Moneycontrol
Sep 20, 2017 11:20 AM IST | Source: Moneycontrol.com

Why betting on stocks with high promoter pledges is a risky affair

Depending on the circumstances, promoter pledge of shares could either be read as a sign of great conviction or an act of desperation.

Why betting on stocks with high promoter pledges is a risky affair

Tejas Khoday

The stock market in India has witnessed numerous instances of the promoters pledging their shares. Consequently, thousands of common investors tend to wonder about such trends and wish to know the reason behind this, which in fact is not a complicated riddle to solve.

By and large, the promoters pledge their shares to raise the debt for their business and meet the planned expenditure including future growth. It could be to raise working capital loans or long-term loans to increase their holdings in the company or to even finance an acquisition.

Since promoters' equity stake is their proclaimed asset, they can utilise the amount raised in any way. It is a good sign as long as the funds are being utilised for the same company. But the investors should be wary if the funds are being used for personal reasons or towards activities which will not benefit the company.

In such a scenario, it is essential for investors to know what are the risks associated while investing in high pledge companies. They must gear up to identify risk vis-à-vis volatility while investing and realise that when promoters pledge their shares to raise loans, it can have a major impact on the stock price.

Since the pledged shares are liquid and traded on the exchange, the price can fluctuate quite a bit. In the event that the stock price goes down below a certain limit agreed by both parties to loan agreement, the promoter has to pledge additional shares to ensure that collateral value is maintained.

The loans are structured in a way that collateral value has to be updated on a timely basis in a marked-to-market type of setup. In case the promoter fails to pledge additional shares when required or repay the loan on time, the bank/lender reserves the right to sell the pledged shares in the open market to recover the value of the outstanding loan.

The possibility of this happening can have a significant impact on the stock and the prices might become more volatile than usual. The act of selling a huge chunk of shares by lenders in the open market can make the stock prices crash if there are no immediate takers. It is common for promoters to pledge their shares and raise debt capital, but the danger is when they pledge a significant portion of their ownership in the company.

Depending on the circumstances, it could either be read as a sign of great conviction or an act of desperation. For example, if a promoter group is raising capital to purchase an additional stake in their own profit-making business, then it's a good sign.

However, if the business is not doing well and the promoters are betting on a turnaround amidst grim circumstances or acting out of an emotional bias, then it's a warning sign. Also, if a promoter is pledging his shares to raise debt for a new business with no proven revenues or cash flows, it could become a problem. If the expectations turn sour, the pledged shares can turn into a stranglehold for the promoters and it is not desirable to the existing shareholders either.

Most Indian companies are promoter-centric as they have the most dominant share of the ownership structure. Forced selling by the lenders in the event of non-payment of loans could set off a chain of unpredictable reactions which would ultimately hurt the existing shareholders.

If investors have sufficient knowledge about their financial health and are confident of a bright future, then they could own shares. If the company's earnings continue to grow, everything will be fine. Most companies which have high promoter pledged shares are small and mid-cap by size.

As of August 11, the total value of promoters' pledge holding from 3141 companies stands at Rs 2,48,181 crore. In my opinion, it is best to stay away from them because if the promoters are unable to repay the loans, they might indulge in other activities like increasing their salary compensations, perks, bonuses or other unethical practices to earn money for as long as they continue to be in control.

Also, considering the shareholding structure of small companies, the promoters control the board and the board appoints the executives. Such an environment is likely to have corporate governance issues and hence, it is irrational to expect wealth creation.

Thus, the question emerges as to what is the difference between pledging of shares by general shareholders and promoters? Indeed, the ownership of other shareholders is usually much smaller and mostly their interests are financial rather than strategic.

If they borrow shares and are unable to repay, the lender will sell their shares but it will not have any material impact on how the company is run unless the size of ownership was significant enough to instigate a hostile takeover which is rarely the case.

However, the consequences of the lender liquidating promoters' pledged shares in the open market can have a game changing impact on the future of the company liquidating promoters' pledged shares in the open market can have a game-changing impact on the future of the company amidst the legal disclaimers which can be referred to SEBI in case of serious anomalies for redressal of grievances.

The writer is Co-founder & CEO, FYERS
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