Andrei Simonov, Stockholm School of Economics

2007-2012

First part of the project was done as planned. The paper was presented on many conferences and seminars in Europe and North America and published in prestigious Review of Financial Studies. Those results generate a lot of interest by general public. Number of media sources (including Wall Street Journal, The Times of London, Dagens Nyheter) published the report about our research (see List of Media Citations in Reference Section).

Second part of the project is evolving into the project about the role of investment banks in determining firm' corporate policies (see below #6). Yet, spin-offs of the project are related to behavior of banks in crisis and behavior and ability of financial managers.

2. The projects' most important results as of today

We study holdings in takeover targets by financial conglomerates which affiliated investment banks advise the bidders. For every lead advisor in each deal we identify the stake that it holds in the target firm. This is based on the position the advisor holds either directly or through other financial entities--insurance firms, commercial banks, mutual funds, pension funds, and hedge funds--affiliated with the financial conglomerate to which the advisor belongs. We first provide evidence suggesting that advisory banks take positions in the target before the announcement of the deal. In fact, ownership by such advisors helps predict whether a firm will be a takeover target. Conditioning on firms with similar industry and size characteristics, firms in which advisory banks hold stakes are 45 percentage points more likely to become targets. These results are consistent with the possibility that the advisory bank exploits its privileged information about the intention of the bidding company to acquire, the identity of the potential target and the reservation price of the bidder. This information--unavailable to other market players--gives the advisory bank an informational advantage ahead of the deal. The bank would exploit it by taking a position in the target firm, expecting its price to increase, and then realizing the gain due to the appreciation of the value of the target around the time of the deal announcement.

While our results are consistent with this possibility, we also consider alternative hypotheses. It could be that the bank's position in the target is due to its proprietary trading desk and asset management arm's ability to perform good economic analysis of the target. To address this issue, we compared the trading performance of the advisory bank with that of a standard merger arbitrage strategy. A merger arbitrage strategy based on selling the bidder and buying the target, conditional on information about advisor behavior, delivers a raw return of 4.50% per month (4.08% net of risk), versus a mere 0.97% per month (0.48% net of risk) in the case of the standard merger arbitrage strategy. We then compare the trading performance of the advisory bank with that of other similar banks not advising the deal. The return accruing to the advisory bank is 3.36% per month for the value-weighted strategy, compared with 1.93% when the bank does not advise.

We then relate the advisory stake to the characteristics of the deal. We show that if the advisory bank holds a stake in the target firm, the target's premium is 551 basis points higher than when the advisory bank holds no such stake. An increase of one standard deviation in the average fraction (dollar value) of the target firm held by the advisor to the bidder is related to a premium 235 (220) basis points higher than average. Also, the presence of the advisory bank among the shareholders of the target is related to a lower probability of deal failure. In particular, its presence reduces the probability of failure of the bid from 23.88% to 17.12%, or by 28 percentage points. We interpret these findings as suggesting that advisors take advantage of their privileged position, not only by acquiring positions in the targets in the deals on which they advise, but also by directly affecting the outcome of the deal in order to realize higher capital gains from their positions.

Our results contribute to the literature on mergers by shedding new light on the role of advisors. We identify a subset of institutions that induce a higher premium not because of better governance, but because of their speculative behavior.


3. New questions generated

Our results provide new insights into the conflicts of interest affecting financial intermediaries simultaneously advising on deals and investing in equities. It raises the question about the real cost of universal banking.


4. Presentations in national and international conferences

The project was presented in the following conferences and universities' seminar series:

Conferences:

2007: CEPR ESSFM, Gerzensee (focus session);

2008: AFA Meeting; Eastern Finance Association; 2nd Global Finance Academy conference, Dublin; FIRS Meeting (Anchorage); RS-DeGroote Lecture (Toronto);

2009: WFA Meeting; FIRS (Prague); NBER Summer Institute, Market Institutions and Financial Market Risk Project; EFA Meeting (invited ECB session); Fourth BI-CEPR Conference on Money, Banking and Finance (Rome); Tenth Bank of Finland/CEPR Conference on Credit Crunch and the Macroeconomy (Helsinki); Fifth NYFed/NYU Stern Conference on Financial Intermediation; 2009 UniCredit conference on Banking and Finance (Rome).

