The Cost of Advice
In Mergers and Acquisitions
Rebel A. Cole
Kenneth Ferris
Arie L. Melnik
Presented at the 4th ICAF conference,
Corfu Island, August 2012
Introduction 1
- Mergers represent large investments by acquiring firms.
- Firms that initiate mergers use external advice.
- Three types of advice are involved:
1. Accounting and legal advice (ref due diligence)
2. Financial advice (usually by investment bankers)
3. Strategic advice (about post merger integration)
Our focus is on the early stages (even before the announcement).
Introduction 2
- Finance literature focuses on stock price changes.
- Planned mergers are not always executed.
- The prices of terminated mergers do not revert to preannouncement levels (existing puzzle).
- One possible reason is out-of-pocket expense.
- Cost of advice is financially important to providers of
services.
- It is important to estimate actual direct cost of proposed
merger.
- We focus here on M&A in the financial sector (SIC-6000).
objectives
- The purpose of the study is to examine the market for
advice services.
- We examine if accounting and legal costs of advice
increase with the financial size of expected deals
- We ask if advice on international mergers is more
costly than domestic mergers.
- We inquire if accounting advice on cash deals is
cheaper than advice on share-per-share transaction.
Contributions
- First, we provide the first credible evidence on the
direct costs of merger offers
- Second, we provide new evidence on the
determinants of these costs.
Literature review
- Auditors have economic power vis-à-vis clients (Fields
et al, 2004, Lyon and Maher, 2005). In our case, clients
are large banks.
- Pricing research of accounting services is about audit
related tax advice. We consider a different market.
- This particular market produces transitory but
significant income for accounting and legal firms.
- Considerable legal research deals with the value of
fairness opinion (Davidoff, 2006, Kisgen et al, 2009,
Bugeja, 2005)
Framework from M&A point of view
- M&A transactions involve advisory services that are
priced separately from the financing of the merger.
- An acquirer buys 3 different products:
1. accounting and legal advice
2. execution of transaction
3. post deal advice
- The last 2 types may involve a bonus for success but
the first is not related to success.
- The range is between 0.2-1.0%. Small share but large
dollar volume.
Content of Advice
- Preliminary stage consists of 2 main lines:
1. information about possible operational risk as in
Brown et. al (2007, 2011). Examples are: protection
of clients, past compliance, exact ownership
structure
2. accounting policy and stability. Examples are:
continuity and consistency of results. Compliance
with GAAP, income structure from core operations
and consistency of profit margins.
Data
- This is hand-collected data on the cost of accounting and
legal advice in the financial sector.
- We have data on selected mergers in the period of 19872006, including amounts paid to external advisors.
- The list of cases include small deals and major acquisitions
of familiar names.
- Most of the providers belong to the “big 7” in some
periods and “big 4” in others.
- The advice data set was merged into the SDC (platinum)
merger data base.
- We screened out non-merger purchases of equity.
Definition of variables
COSTit = α + β 1 VADit + β 2 IDit + β 3 VMit + β 4 COMBit + β 5 HWit + ε it
COSTit is the payment for advice by an acquirer i at time t. This variable is expressed as a percentage
of the size of the deal and is measured in basis points.
VADit is the dollar value of the deal. This variable is entered in logarithmic form.
IDit is a dummy variable indicating cross-border acquisitions, denoted “one” if the tender is for a firm
located in a different country.
VMit is a dummy variable indicating a “visible merger.” Visible mergers are defined by public
exposure. To be included in this group an intended acquisition had to be covered five times (in
different dates) in at least one of the major US newspapers (Wall Street Journal, New York Times
and Washington Post).
COMBit is a dummy variable indicating transactions that involve a combination of cash and stock
exchange payments (for the target’s shares). Such transactions are presumably more difficult to
evaluate than strait cash deals and therefore may require more work.
HWit is the hours of work, an alternative measure of deal size. This variable is calculated as the value
of the payment divided by the hourly labor cost in the auditing (and legal) industries as
estimated by the BLS.
α is the intercept term.
β j, j = 1 to 5 are parameter estimates for our five explanatory variables.
ε it is an i.i.d error term.
Notes on the Empirical Model
- Empirical studies of accounting services use “Fee
Drivers”. Examples are:
1. Client characteristics (size, business risk, complexity)
2. characteristics of the accounting industry
3. characteristics of the engagement/deal
Turpen (1995) and Hay et. al (2004) provide a summary
and review of earlier studies that analyze audit
service pricing.
Descriptive Statistics
- In table 1, for each variable in column 1 we present
the mean, median and standard error.
- In column 3 we note that the average cost of advice
is 47. basis points of the value of the deal.
- The average number of work hours of advice is 13.6
thousand.
- The average value of the deal is 963 million.
- A third of the sample deals are international.
- Three-fourth of the deals involve cash.
Empirical Results: Table 1
Variable
Measure
Mean
Median
S.E
Cost of advice
Basis Points
0.472
0.459
0.012
Cost of Advice
$ Millions
5.26
1.54
1.05
Cost per hour of advice
$
508
522
8.11
Hours of advice
Thousands
13.6
3.40
3.60
Value of deal
$ Millions
963
394
158
International
Dummy
0.325
0
0.037
Visible Deal
Dummy
0.425
0
0.039
Cash
Dummy
0.766
1
0.034
Stock
Dummy
0.361
0
0.038
Combo
Dummy
0.253
0
0.035
Tender
Dummy
0.158
0
0.029
Empirical Results
COSTit = α + β 1 VADit + β 2 IDit + β 3 VMit + β 4 COMBit + β 5 HWit + ε it
- in table 2 the cost of advice is measured in basis points.
- The size of intended transaction is the main contributor
to the price of advice.
- The number of hours is also a determinant of cost
(column 4). It is highly correlated with deal size.
- Deal complexity (combo) also raises the cost of advice.
- International deals (more complex) also increase the
cost of merger advice.
Summary
The principal findings are, first cost of advice increases
with the financial size of the intended target. Second,
complexity of acquisition has a positive impact on
cost. Third, high out-of-pocket expenditures of
advice may partially explain the negative price
reaction (of the bidder upon announcement) and
why the negative effect is not entirely reversed when
the merger proposal is terminated.
Intercept
Log (Value of Deal)
1
2
3
0.062
0.063
0.285
0.95
0.98
3.17
0.058 ***
5.48
International Deal
Visible Deal
Combo
***
5.49
0.082 ***
0.081
***
0.393
0.019
1.23
***
0.080
***
0.081
3.52
3.61
3.66
0.036
0.034
0.030
0.032
1.57
1.55
1.41
1.52
0.038
0.033
1.56
1.35
0.0022
0.028
3.43
6.51
0.296
0.293
0.058
**
0.058
***
22.59
3.52
2.36
Tender
0.058
4
**
2.37
***
-0.009
-0.3
Hours of Advice
***
Log(Hours of Advice)
Adjusted R2
F-Statistic
0.241
0.245
10.83 ***
13.60
***
14.00
***
17.07
***
Finally…
Thank you for your attention!