“Don’t get high on your own supply”
- Elvira Hancock, Scarface
There is an old Russian joke that tells of a peasant that owns one cow who hates his neighbor because he owns two. One day, the peasant happens across a sorcerer, who tells the peasant he will be granted a single wish. Anything he desires. His wish? “Kill one of my neighbor’s cows.”
FOMO, or “Fear Of Missing Out,” is a real thing for many people, and we’ve had plenty of opportunity over the past several years to miss out while hordes of imbeciles generate vast, if fleeting, paper wealth in bubbles ranging from crypto tokens and ICOs, to fake meat and, of course, cannabis stocks.
While I get no joy out of seeing people lose a cow, or money, wouldn’t it be nice have a way to participate in some of the silliness without risking much, if any, of your capital? Wouldn’t it be nice to unload some grotesquely overvalued paper onto greedy saps without having to bear the risks of short-selling or becoming a venture capitalist? What if I told you there was a way for you to participate in the cannabis sector, have a shot as a sizeable gain, and the downside is that you get your money back with interest and, at your option with some modest risk, retain a sizeable long-term option on the opportunity on the off chance it doesn’t eventually collapse?
Most people aren’t familiar with SPACs, or "Special Purpose Acquisition Companies." Those that are familiar generally look at them as either pure low-return / low-risk arbitrage opportunities, or as a way for generally sketchy companies to go public without the rigors of a proper IPO underwriting process or having to deal with a private equity overlord. Please withhold your judgement for now.
Crash Course on SPACs
A SPAC is a publicly listed shell company that raises a pile of cash and then has a period of time (e.g., 24-36 months) to use that money to go and find an operating business to acquire or with which to merge (a “qualifying transaction,” or “QT,” if you want to impress your friends).
SPAC transactions have several unique features, the most common of which are:
- Gross SPAC IPO proceeds are placed in an interest-bearing trust account.
- Underwriters defer 50% or more of their fee, and the cash portion is funded by the sponsor/creator of the SPAC, as are the expenses of locating a target.
- Public SPAC investors receive a unit consisting of a share plus a half or full warrant, with the warrant typically exercisable for 5 years following the completion of the qualifying transaction, with exercise price modestly above the IPO price (115% is common).
- When the SPAC sponsor finds a proposed qualifying transaction, investors individually get to decide if they want to stay in the deal or get all of their money back plus interest from the trust account. Often, they can even vote in favor of the transaction but still redeem.
- Whether or not investors redeem out of the SPAC, with interest, they often get to keep the warrants. (Important: This is not the case in this opportunity, which has pros and cons.)
For a SPAC IPO investor, the real “downside” to the transaction is that the modest interest you earn for the duration of the SPAC is your return, and the warrant becomes worthless either because of the redemption (if the warrants and stock do not separate before the QT), the QT never happens or, like many SPACs, the QT is with a subpar business and the stock eventually goes in the tank.
If it’s not obvious from the above, SPACs are very attractive vehicle for arbitrageurs, particularly arbitrage hedge funds. Such investors will buy into a SPAC IPO, and if possible, look to dump the SPAC shares while keeping the warrant, or more commonly, wait until a QT is announced and either unload the stock above the redemption value (cash + accumulated interest) or simply redeem. They will either keep the warrant as a long-term option or monetize it, as the warrants are usually separately listed securities (pre or post-QT).
Sponsors, of course, have a love-hate relationship with the arbs. On the one hand, they provide a large chunk of many SPAC IPO proceeds. On the other hand, they are soulless, heartless, cold-blooded investors that usually have no interest in bearing any risk and staying in past the qualifying transaction.
This tension puts pressure on sponsors to place as much stock as possible with non-arbs (let’s call them “saps” for now so we don’t get confused), find attractive deals at good prices (an oxymoron these days) or have enough sizzle to attract enough new saps into the name before the redemption date in order to take out the arbs, and to sometimes arrange backstop financing so deals don’t fail. Given sponsors underwrite the upfront costs of a SPAC, they are out real money should it fail.
It should also be mentioned that the economic reason sponsors do SPACs is that they receive a chunk of the post-QT company with a carried interest that is outsized versus their cash investment. In some cases, like today's opportunity, the sponsor is also an investment bank that is no doubt drooling over potential future trading and investment banking revenue.
The SPAC market is always changing and evolving. Previously, these blind pools would go out with a broad mandate and often come back near the end of the target search period with some trashco that private equity balked at but has existing shareholders that want the hell out or at least have a path to liquidity. One of the more interesting recent developments is that some SPACs are becoming more sector-focused. Some savvy sponsors have identified that raising SPACs dedicated to a bubble sector flooded with retail investors and silly institutions is a great way to both make a relatively easy buck and maximize the chance of attracting saps to a QT to avoid “arbitrage hell”, where 98% of investors redeem out of your janky deal and leave you holding the bag for the expenses.
The crypto market would have been SPAC-worthy had it not been for the fact that anyone could easily blow his or her brains out directly buying “coins” and other strings of code while railing against “the system” of which public stock exchanges were a part.
