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The Dark Role of Investment Banks in the Market for Corporate Control. A. Bodnaruk, M. Massa & A. Simonov. Why M&A arb and inv banks?. Market for corporate control should discipline management. But it does not…
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The Dark Role of Investment Banks in the Market for Corporate Control A. Bodnaruk, M. Massa & A. Simonov
Why M&A arb and inv banks? • Market for corporate control should discipline management. But it does not… • Long-term performance of merged companies are mixed at best. Usual explanations are hubris and empire building • In 1990-es we had a lot of M&A activity that resulted in massive distraction of shareholder wealth.
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 commissions and fees (~0.5 -1% of target value) are justified by lower transaction costs and superior expertise
A small detail … • Investment banks are privy to the information about the upcoming bid • Do they exploit it? • If so, is it a service to a target (toehold) or greed? • If it is greed how far does it go? • Just take positions and hope for the deal to go through or • Affect the outcomes of the deals (to maximize their profits)?
A little bit of mechanics of M&A Arb • Upcoming bids are difficult to predict • Arbitrageurs take positions 1 or 2 days after the bid announcement • Miss most of the price increase
M&A Arb Primer: • Profits=p(success)* spread + (1-p)*LNN
The rise of M&A arb in Inv. Bank • First time documented: Kidder, Peabody & Co in mid-80es set up M&A Arb (run by Martin Siegel) 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.
Good old times? • Book published in 85: “I considered whether to talk about behind the scenes maneuvering and smoke-filled rooms, but I decided I wanted to do a serious book on arbitrage” • Who wrote it?
Is it conflict-free now? • In 2003 SEC fines Deutsche Bank $750,000 for hiding a conflict of interest when it voted (in Compaq/HP merger). A judge who heard evidence during a hearing in 2002 said: "This fact raises clear questions about the integrity of the internal ethical 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 all under one roof, remain particularly well-positioned to capitalize on inside information… In a July 7 speech, Hector Sants, managing director of wholesale and institutional markets at the F.S.A., described why his focus was shifting to institutions. “Our spotlight will shine in particular on relationships between investment banks and their clients,” he said, “because we believe the risk of market abuse is highest where a client can be made an insider on a forthcoming deal.”
What we show: • Investment Banks advising the bidder are taking positions in target. • In “suspicious ”deals premiums are larger • “Suspicious” deals have higher probability of being completed; they also are more likely to have target termination fees. • Positions that IBs take are very profitable and cannot be replicated based on publicly available info • We also show some evidences that “suspicious” deals are bad in the longer run • Overall our evidence are consistent with not just benefiting, but engineering deals to their own advantage
Literature: M&A arb. • Larcker and Lys (1987) : superior ability to predict offer outcomes leads to their abnormal returns. • Cornelli and Li (2002) and Gomes (2001) suggests an active role for arbitrageurs. The information advantage that an arbitrageur possesses arises from her own holdings and that these holdings influence offer outcomes and deal characteristics. • Mitchell & Pulvino (2001), Baker and Savasoglou (2002): a is there, but they are not mkt neutral. • Rau (2000): Contingent fees are + correlated with past market share (and successful completion) and – correllated with future performance • Matvos & Ostrovksy (2006): many institutions have positions in both target and bidder and benefit from M&A arb.
Literature: Conflict of interest • Acharya and Johnson (2005): lending banks use private information regarding corporate clients to trade credit default swaps. • Irvine, Lipson and Puckett (2004): institutional investors receive tips regarding the content of forthcoming analysts’ reports • Ritter and Zhang (2006): lead underwriters allocate hot initial public offerings to affiliated funds. • Ellis, Michaely and O’Hara (2000): NASDAQ market makers belonging to a financial group support the stock price of those firms whose IPO has been underwritten by the investment bank belonging to the group.
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 same companies (the same analysis leads to the same conclusion). • IBs can take position in the target on behalf of the bidder (toehold).
Good or Bad? • Information Hypothesis (or informed trading one): Asset Management Arm uses M&A private info to take positions • Conditioning Hypothesis: IB plays active role in selecting the target and making bidder to agree to pay higher price.
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 Wayman they need to do "something extraordinary" to win over DB. • Mar. 17-19(?). HP executives confidentially hire DB investment bankers to provide "market intelligence" during the proxy fight, agreeing to pay them $1 mln, with a $1 mln bonus if the merger goes through. Then they asked DB IBs to intervene. The bankers contact Dean Barr, a top exec from DB Asset Management. On March 19 vote was changed. • At the same time, DB accumulated 5.268 mln shares in COMPAQ. Rough profit estimate:$20mln (fine was $0.75mln)
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.
Brands are changing Bought by MK 1989-94
Insiders • A brand is labeled as non-insider arbitrageur if its holdings in targets go from zero to positive in at least 20 deals in our sample following bid announcement • Insider arbitrageurs include brands which either advise to acquirer (insider to acquirer) or to target or provided a loan to a target no more than three years prior to first bid (insider to target).
