Warrant Arbitrage
#133: On Kickers and Screamers.
The Great SPAC Boom of 2020/2021 ushered hundreds of companies to the public markets through the backdoor. To little surprise, most of these companies incinerated value, leaving the tattered dreams of shareholders in their wake. But the rise of SPACs also brought a new class of security to prominence: publicly traded equity warrants.
Warrants — similar to call options — are not new, but traditionally, they have been limited to niche industries, private deals, or packaged as a part of a structured financing. Publicly traded warrants were relatively rare. SPACs changed the landscape by standardizing terms, raising liquidity and awareness, and bringing hundreds of these new securities to the market. Many continue to trade today.
This year as I’ve explored the SPAC universe, searching for Gems in the Junkyard, I’ve become intrigued by these strange little hybrid securities. How do they trade in practice? How can their leverage be utilized? Do arbitrage opportunities exist?
In this 133rd installment of The Last Bear Standing, I dive into the world of warrants.
Background
In a typical SPAC IPO structure, the initial public investors are granted some number of warrants along with the common shares. Warrants are effectively free out-of-the-money (OTM) call options on the common shares which become exercisable after the SPAC has completed a merger with the target company. Providing warrants helps induce initial investors to put up capital for the blank check offering.
In polite parlance, we might describe these warrants as a “promote”. More casually we might call them equity kickers. Regardless of the verbiage, if the common share price rises above a certain threshold the warrant holders benefit at the expense of dilution to post-IPO common shareholders. The actual dilution will vary depending on the number of warrants offered, the capital structure of the merger, PIPE terms, and so forth. But the terms of SPAC warrants are fairly consistent:
$11.50 strike price (15% over the $10.00 SPAC IPO price)
“Detachable” and separately traded 52 days after the SPAC IPO
5-year expiration after the completion of a successful merger
Company can force redemption if the common stock trades over $18 for 30 days
These warrants are a lot like call options. Their value will vary with the underlying share price, time to expiry, and implied volatility. But there are some key distinctions.
First, rather than a derivative contract, this is a direct equity obligation of the company. Your counterparty is the company, not an options dealer like Citadel. If the warrants are exercised, new shares are issued by the company and the company may receive net proceeds depending on the exercise terms1. Warrant valuations will also impact the P&L of the company.
Second, warrants trade on equity exchanges like the NYSE or NASDAQ under their own ticker symbol, while options trade on derivative exchanges like the CBOE. Often the warrant ticker simply adds a “W” or “/W” to the company’s ticker (i.e. common stock ticker ABC may have its warrants trade as ABCW or ABC/W). This different venue impacts liquidity, bid-ask spreads, trading participants, and pricing efficiency.
Third, the company’s redemption rights can force an early exercise of the warrants, whereas call options have “unlimited” upside through expiry. While the warrant value is not “capped”, the redemption clause can shorten the duration of the security and eliminate its option value.
Finally, the initial 5-year duration of the warrants is typically much longer than the options contract available for small-cap stocks.
Together, these distinctions impact the practical trading of warrants and at times can breed opportunity.