East Stone Acquisition (ESSC) – Options Trade – 100% Upside

Current Price: $0.45

Expected Price: $0

Upside: 100%

Expiration Date: 21st of January 2022

 

This is idea involves selling OTM put options on SPAC with the exercise price below trust value. The bet will pay off if SPAC transaction does not close over the next month. Selling options is very risky and this is not investment advice. Do your own diligence before investing.

East Stone Acquisition is a SPAC that has already signed a definitive agreement with the target. In the recent vote to extend the business consummation deadline by three months (till the 24th of Feb) 97% of shareholders (except for backstop parties) have chosen to redeem leaving the free-float at barely 5% of the outstanding shares. Market cap is under $100m making it a perfect set-up for short/gamma squeeze that started this Monday (13th of Dec). Yesterday’s shares reached a peak of $26/share and then dropped back considerably. This volatility increased ESSC options liquidity, opening up opportunities for various trades.

One of the possibilities is selling January $10 puts. Trust value stands at $10.26 vs current ESSC price at $14.00. If there is no vote on the transaction by the option expiration date (21st of Jan), ESSC will likely continue to trade at or above trust value and put sellers will pocket the whole premium. However, in the unlikely event that the meeting to vote on the transaction happens till then, losses on this trade are likely to be considerable.

ESSC Jan’22 $10 put option price history:

Our previous options trade idea ended well (see here – AMC), however, it was a slightly different bet, albeit also on meme stock. Might turn out less favourably this time.

The Squeeze

Before the recent deadline extension vote, ESSC has traded close to its trust value at around $10.2/share. Shares started appreciating in Dec as investors started noticing very low remaining free float (free float should be around 0.4m shares) and then stock’s popularity blew up this week. ESSC started squeezing on Monday (+33% during the day) and continued upwards yesterday (another +41% at the peak yesterday).

With the increased popularity and such minuscule float, it’s quite likely that ESSC will continue to be very volatile for at least a few more weeks and continue to trade substantially above the trust value.

 

The Main Risk

The only real risk to the Jan $10 put option bet is the shareholder meeting taking place before the option expiration, the 21st of January. In this case the downside support by the trust value ($10.26/share) would disappear and ESSC might decline considerably given investor skepticism re the planned transaction. Just the announcement of the meeting date will likely be sufficient to drive up put option premiums.

The meeting date hasn’t been announced yet and with the current holiday season ahead, the chance of management finalizing the deal before the options expire seems to be minimal. Moreover, the last meeting was announced almost a month in advance – the 22nd of October, while the meeting that was supposed to be held on the 18th of November (was later adjourned). According to the bylaws, the minimum notice period is 10 days, making the 11th of January the cut off date for this trade.

The merger process itself has already taken much longer than initially expected (announced in Feb’21). The company has already extended the merger deadline 3 times providing limited explanations for the delays (see background below). If management expected to close the transaction in early January, this would likely had been communicated to minimize shareholder redemptions on the recent extension vote. Instead, the annual report (which came out after the extension) says that closing is expected in Q1 2022:

The Transactions are expected to be completed by the first quarter of 2022

If everything goes well, the same timing risk can actually turn upside down – once it’s clear that transaction won’t close before the 21st of Jan (that should be known on the 11th of Jan or earlier), the premium on $10 strike put options should evaporate pretty much immediately.

 

Background

ESSC SPAC was founded in Jan’20 by Chinese businessmen Sherman Lu (independent director of BOC Internation – Bank of China’s subsidiary) and Charlie Hao. The SPAC was intended to focus on fintech business space in North America and Asia-Pacific with an overall transaction value between $300 million and $1.0 billion.

The merger deadline was set for 15 months, but with the option to make two 3-month extensions. Each adjournment had to come with a $0.10/share extension payment from the sponsor.

ESSC quickly found a target – Ufin Holdings (Chinese digital marketing platform) for EV of $300m. The merger was expected to close in early 2021. Then, in Feb’21 (during the SPAC bubble peak), without any additional announcements for 4 months, the company suddenly released a PR stating that now it is merging with JHD Holdings – online and offline merchant enablement service platform with 90k independent retailers in lower-tier/emerging areas of China. Platform services include point-of-sale, supply chain, and logistics, fintech/payment capability, etc. The deal was valued at $1bn (around 12x+ 2020 revenues). More details can be found in this presentation. JDH financials:

Closing was expected in Q3’21. Thus, and the company made two outside date extensions – one in May and another in August – that were allowed without shareholder approval. The extension payments were covered by the JDH loan to the sponsor and increased trust value to $10.26/share.

