A view to a deal: the effect of upcoming investment banking transactions on financial analysts’ target price estimates

Abstract

This study investigates whether sell-side analysts issue inflated target price estimates to compete for investment banking mandates in the European Union (EU), and whether country-specific weaknesses in regulatory enforcement diminish the mitigating effects of stricter financial-market regulation. We find that, irrespective of previous business ties with the target firm, target prices become more optimistic (and, as a consequence, less accurate) in the run-up to an investment banking transaction for target firms located in countries with weaker enforcement regimes. In contrast, for firms in countries with stronger enforcement regimes, we observe the opposite to be the case. Furthermore, we find that analysts’ optimistic biases have been mitigated, but not fully eliminated, since the implementation of the European Markets in Financial Instruments Directive (MiFID) in 2007 in low-enforcement countries. Overall, our results demonstrate that reducing country-level differences in enforcement constitute a significant factor in effectively regulating analysts’ conflicts of interest, and in improving investor protection within the EU.

KEYWORDS:

• Accuracy
• conflict of interest
• enforcement
• MiFID
• optimism
• sell-side analyst

Acknowledgements

We wish to thank the editors, two anonymous reviewers, Michel Dubois, participants at the FMA International Conference, and participants at the BAFA Northern Area Group conference for their helpful comments.

Disclosure statement

No potential conflict of interest was reported by the author(s).

Correction Statement

This article has been republished with minor changes. These changes do not impact the academic content of the article.

Notes

1 See also Asquith, Mikhail, and Au (2005), and Huang, Mujtaba Mian, and Sankaraguruswamy (2009).

2 For a review of the literature on conflicts of interest in equity research, see Ramnath, Rock, and Shane (2008).

3 See, for instance, Lin and McNichols (1998), Michaely and Womack (1999), Bradshaw, Huang, and Tan (2019), as well as Arand and Kerl (2015). For further examples, see Ramnath, Rock, and Shane (2008), especially Table 5, Panel B.

4 Ljungqvist, Marston, and Wilhelm (2006, 2009) analyze a sample ranging from 1993 to 2002, thereby preceding much of the US regulation targeting analysts’ conflicts of interest.

5 The equivalent US regulations are the Regulation Fair Disclosure (RegFD, 2000); and the NASD Rule 2711, NYSE Rule 472, and the Global Analyst Research Settlement (2002). In 2010, however, US regulators relaxed some requirements concerning the need for a strict separation of a firm’s research and investment-banking functions in an amendment to the Global Analyst Research Settlement. Moreover, in 2015 the Financial Industry Regulatory Authority (FINRA) Rule 2241 superseded the NASD Rule 2711, as well as the NYSE Rule 472, and followed a more principle-based approach for addressing conflicts of interest. In particular, it liberalized certain provisions related to the interaction between firms’ investment-research and investment-banking functions.

6 MiFID defines an investment firm as ‘[…] any legal person whose regular occupation or business is the provision of one or more investment services to third parties and/or the performance of one or more investment activities on a professional basis.’ Directive 2004/39/EC, Article 4(1), no. 1.

7 ‘The measures and arrangements adopted by an investment firm to manage the conflicts of interests that might arise from the production and dissemination of material that is presented as investment research should be appropriate to protect the objectivity and independence of financial analysts and of the investment research they produce.’ Directive 2006/73/EC, no. 29.

8 ‘[T]he investment firms themselves, financial analysts, and other relevant persons involved in the production of the investment research must not accept inducements from those with a material interest in the subject matter of the investment research.’ Directive 2006/73/EC, Article 25(2c).

9 ‘Financial analysts should not become involved in activities other than the preparation of investment research where such involvement is inconsistent with the maintenance of that person's objectivity.’ Directive 2006/73/EC, no. 29.

10 For the US, studies by Chen and Chen (2009), Kadan et al. (2009), Clarke et al. (2011), and Guan, Lu, and Wong (2012) find that, overall, regulatory measures (NASD Rule 2711, NYSE Rule 472, Regulation Fair Disclosure, and the Global Analyst Research Settlement) have been successful in reducing bias in analyst research.

11 These EU member states are Austria, Belgium, Czech Republic, Denmark, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, the Netherlands, Poland, Portugal, Slovenia, Spain, Sweden, and the United Kingdom. The other EU countries are not included because of poor data coverage and/or late accession to the EU.

12 See Table 2, Panel B, for country-specific MAD and MiFID implementation dates.

13 We omit the years 2004 and 2005 at this point as respective country-year data are incomplete, and respective levels and ratios may be misleading.

14 The CESR published this report with the goal of ‘[…] inform[ing] the EU Institutions and market participants about the different legal frameworks to apply sanctions and administrative measures under the Market Abuse Directive across the EU.’ CESR 2007, p. 2.

15 Appendix Table A1 summarizes the definitions of all the variables.

16 Gao and Ritter (2010) find that, in their sample of seasoned equity offerings, most of the transactions were announced about two months prior to the issue date, which is consistent with our assumption that underwriters and advisors are typically announced 90 days or less before a transaction.

17 Detailed results, including control variables’ coefficients for the full regression model, as well as for the −180, −91 and −90, −30 sub-samples, are reported in Appendix Table A2.

18 The impact of run-up and prospective affiliation on optimism in low-enforcement countries is positive, with the overall coefficients being 0.29 (Run-up + Run-up × Low enforcement = −0.0732 + 0.365 ≈ 0.29) and 0.72 (Run-up + Run-up × Low enforcement + Prospective affiliation + Prospective affiliation × Low enforcement = −0.0732 + 0.365 −0.251 + 0.676 ≈ 0.72), respectively. An F-test shows that these coefficients are significant, with p-values smaller than 0.01 for run-up, and smaller than 0.05 for prospective affiliation.

19 The overall coefficients are −0.15 for run-up-only analysts and −0.13 for prospective affiliated analysts. An F–test yields p-values below 0.01 in both cases.

20 The overall coefficients are 0.09 for run-up-only analysts and 0.07 for prospective affiliated analysts, with the difference statistically not being greater than zero (p > 0.1).

21 Results are available from the authors upon request.

22 We are grateful to an anonymous referee for raising this potential problem.

23 Cf. Appendix Table A2.

24 The full correlation matrix is available upon request from the authors. Correlation coefficients tend to be above 0.5 or below −0.5 for some of the interaction terms and their baseline variables, which is to be expected, given the design of our study. Since, in respect of the interaction terms, we are primarily interested in the marginal effects of being in a run-up period or of introducing or enforcing regulation, our results should be robust to potential multicollinearity. See Brambor, Clark, and Golder (2006) for a detailed methodological discussion.

25 Moreover, our narrow definition also reflects regulatory practices. For instance, the European Market Abuse Directive (MAD) demands analysts and investment firms disclose any lead or co-lead mandates in a public offer of financial instruments of the issuer (MAD Article 6.1.d), and any provision of other investment-banking services (MAD Article 6.1.e) over the previous 12 months.

Additional information

Notes on contributors

Benno Kammann

Benno Kammann received his doctorate from University of Oldenburg and now works for Hamburg Commercial Bank.

Jörg Prokop

Jörg Prokop is Professor of Finance and Banking at University of Oldenburg.