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Merchant Banking | Definition, Objectives, Scope, Functions, Types, Advantages & Disadvantages

Merchant Banking


What is Merchant Banking ?


A merchant bank may be defined as a financial institution, which extends financial support to business organisations in the form of share ownership, in lieu of loans. It also offers advisory services to such organisations on corporate matters, in which it has an expertise. There is another class of banks known as investment banks, which specialize in the creation of capital for others, such as companies, Governments and other entities. The activities of investment banks include underwriting in respect of new debts/equities for their clients, providing support in sale of securities, facilitating mergers and acquisitions, reorganizations, and broker trades for investors (institutions as well as individuals). They also provide guidance to issuers regarding the issue of stocks.

There is a striking similarity between the activities undertaken by the merchant banks and investment banks. In fact in some countries, they are referred to as synonyms engaged in the same kind of activities. Nonetheless, there are some minor differences between the above two. While the activities of a merchant bank are exclusively fee-based, the activities of an investment bank may be fee-based as well as fund-based. Further, the investment banks commit their own funds. However, any distinction - between the two is mostly theoretical, and in practice there is hardly any difference in their activities.

Traditionally, merchant banks frequently venture into the area of securities underwriting, whereas a number of merchant banks undertake the activities of trade financing. A merchant bank is different from a traditional bank in as much as the definition of banking does not apply to them. They do not accept deposits for their safekeeping, and pay interest thereon. Their activities are altogether different from the activities undertaken by a normal banking company, as defined under the section 5 of the Banking Regulation Act, 1949, which states "Banking" means accepting, for the purpose of lending investment, of deposits of money from the public, repayable on demand or otherwise, and withdrawal by cheque, draft, order or otherwise. "Banking Company" means any transacts the business company which of banking (in India).

Merchant banks constitute highly specialized and professionally managed financial institutions, which have expertise in tendering advice to their clients. with regard to wealth creation, after undertaking appropriate risk-analysis exercise in respect of monies received from them. Such expert advice may relate to the securities underwriting, stock and bond trading, mergers and acquisitions, private equity placements, corporate restructuring, syndication of loans, pricing of securities, etc.

Definition of Merchant Banking


Rule 2(e) of SEBI (merchant bankers) Rules 1992, defines who a merchant banker is :
"Merchant banker means any person who is engaged in the business of issue management either by making arrangements regarding selling, buying or subscribing to securities as manager-consultant, advisor or rendering corporate advisory services in relation to such issue management".

According to D.Cox :
"Merchant banks are the financial institutions providing specialist services which generally include the acceptance of bills of exchange, corporate finance, portfolio management and other banking services".

According to M.J. Rosenberg, merchant bank as :
"An organisation that underwrites securities for corporations, advice's such clients on mergers, and is involved in the ownership of commercial ventures".

Objectives of Merchant Banking 


Merchant bankers play an important role in Indian financial sector as they facilitate in achieving following objectives :
  1. They help in creation of capital.
  2. Merchant banking activities are the forces behind the formation of a secondary market, which encourages the industrial activities in cur country.
  3. Merchant banks facilitate and boost economic entrepreneurship.
  4. They undertake various jobs pertaining to the preparation of project reports conduct of market research and pre-investment surveys.
  5. Appropriate financial support is extended by the merchant bankers to venture capitalists.
  6. A data bank is constructed as human resources by them.
  7. They are also the providers of housing finance.
  8. Merchant bankers are an important source of seed capital for start-up organisations.
  9. The area of issue management is one of the core activities of the merchant bankers.
  10. Underwriting is another area in which the merchant bankers have an expertise. 
  11. They identify new projects on behalf of their clients, and also provide assistance in obtaining various approvals from different Government departments.
  12. They extend services regarding provision of financial clearance.
  13. Mobilization of public funds is facilitated by the merchant bankers.
  14. National savings are channelized towards productive areas by the merchant bankers.
  15. For the larger interests of all the concerned, investors conferences are arranged by them from time to time.
  16. For the purpose of 'listing', they seek the necessary permissions, on behalf of their clients, from that stock exchanges. 
  17. As part of their role as 'issue managers', they are responsible for getting the data in respect of the application money collected at various branches of banks on a day-to-day basis.
  18. Appointment of bankers, brokers, underwriters, etc. are done by the merchant bankers.
  19. In the cases of ventures undertaken by NRIs, merchant bankers take the responsibility of supervising the process on behalf of their clients.
  20. In the area of fund-based activities also, merchant bankers offer their services.

