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INCENTIVE-BASED FEE STRUCTURES IN INVESTMENT BANKING

Ted Azarmi, California State University, Long Beach

Christine Haecker, Eberhard-Karls-Universität Tübingen

Case Objectives and Use

This case is expected to initiate a class discussion about an incentive-based fee structure for the intermediary in mergers and acquisitions.  The goal of this case study is to interest students in the problem of designing an optimal fee structure that simultaneously guarantees maximum sale price to the seller as well as maximum income to the intermediary.  Specifically, the case shows the necessity of such an optimally designed fee structure as a tool to mitigate the agency problem between seller and intermediary in mergers and acquisitions, which is inherent in the customarily used Lehman compensation approach.  Students are expected to compare the respective strengths and weaknesses of various compensation approaches, such as the Lehman formula, Reversed Lehman formula, Straight-Compensation, and a novel approach intended to ease current shortcomings.  The case was designed for higher-level undergraduate courses in Finance, as well as for graduate level courses (MBA).  Written as a decision version, the case was designed to connect theory (specifically the agency problem) with a real-world example of the world of investment banking, one of the highly desirable areas within corporate finance.  

Case Synopsis

Jessica Collins is setting up her own investment banking firm targeting private mid-sized Sellers.  She is pondering how to design her fee structure.  She desires to use this fee structure as a marketing tool, and wants to lay the groundwork for satisfied clients, who, so she hopes, will bring her future business based on word-of-mouth propaganda.  Thus, it is critical for her to design an optimal fee structure that simultaneously guarantees maximum sale price to the seller as well as maximum income to the intermediary.  She is dissatisfied with the customary Lehman formula as a compensation structure, as this structure does not align the interests of the Seller and the Banker, thus providing room for agency problems.  Subsequently, Jessica considers Reverse Lehman compensation structure and a straight-commission structure, and critically evaluates respective advantages and shortcomings.  Finally, she sets out to devise her fee structure that, in her eyes, assures that she will negotiate the highest possible purchase price, thus acting in her client’s best interest.  

As the case is designed as a decision version, the eventual design of Jessica’s optimal fee structure is left up to the student, in order to practice and improve logical thinking as well as problem solving abilities.

This case was prepared by Ted Azarmi, California State University, Long Beach, and Christine Haecker, Eberhard-Karls-Universität Tübingen, and is intended to be used for class discussion rather than to illustrate either effective or ineffective handling of the situation.

Presented to and accepted by the North American Case Research Association (NACRA) for its annual meeting, November 2003, Tampa, Florida.  All rights reserved to the authors and NACRA. © 2003 by Ted Azarmi and Christine Heacker.

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