June 3, 1999

Heard on the Street
Wall Street Top Deal Makers
Aren't the Best Matchmakers

By ROBERT MCGOUGH
Staff Reporter of THE WALL STREET JOURNAL

Wall Street's top deal-making firms can boast about advising corporate America on big tender offers and raking in huge merger fees.

So, they also can brag about putting together superior deals, right? Not quite.

The stocks of acquirers whose tender offers were handled by top-tier investment banks -- those doing the most merger-advisory business -- actually performed worse over the next three years than the stocks of acquirers advised by less-active merger-advisory firms, according to Raghavendra Rau, a Purdue University professor who studied the subject.

Shares of first-tier advisory clients gained 0.63 percentage point more than a benchmark of similar companies in the three years after the completion of the tender offer. Third-tier bankers' clients gained 20.16 percentage points more than the benchmark companies.

The biggest investment bankers get hired "to complete a deal, irrespective of whether the deal actually adds value or destroys value for the acquirer," Mr. Rau says. In a study of merger transactions between 1980 and 1994, Mr. Rau found that "investment banks focus on completing the deal, rather than on preventing poor deals."

Why the disparity among advisers? A larger percentage of the fee of the top-tier investment banks was tied to completing the deal than for lower-ranked rivals, the study found. First-tier banks got 73% of their pay in tender offers from contingency fees, compared with 61% for second-tier banks and 64% for third-tier banks. The higher a contingency fee paid by an acquirer in a tender offer, the worse its stock generally performed over the next 12 months.

Clients of first-tier investment banks also tended to pay a high premium over the stock-market price to acquire their targets. For instance, in tender offers, the study found that clients of first-tier investment banks paid a median premium of 56% above the market price, compared with 38% for clients of third-tier banks.

Consider companies exhibiting merger hangovers last week. High hopes for a pair of once-promising marriages sank further when First Union and McKesson HBOC both ran into earnings trouble. McKesson, for the second time since its merger, "revised" its earnings downward because of accounting problems at HBO & Co., which it acquired late last year. First Union has had trouble digesting its massively expensive acquisition of CoreStates Financial in late 1997, and warned -- for the third time this year -- of earnings disappointments ahead.

Also last week, Cendant announced the sale of its vehicle-leasing business to Avis (which it partially owns) for $1.8 billion -- and loudly voiced the hope that this action would finally allow the company to move beyond the crisis caused by last year's accounting scandal at CUC International, which it bought late in 1997.

Executives at these three companies have been under pressure over the problems resulting from their mergers, and their investment bankers certainly didn't force them to do the deals. But the question also arises: Where were the investment bankers who were advising the buyers? Why didn't they warn the companies away from such bad deals?

Morgan Stanley Dean Witter, which advised First Union in its CoreStates acquisition, says it doesn't comment on matters concerning clients. Merrill Lynch, which was an adviser to Cendant's predecessor in its acquisition of CUC International, says it doesn't comment on specific transactions.

Naturally, investment bankers bristle at the suggestion that they don't have their clients' concerns at the top of their agenda. They say it would be bad business to treat clients poorly. In many instances, bankers say they advise clients not to do deals -- and that clients sometimes go ahead with the deals anyway.

Jack Levy, Merrill's head of global mergers and acquisitions, says he tells clients: "This is what it's worth, this is what it takes to win and this is what I think you can afford to pay. Sometimes the price to win is more than it's worth, or more than you can afford to pay, and then I'd advise the client to say no."

Moreover, investment bankers say that they don't audit financial statements, which are provided by management, and that they can't be expected to uncover accounting fraud that might cripple a deal.

Still, many specialists believe it is fair to raise questions about investment banks' priorities in doing deals. "I don't think you can be too cynical about anything having to do with investment banking," says Ralph Wanger, manager of $3.4 billion Acorn Fund.

The Rau study looked at the market share of investment banks in mergers and acquisitions in the 15 years through 1994. It found that a select few firms -- First Boston (now Credit Suisse Group's Credit Suisse First Boston), Goldman Sachs, Lazard Freres, Morgan Stanley and Salomon Brothers (now Citigroup's Salomon Smith Barney) -- dominated the rankings during that period.

The study tried out two explanations for why these firms were the top-ranked deal makers. One theory: They put their clients into superior deals. The proof would be if their clients' stock performed better than the stock of acquirers that hired second- or third-tier investment banks.

But evidence that the top investment banks got there by arranging superior deals was scarce. For instance, first-tier investment banks were about as likely to complete tender offers that provoked a "bad" reaction in the market -- a relative decline in the acquirer's stock price when the deal is announced -- as deals that got a good market reaction.

Clients of top-tier banks fared better in mergers, where a proxy vote closes the deal, than in tender offers. In all, however, there was little evidence that top banks got their exalted positions by executing superior deals. That leaves theory No. 2: that investment banks get hired to complete a deal -- no matter what the cost.

Mr. Rau doesn't believe second- and third-tier investment banks are talking more clients out of expensive deals than top-tier investment banks. Instead, he surmises that the top-tier investment banks are simply better at boosting the price of deals to the point that they get completed. Money talks.

There are other reasons for the dominance of a few firms in the deal-making business. Samuel L. Hayes, a Harvard business-school professor, says the most experienced deal makers are favored "when you are under siege. If you're looking for a brain surgeon, you're not price sensitive, you simply want the best brain surgeon."

Brian Posner, manager of $630 million Warburg Pincus Growth and Income Fund, says before he even examines the financial impact of a proposed deal, he tries to understand whether the deal fits into the acquirer's strategy. If not, he sells.

Seldom do money managers leap for joy when companies they own announce they are buying another company. "Acquisitions are generally bad ideas," Acorn's Mr. Wanger says. "The reason acquisitions are made is that the acquiring company overpays."