Conflicts of Interest within Investment Banks Analysts and Proprietary Traders

On average the trading of an acquirer by the advisor bank following the announcement of an acquisition is in line with the recommendations made by the advisor’s analyst.. In contrast, if

Conflicts of Interest within Investment Banks:

Analysts and Proprietary Traders

David HaushalterPenn State UniversityE-mail: gdh12@psu.eduPhone: (814) 865-7969

Michelle Lowry

Penn State UniversityE-mail: mlowry@psu.eduPhone: (814) 865-1483March 21, 2008

Abstract:

We examine the interaction between an investment bank’s trading, analyst recommendations, and advising activities around mergers Banks advising an acquirer provide higher analyst recommendations to acquirers than non-advising banks around the time of the merger On average the trading of an acquirer by the advisor bank following the announcement of an

acquisition is in line with the recommendations made by the advisor’s analyst However,

additional tests show that this relation only holds for banks that do not rely heavily on investmentbanking as a source of revenue The results are consistent with arguments that the conflicts faced

by analysts differ predictably across firms Traders within an investment bank are cognizant of the incentives of the in-house analysts, and knowledge of such incentives significantly affects theextent to which they rely on their recommendations when making trades

 We thank Lubomir Petrasek for excellent research assistance.

to the banks themselves.

To study the conflicts between investment banking activities and other aspects of a bank’s operations, we focus on mergers Although conflicts of interest can be ongoing, they are arguably particularly large when a bank is advising a merger First, analysts can be important in both enabling the bank to land a merger deal and in increasing the probability that the deal will

be completed (see, e.g., Becher and Juergens, 2005) Mergers are a large source of revenues for investment banks For example, in 2006 alone, the top 20 investment banks earned almost $35 billion in fees from underwriting mergers and acquisitions.1 This is about half of the total fees that they earned from all investment banking activities Second, the insights of analysts into the expected costs and/or synergies of the merger can make their resulting recommendations

particularly valuable The value of companies can change dramatically around mergers, and the ability of analysts within the investment banks to forecast these changes can have dramatic

effects on their personal reputations.2

The first portion of the paper explores the ways in which analysts support the M&A advisory business Specifically, we examine changes in analyst recommendations prior to, around the time of, and following merger announcements and completions We find that

analysts of the advisor firm issue significantly more optimistic recommendations around the merger, compared to non-affiliated analysts This finding is consistent with the findings of Michaely and Womack (1999) and Lin and McNichols (1998), among, others, who find that affiliated analysts are more optimistic than non-affiliated analysts around equity offerings Both

of these studies conclude that the affiliated analysts are being overly optimistic to support the investment banking business However, the possibility that affiliated analysts truly have a rosier outlook regarding the prospects of the acquirer company cannot entirely be ruled out It would not be surprising if acquiring companies were more likely to choose an advisor that thought well

of the merger in question, as opposed to one that had a more negative outlook

The second portion of the paper attempts to distinguish between the potential reasons thataffiliated analysts are more optimistic than non-affiliated analysts, i.e., to determine if advisor firm analysts are being overly optimistic in an effort to support the investment banking business

or if the advisor firm analysts truly have more positive expectations regarding the merger To shed light on this issue, we contrast the actions of the advisor firm analysts with those of the advisor firm traders It seems reasonable to assume that traders within a given institution would have more information regarding the incentives and pressures that analysts within their own bankface, compared to analysts at other banks If the bank’s traders perceive that their firm’s analystsact independently from their investment banking arm, then we would expect that its traders

2 As shown by Moeller, Schlingemann, and Stulz (2005), returns to acquirers around the announcement of mergers

at the 5% and 95% level range from -6% to 7% between 1980 to 1997 and -19% to 13% between 1998 and 2001

would buy more shares of upgraded stocks In contrast, if the bank’s traders perceive analysts to upgrade acquirer stocks in an effort to win or support the investment banking business, we expect that its traders would ignore the recommendations of these affiliated analysts Our

comparisons focus on the recommendations of and trading in the acquirer firm

We find no evidence that the institutional traders of the advisor firm trade in line with their analysts’ recommendations (on the acquirer firm) prior to the merger However this

association changes markedly after the merger: there is a significant positive relation between anadvisor’s analyst recommendations and its trading following the merger Mergers in which an advising firm’s analyst upgrades the acquirer’s stock are associated with significantly larger increases in share ownership of the acquirer by the advisor bank

