When It Pays to Pay Your Investment Banker

In our paper, When It Pays to Pay Your Investment Banker: New Evidence on the Role of Financial Advisors in M&As, forthcoming in the Journal of Finance, we provide new evidence on the role of financial advisors in M&As. Mergers and acquisitions (M&As) constitute one of the most important activities in corporate finance, bringing about substantial re-allocations of resources within the economy. In 2007 alone, when the most recent merger wave peaked, corporations spent $4.2 trillion on M&A deals worldwide. Investment banks advised on over 85% of these deals by transaction value, generating an estimated $39.7 billion in advisory fees.

The investment banking industry is dominated by a group of the so-called “bulge bracket” firms. These top-tier investment banks have built up reputation as experts in capital markets transactions, which, theoretically, should ensure that they perform superior services for their clients in return for premium fees. Surprisingly, however, the pertinent empirical literature fails to support this intuitive reputation-quality mechanism, and reports a negative or, at best, insignificant relationship between bidder financial advisor reputation and bidder returns in mergers and acquisitions. 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 where 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 US acquisitions of public, private, and subsidiary firms announced over the period from 1996 to 2009. In an important departure from prior studies, we examine separately the specific types of acquisitions identified on the basis of the target firm listing status for two reasons: Firstly, 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 contend 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. Secondly, public acquisitions require more skill and effort on the part of the advisors as: i) it is more difficult to capture gains in public acquisitions due to greater bargaining power of public targets compared to that of unlisted firms; ii) these deals entail increased disclosure and, more frequently, require regulatory and/or shareholder approvals, increasing complexity and demanding strong advisor professional qualifications; iii) 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; this inhibits the ability of the bidder to arrange any form of post-deal indemnification from the seller, putting, 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 to 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 only. 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 fees at a premium 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. There is, however, 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, arising from the choice of advisor 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 pre-announcement stock-price run-ups. Top-tier advisors are also preferred by bidders when acquiring relatively larger targets. Therefore, OLS estimates are potentially biased, and 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.

Finally, this study examines the so-called “in-house” acquisitions, where the bidding firm does not retain an investment bank for the transaction. We examine the determinants of this choice and find that firms with high “in-house” M&A expertise are less likely to use external advice. This study has important contributions to the M&As and financial intermediation literature. First, it provides new evidence on the effect of investment bank reputation on bidder returns, which sheds light on the puzzling evidence found in prior work on the subject. Specifically, we find that bidding firms do gain more when employing top-tier advisors rather than non-top-tier advisors, but only in public acquisitions. We also show that this quality comes at a premium price in advisory fees. Second, this is the first study, to our knowledge, to explicitly account for the endogenous nature of bidder-advisor matching. Third, it offers new insights on the determinants of the decision to retain a financial advisor and shows that in-house M&A expertise, among others, is an important determinant. Our findings also have important implications for practice. For instance, we provide justification for the current practice of constructing “League Tables” of financial advisors based on the value of deals they advised. This is consistent with the notion that the position of the investment bank in these rankings signals the quality of its services. In addition, the ability of top-tier financial advisors to charge premium fees provides incentives for advisors to build up and protect their reputational capital, encouraging them to render superior services in the future.

The full paper is available for download here.