Minority Shareholder Pitfalls

by puneinvestor

134668087_49ef6801c2_o

When analysing an investment opportunity, it is important to verify that management has a history of treating minority shareholders fairly. Here’s a handy list of potential red flags.

Equity or debt investments in other companies

Owing to the history of family ownership of companies in India, many extended families control groups of companies. The family’s group-wide interests sometimes override those of minority shareholders in individual companies. It is technically and ethically not okay for the controlling shareholder to use the strength of one group company (having a unique set of minority shareholders) to prop up another group company that might need financial support. Such investments rarely provide adequate compensation to the investing company for the risks being taken. Sometimes the risks are high enough to warrant no investment whatsoever. A subset of this type of issue is mergers between group companies. In this manoeuver, a weakening company is rolled into a stronger one with the shareholders of the latter bearing the brunt.

Joint ventures (JV) or subsidiaries with promoters as shareholders

This is a particularly pernicious form of theft of minority shareholder property. A subsidiary or JV is set up with promoters or their relatives as shareholders and directors of the subsidiary — this is an excellent way to pilfer away a large portion of the economic interest of a company. In the cases where I have seen this, management could easily have set up wholly-owned subsidiaries or made the required investments within the parent companies. Instead, they will provide a nonsensical explanation for why the subsidiary was necessary or better still won’t bother with an explanation at all.

Loans and advances (L&A) written off

This is quite a well-known trick used by shady managements to siphon off some moolah. Loans are made to entities and carried on the balance sheet for a few years as good. Then, quietly, they are written off. There is very little reporting by management about why the loan was made or what went wrong. Usually, the amounts written off are quite significant relative to the bottom line of the company. While balance sheet line items pertaining to investments are quite detailed, the L&A line item is almost never broken out by entity receiving the loan. It is an opaque sliver of data merrily used to tuck away shenanigans.

Related party transactions like royalties, rents or asset transfers

Everything on this list is about money or interest effectively being transferred to related parties. This particular point covers related party transactions officially acknowledged as such but claimed to be made at arm’s length. Any transfers that don’t seem like they are fair or at market value should be investigated further. There is plenty of wiggle room in the rules and regulations for managers to be grossly unfair to minority shareholders while following the letter of the law.

Huge or maximum allowable salaries to promoter managers

If promoter managers pay themselves exorbitantly in relation to the bottom line or squeeze out every paisa they can, through salaries and bonuses, that’s a red flag for me. Again, family-controlled enterprises are more guilty of this offence. A few too many cousins and nephews are squeezed into the salary cap mandated by the regulator. Of course, at the end of the day, you must make judgment calls about the value being brought to the table by executive management, but it’s good practice to keep an eye on compensation levels.

Preferential allotments of equity or warrants

In my book, preferential allotments are guilty until proven innocent. It’s always better to see a company do a rights issue than a selective issue to promoters or other investors. If the company can offer shares to a few investors, it should offer the same deal to all shareholders. The main argument put forward by proponents of these issues is that funds can be raised quickly and efficiently. They may have a theoretical point, but in practice this flexibility is abused far too often.

There can be grey areas in making assessments about the quality of corporate governance at a company, so there’s no need to write off a management team based on one iffy transaction here or there. However, if you intend to become a minority shareholder, it is very important to check for a pattern in this matter. If you don’t, you could end up with a cheat as your senior partner.

.

.

.

.

.

Image © J B