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E-MailFrançois Derrien is professor of finance at HEC Paris, and Olivier Dessaint is assistant professor of finance at University of Toronto Rotman School of Management. This post is based on their recent article, forthcoming in the Review of Finance.
In the article The Effects of Investment Bank Rankings: Evidence from M&A League Tables, forthcoming in the Review of Finance, we study how league tables affect the behavior of investment banks in the M&A industry. League tables are simple rankings based on banks’ market shares. Anecdotal evidence suggests that banks pay a lot of attention to them. To understand why this is the case, we first ask whether current league table ranks affect future M&A activity. One might think that league tables, which contain public information on bank activity that is simply repackaged into a ranking, are just a sideshow. In this case, they may matter because they affect the self-image of bankers, their status or their compensation. Alternatively, inexperienced managers may rely more on league tables to choose these advisors because they believe that the rank of a bank in the league table, which reflects past demand from other clients, is a good measure of its expertise. Hiring high-ranked banks signals the quality of the transaction to other stakeholders of the company (e.g., board members, shareholders, employees, customers, suppliers).
To explore the relation between league table ranks and future M&A activity, we use a series of empirical strategies. First, we show that recent changes in the league table rank of a bank are correlated future changes in its number of M&A mandates, controlling for known determinants of M&A activity. League table rankings affect predominantly the demand of inexperienced M&A clients, consistent with the view that league tables are a useful source of information mostly for managers who are not familiar with the M&A market.
To establish causality between rankings and future deal flow unambiguously, we employ two additional specifications. First, we use the fact that league tables report only the top 25 banks in the ranking, even though banks right below rank 25 are very similar to banks right above that rank in terms of M&A market share. Consistent with the view that the visibility offered by the league table affects the future deal flow of a bank, we find that for banks that are close to rank 25, entering (exiting) the league table increases (decreases) the number of M&A transactions by about 20%.
Second, we try to identify exogenous changes to league table ranks, i.e., rank changes that are not linked to changes in bank characteristics. To do so, we exploit the fact that when a bank is acquired, it disappears from the league table. Thus, banks ranked below the acquired bank in the league table mechanically gain ranks, while banks ranked above it are unaffected. Consistent with our previous results, we find that banks that benefit from such an exogenous gain of ranks increase their deal flow more than unaffected banks.
The impact of league tables in terms of future M&A activity creates incentives for banks to manage their positions in these rankings. We hypothesize that banks engage in such “league table management” if its costs in terms of current earnings, execution efforts and reputation risk do not exceed its expected benefits. In testing this hypothesis, we face two empirical challenges. First, we need to identify ways for banks to manage their league table ranks. Second, if all banks constantly manage their rankings with the same intensity, then league table management should not affect rankings, and it might not even be observable to researchers, as the tournament literature shows. Thus, we also need to identify variations in the incentives of banks to manage their league table rankings.
We argue that banks can use at least two league table management tools. First, they can exploit the construction rules of league tables. These rules are such that, in most cases, all the banks that participate in a transaction obtain the same league table credit regardless of their role in the transaction. Thus, mandates associated with low effort (and low fees) but with full league table credit, like fairness opinions, are natural league table management tools. A fairness opinion, or FO, is a third-party assessment of the fairness of the pricing of a proposed transaction. FOs are financially unattractive because their fees are usually very low—in our sample, the median fee is 14bp (about 500 thousand dollars) for FOs, vs. 66bp (about 2.75 million dollars) for regular advisory mandates. However, FOs are beneficial in terms of league table credit because FO providers obtain the same league table credit as regular advisors. Second, banks willing to improve their position in the league table can cut their fees. By doing so, they reduce their current earnings but they increase their chances of obtaining mandates, thereby increasing their expected league table rank and their future deal flow.
We identify variations in the incentives to manage league table rankings as follows. First, the impact of a given transaction on a bank’s position in the ranking depends on the difference between the league table credits accumulated by the bank and its competitors since the start of the period. If this difference is large, participating in the next transaction is unlikely to help the bank preserve or improve its rank in the league table. By contrast, if the bank is close to its competitors in terms of league table credits, it can gain ranks by increasing its activity marginally but it can also lose ranks if its competitors do the same. In this case, the bank has a lot to gain from participating in the next transaction. This variation in the relative league table impact of M&A transactions is our primary measure of a bank’s incentives to engage in league table management. Our second measure is recent performance in the league table, which may affect the costs and benefits of league table management. In particular, league table management is potentially less costly (in terms of foregone M&A fees and reputation cost) for banks that have lost ranks in recent league tables.
We find that banks are more likely to do FOs and to reduce their fees when their incentives to do so are greater. Specifically, we show that when there are multiple advisors for the same deal and the same client (i.e., multiple banks facing the same demand), the bank that benefits the most from the deal in terms of ranking (because the deal leads to a larger reduction in the gap with its competitors in the league table) is more likely to do a FO and to charge lower fees, as is the bank with the poorer relative performance in recent league table rankings.
Finally, we investigate the implications of this strategic response to league table rankings. We find that league table management affects the quality of services delivered by banks. In particular, fairness opinions likely to be motivated by league table concerns are associated with lower valuation accuracy and higher uncertainty about the “fair” price of the transaction. Overall, the results suggest that league tables, because they affect banks’ future activity, also affect their behavior, with at least two effects for their clients: On the one hand, league tables exacerbate competition for mandates and can induce banks to cut fees, a positive outcome for M&A clients. On the other hand, league table management seems to have a negative impact on the quality of some services provided by banks.
The complete article is available for download here.
