The Role of Equity Underwriting Relationships in Mergers and Acquisitions* Hsuan-Chi Chen Anderson School of Management, University of New Mexico Albuquerque, NM 87131, USA E-mail: [email protected] Keng-Yu Ho Department of Finance, National Taiwan University Taipei City 106, Taiwan E-mail: [email protected] Pei-Shih Weng Department of Finance, National Sun Yat-sen University Kaohsiung City 804, Taiwan E-mail: [email protected] Chia-Wei Yeh Department of Banking and Finance, National Chi Nan University Nantou County 545, Taiwan E-mail: [email protected] This draft: September 17, 2020 * This paper has benefited from comments and suggestions from Sevinc Cukurova, Ying-Chou Lin, and Hilmi Songur. We thank seminar and conference participants at National Central University and the meetings of Desert Finance Festival, Eastern Finance Association, and Financial Management Association for their helpful comments and suggestions. Hsuan-Chi Chen gratefully acknowledges support from Anderson School of Management at the University of New Mexico. Address for correspondence: Hsuan-Chi Chen, Anderson School of Management, University of New Mexico, Albuquerque, NM 87131, USA. E-mail: [email protected] 1 The Role of Equity Underwriting Relationships in Mergers and Acquisitions Abstract We examine the role of equity underwriting relationships in subsequent mergers and acquisitions (M&As). Firms, either the bidders or targets, tend to choose their M&A advisors with prior equity underwriting relationships. Consistent with the cost-saving hypothesis, retaining their prior underwriters as future advisors is related to cost reduction in the M&A advisory. Firms also experience shorter deal duration if they hire relationship advisors. This study contributes to the further understanding of how firms derive value from investment bank relationships. Keywords: Underwriting; Financial Advisor; Merger and Acquisition JEL Classification Codes: G00; G20; G30 2 1. Introduction The study on relationship banking has received considerable attention in the literature. For example, prior bank-firm relationship can increase the likelihood of winning subsequent securities underwriting business (e.g. Yasuda (2005); Ljungqvist, Marston, and Wilhelm (2006, 2009), among others). Extending the line of research on relationship banking, this paper investigates how the prior underwriting relationship affects subsequent M&A advisory for the same underwriter-client pair. Our particular interest on M&A advisory is also motivated by the fact that one major source of revenues for many banks comes from the provision of corporate mergers and acquisition advisory services. According to the calculation of Golubov, Petmezas, and Travlos (2012), financial advisors were involved in M&As worth more than $4 trillion in 2007 alone (accounting for more than 85% of all transactions by dollar amount) and earned advisory fees of about $40 billion. Furthermore, M&As are one of relevant corporate decision making for firm operation. Cartwright and Schoenberg (2006) conduct a survey of the thirty years of mergers and acquisitions research and point out a broad range of management disciplines related to M&As. In addition, based on the data from SDC platinum of Thomson Reuters, though the financial crisis hit the global economy in 2008, the number of M&A deals announced was over 38,000 globally and the value of worldwide M&As was aggregated to $2 trillion for the following year. Both the evolving nature of M&A activity and its impact on the revenues of advising investment banks make it important and relevant to investigate the association between the prior underwriting relationship and subsequent M&A advisory. Our study explores the effects of prior equity underwriting relationships on subsequent M&A advisory by examining (1) the chance of winning M&A advisory business for prior underwriting banks; (2) the advisory fees paid by firms; and (3) the quality of merger advisory. Overall, we find that the established underwriting relationship significantly affects 3 subsequent M&A advisory. Our findings, combined with the results of previous studies (e.g. Ljungqvist et al. (2009)), suggest that a firm’s underwriting and M&A advisory relationship with banks exhibit roundtrip effects. When a firm issues stocks in the public market, the issuer establishes its underwriting relationship with banks that underwrite its shares. There are several reasons for studying equity underwriting relationships. First, James (1992) proposes that underwriters may invest in relationship-specific assets with the IPO underwriting client from due diligence, which would be helpful in underwriting subsequent equity offerings. Second, Hansen and Torregrosa (1992) suggest that underwriters gain valuable information as