Bridge over ocean
8 August 2019 CFA Institute Journal Review

Does Corporate Social Responsibility Reduce the Costs of High Leverage? (Digest summary)

  1. Priyanka Shukla, CFA

It is commonly acknowledged that a high-leverage firm can lose market share because of customer or competitor actions. By reducing the cost of high leverage, corporate social responsibility (CSR) can help firms keep customers and ward off predatory competitors. The authors’ results support the stakeholder maximization view of CSR.

What Is the Investment Issue?

The authors seek to answer two questions. First, does corporate social responsibility (CSR) attenuate the negative effects of high leverage for a firm? And second, if so, how or through what channels does it mitigate such effects?

The authors explore CSR’s role in risk management and its effect on the firm’s value and state that “CSR investment is akin to an insurance product. Firms pay insurance premiums in the form of CSR investments when they are financially healthy, and they receive the benefits of CSR insurance when they are in distress.”

Many firms and institutional and retail products directly or indirectly incorporate CSR into their product or marketing design. Institutional investors on the buy side are increasingly factoring CSR and environmental, social, and governance (ESG) risks into their investment strategies and portfolios. On the retail side, millennial investors might weigh CSR factors more heavily in their investment philosophy than older generations do.

How Did the Authors Conduct This Research?

The authors use the Fama–French industry classification to calculate variables, including industry-adjusted sales growth for US firms using the Compustat database. Next, they use the MSCI ESG STATS database to calculate industry-adjusted CSR scores for each firm. After excluding missing values and outliers, the final panel data consist of about 16,000 total firm-year observations for 2,700 firms during 1996–2012.

The authors posit that CSR affects the costs of high leverage. They create a regression model that uses CSR, high leverage (HLEV), and the product of CSR and HLEV and other control variables as independent variables, with industry-adjusted sales growth as the dependent variable. Next the authors examine the channels through which the effect of CSR on high-leverage costs operates. They use R&D expenditure as a proxy for product specialization; industry average level of debt as a proxy for the financial strength of competitors; and the four-firm concentration ratio and the Herfindahl–Hirschman Index (HHI) as proxies for industry concentration. They define high and low customer sensitivity following previous research.

What Are the Findings and Implications for Investors and Investment Professionals?

The authors find that CSR mitigates the cost of high leverage, as measured by change in sales growth, through both the customer and competitor channels. It helps highly levered firms better retain customers and ward off predatory competitors.

Specifically, leverage negatively affects sales growth, with high-leverage firms showing 1.6% lower sales growth relative to the industry. But CSR significantly mitigates the negative effects of high leverage. CSR has a greater effect when customers purchase a specialized product, because there is an implicit claim of servicing.

Also, the effect of CSR is higher in more customer-sensitive industries (versus more industrial buyers). The effect of CSR on high-leverage firms is larger for firms from more-concentrated industries.

These results may be useful to risk managers, institutions, and investors as competitive forces continue to move the industry to more transparency and disclosure on CSR.

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