How Corporate Credit Ratings Induce Short-Termism

Credit rating agencies were under particular scrutiny in the recent financial crisis, as critics argue they gave too high ratings to securities that turned out to be toxic. One potential culprit is the "issuer-pays" model, where it is the company being rated that pays for credit ratings, which may encourage rating agencies to be overly-generous to win business.

But, a recent paper by my new LBS colleague Taylor Begley points to an important additional cost of corporate credit ratings - and one that arises even if ratings are perfectly accurate. Companies may engage in short-term behavior to achieve a particular credit rating. This problem arises because credit ratings are discrete categories (e.g. AAA, AA+, BB) rather than a continuous number (e.g. 93.2, 87.8). Thus, a company has a strong incentive to just get into the AAA- category than be at the top of the AA+ category.

In turn, a major driver of credit ratings is a company's financial ratios. For example, for firms with an excellent business risk profile, a Debt/EBITDA ratio of 1.5-2.0 typically leads to a rating of AA; a ratio of 2.0-3.0 typically leads to a rating of A. For firms with a fair business risk profile, a Debt/EBITDA ratio of 1.5-2.0 typically leads to a rating of BBB-; a ratio of 2.0-3.0 typically leads to a rating of BB+ (which is below investment-grade, i.e. has "junk" status). (Source: Standard & Poor's Business Risk / Financial Risk Matrix).

These discrete thresholds thus give companies incentives to be lie just below a threshold. They can achieve this by short-term behavior such as cutting research and development (R&D). This increases EBITDA, thus reducing the Debt/EBITDA ratio and potentially meeting the threshold. Importantly, the incentives to engage in short-termism depend on where the firm is compared to the next lowest threshold. A firm with a Debt/EBITDA ratio of 2.1 has strong incentives to engage in short-termism, because it has a high chance of being able to lower it to below 2.0, but a firm with a Debt/EBITDA ratio of 2.5 has much weaker incentives. Taylor indeed finds that firms close to a threshold are significantly more likely to cut not only R&D, but also selling, general, and administrative (SG&A) expenses, which contains expenditure in advertising, information technology, employee training, and other forms of organizational capital.

Other papers have previously found evidence of short-termism to meet other types of thresholds - for example, companies may cut R&D to ensure their earnings fall just above analyst earnings expectations. But a particularly novel finding of this paper is that Taylor is able to document negative long-run effects of such short-termism. Companies close to ratings thresholds subsequently suffer declines in the number of patents that they produce, and also the number of citations to their patents (a measure of the quality of innovation). They also experience declines in profitability and valuation ratios.

The cost of credit ratings that critics typically focus upon is that inaccurate ratings lead to redistributional consequences. If the ratings of a security are too high, the buyer pays too much for them. Thus, the seller wins and the buyer loses. While these redistributional concerns are clearly very important, they don't directly affect the overall size of the pie (sellers get a larger slice, buyers a smaller slice). In contrast, Taylor shows that credit ratings have efficiency (rather than just redistributional) consequences - they affect the overall size of the pie. If companies cut investment to meet ratings thresholds, they erode their future value, making everyone worse off in the long-run. This is a particular concern for the 21st century firm, whose value is especially driven by intangible assets (such as brand strength, innovative capabilities, and corporate culture) which requires several years to build and bear fruit.

The paper certainly does not argue that credit ratings should be scrapped; these costs must be weighed against their numerous benefits. Many financial targets (e.g. analyst earnings expectations) also have the potential to lead to short-termism. Rather, the paper highlights a potential cost to credit ratings that boards may be able to mitigate. One potential remedy that discussed in a previous post is to increase the vesting period of executives' stock and options, to tie them to the long-run performance of the firm. 

Reforming CEO Pay - The Dangers of Short-Term Incentives

(This post originally appeared on LinkedIn)

Executive pay is a high-profile topic about which almost everyone has an opinion. Many shareholders, workers, and politicians believe that the entire system is broken and requires a substantial overhaul. But, despite being well-intentioned, their suggested reforms may not be targeting the elements of pay that are most critical for shareholder value and society.

Level 1 Thinking: The Level of Pay

Much of the debate is on what I call a Level 1 issue - the level of pay. For example, in September 2013, the SEC mandated disclosure of the ratio of the CEO’s pay to the median employee’s pay. The European Commission is contemplating going further and requiring a binding vote on this ratio. Separately, proposals to increase taxes – most prominently made by Thomas Piketty – are a response to seemingly excessive pay levels.

While high taxes or ratio caps would indeed address income inequality (an important topic, but beyond the focus of this article), it's very unclear that they would do much to improve shareholder (or stakeholder) value. The levels of CEO pay, while very high compared to median employee pay – and thus a politically-charged issue – are actually very small compared to total firm value. For example, median CEO pay in a large US firm is $10 million – only 0.05% of a $20 billion firm. That’s not to say that it’s not important – a firm can't be blasé about $10 million – but that other dimensions may be more important.

Level 2 Thinking: The Sensitivity of Pay

Instead, what matters for firm value isn't the level of pay, but the incentives that it provides to CEOs: as Jensen and Murphy (1990) famously argued, “it’s not how much you pay, but how”. Level 2 thinking studies the sensitivity of pay to performance. Specifically, it looks at how much of a manager’s total pay is comprised of stock and options (which are sensitive to firm value) rather than cash salary (which is less so). As the thinking goes, greater stock and options align the CEO more with shareholders and thus provide superior incentives. Indeed, Jensen and Murphy bemoaned the low equity incentives at the time as evidence that CEOs were “paid like bureaucrats”.

