Cleary: Doing Good Gives Firms an Investment Edge
Given the growing interest in corporate social responsibility (CSR), researchers have been busy trying to make the business case for being a good corporate citizen. Most of the research has focused on potential profit-based outcomes. Queen’s School of Business finance professor Sean Cleary, with colleagues Najah Attig (Saint Mary’s University), Sadok El Ghoul (University of Alberta), and Omrane Guedhami (University of South Carolina), opted to search for CSR benefits elsewhere — in firms’ access to financial capital. In their paper in the Journal of Business Ethics, they show that firms scoring higher on CSR measures are able to access capital at a lower premium than firms scoring lower. In this conversation, Cleary explains how the study was conducted and what it means for managers and investors.
On why and how the study was undertaken
Up to now profit-based measures have mainly been used to try to capture CSR’s effect. But if you look purely at profitability, you’re normally measuring historical performance. We’ve chosen to look at access to financial capital, specifically at investment-cash flow sensitivity, which is an indicator of financial constraints or ease of raising external financing.
In a nutshell, investment-cash flow sensitivity relates to the wedge between the cost of internal and external capital. The lower the wedge the better. For example, a large firm that’s well governed may pay 9.5 percent for externally-sourced investment funds versus 9 percent for internal funds. A smaller firm that’s not as well known may face a cost of, say, 10 percent for internal funds but 14 percent for external funds: obviously they’re going to try and finance everything in-house. The lower the wedge the more able firms are to finance their investment projects.
To examine the relationship between CSR and investment-cash flow sensitivity, we used financial data and CSR-ratings from a number of government and media sources as well as company filings for some 3,000 firms for the period 1992 to 2010. The CSR ratings covered seven different areas: community, corporate governance, diversity, employee relations, environment, human rights, and product characteristics.
On what the study found
Our results suggest that CSR tends to reduce the wedge between internal and external funds and, in turn, the investment-cash flow sensitivity.
There are a few factors that explain this relationship. One, by investing in CSR, firms not only strengthen their reputation as socially responsible actors but they also enhance their political visibility, which subjects them to more public pressure and monitoring. And two, CSR seems to improve firms’ “information quality.” CSR attracts greater investor and media attention, which increases the demand for information disclosure. Executives of these firms tend to produce higher quality financial reports and are less likely to engage in earnings management. The markets react by saying, Yes, this is a good thing, there’s management quality and integrity. As a result, they don’t require a big wedge between the cost of internal and external funds.
We also found that investment-cash flow sensitivity decreases when CSR strengths increase. This suggests that a firm’s ability to build strong ties with its stakeholders, which translates into a stronger competitive advantage and better access to financial capital, depends on the firm’s ability to engage in proactive CSR.
Some of the dimensions of CSR created more of a powerful affect than others. The community, diversity, and human rights CSR activities are the key drivers. These are more socially desired initiatives — discretionary efforts — as opposed to socially required CSR initiatives relating to, say, employee rights or environmental responsibility.
Our findings are in line with recent evidence showing that CSR is associated with lower cost of bank debt, higher credit ratings, better access to finance, higher earnings quality, lower equity financing costs, increased disclosure, and enhanced credibility.
On practical implications
For practitioners and regulators, our findings suggest that an effective way to foster firm growth and protect the interests of stakeholders is to provide firms with incentives to invest in CSR. For example, regulatory authorities can design training programs and disclosure requirements that make it easier to adopt CSR practices.
Investors and portfolio managers may want to take into consideration firms’ non-market strategic behaviour when selecting stocks, because such behaviour is likely to strengthen firms’ competitive position and ease their access to external financing. Investors aren’t going to form a portfolio based solely on CSR, but when they’re going through the myriad of factors, a higher SRI (socially responsible investing) score is a positive thing. Even if you’re not an SRI-investing firm, it’s probably something you'll want to include on your checklist.
— Interview by Alan Morantz