MODULE 2:
MERCHANT BANKING
INTRODUCTION
Financial services are rendered through numerous intermediaries
who are known by different names.
One of the prominent intermediaries is known as Merchant
banker. Merchant banking differs from country to country.
Merchant banking had its origin in UK and USA in early fifties.
HISTORY OF MERCHANT BANKING
Merchant banks first arose in the Italian states in the middle
ages when Italian merchant houses generally small, family-owned
import-export commodity trading businesses. They began to use
their excess capital to finance foreign trade in return for a share
of profits. This trade generally consisted of lengthy sea voyages.
Thus, the investments were very high risk: war, bad weather and
piracy were constant threats, and by their nature the voyages
were long term and illiquid.
Later, the center for merchant banking shifted from the Italian
states to Amsterdam and then, in the eighteenth century London,
where immigrants from Russia, France, Ireland, Prussia and the
Italian states formed the core of early British merchant banking.
Like the Italian and Dutch houses before them, these British
houses were generally small, family owned partnerships, and
most of them continued both to trade for their own businesses
and to finance the trading by others. By the end of eighteenth
century however, the British merchant houses had increased in
marketing or finance. As the nineteenth century opened, virtually
no mercantile houses remained focused on both trade and
finance.
MEANING
Merchant banking is a financial institution that provides capital
to companies in the form of share ownership instead of loans.
Merchant banking is a combination of banking and consultancy
services. It provides consultancy to it’s clients for financial,
marketing, managerial and legal matters. Consultancy means to
provide advice, guidance and service for a fee.
In short, merchant banking provides a wide range of services for
starting until running a business. It acts as Financial Engineer
for a business.
DEFINITIONS OF MERCHANT BANKING
1. According to Dictionary of Banking and Finance:
“Merchant bank is an organization that underwrites
securities for corporations, advices such clients on mergers
and is involved in the ownership of commercial banking”
2. According to Securities and Exchange Board of India rules
1992: “Merchant banker is any person who is engaged in
the business of
issue management either by making
arrangement regarding selling, buying or subscribing to
securities or acting as manager consultant , advisor or
rendering corporate advisory services in relation to such
issue management.”
On the basis of the above definition, the merchant banking
provides number of specialized services like lending money on
short or medium terms or advising companies on the best
method of raising long term loans.
FUNCTIONS OF MERCHANT BANKS
The basic function of merchant banker or investment banker is
marketing corporate and other securities. Merchant banks
perform a number of services concerning various aspects of
marketing i.e. organization, underwriting and distribution of
securities.
At present, Merchant bankers cover a wide range of activities
which are:
1. Corporate counselling: Merchant banking helps its clients to
raise finance through issue of shares, debentures, bank loans
etc. it helps its clients to raise finance from the domestic and
international market, to improve performance and increase the
market value of its equity shares.
2. Broker in Stock exchange: Merchant bankers act as brokers
in stock exchange. They buy and sell shares on behalf of their
clients. They also advise their clients about which shares to buy,
when to buy, how much to buy and how much to sell.
3. Project counselling: Merchant bankers help their clients in
many ways.
For e.g. advising about location of a project,
preparing a project report, conducting feasibility studies, making
a plan for financing the project, finding out sources of finance,
advising about concessions and incentives from government.
4. Issue management: Merchant banks advice and manage the
public issue of companies. They provide following services;
a) Advice on the timing of public issue.
b) Advice on the size and price of the issue.
c) Acting as manager to the issue, and helping in accepting
applications and allotment of securities.
d) Help in appointing underwriters and brokers to the issue,
listing of shares on the stock exchange, etc.
5. Revival of sick industrial units: Merchant banks help to
revive (cure) sick industrial units. It negotiates with different
agencies like banks, term lending institutions, and BIFR (Board
for industrial and financial reconstruction). It also plans and
executes the full revival package.
6. Portfolio management: A merchant bank manages the
portfolios (investments) of its clients. This makes investments
safe, liquid and profitable for the client. It offers expert guidance
to its clients for taking investment decisions.
7. Bill Discounting: Bill discounting is an important function
which is recognized as an activity of merchant banking in foreign
countries. But this facility is not provided by merchant banks in
India to the corporate units. Bill discounting is a service against
which merchant banks have to arrange funds against the bills
which have been discounted.
8. Venture Capital: It is a form of equity financing especially
designed for funding high risk and high reward projects. Many
merchant bankers maintain venture capital funds to assist
entrepreneurs who lack capital to be risked. It may be provided
for unproven ideas, products technology-oriented or start-up
funds. Venture capital has emerged as a new merchant banking
activity.
9. Bought Out Deals: When a promoter thinks that public issue
made to raise capital, will not be fully subscribed, he may
approach merchant bankers and places the shares of company
initially with him, which are offered to public at a later stage, the
route is known as bought out deal.
10. Factoring: Factoring is a mixed service having financial and
non-financial aspects. The merchant bank can take up the
assignment of collection of book debts and can provide advance
with a certain margin against factored debts. Merchant banks are
also required to perform activities like sales, ledger
administration, credit collection, etc. and are entitled to service
charges for factoring services and provide financial help to
clients, providing information about prospective buyers, financial
counseling and assisting in managing the liquidity.
