When a hedge fund moves in on a stock just ahead of some good news you always have to wonder if the fund got lucky, made an inference from public information that worked out, or (as many will inevitably suspect) was acting on insider information. To shed some light on the issue, a team of researchers focused abnormal hedge fund trading activity ahead of M&A announcements, and while the evidence is circumstantial it suggests that insider trading is fairly common in such circumstances.
“Our results from the full battery of tests we conduct are suggestive of some short-term hedge funds opportunistically taking advantage of material non-public insider information,” write Rui Dai, Nadia Massoud, Debarshi Nandy and Anthony Saunders in their paper Hedge Funds in M&A Deals: Is There Exploitation of Insider Information.
Criteria based on Galleon insider trading conviction
As a starting point, the authors take some inspiration from the case of Galleon hedge fund founder Raj Rajaratnam who was convicted of multiple cases of securities fraud, including buying more than half a million shares of Clearwire Corp (NASDAQ:CLWR) based on a tip of an upcoming M&A announcement in March 2008, but hadn’t taken any position on the company in previous quarters.
So they define a short-term hedge fund as one that takes a position on a stock ahead of an M&A announcement with not activity in the three previous quarters and restrict their analysis to these short-term funds (nb their use of short-term has nothing to do with a fund’s normal strategy, only with its relation to a specific deal announcement).
Hedge funds benefiting from tip-offs: Evidence circumstantial, but suggests insider trading
The study makes a couple of findings that, taken together, are pretty suggestive. First, short-term hedge fund holdings correlate with the target company’s premium, and larger short-term hedge fund holdings causes the target company’s price to go up more ahead of the announcement. It also found that short-term hedge funds are abnormally likely to also initiate a position on the potential acquirer. Finally, the more third parties included in the deal (investment bankers, lawyers, financial advisors) the more short-term hedge fund activity there is ahead of the deal announcement.
In other words, hedge funds are most likely to initiate a new position when the upcoming M&A announcement includes lots of third parties and is going to offer a pretty good premium, but the activity also drives the prices up and actually makes deal completion less likely.
It’s possible that some hedge funds are just better at identifying possible acquisition targets than others, but the authors don’t find this explanation convincing in general. First, timing M&A activity is uncertain, so you this argument makes more sense for hedge funds that gradually build a position in a possible acquisition target and are eventually rewarded. Also, if a hedge fund is better able to identify M&A targets, that competitive advantage should show up on a regular basis. The study only looks for repeat hits in successive quarters (which doesn’t seem like a good standard), but it doesn’t find that short-term hedge funds are able to consistently predict M&A activity.