The case for legalising insider trades

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I love hotels. Love them. I lived in a hotel in New York City for three years in the 1990s: The Chelsea Hotel on 23rd Street, which is being taken over by Andre Balazs and probably turned into a boutique. I hope it doesn’t lose its character. When I was a kid I went through a period where I couldn’t imagine a better job than running a hotel. Whenever I stay in the city I try to stay in different hotels. I think I’ve stayed in just about every hotel in NYC and that’s not easy to do.

So when Blackstone decided to reach out and buy Hilton for $26bn I took notice. CNBC, intuitively realising my expertise in the space, called me up to brainstorm with Melissa Francis on On the Money about what the next public hotel targets could be. But more importantly, they also wanted to discuss what turns out to be a very dark secret on Wall Street: every deal ever done on this planet has insider trading in it and the Hilton deal was no exception. The only exception was that because of the size of the deal, people actually took notice.

On July 2, the day before the deal was announced with Blackstone, Hilton shares were at $33.87. On July 3 they made one of their biggest moves ever, closing almost 7 per cent higher at $36.05 on double the normal volume. Oh, it was also a half day. Then Blackstone offered $47.50 a share for Hilton. So there’s no reason to guess here. Illegal insider trading occurred. Someone knew something, then told someone, who bought Hilton shares. Certainly they’ll catch one or two criminals here but not all. There’s no way. It’s a $26bn deal and there were holes on this all over the world probably.

If every hole in a ship leaks you need to work on plan B and jump off that ship, hopefully with a life preserver. That’s the situation we have here. Giving all credit to the Securities and Exchange Commission, they just do not have enough manpower to combat the problem. It’s a hard thing to make insider trading legal. The gut reaction is that it will then be a free-for-all in the markets and the little guy, the retail investor, will get taken advantage of. However, this is just simply not the case. Here are the benefits to making insider trading legal:

● The more information in a market, any market, the more efficient prices become. If informed investors start buying or selling based on privileged information, asset prices will rise to their “correct” level. For instance, in the Hilton case, we probably would have seen a smooth progression of the stock price from $33 to $45 over the past month as talks progressed, instead of the spike in just one day.

● Fraud will be exposed earlier. Enron is an example where tens of thousands of investors got burned because they were piling into the stocks during the later stages of its fraud. If insiders were selling we would’ve seen a much swifter move down, and probable fraud exposed.

● Companies will either become more transparent, to keep the retail investor happy, or will themselves enforce secrecy rather than being complacent with the idea that the law somehow protects their secrets.

● One concern is that there will be a flight of liquidity because people will be concerned about the legitimacy of our markets. Rather, the opposite will occur. More enforcement dollars will be used to uncover actual frauds such as the next Enron or Worldcom. Arguably, these frauds are a thousand times more dangerous for the retail investor than what is probably a victimless crime such as insider trading.

● Insider trading is almost impossible to prosecute and the government wastes countless dollars trying.

The Blackstone/Hilton deal was interesting for many other reasons. For one, at 16 times cash flows, it’s the largest multiple deal of this size that I’ve seen and opens up several hundred more public companies as takeover targets. It’s as if the entire market is for sale. Wyndham, at 13 times earnings before interest, taxes, depreciation and amortisation, is a great example and would have synergies by merging the Ramada/Travelodge/Days Inn brands with Hilton (or with Four Seasons, for that matter, owned by Prince Al-Waleed and Bill Gates). Wyndham also has an impressive buyback programme in place and I like its vacation home business since that’s one area that, demographically, is destined to have a nice 30-year run ahead of it.

As far as what effect the Blackstone deal will have on current Hilton hotels, I have two comments. First, I think the deal will have more of an effect on the La Quinta hotels Blackstone already owns. They get to take down the La Quinta sign, slap on a Hilton sign and maybe charge 50 per cent higher prices a night. Nice! And, finally, I hope Blackstone doesn’t remove the Conrad Hilton autobiography that’s in every nightstand of a Hilton hotel. It’s one of the best business autobiographies I’ve read.

james@formulacapital.com

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