No one in finance can have failed to notice private equity’s impact on merger and acquisition activity. Fuelled by the availability of wholesale bank credit and a broadening, yield-hungry investor base, including hedge funds and other institutional non-bank investors, leveraged buyouts (LBOs) have proliferated.1 A somewhat neglected fact has been that larger deals brought larger syndicates in both debt and equity financing and also a considerably broader unrelated or only tangentially related universe of participants involved in other activities such as underwriting and due diligence. In recent research, we revisit the topic of insider trading given this changing landscape of how LBO deals are organised. Larger syndicates have led to more insiders and increased the likelihood of insider trading. The fact that there is insider trading has certainly received media attention2 but our research shows that it is really the number of insiders that matters.
Identifying suspicious trading
We study four markets to track suspicious activity. First, we calibrate “normal time” stock volume, return, the volume of exchange traded call options, credit default swap (CDS) spreads, and bond spreads. Using this “normal time” econometric model, we extract daily abnormal activity for a three-month period prior to the bid date. Unusual levels of activity are captured by the maximum daily excess over normal levels for the five-day window preceding the bid and the aggregate of the daily excesses.
Who are the insiders?
We created three measures to count the number of debt participants, differentiating by the time when the debt was incurred and the status of the banks. The first and narrowest measure looks at syndicated facilities entered into within six months after the bid and counts only the lead banks. The second measure also counts the number of lead banks but uses a broader sample of bank facilities, looking at all syndicated facilities active on or six months after the date of the bid. The broadest definition includes all banks participating in all syndicated facilities active on or six months after the date of the bid, including non-bank investors such as hedge funds and other asset management institutions. Using the measure of lead banks only, the median is one equity buyer and 5 lead banks. Larger targets, measured by capitalisation, have more equity buyers and more lead banks involved.
How and why a proliferation of non-public information can leak out to a broad audience is best explained through a simple time line example. At the very initial stages, Firm A considering a bid for Firm Z will have a Commitment Letter from several banks who will become the lead banks if the deal progresses. When the tender offer is announced the names of the Lead banks will become public. Then when the deal is later agreed, the lead banks will go out into the market looking for junior partners to join the facility, including non-bank institutions. Once the syndication process is complete the loan can be actively traded. During this process, information is transferred amongst all these participants and their respective advisors.
But do more Insiders lead to more suspicious activity?
Regression analysis reveals that syndicate sizes explain our measures of abnormal trading activity. However, it appears that different insiders use their information only in their respective capital markets. The number of equity insiders is correlated with unusual stock price activity and option trading. Similarly, the number of lead LBO debt banks is correlated with suspicious activity in the debt markets. To be precise, there is no close relationship between the stock price activity and the number of banks involved in the debt element of the financing. Similarly there is no significant relationship between the credit market activity and the equity syndicate size. This is evidence of market segmentation in insider trading. Whilst the size of the bid premium (hence the payoff from insider trading) and a stock’s volatility and liquidity do have an impact on the results, the central theme that more insiders brings more insider trading prevails.
Conceptually, should more insiders lead to more insider trading? Competition amongst insiders should reveal information as price changes instantaneously if markets are frictionless, and beyond a few insiders, there should be little impact on the activity from additional insiders.3 It is the existence of barriers to competitive forces, such as wealth limitations, risk parameters and other exposure constraints as well as equity and debt market segregation, that creates imperfect competition between insiders and permits a larger number to exploit their information.
If insider trading has increased and is likely to be linked to the number of participants, then why have the enforcement regimes not retaliated? One issue could be that the regulators have not reacted promptly to the changing nature of how non-public information is disseminated in LBO deals. Indeed, in our research paper, we show theoretically that as the number of insiders increases, regulators should lower the threshold of abnormal trading activity beyond which they trigger an investigation. The problem is of course that detecting the symptoms of insider trading in the form of unusual price or spread activity is only the first step. Identifying the perpetrators is not straightforward given the lack of transparency, especially in the complex over-the-counter derivative markets. Furthermore, differentiating between legal hedging and trading and that derived from asymmetric information takes considerable resources. What is clear is that for any enforcement regime to be effective, it will need to be robust to the changing landscape – the increasingly cross-border dimensions of leveraged buyouts, the global location of their participants and hence their trading activity, and the growth in the use of over-the-counter instruments.
Acharya, V.V. and T. Johnson (2007), “More Insiders, More Insider Trading: Evidence from Private Equity Buyouts,” CEPR Discussion Paper 6622, December.
Holden, C. W., and A. Subrahmanyam (1992), “Long-lived Private Information and Imperfect Competition,” Journal of Finance, 47, 247–270.
Altman, E., 2007, “Global Debt Markets in 2007: New Paradigm or the Great Credit Bubble?," Journal of Applied Corporate Finance, 19, 1731.
1 See Altman (2007). Based on a sample of 178 US public-to-private deals of greater than $100 million in value in the period 2000-2006, the trend in activity and size is strikingly evident. In 2002 with just 15 observations the size of the 90th percentile was just short of $ 1.5 billion. By 2006 this was the median size from 64 observations (Acharya and Johnson, 2007).
2 See “Boom time for suspicious trades” by Victoria Kim and Brooke Masters, Financial Times, August 6th 2007. A May 2007 Bloomberg Markets “Insider Trading” study of the 17 biggest takeovers in the preceding year found that in the three days before the bid announcement, trading volume jumped 221% compared to the average for the prior 50 daysA Wall Street Journal study of December 2006 revealed unusual spikes in CDS fees ahead of 30 LBOs.
3 Holden and Subrahmanyam, 1992