Scope of Merchant Banking 


The various scope / Features of merchant banking are follows :

1) Growth of New Issues Market : 
As the India market is among the largest growing market so the various domestic and foreign investors are entering the market for doing business. The various types public and private problems are also arising.

2) Entry of Foreign Institutional Investment : 
The is globalization in the Indian capital market. is permission given to the foreign institutional invest in India as they require the suggestion from merchant banks for the business in India. The various number of joint venture also need different types of services of Merchant Banks.

3) Changing Policy of Foreign Investment :
There is liberalization in the policy making. The foreign investments need the services Merchant Banks for project appraisal, financial management, financial re-structuring, etc.

4) Development of Debt Market : 
The debt instrument helps in raising large amount of capital for the business. The making of debts market is also done by merchant banks.

5) Innovations in Financial Instruments : 
The innovative financial instrument has increased. The merchant banks are the origin of the innovative type of financial instruments.

6) Corporate Re-Structuring : 
The liberalization and globalization are the reason for the capital structuring. The presence of competition in f corporate sector is the reason for corporate structuring. The companies also adopt corporate re-structuring if they want to change their strategies, structure and working.

Functions of Merchant Banking


Role of merchant banking / The important activities undertaken by merchant banks and various services provided by them are as follows :

Functions / Role of Merchant Banks

1) Underwriter : 
Underwriters may be defined as a group of financial institutions/entities, which give an assurance not only for getting an issue fully subscribed, but also to absorb the balance securities, in case of failure of the issue to get fully subscribed by the public. Underwriters are duly paid for the services rendered by them in the form of commission as agreed upon between the security issuer and the underwriter, which are subject to various terms and conditions stipulated under the Companies Act. Underwriting services are provided by the commercial banks, term lending institutions, investment companies, brokers, etc.

In the overall development of the primary market, the role played by underwriters is very crucial, although underwriting per-se is not. mandatory for an issuer. Before coming out with the issue, the issuer appoints underwriter/s, with due discussion with the merchant banker/lead manager. The details with regard to underwriters are mentioned in the prospectus issued by the company.

2) Banker : 
Bankers are yet another constituent of the primary market, who perform an important role in the market function and its development. 'Bankers to an issue are the bankers, who are responsible for the acceptance of application money, from the prospective investors, for the issue of securities. They also take the responsibility for the refund of application money to those applicants, whom no security could be allotted.

3) Broker : 
Brokers are individuals/entities who are primarily engaged in the business of obtaining subscriptions to an issue by approaching the prospective investors and convincing them suitably. Appointment of brokers by an issuing company is not mandatory under the existing law. They are at liberty to appoint as many brokers as they deem fit, or not appoint any broker, if they decide to do so. Brokers to an issue are required to give their willingness by way of a consent letter, copy/copies of which need to be filed, along with the prospectus, to the Registrar of Companies (RoC). The broker/s. appointed by the issuer/manager of the issue. manages the preliminary distribution of securities in a coordinated manner. They attempt to secure as much direct subscription as possible from a wide range of potential investors. The maximum brokerage payable in respect of all the public issues of industrial securities is @1.5%. irrespective of the fact whether the issue is underwritten or not. The maximum brokerage payable in respect of the listed companies, on private placement basis is @0.5%. As far as the promoters' quota is concerned (including the amount taken up by the directors, their friends and employees, and in respect of rights issue taken by/renounced by the existing shareholders), no brokerage is allowed to be paid. Similarly, no brokerage is permitted to be paid i in respect of the following cases : 
  • If the applications are made by the institutions/banks as their part of underwriting obligations.
  • If, as a result of under-subscription of the issue, amounts are devolved on the underwriters.  

