Till pledge do us apart

Ever tried reaching out to Nikhil Gandhi on his handheld? If you do, you’ll hear verses from the Hanuman Chalisa, which he has for a caller tune. Gandhi does need divine intervention, given that he is among the several promoters of India Inc who have pledged their family silver (holdings) with lenders to raise money.

Thanks to Ramalinga Raju of Satyam fame, now the whole world knows what the owners of listed companies are up to with their personal shareholding. Thanks to Sebi, it is now mandatory for promoters of listed companies to disclose details of their pledged holdings. Though  prevalent for some time now, investor concerns around this alternative source of financing has been rising.

For the fiscal just gone by, around 119 companies from the BSE 500 universe have seen their owners pledge stakes worth over ₹1 lakh crore at current market prices (see: Desperate measure). There’s more: 28 promoters have pledged between 70% and 100% of their holdings with lenders — making them more vulnerable than the others (see: Birds of a feather). And Gandhi, the promoter of Pipavav Defence & Offshore, ranks third, for he has pledged, 97% of his holding.

To begin with, pledging of shares is normally done for two reasons. One, it could be in the form of secondary collateral (akin to a guarantee from the promoter) when a company avails of a long-term loan for setting up a greenfield project or expansion.

Two, it could also be used as additional collateral against medium-term loans availed by the promoter, either for the company or for his personal need, from banks and non-banking finance companies (NBFCs). “Pledging against shares is a perfectly legal thing as it helps good promoters to raise funds at better rates if they pledge shares as collateral,” says Anil Singhvi, chairman, of Ican Investment Advisors.

From the BSE-500 universe, the last time we saw 119 companies pledge their holding was in the crisis-ridden year of FY09. That number has remained more or less constant ever since. The reason is not hard to fathom: though the market recovered from its 2009 lows, the interest rate tightening by the Reserve Bank of India (RBI) since 2010 meant that credit was not coming cheap, thus forcing promoters to resort to pledging of shares.

According to Nirmal Jain, chairman of IIFL, “FY12 was even worse than FY09, especially for mid-cap promoters whose shares have taken a battering. Don’t go by the benchmark indices… pain is very much in the system.”

Jain is not exaggerating. Companies across sectors — be it real estate, cement, steel or capital goods — have been battling on two fronts: surging input costs and rising interest rates. Mid-cap promoters are the worst affected as bankers have turned selective about lending, given the deteriorating business outlook in the wake of a slowing GDP. This has forced several promoters to knock on the doors of NBFCs and private financiers to raise funds. 

The scary part about financing against share pledging is that a falling stock market puts pressure on the borrower to make good the decline in the value of the collateral. It can be in two ways, either top up with more holdings or pay cash upfront. In the event that the promoter is unable to pay, the lender can either sell the shares or take ownership of the stake since selling a large number of shares will only exacerbate the price drop.

That risk is particularly high in the case of small- and mid-cap companies. Currently, there are around 72 small- and mid-cap stocks where the pledged shares account for a significant chunk of the company’s overall market cap. There are 12 companies where the value of the pledged shares is between 60% and 80% of the total market cap (see: Risky, riskier, riskiest on page 84). With the market already down 16% y-o-y, any negative event will only accentuate the crisis.

Collateral damage?

So, how exactly are the promoters trying to wriggle out the hole that they find themselves in? Of the 28 companies from the BSE 500 universe, most promoters have pledged their holdings as collateral for loans and in other cases,  their stakes have been pledged as part of the corporate debt restructuring (CDR) process.

Thomas Cook, Gujarat Pipavav Port and Pipavav Defence & Offshore top the list as their promoters have pledged 100% and 97% of their holdings, respectively. In the case of Thomas Cook, the parent company has put the profitable Indian arm on the block, besides pledging its stake in the subsidiary to avail of credit facilities back home. Though the management of Thomas Cook India refused to comment, latest reports state that the parent company has found a buyer for its Indian arm.

In the case of Maersk Sealand-owned Pipavav Ports, the promoters pledged the shares as collateral in 2009 with IDFC for a ₹1,200 crore loan. “The tenure of the loan is for 12 years with an initial moratorium of three years,” says Prakash Tulsiani, managing director. Ruling out chances of the pledge being invoked (sold) by the lender, Tulsiani states that the company is on course to release the pledge since part prepayments have already brought the loan outstanding to
₹675 crore.

Gandhi, too, chooses to play down concerns over his holding. “We have pledged part of our stake for a long-term debt of ₹1,100 crore from IDBI for building Pipavav’s infrastructure and the rest with an IL&FS-led consortium for a medium-term loan of ₹650 crore. The fund was used to buy out Punj Lloyd’s stake in the company,” he says.

