Money Stuff: Honey, I Insider-Traded Your Merger

Look, if your spouse works as a mergers and acquisitions manager at a big public company, and her company acquires another public company, and you “methodically sold all [your] positions in both [your] individual brokerage account and [your] Roth IRA (totaling approximately $2.16 million)” to buy shares of the target stock before the deal was announced, and then you sell the target stock when the deal is announced and make a profit of $1.76 million: That is insider trading and you will get arrested. I don’t need to know any more facts. Your spouse worked on the deal, you sold everything you owned to buy the target stock, the regulators can very easily put those two facts together, and when they ask you what happened and you are like “crazy coincidence right?” they will absolutely not believe you, nor should they. Bad, bad, bad look.

No, the only question is: Will your spouse get arrested? Because there are two possibilities here:

1. Your spouse used the inside information from her job to tell you about the coming deal, knowing that you would trade on it. She “tipped” you with the inside information, expecting (as your spouse) to share in your profits. So she, like you, is guilty of insider trading.
2. Or your spouse didn’t tip you. Maybe she kept the information secret from you, but you snuck onto her computer at night and read her email and figured it out. Or, much more likely, she mentioned to you what she was working on, but she expected (as your spouse) that you would keep her confidences and not go out and trade on the information like a moron. In that case, you are guilty of insider trading — you misappropriated information that you got from her in breach of a “duty of trust or confidence” — but she is just an innocent victim.

In general this seems like a hard question for investigators to resolve. (If you have gone and insider traded on your spouse’s information, the least you can do is say that it was all your idea and she knew nothing about it, whether or not that is true.) Sometimes it’s easier though. Here’s a pretty grim US Securities and Exchange Commission case:

The Securities and Exchange Commission [Thursday] charged Tyler Loudon of Houston, Texas, with insider trading ahead of a February 2023 announcement that London-based oil and gas company BP p.l.c. agreed to acquire TravelCenters of America Inc., a full-service truck stop and travel center company headquartered in Ohio. Loudon allegedly made $1.76 million in illegal profits from his trading.

According to the SEC’s complaint, Loudon allegedly misappropriated material, nonpublic information about the proposed acquisition from his wife, a BP mergers and acquisitions manager who worked on the planned deal. The SEC alleges that Loudon overheard several of his wife’s work-related conversations about the merger while she was working remotely. 

Loudon also pleaded guilty to criminal charges. The SEC complaint describes how Loudon found out about the deal, which is standard post-Covid it’s-easy-to-insider-trade-when-you-work-from-home stuff:

Loudon and his wife generally worked in home offices within 20 feet of each other. As a result, they frequently overheard and witnessed each other’s work-related conversations and video conferences. In late December 2022, Loudon and his wife traveled to Rome, staying in a small Airbnb where Loudon’s wife regularly worked on the TA acquisition and discussed the deal while Loudon was seated nearby.

But also: “Loudon’s wife acknowledged discussing aspects of the acquisition with Loudon during the normal course of marital communications.” This is not a case where she rigorously kept the deal secret from him, and he broke into her laptop: It’s a case where a husband and wife talked about their days, and she trusted that he would not go and insider trade on the deal. Because why would he do that? That would be crazy!

Anyway, after the deal, regulators of course checked into whether anyone who worked on the deal, or their contacts, traded in the stock. Loudon’s wife mentioned this to him, and he realized what he had done:

One week later, on April 3, 2023, Loudon confessed to his wife that he had traded in TA prior to the acquisition announcement. Loudon did not tell her the number of shares he purchased or the profits he realized from their sale. Loudon told his wife that he had bought the TA shares because he wanted to make enough money so that she did not have to work long hours anymore.

“I was doing it for you!” Bad!

Stunned by this revelation, Loudon’s wife reported the trading to her supervisor at BP. In turn, BP placed her on administrative leave. BP reviewed Loudon’s wife’s emails and texts, finding no evidence that she knowingly leaked the acquisition to Loudon or otherwise knew of her husband’s trading. BP nonetheless terminated her employment.

Well, so, she’s not working long hours anymore.

