The risk for investors arises when the promoters have pledged either all or a significant percentage of their holding as it could trigger a volatile price movement in a falling market.
The pledging of shares by promoters is an important factor to be considered while investing. But often it is overlooked by many investors. Majority of the shares in the companies are held by promoters, who also manage the day-to-day affairs of a company and take key policy decisions of the company. Let us understand what is pledging of shares by the promoters and its associated risks on individual investors.
What is pledging of shares
It is nothing but availing loan against the shares one holds. So, whenever the promoters need money, they pledge some or all of their shares with the bankers or lenders as a collateral and avail loans. They could raise loan for various purposes such as working capital requirements, funding of other ventures, to carry out new acquisitions, personal obligations, etc. So, the loans could be raised to meet either business or personal requirements.
Generally, pledging of shares is the least preferred option for the promoters to raise funds. It is relatively safer to raise funds through equity or debt for the promoters. However, if the promoters are looking forward to pledging their shares, then it means that all the other options and sources of raising fund have been closed. The point to be noted is that when promoters are pledging their shares, ownership is retained by the promoters.
The promoters often go for this source of funding in a rising interest rate scenario. The cause of concern for investors arise when the promoters in your company has pledged either all or a significant percentage of his /her holding as it could trigger a volatile price movement in a falling market.
Higher the percentage of promoters pledging, higher could be the risk of volatility in the company’s share price. This happens because when the share prices fall, the overall value of the pledged collateral falls. This would put pressure on the promoter either to repay the loans or to produce more assets as collateral.
If the promoter fails to do either one of them, then the bankers / lenders may be forced to sell some of the shares to ensure that the loan does not turn into a
bad loan. If the promoter is unable to meet obligations of borrowing, the ownership of shares is also transferred to the lender, who in turn sell it in the market to recover loans.
If the promoters have pledged a significant percentage of shares, then it is always important to find out the reasons for the same. A decrease in pledging of shares over a period time is a good sign for the investors. But an increase in pledging of shares could be dangerous to both promoters and shareholders. However, pledging of shares is not always bad for the companies. If the company has an increasing trend in the operating cash flow and great future prospects, then pledging of shares is not a major concern. For a fundamentally healthy company, 5-10% pledging of shares should not be a problem.
To conclude, pledging of shares is generally seen in companies where the shareholding of the promoters is high. Avoid investing in companies with high or increasing pledging of shares by the promoters, to avoid unnecessary troubles.
(The writer is a professor of finance and accounting in IIM Tiruchirappalli)