Monday, June 22, 2015

Investment Banking: The Dark Side of Corporate Finance

Investment banker valuation and securities pricing are heavily used inter alia in IPOs (e.g. offering pricing ranges) and M&A (e.g. fairness opinion). They involve translating a firm’s expected operating performance into a price in markets subject to asymmetric information. The price estimates are often more influenced by momentum than fundamentals. Thus, they can diverge from intrinsic value based discounted cash flow measures-sometimes intentionally.

Investment bankers can help bridge the gap between price and value among buyers and sellers of capital and firms. They do so by posting their reputation (the value of which varies considerably) as a signal, for a fee, to give the parties comfort that the offered price is fair based on their due diligence and technical analysis. The analysis is based on well know business tools like discounted cash flow and risk adjusted returns-at least on the surface.

The techniques used, however, are frequently a fig leaf behind which many other factors (sometimes conflicting) are taking place. These include:

1)     Objectives: What price (value) is the investment banker seeking to justify for his client or himself?
2)     Inputs: How were the inputs selected based on the firm, industry and market considerations? There is a great deal of (black?)“art” (subjectivity) in selecting key estimates for sales growth, operating profit margins, taxes, working capital, CAPEX,  and WACC.
3)     Who does the Investment Represent? For example, with IPOs, although representing the issuer, the investment banker is frequently more concerned with maintaining good investor relations as the source of his long term franchise value. Therefore he is inclined to under price the offering.
4)     Reverse Engineering: Is the valuation really independent or reverse engineered to justify a desired result? Remember, Investment Bankers do not get paid unless the deal closes. As Warren Buffet notes -fees too often lead to transactions rather than transactions leading to fees. This why his 2014 annual report contains so many Investment Banking “slams”.

In theory, there should be no difference between practice and theory, but in reality there is a big difference. Surveys showing an alignment of academic valuation approaches and investment banking practice (see valuation from the field which references once such survey) should be taken with more than the customary grain of salt. Investment Bankers herd and like to hide behind “best practices” (i.e. “me-too-ism”) to look smart and reduce legal liability. No one wants to admit they are using “primitive” earnings multiples unadjusted for risk or the time value of money in their analysis.

Having practiced the black art for many years, I can assure you that Investment Bankers are in the sales business. Therefore, the real motivation behind the various valuation estimates must be considered when reading their presentation booklets. Cash flow matters, but the question is whose cash flow are we discussing-the client or the banker’s? The Salomon Brothers quote from Liar's Poker  says it best-“do you want to be a winner or the client?” Bottom line-do your own analysis and come to your own conclusions. Academic finance as practiced by Investment Bankers can be dangerous to your wealth.

Joe- a hopefully reformed ex-Investment Banker.

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