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. 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.