How Promoters benefit from Related Party Transactions

We believe that an investment in a stock is a faith in the integrity and shareholder-friendliness of the promoters. But many times, related party transactions break this faith.

Stock investment is much more than the part-ownership of the company. This is because the person-in-charge of the company, the promoter, can play God. He decides the fate of the minority shareholders in the company.

If the promoter chooses, then he/she can easily ensure that the minority shareholders will never benefit from the fruits of good business performance of the company. The promoter/management stands between the business of the company and the minority shareholders.

Investors would remember numerous instances in the corporate world where the promoters siphoned off the money from the business and the minority shareholders paid the price for promoters’ misdeeds. In many such instances, the promoters made merry while the wealth of the minority shareholders was destroyed.

Whenever, an investor analyses such instances, then she notices that in most such cases, the promoters used “Related Party Transactions” as a route to take the money out of the company.

Related party transactions represent the transactions entered by the company with the promoters/managers, their family members, and the companies/entities owned by them.

Any transactions where a company buys/sells goods or services, gives/takes loans, invests/gets investment from promoters and their entities, is regarded as a “Related Party Transaction”.

Law has made it mandatory for companies to disclose all the transactions that they enter with promoters/related parties in the annual report. These transactions are summarized in a section in the annual report called “Related Party Transactions”.

Related party transactions section is the single most important part of the annual report for assessing the management quality of any company. Investors must study this section of the annual report to understand the attitude of promoters and their commitment towards the company.

This section is usually presented in the last parts of the annual report after all the financial statements including their detailed notes are over. Therefore, it is highly probable that investors may miss reading this section as either they take it as an unnecessary section or they may be tired after reading more than a couple of hundred pages before they reach the “Related Party Transactions” section.

However, repeatedly, the events of the corporate world have proved to the investors that they may ignore the related party transactions at their own peril.

Our experience of analysing hundreds of companies for our website as well as for our personal investments has shown that in nearly all the cases of promoters’ siphoning off the money, the related party transactions section has had the cues.

Whether it was interest-free/cheap loans given by the company to the promoters or selling assets of the company dirt-cheap to the promoters or buying promoters’ assets at a sky-high valuation, the related party transactions section contained an entry mentioning the transaction.

We believe that if an investor focuses on the “Related Party Transactions” section of the annual report while doing their stock analysis, then she can pick up the red flags related to promoters’ misbehaviour at an early stage. As a result, she can safeguard her hard-earned money from negative surprizes later-on.

In the current article, we aim to highlight to an investor our learning from analysing hundreds of companies about how promoters benefit themselves at the cost of minority shareholders using related party transactions’ route.

The current article would attempt to highlight the different types of transactions entered by the companies with their promoters that had the potential of shifting economic benefits from the company to its promoters.

In addition, the current article would provide real-life examples with references to the different segments of the annual report that provide the essential information to conclude the nature of these transactions.

We recommend that an investor should focus on the process of identifying the transactions, and the various sections of annual reports providing this information so that she may incorporate this process in her own analysis framework. Such learning will help her improve her own stock analysis as well as protect her hard-earned money while she takes investment decisions.

Let us now delve into different related party transactions and the impact that they have on the company and its minority shareholders.

Different types of related party transactions that investors should focus on

As mentioned earlier, any transaction between a company and its promoters, their relatives & their entities is a related party transaction. These transactions come in all shapes and size like lending transactions to the company and from the company, investment in the company and from the company, sales & purchases to the company and from the company, consulting services provided to the company and from the company etc.

As per our experience, the key related party transactions between the company and its promoters that an investor should pay attention to as they have the potential to shift economic benefits from the company to the promoters usually fall under following important categories:

1. Lending transactions between the company and the promoters:
   1. When a company gives loans to the promoters:
      1. Many times, companies give loans to promoters and then write them off later. It indicates that the company cannot recover the money from the promoters. It effectively means that the company has given free money to the promoters.
      2. On other occasions, companies give interest-free/cheap loans to promoters and their entities. It means that the promoters enjoy cheap money in their personal ventures whereas the minority shareholders bear the cost of the funds esp. if the company has taken loans from banks to give the money to promoters.
   2. When a company takes loans from promoters at a high-interest rate:
      1. Many times, companies take loans from the promoters; however, they pay such a high-interest rate to the promoters for these loans, which is higher than the cost at which the company can take money from the banks or the interest rate that the promoters will get if they put the money in fixed deposits in the banks. As a result, the promoters gain at the cost of minority shareholders of the company.
2. Buying and selling assets/equity stake between the company and promoters’ entities:
   1. When companies buy assets/companies from promoters at a high price:
      1. It represents a situation where the promoters get a higher price by selling their assets to the company than what they would generally get from the market. In such cases, ultimately, the minority shareholders pay the price.
      2. It also includes the cases where the promoters enter into a joint venture with the company to start a new business and later when the business fails, then the company buys the stake of the promoters to bail them out. In such cases, ultimately, the minority shareholders bail out the promoters.
      3. On other occasions, the company invests and provides seed capital to the promoters to help them start their personal ventures. It is effectively, the minority shareholders funding the personal ventures of the promoters.
   2. When companies sell assets to the promoters at a cheap price:
      1. In such cases, the promoters first make the company buy an asset from the market, and then, in turn, they purchase it from the company at a lower price.
      2. Many times, the companies create assets/businesses by investing money and resources, and then promoters buy it at a cheap price from the company.
      3. On other occasions, the promoters make the company buy assets from the market and then the promoters use these assets for their personal use free, at no cost to themselves. Investors would have noticed instances of promoters using the company money to purchase yacht; private jets etc. that promoter use for their personal purposes.
      4. In all the above cases, the minority shareholders end up bearing the cost for the promoters’ gains.
3. When companies give advances or security deposits to the promoters at generous terms:
   1. Many times, companies give interest-free deposits to promoters while entering into business dealings with the promoters. At times, these deposits are disproportionately large. At times, when the company takes a building owned by the promoters at rent from them, then it may give them an interest-free security deposit that may be equal to the purchase cost of the building. So effectively, first, the minority shareholders help promoters buy the building by giving them the large security deposit and then pay them the rent for allowing the company to use the building.
4. When companies enter into sale/purchase/consulting/contracting business transactions with promoters.
   1. In such cases, it is the promoters who decide how much business or how much profit margin they will leave for the listed company and how much profit margin whey will keep for themselves. In almost all such cases, the listed company and the minority shareholders are at the mercy of the promoters.
5. When promoters own competing businesses in their personal capacity.
   1. In such situations, the investors would believe that the promoters source the business from the customers and, in turn, the promoters as managers of the listed company, as well as owners of their personal business, decide how much business to allocate between the listed company and their personal business. The listed company and the minority shareholders are completely at the mercy of the promoters to let any business flow through the listed company. Moreover, at times, when the personal business of the promoters is running at full capacity, then they may outsource some job/contract work to the listed company, keeping high margin final marketing business in their personal business.
6. When companies provide guarantees to lenders on behalf of promoter group entities.
   1. In such situations, it may seem that the listed company has not entered into any monetary transaction with the promoters. However, the guarantee given by the listed company ensures that the promoters enjoy the fruits of their personal business until the time it runs successfully. In case, their personal business fails, then they would not bear the consequences personally, as the banks will recover their loans from the guarantor i.e. the listed company. Such situations are equivalent to the promoters enjoying high returns in their personal businesses without facing the risk because the risk is ultimately borne by the minority shareholders giving the guarantee via the company.

An investor would appreciate that there is more than one way in which the promoters can easily take out the economic benefit from the company at the cost of minority shareholders. Therefore, investors need to be very cautious in their analysis before they make an investment decision about any company.

Let us see different real-life examples where the promoters have entered into related party transactions with their companies. Let us see how an investor can identify and interpret these related party transactions by reading the annual reports and other publicly available documents.

1) Lending transactions between the company and the promoters

Lending transactions between the company and the promoters take both the forms, when the company gives loans to the promoters & their entities and when the promoters give loans to the company. In both circumstances, there are many opportunities for the promoters to take out economic benefits from the company.

Let us see each of these situations with examples below.

A) When a company gives loans to the promoters:

In situations when companies give loans to the promoters, then investors would notice that the promoters enrich themselves via two methods.

In the first situation, the company gives loans to the promoters and then later it writes-off these loans indicating that it cannot recover these loans from the promoters. Such a situation is like giving free money to the promoters.

In other situations, the company gives loans to the promoters; however, it gives these loans as interest-free or at a very low-interest rate than what the promoters would get from banks or other lenders.

In both these situations, the promoters of the company enjoy the benefits of free/cheap money and the minority shareholders bear the cost of it.

Let us see real-life examples of both of these situations.

i) Companies give loans to the promoters and then write them off:

As described earlier, these circumstances are like handing over free money to the promoters where the promoters get the money from the company and then never return it.

The following companies present such a situation to the investors.

a) Escorts Ltd.

Escorts Ltd is an Indian company involved in the manufacturing of tractors & agricultural machinery, construction equipment and railways equipment.

While analysing the company, an investor comes across many instances where the company has given loans to related parties and various inter-corporate deposits that it wrote-off indicating that it would not be able to get this money back.

In one instance, in FY2017, Escorts Ltd disclosed that it fears that it would not be able to recover an advance given to one of the related parties.

FY2018 annual report, page 140:

The company has reported similar incidences in the past as well.

In the FY2005 annual report, the auditor of the company highlighted that Escorts Ltd has given loans of about ₹11.55 cr to related party companies (under section 301 of the Companies Act) from which it is not able to get the money back. As per the audit report, in FY2005, Escorts Ltd has stated that ₹6.91 cr is doubtful for recovery.

FY2005 annual report, page 29:

The Company has granted unsecured loans to three companies covered in the register maintained under Section 301 of the Companies Act, 1956. The maximum amount involved during the period was Rs.12.51 crores and balance of the loans granted to such companies was Rs.11.55 crores as at September 30, 2005.

As explained to us, in respect of outstanding loans including interest accrued up to June 30, 2004 the repayments are not forthcoming due to financial constraints of these companies. In view of the aforesaid, no interest has been charged during the period under review. A provision amounting to Rs. 6.91 crores has been made for the amount considered doubtful of recovery.

In FY2009, Escorts Ltd provided for the ₹25 cr of inter-corporate deposits given by it to other companies indicating that it might be difficult to recover this money.

FY2009 annual report, page 117:

Investors would appreciate that giving money to counterparties and then acknowledging that it would not be able to recover them is effectively handing over the money of the shareholders to the counterparties.

An investor may read our complete analysis of Escorts Ltd in the following article: Analysis: Escorts Ltd

b) India Glycols Ltd.

India Glycols Ltd is an Indian company manufacturing glycols, ethylene oxide derivatives using renewable raw material (alcohol, molasses), guar gum derivatives, alcohol & spirits, industrial gases, and nutraceuticals.

While analysing the company, an investor comes across instances where the company has given loans to the promoter group entities and then provided for them indicating that it would not be able to recover the money. At times, India Glycols Ltd gave additional money to the promoters’ entity so that the entity could repay the earlier loan to India Glycols Ltd. It is called evergreening in banking situations.

While analysing the transactions of India Glycols Ltd with its promoter group entities, an investor notices that the company via its subsidiary, IGL Finance Ltd, had made investments in preference shares of one of the promoter group entity, Hindustan Wires Ltd (HWL) at least since FY2006 (the earliest available data in the annual reports).

FY2007 annual report, page 46:

India Glycols Ltd disclosed in the FY2009 annual report that Hindustan Wires Ltd is an entity over which the key management personnel have significant influence.

FY2009 annual report, page 56:

Enterprises over which Key Management Personnel have significant influence:

• Ajay Commercial Co. (P) Ltd.
• J. B. Commercial Co. (P) Ltd.
• Kashipur Holdings Limited
• Polylink Polymers (India) Ltd.
• Hindustan Wires Limited

Moreover, as per the corporate database Zaubacorp, Mr. Uma Shankar Bhartia is the director of Hindustan Wires Ltd since 1981. (checked on March 25, 2020, click here)

In FY2007 and some of the subsequent annual reports, the company reported only the net amount of investment after provisions. Therefore, it was not possible to ascertain the total amount invested by India Glycols Ltd in these preference shares.

However, the company provided additional information in the FY2012 annual report, which indicated that the company had invested about ₹4.90 cr in the preference shares of Hindustan Wires Ltd. (4.68 + 0.22 = 4.90). The company acknowledged that out of the total investment value of ₹4.90 cr in these preference shares, the value has already diminished by ₹4.16 cr (=3.97 + 0.19). Therefore, the current value of these preference shares is only 0.74 cr representing a loss of value of 85% (4.16 / 4.90 = 0.85).

FY2012 annual report, page 84:

In FY2014, India Glycols Ltd provided money to Hindustan Wires Ltd (HWL) by way of fresh investment in the company so that HWL could repay its earlier investment in preference shares.

FY2014 annual report, page 76:

The subsidiary company, IGL Finance Limited, was having a provision of ₹416.00 Lacs towards diminution in the value of investments in the Preference Share Capital of Hindustan Wires Limited. During the year, the entire amount so invested was received back on redemption of Preference Share Capital. However, further investment of the similar amount was made in the Preference Share Capital of the said Company by the subsidiary company.

An investor would appreciate that such an investment by the company in HWL to enable HWL to repay its earlier preference share amounts to evergreening.

Therefore, an investor would appreciate that she needs to read the annual reports in detail in order to identify the instances where the companies have handed over free money to the promoters. This is because ultimately, the minority shareholders bear the cost of these funds.

An investor may read our complete analysis of India Glycols Ltd in the following article: Analysis: India Glycols Ltd

ii) When a company gives interest-free/cheap loans to promoters:

While analysing companies, investors would come across situations where the companies have given loans to the promoters either interest-free or at a very low-interest rate. Many times, these interest rates are lower than the cost at which the company had borrowed the funds from its lenders.

This effectively presents a situation where the company borrows funds at a higher cost from the market (banks/financial institutions etc.) and then gives cheaper loans to the promoters. In such situations, the minority shareholders have to bear the cost of the funds.

Let us see examples.

a) Virat Crane Industries Ltd:

Virat Crane Industries Ltd is manufacturer & seller of ghee prepared from buffalo milk ‘Durga Ghee’ and from cow milk ‘Kamadhenu Ghee’, in Andhra Pradesh and Orissa.

While analysing the company, an investor notices that the company has given interest-free loans to its associate companies (promoter group companies). As per FY2015 annual report, page 61, Virat Crane Industries Ltd has given interest-free loans of ₹8.4 cr. to its group entities, which are not its subsidiaries.

As highlighted, these loans are interest-free, effectively meaning “free money”. It is not clear the benefit these free loans provide to shareholders of Virat Crane Industries Ltd.

An investor may read our complete analysis of Virat Crane Industries Ltd in the following article: Analysis: Virat Crane Industries Ltd

b) IST Ltd:

IST Ltd is an Indian auto ancillary player, which is primarily earning its profits by being the parent company of the landowner of a Unitech Infospace.

While analysing the company, an investor notices that in FY2016, IST Ltd has invested funds (₹8.11 cr) in two related parties: Vinayakinfra Developers Private Ltd and IST Softech Private Ltd.

