The purpose of this knol is to describe recent events impacting investment banks, changes in the traditional investment banking model, fairness opinions, and how to select an investment bank.
Amid the turmoil of the 2008 credit crisis, the traditional model of the mega independent investment bank as a highly leveraged, largely unregulated, innovative securities underwriter and M&A advisor foundered. Lehman Brothers was liquidated and Bear Stearns and Merrill Lynch were acquired by commercial banks J.P. Morgan Chase and Bank of America, respectively. In an effort to attract retail deposits and borrow from the U.S. Federal Reserve System (the “Fed”), Goldman Sachs and Morgan Stanley converted to commercial bank holding companies subject to Fed regulation.
While the financial markets continue to require investment banking services, they will be provided increasingly through “universal banks” (e.g., Bank of America/Merrill Lynch and Citibank/Smith Barney), which provide the customary commercial banking as well as investment banking services. In addition to those already mentioned, traditional investment banking activities also include providing strategic and tactical advice and acquisition opportunities; screening potential buyers and sellers; making initial contact with a seller or buyer; and providing negotiation support, valuation, and deal structuring guidance. Along with these investment banking functions, the large firms usually maintain substantial broker-dealer operations serving wholesale and retail clients in brokerage and advisory capacities. While the era of the thriving independent investment banking behemoth may be over, the role of investment banking boutiques providing specialized expertise is likely to continue to thrive.
Fairness Opinion Letters and Advisory Fees
Investment bankers derive significant income from writing so-called fairness opinion letters. A fairness opinion letter is a written and signed third-party assertion certifying the appropriateness of the price of a proposed deal involving a tender offer, merger, asset sale, or leveraged buyout. It discusses the price and terms of the deal in the context of comparable transactions. A typical fairness opinion provides a range of “fair” prices, with the presumption that the actual deal price should fall within that range. Although such opinions are intended to inform investors, they often are developed as legal protection for members of the boards of directors against possible shareholder challenges of their decisions.
The size of an investment banking advisory fee is often contingent on the completion of the deal and may run about 1–2 percent of the value of the transaction. Such fees generally vary with the size of the transaction. The size of the fee paid may exceed 1–2 percent, if the advisors achieve certain incentive goals. Fairness opinion fees often amount to about one fourth of the total advisory fee paid on a transaction (Sweeney, 1999). Although the size of the fee may vary with the size of the transaction, the fairness opinion fee usually is paid whether or not the deal is consummated. Problems associated with fairness opinions include the potential conflicts of interest with investment banks that generate large fees. In many cases, the investment bank that brought the deal to a potential acquirer is the same one that writes the fairness opinion. Moreover, they are often out of date by the time shareholders vote on the deal, they do not address whether the firm could have gotten a better deal, and the overly broad range of value given in such letters reduces their relevance. Courts agree that, because the opinions are written for boards of directors, the investment bankers have no obligation to the shareholders (Henry, 2003).
Selecting Investment Banks
The size of the transaction often determines the size of the investment bank that can be used as an advisor. The largest investment banks are unlikely to consider any transaction valued at less than $100 million. Investment banking boutiques can be very helpful in providing specialized industry knowledge and contacts. Investment banks often provide large databases of recent transactions, which are critical in valuing potential target companies. For highly specialized transactions, the boutiques are apt to have more relevant data. Finally, the large investment banks are more likely to be able to assist in funding large transactions because of their current relationships with institutional lenders and broker distribution networks.
In large transactions, a group of investment banks, also referred to as a syndicate, agrees to purchase a new issue of securities (e.g., debt, preferred, or common stock) from the acquiring company for sale to the investing public. Within the syndicate, the banks underwriting or purchasing the issue are often different from the group selling the issue. The selling group often consists of those firms with the best broker distribution networks. After registering with the Securities and Exchange Commission (SEC), such securities may be offered to the investing public as an initial public offering (IPO), at a price agreed on by the issuer and the investment banking group. Alternatively, security issues may avoid the public markets and be privately placed with institutional investors, such as pension funds and insurance companies. Unlike public offerings, private placements do not have to be registered with the SEC if the securities are purchased for investment rather than for resale. Bao and Edmans (2008) find that, in selecting an investment bank as a transaction advisor, the average magnitude of the financial returns on the announcement dates for those deals for which they serve as an advisor is far more important than the investment bank’s size or market share.