A CIO argued recently that SPACs are risk-free. I investigate his motivations from three perspectives and examine if the market agrees.
Introduction
A Chief Investment Officer I work with recently argued that pre-business combination SPACs are risk-free assets. This is because the funds raised by these entities during IPOs are held in escrow while waiting to be deployed. These funds typically get invested in government bonds such as US treasuries. In the meantime, such government bond holdings also receive interest income.
I wrote about SPAC parties previously, arguing it’s a sign of a stock market fall. In this post, I try to detail the motivations of the CIO and present a simple analysis to check if his argument stands.
Why asset managers invest in SPACs
To make sense of the question, we first need to understand what motivates it.
Asset managers receive fees as a percentage of the asset under management. Any single specialized asset class would have more volatility than the broad market. More volatility means a higher likelihood of having a larger AUM in the coming months. This implies higher fees for the asset manager and his firm.
The flip side is that higher volatility also increases the likelihood of a loss by the investors. This may also reduce the asset management fees generated by these accounts. However, in an asset manager that continues to bring in new accounts and new fund flows, the overall management fees can be pretty stable. In the case of financial contracts where investors are tied-down for years, these fees might even increase despite losses to existing investors.
Thus, the risk to the asset managers in businesses with new business growth are non-symmetrical. When the market is up, the managers rake it in, and investors get a share. When the market is down, investors will take the loss, while managers may not even notice a drop in their income.
In addition, some asset managers might charge trading commissions on these accounts. Even if the asset managers do not pocket any trading commissions, they would have paid these to their brokers. These custom ensure they receive perks such as sports events tickets, Christmas hampers and whatnot. Such perks do not flow to the investors whose money are being “invested”.
As such, investing in high volatility vehicles such as these instead of boring index funds or ETFs tracking the broader stock market makes financial sense for the asset managers.
Why seek to classify SPACs as risk-free
I had laid out in the introduction the CIO’s ostensible rationale for arguing that pre-business combination SPACs are risk-free assets. The real question is, why would he want to do that? Why wouldn’t he just go out and buy a bunch of it for the sake of his bonus and his firm’s earnings already?
That comes down to three possible aspects. The first is regulatory, the second about credit ratings, and the third investors’ expectations.
Regulatory motivation
In some long-term financial contracts, financial firms pool the investors’ fund. Such pooled funds typically have regulatory constraints around them. These include the type of assets the funds can invest in, the limits for each type of permissible assets etc. More sophisticated regulatory regimes also use a measure called “risk-charge”. These determine how much capital the firms need to set aside to back up their investment risks.
Regulators dictate the risk charges. Simplistically, domestic government bonds are risk-free, so have zero risk-charge. Private equities and more complex and less transparent assets may get a risk charge of say 50%. Corporate bonds and listed equities get a charge of something in between. In other words, the riskier the asset, the more capital firms need to set aside.
As a CIO, you want to invest in the most volatile asset possible (see above) while minimizing the amount of capital associated with it. Pre-business combination SPACs offer such an opportunity. As an asset class, its price-performance since 2020 has been second only to possibly BTC. Yet, their US Treasuries underlying might be sufficiently plausible to argue for zero risk-charge. High fees for no capital! Who can argue against the notion that risk-free SPACs are the best thing since sliced bread?
Credit ratings motivation
Financial firms are the biggest bond issuers in the corporate bond market. They routinely account for more than a third of all bond issuance in any given year. To ensure there is sufficient demand for the bonds, firms need a credit rating.
The independence of credit rating agencies has been in doubt since the Global Financial Crisis of 2008. Still, they try their level best to appear independent by having a slew of metrics to back up their credit rating calls.
One of the many metrics these agencies rely on is the high-risk asset (“HRA”) ratio. These ratios get different names depending on which agency you refer to. They essentially mean the same thing: how much risky assets is the firm investing as a percentage of the firm’s equity? A lower ratio can be used to justify a better credit rating.
As a CIO, you do not want to be seen as an obstacle in the CEO/CFO’s fundraising effort. You would also try your best to keep the proportion of equities below the stated thresholds. If you can argue that SPACs should be excluded from credit rating agencies HRA, you would.
Investors’ expectations motivation
The next time you are enticed into signing up for a long-term financial contract, look for a section called “Strategic Asset Allocation” (“SAA”).
This section tells the investor how the asset manager intends to manage the funds. The manager will typically allow himself a range in which he “can take advantage of market dislocation.” For riskier assets such as equities and alternative assets, the range will include a maximum. In other words, the manager promises he will not invest more than, say, 50% of the investor’s money in these assets.
In a rising market, such as the one we are in now, you can breach such maximum quickly. There are two ways to go rectifying such a breach. The first is to reduce offending asset positions. The second is to seek investors’ waiver.
Seeking waivers is an administrative hassle few I had worked with would attempt. The second is a self-sacrificing act no self-respecting asset manager would even dream of. Cutting back on high volatility asset means reducing income. Anyone who performs such an act, not least voluntarily, is unfit for the financial industry.
Hence, the CIO mentioned came up with a third way. And that is to argue there has been no breach. The concerned assets should not be counted in the first place!
Are SPACs risk-free?
Out of curiosity, I looked at what the market says about SPACs. To test the hypothesis that this is risk-free, I used a concept called tracking error. This is the divergence between the price behavior of a position or a portfolio and the price behavior of a benchmark. A lower tracking error indicates an asset tracks its benchmark better.
For the benchmark, I use the on-the-run 2-year US treasury. This is to better match with the pre-business combination period of a typical SPAC.
For the SPAC, I chose Pershing Square Tontine Holdings Ltd (NYSE: PSTH) out of simplicity. The Economist recently praised it for offering common investors a better deal than other SPACs:
Investors’ willingness to accept poor returns may wane as they become more familiar with SPACs. They certainly grasp that those like Mr Ackman’s, which will issue him 6.7% of the shares in the merged firm only once investors earn a 20% return, are more sensibly structured, valuing it more handsomely than the rest.
The Economist, 2021 Feb 19th
I also looked at 2 other assets for comparison. The first is an iShare ETF that tracks 1-3 year US Treasuries. The second is the broad equity market index S&P500 (“SPX”).
As it turns out, the ETF has an annualized tracking error of 0.00229 against the benchmark. SPX has an annualized tracking error of 0.173. PSTH, Ackman’s SPAC, has an annualized tracking error of 0.603. This is 263x that of the ETF and 3.5x that of SPX.
Thus, the SPACs with the most investor-friendly terms has volatility of 3.5x that of the broader equity market. I hesitate from investing more time looking at other SPACs. So much for SPACs being risk-free.
Conclusion
To summarize, we have looked at three possible motivations for the CIO to try to classify SPACs as risk-free. These include regulatory, credit ratings, and investors’ expectations reasons. We have also looked at the market data. This suggests, despite the use of escrow accounts and government bonds, the market actually thinks SPACs are at least 3.5x riskier than the broader equity market.
I had once thought that “sell your own grandmother” was just a saying. It turns out it is also a lucrative business line. Given this backdrop, perhaps I should not be surprised that a well-paid and educated person such as the CIO would attempt to decree SPACs risk-free.
