In January 2023, short seller Hindenburg Research put out a report claiming that executives at one of India’s largest conglomerates were manipulating the company’s stock price.
The Adani Group and its multibillionaire founder Gautam Adani strenuously deny the accusations, but the report instantly wiped off as much as $140bn from the conglomerate’s market value and sent ripples through the country’s establishment. It also catapulted the New York-based Hindenburg and its founder Nathan Anderson into Wall Street lore.
Few saw it coming. But one that did was a hedge fund in New York almost 13,000 kilometres away from the Indian conglomerate’s headquarters.
Kingdon Capital Management had received a draft of the short seller’s report in November 2022 as part of an agreement it had signed with Hindenburg a year earlier, India’s markets regulator revealed in June.
The hedge fund, which was founded by Mark Kingdon in the 1980s, had set up a special fund in Mauritius and had started building a short position on Adani two weeks before Hindenburg released its report.
Kingdon, which has less than $1bn in assets under management, turned a $22mn profit from the trade. As part of the agreement, Hindenburg received a 25 per cent cut of the spoils.
The Securities and Exchange Board of India’s unmasking of Kingdon as the financier behind one of the most talked about short positions in recent memory has cast a spotlight on the world of activist short selling.
In particular, it has invited scrutiny of the financial agreements between the forensic research firms such as Hindenburg that do the digging and the secretive hedge funds like Kingdon that act as their silent partners to fund these trades. Hong Kong-based fund Oasis Management and Toronto’s Anson Funds Management have also operated in this market.
While traditional short sellers seek out overvalued companies to bet against, often balancing them against long positions in the same sector, activist short sellers tend to explicitly look for evidence suggesting malfeasance.
Hindenburg, for example, says that it seeks out situations where there might be some combination of accounting irregularities, undisclosed related-party transactions, and illegal or unethical business or financial reporting practices.
The New York-based firm was the first to allege fraudulent behaviour at electric truck maker Nikola, whose founder Trevor Milton was eventually convicted of securities and wire fraud. It also called Nigeria’s Tingo Group “an obvious scam” six months before US regulators charged the founder with “massive fraud”.
Not content with waiting for price discovery to show up in the markets, activist short sellers blast out their findings through interviews, social media campaigns and publishing research reports.
Their approach has divided the market. To some, they are a necessary voice of reason that counteracts the animal spirits driving market euphoria, especially during periods of heightened monetary stimulus.
“It’s hard to be a stock picker in this environment because as money comes into the market it lifts all boats,” says Anderson, who founded Hindenburg in 2018. “The frauds get bigger and more resilient to evidence.”
But a criticism from their detractors is that activist short sellers working together to sow fear, uncertainty and doubt about a company’s operations can become a self-fulfilling prophecy, moving markets just by revealing a bet against a particular company. This approach is akin to “walking into a crowded cinema and shouting fire”, one long-only investor says.
Now, the hedge funds who have quietly funded the trades are coming under increasing regulatory scrutiny, with some already accused of failing to disclose agreements to their investors — potentially threatening a subsystem of traders who view themselves as performing a vital service in keeping Wall Street clean.
Carson Block, founder of short seller Muddy Waters, laments the fact that the regulatory regime in the US is both “over-policed” — increasing paperwork requirements and mounting costs, which disproportionately hurts smaller players — and “under-policed in the sense that nobody who was doing things wrong at large scale was ever meaningfully punished”.
He says: “The regulators just don’t pursue the big fish when it comes to corporate malfeasance.”
The activist cohort has risen as more traditional short sellers have fallen by the wayside.
Last November, renowned short seller Jim Chanos, a self-styled “real-time financial detective”, told his backers he was closing his main short-focused hedge funds after more than three decades. A short-only portfolio was an increasingly tough sell to investors, he said. Assets in his firm Kynikos Associates had plummeted from a peak of $7bn at the end of 2008 to less than $300mn.
