The Valuation Impact of Financial Advisors: An Empirical Analysis of REIT Mergers and Acquisitions

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This paper analyzes the effect of financial advisor-monitors on the valuation of real estate investment trust (REIT) mergers. Advisor choice determinants and the effect of advisors on transaction value are examined using a sample of REIT mergers for the 1981 to 2001 period. A two-stage target firm pricing model is estimated: the first stage (logit) estimates the probability of advisor use and the second stage analyzes the effect of advisors on target firm valuation. The results indicate that financial advisor monitoring, possibly by reducing information asymmetries, has significant positive effects on the value of REIT acquisitions.

Merger and acquisition activity in the financial services sector has increased dramatically over the last decade. Real estate investment trusts (REITs) have been at the forefront of this trend. And the pace of merger activity in this sector appears to have been accelerating in recent years.1 While the reasons for this upsurge in merger activity are diverse and complex, the overriding factors are likely the drive for efficiency gains and risk reduction necessitated by increasing competitive pressures.2 Mergers may produce efficiency gains by combining complementary inputs, focusing post merger firm activities, or generating scale economies. Mergers may reduce risk by diversifying the firm's activities either geographically or in different product markets or both. Risk reducing mergers generate efficiencies by reducing the firm's cost of capital.

At the same time that incentives to merge have increased, legislative and regulatory initiatives have rendered the acquisition process more complex. New laws and regulations, a consequence of recent corporate accounting scandals, require greater documentation and disclosure, particularly for acquiring firms. The result has been a large increase in compliance costs for all transaction participants.

A consequence of increasing acquisition complexity is greater reliance being placed on external financial consultants (advisors) by both acquiring and target firms. These advisors, typically affiliated with commercial or investment banks, are employed to monitor the transaction process. While the new environment clearly increases acquisition costs, the wealth effects of well-structured REIT transactions have nonetheless been large due to the strong performance of commercial real estate in recent years. The most crucial aspect of the transaction is determining the wealth maximizing transaction price. To this end, financial advisors evaluate, validate, and negotiate transaction terms. Presumably, they increase market efficiency by reducing information asymmetries between acquiring and target firms. In this role, advisors are said to perform a monitoring function.

Several studies attribute wealth gains for corporate mergers monitored by financial advisors to reductions in information asymmetries. Bowers and Miller (1990) report positive wealth effects in mergers monitored by advisors affiliated with top tier firms. Hunter and Walker (1990) measure the value of advisor services by the fees assessed and find a positive relationship between fees and wealth gains. Saunders and Srinivasan (2001) find that financial advisory fees vary in accord to the duration of the principal-agent relationship. Consistent with compensation for superior monitoring, longstanding relationships include a premium. Kale, Kini, and Ryan (2003) study the role of financial advisors in successful corporate acquisitions. They report systematic differences in transaction characteristics and wealth effects based on both the participation and reputation of financial advisors.3

This paper extends the analysis of the impact of financial advisors on merger transaction valuation in two ways. First, the focus is on REIT acquisition transactions, which have not been addressed previously in the literature. Because estimates of expected cash flows require analysis of localized real property markets, information asymmetries may be greater in the case of REITs, suggesting an enhanced monitoring role for advisors and possibly larger resulting wealth effects. …