The Journal of Finance

How to Cite

FERNANDO, C. S. MAY, A. D. and MEGGINSON, W. L. (2012), The Value of Investment Banking Relationships: Evidence from the Collapse of Lehman Brothers. The Journal of Finance, 67: 235270. doi: 10.1111/j.1540-6261.2011.01711.x

ABSTRACT

We examine the long-standing question of whether firms derive value from investment bank relationships by studying how the Lehman collapse affected industrial firms that received underwriting, advisory, analyst, and market-making services from Lehman. Equity underwriting clients experienced an abnormal return of around 5%, on average, in the 7 days surrounding Lehman’s bankruptcy, amounting to $23 billion in aggregate risk-adjusted losses. Losses were especially severe for companies that had stronger and broader security underwriting relationships with Lehman or were smaller, younger, and more financially constrained. Other client groups were not adversely affected.

The question of whether firms derive value from investment banking (IB) relationships has received considerable attention in the literature, especially since the increasingly competitive market for IB services would suggest that firms can switch investment banks costlessly. Extant research has failed to come up with an unambiguous answer, however, due in part to the difficulty in measuring the value of relationship capital.

The sudden collapse of Lehman Brothers on September 14, 2008 (then the fifth largest investment bank in the world) provides a unique natural experimental setting to measure the value of the relationships that client firms had with Lehman. Whereas large U.S. financial institutions in distress have almost invariably been prevented from declaring bankruptcy by being acquired by other large institutions (often with the intervention of the U.S. government), Lehman was explicitly allowed to fail. 1 This unprecedented collapse was all the more shocking because Barclays Bank had been negotiating an acquisition with Lehman’s managers right up to Saturday, September 13, 2008, the day before Lehman announced the largest bankruptcy filing in U.S. history. When stock market trading resumed on Monday, September 15, 2008, Lehman’s stock lost virtually all its value, the U.S. stock market experienced one of its worst single-day losses, and the entire global financial system was pushed to the edge of collapse.

The acquisition by an investment bank of valuable private information about a firm (James (1992). Schenone (2004). and Drucker and Puri (2005) ), investment bank monitoring (Hansen and Torregrosa (1992) ), investment by banks in institutional investor networks (Benveniste and Spindt (1989). Cornelli and Goldreich (2001). Ritter and Welch (2002). and Ljungqvist, Jenkinson, and Wilhelm (2003) ), switching costs incurred by firms in moving to a new underwriter (Burch, Nanda, and Warther (2005) and Ellis, Michaely, and OHara (2006) ), and optimal firm-underwriter matching (Fernando, Gatchev, and Spindt (2005) ) would all suggest that the relationship is jointly valuable to the firm and its underwriter. However, there is no clear evidence on the extent to which client firms receive a share of any value created from the relationship. Moreover, there is considerable evidence that client firms frequently switch underwriters, especially to those of higher reputation (Krigman, Shaw, and Womack (2001) and Fernando et al. (2005) ), which also raises questions about the extent to which client firms share any value created by the relationship. In addition, while investment banks provide a variety of services in addition to underwriting equity and debt offerings, the extent to which these services create value for clients from a long-term investment bank relationship is also unknown.

We examine how the Lehman collapse affected industrial firms that received equity and debt underwriting, advisory, analyst, and market-making services from Lehman by studying how their stock prices reacted on Monday, September 15, 2008, and over various short-term windows around that day. We identify more than 800 public industrial companies that received one or more of these five services from Lehman, as well as a comparable number (946) of firms that received equity underwriting services from Lehman’s competitors. We address two specific research questions: First, did Lehman’s collapse impact its IB clients over and above the impact the firm’s collapse had on the equity market in general, and second, did the impact of Lehman’s failure vary with the type of IB service received, client characteristics, and/or the strength of the client’s relationship with Lehman? These questions are central to understanding how intermediaries create value for their clients. To our knowledge, this is the first study that attempts to isolate the value of the investment bank relationship to clients using a broad group of client firms and all major IB services.

Companies that had used Lehman as lead underwriter for one or more equity offerings during the 10 years leading up to September 2008 suffered economically and statistically significant negative abnormal returns. Based on FamaFrenchCarhart four-factor model adjusted abnormal returns, the 184 equity underwriting clients that we study lost 4.85% of their market value, on average, over a 7-day period spanning the five trading days before and the first and second trading days immediately after Lehman’s bankruptcy filing, amounting to approximately $23 billion in aggregate risk-adjusted losses. We arrive at similar value loss estimates and conclusions using alternative return generating models. These losses were significantly larger than those for firms that were equity underwriting clients of other large investment banks, and were especially severe for companies that had stronger and broader underwriting relationships with Lehman, including equity clients that also engaged Lehman for debt and convertible debt underwriting. Losses were also higher for smaller, younger, and more financially constrained firms. No other client groups were significantly adversely affected by Lehman’s bankruptcy.

