Hey Folks!
Let’s take a look at a SPAC that has generated massive interest and buying over the last few weeks. East Stone Acquisition Corp, which is set to take JHD Holdings public is a high redemption SPAC that may see a Gamma Squeeze. While SPAC traders aren’t strangers to high-redemption SPAC plays, what makes ESSC so interesting is that it has a NAV floor is still in place, and one of the lowest free floats on the market after the SPAC made several backstop agreements. Let’s take a closer look at the deal to understand the specifics and the opportunity to profit.
Background About the DealÂ
East Stone Acquisition Corp announced a definitive agreement to merge with China’s merchant enablement services platform JHD Holdings limited, at a $1 billion valuation (subject to certain adjustments for cash and debt). For those unfamiliar, JHD operates in China under the brand name Ji Hui Duo and offers an online and offline merchant enablement services platform in emerging cities in China.
The platform gives merchants a full suite of services and technologies, including point-of-sale, supply chain logistics, and payment capability. Established in 2016, the company’s platform serves over 95,000 independent merchant stores (as of June 30th, 2021). The platform has also enabled 3,000 outlets to become licensed rural financial institutions, enabling banks to extend their brand network to serve most customers.
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Red Flags in the DealÂ
ESSC’s merger with JHD Holdings should ring alarm bells for anyone who has been previously burned by founders looking to cash in through SPACs. The deal exhibit all the symptoms of a bad transaction, including misaligned executive incentives, hefty financial projections coupled with a premium valuation, suspect deal history, and links to China (a key risk considering the recent performance of US Listed Chinese Companies).
CEO Sheman Lu and CFO Charlie Has are set to make more than $30 million once the transaction closes (without incentives being tied to share performance), indicating that the merger is an opportunity for a payday rather than creating any real shareholder value. East Stone also has a suspect transaction history, with an earlier deal with Chinese SaaS company Ufin Holdings (the deal was announced in November 2020 with a valuation of $300 million) being called off once the merger with JHD was announced.
Furthermore, founders at JHD are also looking to cash out at a premium valuation. The deal, which values JHD at $1 Billion, implies a pretty steep valuation at a Price/Sales multiple of 12.5x, with the company not expecting to post profits over the next few years as it looks to prioritize growth (EBITDA was -$24 million in 2020). Perhaps the biggest risk that investors face when investing in the ESSC-JHD’s Deal is the company’s links to China.
Over the last six months, Chinese Companies have cumulatively lost over $600 Billion in Market Cap (248 Chinese Stocks). With new US Laws requiring more disclosures from the auditors of Chinese companies, combined with pressure from Chinese regulators on Companies with a lot of data to list in China instead, it appears that the market for Chinese stocks in the US has blown up, and more pain may be on the way.
Terms of the DealÂ
While East Stone Initially Announced a deal with JHD Holdings back in February this year, the SPAC has generated a lot of buzz in December, from folks over at both Twitter and Reddit. Speculation around the deal started ramping up late last month when SPAC shareholders voted on extending the completion date to February 24th, 2022 from the previously agreed date of November 24th (the third extension since the deal was announced).
As the extension took the deal past its original termination date (and 2x free extensions set in the deal prospectus), the extension required a special shareholders meeting, with investors being able to redeem their shares. With the red flags around the deal being evident, over 76.3% of the shareholders decided to redeem their shares (10.53 million out of 13.8 million). As per the terms of the deal, if ESSC Fails to close out the merger with JHD by 24th February, the SPAC trust will be liquidated, with shares being redeemed at NAV (which stands at a floor of $10.26 due to additional capital being paid in for the two extensions).
Just before shareholders of the SPAC voted to extend the merger date for the deal, management secured a forward share purchase agreement with 4 arbitrage funds (who would hold common stock bought below NAV to redeem at a profit). The agreement with these funds (namely Glazer Capital, Sea Otter Capital, and Meteora Capital) indicate that they are entitled to sell their shares back to the business for $10.41 if they hold it for 3 months after the deal closes, or sell it in the open market for at least $10.26.
Other terms included receiving nearly 400k founder shares in exchange for voting to extend the merger and not redeem the shares (shares aggregating close to 2.8 million). With a majority of the remaining float being subject to the conditions of the backstop agreement, the free float for the SPAC is close to 341k (which is the lowest tradable float of a SPAC so far). The reported short interest is currently close to 85,000 shares, implying that there is an opportunity for a gamma squeeze on the day of the merger vote.
Profiting from the DealÂ
While it may be tempting to short the underlying stock by hedging with a long position on warrants, most of the remaining shares are restricted from being hedged to anything but a net-long position (with the warrants being un-exercisable). Before the deal closes, the maximum amount of shares that can be short is close to 300k, with anything above that violating terms of the backstop agreement. Those looking to short the stock should hedge the position to prevent significant losses from the squeeze.
The best way to profit from the trade is by buying common stock closer to NAV ($10.26). The squeeze can only happen before the merger, after which the float is expected to be significantly diluted due to convertible notes/options being exercised. ESSC is currently trading close to $10.66, implying a premium of $.4 or 3.75%. If the stock continues to rise from the current levels, the risk premium will increase, making the risk/reward scenario less appealing, but should the stock return closer to NAV, it would make the trade more appealing.