Odds are, when you’ve heard the term ‘insider trading’ it has been portrayed as something highly illegal, and a disruptive force in publicly-traded markets. While this is accurate, it is only half the story and in the world of private equity real estate there is a very different perspective.
In this article we will examine the two sides of insider trading: inside trades made in publicly traded markets, as opposed to insider trading in private equity transactions. Why is the first illegal and highly looked down upon by essentially everyone in the financial markets, but the second is perfectly legal and actually a positive thing?
Let us start by looking at publicly traded securities.
Insider Trading In Publicly Traded Securities
The legal definition of insider trading, according to the SEC, is trading (buying or selling) done by anyone who has ‘material, non-public information’ about a publicly traded security.
The following example (purely fictional) of a financial trade would be an instance of the illegal sort of insider trading. In February 2020, a politician caught wind of the coming retail shutdown in the U.S. before the general public. As a result of this information, he sold two million dollars’ worth of stocks he held within the S&P 500.
Now let us look at why exactly the above trade would be an illegal one. There are two components to an illegal insider trade: the information motivating the trade needs to be material or “financially significant”, and not available to the general public. The politician in the example above was aware of the coming shutdown before the general public. This satisfies the non-public aspect of illegal trading.
Secondly, the politician was acting on the knowledge that retail stores would be shut down across the United States. This would constitute ‘financially significant’ knowledge, as it would impact retailers across the United States, and therefore the S&P 500 as well.
Simply put, the very same reason that people engage in illegal insider trading is the very same reason why it is not legally permissible: they have access to financially significant information that others on the market do not. This gives them an unfair competitive advantage because they trade on an ability to buy or sell securities at a more favorable price than others would be able to.
However, it should also be noted that insider trading is extremely hard to prove in actual instances, because it is so difficult to know who came into what information at specific times.
3 Famous Examples of Illegal Public Securities Trades
Here are a few famous examples of people engaging in illegal insider trading in public securities.
1. Jeffrey Skilling
As a stark example of the risks of insider trading, consider the fact that Jeffrey Skilling, former CEO of Enron was only recently released from federal prison to a halfway house, and only released from that halfway house on February 20, 2020. He was originally sentenced in 2006.
Skilling was charged with a variety of financial crimes, including securities fraud and other violations in the markets. His insider trading consisted of using mark-to-market (MTM) accounting to make Enron look much more profitable than it actually was and trading the company’s stock at prices that were effectively inaccurate.
More specifically, MTM accounting is the practice of marking a company or its assets as being valued at current market prices, rather than their book value. An asset’s book value factors in the value of the asset, minus any relevant depreciation the asset may have undergone.
Skilling was able to benefit financially by representing Enron in a falsely profitable light and trading shares under those false MTM valuations when in fact his company had lost much of its value.
2. Michael Milken And Ivan Boesky
Michael Milken essentially founded the high-yield-corporate-bond investment industry. Several decades ago, it was common practice for investors to set up mergers and acquisitions through these types of trades, and Milken had inside information of these happenings due to his close ties to the industry.
Ivan Boesky was a stock trader who rose to prominence in the 1980’s, with a net worth of over $200 million from his trading strategy that involved betting on company takeovers. Boesky began receiving stock tips from Milken and was placing such large and consistently correct trades that the U.S. Securities and Exchange Commission (SEC) launched an investigation into Boesky’s trading.
His trades were often bold but suspicious, with him making sweeping purchases of a company’s stock less than a week before it was bought out by a more successful firm. Ultimately, once his insider trading was discovered, Boesky agreed to aid the SEC in exchange for a lighter prison sentence, and got Milken arrested too.
Boesky was sentenced to three and a half years in the Lompoc Federal Prison Camp in California and was fined $100 million. Milken was convicted as well and spent 22 months behind bars.
3. Martha Stewart And ImClone
In the early 2000’s, media personality Martha Stewart received an inside tip from her broker that shares of a drug company called ImClone were about to drop, because the FDA had denied approval to its new monoclonal antibody drug.
Stewart then sold $230,000 worth of shares in the company prior to ImClone’s stock taking a sharp drop and avoided the sizable losses she otherwise would have incurred. ImClone’s founder, Samuel D. Waskal had also engaged in insider trading, selling off huge amounts of shares in the company, and urging his family and friends to follow suit before the company’s stock price tanked following the FDA announcement.
Stewart, Waskal, and Waskal’s associates made these trades just one day before the FDA’s announcement, arousing suspicion and triggering an investigation by the SEC. The end result was that Waskal was sentenced to seven years and three months of prison time, with Stewart and her broker receiving a sentence of five months in prison, another five spent in home confinement, and two years of probation following their release.
Stewart was also fined $30,000, while her broker was required to pay $4,000 in restitution, and Waskal ended up paying $4 million in insider trading fines and unpaid taxes he owed on other financial transactions.