The company is looking at clearing IL&FS’ loan by raising funds through a sale of its stake in SEZs and industrial parks or by roping in a PE partner in Pipavav Defence’s parent company, Skil Infra. “We are planning to clear the loan by October by when the deals will be struck,” elaborates Gandhi. Pipavav Defence has an extremely  robust order-book of ₹6,700 crore, which is about 4.5 times trailing 12-month revenues.

We also have three companies from the beleaguered realty sector: HDIL, Parsvnath and Ansal. In HDIL’s case, the promoters have pledged 96% of their holding with IL&FS. While the management declined to comment, Sandipan Pal, an analyst with Motilal Oswal, says the company’s cash flow situation is only deteriorating.

“No new projects were launched over the past 18 months because they don’t have money to execute projects.” HDIL’s profits have fallen to ₹155 crore in Q3FY12 from ₹228 crore in the previous quarter a year ago. Given the company’s poor cash flow, it seems highly unlikely that the promoters will be able to revoke the pledge. Similarly, in the case of Parsvnath Developers, the promoters had to pledge their shares as collateral for loans taken to fund the company’s expansion plans.

“The problem is, when the share was pledged the company’s stock was quoting at a higher price than what it is now. When the share price started falling, the promoters had to further increase their pledge,” says Deepesh Sohani, analyst with MF Global. Parsvnath chairman Pradeep Jain was unavailable for comments.

But not all realty players are in a spot. Take the case of Ansal, which has availed of loans from Yes Bank and IFCI. The promoter has managed to reduce the pledged share from its peak level of 98% to 77% as of March 2012 by partly repaying the loan. Says JMD & CMD Anil Kumar, “With improving free cash flows, efforts are being made to pay off the debt and release the pledge.”

There are two IT companies, Glodyne Technoserve and Subex, where the promoters have pledged 84% and 94% of their holdings, respectively. Annand Sarnaaik, CMD of Glodyne, explains that the pledge is a collateral for term- and working capital-loans taken from State Bank of India (SBI) and Cholamandalam.

The management expects the quantum of pledged shares to come down substantially as revenues continue to grow at a healthy pace. As for Subex, the pledge was created with Axis Bank and SBI for term loans. But given that the company has been struggling to repay its FCCB holders for some time now, the promoters will find it tough to bring down their pledged holding. The company, which recently got RBI approval to restructure its $131 million FCCB due in July, is eyeing a revenue growth of 15-20% in FY13 on the back of recent orders bagged.

Of the two pharma companies, Orchid Chemicals, where the promoter has pledged shares with Cholamandalam Securities and IFCI Financial Services, refused to comment for the story. In the case of sterile drugs firm, Strides Arcolab, the promoters have pledged 70% of their holding. Unlike Orchid, the company does not face cash flow issues following the recent sale of its Australian unit, Ascent Pharmahealth, for $393 million.

The promoters of packaging major Uflex pledged 76% of their stake with IFCI for ₹250 crore to part fund the company’s capacity expansion in 2010. According to a senior company executive, “The promoters have repaid half of the loan and the outstanding amount will be paid back by October 2013.”

In the case of Suzlon, which has been grappling with leverage issues, the promoters pledged 89% of their holding as secondary collateral when the company re-financed its ₹10,690 crore debt in FY11. The high-profile Vijay Mallya, whose Kingfisher Airlines has run into rough weather, too, has pledged 94% of his stake in United Spirits. 

Soup song!

While some promoters are sitting pretty (so far), there are others whose stakes have been pledged as part of a debt revamp package. CDR, first introduced in 2001, allows a financially troubled company, with loans of more than ₹20 crore, to restructure those loans subject to it being approved by 75% or more of its lenders. Usually, under the revamp, lenders help highly leveraged companies by lowering the coupon rate and lengthening the repayment tenure. In some cases, part of the debt is also converted into equity.

Due to the downturn in the economy and a volatile stock market, many companies have sought debt restructuring under the CDR package. Wockhardt, Jindal Stainless, GTL, KS Oils, Jai Balaji and Alok Industries are some names that are in the CDR ambit or in the process of restructuring their debt.

Putting the picture in perspective, Pratip Chaudhari, chairman of SBI, the country’s largest public sector bank, says, “The past three years were relatively good. But then, just like in a cricket match where you are cruising at 100 for no loss, and in the next few overs you lose five wickets. The downturn in the investment cycle in FY12 has turned a lot of calculations upside down.”

