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Investment banks advising takeover targets

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Abstract

Should takeover target firms hire top-tier investment bank advisors? For a sample of mergers and acquisitions between publicly traded U.S. acquirers and targets, in deals in which targets hire top-tier banks, targets earn higher premiums and abnormal returns; the probability of stock payment is lower, especially when bidder stock is potentially overvalued; acquirers, however, do not necessarily earn lower abnormal returns, and combined returns are higher. Controlling for self-selection does not erode, but, in some cases even strengthens the results. The evidence suggests that top-tier investment banks advising targets benefit shareholders of client firms by making better deals, instead of simply bargaining against the acquirers. The findings shed light on the role of advisor incentives when linking advisor quality and shareholder wealth.

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Notes

  1. McLaughlin (1990, p227) reports that, in some hostile takeover cases, target advisors are paid contingency fees only if targets stay independent. These contract terms favor entrenched management at the expense of shareholder value. In a later section (Section 5), I reexamine this issue and find that, on average, hostile deals are more likely to complete with target advisors than without.

  2. The sampling procedure, which is quite similar to many large sample studies in the mergers and acquisitions literature, focuses on publicly traded acquirers and targets covered by both CRSP and COMPUSTAT, and is thus biased toward larger firms and firms that have used investment banking services. These firms are more likely to hire investment bank advisors when becoming takeover targets. For total of 9,546 deals involving publicly traded targets with transaction value exceeding $1 m (excluding buybacks, exchange offers and recapitalizations deals) from 1980 to 2003, the equal-weighted (value-weighted) percentage of targets hiring bank advisors is 63.7% (96.1%), based on data from SDC.

  3. Bank advisors may also get involved at the end of the deal process, in which case they provide “fairness opinions” only. In the sample used in this study, only 4.6% (106 out of 2,309) target advisors are recorded as providing “fairness opinions” only, with 2.71% (18 out of 663) for top-tier and 5.41% (88 out of 1646) for non-top bank advisors. Excluding these advisors does not affect the main findings.

  4. The determinants of target hiring top banks are examined in a later section.

  5. Recently Bao and Edmans (2011) challenge the efficiency in practice of using market share as the basis for giving mandates when deciding which investment banks to hire as merger advisors. They document significant persistence in acquirer bank advisors’ performance. They find that investment banks past market share, instead of their past performance, predicts future market share, which is mainly due to acquirers’ failure to learn.

  6. Due to the longer time-span covered in this study than in Rau (2000) and changes in the investment banking industry in the latter period, I check the robustness of this definition by adding into or dropping from the “top” list those banks that fall in the gray area, including Lazard Freres, Merrill Lynch, and Lehman Brothers. The main results in this paper do not change. Details are discussed in the robustness check section.

  7. Considering mergers involving these banks, the following names are also recognized as top banks: First Boston, Citigroup, Salomon Smith Barney, and Schroder Salomon Smith Barney.

  8. Using market model and continuously compounded returns to estimate expected returns as suggested in Schwert (2000) yields qualitatively similar results.

  9. Other measures, such as the transaction value excluding assumed liability divided by target market value of equity, are also constructed for the purpose of robustness. The results are robust.

  10. In my sample, the correlation coefficient is .334 between offer premium and return-based premium, .655 between target abnormal returns and return-based premium, and .350 between target abnormal returns and offer premium.

  11. See also Rau and Vermaelen (1998), Agrawal and Jaffe (2000), and Mitchell and Stafford (2000).

  12. If market-to-book measures investment opportunity, a similar argument can be reached: Banks on the acquirer side advise issuing stocks when issuing stocks is not optimal (low investment opportunity).

  13. The four-month period is chosen so that the target firms’ stock price runup (Schwert 1996) due to possible information leakage does not go into the prior return variable.

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Authors and Affiliations

  1. School of Hotel Administration, Cornell University, 435 B Statler Hall, Ithaca, NY, 14853, USA

    Qingzhong Ma

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Correspondence to Qingzhong Ma.

Additional information

The article is revised from Chapter 1 of my dissertation at the University of Southern California and was circulated under the title “Mergers and Investment Banks: How Do Banks Help Targets?” I thank my advisors John Matsusaka (Chair), Micah Officer, and Oguzhan Ozbas for their careful guidance. Helpful suggestions were received from Charles Chang, Jack Corgel, Harry DeAngelo, Alex Edmans, Larry Harris, Paul Malatesta, Pedro Matos, Aris Protopapadakis, Daniel Quan, Guofu Tan, Andrey Ukhov, Mark Weinstein, Athena Wei Zhang, two anonymous referees, and participants at seminars at California State Polytechnic University Pomona, Cornell University, FMA 2006, and University of Southern California. Financial support from the Marshall School of Business at USC and School of Hotel Administration of Cornell University is greatly appreciated.

Appendices

Appendix A: Investment banks’ activities in advising targets

The acquisition of Promus by Hilton announced on September 7, 1999 (Data source: DEF 14A “Other definitive proxy statements” filed by Promus 10/21/1999, file number 001–13719. Available online via the following link: http://www.sec.gov/Archives/edgar/data/1049533/0000912057-99-001758.txt)

1.1 Overview of the deal

On September 7, 1999, Hilton and Promus made a joint announcement regarding the acquisition of Promus by Hilton. According to the acquisition terms, Promus stockholders would receive in the aggregate for their shares approximately $1.66 billion in cash and 113 million shares of Hilton common stock.