The finding that traders’ buys and sells are more closely tied to analyst recommendations following the merger is consistent with at least two different scenarios First, advisor firm analysts may provide more accurate recommendations following the merger, perhaps due to better information The in-house traders would be more likely to act on the analyst upgrades or downgrades if they were perceived as higher quality, resulting in a stronger positive relation between recommendations and trades in the quarters following the merger Alternatively, both the analysts and the traders of the advisor bank may face a greater conflict of interest following the merger Suppose both analysts and traders are pressured to support the investment banking business, for example by issuing positive recommendations and by purchasing the stock It is possible that pressure from the investment banking business causes analyst upgrades and in-house purchases of the stock at the same time, thereby producing a positive relation between the two in the quarters following the merger

To distinguish between these alternative explanations, we attempt to classify investment

banks into those for which the conflict of interest from investment banking is likely to be more

or less severe Specifically, we classify investment banks into those that rely heavily on

investment banking revenues versus those for which investment banking is less important If there exists some expectation that the traders and analysts both support the investment banking arm, then this expectation should be greater in those firms for which investment banking is a relatively more important source of revenue That is, we would expect the post-merger relation between analyst recommendations and in-house trading to be strongest in investment banks that rely most heavily on investment banking as a source of revenue Alternatively, if traders

perceive the analysts to have more accurate forecasts following the merger (due to more

available information), then we would expect this increase in accuracy to be greatest among those banks where the conflict of interest from investment banking is particularly low In this case, we would expect the post-merger relation between analyst recommendations and in-house trading to be strongest in those investment banks that rely least on investment banking as a source of revenue

We find that the positive relation between analyst recommendation changes and in-house trading is only significant among those investment banks that rely least on investment banking as

a source of revenue, i.e., in those banks where analysts are likely to face the lowest conflicts of interest Within these banks, traders’ actions indicate that they perceive analysts’ post-merger recommendations to be particularly valuable In contrast, in banks where investment banking revenue is an important source of revenue, i.e., where the conflict of interest faced by analysts is likely to be quite high, the traders show no significant tendency to buy and sell in line with analyst recommendations The in-house traders are evidently aware of the conflicts faced by analysts, and as a result they disregard their recommendations

We also find that the relation between analyst recommendations and in-house trading varies according to the percentage of investment bank revenue that comes from trading activities.Among those banks that rely most heavily on trading as a source of revenue, there is a

significantly stronger relation between analyst recommendation changes and in-house trading These findings are consistent with an interpretation that analysts’ objective functions differ in predictable ways across institutions Within investment banks that rely most heavily on trading, analysts are expected to provide the most accurate recommendations, and consequently traders within these institutions are much more likely to act on these recommendations In contrast, within banks that rely most heavily on investment banking as a source of revenue, analysts are expected to support the investment banking business, and consequently the in-house traders pay little heed to their recommendations

Our findings contribute to several streams of literature First, our study relates to the debate regarding analyst incentives and the extent to which conflicts of interest cause analysts to issue overly forecasts and recommendations Michaely and Womack (1999), Dugar and Nathan (1995), and Lin and McNichols (1998), among others, find that analysts employed by

underwriters of security offerings tend to be more optimistic than other analysts However, Cowen, Groysber, and Healy (2006), Jacob, Rock and Weber (2003), Clarke, Khorana, Patel, and Rau (2004), and Agrawal and Chen (2005) find no evidence that conflicts of interest from investment banking make analysts more optimistic or less precise We take a new approach to this problem, by considering the ways in which analyst incentives are likely to vary both over time and across investment banks

Second, although there are a number of papers on analyst actions around equity issues, there is relatively little evidence on analyst actions around mergers and acquisitions M&A

activity is a substantial source of revenues for many investment banks, and our study increases our understanding on the ways in which investment banks potentially compete for this business.

