One More Thing For Governance Day

Felix Salmon put up a great note from a reader about investment banking conflicts; it's fantastic so go read it. But this is a tiny bit unfair: You and many other commentators seem to have some misconceptions about what exactly large, sophisticated clients such as El Paso’s board hire investment bankers to do. Its always funny how, in the minds of pundits everywhere, those conniving and all-powerful one-percenters who sit on corporate boards become impotent and completely incapable of independent decision-making once an investment banker walks into the room. The basic argument is that repeat-player investment bankers provide value not by telling brainless executives whether to accept or reject a merger, but by providing intelligent decisionmakers with access and relationships, and relationships come with conflicts. As he says: When sophisticated clients (management teams, company boards, PE funds, etc) hire M&A bankers, they typically hire them for two main reasons (in addition to the legally required shams referred to as “fairness opinions”): Execution and Connections. Of those things, connections are higher-value and inextricable from conflicts. If you're hiring someone to sell you to Company X, a bank who has done work for Company X - heck, who owns 20% of Company X - is the bank you want. And sure maybe their "conflict" will cause them to advise you to sell for a lowball price so that Company X appreciates them more but, hey, nobody's forcing you to take their advice. So, yes, this is all true. But he's maybe a little too harsh on the commentators and their misconceptions.
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Felix Salmon put up a great note from a reader about investment banking conflicts; it's fantastic so go read it. But this is a tiny bit unfair:

You and many other commentators seem to have some misconceptions about what exactly large, sophisticated clients such as El Paso’s board hire investment bankers to do.

Its always funny how, in the minds of pundits everywhere, those conniving and all-powerful one-percenters who sit on corporate boards become impotent and completely incapable of independent decision-making once an investment banker walks into the room.

The basic argument is that repeat-player investment bankers provide value not by telling brainless executives whether to accept or reject a merger, but by providing intelligent decisionmakers with access and relationships, and relationships come with conflicts. As he says:

When sophisticated clients (management teams, company boards, PE funds, etc) hire M&A bankers, they typically hire them for two main reasons (in addition to the legally required shams referred to as “fairness opinions”): Execution and Connections.

Of those things, connections are higher-value and inextricable from conflicts. If you're hiring someone to sell you to Company X, a bank who has done work for Company X - heck, who owns 20% of Company X - is the bank you want. And sure maybe their "conflict" will cause them to advise you to sell for a lowball price so that Company X appreciates them more but, hey, nobody's forcing you to take their advice.

So, yes, this is all true. But he's maybe a little too harsh on the commentators and their misconceptions. They're getting those misconceptions from somewhere; after all, there's a reason that El Paso has been in the news lately. There was that court decision. The "legally required shams referred to as 'fairness opinions'" can't be consigned to a parenthetical.

Felix's correspondent is a guy who has actually been an investment banker, and has used investment bankers while in private equity. If you are an investment banker, or a consumer of investment banking services, your view of those services will be roughly the view he outlines*: bankers provide a mix of tactical advice, financial modeling assistance, market knowledge, execution expertise, and introductions and relationships.

But if you are a Delaware court or, let's be fair, a shareholder, your view will come from what you actually see. And what you see is: banks provide fairness opinions (and the underlying comp-and-DCF analyses). They tell boards, and by extension shareholders, whether the price obtained in a merger is a good price, or is not a good price.

That is actually a stupid function for banks to provide. Like, let Egan-Jones do it. But through a quirk of history,** it is a function provided by the investment banks, and a function examined with great intensity by courts - who like nothing more than producing paint-stripping 50-page opinions excoriating the unfairness of particular fairness opinions.

That quirk is, I suspect, a fertile source of badness. There's the badness identified by Felix's correspondent: the public gets suspicious of investment banks for having the relationships that are the source of their value. There's a badness in court decisions: one way to read the M&A decisions that require additional go-shop periods for target companies which never produce overbids is that the court believes that the M&A deal is just about an objectively determinable "fair" price, whereas it's actually about contacts and context and relationship, and various human factors combine in unsurprising ways to prevent an overbid in a court-ordered go-shop.

It is also maybe a source of principal-agent badness: bankers really do provide value by creating relationships, and by understanding the human dynamics at work in a merger. That involves building friendships and trust not with a black box with arrows pointing to shareholders, but with the actual human beings who run companies. As long as everyone understands that bankers work with and for those human beings, that's great. But when people begin to think that the banks' role is to provide only objective computation of merger fairness, and to work cold-bloodedly to get the highest price regardless of what that does to repeat-player relationships, then they set themselves up for disappointment.