2010: AFA Meeting; IBEFA conference; Paris Corp. Fin. Conference (2 papers); CEPR meeting "Bank Crisis Prevention and Resolution" (Amsterdam, Netherlands); FIRS Meeting (Florence); WFA Meeting; EFA Meeting (Frankfurt); 2010 ES World Congress (Shanghai).


Seminars:
University of Cyprus
Higher School of Economics, Moscow
New Economic School, Moscow
University of Bath
NHH, Bergen
Tel Aviv University
HEC Toulouse
Banque de France
Swedish Riksbank
University of South Carolina
Michigan State University
University of Rochester
Notre Dame University
Arizona State University
Rutgers University
UC-Davis
University of Toronto
Temple University
Virginia Tech
University of Colorado
University of Washington


5. Spin-off effects produced by the project

In the spinoff project we study how related conglomerates, financial conglomerates that had a previous advisory/underwriting relationship in the bond market with a firm and hold an equity stake in it, condition the firm's payout policy. We focus on share repurchases. We argue that the prior underwriting/advisory position in the bond markets leaves the conglomerate with a reputational concern about the institutions it has helped to place bonds with that induces it to use its equity stake to push against the wealth transfer from bondholders to equityholders embedded in the repurchase. We find a negative correlation between the probability of the share repurchase and the equity ownership by the related conglomerate. An equity stake of the related conglomerate is also associated with lower stock abnormal returns, both around the repurchase and in the long run. In particular, companies with equity ownership by related conglomerates exhibit 3(7)-day abnormal returns lower by 0.65%(1.32%) and 1(2,3)-year abnormal returns lower by 4.52% (8.64%,12.17%) then the abnormal returns of companies with no equity ownership by related conglomerates. This leads to lower wealth transfer from the bondholders to the equity holders. Indeed, the related conglomerate's stake is linked to a lower increase in the bond yields: the higher the stake, the lower the drop in price of the bonds around the repurchase. We present evidence that equity ownership by related conglomerates reduces the magnitude of wealth transfer in our sample by about 1/3.

Another spin-off project is related to the effect of recent bank bailouts on the firms. It uses micro-data from Japan. Exploiting the Japanese banking crisis of the 1990s as a laboratory, we investigate the effects of bank bailouts on the supply of credit and on the valuations and the real performance of banks' clients. Consistent with recent theories, our findings indicate that the size of the capital injections relative to the banks' initial financial conditions is crucial for the success of bank bailouts. Capital injections that are sufficiently large to reestablish bank capital requirements increase the supply of credit and spur investment. In contrast, not only do capital injections that are too small fail to increase the supply of credit, but they also encourage the evergreening of non-performing loans and favor investment by unviable "zombie" firms.

Yet another spin-off of the same project is related to study of behavior of financial managers. We provide direct evidence on the effect of financial expertise on investment outcomes. We analyze private portfolios of mutual fund managers. We find no evidence that financial experts are making better investment decisions than their less financially astute peers: they do not outperform, do not diversify their risks better, and do not exhibit lower behavioral biases. Managers do much better in stocks they share with their mutual funds; however, only about 22% of them have any mutual fund-related positions. Some managers, particularly more experienced ones, seem to be aware of the limitations to their investment skills as they increase their holdings of mutual fund related stocks following bad performance of their portfolio. Our results demonstrate that day-to-day knowledge of finance does not improve investment decisions.

6. Project finances, SEK
Project costs were salaries to Simonov and Bodnaruk 866 160, LKP 471 364, travel costs 53452, Data purchases and editing 98557 and overhead 360467.