Our paper proceeds as follows Section 2 reviews prior literature on conflicts of interest within investment banking Section 3 outlines the data Section 4 describes analyst

recommendations and institutional ownership around the merger Section 5 includes empirical tests on the relation between analyst recommendations and institutional trades, by the advisor investment bank Section 6 investigates how the relation between analyst recommendations and institutional trades varies depending on the likely magnitude of the conflict of interest faced by analysts Finally, Section 7 concludes

2 Related Literature

A substantial body of literature has examined the value of analyst recommendations Givoly and Lakonishok (1979), Stickel (1991), Womack (1996), Barber, Lehavy, McNichols andTrueman (2001), Jegadeesh, Kim, Krische, and Lee (2004), Loh and Mian (2005), and Busse andGreen (2002) all show that analysts’ earning forecasts and stock recommendations have

investment value Consistent with analyst recommendations being value relevant, research by Jackson (2005), Hong and Kubik (2003), and Mikhail, Walther, and Willis (1999) shows that analysts are motivated to increase their reputations by issuing the most informative forecasts and recommendations.3 In the merger framework, Becher and Juergens (2005) find that analysts have insight into the value of a merger, and as a result they can impact the outcome of a merger

Although considerable evidence suggests that analyst recommendations have value, there

is also a large literature on the conflicts of interest that analysts face Specifically, as discussed

3 Ljungqvist, Malloy and Marston (2006) find that the importance of accuracy for career outcomes has become more limited in recent years.

in detail by Mehran and Stulz (2007), analysts face pressure from within their firm to issue overly optimistic forecasts and recommendations to support the investment banking business

While there is broad consensus that analysts face conflicts of interest, the effects of such conflicts are disputed Lin and McNichols (1998), and James and Karceski (2006), among others, find that analysts employed by underwriters of security offerings tend to be more

optimistic than other analysts Findings of Michaely and Womack (1999), Aggarwal,

Purnanandam, and Wu (2005), Barber, Lehavy, and Trueman (2007) suggest that this optimism contributes to inflated stock prices

The findings of Dugar and Nathan (1995) and McNichols, O’Brien, and Pamukcu (2006) similarly show that affiliated analysts are more optimistic However, they find that the market discounts the affiliated analysts’ recommendations Agrawal and Chen (2005) and Bradley, Jordan and Ritter (2006) reach similar conclusions

Finally, papers by Cowen, Groysber, and Healy (2006) and Jacob, Rock and Weber (2003) find no evidence that a conflict of interest from investment banking causes analysts to issue overly optimistic or less precise forecasts Similarly, Agrawal and Chen (2004) find no evidence that accuracy or bias in earnings forecasts are related to the importance of investment banking as a source of revenue to the financial institution.4

Part of the inconsistency in these streams of prior literature is potentially related to the fact that not all analysts face the same conflicts at all times with respect to all stocks Ljungqvist,Marston, Starks, Wei, and Yan attempt to address this issue by separating stocks by the level of institutional ownership Analysts’ career paths are largely influenced by the All-Star rankings,

4 Note that Agrawal and Chen’s (2004) examination of earnings forecasts shows no evidence of a conflict of interest from investment banking resulting in overly optimistic forecasts In contrast, Agrawal and Chen’s (2005) study of analyst recommendations yields the opposite conclusion This difference is consistent with Mehran and Stulz’s observation that more evidence exists suggesting that recommendations are biased and less evidence suggesting that

which are based on institutional investor feedback Consequently, it follows that an analyst’s incentives to provide unbiased, accurate recommendations are highest in those stocks with the highest institutional ownership Consistent with this conjecture, the authors find that

recommendations relative to consensus are positively related to investment banking relationshipsand negatively related to ownership by institutional investors

