Risk consultants and corporate detectives — the eyes and ears hedge funds pay for

This post is drawn from The Street-Smart Trader by Ian Lyall. Republished with permission.

There is a part of the investment industry that rarely makes it into the glossy brochures. No fund manager will put it in their marketing materials. It does not appear on the regulatory disclosures that land in your inbox each quarter. But it exists, it is legal in most of its forms, and it is one more reason why institutional money operates in a fundamentally different world to private investors.

The world in question is corporate intelligence. Risk consultancies. Former spies turned research analysts. Private investigators with access to satellite imagery and foreign-language databases. These firms exist to give paying clients an information advantage, and their paying clients are, overwhelmingly, the largest pools of capital in the City.

The names that crop up most often are Control Risks and Kroll Associates, though both companies would insist their work is firmly within the bounds of legitimate due diligence. Control Risks was founded in London in 1975 by former military and intelligence officers to help companies navigate kidnap and ransom situations. Over time the work expanded into political risk, reputational due diligence, and the kind of deep background research that simply takes more resource than most organisations can assemble internally. Kroll, founded in New York in 1972 by Jules Kroll, built its reputation investigating fraud and asset tracing, and was for many years the go-to firm for anyone trying to find money that had been hidden or moved. Both firms are professional, legitimate, and expensive. Their clients include law firms, banks, governments, and hedge funds.

The Hanson and ICI episode from 1991 gives a sense of how this world and the stock market can intersect. Lord Hanson began building a stake in ICI, the chemicals giant, in late 1990 and early 1991. When the stake became public in May 1991, the share price reacted sharply. Hanson had assembled a near 3 per cent holding before any announcement was made, and the episode prompted considerable debate about whether information about the stake had been in wider circulation beforehand, and whether intelligence firms had played any role in the run-up. No charges followed, but the episode became a case study in how large institutional manoeuvres can generate enormous information flows before the market learns what is happening.

The practice has not stood still since then. A Politico investigation in the years following the financial crisis found that hedge funds had been paying for the services of what the piece described as CIA-trained deception detectives, operating through a firm called Business Intelligence Advisors. The individuals involved had backgrounds in the US intelligence community and were being retained to help fund managers evaluate the credibility of sources, assess whether corporate executives were being forthcoming or evasive, and build intelligence pictures of the companies they were considering trading. It sounds extraordinary when written down plainly. But it was not necessarily illegal, and it was happening.

The framework that separates legitimate intelligence-gathering from market abuse is known as mosaic theory. The idea is that a fund manager can legally build a view on a company by assembling multiple pieces of individually public or innocuous information. None of the pieces on their own would constitute inside information. But put together they form a picture that is more detailed and more actionable than anything available to ordinary investors. The analyst reads the supply chain data, interviews former employees, reviews satellite imagery of factory carparks, monitors shipping records, and cross-references all of it to arrive at an earnings estimate that is meaningfully different from what the consensus expects. That process, done carefully, is legal.

The grey area begins where mosaic theory ends. If any single piece of information in the mosaic came from someone inside the company who had a duty to keep it confidential, the entire trade potentially becomes contaminated. UK law under the Market Abuse Regulation, which replaced the older Directive of the same name and has been retained in UK law post-Brexit as part of the retained EU law framework, draws the line at the point where a person trades on the basis of information that is precise, not publicly available, and material enough that it would affect price if it were disclosed. The problem for enforcement is that the mosaic can be very difficult to unpick. When a fund that has done extensive channel checks and intelligence work trades ahead of a profit warning, it is genuinely hard to prove that any single piece of inside information was the proximate cause.

What makes this especially relevant for private investors is not that any of it is necessarily corrupt. Most of the work done by firms like Control Risks and Kroll is entirely above board. The problem is structural. The investment world has always been divided between those with access to information and those without. What the corporate intelligence industry does is extend and deepen that divide. A hedge fund with the budget to retain a serious research firm, conduct satellite monitoring, and run former intelligence professionals through a body of channel checks is operating with a level of informational resource that simply cannot be matched from a desktop screen and a broker note.

The FCA has acknowledged the challenge. Its market cleanliness statistics and annual reviews of suspicious trading patterns around announcements show that the problem has not gone away, even as enforcement has become more sophisticated. The regulator takes market abuse seriously and has secured convictions and substantial financial penalties in a number of cases. But the intelligence advantage that stops short of a specific breach is, by definition, not something the FCA can touch.

For private investors, the lesson is not to feel defeated by this. It is to be clear-eyed about where you are in the information hierarchy and to invest accordingly. Trying to predict short-term price movements in shares that are heavily covered by institutional research and intelligence operations is a difficult game to win. Understanding the structural forces at work, and positioning around them rather than against them, is usually the more productive approach.

Street Smart is a series drawn from first-hand experience of the City of London, updated as each new chapter arrives.

Disclaimer: The value of investments can go down as well as up, and you may get back less than you invest. This article is for informational and educational purposes only and does not constitute financial advice. Always do your own research and consider seeking independent advice before making any investment decision.