Clay Finck (01:42):

Let’s start at the most basic level as we’re going to be talking about SPACS today. Could you explain to our audience what SPACs are and how they even work?

David Sherman (01:52):

Sure. SPACs are a publicly traded company. They were issued with an IPO where the money that was raised for the IPO, the cash is put into a trust account for the benefit of shareholders. And then the company looks for an acquisition to either merge with or take over where the target gets the benefit of the use of their cash, as well as the opportunity to be publicly listed as part of a business combination. So if you’re a private company, either from venture capital field or from LBOs or a division of a public company and you want to go public, you can either go public through traditional IPO routes where you can merge with a SPAC. And then to the extent that shareholders approve the transaction and are excited about it, the proceeds from the cash would then end up on your balance sheet as part of your cash. Just like you get IPO, you get cash proceeds.

David Sherman (02:41):

However, shareholders of the SPAC can vote in favor of the deal, but choose not to participate in the merged company. They can say, I know that there’s cash in a trust account and I don’t really want to participate in the deal. I want my cash back. So they can redeem their shares, like a change of control provision in a bond and get their cash back. So today, if you buy an IPO or a secondary piece of a SPAC for the shares themselves, you get the ability to either get your trust amount back, which is typically $10 or more per share, and SPACs are typically issued at $10 a share, or you can participate and roll into the new deal. And it really depends on which one you like, and you can do that.

David Sherman (03:24):

Now, let’s say the people that have the SPAC back don’t find a deal very quickly. They actually have an expiration date. There’s a liquidation date that requires the public company to find a transaction or liquidate. And if they liquidate, again, the proceeds and the account go to the shareholders of the public company, so they would automatically get it. So if the trust account has $10 or more in trust, and it’s invested in treasuries and you get the benefit of that interest in treasuries, and you buy it below the value, which is $10 or less, by definition, what you really have is you have a zero coupon bond with a fixed majority of two years or less, because liquidation date currently is about 15 to 18 months, but typically it’s two years or less. And if they announce a deal sooner, you get your money back sooner, or you can participate in the deal. Or people are so excited, it’s the next DraftKings. It goes up a lot. Or the next DWAC, Donald Trump media empire, it goes up a lot. You get to participate. So if you buy it, you have this convertible bond security. And then obviously once the transaction’s approved and you roll into the deal, you have a more traditional small cap or SMID cap stock.

Clay Finck (04:32):

It seems to me like investing in these SPACs is almost like a bet on management for them to go out and find a good deal. I’m curious, since shareholders are able to redeem their units or shares for that usually $10 price target, why is it that they ever trade below that?

David Sherman (04:51):

So first of all, it may or may not be in a bet on management. I know there’s a lot of conversation about actively managed SPACs and picking the right management team. Yet the most successful in the history of SPACs, and I’ve been doing this since 2005, is probably the Donald Trump’s SPAC that was done by Digital World Acquisition, DWAC. And that management team, maybe others would find this offensive, but I would call it on a scoring chart, a mediocre team at best. They were investment bankers that were okay investment bankers. They were first back liquidated, so they didn’t have a history of very successful SPACs.

David Sherman (05:25):

What they did was they were able to find a deal off the beaten path, which I’m sure many weren’t interested because of the geopolitical inner fighting in our country. So it’s not geo, it’s just politic fighting, and there’s a brand evidently and they were able to latch onto it. Whether ultimately that company is successful or not is a different investment decision post merger, and even now where it’s trading above trust value. So I’d like to say that expertise and being around the hoop and knowing management makes a big difference, it may or may not.

David Sherman (05:53):

And one of the reasons it’s not as important, and I do want to emphasize this, is when you buy a SPAC, you have the right to redeem your shares. So you can buy it like a yield product, a short term yield product, one year, 10 months or longer, but no longer than two years, right? And you can buy it at a discount to the trust value, locking in a yield like you would with commercial paper or money market securities. And you have treasuries as your credit risk. And the management gives you that opportunity to potentially capitalize on a return in excess of that future value, present value, zero coupon equation.

David Sherman (06:27):

Now you ask why do SPACs trade at a discount? So typically SPACs are issued in the IPO as a unit. So you’re given a stock and typically a warrant and or a right. So the warrant is typically struck at 11.50 a share because the SPAC issued at $10 a share, so it’s a 15% premium. And that warrant typically is a five year life. And there are people that just want to buy the warrants, there are people that just want to buy the stock, and there are people that want to own both. And the warrant people are actually making much more of an investment on the confidence of the management between the SPAC of finding a good deal, because the warrants have no value if the company liquidates. Only the shareholders have that right to the trust account and they have no redemption, right?

David Sherman (07:09):

So if you own a portfolio of these warrants, it’s almost like owning a portfolio of venture capital investments. And I would recommend if you’re going to be a warrant buyer, you might think you can pick the best warrants, but remember they haven’t announced a deal yet. And even if they announced a deal, you might think you’re a great venture capital investor. But what I’ve learned since my investment world, going back to my beginning career in 1984, ’85, ’86 period and being tutored by Joe Steinberg, was if you’re going to do venture capital, you want a big portfolio. So I would recommend if you buy the warrants as a focus, think of them as a portfolio of options.On the stock, it’s very different, right? You can capture the fixed income like nature due to the redemption provision, the liquidation provision backed by treasuries.

David Sherman (07:54):

Now I didn’t answer your question on why did the stocks trade at a discount? They traded at a discount because of two reasons. One, it’s like any bridge financing, you need to get paid something to tie up your money. There’s an opportunity cost of capital. And two, it’s not very interesting if to invest in a stock betting that the stock’s going to announce a good deal and then it’s going to go up and make a zero return on my capital. Now there was that period, I call it the mean period, between Labor Day of 2020 and St. Patrick’s Day of 2021, to be simple, where SPACs did trade above their trust value. And I don’t mean the units, I mean the stocks, because they were paying a premium to get into those potential great deals.

