48515878 dark side of investment banker

7/31/2019 48515878 Dark Side of Investment Banker

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The Dark Role of InvestmentBanks in the Market for Corporate

Control

A. Bodnaruk, M. Massa & A. Simonov


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Co o

Why M&A arb and inv banks?

Market for corporate control shoulddiscipline management. But it does not

Long-term performance of mergedcompanies are mixed at best. Usualexplanations are hubris and empire building

In 1990-es we had a lot of M&A activity thatresulted in massive distraction ofshareholder wealth.


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Investment banks in M&As

Advise to the bidder on the strategy

Evaluate the assets of the target

Help to execute transactions

Certify the deals Provide assistance in the negotiations

As many as 17 investment banks were working on

Arcelor/Mittal deal (FT,June 28th 2006)

Servaes and Zenner (1996): Hefty commissionsand fees (~0.5 -1% of target value) are justifiedby lower transaction costs and superior expertise


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A small detail

Investment banks are privy to theinformation about the upcoming bid

Do they exploit it?

If so, is it a service to a target (toehold) orgreed?

If it is greed how far does it go?

Just take positions and hope for the deal togo through or

Affect the outcomes of the deals (to

maximize their profits)?


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A little bit of mechanics of M&A Arb

Upcoming bids are difficult to predictArbitrageurs take positions 1 or 2 days after

the bid announcement

Miss most of the price increase


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M&A ArbPrimer:

Profits=p(success)*spread + (1-p)*LNN


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High SR, but not mkt neutral


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The rise of M&A arb in Inv. Bank

First time documented: Kidder, Peabody & Coin mid-80es set up M&A Arb (run by MartinSiegel) that provided lion share of overall profit

for the whole KP. Now most banks do have proprietary trading

desks that are involved in M&A arb.


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Good old times?

Book published in 85: I

considered whether totalk about behind the

scenes maneuveringand smoke-filledrooms, but I decided Iwanted to do a serious

book on arbitrage Who wrote it?


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Is it conflict-free now?

In 2003 SEC fines Deutsche Bank $750,000 for hiding aconflict of interest when it voted (in Compaq/HP merger). Ajudge who heard evidence during a hearing in 2002 said: "Thisfact raises clear questions about the integrity of the internalethical wall that purportedly separates Deutsche Bank's asset

management division from its commercial division." NY Times, Aug. 26, 2006:

it is undeniable that brokerage firms, with their varied businesses allunder one roof, remain particularly well-positioned to capitalize oninside information In a July 7 speech, Hector Sants, managing

director of wholesale and institutional markets at the F.S.A., describedwhy his focus was shifting to institutions. Our spotlight will shine inparticular on relationships between investment banks and their clients,he said, because we believe the risk of market abuse is highest wherea client can be made an insider on a forthcoming deal.


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What we show:

Investment Banks advising the bidder are takingpositions in target.

In suspicious deals premiums are larger

Suspicious deals have higher probability of being

completed; they also are more likely to have targettermination fees.

Positions that IBs take are very profitable and cannotbe replicated based on publicly available info

We also show some evidences that suspicious dealsare bad in the longer run

Overall our evidence are consistent with not justbenefiting, but engineering deals to their ownadvantage


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Literature: M&A arb.

Larcker and Lys (1987) : superior ability to predict offeroutcomes leads to their abnormal returns.

Cornelli and Li (2002) and Gomes (2001) suggests an activerole for arbitrageurs. The information advantage that an

arbitrageur possesses arises from her own holdings and thatthese holdings influence offer outcomes and dealcharacteristics.

Mitchell & Pulvino (2001), Baker and Savasoglou (2002): a isthere, but they are not mkt neutral.

Rau (2000): Contingent fees are + correlated with past marketshare (and successful completion) and correllated withfuture performance

Matvos & Ostrovksy (2006): many institutions have positions

in both target and bidder and benefit from M&A arb.


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Literature: Conflict of interest

Acharya and Johnson (2005): lending banks useprivate information regarding corporate clients totrade credit default swaps.

Irvine, Lipson and Puckett (2004): institutional

investors receive tips regarding the content offorthcoming analysts reports

Ritter and Zhang (2006): lead underwriters allocatehot initial public offerings to affiliated funds.

Ellis, Michaely and OHara (2000): NASDAQmarket makers belonging to a financial groupsupport the stock price of those firms whose IPOhas been underwritten by the investment bankbelonging to the group.


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Good or Bad?

IBs can reduce cost of acquisition by using

their expertise (Servaes & Zenner 96). It is just so happen that IB and Asset

Management arms pick up the samecompanies (the same analysis leads to the

same conclusion). IBs can take position in the target on behalf

of the bidder (toehold).


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Good or Bad?

Information Hypothesis (or informed

trading one): Asset ManagementArm uses M&A private info to takepositions

Conditioning Hypothesis: IB playsactive role in selecting the targetand making bidder to agree to payhigher price.


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Example: Compaq/HP/DB timeline

March 15, 2002. Officials of DB asset management division,which owns 17 mln HP shares, vote against the deal.

March 17. In a voice mail Fiorina tells CFO Bob Waymanthey need to do "something extraordinary" to win over DB.

Mar. 17-19(?). HP executives confidentially hire DBinvestment bankers to provide "market intelligence" duringthe proxy fight, agreeing to pay them $1 mln, with a $1 mlnbonus if the merger goes through. Then they asked DB IBs

to intervene. The bankers contact Dean Barr, a top exec fromDB Asset Management. On March 19 vote was changed.

At the same time, DB accumulated 5.268 mln shares inCOMPAQ. Rough profit estimate:$20mln (fine was

$0.75mln)


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Data

CRSP+COMPUSTAT

SDC + newspaper clipping from FACTIVA

Spectrum IH and 13F Link between 13F and SDC was created

Info used: SEC (Adviserinfo), Morningstar,

web.


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BRAND

AXA Brand

AXA Advisors Sanford S. Bernstein

AXA Equitable Life Alliance Bernstein

And many others


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Brands are changing

Regions Financial

Morgan Keegan

(till 2001)Regions Financial

T. J. Raney Schariff Jones

J. Lee Peeler Cumberlend Sec

Morgan Keegan

Bought by MK

1989-94


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Insiders

A brand is labeled as non-insider arbitrageurifits holdings in targets go from zero to positive inat least 20 deals in our sample following bid

announcement Insider arbitrageursinclude brands which either

advise to acquirer (insider to acquirer) or totarget or provided a loan to a target no more

than three years prior to first bid (insider totarget).


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Are IBs smart or get help?


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Can it be that they are acquiringtoehold?

Unlikely. Conditional on taking position, itshould be large (Eckbo & Betton 2001:8.5%, Jenter 2006: 17%). Our position is

about 0.6%...


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Potential insiders variables

Ownership by Pot. Insidersis the fraction of the company whichis held by brands acting as advisors on at least 5 deals in oursample.

Ownership by Pot. Insiders $is the log of one plus the Dollar

value of the stake of the potential insiders holding positions inthe company. Prices are measured at t-62

Potential insiders share of arbitrage is the Dollar value of thestake of the potential insiders holding positions in the company,divided by the aggregate arbitrage capital in the market.

Ln(N Potential Insiders) and Ln(N Deals) measures are thelogarithm of the number of potential insiders in the companyand the logarithm of the combined number of deals thesebrands advised over the sample period


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Actual insiders

Ownership by Advisorthe fraction of thepotential target equity held by the advisor to

bidder Ownership by Advisor $- i.e., the log of

dollar value (plus one) of the advisorybanks position.

Ownership by Advisor Dummy


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Other variables:

Total changes in arbitrage capital (mkt-wide)(Cornelli and Li, 2002, Baker and Savosoglu,

2002, Hsieh, 2001) Institutional ownership (Stulz, Walkling and

Song, 1990)

ROE, B/M, Size, Sales Growth, AccountingLiqudity, P/E, D/E for both target and bidder

Industry herfindahl, momentum, volatility

Contractual features (as in Officer)


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Probability of Becoming Target

Increasing Ownership by potential insiders byone standard deviation increases probability ofbeing takeover target from 1.8% to 2.1%, or by

17 pct pts. Increasing Ownership by potential insiders $ by

one standard deviation increases probability ofbeing takeover target from 1.8% to 3.5%, or by

92 pct pts. Increasing Potential insiders share of arb capital

by one standard deviation increases probabilityof being takeover target from 1.8% to 2.5%, orby 40 pct pts.