Although all of the above studies examine analyst conflicts and are therefore obviously related to our research question, there are only a few prior papers that link analyst

recommendations with institutional trading, as we do Chen and Cheng (2002) find that

quarterly institutional trades are correlated with consensus stock recommendations However, they compare all institutional trading with consensus recommendations, rather than matching institutions with their own recommendations, as we do

The paper potentially most closely related to our own is Chan, Chang, and Wang (2005) Similar to us, they match quarterly trades of financial firms with in-house recommendations However, their specification as well as the focus differs considerably from ours The primary objective of our study is to examine conflicts of interest within investment banking As

discussed previously, we believe that quarters around mergers provide an ideal setting to

examine such issues In contrast, Chan et al focus more solely on the value relevance of

recommendations in a more general setting, and correspondingly they examine all

recommendations, not just those around a corporate event Consistent with the analyst

recommendations having value, they find that in-house trade is more positive around upgrades than downgrades Differences between their findings and our own are discussed in more detail later

3 Data

Our data consists of mergers and acquisitions between 1995 and 2004, as obtained from the Securities Data Company (SDC) database To ensure that the merger is a material event for the acquiring firm, we require the market value of the target to be at least 5% of the combined market capitalization of the bidder and the target Both targets and acquirers are public firms traded in the U.S., and the acquirer must be publicly traded for at least three years prior to the merger announcement We require each bidder firm to be followed by analysts, as listed on the IBES recommendation database, and to have institutional ownership, as listed in the Spectrum 13(f) filings, one year prior to the announcement of the acquisition

Our analysis necessitates merging the SDC merger data, the IBES recommendation data, and the Spectrum institutional holdings data For each merger, we identify the advisory

investment bank from SDC We match by hand the identity of this bank with the IBES broker code and with the Spectrum institutional name In matching the institutions between the SDC, IBES, and Spectrum databases, we are careful to account for both mergers between investment banks and for banks reporting under different names (e.g., Smith Barney Inc and Smith Barney

& Co) We attempt to match every investment bank that served as an advisor in at least 10 deals over our sample period The only banks that were not matched were those such as Houlihan, Lokey, Howard & Zukin and Greenhill & Co, LLC, neither of which have either a trading desk

or analysts Mergers in which the advisor either did not have an advisory arm (i.e., wasn’t listed

in IBES), didn’t have a trading arm (i.e., wasn’t listed in Spectrum), or served as an advisor in less than ten deals are omitted from our sample

For our analysis of analyst recommendations, we obtain advisor firm recommendations and consensus recommendations from IBES The summary data are available monthly, on the

15th day of each month, and they represent the average of all outstanding and new

recommendations made during the previous month.5 For the independent analyses of analyst recommendations, we use the analyst recommendations 1, 4, 7, 10, and 13 months prior to the merger announcement, and the recommendations 1, 4, 7, 10, and 13 months following the

merger completion In addition, to assess the effects of the merger completion, we compare analyst data one month following merger completion to one month preceding merger

completion

Institutional holdings data are reported in Spectrum quarterly, on March 31st, June 30th, September 30th, and December 31st of each year We calculate total shares held by each advisor institution and each non-advisor institution one through five quarters prior to merger

announcement and one through five quarters following merger completion

Our interest in analysts’ response to the merger and also institutional traders’ response to the analysts dictates the merging of the three datasets Specifically, we match each quarterly institutional reporting date to the prior analyst consensus For example, the December 31st

institutional data would be matched to the December 15th analyst recommendation data Thus, for a merger on either October 12th or December 8th, quarter +1 relative to the merger

announcement would represent the December 31st institutional data, and we would use the corresponding December 15th analyst recommendation data

Although these examples pose no serious difficulties, there are other cases for which comparing analyst recommendation data and institutional trading data around the merger proves

to be especially problematic Not surprisingly, these difficulties are driven primarily by the infrequent interval at which the institutional trading data are available For example consider a

