Know more about promoter's pledging of shares
Pledging of shares:
Pledging of shares is an arrangement, in which, the promoters of a company use their shares as collateral to manage their financial requirements. Pledging of shares is common for companies that have high shares owned by investors. The borrower of pledged shares continues to retain the ownership of the assets and earn interests & capital gains on those shares.
The value of shares keeps changing, which results in a change in the value of the collateral of the pledged shares. The promoters have to maintain the value of the collateral. The minimum collateral value is agreed in the contract and if the value of the pledged shares falls below the amount fixed in the agreement, the borrowers must provide additional shares or pay cash to make up for the shortfall of the collateral. Banks or lenders have the right to sell the pledged shares in the open if the borrower is unable to repay the collateral value or make up for the difference in the values. The pledged shares are lost if they are sold in the open market, which reduces the promoters’ shareholding.
Effect of Pledging on stock valuations:
Pledging of shares is a common practice in companies. A small percentage of promoter pledged shares should not raise any red flags. However, if you find that the company has a high percentage of promoter’s shares being pledged, then you need to consider the associated risks:
- Higher volatility in stock prices: If a company has a high percentage of promoter’s shares, then it usually witnesses high volatility in the market price of its shares. As the shares are pledged for availing some credit, a slight panic in the market may drive the share price down, triggering the promoters to maintain the collateral, which may result in the sale of shares, held by the financial institution.
- Skewed management decisions: If a company has a high percentage of promoter’s shares, then it might find it difficult to sustain profits since the borrowed funds are at a high cost. Hence, the company experiences pressure on future earnings.
- Possible loss of control of the company: There can be cases where the promoters lose the management control of the company. Let’s say that the promoters owned a 60 per cent stake in the company and pledged half of it for a loan. If the company fails to repay and the lender decides to sell the pledged shares in the open market, then the promoters will be left with only a 30 per cent stake in the company and risk losing control over the company.
- Possible value trap for value investors: Value investors try to look for stocks that are undervalued as compared to their intrinsic value. Many companies with a high percentage of promoters' shares being pledged trade lower, making them attractive to value investors.
Remember, if you find a company with more than 15-20 per cent of promoters' shares being pledged, then you must ensure that you assess its cash flow before making any investment decisions. Also, if a company has a high amount of pledged promoter shareholding, then stock price erosion is a distinct possibility. A small percentage of pledging should not raise any red flags, whatsoever.
---