Equity investments carry a lot of risk. This is not just a standard disclaimer but a fact that has often been borne out. Macro risks such as global events, policy changes and industry cycles add volatility to company performance and stock price. But worse are the vagaries of decisions taken by majority shareholders to the detriment of minority or small retail investors.
Management decisions — be it allocating capital, mergers or other restructuring — impact company performance and investors. Often, those who hold majority stake in a company may decide to ignore the concerns of smaller shareholders. As a result, even if the decision works out profitably for the promoters, other investors get a raw deal. Some examples include merger terms that are unfavourable to those with small stake holdings, promoters pledging their personal share holdings, inefficient use of funds and unfavourable operation and pricing decisions.
Debt do us part: Cairn-Vedanta
A common issue faced by retail investors globally is the issue of related party transactions by promoters. For example, a promoter, who may also have ownership interests in another company, may decide to grant favours to the other entity. This could be by way of pricing terms for product or service purchase or price and terms during an acquisition.
A recent example that irked many minority shareholders was the deal between Cairn India and Vedanta. Oil and gas major Cairn was cash-rich, while its parent Vedanta, a global mining major, was debt-strapped. Vedanta was given a two-year term ‘loan’ of $1.25 billion in June 2014 at a floating rate of LIBOR plus 3 per cent. Minority shareholders had no say in this. The loan was later extended by two more years in June 2016.
Also, Cairn was to be acquired by Vedanta on a 1-1 swap ratio, with Cairn shareholders getting one redeemable preference share (coupon of 7.5 per cent and tenure of 18 months). The benefit for Vedanta would be access to the nearly ₹17,000 crore cash lying with Cairn to pay off part of Vedanta’s debt plus the waiver of the sizeable debt already taken.
The deal valuation was not seen favourably and there were other concerns. For example, Cairn would have to compete with other capex-heavy segments in Vedanta for capital for its expansion. So, the proposal met with stiff resistance — LIC, which owns 9 per cent shares in Cairn India as of June quarter (and is also a shareholder in Vedanta) was not happy.
Its approval was crucial, thanks to the new Company Act, which required that majority of the minority shareholders agree to the proposal. Vedanta revised the deal to give Cairn India shareholders 1-1 swap ratio and four redeemable preference shares. Not the best of deals possibly for Cairn, but it got the nod from minority shareholders and, importantly, the small shareholders could not be lightly ignored, as in the past.
Pledging problems: Tree House
Another common problem faced by retail investors is the uncertainty and volatility caused by promoters pledging their shareholdings. Just as loans can be raised on assets such as property and financial holdings such as fixed deposit receipts, lending institutions accept shareholdings as collateral when giving loans. Promoters, who own controlling stake in a listed company, may pledge their share to raise money — for their personal needs or for the company. Promoters continue to retain their ownership though the shares are pledged.
So, what is the problem with this? When the share price swings — which may be due to company-specific developments or broader market trends — the value of the collateral security may fall. If it dips below the margin of safety set by the lender, a margin call may be triggered. At this point, promoters have to make up for the shortfall, either by pledging more shares, paying money or providing other collateral. If not, the lenders may sell the shares in the open market.
Minority shareholders may find share value erosion due to sudden selling. Also, shares may be diluted as more shares are available in the market. It is also likely that the ownership may switch hands.
The practice of pledging shares is quite rampant — as of June 30, promoter share pledging in NSE-listed companies hit a seven-year high, as per a report by Prime Database. A third of the over 1,500 companies had their promoter holdings pledged. The number has gone up from 496 a year back to 509 in June and to 522 as on August 11, 2016. In 45 companies, shares were invoked in the last year.
One recent example is the stock price decimation faced by investors in Tree House Education & Accessories, a pre-school operator. The company had sizeable promoter shares pledged and the stock price began to correct in September 2015 due to issues such as long receivable cycles. The fall led to more pledging and stake sale by the promoters. There was also a merger offer by Zee Learn — this was unfavourable to minority shareholders but found favour with Tree House’s promoters, possibly given the company’s financial situation.
The stock has dropped from about ₹400 in September 2015 to ₹35 levels currently. Promoter pledging has zoomed from 32 per cent to 99 per cent in this period. Zee has withdrawn the acquisition offer, leaving minority shareholders with an important lesson to learn.
Cash central: Coal India
It is not just large promoters or small cash strapped ones that mess up minority shareholders. The case of public sector unit Coal India shows that even when government holds the majority stake, small investors are no better off.
The investment case for Coal India is quite straight-forward — the company is the dominant supplier of coal, with high pricing power. It is cash-rich and could expand overseas with its hoard of money. But minority investors such as the Children's Investment Fund Management of UK had to fight an unsuccessful, two-year battle against Coal India and the government between 2012 and 2014.
Given Coal India’s strengths, its stock price performance has not been bright. This was due to the various pressures it faces. For example, the government plays a big role in setting coal prices. To ensure that coal is available to power plants and consumers at reasonable prices, Coal India is asked by the government to sign fuel-supply agreements with power producers. The government also places various limitations on e-auction of coal, such as a high margin segment, which dents profits.
Another issue in many cash-rich PSUs is the government’s desire to dip into the money. For instance, Coal India and other PSUs with a sizeable cash pile are required to pay a special dividend, which helps meet the government deficit. Profit-making enterprises are also required to issue bonus shares to existing shareholders. And to fund expansions, PSUs are advised not to rely on cash but consider market borrowings.
It may seem that all shareholders benefit from dividends, bonus and efficient capital allocation. But the promoter’s short-term desire for cash and lack of interest in finding investment opportunities can be detrimental to the long-term growth of the company and value creation for retail investors.
More mojo: Maruti Suzuki
Given the many issues faced by small shareholders, the Companies Act of 2013 has provided more protection and there is more awareness in the system. One good example of minority shareholder activism was in Maruti Suzuki India. The firm wanted to become a distributor of cars manufactured directly by the Suzuki Motor Corp, its Japanese joint venture partner.
Given Maruti’s expertise, minority investors felt it could build, operate and market cars by itself. Maruti put the matter to vote and received majority approval from the minority shareholders for the proposal.
The new Companies Act has also introduced the concept of class action lawsuit as a recourse to small investors who suffer losses due to mismanagement. Thanks to electronic voting, minority shareholders can have a say in various resolutions without a lot of effort.
Also, related party transactions are required to be approved by minority shareholders. There is also a new proposal where Sebi may ask companies to seek minority shareholder approval before granting non-promoters, such as private equity funds, special powers relating to the firm’s operations.