If a party obtains information about a public firm before its initial public offering (IPO), and the party themselves is not an insider of the firm, should they be allowed to profit from the information after the IPO? We investigate this question in our research paper, “Outside Insiders: Do Limited Partners Obtain Valuable Information about Stocks Backed by their Venture Capital Funds?” As the title implies, we find that this situation can occur when the IPO is backed by a Venture Capitalist (VC).
Venture Capital backed IPOs account for more than half of all IPOs. In the years before a company’s IPO, the VC funds that back it often are deeply involved with the company. They are often on the board of directors, and they help the startups by providing strategic advice, professionalizing firm management and attracting better resources. Thus, before the IPO, VC funds have plenty of opportunity to obtain information that may not be fully released to the public at the IPO.
However, these VC funds are not merely acting on their own behalf. They are investing other people’s money. Their investors are called the Limited Partners (LPs) of the VC fund, and they are usually large institutions such as investment banks, sovereign wealth funds, hedge funds, nonprofit endowments, and pension funds. These institutions have a fiduciary responsibility to their investors to obtain information about the VC fund’s investments. They could gain information from their VC fund through the fund’s quarterly investment reports, through official meetings of LPs and general partners, and through investment advisory review boards on which LPs often serve. Because these LPs are often active in the stock market, this raises the possibility of a limited partner obtaining information about a startup before the IPO and using this information to profit in the stock market.
However, this argument is not a priori valid. It is possible that any information the LP receives before the IPO is released to the public during the IPO process. Even if one were to find that LPs trade profitably on stocks that they are connected to through their VC, this may be explained by other theories. For example, LPs, as large institutions, may simply be better investors in IPOs.
In our paper, we evaluate LPs’ investments in newly listed stocks whose lead VC fund has an investment from the LP (we call these “connected stocks”). We find that an LP earns risk-adjusted returns on connected stocks that are 14-20% higher per quarter than that same LP’s investments in unconnected newly listed stocks. These findings are robust to controlling for a laundry list of control variables, different methods of risk adjustment, return horizons, and regression specifications. These returns are similar in magnitude to previous findings of the profits from legal insider trading.
Alternatively, we also evaluate LPs’ investment performance when they invest in newly listed stocks when they have a previous business relationship with a venture capitalist backing the IPO, but do not have a direct investment in the specific fund backing the IPO (we call these “relationship stocks”). We do not find any evidence of increased performance when LPs invest in relationship stocks. This indicates that our findings are due to formal communications that the LP receives through its VC fund.
We presume that connected LPs obtain their information prior to the IPO. If this presumption is correct, then LPs’ trades in connected stocks do not violate current insider trading rules. However, the findings in this paper pose two important questions. Should the LPs’ information advantage when investing in connected stocks be considered fair? If not, should LPs be required to disclose their holdings in connected stocks, similar to the process currently in place for directors, officers, and large blockholders of newly public firms? Any regulation inevitably imposes costs, which very well may outweigh the intended benefits. We believe that both of these questions deserve further research.
The preceding post comes to us from Umit Ozmel Yavuz, Assistant Professor Purdue University – Krannert School of Management, Mehmet Deniz Yavuz, Assistant Professor Purdue University – Krannert School of Management and Timothy Trombley, soon to be Assistant Professor at San Diego State University. The post is based on their article entitled “Outside Insiders: Do Limited Partners Obtain Valuable Information about Stocks Backed by their Venture Capital Funds?”, which is available here.