Q&A: Rotation Capital's Rothfleisch On SPAC 2.0

Aug 11 2017 | 7:43pm ET

Editor’s note: Corporate actions have long been a staple of event-driven investors, but activity levels can rise and fall with the credit cycle and make late-stage investing more daunting. Indeed, notes Rotation Capital CEO Matt Rothfleisch, “winter is coming”…and investors should adapt to incipient changes in market conditions accordingly. We recently caught up with Matt to hear his thoughts on investment approach, the revitalized SPAC market, opportunities in distressed instruments, and the general market outlook.   

FINalternatives: Can you tell us a bit about Rotation’s investment strategy?

Rothfleisch: We are fundamental, value investors at our core with an ability to navigate corporate action events through multiple product trade construction.  Rotation Capital looks for situations with identifiable catalysts, optionality and real assets where operational improvements and balance sheet transformation can drive value. 

We take a proactive, leadership role in our investments and partner with management to facilitate a positive outcome.  This skillset has been accumulated over many years and can be applied across all of the areas in which we invest.  Rotation specifically focuses on events such as Restructurings, Recapitalizations, Debt Exchanges, M&A, Tenders, Litigations, Liquidations, SPACs and Capital Structure Arbitrage.   

Where are you finding the most opportunities? 

Recently, we have been generating quite a bit of alpha from investments in SPACs, both the equity and warrant components.  I strongly believe that traditional SPAC buyers have historically done little fundamental work on the proposed acquisition targets and repeatedly leave money on the table as they exit situations.  They perceive their warrant PNL as “found money” when a transaction successfully closes because they were granted that instrument for free at the time of the IPO. Our ability to layer on a fundamental view and take positions in situations that are ignored by the original investor base has proven successful time and again. 

Unlike traditional risk arbitrage that depends on handicapping regulatory risk, our ability to predict whether a SPAC transaction will close or be successful is more dependent upon our capital markets expertise and our barometer for market acceptance and value. 

We are also finding select opportunities in distressed, where we can take a proactive role in the process and structure the transaction to influence the outcome.  However, this area of our portfolio remains less than 20% of our gross exposure due to the overall strength of credit.  Because of this dynamic, we have recently increased our synthetic put allocation in Capital Structure Arbitrage to 40% in order to protect the portfolio in a downturn and participate in potential credit events with less directional exposure. 

What are SPACs? 

The term stands for Special Purpose Acquisition Company. They are “blank check” investment vehicles that enable a management team to raise capital via an IPO with the purpose of subsequently acquiring an operating company.  The vehicle has no commercial operations until it effects a “business combination” (merger/acquisition of an operating business), after which the target business becomes a publicly traded entity (similar to a reverse merger).

So SPACs are back? 

Yes, we believe this is SPAC 2.0.  Post the financial crisis, SPACs have addressed many historical inefficiencies, making the product more attractive to sponsors, investors and target companies. 

As a result of “building a better mousetrap,” the amount of issuance has increased along with the quality of the sponsors bringing transactions and subsequent performance of the deals. Previously, the asset class had some taint due to the structural flaws that were in place pre-crisis. This old perception created an aversion for new entrants, creating what we believe is an under-followed opportunity for us to exploit.

What are the advantages of SPAC 2.0?  

In SPAC 2.0 the minimum voting thresholds for deal approval have been changed, allowing for transactions to be completed with effectively no shareholder vote.  This dynamic allows investors to vote “yes” but still redeem their shares to the trust.  Hedge funds can no longer practice “greenmail,” forming voting blocks to hold up transactions and force concessions.  

Additionally, the amount of warrants issued and their respective strike prices significantly reduces dilution to potential target companies versus the past structure. Sponsors are now “top tier” with proprietary deal sourcing and operating capabilities and are structurally locked-up for longer in the new configuration. Finally, the timeframe for finding deals has been shortened  from up to 30 months to 18-24 months, while the proceeds held in trust now account for 100% of the proceeds versus lower percentages in earlier deals.

Where are we in the credit cycle?

I believe we are in the late innings of the credit cycle and that “winter is coming." The overall credit market is not compensating us for the risk.  Credit has rallied significantly from the bottom, absolute yields are unattractive, volatility remains muted, credit curves are flat and defaults away from specific sectors are non-existent.  Wide-open capital markets have “kicked the can” for many companies and issuers are now once again able to push the boundaries of structure though dividend transactions and covenant light deals.  

Against this backdrop, we are very light in our long credit exposure and will remain opportunistic when these names finally crack in order to purchase distressed longs.  In the interim, we are dramatically increasing our Capital Structure Arbitrage exposure to reflect this negative bias.  These trades initially behave like synthetic puts, but during periods of dislocation, distress and increased volatility, we can monetize our short positions and use our lower-priced senior exposures to gain a seat at the restructuring table.

Are you seeing many distressed situations? 

In every market, there are always distressed situations.  But unlike 2008, when you could take a shotgun approach because there were so many opportunities, today we need to be very selective.  Today’s distressed companies are in cyclical or unfavorable industries that are facing swift secular change.  

Additionally, with capital markets wide-open, those that can’t refinance are stuck there for a reason.  Unlike past cycles, when good companies with over-leveraged balance sheets needed relief, some of today’s distressed companies might not have a reason to exist.  This is particularly true in retail, which could face very low recovery values.  We tend to gravitate towards industrial situations with real assets.  

Can you give an example of a recent distressed situation? 

In June, we completed an out-of-court restructuring of a trucking company that hauls cars to dealerships and ports. We were influential in creating the consensual outcome with bondholders and the owners/management. We were members of the Steering Committee that negotiated all aspects of the transaction, which resulted in a good outcome for the entire class. 

 What do you see as the current market opportunity set? 

We have deployed dollars implementing a barbell approach in SPACs and middle-market distressed.   This allows us to participate in the wings of equity exuberance with less risk while picking our best few horses in credit on the other side.  In the middle, we are trading events that happen in all market cycles and adding to our capital structure arbitrage book and fundamental short book to protect in a downturn.  

Our SPAC book continues to be a major source of alpha for the fund and allows us to participate in open financing markets, a robust M&A environment and equity markets pushing highs, while partially protecting our downside through the structure.  Since the credit market isn’t giving it to us, we won’t chase overpriced situations for the sake of deploying assets in the space.  I believe overall credit risk is currently asymmetric and we are not getting compensated for the generic risk both by rating category and overall leverage.   It is time to be selective, but we are finding ways to make money.

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