In recent years, the debt mutual funds have started lending money to promoters against their shares. Giving the inefficiency of the PSU banks in providing loans to corporate promoters in a quick way, the non-banking financial houses like mutual funds come up as an alternative way of lending where promoters lend money from mutual fund house against their own shares as collateral.
The Securities & Exchange Board of India (SEBI) has taken a step in conducting a detailed probe into such complex lending structures and asked the mutual fund trustees to review the exposure and risk management practices of the debt schemes and aware investors of the promoters pledging.
In this article, we’re going to discuss the major risks of lending money to promoters by the mutual fund houses.
3 Major Risks of Lending Money to Promoters
Although there is nothing illegal in lending money to promoters against their shares however you need to understand that these loans are quite risky. Some of the major risks involved in lending money to promoters are given below:
Default Risk: Default risk is one of the major and most common risks in any loan. So, definitely, there is a risk of default when lending to promoters. You must know that the market reacts suddenly when investors find out that the promoters have pledged their own shares.
Well, what’s the worse could happen?
It could lead to a sharp fall in share prices. Because –
- First, it will signal that the promoters who supposed to be an insider to the corporate business are trying to exit.
- Second, corporate promoters hold a huge amount of shares. When these shares will be on sale in the open market, it will increase the supply without any corresponding increase in demand. As a result, share prices plummet rapidly.
Liquidity Risk: It is another drawback of mutual funds’ lending to promoters where two parties are under a bilateral agreement. However, it is not an active market or secondary market where such contracts are traded. As a result, when the fund house lends money to the promoter, it left with no option except to retrieve that money from the promoter itself.
Also, they have to hold the shares until maturity and cannot sell to the third party without taking a substantial haircut.
Due Diligence: The fund houses are not capable of conducting due diligence for the loan that they gave to some promoter. They just trust the judgment of another person they’re lending to. For instance, if a promoter plans to pledge the shares to lend money from a fund house and then invest in other business.
So, if we take this from the lending point of view, it is unreasonable!
Hope, this will help you to look around add help you in understanding the risks involved in lending money to the promoters.