Misconduct Synergies from Mergers
Like many sectors in the U.S. economy, the registered investment advisory (RIA) industry has seen a recent increase in consolidation through mergers and acquisitions (M&A). The RIA industry has also experienced widespread and well-documented misconduct among employees. For example, Egan, Matvos and Seru (2019) report that 7 percent of financial advisors have misconduct records. Beyond the traditional cost and revenue synergies, what is the potential impact of M&A transactions on employee behavior? Mergers can increase value if they improve monitoring and disciplinary mechanisms that reduce employee wrongdoing at the combined firm.
In a new paper, we use the RIA industry as a laboratory to test for evidence of “misconduct synergies” (i.e., reductions in disclosures of employee misconduct) following M&A transactions. Consistent with misconduct synergies, we find that disclosures of new disciplinary events in the combined firm drops by between 25 and 34 percent following mergers. This reduction is driven mainly by ”separations” – employees leaving companies voluntarily or involuntarily – of target firm employees with past incidents of misconduct. Layoffs following mergers are a well-documented source of cost savings in M&A (e.g., Bhagat et al. (1990); Haleblian et al. (2009); Lee et al. (2018)); however, the question of whether the “right” employees leave is an open and important question on which our research sheds light.
While the hypothesis that M&A disciplines rank-and-file employees is plausible, it is also difficult to test because employment records and instances of fraud and misconduct are generally unavailable for individual employees. Reporting requirements in the investment advisory industry make it a particularly useful setting because we are able to observe disciplinary and regulatory events at the firm level through the SEC’s Form ADV. We also observe registered advisers’ individual employment and disciplinary histories through data made available to the public via FINRA’s BrokerCheck system. We use the term “All Employee Disclosures” to describe any disclosure across the 23 categories of disciplinary events in the FINRA BrokerCheck data. These include customer disputes, regulatory investigations and actions, certain criminal and civil proceedings, and bankruptcy filings. It is important to emphasize that not all of these disclosures are evidence of employee wrongdoing. To account for this, we separately analyze the six categories of disclosures that Egan, Matvos and Seru (2019) consider to be most indicative of employee misconduct. We use “employee misconduct (EMS)” to describe this subset of less ambiguous disclosures, and we conduct all of our analyses using both disclosure measures.
We begin the paper by documenting correlations between employee misconduct and investment advisory firm performance. Because advisory fees in the investment advisory industry are typically earned as a percentage of assets under management (AUM), the analysis assumes that the level of AUM is a reasonable proxy for advisory firm value and performance. We find that advisory firms with fewer incidences of past misconduct (per employee) have significantly larger future AUM. Estimates imply that a one standard deviation increase in disclosures of misconduct is associated with between 5.4 and 6.8 percent lower AUM the following year. Moreover, past employee disclosures predict future business closure, an event that is costly to firms and their customers. The estimates imply that a one standard deviation increase in misconduct is associated with a likelihood of closure that is between 8.3 and 9.8 percent higher than the average closure rate of 0.96 percent in the sample. These correlations suggest that any reductions in misconduct following M&A transactions are likely to be relevant to the value of the firm.
There are several forces that might drive variation in misconduct near M&A events. Under the traditional view of market discipline (Manne (1965)), poor performing firms are purchased by better firms, resulting in efficiencies. Indeed, there is widespread evidence of the “good buys bad” hypothesis in that high-Q firms (firms with a high ratio of market to book value) tend to buy lower-Q firms. This empirical regularity is formalized as a “Q-theory of mergers” in Jovanovic and Rousseau (2002). In the investment advisory industry, mergers in which good firms purchase bad ones might result in larger AUM or reductions in misconduct-related fines (or both). Under this view of market discipline, two hypotheses are relevant to our setting. First, we would expect high-misconduct firms to be targets of low-misconduct acquirers. Second, following the transaction, we would expect to observe lower misconduct by target-firm employees.