“The longer markets stay ebullient and stay elevated, particularly in the US, the fewer people think they need hedged products or any type of funds that might provide protection to the downside,” Chanos tells the Financial Times.
He is not alone. Many short sellers had their wings clipped by the decade-long bull run that followed the financial crisis. Bill Ackman swore off short selling in 2022 after a five-year battle against global nutrition company Herbalife during which he lost close to $1bn.
David Einhorn, who raised concerns about Lehman Brothers’ risk practices prior to its collapse, has, like Chanos, been curtailed by an unsuccessful wager against Elon Musk’s electric car company Tesla.
Investors, meanwhile, have pulled almost $130bn from equity hedge funds since 2016, according to data provider Hedge Fund Research.
“Since the global financial crisis there’s been a long bull market that has made short selling very difficult,” says Whitney Tilson, a hedge fund manager who closed his firm in 2017 out of frustration that his short book was underperforming. Tilson now provides investment advice through a newsletter with one top tip: avoid short selling entirely.
But some continue to carve out a successful, albeit controversial niche in activist short selling. Much of the credit for the emergence of these funds, according to several members of their cohort, goes to Muddy Waters and Block.
A fast-talking accounting nerd known as much for his forensic investigation skills as he is for his liberal use of expletives, Block launched Muddy Waters as a research outfit in 2010. It was named not for the blues guitarist, but after the Chinese proverb “muddy waters make it easy to catch fish”.
The firm published a report on a Chinese business called Orient Paper, and Block borrowed $2,000 on his credit card to bet against the company. The report went viral and Block was soon fielding calls from investors who offered to pay for his research before publication.
This heralded the arrival of so-called balance sheet arrangements, whereby the likes of Muddy Waters and Hindenburg are often paid to generate ideas. They are in effect a profit-sharing agreement whereby the research firm takes a cut of the winnings made on the trade. The contracts are typically negotiated individually, principally based on a firm’s record.
The cut ranges from 15 per cent for newer entrants to the practice, to 35 per cent for more established players such as Hindenburg, according to market participants.
Hindenburg was set to receive 30 per cent of the profits Kingdon made from the Adani position, according to the Indian regulator, but the hedge fund renegotiated that down to 25 per cent.
There are several benefits for activists, particularly those who are just starting out and need money to execute their ideas.
“You have an idea and if you do well, everyone does well,” says an activist short seller who frequently uses the arrangements. “If you’re someone with really unique and interesting ideas and you don’t work at an individual fund you can piggyback off a larger infrastructure where they have a lot more sophisticated trading.”
But often they have little option but to enter into these agreements. Finding a bank that will act as a counterparty to the short trade can be difficult either because of size or headline risk. Large banks who cater to the very clients that short sellers target do not necessarily want to be seen as being in bed with the enemy.
Using a profit-sharing agreement can circumvent this issue because a larger, more established hedge fund that has pre-existing relationships with banks can put on the trade.
But there are also drawbacks for the activists relying on what is inherently an unreliable income stream. It is almost exclusively dependent on reputation with no locked-up capital or investor funding to fall back on if a report does not land.
“You have the flexibility to work on a name and dive into it for months at a time but the downside is that you don’t have a lot of stability,” says the activist short seller who has used the arrangements. “It’s an easier business to do if you don’t have three kids in private school.”
Activist short sellers tend to relish being in the spotlight but that comes with its own difficulties, including legal and at times physical threats. “They all fall into the lower-middle-class, chip-on-the-shoulder category,” says one hedge fund source. “They want to make money and show the world they are right and spit in the eye of the man.”
For the hedge funds involved — the balance sheet providers — backing the work of activist short sellers allows them to take potentially lucrative positions without attracting attention for being a market contrarian.
Short sellers are largely viewed by corporate America as a blight on the market. Retail investors often dislike them too, and increasingly have the ability to mount so-called short squeezes against them. Melvin Capital, which had more than $12bn in assets in January 2021, was forced to shut down entirely just over a year after retail traders pushed up the share price of video game retailer GameStop and cost the firm billions of dollars in one of the most well-executed short squeezes in history.
