UNIT – 1
Merchant banking is a combination of banking and
consultancy services. It provides consultancy to its clients for
financial, marketing, managerial and legal matters.
Consultancy means to provide advice, guidance and service. It
helps a business person to start a business. It helps to raise
(collect) helps finance .It helps to expand and modernize the
business .It help in restructuring of a business. It helps to review
sick business units. It also helps companies to register, buy and
sell share at the stock exchange.
Definition
Merchant banking can be defined as a skill-oriented professional
service provided by merchant banks to their clients, concerning
their financial needs, for adequate consideration, in the form of
fee.
Merchant banks are a specialist in international trade and thus,
excel in transacting with large enterprises
OBJECTIVES
Here are some of the objectives of merchant banks:
1. Provide funds to companies — this usually includes loans
for startup companies. They decide how much money a
company needs to function through proposals created by these
companies. They also help their clients raise funds through the
stock exchange and other activities. Merchant banks act as a
foundation for small scale companies in terms of their finances.
2. Underwriting — this is like insurance where banks sign into
documents that agree to provide financial payment to their
clients in case of any damage or losses. This is very important
for clients to ensure that the bank will help them gain more
income. If not, in case they would incur losses, the bank will
pay them for the losses.
3. Manage their portfolios — the bank will look into the
companies’ assets and will do the computation of their credits
and debits to ensure they are not incurring any losses. They
also provide other kinds of services to check on the liquidation
of assets to track the income made by these companies and
study how they can make it better.
4. Offering corporate advisory — they offer advises especially
to starting companies and those that would want to expand.
This advice involves financial aid to ensure that the company
will be successful and will not have any problems along the
way.
5. Managing corporate issues — help incorporate securities
management, they also serve as an intermediary bank in
transferring capitals.
CHARACTERISTICS OF MERCHANT BANKING
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High proportion of decision makers as a percentage of total
staff.
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Quick decision process.
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High density of information.
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Intense contact with the environment.
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Loose organizational structure
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Concentration of short and medium term engagements
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Emphasis on fee and commission income.
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Innovative instead of repetitive operations
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Sophisticated services on a national and international level.
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Low rate of profit distribution.
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High liquidity ratio
QUALITIES OF A GOOD MERCHANT BANKERS
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Ability to analyse
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Abundant knowledge
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Ability to built up relationship
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Innovative approach
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Integrity
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Capital Market facilities
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Liaisoning ability
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Cooperation and friendliness
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contacts
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Attitude toward problem Solving
Functions of Merchant Banking
The important functions of merchant banking are depicted below.
Raising Finance for Clients: 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. This finance is used for
starting a new business or project or for modernization or expansion of the
business.
Broker in Stock Exchange : Merchant bankers act as brokers in the stock
exchange. They buy and sell shares on behalf of their clients. They conduct
research on equity shares. They also advise their clients about which shares to buy,
when to buy, how much to buy and when to sell. Large brokers, Mutual Funds,
Venture capital companies and Investment Banks offer merchant banking services.
Project Management : Merchant bankers help their clients in the 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 the government.
Advice on Expansion and Modernization : Merchant bankers give advice
for expansion and modernization of the business units. They give expert advice on
mergers and amalgamations, acquisition and takeovers, diversification of business,
foreign collaborations and joint-ventures, technology up-gradation, etc.
Managing Public Issue of Companies : Merchant bank advice and manage
the public issue of companies. They provide following services:
 Advise on the timing of the public issue.
 Advise on the size and price of the issue.
 Acting as manager to the issue, and helping in accepting applications and
allotment of securities.
 Help in appointing underwriters and brokers to the issue.
 Listing of shares on the stock exchange, etc.
Handling Government Consent for Industrial Projects : A
businessman has to get government permission for starting of the project.
Similarly, a company requires permission for expansion or modernization
activities. For this, many formalities have to be completed. Merchant banks do all
this work for their clients.
Special Assistance to Small Companies and Entrepreneurs : Merchant
banks advise small companies about business opportunities, government policies,
incentives and concessions available. It also helps them to take advantage of these
opportunities, concessions, etc.
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.
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.
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.
Corporate Restructuring : It includes mergers or acquisitions of existing
business units, sale of existing unit or disinvestment. This requires proper
negotiations, preparation of documents and completion of legal formalities.