David Sherman (08:39):

I’d rather like to know what the deal is and overpay for it and miss that first pop, knowing what I’m getting and get a return on my capital while I wait. They’re not exactly call options, right? Because you’re putting up the full capital. You don’t get the gearing or the leverage. You do want a call option. Never in the history of SPACs since I’ve invested, again, since 2005, did I see anything where it traded at a premium, other than that SPAC mean period of Labor Day to St. Patrick’s Day. That is an anomaly, in my opinion. They’ve traditionally traded a discount to reward investors. And in fact, as rates have started to go up, the amount of yield you can lock in or the bigger the discount has occurred.

Clay Finck (09:16):

Why is it that some companies would rather go through an IPO process through SPAC rather than the traditional IPO process that requires more regulatory hoops to jump through?

David Sherman (09:29):

Well, you answered your own question, right? More regulatory hoops means more headaches. That may or may not be the case, by the way. But yes, one of the distinct uniquenesses or differences of a SPAC versus a traditional IPO is a SPAC is viewed as a business combination of merger. And the rules for mergers and business combinations from a disclosure standpoint are different than a traditional IPO. Now it may be that the SEC decides that that’s an unfair playing field and they may change the those rules. But if they do, they’re going to have to affect the rules of mergers as well. So I’m sure we’re going to get rules. I think the rules will only make the asset class, the SPAC asset class, better, sounder, and more beneficial for the investor.

David Sherman (10:12):

That being said, look, you can do direct listings now, which you couldn’t do before. You can do traditional IPOs. You can do SPACs and don’t forget, you can also sell to third parties. This may be a way that’s a little less expensive for people to put their company up for sale by merging to a SPAC and seeing what comes up. It traditionally has been quicker to get into the public market via SPAC. That’s not necessarily the case today because the SEC’s so backed up, but it is still traditionally a quicker way. It allows more information to be provided to the underlying equity investor, to encourage them to get excited about the transaction. And with that has the benefits of you get more information and the negatives of buyer beware, right? But it has that benefit.

David Sherman (10:56):

And also it’s the media. And what they really like is you’ve already paid for all of the public stuff, right, the SPAC has, so the prize is the cash. They’re going in for the listing and the cash and it’s that simple. University of Chicago recently came out with an academic piece that discusses some of the merits of SPAC as a capital formation tool. And one of the reasons we … even though I’ve been investing in SPACs since 2005, and I invest in the entire product life cycle from the sponsor capital, who are the guys that put up the risk capital to get it public, to the IPO, to the fixed income, like nature of SPACs, to even at the end of the day, providing the additional capital called PIPES, private investments in public equities that provide additional cash case this [inaudible 00:11:40] redemptions are just more cash. It’s a form of pre-merger capital formation.

David Sherman (11:43):

Or even afterwards, right? Even though I had that long history, I never thought it could be a single asset class to manage money around because it was too small a market, but it’s gotten adopted by real institutions, right? You have hedge funds like Elliot. You have venture capital, private equity growth firms and investment banking firms like Warburg Pincus. And those are just some. Those are traditional Wall Street firms. Then on top of it, you have people like Bill Foley, right, who has built a successful entrepreneur doing this. You have other successful entrepreneurs willing to issue SPACs because they have a network and knowledge and see undervalued opportunities to try to take it public. It’s become an institutionalized product.

David Sherman (12:22):

Since we’re on the topic, people have been concerned, oh, the asset class went through the mean period, but it’s going to shrink, but let me be clear. There is currently 716 SPACs as of March 8th, last Friday, out there of which 613 are looking for a target, 103 have announced deals. The total cash value of these SPACs is $186 billion. Now, a $186 billion market is definitely a single asset class today. And you can get this information every week from a website called spacinformer.com, S-P-A-C informer.com, which is an affiliate of ours. And we charge nothing for you to have the privilege of getting free information, but remember you get what you pay for.

Clay Finck (13:09):

I definitely was not familiar with SPACs prior to the last couple of years, so I was surprised to see that they’ve been around for decades. We’ve seen a substantial increase in the number of SPAC IPOs over the last couple years. Do you believe that this is just due to the excess liquidity in the market? Or what do you attribute that to?

David Sherman (13:30):

So I’m going to answer your question with something you very rarely hear in the investment world. I don’t know. And for me to answer that question would be pure speculation. That said, I think you’ve seen asset classes outside of SPACs that have also had huge inflows. The venture capital community and asset class has grown exponentially over the last 10 years. The private equity market, which is definitely not due for decades now has been growing at very, very high growth rates. I think as there is more money flowing around in the United States particularly, but also the world, either because there’s been wealth creation and wealth handed down to others and there’s been increased savings, believe it or not. And because of technology improvements and new companies emerging, and it’s just been a really bullish market. Those create opportunities to raise capital.

David Sherman (14:21):

It’s got its negatives and it’s positive, but I remember a period called 2000 and you could raise money for anything that sounded internet like. So people chase growth and SPACs are a form of allowing one to embrace growth. By the way, I can remember a period where you could buy etoys.com and the enterprise value exceeded Toys “R” Us. And we know how that worked out for Toys “R’ US. And the equity value was very high, yet the convertible bonds were trading below 60. And something’s wrong with that picture when lenders are saying, you’re distressed and I want mid teens to high teen yields and low prices and the equities like this, and it went bankrupt. But that just shows that there is in markets where there’s new technology, new productivity tools, new growth opportunities mixed with capital formation, mixed with a relatively bullish market, how you get very mixed views where [inaudible 00:15:23] guys are typically skeptics and equity guys are typically more positive.

Clay Finck (15:27):

I couldn’t help, but look up Buffet’s thoughts on SPACs. He made the point that if you gave him two years to purchase a business, he’d be able to purchase one, but there’s definitely no guarantee that it would be a great purchase. And I might mention that we’re big fans of Buffet and Munger here at TIP. Also, Buffet and Munger are big on looking at the incentives of the economic actors. Do you believe there is an incentive for the sponsors to put together a deal just to get their payday, even though the deal probably isn’t in the best interest of the shareholders?