4) Registrar : 
The registrar to an issue is essentially an intermediary in the primary market, who undertakes the following activities :
  • Collection of applications along with the application money from the investors.
  • Maintenance of a proper record of the applications/monies received from the investors.
  • Maintenance of a proper record of monies paid to the seller of the securities.
  • Advising the issuers in taking decision with regard to the basis of allotment of securities in consultation with the stock exchanges.
  • Finalization of the allotment of securities and issuance of allotment letters.
  • Other processes associated with the issue of capital, e.g. refund order certificates and other related documents.

5) Debenture Trustee :
They are the trustees specifically appointed and entrusted with the responsibility of keeping a watch on and protecting the interests of debenture holders. Their appointment is made by the issuer of the debenture before the actual issue. Debenture trustees are required to get themselves registered as such with the SEBI, before they get any assignment as debenture trustees.

6) Portfolio Manager : 
The term 'portfolio' refers to the total securities held by an individual/entity. Portfolio managers, as the nomenclature suggests, are the managers of portfolios of their clients, by the virtue of a contract entered into between them and their clients. Their activities are governed by the terms and conditions of the said contract, Portfolio managers are generally authorized by their clients to manage, in a judicious manner, the securities/funds held by them under their portfolio.

Services of Merchant Banks 


Merchant banks offer a wide range of services to their clients, some of which have been discussed in the following points :

1) Corporate Counselling : 
Corporate counselling one of the fundamental/core services offered by a merchant bank. Due to abundant demand for this service from each and every industrial unit, whether new or old, the scope for this activity is unlimited. Corporate counselling includes a number of merchant banking activities, e.g. project counselling, project management, loan syndication, working capital management, capital re-structuring, public issue management, fixed deposit, lease financing etc.

2) Project Counselling : 
Project counselling is one of the constituents of corporate counselling activity undertaken by the merchant banks. The services associated with project counselling pertain to project finance, including the preparation of project reports, cost of f the project and management of the financing design. Appraisals of various projects are carried out on the basis of their location, marketing/technical feasibility, financial viability, etc.

3) Loan Syndication : 
Under the loan syndication, a loan is arranged by a merchant bank for its client, who may be a big corporate, Government department, or a local authority. To start with, the merchant bank has to arrive at/finalize the project cost, which is followed by the next step. i.e. designing the capital structure, deciding the level of the promoters' stake/contribution in the project, and estimating the amount of term loan to be raised from the financial institutions. In this connection, it is relevant to ensure that various guidelines and other requirements pertaining to the financing of industrial projects are meticulously adhered to. A comprehensive service, covering all the activities associated with the loan syndication, is extended by the merchant bankers.

4) Management of Capital Issues : 
Management of capital issue involves a number of activities, which go much beyond simply selling of various securities, viz. equity shares, preference shares and debentures or bonds to the investors. Some of such activities are as follows :
  • Preparation of the action plan and budget for all the expenses associated with the issues.
  • Obtaining the consent letter from SEBI, and finalizing the draft prospectus.
  • Identifying and picking-up the brokers/underwriters.
  • Selection of the advertising agency for the publicity of pre-issue and post-issue matters. 
  • Co-ordination with the 'bankers to the issue, 'stock exchanges'. 'underwriters', and 'brokers'.
  • Merchant bankers also act as advisors to the issuer with regard to the appropriate kind of the security which needs to be issued.
  • Maintenance of a close liaison among-st various agencies associated with the issue.
  • Finally, a merchant banker is responsible for overall management of the issue, so that it is fully subscribed.