In the just concluded fiscal, a record 392 cases, involving an aggregate debt of ₹206,493 crore, were referred to the CDR cell. Of the list, 292 cases, involving an aggregate ₹150,515 crore, were approved, while 41 cases with ₹35,161 crore of debt are under consideration.

“Cases in CDR are only admitted if there is viability in the business either through a moratorium on interest payments or, in some cases, by taking a hair cut. If none of the criteria can be met, the cases are not approved,” says Chaudhari. While rejigging the debt, lenders demand 50% of the promoters’ holding be pledged as collateral. “That ensures the management sticks to the roadmap chalked out,” says the
SBI chairman.

In the case of the Ratan Jindal-owned Jindal Stainless, its ambitious $2-billion expansion plan in 2008 ran aground as falling demand, rising costs and burgeoning debt played spoilsport. The group went in for debt restructuring in FY11 with a consortium of lenders led by SBI. “The pledge was given as a comfort to lenders,” says Arvind Parakh, ex-director (finance) of Jindal Stainless, who negotiated the deal. Accordingly, the promoters pledged 88% of their stake.

Edible oil major KS Oils also opted for restructuring of its loans, which entailed converting part of the working capital loan into term loans and part debt into compulsorily convertible debentures and cumulative redeemable preference shares. Another case being considered for approval involves the ₹2,000 crore debt recast of Kolkata-based steel maker Jai Balaji Industries. Similarly, textiles player Alok Industries, too, is seeking a rollover of its debt of close to ₹10,000 crore.

Unlike other companies that had to pledge their promoter holding as part of the CDR, the promoters of GTL got back their stake thorough a unique arrangement. The promoter, Global Holding Corporation, had in 2011 pledged 29.3% stake in the company with ICICI Bank for a term loan of ₹650 crore, but the bank invoked the pledge in July 2011 following a steep crash in the prices of GTL shares, thus becoming a stakeholder.

But in May 2012, as part of a debt restructuring process, it transferred the debt into the books of Chennai Network Infra (CNIL), a special purpose vehicle (SPV) created by GTL to acquire Aircel’s tower portfolio in 2010. Consequently, the bank returned the holding to GTL, thus restoring the promoter’s stake to 52.66%. Incidentally, CNIL, which had given a corporate guarantee for the GTL loan, too, is under CDR purview.

As far as Essar Oil and SKNL are concerned, these companies have been part of the CDR for some time now, with their promoters pledging 86% and 84% of their holdings, respectively. According to Essar Oil officials, the company’s CDR exit proposal has been approved by majority of its lenders and is now awaiting final approval of the core group. The process is expected to be completed in the current quarter (Q1FY13).

But given that the company incurred losses of ₹4,199 crore in FY12 compared with a profit of ₹654 crore in FY11, a quick approval looks doubtful. Besides, Essar’s net worth, too, has fallen from ₹6,538 crore in FY11 to ₹3,613 crore. However, in the case of SKNL, Nitin Kasliwal, vice-chairman and managing director, points out that the company had come out of the CDR purview in 2009, but the lenders are yet to release the shares. “The process of releasing the shares is taking a bit longer than usual but over the next couple of quarters we expect it to happen,” says Kasliwal, without detailing the reasons for the four-year delay. 

Though we have delved into just a handful of CDR cases, the number of fresh pledges created in the new fiscal will be on the rise as promoters of the 292 companies sign on the dotted line. While the promoters will heave a sigh of relief, it will be the bankers who will face the music. After taking a haircut and allowing a moratorium on interest payments, the lenders will be still exposed to the risk of a fall in the value of collateral in the event of a market crash. While banks may have no choice but to walk the talk, the plight of NBFCs is possibly even worse.

Art of pledging

Pledging against shares has been prevalent for more than two decades now, but the entry of new generation NBFCs has given a fillip to this business. While IL&FS Financial Services and IFCI are classified as systemically important NBFCs, given their lineage, the new kids on the block are Religare Finvest, Edelweiss Capital, and IIFL. Indiabulls Financial Services, too, was aggressive in the business until it was reverse merged with its mortgage funding arm early this year.

Let’s take a look at the biggies in the business. While IL&FS chose not to participate in the story citing client confidentiality, TK Ray, executive director of IFCI, which has a loan book of ₹17,000 crore, had this to say. “Promoter financing against shares make up for 30% of the total loan book, while the rest is lent as term loans, where the secondary collateral is the pledge.”

