Chairmen look beyond share pledges
International banks have pulled back from providing share-backed financing to chairmen and controlling shareholders in Asia, as new forms of financing provide alternatives that provide more resilience during market downturns.
Pledging shares against a loan gives borrowers a much lower cost of funding and is less risky for lenders than uncollateralised lending. A loan to value ratio of 35%-40% is typical, meaning that there is some cushion if the share price slides.
Share-backed lending used to be popular in China, India and Indonesia, but appears to be used less often now.
“Eight or nine years ago, Asia was our biggest region for share-backed loans,” said the Asia investment banking head at a western bank. “Now it’s the smallest.”
While share-backed loans are cheap for borrowers, rapid drops in share prices can lead to a spiral of selling, as lenders require borrowers to top up the reduced value of the share collateral, or failing that hand over the shares.
“During a market downturn, having major shareholders with shares pledged becomes a lightning rod for volatility because you see rapid-fire selling and that hurts everyone,” said Kher Sheng Lee, co-head of Asia Pacific and deputy global head of government affairs at the Alternative Investment Management Association.
In January 2019 Jiayuan International’s share price plunged 80% in a single day. A few days later, the developer announced that around 3% of the shares owned by its controlling shareholder had been offloaded in forced sales by securities brokers, implying that he had pledged them against loans.
In 2020, lenders to China’s Luckin Coffee suffered heavy losses after a company controlled by the family of chairman Charles Zhengyao Lu defaulted on a US$518m share-backed loan, a week after the company admitted inflating its 2019 sales.
Attractive alternatives
“A lot of chairmen have moved to collar financing,” said the investment banking head. Loans are accompanied by equity derivatives with a ceiling and floor price, limiting the risk for borrowers. If the share price falls through the floor, borrowers can add more shares to top up the margin, or amend the terms to roll over the financing at a lower floor price.
Another Asia investment banking head said share-backed borrowing by controlling shareholders had declined a lot in the past two or three years, partly due to the emergence of more attractive alternative forms of financing.
“In India, there have been a spate of equity issues so the ability of promoters to raise capital has been satisfied,” he said. “Holdco financing or mezzanine financing is more readily available for promoters now. It’s much easier for companies to do subordinated borrowing now. There is a lot of private credit chasing them.”
Private credit give borrowers more flexibility to manage facilities if they have trouble meeting repayment schedules, and they can usually pay an increased rate of interest in return for a waiver of default.
“We are seeing loans pledged against more diversified portfolios these days,” said an Asia ECM head. “Wealth clients are asking more about derivatives.”
Bankers said Chinese banks have been increasingly active in providing share-backed loans to company chairmen.
Such transactions are very opaque. In jurisdictions like Hong Kong and India, there are very limited disclosure requirements, so the public has no idea whether a large amount of shares are pledged – until they are reported sold.
Under Hong Kong’s rules, after the first year of listing, pledges of shares by a controlling shareholder, defined as someone with a stake of 30% or more, to a financial institution do not need to be disclosed if the financing is for personal use.
When Hong Kong’s Securities and Futures Commission in 2005 considered changing disclosure rules for share pledges, it noted: “It is likely that disclosure will in itself cause market fluctuations.” After gathering market feedback it decided not to make any changes.
In 2017, shares in China Huishan Dairy plunged 85% in a few hours as the result of unwinding a loan backed by almost all the controlling shareholder's stake. At the time Ashley Alder, then CEO of the SFC, told Reuters the regulator needed to take a “hard look” at the use of share pledges and consider whether shareholders needed to know about them earlier. No changes have been made since then.
“The rules around disclosure are fragmented around Asia,” said AIMA’s Lee. “We would welcome any measures that would improve transparency.”
Some worry that new entrants to the business might not put the appropriate safeguards in place, like holding the shares in custody.
“If they are not structuring these things properly, you could have the same shares being pledged to two different lenders and the lenders might not know,” said one market participant.
The second Asia investment banking head said that his institution had stopped providing share-backed loans to controlling shareholders and now focuses on share-backed lending to private equity sponsors, which tend to have higher compliance standards.