Transaction Costs, Incentive Structures, Free Markets and the Nature of Investment Banking
Disclaimer: This is not a post about life in an investment bank (The books, Monkey Business and Liar’s Poker have done a great job describing that). It is also not about investment banking bonuses about which lot has been written (My personal take is that much of the criticism is absolutely justified), though some inferences about the culture surrounding bonuses could be derived from it. And finally, it is not about those parts of investment banks that sold worthless, toxic assets to the poor, (well, not really …) unsuspecting buyers and almost ruined the world. This is about the mythical, much glorified advisory business of investment banks.
Over the past year, much has been written about investment banks, their role in causing the subprime crisis, the tax-payer funded bail-outs, the brazen, almost obscene culture of bonuses etc. But lot of these has focused on the derivative structuring / trading and securities side of the business. The advisory business (popularly construed to be M&A / corporate finance advisory) has avoided scrutiny. In this article, I intend to touch upon a few basic economic concepts and use them to examine the structure of the business model for the advisory business.
The concept of transaction costs is one of the oldest and most researched concepts in economics. Ronald Coase used this concept in his famous paper, “The Nature of the Firm” to explain the limits of a firm and why we do not have infinitely large firms who never use the market (The paper is a must read for two reasons; first, it’s a lesson that wonderful insights can be generated without using nth-order multiple differential equations; second, it’s a reminder of the kind of elegant language we seem to have left behind somewhere). Theoretically, one does not need firms. For instance, you and I can enter into separate contracts with raw material producers, manufacturers, marketing firms etc. In fact, this is how a lot of business was done in the ancient ages. (However, theoretically, one can also argue that this “contracting agent” is in fact a firm, but let us not get into that argument) But each time, we use the market (through entering into contracts or making spot purchases), there is a cost; costs of procuring information about vendors, cost of ascertaining quality and fair prices and finally costs of enforcing the contracts and ensuring sanctity of transactions. There are transaction costs. And whenever these costs become substantial, it might be beneficial to carry out that activity in-house or within the firm. Conversely, there are costs associated with carrying out activities and when these dominate; you are better off using the market. Transaction costs, therefore, are central to decision making and can be construed to be, in some ways, a necessary evil.
Principal – Agent Problem and Incentive Structures
The construct of the Principal – Agent problem is again, something that would be very familiar to students of economics. In fact, it would be difficult to come up with a concept more intuitive than this. Think of a firm owned by a large number of diverse shareholders who cannot directly run the firm. Therefore, they appoint a management to run it on their behalf. The shareholders (or the Principals) would like the management (the Agents) to maximize value to the shareholder; the management might have other objectives – increase the extent of their empire and authority, diverting earnings as salaries and bonuses instead of paying them as dividends to the shareholder or investing them back in the business. This is an age old problem. To counter this, the shareholders do a number of things such as appoint a Board of Directors who have access to material information, supervise the functioning of the management etc. (One may also think of citizens (principals) electing legislators to monitor the functioning of a government (agents))
Why does the Principal – Agent problem exist? Because the agents inherently have different incentives than the principals; and the agents have access to information which the principals don’t.
Therefore, the principals also devise an appropriate incentive structure to “motivate” the agents to act in their best interest. Think of stock options, variable compensation linked to EVA or other metrics designed to measure shareholder value. (As an aside, you can also think of the cost of designing these incentives and managing a Board as “transaction costs” for owning a firm that you do not directly manage)
The Free Market
The concepts of Free Market and Perfect Competition need no explanation. Even if we don’t know / recollect the definition, each one of us intuitively understands the concepts. There is complete information, a number of willing buyers and sellers (none large enough to influence the price), free entry and exit of players etc. The aspects I want you to focus on are the presence of complete information and free entry of players.
Information is often (almost always) present in an asymmetric manner. Some participant has more information than others and she has an incentive to not disclose it / selectively disclose. This information asymmetry in a way creates costs to using the market, i.e. transaction costs.
Investment Banking (Putting It All Together…)
So, why did I launch into an Economics 101 crash course? (I am assuming there are readers who have taken the pain of reaching this point in the article) Now, I want you to think about all the above concepts as I describe the advisory function of an Investment Bank.
What do Investment Banks do? (I am not sure I can give a convincing answer after a year of doing it) But let me try. Banks in their advisory role advise their clients (actual or would-be) who are either large firms, conglomerates or private equity firms on potential acquisitions / mergers / divestments etc. They help clients figure out suitable targets / buyers, arrive at a right valuation, figure out a neat transaction structure to optimize on regulations and tax incidence and help in financing for a transaction if required. For these services, banks get paid a fee (which is usually a percentage of the transaction size) and the fee is paid only if a transaction is consummated.
