- Top of page
- DATA AND SAMPLE
- DISCUSSION AND CONCLUSION
We investigate whether superior performance on corporate social responsibility (CSR) strategies leads to better access to finance. We hypothesize that better access to finance can be attributed to (1) reduced agency costs due to enhanced stakeholder engagement and (2) reduced informational asymmetry due to increased transparency. Using a large cross-section of firms, we find that firms with better CSR performance face significantly lower capital constraints. We provide evidence that both better stakeholder engagement and transparency around CSR performance are important in reducing capital constraints. The results are further confirmed using several alternative measures of capital constraints, a paired analysis based on a ratings shock to CSR performance, an instrumental variables approach, and a simultaneous equations approach. Finally, we show that the relation is driven by both the social and environmental dimension of CSR. Copyright © 2013 John Wiley & Sons, Ltd.
- Top of page
- DATA AND SAMPLE
- DISCUSSION AND CONCLUSION
In recent decades, a growing number of academics as well as top executives have been allocating a considerable amount of time and resources to corporate social responsibility (CSR) strategies—i.e., the voluntary integration of social and environmental concerns in their companies' operations and in their interactions with stakeholders (European Commission, 2001). According to the latest UN Global Compact-Accenture CEO study (2010), 93 percent of the 766 participant CEOs from all over the world declared CSR as an ‘important’ or ‘very important’ factor for their organizations' future success (UN Global Compact-Accenture, 2010). Despite this large amount of attention, a fundamental question remains unanswered: does CSR lead to value creation and, if so, in what ways? The extant research so far has failed to give a definitive answer (Margolis, Elfenbein, and Walsh, 2007). In this article, we argue and provide empirical evidence for one specific mechanism through which CSR may generate value in the long run: by lowering the idiosyncratic constraints that a firm faces in financing operations and strategic projects and allowing it to undertake profitable investments that it would otherwise bypass.
By ‘capital constraints,’ we refer to those market frictions that may prevent a firm from funding all desired (i.e., net present value-positive) investments. This inability to obtain finance may be ‘due to credit constraints or inability to borrow, inability to issue equity, dependence on bank loans, or illiquidity of assets’ (Lamont, Polk, and Saa-Requejo, 2001: 529). Prior studies found that capital constraints play an important role in strategic decision making by directly affecting the firm's ability to undertake major investment decisions (Stein, 2003) and by influencing the firm's capital structure choices (e.g., Hennessy and Whited, 2007). Moreover, capital constraints are associated with a firm's subsequent stock market performance (e.g., Lamont et al., 2001).
The thesis of this article is that firms with better CSR performance face lower capital constraints. This is due to several reasons. First, superior CSR performance is linked to better stakeholder engagement, limiting the likelihood of short-term opportunistic behavior (Benabou and Tirole, 2010; Eccles, Ioannou, and Serafeim, 2012) and, as a result, reducing overall contracting costs (Jones, 1995). Second, firms with better CSR performance are more likely to disclose their CSR activities to the market (Dhaliwal et al., 2011) to signal their long-term focus and differentiate themselves (Spence, 1973; Benabou and Tirole, 2010). CSR reporting creates a positive feedback loop: (1) increases transparency around the social and environmental impact of companies and their governance structure; and (2) may change the internal control system that further improves compliance with regulations and the reliability of reporting. Therefore, the increased data availability and quality reduces the informational asymmetry between the firm and investors (e.g., Botosan, 1997; Khurana and Raman, 2004; Hail and Leuz, 2006; Chen, Chen, and Wei, 2009; El Ghoul et al., 2011), leading to lower capital constraints (Hubbard, 1998). In sum, because of lower agency costs through stakeholder engagement and increased transparency through CSR reporting, we hypothesize that a firm with superior CSR performance will face lower capital constraints.
To investigate the impact of CSR on capital constraints, we use a panel dataset from Thomson Reuters ASSET4 for 2,439 publicly listed firms during the period 2002 to 2009. Thomson Reuters ASSET4 rates firms' performance on three dimensions (‘pillars’) of CSR: social, environmental, and corporate governance. The main dependent variable of interest is the ‘KZ index,’ first advocated by Kaplan and Zingales (1997) and subsequently used extensively in the corporate finance literature (e.g., Lamont et al., 2001; Baker, Stein, and Wurgler, 2003; Almeida, Campello, and Weisbbach, 2004; Bakke and Whited, 2010; Hong, Kubik, and Scheinkman, 2011) as a measure of capital constraints.
