Do Investment Banks Have Incentives to Help Clients Make Value‐Creating Acquisitions?

• Date: 01 September 2016
• DOI: http://doi.org/10.1111/jacf.12197
• Published date: 01 September 2016

In This Issue: Active Investors and Valuation

Columbia Business School Centennial Roundtable

The Achievements and Future of Business Education

8Glenn Hubbard, Columbia Business School; Geoff Garrett,

Wharton School of Business; Nitin Nohria, Harvard Business

School; and Garth Saloner, Stanford Business School.

Moderated by Jan Hopkins

Columbia Business School Centennial Roundtable

Value Creation by Active Investors (and Its Potential for Addressing Social Problems)

26 Russ Carson, Welsh, Carson, Anderson, and Stowe; and

Paul Hilal, PCH Capital. Moderated by Trevor Harris,

Columbia Business School

University of Texas Roundtable

Recent Trends in U.S. Venture Capital

36 Brooks Gibbens, FinTech Collective; Jake Saper,

Emergence Capital; Glenn Schiffman,Guggenheim; and

Venu Shemapant, LiveOak Venture Partners.

Moderated by Ken Wiles, University of Texas at Austen.

Drivers of Shareholder Returns in Tech Industries

(or How to Make Sense of Amazon’s Market Value)

48 Gregory V. Milano, Arshia Chatterjee, and David Fedigan,

Fortuna Advisors LLC

Private Equity, the Rise of Unicorns, and the Reincarnation of

Control-based Accounting

56 Jerold L. Zimmerman, University of Rochester

A Better Way to Measure Operating Performance

(or Why the EVA Math Really Matters)

68 Stephen F. O’Byrne, Shareholder Value Advisors

Estimating the Cost of Capital Using Stock Prices and Near-term Earnings Forecasts 87 Peter Easton, University of Notre Dame

What Cost of Capital Should You Use? The Market Has an Answer 95 Leon Zolotoy and Andrew John, Melbourne Business School

Do Investment Banks Have Incentives to Help Clients

Make Value-Creating Acquisitions?

103 John J. McConnell, Purdue University, and Valeriy Sibilkov,

University of Wisconsin-Milwaukee

Valuation of a Developmental Drug as a Real Option 118 John Lynch and Richard Shockley, Indiana University

VOLUME 28 | NUMBER 3 | SUMMER 2016

APPLIED CORPORATE FINANCE

Journal of

Journal of Applied Corporate Finance • Volume 28 Number 3 Summer 2016 103

Do Investment Banks Have Incentives to Help Clients

Make Value-Creating Acquisitions?

* This article draws heavily on our previously published article, Sibilkov, Valeriy, and

John J. McConnell, 2014, “Prior client performance and the choice of investment bank

advisors in corporate acquisitions,” Review of Financial Studies, Vol. 27, No. 8, pp.

2474 - 2503.

1. Roll (1986), Varaiya and Ferris (1987), and Varaiya (1988) present evidence

consistent with the view that winning bidders often overpaid for their publicly-listed tar-

gets. Faccio, McConnell and Stolin (2006) present evidence that the same is not true for

privately-held targets. Full citations of all studies cited are provided in the References at

the end of the article.

2. Ruback and Jensen (1983) review the literature on the market for corporate control

and conclude that on average publicly-listed target rm shareholders beneted, while the

shareholders of the acquirers “[did] not lose.” Lang, Stulz, and Walkling (1989) docu-

ment that average returns around tender offer announcements were signicantly positive

for public target rms and were around zero for the acquiring rms. In their survey, Jen-

sen and Warner (1988) discuss studies that have argued that managers in acquisitions

have not always acted in the interest of shareholders.

3. See “Bid ‘Em Up Bruce” in the August 7, 1989 Forbes.

4. See “‘Bid ‘Em Up Bruce’: A Winner, Hands Down” by Robert Lenzner in the October

14, 2009 Forbes.

5. Figure is estimated from Securities Data Corporation (SDC) data.

BT

o many observers, it has long seemed ev ident that

there is a potential conict bet ween the interests

of the investment bankers that do M& A advi-

sory work and the shareholders of the acquiring

companies they advise. e potentia l conict arises because

advisory contracts a re structured to reward the bankers for

“getting deals done,” with much less reward for dea ls that

don’t get done. In other words, contracts are structured so

that the bankers generate t he lion’s share of their fees from

those transact ions in which their corporate clients end up

acquiring the companie s they target—but negligible amounts

for advisory work that doesn’t lead to a transaction.

Unfortunately for shareholders of the acquiri ng corpo-

ration, overpaying for an acquisition is a fairly surere way

of ensuring that an acqu isition takes place. Indeed, there is

body of evidence from the 1970s and 1980s that suggests

that acquirers, on average, were wil ling to do just that.

1

For

in the many M&A dea ls that got done during those decades,

the shareholders of the companies acquired usually seemed

to fare signicant ly better, on average, th an the shareholders

of the companies doing the acquiring. 2

It seemed reasonable, then, that investment bank ing

M&A departments would come under su spicion for oer-

ing their corporate clients unrealistical ly high estimates of

the value of potential acquisitions. In fact, one leading U.S.

business magazine3 put Bruce Wasserstein, a particularly

successful M& A banker, on its cover in an otherwise unat-

tering 1989 portrayal. As a columni st for the same magazine

wrote 20 years later,

In a 1989 cover story, Forbes gave Wasserstein the emblematic

nickname of “Bid ‘Em Up Bruce,” observing that he used a brand

of rough “psychological bully ing” to get his clientèle of corpor ate

empire builders to pay whatever pr ice was necessary for victory.4

And yet, as that colum nist went on to point out, Wasser-

stein’s career on Wall Street did not seem to have suered

from his reputed indierence to the shareholders of his corpo -

rate clients. Early scholarly ev idence on that question tended

to support the notion that banks a nd bankers were not penal-

ized for facilitating overpriced de als.

In a study that was recently published i n the Review

of Financial Studies, we re-ex amined the evidence on the

questions: Do bankers pay any pena lty for advising on value-

destroying acquisitions? Or, conversely, is there any reward

to bankers for creating va lue for their acquisition-minded

clients? ese questions would seem to be importa nt given

that, in the United States alone, corporate acquirers paid

investment banks over $20 billion in adv isory fees to facilitate

their acquisitions during the deca de 2002-2011.5

Previous Research

One of the rst studies of advisory c ontracts in mergers and

acquisitions was conducted by Robyn McLaugh lin, while a

nance professor at Boston College, and its ndings were

published in an article in t he Journal of Financial Economics

in 1990. McLaughlin studied advi sory contracts in corpo-

rate tender oers from 1978-1985. He observed that the

compensation advisors are paid— the advisory fees —were

not contingent on whether the transaction create s value for

the client, which is the acquirer. In the t ypical contract, more

than 80% of the advisor y fee was paid only if the acquisition

was completed. He noted that such contracts appea red to

create a severe conict of interest in which t he advisor had an

incentive to complete the acquisition regardless of the valua-

tion consequences for the acquirers’ shareholders.

When discussing his ndings, McLau ghlin went on to

speculate that other mecha nisms, such as the reputation of the

advisor, could possibly work to limit the conict of interest

between the investment ban ker and its acquirer client. at is,

by John J. McConnell, Purdue University, and Valeriy Sibilkov, University of Wisconsin-Milwaukee*