Among the private NBFCs, IIFL is a relatively smaller player since promoter financing against shares accounts for around ₹100 crore of the NBFC’s total loan book of over ₹7,000 crore. In the case of Religare Finvest, of the ₹13,000 crore loan book, the capital market exposure is ₹2,300 crore, of which around ₹800 crore is on account of promoter financing against shares.

Predictably, all the players vouch for their credible credit assessment function. “We do not go by the value of the collateral, but by the underlying strength of the business since it’s the cash flows from which the company is going to repay the loan. So, as a lender the end use of funds is very important,” says Ray.

Echoing similar views, Kavi Arora, managing director & CEO of Religare Finvest, says, “We are not merely content with the value of the collateral, despite having a cover that is two times the loan amount, and ensure due credit check.” In the case of IIFL, Jain says the company stays off unknown small- and mid-cap companies. “We do not lend if both the promoter and the listed entity are leveraged.”

While the interest rates could vary depending on the promoter and the value of the collateral, private NBFCs charge anywhere between 14% and 30%. “The problem is that very good promoters are looking for cheaper rates and the ones ready to pay higher coupon are not our potential clients,” says Jain.

What queers the pitch for NBFCs is the rising cost of funds. “Typically, borrowing against securities is for anywhere between three and 12 months, but pricing depends on the movement of short-end of the yield curve,” says Arora. Little wonder that promoters tend to knock the doors of bigger lenders such as IFCI, which usually lend at 1-1.5% over and above the benchmark base rate of 12-13%.

But the fact that the lender’s book has more than 16 companies, where it holds between 5% and 33% stake, indicate that cheap borrowings do not necessarily mean that promoters won’t default. “It’s not that we are here for charity. But when the economic cycle turns for the worse you can only bide time and give earnest promoters a chance to turn around their business. Once that is achieved, we can either return the stake to the promoter or sell it in the open market or to a strategic investor. Having said that, we are comfortable about holding 5% stake in a company,” says Ray.

But taking such an approach exposes lenders to the volatility on the bourses. Take the controversial case of the beleaguered Kingfisher Airlines, where SBI along with other lenders had to convert part of their debt into equity at a premium of 60% (₹64.48/share) to the then-prevailing stock price of ₹39.9 a share, in April 2011. Today, the stock is down 78% to ₹13. 

But selling stocks is not an easy option, especially for state-owned lenders. “For example, in the case of Kingfisher, if I need to cover the value of the collateral I need to go short in the F&O market, which will only put further pressure on prices. It won’t help, especially when a company is seeking a strategic investor,” says Chaudhari.

Agrees Ray, “While we can exercise the option of selling the stock in the case of unscrupulous promoters, in most cases we have to hold on to the shares as we don’t want to complicate matters for the company and other lenders as well.” That is one reason why IFCI is also going easy by not selling some promoters pledges, valued around ₹500 crore.

Though rules and regulations permit lenders to oust a management, it’s far from easy. While Chaudhari chooses to disagree, highlighting the case of the Pramod Mittal-owned Ispat Industries, which was sold to JSW Steel for over ₹2,000 crore in 2010, Ray feels otherwise. “Such cases are far and few between. Unless the promoter is also willing to sell out, you cannot force a change.” And then, it may not be easy to buy a strategic buyer especially if the company is sick. For instance, even JSW is now struggling with a pile of debt after the Ispat acquisition.

Private lenders are in no better position either. “Unlike retail lending against shares where clients are asked to pay up if there is a fall in the value of the collateral, promoter financing is a relationship business and you have to take into account several factors before engaging in a sale,” says Arora.

But that did not stop Religare from selling the pledged shares of Orchid Chemicals, whose promoter Raghavendra Rao had raised money to hike his stake in the company. But that massive selling in 2008 was triggered by the fire-sale by Bear Stearns, which sold 650,000 shares of Orchid. Terming it a one-off market event, Arora says. “You can’t insulate yourself from a fire-sale. That is a risk you have to live with in securities lending.”

Use and abuse!

All said and done, promoters resort to pledging only as a last resort when easy money is in short supply. Though the lenders claim that due diligence is done to ensure that funds are used for business purpose, the option of utilising the funds always rests with the promoter, who in most cases is also part of the management.

Agrees IFCI’s Ray, “There always will be promoters who know how to play with the liquidity in the system.” Something that is amply evident in small- and mid-cap companies. Although mostly the official reasons could be funding of company operations, more often than not, these funds land up in the stock market. According to market sources, the promoters at Shree Ashtavinayak Cine Vision, were continuously pledging shares every quarter with a corresponding increase in the share price as well.