5 Consistent with IBES’ calculations of the consensus estimates, we match an advisor analyst’s recommendation (as obtained from the detail database) with the subsequent consensus recommendation (as obtained from the summary database)

merger on September 23rd Using the measurement intervals described above, quarter +1 would correspond to the September 30th institutional trading data However, the preceding analyst consensus data would be from September 15th, a date that actually precedes the merger

announcement There is an obvious difficulty in capturing analyst recommendations to the merger and the corresponding trades of the institutions in such cases We therefore eliminate anycase where the date of the merger announcement falls in between the first available institutional reporting data and the corresponding (i.e., most recent) analyst consensus recommendation data

As shown in Table 1, these requirements result in a sample of 726 mergers, of which 403 are stock acquisitions, 96 are cash, and 227 are mixed Many of the mergers have more than one advisor Due to our interest in conflicts of interest at the investment bank level, many of our analyses focus on advisor-level recommendations and trading Our sample includes 816 advisor-level observations The sample is spread over time, with the largest number of transactions occurring in the late 1990s This concentration is consistent with the finding in prior literature that M&A activity tends to be particularly high when the stock market is strong Looking at the industry distribution, the largest number of mergers is in the business equipment and finance industries

Table 2 provides descriptive statistics on the full sample, the sample divided by the presence or absence of analyst coverage by the advisory firm, and the sample divided by the presence or absence of institutional ownership by the advisory firm Median market

capitalization is measured one month prior to the announcement of the merger, and all other financial data reflect medians measured at the end of the fiscal year preceding the announcement

of the merger Relative merger size represents the market capitalization of the target firm

divided by the sum of the market capitalizations of the target and acquirer firm, where all market

capitalizations are measured one month prior to the announcement of the merger

The median market capitalization of the acquirer firm is approximately $1.8 billion We find that the market capitalization is significantly larger for firms in which the advisor firm provides analyst coverage and in which the advisor firm owns shares This likely reflects the fact that both analyst coverage and institutional ownership are greater in larger firms, as shown

by Gompers and Metrick (2001) and Barth, Kasznik, and McNichols (2001) Similar inferences can be made based on the total assets and the sales of the acquirer firms Market-to-book is significantly higher and working capital as a fraction of total assets is significantly lower for firms in which the advisory firm owns shares The significant differences in market-to-book are consistent with Barth et al’s (2001) finding that analysts are more likely to cover growth firms Finally, relative merger size is significantly lower for companies in which the advisor firm issuesrecommendations This is potentially driven by differences in firm size – companies in which the advisor firm issues recommendations are significantly larger, meaning a given target size will

be relatively smaller

4 Analyst Recommendations and Institutional ownership around the merger

As discussed in section 2, prior literature provides contradictory evidence on the extent ofanalyst optimism due to conflicts from investment banking The majority of this prior literature has focused on analyst forecasts and recommendations either around equity offerings or across all firms However, little is known about analyst recommendations around mergers Notably, the magnitude of fees from advising M&A banks likely make it one of the most competitive areas of investment banking.6 Therefore, M&A provides a setting in which the pressures from investment banking on a bank’s other activities are potentially the greatest Tables 3 and 4

6 For example, as discussed above, fees from advising M&A in 2006 exceeded $35 billion.

examine the extent to which analyst recommendations appear related to either expected or recent M&A advisory business by the investment bank

The first column of Table 3 shows the percent of all 816 advisors (across the 726

mergers) that issue recommendations in the acquirer company, from five quarters prior to the announcement of the merger to five quarters following the completion of the merger That is, theanalysis is at the advisor level rather than the deal level, meaning a deal in which there are two advisors would be represent two observations We assume that the investment bank has little idea

of an upcoming merger on which they could potentially advise five quarters ahead of time In contrast, one quarter prior to the merger, an investment bank might know that a merger is likely and consequently decide to initiate coverage in the hopes of increasing the chances of winning the advisory business

