Credit rating agencies play a crucial role in determining how much a firm pays for its finance. But research by Professor Taylor Begley shows that in trying to secure high scores, managers too often cut R&D spending in order to flatter their profit figures. That hits their companies’ longer-term performance. Value is destroyed. Could longer-term compensation packages discourage this damaging behaviour?
Companies have good reason to worry about their credit rating. A good rating gives easier access to finance. A bad one can mean that the company pays more for its loans: to slip down the credit rankings costs money. Hence it is little wonder that companies will strain every financial sinew to secure as high a rating as possible.
But research by London Business School’s Taylor Begley shows that in chasing a good rating, companies may be damaging their long-term prospects. They may have secured a stamp of financial approval, but in doing so, they have done themselves a disservice.
Why? Because firms that are near the boundary between one credit rating and another are likely to reduce spending on intangible assets such as research and development. That cuts costs, boosts the firm’s short-term reported earnings, and gives it a better chance of edging into a higher credit category – or, indeed, retaining a good rating when it would otherwise be in danger of seeing its rating fall.
Look further ahead, however, and the cuts in spending are likely to dent the company’s performance. Profits suffer. By other measures – such as the number of patents secured, for example – long-term growth is likely to be hit.
A company whose debt/EBITDA ratio was near one of the boundaries set by rating agencies was 40 percent more likely to cut research and development spending
It is striking that the ratings agencies themselves appear to recognise that in trying to manipulate their finances so they appear financially strong today, companies may be damaging their performance in the future. Begley quotes from the Standard and Poor’s 2008 handbook. It says: “We do not encourage companies to manage themselves with an eye toward a specific rating. The more appropriate approach is to operate for the good of the business as management sees it and to let the rating follow."
The handbook acknowledges that “Ironically, managing for a very high rating can sometimes be inconsistent with the company’s ultimate best interests, if it means being overly conservative and forgoing opportunities.”
That appears to deal with exactly the point that is highlighted in Begley’s work. But as he points out, “The problem is that you flip two pages later in the handbook and there is a grid showing the financial measures that the agency will be looking at.” The implication is clear: the ratings agency may insist that companies should not manage their affairs simply to secure a good credit rating; but that rating is likely to be largely influenced according to numeric measures about the business here and now. Those measures fail to capture more subtle determinants of the future performance of the company.
Of course, there are circumstances when it is commercially sensible for a company to cut spending on research and development. “But maybe managers have difficulty in explaining the difference between good R&D and bad R&D,” says Begley.
Furthermore, from an individual manager’s point of view, reducing spending on R&D could appear perfectly sensible. Cutting costs in this way may indeed improve a company’s stated finances, and therefore ensure that it climbs over the boundary between two bands of credit rating: that in turn could help the company by reducing the cost of finance when issuing a bond, for example. And if the company’s short-term finances look strong, the managers responsible may gain financially in the form of pay and bonuses; they are likely to be less concerned about the company’s performance in ten years’ time when they may well have moved on or retired. “From an individual’s point of view, it is not necessarily irrational,” says Begley.
Begley looked at data from almost 700 companies and their behaviour over almost two decades. And he focused on what these companies did when they were approaching a time when they would be issuing bonds.
Begley looked at one of the key metrics used by rating agencies when assessing a company’s credit-worthiness – the ratio between debt and earnings as measured by earnings before interest, tax, depreciation and amortisation (EBITDA). All else being equal, a high figure for debt/EBITDA means a company is likely to be seen as less financially robust than one where the ratio is low. Ratings agencies set arbitrary thresholds when looking at debt/EBITDA. For example, they may say that a company where the ratio is fractionally above 2.0 deserves an inferior rating to that of a company where the ratio is a whisker below 2.0.
So companies near a boundary such as this have a strong incentive to ensure they are the right side of the line when their finances are being scrutinised by ratings agencies ahead of a bond being issued. Cutting R&D is a quick and easy way to reduce costs, increase earnings and boost the chance of securing a strong credit rating.
Meanwhile, companies whose debt/EBITDA ratio is a long way from one of these thresholds set by a credit rating agency can be more relaxed. They can feel reasonably confident about what their credit rating is likely to be – without having to cut costs to increase EBITDA. This was Begley’s control group.
Begley came up with a striking finding. As a bond issue loomed on the horizon, a company whose debt/EBITDA ratio was near one of the boundaries set by rating agencies was 40 percent more likely to cut research and development spending than a company in the control group. Spending under the umbrella of “selling, general and administrative” – typically advertising, IT and training – was also likely to be cut, although the effect was less strong.
But does any of this really matter? Begley’s research shows that it emphatically does. The companies who – with good reason – were most anxious about their credit ratings because they were close to a debt/EBITDA threshold were less likely to come up with useful patents in the years following their bond issue. They also were more likely than the control group to see a decline in return on assets and return on equity. Finally, Begley found that over the four years following a bond issue, companies that had been near a debt/EBTDA threshold - and therefore were more likely to cut R&D – would see their market value underperform in subsequent years.
Overall, the research produces some pretty downbeat conclusions. It adds to the already vast amount of evidence that in many ways, short-termism damages long-term prosperity.