Can it be that they are acquiring toehold? • Unlikely. Conditional on taking position, it should be large (Eckbo & Betton 2001: 8.5%, Jenter 2006: 17%). Our position is about 0.6%...
“Potential insiders” variables • Ownership by Pot. Insiders is the fraction of the company which is held by brands acting as advisors on at least 5 deals in our sample. • Ownership by Pot. Insiders $ is the log of one plus the Dollar value of the stake of the potential insiders holding positions in the company. Prices are measured at t-62 • Potential insiders’ share of arbitrage is the Dollar value of the stake 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 the logarithm of the number of potential insiders in the company and the logarithm of the combined number of deals these brands advised over the sample period
“Actual” insiders • Ownership by Advisor –the fraction of the potential target equity held by the advisor to bidder • Ownership by Advisor $ - i.e., the log of dollar value (plus one) of the advisory banks’ position. • Ownership by Advisor Dummy
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, Accounting Liqudity, P/E, D/E for both target and bidder • Industry herfindahl, momentum, volatility • Contractual features (as in Officer)
Probability of Becoming Target • Increasing Ownership by potential insiders by one standard deviation increases probability of being takeover target from 1.8% to 2.1%, or by 17 pct pts. • Increasing Ownership by potential insiders $ by one standard deviation increases probability of being 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 probability of being takeover target from 1.8% to 2.5%, or by 40 pct pts.
Matched sample Probability of becoming a target increases from 4.2% to 6.1%
Premium • We follow Schwert’s (2000) definition of Target Abnormal Return Premium. We use both one-factor and four-factor adjusted premiums. • Loadings are determined using 253 trading days ending at day -64 (i.e., trading days (-316, -64)).
Premium • An increase of one standard deviation in the advisor stake (corresponding to approximately a 0.53% ownership of the firms) increases the target firm’s premium from 25.5% to 27%, or by 6 percentage points. • It goes to 28.4% and 31.1% in the case of Ownership by Advisor to Acquirer $ and Ownership by Advisor to Acquirer Dummy respectively.
What about trading strategy? • Let us look at actual profitability of the positions IBs are taken. We compare • Return on positions held by actual advisors • Return on positions taken 1 day after deal announcement (separately for deals that are not held and held by advisors) • Returns on Cash/Stock deals
Fama-French-Carhart regressions • a is about 4-4.5% per month • It seems that there is no systematic risk in “advisor takes positions”
Strategy based on prob of becoming target • We can build the strategy looking at medium size companies (deciles 4-9) using probit of becoming target with actual and potential insiders and selecting top X stocks (by predicted prob)
Next step • Are IBs just making money by taking positions or do they go further? Would they engineer the deal? • We will show that they make completion of the deal more likely, they also use contractual features that increase success • Usual disclaimer about potential reverse causality applies • We present weak evidence that the deals are suboptimal for the companies
Target Termination Fee • Target termination fee (fee payable by target to bidder if target walks away from mutually agreed deal) enhances chances of deal being complete (Officer, 2002)
Probit estimates • Even controlling for all other contractual features results hold • An increase of advisory stake by one standard deviation increases probability to have target termination fee from 40% to 44.7%, or by 12 pct points.
Success • Deal non-completion is the biggest risk M&A arbitrageur is facing. • In deals with holdings by advisors probability of completion is higher by almost 6%!
Probit • The results survive control variables • An increase in the advisory stake of one standard deviation 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$ and Ownership by Advisor to Acquirer Dummy, respectively. • So, 10-25% of RISK of non-completion are gone!!! • Alternative: instrument target term fee with Ownership by Advisor variables. Actually, works similarly.
Profit Margins next FY after completion: • Profit Margins are lower by about 2% • Similar results holds for ROA, ROE X X
Who’s the biggest loser? • Which bidders are most likely to be taken advantage of? • We construct measures of bidder sophistication related to the prior experience in financial markets and the relationship with advisor • these include # of bond & equity issues, # of M&As conducted in the previous 3 years, both unconditionally and with the help of current bid advisor Result: Companies with low experience and no prior relationship with deal advisor are suffering the most.
Other results • Similar to term. fees result was obtained for collar (but smaller econ. magnitude). • In the deals with large distraction of shareholder wealth, more than half has IB position in the deal.
Conclusion • We provide evidence that advisors to the bidders have positions in the target before the deal. The existence of a direct stake of the advisor to the bidder increases the probability that the deal is successful as well as the 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 getting involved in M&A Arb, but also by directly affecting the outcome of the deal in order to fetch a higher capital gain from their positions. • These results provide important insights on the conflicts of interest that affect financial intermediaries that can both advise and invest in the equity market.