Results show that the percent of advisors issuing recommendations on the acquirer company increase substantially over time, from 52% of advisors five quarters prior to the

merger, to 68% one quarter prior to the merger, 73% one quarter after the completion of the merger, and 82% five quarters after the completion of the merger Column 2 shows similar increases in the total number of recommendations per company Moreover, the last column shows that the median market capitalization of the acquirer companies is also increasing

substantially over time, suggesting that at least a portion of the increase in coverage is driven by increases in firm size

In an effort to isolate the portion of increases in advisor coverage that is driven by efforts

to win M&A advisory business, column 3 shows the percent of total recommendations that represent recommendations by the advisor firm Interestingly, this percentage increases

substantially from five quarters prior to the announcement to one quarter following the

completion The substantial increases around the time of the merger are consistent with efforts

to win and/or support the M&A advisory business

Columns 4, 5, and 6 of Table 3 show similar statistics for advisor firm ownership in the acquirer company Similar to inferences from analyst coverage, we find increases in the

percentage of advisor institutions that own shares, from 58% five quarters prior to announcement

to 69% five quarters following completion However, there is no evidence that increases in the incidence of the advisor firm owning shares in the acquirer company are related to the merger

In fact, advisors as a percent of all institutions that own shares in the acquirer company actually decrease around the time of the merger, indicating that non-advisor institutions are investing in the acquirer firms for the first time faster than advisor institutions The observed increases in advisor firm ownership are likely driven by increases in firm size

Finally, column 7 of Table 3 shows the percent of advisors that both issue

recommendations and own shares in the acquirer company Consistent with the other statistics, this percentage increases markedly over time, from 27% five quarters prior to the announcement

to 58% five quarters following completion

Table 4 looks more specifically at the dynamics of analyst recommendations and

institutional ownership in the period immediately surrounding the merger Panel A focuses on the analysts’ recommendations, Panel B on institutional ownership across all institutions, and Panel C on institutional ownership across institutions that have an investment banking arm

Looking first at Panel A, we see that non-advisor analysts are more likely to both upgradeand downgrade the acquirer stock following announcement of the acquisition One potential reason for the greater activity in both directions among non-advisor analysts is that the

announcement of the merger was more of a surprise to them However, it is nevertheless

surprising to observe a significantly greater portion of non-advisor analysts upgrading the stock

It is possible that the higher average rating among advisor analysts prior to the merger

announcement explains part of this difference (Moreover, the first two columns of Table 5 show that the average advisor rating continues to be higher following the merger.) More

consistent with our expectations is the difference in the percentage of analysts downgrading the acquirer stock following the merger announcement, with 4% of non-advisor analysts

downgrading, compared to only 1% of advisor analysts

The third row of Panel A shows the average recommendations as well as upgrades and downgrades following merger completion, where upgrades and downgrades are relative to the quarter prior to completion (but by definition subsequent to the merger announcement)

Consistent with predictions, we find that more advisor analysts upgrade the acquirer stock following merger completion; however the difference is not significant The percentage of analysts downgrading the stock is similar between advisors and non-advisors

Panel B examines similar issues as pertaining to the institutional ownership by the

advisor versus non-advisor firms Columns 2 and 3 of Panel B of Table 4 suggest that the advisor firm institutions are more active traders than non-advisor institutions They are more likely to both purchase and sell shares in the acquirer company in the quarter prior to and

following announcement

Panel C suggests that at least a portion of this difference reflects differences between investment bank versus non-investment bank institutions It is possible that institutions behave differently if they have an investment banking business Such institutions may be pressured to support the investment banking business Alternatively, the traders associated with investment banks may hold different positions for other reasons, for example lower trading costs, better

information on more firms, etc To examine the extent to which such issues affect our analysis,

we restrict the sample of institutions to those that have an investment banking business

Specifically, we restrict the sample of institutions to those who are in our M&A sample, i.e., those that served as advisors in at least ten deals over our sample period and had both analysts and a trading desk

Once we restrict the sample of institutions to those with a significant investment banking business (i.e., Panel C), we find that institutions of the advisor firm are significantly more likely

to buy shares in the acquirer company, but there is no difference in the probability of selling shares after the merger announcement