Contrary to the idea that M&A provides market discipline to poor-performing target firms, Rhodes-Kropf and Robinson (2008) report a “like buys like” result. While it is true that acquirers tend to purchase firms with valuations that are lower than their own, it is also the case that high-valuation firms tend to buy other high-valuation firms, and low-valuation firms tend to buy other low-valuation firms. In fact, Rhodes-Kropf and Robinson (2008) report that acquirers and targets are typically less than one valuation decile apart, even after controlling for industry. To explain this, they present a model in which gains from M&A come from complementarities rather than from a substitution of “bad” for “good.” We examine two testable predictions from Rhodes-Kropf and Robinson (2008) that are distinct from what we would expect under the market discipline hypothesis. First, if complementarities are important, then targets and acquirers will match according to levels of wrongdoing. Second, following the transaction, we should observe improvements in employee misconduct, but these improvements could come from employees of either the target or the acquirer.
Our analysis reveals several interesting patterns. First, most M&A activity is occurring among firms with cleaner records. Both targets and acquirers tend to have lower levels of pre-merger employee misconduct relative to firms that do not engage in M&A. Second, within the sample of targets and acquirers, we find evidence that relatively low (high) misconduct acquirers tend to purchase low (high) misconduct targets. This is consistent with Rhodes-Kropf and Robinson (2008). Finally, inconsistent with the view that superior firms take over poor performing ones, we find that employees of acquirers and targets have similar disciplinary records, with acquirers experiencing even more recent disciplinary disclosures compared with targets.
In our main analysis, we document significant decreases in employee misconduct following M&A transactions. Misconduct falls by between 25.4 and 34.1 percent, depending on the definition of misconduct that we apply. What causes this decline? Are there more post-merger layoffs and separations among employees with disciplinary disclosures? Or, do the improvements occur through better employee behavior following the merger? When we examine separation patterns following M&A transactions, we find that pre-merger employees of the acquirer are more likely than target firm employees to stay with the combined firm. Target employees with misconduct histories are more likely to depart. For target firm employees, we do not observe any significant sensitivity of employment separations to misconduct prior to the merger. This sensitivity becomes significant following the merger. Thus, the evidence suggests a tightening of discipline for target firm employees can explain some of the improvements in rates of misconduct that we observe following the merger. We also observe increased sensitivity of separations to misconduct of acquiring firm employees; however, the magnitude of the increase is much less than in the case of targets.
To help interpret the overall findings, we conduct two sets of tests. First, we compare each true merged firm with a pseudo merged firm based on pre-event disclosures, recent growth in disclosures, the number of employees, and state where the advisory firm is headquartered (i.e., a difference-in-differences approach). We find a significant post-event reduction in misconduct in the true merged firm relative to the control. Second, we conduct counterfactual analysis to examine the time series of misconduct of all employees, under the assumption that separated employees who stay in the industry remain employed by the newly merged firm. We then compare this time series with misconduct events by employees that actually worked for the target, acquirer, and combined firm. The counterfactual analysis shows that we would have observed flat or even increasing misconduct following the mergers if all employees had remained with the combined firm post-acquisition. This reinforces our finding that post-merger separations drive the reductions in misconduct that we observe.
Although the focus of our work is on the investment advisory industry, the challenge of managing corporate misconduct is broad. Employee wrongdoing exposes corporations to legal and regulatory risk and can damage firms’ reputations. The changes in amounts of misconduct that we document can increase our broader understanding of wrongdoing and of the sources of value creation in M&A more generally. Across-the-board layoffs of rank-and-file employees following M&A have been well-documented, but our paper sheds light on targeted departures that may further enhance value, even in a world in which “like buys like.”
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This post comes to us from professors Emmanuel Yimfor at the University of Michigan’s Stephen M. Ross School of Business and Heather Tookes at Yale School of Management. It is based on their recent paper, “Misconduct Synergies,” available here.