Imperfect Information In Commercial Real Estate
Although insider trading is illegal and severely punishable in the context of the stock market and other markets where public securities are bought and sold, it is a different matter when it comes to investing in commercial real estate.
In private equity in real estate, when one party has information that the other does not possess, the deal still goes through but the ‘insider information’ simply is not priced into the transaction. In fact, this is the very thing that sets successful commercial real estate investors apart from those who are not as profitable. Insider information in real estate is simply known as ‘imperfect information,’ and no one is prosecuted or punished for utilizing it for financial gain.
That is because, in commercial real estate, the very foundation of recognizing and capitalizing on a valuable asset is obtaining and then acting on information that the person selling it does not have.
Most of the time, someone buying a commercial property is doing so because they expect it to be profitable for them over the long term. This involves seeing more value in it than the seller is charging them for the asset, otherwise they simply would not be purchasing it. If the seller saw in the property what the buyer saw in it, they either would not be selling it, or would raise the price to reflect its true value.
In commercial real estate, making a trade where you secure more value than you pay for is known as ‘buying right.’ The best way to buy right is to do your research on a property and the socioeconomic trends of its surrounding area so thoroughly that you have noticed a source of value that the seller either overlooked or lacked informational access to, allowing you to buy the asset for less than it is actually worth.
Let us take a look at a quick case study. But before we do, just remember these key takeaways:
- When it comes to investing in any security, a ‘good’ trade is one where the true value of the asset exceeds its price.
- In public securities such as publicly traded stocks, government bonds, corporate bonds, etc., trading on insider information is illegal and those convicted of it are typically fined a higher amount of money than they gained on their illegal trade, in addition to serving prison time.
- In the world of private equity real estate investing, however, insider trading is not only legal, but essential to trading profitably in the market.
A Profitable Trade On Imperfect Information
Here is a simple example of executing a profitable trade on imperfect information. Imagine that a sponsor was buying a retail space in a college city. The sponsor has a previous connection to a franchise restaurant tenant in a different city, who wants to set up shop in the college town but is having trouble finding a business location. Seeking help sourcing a property, the tenant goes to the sponsor for help.
The restaurant tenant shares data with the sponsor that convincingly suggests that their franchise would perform well in a university town. The sponsor agrees to help, and finds an available space just five minutes from campus. He initiates a negotiation to buy it from the current owner at $130 per square foot. From the perspective of the present owner, it is a good trade, because it is roughly equivalent to what similar properties in the area are selling for.
But the seller does not know what the sponsor does, and therefore they have completely different perceptions of the actual value of the property. The sponsor has done his due diligence on the market and asset class, calculated his expenses for upgrading the property to meet the needs of the new tenant, and run that information against the projected value the restaurant owner would bring to the space as its new tenant.
Within three months of purchasing the space, it was on track to deliver an above-average annual return, and its worth per square foot had already risen from when the space was purchased.
In other words, the sponsor in this example made a profit off insider information that the seller of the asset could not possibly have possessed. He then formulated a strategy around this information and conducted underwriting on the property to weigh the costs associated with his business plan to upgrade the space so the restaurant owner could move in, against the insider data he received about the potential profitability of the space.
Join The Starpoint Insiders
At Starpoint, our track record speaks for itself. Our ability to execute profitable real estate deals stems from our capacity to spot and capitalize on value through insider information. In fact, it is one of our guiding lights when evaluating deals that have either been brought to us, or that we have sourced in the market.
We always make sure to ask, where the ‘unfair advantage’ lies in any specific trade we might make. In other words, once we have conducted our due diligence on an asset, we do not add it to our real estate portfolio without clear and convincing data that it will generate positive returns and is worth more in the context of our business plan than we purchased it for.
Accessing and then profitably trading on non-public information is a key component of our business strategy at Starpoint. It has allowed us to achieve profits regardless of broader market trends and cycles, because no matter what is going on in the market, there will always be profitable opportunities for investors who know how to seek out and leverage insider information to their advantage.
In fact, we have become so good at finding opportunities that others miss based on information no one else has, that even our employees profitably, and legally, invest in our deals with their own savings on a routine basis.
They know, more than anyone else, not only the unfair advantages we find in opportunities around the country. They know when we are buying right. They are the insiders who alone have access to ‘non-public, material [financially significant] information’ held within the walls of the company, they know how we have used and continue to use that information to deliver outsized returns for our investors for decades, and it is they who are actively working on our projects to ensure we win every time.
No one else knows the true workings of a private equity real estate company as well as the insiders who work here at StarPoint and that they invest in our deals is a level of confidence that you will not find at many other real estate firms. Contact us to learn more about how to benefit from insider trading here at StarPoint and discover how you can join the team in our next investment together.