Case 089Debt fund credit decisionsHard
A fund lent Rs 150 crore through NCDs secured by promoter shares at 2.0x cover. The share price falls 45%, cutting cover to 1.1x, and the stock trades only Rs 12 crore a day. Invoke the pledge and sell, demand a top-up, or wait?
1The situation
A credit risk fund holds Rs 150 crore of non-convertible debentures issued by Trivikram Holdings, an invented promoter holding company whose main asset is a controlling stake in a listed group company. The NCDs are secured by a pledge of those listed shares, worth Rs 300 crore at issue, 2.0 times the debt. The documents require the promoter to top up the security within seven days if cover falls below 1.5 times, and let the trustee invoke the pledge and sell if cover falls below 1.2 times or a top-up is missed.
Over eight weeks the listed company's shares have fallen 45% on an accounting question raised by a short seller. The pledged shares are now worth Rs 165 crore, cover is 1.1 times, and the stock trades about Rs 12 crore a day. Other lenders hold pledges over more of the promoter's shares. For the arithmetic, assume a forced sale realises 25% below the current price, and test a further 30% fall if the fund waits.
2Your task
Should the fund invoke the pledge and sell, demand a top-up, or wait, and what does each choice cost?
Quick check
At 20% of daily volume, roughly how long would it take to sell Rs 165 crore of pledged shares?
Worked solution
Try it on paper, then open one step at a time.
30-second answerThe answer to give first
Demand the top-up now and prepare to invoke at the same time; do not wait. Cover of 1.1 times already breaches the 1.2 times invocation level. A forced sale today might recover about Rs 124 crore, a loss near Rs 26 crore; another 30% fall would take recovery to about Rs 87 crore. Selling takes about 69 trading days at 20% of volume, and other lenders face the same arithmetic. Share-backed security is worth only what can be sold before the price falls further.
Step 1What is the security really worth?
Not its screen price. A pawnbroker who lends against gold can sell it in an afternoon; one who lends against a rare painting has to find a buyer, and the price falls the longer he looks. Pledged shares are worth what can be sold, at the pace the market allows, before the price moves further. On screen the shares are worth Rs 165 crore, 1.1 times the debt. But the stock trades Rs 12 crore a day. Selling the whole day's volume would take about 14 days and crush the price; at a sustainable 20% of volume it takes about 69 trading days, more than three months.
Step 2When should the fund have acted?
Read the cover path. It fell from 2.0 times to 1.76, 1.60, 1.44 by week 4, already below the 1.5 times top-up trigger, then 1.24 and 1.10. The moment to demand a top-up was week 4, when cover first broke 1.5 times; the documents gave the fund that right precisely so it would act before the cushion disappeared. Every week of waiting since then has cost cover. The lesson is about process: a covenant only protects a lender who monitors it daily and acts on the day it is breached.
Step 3What does each choice cost?
Price them. Invoke and sell now: if a forced sale realises 25% below today's price, the fund recovers about Rs 124 crore and loses about Rs 26 crore, 18% of the exposure. Demand a full top-up to 2.0 times: the promoter must add Rs 135 crore of security, unlikely when his main asset has just fallen 45%; restoring 1.5 times needs Rs 60 crore, more plausible if he has unpledged shares or other assets. Wait: if the price falls another 30%, the shares are worth Rs 115 crore and a forced sale then recovers about Rs 87 crore, a loss of about Rs 63 crore. Waiting only pays if the accounting question is resolved quickly, and the fund has no edge in predicting that.
| Choice | Security value, Rs crore | Likely recovery, Rs crore | Loss on Rs 150 crore |
|---|---|---|---|
| Invoke and sell now | 165 | 123.8 | 26.2 |
| Wait, price falls another 30% | 115.5 | 86.6 | 63.4 |
| Top-up to 1.5x, then reassess | 225 | Full, if the promoter delivers | None yet |
The deciding fact is the other lenders. If the promoter has pledged most of his stake across several lenders, each will invoke when its own trigger is hit, and their selling is what pushes the price down. Pledged shares create a run: the first lender to sell gets the best price, and the last gets what is left. So the plan is to serve the top-up notice today with the seven-day deadline the documents allow, accept security in cash or other liquid assets, and in parallel line up a negotiated block sale to an institutional buyer, which may realise a smaller discount than selling on the screen. If the top-up does not arrive, invoke and sell in a planned way. The fund should also tell investors promptly and follow the valuation agencies' marks; if the issuer misses a payment, the fund may be able to ring-fence the NCD in a segregated portfolio, so that investors who redeem now do not leave the loss to those who stay. Confirm the current rules for that. The limit: the 25% sale discount is an assumption, and a strategic buyer for a controlling stake could pay a premium rather than a discount.
Where candidates lose it
Candidates read 1.1 times cover and conclude the fund is still fully covered, so it can wait. Cover on screen is not cover in cash; the stock's daily volume decides how much of that 1.1 times the fund would ever see.
The second miss is treating the decision as the fund's alone. Other lenders with pledges over the same shares will sell when their triggers hit, so delay is not neutral; it moves the fund to the back of the queue.
What the interviewer asks next
- The promoter offers unpledged shares of a different, unlisted group company as top-up. Would you accept them?
- How should the fund's NAV reflect the NCD while the decision is pending?
- What covenants would you write into the next share-backed deal to avoid this?
- How would a segregated portfolio change the outcome for investors who stay and those who leave?
Company names and figures are illustrative.