By Dilish K. Daniel
What is pledging and how is it done?
Pledging of shares simply means taking loans against the shares that one holds to meet business or personal requirements. It is done bygiving shares as collateral to lenders. This is one of the options that the promoters of companies uses to secure loans to finance future growth plans,meet working capital requirements,fund takeovers & mergers, and meet personal needs. Typically, the amount that is rented by banks and NBFCs to promoters as part of the pledge is less than the market value of the shares(or collateral). This differential is the margin which these lenders retain as security. This minimum collateral value is agreed in the contract between the lenders and the promoters. Thus ifthe price of the shares falls, the value of the collateral will also decrease. In order to make up the difference in the collateral value, the promoters will have to either come up with additional cash or pledge more shares to the lender. Otherwise the lender will have the right to sell the pledged shares. As long as the lenders don’t invoke their rights on the pledged shares, the ownership remains with the promoters as well as they don’t have any personal liability other than to the extent of their pledged shares
Why promoters pledge their shares?
Since the shares of a company
are considered as assets, it can be put to use as a security to take loans from
the banks. However, on a comparative
basis, it is safer to raise funds through either equity or debt. Then why do
promoters still look to raise funds through a pledge? The simple answer is that
all other options of raising fundsareexhausted. It could also mean that the management
is finding it hard to manage the existing debt which is prompting them to go
for pledging. It is generally observed that pledging
activitiesare high during periods of economic slowdown.
Is pledging a risk for the investors?
High level of pledging by
promoters is seen as a negative sign for the company and indicates poor cash flows, deteriorating
credit situation and promoters’ inability to meet short-term working capital
requirements. When a pledge is executed for purely working capital needs, it is
a little risky suggesting that company is finding it hard to raise capital.
Moreover, if things don’t go well as planned by the company, pledging can
eventually lead the company to a debt trap. The company will have to stand on a
pile of debt and consequent interest payments on the debts can reduce the
profitability ultimately
affecting their growth plans. Even good companies can end up in deep trouble.Thus
pledging of shares is one of the many important factors to check before
investing which many tend to overlook. High levels of pledging definitely a point of concern for all investors.
The possible consequences of pledge
Pledging of shares can create issues if the share price falls continuously. It may be due to many factors, like poor performance, negative news etc. This is because the promoters will now have to consistently pledge more shares to cover up the difference in the collateral value. This will further increase the pledge ratio raising a red flag. The stock price can also fall heavily on any news that lenders are selling the shares in the open market that are pledged. This may result in a further decline in the collateral value because of the panic selling by the public. Besides this sudden supply of shares can lead to further fall in price and is a risk for investors who may now have to sell the shares for a loss. Another adverse effect of selling pledged shares by the lenders is the change in the shareholding pattern of the company. This may affect the voting power of the promoters as they are holding fewer shares now which will affect their ability to make crucial decisions and can be fatal for current shareholders.
An analysis:The fall of Zee Entertainment share price
On 25th ofJanuary 2019, ZEE Entertainmentsaw a fall of around 30-35% in their stock prices even when their core business was running very efficiently. The stock price of ZEE was around Rs.600 in January 2018 and the market cap was almost Rs.60,000 crores. Then the stock scooped down to below Rs 320 in January 2019 with the market cap almost halving in a period of one year. This happened because the promoters pledged their shares to take loans (~Rs15000cr) to be used for other businesses (infrastructure business) which didn’t go well as expected. As a result Zee group faced intense pressure on loan repaymentrequiring promoters to sell their stake. Consequently the lenders also invoked their rights tosell the pledged shares. Promoter holdings ason March 2018 was ~42% which got reduced to~22% by September 2019 with 90%of it pledged. Thus, what we witnessed is a classic case of how promoter pledge can harm the company and its investors even with no major corporate governance issues. The promoter share pledge led to market-cap erosion which was primarily due to taking loans on shares of their successfully running business to help run their other uncertain businesses.
When is pledging considered less risky?
Around 5-10% pledging of sharesseen in fundamentally healthy companies should not be considered as a problem.If the company has ample future growth prospects such as an increasing operating cash flow and exiting growth plans, pledging of shares is not a big concern for them. Pledging for reasons like funding new projects and financing mergers and acquisitions are seen as okay as it is normally assumed that the promoters are trying to improve the company and they are ambitious about their plans.Thus, many a times, pledging of shares helps in the expansion of the company or to carry out new projects which can result in increased revenue in the future. It can be also seen that during a bull market, pledging of shares do not create many issues as the market is moving upwards and the investors are clearly optimistic and don’t bother a lot.
An Analysis: How granules is overcoming the pressure of promoter pledge..
Granules’ promoter pledge ratio in December 2018 reached a high of 60% dragging the price below Rs 90. Though this was a big concern for investors, there were some differences between the nature of pledge between Granules and Zee. Granules’ promoters took the loan specifically for the expansion of company facilities which is a very good theme. Besides, they have a solid plan to completely eliminate the pledge by March 2021 which is going well as of now. For example in March 2019, the promoters sold 5 million equity shares to mobilize about Rs 50 crore while monetized personal assets worth Rs 50 crore to repay Rs 100cr debt whichsubsequently brought down the promoters’ pledge ratio to ~43 percent from 60 percent. This has given more confidence to the investors whereby pushing back the beaten down stock above Rs120 levels. This is an example of why some shares still hold the ground despite higher pledge ratio.
Conclusion In general, pledging of shares is seen as a sign of poor cash flow. Thus decreasing the pledge ratio over time is very important. Even quality companies can be entrapped on pledge related issues. However, one should understand that there is nothing strange as such about pledging shares. Promoters usually offer their shares to provide additional collateral for maintaining debt lines or infuse capital. But when pledging is done to fund other business interests (like personal needs), it becomes risky, especially when such businesses under perform and do not generate cash flows. Thus one needs to be very careful while investing in companies with pledged shares. A detailed analysis of why the pledge was taken, ability to generate returns and repayment plans of promoters needs to be considered before any investment is made. In short, one can say that avoiding companies with heavily pledged shares is the best strategy for all investors.
