On the Institutional Investor puzzle in pledging firms: Evidence from India

This study examines institutional investor behavior toward pledging firms. It focuses on pledging as a popular yet risky alternative financing source in resource-constrained emerging markets. The “Pledging-Aversion” view suggests that pledging often signals financial vulnerability due to margin call risks and may deter institutional investors. On the contrary, the “Pledging-Opportunity” hypothesis suggests that institutional investors may view such firms as a strategic investment opportunity due to the disciplining effects of pledging. Our panel regression analysis of 3,153 non-financial Indian-listed firms from 2010 to 2020 shows that institutional investors hold significantly higher stakes in pledging firms. We further explain that institutional preference for pledging firms is driven by their undervaluation and reduced holdings by controlling shareholders. Additional analyses show that institutional investors exercise caution when investing in pledging firms. They invest only in pledging firms with favorable attributes, such as affiliation with a business group, lower pledging intensity, lesser earnings management, and higher dividend payments. Finally, we document significant heterogeneity across investor types: foreign institutional investors and financial institutions view pledging firms as opportunities, whereas mutual funds adopt a risk-averse stance. The findings are robust to endogeneity concerns and alternate measures of key explanatory variables. Our study contributes to the literature by highlighting how and when pledging firms can act as a value buy, offering lower expropriation risks for institutional investors.