New York, NY – The arrest a few weeks ago of billionaire hedge fund icon, Raj Rajaratnam, and five others in what has been termed the largest insider trading scandal involving hedge funds has caused a great deal of consternation on Wall Street. Not only are analysts and investment managers at other hedge funds nervous, but executives at various expert network providers are also wondering if they could potentially get dragged into this mess. In fact, some are going so far as to say that the Galleon scandal could have a chilling effect on the entire independent research industry over the near-term. This blog will discuss these issues.
Galleon and Expert Networks
The basic allegations behind this scandal are that Raj (and other accused hedge fund professionals) had broken insider trading rules by speaking with senior executives inside publically traded companies, as well as others at consulting firms, PR firms, and ratings agencies who shared specific information on earnings results and material pending deals that Raj and others profited from.
However, it is also widely known in the hedge fund industry that Galleon Group spent millions of dollars on various expert networks to gain access to public and private company employees, consultants, and other industry experts for one-on-one telephone consultations. Unfortunately, the details of the current insider trading scandal has placed a harsh spotlight on the growing expert network industry, as outsiders wonder if Raj and his cronies used expert networks to gain their illicit informational advantage.
It is important to note that thus far, it looks like the SEC’s current insider trading case is built on the network of contacts that Raj Rajaratnam had built up over the decades he had been on both the sell-side and buy-side, and not on experts sourced by existing expert networks. Unfortunately, this detail may not have a tremendous impact on how the case impacts the expert network industry over the near term.
Who is Really On The Hook?
Many in the expert network industry have been quite concerned for a few years that a scandal like the current Galleon Group debacle could bring down the entire business. Consequently, the largest expert network providers, including Gerson Lehrman Group, Guidepoint Global (and the Vista Research business recently acquired from S&P), Coleman Research Group, and DeMatteo Monness have all focused a great deal of attention in the past few years to build professional compliance policies, processes and tools to reduce the risk of such an occurrence.
In fact, the extensive “Terms and Conditions” that most experts are required to sign, the expert training provided by most of the largest expert network providers, and the data and tools that have been implemented to keep investors from accessing experts who might have insider information have all reduced the risk that the expert network providers will be found culpable an a situation like the Raj Rajaratnam insider trading case.
While we are not lawyers, and don’t understand the legal issues surrounding insider trading cases, it appears to us that the largest expert network providers have done a good job over the last few years in limiting their legal liability, and placing the real risk with either the experts, or with the investors who speak to the experts. Consequently, we would be extremely surprised if any of these larger, more professional expert network providers, would suffer serious legal problems arising from current insider trading case.
Despite the fact that most expert networks are unlikely to face severe legal consequences, we would not be surprised if the entire expert network industry experiences decreased investor demand over the next few quarters.
This view is based on the fear on the part of hedge funds and mutual funds that the Galleon insider trading case is a sign that the SEC plans to be more aggressive in enforcing Reg FD and insider trading rules. We think this will prompt buy-side investors to be much more careful in their use of expert networks to speak with company employees and industry experts who might possess material nonpublic information about publically traded companies.
This potential development, on top of the fact that the expert network industry has faced stiff price competition over the past two years, would have serious negative revenue consequences for many expert network providers.
As a result, we believe buy-side investors will be forced to rely less of experts and instead they will be required to do more of their own rigorous research. This transition could have a positive impact on their use of other types of investment research like third-party channel checks, quantitative surveys, deep investigative research, forensic accounting, and traditional fundamental research based on proprietary primary data.
Over the longer term we think that buy-side investors will resume their use of expert networks as an integral part of their research process – with one major difference. We suspect that buy-side investors will pay even more attention to the compliance processes, procedures, and tools that a potential expert network provides to help investors manage their use of experts. Consequently, we would not be surprised if firms like GLG, Guidepoint, Coleman or DeMatteo Monness might benefit, while smaller firms with less compliance infrastructure would lose out.
Certainly, we would not be surprised if in response to the current scandal, some major expert network providers might actually prohibit client access to public company employees. This is a trend that has picked up steam with some large mutual and hedge funds in recent years – with some going so far as to mandate that they would not allow their PMs or analysts to contact public company employees until they had left the companies employ for at least six months.
While it is still too early to tell exactly what changes will come as a result of the recent Galleon insider trading case, we think that the independent research industry will be impacted. Over the short-term, we expect that buy-side investors will curb their use of experts out of fear that speaking with company insiders could get them caught up in future insider trading or Reg FD investigations brought on by a more proactive SEC. However, over the longer-term we think the buy-side will resume their use of expert networks as an integral part of their research process, with those firms that have developed more rigorous compliance systems benefiting over those firms with weaker offerings in this area.