There is no information in the annual report or in the public domain, which can lead an investor to assess whether these companies have any operating business and if the money can be safely returned.

Moreover, as per the related party section of FY2016 annual report, these investments (₹8.11 cr) are earning an interest of about ₹63 lac, which amounts to a return of 7.75% (= 0.63/8.11).

The rate of interest of 7.75% being charged from related parties is low because as per FY2016 annual report IST Ltd has taken a loan of ₹12.5 cr. from an NBFC at 9.50%.

Such a situation is equivalent to borrowing at a higher rate of interest from the market at the cost of minority shareholders of IST Ltd and then giving benefit to related parties by passing on the loan to them at a lower cost.

An investor may read our complete analysis of IST Ltd in the following article: Analysis: IST Ltd

c) National Peroxide Ltd:

National Peroxide Ltd is a Wadia Group company and the largest manufacturer of hydrogen peroxide (H2O2) in India.

While analysing the company, an investor would notice that at many points of time in the past, the promoters of National Peroxide Ltd have used the resources of the company to help their other group companies. At times, the promoters made National Peroxide Ltd take a loan from financial institutions so that it could then give this money to other Wadia group companies.

c.i) National Peroxide Ltd took loans to give money to Wadia group companies (FY2015):

While analysing the financial position of National Peroxide Ltd over the years, an investor notices that in FY2015, the total debt of the company increased by ₹69 cr, from ₹4 cr in FY2014 to ₹73 cr in FY2015.

At the same time, in the FY2015 annual report, the investor notices that National Peroxide Ltd had given loans of ₹65 cr to different Wadia group companies, which had increased by ₹46 cr during the year from ₹19 cr in FY2014.

• Bombay Dyeing Real Estate Co. Ltd: ₹5 cr
• Archway Investments Ltd: ₹30 cr and
• Macrofil Investment Ltd: ₹30 cr

FY2015 annual report, page 86:

An investor may note that Archway Investments Ltd and Macrofil Investment Ltd are part of the companies through which the Wadia group owns its shareholding in National Peroxide Ltd.

FY2015 annual report, page 37:

As per the FY2015 annual report of Bombay Dyeing & Manufacturing Company Ltd (BDMCL), Bombay Dyeing Real Estate Co. Ltd (BDRECL) is its associate company where BDMCL holds a 40% stake.

FY2015 annual report of BDMCL, page 23:

This seems like an incidence where the promoter group is using National Peroxide Ltd as an avenue to raise loans from banks and then forward this money to its group companies for their benefit.

Further advised reading: Why Management Assessment is the Most Critical Factor in Stock Investing?

The credit rating agency, India Ratings, highlighted this transaction in its report for National Peroxide Ltd in Feb 2016.

NPL borrowed INR500m long-term loans and INR150m working capital demand loan (WCDL) in FY15. While the latter was availed to fund incremental working capital requirements, the term loan was largely deployed in group entities.

c.ii) National Peroxide Ltd again took loans to give money to Wadia group companies (FY2019):

While analysing the FY2019 annual report, an investor notices that at the end of National Peroxide Ltd had given loans of ₹238.5 cr to different Wadia group companies. These loans to the group companies had increased by ₹173 cr in FY2019; from ₹65 cr in FY2018 to ₹238 cr in FY2019.

FY2019 annual report of BDMCL, page 122:

An investor would also notice that in FY2019, National Peroxide Ltd took loans of ₹80 cr from its lenders. The company used to be a debt-free company in FY2018.

An investor may notice that in FY2019, the company did a capital expenditure of ₹75 cr on the capacity expansion project and the company may have taken the loan for usage in the expansion project. The credit rating report by India Ratings for the company in July 2018 mentioned that National Peroxide Ltd plans to take a loan of ₹125 cr to meet the total project cost of ₹200 cr.

NPL is undertaking a capex of INR2,000 million to increase its capacity to 1,50,000 metric tonnes per annum from 95,000 metric tonnes per annum. The debt of INR1,250 million undertaken to fund the capex and a decline in sales due to lower production will weaken the credit metrics in FY19; however, the ratios will remain commensurate with the ratings

However, an investor may appreciate that money is a fungible commodity. National Peroxide Ltd could have used its business profits to fund the capital expenditure instead of giving them as loans to group companies.

Therefore, a situation where a company takes loans to meet its capital expenditure and gives its cash reserves to group companies is no different from the situation where the company uses its cash reserves to meet the capital expenditure and takes loans to give money to the group companies.

National Peroxide Ltd could have avoided the debt and the interest cost if it used its business profits to meet the capital expenditure instead of giving this money to the group companies.

Looking at the above examples, an investor would appreciate that there is ample scope for the promoters to take economic benefits from the company when they take loans from the company.

However, an investor would notice that in cases where the company takes loans from its promoters, even there, the promoters find many opportunities to take our economic benefits from the company.

An investor may read our complete analysis of National Peroxide Ltd in the following article: Analysis: National Peroxide Ltd

B) When a company takes loans from promoters at a high-interest rate:

While analysing companies, an investor would come across many instances where companies end up taking loans from the promoters, their relatives, or promoter controlled entities.

Many times, however, the investor would notice that the company pays a high-interest rate to the promoters for these loans. The interest rate may be even higher than the rate at which the company can take money from the banks.

In addition, the interest rate would be higher than what the promoters would get if they put the money in fixed deposits in the banks.

As a result, in such transactions, the promoters earn a higher return on their money given as a loan to the company at the cost of minority shareholders of the company.

Let us see some examples.

i) Sharda Motor Industries Ltd:

Sharda Motor Industries Ltd is one of the leading manufacturers of the automobile exhaust system, seat frames, seat covers and white goods parts in India.

While analysing the company, an investor notices that the company has taken loans from financial institutions as well as from related parties. What comes as an insight for the investors is that the loans from related parties are at a higher interest rate than the loans from financial institutions.

While analysing the past annual reports, an investor would notice that Sharda Motor Industries Ltd has year after year taken loans from related parties/promoters.

FY2010 annual report, page 35:

FY2012 annual report, page 65:

FY2014 annual report, page 47:

FY2016 annual report, page 75:

FY2018 annual report, page 74:

Therefore, an investor would note that the promoters/related parties have continuously lent money to Sharda Motor Industries Ltd and earned interest on the same from the company.

While assessing the interest rate, which is paid by Sharda Motor Industries Ltd on these loans to related parties viz-a-viz loans from other financial institutions, the investor notices that the interest rate on these loans from related parties has been continuously higher than the interest rate on the loans provided by financial institutions.

As per FY2014 annual report, the loans from financial institutions were at an interest rate of 7.75%-8.45% whereas the loans from directors/related parties were at an interest rate of 10%-12%.

FY2014 annual report, page 44, 45 & 47:

The ECB loan consists of 2 loans:

i) First loan of US $ 2.0 Million was taken in August, 2012 and repayable in 15 instalments of US$ 133,333 commencing from 26.01.2014. The loan carries an interest rate of 8.45% p.a.

ii) Second loan of US $ 6.0 Million was taken in January, 2014 and repayable in Six instalments. The Loan carries an interest rate of 7.75% p.a.

c) Directors Loan: Payable on demand. The loan is taken on an interest rate of 10% – 12%.

As per FY2016 annual report, the loans from financial institutions were at an interest rate of 7.75%-8.45% whereas the loans from directors/related parties were at an interest rate of 10%-11%.

FY2016 annual report, page 72 & 75:

The ECB loan consists of 2 loans:

i) First loan of US $ 2.0 Million was taken in August, 2012 and repayable in 15 installments of US$ 133,333 commencing from 26.01.2014. The loan carries an interest rate of 8.45% p.a.

ii) Second loan of US $ 6.0 Million was taken in January, 2014 and repayable in Six installments. The Loan carries an interest rate of 7.75% p.a.

d) Loans From Related Parties: Loans from Related Parties are payable on demand. The loan is taken on an interest rate of 10% – 11%.

Therefore, an investor may interpret that Sharda Motor Industries Ltd has access to cheaper sources of funding from other financial institutions. However, it continued to rely on the loans from promoters/related parties to meet its cash flow requirements.

Investors may keep in mind that availing costlier loans from related parties when other cheaper sources of funds are available to any company may seem an attempt to shift disproportionate economic value from the company to the related parties/promoters.

An investor may read our complete analysis of Sharda Motor Industries Ltd in the following article: Analysis: Sharda Motor Industries Ltd

ii) Nile Ltd:

Nile Ltd is an Indian manufacturer of Lead and its alloys, supplying primarily to battery manufacturer Amara Raja Batteries Ltd.

While analysing the FY2017 annual report, an investor notices that the company has taken loans from the related parties (directors) as well as from banks. The investor notices that the loans from related parties are at a higher interest rate than the banks.

As per the annual report of FY2017 of Nile Ltd, the company has taken deposits of ₹9 cr. from related parties (page 56):

The company has also disclosed on page 46 of FY2017 annual report that these deposits bear an interest rate of 10-12% (weighted average cost of about 11%):

The cost of bank debt for the company in 2017 was as follows:

• HDFC Bank: 1 year MCLR + 0.7% = 8.15% (at Aug 9, 2017) + 0.7% = 8.85%
• Kotak Mahindra Bank: 6 months MCLR + 0.55% = 8.35% (at Aug 9, 2017) + 0.55% = 8.90%

Therefore, it seems that in case the company is in urgent need of funds, then it can raise funds from the banking system at a lower rate than the prevailing interest on the deposits from related parties.

An investor may read our complete analysis of Nile Ltd in the following article: Analysis: Nile Ltd

iii) Kanchi Karpooram Ltd:

Kanchi Karpooram Ltd is a manufacturer of camphor and its derivatives like gum rosin, value-added resins and fortified rosin. The company is based in Kanchipuram, Tamil Nadu.

While analysing the company, an investor notices that the company has raised loans from the banks as well as from its related parties (directors). An investor notes that the loans from the directors are at a much higher rate when compared to the loans from the banks.

While analysing the past annual reports of Kanchi Karpooram Ltd, an investor notices that for many years, the promoters have put money in the company in the form of loans. At the face of it, these loans seem a help by the promoters to the company to meet cash flow requirements.

However, when an investor notices the interest rate paid by the company on these loans from directors, then she notices that the interest cost on these loans is 13%, which is higher than the interest rate charged by banks to Kanchi Karpooram Ltd.

FY2018 annual report, page 66:

The loans taken by Kanchi Karpooram Ltd from lenders like HDFC Bank are in the range of 9.61% to 10.15%.

As a result, an investor would notice that the high cost of the interest rate paid by Kanchi Karpooram Ltd to directors does not seem to be in the best interest of the company.

Moreover, if an investor notices the interest rate available to individuals when they deposit money with banks, then she notices that an individual is able to get only an interest rate ranging from 5% to 7% from banks like SBI etc

Therefore, the loans from promoters to Kanchi Karpooram Ltd might be an attempt to get a higher interest rate on their funds than the interest rate provided by banks on the fixed deposits as the promoters are getting an interest rate of 13% from the company whereas the banks may provide an interest of 5%-7% on the fixed deposits.

An investor may read our complete analysis of Kanchi Karpooram Ltd in the following article: Analysis: Kanchi Karpooram Ltd

Until now, we saw cases where the companies were in the need for external funds and had taken loans from both the lenders as well as the promoters. In these cases, the companies had been paying a higher interest rate to the promoters than what was available to them from lenders. Therefore, it seemed that the companies could have taken loans at a lower interest rate from the banks instead of paying a higher interest rate to the lenders, which is against the interest of minority shareholders.

However, investors would also come across cases where the companies are cash-rich and do probably do not need any loan at all. However, still, the companies take loans from the promoters and pay them a higher interest rate than what the promoters would otherwise get from the fixed deposits in the banks.

Let us see an example.

iv) Datamatics Global Services Ltd:

Datamatics Global Services Ltd is an Indian company providing Information Technology, business process management (BPM), engineering, data, and analytics services. The company provides IT products for robotics process automation (RPA), analytics, business intelligence, and automated fare collection (AFC).

While doing the financial analysis of the company, an investor notices that Datamatics Global Services Ltd has been a cash-rich company throughout the last 10 years (FY2010-2019). The cash & investments of the company have increased from ₹69 cr in FY2010 to ₹130 cr in FY2019. During this period, the cash & investments peaked at ₹193 cr in FY2016.

Looking at such a cash-rich situation, an investor may believe that the company does not need to look for outside sources of cash to meet its requirements.

However, when an investor reads past annual reports, then she notices that Datamatics Global Services Ltd has taken loans from its directors, which are promoters of the company at an interest rate of 9%.

FY2016 annual report, page A85:

When an investor reads the related party transactions section of the annual report, then she notices that the above loan is provided by the promoters’ family members to the company.

FY2016 annual report, page A102:

The loans from the promoters appear in other years also like in FY2019.

FY2019 annual report, page 95:

These instances of taking loans from promoters and paying them interest seem counterintuitive for any cash-rich company. It may be due to any of the following situations:

a) Promoters want to make higher returns on their money by lending it to Datamatics Global Services Ltd:

Lending by the promoters to the company may indicate a situation that the promoters are flush with funds and are not finding opportunities to deploy those funds anywhere else at attractive rates of return. Therefore, they had lent this money to Datamatics Global Services Ltd and in turn ensuring that they get an interest income from Datamatics Global Services Ltd, which is higher than the interest income available to them outside.

From the above discussion, an investor notices that the company paid an interest rate of 9% to the promoters for the loan taken by it. The interest rate available for fixed deposits in the banking system currently ranges from 5% to 7%.

The lending of money by the promoters to Datamatics Global Services Ltd might indicate that the promoters are getting an interest rate of about 9% from the money put in by them into Datamatics Global Services Ltd against the interest rate of about 6%, which they might get when they put money as deposits in the banks.

b) Liquidity stress in Datamatics Global Services Ltd:

Another interpretation for the loans from promoters by a company can be that actually, the company is facing liquidity stress, as it might not be making sufficient cash from its business to meet the requirements of its operations and the debt repayments to lenders.

As a result, the promoters had to infuse money into the company to support its operations and debt repayments to outside lenders.

This interpretation would lead an investor to believe that if the promoters do not lend the money in the company, then the company would find it difficult to run its operations and it might default to the outside lenders.

Additionally, this interpretation will question the credit rating of A1 assigned by CRISIL and ICRA to Datamatics Global Services Ltd. The credit rating of A1 indicates a strong financial position with a low probability of default.

However, an investor would notice that in recent times, she would have seen cases where companies with a high credit rating as well as with high cash & investments defaulted to their lenders.

• IL&FS defaulted despite a high credit rating: An investor may remember the case of IL&FS, which defaulted to its lenders in FY2019. The company was rated AAA (highest safety) about two months before it defaulted. (Source Times of India: Why IL&FS was ‘AAA’ till two months ago)
• Cox & Kings defaulted despite having high cash & investments: An investor may also recollect the case of Cox & Kings, which defaulted recently on repayments of a few hundred crores rupees despite having cash & investments of thousands of crores rupees. (Source Moneycontrol: Defaults raise a curious case of mismatch at Cox & Kings)

The above two examples indicate that in the current environment neither a high credit rating nor the presence of high cash & investments can ensure a strong liquidity position of the company. Therefore, investors must stay vigilant when they analyse companies for investment.

