It’s no secret the SEC is cracking down on insider trading among hedge fund managers. Just ask Raj Rajaratnam and his friends, and Art Samberg, to name just two recent high-profile targets.
And, don’t forget that earlier this year the SEC created a task force that, among other areas, will target hedge funds and other alternative investment firms.
One area they could be looking at are the private loans made by hedge funds to small desperate companies. According to a new academic paper believed to be soon published in the Journal of Financial Economics, in 2005 alone, hedge funds and other institutional investors provided almost 50 percent of the $509 billion loans made in the “highly leveraged” segment of the syndicated loan market.
The authors assert that hedge funds are more likely to lend to highly leveraged, lower credit quality firms, where access to private information is potentially the most valuable and where trading on such information may lead to enhanced profits. Sure enough, the authors found “evidence consistent with the short-selling of the equity of the hedge fund borrowers prior to public announcements of both loan originations and loan amendments.”
Now, the authors stressed they are not saying hedge funds are engaging in insider short selling.
However, the law firm Dewey & LeBoeuf LLP recently warned in a Client Alert that the study could lead to a rash of investigations. “When you see a study like this that seems to show statistical significance, you can be pretty sure you might see more scrutiny,” says Christopher J. Clark, a partner in Dewey & LeBoeuf’s Litigation Department and co-head of the firm’s White Collar Criminal Defense and Investigations Practice Group. He likes this paper to the academic paper that spawned the SEC’s probes of backdating of stock option grants several years ago.
The authors looked at loan information from the DealScan database provided by Thomson Reuters. Keep in mind that the study restricted its sample to the period from January 2, 2005 to July 6, 2007 since equity short-selling data was only available for this time period under regulation SHO (RegSHO). Adopted by the SEC on June 23, 2004, under Regulation SHO all Self Regulatory Organizations (SROs) had to make tick-data of short-sales available to the public after January 1, 2005. The mandatory public disclosure of short-sale data was eliminated after July 6, 2007.
The authors--Nadia Massoud, Schulich School of Business, York University; Debarshi Nandy, Schulich School of Business, York University; Anthony Saunders, Stern School of Business, New York University; and Keke Song, Schulich School of Business, York University--tracked the trading of 105 U.S. companies that borrowed from hedge funds and 255 companies that borrowed from commercial banks, according to Dewey & LeBoeuf.
Interestingly, the authors found that the companies that borrowed from hedge funds saw, on average, a 74.8 percent increase in the volume of short sales during the five-day period prior to the announcement of the new loans as compared to the volume 60 days before announcement, according to an earlier report in The Wall Street Journal. This compares with those companies that borrowed from commercial banks, which experienced virtually no difference in the volume of short sales between those two periods. In addition, prior to the announcement of amendments to existing loans from hedge funds, short selling increased by 28.4 percent, while short selling fell by 17.4 percent prior to the announcement of amendments for bank loans, according to the WSJ.
Now, none of this suggests hedge fund managers engaged in wrongdoing. However, the authors assert that the entry of hedge funds into the private loan market raises a number of important questions and issues that so far have not been addressed.
They suggest there could be a conflict of interest when hedge funds participate in syndicated lending, while at the same time shorting the stocks of borrowing firms. “This issue is especially pertinent since hedge fund lenders, like banks are ‘quasi-insiders’ and thus privy to private information about the performance of borrowing firms around both loan originations and loan renegotiations,” the report states. “However, hedge funds are not subject to the same degree of oversight and regulation as banks.”
At the very least, this report is likely to lead to more scrutiny of these trades. Says DL’s Clark: “You can guess people will draw a lot more subpoenas.”
Stay tuned.
Stephen Taub, who has covered the hedge fund industry for 30 years, is a contributing editor to Institutional Investor and Absolute Return-Alpha magazines.
