Do Hedge Funds Trade On Insider Information?
A very interesting research paper currently in publication by a team from York University headed by Nadia Massoud asks "Do Hedge Funds Trade on Private Information? Evidence from Syndicated Lending and Short-Selling" and analyzes whether or not hedge funds actively trade in the public securities of companies that had approached said hedge funds with private, capital structure specific (in this case loan syndication and amendment) information. The paper focuses on the period between 2005 and 2007, when the first wave of second- and third-lien debt that had been issued by crappy companies to hedge funds, was starting to become impaired and led to wave after wave of covenant and other bank loan amendments, designed to allow the borrower some breathing room. Massoud also tracks whether or not in the days preceding the public announcement of a covenant amendment, traditionally seen as a sign of weakness by any borrower company, there was a spike in short-selling activity by hedge funds, courtesy of an interval between January 2nd 2005 to July 6th 2007, when RegSHO had made public extensive detail on equity short-selling data (why this is no longer the case one has to ask the corrupt SEC, but that is a question for after the next 10,000 point Dow flash crash when the SEC's headquarters will finally be surrounded by rioting former investors who have had enough). The paper finds conclusive evidence that companies that come to lenders in hopes of amending syndicated credit facilities do indeed see aggressive shorting of their stock into the days preceding the formal announcement, implying that there is obviously material non-public information abuse and frontrunning. Here, the authors of the paper however, make a blatantly wrong assumption that this frontrunning originates almost exclusively from within the hedge funds that had been approached with the material non-public disclosure of weakness. We are happy to demonstrate that not only is that not necessarily the case, but to explain why certain sections of FT holding company Pearson can charge over $100,000 a year for premium subscription to their content by rich hedge fund subscribers, thereby once again creating a very tiered information market. We speak of course of Pearson niche media subsidiary www.debtwire.com
First, a brief observation of the York paper's conclusions. As the charts below summarize, there is almost no doubt that hedge funds tend to aggressively take advantage of previously nonpublic information, which they know upon publication will resut in an adverse impact to the stock. The first chart shows Short-Selling Activity around Loan Originations and Loan Amendments. As the paper explains: "This Figure shows short-selling activity around the announcement (day0) of loan originations (Panel A) and loan amendments (Panel B). Shorting activity is measured as the ratio of daily total number of shares being shorted to the average daily trading volume over the window (-120,-61) (Short/Avol). For any given borrower, the benchmark “normal” shorting activity is defined as the company’s average Short/Avol ratio over the period from January 2nd 2005 to July 6th 2007 but excluding the event period(s), which is the window (-60, +60). The darker and the lighter columns plot the abnormal daily Short/Avol ratios of the unmatched hedge fund borrower sample and bank borrower sample, respectively." In summary, the more active the shorting ahead of t-0, the greater the likelihood of someone abusing advance knowledge that there will be a negative announcement of either a loan or an amendment. Indeed, the far greater increase in shorting ahead of unfavorable amendments compared to favorable, confirms this. Note that in the "control" sample, where the companies had borrowed money from banks, and not hedge funds, there was no additional active shorting in the stock, confirming that banks tend to look at their clients as a long-term asset, as opposed to hedge funds, who are happy to rape and pillage anyone they encounter.
The second chart confirms more of the same - it looks at Abnormal Short-Selling Activity around Loan Amendments Sorted by Favorable and Unfavorable Amendments, and once again it is obvious that hedge funds will actively short a company's stock about a week in advance of a negative capital structure announcement.
There is much more in the paper, and we suggest everyone (especially the regulators but since they are all watching porn 24/7 we are not holding our breath) read it, but we want to bring particular attention to one episode. When the authors looked at the first episode (of many) when distressed rental company Movie Gallery was lurching into bankruptcy, and needed to promptly execute a waiver on its credit facility, the authors observed something peculiar. We present footnote 6 on page 4 (emphasis ours):
On March 6, 2006, executives from Movie Gallery held a private conference call for their lenders to discuss that industry conditions had primarily caused the company to recognize a record loss of $522 million. These losses violated one of the major covenants of a $1.35 billion syndicated loan extended by hedge fund lenders such as Highland Capital Management, Canyon Capital, and Silver Point Capital. The Movie Gallery executives requested that their lenders amend the existing loan contracts and relax the existing financial covenants. Nearly two weeks after the private conference call, on March 17, 2006, Movie Gallery publicly announced their loan covenant amendments to the public. However, between the conference call on March 6, and the announcement on March 17, short-selling of Movie Gallery’s stock rose significantly. In particular, between March 7 and March 13, the weekly cumulative short-sale volume increased from 0.4 million shares (1.23% of the outstanding shares) to 3.04 million shares (9.5% of the outstanding shares). By March 13, Movie Gallery’s stock price had fallen by 61% as its closing price dropped from $3.27 on March 6, 2006 to $2.01 on March 13, 2006. See The New York Times cover story, “As Lenders, Hedge Funds Draw Insider Scrutiny” by Jenny Anderson, October 16, 2006.