David Sherman (16:03):

So I’d like to break in a couple points. It’s an excellent question, by the way. So first of all, I want to address the Buffet comment a little bit, and then we can address alignment of interest, which I think is ultimately where you’re headed. So, first of all, I’m a huge person who respects Warren Buffet. Indirectly, I’ve been a beneficiary of Warren Buffet’s golden touch with my employment for 10 years at Leucadia National and his joint venture with Leucadia, now Jeffries, with Leucadia’s multiple opportunities. And he’s a brilliant man. I also teach a global value investing class at the NYU business school with a gentleman named Jamie Rosenwald who started the course. And one of the things we do is cover Buffet’s letters as part of our curriculum.

David Sherman (16:46):

And one of the things I do want to tell, which is a complete sidebar to your question, is I think people have become very shortsighted in their investment. And this does go to a two year horizon, which is, I think, part of what Warren’s talking about. They become very shortsighted. And I think that’s human nature because I think in general, we’ve all become much more shortsighted and much more focused on instant gratification. And think about technology today. They went from faxes to emails, and before faxes, you had FedEx. Well, what did FedEx do? It was a business that said I’m going to disrupt the postal business because I believe people will pay huge premium to get a package overnight, to respond quicker.

David Sherman (17:23):

Now people are like, oh, FedEx it, send it second debt. Well, then faxes came through, now you have email. So think about the amount of response time people are expected to do, and the amount of volume they’re doing versus let’s say 20 years ago. Right? And that’s created more of a, do it now, get it done now syndrome. And that’s just in a simple business example. So look, I think the world has sped up and that’s just a general comment of whether [inaudible 00:17:48] or not. But the point of this is if you look at Warren Buffet’s returns, which he posts in the history, go back to those early years and look at some of those really big drawdown he had. And ask yourself if you were investing with Warren Buffet, would you think long term, or would you redeem? Or would you even say I’m not giving it because of look at those numbers? But if you would’ve redeemed or skipped the guy, you would’ve missed the G.O.A.T.

David Sherman (18:14):

So I think it’s important to look at things in a frame of time and match assets with liabilities. As far as Warren Buffet’s comment about, if you give him two years, he’ll find acquisition, but he might likely overpay for, well, that in and of itself is a statement that doesn’t make any sense, because Warren Buffet doesn’t overpay for anything. He’ll pay fair, but he doesn’t overpay. And whether it’s two years or 10 years, he’s gone long spells of not finding acquisitions, but he also had multiple acquisitions in a short period.

David Sherman (18:39):

I think the ability to find an acquisition that makes sense is traditionally based on the valuations you can get of acquisitions. And I think it’s more a comment that today the world is generally expensive, even as we’re speaking, and there’s a war going on in Ukraine, and the feds raising rates, and the stock markets dropped quite a bit this year. And people who are unfamiliar with true bear market’s like, oh my God, what’s going on? So in any event, I think valuation’s key. And one of the things I think, unfortunately, that has occurred is you’ve had an explosion of SPACs that allow capital formation and allow people to go public. At the same time that venture capital valuations have been on the high side and private equity valuations have been on the high side, in a very low interest rate environment.

David Sherman (19:27):

And when we talk about valuation, everything relates to a fixed income yield. I mean, I don’t happen to think the riskless asset is a U.S. treasury, which we’re taught in school. I think it’s your mortgage rate, because you got to pay it off and you got to live somewhere. One of the things that’s going on right now is we’re going through a reevaluation period and that’s going to make acquisitions potentially cheaper, but the great companies will still be more expensive. So is two years enough? I think it really depends on the network and the valuations. And there may be too many SPACs to find that many good deals. I don’t dispute that.

David Sherman (20:02):

And I also think that the sellers, if you’re a venture capital, you’re selling, because you can go public at a higher valuation. Then you can do another round of financing and you probably need cash, right? And private equity, you’re going to delever a higher valuation, but private companies have always gone public because they thought that was a cheaper capital formation than doing a private funding. But I think it’s important when you look at deals that they’re going to be a lot of overpriced deals.

David Sherman (20:28):

The other thing I want to comment about Buffet’s comment is you’re dealing with a man who he just announced he’s buying Alleghany, I think, for $11 billion. The general SPAC total enterprise value is about one to three billion, so this is a rounding error. So we know that as you look at smaller transactions, in theory, you should get paid more money. You don’t always, but you should. So where does that lead? And then we’ll go to a line of interest.

David Sherman (20:55):

The targets are out there. It is highly likely that most SPACs will overpay for these targets, which has always been the case, just like most IPOs don’t go up and continue to go up, right? Because typically it’s an arbitrage realization between private values and public facts. It’s why I hate comp analysis or comparative analysis. I want to know how much money can I take from the company and either buy back my shares or distribute to shareholders so my piggy bank gets bigger. But a multiple to revenue of 10 times where it’s losing 30% on its revenue here is not a great business, I understand. It doesn’t meet my value metrics.

David Sherman (21:36):

Now, as far as alignment of interest, it’s a problem, right? Why is it a problem? Well, let’s start with the biggest problem. When SPACs are taken public in an IPO, where the cash goes into the collateral account and they are looking for a deal, that capital to get it public needs to come from somewhere. So if you’re doing a 200 million IPO of a SPAC, it’s going to take somewhere between eight and 15 million dollars of risk capital to actually just get the SPAC up and running and build a team and go look for the stuff.

