Hedge Funds in M&A Deals: Is there Exploitation of Insider Information?

Rui Dai

Wharton Research Data Services, University of Pennsylvania

Nadia Massoud

Melbourne Business School, The University of Melbourne

Debarshi K. Nandy

International Business School, Brandeis University

and

Anthony Saunders

Stern School of Business, New York University

Abstract

This paper investigates trading patterns in target and acquirer firms prior to the public announcement of M&A deals. We analyze this issue by differentiating whether the trading is conducted by hedge funds with short-term investment horizons (henceforth, short-term hedge funds) or other institutional investors in both the equity and derivatives markets. We consider several alternative explanations for short-term hedge fund trading patterns prior to the public announcement of M&A deals, such as those related to a hedge fund’s skill in identifying profitable trades’ ex-ante; however our results seem inconsistent with these alternative explanations.

Hedge Funds in M&A Deals: Introduction

Over the last couple of years there has been a marked increase in allegations and prosecutions regarding the misuse of insider (or material non-public) information in mergers and acquisitions (M&As) which has attracted the attention of regulatory authorities and researchers. While the generation of superior knowledge about a company from public, non-public, and nonmaterial information is not illegal, the use of material insider information certainly is.

Over the last few years the Wall Street Journal, has reported several times that the SEC has been investigating potential insider information leakages prior to the public announcement of M&A deals. As part of their investigation, the SEC sent subpoenas to more than 30 hedge funds, some of which were related to trading in Schering-Plough Corp stock prior to its takeover by Merck & Co. in 2009, while others were related to MedImmune Inc.’s takeover by AstraZeneca PLC in 2007.1 Additionally, in two other cases involving the Galleon and Jefferies hedge funds, the SEC arrested over a dozen people for leaking and trading on insider information prior to M&A deals.2 Indeed, in May 2011, Raj Rajaratnam, founder of the $7 billion Galleon hedge fund was found guilty of 14 counts of securities fraud, many related to M&A activity.3 However, so far, the question as to what extent hedge funds may be involved in such activities has not been established or examined systematically in the finance literature. The high turnover of their portfolios, their undiversified investment strategies, and the absence of reporting requirements makes hedge fund trading less conspicuous to market regulators; while the absence of regulatory disclosures and intensive use of short selling and derivative trading strategies impede insightful investigation.

It has been shown in the prior literature that trading on insider or material non-public information not only leads to considerable profits around mergers and acquisitions but also imposes externality costs such as higher target premiums or lower probability of deal completion.5 For example, in the weeks after a board meeting of First Federal Bancshares Inc. (FFBI), to consider offers from potential acquirers, its stock price jumped from $18 to an 18- month high of $24. First Federal’s merger proxy statement claimed “[i]t was the board of directors’ belief that the increase in the price of the stock most likely reflected speculation of a merger and not an actual increase in the intrinsic value of FFBI.”

In this paper, we analyze trading patterns in target and acquirer firms around M&A announcements. We analyze this issue by using an extensive hedge fund dataset which allows us to analyze the trading patterns of hedge funds around corporate M&As. Specifically, we investigate the extent to which hedge funds take long positions in a target’s stock in the quarter prior to an M&A announcement, without having held any positions in that stock in the past 4 quarters. We define such hedge funds as short-term hedge funds. Additionally for the same deals, we examine the abnormal trading patterns in the short positions of the acquirer’s stock prior to the announcement.

Hedge funds in M&A deals

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