Financial crisis fallout: compensation changes, more regulation

Author: Nancy Writer

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What lies ahead in the roller-coaster world of finance? That’s the area of study for Matthew Cain, assistant professor of finance, who joined the faculty at the Mendoza College of Business in July 2008. He conducts research on mergers and acquisitions, corporate governance, and financial contracting. His recent research looked at the role of investment banks in providing fairness opinions in mergers. In addition, he teaches a course on mergers and acquisitions to both undergraduates and MBA students. In He recently shared some thoughts on what’s to come in the financial world.

Q. What research are you working on now?

A. I have a lot of different projects, but one that is most pertinent is researching the accuracy of fairness opinions, which are provided by investment banks in mergers and acquisitions. When an investment bank serves as an advisor to a target company or an acquirer in a merger, through the fairness opinion process it gives advice to the board of directors and the management team to help them negotiate an offer price that’s presumably fair to the shareholders. I looked at whether the investment banks are conducting unbiased valuations of the target companies, or are they producing biased valuations, telling management or directors what they want to hear.

One of the conclusions is that the investment banks are optimistically biased when they go through the fairness opinion process for acquirers. I found that on average, investment banks say the target company is worth about 20 percent more than the offer price. This may mean that the banks are telling the acquirer, “You’re really smart, you’re getting a great deal, you’re paying $10 per share for this target and it’s really worth $12 a share.” What’s surprising, though, is that when investment banks provide fairness opinions to the target companies, they’re more accurate on average. A potential explanation is if the investment bank’s client is the acquirer, the bank may be trying to get future business. But if the client is the target company, that relationship probably disappears once the merger is effective, so the bank doesn’t have the incentive to bias the valuations.

Q. What issues in today’s headlines relate to your research interests?

A. I'm watching the news stories about the government putting pressure on banking and its compensation practices. There's been an outcry over what some people call excessive bonuses or excessive compensation. I find that somewhat concerning because some of the time we are talking about performance-based compensation, which can be a good thing when it rewards high performers and when it punishes low performers. Some of the investment banks are starting to move away from performance-based compensation. Some are going to increase the level of base pay and reduce the bonuses for most of their employees.  Some banks have fired the people who are responsible for the poor performance of a division.  So now, going forward, how do you attract and retain talented employees? You've got other divisions that are still very profitable. Are we going to punish the employees of those successful divisions? 

Q. What do you think about investment banks moving away from performance-based compensation?

A. I think we may see them swing from one end of the spectrum all the way to the opposite. Maybe in the past few years, employees been compensated for excessive risk taking.  I think there may be a backlash where they’re not given enough incentives to take reasonable amounts of risk. The compensation structure probably needs to be addressed at most banks, and they need to make sure they are not giving employees an incentive to take bad risks. I think it’s a good thing that they’re revisiting their compensation practices, but they may swing a little too far on the opposite direction, where we’re not giving employees enough incentive to perform at the top of their game. That’s a common thing: when you’ve got a crisis, the tendency of backlash. We may see a bit of that with the regulatory structure as well.

Q. Will we see additional regulations on the investment banking industry?

A. Almost certainly we will. I don’t think anybody knows right now how that will look a year or two from now. Some of the talk is about taking power away from the Securities and Exchange Commission and giving more power to the Federal Reserve. There is other talk about setting up new regulatory bodies. Almost certainly hedge funds and investment banks will be more heavily regulated than they have been. Whether that’s a good or bad thing probably will depend on how well they set up the regulatory structure, whether the rules they establish are reasonable. 

Q. What trends do you see in the world of mergers and acquisitions? Are companies able to borrow again like they could a few years ago?

A. Not at this point. Private equity deals are funded by large private equity companies, and they historically raise a large amount of debt financing to pay for the acquisitions. Last year, the private equity market fell apart because they couldn’t get debt financing, and it still hasn’t had a rebound yet. They’re still struggling to get debt financing on reasonable terms. When we see a resurgence in private equity deals, that will be a good sign that financing is becoming more available. I think in a year or two we should start to see that market returning to normal, but it’s dangerous to speculate on this economy.

Q. How do you incorporate real-world financial events in your teaching?

A. The fall semester of 2008 was a really interesting time because that’s when the whole financial crisis exploded. One thing I did for my undergraduate mergers and acquisitions students was to bring in a Notre Dame alumnus who is a partner at one of the world’s largest private equity firms. He talked for more than an hour and answered questions, explaining what was going on and laying out what the next 12 months were going to look like. He said we will see the residential real estate market going down, and after it bottoms out we will see the commercial real estate market going down. This was a prediction he made last fall, and now in May we are just starting to see the commercial real estate market taking a hit.  I think it was the students’ favorite day of the semester because they got to pick the brain of someone who is operating in these markets at a very high level. I was able to use some of the difficulties in the market as a real-world example to illustrate concepts that aren’t always the most exciting in class. I like the Notre Dame network for our successful graduates and being able to tap into that knowledge base.