1.2 Background

Hilton has considered expanding its business through acquisitions of other hotel companies. In April 1999, Hilton management expressed its interest in acquiring Promus, but Promus did not respond favorably.

In an announcement on May 25, 1999, Promus lowered its earnings expectations due to softening market conditions, restructuring costs, and deteriorating performance of its Doubletree and Red Lion hotels. Its stock price dropped from $30.50 on May 24 to $23.75 on June 2.

In light of the Promus announcement, Hilton accumulated 500,000 shares of Promus common shares at a cost of $14.2 million from July 6 to July 15, and, on July 16, Hilton sent a letter to Promus discussing the potential acquisition of Promus at $37.00 per share.

On July 29, the Promus board of directors held a regular meeting and rejected the Hilton offer dated July 16. This decision was communicated to the Hilton management on August 2.

1.3 Identifying potential bidders

Promus hired Salomon Smith Barney as financial advisor and, during the week of August 2nd, the Promus management and Salomon contacted a number of companies in the hotel industry to weigh their interest in a strategic transaction with Promus. The following week, confidentiality agreements were signed between Promus and several of these parties and discussion of potential transactions began.

During the same time, Promus met with the management of Hilton and encouraged Hilton to join the auction process, claiming that Promus would be willing to consider any proposal from Hilton that was superior to its July 16th letter. On August 16, 1999, Hilton’s July 16 proposal was withdrawn.

1.4 Screening bids and negotiating terms

Beginning on August 16th, Promus management met with the parties that signed confidentiality agreements and provided private information to them. These parties were asked to present indications of interest and value ranges. On August 23, the Promus management and Salomon got authorization from the board to continue discussions with the parties and to initiate negotiations with Hilton.

Between August 17 and 24, financial advisors representing Hilton and Promus had various discussions. On August 25, a confidentiality agreement was executed. On August 26, the management and financial advisors of the two companies met in Denver, Colorado to discuss an acquisition. At the meeting, the Promus representatives urged Hilton to make its best offer. Hilton, in response, proposed a per share price of $38.50 paid with 55% cash including a “collar” centered on the Hilton stock price and a cash-out of outstanding Promus stock options. On August 27, the Promus board authorized its management to proceed with further discussions with Hilton for a definitive agreement. Due diligence and negotiations between Hilton and Promus continued throughout the week of August 30. On September 1, both companies issued a press release separately concerning the ongoing discussion of a deal between the two companies.

1.5 Providing a “fairness opinion”

At the Promus board meeting, financial advisor Salomon and legal advisor Davis Polk & Wardwell made presentations to the board. Salomon delivered its oral “fairness opinion,” which was subsequently confirmed in writing. The board unanimously approved the deal.

The acquisition was jointly announced by Hilton and Promus on the morning of September 7.

1.6 SEC filing by Promus

DEF 14A “Other definitive proxy statements” filed by Promus 10/21/1999, file number 001–13719. Available online via the following link: http://www.sec.gov/Archives/edgar/data/1049533/0000912057-99-001758.txt

1.7 SDC recording

The SDC records the acquisition of Promus by Hilton as announced on September 7, 1999. The target advisor is Salomon Smith Barney, and the acquirer advisors include Morgan Stanley and Donaldson, Lufkin & Jenrette. The total transaction value is $3.64 billion. The total target advisor fee is $14 million, while the total acquirer advisor fee is $12 million.

1.8 The Wall Street Journal reporting

The Wall Street Journal reported the merger talk between Hilton and Promus on September 1, 1999 and a confirmation of the acquisition on September 8, 1999.

Appendix B: Variable definitions and data sources

Acquirer abnormal returns: the cumulative abnormal returns to acquirers from 1 day before the first bid the acquirer made to the target to 1 day after the current bid, with expected returns predicted by the Fama-French three-factor model estimated over [−360, −61] days before the first bid. (CRSP)

Acquirer has a bank: a dummy that equals one if the acquirer hires a bank. (SDC)

Acquirer has a top bank: a dummy that equals one if the acquirer hires a top bank. (SDC)

Acquirer size: the acquirer’s market value of equity, measured at the month end before the current bid announcement. (CRSP)

Acquirer M/B: the market-to-book ratio of the acquirer, where market value is the market value of equity at month end before announcement, and book equity is the most recent quarterly book equity (quarterly Compustat #59). (Compustat, CRSP)

Any stock dummy: equal to one if the percent of stock payment in the deal is positive, and zero otherwise. (SDC)

Combined abnormal returns: the combined acquirer and target cumulative dollar abnormal returns (daily abnormal return times lag market value of equity) divided by the combined market value of equity, measured at the day before the respective cumulating window.

