Andrey Golubov, Dimitris Petmezas, and Nickolaos G. Travlos
When it pays to pay your investment banker: New evidence on the role of financial advisors in M&As
Journal of Finance | Volume 67, Issue 1 (Feb 2012), 271–312

Corporations spend trillions of dollars on mergers and acquisitions (M&A) every year. Since a typical firm does not have in-house deal making expertise (though some “serial acquirers” do have internal M&A departments) most of these deals are originated, structured, or negotiated by corporate finance advisory firms—predominantly investment banks. In fact, the data show that about 85% of deals by transaction value are handled by M&A advisors, with most of the business going to the so-called “bulge bracket”, or top-tier, investment banks. Given the high stakes involved, it is only natural that investors, executives, and economists are wondering whether it pays off to employ one of these highly reputable advisors.

Theoretically, it is well understood that, in a setting where the quality of the product or service cannot be assessed prior to the purchase, and where the providers interact with the market repeatedly, reputation plays an important role. M&A advisory market suits this description well. In fact, investment banks routinely cite their league table positions in pitch books when trying to win mandates. Whether these league tables are informative and signal the quality of the advisor is a question that intrigued academics in the past.

Surprisingly though, the early empirical evidence indicates that employing a reputable financial advisor does not lead to better acquisitions, as measured by the short- and long-run abnormal stock returns of the acquiring firms—a measure that reflects shareholder value creation from the deal. Puzzled by this fact, in our JF paper we re-examine the effects of investment bank reputation on the price and quality of their M&A advisory services.

Hiring reputed investment bankers helps when acquiring public targets

Specifically, we look at all U.S. M&A deals between 1996 and 2009 where the identity of the bidding firm's advisor was available. During this period, the Top-8 advisors by market share (the value of deals they advised on) were Goldman Sachs, Merrill Lynch (now owned by Bank of America), Morgan Stanley, J.P. Morgan, Citi, Credit Suisse, Lehman Brothers (whose North American investment banking arm was bought out by Barclays Capital), and Lazard. We designate this group of banks as top-tier and all others as non-top-tier, and compare the outcomes of M&A transactions between the two groups of advisors (the results are equally strong if we focus only on Top-5, or extend the group to Top-10 to include UBS and Deutsche Bank).

Consistent with the notion that reputable advisors should provide higher quality services, we find that bidders employing top-tier advisors enjoy better stock price reactions around deal announcements, but only when acquiring other public firms. In particular, we find that, other things being equal, employing a top-tier bank in a public firm takeover results in a 1.01% better (less negative) market response. This translates into a $65.83 million shareholder value improvement for a mean-sized bidder—an economically non-trivial estimate.

The fact that the effect of advisor reputation on deal quality is only present in public firm acquisitions is noteworthy. We attribute it to two non-mutually-exclusive facts.

First, public firm takeovers entail greater visibility and scrutiny from all the market participants, and greater visibility in turn creates greater reputational exposure. Intuitively, providing bad advice in a highly prominent situation should lead to a greater reputation loss. This incentivizes the advisors to do their best in public firm acquisitions. Second, public firm takeovers are more complex in many respects and thus require greater skill on the part of the advisor—allowing for the expertise of top-tier advisors to shine through. In particular, these deals entail increased disclosure requirements and frequently require shareholder and regulatory approvals. Moreover, public targets have greater bargaining power as compared to private targets, making it more difficult for the bidder to appropriate synergy gains in these deals. Further, it is impossible to incorporate specific post-deal indemnification for hidden or undisclosed liabilities into the merger contract given the dispersed nature of the selling shareholders in public firm acquisitions, giving the advisor a one-and-only chance to identify and price any such contingencies. Collectively, these attributes of public firm acquisitions make the effect of advisor reputation on acquisition outcomes relatively more pronounced. It turns out that prior conclusions were based on tests which did not take this and other potentially confounding factors into account.

