The financial system has developed several mechanisms to align interests of managers and investors. Our study focuses on one such mechanism—credit rating agencies. The financial crisis of 2008 highlighted the importance of well-functioning credit rating agencies. The failure of credit rating agencies during the crisis was a focus of the Dodd-Frank Act of 2010 (“Dodd-Frank”), which attempted to restore integrity to the credit rating process.
Credit ratings are important since they offer firms the opportunity to tap the bond market. The corporate bond market is an important source of debt financing which enables firms achieve positive NPV investment opportunities. Prior cross-sectional evidence highlights that firms with bond ratings are more likely to conduct acquisitions due to a reduction in financial constraints. We differ from prior work by emphasizing that credit rating agencies not only open the doors to additional capital supply but also add an additional layer of monitoring. We label this the “implicit monitoring effect,” implying that managers simply do not want to face company credit rating downgrades since that would result in increased cost of capital. Therefore, management refrains from credit rating negative actions, such as acquisitions, which on average have proven to be credit rating negative. Our insights are two-fold: first, the initial effect of obtaining a credit rating is increased acquisition activity as firms first enter the bond markets to finance large and pre-planned acquisitions. Second, we find that this initial effect is temporary as credit ratings dampen acquisition activity after the first acquisition following the initial rating.
The first effect that credit ratings have on acquisitions stems from the increased capital supply. A firm obtaining a credit rating is able to access a new pool of funds from the debt markets. This enables financially constrained firms to realize their investment opportunities. As illustrated in the subsequent graph, firms exhibit increased acquisition activity in conjunction with their initial credit rating at t=0. Our evidence further supports the notion that a large fraction of firms seek their initial rating to realize a large and high quality acquisition opportunity. We further report that this effect is strongest among firms likely to face bank financing constraints. In sum, our findings support the idea that large and profitable acquisition opportunities trigger firms to seek a credit rating to overcome bank lending constraints.
Following the initial credit rating, firms refrain from acquisitions in order to manage their rating levels as illustrated in the graph above. Prior studies show that conducting acquisitions have a negative credit rating impact, which potentially results in an increased cost of capital. Therefore, management avoids further acquisitions and also reallocates investments into low-risk targets to preserve their credit rating. We identify the effect by studying the acquisition behavior around Dodd-Frank. This Act incentivized credit rating agencies to provide more informative ratings, creating a greater threat of credit rating downgrades. Consequently, credit rated firms reduced their acquisition activity relative to non-rated firms, showing that managers are likely to self-discipline to maintain current rating levels. We further show that it is not only the amount or size of acquisitions that decreases following the first acquisition after the initial rating, but the acquired targets also exhibit lower volatility and are more likely to diversify the operations of the acquirer.
To conclude, our study reports on the initial and subsequent impact of obtaining credit ratings on investment activity. Managers initially seek bond market access to overcome bank lending constraints. But they also self-discipline to maintain their credit rating levels. Our study provides evidence on the dual role that credit rating agencies play in aiding firms to obtain financing but also in adding an additional layer of monitoring. Our study has implications for regulators by showing the importance of well-functioning credit rating agencies and their impact on corporate investments.
Magnus Blomkvist is an Associate Professor of Finance at Audencia Business School in Nantes
Karl Felixson is a Lecturer of Finance at Hanken School of Economics in Helsinki
Eva Liljeblom is a Full Professor of Finance at Hanken School of Economics in Helsinki
Hitesh Vyas is Adjunct Professor of Finance and Marketing at Audencia Business School in Nantes
This post is adapted from their paper, “The Initial and Subsequent Credit Rating Effects on Acquisitions,” available on SSRN.