Value-Based Management Sophistication, Risk Management, and Shareholder Value: Evidence from Credit Ratings

Abstract

This study investigates the risk management and shareholder value consequences of value-based management (VBM). Risk is a defining feature of the VBM framework. It sets the benchmark for the firm’s economic returns, as reflected in the cost of capital, and influences management decisions on the path to value creation. Focusing on credit risk as a key dimension of firm risk, we follow a sample of large, listed European firms from 2005 to 2020 and infer the extent of their VBM practices, defined as VBM sophistication, from corporate annual reports and changes in credit risk from external credit ratings by Moody’s. We find that VBM sophistication promotes decreases in credit risk, i.e., rating upgrades, while it is not associated with mitigating risk increases, i.e., rating downgrades. We establish financial constraints as a plausible moderator of this relationship, suggesting that the main result is driven by firms that use sophisticated VBM systems and face particularly high costs of increasing credit risk. Finally, we exploit discrete changes in credit risk (i.e., credit rating changes) to demonstrate that VBM-induced risk management creates value for shareholders. We examine both short-term capital market reactions to rating changes and correlations with future Tobin’s Q and find that VBM sophistication positively influences shareholder value in the context of credit risk increases but not decreases. In sum, this paper provides evidence of the risk management effect and shareholder value effect of VBM.

Keywords: Credit Risk, External Credit Rating, Financial Constraints, Risk Management, Shareholder Value, Value-Based Management

Classifications: G14, G24, G32, M41