Unique rights give to early investors in special-purpose acquisition companies (SPACs)—which aim to purchase promising startups and then take them public—if benefiting some of the “biggest players in finance, particularly hedge funds.” This according to a recent article in The Wall Street Journal.

The article explains the trade mechanics: “Hedge funds give the SPAC money for up to two years while it looks for a merger target. In return, they get a unique right to withdraw their investment before a deal goes through that minimizes any loss on the trade. At the same time, the potential return for early investors is huge if the SPAC shares rise because they also initially receive shares and warrants giving them the right to buy more shares at a specified price in the future.”

New York University assistant law professor Michael Ohlrogge calls it “a free lunch—there’s no way around it.” He and Stanford Law School’s Michel Klausner studied SPACS for the period between January 2019 and June 2020 and reportedly found that hedge funds “nearly always sold their shares or withdrew before deal completion,” and that the average annualized return for those that withdrew was 11.6%.

The professors argue, however, that the gains for early investors often come at the expense of other stakeholders, “particularly those who take on more risk when buying shares later in the process after a deal is announced or goes through.”

The article notes that although SPACs are still a small part of markets, the trend is “another result of the unique financial conditions resulting from the pandemic and ultralow interest rates.” In the past, when it was more costly to borrow money, returns from the hedge-fund trade were more limited and therefore the enthusiasm was not as high. The momentum generated last year, however, made the SPAC trade much more attractive.

The article concludes with a comment from Westchester Capital Management managing member Roy Behren: “There’s a frothy feel to the SPAC universe.”