Much of the vast literature on corporate governance focuses on internal issues, such as board characteristics. Yet external governance – the market for corporate control, often known as the takeover market – is critical to determining how well a company is run. Managers are less likely to exploit shareholders when subject to the discipline of the takeover market, making it a governance instrument for reducing agency problems. In a new study, we demonstrate the impact of the takeover market on companies by investigating how it affects an important measure of their financial health: credit ratings.
Credit ratings provide information on a company’s default risk, enabling investors to easily assess the general risks of a broad range of companies by employing a single, well-known scale. Moreover, credit ratings are essential in regulation and private contracting as a tool for risk monitoring and risk reduction and have a substantial impact on the cost of corporate borrowing, which is a large component of the cost of capital.
Although the agency conflict between managers and shareholders has received far greater attention, the agency conflict between shareholders and debtholders is also critically important, particularly for credit ratings agencies. The agency cost of debt is frequently discussed as risk-shifting and underinvestment problems. First, a conflict between equity and debt claimants may arise when stockholders expropriate the wealth of debtholders through risky investments. Consequently, debtholders do not receive a rate of return commensurate with the degree of risk they face. In this instance, shareholders receive most of the gains (i.e., when high-risk ventures are successful), but debtholders bear most of the costs. This issue is often referred to as the asset substitution problem, in which riskier assets are swapped for safer ones. Second, managers acting on behalf of shareholders might reject projects with positive net present values if they feel that most of gains will flow to debtholders. This is referred to in the literature as the underinvestment problem and reflects poor investment decisions made by the firm. Both risk-shifting and underinvestment contribute to an increase in agency cost of debt.
In theory, it is unclear what the effect of the takeover market should be on credit ratings. On the one hand, it prevents managers from taking opportunistic actions against shareholders, resulting in higher firm value. Therefore, both shareholders and debtholders are better off as a result. On the other hand, the discipline of the takeover market may reduce the agency cost between managers and shareholders but raise the agency cost between shareholders and debtholders. In this case, a more active takeover market should result in poorer credit ratings.
Utilizing a unique measure of takeover vulnerability largely based on the staggered implementation of state laws, we demonstrate that increased takeover vulnerability has a substantial positive effect on credit ratings. Specifically, a rise in takeover susceptibility by one standard deviation results in a 7.89 percent improvement in credit ratings. Therefore, the impact of takeover vulnerability on credit ratings is not only statistically significant, but also economically relevant. We also demonstrate that a firm’s likelihood of being granted speculative-grade credit ratings decreases dramatically when the takeover market exerts greater pressure.
Insofar as credit ratings are a reliable proxy for credit risk, one possible explanation for our findings is that takeover threats lower the managerial agency cost more than they raise the debt agency cost. Our findings are also consistent with those of previous research, which indicates that an increase in takeover threats greatly boosts the value of a company. Importantly, we rely on a distinctive proxy for takeover vulnerability based on plausible exogenous factors, such as state legislation. Therefore, endogeneity is far less likely in our study than in previous studies. Our findings are thus more likely to indicate causation rather than simply an association.
Our findings contribute to the literature in a variety of ways. First, we augment a critical body of work that investigates the takeover market as an essential governance instrument. We demonstrate that credit rating agencies understand the importance of the takeover market in reducing agency costs and issue credit ratings accordingly. Second, our research adds to the body of knowledge on credit ratings. While much of the research in this area focuses on the effects of internal governance on credit ratings, the impact of external governance mechanisms, such as the takeover market, is far less known. We demonstrate that takeover vulnerability is a substantial determinant of credit ratings. Finally, our findings contribute to research on the agency cost of debt. We demonstrate that the pressure associated with the takeover market does not seem to increase the agency cost of debt, or at least not enough to outweigh the advantages from lowering the agency cost between shareholders and management.
This post comes to us from professors Pattanaporn Chatjuthamard at Sasin GIBA (Bangkok), Viput Ongsakul at NIDA Business School (Bangkok), and Pornsit Jiraporn at Pennsylvania State University. It is based on their recent paper, “Do Hostile Takeover Threats Matter? Evidence From Credit Ratings,” available here.