ground and driving up yields to as high as 15% or 16% last October.

Yields have come down significantly as funds caught the scent of the popular strategy, but are still in the 7% to 8% range, on average, analysts say. When investors' rush to cash pushed Treasury yields to abysmal levels, the premium became even more attractive.

"The SPAC common are really the best risk-adjusted investment I've ever seen in my career," says Neil Danics, a former risk-arbitrage hedge-fund manager who now runs the site SPACAnalytics.com. "You're basically buying the same short-term Treasury that yields zero, but you're buying it at 7% with greater upside if a good deal is announced."

SPACs, which must find a deal within a two-year period, or liquidate and return cash to investors, have traditionally been seen as having the safety of cash, with potential for huge upside if managers produce a successful IPO. SPAC shares come with warrants to purchase additional securities if a deal comes to fruition.

"Typically, it would be priced at $10 and trade at about $10," says Danics. "It wasn't a typical IPO where it's priced at $10 and can trade at $7."

Beginning in 2005, SPACs trading on the open market became flooded with funding from hedge funds and institutional investors. That boom ended as the financial crisis heated up last year -- creating a strange but immensely profitable scenario in an ordinarily sleepy market.

For example, recently an investor could purchase a share of Advanced Technology for $7.73, which carries an implied yield of 15.4% if held to maturity, according to investment bank Morgan Joseph. The maturity comes to pass in just over two months, when Advanced Technology is scheduled to submit a letter of intent on June 22. At that point, shareholders will vote on a deal, if announced, and be eligible to receive their portion of Advanced Technology's assets.

"SPACs became interesting because just like any of these kinds of closed-end funds, some of them are very compelling and trading at such huge discounts to net-asset value," says Andrew Schneider, managing partner and founder of HedgeCo Networks. "You can get in right now in some of these at 50%, 60%, 70% discounts to NAV -- even computed in a conservative fashion."

But the SPAC window of opportunity may soon be closing. HedgeCo has consulted about 10 new hedge funds with $500 million in assets dedicated to SPAC arbitrage and other closed-end fund strategies. AQR Capital -- a Greenwich-based alternative investment firm with $20 billion under management -- is one such company, whose diversified arbitrage mutual fund launched in January.

In a fact sheet about the fund, which engages in several arbitrage strategies, AQR outlined plans to take advantage of a lack of liquidity in the "thinly traded" SPAC market. A spokesman for AQR says the firm is not concerned that it missed the height of the market last fall, since it expects attractive risk-adjusted returns for some trades.

One investor in the fund, Lee Munson, was excited about the prospects, and the fact that AQR's fees -- which are capped at 1.5% for Class-N shares and 1.2% for Class-I shares -- are much lower than the huge costs assessed by hedge funds when markets were booming.

" I love it because there's none of this two-and-20 crap," says Munson, referring to the 2% management fee and 20% performance fee that hedge funds were known for charging.

Another question lingers for SPAC returns: Whether the M&A and IPO markets will recover any time soon. Schneider says about 740 SPACs trade on the market today, but new launches have slumped significantly as M&A activity seized up amid a lack of financing last year. Most of the few deals announced were voted down by SPAC shareholders. They preferred to reclaim original investments, rather than take a chance of loss in the IPO market.

The result was a downward trend in SPAC launches, which started climbing in 2005. That year, the number of launches more than doubled from 12 to 28, and average gross proceeds climbed from $485 million to $2.11 billion, according to SPACAnalytics.com. The market reached a height of 66 SPACs and average gross proceeds of $12.09 billion in 2007, but has since come crashing down to 17 launches and $3.84 billion in proceeds last year.

Thomas Kirchner invests in SPACs as manager of the Pennsylvania Avenue Event-Driven Fund, and noted the trend in his blog in January. Kirchner says opportunities have largely disappeared, as dollars chasing the strategy exceed the opportunities, especially with fewer funds available to invest in.

"You could buy SPACs last year at 15% discounts to their liquidation values," Kirchner says in an email. "Now, you're lucky to get annualized returns of more than 5% on that strategy."

Still, the strategy hasn't gotten as much attention as another popular arbitrage strategy that hedge funds have been using, which involves bets on the debt and equity of major financial institutions like Citigroup ( C), AIG ( AIG), Bank of America ( BAC), Wells Fargo ( WFC) and JPMorgan Chase ( JPM). But some top SPACs like Victory Acquisition Corp. ( VRY), Triplecrown Acquisition Corp. ( TCW) and Liberty Acquisition Holdings Corp. ( LIA) have received more liquidity as more funds became interested in the trade.

The trend has rendered SPAC warrants nearly worthless, leaving investors with dwindling opportunities to buy SPAC shares at big discounts. With all the sideline cash flooding into the relatively small market, it may not be long before yields shrink to nil.

"At some point," says Tina Pappas, a managing director at Morgan Joseph, "arbitrage opportunity disappears when everyone finds out about it."

If you liked this article you might like