The results confirm that firms with superior CSR performance face lower capital constraints. We test and confirm the robustness of the results in several ways. We substitute the KZ index with several other measures of capital constraints, including an indicator variable for stock repurchase activity, an equal-weighted KZ index, the SA index (Hadlock and Pierce, 2010), and the WW index (Whited and Wu, 2006). Moreover, we construct measures and test empirically for the two hypothesized mechanisms—stakeholder engagement and CSR disclosure—and we find that both variables are significantly related to capital constraints in the predicted direction. Furthermore, in subsample analysis, we find that the link between CSR performance and capital constraints is economically larger and highly significant for the subsample of firms that are most capital constrained, contradicting the argument that CSR is a ‘luxury good.’ Importantly, the results remain unchanged when we use the introduction of ESG (environmental, social, governance) ratings as a shock to CSR performance (Chatterji and Toffel, 2010) and subsequently investigate changes in the CSR index and capital constraints for a paired sample of firms. We also implement a two-stage feasible efficient generalized method of moments (GMM) estimation and a three-stage least squares simultaneous equations model with validity-tested instruments, mitigating potential endogeneity concerns or correlated omitted variables issues and increasing confidence in the directionality of our results. Finally, we explore the impact of the three components of CSR individually and find that the impact on capital constraints is driven by social and environmental performance, suggesting that both social and environmental issues are relevant for investors.
Corporate social responsibility
Numerous studies have investigated the link between CSR and financial performance through a theoretical and an empirical lens. In particular, research rooted in neoclassical economics argued that CSR unnecessarily raises a firm's costs, putting the firm in a position of competitive disadvantage vis-à-vis its competitors (Friedman, 1970; Aupperle, Carroll, and Hatfield, 1985; McWilliams and Siegel, 1997; Jensen, 2002). Predominantly based on agency theory, some studies have argued that employing valuable firm resources to engage in CSR results in significant managerial benefits rather than financial benefits to the firm's shareholders (Brammer and Millington, 2008).
In contrast, other scholars have argued that CSR can have a positive impact by providing better access to valuable resources (Cochran and Wood, 1984; Waddock and Graves, 1997), attracting and retaining higher quality employees (Turban and Greening, 1997; Greening and Turban, 2000), allowing for better marketing of products and services (Moskowitz, 1972; Fombrun, 1996), creating unforeseen opportunities (Fombrun, Gardberg, and Barnett, 2000), and contributing toward gaining social legitimacy (Hawn, Chatterji, and Mitchell, 2011). Furthermore, CSR may function similarly to advertising, increasing demand for products and services, reducing consumer price sensitivity (Dorfman and Steiner, 1954; Navarro, 1988; Sen and Bhattacharya, 2001; Milgrom and Roberts, 1986), and even enabling firms to develop intangible assets (Gardberg and Fombrun, 2006; Hull and Rothenberg, 2008; Waddock and Graves, 1997). From a stakeholder theory perspective (Freeman, 1984; Freeman, Harrison, and Wicks, 2007; Freeman et al., 2010), which suggests that CSR includes managing multiple stakeholder ties concurrently, scholars have argued that CSR can mitigate the likelihood of negative regulatory, legislative, or fiscal action (Freeman, 1984; Berman et al., 1999; Hillman and Keim, 2001), attract socially conscious consumers (Hillman and Keim, 2001), or attract financial resources from socially responsible investors (Kapstein, 2001).
Empirical work investigating the link between CSR and corporate financial performance (measured by various accounting or stock market measures) has resulted in contradictory findings, ranging from a positive to a negative relation, to a U-shaped or even to an inverse-U shaped relation (Margolis and Walsh, 2003; Margolis et al., 2007). According to McWilliams and Siegel (2000: 603), such conflicting results were due to ‘several important theoretical and empirical limitations’ of prior studies; some have argued that prior work suffered from ‘stakeholder mismatching’ (Wood and Jones, 1995), the neglect of ‘contingency factors’ (e.g., Ullmann, 1985), ‘measurement errors’ (e.g., Waddock and Graves, 1997), and omitted variable bias (Aupperle et al., 1985; Cochran and Wood, 1984; Ullman, 1985).