Merchant bankers offer all these services to their clients.
Money Market Operation : Merchant bankers deal with and underwrite
short-term money market instruments, such as:
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Government Bonds.
Certificate of deposit issued by banks and financial institutions.
Commercial paper issued by large corporate firms.
Treasury bills issued by the Government (Here in India by RBI).
Leasing Services : Merchant bankers also help in leasing services. Lease is a
contract between the lessor and lessee, whereby the lessor allows the use of his
specific asset such as equipment by the lessee for a certain period. The lessor
charges a fee called rentals.
Management of Interest and Dividend : Merchant bankers help their
clients in the management of interest on debentures / loans, and dividend on shares.
They also advise their client about the timing (interim / yearly) and rate of
dividend.
History of Merchant Banks
The history of merchant banks can be traced back to Italy in the late Medieval
times as well in France in the 17th and 18th centuries. Merchant banks began
operating as organized money markets consisting of merchants financing the
transactions of other merchants. French merchant Marchand Banquer invested all
his profits by integrating the banking business into his merchant activities and
became a merchant banker.
In the United Kingdom, merchant banks started in the early 18th century. The
oldest merchant bank in the United Kingdom is Barings Bank, which was
established by a German-originated family of bankers and merchants. It was
founded in 1762 and was the second oldest merchant bank in the world after
Berenberg Bank. The bank was, at one time, referred to as the sixth great European
power after Germany, Russia, United Kingdom, Austria, and France after it helped
finance the US government during the 1812 War.
The growth of trade and industries in the 19th century led to the emergence of
merchant banks in the United States. The first merchant banks in the United States
were JP Morgan & Co and Citi Bank. The industry was mainly dominated by
German-Jewish immigrant bankers and Yankee houses with close ties to expatriate
Americans who settled in London as merchant bankers.
However, with the growth of the financial world, corporations overshadowed
family-owned businesses in the banking business. The corporations included
merchant banking as one of their areas of interest, a characteristic that banks hold
until today.
ISSUE MANAGEMEN OR INITIAL PUBLIC OFFER (IPO’s)
Definition: Initial public offering is the process by which a private company can
go public by sale of its stocks to general public. It could be a new, young company
or an old company which decides to be listed on an exchange and hence goes
public.
Companies can raise equity capital with the help of an IPO by issuing new shares
to the public or the existing shareholders can sell their shares to the public without
raising any fresh capital.
The IPO Process: A Step-by-Step Guide to Going Public
Step 1: Choose an IPO Underwriter
The first step of the IPO process requires the company to select an investment
bank. These banks are registered with the SEC (Securities and Exchange
Commission) and act as underwriters. IPO underwriters are specialists who work
alongside the company issuing the IPO. They help determine the initial offer price,
buy the shares from the issuing company and then sell the shares to investors.
Usually, they have a network of potential investors to reach out to in order to sell
the shares. There a few things to consider when choosing an underwriter:
Reputation
Quality of research
Industry expertise
Network distribution reach
The company’s prior relationship with the investment bank
The underwriter’s past relations with other companies.
Underwriting an IPO can be a long and expensive process. It requires time, money
and a team of experts. But a good underwriter can be the difference between a
successful IPO and an IPO failure.
Step 2: Due Diligence
Due diligence is the most time-consuming part of the IPO process. In this step,
there’s a pile of paperwork the company and underwriters fill out. The issuing
company needs to register with the SEC. Then, there are contracts between the
company and the underwriter.
Firm Commitment. This agreement states the underwriter will purchase all shares
from the issuing company. They will resell them to the public.
Best Efforts Agreement. The underwriter does not guarantee an amount of money
but will sell the shares on behalf of the issuing company.
Syndicate of Underwriters. Sometimes IPOs come with large risk, and the bank
doesn’t want all of it. In this case, a group of banks will come together under the
leading bank to form an alliance. This alliance allows each bank to sell part of the
IPO, diversifying the risk.
Engagement Letter. There are usually two parts of an engagement letter:
The reimbursement clause states the issuing company will cover the underwriter’s
out-of-pocket expenses.
The gross spread, also known as the underwriting discount, is typically used to pay
the underwriter’s fee and/or expenses. It can be found by taking the price the
underwriter paid for the shares and subtracting it from the price they sell them for.