The conditions included ESSC shareholder approval, regulatory and SEC consents, and ESSC having not less than $110m in its trust value (had $141m initially), counting also some additional funds besides Trust assets. So far, nothing has been mentioned with regards to regulatory approvals so these might still be outstanding as well (the recent annual report has the same copy-pasted text as before).

In October, the company announced a shareholder meeting to amend the bylaws in order to allow for another 3-month to consummate the transaction. Again, limited details were provided for the reasons behind the delays. Clearly, management was expecting huge redemptions as right before the meeting it made a backstopping agreement with certain backstop parties to hold on to 2.9m shares and not redeem these. Backstopping parties agreed to hold the shares for a certain period after the merger closing and will be able to sell them back to the sponsor for $10.41/share (or in the open market above $10.26). For this favor sponsor will transfer additional 400k shares ($4m!!) to backstop parties.

Before the latest vote, ESSC had 17.7m outstanding shares out of which 4.3m belonged to management and 0.1m to bankers. At the meeting, a total of 10.5m shares were redeemed. So the company has around 7.2m shares left with almost all of these in the hands of sponsor and backstop parties.

17 COMMENTS

    1. dt

      Had looked at this, but seems like premiums on calls are too small to offset the risk of ESSC common falling sharply after the meeting.

  1. g4734g

    I am in this trade but for the December strike…….Many high flying spacs are now at 6 or 7 or 8 or lower now that the floor has been removed (PL, RDW)…..ESSC filed SEC Revison 4 30 days ago. Unless there are issues, they are due to announce merger vote any day now……which will likely be scheduled between 10 and 21 days out from the date the SEC deems their filing “effective”….And you don’t have protection up until the merger vote, the redemption expires two days prior. I think the odds are far greater than 50% the meeting is scheduled for Jan 25 or earlier and you get left with no floor if you sell Januarys. The market knows this and that is why there is so much juice in the Jan 10 puts despite the stock trading at 15

    1. dt

      Thanks. Would appreciate it if you elaborated a bit more:
      – Is it really only a matter of SEC deeming the revised proxy effective before ESSC can announce the meeting date?
      – Are the proxies usually made effective within 30 days after filing if there are no issues?

      Fully agree that if ESSC announces a meeting date and if the redemption date falls before the Jan expiration date, then this trade is bad idea. We noted this as a key risk.

  2. g4734g

    The whole process averages about 120-160 days……..haven’t seen much shorter than 90-100 and of course if they get sidetracked they can last a year or more, and then fall through. 4th revision is generally the final submission to the SEC and since there have already been 5 back and forths with the SEC, (Definitive agreement, preliminary agreement, rev 1, rev 2 and rev 3) its usually approved within a very short period of time….a few days to a couple of weeks. (the fact that ESSC has not been deemed effective yet, 30 days after their rev 4 submission, does suggest possible complications they are working through)

    Once the proxy is deemed effective, yes, the company can and usually does schedule the vote immediately. They have to allow 10 days notice to shareholders, but 14-21 days is more the norm

  3. g4734g

    ESSC certainly has taken longer than average, sitting at 300 days, most likely due to increased scrutiny from the SEC because of the China connection.

  4. dt

    After further research, I continue to think the process will take much longer and a new preliminary proxy will need to be filed before the SEC review. SEC might still reject this due to forward purchase agreements with the backstop parties. The parties also might still be in negotiation stage as the redemptions were 2x higher than the max redemption allowance indicated in the last preliminary proxy. Please let me know if you think my thoughts below are incorrect.

    The latest preliminary proxy for a business combination is as of 5th of Nov, however:
    – It did not include any information on the backstop parties and forward share purchase agreements which have only been announced only on the 15th of November.
    – It included $110m minimum cash condition (in the Trust as well as other items), which in turn assumed max redemptions of 5.4m shares. In the extension vote a total of 10.5m shares were redeemed. On top of that $30m related to backstop agreements will be placed in escrow and not available for business combination for up to 3 months. So I understand that minimum cash condition cannot be met ($50 shortfall) as it stands in the current agreement. This will, first of all, need to be renegotiated and agreed with the sellers.

