Notes of Note from John F. Ince

Very very interesting …. Companies that borrow money from hedge funds often see a sharp rise in bets against their shares before the loans or loan amendments are announced, new research shows, suggesting that fund managers or others privy to these deals may be illegally trading ahead of the announcements.

The sharp spike contrasts with little change in the short selling of companies that borrow money from banks, according to the research.

“Hedge fund lenders, like banks, are ‘quasi-insiders’ and thus privy to private information about the performance of borrowing firms,” the authors write. “However, hedge funds are not subject to the same degree of oversight and regulation as banks.”

The paper, by four academics and accepted for coming publication in the Journal of Financial Economics, tracks the trading of 105 U.S. companies that borrowed money from hedge funds between January 2005 and July 2007—a period when regulators began demanding more information about short selling.

The academics found that the average company receiving a new loan from hedge funds saw a 74.8% spike in the volume of short sales during the five days preceding announcement of the new loan, as compared with the volume of short selling 60 days before the deal.

By contrast, 255 similar companies turning to banks for loans saw little change in the volume of short selling during the five days prior to the announcement of new loans.

Short selling also jumped 28.4% before the announcements of amendments to existing loans from hedge funds, compared with a drop of 17.4% in short selling before the announcements of amendments for bank loans.

Short selling after a loan is announced might be expected, as investors and lenders hedge their exposure or bet against a company taking on debt at a high rate. But when it jumps before the announcement of a loan, the activity raises questions about whether the very firms lending money are using nonpublic information to trade against their borrowers, or whether information is leaking out to others.

via Hedge-Fund Lending Draws Scrutiny – WSJ.com.

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