5) Portfolio Management : 
Management of their clients portfolio is yet another service offered by the merchant bankers. Portfolio management envisages handling of the clients' portfolio in an efficient manner so as to achieve the twin objectives of investment, viz. keeping the risk at the lowest level and returns at the highest. Portfolio of a client may contain a variety of financial securities, such as equity, debentures, units of mutual funds, derivative products, etc. In addition to managing the existing portfolios, the merchant bankers also advise their clients with regard to the fresh investments in financial instruments, keeping in view the safety, liquidity and return. It is, therefore, necessary for a merchant banker to keep themselves updated with the latest developments taking place in the market.

6) Advisory Services to Mergers and Takeovers : 
In the cases of mergers and takeovers, the merchant bankers play the role of intermediaries, safeguarding the interests of both the entities. They also facilitate necessary authorizations from Government/RBI/any other agency. The terms mergers and takeovers are mostly used simultaneously giving an impression similarity between the two. However, they differ from each other; the term 'merger' denotes amalgamation of two companies in such a way that after the merger, only one company continues, whereas the other dissolves. Under the takeover, one company is purchased by another by way of procuring the controlling interest in the share capital of the company which is being taken over.

7) Consultancy to Sick Industrial Units : 
Merchant banker act as consultant and guide not only to the healthy industrial units for their further progress and expansion, but also to the sick units by evaluating their technology & processes, and restructuring their capital base. They also facilitate finalizing the rehabilitation programmes for the sick industrial units keeping in view the guidelines issued by the banks, so that the same may be accepted by them. Further, they ensure to get necessary authorization from the Board of Industrial and Financial Re construction (BIFR) under Sick Industrial Companies (special provisions) Act 1985 (SICA), for such sick units' financial re-construction and technical rehabilitation.

8) Leasing : 
The merchant bankers role in extending services to leasing companies include arranging lease finance for them, advising on profitable structuring of the lease transaction, facilitating the legal documentation and tax counselling.

9) Foreign Currency Financing : 
Merchant bankers undertake the job of arranging foreign currency finance, Le. funds for foreign trades. Such finance may be in the shape of export-import trade finance, euro currency loans, Indian joint venture abroad or foreign collaborations Major areas pertaining to the foreign currency financing, which are carried out by the merchant bankers are :
  • Providing support for undertaking the study of turn-key and construction contract projects.
  • Helping out the working groups with various Government agencies including Reserve Bank of India (RBI) and Exchange Credit and Guarantee Department (ECGD).
  • Facilitating their clients in opening and operating banks accounts overseas.
  • Arranging export credit facilities from the Export and Import Bank (EXIM Bank) for the export of capital goods. They also facilitate required authorizations from Government departments. 
  • They manage the exchange risks, their clients are exposed to, by guiding them in respect of getting forward cover.
  • Making arrangements of foreign currency guarantees' and 'performance bonds for their exporter-clients.

10) Providing Venture Capital Financing :
Companies desirous of venturing into novel projects are assisted by the merchant bankers in obtaining necessary venture capital finance.

11) Corporate Advisory Services : 
Merchant bankers provide corporate advisory services to their corporate clients through the branches specifically designed and set up for the purpose. Corporate advisory services are the services which are are provided to various corporate bodies in respect of the financial matters pertaining to their operations. Providers of such services may range from the advisory boards of the companies to professional bodies, including the merchant bankers, who have expertise in providing such services. Some examples of the corporate advisory services provided by them are :
  • Corporate Finance in Solutions related to Problems of Business Operations. 
  • Corporate Finance in Mergers and Acquisitions.
  • Corporate Finance in Planning of Business Services. 
  • Corporate Finance in Generating Funds.

