Investment Overview:

This is a pairs trade idea between FPAC and MSTR, as both companies own crypto assets (predominantly bitcoin), but MSTR trades at a significant premium to NAV / the value of its crypto assets, whereas FPAC may trade at a discount, arguably because it is tainted as a SPAC.

We own FPAC outright but believe that investors who do not want to take crypto risk can be short MSTR (via convertible bonds, stock, or puts) and isolate the large NAV premium, which we believe should collapse over time due to (i) increased corporates investing in bitcoin / bitcoin/crypto business IPOs, (ii) other US Bitcoin ETF Approvals, or (iii) MSTR stock issuances through its large ATM facility. I will spend the bulk of this writeup focused on FPAC, which is the more complicated business and unique situation, but will touch on the large NAV premium at MSTR towards the end.

FPAC Situation Overview:

Far Peak Acquisition Corp. (“FPAC”) is a post-announce, pre-close SPAC founded by Tom Farley, the former President & COO of ICE & NYSE.  The SPAC has announced the acquisition of Bullish Global, a start-up cryptocurrency exchange which is pursuing a centralized exchange strategy with a built-in decentralized exchange (“DEX”). Bullish has been piloting the exchange over the summer and aims to launch it in Q4’21, around the same time as the business combination. The Company has the backing of deep-pocketed strategic partners including (i) Peter Thiel, (ii) Alan Howard, and (iii) Louis Bacon. As part of the business combination, Farley will transition to being the full time CEO of Bullish.

The transaction is contemplated at an equity valuation of ~$10.8BN, which is comprised of ~$8.3BN of net cash/owned token value and a $2.5BN TEV implied of the underlying exchange.

I view Bullish as an interesting way to own crypto through a corporate, as its valuation is floored by the tokens/cash it owns on balance sheet with upside from (i) underlying exchange performance and (ii) a rerating of crypto assets to corporate premiums (detailed below).

Note: the value of treasury assets / tokens held is significantly higher today at $8.3BN as opposed to the $6.5BN in the image above → the presentation assumes a bitcoin price of $32,000, as compared with a market price of $45,000 today.

Crypto Exchanges:

The crypto exchange market is rapidly evolving – given the wide range of market participants, each competitor has created a separate niche that attracts different types of customers.

There are three venue types to trade cryptocurrency today: (i) Centralized Exchanges that are regulatory compliant with KYC/AML policies (Coinbase, Kraken, etc.), (ii) Centralized exchanges with no regulatory compliance (Binance, OKEx, Huobi), or (iii) Decentralized exchanges (Uniswap, Sushiswap, Balancer, Pancakeswap). Centralized exchanges with no regulatory compliance is the majority (~2/3) of trading volume – Binance was the platform for over 40% of crypto volume in H1’21, and OKEx / Huobi were each 10-15%.

Currently, the crypto exchanges are overearning relative to traditional exchanges given their high transaction fees and high margin rates. Retail take rates for COIN are 1.4% on average for transaction volume, while traditional retail fees for many other asset classes are near zero (would note that COIN pro / institutional fees are much lower at around 50bps)..

Decentralized Finance Overview:

Decentralized Finance (“DeFi”) is a general term that refers to cryptocurrency applications built on self-regulating or self-governing platforms, the biggest applications of which are decentralized exchanges, lending protocols, and payments today. These platforms have no central authority that governs how the application operates. As such, individual investors can serve as lenders or margin providers in roles that banks or exchanges have typically played.

Accordingly, DeFi has created a more passive income generating stream for the cryptocurrency asset class. As crypto assets do not inherently produce yield, DeFi has created yield by sharing protocol profits amongst pool participants.

Decentralized exchanges (“DEXs”) have certain attributes that make them attractive relative to centralized exchanges. Trading fees are lower (30bps vs. 1-2% for COIN), incentives / annual yield for exchange participants, and a lack of overt regulatory restrictions all stand out as attractive features of DeFi. DEXs have grown significantly over the past 12-15 months, with Total Value Locked under contract in DEX exchanges equivalent to ~$90BN today, up from $11BN at the end of last year.

On a similar note, DeFi volumes have grown exponentially – DeFi daily volumes were $3BN in December 2020 and are now over double that.

Liquidity Pools:

The key mechanism for DEXs to ensure market liquidity in lieu of an order book is known as a “liquidity pool.” As part of a liquidity pool, tokenholders contribute their tokens to a pool of assets. In exchange, tokenholders, known as “liquidity providers” (“LPs”) receive volume-based trading fees pro rata from the protocol. LPs are also entitled to any fees from margin loans against the pool.

Liquidity pools are mathematically designed to rebalance such that they stabilize the price of the currency pair. Tokens are contributed to the pool in pairs (eg. If a tokenholder wants to contribute bitcoin to a bitcoin/USD pool, they must contribute both bitcoin and USD in equivalent value amounts. The pool represents its own ecosystem with its own pricing (pricing is relative between the two legs of a pair). As a token is sold out of the pool, its relative price in the pool increases as it becomes more scarce, above the market price at other exchanges. The price of the paired token declines – to a point where arbitrageurs are incentivized by the price variation to enter the pool and stabilize the price by selling the scarce token and buying the other one.