And once the pledging peaked, the stock also lost steam (see: All play, no work). The ramp up happened even as fundamentals kept deteriorating. The company ended FY09 with an 83% drop in profit from ₹12 crore to ₹2 crore and by Q4FY10 it had slipped into losses.   

 Though disclosures were made mandatory since the fourth quarter of FY09, according to market experts, quite a few mid-cap promoters had already pledged their holdings way back in 2007. Though data for Koutons Retail is available only since 2009, one can infer from the price trend that as the stock started to tank the promoters were caught in a trap and had to top up their pledge. That was in Q3FY11. Prior to 2009, the stock had a dream run on the bourses. 

Agreeing on the systemic abuse in the market, Ambareesh Baliga, chief operating officer, Way2Wealth Brokers, says, “Some promoters indulge in market operations to increase shareholder (promoter) wealth and for institutional placements at higher valuation. They don’t realise that it is a maze and once the stock corrects, it has a cascading effect, gobbling up the rest of their holdings as a pledge. In extreme situations, promoters end up losing their holdings to margin calls.”

And then there are smart promoters who know how to play the game well. Take the case of Raj Oil Mills, which had made a public issue in 2009 at ₹120 a share. The promoter holding, which was 53% post the issue, dropped to 23% as pledged shares were sold off by the financiers.

The stock crashed 75% in the past 52 weeks from about ₹38 to ₹9 and about 92% since the listing. The promoters have now come up with a novel idea of allotting themselves warrants convertible to equity shares at ₹14, thereby increasing their holdings three times, which will ward off any takeover threat. Promoters may not want to do a market purchase as that will push up the market price.

Besides, they would also be limited by creeping acquisition norms. “This could be a modus operandi that other promoters may look at: Pledge the shares at a high price, default on the margin calls, let the financiers sell the stock, take advantage of the low stock price and allot yourself shares under the preferential route,” says Baliga. 

The moot question is, who finally bears the brunt — the ordinary shareholder or the financier? In most  cases it is minority shareholders who get taken to the cleaners. So, should pledging be viewed as a big negative? “Ultimately, every promoter has the right to pledge his shares for personal use. But given the fallout of such a move, Sebi should make it mandatory to disclose how much money was raised and for what purpose,” says Singhvi of Ican.

Such a move would go a long way in addressing governance issues. Concurring with Singhvi, Aniruddha Dutta, head of thematic research and mid-caps at CLSA, says, “While there is a limit to how much disclosure you can ask a promoter to make, it will help assuage investor concerns to a certain extent. Mere disclosures stating that funds are for general corporate purpose or personal also don’t mean anything unless its end use is clearly defined, because as an investor you have no idea where the money is being spent. And, therefore, it boils down to your view on management quality and its track record.”

While the issue of end-use of funds has always been controversial, it will be a welcome measure if the markets regulator indeed forces the promoter to make elaborate disclosures. While the probability remains, for now the question for investors is whether to stay invested or feel jittery about high promoter pledges. In the case of the 28 stocks mentioned earlier, there is a fair bit of domestic institutional exposure.

For example, Reliance Mutual Fund holds between 1% and 6% stake in United Spirits, Era Infra, Strides Arcolab, Shiv-Vani, Jindal Stainless and Jyoti Structures. In some cases, astute investors such as Rakesh Jhunjhunwala and Shivanand Mankekar, too, have holdings. While Jhunjhunwala holds around 8.51% stake in Bilcare and over 3% in Orchid Chemicals, Mankekar holds close to 2% each in Strides Arcolab and Wockhardt.

While the presence of well-known names does lend credence to an underlying stock, given that the sinking feeling on the Street is here to stay, staying off pledged stocks, especially mid-caps, would be prudent. Says Dutta of CLSA, “You can hold on to a stock for an event, such as a strategic sale or a buyout, to play where the company has strong brands or assets. But that is largely an event-based strategy only highly sophisticated investors like high net worth individuals or institutional investors should take. The average investor would be better off avoiding stocks where both the company and the promoters are highly leveraged.”

Agrees Jain of IIFL, “Let’s understand one thing very clearly: if you want higher returns then be cognizant of the risks in investing in equities. If a Tata or Bajaj group company pledges 100% of its promoter holding, nobody will even bat an eyelid because you know the reputation and profile of the promoters. But for the rest, if you are not comfortable, just dump that stock.” As for Gandhi, he believes the smiles will be back once the bulls stage a comeback. Till then, keep praying.

— With inputs from Kripa Mahalingam, Sudipto Dey and Shabana Hussain