When It Pays to Pay Your Investment Banker

Just stumbled across a fascinating paper about bulge bracket brokers, and whether they are worth their salt or not.

Andrey Golubov, Dimitris Petmezas and Nickolaos Travlos of the Cass Business School, the University of Surrey and the ALBA Graduate Business School examined almost 5,000 deals conducted between 1996 and 2009 to find out.

They found that if you were making a public listing for the first time, the returns were over one percent higher than if the firm used an adviser outside the top tier.

For the average bid, that equates to an increase of over $65 million in shareholder value, even after fees are paid, and so yes, they are worth their salt.

You can read the whole thing by clicking here, or checkout the abstract of the paper below:

The investment banking industry is dominated by a group of so-called “bulge bracket” firms.

These top-tier investment banks have built up a reputation as experts in capital markets transactions, which, theoretically, should ensure that they perform superior services for their clients in return for premium fees (Chemmanur and Fulghieri (1994)).

Surprisingly, however, the relevant empirical literature fails to support this intuitive reputation–quality mechanism, reporting a negative or at best insignificant relationship between bidder financial advisor reputation and bidder returns in M&As (see, e.g., McLaughlin (1992), Servaes and Zenner (1996), Rau (2000), Hunter and Jagtiani (2003), and Ismail (2010)).

This raises several interesting questions:

• Does the reputational capital mechanism fail in the market for merger advisory services?
• If so, why do firms employ top-tier advisors?
• Are top-tier banks employed just as execution houses to ensure deal completion for their clients?
• Finally, are there situations in which it pays off to pay for a top-tier financial advisor?

Motivated by the conflicting empirical evidence on the subject, we address these questions and revisit the role of financial advisors in M&As by examining the relationship between investment bank reputation and the price and quality of their merger advisory services.

We use a large and comprehensive sample of U.S. acquisitions of public, private, and subsidiary firms announced over the period from 1996 to 2009.

In an important departure from prior studies, we separately examine different types of acquisitions identified on the basis of the target firm's listing status for two reasons.

First, reputation is not equally important in all transactions, and its effect is more pronounced in situations that create relatively larger reputational exposure. Indeed, as Rhee and Valdez (2009) suggest, greater visibility leads to greater potential reputational damage.

This provides investment banks with relatively greater incentives to act in the best interests of their clients, as bad advice in prominent situations should lead to a greater loss to the advisor's reputational capital.

We argue that these incentives are profound in the case of public acquisitions, as these deals are closely followed by the market and often involve publicity as part of the bargaining process.

Second, public acquisitions require more skill and effort on the part of the advisors as:

(1)   it is more difficult to capture gains in public acquisitions due to greater bargaining power of public targets compared to that of unlisted firms ((Fuller, Netter, and Stegemoller (2002) and Officer (2007));

(2)   these deals entail increased disclosure and frequently require regulatory and/or shareholder approvals, increasing deal complexity and hence demanding strong advisor professional qualifications; and

(3)   given the dispersed ownership of public targets, there is typically no identifiable party to stand behind any hidden or undisclosed liabilities of the target firm after closing the deal, which inhibits the ability of the bidder to arrange any form of postdeal indemnification from the seller, and thus puts ex ante pressure on the bidder's investment banker to perform. In sum, we argue that advisor reputation is relatively more important in acquisitions of public firms.

We find strong support for our conjectures.

In particular, partitioning the sample by target listing status, we find that top-tier advisors are associated with higher bidder returns in public acquisitions.

The effect is economically significant: we estimate that using a top-tier advisor is associated with an average 1.01% improvement in bidder abnormal returns, which translates into a $65.83 million shareholder value enhancement for a mean-sized bidder.

We further find that, in these transactions, top-tier advisors charge premium fees relative to those charged by their less reputable counterparts.

Specifically, the top-tier fee premium is on the order of 0.25% in absolute terms.

This finding is in line with the “premium price–premium quality” type of equilibrium modeled in the seminal work on the reputational capital. In contrast, there is no effect of financial advisor reputation on bidder returns in acquisitions of unlisted firms (private or subsidiary firms).

Importantly, when examining the sources of the top-tier improvement, we find that they stem from the ability of top-tier bankers to identify and structure mergers with higher synergy gains.

We also find evidence of their ability to secure a greater share of synergies for the bidding firm, but this is hampered when the target advisor is also top-tier.

As for deal completion, there is only limited evidence that top-tier advisors are associated with higher deal completion rates.

Finally, deals advised by top-tier investment banks take less time from announcement to completion.

We also consider endogeneity of bidder-advisor matching that arises from the advisor choice being correlated with certain observed or unobserved bidder- and/or deal-specific characteristics.

Specifically, we show that top-tier advisors are hired by larger firms with higher book-to-market ratios and idiosyncratic volatility but lower preannouncement stock-price run-ups.

Top-tier advisors are also preferred by bidders when acquiring relatively larger targets. OLS estimates are therefore potentially biased.

To address this concern, we advocate the use of a self-selection control to reveal the pure effect of advisor reputation.

All our results continue to hold after controlling for endogeneity using the two-stage Heckman (1979) procedure and its extension—a switching regression model with endogenous switching.