Chasing ratings, damaging innovation

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.

Begley says: