Capital Structure Arbitrage

When a company has more than one tradeable share class (e.g. additional nonvoting common share class or preferred shares) it is usual for a certain discount to exist among the classes. There might be various reasons for that – a voting benefit of voting shares, liquidation preference of the preferred stock, or the difference in free-float/liquidity/inclusion in major indices. Over the years this discount settles into a certain average and sometimes due to unexpected events (e.g. market crisis) or some untraceable reasons, the discount widens significantly. Such situations offer a play on the capital structure arbitrage.

Sometimes this opportunity may also be induced by a clear corporate event. For example:

  • The share price of a recently SPAC-listed, controversial company skyrockets, and substantial uncertainty remains regarding the future performance of its stock (high risk of bubble burst). These dynamics may create a price discrepancy between its stock price and warrants. Hyped-up stocks usually have a very limited and expensive borrow, however, there might be a possibility for a synthetic short (options play). Due to high volatility, unhedged trade is extremely risky and speculative.
  • For certain reasons (e.g. to simplify capital structure) a company intends to eliminate all of its outstanding warrants and offers to exchange them into stock or cash. This provides a rather straightforward arbitrage opportunity for a hedged trade. Unhedged position is also possible (longing warrants only), however, it offers much greater risk due to common stock volatility. Dilution plays a big role here – the more common shares are expected to be issued, the higher the risk of post-transaction sell-off. It is important to get a picture of the company’s background and financial condition to understand why is the offer being done and how likely further dilution is.
  • Overall, hedged trade involves borrow-related risks – fee increases/potential short squeeze/early option exercise (for synthetic short) and also higher potential loss in case the transaction is terminated (can get burned from both sides). Unhedged position is exposed to the common share price changes – the upside can get eliminated even before the transaction is closed, while post-closing sell-off is also a risk here.

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