After Loudon’s confession, Loudon’s wife moved out of their house and generally ceased all contact with Loudon. A few weeks later, Loudon delivered a handwritten note to his wife apologizing for violating her trust and asking for her forgiveness. Loudon’s wife initiated divorce proceedings in June 2023.

I think that’s the worst insider trading case I’ve ever read? Between her prompt reporting to BP, their review of her texts and emails, and the immediate divorce, it seems pretty clear she wasn’t in on the insider trading. Still, terrible.

I wrote a few weeks ago about Bill Ackman’s plan to raise a new closed-end fund for US retail investors. I started by talking about Ackman’s existing closed-end fund for retail investors, Pershing Square Holdings (PSH), which is listed in Europe and which, at this point, is Ackman’s main investing vehicle, holding about $12.3 billion of his $15.8 billion of net assets under management. [1]  PSH is mostly pretty simple: It does some hedging and derivatives trading, but mostly it owns the stocks of a small number (currently 10) of large public companies. It has a small amount of debt. And it charges hedge-fund-ish fees, an annual management fee of 1.5% of assets and a performance fee of 16% of gains.

So you can pretty easily figure out PSH’s net asset value (NAV): Add up the value of its liquid public holdings, subtract the debt, and you get a decent estimate of how much each share of PSH is worth. And in fact PSH’s net asset value is reported regularly on Bloomberg and on PSH’s website. But PSH’s shares, which trade on the Amsterdam and London stock exchanges (and over the counter in the US [2] ), generally trade at a discount to NAV. On Friday, the stock closed at $48.80, a 26.3% discount to the $66.21 NAV. I wrote: “I don’t know exactly why PSH trades at a discount, but,” and then went on to talk about other things.

Several readers emailed me to propose explanations for why PSH trades at a discount, but the  simplest explanation is that the discount capitalizes the fees. [3]  Say you have $100 to invest. PSH consists mostly of a short public list of publicly traded stocks. [4]  You can look at the list of stocks that PSH owns and then replicate it yourself, just buying $100 of those stocks. Then you will own $100 worth of stocks. If the stocks go up 20% in a year, then next year you will own $120 worth of stocks. 

Or you can put $100 into PSH. Assume counterfactually that PSH trades at no discount: You put in $100 for $100 worth of NAV. Then you will (indirectly) own $100 worth of those same stocks. If the stocks go up 20% in a year, then next year you will own — well, you’ll pay $1.50 in management fees and $3.20 (16% of 20% of $100) of performance fees, so you’ll own $115.30 worth of stocks. This is worse. The following year you will also pay fees, and on plausible assumptions those fees will end up eating a large chunk of your gains, enough to explain a 26% discount. [5]

Again, just buying the stocks that PSH holds should cost you $100. PSH is a package consisting of (1) the stocks it holds (2) minus its fees, so it should cost less than $100. Thus the discount.

Now, this argument is far too crude. The counterargument is that PSH is actually a package consisting of (1) stocks (2) minus fees (3) plus Bill Ackman’s investing skill, which allows him to change the portfolio over time, selling the stocks that will go down and instead buying other, better stocks that will go up. If you just buy his most recently disclosed portfolio, you avoid the fees but also miss out on his investing skill. Buying the stocks Ackman owns now is not actually a good substitute for buying the stocks (and derivatives, etc.) that Ackman will own over time.

But the market, at least for PSH, seems to attribute more (negative) value to the fees than to the skill. And part of what we talked about last time was that Ackman’s new US fund seems to be a bet that US retail investors will attribute more value to the skill. Also the US fees will be lower.

In any case, this situation does suggest a simple trade, which is “stop paying the fees and give us the stocks”:

1. You can buy PSH’s shares at a 26% discount to net asset value. PSH is a pot full of $12.2 billion worth of stock, but that pot trades for $9 billion.
2. So buy all of PSH, or at least a controlling stake.
3. Crack PSH open, take out the $12.2 billion worth of stocks, give them to yourself and stop paying the fees.
4. Sell them if you want, whatever; the point is that you bought $12.2 billion of stocks for $9 billion.

