August 5, 2016
What We’re Reading This Week
Insider Trading…Sort Of
I have written a lot on insider trading over the past 12 months. Like this, this, and this. There are some overarching themes here, like insider trading is hard to define. I’ve always been curious about the ethics of investor relations departments at large corporations. Essentially, companies are not allowed to selectively disclose material, nonpublic information. However, all large, public companies have an investor relations department that exists exclusively to talk to investors about the company. Mainly, they are talking to large, institutional investors and investment company analysts. The investment committee at a firm I once worked for would routinely send analysist to companies on our investment focus list for private tours with company executives and the investor relations department. I don’t want to suggest that meetings were specifically to receive material, nonpublic information but at the same time, there aren’t very many other good reasons to have a meeting like that. They are affectionately referred to as “due diligence” trips as if one might visit Proctor & Gamble and find them not making band aids and mouthwash but rather, hosting illegal dogfights. Anyway, the Wall Street Journal found that companies are consistently steering analysist to reduce earnings expectations. Historically, 75% of companies in the S&P index beat estimates on a quarterly basis which in turn drives up the share price. This statistic has remained consistent during both bull and bear markets. According to the article, investor relations departments use “nudges” and “signals” to gently push analysts to lower forecasts. These signals have become so commonplace that it is “more about theatrics than reality.” The nudges also usually only go to a select group of analysists, which sort of feels “nonpublic.” This allows clients of said firms to profit by buying a company’s stock ahead of the earnings release. This sort of feels “material.” While this may not technically be “insider trading” (which isn’t technically illegal anyway) there is a strict law called Regulation Fair Disclosure which specifically outlaws the practice of giving earnings forecasts to select analysists. Because of this, most firms are not overtly giving this information away but are instead relying on code words and phrases which is not expressly prohibited. Part of me wishes they used hand gestures too, like a third base coach. Finally, like everything else in the industry, it comes down to incentives. How does the economy of stock analysts and investor relations departments work? As an analyst, you want “secret” information and as a company you want to be rated a “buy.” If the analyst rates your company a “sell” you won’t be as willing to give them special nudges. If the company doesn’t fly analysts out to wine and dine them as well as tell them super-secret info then they might not rate the company as a buy. Investors are left on the sidelines thinking analysts are helping them to know what companies to buy in a level playing field. The truth is, it’s not a level playing field and while analysts may know what stocks to buy they may not be telling the investor the whole story.
The Journal was a font of interesting news this week. Prosper, an online lender is apparently in advanced talks with investment firms to sell them approximately $5 billion of loans. That’s not very interesting, nor is the fact that the firms are buying the loans at face value. What’s interesting is that in exchange for the purchases the investment firms will receive private equity warrants in Prosper itself. You don’t really see that much, except, like, credit unions, which is this exact business model except not-for-profit. Online lending has long been heralded as the future of personal finance and exists primarily as a competitor to brick and mortar banks. Many firms like Prosper set out to change the banking industry, but as they have matured they are starting to look more and more like banks. Unless they look like credit unions, I guess. Another fun tidbit from the article is that “the potential buyers are also talking to banks about borrowing money to support their loan purchases.” The only way that could make me happier is if they were borrowing from Prosper to fund the loans and potentially buying their own loans. A financial ouroboros. Can you imagine that conversation at the bank though?
Investment Company: We’d like to borrow several million dollars to purchase an investment.
Bank: Sure, what kind of investment are you buying?
Investment Company: Consumer loans, but we will also get equity in the lending firm!
Bank: Well we can do both of those things for you, with our bank.
Investment Company: Oh, well, no thanks, we think marketplace lending is the future…
Bank: But you’re here…
Investment Company: Uhhhh….
The first article in this blog outlines potential issues that a buyer may face when accessing a seller through an intermediary. Investment companies face similar issues when they buy debt instruments from banks (an intermediary) or marketplace lenders (another intermediary) like in the second article. It only feels natural to finish with an article on how some investment companies are circumventing the middle-man and lending directly. Investment firm Ares Management LP lent Thoma Bavo LLC $1.1 billion ($200 million more than bank competitors) to buy Qlik Technologies. As banks have faced more stringent regulation and lending policies investment firms have begun to arrange debt for riskier borrowers. It’s sort of interesting right? Banks got into a lot of trouble because they were using assets to invest in risky debt instruments without the clients’ knowledge and in some cases just lying about the safety of the debt, either to itself or the investor. This led to many people advocating, naively, for the return of the Glass-Steagall Act of 1933, the law that prohibited banks from engaging in the investment business. Now, because we live in a capitalist country, and where there is demand there will eventually be supply, investment companies have decided to step into this space. These loans tend to be pretty profitable for the underwriter, as long as the borrower pays and investment companies can make these loans without the same regulations and scrutiny as a traditional bank. Ultimately, I think this is good. The issue with banks making risky loans has to do with their ability to remain solvent should the borrowers default. Even more simply, in the past (and present), banks make the loan then sell it to an investment company later. This just sort of feels natural.
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