More recent work focuses on understanding the role of capital markets as an intermediate mechanism through which CSR can create long-term value. For example, Lee and Faff (2009) show that firms with high CSR scores have lower idiosyncratic risk, while Goss (2009) shows that firms with low CSR scores are more likely to experience financial distress. Moreover, Ioannou and Serafeim (2013) show a positive impact of CSR on sell-side analysts' recommendations, while Goss and Roberts (2011) find that firms with the worst CSR scores pay seven to 18 basis points more on their bank debt compared to firms with higher scores. Relatedly, Dhaliwal et al. (2011) find that the voluntary disclosure of CSR activities leads to a reduction in the firm's cost of capital while attracting dedicated institutional investors and analyst coverage. El Ghoul et al. (2011) focus on a sample of U.S. firms and find that firms with better CSR scores exhibit lower cost of equity capital.
In this article, we contribute to this emerging literature that investigates the relation between capital markets and socially responsible firms by focusing on the critical impact that CSR has on idiosyncratic firm capital constraints. Unlike prior studies that mainly focused only on U.S. firms, our findings are based on a broad sample of firms originating from 49 countries. Moreover, our study adds to prior work by considering other forms of capital constraints beyond the cost of equity or debt, including the inability to borrow, the inability to issue equity, the dependence on bank loans, or the illiquidity of assets (Lamont et al., 2001). More importantly, this article identifies the mechanisms through which better CSR performance contributes to lower capital constraints. As we explain in the following section, understanding the impact of CSR on capital constraints is important given that prior literature has documented the key role of capital constraints in strategic investment decisions (Stein, 2003).
Companies undertake profitable (i.e., NPV-positive) investments with the goal of achieving superior performance and competitive advantage. The ability to finance such strategic investments, though, is directly linked to the idiosyncratic capital constraints that each firm faces. The investment function is derived from the firm's profit-maximizing optimization and postulates that investment depends on the marginal productivity of capital, interest rate, and tax rules (Summers et al., 1981; Mankiw, 2009). As Stein (2003: 125) notes, according to this paradigm ‘nothing else should matter: not the firm's mix of debt and equity financing, nor its reserves of cash and securities, nor financial market ‘conditions,’ however defined.’ Yet subsequent studies that examine equity and debt markets show that cash flow (i.e., a firm's internal funds) also plays a key role in determining the firm's level of investment (Blundell et al., 1992; Whited, 1992; Hubbard and Kashyap, 1992). Importantly, some studies show that financially constrained firms are more likely to diminish investments in a wide range of strategic activities (Hubbard, 1998; Campello, Graham, and Harvey, 2010), including investments in inventory (Carpenter, Fazzari, and Petersen, 1998) and R&D activities (Himmelberg and Petersen, 1994; Hall and Lerner, 2010), pricing for market share (Chevalier, 1995), and labor hoarding during recessions (Sharpe, 1994)—significantly and adversely affecting the capacity of the firm to grow over time.
In terms of firm survival and performance, it is also critical to understand that capital-constrained firms are forced to forgo investments that they would otherwise make. In other words, these are investment opportunities that are profitable (i.e., NPV-positive) yet they are not pursued due to financing frictions. It follows then that, all else equal, the relaxation of capital constraints for such firms would enable them to undertake otherwise profitable investments and improve their performance. Recently for example, Faulkender and Petersen (2012) use the American Jobs Creation Act (AJCA) of 2004 as a temporary shock to the cost of internal financing and find that, indeed, AJCA resulted in large increases in investment, but only among the subset of firms that were capital constrained.
A second set of studies has explored how capital constraints affect the firm's entry and exit decisions into markets or industries. More specifically, using personal tax return data on entrepreneurs, Holtz-Eakin, Joulfaian, and Rosen (1994a) find that the size of an individual's inheritance—regarded as an exogenous shock to one's wealth—had a significant positive effect on the probability of becoming an entrepreneur. A follow-up paper (Holtz-Eakin, Joulfaian, and Rosen 1994b) shows that firms founded by entrepreneurs with larger inheritances (thus, lower capital constraints) are also more likely to survive. Aghion, Fally, and Scarpetta (2007) document a similar mechanism using firm-level data from 16 economies, comparing new firm entry and their subsequent postentry growth trajectory.