You can’t really do that, for various reasons. One reason is that Ackman himself owns a lot of the shares. Another is that if you actually go and buy all the PSH shares you’ll push up the price and the math might no longer work. [6] Still the fact that a pot of $12.2 billion of large publicly traded stocks is available for $9 billion does create a temptation.

For instance, Bloomberg’s Yiqin Shen reported last week:

Elliott Investment Management targeted Pershing Square Holdings in 2017, when Paul Singer’s firm privately tried to force fellow activist Bill Ackman to liquidate his listed company.

Ackman disclosed the details of the battle around the fund publicly for the first time during a three-hour interview on the Lex Fridman Podcast. The billionaire posted the discussion on X, the social media site formerly known as Twitter, on Tuesday.

Elliott took a big position in Pershing Square Holdings, a closed-end vehicle that traded at a discount to the value of its assets, while shorting the underlying securities held in the fund, Ackman said. It was a bet that the target would be forced to liquidate, allowing investors to profit from the shakeup.

“I envisioned an end where the permanent capital vehicle ends up getting liquidated and another activist in my industry puts me out of business,” Ackman said.

Ackman managed to fend off Elliott by snapping up shares in his own company, effectively buying control, he said. He borrowed $300 million from JPMorgan Chase & Co., to help him to do this.

“I give JPMorgan enormous credit in seeing through it,” Ackman said. “It’s a handshake bank and they bet I’d succeed.”

Here are the interview and Ackman’s X post. Closed-end fund activism is a popular trade, and Ackman’s buddy Boaz Weinstein has made a crusade of it. (Though not against Ackman; that would be rude.) In some ways it is the most schematic possible form of activist investing:

1. There is a company with publicly traded stock. 
2. The stock price is below the company’s fundamental value.
3. The company is paying its management a lot.
4. An activist buys up all the stock and tries to kick out management.
5. Management says “no, you don’t understand, we are getting paid for creating long-term value, and the market is too focused on the short term so the stock price does not incorporate all the long-term value we are creating.”
6. The activist disagrees.

Sometimes management’s long-term plans are good and worth the money, other times they aren’t. Here, management won.

When we previously talked about PSH, I emphasized what a good idea it was, and is, for Ackman (or any other hedge fund manager) to have a permanent capital vehicle. If you run a hedge fund and you have disappointing performance, your investors can ask for their money back, and eventually you have to give it to them, and then you don’t run a hedge fund anymore. If you run a closed-end fund and you have disappointing performance, no one can ask for their money back — that’s kind of what “closed-end” means — and so you get to keep running a hedge fund forever. But not literally; you can’t keep running even a closed-end fund forever if you keep disappointing your investors. There is a safety valve. The safety valve is that someone can buy up all the shares and do activism on you.

Just a very dumb simple model of private credit is:

1. People — asset managers, sovereign wealth funds, banks, rich individuals, whoever — have flocked into private credit because it can offer higher yields than traditional bonds and syndicated bank loans.
2. Why would you want to borrow from them? “Private credit has higher yields than bank loans” is a great pitch to lenders, who want to receive higher yields, but it is a bad pitch to borrowers, who want to pay lower yields.

There are answers. The one that I have probably heard the most is that private-credit lenders can be faster and more decisive: If you are a company looking for a loan, or a private equity firm looking for buyout financing, going to one or two direct lenders and saying “can you lend me the money” and having them reply “yes, here are the terms, sign here” is better than going to a bank and having them say “we’ll need a one-month marketing process, here are the indicative terms but we reserve the right to flex based on market conditions.” In private credit, borrowers deal directly with the people making the lending decision; in bonds and bank loans, they deal with intermediaries. In a choppy market, it is worth paying up a bit for certainty of execution.

There are a few other answers. If you don’t deal with intermediaries (banks), you don’t pay their fees; the economic model of private credit might be not just “private credit lenders charge more than syndicated loan and bond investors” but “private credit lenders charge more but you save on bank underwriting fees.” Also you could imagine private credit firms being nicer to deal with if you run into trouble and need to restructure your debts: You have fewer lenders, you know who they are, they can’t sell their loans, they probably all work on the same floor as private equity investors so they sympathize with your troubled private equity buyout, etc.