David Sherman (22:05):

So I mean the 200 million’s going to go into a trust account and it might even be more than 200 million because they might take 204 million, right? So that means of the 12 million that the sponsor’s putting up, four is going into the trust account for redeemers or liquidation. That means their other eight million is what’s eating up their costs that are cash payments as well as future. If they don’t find a transaction or they find a transaction and they don’t close it, they lose all the risk capital. So a SPAC’s sponsor’s primary focus is finding a deal to close period, end of story, because if it liquidates, the sponsor loses everything. So they’re incentivized. Good, bad, who knows? Just get the deal done.

David Sherman (22:46):

Now the other part is most sponsors syndicate that risk capital. So you can actually have sponsors who have practically no skin in the game from a capital standpoint, but share a significant part of the proceeds of being the sponsor, right? That’s even worse of an alignment of interest. Now we haven’t talked about what the sponsor gets. This is the egregious part. A sponsor who puts up this risk capital, so example before was 12 million on a 200 million deal, which is pretty high, but it’s assuming a SPAC is collateralizing a $10 IPO with call it 10,20 or 10,30 in trust. So the IPO sponsors locking it at two to 3% gross yield just on the cash collateral before the value of the warrants, which we haven’t talked about, but let’s focus on this.

David Sherman (23:29):

So they put up the risk capital. Well, they need something for this and if they’re going to syndicate it, the guys who are buying this syndicate need something. So in SPACs, the sponsors typically get 20% of the value of the IPO if they do a deal. That means if it’s a 200 million deal and it trades at $10 a share, they just made $40 million of value. They didn’t make it minus their cost. Okay? So they made $28 million as an example, that’s pretty good gearing. And they still get warrants so they could make more. And if it trades at $5, they still make money. Their break even is usually around, depending on how they syndicated or didn’t syndicate it, but it’s usually between two and three hours a share. So this back trades above three bucks, they’re probably making money. That’s another problem with the alignment of interest.

David Sherman (24:11):

Now the sponsor will argue, I have to find the deal. I don’t get paid to find the deal. There’s costs, I eat it, I’m taking all the risk. Oh, and by the way, everyone knows these economics I’m dealing with because they’re [inaudible 00:24:23] closed. So here’s what happens when I find a deal. The targets says, oh, I’ll take a little of your sponsor shares. And then when they go raise the pipe money or the additional capital to support redemptions and additional capital, they’ll take a little of the founder shares. It doesn’t matter. If you think about the fee, it’s almost more egregious than hedge funds. So, that’s problem one.

David Sherman (24:42):

What’s problem two? The companies that are selling want the best price. They’re not interested in creating value generally in a cheap price. That’s true in an IPO as well, by the way. But I think the difference is in an IPO, I think there’s a little bit more of a commitment to try to price it more fair, right? Because you’re not giving so much up to some group that isn’t part of it. You’re giving it to investors directly. In addition, you have to think about the consequences of the merger’s private equity. I mean, the shareholders. So take Buzzfeed, which we participated in anchoring the pipe, which is a convertible bond. You’ve got shareholders that are now suing Buzzfeed. These are employee shareholders, shareholder who worked at Buzzfeed, who got shares working there, arguing they got locked up and they didn’t have enough time them to get out at a good price. So there is an alignment of interest problem.

David Sherman (25:29):

Okay, let’s go one more, investment bankers, lawyers and accountants. Now the accountants actually don’t charge a lot, but those investment bankers charge a lot. Where do they charge? They charge for the IPO. And many of them deferred their fee until the IPO finds a deal. So they’re already now tainted. Then you’ve got the investment bankers who want to help you find the target. Then you’ve got the investment banker raising that represents the target. By the way, you have lawyers for all these things too. Okay. Then you have the investment bankers focusing on the pipe and you have lawyers there, so there’s a lot of hands grabbing. And there’s the old joke. You go to the docs and they show you many yachts and they say, this is JP Morgan’s yacht. And somebody says, yeah, but where are the client’s yachts? So, that’s a problem.

David Sherman (26:14):

And let me give you an idea. It’s not unusual to see 20 and $30 million fees in the merger to cover all this. Well, it’s a billion dollar enterprise value. You just took 3% out. And going back to Warren Buffet, something brilliant happened just the other day. He announced he’s going to merge with Alleghany, he’s going to buy Alleghany. And he said, but investment bankers don’t add enough value. But he said, Alleghany, you want to pay your investment bankers, that’s fine with me, but it’s not coming out of my pocket. So I’m paying you X per share and you’re going to reduce that share price by what you’re paying the investment bankers to your shoulders, but not to me. Right? And it was actually a pretty reasonable number.

David Sherman (26:50):

You’ve got a lot of people looking to make money. Yeah, that’s true in IPOs too, by the way. I don’t think it’s any different in IPOs. There may be less parties involved, less transactions. It’s a problem in the Wall Street environment in that when a lot of money’s there, you figure out how to charge lots of fees and you say, well, it’s not a big number.

Clay Finck (27:09):

Yeah. I completely agree that the incentives don’t really seem to be aligned. And the 20% fee that you mentioned just seems egregious. With that, what you typically hear or read in the news is that SPACs are risky speculative investments where you can lose a lot of money. You see these deals where some of these companies are doing zero revenue. And back to Buffet, Buffet has been someone that has completely avoided IPOs. Now with that, let’s transition to CrossingBridge. You guys approach the space much differently by focusing on pre-merger SPACs specifically. Could you tell us a little bit more about pre-merger SPACs and what makes them different from what we usually see in the headlines?

David Sherman (27:55):

So nothing would make me happier than spend some time talking about pre-merger arbitrage and SPACs and how it’s a fixed income like strategy. Before we do that though, I do want to address two things. I don’t know if Warren Buffet’s ever bought an IPO or not. I’ll take your word for it, but I will tell you that Warren Buffet also never bought tech stocks and now he does. So I think it’s not that there’s necessarily hard rules in the sand. I think people have hard rules, but an inquisitive person who’s mindful and disciplined also recognizes sometimes things change, so that’s one.