Top-tier banks do better deals for bidders and choose better synergy pairs

An issue of potential concern in interpreting our results is that of endogeneity (omitted variable bias). Specifically, do top-tier banks actually do better deals, or do they simply match with higher quality acquirers (i.e. positive-assortative matching)? We explicitly model this possibility in our tests employing an econometric technique known as a switching regression model with endogenous switching. Specifically, the estimation is in two stages whereby we first model the choice of a top-tier vs. a non-top-tier advisor as a function of various client- and deal-specific characteristics, and then pass on the estimation results to the second stage which models bidder returns. We also use this setup to estimate a counterfactual outcome, i.e. the bidder return that would have been most likely obtained had an alternative type of advisor been chosen, and the associated improvement. The results of this analysis indicate that improvements in bidder returns brought about by top-tier advisors are indeed driven by advisor skill rather than by observed and unobserved firm characteristics.

Naturally, it is interesting to ask where this improvement in acquirer returns is coming from. Do top-tier banks identify and structure fundamentally better mergers (i.e. those with higher synergies)? Or do they merely help extract more wealth from the target shareholders by negotiating more favorable terms for the bidder? In order to answer these questions we construct measures of the overall synergy gain (defined as the combined abnormal announcement stock return of the bidder and the target) and the share of the overall synergies accruing to the bidder. It appears that both factors are at play, with top-tier bankers designing deals that generate higher overall synergy gains, as well as being able to get a higher share of the synergies to accrue to the bidder (the latter is, however, not detectable when the advisor on the target side is also top-tier, whose efforts in extracting the benefits for the target cancel out those of the bidder's advisor).

Reputed investment-bankers are expensive, but you get what you pay for

These gains do come at a premium price. Bidders employing top-tier banks pay higher advisory fees, 0.25% higher in absolute terms for comparable transactions. When compared to an average advisory fee of 0.65% this represents almost a 40% premium in relative terms. Our finding of a premium fee is also consistent with the theoretical “premium price – premium quality” equilibrium modelled in the seminal reputation literature. But on the net, bidders still gain from employing a top-tier bank. (In an efficient market, our measure of deal quality—abnormal announcement returns—should be capturing the expected higher cost of employing a top-tier advisor and thus represents a “net” outcome.) Executives and directors of prospective acquirers concerned with potential disruption to their businesses coming from a pending deal might also like to know that top-tier advisors complete deals quicker than non-top-tier banks. Of course, not all firms can benefit from this by switching to a reputable advisor because, as we show, the latter serve a specific clientele—they advise on relatively larger deals by larger firms with higher stock return volatility and book-to-market ratios and lower stock-price run-ups.

Consistent with reputation being relatively more important in public firm takeovers, we do not find evidence of shareholder value gains from employing top-tier investment banks in acquisitions of private firms or subsidiary firms. There is not enough data on advisory fees for these private and subsidiary deals in order to ascertain whether top-tier advisors charge premium fees in these deals as well.

Importantly, there is no evidence that top-tier advisors are more fixated on deal completion than their less reputable counterparts (we do find a positive association between advisor reputation and deal completion in a subsample of subsidiary firm acquisitions, but this result is based on a very small sample of withdrawn subsidiary deals). Thus, the reputational forces prevent top-tier banks from closing more deals in the lure of fees that are contingent on closure.

Finally, we examine the choice of acquirers to go “in-house” (that is, not to retain a financial advisor at all) on their deals. We show that acquirers with more experience of doing deals on their own (independent of the number of prior acquisitions in general) are more likely to go in-house again.

We believe our results have important implications for both academic and practitioner worlds. For instance, contrary to prior beliefs, our findings confirm that the reputational forces are indeed functioning in the market for merger advisory services. Further, they justify the current practice of relying on league tables as a signal of advisor ability and quality. Finally, our finding of a fee premium for top-tier financial advisors should serve as an encouragement to investment banks to continue to build-up and protect their reputational capital by providing high quality services in the future.

Unknown Artist: Murals of two Buddhist deities in the Ajanta Caves. India, 2000 years old.. Carved from hard lava rocks, the caves are one of architectural wonders of India. They show the finest surviving examples of early Indian paintings. Originally, they were prayer halls for monastic Buddhist monks. Thus, they contained masterpieces of Buddhist religious art. So far, so good. But they were also art galleries with paintings depicting affectionate couples and decked-up princesses. The caves themselves had been lost to thick jungle for centuries and were only accidently rediscovered in the 19th century by a British officer hunting a tiger. How would “affectionate” couples have looked to the Victorian puritan, when it was even deemed improper to say “leg” (rather than “limb”)?