    So it seems that the timeline will look like this:
    1) New agreement reached with the ammened minimum cash condition (discussions likely ongoing already since the extension vote) and seller receiving basically zero in cash from this combination with SPAC.
    2) A new preliminary proxy filled;
    3) SEC reviewing the preliminary proxy (more on this below);
    4) Filling of definitive proxy.

    For all of this, the company has only 19 days before the 11th of January – the last day to file definitive proxy in order to have the meeting on the 21st of January, option expiration date.

    When it comes to SEC review, I am really not sure how the commision will look at forward share purchase agreements when basically all the other public shareholders have redeemed their shares and the remaining Trust funds are placed in escrow and not available for business combination (to ensure sufficient cash to redeem backstop parties). These agreements basically do not fit at all with the purpose of SPAC and are a workaround to attempt business combination when all shareholders wanted to be redeemed. If this is allowed, then any SPAC might want to attempt this as long as the selling company agrees with zero cash infusion to become public.

    If you are aware of any precedents where similar forward purchase agreements with escrow lockups were allowed to proceed by SEC, please share.

    3
  5. dt

    A further peculiarity – yesterday Sea Otter Securities (one of the backstop parties) filled 13G showing they only hold 125k shares vs 974k shares before the extension vote. It seems Sea Otter have sold down their position into the market mania. And it seems that backstop agreement allows selling in the open market and only obliges backstop parties to repurchase these shares at TRUST VALUE either from redeemed shares or open market.

    “If, on the day that is three trading days prior to the Business Combination Meeting, the Investors hold fewer than 974,658 Public Shares, the Investors shall purchase Public Shares at trust value, in the first instance in the form of Public Shares tendered for redemption from the Escrow Agent (as defined herein) (the “Business Combination Redeemed Shares”), and if such Business Combination Redeemed Shares are not sufficient to allow the Investors to own at least 974,658 Public Shares, then the Investor shall thereafter purchase Public Shares, at trust value, in the open market, up to a number of Public Shares such that the Investors hold 974,658 Public Shares as of the time of the Business Combination Meeting.”

    https://www.bamsec.com/filing/121390021058878/2?cik=1760683

    Hard to imagine these kinds of speculations by backstop parties at the expense of public SPAC investors will sit well with SEC when approving these forward share purchase agreements.

  6. g4734g

    DT, these are excellent points and do support the argument that this will not be the standard time frame between filing of Revision 4 and meeting date. (as we have already seen with 40 days having elapsed)

    However, the key date for those making this trade is not a Jan 21 or later meeting date, it is a Jan 27th or later meeting date in order to be completely free and clear. If the meeting date were Jan 26, shares put to you on Jan 21 would not be eligible for redemption. Redemption would expire on Jan 24 and there is no guaranteed delivery and your put shares wont settle until Tuesday Jan 25.

    And these dates assume your broker allows you to redeem on the SPAC redemption expiration date which many will not do and others will only do on “best effort basis”.

    In this particular case the buy/write strategy actually has a two day advantage over the put selling strategy as settlement on the shares occurs two days after you put the trade on

    We are still 40 days from Jan 27/28, so too long for me

    1
  7. dt

    Last Friday ESSC published a new preliminary proxy. If I understand correctly, yet another preliminary proxy will need to published as this one still includes the minimum cash condition of $110m which will need to be waived or merger gets terminated.

    “As of the date hereof, the closing condition in the Business Combination Agreement which requires East Stone to have no less than $110,000,000 of cash at Closing has not been satisfied, and unless additional financing, whether in the form of Equity Investments or otherwise, are obtained, then JHD will have the right to waive this closing condition or terminate the Business Combination Agreement.”

    It is not yet clear if JHD is still willing to merge with this zero-cash SPAC. All the company gets is s public listing for 13% ownership dilution. Merger background description ends on the 12th of Nov with the backstop parties agreement. No further discussions/exchanges with JHD have been noted.

    https://www.bamsec.com/filing/121390021065892?cik=1760683

    I continue to think that the timeline (further discussions with JHD, another preliminary proxy, SEC review, definitive proxy and shareholder meeting) is too tight for the meeting to happen at the end of January.

