Two scholars affiliated with the State University of New York at Albany recently looked into the roles of hedge funds in corporate misreporting. Specifically, they used a database of PIPE issuers.
The resulting paper, by Na Dai (Associate Professor of Finance at SUNY) and Alfred Zhu Liu (Assistant Professor of Accounting) maintains that PIPE issuers “are more likely to engage in financial misreporting when a hedge fund is the lead investor in the offering.” This is a good time for an immediate correlation-is-not-causation notice. These authors are not contending that hedge funds cause the financial misreporting.
It might be, rather, that the causal arrow points the other way, the misreporting causes the hedge fund interest. As these authors say, “hedge funds might be more willing to invest in companies that are temporarily over-valued” than are other investors, precisely because the hedge funds can simultaneously short-sell the underlying publicly available securities. This one might call the smart-hedge-funds theory, because it posits that hedge funds, more than other investors, know the misreporting is going on and figure out how to make use of it.
Or it could be that hedge funds are ignorant compared to other investors, and so buy into misreporting firms that other investors avoid. This one might call the dumb-hedge-funds theory.
Often Investors, Often the Lead Investors
The PIPE (private investment in public equities) market is big. Between 1999 and 2015 PIPE offerings in the U.S. raised $600 billion in equities. During this period, hedge funds participated in more than half of those offerings. A hedge fund was the one investor contributing the largest chunk of capital to the specific transaction (the “lead investor”) in 500 out of 1820 of the transactions in the database.
Dai and Liu use accounting restatement as their proxy for misreporting. On that basis, they find both “a significant increase in the frequency of misreporting around PIPE issuance” and a positive association between hedge fund presence on the one hand and this misreporting on the other.
Back to the question of “why”. These authors don’t use the “smart” and “dumb” labels I’ve introduced above, but those labels are fair paraphrases of their approach. They reason that if the “smart” theory is correct, one would expect hedge funds to protect themselves from the negative consequences of the misreporting, not just by hedging on the short side, but by requiring higher discounts in the PIPE itself, and/or by requesting more investor-friendly contractual terms.
Dai ad Liu find “that hedge funds do not charge misreporting firms higher discounts,” but they do require extra protections in the tailored contracts when they invest via PIPEs in firms with ongoing misreporting.
Investor of Last Resort
To appreciate this finding; it helps to remember who PIPEs issuers typically are. As these authors describe the market, the issuers are often resorting to PIPEs because of financial distress. They are small and/or poorly performing firms “that have low or no analyst coverage and higher-than-normal illiquidity, leading to very limited access to external financing.” They have strong incentives, then, to fudge the books to make the issuance appear attractive.
The existing literature on PIPEs already documents that the negotiated contract is an important means by which investors, especially hedge funds, address the problems endemic to such issuances. Brophy et al. made that point eight years ago, in a paper in Review of Financial Studies, “Hedge funds as investors of last resort.”
Some of the contractual provisions that serve this purpose are: anti-dilution clauses, investor call options, investor rights of first refusal, and redemption rights. Dai and Liu constructed an “investor protection index” (IP) to quantify such provisions in a specific PIPE contract. The average IP is 1.31. It is only 1.26 if there has been no restatement within the 12 months prior to the PIPE closing. But it is significantly higher, 1.55, if there has been a restatement in that year. Further, hedge funds get much higher IP than non-hedge fund investors do in that situation. Such evidence seems to put an end to the dumb hedge fund hypothesis.
Our authors conclude that “hedge funds differ from other types of investors in that they do not preclude issuers of higher information risk and instead utilize more sophisticated contract features to protect themselves.”