INVESTOR LETTER #86
What Are Related Party Transactions (RPTs)?
Learn what Related Party Transactions (RPTs) are, why companies enter into them, and how investors evaluate whether these transactions are fair, transparent, and in the best interests of all shareholders. While many RPTs are legitimate business arrangements, excessive or poorly disclosed transactions can be a warning sign of weak corporate governance.
INVESTOR NOTE
A business owner thinks in decades. A speculator thinks in minutes.
The Family Business Dilemma
Imagine three friends start a company together. One of them also owns a transport business. Instead of finding the best transport company in the market, he gives all the transportation contracts to his own business at higher prices. The company pays more than it should, his transport business earns extra profit, and the other two owners unknowingly lose money. This is why investors pay close attention to related party transactions.
Who Is a Related Party?
A related party is anyone who has a close relationship with the company. This could include promoters, directors, senior executives, their family members, or other companies they control. Because of this relationship, there is a possibility that decisions may not always be completely independent.
What Counts as a Related Party Transaction?
A related party transaction can include buying or selling goods, providing services, renting property, giving loans, guaranteeing debt, paying management fees, or entering into business agreements with related parties. These transactions happen in many companies every day.
Not Every Transaction Is Suspicious
Many businesses operate through multiple companies within the same group. They may share office space, provide services to one another, or buy raw materials from a sister company. These arrangements can be perfectly reasonable if they are carried out on fair commercial terms.
The Real Risk Is Conflict of Interest
Problems arise when the people making decisions also benefit personally from those decisions. Instead of acting in the best interest of all shareholders, they may favor themselves or their family businesses. This conflict of interest can quietly transfer wealth away from minority shareholders.
Fair Price Is Everything
Imagine buying a laptop from your brother. If he charges the same market price everyone else pays, there is no issue. But if he charges double simply because you're family, the transaction becomes unfair. The same principle applies to companies. The relationship itself isn't the problem—the pricing and fairness are.
Small Transactions vs. Large Ones
Occasional and reasonably sized related party transactions are common in business. However, if a large portion of the company's revenue, expenses, or assets involves related parties, investors should understand why and evaluate whether those arrangements truly benefit the company.
Transparency Builds Trust
Honest management openly explains why related party transactions exist, how prices are determined, and why the arrangements are beneficial for the company. Clear disclosures and detailed explanations usually increase investor confidence.
Warning Signs Investors Should Notice
Repeated loans to promoter-owned companies, unusually expensive purchases from related businesses, assets being sold below market value, excessive management fees, or complicated transactions that are difficult to understand deserve closer investigation. Complexity often hides problems.
Where to Find These Transactions
Companies are required to disclose related party transactions in their annual reports and financial statements. Reading the notes to the accounts may seem boring, but this is often where investors discover important information about how management treats shareholder money.
Good Governance Is More Than Following Rules
A company can comply with every legal requirement and still make decisions that are unfair to minority shareholders. Great management doesn't just ask, 'Is this legal?' They ask, 'Is this fair to every shareholder, including those who own just one share?'
One Question Before You Move On
Whenever you come across a related party transaction, ask yourself: 'If the promoter and the company were complete strangers, would this deal still happen on the same terms?' If the answer is yes, it's probably a fair transaction. If not, it deserves much deeper investigation.
INVESTOR PRINCIPLE