Think of it as wholesale. Because the underwriter is buying all of the shares, they
receive a discounted price.
For example, there are 1,000 shares each priced at $10. The underwriter purchases
them for $8 per share, spending $8,000. Then, the underwriter sells the shares on
the market at their $10 value, making $10,000. That’s a gross spread of $2,000.
Letter of Intent. There are three parts to a letter of intent:
Underwriter’s commitment to the company
Company’s agreement to provide all information and cooperate
Company’s agreement to offer underwriter a 15% overallotment option.
Red Herring Document. This is a preliminary prospectus that includes information
about the company’s operations and prospects except for key issue details, such as
price and number of shares.
Underwriting Agreement. Once the price of shares is determined, the underwriter
is legally bound to purchase the shares at the agreed-upon price.
S-1 Registration Statement. This is required to be submitted to the SEC. There are
two parts:
Information Required in Prospectus — The prospectus is a legal document
provided to everyone who is offered and/or buys the stock. It must clearly describe
the company’s business operations, financial state, operations results, risk factors
and management. Audited financial statements must also be included.
Information Not Required in Prospectus – Includes additional information and
exhibits that the company is not required to deliver to investors but must file with
the SEC.
Step 3: The IPO Roadshow
An IPO roadshow is a traveling sales pitch. The underwriter and issuing company
travel to various locations to present their IPO. They market the shares to investors
to see what demand, if any, there is. Looking at investor interest, the underwriter
can better estimate the number of shares to offer.
Step 4: IPO Price
Once approved by the SEC, the underwriter and company can decide the effective
date, number of shares and the initial offer price. Typically, the price is determined
by the value of the company. This is done by the valuation process and occurs
before the IPO process even begins.
There are a couple factors to consider when pricing an IPO:
Value of issuing company
Reputation of issuing company
Success/failure of the IPO roadshow
The issuing company’s goals (i.e., amount of money to raise)
The condition of the economy.
It’s common for an IPO to be underpriced. When underpriced, investors will
expect the price to rise, increasing demand. It also reduces the risk investors take
by investing in an IPO, which could potentially fail.
Step 5: Going Public
Now that everything is decided, it’s time for the IPO to go live! On the agreedupon date, the underwriter will release the initial shares to the market.
Step 6: IPO Stabilization
There is a short window of opportunity where the underwriter can influence the
share price. During the 25-day “quiet period,” which occurs immediately after the
IPO, there are no rules preventing price manipulation. The underwriter ensures
there’s a market and buyers to maintain an ideal share price. There are a couple of
strategies used by underwriters:
Greenshoe Option
In the letter of intent, there is a clause that allows an overallotment option. Also
known as the greenshoe option, this allows underwriters to sell more shares than
originally planned. Then the underwriter buys them back at the original IPO price.
If the share price decreases, the underwriter buys back the over-allotted shares. The
underwriter will make a profit because the price is less than what they originally
sold it for.
If the share price increases, the underwriter has the option to buy the shares at the
original IPO price, avoiding loss. This is stated in the contract with the company
under the overallotment clause.
Overallotment is a popular choice because it’s both SEC-permitted and risk-free.
While overallotment is the legal term, it’s commonly referred to as the greenshoe
option because Green Shoe Manufacturing (now Stride Rite) was the first company
to do it.
Lock-Up Period
At the beginning of this article, it was mentioned that when a company goes
public, anyone who already owned shares could cash out. However, those shares
can only be sold following a lock-up period.
A lock-up period is a predetermined amount of time, usually lasting between 90
and 180 days, when insiders who owned shares before the company went public
are not allowed to sell their stock. This avoids flooding the market with the
company’s shares and driving the price down.
Step 7: Transition to Market Competition
This is the final stage of the IPO process. After the 25-day quiet period, the
underwriter and investors transition from relying on the prospectus to looking at
the market.
Everything is now public and out of the underwriter’s hands. The underwriter can
provide the company with estimates on the company’s earnings and post-IPO
valuation. The underwriter also moves into the role of advisor as the shares
fluctuate in the public market.