David Sherman (28:27):

Two, there are actually very few SPACs that have zero revenue. And if they are, they’re typically SPACs that are more like drug development, which you also see in IPOs. That said, there are a ton of overpriced, mispriced SPACs, which is going to work to your listenership in that a lot [inaudible 00:28:44] are value investors go to the stock market, look at all those SPACs that were done and now look at their prices today. I mean, Casper, which we’ve all heard, it was a SPAC that was done, stock collapsed, rightfully so. Company did a hundred percent the right strategy of realizing that you can’t be direct to consumer without having bricks and mortar in the long run to meet the most addressable value.

David Sherman (29:07):

They raise convertible bonds. The business model has real issues. The stock dropped below three, they’re taking it private. I assure you they’ll rationalize their marketing and they’ll make money as a private company, right? Because as a public company, they were using other people’s money and the cash they raise. But as a private company, they’re going to conserve that cash and rationalize it. And instead of focusing on growth, focus on cashflow. And I think you’re going to see all kinds of opportunities in post merger SPACs. I don’t want to pick names that we’re looking at. We can have a separate conversation or podcast about it, but there will be those opportunities. It’ll also be a great vulture investor market with all the converter bonds and fixed income pipes that are being done.

David Sherman (29:47):

But I do think it’s a mistake not to look at the aftermarket as a potential value opportunity. Unfortunately, there’ll be a lot of stones you have to turn over before you may find one. And the accounting’s not generally as good and disclosure’s more marketing based. Now, that’s not what we do in most of our funds. We’re fixed income. We’re extremely disciplined. I actually joke with people and say we’re like a paint by numbers person. Everybody’s trying to find in my profession the greater good of managing money. I’m not sure it’s like being a doctor where you save lives. I’m not sure the greater or good of managing money to make money one money, but it’s a living. I really like it.

David Sherman (30:26):

So I think my art is a paint by numbers picture or artwork. Why? Because in paint by numbers, there are rules. And if you follow the rules, you get a pretty good looking picture and you got to stay within the lines. So, that’s about paint discipline. Specifically in that regard, and I think it’s important when we talk about it, there’s a strategy. We do not create it. It’s been around for a long time. We’re a follower, not a creator, but it’s called pre-merger SPAC arbitrage and it’s very simple. It’s because SPACs have a liquidation date. And if they announce a deal, you can choose not to participate and get your money back. In both cases, you get what’s in the trust value, and the trust value is generally T-bills.

David Sherman (31:05):

And you get to vote on whether they do the deal or not. And they’ve separated the put feature from the vote. So of course you’re going to vote for the deal because you want to get your money back, right? Why would you vote against the deal and let the life of the SPAC continue, right? So if you know that your credit risk is T-bills and you know what’s in the collateral account because they give it to you every 10Q, it’s publicly available information and basic math can tell you how to divide the trust account by the number of shares. And if you can’t do that, you probably should outsource your investing. Okay?

David Sherman (31:36):

So now you know how much you have per share in trust. You know what the market prices of the stock. I’m not talking about the warrants. There’s a deal discount generally, right? And you know what the liquidation date is. And by the way, now that rates are finally going up, you’ll earn interest on those T-bills. They typically invest in six month or less T-bills. So if it’s a one year SPAC, they invest in a ladder to six months when they reinvest. If they haven’t found a deal, you’re going to get a higher rate today. Right? So if a SPAC … and when they do the IPO, they’re all over-collateralized today, they didn’t always.

David Sherman (32:06):

Let’s take a new issue. This last week there was a new issue. They issued $10.25 cents in trust and you paid $10 and you got a unit. So you got a two and a half percent gross yield, plus you got the warrant. Now, when you sell the warrant, if you choose to do that, your stock price is going to go down by pretty much what you sold the warrant for. Right? But since you’re going to be able to get it back when you put it or liquidate, you’re selling something that gives you money today, but you’ll have a mark to market hit. But when you liquidate or redeem, you’re getting it at par. So warrants today are like half a warrant. And the life of this thing is typically 15 months.

David Sherman (32:41):

Okay, so I’ve gotten 15 month or a year and a quarter maturity, two and a half percent gross yield, plus a warrant that’s worth one to one and a half percent when I sell it. That’s 4% worth three and a half percent for 15 months. I’m making more than 3% in T-bills, I have mark to market risk. But if I do the math right, I’m disciplined, and by the way, they announce a deal in six months and close it in six months, I put it double my return, seven and a half months to be exact. So the [inaudible 00:33:08] nature is that discount with the intent that you’re always going to redeem, Or if it’s Donald Trump’s deal, you’re going to sell. But once it’s trading above trust value, it’s a different analysis.

David Sherman (33:19):

So Donald Trump announced this deal. We were out by 11 o’clock that day. I didn’t get the 60, $80 a share. I’m stupid. You know what? That’s not what we do. What we do is, oh, it’s at 19? That’s $9 above trust. Sorry, we’re out. That’s what we do. So if you do SPAC arbitrage, you have to always redeem and make sure you do it properly, and check your record dates. You have to be prepared to liquidate. If you’re going to use leverage or you need cash or your asset liability match, you have to be able to hold to maturity, because there is mark to market risk, especially since hedge funds leverage these products four times, five times, six times. And one day you might get a tap on the shoulder and see those spreads really blow out. And you can side to sell the warrants or not. We always sell the warrants.

David Sherman (34:02):

There are other SPAC ETFs that may say they’re doing what they’re doing, but have the ability to participate in the deal. There are even SPAC ETFs that only do the deal things. But ours is a hundred percent focused on below trust account, liquidate or sell or redeem, don’t roll and capture that discount. Now, what does that mean? Are we going to outperform? I’d like to tell you as an active thing, we’re going to outperform them if you do it yourself, but who knows? But if you do it yourself, today, 140 billion of the SPAC market, according to SPAC Informer, are trading at yield to liquidations of greater than 3%. And by the way, the average maturity on this is probably about 11 months.