  8. dt

    I have received a couple of questions regarding our newsletter update on ESSC where we noted “with the stock trading much closer to trust value than at the time of writing, covered call trades also provide similar upside with less risk.”

    Wanted to add some further color why I think selling covered calls now presents lower risk than selling puts.

    I do not think that put and call premiums will follow the same path if the redemption date happens before the option expiration (less and less likely with every passing day).

    My expectation is for put premiums to skyrocket in anticipation of stock falling down after the redemption date (when the trust value support of $10.26 becomes irrelevant). This is a big risk of selling ESSC put options. The same dynamics do not apply for selling calls. One might expect another short squeeze in the days between redemption deadline and option expiration but it is a very low likelihood event – much less likely than ESSC dropping below trust value after the redemption deadline.

    1
  9. mikekyddd

    But the question remains WHY? You are stating and repeating a conclusion–“The same dynamics do not apply for selling calls”– without explaining WHY you believe vol. will get out of line. I contend it will not get too far out of line as the conversion/reversal (I still cant keep them straight) rarely trades for more than a dime.
    I do agree the meeting is unlikely to get announced and obviously the option market now agrees.

    1. dt

      Dynamic for puts and calls will be different primarily because of the elimination of trust value support.

      Imagine it becomes clear today that the redemption date will happen before the option expiration. Even if the stock price stays at the same levels put premiums will shoot up as the floor of $10.26 has been removed. You do not have this risk with buy/write calls – if ESSC stocks stays at the same levels call premiums should not be affected by much by the announcement.

  10. g4734g

    As a reminder the buy/write has a two day advantage over the outright put sell strategy……You cant tender unsettled shares regardless who your broker is….actually you can, they just get returned to you the morning after you try and tender. I have been caught twice by a surprise where my ability to tender expired prior to option expiration. it is not fun….the IV on both the calls and puts skyrocket and premiums follow.

    I have entered this trade on the buy write strategy and as I think there is “double protection” now….(although no guarantee) One, the price is now over 12 a share and two, we are witching a 3 week window of option ex and there is holiday in there which may or may not impact the scheduling of the meeting…Technically they could schedule the vote as little as 10 days from the date the proxy is deemed “effective”, but it is more customary to be closer to 3 weeks.

  11. dt

    We are closing ESSC options trade – while I still think meeting/redemption get delayed beyond this month and the put options (Jan $10) will expire worthless, the options now trade at $0.1 vs $0.45 at the time of the write-up and the small remaining upside is not worth the risk. Booking 80% gain in 3 weeks on this case.

    As for covered calls, at the time we noted it (30th of Dec) the stock was at $10.8 and calls (Jan $12.5) traded at $0.55. – i.e. it was possible to create ESSC at trust value with no downside risk on the position if options expire before the redemption date. Subsequent to the squeeze over the last few days, the stock is at $12.93 and options at $2.00, resulting in net gain of $0.68/share. So we are pocketing these gains and closing this position well.

    Further trading opportunities on ESSC might reappear down the line.

    1
  12. dt

    For anyone still following, ESSC filled another revised proxy and minimum cash condition still has not been waived, putting this merger at real risk. Nevertheless, ESSC price option premiums are again at elevated levels.

    “As of the date hereof, the closing condition in the Business Combination Agreement which requires East Stone to have no less than $110,000,000 of cash at Closing has not been satisfied, and unless additional financing, whether in the form of Equity Investments or otherwise, are obtained, then JHD will have the right to either waive this closing condition or terminate the Business Combination Agreement. As of the date hereof, East Stone has not received such commitments for additional financing sources or an assurance from JHD that it will waive the minimum cash condition, and amounts remaining in the Trust Account, whether or not there are any Redemptions in connection with the Business Combination, will be insufficient to meet this requirement. In the event that this minimum cash condition is not met or otherwise waived, then East Stone may not complete the Business Combination with JHD”

    1
  13. g4734g

    Thanks DT, puts down to zero bid so this looks like its going to work out well….I played the buy/write strategy and that looks good to…..MCMJ just delayed their vote……selling Jan puts is a similar trade to the ESSC trade, although premium at the moment is only 20 cents.

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