November 28, 2005
More on "Undeserved" Compensation: Investment Bankers
Posted by Christine Hurt

Yesterday, the NYT had another article touching on "undeserved" compensation.  This time, the target was investment banks that put together mergers that ultimately (or even quickly) tank.  Of course, real estate brokers get commissions regardless of whether your house turns out to be your dream home or a money pit, and I'm sure that matchmakers in their day didn't have to return their fees when a marriage went sour, but I too have wondered about the agency problems inherent in having someone tell you whether a merger makes financial sense when that person will get a "ginormous" fee if it does, but zero if it doesn't.

When I was in practice, the custom was for investment banks to receive no fee if a merger/acquisition fell through but to have first dibs at the next merger the client proposed.  The high success fee compensates the investment bank for all of the undone deals, and for repeat players (both clients and banks), the end result is theoretically a wash.  Perhaps this industry custom decreases somewhat the incentive for an investment banker to push a merger that doesn't make sense, but (as I tell my students) never underestimate the value of money in your hand.  Also, the L&E answer to this agency problem is that the investment banker will feel reputational constraints to push the bad merger, but I'm not convinced of that, either.  There are just too few fancy investment banks for the fear of reputational backlash.  Because the cost of this agency problem is inevitably borne by the shareholders, not merely the managers who listen to the investment bankers, it may be a problem that we should care about.  However, what is the solution?

The article has no solution, but mentions the possibility of paying investment banks in lengthy stock options or paying by the billable hour.  The first proposal requires the banks to take on systematic risk and the risk of other unforeseen factors, which may not be feasible and may cause banks to demand an even larger return.  The second proposal sounds about right because after all, M&A lawyers are paid by the hour, right?  Theoretically, lawyers have the duty/ability/incentives to tell their clients when to walk away from the table.  However, the billable hour is rife with its own problems, and I suspect that the bottom line would end up being the same or possibly even more lucrative for the bank.

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