When a financial markets veteran and banker like Uday Kotak expresses concern over promoters pledging their shares, you take note. In a recent interview with CNBC-TV18’s Shereen Bhan, he averred that a pledge of over half a promoter’s holding was a risk alert.
The markets have heard him—and veterans like him in more discreet conversations—and reacted to the “high pledge” phenomena with a strong thumbs down. Investors are clearly spooked after two prominent groups, Essel and Reliance (Anil Ambani), sought moratoriums to service their loan against shares obligations. There are fears that more skeletons could spill out of the pledged shares cupboards, a very distinct possibility, and singe several NBFCs and mutual funds, besides, of course, the companies whose shares were pledged.
And while we shall all wait to see how things unfold, this might be a good time to take a closer look at the pledged shares phenomenon and what’s good, bad and ugly about it.
I’ve been in the world of business, so I know that entrepreneurs, especially first generation, go to great lengths to put together the capital to seed their ventures. They could even borrow against family assets to fund their business dream. Not all are successful, though, but that’s how business is—even the best and brightest can fail. Many of these entrepreneurs are god-fearing, honest people. It is quite possible, that after achieving success in business, and with their only real wealth being their equity, they leverage this to repay the people who pitched in with the money to get the business off the ground. Such an entrepreneur can hardly be faulted for pledging a part of her / his equity.
Similarly, you could have entrepreneurs like Subhash Chandra, who claim that their intent is not to default, but they have made some bad business choices and now they have little option but to sell their successful business of years to pay down their personal debt.
But these are instances of distress situations. There can also be positive scenarios. For one, a promoter could pledge part of her/ his holding to invest further in the business by subscribing to additional shares in a public/rights offer. It is also possible that a promoter decides to seed another venture, which could add value to the core business, but might be seen by the shareholders as a long-gestation, high-risk move. To avoid a conflict, the promoter may decide to take on the risk by funding the venture himself, by leveraging his one big asset, his equity.
There are several such scenarios that one could cite, where the promoter may have pledged shares without any intent to compromise the existing business or the interests of public shareholders. If we are able to make the distinction, the current market sentiment that is leading to a pummelling of all stocks with high promoter pledges, might throw up an opportunity to invest cheap.
The second lot of promoters can be classified as those who have pledged their shares, not for the purposes of adding any value to their business or to seed any other genuine venture, but more to create personal assets with clear disregard for the consequences of their actions on the publicly listed company’s business and interests of the other stakeholders (lenders, creditors, customers and shareholders). This is more likely to happen in the case of companies where the promoters see greater value in cashing out when the times are good, because they clearly see a dismal future.
A deterioration in business of the company after the promoters have raised funds through high pledging of their equity should be a signal for concern.
This should be a red flag for lenders, who will now be dealing with owners who have already extracted much of the value of their equity in the company. It heightens the risk of the promoters walking away if the situation is not managed carefully, with the lenders left to shut the stable door after the horse has bolted.
Using pledged shares as a yardstick for good governance can be a big folly. A dishonest promoter has many more ways of taking out money from a business than just pledging shares to cash in on its value. A testament to this is the several accounts in the IBC (Insolvency & Bankruptcy Code) process today, where despite good, productive assets the businesses did not perform.
The long line of suitors for many of these assets clearly reveals that they have great value. Yet, in several cases, it is quite likely that the assets were not generating enough cash to service the company’s debts and deliver shareholder returns only because this was being siphoned off in various ways by the promoters. Such businesses pose an even greater risk to public shareholders, even if the promoters’ shares are not pledged at all.
In fact, a promoter who needs to pledge shares to raise money is likely more honest than one who doesn’t.