Finally, both panels B and C indicate that non-advisor institutions are more likely to

purchase shares and less likely to sell shares following completion of the merger This is exactly

opposite our prediction In an attempt to understand this result, we re-calculate these statistics based solely on cash mergers Within the cash subsample, we find no evidence that non-advisor firms are more likely to buy shares following completion This leads us to believe that this apparently puzzling result in the full sample reflects the exchange of shares in stock mergers, in particular the institutions that had held shares in the both the target and acquirer company now owning more shares of the combined entity

In sum, Tables 3 and 4 provide substantial evidence of both analysts and institutional traders behaving differently when they belong to the advisor versus non-advisor investment bank The next section examines this conclusion in more depth, by investigating the relation between analyst recommendations and institutional trades

5 Relation between analyst recommendations and institutional trades

As a first step towards understanding the relation between analyst recommendations and institutional trades, Table 5 provides some descriptive evidence Quarters -3 through -1, as labeled in the top row of each panel, represent the quarters prior to the merger announcement, and quarters +1 through +5 represent quarters following merger completion For example, consider a merger announced on April 12th, 1998 and completed on August 20th, 1998 In this case, the quarter -1 institutional trading data would be measured on March 31st, 1998 and the quarter -1 analyst recommendation data would be measured on March 15th, 1998 For quarter -2,institutional trading data would be measured on December 31st, 1997 and analyst

recommendation data would be measured on December 15th, 1997 Analogously, quarter +1 institutional trading data would be measured on September 30th, 1998 and quarter +1 analyst recommendation data would be measured on September 15th, 1998 Upgrades and downgrades are measured relative to the analyst’ recommendation one quarter prior

Looking at the first row of Panel A, we see that there are 18 instances of advisor firm analyst upgrades three quarters prior to merger announcement Of these 18 cases, 44% are associated with decreases in institutional holdings by the advisor firm, relative to the previous quarter, and 50% are associated with increases in institutional holdings by the advisor firm To the extent that analyst upgrades are viewed as positive information, we would expect them to be associated with a greater percentage of affiliated institutions buying shares, versus selling shares.However, we see little evidence of this at quarter -3

Evidence of traders following affiliated analysts recommendation changes is strongest in quarters -1 and +2 (Note that inferences on quarter +1 are difficult because the institutions are

so often net buyers of shares in stock acquisitions.) For example, upon an affiliated analyst upgrade in quarter -1, 67% of in-house institutions (i.e., institutions within the same investment

bank) buy shares compared to only 27% selling Similarly, in quarter +2 after the merger, an analyst upgrade is associated with 68% of in-house institutions buying compared to only 32% selling However, little if any relation is seen in the quarters farther from the merger.

Inferences are similar based on downgrades To the extent that downgrades contain negative information, we would expect a greater frequency of selling by affiliated institutions, compared to buying Consistent with this prediction, an affiliated analyst downgrade in quarter +2 is associated with 65% of in-house traders selling, compared to only 23% buying Statistics are similar for quarters 3 and 4, albeit weaker However, there is no evidence of any relation in other quarters

In sum, Table 5 shows a substantially stronger relation between analyst

upgrades/downgrades and in-house trades immediately around the merger, and little if any relation at other times Our evidence is somewhat inconsistent with the findings of Chan, Cheng,and Wang (2005) who find a significant relation between analyst recommendations and in-house trading throughout time It is possible that their larger sample size (which they obtain by looking

at all firms across a ten-year sample period) gives them more power to find significant

differences Nevertheless, it remains the case that our analysis suggests a stronger relation around the merger event

Tables 6 and 7 examine this relation between analyst recommendations and changes in institutional holdings in a regression framework The matching of the merger data, institutional holdings data, and analyst recommendations data is as described above The dependent variable

is the change in advisor shares held from quarter t-1 to t, divided by the quarter t-1 holdings Foreach firm, regression observations include t-4 to t-1 (relative to announcement) and t+1 to t+5 (relative to completion) We omit the period of time between the announcement and completion