Intermediaries Involved in an IPO
Merchant Banker
The merchant banker is a financial intermediary in the IPO issue process. Its
functions can be divided into two categories:1. Pre-Issue – This includes compliance with the mandatory requirements of SEBI
and other regulatory authorities. Completion of formalities for listing the shares on
the stock exchange. The merchant banker is also responsible for the appointment of
various agencies involved in the issue process.
2. Post-Issue – This includes management of escrow accounts, determining the
final price at which the shares will be issued, allotting shares to all applicants,
ensuring refund to all unsuccessful applicants, and issuing allotment letters. It also
oversees all agencies and ensures that they adhere to the set processes.
Merchant Bankers are also called Book Running Lead Managers or BRLMs in
case of public issues that are book built. Examples of the world’s largest merchant
banks include J.P. Morgan, Goldman Sachs, and Citigroup.
Registrars to the Issue
The Registrars are responsible to finalize the basis of the allotment in the IPO.
They create a final list of applications that are valid and eligible and delete the
invalid ones.
Further, they ensure that the Demat accounts of the applicants are credited with the
allotted shares and rejected applicants receive their refunds.
The Lead Manager coordinates with them to ensure that the flow of applications
from the collecting centers to getting them processed and all other essential steps
are followed in time. The Registrar along with the Lead Manager ensures that the
process is followed right until the end.
Bankers to the Issue
Bankers to the issue are financial intermediaries who are responsible for bankingrelated processes like:
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Acceptance of application and application amount
Transfer of funds to the promoters of the company
Managing refunds for rejected applications
Payment of dividend
In the IPO process, the bankers play a critical role by enabling the movement of
funds and making clear funds status available to the registrars to finalize the basis
of allotment.
Underwriters
Underwriters are intermediaries who agree to purchase the shares issued by the
company if some shares of the company don’t get sold. They work with the issuing
body, determine the price of the securities, purchase them from the issuer, and sell
them through their network.
Underwriters earn by taking underwriting fees from the issuers and also by selling
the underwritten shares at a profit. Having said that, they also carry the risk of
losses if they are unable to sell all the shares at the specified price.
How one can apply in IPO's online?
To apply in IPO's online, an investor has to open an demat account / trading
account with financial institution that provide this facility. Most national banks
(SBI, HDFC, ICICI, PNB etc.) and popular stock brokers (Sharekhan, Angel etc.)
in India offers facility to apply IPO's online. Once account is open one should
follow below steps to apply online.
 First login in your trading account and select the IPO you wish to invest in.
 Transfer funds from your bank account to your trading account.
 Select the number of shares you want to apply for and the price at which you
want to bid for (or use cut off option) and then press submit button.
If you get the allotment, the shares will be credited to your demat account. The
remaining money will be credited to your bank account through ECS.
The most convenient way to apply in an IPO online is using 3-in-1 account offered
by banks including ICICI Direct, HDFC Securities, Kotak Security etc.
The process of applying IPO's online is extremely convenient. It takes just 2
minutes to order IPO shares online.
Types of Financial Instruments
Debt vs Equity Instruments
Debt and Equity instruments differentiated based on them based on the type of
claim that the holder has on it. When the claim os for a fixed dollar amount it is a
debt instrument. For example a car loan, Infrastructure bonds issued by the
Government of India, Bonds issued by private companies. Debt instruments can be
either short term less than one year or long term with tenure greater than one year.
In comparison to this equity, instruments obligate the issuer of the financial
instrument to pay the holder an amount only if profits have been earned and after
the debt payments are made. Common examples of equity instruments are common
stock or a partnership share in the business. However, some securities fall in both
these categories and have attributes of both. One such example is preferred shares,
convertible bonds.
Foreign Exchange
Foreign exchange does not fall into any of the above buckets and has its category.
Foreign exchange instruments in the form of cash are spot foreign exchange and in
the form of exchange-traded derivatives are currency futures and in the over the
counter derivatives are foreign exchange options and outright forwards.
Instruments based on Types –
Cash vs Derivatives
Cash instruments can be defined as the instruments whose value can be determined
directly in the markets and securities which are readily transferrable. Derivative
instruments derive their value and characteristics from an underlying asset, index,
common stock. They can either be exchange-traded or over the counter derivatives.
Bonds – Bond is a type of long term debt instrument in which the issuer owes the
holder debt and is obligated to pay interest (coupon payments) for the specified
amount of period (maturity date) at a later date.