Therefore, an investor would notice that the loan given by promoters to Datamatics Global Services Ltd might indicate a situation where the company is facing cash flow constraints to run operations and repay outside lenders. On the other hand, if Datamatics Global Services Ltd has a strong cash flow position to run its operations smoothly and has the ability to repay all its outside debt on its own, then the loans from promoters might indicate an attempt by them to get higher interest rates on their money than the deposit rates from banks.

We would suggest that the readers/investors may contact the company directly to seek clarification and should do further analysis to arrive at their own conclusion regarding it.

An investor may read our complete analysis of Datamatics Global Services Ltd in the following article: Analysis: Datamatics Global Services Ltd

Looking at the above cases, an investor would appreciate that she should be very cautious when she notices lending transactions between the companies and their promoters. This is because in such transactions whether the company gives loans to the promoters or the company takes loans from the promoters; in both situations, there are many opportunities for the promoters to benefit themselves at the cost of minority shareholders.

Let us move ahead from the lending transactions and now, focus on the situations where the companies and the promoters enter into transactions for selling or buying assets or equity stake from each other.

2) When companies buy or sell assets/equity stake from promoters

An investor would appreciate that in the cases where companies enter into buying or selling transactions for assets with the promoters, then the promoters can easily take away the economic benefit from the company in both the situations.

This is because the promoter can easily take out economic benefits from the company by either making the company buy assets from them at a higher price than the market or by making the company sell assets to them at a lower price than the market. In both situations, the minority shareholders bear the cost.

Let us see the possibility of such situations in real-life examples.

A) When companies buy assets/full entities/part equity stake in joint ventures from promoters:

While analysing companies, an investor would come across various instances where companies buy either physical assets or entire shareholding of the entities owned by promoters or part ownership in the venture owned by the promoters.

Investors would appreciate that all such instances present opportunities for promoters to benefit themselves at the cost of minority shareholders.

Let us see these instances in real-life companies.

i) When companies buy assets from promoters at a high price:

Such instances represent situations where promoters sell their entities to the company at a price, which is seemingly higher than the fair value of sold assets. Therefore, the promoters benefit by getting a value that is higher than what they might have got if they had attempted to sell the asset/entity in the open market to any third party.

Let us see examples.

a) Globus Spirits Ltd:

Globus Spirits Ltd is a manufacturer of country liquor (IMIL) and bottler for Indian made foreign liquor (IMFL) having a presence in multiple states with distilleries in Rajasthan, Haryana, West Bengal, and Bihar. The company owns IMIL brands like Nimboo, Narangi, Heer Ranjha, and Ghoomar.

In the past, Globus Spirits Ltd purchased the distillery unit from one of the promoters’ entities. The analysis of this purchase transaction provides some insights to the investor about related party transactions.

While analysing the financial performance of the company, an investor notices that in the past FY2010-2011, Globus Spirits Ltd merged the distillery unit of Associated Distilleries Ltd (ADL) located at Hisar with itself by issuing 3.24 million shares of Globus Spirits Ltd to the owners of Associated Distilleries Ltd.

FY2011 annual report, page 9:

Merger of Demerged Undertaking of ADL into GSL.: Associated Distilleries Limited (ADL) is an unlisted company and is engaged in the business of manufacturing, marketing and sales of industrial alcohol comprising rectified spirit, extra neutral alcohol, Country Liquor. During the year the demerged undertaking of ADL has been merged into Globus Spirits Limited (GSL) on a going concern basis with effect from April 1, 2010 in pursuant to sanction of the scheme by the order of Hon’ble High court of Delhi vide dated 24.08.2011. The valuation study was independently conducted by Ernst & Young (E&Y). The board has approved the distribution ratio of 1:6 for the merger of the demerged undertaking of ADL into GSL i.e. for every 1 equity share of ADL of Rs.10 each fully paid up, 6 equity shares of Rs.10 each fully paid up will be issued according to the valuation criteria suggested by E&Y based on the CCM, DCF Market Price & the NAV method to value companies. GSL has to issue additional 3.24 million shares which will take the post dilution equity share capital of GSL to 22.99 million shares of face value Rs. 10 each.

An investor may note that Associated Distilleries Ltd is a related party of the company as it is owned/controlled by the family of promoters of the company.

FY2010 annual report, page 40:

The merger involved almost all the assets of ADL except freehold land, building, road, and the temple. In addition, all the liabilities of ADL were transferred to Globus Spirits Ltd. As per the FY2011 annual report, the book value (i.e. net assets = assets – liabilities) of the demerged unit of ADL, which the shareholders of Globus Spirits Ltd received was ₹9.9 cr.

FY2011 annual report, page 37-38:

The merger was effective from the date of April 1, 2010. It indicates that all the assessment of valuation including the assets & liabilities of a demerged unit of ADL as well as the market price of shares of Globus Spirits Ltd was done taking April 1, 2010, as the reference date. Therefore, an investor may estimate the market value paid by the shareholders of Globus Spirits Ltd to owners of ADL based on the market price of shares of Globus Spirits Ltd on April 1, 2010.

On April 1, 2010, shares of Globus Spirits Ltd closed at ₹139.70 on Bombay Stock Exchange (BSE). As a result, by issuing 3.24 million shares, Globus Spirits Ltd effectively paid a consideration of about ₹45 cr. for the Hisar unit to its promoters. (₹139.70 * 3.24 million shares = ₹452.6 million = ₹45.26 cr.)

Therefore, an investor may appreciate that in this transaction the shareholders of Globus Spirits Ltd purchased the Hisar unit having a book value of ₹9.91 cr. from the promoters at a consideration of ₹45 cr.

a.i) Financial performance of Associated Distilleries Ltd during the merger period:

While analysing the merger, an investor finds the financial performance of ADL for FY2010 and FY2011 in the annual report of Globus Spirits Ltd for FY2011.

FY2011 annual report, page 21:

The above data indicates that in FY2010 and FY2011, ADL generated profits of ₹6.4 cr. and ₹12.6 cr. respectively. Therefore, shareholders of Globus Spirits Ltd may believe that for ₹45 cr., they have got an asset generating profits of about ₹6-12 cr. every year.

However, an analysis of Associated Distilleries Ltd before the merger and after the merger indicates a different picture.

a.ii) Financial performance of Associated Distilleries Ltd before the merger period:

While analysing the red herring prospectus (RHP: Source) filed by Globus Spirits Ltd for its IPO in 2009, an investor gets to know about the financial performance of Associated Distilleries Ltd for FY2007, FY2008 and FY2009.

IPO Red herring prospectus, page 201:

By analysing the above data, an investor notices that before the merger during FY2007, FY2008 and FY2009, the financial performance of Associated Distilleries Ltd was continuously declining year after year. During this period, Associated Distilleries Ltd was generating a net profit after tax of about ₹50 lac (₹5 million).

a.iii) Financial performance of Associated Distilleries Ltd after the merger period:

While analysing the FY2016 annual report of Globus Spirits Ltd, an investor finds that the auditor of the company has highlighted about a plant of the company, which is lying unutilized for more than three years i.e. at least since FY2012-FY2013.

FY2016 annual report, page 52:

Attention is invited to Note 11 of the consolidated financial statement in respect of Plant & Machinery having Net book value of Rs. 3,278. 63 Lacs (Gross Book Value – Rs.5,580.40 Lacs) that are currently unutilized for over 3 years  as on the balance sheet date, for which the management is evaluating alternative use and is of the view that no impairment is considered necessary at this stage. In absence of impairment assessment, we are unable to comment on recoverability of carrying value of such assets and consequent adjustment that may be required upon such assessment.

The auditor has highlighted that the plant is lying unused for many years and the management is looking for some alternative uses for this plant. Moreover, the auditor is not able to confirm the recoverability of the carrying value of this plant.

The management of the company in its response to the auditors’ qualified opinion, communicates to the shareholders in the directors’ report that the plant under question, which is lying unused since more than last three years (i.e. at least since FY2012-FY2013) is Hisar plant.

FY2016 annual report, page 19:

Response on Audit Qualification 2:- As on March 31, 2016, fixed assets include Plant and machinery valued at ₹3,278.63 lacs (Gross Book Value – Rs. 5,580.40 lacs) situated at Hissar, Haryana, which are currently unutilised since 3 years for which the Company is in the process of evaluating alternative use, and is confident that the value in use of these assets would be higher than the carrying value and therefore no impairment provision / realisable value assessment is required at this stage.

As per the above explanation, it seems that the Hisar plant, whose purchase transaction was completed by Globus Spirits Ltd in FY2012 by paying ₹45 cr. in shares to its promoters, stopped working within a year after the purchase transaction and the company is now looking for alternative uses for this plant.

As per the clarification provided by the management, the alternative uses of the Hisar plant can generate good value for the shareholders. Investors may seek updates from the company about the status of the Hisar plant and if the management is able to find an alternative use for it.

On the face of it, this might seem like a transaction where the distillery unit at Hisar was performing at a very low level of profits ₹50 lac per year before the merger. During the merger period, the performance of the company increased and the distillery started making profits of ₹6-12 cr per year. Based on this performance, Globus Spirits Ltd purchased the unit at about ₹45 cr despite the unit having a book value of about ₹9 cr. However, just after one year from the purchase, the unit stopped production.

An investor may read our complete analysis of Globus Spirits Ltd in the following article: Analysis: Globus Spirits Ltd

b) Datamatics Global Services Ltd:

Datamatics Global Services Ltd is an Indian company providing Information Technology, business process management (BPM), engineering, data, and analytics services. The company provides IT products for robotics process automation (RPA), analytics, business intelligence, and automated fare collection (AFC).

While analysing the company, an investor notices that in FY2019, the company acquired a stake in one of the promoter group entities. This transaction provides some insights to the investors about the assessment of related party transactions of companies.

In FY2019, the company acquired a 51% stake in a company, Datamatics Staffing Services Limited (DSSL). FY2019 annual report, page 103:

On March 17, 2019 one of the subsidiary, Datamatics Digital Limited acquired 51.00% of the issued share capital of Datamatics Staffing Services Limited (DSSL).

While reading the related party transactions sections of past annual reports, an investor gets to know that Datamatics Staffing Services Limited (DSSL) is one of the companies controlled by the relatives of key management personnel. FY2019 annual report, page 106:

Relatives of Key Managerial Personnel and Enterprise owned by Key Managerial Personnel:

• Mrs. Asha L. Kanodia
• Mrs. Aneesha Dalmia
• Mrs. Priyadarshini Kanodia
• Datamatics Staffing Services Limited (till March 17, 2019)
• Datamatics Business Solutions Limited
• Datamatics Infotech Services Private Limited

Therefore, an investor gets to know that in FY2019, Datamatics Global Services Ltd has acquired a 51% stake in DSSL, which is a promoter group entity.

While reading the FY2019 annual report, the investor gets to know that Datamatics Global Services Ltd paid a sum of ₹7.4 cr to acquire 51% stake in DSSL. This effectively values DSSL at ₹14.5 cr. (value of 100% stake 14.5 = 7.4/0.51).

FY2019 annual report, page 104:

The above data indicate that Datamatics Global Services Ltd paid an amount of ₹7.4 cr to acquire 51% stake in DSSL, which amounts to net assets of about ₹2 lac (₹0.02 cr). This amount to a payment of a price to book value ratio (PB Ratio) of 370 (= 7.4/0.02).

An investor may think that DSSL is a staffing/recruitment services firm and therefore, assets may not be the best representative of its true business/economic value. Therefore, the investor may believe that price to book value ratio may not be the best judge of the fair value of DSSL.

Therefore, when an investor analyses the earnings of DSSL in FY2019, then she notices that in FY2019, it had contributed a profit of ₹4 lac (₹0.04 cr) to the consolidated profit after tax of Datamatics Global Services Ltd. FY2019 annual report, page 113:

It indicates that in FY2019, DSSL reported a total net profit after tax (PAT) of ₹7.8 lac (₹0.078 cr = 0.04/0.51)). It represents that out of 100% PAT of DSSL (₹7.8 lac), 51% share of Datamatics Global Services Ltd is ₹4 lac (= 7.8*0.51).

By taking the total PAT of DSSL as ₹7.8 lac, an investor may conclude that Datamatics Global Services Ltd paid a price to earnings ratio (PE Ratio) of about 185 to acquire DSSL (185 = 14.5/0.078). This is after assuming the valuation of ₹14.5 cr of the entire DSSL as Datamatics Global Services Ltd paid ₹7.4 cr for 51% stake.

Whether an investor looks at the PB ratio of 370 or the PE ratio of 185, it seems that Datamatics Global Services Ltd has paid a rich valuation to acquire a 51% stake in DSSL.

Further, an investor may think that Datamatics Global Services Ltd has paid a rich valuation for acquiring DSSL considering its business potential, which may not be represented in its past performance.

However, when an investor analyses past annual reports of Datamatics Global Services Ltd, then she notices that DSSL was incorporated on April 25, 2003 (Source: Zaubacorp) and is present in the related party transactions section of Datamatics Global Services Ltd at least since FY2008 (the earliest available annual report at the website of Datamatics is for FY2008).

FY2008 annual report, page 39:

Relatives Of Key Managerial Personnel:

• Mr. Sameer Kanodia (upto 30.01.08)
• Mrs. Asha Kanodia
• Mrs. Anju Kanodia
• Datamatics Staffing Services

Therefore, an investor gets to know that DSSL has been in existence for the last 16 years and during this entire period, the company could reach a business profit of ₹0.078 cr in FY2019. Therefore, an investor may believe that the current profits of DSSL provide a reasonable idea about the business potential, which the promoters could achieve after running the company for 16 years.

Investors may contact Datamatics Global Services Ltd directly to get clarification about the valuation methodology used by the company for purchasing a stake in DSSL.

An investor may read our complete analysis of Datamatics Global Services Ltd in the following article: Analysis: Datamatics Global Services Ltd

c) Bhageria Industries Ltd:

Bhageria Industries Ltd is an Indian player dealing in dyes & intermediaries and solar power projects.

During FY2017-2018, Bhageria Industries Ltd was in the process of merging one of the promoter group entity Nipur Chemicals Ltd, which had a similar line of business, into itself in an all-share deal. The all-share deal means that instead of cash, Bhageria Industries Ltd will pay to the shareholders of Nipur Chemicals Ltd by way of shares of Bhageria Industries Ltd.

An analysis of this transaction provides good learning for the investors.

Nipur Chemicals Ltd is a promoter group company of Bhageria Industries Ltd. An investor can look at the following multiple information pieces to reach this conclusion:

c.i) Nipur Chemicals Ltd is a shareholder in Bhageria Industries Ltd:

At June 30, 2017, Nipur Chemicals Ltd holds 0.29% shares in Bhageria Industries Ltd:

c.ii) Key management people of Nipur Chemicals Ltd are classified as promoters in Bhageria Industries Ltd:

As per the corporate database website, Zauba Corp, the key management positions of Managing Director and Whole Time Directors are held by the promoter family members of the company, Mr. Deepak Bhageria, Mr. Dinesh Bhageria and Mr. Rakesh Bhageria respectively.

As per the shareholding pattern of Bhageria Industries Ltd shared above and another image below, Mr. Deepak Bhageria, Mr. Dinesh Bhageria and Mr. Rakesh Bhageria hold 5.25%, 1.13% and 5.10% stake in the company respectively and have been classified as promoters of Bhageria Industries Ltd. They also hold additional shares in the names of their respective HUFs (Hindu Undivided Family).