Importantly, liquidity pools eliminate the need for order book rebalancing, solving a major efficiency of a centralized exchange.

Bullish Overview:

Bullish is a new decentralized cryptocurrency exchange scheduled to launch in late 2021, focused on Bitcoin (as compared to ETH for existing DEXs) with over 150,000 tokens on balance sheet. Management is targeting a >$1BN liquidity pool between its owned tokens on balance sheet and third-party pool contributions.

The Company brings a unique business model – it combines the benefits of a centralized exchange with the concept of an automated market maker / liquidity pool, all backstopped with the deepest liquidity pool in the space given the amount of tokens Bullish has on balance sheet (over $8BN vs. Uniswap TVL of ~$5BN). The Company plans to have KYC/AML to become regulatory compliant in the US such that the automated market maker is available for institutional clients to use, which we believe will open up a new segment of TAM of institutional investors who want to trade crypto, benefit from DeFi style yield, and do so in a regulatory compliant way.

Its scale allows Bullish to charge the lowest transaction fees for traders and experience less liquidity pool pricing volatility to create increased depth to the order book (Company plans on charging 10bps as a baseline, which can increase during times of volatility).

The Company will generate revenues from 3 streams: (i) market making (fees from trading activities on its order book), (ii) margin revenues (interest for providing margin trading) and (iii) fees charged to third-party liquidity providers of 25%.

Bullish is backed by block.one (the current owner of the tokens), which is run by Brendan Blumer – a serial tech/crypto entrepreneur. While block.one certainly has credibility issues related to its unsuccessful ICO of EOS a few years ago, Farley’s involvement adds credibility to the team and their ability to legitimately execute. Additionally, the Company was seeded by several deep pocketed financial investors who are part of their advisory board, including Peter Thiel, Alan Howard, Christian Angermayer, Mike Novogratz/Galaxy, and Louis Bacon. Farley brings institutional and exchange knowledge, and has experience in crypto in the past – he led NYSE’s $10MM investment in COIN in 2013 and NYSE’s add on investment of $75MM in 2015 – and he sat on the COIN Board.

Earnings Power:

Exchange earnings power is going to be uncertain as the exchange is still a startup, but the Company runs a variety of P&L scenarios assuming different levels of ADV at a 16bps trading spread (10bps base transaction fee + 6bps volatility trading fee) and daily pool turnover of 8-18%. Management assumes 9% of its book will be used for margin-lending at an APR of 21%, which I believe is in-line with the industry.

Comparatively, other DeFi exchanges charge 30bps and pool turnover tends to be 20-30% historically, which implies much higher ADV. Bullish also assumes $10BN in pool size on day 1, when the Company will actually have almost $8.5BN of tokens by itself assuming no third party participation.

Margins seem conservative to us – asset-lite exchanges can earn 50%+ margins (ICE, CME, LSE, etc.), and Bullish should be structurally more profitable given its asset heavy balance sheet and the higher spreads / trading volatility in the underlying asset.

FPAC Valuation:

I think an SOTP makes the most sense for valuing this business. Post business combination, the value of the stock will be driven by (i) the market value of the cash/tokens held on balance sheet and (ii) a valuation of the exchange as it begins generating revenues. Today, Bullish’s owned cash/tokens represent $8.2BN or so of market value, so 75%+ of the equity value is derived from financial assets. Assuming a $10 stock price, the Company has $7.50/share of cash. Far Peak has struck the Purchase Price with Bullish such that the crypto asset transfer takes place 3 days prior to close at a valuation that fixes a $2.5BN value for the exchange.

At the low end of the ADV forecast of $800MM, which would represent 10-15% of current DeFi trading volumes (would note that Uniswap does $1.7BN on average and growing and Pancakeswap does $950MM on average and growing), the exchange should generate >$200MM of EBITDA, which represents a 12.5x multiple to the exchange TEV of $2.5BN. At the high end of the range of ADV forecasts, the implied EBITDA multiple for the exchange is ~5x. Traditional exchanges trade between 15-25x EBITDA, COIN trades at 17x. There are obviously risks to hitting these projections as detailed below, but the $2.5BN TEV does not seem crazy.

MSTR Relative Value:

What is most interesting about this situation to me is that there is a bifurcation between how Bullish’s crypto assets are being valued by the market vs. another corporate, MicroStrategy. MicroStrategy has 2 primary sources of value: (i) a business intelligence software business and (ii) bitcoin held on balance sheet. MSTR trades at a 68% premium to NAV today (applying a 3x revenue to the software business) as investors (including a large retail shareholder base) have used MSTR as a proxy for owning bitcoin through a corporate.

