About Banking

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iMIT Sloan School of Management
MIT Sloan Working Paper 4467-04
February 2004

Investment Banking and Analyst Objectivity:
Evidence from Forecasts and Recommendations
of Analysts Affiliated with M&A Advisors

Adam Kolasinski and S.P. Kothari

© 2004 by Adam Kolasinski and S.P. Kothari.
All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission, provided that full credit including © notice is given to the source.

This paper also can be downloaded without charge from the
Social Science Research Network Electronic Paper Collection: http://ssrn.com/abstract=499068

Investment Banking and Analyst Objectivity:
Evidence from Forecasts and Recommendations of
Analysts Affiliated with M&A Advisors
By

Adam C. Kolasinski
MIT Sloan School of Management
50 Memorial Drive, E52-458
Cambridge, MA 02142-1261

(617) 253-3919
ack@mit.edu

S.P. Kothari
MIT Sloan School of Management
50 Memorial Drive, E52-325
Cambridge, MA 02142-1261

(617) 253-0994
kothari@mit.edu

First draft: September 2003
Current version: February 2004

We are grateful to George Benston, Kevin Rock, Jay Shanken, Antoinette Schoar, Joe Weber, and seminar participants at Emory University and MIT for helpful comments. We would like to thank William Fronhoefer for providing insights about institutional details.

2

Abstract
Previous research finds some evidence that analysts affiliated with equity underwriters issue more optimistic earnings growth forecasts and optimistic recommendations of client stock than unaffiliated analysts. Unfortunately, these studies are unable to discriminate between three competing hypotheses for the apparent optimism. Under the bribery hypothesis, underwriting clients, with the promise of underwriting fees, coax analysts to compromise their objectivity. The execution-related conflict of hypothesis postulates that the investment banks employing analysts who are more bullish on a particular stock are better able to execute the deal, and so the banks pressure their analysts to be bullish in order to enhance their execution ability. Finally, the selection bias hypothesis postulates that analysts are objective, but because of the enhanced execution ability, banks with more optimistic analysts are more likely to get selected as underwriters. We test these hypotheses in a previously unexplored setting, namely M&A activities. Depending on whether an analyst is affiliated with the target or the acquirer and whether the analyst report is about the target or the acquirer, the hypotheses predict analyst optimism in some cases and pessimism in other. Therefore, examining the issue of analyst bias in the M&A context allows us to shed some light on alternative explanations for the impact of analyst affiliation on the properties of analyst forecasts and recommendations.

Investment Banking and Analyst Objectivity:
Evidence from Forecasts and Recommendations of
Analysts Affiliated with M&A Advisors
1. Introduction
Analysts play an important role in the securities underwriting business, and this role has become a topic of increasing interest to regulators and academics. Several studies find evidence that analysts affiliated with investment banking firms (“affiliated analysts”) issue positively biased recommendations and overly optimistic long-term earnings growth forecasts of stocks underwritten by their employers.1

Lin, McNichols and O’Brien (2003) find that affiliated

analysts are slower to downgrade their recommendations of client firms than unaffiliated analysts, and Bradshaw, Richardson and Sloan (2003) offer evidence that analysts’ consensus growth forecast for firms issuing securities is more optimistic than for firms not issuing any securities.

Consistent with the academic research suggesting that economic incentives stemming from investment-banking relations and brokerage commission revenues optimistically skew the tone of affiliated...
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