Moreover, credit rating agency CARE Ltd in its report of Nov 2016 has mentioned Nipur Chemicals Ltd as a group associate of Bhageria Industries Ltd.

As per press release dated November 14, 2016, the Board of Directors of BIL have approved the amalgamation of Nipur Chemicals Ltd (NCL), a group associate, engaged in similar line of business with the company. However, the proposal is subject to approval of shareholders, lenders/creditors, court of law and regulatory authorities.

Therefore, an investor would appreciate that Bhageria Industries Ltd is proposing to effectively purchase a promoter group entity by making payment by way of shares of Bhageria Industries Ltd.

The effective value of consideration proposed to be paid (i.e. the value of shared of Bhageria Industries Ltd proposed to be given to shareholders of Nipur Chemicals Ltd comes to be about ₹229.11 cr. based on the closing price of Bhageria Industries Ltd shares (₹385.55) on BSE on November 11, 2016, which is the available reference price on November 14, 2016, when the board of Bhageria Industries Ltd approved the Scheme of Amalgamation. (November 14, 2016, was a trading holiday on account of Gurunanak Jayanti).

Bhageria Industries Ltd has informed BSE that the Board of Directors of the Company at its meeting held on November 14, 2016, has approved the Scheme of Amalgamation of Nipur Chemicals Limited (Transferor Company) with Bhageria Industries Limited (Transferee Company) under Sections 391 to 394 of the Companies Act, 1956 read with Sections 100 to 103 and the corresponding provisions of the Companies Act, 2013 as applicable. The Scheme is subject to the approval of the shareholders, Hon’ble Mumbai High Court and all other regulatory approvals.

An investor may arrive at this calculation in the following fashion:

As per page 11 of the Scheme of Amalgamation document available at the website of Bhageria Industries Ltd, the consideration to be paid to shareholders of Nipur Chemicals Ltd is 11 shares of Bhageria Industries Ltd for every 10 shares of Nipur Chemicals Ltd held by its shareholders.

In consideration of the amalgamation of the Transferor Company in the Transferee Company, the Transferee Company shall, without any further act or deed, issue and allot 11 (Eleven) Equity Shares of Rs. 5/- each credited as fully paid-up (the “New Equity Shares”) of the Transferee Company for every 10 (Ten) equity shares of Rs. 10/- each fully paid-up held by the equity shareholders in the Transferor Company, as on the Record Date.

As per page 3 of the Scheme of Amalgamation document, Nipur Chemicals Ltd has 5,402,300 shares.

Therefore, the total number of shares of Bhageria Industries Ltd to be paid/given to Nipur Chemicals Ltd would be 5,942,530 (= 11 * 5,402,300 / 10).

The value of 5,942,530 shares of Bhageria Industries Ltd at the closing price of November 11, 2016, at BSE (₹385.55) comes out to be ₹229.11 cr.

An investor may have a look at the business performance of Nipur Chemicals Ltd. The financials of Nipur Chemicals Ltd are present on page 47 of the Scheme of Amalgamation document:

An investor would notice that Nipur Chemicals Ltd has:

• Sales of ₹59.59 cr. in FY2016 and annualized sales of ₹64.54 cr. in FY2017 (i.e. double of H1-FY2017 sales of ₹32.27 cr).
• Net profit of ₹7.75 cr. in FY2016 and annualized net profit of ₹12.52 cr. in FY2017 (i.e. double of H1-FY2017 profit of ₹6.26 cr).
• The net worth of ₹44.84 cr. at March 31, 2016, and ₹51.10 cr. at Sept 30, 2016.

An investor may use these parameters and the total consideration to arrive at the valuation levels of Nipur Chemicals Ltd:

• Price to Sales Ratio (P/S ratio) of about 3.85 based on FY2016 sales (229.11 / 59.59) and 3.55 based on annualized sales for FY2017 (229.11 / 64.54)
• Price to Earnings Ratio (P/E ratio) of about 29.56 based on FY2016 profit (229.11 / 7.75) and 18.30 based on annualized profit for FY2017 (229.11 / 12.52)
• Price to Book Value Ratio (P/B ratio) of about 5.11 based on March 31, 2016, net worth (229.11 / 44.84) and 4.48 based on the net worth at September 30, 2016, FY2017 (229.11 / 51.10)

The above approach will provide an investor with a perspective of the consideration being paid by Bhageria Industries Ltd to merge/acquire the business of Nipur Chemicals Ltd.

Based on these valuation parameters of P/S ratio of 3.85, P/E ratio of 29.56 and P/B ratio of 5.11, an investor may arrive at her own conclusion regarding the valuation being paid by Bagheria Industries Ltd to acquire the promoter group entity, Nipur Chemicals Ltd.

An investor may read our complete analysis of Bagheria Industries Ltd in the following article: Analysis: Bagheria Industries Ltd

ii) When companies enter into joint ventures with the promoters:

In addition to the above examples, where the listed company bought out/merged the entity owned by the promoters, many times, an investor would come across situations where listed companies enter into joint ventures (JV) with the promoters.

Many times, such cases involve frequent investment from the venture partners (the company and the promoters) into the JV. Each of these investment transactions by the promoters and the companies presents a potential opportunity where economic benefit can be transferred from the minority shareholders to the promoters.

Let us see an example.

a) WPIL Ltd:

WPIL Ltd is an Indian company involved in fluid handling by way of making pumps and execution of turnkey water supply projects for irrigation, oil & gas, power, and other industries.

While analysing the business of WPIL Ltd, an investor gets to know that the company has a subsidiary in Singapore, which plays a very important part of its overall business. However, the investor notices that WPIL has only 61.53% stake in this subsidiary. Further analysis by the investor to find more details about the Singapore subsidiary of WPIL Ltd provides good insights to an investor about the manner in which many of the foreign businesses of the companies may be structured along with the promoters of the company.

While analysing the business of WPIL Ltd, an investor notices that currently more than half of the revenue of the company is generated by its international subsidiaries. In FY2019, the standalone revenue of WPIL was ₹533 cr and the consolidated revenue was ₹1,156 cr. It indicates that the subsidiaries of the company are currently playing a very important role in the overall business of WPIL Ltd.

Out of these international subsidiaries, the most important subsidiary is Aturia International Pte. Limited (Singapore), which was previously named WPIL International Pty Ltd. – Singapore. WPIL Ltd holds its stake in most of the other international subsidiaries through the Singapore subsidiary.

The importance of the Singapore subsidiary becomes clear to the investor when she notices that along with its subsidiaries, it contributes about 72% of the consolidated profits of WPIL Ltd.

FY2019 annual report, page 191:

In the FY2019 annual report, an investor notices that WPIL Ltd currently holds a 61.53% stake in Aturia International Pte. Limited (Singapore), which in turn holds a 100% stake in 9 other subsidiaries. As a result, in the FY2019 annual report, an investor reads that WPIL Ltd has a 61.53% stake in 10 subsidiaries. Almost all the subsidiaries except Sterling Pumps Pty Ltd of Australia are owned by the Singapore subsidiary.

FY2019 annual report, page 120:

Looking at the importance of Singapore subsidiary, an investor wishes to know about the counterparty who owns the balance 38.47% stake in Aturia International Pte. Limited (Singapore).

The investor gets to know about the other counterparty while reading the FY2017 annual report.

In the FY2017 annual report, on page 121, WPIL Ltd intimated its shareholders that its stake in the Singapore subsidiary has decreased from 76.84% to 61.53% as the minority shareholders have put in $2,000,000 (₹12.97 cr) in the company.

The name of WPIL International Pte. Limited was changed to ‘Aturia International Pte. Ltd.’ with effect from 24th February, 2017 During the year the Minority Shareholder of Aturia International Pte. Ltd. contributed USD 20,00,000 (equivalent to Rs. 12,97,00,000/-) towards its Share Capital consequent to which our Company’s share in Aturia International Pte. Ltd. has been changed to 61.53%.

In the same annual report on page 18, WPIL Ltd intimated that the promoters of the company have put in more capital in the Singapore subsidiary.

Fresh capital was injected into Aturia International by the promoters to meet the equity requirements of its subsidiaries especially Mathers U.K.

These two disclosures seem to indicate that the promoters of WPIL Ltd are the minority shareholders in the Singapore subsidiary. However, for the final answer, investors may contact the company directly to confirm the identity of the minority shareholders in the Singapore subsidiary.

Advised reading: How should investors contact Companies/Management for clarifications or additional information?

Moreover,  an investor notices that in FY2016-17, the company has given loans of ₹6 cr to a promoter entity.

FY2017 annual report, page 16:

One of the possibilities may be that the promoters might have used this loan from WPIL Ltd to invest in the Singapore subsidiary to increase their stake.

Looking at all these possibilities, it is advised that an investor may directly contact the company to know about the minority shareholders of the Singapore subsidiary.

a.i) When WPIL invests money in Singapore subsidiary, the stake provided is costlier. Whereas when the said “Minority Shareholders” (?promoters) invest money in Singapore subsidiary, the stake provided is cheaper.

While reading the past annual reports of WPIL Ltd, an investor notices that in FY2016, WPIL Ltd had invested ₹28.42 cr in the Singapore subsidiary and as a result, its stake in the subsidiary increased from 51% to 76.84%.

FY2016 annual report, page 111:

The Company during the year has contributed Rs. 28,42,40,000/- towards the Capital of its Subsidiary WPIL International Pte Limited in Singapore, consequent to which its shareholding in the Company has increased from 51% to 76.84%.

While assessing the valuation of the Singapore subsidiary at which WPIL Ltd invested its money, an investor notices that the value is ₹110 cr. An investor may infer this value from the fact that ₹28.42 cr represents a 25.84% stake (= 76.84 – 51.00) of the Singapore subsidiary (₹110 cr = 28.42 cr/0.2584).

While assessing the valuation at which the Minority Shareholders (?Promoters) put their money the next year i.e. in FY2017, the investor notices that the valuation of Singapore subsidiary offered to the minority shareholders is ₹84.72 cr. An investor may infer this value from the fact that in FY2017, the minority shareholders invested ₹12.97 cr and their stake in the company increased from 23.16% to 38.47% (i.e. the stake of WPIL Ltd in the Singapore subsidiary decreased from 76.84% to 61.53%. See the discussion above).

In this case, ₹12.97 cr represents the value of 15.31% stake (i.e. 76.84 – 61.53 OR 38.47 – 23.16). Therefore, the overall value of the Singapore subsidiary in FY2017 was assigned to be ₹84.72 cr (= 12.97 cr/0.1531)

An investor would note that this difference in valuation represents a 23% decline in the value of Singapore subsidiary over a period of about one year from FY2016 to FY2017. Whereas during this period, the Singapore subsidiary had completed the acquisition of the Italian operations, which turned out to be highly profitable for the company.

FY2016 annual report, page 111:

The Singapore Subsidiary had during the year ended 31st March 2016 completed the acquisition of an European Group (namely Gruppo Aturia S.p.A along with its subsidiaries in France and Switzerland).

Credit rating report of WPIL Ltd, Nov. 2018 from CARE Ltd:

The company reported PAT (consol.) of Rs.35.67crore in FY18 vis-à-vis loss of Rs.1.89 crore in FY17 mainly backed by improvement in the financial performance of one of its step down subsidiary namely Gruppo Aturia SPA.

Therefore, an investor would notice that when the promoters enter into joint ventures with their listed companies, then every occasion of putting additional money in the joint venture provide an opportunity for the promoters to shift economic benefits from the company and the minority shareholders.

An investor may read our complete analysis of WPIL Ltd in the following article: Analysis: WPIL Ltd

In addition, many times, investors would notice that the promoters start the joint venture (JV) with the company. They invest money at the initial stage; however, when the business does not do well, then the promoters refuse to invest any further money in the JV and the listed company that ends up making all the subsequent investments.

In addition, when in the end, the business of the JV does not do well, then the promoters sell JV to the listed company. This is equivalent to the minority shareholders bailing the promoters out of the failed joint venture.

Let us see an example.

b) Balaji Amines Ltd:

Balaji Amines Ltd is an Indian manufacturer of Amines and its derivatives (methylamine, ethylamine, DMF etc.) along with running a five-star hotel.

While analysing Balaji Amines Ltd, an investor notices that in the past, the company had formed a joint venture Balaji Greentech Products Ltd (BGPL), with its promoters. The analysis of this subsidiary, the investments and the ultimate fate of this transaction provides many lessons to the investors.

Balaji Amines Ltd had formed a subsidiary company, Balaji Greentech Products Ltd (BGPL), in which the company held 66% equity stake. The balance 34% stake is held by primarily the promoter Reddy family. As per the scheme of amalgamation document filed by the company to BSE (accessible here), page 27, the shareholding pattern of BGPL at March 31, 2017, is as below:

Most of the key shareholders of BGPL, apart from Balaji Amines Ltd, are the members of Reddy family who also occupy the executive positions on the board of Balaji Amines Ltd. Upon analysis, an investor would notice that M/s APR Holdings & Investments Private Ltd is part of promoters group through which promoters own 14.74% of Balaji Amines Ltd. Moreover, the directors of the company M/s APR Holdings & Investments Private Ltd are A. Prathap Reddy and A. Shakuntala Devi, which indicates that this company represents the promoter group. (As per corporate database: corporatedir.com)

As per our experience of analysing different companies, we believe that the investments done by listed companies in partnership/venture with promoter group, many times, do not prove to be in the best interests of minority shareholders.

This is because if the venture is profitable, then the promoters get a higher share of the economic benefits in the venture by way of their additional shareholding in the venture over and above the interest through the shares held by the listed entity.

To illustrate, if in BGPL, 66% stake is held by the listed entity Balaji Amines Ltd (in which at March 31, 2017, promoters own 54.46% stake and minority shareholders own 45.54% stake) and 34% stake is held by Reddy family, then the net stake of Reddy family in BGPL would be 69.94% (66%*0.5446 + 34%) and the stake of minority shareholders in BGPL would be only 30.06% (66%*0.4554 OR 100%-69.94%).

Instead, if the investment in BGPL would have been done entirely by the listed entity, Balaji Amines Ltd, then the stake of promoters and minority shareholders in BGPL would have been 54.45% and 45.54% respectively, which is the same proportion held by them in the listed entity Balaji Amines Ltd.

An investor would appreciate that in both the above scenarios, i.e. whether the investment in BGPL is done by Balaji Amines Ltd entirely or in collaboration with promoters, there is not going to be an effective change in the way in which the operations of BGPL are going to be managed. In both cases, it is the members of the promoter family with the board (i.e. same independent directors), who are going to take all the operational decisions for BGPL. The only difference in part investment by promoters is that they get a higher share in the economic benefit by putting in the same level of efforts to manage the venture.

In many cases, when the venture is successful, then the promoters keep enjoying the higher economic benefits, whereas in cases, when the venture does not do well, then the listed entity has to bail out the venture.