Still my general view of lending markets is that if one product offers some long appealing list of qualitative advantages, and the other product is three basis points cheaper, everyone prefers the cheaper product. The Financial Times reports:

Roughly $10bn of so-called private credit loans have been refinanced in public markets, as borrowers pay down burdensome loans in favour of a cheaper alternative, according to data from Bank of America.

Private equity firms that buy out companies are taking advantage of a recovery in global corporate bond and loan markets, after the Federal Reserve signalled that inflation had been sufficiently tamed for it to begin cutting interest rates.

That shift has opened the door for investment banks to pitch hard for business that they lost to private lenders after rates dramatically rose in 2022, with the banks hoping for a revival of lucrative fees.

“Pressure is coming from sponsors for the coupons to be cut and this is just a race to the bottom between the banks and the direct lenders,” said Neha Khoda, a strategist at Bank of America. …

The changing market conditions offer an opportunity to banks, which were saddled with billions of dollars of losses on the deals they agreed to finance in 2022. … The losses limited lenders’ interest in extending new loans, and when they did the terms were often too expensive for private equity firms to turn to.

This is the good and bad side of the “private credit is faster and more decisive” point: If you got a commitment letter from some banks for a leveraged buyout financing in 2022, and then rates shot up, then when that financing closed months later you got an outrageously good deal. (Ask Elon Musk.) But the banks were burned by the outrageously good deals they gave out in 2022, so they could only offer pretty bad deals in 2023. Now they are back.

If you do a “private IPO,” what does the P stand for? “Private initial public offering”? You see the problem. Here’s the Wall Street Journal:

The concept is being bandied about on Wall Street as investors and bankers search for ways to keep the money flowing. The contradictory moniker refers to stock sales in which early backers privately sell to longer-term investors such as mutual funds or sovereign-wealth funds, sidestepping the traditional IPO process. 

Private IPOs don’t come with the splashy bell-ringing ceremony of a traditional debut or result in publicly traded stock. They do allow companies to avoid the potential embarrassment of a new listing falling flat. 

Some on Wall Street balk at the name, seeing it as window dressing for private placements, which are sales of shares from one private owner to another and have been used for years. Skeptics say bankers, never a group to sit still, are playing with semantics to drum up business.

What’s more, some mutual-fund managers who have been approached to do private IPOs are wary. While they might get better prices and bigger allotments of shares in a private IPO, the liquidity—or lack of it—is a big drawback. If the managers buy stakes this way, it isn’t clear when they would be able to sell them.

We have talked about this phenomenon before, and I have argued that it kind of doesn’t make sense? In general, you would expect the public markets to put a higher valuation on reasonably mature companies than the private markets, because liquidity is valuable, and public markets are much more liquid. You should pay more for stock that you can sell than for stock that you can’t sell. If you are a company considering going public, and you decide not to because you don’t think you’ll get a good enough price, why would you get a better price in a “private IPO”?

I suggested a few weak counterarguments:

1. Maybe private investors are systematically mistaken about valuation? Seems weird.
2. Maybe illiquidity is actually valuable: If you can’t sell a stock, you won’t sell it in a foolish panic, so maybe your long-term returns will be higher. Again it would be strange if this were generally true. 
3. Maybe going public actually destroys value, because of public financial reporting or compliance costs or short-termism or short selling or whatever, so private valuations should be higher.

Eh. Anyway the “semantics” point seems right. Lots of private companies have done trades — private placements, Series G fundraising rounds, employee tender offers, etc. — that have the essential shape of “the company stays private but somebody buys stock.” What makes a trade a “private IPO” instead of “selling stock”? Is it that the buyer of the stock is a mutual fund? I think the answer might be “it is pitched to you that way by an investment bank.”

Last week I described BOXX, the Alpha Architect 1-3 Month Box ETF, an exchange-traded fund that is meant to pay money-market interest rates without taxes, using options strategies. I wrote: “The first thing you want to do is turn interest income into capital gains. … In some sense this should be easy.” Some assets pay you a return that is called “interest,” which is fixed and paid in installments and taxed at ordinary income rates; other assets pay you a return that is called “appreciation,” which you receive when you sell the asset and which is taxed at lower capital gains rates. There is some economic equivalence between these things; assets that don’t pay interest generally appreciate at some rate that compensates you for the use of your money, sort of like interest does.