However, while seemingly intuitive, the idea that better-incented CEOs perform better is unclear. Out of all the banks, Lehman Brothers had arguably the compensation scheme closest to what Level 2 thinkers argued is the ideal – very high employee stock ownership. Using a larger sample, Fahlenbrach and Stulz (2011) “find some evidence that banks with CEOs whose incentives were better aligned with the interests of shareholders performed worse and no evidence that they performed better.” Indeed, the European Commission has recently capped banker bonuses at two times salary, seemingly reducing bankers’ incentives to perform well – but also reducing their punishment if things go badly.

Level 3 Thinking: The Structure of Pay

The concern with high equity incentives is that they encourage CEOs to pump up the short-term stock price at the expense of long-run value – for example, writing sub-prime loans and then cashing out their equity before the loans become delinquent. But, the root cause of this problem isn't the amount of stock and options that the CEO has, but their vesting horizon – whether they vest in the short-term or long-term, and thus whether they align the CEO with short-term or long-term shareholder value. Level 3 thinking thus focuses on the structure of pay.

There's anecdotal evidence that horizons mattered in the financial crisis. Angelo Mozilo, the former Countrywide CEO, made $129 million from stock sales in the twelve months prior to the start of the crisis; a Wall Street Journal article entitled “Before the Bust, These CEOs Took Money Off the Table” documented similar practices among other bank CEOs. But, we can't form policy based on a handful of anecdotes - it's important to undertake a systematic study.

In this paper, Vivian Fang (Minnesota), Katharina Lewellen (Dartmouth) and I study how a CEO behaves in years in which he has a significant amount of shares and options vesting. CEOs typically sell their equity upon vesting to diversify, and so vesting equity makes them particularly concerned about the short-term stock price.

We find that, in years in which the CEO has significant equity vesting, he cuts investment in many forms - R&D, advertising, and capital expenditure. Moreover, in these years, he's more likely to exactly meet or just beat analyst earnings’ forecasts – if the forecast is $1.27 per share, he reports earnings of $1.27 or $1.28. Indeed, the magnitude of the investment cuts is just enough to allow the CEO to meet the target. Thus, vesting equity induces the CEO to act myopically – to cut investment to meet short-term targets. These results are robust to controlling for the CEO’s other equity incentives, such as his unvested equity and voluntary holdings of already-vested equity.

In this paper, Luis Goncalves-Pinto (National University of Singapore), Yanbo Wang (INSEAD), Moqi Xu (LSE) and I show that, in months in which the CEO has vesting equity, he releases more news. This is an easy way to pump up the short-term stock price, as news attracts attention to the stock. This attention also increases trading volume, which allows the CEO to cash out his equity in a more liquid market. Indeed, we find that these news releases lead to significant increases in the stock price and trading volume in a 16-day window, but the effect dies down over 31 days, consistent with a temporary attention boost. The median CEO cashes out all of his vesting equity within 7 days, so within the window of inflation.

The increase in news releases only relates to discretionary news (such as conferences, client and product announcements, and special dividends), which are within the CEO’s control, and not non-discretionary news (such as scheduled earnings announcements). Moreover, the CEO reduces discretionary news releases in both the month before and the month after the vesting month, suggesting a strategic reallocation of news into the vesting month and away from adjacent months. In addition to releasing more news items in the vesting month, the CEO releases more positive news – media articles immediately following these news releases contain significantly more positive words than normal.

Why Do We Care?

Both consequences of vesting equity are important. Investment is critical to the long-run health of a company. Indeed, in the 21st century, most firms compete on product quality rather than cost efficiency, for which intangible assets – such as brand strength and innovative capabilities – are particularly important. Building such intangibles requires sustained investment, particularly in R&D and advertising. Moving to news, many stakeholders, such as employees, suppliers, customers, and investors, base their decision on whether to initiate, continue, or terminate their relationship with a firm on news, or on stock prices that are affected by news. In addition to these efficiency consequences, news also has distributional consequences by affecting the price at which shareholders trade. Indeed, Regulation FD aims to “level the playing field” between investors by prohibiting selective disclosure of information. Public news releases to all shareholders achieve this goal – but the CEO may delay news until months in which he has vesting equity.

What Can Be Done?

One solution is to lengthen vesting periods. While increasing vesting horizons from (say) 3 to 5 years may not be as politically alluring to voters as a rant about the level of pay, it will likely have a much greater effect on shareholder value and society. For example, such a change will now incentivize the CEO to engage in a long-term investment with a 4-year horizon.

Can clawbacks achieve the same thing, e.g. pay out a bonus upon good short-term performance and then claw it back if long-term performance lags? Despite being widely heralded and attracting much fanfare, the legality of clawbacks is very unclear: I know of no cases in which a clawback has been successfully implemented. The CEO may have spent the money, or transferred it to a spouse or a relative. Trying to claw back a bonus that you have prematurely paid (based on short-term performance) is like shutting the barn door after the horse has bolted. The best solution is not to pay out the bonus in the first place, but wait until 5 years.

Is the lengthening of a vesting horizon simply kicking the can down the road? All equity has to vest at some point, and doesn’t this mean that the CEO will now act myopically in 5 years’ time rather than 3 years’ time? I have some sympathy with this concern – indeed, one of the other implications of our papers is that boards of directors, and other stakeholders, should scrutinize CEOs in months (or years) in which they have significant equity vesting. Since most of the current focus is on Levels 1 and 2 of the CEO’s contract, most stakeholders don’t pay attention to vesting horizons. But, the main benefit will be on the CEO’s behavior today – such a lengthening will now encourage him to take that 4 year project.

In short, paying CEOs according to the long-term will ensure they have the long-term interests of the firm at heart.