The Strange Case of The Galleon Group

Last Friday, something happened on Wall Street you don't often see anymore.

A Hedge Fund operator actually got busted!

Yes, the Feds finally caught someone doing something wrong.
Raj Rajaratnam,the Principal and CEO of The Galleon Group,
a minor league hedge fund ($3.7 billion under management),
did the "perp walk", accused of insider trading.

He is alleged to have bought shares of Hilton Hotels Corp
(HLT), prior to its acquisition by The Blackstone Group
in a leveraged buyout in 2007, on an "insider" tip from
Moody's, the investment rating agency, making a
$ 4 million profit in two days.

Moody's was working with Blackstone in performing
due diligence on the buyout, which involved potential
rating changes on Hilton's outstanding debt. As such,
Moody's owed a fiduciary duty to Blackstone and Hilton
to keep its work secret.

But in reality, such things are never kept secret for very long.
And this one was leaked out to Galleon for a mere $10,000 - chump
change by today's standards.

But there's more to this story than meets the eye. The Squid
(Goldman Sachs), J.P. Morgan, Citigroup, UBS, and all of the
other operators of The Great Wall Street Casino all earn their
profits by taking advantage of "material, non-public inside
information". The Squid, for example, has spent tens of millions
of dollars on advanced computerized research and trading
systems designed to safely ferret out just this sort of information
electronically.

So why, all of a sudden, is the SEC coming down so hard on a
minor player? After all, $3.7 billion is the typical "book" size
that a mid-level trader on The Squid's "prop desk" would be
running. Why Galleon? For several reasons.

First of all, Rajaratnam and his colleagues were outsiders.
They are all, with few exceptions, Sri Lankan citizens
and ethnic Tamils. Much of their capital is alleged to have come
from the worldwide Tamil diaspora - both Indian and Sri Lankan.
And early in 2000, Galleon Group came under State Department
suspicion of being a funding source for the Eelam Tigers -
the rebel group engaged in a protracted and bloody conflict
with the Sri Lankan government. That put them on the
SEC "watch list" - a list that folks like Bernie Madoff
were somehow never able to make.

Second, the way that they went about "obtaining" their inside
information was just bush league . Cell phones, secret
meetings, and envelopes stuffed with cash are outdated
now.

That's so 1980's - Michael Milken and Ivan Boesky
and the like.

Instead, if you are going to trade on non-public
inside information today, you do things the way
The Squid does things.

First of all, you use your trading systems to scour
the debt and equity markets for companies that
might be going into "play". There are almost
always telltale electronic signs of this that you
can spot - but only if you've first made the multi-million
dollar investment in computerized research and analysis.

Lesser players like Galleon have to do it the
old-fashioned way- tips and bribes.

Second, your Research Department correlates
the raw trading information with the "rumors"
flowing in to the department every day. Since
all of this is computerized, you can generate
"actionable intelligence" in a matter of seconds.

Then - you execute. But not the way Galleon did it.
You never make a move in the public markets that
after the fact might prove to have been market-moving
in the light of subsequent events, which you might be
accused of having private knowledge of beforehand.

Instead, you split your order. You buy or sell in the public
markets only so much as to make the move look routine ;
an everyday client order. The rest goes "off books" - through
a "dark pool" on a private exchange, which won't show up on
the tape until way later. That way, there's no incriminating
paper trail.

Second, you don't leave money on the table if there's more to
be made. You make a corresponding move in the debt
markets, going long if you think the deal might reduce
the target company's leverage, or short if you think it
will increase, remembering always to hedge the other way
with the appropriate CDS's. Or, you just might keep it simple
and buy the corresponding CDS itself. Since that market is
completely private, so much the better.

And if you're The Squid, you can do this all electronically -
no muss, no fuss, and no incriminating humans anywhere
in the equation. And most likely, Galleon would have had
access to none of these wondrous money-making tools.

Finally, there's the political environment. The natives are
finally getting restless. The Regulatory Gods are getting
angry - and they are demanding that a propitiating
sacrifice be made. So, let's go looking for a scapegoat.

And a small hedge fund, manned by outsiders, who might
have in the past been linked to terrorists, is the perfect
candidate. And there's another lesson here. If you're
a little guy, especially if you're an unsavory little guy, it's
too dangerous to go it alone. You need protection.The
kind of protection that only The Squid offers its loyal
clients.

So, the next time you come across a juicy tidbit like
Hilton, go see the Godfather - the Lord of The Squid.
He'll put your deal together for you - nice and safe -
and your $4 million profit (or likely much more than that)
will be in your Squid account that very day.

And the "vig"? Minimal. More likely, Father Squid will
reward you for your loyalty by cutting you in on the
next juicy deal he uncovers. All you have to do is
be loyal and be ready to do him some future small
favor or service.

Because if The Squid helped you make $4 million,
he likely made $20 or $30 million on the same information.

And The Squid (and JP Morgan, and UBS, and Morgan Stanley)
do what Galleon got busted for every day.

To them, trading on inside information is routine,
everyday business.

It's not what you do, it's how you do it that counts.