Promoter share pledge: India’s own subprime?
While income is real, paper profits are just that – gains only on paper.
The essence of subprime was that less creditworthy borrowers were provided home loans, and over-eager lenders eyeing year-end bonuses added top-up debt for foolish consumers, whose home value was climbing by the day on paper. Few thought it could reverse.
When the going was good, the borrowed money was splurged on cars, travel and fancy gadgets leading to an unprecedented consumption boom. It was a classic case of `wealth effect’ scoring over the ‘income effect’. That translates into funding consumption with notional profits rather than actual income. While income is real, paper profits are just that – gains only on paper.
The music stopped playing after having reached a crescendo, and then property prices began sliding all over the US. When home prices fell below the loan value, thousands immediately lost the roofs over their heads. The borrowers, now sunk into the subprime sinkhole, realised what unbridled leverage could do to their lives.
Fast forward a decade. In 2019, the stage is India and the leverage game is playing out in a different corner – promoter funding, though the scale is tiny. Back of the envelope calculations show promoters’ loan against shares may be at least Rs 1.2 lakh crores based on disclosure of Rs 2.4 lakh crores worth pledges.
It is legitimate commercial activity to borrow money to fund a business. Lenders mostly fund with physical assets as collateral.
Another source of funding could be financial assets – shares and bonds. Borrowing by itself is not bad, but how much in relation to net worth and for what purpose it is used determine the fate of the borrower. Unlike physical assets, such as real estate or gold, the slide in the value of financial assets could be quite quick and steep, leaving the lenders vulnerable if they do not have sufficient cover.
Zee Group’s Subhash Chandra and ADAG Group’s Anil Ambani were at the centre of the recent spectacle. Both businessmen borrowed by pledging their equity ownership in listed companies. As covenants for these loans were breached, some lenders began selling the collateral – pledged stock – and caused an even deeper slide in those shares.
While the practice may be legitimate, it raises two questions – one for the broader financial system and the other for minority stakeholders.
In most cases of pledge, it is ‘double leveraging’ where a holding company borrows funds with its shares as collateral and invests as equity in a Special Purpose Vehicle. Assuming a 2 for 1 debt to equity from a lenders’ perspective, it could actually translate into 8 for 1 or even more.
When the value of pledged stock falls, some promoters wouldn’t even mind as they might have already saved up for such a contingency.
“In some instances, the shares pledged by unscrupulous promoters could go down in value and the promoters may not mind losing control of the company as there is a possibility of diversion of funds before the share price collapse,” says the RBI Financial Stability Report of December 2014.
In Chandra and Ambani cases mutual funds are reported to have agreed not to sell the collateral despite covenant breaches.
Why did the lenders decide not to sell for a few months despite the covenant breachRs
The answer is to protect the value. But which value - the value of the business for promoters, or the value for mutual fund unit holdersRs
This is akin to being on a wing and a prayer. What if values don’t recover? If there’s a loss in promoter funding, will the asset management companies compensate investors? That the entire business is run on the Net Asset Value, it’s a case of heads I win and tails you lose.
Why are banks and mutual funds different? Why funds can’t be patient with defaulters unlike banks?
In a bank, all deposits are perceived to be guaranteed and the returns are assured. Furthermore, banks have at least 30% of deposits in liquid form and sovereign bonds, which could be turned into cash anytime. That’s why despite $120 billion of stressed assets depositors are not losing sleep.
Redemptions after IL&FS default reflects the shaky ground that mutual funds are in. By agreeing to standstill agreements, verbally or written, the industry has opened a new imprudent avenue for others too. Can the funds deny such a facility to any other promoter facing a similar situationRs
The Securities & Exchange Board of India’s recent side-pocketing – the act of ring-fencing bonds of defaulters from NAV calculations – may have encouraged fund managers to be lax on underwriting standards and less vigilant. But mutual funds, which have expanded over the past two decades to emerge as the primary wealth-creation vehicle for the average Indian saver, may be squandering away the gains if they don’t put prudence above passion.