A third stream of literature accounting for both incumbents and new entrants (see Levine (2005) for a comprehensive review) argues that capital constraints affect smaller, newer, and riskier firms relatively more, channeling capital to where the marginal return is highest. As a result, countries with better functioning financial systems that can ease such constraints experience faster industrial growth. Given the idiosyncratic levels of constraints faced by companies of various sizes, scholars turned to capital constraints as an explanation for why small companies pay lower dividends, become more highly leveraged, and grow more slowly (Cooley and Quadrini, 2001; Cabral and Mata, 2003). For example, Carpenter and Petersen (2002) show that the asset growth of small U.S. firms is constrained by their internal capital and that firms able to raise additional external funds enjoy higher growth rates. Becchetti and Trovato (2002) find qualitatively similar results using a sample of Indian firms, and Desai, Foley, and Forbes (2008) confirm the same relation in a currency crisis setting. Finally, Beck et al. (2005), using survey data from global companies, document that firm performance is vulnerable to various financial constraints and that small companies are disproportionately affected due to tighter limitations. In sum, the literature to date has revealed that seeking ways to relax capital constraints is crucial to firm-level survival and growth, industry-level expansion, and even country-level development.
The link between CSR and capital constraints
Based on neoclassical economic assumptions that postulate a flat supply curve for funds in the capital market at the level of the risk-adjusted real interest rate, Hennessy and Whited (2007: 1705) argue that ‘a CFO can neither create nor destroy value through his financing decisions in a world without frictions.’ However, in reality, the supply curve for funds is effectively upward sloping rather than horizontal—at levels of capital that exceed the firm's net worth—because of market imperfections such as informational asymmetries (Greenwald, Stiglitz, and Weiss, 1984; Myers and Majluf, 1984) and agency costs (Bernanke and Gertler, 1989, 1990). In other words, when the likelihood of agency costs is high and the amount of capital the firm requires for investments exceeds its net worth (and it is, therefore, uncollateralized), capital providers are compensated for their information (and/or monitoring) costs by pricing capital at a higher interest rate.1 Consequently, the greater these market frictions are, the steeper the supply curve and the higher the cost of external financing.
It follows then that the adoption and implementation of firm strategies that reduce informational asymmetries or reduce the likelihood of agency costs make the supply curve for funds effectively less steep. Therefore, better access to funds lowers the idiosyncratic capital constraints the firm is facing, favorably impacting its strategic objectives by allowing it to undertake major investments that would not otherwise have been profitable and/or by influencing the capital structure choices of the firm (e.g., Hennessy and Whited, 2007).
We argue that the adoption and implementation of CSR strategies that lead to superior CSR performance result in lower idiosyncratic capital constraints for the firm because of two complementary mechanisms. First, superior CSR performance captures the firm's commitment to and engagement with stakeholders on the basis of mutual trust and cooperation (Jones, 1995; Andriof and Waddock, 2002). Consequently, as Jones (1995: 420) argues, ‘because ethical solutions to commitment problems are more efficient than mechanisms designed to curb opportunism, it follows that firms that contract with their stakeholders on the basis of mutual trust and cooperation […] will experience reduced agency costs, transaction costs, and costs associated with team production.’ Such agency and transaction costs, according to Jones (1995: 422), would include ‘monitoring costs, bonding costs, search costs, warranty costs, and residual losses.’ Moreover, superior engagement with stakeholders can enhance a firm's revenue or profit generation—also contributing toward the persistence of superior profitability (Choi and Wang, 2009)—through higher quality relationships with customers and business partners and among employees; this, in turn, improves interactions with customers and new product development.2 In other words, superior stakeholder engagement may directly limit the likelihood of short-term opportunistic behavior (Benabou and Tirole, 2010; Eccles et al., 2012), and it also represents a more efficient form of contracting with key stakeholders (Jones, 1995) that could lead to enhanced revenue or profit generation which, in turn, is rewarded by the markets.
