Outside Insiders

Tuesday, October 17, 2017

Does access to information prior to an initial public offering (IPO) generate a trading advantage after the IPO? That's the question posed by researchers from Purdue University’s Krannert School of Management, who find that the information obtained by non-insider institutions through their connections prior to the IPO may remain valuable in subsequent quarters.

Deniz Yavuz, an associate professor of finance, coauthored the study with Umit Ozmel, an associate professor of strategy, and Timothy Trombley, who earned his PhD in finance at Purdue’s Krannert School before joining the faculty of San Diego State University.

“We find that limited partners (LPs) of venture capital firms (VCs) earn very high returns from their investments in newly listed firms backed by their VCs,” Yavuz says. “VC backed startups have raised more than $160 billion in the last 30 years through initial public offerings, accounting for more than half of all IPOs in recent years. VC funds typically have had investments in these startups for several years prior to the IPO, particularly if they are the lead VC fund of the funding consortium.

“During this time, the LPs of the VC funds obtain information about these startups. Lead VC funds are often are especially involved with the companies in which they invest, offering them plenty of opportunity to obtain information and pass it on to their LPs. Consistent with this possibility, we find that LPs’ investments in connected stocks (backed by their lead VC funds) have an average raw return of 12.43 percent in the next quarter corresponding to about 60 percent annual returns.”

For example, CALPERS’ (the California Public Employees’ Retirement System) invested in a VC fund called Alta BioPharma Partners III that was established in 2003. The VC fund invested in Aegerion on Dec. 29, 2005, as the lead fund and participated in six total rounds of funding. Aegerion had its initial public offering on Oct. 22, 2010, and the researchers observe that CALPERS held a position in the stock on Dec. 31, 2010. From that date through Mar. 31, 2011, the share price of Aegerion rose by 16.9 percent.

“We show for the first time that the information that non-insider institutions obtain through their connections prior to the IPO may still be valuable after the IPO,” Yavuz says. “Our results indicate that institutional investors can obtain additional benefits from investing in private equity other than the returns on the private equity investment itself.  Other investors are disadvantaged in trading against these institutions that are not recognized as insiders by regulators.”

Yavuz says the study has important implications for recent policy debates about insider trading.

“In an attempt to make insider trading violations easier to prosecute, some members of Congress have proposed bills that can potentially impose a broad ban on trades that use information that is not publicly available,” he says. “Our findings indicate that this may have unintended consequences that might spill over to private equity investing, where information is legally acquired as a part of an LP’s fiduciary duty to monitor its investments. Such a wide definition of insider trading could very well disincentivize these institutional investors from investing in either private equity or newly listed connected stocks.”

The paper, titled "Outside Insiders: Does Access to Information Prior to an IPO Generate a Trading Advantage after the IPO," is forthcoming in the Journal of Financial and Quantitative Analysis. A downloadable PDF is available at: http://web.ics.purdue.edu/~myavuz/ozmel_trombley_yavuz_WP_2015.pdf.