Promoter Pledging: Is it a sign of concern?

Promoter Pledging: Is it a sign of concern?

While investors will readily look at various financial flags of a company before deciding on parking their funds, they rarely, if ever, take a closer look at promoter pledging. There is also a misconception that promoter pledging means that a company is in financial distress. Armaan Madhani explains what such pledging means and how they work as guidelines to a company’s overall health

In the pursuit of discovering fundamentally strong stocks that are capable of compounding wealth over the long term, investors thoroughly analyse earnings’ growth, industry prospects, peers, ratios, moats, management and valuation.However, investors often tend to downplay or even overlook the promoter shareholding pattern. Examining a company’s promoter shareholding pattern is one of the most significant yet underrated parameters while forming an investment hypothesis. There is a good chance that you must have encountered the term ‘promoter pledging’. It has substantial influence over a stock’s performance and can often ruffle feathers among investors and shareholders. Here is all you need to know about promoter pledging.

Defining Promoter Pledging

Let’s start from scratch. A promoter is the one who conceives an idea for setting up a particular business and performs a range of formalities required for starting a company. A promoter is the person who assembles the men, the money and the materials into a going concern. Promoter holding denotes the percentage of shares held by the promoters of an enterprise out of the total equity capital. Promoters usually possess majority holding of the company and hence it is critical to keep a precise record of promoter ownership. The securities market watchdog, Securities and Exchange Board of India (SEBI), has mandated that all the promoters of listed companies are obligated to disclose their holding pattern and any encumbrances (i.e. pledging) made or discharged within seven days from such creation or discharge.

Investors can easily track these details at any moment on the official BSE and NSE websites. Promoter pledging is an arrangement in which the promoters of a company take loans at a given interest rate and use their shares as collateral. Shares are a type financial asset and hence can be pledged to raise funds. According to the norm laid down by the Reserve Bank of India (RBI), a loan to value (LTV) ratio of 50 per cent is to be maintained at all times when lending based on stock pledge. The lenders i.e. banks and financial institutions can fund only half of the value of the promoter’s holding that is being pledged. For example, the promoters will have to pledge their shares worth Rs200 crore to secure a loan of Rs100 crore.

The difference between the loan amount and the current market price of the shares is kept as a security by the bank. If the market price of the pledged shares falls below a certain level, it immediately triggers a ‘margin call’, which requires the promoter to reduce the loan liability by pledging additional shares or furnishing cash to make up for the shortfall in the value of the collateral. If the promoters fail to do so, then the bank reserves the right to sell the shares in the open market in order to recoup losses. Any shortfall in margin due to fluctuations in share price should be made good by the promoters within seven working days.

Reasons for Promoter Pledging

Considering that a large chunk of the promoters’ wealth is most likely held in the form of their shareholding in the company, pledged shares as collateral aids promoters to swiftly raise additional funds when needed. It is a common practice in companies where the promoter holding is high. Promoters generally utilise the proceeds from share pledging to fund new ventures, execute capital expansion plans, conduct acquisitions and meet working capital requirements. Promoters may even meet their personal expenses by pledging shares. Another valid reason for promoter pledging could be that the promoter is optimistic about the company’s future prospects and senses that the company is undervalued at the current share price.

The promoters might raise funds by pledging their shares and using the funds to purchase more shares of the company from the secondary market and increase their corresponding stake. Raising funds via debt or by issuing additional equity is relatively safer than promoter pledging. By and large, pledging of shares is considered as the last resort for the promoters to raise funds. It implies that all the other sources to raise capital are unavailable to the company. This could include sources such as banks, private lenders, etc. In such a case, promoters can use their shares as assets that can be pledged to raise funds.

Implications on Stock Price

Funds raised via promoter pledging are an indication of the promoters’ inability to raise funds at cheaper rates and normally carry high interest rates. If a company has a high promoter pledge, servicing the interest consumes a significant portion of the company’s profits margins, thereby pressurising earnings’ growth and impairing future financial performance. We should keep in mind that promoters pledge their shares as collateral with the lenders and the share prices incessantly keep fluctuating. Hence, the value of the shares pledged as collateral is also in a state of constant flux. During a bull market, promoter pledging does not tend to create many issues as soaring stock prices increase the value of the collateral.