Second, prior studies have shown that firms with superior CSR performance are more likely to publicly disclose their CSR strategies by issuing sustainability reports (Dhaliwal et al., 2011) and are more likely to provide assurance of such reports by third parties, thereby increasing the credibility of such reports (Simnett, Vanstraelen, and Chua, 2009). Consequently, CSR reporting: (1) increases transparency with regard to the social and environmental impact of companies and their governance structure; and (2) may lead to changes in internal control system that further improve the compliance with regulations and the reliability of reporting. As a result, the extended availability of credible data about the firm's CSR strategies, in addition to its financial disclosures, further reduces informational asymmetry and results in lower capital constraints (Hubbard, 1998). Moreover, the resulting changes in internal managerial practices (Ioannou and Serafeim, 2011) may also reduce the likelihood of agency costs in the form of short-termism.
To summarize, we postulate that firms with superior CSR performance will face lower idiosyncratic capital constraints because of two mechanisms: (1) reduced agency costs and revenue/profit-generating potential resulting from more effective stakeholder engagement; and (2) reduced informational asymmetry resulting from more extended and more credible CSR disclosure practices and transparency.
DISCUSSION AND CONCLUSION
- Top of page
- DATA AND SAMPLE
- DISCUSSION AND CONCLUSION
In this article, we investigate whether CSR strategies affect the firm's ability to access finance in capital markets. Although it has been argued in the past that CSR may impose unnecessary costs to a firm (e.g., Galaskiewicz, 1997; Clotfelter, 1985; Navarro, 1988) and thus hinder its ability to access capital, here we provide evidence that, in fact, the reverse is true: firms with better CSR performance face lower capital constraints. We argue that this negative relation between CSR performance and capital constraints materializes via two distinct mechanisms. First, better CSR performance is associated with superior stakeholder engagement (Choi and Wang, 2009) that, in turn, significantly reduces the likelihood of opportunistic behavior and introduces a more efficient form of contracting with key constituents (Jones, 1995). In other words, stakeholder engagement based on mutual trust and cooperation reduces potential agency costs by pushing managers to adopt a long-term rather than a short-term orientation (Eccles, et al., 2012). Moreover, superior stakeholder engagement enhances the revenue or profit generating potential of the firm through higher quality relationships with customers and business partners and among employees. Second, firms with better CSR performance are more likely to publicly disclose their CSR activities (Dhaliwal et al., 2011) and consequently become more transparent and accountable. Higher levels of transparency reduce informational asymmetries between the firm and investors, thus mitigating perceived risk. Since the literature to date has argued that market frictions such as informational asymmetries and agency costs are the main reasons firms face upward sloping supply curves in the capital markets, our results show that firms with better CSR performance face a capital supply curve that is effectively less steep.
These results have implications for the current debate on whether and, importantly, in what ways CSR initiatives lead to value creation. Here, we document that firms with better CSR performance are better positioned to obtain financing in the capital markets. In turn, relaxation of capital constraints positively impacts the ability of firms to undertake profitable strategic investments that otherwise they would not; it also has a positive impact on stock market performance (e.g., Lamont et al., 2001).
With this study, we contribute to an emerging literature within CSR that highlights the important role that capital markets play in evaluating the potential for long-run value creation by firms that adopt CSR strategies (e.g., Lee and Faff, 2009; El Ghoul et al., 2011; Goss and Roberts, 2011). Allocating scarce financial capital to their most productive uses is the fundamental role that financial markets play and, in this article, we show that CSR has a significant impact on this capital allocation process: market participants are more willing to allocate scarce capital resources to firms with better CSR performance. Moreover, by disaggregating the CSR performance into its components, we are able to show at a more fine-grained level that both the social and the environmental aspect of CSR activities reduce capital constraints.
With our work, we also contribute to the extant literature on capital constraints. Prior studies in this area typically consider a portfolio of financially constrained versus a portfolio of financially unconstrained firms and investigate how the two portfolios exhibit different sensitivities of investment to either cash flow (Fazzari, Hubbard, and Petersen, 1988; Kaplan and Zingales, 1997; Hubbard, 1998; Cleary, 1999; Alti, 2003; Gatchev, Pulvino, and Tarhan 2010) or to nonfundamental movements in stock prices (Bakeret al., 2003). However, few studies (e.g., Lamont et al., 2001) have investigated which firms are more likely to be financially unconstrained and what characteristics, if any, the firms in each portfolio share. Our article contributes to this literature by showing that firms that engage in CSR activities face lower capital constraints, thus identifying tangible firm characteristics that are linked to the capital constraints a firm faces.