In case of BGPL, the listed entity had to invest multiple times in BGPL by way of capital advances and Cumulative Redeemable Preference Shares apart from the original equity investment to support the operations and debt payments of BGPL. In total, by March 31, 2017, Balaji Amines Ltd has invested a total amount of ₹56.54 cr. in BGPL: ₹5.94 cr. of equity investment, ₹27.1 cr. of capital advances and ₹23.5 cr. of Cumulative Redeemable Preference Shares. (FY2017 annual report of Balaji Amines Ltd, page 96):

The credit rating agency, India Ratings, assessed the credit strength of Balaji Amines Ltd by assuming that all the debt of BGPL would have to be paid off by Balaji Amines Ltd from its cash flows. (December 2015 credit rating rationale by IndRa):

BAL has extended support to Balaji Greentech Products Limited (BGPL) by way of equity and preference capital to meet the latter’s debt repayment commitments. During FY16, BAL has infused INR54.8m to pre-pay the outstanding term debt of BGPL as its performance remained weak. Hence, Ind-Ra has factored in the debt servicing requirement of BGPL in BAL’s cash flow. However, BAL has not guaranteed BGPL’s debt.

Further Reading: 7 Important Reasons Why Every Stock Investor Should Read Credit Rating Reports

Therefore, an investor would appreciate that credit rating agency IndRa put the entire burden of debt payments of the weak entity (BGPL) on Balaji Amines Ltd, which would have the impact of lowering the assessed credit strength of Balaji Amines Ltd.

This treatment by credit rating agency treats as if Balaji Amines Ltd holds 100% shares in the BGPL and not 66%, which is the actual shareholding. Effectively, minority shareholders have to bear the impact of 45.54% share of BGPL instead of 30.06% share, which is their actual indirect stake as calculated above.

Moreover, when it finally decided to close the operations of BGPL due to continued losses, the first option, which was thought was to sell the company/its assets to any third party. However, when no buyer could be found for BGPL, then it was decided to merge BGPL with Balaji Amines Ltd. This effectively means that Balaji Amines Ltd bought BGPL when no other buyer was found.

While assessing the valuation of BGPL for merger into Balaji Amines Ltd, the valuation expert concluded that there is no positive value in BGPL. The valuer assigned a negative value of ₹8.23 cr. to BGPL (page 67 of the scheme of amalgamation document referred above)

Upon reading the scheme of amalgamation, the investor would note that the value of negative ₹8.23 cr. for BGPL has been arrived at after valuing its land parcel at ₹7.86 cr, which is about 5 times of the value at which it was carried on the balance sheet of the company for ₹1.63 cr. (probably the initial purchase price of the land parcel). (Page 68 of the scheme of amalgamation document referred above)

An investor would appreciate that the market value of land keeps on varying depending on the person valuing it, time of valuation and whether there is any real buyer available to pay the quoted price or not. Therefore, if the market value of the land parcel owned by BGPL changes, then the negative value of BGPL also keeps on fluctuating.

Moreover, when the amalgamation decision is taken, then it has arrived at that as the BGPL is not bringing any positive value to Balaji Amines Ltd, therefore, the shareholders of BGPL would not be offered anything in lieu of their stake in BGPL. (Page 69 of the scheme of amalgamation document referred above):

So it might seem that the shareholders of Balaji Amines Ltd are getting the company BGPL and its assets for free. However, it is to be noted that BGPL does not have any positive value. It has a negative value of ₹8.23 cr. Therefore, effectively, after the amalgamation, the negative value/burden of ₹8.23 cr. would be owned up by all the shareholders of Balaji Amines Ltd in proportion to their shareholding in Balaji Amines Ltd.

An investor would appreciate that this situation indicates that the minority shareholders of Balaji Amines Ltd would have to bear the 45.54% of the negative value of BGPL (i.e. ₹3.75 cr. = 8.23*0.4554) and not the 30.06% (₹2.47 cr. = 8.23*0.3006) of their indirect shareholding of BGPL through the 66% stake held by Balaji Amines Ltd in BGPL and the promoters might end up owning 54.46% of the burden of BGPL and not the 69.94%, which was their effective direct and indirect holding of BGPL.

Therefore, an investor would appreciate that in cases where promoters enter into partnerships/venture with their own listed entity, then it is a situation that should be assessed by minority shareholders with caution. This is because many times, for all practical purpose, the listed entity ends up owning the entire burden when things go wrong like infusing funds to repay debt, buying the company by way of amalgamation etc.

In the case of BGPL, an investor would expect that Balaji Amines Ltd and the promoter family would bring in funds in the ratio of 66:34 to support BGPL. Whereas it seems that only the listed entity Balaji Amines Ltd had put in additional funds to support the company because all the investment in Cumulative Redeemable Preference Shares of ₹23.5 cr. is done by Balaji Amines Ltd and none of it is by the promoter family.

Whether or not the listed entity has explicitly provided guarantees on behalf of the venture, it has to bear the full impact of the liabilities of the venture like the credit rating assessment by India Ratings by merging the liabilities of BGPL with cash flows of Balaji Amines Ltd.

Whereas in cases when the venture turns profitable and does well, then the minority shareholders do not get the return in proportion to the risk taken by them because their indirect shareholding in the venture is lower than their stake in the listed entity, which is the result of the shares held by promoters directly in the venture as calculated above.

An investor may read our complete analysis of Balaji Amines Ltd in the following article: Analysis: Balaji Amines Ltd

Nevertheless, an investor would notice that many times, companies buy equity/make investments into the promoter group entities when they are surplus with cash. In such situations, an investor may think that the promoters realize that the listed company has a lot of cash and they get tempted to use some of it for their personal benefits. As a result, they sell assets/entities or part equity stakes of their entities to the listed company.

However, many times, an investor would also come across situations when the listed company was not cash-rich. Instead, the listed company was itself carrying a lot of debt to run its business operations. Investors would notice that in many cases, promoters make the listed entity invest in their personal/other businesses by making the listed company take debt.

iii) When companies invest in promoters entities by raising debt:

In such instances when the listed companies who have existing debt on their books but still invest money in the promoter group entities, then it is equivalent to the minority shareholders taking the debt to help the financial position of the promoters’ entities.

Let us see an example.

a) HEG Ltd:

HEG Ltd is one of the leading graphite electrode manufacturers in India.

While analysing the past annual reports of HEG Ltd, an investor notices that the company has been investing in the promoter group companies/associates on a regular interval. An investor would notice that the company has invested money in the group companies even when it had debt outstanding on its books.

Investing in the group companies when a company has debt outstanding may be interpreted as an alternative use of funds where a company believes that helping group companies with investments is a better option than increasing the value to the equity shareholders by repaying the debt of the company.

Investors may note that the enterprise value of any company accrues to lenders and equity shareholders. Therefore, whenever a company reduces the debt on its books, then the enterprise value accrues to the equity shareholders.

Investors may make an opinion about whether investing money in the group companies is a preferable option than repaying the debt of the company and increase value to the equity shareholders.

Moreover, while analysing the auditor’s report section of the FY2009 annual report of HEG Ltd, an investor gets to know that the company provided a helping hand to the promoter group company/associate by way of a short-term loan of ₹100 cr.

FY2009 annual report, page 38:

(a) The Company has granted unsecured loan during the year to one of its associate companies listed in the register maintained under section 301 of the Companies Act, 1956. Apart from this loan, the company has not granted any other loans, secured or unsecured, to companies, firms or other parties listed in the register maintained under section 301 of the Companies Act, 1956.

(b) The maximum amount outstanding during the year is Rs. 100 Crore and year end balance of such loan is Rs. Nil. In our opinion, the rate of interest and other terms & conditions of such loan are, prima facie, not prejudicial to the interest of the company.

It is advised that an investor should keep in mind these transactions by the companies in the group/associate companies while making her opinion about any company.

An investor may read our complete analysis of HEG Ltd in the following article: Analysis: HEG Ltd

In the above discussion, we noticed multiple instances where the listed company bought assets/entities from the promoters, and in turn, it seemed like the economic value got shifted from the minority shareholders to the promoters.

However, investors would notice that such situations are not limited to when companies buy a stake from the promoters.

While analysing companies, an investor would notice that the position of a minority shareholder is not any better in situations where the promoters buy entities from the listed company.

The transactions where the promoters buy assets from the listed company also provide enough opportunities for the promoters to shift economic benefits from the company.

B) When companies sell assets to the promoters:

An investor would appreciate that when the promoters buy assets from the listed company, then they can easily take out economic benefits from the company if they can make the company sell the assets to them at a cheaper price than the fair market price.

In such cases, the promoters may first make the company buy an asset from the market, and then, in turn, they purchase it from the company at a lower price. On other occasions, the promoters make the company buy assets from the market and then the promoters use these assets for their personal use free at no cost to themselves. Investors would have noticed instances of promoters using the company money to purchase yacht; private jets etc. that promoter use for their personal purposes.

In other instances, the listed companies create assets/businesses by investing money and resources, and later, the promoters buy it at a cheap price from the company.

In all the above cases, the minority shareholders end up bearing the cost for the promoters’ gains.

As a result, such transactions where the promoters buy assets from the listed company, require detailed due diligence from the investors.

Let us see some examples.

i) India Glycols Ltd:

India Glycols Ltd is an Indian company manufacturing glycols, ethylene oxide derivatives using renewable raw material (alcohol, molasses), guar gum derivatives, alcohol & spirits, industrial gases, and nutraceuticals.

While analysing the company, an investor notices that in FY2015-FY2016, India Glycols Ltd sold its rental business division (an office building complex) to its promoters. An analysis of this transaction provides a framework to the investor to assess such transactions of the sale of the asset by the companies to its promoters.

While analysing the past annual reports of India Glycols Ltd., an investor notices that in FY2015, the company established a new wholly-owned subsidiary, IGL Infrastructure Pvt. Ltd (IGL Infra) and then transferred its commercial building (rental business division) to IGL Infra on March 31, 2015, for consideration of ₹184 cr.

FY2015 annual report, page 79:

On receipt of approval of the shareholders and NOIDA Authority, during the year the Company had entered into a Business Transfer Agreement (BTA) with wholly owned subsidiary company, IGL Infrastructure Private Limited (‘IGL Infra’) (formed during the current year) for sale of its Rental Business Division on slump sale basis w.e.f. 30 th Mar 2015 for consideration of ₹18,420.00 Lacs, pending receipt of the final ‘NOC’ from 2 banks (approval since received). The consideration has been included under Short Term Loans & Advances Receivable. Profit on sale this amounting to ₹5,194.26 Lacs is included under exceptional items. (Refer Note No. 46(d)).

While searching about this commercial building on the internet, an investor comes across an equity research report of India Glycols Ltd prepared by PINC Research dated June 3, 2008, uploaded on the Business Standard website (Click here). The PINC report indicates that the building has three towers (270,000 sq.ft.) out of which one tower (about 70,000 sq.ft) is occupied by India Glycols Ltd as its corporate office.

PINC research report, June 3, 2008, page 7:

In FY04, IGL acquired 3.5acres land in Noida, worth ~ Rs64mn. It has constructed 3 towers with a total floor space area of 270k sq.ft. Of this, 70k sq.ft. (one tower) will be used for its new corporate office , while the rest will be leased out.

While analysing the subsequent annual reports, in FY2017 annual report, an investor gets the information about rent being paid by India Glycols Ltd to IGL Infra for occupying one tower of 70,000 sq.ft.

FY2017 annual report, page 147:

Rent & Maintenance Paid to :

• Polylink Polymers (India) Ltd. ₹13.80 Lacs (Previous Year ₹ 13.67 Lacs)
• IGL Infra ₹ 1,054.61 Lacs (Previous Year ₹ 1,041.42 Lacs)
• Kashipur Holding Limited ₹ 10.77 Lacs (Previous Year ₹ 10.68 Lacs)

An investor gets to know that India Glycols Ltd is paying a rent of about ₹10 cr per year for 70,000 sq.ft. in the commercial complex.

Assuming the same rent for the remaining space, an investor may conclude that the entire area of 270,000 sq.ft. may fetch a rent of ₹38 cr per year (10 * 270,000 / 70,000 = 38.57)

Going by the usual capitalization rate (rental yield) of about 8% for commercial properties, a property providing rent of ₹38 cr per year may be valued at ₹475 cr (38 / 0.08 = 475)

In light of this calculation, it seems that India Glycols Ltd has sold the commercial property at a cheaper price.

However, before an investor makes her final decision, she needs to keep in mind the following things:

• It is assumed that India Glycols Ltd is occupying only 70,000 sq.ft. and paying a rental of ₹10 cr per year for this area. If the area occupied by India Glycols Ltd is different, then the entire calculations will need a revision.
• It is assumed that the rental yield/capitalization rate of 8% is normal for commercial properties. Investors may do their own diligence to arrive at the rental yield by doing market research etc. This is because using a different rental yield will change the value of the property.

An investor may seek clarification about these inputs from the company directly so that she may make an informed decision.

Moreover, when an investor attempts to find out the counterparties to whom, India Glycols Ltd sold the rental business division via IGL Infra, then she notices that IGL Infra has been sold to the promoters.

The related party details section of the FY2016 annual report shows that the status of IGL Infra changed from a subsidiary to an enterprise over which key management personnel have a significant influence on Sept. 15, 2015.

FY2016 annual report, page 120:

Relationship
A. Subsidiary Company

• IGL Infrastructure Private Limited (IGL Infra) (Ceased on 14.09.2015)

D. Enterprises over which Key Management Personnel have significant influence:

• IGL Infrastructure Private Limited.(IGL Infra) (w.e.f. 15.09.2015)

Moreover, corporate database website Zaubacorp shows that the current promoter-CMD Mr. Uma Shankar Bhartia and his wife Jayshree Bhartia are the current directors of IGL Infrastructure Private Ltd (checked on March 24, 2020) (Click here)

Therefore, an investor would acknowledge that the sale of rental business division by India Glycols Ltd represents a transaction where a commercial building is sold by the public listed company to its promoters. In the transactions of sale of assets of the public listed company to the promoters, it is advised that investors should do in-depth due diligence. This because such transactions provide an opportunity for the promoters to benefit at the cost of minority shareholders if the assets are sold to the promoters at less than their fair/market value.

Therefore, it is advised that an investor should do further analysis in terms of the area occupied by India Glycols Ltd in the commercial building for which it is paying a rent of about ₹10 cr per year to IGL Infra. In addition, she should find out the total leasable area of the commercial building as well as ongoing rental yields in the market so that she can arrive at a reasonable independent value of the commercial building.

An investor may also contact the company directly to seek clarification/help for the above inputs to aid her analysis.

An investor may read our complete analysis of India Glycols Ltd in the following article: Analysis: India Glycols Ltd

ii) Kokuyo Camlin Ltd:

Kokuyo Camlin Ltd a leading manufacturer of stationery & related products owning brands Camel and Camlin. The company is now a subsidiary of Kokuyo Co. Ltd of Japan.

While analysing the company, an investor gets to know of an instance where the company started a new business. The promoters of the company, being the managers run the business to the ground and then the promoters buy the new business themselves from the company at one-tenth of the original investment value.

While analysing the past business performance of the company, an investor notices that the company had started a new business line of pre-schools in FY2010. The company formed a wholly-owned subsidiary, Camlin Alphakids Limited for this purpose and opened the preschool business in collaboration with “Headstart Parade” an early child development centre.