On the contrary, heavy promoter pledging during bear markets is viewed as risky and a recipe for disaster by the markets. A sharp decline in stock prices will trigger margin call by the lender i.e. the bank. If the promoter fails to pledge additional shares to match the current loan value or pay cash to reduce the loan liability, then the ownership of the shares is transferred to the bank, which can sell the shares in the open market to recover its losses. As a result, additional shares of the company are infused into the market and there is a decrease in promoter holding. The excess supply of shares in the market induces a steep fall in the share price, changing the overall shareholding pattern of the entity.

When the news of forfeiture breaks out, there is mass hysteria among investors in the form of rampant panic selling and the stock price plummets further. In extreme situations, when pledged shares are sold in the open market, there is a high probability that promoters might also lose majority holding and control of their company. Satyam Computers and Yes Bank are noteworthy examples. Ergo, companies with high promoter pledging are more likely to experience high volatility in their stock prices. Investors must keep a close eye on promoters’ holdings and pledging as it eventually affects managerial power as well as thei r voting rights.

Current Scenario of Promoter Pledging

As on September 2, 2021, from the more than 5,000 companies listed on the Bombay Stock Exchange (BSE), 736 companies have reported promoter pledges which are valued at approximately Rs3.75 lakh crore. Amid buoyancy in the markets, promoter pledging has dipped for a second straight quarter in a row. According to a report by Kotak Institutional Equities (KIE), pledged promoter holdings as a percentage of total promoters’ holding declined to 1.61 per cent in the June 2021 quarter from 1.64 per cent in the March 2021 quarter. The value of promoter pledged holdings stood at Rs1.7 trillion, 0.81 per cent of the total market capitalisation of the BSE 500 index.

Speedy recovery from the pandemic-induced disruptions, improvement in earnings and balance-sheets in H2FY21, sustained deleveraging trend and soaring stock prices have reduced the number of shares needed to be put up as collateral, thereby helping a plethora of promoters to release a portion of their pledged shares. Adani Group firms have been the most active in reducing promoter pledges in the recent quarters. Adani Green Energy has witnessed its pledged promoter shareholding reduce for the seventh straight quarter, while peers Adani Enterprises, Adani Power and Adani Transmission have seen promoter pledging drop for the fifth consecutive quarter.

From the BSE 500 index, Crompton Greaves, Deepak Fertiliser, Max Financial, Future Retail, Dish TV, Jindal Steel and Power, Emami, KPIT Technologies and Laurus Labs have seen a substantial decline in pledged shares over the last four quarters. Meanwhile, promoter pledging has significantly shot up in the case of IndusInd Bank, Indus Towers, Wockhardt, Aurobindo Pharma, Johnson Controls and Aster DM Healthcare.

Conclusion

Investors should be aware of their risk appetite before investing in companies with promoter pledging. About 5 per cent to 15 per cent of promoter pledging is, broadly speaking, efficiently managed by companies. However, the problem arises when pledging skyrockets and financial health keeps deteriorating. The past is replete with examples of quality companies often becoming victims if promoter pledging is not reduced over time. It can be observed from the following tables that a decrease in promoter pledged shares over time is a positive sign and often rewarded with increased investor participation.

An increase in pledged shares is a red flag and not well received by market participants. Investors must keep in mind that high promoter pledging does not necessarily indicate that a company or its promoter is cash-strapped in financial stress and facing debt problems. An ideal example would be Vedanta India, a leading diversified natural resource company. Promoters of Vedanta India have pledged 99.99 per cent of their holdings since the quarter ended September 2020. The company has seen significant improvement in ROE due to the increase in operating margin and their stock price has zoomed by more than 90 per cent since the beginning of 2021.

Modest promoter pledging when combined with stable free cash flows, healthy operating performance, strong balance-sheet, low debt to equity and robust corporate governance is not a red flag. Even the celebrated consistent compounder Asian Paints currently has 9.03 per cent of pledged promoter holding. However, heavy promoter pledging together with high debt, cash crunch, weak operating performance and poor fundamentals is a grave sign of concern and investors should keep their distance from such companies. The bottom-line is that while, as an investor, you may be carried away by the many other tell-tale indicators of a company’s performance, do look out for promoters’ pledging too. It could be the one factor that could tilt the scales between buying a stock or avoiding it.

 

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