Apart from financial performance, investors also give importance to the promoters of a company. Promoters who are known to adhere strictly to corporate governance principles add to the attractiveness of the company. Savvy investors derive a deep sense of comfort with such promoters. The converse is also true. Promoters who are notorious for corrupt activities in their business are largely shunned by long-term investors. In other words, almost all actions of promoters of companies are monitored in the markets. Pledging of shares by promoters is an important one. Let us understand the impact of pledging of shares by the promoters of a company on the valuation of its stock.
Why do promoters pledge shares?
Most of us borrow money many times in life. Sometimes we avail a home loan to buy a house, or we borrow money to fund the higher education of our children. But lenders require collateral. Without collateral, lenders do not lend easily. Similarly, promoters of companies borrow from time to time—either to fund business carried out by their company or to fund their ventures, which are being carried on outside of the listed company. Whatever be the case, they may pledge their shares—offer their shares in the company as collateral when borrowing money.
Many a time, lenders ask for personal guarantees from promoters. This is because the business environment in any sector is dynamic in nature. To add to the uncertainty, there is competition. These factors increase the unpredictability in the revenue growth of companies. Lenders are aware of this. Hence, they ask for personal guarantee of promoters. These personal guarantees need to be backed by an asset that can be sold quickly. Promoters’ stake in a company makes good collateral for a loan as it can be sold quickly.
If a promoter agrees to pledge his/her shares while borrowing, it offers an additional sense of security or a means to recover money for a lender. Lenders can lend to an already indebted company or promoter if they know that they can recover their money in no time at the first sign of trouble. Also, since promoters provide collateral, they can negotiate with banks over the rate of interest payable.
Further, there are situations in which promoters do not have any option but to pledge shares. This happens when promoters exhaust other means of funding.
How does lending backed by pledged shares work?
Usually, promoters approach a bank or non-banking financial company (NBFC) for loans. The loan-against-shares (LAS) deal is agreed upon between the promoters and the lender. Promoters agree on the cover they are supposed to offer in collateral. The cover is generally expressed as a percentage of the borrowed fund or multiple of the borrowed fund. For example if an LAS deal calls for two times cover, then a promoter has to arrange collateral in the form of pledged shares that are valued at two times the loan amount. If a promoter wants ₹100 crore as loan, he/she has to offer shares worth ₹200 crore as collateral.
But LAS deals involve a certain amount of uncertainty. Stock markets are volatile and the share price of a company fluctuates. This impacts the value of the pledged shares. In a booming market, if the stock price of a company goes up, then the cover also goes up. The trouble begins in a bear market or when the price of stock of the company falls. The cover offered in the form of shares may fall short when the stock price falls. For example, pledged shares worth ₹200 crore were offered as a cover were equal to two times the money borrowed – ₹100 crore. If the stock price corrects by 10%, then the stock offered as pledge also stands lower by 10% at ₹180 crore.
Due to these factors, LAS deals have clearly specified rules. If such a ‘covenant breach’ (the industry parlance for a fall below the prescribed level of cover for loan) takes place, then promoters are supposed to offer additional security within a predetermined period of time. In the above case, promoters will be expected to offer shares worth ₹20 crore as an additional security. If a promoter fails to do so, then the lender has the right to sell shares on the stock exchange and recover the money.
It must be noted here that when shares are offered as collateral, promoters retain their ownership rights attached to those shares. Promoters are also eligible to receive dividends on those shares, unless otherwise specified.
Impact on stock valuation
When a promoter opts for a loan against shares and pledges the shares as collateral, the same is reported to stock exchanges. This may not necessarily result in an adverse situation. For a company which is closely held by promoters, a pledge of a small fraction of shares need not be a bad omen.
But if a promoter pledges a substantial stake in a company, then analysts may take it as an adverse development. In such a situation, it is believed that promoters may be in need of money. If the stock price of such a company corrects and the lender sells its shares in the market to recover money, then the promoter may lose control over the company. These developments have an impact on the valuation of the company. The other shareholders could turn cautious, and may exit the stock. This may lead to sustained selling pressure on the stock. As the valuation of the stock contracts, its price also falls. This leads to more share pledging by promoters. And this vicious cycle continues.
Hence, to avoid being stuck in such a situation, it is advisable for investors to check the capital structure and indebtedness of the company they are investing in. Long-term investors avoid investing in companies that have high debt and pledging of shares by its promoters. These two factors severely impact the earnings’ prospects of such companies and also their stock valuation.
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