11. Underwriting: it refers to a contract by means of which
merchant banker gives an assurance to the issuing company that
it would subscribe to the securities offered, in the case of nonsubscription by the public. The liability of merchant banker
arises in case of under subscription.
12. Loan/Credit Syndication: They provide specialized services
in preparation of project and loan applications for raising shortterm as well as long-term credit from various banks and financial
institutions, for financing the project or meet working capital
requirements, along with managing Euro-issues and raising
funds abroad.
13. Services to public sector units: merchant banks offer many
services to public sector units and public utilities. They help in
raising long term capital, marketing of securities, foreign
collaborations and arranging long term finance from term lending
institutions.
14. Other Specialized Services: Merchant banks also provide
corporate advisory services on various issues like mergers,
takeovers, tax planning, recruitment of executives and cost and
management audit, etc.
Role of a merchant banker
Merchant bankers play a dynamic role in economic development
of the country. The services rendered by them are development
oriented and much helpful for trade and industry to grow and
survive. The merchant banking activities have no fixed boundary
in which they have to work. The merchant bankers have to renew
their skills, develop expertise in new areas so as to equip
themselves with the knowledge and techniques to deal with new
emerging problems. A merchant banker is called as ‘Moving
Bottom’ i.e. one who never sits at one place and always moving.
It can be observed that he is the most critical link between a
company raising funds and the investors. They play a diversified
role in the following fields:
1. Acts as a promoter: Merchant banker plays the role of a
promoter. He translates the ideas into ventures by providing a
number of promotional services such as identification of projects,
preparing feasibility reports, obtaining government approvals,
raising funds for the project etc.
2. Acts as a corporate advisor: After the project is promoted, a
merchant banker provides a number of services for the
successful functioning of the enterprise. He helps the
entrepreneurs by providing expert advice on various issues such
as financial planning, issue management, credit syndication,
investment management, etc.
3. Acts as a financial and investment expert: He guides the
corporate clients in various areas such as covering financial
reporting, project measurement, working capital management,
financial requirements and the sources of finance, evaluating
financial alternatives, rate of return and cost of capital, etc.
4. Acts as ‘manager’ to the issue: Merchant banker settles the
fee for advocate/solicitors advice, accountants certification,
brokers and bank’s charges, commission of underwriters and
coordinates with syndicated merchant bankers and principal
brokers, stock exchanges etc. acting as manager to the issue.
5. Acts as a rehabilitator: He also plays the role of a
rehabilitator at the time of acquisition, merger, take over,
amalgamation, etc and helps in their successful implementation.
6. Acts as transfer agent and paying agent: Many merchant
banks act as agent for their client companies for maintaining
registers of shareholders and debenture holders and to act as
transfer agents and paying agents for interest and dividend, etc.
7. Masters in all trading activities: They ride the high horse in
the capital market. The merchant bankers role extends to such
services as company formation, syndication of project finance,
FERA activities, global loans, international finance, feasibility
expansions, capital restructuring, corporate tax planning, leasing
finance, etc.
Classification of Merchant Bankers
The SEBI has classified ‘merchant bankers’ under four
categories for the purpose of registration:
1. Category I Merchant Bankers.
They can act as issue manager, advisor, consultant,
underwriter and portfolio manager.
2. Category II Merchant Bankers.
They can act as advisor, consultant, underwriter and
portfolio manager. They cannot act as issue manager on
their own but can act as co-manager.
3. Category III Merchant Bankers.
They are allowed to act as underwriter, advisor and
consultant only. They cannot undertake issue management
and portfolio management and they cannot act as comanagers.
4. Category IV Merchant Bankers.
They can merely act as consultant or advisor to an issue of
capital.
General Obligation and Responsibilities
1. No merchant banker, other than a bank or a public financial
institution, is to associate with any business other than that of
the securities.
2. Every merchant banker shall maintain a copy of balance sheet,
profit and loss, auditor’s report and a statement of financial
position, for a period of 5 years.
3. Take steps to rectify the deficiencies made out in the auditor’s
report.
4. Appointment of lead merchant bankers, agreeing to their
mutual rights, liabilities and obligations relating to the issue.
5. The lead banker under category I, shall accept underwriting
obligation of 5% of the total underwriting commitment or Rs. 25
lacs, whichever is less.
6. Submission of due diligence certificate to the Board in Form C.
7. Furnish the particulars of the issue, draft prospectus and
other documents to the Board.
8. Appointment of compliance officer to monitor the compliance
with rules and regulations, notifications, guidelines, etc.
9. Make available all books, accounts, documents for inspection,
allow access to the premises and provide all assistance to the
board.
10. Liability for action in case of default, as provided under SEBI
Regulations, 2002.
