Debt raised on the basis of shares pledged by promoters can work only if a prudent level of overall cover, commensurate with risk, is available through promoter holdings (both pledged and unencumbered) on the overall promoter debt raised through holding or investment companies, Crisil, India’s top credit rating agency, said today.

Releasing a status report on such transactions titled ‘Covering the pledge’, Crisil said such debt, backed by inherently volatile equity shares from promoters as collateral rather than cash flows, is seldom repaid on maturity and often refinanced. They are, therefore, exposed to high market risk and typical transaction-level cover agreed to is often inadequate.

Of the ~Rs 38,000 crore of rated debt¹ in the market, about 90% had a transaction cover less than 2 times, and in some cases, as low as 1.2 to 1.3 times.

To put things in perspective, data on companies in the Nifty 500 Index for 2005-18 indicates that at an overall cover of 1.3 times, in 9 out of 10 cases the market value of such shares could have dropped below the debt contracted within a month, leading to losses to lenders. And in 5 out of 10 cases, an overall cover of even 1.8 times could have fully depleted within a month because of the fall in share price, making refinancing difficult.

In case of a breach of covenants, lenders typically have less than a month to liquidate pledged shares. And the equity market may not have the depth and liquidity to absorb simultaneous liquidation by multiple lenders. Besides, enforceability of pledged shares has faced both legal and practical challenges in the past.

Reasons why assessing such transactions on the basis of overall cover available on the entire promoter debt is necessary. A high overall cover will ensure transaction covenants can be complied with because of the availability of unencumbered shares as top-ups to avoid pledge invocation.

Says Gurpreet Chhatwal, President, Crisil Ratings, “The overall cover acts as the first line of defence. It determines refinancing ability, and provides flexibility to pledge additional unencumbered shares to maintain the minimum pledge cover requirements and prevent breach of covenants in any specific transaction.”

Crisil’s overall cover requirement for assessing the debt of promoter holding companies depends on the rating category, an auto-correct feature that adjusts based on the state of the market and sensitivity of the specific stock to overall market movement. Crisil also factors in the credit profile of the company whose shares are pledged, and the quality of the management.

Says Somasekhar Vemuri, Senior Director, Centre of Excellence, Crisil Ratings, “Crisil typically considers a ‘base’ or minimum cover of 4 times for a promoter holding company to be rated in the ‘A’ category. The overall cover requirements also take into account the state of the equity market, stock-specific volatility, future debt-raising plans and management stance on leverage levels.”

¹ Data related to rated ‘pledge’ debt as of January 15, 2019. Crisil has not rated any of these transactions.

Annexure

Quantifying pledge-based rated debt in India

• An estimated Rs 38,000 crore of rated debt (accounting for 30-40% of total pledge debt of promoters), backed by pledge of shares, has been raised from the market to date. More than 60% of this is rated in the ‘AA’ category or above, and almost 90% is in the ‘A’ category or above
  
• ~90% of the rated pledge debt has transaction cover of less than 2 times. This is in sharp contrast to the Reserve Bank of India’s (RBI’s) prescription of a minimum collateral cover of 2 times for lending against shares by banks and non-banking financial companies (NBFCs)
  
• ~10% has transaction cover of 1.3 times or lower, and provides for additional illiquid collateral (unlisted shares, real estate mortgage) to compensate for the lower cover
  
• For ~30% of the rated pledge debt, the pledged shares have to be liquidated within 10 days in order to recover debt and avoid a payment default following invocation
  
• The rated pledge debt transactions are backed by shares of 32 listed companies, of which, 13 are rated in the ‘A’ category or below, or are unrated