David Sherman (34:40):

So I don’t know, 3% for 11 month money backed by treasuries? Oh, most of its capital gain, not worth your income? Sounds pretty good if you want to … What are we in? We’re in March. Let’s say you have a kid going to college in September. Well, you got tuition in September. You got tuition in January, the following year. Let’s take the January tuition. You could go buy a portfolio of SPACs, make 3%, most of it capital gain, right? As opposed to [inaudible 00:35:06] income, that’s a lot better than a CD, a lot better than a T-bill, a lot better than a money market fund. And if you’re an ultra short duration fund, you got wiped out when you didn’t expect to right at the moment, because a rising rates. So it’s a really good long term cash alternative.

David Sherman (35:20):

Now, who are the investors that buy the pre-merger SPAC ETFs? What you would expect, merger arb guys, high yield investors, distressed investors, right? These are the hedge funds with some of the sharpest trading elbows, and they’re levered. They’re levered four to one, five to one, six to one, millenniums in it, citadels in it. So you do run the risk that liquidity premium, which I still think even today is not being valued enough. And I am concerned today with what’s going on geopolitically with Ukraine and China and all that, that there’s counterparty risk that isn’t properly being considered. I mean, I just read today something about … that European banks are looking at $100 billion of exposure just to Russia. Okay?

David Sherman (36:06):

The market hasn’t seized up. Hopefully it won’t seize up. I’m not predicting it will seize up, but if you just have a bad market, no big deal. And SPACs have held up really well in a rising rate environment in a tough take. But if you get liquidity events that are counterparty related, like ’08, you’re going to see SPAC pricing drop because people want to get it paid more of a premium. And believe me, there’s a price that’s going to stop dropping because at some point Warren Buffet for the insurance company will buy SPACs if he can buy treasuries at six and 7% after one year. So if you’re going to do this, be prepared that you could have a drop and in this environment, maybe not get fully invested in them, right? Thinking you can have some dry power. But that being said, it’s a good alternative.

David Sherman (36:47):

I mean again, a lot of these hedge funds have four, five, six to one leverage in them. So if they get a tap on the shoulder, it’s going to have the least price decline to de-risk. Right? So we haven’t seen that. I will tell you in ’08 and COVID, the draw downs existed. They were not terrible, relative to a high yield book or even an investment grade book during COVID before the Fed came to the rescue. But you have to remember, during COVID I could buy [inaudible 00:37:12] bonds that were [inaudible 00:37:14] call that were backed by treasurers at 7%.

Clay Finck (37:17):

So if I’m understanding this correctly, there could be a draw down in the price of the SPAC or your initial principle. But if you hold it out, you’re eventually going to be able to redeem it for the share price. Am I understanding that correctly?

David Sherman (37:32):

Exactly. You know the saying in value investing value won’t earn out? Well here you have an exit date, you have a termination date, you have a guarantee date you can crystallize getting your money back. And you know you’re going to get your money back unless treasuries default, in which case maybe then you won’t get your money back, as long as you properly redeem or make sure you liquidate.

Clay Finck (37:50):

Are there any risks people should consider with this sort of pre-merger strategy? I like how you’re able to protect your principle, but give you this venture capital type approach where you’re giving yourself some exposure to that upside such as what happened with Donald Trump’s SPACs. So I’m curious, are there any risk at all that people should be considering in this strategy?

David Sherman (38:12):

There are risks. There’s no free lunch. I haven’t found anything that isn’t risk. I even think there’s risks in T-bills and we can talk about that. And I mentioned in a Wall Street Journal article risks. Look, one of the risks is you could have sovereign government, U.S. Treasury default risk. You could have the risk that you have a bad actor as a sponsor for some reason, which would make absolutely no sense, maybe put into bankruptcy. It wouldn’t make sense. It might not even legitimately be able to be put in bankruptcy. There’s no rhyme or reason how this would work out. I think there’s an extreme, extreme potential of this. It’s not an event I’m concerned about. Right? And then the bankruptcy court has to argue, are you adequately secured or is it a contractual obligation?

David Sherman (38:52):

You’re talking about a lot of technical nuances, but it’s an example of a risk that people take that one should understand and just either accept it or not accept it. Right? But I’m not concerned about this risk. When I was at Leucadia, we wouldn’t lend out our securities to make income because lending securities took on counterparty risk, and everybody thought we were really, really stupid. And the only time you ran into counterparty risk in lending securities in the history of my career of significance was 2008, and he had a problem. So you should never say never. You should be aware of risks, but you should be able to judge them.

Clay Finck (39:28):

You also mentioned earlier that there are high redemption rates, meaning people are wanting their money back rather than holding the actual shares. So I’m curious why that is and who ends up holding the shares? Is it shares that just aren’t issued since they aren’t being redeemed? Or how does that work?

David Sherman (39:46):

So after a SPAC announces a transaction, there’s a record date. You want to make sure you own your securities by that record date, not by them post record date, because then you’re going to get stuck rolling into the deal. That’s one of the risks, by the way. And if you have the right to choose to redeem, which means you’re saying I’ll take the cash, my proportional amount of cash. And in return, I’ll give you my stock. So it’s almost like the company’s buying back their stock for the trust of value. It’s no longer outstanding. It’s as if it was purchased or redeemed. So it goes out of float and it goes out of issuance.

David Sherman (40:21):

High redemptions are a function of bad deals. If it’s a good deal, nobody redeems because the value of the transaction exceeds the trust account. And those who are planning to practice pre-merger SPAC arbitrage will have sold to someone who wants to own that stock. Gore’s brothers have traditionally done good deals. Good’s Potato Chips is an example of a private company that has been hugely successful as a SPAC. That’s just a cash flow consumer company, right? But you have DraftKings, you have various others. So there are plenty of reasonable companies where they trade above the trust value and people want to own them. Right? The problem is you’ve got a lot of SPACs out there with mediocre sponsors, with misalignments of interest, the need to get a deal done and valuations are high. And at some point there has to be sanity. So high redemptions are really a function of the quality of the deal at the time it’s announced from a perception standpoint.