MERCHANT BANKING IN INDIA
Merchant banking services in India were started only in 1967 by
National Grindlays Bank followed by CITI bank in 1970. The state
bank of India was the first Indian commercial bank to set up a
separate merchant banking division in 1972.Later, the ICICI set
up its merchant banking division in 1973 followed by a number
of other commercial banks like Canara bank, BOB, BOI,
Syndicate bank, PNB, Central bank of India, UCO bank. The
FERA regulations in 1973 which required a large number of
foreign companies to dilute their shareholdings in India, gave a
boost to the merchant banking activities in India. Since then, a
number of development banks and financial institutions such as
IFCI and IDBI have also entered this field.
Merchant banking activities in India broadly include issue
management, project counseling, and capital structuring and
portfolio management.
Deregulation and liberalization of the industry in India has
accounted for changes in the financial sector. As the
liberalization policy continues and the financial market is
expanding rapidly, the future for the country’s merchant bankers
seems to be buoyant.
Scope for merchant banking in India
a) Entry of foreign investors: Foreign institutional investors
invest in primary and secondary market and also permit
Indian companies to directly tap foreign capital through
euro issues. NRIs need the services of merchant bankers to
advice them for investment in India.
b) Changing policy of financial institutions: With the
changing emphasis in the lending policies of financial
institutions from security orientation to project orientation,
corporate enterprises would require the expert services of
merchant bankers for project appraisal, etc.
c) Development of debt: The concept of debt market has set
to work through National Stock Exchange and the Over the
Counter Exchange of India. Experts feel that of the
estimated capital issues, a good portion may be raised
through debt instruments which will offer tremendous
opportunity to merchant banker.
d) Innovations in financial instruments: The Indian capital
market has witnessed innovations in the introduction of
financial instruments such as non-convertible debentures
with detachable warrants, zero coupon bonds etc, which
has further extended the role of merchant bankers as
market makers for these instruments.
e) Corporate Restructuring: Companies are reviewing their
strategies, structure and functioning. This had led to
corporate restructuring including mergers, acquisitions
splits etc which offers good opportunity to merchant
bankers to extend their area of operations.
f) Disinvestment: The government will sell the shares of
identified public sector at any time during the year when
they get a good price above minimum stipulated level. This
is likely to provide good business to merchant bankers in
future.
Recent Developments in merchant banking establishments in
India
1) Setting up of banks subsidiaries: In order to meet the
growing demand for broad based financial services from the
corporate sector more effectively, the merchant banking
divisions of the nationalized banks have started forming
independent subsidiaries.
2) Reorganization of private firms: Expecting tough
competition from growing number of merchant bankers
have also started reorganizing their activities.
3) Establishment of SUA: IN order to educate and protect the
interest of investors, to provide information about new
issues of capital market etc. The Stockbroker Underwriters
Association (SUA) was established in 1984 which works in
4)
5)
6)
7)
co-ordination with merchant bankers and takes steps for
promoting the activities of capital market.
Securities and Exchange Board of India: To develop and
regulate securities market, investor protection and to
formulate rules and guidelines for regulation of securities
market, the central government constituted the securities
and Exchange board of India on April 4, 1988.
Discount and Finance House of India: DFHI was
incorporated as a company under the Companies Act, 1956
with an authorized and paid up capital of Rs. 100 crores.
DFHI aims at providing liquidity in money market as it deals
mainly in commercial bills.
Credit Rating Information Services of India Ltd.
(CRISIL): CRISIL has been set up in 1987 to provide help to
investors, merchant bankers, underwriters, brokers, banks
and financial institutions. CRISIL rates various types of
instruments such as debt, equity and fixed return securities
offered to the public. It helps the investors in taking
investment decisions.
Stock-Holding Corporation of India Ltd. (SHCIL): SHCIL
was set up in 1986 by the All India Financial Institutions to
take care of safe custody, delivery of shares and collection of
sale proceeds of the securities. The setting up of SHCIL is
bound to affect the capital market in the future.
Problems/ limitations of merchant bankers
1) SEBI guidelines have authorized merchant bankers to
undertake issue related activities only with the exception of
portfolio management, which have made the merchant
bankers either to restrict their activities or think of
separating these activities from the present one.
2) SEBI guidelines stipulate a minimum net worth of Rs. 1
crore for authorization of merchant bankers, by which small
and specialized merchant bankers may have to close down
their business. The entry is denied to young, specialized
professional into merchant banking business.
3) Non co-operation of the issuing companies in timely
allotment of securities and re-fund of application money is
another problem of merchant bankers. They have to seek
the co-operation of the issuing company to shoulder the
responsibility.
Conclusion
There has been a sharp decline in the number of public issues
and the total public issue mobilization in recent years. The
declining number of public issues has led to a major shake out in
merchant banking sector. With the situation turning bad, many
merchant bankers have not renewed their registration with the
SEBI and allowed it to lapse. The move of SEBI to tighten
merchant banking norms after the CRB Capital Market Scam
also made it difficult for the merchant bankers to function
without adequate fund support.
Segregation has been brought about between the fee based and
fund based activities and merchant bankers have been prohibited
from carrying on any fund based activities such as acceptance of
deposits, leasing and bill discounting.