they monitor the underwriting process and investigate issuing firms with the purpose of improving performance and disciplining errant management. Third, by examining the impacts of failure or near failure of investment banking firms on their industrial clients, Fernando, May, and Megginson (2012) and Kovner (2012) provide evidence supporting the importance of equity underwriting relationships. To the extent that both theories apply to subsequent M&A advisory, either the theory of relationship-specific assets or the theory of underwriter monitoring predicts that the equity underwriting relationship increases the likelihood of advising subsequent mergers and acquisitions for prior underwriting banks. For the research question that whether an established underwriting relationship between banks and issuing firms affects the costs of M&A advisory, we develop the cost-saving hypothesis from both the relationship-specific capital and underwriter monitoring viewpoints, respectively. First, if the underwriting bank acquires a better understanding of the client’s operation and learns to work more effectively with the client from due diligence in the underwriting process, the benefits of such soft information may be helpful for financial advisors in subsequent information collection activities when they engage in their prior clients’ M&As. Second, the monitoring component of the underwriting relationship 4 may partially fulfill the monitoring function that is required in the advisory process. Advisory costs will be lower as long as issuing firms can capture part of cost savings. Overall, both the relationship-specific capital and the underwriter monitoring viewpoints predict that the underwriting relationship can reduce the cost of subsequent M&A advisory to issuers if cost savings are shared between advising banks and issuing firms. In addition to examining the effect of prior underwriting relationship on the advisory fees, we also analyze the effect of underwriting relationship on the time to resolution (deal duration). Similar to Golubov et al. (2012), we posit that financial advisors with better understanding of the company via prior underwriting relationship would provide higher quality service. Therefore, the relationship M&A transactions will exhibit better service quality than otherwise. The literature also indicates that prior underwriting relationship could be valuable to both firms and underwriting banks. Relevant to our research question, Ljungqvist et al. (2006) find that the main determinant in securing underwriting mandates is the strength of prior underwriting and lending relationships rather than aggressive analyst behavior. Burch, Nanda, and Warther (2005) examine the nature of underwriter-client relationships and their impact on the pricing of subsequent underwriting services for both common stock and debt offers. They find that loyalty to an underwriting bank reduces fees for common stock offers but increases fees for debt offers. Similarly, Ellis, Michaely, and O’Hara (2011) provide empirical results suggesting that if firms have used the banks in prior debt underwriting or lending, the banks are more likely to be retained. Moreover, Chen, Ho, and Weng (2013) investigate the relation between the IPO underwriting and subsequent lending. They find that when a bank underwrites a firm’s IPO, the bank is more likely to provide the issuer with future loans at a lower cost, compared to banks without an IPO underwriting relationship. Their findings imply 5 that the underwriting banks share information surplus with the IPO firms in the post- IPO loans. While the above studies tend to suggest that prior underwriting relationship plays a beneficial role for subsequent corporate financing, including lending and underwriting, the effect of prior underwriting relationships on the merger advisory mandate are unexplored. Also, some studies have examined the effect of non-underwriting relationship on the likelihood of winning a merger advisory mandate. For instance, Saunder and Srinivasan (2001) examine the relationship between merger advisor reputation and its ability to retain clients. They find that firms are more likely to switch if their advisor is not a top tier investment bank. Hayward (2003) posits that if a firm has used an investment bank in a previous merger, the bank would abuse the power to induce the client to hire it again for subsequent stock-financed acquisitions. Bao and Edmans (2011) suggest that merger advisory mandates are given on the basis of past market share league tables, but such mandates result in significant negative returns for the acquirers. Forte, Iannotta, and Navone (2010) find that the decision to hire an advisor in M&As is related to the intensity of the previous banking relationship.