These results show that Lehman’s collapse did, in fact, impose material losses on its customers, but for the most part these losses were confined to those companies that employed Lehman for equity underwriting. Furthermore, to the extent that investors partially anticipated Lehman’s failure before the days surrounding Lehman’s bankruptcy announcement, these estimates may actually understate the losses suffered by Lehman’s equity underwriting clients. More broadly, these results tell us that underwriting is the principal portion of the overall IB relationship that is irreplaceable without significant cost and whose value will be forfeited if the relationship were to be involuntarily ruptured.

The rest of our paper is organized as follows. In Section I, we briefly review the existing literature on firmintermediary relationships in corporate finance and formulate our empirical hypotheses. Section II describes our data and methodology. Section III presents our findings on the impact of the Lehman collapse. Section IV concludes.

I. Background

The extant theoretical and empirical literature has examined ways in which a long-term equity underwriting relationship between an investment bank and a client firm can create value for both parties. The first such channel is economies of scale. James (1992) and Burch et al. (2005) show that set-up costs in the IPO due diligence process create durable relationship capital that lowers underwriting spreads for firms that are expected to issue equity again, and Kovner (2010) provides evidence of valuable relationship capital being created for IPO clients. Equity underwriters also create significant value for their clients by monitoring (Hansen and Torregrosa (1992) ) and investing in the development and maintenance of institutional investor networks that serve as channels not only for collecting information but also for the distribution of shares through book building, thereby reducing the indirect costs of equity offerings. 2 Finally, the presence of switching costs also suggests that an underwriting relationship will be valuable because of the cost of rupturing it to establish a new equity underwriting relationship (Burch et al. (2005) and Ellis et al. (2006) ). However, these studies do not account for the added benefit that firms may receive by employing a higher quality underwriter. Krigman et al. (2001) and Fernando et al. (2005) show that seasoned firms often voluntarily switch from lower to higher quality underwriters, which suggests that the benefits of establishing a new underwriting relationship may sometimes outweigh the costs.

Burch et al. (2005) argue that firms derive less value from a debt underwriting relationship based on their finding that, in contrast to repeat equity issuers, which benefit from significantly reduced underwriting fees for subsequent offerings, debt issuers are actually penalized (charged higher underwriting fees) for retaining the previous underwriter for subsequent bond offerings. While several studies, including Rajan (1992). Boot and Thakor (2000). Schenone (2004). Yasuda (2005). and Bharath et al. (2007). argue that an existing lending relationship between a bank and borrowing firm can be mutually beneficial, it is unknown whether these findings carry over to debt underwriting, although some of these studies also document economies of scope between lending and underwriting. 3 In addition, in contrast to equity offerings, debt ratings by rating agencies make underwriter debt certification and placement less valuable to clients.

Studies that examine the relationship between acquiring firms and the investment banks that advise them generally show that banks do provide valuable advisory services to acquirers involved in takeover contests, and that employing more prestigious banks is associated with superior outcomes for clients. 4 However, these studies also generally find that banks advising clients on acquisitions face conflicts of interest between their desire to provide unbiased advice and their desire to consummate deals to collect completion payments. In addition, there is no evidence that client acquirer firms derive persistent value from such a relationship or that any relationship is not transferable to another investment bank without a significant cost to the client. Much of the private information collected during the Mergers and Acquisitions (M&A) process pertains to the target firm and this information loses value immediately after a deal is consummated.

The IB literature indicates that security analysts employed by prestigious banks can provide valuable services to client firms, as shown by Mikhail, Walther, and Willis (2004) and Ivković and Jegadeesh (2004). However, it is less clear whether that relationship is firm- (between client firm and bank) or person-specific (between client firm and analyst). The available evidence suggests that any value in an existing analyst relationship will simply be transferred costlessly to a new bank that employs the analyst after the original bank’s failure (Ljungqvist, Marston, and Wilhelm (2006) and Clarke et al. (2007) ).