Clay Finck (41:21):

Let’s transition to talk a little bit about the general market. You seem to be very familiar, in tune with what the Fed’s doing, interest rates and such. So I’m curious to get your general take on the market for the rest of 2022.

David Sherman (41:37):

We’re a bottom up manager. So most of our views on the world are from being in the trenches, looking at what’s happening and then formulating an opinion of what the world is telling us from being a bottom adventure. I am not a Gundlach or a Rosenberg or a Malden or even a Jim Brandt or Jeremy Siegel or any of these financial pundits who really understand top down. And I think it’s important that people recognize their strength and weakness and figure that out. We believe when the Fed said they were going to raise rates that they were, I don’t know. I think it’s probably a pretty safe thing to do. And if I’m wrong, I just underperformed, but believe the Fed, particularly this Fed.

David Sherman (42:14):

So we felt the Fed was going to raise rates. And more importantly, we felt the Fed was committed to trying to de-leverage its balance sheet. We were less comfortable to how much success they would have, but we felt they were committed to that. And we do think that balance sheet has hedge fund like qualities. And I recommend people read Jim Grant’s work on the balance sheet of the Fed. But that said, I was much more concerned about the de-leveraging of the balance sheet than I am the Fed raising Fed fund rates or ultra short term rates, because our rates are already low. We had a yield curve that we felt was going to steep in and it did last year, and we felt now it’s going to flatten a little bit.

David Sherman (42:52):

And the effect on corporate America, which is in pretty good shape and the consumer, which quite frankly currently is in good shape because they can get jobs. They got stimulus checks, et cetera. And yes, I know that half of America is really struggling paycheck to paycheck or worse, but they’re actually better today than they were five, 10 years ago. And this is not a political comment, it’s just a balance sheet comment. So we came into the year with a defensive mindset. And the reason I concern about the Fed de-leveraging was if the Fed stops buying a trillion dollars of securities, fine. So by definition, mortgage backed securities, commercial backed securities, asset backed securities, which is most of their book, right?

David Sherman (43:28):

Those spreads are going to widen because to induce other buyers, which are out there, they got to pay them more spread because the Fed’s the most aggressive buyer. And when your spreads widen out, it doesn’t stop it. Government agencies and investment rates, it flows all the way through, right? Because if I can make more on a triple A, then I need to make more on a double A all the way down the way. And if they raise rates, in theory, you got to get paid more in their cap rate.

David Sherman (43:52):

The reason I was less concerned about sure rates being raised also is it’s a perception thing. Unless it can affect the middle of the curve or the five to ten year or longer, you’re not really affecting valuations, just affecting working capital funding, which changes margins, but not huge. A 1% change in interest rates for somebody who’s using it as a working capital margins not going to affect your aggregate profitability that much, even in high leverage. So it’s the balance sheets. We made that decision to be defensive based on the facts of what we were seeing by the Fed, the facts that in order to have long term inflation, you need wage pressure. We’re not quite sure where that’s going.

David Sherman (44:28):

But we also saw, regardless of what’s happening with Russia, right, the continued and increasing tension between the United States and China, Taiwan is a target of China no matter what. Our view is, if you think the Ukraine situation is something that’s difficult to deal with, we have to start thinking about how that’s all going to unfold, because I think China has said that they’re taking over Taiwan, that it’s theirs. I don’t want to argue the merits of that or not. China’s been pretty good about following their words. Unless there’s regime change at China from the people themselves, I think we have to assume that at some point, either coercively or voluntarily, Taiwan is going to end up more and more apart of China. And that’s not such an issue except that we have a lot of semiconductor manufacturing, various other things that’s going to bring prices to go up and sourcing here.

Clay Finck (45:21):

Final question before I give you a handoff. I just pulled up the treasury rates here on March 23rd. I see the two year rate today is 2.15% and the 10 year rates 2.37%. With the two year, the rate is accelerating rapidly, meaning the bond holders are selling off those treasuries. Is an inverted yield curve where these rates cross something that you’re keeping your eye on? Or is there anything else you’re watching to see, okay, the Fed is not going to be able to continue to unwind?

David Sherman (45:54):

So there are a couple things. First of all, I think the market is ahead and has been ahead of the Fed’s movements. And I think the market’s very, very worried about the large increases in prices. And there’s no question, even the bearish oriented people were taken by surprise that the large amount of reaction from the two year and one year part of the curve. And I think there’s a Bloomberg article that came out last night and said this is the biggest bond route, fixed income route there’s been in the history of fixed income. And I think they’re really talking about the short end of the curve by the way. And I think unfortunately, a lot of people parked money as a haven of safety, right? Because the stock market had run so much. And there are even the people that have permanently parked it there because they’re still recovering from either ’08 or COVID, right, that people are really feeling pain. And ultimately the loss aversion sets in and people decide they’re going to sell.

David Sherman (46:45):

What’s concerning is not an inverted yield curve. What’s concerning is I haven’t seen a capitulation trait, right? So I think SPACs are a great way of measuring capitulation. The SPAC market’s sideways, call it flat. Maybe it’s down a little, but call it flat, since the end of October, actually. Yet the yield as an asset class has gone up, so their yield’s gone up. They’re relatively flat. Now they’re short date of duration. That’s a pretty good defensive outcome in earning more yield. What you would see in the capitulation trait is where there’s a tap on the shoulder, you would see that yield really blow out. You’d see prices, et cetera. You haven’t seen that. You haven’t seen a capitulation.