FY2010 annual report, page 29:

The Company has ventured into pre-school activity through, a 100% Subsidiary – Camlin Alphakids Limited. A model pre-school was opened in Andheri, Mumbai in collaboration with Headstart–Parade an early child development centre. This is not just a school but a medium to create awareness about drawing, painting and other extracurricular activities.

The management of the company was enthused by this new initiative and wanted to grow it to be a new revenue line. The Chairman of the company informed in its address to shareholders that the company has opened one pre-school in Andheri in FY2010 and it planned to open two more in Mumbai region in Thane and Kharghar soon.

FY2010 annual report, page 5, Chairman’s message:

New business opportunity: We serve India’s education space. We have closely followed the education opportunity in India. Within this, we feel there is a good opportunity to grow the pre-school space. Camlin has made a modest beginning by starting our own pre-school called Alphakids in Andheri, Mumbai. The response has been extremely encouraging. Consequently, we will be opening 2 more pre-schools in 2010-2011 in Thane and Kharghar respectively. Going forward, we intend to grow this business and create another revenue stream for Camlin shareholders.

The company was very bullish on pre-school business and started putting additional money in the subsidiary to grow the business.

FY2011 annual report, page 44:

The money was being put in the subsidiary in the form of equity (common shares and preferred shares) as well as interest-free loans.

FY2012 annual report, page 53:

The subsidiary was not making money and the company justified the investments stating that the management of the company is getting very good experience in running the pre-school business. FY2013 annual report, page 14:

The Companies subsidiary viz Camlin Alphakids Limited which is in the pre-school business incurred an operational loss of ₹ 161.87 lacs. The pre-school is in the fourth year of its operation. The Management of this subsidiary has got a good experience and learning from the past operations and the business is being restructured to ensure an early turnaround.

When an investor might have thought that the monetary and time investment is done by the company in the pre-school business would be bearing fruits, the company informed the investors that it is no longer interested in running the preschool business in which it had invested ₹5.35 cr as the business is making losses.

FY2014 annual report, page 17:

DISINVESTMENT OF ENTIRE STAKE IN 100% SUBSIDIARY CAMLIN ALPHAKIDS LIMITED (NOW ALPHAKIDS LEARNING AND ACTIVITY CENTRE LIMITED): Your Company had ventured into the business of running pre-schools in the year 2009 and had set up a wholly owned subsidiary namely Camlin Alphakids Limited. Unfortunately since inception, this business has been incurring huge losses & had never turned around. In the past 5 years, the financials have been EBIDTA negative and have been continuously seeking funding from the parent Company. Till FY 13-14 your Company had invested a total sum of ₹ 535.32 Lacs, out of which by way of equity & preference capital of ₹ 230.00 Lacs and advances of ₹ 305.32 Lacs, a significant portion of which was towards funding of the losses.

Moreover, the company intimated the shareholders that it is selling the business to promoters at one-tenth of the investment value i.e. the company received a total of ₹50 lac in sales consideration for the total investment done of ₹5.35 cr.

FY2014 annual report, page 17:

In April, the entire stake of equity & preference shares amounting to ₹ 230.00 Lacs was sold to one of the promoter Mr. Dilip Dandekar along with his family members and associate company for a total consideration of ₹ 50.00 Lacs. The consideration was finalised based on an independent valuation. Camlin Alphakids Limited ceases to be subsidiary with effect from 1 st  April, 2014.

An investor would appreciate that many times companies sell businesses, which are not making money. Even Camlin Ltd has taken such a decision in the past like in FY2005 when the company decided to exit the pharmaceutical business. However, in the case of pharmaceutical division, the business was sold/handed over to a third party, Liva with the stock, receivables as well as transferring all the employees.

Management has carried out SWOT Analysis of Pharmaceutical Division which solely consisted of marketing activities and in order to pre-empt incurrance of further losses, Management has decided to substantially restrict the operations of this Division w.e.f. 1 st April, 2005. As per the understanding reached between the Company and Liva Healthcare Limited (Liva) in this regard, all stocks have been taken over by Liva, except a small stock of Oncology Products, which shall be liquidated by the Company during the current year. All employees of Pharmaceutical Division have been taken over by Liva with continuity in service. Liva has been arrange for recovery of receivables of the Division.

The case of sale of Alphakids to the promoters of the company at a fraction of the invested value creates a difficult situation. It is akin to seeding the new business and waiting out the initial tough establishment phase of the new business within the company at its cost and once the initial phase is over, then buy the business at a fraction of the cost.

Currently, as per the website of Alphakids, it has expanded to Mumbai, Bangalore, Hyderabad, Kolhapur and Pondicherry.

As per the information available on the Alphakids website, the promoter family (Dandekars) still runs the business and it has attracted investment from Goenka group:

Alphakids International Preschool is one of the most renowned preschool chains in India and is ranked among the top 4 by Education World in its latest survey. It is promoted by one of the founding families of Camlin Pvt. Ltd., and the Goenka Family who are co promoters of a premium international school and college in India.

Therefore, an investor should always be careful while analysing companies where the promoters have been involved in a joint venture with the company or they have sold or purchased assets from the companies.

An investor may read our complete analysis of Kokuyo Camlin Ltd in the following article: Analysis: Kokuyo Camlin Ltd

By now, an investor would notice that she should be very careful in assessing companies where the promoters have been involved in lending or buying/selling transactions of assets with their companies. This is because all these transactions provide opportunities where the promoters can take economic value away from the minority shareholders.

However, after doing the analysis of companies, an investor would appreciate that the potential of promoters benefiting themselves is not limited only to the situations of lending/buying/selling transactions. She would notice that in other situations promoters benefit themselves by making their companies pay them advances/security deposits at very generous terms.

3) When companies give advances or security deposits to the promoters at generous terms

An investor would notice that many times, companies enter into business dealings with their promoters and, in turn, give interest-free deposits to promoters. Such cases become crucial to understand when investors notice that the company has given disproportionately large deposits to the promoters.

Investors would notice that at times, when a company takes a building owned by the promoters at rent from them, then it might give them an interest-free security deposit that may be equal to the purchase cost of the building. Such a large security deposit may be equivalent to handing over the purchase consideration of the building to the promoters without getting any ownership rights for the company.

Therefore, in such situations, effectively, first, the minority shareholders help promoters buy the building by giving them the large security deposit and then the minority shareholders pay them the rent for allowing the company to use the building.

Let us see an example.

A) Fineotex Chemical Ltd:

Fineotex Chemical Ltd, an Indian company manufacturing speciality chemicals primarily for the textile industry.

While reading the FY2012 annual report, an investor notices that Fineotex Chemical Ltd has taken some property on rent from Ms. Kanaklata Tibrewala (wife of the promoter of the company, Mr. Surendra Tibrewala) and in turn, the company is paying her a rent of ₹780,000 per annum. In addition, the company has paid a security deposit of ₹1.95 cr to Ms. Kanaklata Tibrewala for the property.

FY2012 annual report, page 51:

Moreover, in the annual report, the investor also notices that the security deposit paid to Ms. Kanaklata Tibrewala is interest-free in nature.

FY2012 annual report, page 27:

Interest Free deposit towards rented premises paid to relative of director Rs.19,500,000/-(Rs.19,500,000/-)

By looking at the above information, an investor notices that the amount of security deposit (₹1.95 cr) is very high when compared to the amount of yearly rent (₹7.80 lac).

• The security deposit amounts to an advance of about 25 years’ worth of rent of FY2012, whereas the usual term for security deposits in commercial rental transactions is about 6 months of rent.

Payment of such a large amount of security deposit to the promoter family members may be equivalent to funding the purchase cost of the property that the company has taken on rent from the promoters.

An investor may read our complete analysis of Fineotex Chemical Ltd in the following article: Analysis: Fineotex Chemical Ltd

4) When companies enter into sale/purchase/ consulting/contracting business transactions with promoters:

Many times, investors would notice that the promoters start businesses that are seemingly synergistic with the business of the listed company.

Promoters may start companies that might supply raw material to the listed company, supply intermediate products, or provide transport & logistics to the listed company. At times, promoters form services firms and provide staff on contract to the listed company. In other situations, promoters provide consulting services to their listed company.

In all these situations, an investor would notice that the promoters start these adjoining businesses in their personal capacity and then enter into contracts with the company.

Such situations become interesting because the same promoter is on both sides of the contract. The promoter as the manager of the listed company enters into a contract with himself as the owner of the personal business.

While setting the terms of such contracts, it is the promoters who decide how much business or how much profit margin they will leave for the listed company and how much profit margin whey will keep for themselves.

In almost all such cases, the listed company and the minority shareholders are at the mercy of the promoters.

Let us see such examples.

A) Rexnord Electronics & Controls Ltd:

Rexnord Electronics & Controls Ltd is an Indian manufacturer of coolant fans and shaded pole motors mainly used in computer hardware equipment, power supply equipment, textile machines, refrigeration industry, injection molding machines, photocopying machines etc.

While analysing the company, an investor notices that the company is planning to enter into contractual agreements with another entity owned by the son-in-law of the founder promoter of Rexnord Electronics & Controls Ltd.

Rexnord Electronics & Controls Ltd has sought shareholders’ approval to enter into a contractual agreement for sale, purchase, payment of commission and reimbursement of expenses with M/s Excelum Enterprises, which is the firm owned by the son-in-law of the promoter.

As per FY2015 annual report of the company:

“The Company has entered into a Contractual Agreement with M/s. Excelum Enterprises for Sale & Purchase, payment of Commission on Sales (including Overseas Sales) and reimbursement of expenses for an amount not exceeding of ₹2 Crores on annual basis, on such terms and conditions as may be agreed to by the Board.

M/s. Excelum Enterprises is a proprietary firm of Mr. Kunal Tanna being a relative of Mr. Kishore Chand Talwar and Mrs. Nainy K. Tanna, Directors of the Company, this transaction will require approval of the shareholders of the Company. Pursuant to the Section 188 of the Companies Act, 2013 and rules made thereunder, the approval of transactions is required by passing a Special Resolution at the General Meeting for appointment of any agent for purchase or sale of goods, materials or services or property where the amount exceeds 10% of the Turnover of the Company or ₹100 Crores, whichever is lower OR exceeds 10% of the net worth of the Company or ₹100 Crores whichever is lower.”

Mr. Kunal Tanna is the son-in-law of promoter Mr. Kishore Chand Talwar as established by the following section of the annual report for FY2015 (page 15):

As per the above information, it can be deduced that Mr. Kunal Tanna is the husband of Ms. Nainy Tanna who is the sister of Mr. Kundan Talwar s/o Mr. Kishore Chand Talwar.

Mr. Kishore Chand Talwar is the founder promoter of the company.

As a result, an investor may conclude that Mr. Kunal Tanna is the son-in-law of the founder promoter of the company and now the company intends to enter into contractual agreements with the son-in-law of the promoter.

The transactions with M/s. Excelum Enterprises started in FY2015 as witnessed by the related party disclosures on page 40 of the FY2015 annual report.

The dealings with the firm of promoter’s son-in-law, which started in FY2015, are proposed to be expanded in a major way by taking shareholders’ permission going forward.

An investor would appreciate that the son-in-law of the family in Indian society holds a very special place. As per social customs in Indian society, the son-in-law is given special attention and care to ensure that he along with the daughter of the family stay happy with each other. Many times, Indian families cut down on their own consumption in order to ensure that every wish of the son-in-law is fulfilled.

In such a situation, an investor can pray that the contractual dealings of the company with the son-in-law of the promoters’ family would be beneficial to the public shareholders of Rexnord Electronics & Controls Ltd.

An investor may read our complete analysis of Rexnord Electronics & Controls Ltd in the following article: Analysis: Rexnord Electronics & Controls Ltd

B) Fineotex Chemical Ltd:

Fineotex Chemical Ltd is an Indian company manufacturing speciality chemicals primarily for the textile industry.

While reading the annual reports of the company, an investor notices that Fineotex Chemical Ltd has done many transactions with the promoters’ family members & their companies.

i) Transactions with Sanjay Exports, a proprietary firm of the promoters:

While analysing annual reports of the company, an investor notices that over the years, Fineotex Chemical Ltd has done multiple transactions with Sanjay Exports, which is a proprietary firm of promoters.

a) Sale/export of products via the firm:

While reading the past annual reports of the company, an investor notices that previously, the company used to sell goods to Sanjay Exports. It seems like a transaction where Sanjay Exports used to sell these goods onwards in foreign countries.

FY2013 annual report, page 38:

An investor notices that in FY2012 and FY2013 each, Fineotex Chemical Ltd sold about ₹6 cr worth of goods to Sanjay Export, which amounted to about 17.5% of standalone sales in FY2012 (operating revenue of ₹33.3 cr) and 14.5% of standalone sales in FY2013 (operating revenue of ₹40.6 cr).

FY2013 annual report, page 21:

It looks like a significant amount of revenue was from the sales done by the company to Sanjay Exports, which looks natural that would have sold these goods further in foreign countries at an additional profit.

Many times, investors would notice that the dealings of sale and purchase of goods between the company and promoters’ entities have the possibility of shifting of economic benefits from the company to the promoters. It is especially in the cases where either the sales are done at a lower price than the price at which the company could sell its goods in the market or the purchases are done at a price higher than the price at which the company could procure goods from the market.

An investor may appreciate that the company can export the goods to the customers directly. An investor may assume that Sanjay Exports may have access to certain customers who need these goods and in turn, Sanjay Exports is earning trading profits. However, the investors should note that in such a case, instead of dealing with these customers on a personal level, the promoters should share details of these customers with the company, as they are the management team of the company.

Therefore, in cases where an investor comes across instances of the company entering into sales of goods or purchase of goods from promoter entities, then she should be cautious in her analysis.

Investors may remember the case of Jet Airways. In the case of Jet Airways, one of the company of the promoter Mr. Naresh Goyal, Jetair Pvt. Ltd (JPL) acted as a booking agent for Jet Airways. JPL earned a commission of crores of rupees from Jet Airways.

When Jet Airways became bankrupt, then the promoter entity JPL was sitting on cash reserves of crores of rupees. (Source: Naresh Goyal’s firm had Rs 260 crore cash when financial crunch hit Jet Airways – Business Today)

An investor may find many other examples in India as well as the foreign corporate world where the promoters have entered into business transactions with their public listed companies and in turn, generated personal wealth out of such transactions.

b) Purchase of motorcar from Sanjay Exports:

In FY2017, Fineotex Chemical Ltd purchased a car of about ₹41 lac from Sanjay Exports.

FY2017 annual report, page 72:

As mentioned above, investors should be cautious while analysing such transactions of sale/purchase of assets from promoters. This is because such transactions have the possibility of shifting the economic benefits from the company to the promoters in case the fair market value of the car in the second-hand market is less than the value paid by the company to Sanjay Exports.

ii) Transactions with Proton Biochem Private Limited:

While reading the annual reports, an investor notices that almost every year, Fineotex Chemical Ltd (FCL) has business dealings with another promoters entity: Proton Biochem Private Limited (PBPL).

An investor notices that in FY2019, FCL received services worth ₹2.5 cr from PBPL and it collected rent of ₹4.55 lac from PBPL.

FY2019 annual report, page 143:

It might represent a case where promoters by way of PBPL, are using a premise owned by FCL to give services to FCL.