Now the author's observations in interpreting this result are essentially to cast blame on the only parties capable of accessing Movie Gallery's stock price at the time, and having full knowledge of the deteriorating events between March 6 and March 17. In other words, if Massoud's hypothesis is correct, the regulators would have to look to Highland, Canyon and Silver Point for potential fraudulent activity and abuse of non-public info. However, nothing could be further from the truth.
Long time a part of mergermarket, several ultra exclusive online publications such as dealreporter.com, and much more relevantly, debtwire.com, had been using their connections in the hedge fund industry to break stories to an exclusive audience of clients, those willing and able to pay the annual subscription fee of over $100,000. Dealreporter has traditionally been the M&A focused portion of the organization, while debtwire focused on the restructuring, distressed and bankruptcy advisory stories, precisely those that in the period between 2004 and 2007 were widely underreported by the general media, as the skillset associated with this type of analysis was (and still is) vastly lacking within the journalist community. The value of these brands was immediately perceived by an organization such as Pearson plc which ended up ponying up $192 million to acquire the group of businesses.
Due to the clubby niche focus of the readership for a media organization such as debtwire, where those who read it are effectively those who "feed" it articles, it quickly became the most influential source of information in the distressed community, where one story about a bondholder group meeting, or, relevantly to this story, a loan amendment inquiry, could promptly sink a company's bonds and loans (not to mention stock) by a double digit percentage.
Case in point - in the above case, had Massoud had access to debtwire, she would have known that on the very day of the Movie Gallery lender call, or March 6, 2006, at 7:49 pm, Debtwire already had the full scoop, and a write up with all the details sufficient for those who had the ultrapremium access, to trade appropriately in the company's publicly traded securities.
The second this article was made public, and even prior to that, as the author was gathering information and validating the original plant, there were already numerous parties tipped off that Movie Gallery was in deep trouble. And since this information was fully premium-based, there was no leak of this in the broader public domain, especially since in 2006, as we mentioned, very few if any of the journalistic cadre, were smart enough to realize the implications. And of course, once published, those who wished, could easily transact in MOVI's stock, bonds, or loans. The more foolhardy ones picked the stock route, thus potentially exposing themselves to SEC scrutiny, as at this time the regulator was completely unaware that hedge funds could trade in bonds, loans, and, gasp, CDS. We are confident that if the authors of the paper were able to dig down into shorting activity in Movie Gallery's loans and bonds, they would find much comparable information to what they saw in the stock of MOVI.
Obviously, none of this is illegal, and none of this should come as a surprise. On the other hand, one thing that many distressed hedge funds would do at or around the 2005-2007 time period, would be to take a toehold position, leak the news to a specialized media outlet like debtwire, get some more participants in around them, then increase their exposure, even as the bulk of the parties involved, traditionally idiot money funds who would decide what to do with their investments purely on what S&P and Moody's would tell them (and somehow being custodians for retail capital) ended up losing millions as a result of this kind of activity. But again, there is nothing illegal about it - it is merely how the market used to work.
Just like stocks currently, so the distressed market was (not so much anymore, as with the propagation of specialized blogs, the value added of such media as debtwire has fallen precipitously) very much a two-tiered marketplace: those who were on the inside of everything that happened, or at least were smart enough to know someone else was far smarter and more devious, and those that were stupid enough not to realize that they were being taken advantage of.
And this is how the media world has and always will coexit with those who have the capital: there is nothing unique or novel about this arrangement. The moneyed interests will always plant the types of stories they see fit with preferred organizations (either CNBC, which wants to curry favor with all the wrong people, or a place like debtwire, which is fond of its niche reputation of having the exclusive scoop on distressed situations). Yet it should be common knowledge that in the decision-making process, the role of the media should not be ignored, especially when it does exculpate some that may otherwise be falsely accused of wrongdoing, when the finger of blame should be pointed somewhere completely different.
We hope that Ms. Massoud will take this information and adjust her paper accordingly.