Finally, while several studies examine the value of market making for NYSE listed firms, 5 the value of any market making provided by underwriters appears to be short lived, helping to stabilize an offering in the immediate aftermath of an IPO but progressively becoming less important over the ensuing months. Ellis et al. (2000) show that the underwriter is almost always the dominant dealer in the 3-month period after a NASDAQ IPO, and that the underwriter engages in price stabilization during this period. Schultz and Zaman (1994). Aggarwal (2000). and Corwin et al. (2004) also show that the underwriter engages in price stabilization just after the IPO.

Equity underwriting relationships (especially relationships with high reputation underwriters) appear to be potentially valuable to client firms because of equity clients (1) being able to share the benefit of an underwriter’s investment in information generation via reduced fees for subsequent equity offerings and (2) having the ability to benefit from underwriter monitoring and the underwriter’s investment in a network of institutional investors, who provide information and also subscribe to the underwriter’s offerings. If so, the rupture of an existing equity underwriting relationship could potentially be highly damaging for client firms, especially for those relatively small and lesser known companies that rely heavily on their current underwriters to access public stock markets and are unable to easily migrate to other underwriters. In addition, even if some companies are able to swiftly enlist new underwriters, this will involve significant switching costs and any relationship-specific capital embodied in the prior relationship will be forfeited. However, in an environment where a free market exists for underwriter services and underwriter switching is common, the questions of what value client firms obtain by staying in an underwriting relationship and what the sources of this value are, if any, remain unresolved. The question of how this value might be affected by the emergence of co-led underwriting (Shivdasani and Song (2010) ) has also not been examined.

Debt underwriting relationships appear to be less valuable to client firms than equity underwriting relationships. While debt offerings also entail information generation, there is no evidence in the literature to suggest that client firms are able to share in the benefit of an underwriter’s investment in information when it comes to subsequent offerings. In addition, as many debt securities have credit ratings, they are easier to price and place, making underwriter certification and the book-building process considerably less valuable to client firms. Therefore, to the extent that Lehman debt underwriting relationships are valuable to clients, we expect this value to be less than that for equity underwriting relationships.

Although M&A advisory relationships involve intense information gathering before a deal, there is no evidence to suggest that client acquirer firms derive persistent value from such a relationship or that any relationship is not easily transferable to another investment bank. Much of the private information collected during the M&A process pertains to the target firm, and this information largely dissipates after a deal is consummated. In addition, serial acquirers are invariably larger and would have a relatively easier time in transferring to another investment bank for M&A advisory services.

If analyst coverage relationships are analyst-specific rather than bank-specific, as suggested by Ljungqvist et al. (2006) and Clarke et al. (2007). any value that is embedded in the analystclient relationship will simply be transferred to the analyst’s new employers without diminishing the client firm’s market value. Finally, the value of any market making provided by underwriters is short lived, helping to stabilize an offering in the immediate aftermath of an IPO but progressively becoming less important over the ensuing months. Therefore, it seems unlikely that client firms would derive value from a long-term market-making relationship.

Conditional on a relationship developed through the provision of IB services having value, we expect cross-sectional variation in client losses around Lehman’s bankruptcy to be related to the strength of the relationship and client characteristics. For equity underwriting, we conjecture that the number of past equity deals with Lehman and Lehman’s share of the client’s past common stock offerings could capture the strength of the relationship. In addition, the commonality in information used by investment banks across all underwriting services for the same firm (equity, convertible debt, and straight debt) would suggest the presence of economies of scope. If equity underwriting clients that use other underwriting services receive some of this benefit, we would expect to see it reflected in the abnormal return. Furthermore, any client lending facilities that involve Lehman as lead or participant lender would add to the strength of the relationship. Finally, to the extent that Lehman’s ownership of the client’s shares is an indicator of a stronger relationship (Ljungqvist and Wilhelm (2003) and Ljungqvist et al. (2006) ), a negative relation is implied between the client’s abnormal returns and Lehman’s ownership of the client’s shares. Aside from this relationship-based interpretation, Lehman’s failure may have also disproportionately affected clients in which it owned shares because of a supply-side effect. If Lehman’s bankruptcy triggered the sale of its clients shares, either voluntarily or as a result of forced liquidation during the impending bankruptcy process, then a more negative reaction among such firms should be observed.

Regarding client characteristics, we hypothesize that clients with greater immediate need for external capital will be more adversely affected by the loss of an underwriting relationship. Specifically, we expect firms with less financial slack and firms in greater financial distress to have greater need for external capital, and therefore we expect such firms to suffer greater losses in response to Lehman’s bankruptcy. Finally, as smaller and younger firms generally have less established reputations in financial markets, the information production role of an intermediary is more important to them relative to larger, more established firms (Diamond (1991) ), and hence they should be more adversely affected by Lehman’s collapse.