Felix Salmon smackdown watch, banking-conflicts edition [Reuters / Felix Salmon]

* Unless you're an investment banking analyst, in which case you'll be HORRIFIED to learn that "While execution work represents the bulk of the person-hours devoted to a deal, the work is simple enough that if execution work were the primary value-add provided by bankers you would see much lower fees since the work itself is fairly commoditizable." It is actually a significant puzzle to me that investment banking uses two to five years of building multitabbed financial models as training for a career in making lively conversation at client dinners, but whatever.

** That is a shit Wikipedia article, btw. The significance of Smith v. Van Gorkom is that it effectively made a fairness opinions a legal requirement of a public company merger. Somehow that isn't mentioned. Someone should fix that.

Related

Nuns, Whores, DCFs

For some reason it is corporate governance day at Dealbreaker, so here is a grab-bag of inchoate nonsense (for a change!). First of all look at this: The third-largest U.S. proxy adviser recommended that El Paso Corp shareholders vote against a proposed $23 billion sale of the company to Kinder Morgan Inc, switching its position after comments made by a Delaware judge. Egan-Jones Proxy Services said in a report that it was withdrawing its endorsement of the deal because of "the conflicts of interest cited by (Delaware Chancery Court judge Leo Strine) and the attendant doubts cast on the deal." How should you take this? Well, one way to take it would be: if you paid me to tell you how to vote on things, you'd probably want me to look into those things and decide if they're good things for you, and if they are tell you to vote for them and if not etc. So Egan-Jones* went and looked at this merger and decided it was a good merger and that its clients should vote for it. Then they learned about the conflicts of interest cited by the Delaware court, most of which were publicly available long before the opinion came out,** and changed their minds. Suggesting that they didn't really do a bang-up job of examining the merger to begin with. But that's a stupid way of looking at Egan-Jones's role because, really, you're an EP shareholder and you're like "oh Egan-Jones ran a DCF and this price looks good to them"? You can go read the DCFs of actual investment banks if that's the sort of thing that gets you going. Nobody's actually paying proxy advisors (do people pay them? I don't know) for actual advice on how they should actually vote their shares. Instead they're paying (maybe?) for some vague patina of good "corporate governance," which means something like "good processes and independent boards and no conflicts of interest" and gets lots of chin-stroking academic articles written about it.

Delaware Judge Driven To Possibly Obscene Energy Industry Euphemism By Kinder-El Paso Merger

Delaware Chancellor Leo Strine has a bright future in blogging if chancelling doesn't work out for him. Here's how he describes Kinder Morgan's negotiations to buy El Paso, specifically KMI CEO Rich Kinder's price retrade with EP CEO Doug Foshee: Kinder said “oops, we made a mistake. We relied on a bullish set of analyst projections in order to make our bid. Our bad. Although we were tough enough to threaten going hostile, we just can’t stand by our bid.” Instead of telling Kinder where to put his drilling equipment, Foshee backed down. I umm ... I'm pretty sure that that quote from Kinder is approximate. Anyway, this is from Strine's opinion refusing to block the KMI-EP merger from proceeding even though he is pretty pissed about some of the apparent conflicts of interest in the deal, including that Goldman Sachs owns almost 20% of KMI while also advising EP, that the lead GS banker owned some KMI stock that he didn't disclose, and that Foshee negotiated the merger single-handed while also maybe thinking about possibly LBOing EP's E&P business for his own self. Lucrative though my current pseudoprofession is, I suspect that if Strine ever leaves the chancelling racket he'd probably prefer to try his hand at merging and/or acquiring. Certainly he is fond of dispensing tactical advice:

Shareholders Seem Unfazed By Evildoing In Kinder Morgan - El Paso Deal

The shareholder meeting to approve the sale of a public company is always a special occasion, both intense and bittersweet. Shareholders who have loyally stood by the target through its ups and downs over the years want to take some time to say goodbye, but they also know that the debate will be lively and spontaneous and that anything can happen: one passionate orator can sway the crowd for or against the deal. With so much riding on the meeting, space is at a premium; smart shareholders book their flights early, and I would not be surprised if El Paso shareholders camped out outside the Hyatt Regency Houston*, 1200 Louisiana Street, Houston, Texas 77002, far in advance of the shareholder meeting scheduled for 9 a.m. tomorrow. And they will be distraught to learn that the meeting was just moved to Friday. No, just kidding, nobody goes to these** and they're pointless formalities. You can tell because: El Paso today said it was adjourning the shareholder vote on its proposed sale to Kinder Morgan until Friday, instead of Tuesday, following a judge’s criticism of the company’s sale negotiations. But at the same time, El Paso said as of Friday it has received votes from 70% of the outstanding shares, with 98.5% of those shares voting in favor of the deal. That tally is not official and could change. Shareholders that had already cast their ballots now have until Friday’s deadline to change their votes. A simple majority is all that is needed for the vote to be approved. Votes could change until Friday. ARE YOU DYING OF SUSPENSE? I guess everyone already knows this but here we are with an internet so it bears repeating: Shareholder litigation challenging merger and acquisition (M&A) deals has increased substantially in recent years. To study this increase and characterize the recent litigation, Cornerstone Research and Professor Robert Daines of the Stanford Law School reviewed reports of M&A shareholder litigation in Securities and Exchange Commission (SEC) filings related to acquisitions of U.S. public companies valued over $100 million and announced in 2010 or 2011. We found that almost every acquisition of that size elicited multiple lawsuits, which were filed shortly after the deal’s announcement and often settled before the deal’s closing. Only a small fraction of these lawsuits resulted in payments to shareholders; the majority settled for additional disclosures or, less frequently, changes in merger terms, such as deal protection provisions. Interestingly, while requiring additional disclosures is a common outcome, we have not encountered a case in which shareholders rejected the deal after the additional disclosures were provided. That's from this blog post; the slightly longer paper is here. The emphasis is mine and, y'know, look at it: every M&A deal is challenged (actually 96% of deals over $1bn), virtually none (5%) of the challenges result in any improved payment to shareholders, and all the terrible information about conflicts that plaintiffs' lawyers discover somehow never convinces shareholders to change their votes. The one constant is that plaintiffs' lawyers get paid - an average of $1.2mm in the settlements that Cornerstone and Daines looked at. These suits often focus on incentives of the target's investment bankers, who are paid only if a deal is completed; I suspect those bankers would love to be in an industry where they could be paid on 100% of assignments while only succeeding at 5% of them. The El Paso case is interesting because judge is pretty pissed at the conflicts there and how they were handled, and sort of made known that he was thinking about awarding damages to El Paso shareholders - possibly in the form of judicially raising the deal price by 68 cents or so. (That's the difference between, roughly, the price that KMI and EP ultimately agreed on and the higher price of $27.55 in cash that KMI had initially offered.) That's pretty rough justice. Your model of merger negotiations could be that you negotiate to the one market-clearing price where, for a penny more, the acquirer would say no, and for a penny less, the target would say no, but that of course isn't the case. There's just a range of plausible prices and you sort of hope that the deal shakes out in that range based on negotiating acumen or whatever on either side. You sort of hope - I do, anyway - that it doesn't shake out based on a judge picking a number out of a hat. You see that here. Kinder Morgan of course has every incentive now to testify that the final price - call it $26.87, loosely - was as high as it was willing to go, and that it would have walked if El Paso had pushed for any more. But it's willing to close the deal even though it seems like, I dunno, a 50/50 chance that a judge will in effect force it to $27.55. And El Paso shareholders - well, maybe they were screwed by missing out on the chance to get paid $27.55. But of course if that was the only price they were willing to sell at, they wouldn't be selling at $26.87. And 98.5% of them seem fine right there. El Paso Delays Shareholder Vote, But Early Tally Shows Approval Likely [Deal Journal] El Paso Delays Vote on Kinder Morgan Deal (by a Few Days) [DealBook] Developments in M&A Shareholder Litigation [Harvard Law School Monstrosity] * As it happens I've probably spent more time at that hotel than any other in the world, and would be remiss not to recommend the burger at the Shula's in the lobby.. ** I actually went to one once and it was exactly what you'd expect: some executives say nice things about each other for 20 minutes, then about half a dozen retirees get up one at a time to be like "I remember when stamps were a nickel."

Goldman Surprised To Find Carl Icahn Being Kind Of A Dick

Sell-side M&A work is mostly a pretty good and lucrative business model but it has a few flaws. Try to spot a key one here: (1) you represent a target; (2) you spend your days fighting tooth and nail with the buyer to try to make them pay more and give up optionality, and generally to get more of the benefits of the deal for the target than for the buyer; (3) then the buyer acquires the target, fires all the directors and officers, changes the locks, and replaces the stationery; (4) then you get paid. Did you spot the problem? Carl Icahn did: