Leveraged Promoters, Haemorrhaged Stockholders

1. Let’s say that a highly-profitable, listed business is un-leveraged but its promoters are highly leveraged in their personal balance sheets. Let’s also say that loans taken by the promoters are secured by the collateral of the promoters’ shares in the listed company.
2. Let’s further assume that the mistakes were made by the promoters with the money they had borrowed and it’s gone. Or it’s substantially gone. What happens next?
3. What will happen next is that the lenders who hold the collateral will dump it in the market and the stock price will crash. Some lenders may not do this for a while because of other compulsions such as the need to maintain the relationship with the promoters, or the need to avoid creating a massive selling pressure on the stock etc etc. And so they may enter into “standstill agreements.”
4. One problem with such agreements is that the incentive to cheat is high. The lender who abandons the agreement and dumps the stock has the best chance of recovering his money. So, he has an incentive to quietly dump the stock. This kind of thinking amongst lenders make standstill agreements (like cartels) inherently unstable.
5. The other problem is that these agreements are not secret. The market knows. The market knows that the agreement has a limited life and the lenders have thrown a lifeline to the promoters. A lifeline to somehow find the money from somewhere, anywhere to prevent their shares being dumped in the market.
6. And if the market believes that no money will come or not enough will come (and the market may be right or wrong about this belief), then the stock price will crash because of what we call as “supply overhang.”
7. Notice, for the stock price to crash, it is not necessary for the actual dumping of shares to occur, although that’s often the case. But it’s not a precondition. Markets set prices based on expectations and not reality. It’s the EXPECTATION of the stock price crash that creates the stock price crash.
8. And so, for no fault of theirs or the company, the minority stockholders will see the market value of their holdings in the stock plunge by a huge amount leading to a situation I earlier labeled as “Leveraged Promoters, Haemorrhaged Stockholders.”
9. Many value investors, at this time, think along the following lines: “The stock price has crashed by 50% or even more. The multiple is low. The balance sheet is strong. The problem is not in the company. The problem is in the promotors’ balance sheet which is totally irrelevant for the purpose of valuation. And as the price has fallen but the value remains unchanged, the margin is safety has gone up. This is a wonderful opportunity to buy the stock.”
10. And it seems logical to think like that. After all, why should the value of a firm depend on what’s going on in the personal lives of its owners? But can this type of thinking go wrong? If so, then under what circumstances?
11. If we really think a bit more deeply about this, we can visualise situations where the value of the firm is NOT independent of the whatever is happening in the life of the promoters.
12. One example: If the promoters are in deep shit, but the company they own is not, then there’s always the temptation to raid the coffers of the company to escape from the “clutches of creditors.”
13. There are multiple ways this can be accomplished. Just make the company borrow money and then get it to lend that money to a company controlled or “influenced” by the promoters, who then pays off their lenders. If something like that happened, clearly the value of the firm is reduced to the detriment of minority shareholders.
14. Another way: Make the company buy something belonging to the promoters at inflated value and get a friendly and compliant Chartered Accountant to bless the valuation.
15. I could go on to tell you about many more ways to do this, but I think you get the point. The value of a firm is NOT independent of what’s going on in the personal life of its promoters. And that, of course, is a big reason which explains why markets are wary of companies in which a large part of the promoter stake is pledged. They are wary for the right reasons.
16. Another Example: If the lenders do dump the stock then whoever buys a lot of it gets to control the company. What if the new owner is a crooked person who will merge the company into his other company by using a highly favorable swap ratio, blessed, of course, by a friendly and compliant Chartered Accountant?
17. If the ownership of the company is going to change, then to value the business properly, minority investors needs to know how they will be treated by the new owners. And any uncertainty about that must be factored into the valuation equation TODAY.
18. The reason I am citing these examples is to show that while a stock price crash in such situations is likely to create an attractive investment opportunity, it’s not a sure thing. It’s not a slam dunk. Things can still go very very wrong.
19. Of course this does not mean that one should avoid investing in such situations post the stock price crash. What it does mean that the investor’s thought process must factor in these hidden risks and the consequences of those risks.
20. Risk has a way of materialising in ways that people often find hard to imagine. Just as Robert Rubin’s once explained when he described the true nature of risk and who, ironically, saw it manifest itself in his own life a few years later and in the very manner he described it:
21. “Condoms aren’t completely safe,” Rubin said. “My friend was wearing one and he was hit by a bus.”