Loans – Loan is basically lending money from individuals, organizations, banks,
trust etc. Till the time the entire amount is given back the recipient has to pay
interest.
Bond Futures – Futures contract is a predetermined contract where the buyer or
the seller agrees to buy or sell something at a predetermined time and a
predetermined price in the future. The asset is usually a commodity or a financial
instrument. In the case of bond futures, it is a bond.
Options on Bonds – Options gibe the buyer the right but not the obligation to
buy or sell the underlying asset on the option at a specified date and a specified
price depending on the type of option. In case of options on bonds, the underlying
asset bonds.
Interest rate swap – It is a type of interest rate derivate which involves
exchanging interest rates between two parties.
Interest rate cap and floor – This again is a type of interest rate derivative
where the underlying is the interest rate and in case of interest rate cap the buyer
receives payment if the interest rate exceeds the agreed strike price. Similarly, for
the interest rate floor, the buyer receives payments if the interest rate is lower than
the specified strike price.
Exotic derivatives – These are customized derivative products and are complex
to the generally traded vanilla options.
T bills, Deposits, Certificate of Deposits – Treasury bills popularly known
as T bills are issued by the government and are available for 30,60,90,120,360
days. They are considered to be very liquid. Deposits can be a savings bank
account, current account. Certificate of deposits are again issued by the
government and are very liquid.
Foreign exchange instruments – These include currency swaps, foreign
exchange options, foreign exchange swaps and are mainly related to currencies.
What is an Indian Depository Receipt?
An IDR is in Indian rupees and is created by a domestic depository (custodian of
securities registered with SEBI (Securities and Exchange Board of India). It is
issued against the underlying equity of the company to enable foreign companies
to raise funds from the Indian securities Markets. As foreign companies are not
allowed to list on Indian equity markets, IDR is a way to own shares of those
companies. These IDRs could be listed on the Indian stock exchanges. Through the
IDRs, you could directly invest money into international companies.
These are foreign companies that have subsidiaries working in India. Since these
offshoots are not listed, the firms offer shares to Indian investors. Standard
Chartered Plc is the first company to come out with an IDR issue.
Indian Depository Receipts are based on American Depository Receipts introduced
in 1927. Securities and Exchange Board of India (SEBI) first operationalised the
rules of IDRs. The Reserve Bank of India (RBI) issued operations under the
Foreign Exchange Management Act.
The Indian depository receipts had their inception on the BSE and the NSE on June
11, 2010.
Who is eligible to issue Indian Depository Receipts?
The foreign issuing company shall have pre-issue paid-up capital and free reserves
of at least US$ 50 million and have a minimum average market capitalisation
(during the last three years) in its parent country of at least US$ 100 million. It
should have a continuous trading record or history on a stock exchange in its
parent country for at least three immediately preceding years. It should have a
track record of distributable profits for at least three out of immediately preceding
five years. It should be listed in its home country and not been prohibited from
issuing securities by any regulatory body and has a good track record concerning
compliance with securities market regulations. The size of an IDR issue shall not
be less than Rs 50 crores.
An overseas custodian bank is a banking company outside India. It has a place of
business in India. It acts as custodian for the equity shares of issuing company
against which Indian depository receipts are proposed to be issued in the
underlying equity shares of the issuer is deposited. A domestic depository is a
custodian of securities registered with SEBI and authorised by the issuing company
to issue IDRs. A merchant banker is registered with SEBI who is responsible for
due diligence and through whom the draft prospectus for issuance of the Indian
depository receipt is filed with SEBI by the issuer company.
IDR issue process : same as issue management process
As per SEBI guidelines, the Indian depository receipts will be issued to Indian
residents much the same way as domestic shares are issued. The process involves
the issuer company making a public offer in India, and residents can bid precisely
the same way as they bid for Indian shares. The issuing process is the same. The
company needs to file a draft red herring prospectus (DRHP), which would be
examined by SEBI. After SEBI gives its approval, the company sets the issue dates
and files the document with the Registrar of Companies. Following this, the
company goes ahead with marketing the issue. The issue is kept open for a fixed
number of days, and investors can submit their application forms at the bidding
centres. The investors bid within the price band, and the final price would be
decided after the closure of the issue. The receipts would then get allotted to the
investors in their Demat account as is done for equity shares in any public issue.