December 3, 2015

This week the actions of Canada’s bulge bracket banking contender and new data on bond issuance combined to underscore why the big brand name is not always the best route for a corporation hiring an M&A adviser.

First to the actions of Canada’s RBC (Royal Bank of Canada): the nation’s largest bank and an increasingly global player in corporate and investment banking. Canada – and one presumes RBC – is not noted for possessing (or wanting) a racy reputation, yet this week the Supreme Court of Delaware put the Canadian firm at the centre of a ruling with wide-ranging implications for the act of buying and selling companies. This ruling upheld and re-inforced an earlier lower court decision. Both judgments found RBC guilty of conflicts of interest insofar as it had been representing a company even as it sought substantially larger fees from providing financing for the same deal.

In 2011 RBC advised a US ambulance services company called Rural/Metro during its acquisition by private equity firm Warburg Pincus. The deal value was $US728 million. RBC’s M&A group had been engaged by the company’s board to advise on the sale of the company; the bank stood to earn roughly $US 5 million on this assignment. This type of M&A fee is generally calculated as a percentage of the transaction value. The courts both ruled that RBC was set to earn substantially more significant fees from providing the financing and, as such, provided the board with conflict-ridden advice. This led the board to sell the company for less than could potentially have been reached had the process not honed in on a buyer committed to a given financing syndicate.

The lower court judge (Chancellor Travis Lane on the Chancery Court of Delaware, a former corporate and securities lawyer) had, in his 2014 ruling, ordered RBC to pay the shareholders of Rural/Metro $76 million in compensation: 15 times the M&A fee. This built on his 2011 ruling in which he found Barclays’ investment bank (built in part out of the ashes of Lehman Bros.) at fault for similar behavior during the $4 billion private equity purchase of Del Monte. Other bulge bracket banks are facing similar accusations.

The Rural/Metro ruling changes the outlook for many lawsuits against boards. Previously many were filed post-closing of transactions, generally alleging that Boards had failed to get the best price for shareholders. The majority of the time these were dismissed by courts, withdrawn as the cause began to appear hopeless or resulted in some disclosure. Settlements were generally small. This ruling opens up the possibility of board judgment being sharply questioned if a company engages a potentially conflict-ridden bank (a bulge bracket firm or one of Canada’s integrated banks).

This may result in banks engaging in more ostentatious disclosure of potential conflicts of interest. What it won’t do is make these conflicts disappear.

The question of conflict of interest (and the substantial fees to be secured by raising money to fund M&A) was also underscored this week when data on global issuance of bonds was released by Dealogic. The data provider revealed that the amount of corporate bonds placed in the market – a great deal of it to fund M&A – topped $2 trillion for the fourth straight year. Note that this number excludes activity by banks, who have been persistent issuers. 2016 looks set to continue the trend as some of this year’s announced M&A deals are expected close next year and have to be financed.

Some cracks in this scenario are emerging. Vodafone withdrew long-dated issue of bonds worth up to $2 billion when investors considering the issue pushed for better covenant protections if the wireless operator were to become subject to a bid. Likewise in the US market, corporate bond spreads have been steadily climbing since April: a reaction to perceived pressure on corporate profits and the looming rate increase from the U.S. Federal Reserve. Yet higher prices and demands for better covenants are not going to tilt the balance back in favour of M&A advisory fees predominating in the thinking of big banks. For example even a substantial 20% decline in bond issuance and private placement activity (another lucrative source of fees for banks) would not alter the fact that structuring and placing loans is a vast and profitable business line.

The conclusion in fact supports the raison d’etre of Cheverny: bulge bracket and big Canadian banks are riddled with conflicts. A small and focused firm is by far the best choice for a company looking for a sell side adviser. If a company must hire a large bank then at least it should have a co-adviser solely focused on the success of the M&A process. Once upon a time hiring a big brand name seemed the safest choice. No longer.