Not so with cannabis. It’s perfect. Due to legalization in Canada and elsewhere, including several U.S. states, an open-ended growth narrative can be spun. Everyone knows at least a few potheads, so the market is large - it just needs to come in from the black market. And a little snake, errr, CBD oil is the medicine of the future. Despite this, cannabis opportunities are relatively hard to access outside of a handful of expensive and extremely volatile public companies, particularly given it is still illegal federally in the U.S., and with the U.S. investment banks largely on the sidelines.
Canaccord Genuity, an investment bank based in Toronto, launched its first SPAC IPO (Ticker now OTC:CCHWF) a year ago in August 2018. Canaccord Genuity Growth Corp. began trading (as the blind pool) on September 20, 2018, and stayed near the $3.00 issue price in the days and weeks that followed. As one of the most active underwriters and public and private placement agents in the space, it’s not surprising that the company announced its qualifying transaction quickly, and on October 17 announced its QT, a merger with Columbia Care, a U.S.-licensed medical cannabis company.
Interestingly, the SPAC shares melted up on the mere announcement of the QT, which is not common in the SPAC world. Saps secured.
Investors in the IPO at $3.00 per unit saw a near-70% gain in a matter of weeks, and the one-day gain on the QT announcement was nearly 60%. About 2 million shares traded hands in the two days following the announcement, about 15% of the shares outstanding, and by the time the transaction closed in April 2019, it sailed through (why redeem at $3-plus interest when you can dump stock at $5+?)
The post-QT performance hasn’t been as good (note a 3:1 consolidation):
However, the above post-QT chart excludes the warrants that are still listed and trading for $0.57 per 1/3 of a warrant, or about $1.71 equivalent per full warrant:
Turns out a Black-Scholes valuation with a 5-year expiry on a volatile weed stock kicks out a pretty healthy number.
This brings us to the current opportunity. Canaccord has issued a second SPAC, Canaccord Genuity Growth II Corp. (NEO: CGGZ-U), using a similar playbook to the prior SPAC - a $3.00 unit issue price, with each unit consisting of one share and one-half warrant with a 5-year term and a $3.45 exercise price.
It is important to note that the shares and warrants will trade as a unit until completion of the QT. While this reduces the pure arbitrage opportunity to strip the warrants and then redeem for cash plus interest (something I am fond of doing in other SPAC deals), it increases the likelihood of the QT being approved and makes the unit more attractive to potential saps. It is also more likely that the IPO was placed with real, Kool-Aid-drinking cannabis investors.
After an initial run to $3.50, the shares have now drifted back down to just below issue price, likely a result of recent market angst.
It’s estimated that about $3.08 (likely around $3.02 today) will be available in the trust account at the latest redemption date, which is about 19 months away. With shares at $2.98, a ~3.0% return over that period isn’t that great, but is at least in line with the risk-free interest rate and, barring fraud or societal collapse, this is a risk-free return.
However, much more likely is Canaccord announcing a qualifying transaction in the near term to capitalize on the still foamy cannabis market. Recall, its prior SPAC took only about a month, whereas we are about 5 months into this one. A slightly less frothy market for cannabis stocks may not even be a bad thing, as it means private cannabis companies that might be temporarily shut out of the cannabis market and require capital may be more attractively priced, and need the ~$75 million USD equivalent sitting on CGGZ-U’s balance sheet.
(Source: Company filings on SEDAR)
I see a couple of interesting ways to play this.
First, it’s possible that, like last time, the announcement of a qualifying transaction spikes the shares in the SPAC, allowing you to unload some - or all - of your position at a profit (potentially a sizeable one). A similar opportunity was written up by Seeking Alpha contributor Dan Stringer on Social Capital, found here, which has just announced a QT with Virgin Galactic.
Second, assuming the QT is reasonably well-received, you could take on some risk and wait for the QT to close and the warrants and shares to separate. This would allow you to take as much risk off the table as you chose, depending on your view of how each instrument is being priced by the market.
Post closing, I estimate each unit’s half-warrant could be worth $0.40 (per unit) or so, using a mid-30s implied volatility and no price appreciation, although presumably the shares will drop from whatever price they are trading (as in an ex-dividend scenario) by some amount, but you are paying zero for this post-transaction option at the moment.
As Canaccord is one of the most active banks in the space, no doubt it will do everything in its power to put the right deal into this SPAC, as it will want to do further SPACs, in which it can double-dip as sponsor and underwriter, but also triple-dip in raising follow-on capital for whatever it dumps into this thing. I can smell the “Strong Buy” rating from here.
While it could take longer, I expect a QT to be announced in reasonably short order, so view this as an very attractive call option on a potential announcement pop (like the prior Canaccord SPAC), or possibly an attractive way to enter a cannabis investment in a risk-managed way if you actually like the deal, while earning a T-bill-like return while you wait.
Disclosure: I am/we are long CGGZ-U. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This article represents my personal opinions only. It is not a recommendation to buy, sell, short, hold, or avoid any security. It should not be relied upon for any purpose other than entertainment. Numbers and analysis presented have not been proof-read or independently verified. I do not consider myself a pothead. Despite my best efforts I make mistakes. I do get it wrong sometimes. I welcome comments and corrections. Do not assume I will update or comment further on a name. Always consult a financial advisor. Better yet, buy an index fund.