It might be a case where promoters by way of PBPL, have hired a few employees sitting in FCL premises, to provide these services to FCL and are earning money from FCL. In such a situation, the promoters being the managers of FCL may very well hire these same employees in FCL so that FCL can get these services from its own employees and save money.

As discussed above, an investor would appreciate that the business dealings of promoters with the public companies always have a risk of shifting economic benefits from the public shareholders to the promoters. Therefore, investors should be cautious while analysing such transactions.

An investor is surprised to notice that even Fineotex Chemical Ltd had realized in the past that such transaction do not look good on the company and the promoters.

In FY2014, the company highlighted to the shareholders that PBPL is a promoters-owned entity, which does business only with FCL. Moreover, it contributed to about 50% of the turnover of FCL. The company acknowledged that such business transactions of the company with the promoters are not good corporate governance. As a result, the promoters want to sell PBPL to FCL.

FY2014 annual report, page 11:

Resolution No. 8

Proton Biochem Private Limited (Proton) (CIN-U74950MH1994PTC078288) is a related concern of the Company. It is one of the promoters. The shareholdings of Proton is held by the Tibrewala family. It almost exclusively does the processing for Fineotex and contributes around 50% of the Company’s turnover. Though the arrangement is approved by the Central Government and is extremely vital to Company’s business, the Company is advised that it would be a good governance practice to take over the business. One of the easier methods is to make it a wholly owned subsidiary.

However, even after acknowledging that these business dealings are not good from a corporate governance perspective, dealings of FCL and PBPL are continuing.

An investor may read our complete analysis of Fineotex Chemical Ltd in the following article: Analysis: Fineotex Chemical Ltd

It is advised that investors should be cautious while analysing companies, which have business dealings with promoters. This is because, many times, these transactions have the possibility of transferring economic benefits from public shareholders to the promoters.

Nevertheless, an investor would notice that until now, we have seen cases where the promoters of the company have entered into such business ventures that act as supplementary to the business of the company. As a result, the promoters of the company are able to take out a cut from the overall profitability of the listed company by entering into contractual arrangements with the listed company.

However, while analysing companies, an investor would also come across instances where the promoters have created parallel competing-business in their personal capacity which directly compete for business with the listed company.

5) When promoters own competing businesses in their personal capacity.

In such situations, the investors would appreciate that the promoters source the business from the customers and, in turn, the promoters as managers of the listed company, as well as owners of their personal business, decide how much business to allocate between the listed company and their personal business.

The listed company and the minority shareholders are completely at the mercy of the promoters to let any business flow through the listed company.

Moreover, at times, when the personal business of the promoters is running at full capacity, then they may outsource some job/contract work to the listed company, keeping high margin final marketing business in their personal business.

Let us see an example where the promoters owned a competing business in their personal capacity.

A) Shri Jagdamba Polymers Ltd:

Shri Jagdamba Polymers Ltd (SJPL) is an Indian company producing technical textiles, polypropylene/polyethylene woven sacks & fabric and geo-textile products etc.

While reading about the company, an investor gets to know that the promoters of Shri Jagdamba Polymers Ltd (SJPL) have another company, Shakti Polyweave Private Ltd (SPPL), which is in the same business line. The promoters of SJPL run the entire business operations of SPPL.

February 2019 credit rating report of CARE for Shri Jagdamba Polymers Ltd:

The promoters have also promoted the other company; Shakti Polyweave Private Limited (SPPL; rated CARE BBB+; Positive/ CARE A2) which is also engaged in similar line of operations. Both these companies operate under the common management and have business linkages.

While reading about Shakti Polyweave (Website), an investor gets to know that it produces the same products as Shri Jagdamba Polymers Ltd and is a much larger player in terms of manufacturing capacity.

With the growing demand and “constant self evolving” attitude of directors,three divisions were formed within the marketing group relatively termed as AGRO-TECH FABRIC, SPL CONSTRU-TECH FABRIC, SPL PACK-TECH PRODUCTS With the help of this focused marketing approach, company has reached a production level of 30000 tonnes annually and targeting another 20,000 tonnes in next 2 years.

An investor would notice that Shakti Polyweave has a current production capacity of 30,000 MTPA in comparison to the production capacity of 12,000 MTPA of Shri Jagdamba Polymers Ltd. Moreover, as per the above screenshot, the promoters are increasing the production capacity of Shakti Polyweave by another 20,000 MTPA.

As per the credit rating rationale of Shakti Polyweave prepared by CARE Ltd in February 2019, the additional capacity is primarily debt-funded.

February 2019 credit rating report of CARE for Shakti Polyweave Private Ltd:

SPPL is implementing a large size expansion project with a total cost of Rs.72 crore (approximately 1.14 times of tangible net-worth as on March 31, 2018) which is being funded through the term debt of Rs.50 crore, and balance through the internal accruals

In light of the above information, an investor should be aware of the conflict of interest that may arise when the same promoters/management take decisions about Shakti Polyweave Pvt. Ltd and Shri Jagdamba Polymers Ltd.

i) Promoters may prefer Shakti Polyweave Pvt. Ltd to Shri Jagdamba Polymers Ltd:

While analysing the past business history of Shri Jagdamba Polymers Ltd, an investor gets to know that previously, the key role of the company was to act as a contract manufacturer for Shakti Polyweave Pvt. Ltd.

September 2010 credit rating rationale of Shri Jagdamba Polymers Ltd by ICRA Ltd:

The company manufactures woven sacks, tarpaulin and geo-textile products on job work basis and large part of the job work is for Shakti Polyweave Private Limited, a group company, which exports most of its production to USA and European countries.

Thus, an investor would note that the key role of Shri Jagdamba Polymers Ltd in the promoter group was to do contract manufacturing for Shakti Polyweave Pvt. Ltd. Shakti Polyweave would, in turn, sell the goods produced by the company to export markets. Such an arrangement raises the possibility that for any export order, the promoters may split the profit between Shri Jagdamba Polymers Ltd and Shakti Polyweave Pvt. Ltd as per their preferences.

If the promoters decide, then they may easily keep a larger share of profit in Shakti Polyweave and pass on a lower share of profit to Shri Jagdamba Polymers Ltd in the form of contract manufacturing/job work charges.

Possibility of such a situation is removed if the promoters only have one company for the business activity. In such a case, all the profits are availed by one company and the possibility of promoters preferring their private company to the public limited company is mitigated.

ii) Expansion of production capacity in Shakti Polyweave Pvt. Ltd instead of Shri Jagdamba Polymers Ltd:

In the discussion above, an investor would remember that the production capacity of Shri Jagdamba Polymers Ltd is unchanged at 12,000 MTPA since FY2010. On the other hand, Shakti Polyweave Pvt. Ltd, which is already a larger player with a current production capacity of 30,000 MTPA, is undergoing a further capacity expansion of 20,000 MTPA. An investor would also remember that both Shri Jagdamba Polymers Ltd and Shakti Polyweave operate in the same business segment and produce similar products.

An investor may think that the promoters have decided to expand the production capacity of Shakti Polyweave instead of Shri Jagdamba Polymers because Shakti Polyweave may have reached a higher capacity utilization and in turn, it might need additional capacity.

However, while reading the credit rating reports of both the companies, an investor gets to know that in FY2018, Shri Jagdamba Polymers had achieved 88% capacity utilization versus 87% capacity utilization achieved by Shakti Polyweave.

February 2019 credit rating report of CARE for Shri Jagdamba Polymers Ltd:

The growth in total operating income of the company was largely driven by improving capacity utilisation and increasing average sales realization of its products. The capacity utilisation of SJPL’s products improved to 88% during FY18 from 59% during FY16.

February 2019 credit rating report of CARE for Shakti Polyweave Private Ltd:

The growth in total operating income of the company was largely driven by improving capacity utilisation and increasing average sales realization of its products. The capacity utilisation of SJPL’s products improved to 87% during FY18 from 61% during FY16.

(*please note: we believe that the mention of SJPL in the credit rating report of Shakti Polyweave Private Ltd while describing the capacity utilization is a typographical error by CARE Ltd.)

Looking at the above data, an investor would appreciate that in FY2018, both the companies have achieved a similar level of capacity utilization (88% vs 87%). However, still, the decision of promoters to increase production capacity of already larger company Shakti Polyweave instead of Shri Jagdamba Polymers Ltd may indicate that the promoters have decided to grow the already larger company to an even larger level.

Investors would note that since FY2010, the manufacturing capacity of Shri Jagdamba Polymers Ltd is constant at 12,000 MTPA. The major capital expenditure is done by the company during the last 10 years towards the creation of wind-power generation capacity in FY2014 and FY2016. Moreover, as per the credit rating rationale of the company by CARE in December 2017, the promoters plan to create a solar power plant in Shri Jagdamba Polymers Ltd:

Moreover, As on March 31, 2017, SJPL has windmill capacity of 3.6 Mega Watt (MW). SJPL is also planning to install solar power plant with capacity of 3 MW at the total cost of Rs.13.50 crore, which is expected to be funded through the term loan of Rs.10.12 crore and rest through internal accruals. The installation is expected to be completed by March 2018.

Advised reading: How to do Business Analysis of Solar Power Plants

Moreover, investors would notice that the larger of the two companies, Shakti Polyweave Private Ltd was established by the promoters in 1997 whereas Shri Jagdamba Polymers Ltd was established in 1985.

February 2019 credit rating report of CARE for Shakti Polyweave Private Ltd:

Incorporated in December 1997, SPPL is promoted by Mr. Hanskumar R. Agarwal and his family members. SPPL is engaged in manufacturing of polypropylene (PP)/ Polyethylene (PE) woven sacks & fabric, geo-textile products and various technical textile products which find its application in agriculture, infrastructure and packing industry.

Therefore, investors would note that the Shakti Polyweave, which was established by promoters much later than Shri Jagdamba Polymers Ltd has grown to a much larger level and is still being expanded to an even larger level with currently ongoing large capital expenditure.

It might be that Shri Jagdamba Polymers Ltd no longer fits into the future expansion plans of the promoter group. Alternatively, it might be that the promoters prefer to generate more business growth in their privately held company instead of the public listed company.

Investors may note that such a situation of differential treatment would not arise if the promoters hold only one company for doing business in a segment.

iii) Investors of Shri Jagdamba Polymers Ltd at the mercy of promoters to give any business to the company:

After looking at the promoter group structure, an investor would appreciate that the promoters have two companies in the group to manufacture technical textiles: Shri Jagdamba Polymers Ltd and Shakti Polyweave Pvt. Ltd. Both of these companies are run by the same promoter group/management. As a result, whenever, the promoter group/management gets any new order/business opportunity, then it has the discretion whether to give this order to Shri Jagdamba Polymers Ltd and Shakti Polyweave Pvt. Ltd.

As a result, the shareholders of Shri Jagdamba Polymers Ltd are always at the mercy of the promoters to give it any business by not giving the business to Shakti Polyweave. All the distribution of business between Shri Jagdamba Polymers Ltd and Shakti Polyweave Pvt. Ltd is purely based on the goodwill of promoters. The promoters may decide to give all the business to Shakti Polyweave and only give that amount of manufacturing job to Shri Jagdamba Polymers Ltd, which cannot be manufactured by Shakti Polyweave, as used to happen in the past. This raises possibilities of conflict of interest.

Moreover, from the above discussion, an investor would note that Shakti Polyweave is currently undergoing a debt-funded large capital expenditure. An investor would appreciate that the natural intention of the promoter group may be to utilize the newly created capacity of Shakti Polyweave as early as possible and in turn, pay off the debt raised by them in Shakti Polyweave so that the upcoming interest burden can be reduced.

In light of the same, an investor should be cautious while analysing the future possible situations where the conflict of interest of the promoters of the company by way of their privately held company may interfere with the future prospects of Shri Jagdamba Polymers Ltd.

Investors may note that such a situation of conflict of interest can be avoided if the promoters of public listed companies have only one company for running a business segment.

An investor may read our complete analysis of Shri Jagdamba Polymers Ltd in the following article: Analysis: Shri Jagdamba Polymers Ltd

Until now, we have seen instances where the promoters of the company have entered into monetary transactions with their listed company. Such transactions included loans, sale/purchase of assets, business dealings, joint ventures etc. An investor would appreciate that the monetary transactions have the potential of directly transferring economic benefits from the company and the minority shareholders to the promoters.

However, it is not that to transfer the economic benefits, the promoters always rely on monetary transactions. Let us see instances where the promoters used the companies for their benefit by using non-monetary transactions like guarantees to the lenders for loans taken by the promoter entities.

6) When companies provide guarantees to lenders on behalf of promoter group entities.

Many times, investors would come across situations where the listed company has given a guarantee on behalf of the promoter group entities.

In such situations, an investor may think that the listed company has not entered into any monetary transaction with the promoters. Therefore, it may look to the investor that the possibility of the promoters taking economic benefit out of the company is less.

However, the investors would appreciate that the guarantee given by the listed company on behalf of the promoters’ entities ensures that the promoters enjoy the fruits of their personal business until the time it runs successfully. In case, their personal business fails, then they would not bear the consequences personally, as the banks will recover their loans from the guarantor i.e. the listed company.

Such situations are equivalent to the promoters enjoying high returns in their personal businesses without facing the risk. This is because the risk is ultimately borne by the minority shareholders giving the guarantee via the company.

Let us see examples.

A) Navkar Corporation Ltd:

Navkar Corporation Ltd, an Indian container freight station (CFS) player with operations at Jawaharlal Nehru Port Trust (JNPT) and Vapi.

As a part of the analysis of the company, when an investor reads the placement document of Navkar Corporation Ltd for QIP in 2017, then she notices that the company has disclosed that it is a co-borrower in a few loan facilities taken by promoter group companies.

As per the co-borrower lending structure, in case any of the borrowers are not able to repay the loan amount taken by it, then the lender can ask the other co-borrower to repay the loans given by it. Such an arrangement may turn out to be a guarantee for the loan availed by promoter group entities.

2017 QIP placement document, page 54:

Further, certain of our Promoters and members of our Promoter Group are co-borrowers under certain of our credit facilities, which entitle such co-borrowers to draw-down from such facilities. While disbursements have not been made to such persons as on the date of this Placement Document, we cannot assure you that our Company will receive all disbursements from such credit facilities or that such co-borrowers will not exercise their right to receive such disbursements in the future.

When an investor analyses the past disclosures of Navkar Corporation Ltd, then she notices that the company has entered as a co-borrower as well as given guarantees to the loans taken by promoter group entities in the past as well.

As per the 2015 DRHP, the company had given guarantees as well as its properties as security to the lenders for promoter group entities. The company has stated that if the promoters & their entities are not able to repay these loans, then the banks may recover the money from Navkar Corporation Ltd.

2015 DRHP, page 38-39:

Our Company is a co-borrower in relation to certain credit facilities of our Subsidiary, NTL, and an automobile loan availed by our Promoter, Mr. Shantilal Jayavantraj Mehta, and we have also provided corporate guarantees and certain property owned by our Company as security for certain indebtedness of some of our Group Entities. We have mortgaged certain of our properties in relation to certain indebtedness of the Selling Shareholder. For details of the outstanding borrowings of our Company including facilities in relation to which we are a co-borrower or guarantor, see “Financial Statements – Annexure 9 – Restated Consolidated Statement of Borrowings” and “Financial Indebtedness” on pages 326 and 432, respectively. In the event our Promoter or Group Entities referred to above default on their obligations under such facilities and the guarantees and other obligations undertaken by us are invoked, we may be required to fulfill such obligations by the lenders, which would adversely affect our business and financial results.

