As a trader or investor in stock markets, you might have heard about the term ‘pledging of shares. While it is overlooked by many investors, the pledge amount on the promotor’s shares is an important aspect that investors should look at to evaluate signs of financial trouble in the company. A high pledge of shares can be a matter of concern for investors. Let’s understand the meaning of pledging of shares and how it works.
Pledging of Shares Meaning
A company can raise equity capital, issue corporate bonds or apply for a loan with a bank to raise funds for regular operations, working capital needs or expansion. To take a loan, the company needs to offer something as collateral to the lender. Usually, companies offer promotor’s shares to banks or financial institutions to avail a loan. Here shares act as collateral against the loan. This is called pledging of promotor’s share. A high pledging can adversely affect shareholder’s value. It is regarded as a risky investment.
How does Pledging of Shares Work?
Promoters can pledge their shares to increase cash margins for trade opportunities. Pledging shares held by promoters is often regarded as the last resort to raise funds. In other words, it means the other options to raise capital have been closed. A loan is offered after a haircut deduction. The collateral margin can be used for equity trading, to sell options and also options writing.
What is a Haircut?
When a bank or financial institution considers the value of assets as collateral for a loan, it offers a lower value. The lower value is known as the haircut value. A haircut refers to the percentage difference between an asset’s market value and the amount that can be used as collateral for a loan. It is because market prices change over time, and lenders take this fluctuation into account for their valuation and analysis for risk mitigation.
For example, the market value of an asset that a company wants to pledge for a loan is Rs. 10,000, and the bank considers the Rs. 10,000 assets as worth only Rs. 6,000 in collateral. The Rs. 6,000 or 40% reduction in the asset’s value is called the haircut.
A haircut is the lower-than-market value of an asset used as collateral for a loan. The risk of the underlying asset is considered to determine the size of the haircut. Riskier assets face larger haircuts.
How to Pledge Shares
- The promoter of a company needs to initiate a request for the pledging of shares through the trading terminal.
- After receiving the request, the trading terminal will forward it to NSDL/ CDSL for confirmation.
- NSDL/ CDSL authenticates the request via email/ mobile authentication for BOID/ PAN.
- After approval, the promoters can avail collateral margin for trading.
Why Pledging of Shares is Risky for the Shareholders
Promoters need to use their stakes in a company as collateral to take a loan. While pledging of shares won’t create issues when the market is doing well and investors are bullish, problems arise during the economic slowdown.
Because of the fluctuation in stock prices, the value of the collateral also changes correspondingly. Usually, promoters are required to maintain the value of the asset pledged. If the share price drops, the value of the collateral will also suffer. To reduce the difference in the collateral value, promoters have to make up the shortfall by either providing more shares or additional cash to the lender.
In the contract between the lender and promoters, both parties agree to a minimum collateral value. If the value falls below the minimum value and the promoters fail to meet up the difference, it gives the right to the lender to sell the pledged shares to recover the loan.
What is the Risk for Retail Investors in Pledged Shares
When the news of open-market sale of pledged shares surfaces, the stock price can drop dramatically. As a result, the collateral value further declines due to panic selling by the public. Moreover, the selling price of the shares pledged by lenders may also lead to a change of the shareholding pattern of the company and suggest that the company is not in a good financial position. There are chances of sharp fluctuations in stock prices of companies with high pledging.
Hence, investors must keep a close eye on promoter’s holdings because holding fewer shares may affect the voting power and ability of promoters to make crucial decisions.
Investors should avoid companies with a large portion of pledged shares because this will save them unnecessary trouble later. High pledging could be an indicator of poor cash flow or high debt. Before investing, analyze the cash flow statement to view the cash inflows and outflows. Also, check the balance sheet to find out the debt owed to outsiders.
If the company’s financial records are in poor condition along with high pledging, you should refrain from investing in stocks of such a company. If the operating cash flow is increasing, it indicates that the company is efficiently managing its day-to-day expenses. Investing in such a case might not be a risky bet.
A decline in pledged share over time, is a positive sign, while when the pledging increases too much, it raises a red flag. Even leading companies can be a victim if pledged shares are not reduced over time.
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