The Cost of Advice In Mergers and Acquisitions Rebel A. Cole Kenneth Ferris Arie L. Melnik Presented at the 4 th 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 pre- announcement 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 %. Small share but large dollar volume.

Con t ent 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 , 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 COST it = α + β 1 VAD it + β 2 ID it + β 3 VM it + β 4 COMB it + β 5 HW it + ε it COST it 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. VAD it is the dollar value of the deal. This variable is entered in logarithmic form. ID it is a dummy variable indicating cross-border acquisitions, denoted “one” if the tender is for a firm located in a different country. VM it 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). COMB it 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. HW it 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 S.EMedianMeanMeasureVariable Basis PointsCost of advice $ MillionsCost of Advice $Cost per hour of advice ThousandsHours of advice $ MillionsValue of deal DummyInternational DummyVisible Deal DummyCash DummyStock DummyCombo DummyTender

Empirical Results COST it = α + β 1 VAD it + β 2 ID it + β 3 VM it + β 4 COMB it + β 5 HW it + 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.

4321 ***0.393*** Intercept ***0.058***0.058 Log (Value of Deal) ***0.081***0.080***0.081***0.082 International Deal Visible Deal **0.058**0.058 Combo Tender -0.3 *** Hours of Advice Log(Hours of Advice) Adjusted R 2 ***17.07***14.00***13.60***10.83 F-Statistic

Finally… Thank you for your attention!