While reading the secretarial audit report section of the FY2015 annual report as well, the investor comes across that Navkar Corporation Ltd has given a guarantee to one of the promoter group entity: Sidhhartha Corporation Private Limited.

FY2015 annual report, page 16:

The Corporate Guarantee given to Sidhhartha Corporation Private Limited on 18th March, 2011, has been renewed during the F.Y. ended on 31 st March, 2015.

It is advised that investors should keep a close watch on such lending arrangements in which the company has become co-borrower or given a guarantee to the promoters and their entities. This is because, in the event of default by promoters, the lenders would recover the money from the company.

An investor may read our complete analysis of Navkar Corporation Ltd in the following article: Analysis: Navkar Corporation Ltd

From the discussion until now, an investor would appreciate that she should be very cautious while analysing the companies that have had business transactions with their promoters. These transactions may be in the form of loans, sale/purchase, business dealings, or guarantees etc. The investor needs to increase her due diligence in all these cases because each of these transactions between the company and the promoters presents an opportunity for the promoters to take the economic benefit away from the company and the minority shareholders.

An investor would appreciate the importance of reading the related party transactions section of the annual report as one of the key segments of the report to assess the quality of management of any company. Reading this section provides immense insights into the management analysis of the companies.

However, at times investors would come across cases where the management of the companies attempts to avoid the disclosure of related party transactions in the relevant sections of the annual report.

Cases where companies avoided disclosing transactions in “Related Party Transactions” table

An investor would appreciate that the “Related Party Transactions” table is of immense importance in her stock analysis. However, the situation becomes difficult, if the transactions between the company and the promoters are either not shown in the related party transactions table or if they are present, then the transactions are disclosed in such a manner that it becomes difficult to draw any meaningful conclusion from the related party transactions table.

In such cases, it becomes very critical for the investor to focus on other sources of information apart from the related party transactions table of the annual report and at times sources like credit rating reports to extract the additional information so that she may make an informed decision about the management of the company.

Let us see some examples where other sections of the annual report and other sources of information apart from the annual report, helped investors gain insights into the dealings of the companies with their promoters.

A) Sutlej Textiles and Industries Ltd:

Sutlej Textiles and Industries Ltd (STIL) is an Indian company focused on the production of Melange, Modal, Lyocell and Tencel yarns and home textiles segment.

STIL is a part of the K.K Birla group of companies. After the division of the K.K. Biral group assets, STIL came under the control of Nopanys along with some other companies.

However, while analysing STIL, an investor notices that the company did not mention some of the important companies of the Nopany family while disclosing the details of the related parties. Moreover, the investor also notices that STIL had entered into transactions with these important companies of the promoter Nopany group.

As mentioned in the news article published in the Business Line (Nopanys to ring-fence K.K. Birla legacy; to up stake in Upper Ganges, Oudh Sugar), the promoters of Sutlej Textiles and Industries Ltd have inherited two sugar mills: Upper Ganges Sugar & Industries Ltd and Oudh Sugar Mills Ltd as part of the division of business of late Mr. K.K. Birla.

Subsequently, the promoters merged Upper Ganges Sugar & Industries Ltd and Oudh Sugar Mills Ltd into a company named Avadh Sugar & Energy Ltd where the promoters of Sutlej Textiles and Industries Ltd (STIL) Ms. Nandini Nopany and Mr. C.S. Nopany hold key positions (Chairperson and Co-chairperson respectively). (Source: http://www.birla-sugar.com/Our-Companies/About-Us-Avadh)

Therefore, it seems that the promoters of Sutlej Textiles and Industries Ltd have significant influence over Upper Ganges Sugar & Industries Ltd, Oudh Sugar Mills Ltd (merged into Avadh Sugar & Energy Ltd).

However, none of these names appears in the FY2017 annual report of Sutlej Textiles and Industries Ltd under the related party section as the enterprises over which promoters exercise significant control/influence.

FY2012 annual report, page 161:

It might be that due to some legal business structuring/clauses these companies may not fall in the classification of related parties or it might be an omission on part of the company. Therefore, investors may seek clarification from the company about the same.

i) Sutlej Textiles and Industries Ltd  is supporting promoter group entities from the company’s resources:

While analysing the annual reports of the company, an investor would note that Sutlej Textiles and Industries Ltd has been supporting promoter group companies Oudh Sugar Mills Ltd and Upper Ganges Sugar & Industries Ltd over the years.

The company invested ₹50 cr in Oudh Sugar Mills Ltd in FY2012 by way of Cumulative Redeemable Preference Shares (FY2012 annual report, page 63)

These investments we carried at their initial investment value of ₹50 cr until FY2016. However, in FY2017, two developments took place:

• Oudh Sugar Mills Ltd was merged into Avadh Sugar & Energy Ltd. As a result, Avadh Sugar & Energy Ltd and M/s Palash Securities Ltd have issued preference shares to Sutlej Textiles and Industries Ltd in lieu of its investments in Oudh Sugar Mills Ltd.
• As part of IndAS accounting, Sutlej Textiles and Industries Ltd has to disclose the fair value of the preference shares in the annual report of FY2017.

Therefore, while analysing the FY2017 annual report, an investor notices that the value of the initial investment of ₹50 cr along with the due coupon for the interim period has declined in value significantly. The fair value of this investment in FY2015 was ₹22.49 cr, which has increased to ₹28.32 cr in FY2017.

The decision of Sutlej Textiles and Industries Ltd to invest in Oudh Sugar Mills Ltd might be akin to supporting promoter group entities using the resources of the company where the investment has turned into losses.

ii) Sutlej Textiles and Industries Ltd  is supporting promoter group entities from the company’s resources (Part 2):

While analysing the annual reports of the company, an investor would notice that Sutlej Textiles and Industries Ltd has given a loan of ₹40 cr to Upper Ganges Sugar & Industries Ltd in FY2016. (FY2016 annual report, page 131):

The investor would note that Upper Ganges Sugar & Industries Ltd repaid the loan within the financial year; therefore, there was no loan outstanding at the end of FY2016.

However, in the FY2017, Sutlej Textiles and Industries Ltd again gave a loan of ₹40 cr to Upper Ganges Sugar & Industries Ltd, which was also repaid by it within the financial year; therefore, again there was no loan outstanding at the end of FY2017. (FY2017 annual report, page 182):

Moreover, if an investor reads the summary balance sheet presented by Sutlej Textiles and Industries Ltd along with H1-FY2018 results, then she would notice that a loan of ₹40 cr is again outstanding in the books of the company at September 30, 2017.

As the details of the counterparty to this ₹40 cr loan outstanding at September 30, 2017, is not disclosed in the Ltd information in the quarterly results, therefore, it cannot be said with certainty whether this loan is to Upper Ganges Sugar & Industries Ltd (or to Avadh Sugar & Energy Ltd in which it has been merged). Investors may seek clarification from Sutlej Textiles and Industries Ltd about this counterparty.

Therefore, it might be one of the scenarios that Sutlej Textiles and Industries Ltd has decided to continuously support Upper Ganges Sugar & Industries Ltd to the extent of ₹40 cr. As a result, it might advance the loan at the start of the financial year and take repayment before the end of the financial year. Therefore, the loan is not outstanding at the end of the financial year.

This can be one of the scenarios. Investors may seek clarification from the company about this loan as it may also tantamount to supporting promoter group entities using the resources of the company.

An investor may read our complete analysis of Sutlej Textiles and Industries Ltd in the following article: Analysis: Sutlej Textiles and Industries Ltd

B) Shri Jagdamba Polymers Ltd:

Shri Jagdamba Polymers Ltd is an Indian company producing technical textiles, polypropylene/polyethylene woven sacks & fabric and geo-textile products etc.

While analysing the company, an investor notices that some of the transactions that an investor expects to find in as disclosures in the related party transactions are not present in the disclosure table.

While assessing the credit rating reports for the company, an investor gets to know that the promoters of the company have frequently provided loans to the company. CARE in its credit rating report for February 2019 has taken comfort because of such loans.

The liquidity profile of the company is comfortable with current ratio of 1.86 times as on March 31, 2018 and average fund based working capital utilizations at 38% for past trailing 12 months ended October 2018. Moreover, liquidity is supported by healthy cash accruals and need based support from promoters.

In the December 2017 credit rating report, CARE has identified the amount of loans provided by promoters to the company in FY2016 and FY2017.

Moreover, there were unsecured loans from promoters of Rs.11.90 crore of which Rs.8 crore were subordinated to bank loans and hence considered as quasi capital till FY16. However, the promoters have withdrawn the unsecured loans of Rs.6.25 crore during FY17.

From the above disclosure in the credit rating report, an investor can ascertain that at the end of FY2016, the promoters had provided loans of ₹11.90 cr to Shri Jagdamba Polymers Ltd. In FY2017, out of these loans, the promoters withdrew ₹6.25 cr. Therefore, in FY2017, loans of ₹5.65 cr (11.90 – 6.25 = 5.65) remained outstanding.

This data matches with the data present under the section “Loans from Directors and Body Corporates” in the FY2017 annual report, page 66:

In light of the presence of loans from promoters, an investor would expect that the detailed data related to these loans would be present in the related party transactions section of the annual report like:

• What is the applicable interest rate on these loans, how much interest is paid by the company to the promoters for these loans during the year and how much is payable at the end of the year?
• How much money was taken and repaid during the year etc?

However, when an investor analyses the related party transactions section of the annual report, then she notices that there are no such details of these loans and interest payments in this section.

FY2017 annual report, page 75:

An investor would notice that in the detailed table, under different heads, there are no rows for details of loan taken/repaid and interest paid.

In the last two rows, under outstanding balances at the end of the year, it seems that the company tried to provide some information like amount due from key management personnel of ₹83.42 lac, which matches with the amount disclosed under “Loan from Directors & Shareholders”. However, an investor is not able to gain meaningful information about the rest of the loans and their counterparties.

It seems that the disclosures by Shri Jagdamba Polymers Ltd under related party transactions have a room for improvement.

An investor may read our complete analysis of Shri Jagdamba Polymers Ltd in the following article: Analysis: Shri Jagdamba Polymers Ltd

Looking at the above scenarios, an investor would appreciate that her job of assessing management by analysing the transactions of the company with the promoters does not end only with reading the related party transactions table in the annual report. She may find instances where there are additional transactions between the company and the promoters, which may not be included in the related party transactions table.

Therefore, it becomes essential that the investor must read all the sections of the annual report and then read other public documents like the credit rating reports etc. so that she may have a comprehensive view about the related party transactions of the company.

In any case, the investor should be open to the possibility that even after her best efforts; she may not be able to completely uncover the gamut of transactions between the promoters and their company. Therefore, she should always acknowledge her limitations and be open to change her mind about the management of the company whenever in the future, she gets any indication that there is more to the dealings of the promoters with their listed company than what she had known until now.

Nevertheless, we believe that an analysis of the company and its promoters by the investor with respect to the following transactions should help an investor gain a good insight in the assessment of the management of the company:

1. Lending transactions between the company and the promoters:
   • Both when the company gives loans to the company as well as when the company takes loans from the company
2. Buying and selling assets/equity stake between the company and promoters’ entities:
   • Both when the company buys assets from the promoters as well as when the company sells assets to the promoters.
3. When companies give advances or security deposits to the promoters at generous terms:
   • Specifically, focus on instances where the company has given large advances to the promoters or their relatives at generous terms.
4. When companies enter into sale/purchase/consulting/contracting business transactions with promoters.
   • Focus on all the business dealings between the company and the promoters. In almost all such cases, the listed company and the minority shareholders are at the mercy of the promoters.
5. When promoters own competing businesses in their personal capacity.
   • This is the most precarious situation for the minority shareholders as the listed company and the minority shareholders are completely at the mercy of the promoters to let any business flow through the listed company.
6. When companies provide guarantees to lenders on behalf of promoter group entities.
   • In such situations, the promoters enjoying high returns in their personal businesses without facing the risk because the risk is ultimately borne by the minority shareholders giving the guarantee via the company.

After assessing every company on all these parameters, an investor would be able to understand largely the key business dealings between the company and its promoters. However, she should always be aware of the fact that there might be other dealings, which the company/promoters have not disclosed in the annual report. They may have structured the dealings in such a manner that they do not yet fall in the legal definition that determine the inclusion in the public disclosures.

Therefore, the investor should do her hard work in assessing the related party transactions and still acknowledge that she is assessing only the transactions that have been put in front of her. There might be much more to the dealings between the company and the promoters that are not yet presented to her in public disclosures.

With this openness of mind, she may choose to go ahead with her assessment of the management of any company and make an investment decision.

How do you assess the related party transactions of any company with its promoters? What parameters do you use for identifying if the promoter of any company has taken the economic benefits away from the minority shareholders? What has been your experience of using those parameters?

Has it proved a helpful parameter to differentiate good companies from the poor one? It would be great if you could share your experiences with the author and the other readers in the comments section below.

Readers’ Queries about Related Party Transactions

How to interpret related party transactions?

Sir,

I have one question related to Shri Jagdamba Polymers Ltd (SJPL). (Analysis: Shri Jagdamba Polymers Ltd)

From the amount outstanding to the associate companies in the related party transaction section of the annual report (AR), we notice that SJPL has to collect some money from Shakti Polyweave Private Ltd (SPPL). However, how do we know whether SJPL has given the debt to SPPL or it has sold products or job work to SPPL from this data?

In addition, the promoter or key management personnel (KMP) have received interest on their loan given to SJPL. However, the rate of interest is never shown in any AR from 2010 to 2018. Moreover, the loan from the promoter is never shown in the credit rating reports except in the 2017 credit rating report stating that:

“there were unsecured loans from promoters of Rs.11.90 crore of which Rs.8 crore were subordinated to bank loans and hence considered as quasi capital till FY16. However, the promoters have withdrawn the unsecured loans of Rs.6.25 crore during FY17. Hence, from FY17 onwards the unsecured loans have been considered as debt.”

Author’s response:

Hi,

Thanks for writing to us!

The amount outstanding at the end of the year is the result of transactions with the related party during the year. An investor has to analyse each of the items in the related party transactions table to understand all the transactions during the year. It might be a result of loans given/repaid, interest accrued but not paid, job work, rent, remuneration, dividends etc.

An investor may determine the ease of interpretation of such transactions as a measure of disclosure standards of the company. If something is difficult to interpret, then it might be a deliberate attempt to make it so.

Read: Why Management Assessment is the Most Critical Factor in Stock Investing?

Most of the time, companies do not disclose the interest rate being paid to promoters on their loans. However, investors may ascertain the approximate level of interest rate from the amount of loan given by any related party and the amount of interest paid by the company to the related party during the year. For illustration, an investor may refer to the following article in which we have calculated the interest rate on the loans granted by promoters to KNR Constructions Ltd:

Analysis: KNR Constructions Ltd

All the best for your investing journey!

Regards

Dr. Vijay Malik

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Disclaimer

Registration status with SEBI:

I am registered with SEBI as a research analyst.

Details of financial interest in the Subject Company:

I do not own stocks of the companies mentioned above in my portfolio at the date of writing this article.