David Sherman (47:19):

There’s been huge outflows in high yield, primarily driven through the ETF, HYG and JNK. Some in the mutual fund world, but there’s been more out of the ETFs than out of the mutual funds. Again, you haven’t seen the capitulation trade. It’s been relatively ordered, yes. Bid ask spreads have widened a little, spreads the treasury are down, high yield’s certainly down, but it’s been very orderly and you haven’t seen that. In fact, I think HYG has probably got a greater yield to worse in yield of maturity than the cash market, meaning the underlying securities of that. You have a disparity, which shows more pressure on outflows than the actual securities themselves, but you haven’t seen it.

David Sherman (47:56):

So I’m more concerned about where are we in that capitulation trade because I want to be a liquidity provider. I want when people need money, we’re waiting on the silence providing. In the meantime, we are picking away. Inverted yield curve, we’ll see. I am not a believer that the Fed’s going to successfully deleverage its balance sheet and simultaneously do five raises. And the other question is how big are the raises? I think they’re committed to try to do a shock and awe, but not so much the stock market goes cratering, the fixed income market goes cratering. So it’s more talk shock and awe and then [inaudible 00:48:30] based on the market’s reaction. Then the market is up. The [inaudible 00:48:32] up a hundred basis points since the end of the year or more, right? That means the Fed can raise a hundred basis points just to get even where it is.

David Sherman (48:39):

And remember until the Fed does it, you’re rolling down the curve, right? Your two year maturity becomes an 18 month maturity, becomes a one year maturity. So I do think we’ll get a flattening yield curve. I’m not so concerned about an inverted yield curve. Most inverted yield curves are associated with recessions. That actually isn’t always the case. Bank America came out with something that they said until high yield spreads are 600 basis points or more, there’s no indicative of a recession. I would argue by the time it gets to 600 basis points, you’ve missed the foreshadowing, but I think we’re going to get a lot of volatility.

David Sherman (49:08):

I think that what I would advise investors, whether it’s equity, it’s pre-merger SPACs, it’s high yield, it’s Bitcoin, which I don’t know how to think about, I’m just too old. But whatever you do, I have the following recommendations that I think are tried and true is first, know thy self, know what you know, and know what you don’t know. Two, be disciplined and stick to your discipline, forget FOMO. Right? And also that’ll prevent you from avoiding loss aversion because you’ll feel good. I mean, I’ve often said to people, I don’t know how much money I’m going to make and how long it’s going to take, but I know I’m going to make money because it’s a good investment. Right? A good investment is a good investment, right? What you can’t measure is tying and return. But if it’s good, it’s good. And when it’s bad, you got to recognize early.

David Sherman (49:47):

Two, invest in what you know, right? Those are the three most important things. And view market volatility as an opportunity to exit and to buy. But I don’t know how long you can count on a Fed put and I want to be clear about that. So don’t focus on the technicals, focus on the fundamentals. I think that’s really, really important and have a longer term view. I think it’s important. Look, the best example I can give is I don’t invest in venture capital myself because I don’t know what to do. I have allocated some family money to venture capital firms. I don’t pick it myself because I don’t know where’s it going. I’ve done it because I have a fundamental long term belief that we’re in the beginning of a huge technological revolution, both in healthcare, in quality of life products, productivity, nothing like what we saw on the internet. I mean, I think it’s going to be bounds above that.

David Sherman (50:31):

I’m not recommending the Ark investment portfolio per se, but I have allocated to some venture capitals. I stopped allocating to those funds several years ago because I thought valuations got stupid. Right? So why would I allocate somebody who’s now getting fresh money to invest in bad valuations? But I did several years ago and I have the … one of the manager says to me, did you read my letter? I’m like, no. He goes, well, do you read my letters? I’m like, I never read your letters. He said, but you’re an investor in the fund. Don’t you want to know what we own? I said, no. He said, what do you mean? You can learn from it. I said, I can’t. I said, you’re a professional. You’re a venture capitalist. I gave you money. When can I get my money back? He said, when I send it back to you. I said, exactly.

David Sherman (51:11):

So in the next five to 10 years, I’ll know how we did based on how much you send back to me. And otherwise, I can’t do anything. I can’t get my money back sooner. I can’t make a decision, right? It’s not like, oh, I can sell you. I’m stuck with you. I made that decision already. So reading your letters, it’s just going to take time and clutter my brain and I already have enough clutter. Right? I need to focus on what I know. So I leave that story to try to help your listeners.

Clay Finck (51:37):

David, thank you so much for coming onto the Millennial Investing Podcast. This was such an informative conversation. So I really appreciate you being so generous with your time for our audience. Before we close out the episode work, where can the audience go to connect with you and CrossingBridge?

David Sherman (51:52):

So you can go to our website. You can just type in the word Crossing Bridge Funds and Google will take you to the number one thing. You can go to crossingbridgefunds.com. You can go to cohanzick.com, which is the parent company of Crossing Bridge, which also manages money, but not necessarily their … so they’re owned, but Crossing Bridge Funds. You can do a Google search, David Sherman, Cohanzick, David Sherman, Crossing Bridge. You can call us, (914) 741-9600 (914) 741-9600. Hey, email me. If I don’t know the answer, I’m going to say, I don’t know. You’ll get a response within a couple days. Email me, David, D-A-V-I-D, it’s not that hard @crossingbridge.com, or david@cohanzick.com, which is my primary email, C-O-H-A-N-Z-I-C-K.com. You’ll find us, it won’t be a problem.

Clay Finck (52:40):

Awesome. Thanks again, David. We’ll be sure to link all those in the show notes. All right. I hope you enjoyed today’s episode. Please go ahead and follow us on your favorite podcast app so you can get these episodes delivered automatically. If you’ve been enjoying the podcast, we would really appreciate it if you left us a rating or review on the podcast app you’re on. This will really help us in the search algorithm so others can discover the show as well. And if you haven’t already done so, be sure to check out our website, theinvestorspodcast.com. There you will find all of our episode, some educational resources, as well as our TIP finance tool that Robert and I use to manage our own stock portfolios. And with that, we’ll see you again next time.

Outro (53:21):

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