Chitru S. Fernando, Anthony D. May, and William L. Megginson
The value of investment banking relationships: Evidence from the collapse of Lehman Brothers
Journal of Finance | Volume 67, Issue 1 (Feb 2012), 235–270

The question of whether firms derive value from investment banking relationships has received considerable attention in the literature, especially since the increasingly competitive market for investment banking services would suggest that firms can switch investment banks costlessly. Extant research has failed to come up with an unambiguous answer, due in part to the difficulty in measuring the value of relationship capital.

In our JF paper, we examine whether investment bank-client relationships create valuable relationship-specific capital for client firms, using stock market evidence from the period surrounding the collapse of Lehman Brothers. The sudden collapse of Lehman Brothers on September 14, 2008 (then the fifth largest investment bank in the world) provides a unique natural experimental setting to measure the value of the relationships that client firms had with Lehman. Whereas large U.S. financial institutions in distress have almost invariably been prevented from declaring bankruptcy by being acquired by other large institutions (often with the intervention of the U.S. government), Lehman was explicitly allowed to fail. This unprecedented collapse was all the more shocking since Barclays Bank had been negotiating an acquisition with Lehman's managers right up to Saturday, September 13, 2008, the day before Lehman announced the largest bankruptcy filing in U.S. history. When stock market trading resumed on Monday, September 15, 2008, Lehman's stock lost virtually all its value, the U.S. stock market experienced one of its worst single-day losses, and the entire global financial system was pushed to the edge of collapse.

Lehman's equity underwriting clients suffered significantly

We examine how the Lehman collapse affected industrial firms that received underwriting, M&A advisory, analyst, and market-making services from Lehman by studying how their stock prices reacted on Monday, September 15 and over various short-term windows around that day. We address two specific research questions: First, did Lehman's collapse impact its investment banking (IB) clients over and above the impact the firm's collapse had on the equity market in general, and second, did the impact of Lehman's failure vary with the type of IB service received, client characteristics, and/or the strength of the client's relationship with Lehman? These questions are central to understanding how intermediaries create value for their clients. To our knowledge, this is the first study that attempts to isolate the value of the investment bank relationship to clients using a broad group of client firms and all major investment banking services.

In conducting our event study, we begin by constructing samples of firms that correspond to the following categories of investment banking services provided by Lehman: (1) equity underwriting, (2) debt underwriting, subdivided into straight and convertible debt clients, (3) M&A advising, (4) market making on the New York Stock Exchange (NYSE), and (5) equity analyst coverage. We use Securities Data Corporation's (SDC) Global New Issues databases to identify firms that employed Lehman as the lead or co-lead underwriter in at least one public equity, straight debt, or convertible debt offering made in the U.S. market during the ten years preceding Lehman's bankruptcy. We use SDC's Mergers and Acquisitions database to identify acquiring firms that used Lehman as a financial advisor in at least one completed acquisition of a U.S. target announced during the same time period. We identify firms for whom Lehman was the NYSE specialist at the time of the bankruptcy using the NYSE Post and Panel file and firms covered by a Lehman equity analyst at the time of the bankruptcy using Thomson's I/B/E/S database. We confine our samples to non-financial, non-utility firms listed in the Center for Research and Security Prices (CRSP) and Compustat databases with publicly traded common stock (CRSP share codes of 10 or 11). We also screen our samples and exclude a small number of firms that disclosed material derivatives or other financial exposure to Lehman in their SEC filings.

Using standard models of abnormal stock returns, which adjust for overall market movements and firm risk, we estimate the abnormal returns of Lehman's client firms during the day of and days surrounding September 15 (the day of Lehman's formal bankruptcy filing). The table below tabulates the average cumulative abnormal stock returns (CARs) of Lehman's client firms during a period that spans five trading days prior to one trading day after September 15. The abnormal returns are estimated using a four-factor model that includes market, size, book-to-market, and return momentum factors.

1: Cumulative Announcement Returns (CAR) by client category
Client Category Average #Firms
Equity underwriting –4.85%*** 184
Straight debt underwriting –0.37% 53
Cvt. debt underwriting –5.25% 7
M&A advisory +1.30% 87
NYSE Specialist +0.03% 151
Lehman Analyst –0.38% 633
Equity issuers having used Lehman for equity underwriting lost 4.85% of their market value from one week before to one day after Lehman's bankruptcy. Other effects were small and/or rare.

As shown in the table, we find that firms that used Lehman as lead underwriter for one or more equity offerings during the 10 years leading up to September 2008 suffered economically and statistically significant negative abnormal returns. The 184 equity underwriting clients that we study lost 4.85% of their market value, on average, during the period that spans the week before to one day after Lehman's bankruptcy filing, amounting to approximately $23 billion in aggregate, risk-adjusted losses. We arrive at similar value loss estimates and conclusions using alternative return generating models, which are reported in our JF article. Using linear regression methodology, we also find that losses were especially severe among equity underwriting clients that had stronger and broader underwriting relationships with Lehman, including those that floated a large number of equity offerings with Lehman and those that also engaged Lehman for debt and convertible debt underwriting. Losses were also higher for smaller, younger, and more financially constrained firms. As shown in the preceding table, none of the other client groups were significantly adversely affected by Lehman's bankruptcy, on average.

These results show that Lehman's collapse did, in fact, impose material losses on its customers, but for the most part these losses were confined to those companies that employed Lehman for equity underwriting. Furthermore, to the extent that investors partially anticipated Lehman's failure prior to the days surrounding Lehman's bankruptcy announcement, these estimates may actually understate the losses suffered by Lehman's equity underwriting clients. More broadly, these results tell us that underwriting is the principal portion of the overall investment banking relationship that is irreplaceable without significant cost and whose value will be forfeited if the relationship were to be involuntarily ruptured. While most of the investment bank services we study have potential to create relationship-specific capital, our findings suggest that except for equity underwriting, all the other investment bank services appear to be transactional rather than relationship-based. Indeed, even across Lehman's equity underwriting clients, our cross-sectional analysis shows that an equity underwriting relationship with Lehman was especially valuable for firms that had a high degree of dependence on Lehman to access the capital market, especially smaller, younger, and more financially constrained firms. This finding also implies that larger and financially stronger firms (who typically generate the highest volume of business for investment banks) adopt a relatively more transactional stance toward investment banks, even when they seek equity underwriting services.

This study has significant implications for investment banks and the corporate clients they serve. While clearly establishing the presence of relationship-specific capital in equity underwriting, the findings highlight the importance for investment banks of establishing and maintaining reputation, which persists as the primary means by which investment banks can attract and retain higher quality clients. At the same time, however, equity underwriting client firms that switch banks should factor in the cost of any lost relationship-specific capital in their decision to switch.

Goddfried Lindauer (1839–1926): Portrait of Hinepare (Maori). New Zealand, 1890.. Painting Maori subjects in a European style was a distinct New Zealand art form in the 19th century. This Maori woman wore chin decorations, jade jewelry, and a woven cloak. (Are these rabbit ears?) The portrait artists usually came from Europe. Lindauer was one of them. Several Maori chiefs commissioned him to paint their portraits. New Zealand's most exported wine, Lindauer, is named after this artist.