Research identifies the role of credit ratings as a disciplining mechanism for overinvestment behaviours on overconfident CEOs – limiting their over-investment, especially in the case of firms with abundant resources and large debt capacity.
Harnessing Chief Executive Officer (CEO) overconfidence whilst exploiting their risk appetite and over-optimism has long been of interest to management scholars and firms. In this paper, based on the behavioural theory of the firm, we conjecture that information intermediaries moderate the impact of CEO overconfidence on investment decisions.
We hypothesise that overconfident CEOs’ reluctance to access external financing indicates that they will reduce their acquisition activity at high rating levels, where the risk from a downgrade and subsequently the unobstructed access to internal financing is at its highest. After controlling for endogeneity bias, we show that an additional increase in rating by one notch of highly rated firms managed by overconfident CEOs reduces the probability of engaging in acquisition activity by 0.11 percent.
In addition, we postulate that when faced with downgrade risk, overconfident CEOs refocus their acquisition activities to a more conservative investment strategy that does not jeopardise their access to debt financing. We show that overconfident CEOs in firms with investment-speculative boundary ratings reduce the likelihood of engaging in acquisition activity by 15.7 percent when their firms are assigned a negative rating outlook. We also show that this reduction in acquisitiveness by overconfident CEOs at high rating levels is viewed as value-increasing by the market. Overall, credit ratings appear to have positive unintended consequences for the firm in the form of enhancing CEO monitoring and refocusing acquisition strategies.
Keywords: Behavioural theory of the firm, CEO overconfidence, credit ratings, mergers and acquisitions
JEL: G24, G32, G34