The trick is to find an asset that appreciates at the risk-free rate, i.e., that reliably pays you roughly the same return as short-term Treasury bills, but in the form of “appreciation” rather than “interest.” The simplest way to do that would be with a zero-coupon bond — a bond that doesn’t make quarterly interest payments, but just pays you back more at the end than you put in at the beginning — but that’s too simple, and the US tax code looks through that trick and treats the appreciation on a zero-coupon bond as interest. 

So the second-simplest way to do it is by buying a stock (a classic capital asset) and hedging out the stock-price risk. For instance, if you buy a stock and simultaneously sell it in a fixed-price forward contract, you have effectively hedged out the stock-price risk. And that’s roughly what BOXX does, in the form of “box spreads” on S&P 500 index options (get synthetically long the index by buying a call option and selling a put, get synthetically short the index by selling a call and buying a put, and do those things at different strike prices so that you lock in some payoff in the future). 

But several readers emailed to point out that, at least sometimes, the US tax code looks through that trick too. Section 1258 of the Internal Revenue Code recharacterizes some capital gains as ordinary income, if those gains are effectively interest on a “conversion transaction,” meaning a transaction where you (1) buy an asset and (2) simultaneously enter into a contract to sell the asset at a fixed price. [7]  So a simple transaction like “buy a stock and sell it forward” probably produces ordinary income, not capital gains.

Do BOXX’s box spreads produce ordinary income? My understanding is that there is a common view that box spreads are not “conversion transactions,” and in particular that box spreads with index options are covered by different rules. But I do not claim to be an expert, or to give tax advice, and apparently some people disagree. 

Is it … Byju? A few years ago, we talked about John Schnatter, the founder and papa of Papa John’s International Inc., who got in a fight for control of his corporate child. He was a big but not controlling shareholder, and the former but not current chief executive officer; also the company was named after him, with a possessive apostrophe-s. These advantages were large, though not decisive; he never did come back as CEO, and was reduced to maybe eating 40 pizzas in 30 days to prove that he didn’t even like the pizza anymore anyway.

Last month we talked about another possessive-apostrophe-s company, Byju’s, once “the world’s most valuable edutech,” but now not so much. We talked about Byju’s because it was trying to do a rights offering, hoping to raise $200 million at a “post-money valuation … of $220 million to $225 million, a 99% drop from the $22 billion valuation that the startup had attained in 2022,” oops oops oops oops oops. Raising $200 million at a $220 million post-money valuation [8]  is “hey, turns out we blew all your money and the company is worthless, want to try again?” Why would they want to try again? Anyway here’s Byju:

Byju Raveendran, the founder of eponymous edtech group Byju’s, told employees on Saturday that he continues to remain the chief executive of the startup and that rumors of his firing have been “greatly exaggerated,” a day after a shareholder group voted to remove him at an emergency general meeting.

In a 758-word letter, content of which was reviewed by TechCrunch, Raveendran claimed that the shareholders violated several “essential” local rules.

The shareholder group, which included Prosus Ventures and Peak XV Ventures, said in a statement on Friday that the investors “unanimously passed” the resolutions that seek to enact, among other things, addressing governance, compliance issues, financial mismanagement, reconstitution of its board and a change in leadership “so that it is no longer controlled by the founders of T&L.” …

Raveendran claimed in the letter that the extraordinary general meeting lacked the minimum quorum and failed to win majority support for proposed resolutions. Raveendran claimed the EGM was convened without adhering to the procedures set out by law and only 35 of Byju’s 170 total shareholders attended, representing around 45% ownership in the company. …

“Our rights issue has seen an overwhelming response. In fact, such has been the scale of its success that even those who were sitting on the fence are now rushing to get a piece of the action. This momentum is irreversible, and our comeback is now inevitable,” Raveendran told employees.

Ah. If I ran a company that was once worth $22 billion and is now worth $25 million, I would be hesitant to say things like “this momentum is irreversible,” but I guess that’s why I don’t.

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