Musings with Analyst, June 2024

Analysis of Promoter Pledging in India

What is Promoter Pledge?

Promoter pledge refers to the practice where promoters of a company (those who have a significant stake and control in the business) use their shares as collateral to raise funds. Essentially, they pledge a portion of their shareholding to financial institutions in exchange for loans. This is akin to taking a mortgage on a house, where the house acts as collateral against the loan.

Why Do Promoters Pledge Their Stake?

Promoters may pledge their shares for several reasons:

• Business Expansion: To fund new projects, acquisitions, or expansions without diluting their equity stake.
• Debt Servicing: To repay existing debts or manage working capital requirements.
• Personal Financial Needs: To meet personal financial obligations or invest in other ventures.
• Market Opportunities: To capitalize on market opportunities or manage liquidity in the short term.

While pledging shares can be an effective way to raise capital without immediately affecting the ownership structure, it comes with significant risks and potential drawbacks.

Implications of High Promoter Pledge

High levels of promoter pledge are generally viewed negatively by investors and analysts for several reasons:

• As long as the share price of the company is increasing, a high promoter pledge does not pose any risk to the investor. However in a falling market, if the lender resorts to selling the shares, the excess supply will further push down the stock price, exacerbating the investor’s loss.

• Research indicates that companies whose promoters have pledged for the first time tend to manipulate earnings upward, at least during the first year of the pledge.

• In extreme situations, promoters might also lose control of their company when pledged shares are sold in the open market. In case the promoters are unable to repay the money or put additional shares, the financier could choose to sell the shares in the open market which would not only put an adverse pressure on the stock price but also will see a management shakeup.

Real-Life Instances from India Inc.

In India, promoter pledging gained attention during the Satyam scandal in 2009. Post which, SEBI became vigilant and came out with a mandate for listed companies to report their share pledging. Over time, more companies have used share pledging to raise money.

While this was just the teaser, we witnessed several notable instances in India, wherein high promoter pledge lead to the company doomsday:

• Reliance Communications: The Anil Ambani-led firm faced severe financial troubles partly due to high promoter pledges. As the company struggled to repay its debts, the lenders invoked the pledged shares, causing a sharp decline in its stock price and eventually leading to insolvency proceedings.

• Zee Entertainment: In 2019, Essel Group faced a liquidity crisis due to high levels of promoter pledge. The group’s inability to meet repayment obligations led to significant selling pressure on Zee Entertainment’s shares, causing a steep decline in its market value. However, the promoters managed to negotiate a standstill agreement with lenders to avoid immediate selling, showcasing the delicate balance required in managing pledged shares.

• Jet Airways: The airline’s promoters had pledged a significant portion of their stake to raise funds. As the airline’s financial condition deteriorated, the invoked shares further eroded the company’s stock value, leading to a crisis that eventually grounded the airline.

Decline in Promoter Pledge: A Positive Trend

Now, comes the good news. Over the past five years, we have witnessed a steady decline in promoter pledge levels in India. To clarify, the numbers shown below refers to the promoter pledge (%) as a percentage of total promoter holdings.

The boxplot above succinctly represents the data. The short dash that you see on the body of each boxplot is the 50th percentile mark. If you notice, in 2017, a promoter pledge of close to 25% was the 50th percentile mark. That same 50th percentile in 2024 is approximately 10%. Therefore, it goes on to show the declining trend of promoter pledges.

To complete this narrative, it is important to look at the promoter holdings also in conjunction with the above.

Promoter holdings haven’t changed much since 2017, however the change in pledge is a sign of relief for common investors.

You may ask, but what is the reason behind this decline in promoter pledge? Well, it could be for a variety of reasons. Starting from regulatory mandates, wherein the promoters are compelled to cut down their pledges. Or it could be buoyant market conditions which lead promoters to pay back a part or all of their debts.

Conclusion

Promoter pledge is a double-edged sword: while it can provide immediate liquidity without diluting ownership, it also carries significant risks that can negatively impact the company’s financial health and investor confidence. High levels of promoter pledge often signal financial distress and can lead to volatility in stock prices, dilution of control, and overleveraging.

Real-life examples from India, such as Reliance Communications, Zee Entertainment, and Jet Airways, illustrate the dangers associated with high promoter pledging. However, the trend of declining promoter pledges over the past few years is a reassuring sign of improved corporate governance, stronger balance sheets, and enhanced investor confidence.

As the corporate landscape evolves, maintaining a balance between leveraging shares for growth and ensuring financial stability will be crucial for sustaining long-term investor trust and company performance.

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