Should you avoid companies with high pledged shares?

Pledged shares are those against which promoters in need of capital - either for personal use or company's growth - take loans from banks and NBFCs

Deteriorating fundamentals and eroding stock values have pushed lenders of many debt-ridden corporates to sell promoter shares pledged with them in open market, creating concerns for the retail investors.

This week, IDBI Trusteeship Services invoked 7.62 crore pledged shares of promoters in Reliance Power to recover dues. It was met with further selloff in company's shares. Reliance Power is not alone. Shares of Anil Dhirubhai Ambani Group (ADAG) companies are under immense pressure ever since lenders initiated invoking of shares in the past few months. Subhash Chandra-owned Essel Group companies and individual names such as Apollo Hospitals and Sun Pharma too caught investors off-guard.

There is no harm in pledging shares. It is just like pledging gold for a loan. But, in case the market conditions are not good, and shares are falling across-the-board, promoters are required to maintain a margin (of safety for lenders) on collateral (shares) either by paying the additional sum or pledging additional shares. In case, the slump in stock goes out of hands, lenders exercise their rights to sell shares directly, risking promoter's control over the company. In case of Reliance Communications, promoter Anil Ambani's stake in the telecom company had dropped to 21.97 per cent by the end of March quarter (Q4) of the financial year 2018-19 from 53.08 per cent as on December 31, 2018.

Also Read: Anil Ambani's Reliance Communications Enterprises pledges 12.50 cr shares of RCom with IndusInd Bank

Data compiled by Edelweiss Securities shows, JSW Energy (59.97 per cent in Q4FY19 from 47.36 Q4FY18), Reliance Infra (98.34 per cent in Q4FY19 from 69.05 per cent in Q4FY18), Centrum Capital (82.81 per cent in Q4FY19 from 52.8 per cent in Q4FY18) and Apollo Hospitals (78.13 per cent in Q4FY19 from 68.47 per cent in Q4FY18) have seen consistent incremental pledging activity in the past five quarters.

On a quarter-on-quarter basis, JK Tyre & Industries (28.89 per cent versus nil), Reliance Capital (96.93 per cent versus 74.55 per cent), Reliance Infra (98.34 per cent versus 83.59 per cent) and Dish TV (94.6 per cent versus 82.05 per cent) saw maximum jump in promoter pledges in the March quarter. Other notable names included Sun Pharma (10.97 per cent), Apollo Hospitals (78.13 per cent) and Ajanta Pharma (15.83 per cent).

Umesh Mehta, Head of Research, SAMCO Securities says once invested in a heavily pledged company, it is a vicious circle wherein a lot of equity value could be destroyed; hence, retail investors should avoid such companies.

Here is all that you must know about promoters' pledging activity and how it affects your investment:

What are pledged shares?

Pledged shares are those against which promoters in need of capital - either for personal use or company's growth -- take loans from banks and NBFCs (non-banking finance companies). For lenders, these shares are collateral. Retail investors can also take loans against their shares. In some cases, promoters borrow money to diversify in unrelated businesses.

What is the margin call?

Lenders and promoters fix a minimum contract value for the shares pledged, which is typically below the market price. This helps lenders have a margin of safety. When the market price falls below the contract value, it reduces the collateral value (value of pledged shares) and invokes margin call. Promoters are required to make up for the eroded value either by paying in cash or by pledging additional shares.

According to Mehta of SAMCO Securities, lenders offer loans to promoters as a structured product and they usually maintain a cover of two to three times the loan value. "As the minimum contract value varies from lender-to-lender and promoter to promoter, it cannot be generalised," he says.

Ankur Varman, vice president- institutional sales, Emkay Global, says fair value, business prospects and market capitalisation are three criteria used to decide the amount of loan. But, the minimum contract value is often fixed below the adequate level and the whole process doesn't work out the way, it should.

"Debt raised on the basis of shares pledged by promoters can work only if a prudent level of overall cover, commensurate with risk, is available through promoter holdings (both pledged and unencumbered) on the overall promoter debt raised through holding or investment companies," said credit rating agency CRISIL in a report.

"Such debt, backed by inherently volatile equity shares from promoters as collateral rather than cash flows are seldom repaid on maturity and often refinanced. They are, therefore, exposed to high market risk and typical transaction-level cover agreed to is often inadequate," CRISIL report added.

Invoking pledged shares

Lenders have the right to sell pledged shares with them if promoters fail to provide for eroded collateral. The process of selling those shares is called invocation. Not only does it reduce the promoter's stake in the company, but it also triggers a downward pressure on the stock price. As the stock falls more, there arises a need to sell more, thus creating a vicious cycle of a downward spiral on the stock.

"Promoters have to be extremely careful as they can end up losing their entire capital in the company if the price falls drastically," says Mehta.

Revoking pledged shares

When promoters pay off the debt to gain back pledged shares, it is called revocation of pledged shares. In the March quarter, promoters of companies such as Jubilant Foods (12.61 per cent in Q4FY19 versus 18.37 per cent in Q3FY19), Coffee Day Enterprises (72.32 per cent in Q4FY19 versus 79.36 per cent in Q3FY19), Strides Pharma (16.31 per cent in Q4FY19 versus 28.91 per cent in Q3FY19) and Granules India (43.4 per cent in Q4FY19 versus 60.35 per cent in Q3FY19) revoked their pledged shares.

What should investors do?

It is advisable to avoid companies with high promoter pledged shares as in a bear market, stocks of such companies fall steeper than other stocks. Besides, it is difficult for retail investors to access pledging data as promoter pledged shares are not reflected in the balance sheet of companies. "It is extremely difficult to find out about promoter activities in their personal capacity but highly promoter pledged companies in itself is a cause of concern as such companies are susceptible to panic selling," points out Mehta.

However, Varman advises investors to put faith in the business prospects of the company and not get bothered by loans pledged. "If the business is strong and is backed by sound fundamentals and solid building blocks, then events like margin calls taking stocks down are God-sent opportunities to build further positions. Though speculators on leverage may face challenges in times like these," he says.

Varman further cautions that in cases where promoters have diversified in unrelated businesses, minority shareholders should assess if the top management is good enough to take the business ahead because promoter will have his attention divided and may not do justice to the listed entity. "If top management is capable, business fundamentals intact and growth secured, then there is nothing to worry about promoters' interest in unrelated busine