A widespread sell-off in the equity markets amidst the coronavirus (COVID-19) outbreak is likely to deplete the cover available to investors in loan against shares (LAS) transactions. This could require borrowers to pledge additional shares to replenish the share cover, resulting in a rise in the proportion of pledged promoter holdings, says India Ratings and Research (Ind-Ra).

 

In a report, the ratings agency says, "The decline in equity market prices comes against the backdrop of rising uncertainty surrounding the extent of disruption emanating from the COVID-19 outbreak. Equity prices bear a strong correlation with the earnings quality of an entity. Thus, the weakening share price in this case is accompanied by a similar erosion of the liquidity buffers of the underlying borrower. This could affect the entity’s ability to meet any unprecedented cash outflows emanating from an untimely recall of LAS or even pledge additional liquid collateral."

 

In assessing LAS transactions, Ind-Ra evaluated two parameters—the probability of liquidation and the quantum of loss on liquidation. The agency says it believes that in the current market conditions, not only has the probability of liquidation increased, due an increase in encumbrances, but also the loss on liquidation is expected to be higher than what would have been initially factored in by lenders, owing to the sharp correction in equity prices.

 

According to the ratings agency, 21 out of the BSE 500 companies are likely to face early redemption. Ind-Ra says its analysis indicates that 21 BSE 500 companies will be required to pledge more than 100% of the promoter holding as on 19 March 2020 to maintain a minimum 2.5 times share cover, assuming the quantum of LAS transactions outstanding as on 31 December 2019. 

 

"In other words, these entities could be required to pledge additional collateral or deposit cash to maintain the original security cover. For these companies, more than 75% of the promoters’ holding was already pledged as on 31 December 2019. Consequently, investors in these LAS transactions could either be required to restructure these exposures, liquidate the collateral or in some cases also recall the loans," it added.

 

 

According to Ind-Ra, during this period, financial flexibility of corporates to be constrained. Even in cases where the promoters have additional unpledged shares available, the rise in the proportion of shares pledged is likely to impede the financial flexibility of these entities in these challenging times, it says, adding, the proportion of unencumbered promoter shareholding determines the maximum share price correction a LAS transaction can sustain and, hence, is directly related to the probability of liquidationc and by extension probability of default.  

 

Given that Ind-Ra’s adjusted base case assumes a gradual recovery from the COVID-19 outbreak, the recovery in the equity prices could also be protracted. In case there is a further build-up of risk aversion in the capital markets, equity prices could fall further—thereby necessitating additional share pledges to maintain the security cover, it added.

 

Ind-Ra says its analysis indicates that the companies already classified as elevated risk of refinancing as per its asset funding and refinancing risk study are likely to be most affected. A large number of these companies already have a significant proportion of their promoter holdings pledged, it says. 

 

As per the ratings agency’s analysis, of the 58 companies likely to have more than 50% of their promoter holdings pledged, 19 are already in default while another 19 are classified as elevated risk of refinancing.

 

 

According to Ind-Ra, there is a strong correlation between operating cash flows and share price movement. As on 31 March 2019, the total debt outstanding with the aforementioned 58 companies stood at Rs5.35 trillion, while Ind-Ra estimates LAS transactions to account for Rs343 billion (at 3 times share cover) to Rs411 billion (at 2.5 times share cover). "It is imperative to note that the entire quantum of LAS transactions may not be outstanding on the books of these companies; rather promoters often pledge the shares of operating entities to meet the liquidity requirements of other group companies," it added.

 

Ind-Ra’s analysis also indicates that sectors such as power, construction and metals—which have historically been most exposed to cyclical risks and have recently been under stress are likely to see a high proportion of their promoter holdings pledged. This highlights the inherent risk in these LAS transactions—i.e., the high degree of correlation between the earnings, liquidity and share price.

 

Historically, the ratings agency says, players in these sectors have been accessing the LAS market to fund cash flows mismatches. "Incidentally, the fixed asset coverages for these sectors have been low and therefore, the ability of these entities to raise additional funds organically using operating assets has been restricted. This leaves investors in LAS transactions extremely vulnerable as the share covers deplete in tandem with the liquidity of these borrowers," it added.

 

 

In an event of defaults, Ind-Ra sees coercive debt exchange taking place. In the past, there have been cases where the promoter had asked the investor to delay the margin call even in the event of breach of covenant. "The investor or lender had to comply with the borrower as the liquidation of shares may result in a loss on the investment; which they can avoid if they believe that the promoter should be able to make payments after the extension," the ratings agency says.

 

Ind-Ra says it perceives these exchanges as coercive in nature however, given the present situation and the dispensations being provided by the Reserve Bank of India (RBI) and it will evaluate the implications and reflect it appropriately in the rating.