Complete deal dummy: a dummy that equals one if the announced bid finally completes. (SDC)

Hostile: a dummy that is equal to one if the deal attitude is hostile or unsolicited. (SDC)

Lockup option: a dummy that equals one if lockup option is used in the deal. (SDC)

Multiple bidders: a dummy that equals one if the number of bidders is greater than one. (SDC)

Non-top tgt bank * Top acq bank: a dummy equal to one if the acquirer hires one or more top-tier bank advisors and the target hires no top-tier bank advisors.

Number of target SIC: the number of 4-digit SIC codes of the target. (SDC)

Offer premium: the offer price (transaction value excluding assumed liabilities) divided by the target firm’s market value of equity measured at 42 days before the first bid, minus one. It is then restricted between 0 and 200%. (SDC, CRSP)

Predeal announcement: a dummy that equals one if a bid exists within 2 years before the current bid. (SDC)

Prior relation: a dummy that takes on the value one if the target has a prior business relationship (either in underwriting or merger advisory business) with the current top banks for targets that hire top banks in the current deals, or if the target has a prior business relationship with any of the five top banks for targets that hire no top banks in the current deals. The period to search for prior business relationship includes 3 years before the current deal announcement date. (SDC)

Return-based premium: constructed following Schwert (2000). It is the accumulated abnormal returns from 63 trading days before the first announcement (t 0 ) to 126 days after the current announcement (t 1 ) or delisting of the target stock, whichever occurs first. The expected returns are estimated using Fama and French (1993) three-factor models, with coefficients estimated from data of [−316, −64] days relative to the first announcement. (CRSP)

Same industry: a dummy that takes on the value one if the acquirer and target firms share 2-digit SIC codes, and zero otherwise. (SDC)

Target abnormal returns: the cumulative abnormal return from 1 day before the first bid to 1 day after the current bid, with expected returns predicted by the Fama-French three-factor model estimated over [−360, −61] days before the first bid. (CRSP, SDC)

Target has a bank: equal to one if the target hires an investment bank, and zero otherwise. (SDC)

Target has a top bank: equal to one if the target hires one or more top-tier investment bank advisors, and zero otherwise. (SDC)

Target prior year return: the target firm’s buy-and-hold returns over the year 4 months before the first bid, adjusted by CRSP value-weighted market returns. (CRSP)

Target size: the target firm’s market value of equity, measured at the month end before current announcement. (CRSP)

Target termination fee: a dummy that takes on the value one if target termination fee is used, and zero otherwise. (SDC)

Target M/B: the market-to-book ratio of the target firm, where market value is the market value of equity at month end before announcement and book equity is the most recent quarterly book equity (quarterly Compustat #59). (Compustat, CRSP)

Tender offer: a dummy that equals one if the deal is a tender offer, and zero otherwise. (SDC)

Toehold: a dummy that equals one if the acquirer holds more than 5% of the target firm’s shares before the announcement, and zero otherwise. (SDC)

Top tgt bank * Non-top acq bank: a dummy equal to one if the target hires one or more top-tier bank advisors and the acquirer hires no top-tier bank advisors.

Top tgt bank * Top acq bank: a dummy equal to one if the acquirer hires one or more top-tier bank advisors and the target hires one or more top-tier bank advisors.

Appendix C: Defining top-tier investment banks advising targets

I start by downloading all mergers and acquisitions deals (domestic targets only or targets worldwide) from the SDC that have deal value of at least $1 million, announced from 1980 to 2003. I exclude all exchange offers, buybacks and self tender offers. Each eligible advisor is credited for the rank value as recorded in the SDC. I then rank all investment banks each year based on their market share.

Based on the annual ranking, I identify all investment banks (subsidiaries instead of the ultimate parent banks) that entered the top-ten list at least once from 1980 to 2003. For these banks, I search the SDC for the merger/acquisition deals involving them. The codes for relevant banks are combined accordingly. Relevant banks include First Boston (Credit Suisse First Boston), Salomon Brothers (Citigroup, Salomon Smith Barney), UBS Warburg, Rothschild, and Lehman Brothers.

Based on the codes that already take into account the merger history of the banks, I list the annual ranking for these top-ranked banks. Table 11 contains the annual rankings for banks that entered the top-ten list at least five times from 1980 to 2003. I then calculate the number of years for each of these banks that entered the top five, top ten list, and the total years that the bank has been in the market. Four banks, Credit Suisse First Boston, Goldman Sachs, Morgan Stanley, and Salomon Brothers are ranked among the top five for most of these years, and top ten for almost all years. Merrill Lynch, Lazard and Lehman Brothers take the next positions along the list. None of these banks has ever dropped out of the merger advisory market.

The list of top-tier investment banks advising targets mostly concurs with Rau (2000), who ranks investment banks advising acquirers in a similar manner. I follow the definition in Rau (2000), so that the conclusions in this paper are comparable to his. For robustness, I run the main analyses by adding Merrill Lynch and Lehman Brothers also as top-tier investment banks, or by dropping Lazard from the list. The main conclusions in the paper do not change.

Table 11 The overall rankings of the top-ranked investment banks (1980–2003)
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Ma, Q. Investment banks advising takeover targets. J Econ Finan 37, 339–374 (2013). https://doi.org/10.1007/s12197-011-9192-9

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