Why do clients use bankers? Because bankers help perform activities which the firms cannot perform internally in a cost-effective way. Bankers therefore, are a Transaction Cost. Firms agree to bear this cost as long as the in-house option is either expensive or simply cannot deliver work of the same quality. In some cases this is true. For instance, financing requires relationships with stock exchanges, investors who are hedge funds, large insurance companies, mutual funds etc. Most firms would not possess these relationships. Therefore they rely on bankers. Even for an investor, going through a banker avoids the pain of getting to know the company completely, making basic models etc. Financing requires a lot of diligence, documentation etc. which bankers do. Therefore, the transaction cost is justified. What about M&A advisory? Is the in-house option expensive? Difficult to answer, but a case can be made that the in-house option can be made cost-effective based on a simple comparison of compensation packages for executives vis-à-vis advisory fees. Is the in-house option of an inferior quality? An answer to this requires knowing the nature of expertise that a banker brings to the table. He brings access to information about companies through-out the world, market information, valuation practices, regulations etc. Some of knowledge is proprietary to the bank, mostly it can be replicated. For instance, valuation is no rocket science. Similarly, access to market information is easy due to the presence of data providers like Bloomberg. Regulatory knowledge is more easily obtained through lawyers and internal counsel. This is actually being done in a large number of corporate houses and conglomerates who have extremely talented internal M&A teams which perform most of these functions. Also, private equity firms (who possess the same skills as bankers) hardly ever rely on bankers for valuation advice.
I am not trying to make the point that bankers bring no value. My contention is that banking is a transaction cost and firms are constantly going to try to minimize these.
Assume a firm decides that it is going to hire external advisors. The firm signs a mandate letter authorizing a bank to act on its behalf and agrees on a success-based fee which would be a percentage of the transaction size.
Think about it. The firm is a principal who has appointed the bank as its agent. Does the agent possess information that the principal does not? Of course, he does. (This is why he was appointed in the first place!) Does the agent inherently possess incentives which might lead him to behave in a manner that does not further the interest of the principal? This is a slightly difficult question to answer. The firm (principal) would be benefited only by some transactions, depending upon the presence of synergies and the right valuation. But the agents (bankers) are paid only if the transaction materializes. And guess what, they get paid more if the transaction takes place at a higher value.
Therefore, there clearly exists a principal – agent problem. Are steps taken to minimize it? One assumes that the principal exerts a strong, supervisory influence. There are some firms which pay a fixed fee, therefore mitigating the desire of the banker to peddle a high valuation. However, the fee is still paid only if the transaction gets consummated. There are a few instances of retainers, but the retainer is such a small amount, that it is almost inconsequential.
Hence, bankers are structurally incentivized to peddle “wrong” transactions at artificially “high” valuations. This problem can be made more complex by arguing that the principal (management of the firm) is in fact an agent itself (that of the shareholder) and therefore is itself subject to the principal – agent problem! (If empire building on the management’s part is a key principal – agent problem, does this explain the presence of success based fees?) So, should bankers act in the interests of their direct “clients” (the management) or the ultimate beneficiary (the shareholder)? This is one of those intricate legal and ethical debates which I’ll leave for a later discussion.
What leads bankers to act in the best interest of their clients? Some would argue that reputation transcends short-term monetary gain. Most investment banks have been in business for a long time and value their reputation more than one-time fees. Therefore, they can be presumed to give the correct advice. It is an interesting argument, which would be believable; if one could empirically make the case that most mergers and acquisitions are successful in value creation. In fact, one can empirically prove the exact opposite. Bankers would say acquisitions fail because of execution issues and the buyer’s inability to realize synergies by integrating operations. But what if those synergies on which the valuation was based were artificial and never achievable? (An extremely readable book called The Synergy Trap makes this point)
Banks would argue that it is after all a free market and therefore the fact they continue to be hired by clients should be evidence that they deliver value. This is a brilliant and extremely convincing argument! But the market might not be such a “free” market. Why is this so? Because most regulators require valuation certifications and stuff by “registered merchant bankers”. This requires a license from the regulator thereby constraining free markets, allowing lesser firms and higher prices. It is ironical that a regulatory quirk facilitates higher prices and therefore higher bonuses which most regulators are opposing. (Having said that, this is not the only reason for higher bonuses, but it certainly is one). Also, large global firms have access to regulators and investors which smaller firms don’t, thereby contradicting the assumption of perfect information as well.
Therefore, structurally, banks might be viewed as agents (performing a transaction cost) in an imperfect market with incentives diverging from those of their principals!
(I am not making the case that all banks (and bankers) do not act in the best interest of their clients. There are a lot of good, solid banks and exceptional bankers who are extremely talented and deliver lasting value to clients. I am only pointing out the structural incentives generated by the context in which investment banking activity takes place)
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