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Matched sample

Probability of becoming a target increasesfrom 4.2% to 6.1%


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Premium

We follow Schwerts (2000) definition of

Target Abnormal Return Premium. We useboth one-factor and four-factor adjusted

premiums.

Loadings are determined using 253 tradingdays ending at day -64 (i.e., trading days (-316, -64)).

dateresolution

iitRemium

,42min

63

tiF-Pr


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Premium

An increase of one standard deviationin the advisor stake (corresponding toapproximately a 0.53% ownership of the

firms) increases the target firms

premium from 25.5% to 27%, or by 6percentage points.

It goes to 28.4% and 31.1% in the caseof Ownership by Advisor to Acquirer $and Ownership by Advisor to AcquirerDummyrespectively.


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What about trading strategy?

Let us look at actual profitability of thepositions IBs are taken. We compare

Return on positions held by actual advisors

Return on positions taken 1 day after dealannouncement (separately for deals that are notheld and held by advisors)

Returns on Cash/Stock dealsT

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it

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ititPPDPR

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ititluePositionVaPRPDPPDPR


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Descriptive stat


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Fama-French-Carhart regressions

a is about 4-4.5% per month

It seems that there is no systematic risk inadvisor takes positions


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Advisors always make money


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and a lot of money


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Strategy based on prob ofbecoming target

We can build the strategy looking at mediumsize companies (deciles 4-9) using probit ofbecoming target with actual and potentialinsiders and selecting top X stocks (bypredicted prob)


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Four-factor model


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Next step

Are IBs just making money by takingpositions or do they go further? Would theyengineer the deal?

We will show that they make completion ofthe deal more likely, they also usecontractual features that increase success Usual disclaimer about potential reverse

causality applies

We present weak evidence that the dealsare suboptimal for the companies


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Target Termination Fee

Target termination fee (fee payable by targetto bidder if target walks away from mutuallyagreed deal) enhances chances of deal beingcomplete (Officer, 2002)


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Probit estimates

Even controlling for all othercontractual features results hold

An increase of advisory stake by one

standard deviation increasesprobability to have target terminationfee from 40% to 44.7%, or by 12 pct

points.


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Success

Deal non-completion is the biggest riskM&A arbitrageur is facing.

In deals with holdings by advisorsprobability of completion is higher byalmost 6%!


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Probit

The results survive control variables

An increase in the advisory stake of one standarddeviation increases the probability of success

from 77.8% to 80.1%. It goes to 81.6% and 83.4% in the case of

Ownership by Advisor to Acquirer$andOwnership by Advisor to Acquirer Dummy,

respectively. So, 10-25% of RISK of non-completion are gone!!!

Alternative: instrument target term fee withOwnership by Advisorvariables. Actually, works

similarly.


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Profit Margins next FY aftercompletion:

Profit Margins are lower by about 2%

Similar results holds for ROA, ROEXX


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Whos the biggest loser?

Which bidders are most likely to be takenadvantage of?

We construct measures of bidder sophistication

related to the prior experience in financial marketsand the relationship with advisor

these include # of bond & equity issues, # of M&Asconducted in the previous 3 years, both unconditionally

and with the help of current bid advisorResult: Companies with low experience and no prior

relationship with deal advisor are suffering themost.


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Other results

Similar to term. fees result was obtained for collar (butsmaller econ. magnitude). In the deals with large distraction of shareholder

wealth, more than half has IB position in the deal.


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Conclusion

We provide evidence that advisors to the bidders havepositions in the target before the deal. The existenceof a direct stake of the advisor to the bidder increasesthe probability that the deal is successful as well asthe target premium. We explain these findings in terms

of insider trading of the advisory bank. Our findings suggest that advisors not only take

advantage of their privileged position by gettinginvolved in M&A Arb, but also by directly affecting the

outcome of the deal in order to fetch a higher capitalgain from their positions. These results provide important insights on the

conflicts of interest that affect financial intermediariesthat can both advise and invest in the equity market.

I i d b h ki i


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It is good to be the king investmentbanker!

48515878 dark side of investment banker

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