Conversely, attributing $0 value to the exchange business at FPAC, FPAC trades at a 33% premium to NAV (and I believe the exchange has value). Said another way, if FPAC traded at half the MSTR premium today, even assuming the exchange fails completely and is worth $0, the stock could still trade at $10. The MSTR premium has been volatile, as the stock surprisingly swings around much less than bitcoin does (the premium has ranged up to 150% of NAV in the past few months). However, I would point out that the sellside valuations for MSTR all seems to correlate with price targets on bitcoin, so the market has digested that MSTR is a corporate vehicle to own cryptocurrency, and the only such vehicle today.

I’d imagine MSTR’s premium will unwind over time as (i) there are increased corporates investing in bitcoin or bitcoin/crypto business IPOs, (ii) other US Bitcoin ETF Approvals, or (iii) MSTR stock issuances through its large ATM facility. But today, FPAC will be the only meaningful stock with a war chest of crypto assets that rivals that of MSTR. And you are creating it at a meaningful discount to MSTR with upside option value from the exchange being worth something. 

Trade Expression:

While we own FPAC and FPAC warrants outright, investors that are agnostic to crypto may want to hedge out crypto risk by expressing a short on MSTR’s premium or on crypto assets generally.

Crypto volatility is difficult to hedge. Many funds (including ours) struggle to physically buy or short bitcoin. Shorting GBTC, the current bitcoin ETF, also is difficult as there is limited borrow available, if any. While the asset transfer does not happen until 3 days prior to the FPAC business combination (and thus, volatility between now and then does not matter as the valuation is just restruck to $2.5BN of exchange TEV), it presents a risk post business combination.

We view MSTR as the much better short given the NAV premium dynamics highlighted above. MSTR common has borrow available, but has a 33% short interest today (likely some amount of outright short sellers and some amount of convertible arbitrageurs). One could short the 0.75% convertible bonds as those are in the money today as a way to express an equity short.

An alternative form of trade expression may be buying the FPAC warrants/common and selling MSTR calls (recognizing there is a duration mismatch between the two sets of options). MSTR Jan 2021 ATM calls are $100+ bid and imply vol of 80%+. FPAC slightly OTM warrants seem to be pricing in an IV of 30%. The dislocation between the two should be monetizable. FPAC’s warrants seem mispriced --> bitcoin is a 60-70% vol instrument, the FPAC warrants should not be at this large of a discount to that. 

Risks:

There are quite a few considerations to this idea that are worth highlighting:

Bullish startup/software risk:

Bullish hasn’t launched or started trading, early pilot results generally sound like they have been good, but the Company is still beta testing which obviously creates risks on their ability to execute / drive user uptake 

DeFi exchanges in particular have had software hacks/failures which have resulted in tokens being stolen, which create risk for Bullish that is difficult to perfectly handicap

Block.one / EOS:

Bullish is built on the EOS technology stack – there is much less development on EOS (virtually none outside of Block.one) as there is on ETH as EOS has fallen out of favor given its debacle of an ICO process a few years ago. I would note that Brendan Blumer is perceived as not a bad actor like others at Block.one who were around a few years ago and marketed the ICO (watch John Oliver’s cryptocurrency segment on EOS / Brock Pierce to see some of the absurdity and if you want a good laugh)

Crypto volatility will be difficult to hedge:

Many funds (including ours) struggle to physically buy or short bitcoin. Shorting GBTC, the current bitcoin ETF, also is difficult as there is limited borrow available, if any. While the asset transfer does not happen until 3 days prior to the FPAC business combination (and thus, volatility between now and then does not matter as the valuation is just restruck to $2.5BN of exchange TEV), it presents a risk post business combination.

There is significant correlation between bitcoin trading volumes and bitcoin prices:

This is a risk that is difficult to think through, but if bitcoin pricing declines a lot, volumes may temporarily pick up and then decline with pricing. This implies that the two “segments” of the business that I highlight in my sum of parts valuation are actually correlated in value, so it’s hard to bifurcate the two.

The SPAC market seems to have fallen apart since its mania in late 2020/early 2021:

I’m sure everyone on VIC is no stranger to the fact that SPACs have been breaking much lower upon business combination this year. A number of very marginal deals have gotten over the finish line in the euphoria of the last several months, and as enthusiasm for SPACs has faded, many seem to trade below trust on the break. Given that this stock is wrapped around trust value of $10, I’d imagine it is indicative of weak institutional or retail excitement for the transaction. Perusing WSB, there doesn’t seem to be a ton of retail interest in the deal as there have been deals in the past (although I would note that the likely post de-SPAC ticker is very meme-able “$BULL”). While I believe the stock is interesting and has levers for downside protection (given its significant treasury assets on day 1) and upside optionality given the growth in the asset class and structural advantages the exchange may have, the interim trading path may be choppy and could involve a Day 1 rerate lower (although unique to this transaction vs. some other SPACs, there is a floor value of ~$7.50 / share in hard assets on balance sheet)