We recognize a number of limitations to our work. Firms could be in a position to game CSR ratings so as to gain access to the increasingly available SRI funds. This is surely plausible, but it is unlikely for a number of reasons. First, company-reported data is all but one of the many sources that are being used by Thomson Reuters ASSET4 to gather information. The list of sources would also include NGOs (and NGO Web sites), stock exchange filings, and independent news sources. As much as the company could ‘game’ its own reporting, it is unlikely that it would be able to influence to the same degree all of these third-party sources. Therefore, there is a significant degree of triangulation that occurs across numerous information originators.
Second, the Thomson Reuters ASSET4 data have been used extensively for investment purposes by professionals and, thus, have been ‘verified,’ to an extent, by the capital markets. In fact, it is estimated that investors representing more than €2.5 trillion assets under management use the ASSET4 data, including major investment houses. Furthermore, according to Thomson Reuters (2011: 17), ‘every answer to every data point question goes through a multi-step verification and process control, which includes a series of data entry checks, automated quality rules and historical comparisons, in order to ensure a high level of accuracy, timeliness and quality.’ This later issue also relates to a second potential limitation of this study: the quality of our data. Whereas a comprehensive validity test of this new dataset falls outside the scope of this article, this is surely one possible avenue through which our work could be extended in the future. Especially when compared to existing studies and datasets and accounting for our own extensive conversations with Thomson Reuters, we maintain a sufficient amount of confidence in the data.
Another potential issue with our work relates to the emergence of the SRI market and how such funds may influence the capital markets and CSR ratings. First, we note that despite the impressive growth of SRI funds in recent years, when compared to total assets under management globally, the level of SRI funds is still relatively small. As an additional robustness check, we constructed a country-level indicator variable capturing the existence (or lack thereof) of an SRI stock index in every country of our sample. We used this control variable as a proxy for the availability of SRI funds, and across all specifications, the coefficient on this variable remained insignificant. As SRI funds grow over time and in importance, future work adopting a more dynamic approach could seek to understand their potential impact on both the functioning of capital markets as well as the construction of CSR ratings.
Moreover, with regard to a potential link between SRIs and our independent variable, the CSR Index, we argue that although plausible, it is unlikely that investor behavior may be driving managerial decision making. Since stakeholder relations and CSR actions more broadly take several years to build and materialize in terms of profitability, the probability of a large enough SRI base retaining ownership for a sufficiently long amount of time to originate an organizational shift toward CSR strategies is relatively low. This would also require SRIs themselves to engage with the company over a long period of time in such a way as to actively push the corporation toward better CSR practices. In other words, it appears more likely that SRI funds will be attracted to organizations that score high on the CSR dimensions rather than SRI funds directly influencing firm practices, directing them toward being more socially responsible.
While we show that superior CSR performance may relax idiosyncratic capital constraints for firms, several issues remain open for future research. First, using data at the level of strategic projects, it would be interesting to explore whether, and in what ways, increased access to capital affects the type of strategic investments that firms decide to undertake. For example, do firms with better CSR performance pursue strategic projects that are more long-term oriented and more likely to incorporate environmental and social issues in their objectives? Second, whereas capital constraints is one important aspect of capital markets, more research needs to be undertaken in this domain for a better understanding of how capital markets perceive, evaluate, and reward or punish firms that voluntarily engage in CSR initiatives. Moreover, since we do find some evidence that capital constraints may, in fact, affect CSR performance, future research could adopt a more dynamic approach, and investigate over a longer time frame how the causal relationship evolves in the long run, particularly so for firms that are most constrained with low CSR performance, after they decide to undertake such investments in CSR initiatives.
Finally, in a business environment where an increasing number of CEOs consider CSR to be strategically critical and where the general public increasingly appreciates or even demands transparent, honest, and ethical business practices, our results have important managerial implications. We suggest that managers who are able to develop successful CSR strategies and, by extension, engage productively with key stakeholders can generate tangible benefits for their firms in the form of better access to financing.