Share pledging is a practice in which an executive secures a loan by using equity compensation as collateral to secure the loan. There are many instances where promoters have pledged their equity holding in order to secure loans for the company or for their personal needs. The pledged shares act as collateral for the borrowed funds. Should you be concerned about investing in such companies?
The motive to pledge shares could be noble or not. In some cases, the promoters pledge their shares when valuations are high to borrow funds at low rates to meet the personal needs or to invest in unrelated investments such as realty etc. At times pledging could be a part of corporate debt restructuring (CDR) process, where lenders use it to ensure that promoters stick to the new restructuring terms. In short, pledging by itself is not illegal or bad.
But what could explain the rise in promoter pledging in current times? In times of liquidity crunch, slowdown in project clearances and sluggish demand, there are cases when the reasons behind pledging are genuine. However even in such cases, the investors need to be watchful of how these funds are being used.
In the recent stock market crash, stocks which had a higher share of promoter pledging fell the most. The reason for the same is as follows. Promoters of companies who have pledged their shares to raise funds from banks will be asked to top up with more shares as a declining share price lowers the value of the collateral. If the promoters pledge more of their shares in order to meet the value of collateral, the stock price would fall downwards. If on the other hand, the promoters refrain to provide the extra margin than the lenders could sell the shares in the market, pushing down their value. So in both the cases the share prices would decline.
As per an article in Business Standard, since January, while the shares of Jaiprakash Power are down by half, Jaypee Infratech's shares are down by 40%. The Jaypee group promoters have pledged almost 95% of their stake and do not have more shares to pledge. Bajaj Hindustan, Suzlon and Lanco are facing a similar situation.
We would suggest investors to be very cautious with respect to management quality. When you are choosing a stock that has promoter stake pledged, get into the details of pledging. Companies that are over leveraged and where high percentage of shares is pledged could be a value trap for retail investors. Hence, avoid companies with high pledging, dubious management quality and high leverage ratios, no matter how attractive the valuations appear.