Many short sellers tend to build long-term relationships with hedge funds. Kingdon, for example, has received seven reports from Hindenburg and traded on five of them, according to Indian regulators.
Among those who have quietly backed activist short sellers is Oasis Management, a Hong Kong-headquartered hedge fund whose main activity is buying stakes in companies and pushing for changes it hopes will help increase the share price.
Oasis has bankrolled trades for some of the best-known activist short sellers including Muddy Waters — with which it has a long-standing relationship — as well as Texas-based Blue Orca Capital and Viceroy Research, co-founded by British short seller Fraser Perring, according to multiple people familiar with the firm.
Perring’s deal with Oasis came to light in late 2022 after South Africa’s Financial Sector Conduct Authority tried to fine the short seller over a report it had published in 2018 on Capitec, at the time the country’s fourth largest bank.
Oasis made millions on the trade, according to South African regulators, a small portion of which was shared with Viceroy. Capitec recovered quickly from the report and its share price has since increased by around 300 per cent.
Some short sellers see the clandestine nature of balance sheet arrangements as “morally fraught”.
“There should be disclosure of [the] arrangement,” says Matthew Earl, chief investment officer at hedge fund Shadowfall, who highlighted financial irregularities at Wirecard prior to its collapse. “I don’t believe that cuts it in terms of the required disclosure and so effectively what you have is a fund transferring the [reputational] risk and regulatory scrutiny to the other party and not disclosing the fact that they stand to benefit.”
Regulators and the US government seem to agree. Spurred on by banks, corporations and even other short sellers, they are beginning to take action against such funds.
The Department of Justice and the Securities and Exchange Commission launched a wide-ranging investigation into short selling in 2021, including relationships between hedge funds and researchers. Block was among the most high-profile figures to be served with a search warrant by the FBI, though many of his peers were also investigated.
The investigation is continuing but in June, the SEC hit Toronto-based Anson Funds Management, a firm with $2.5bn in assets, with a just over $2mn fine in part for disclosure failures that “rendered its statements about its short strategy misleading.”
A month later the DoJ accused Citron Research and its founder Andrew Left of reaping $16mn in profits from running “a long-running market manipulation scheme and concealing “financial relationships” with hedge funds. The SEC filed a similar complaint in which it identified Anson as one of the hedge funds.
A lawyer acting on behalf of Left said he did not “have a balance sheet arrangement” with Anson and that the DoJ’s allegations related to “a short trade that Left made through Anson, which was a good trade so Anson had to pay him the proceeds of his investment”.
The cases have amplified calls for more transparency around short selling by having traders disclose positions once they get to a certain threshold or be forced to sit on their bets for a set period of time after they release their report.
The SEC has introduced two new complementary rules on short selling, set to take effect early next year. Short sellers and lenders will have to quickly disclose deals to borrow securities while some institutional investors will be required to report short selling activity beyond a certain threshold, which is then shared publicly. Both are being challenged in court by a coalition of hedge fund groups.
Most short sellers have remained defiant in the face of the regulatory interest. “Nate [Anderson]’s research moves stocks, as it should,” says Tilson of the Hindenburg founder. “I wish there were a hundred more of him because there are a hundred times more fraud and promotion.”
Hindenburg has continued to publish reports, including about India’s regulator itself, alleging that Sebi chair Madhabi Buch was conflicted because of prior investments in Adani companies. Buch has called the claims “baseless”. Block still uses the arrangements himself at times, but has also provided funding for other short sellers.
When asked what pushes short sellers to do this work despite the obvious challenges, one activist suggests they are driven by a higher purpose.
“The people that practise this at a high level, why do we continue to beat our heads against a wall doing something that is incredibly difficult, comes at such a cost and is 10 times the work? There has to be something beyond the money . . . the reason that scams and frauds exist is because people say nothing and they’re too scared.”
Additional reporting by Robert Smith in London and Antoine Gara in New York
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