Types of Merchant Banking


Merchant banks may be classified in the following three categories :

1) Full-Service Global Merchant Banks : 
This category of merchant banks are characterized by their world-wide presence and offering a complete range of services. They are generally large financial entities, the services of which are availed by big companies, generally global giants. 
Some examples of the full-service global merchant banks are Jefferies, Goldman Sachs, JP Morgan. Chase & Co., Kotak Investment Banking, etc.

2) Regional Investment Banks : 
Regional investment banks, also referred to as 'speciality investment banks', basically cater to the needs of the clients from a particular region. They possess a specialized acquaintance of the market of that geographical area, and as such are in a position to offer the services according to the demands of their clients. 
Some examples of this category of merchant banks are SBI Capital Markets, Nomura Holdings, CLSA, Maple Capital Advisors, ABN Amro, BNP Paribas, Piper Jaffray, Commerz Bank, Duff & Phelps, etc.

3) Boutique Investment Firms : 
Investment banks of small size, operational at a local level covering a limited geographical area are termed as Boutique Firms. They offer services in respect of specific industries or products, in which they have an expertise. Their proficiency in the area of advisory services, like merger and acquisition makes them much in demand for specific deals. The services offered by them are more in the nature of personalized ones, and at times they try to serve as a partner of their clients instead of being impersonal advisors. Some of the boutique investment firms operational in India are as under :

Name

Area of specialization

Indian firms

MAPE

 

Merger, acquisition (M& A), private equity (PE)

Veda Corporate Advisors

M&A/Structured Finance

Avendus Capital

M & A/PE/Wealth Management

03 Capital

Cross-border advisory/ M &A/PE

Spark Capital

Wealth Management/ Institutional Broking

Dimodia Capital Advisors

M&A/Structured Finance

Global firms

Lazard

M & A

Rothschild Group

M & A

Blackstone

Private Equity

Moelis and Co.

IB

Houlihan Loukey (through Avista Advisory)

IB


Advantages of Merchant Banking


The importance of merchant banking are as follows : 

1) Utilize the Financial Surplus : 
Merchant bankers facilitate directing the surplus funds available with the general public towards the merchant avenues for their meaningful utilization.

2) Synchronized the Activities : 
A number of mediators are involved in the process of 'share issue', e.g. the registrar, bankers, advertising agency, underwriters, brokers, etc. Merchant bankers act as a coordinating agency ensuring their cohesive activities in a synchronized manner.

3) Compliance with Rules and Regulations : 
They play an important role in ensuring that various rules and regulations pertaining to the securities. market are adhered to by the corporate participants of the market.

4) Identification of Investment Prospects : 
They identify and exploit various investment prospects available at domestic and global level.

5) Analysis of Risk : 
Merchant bankers undertake the analysis of inbuilt risks at macro and micro economic levels, which are associated with specific countries/industries/companies and real estate assets. This is achieved by them through the process of extensive due diligence.

6) Execution of Activities :
Organizing the complicated investment proposals and implementation thereof, which involve activities like detailed financial analysis, deal negotiation, transaction execution, etc.

7) Supporting Management and Partners :
Supporting the management and partners of a company in building their value and developing their core businesses or portfolios. This may be accomplished, inter-alia, through :
  • The representation on the companies Boards.
  • Management oversight.
  • Assessing a suitable time and manner in which to reap the benefits of an investment.

Disadvantages of Merchant Banking


The advantages notwithstanding, there are following shortcomings of merchant banking. List of the Disadvantages / Problems of merchant banking are as follows :
  1. The services offered by Merchant banks can be meant for the large corporate clients or smaller business entities with exceptionally rich financial background, held by individuals.
  2. The cases undertaken by the merchant bankers are likely to meet with partial success or in some cases total disaster.
  3. The nature of services offered by merchant bankers is fraught with risks.

Role of Merchant Bankers in Issue Management


A merchant banker plays an important role in undertaking the following activities : (i) appraisal of a project, and (ii) designing the capital structure, as depicted below :

Role of Merchant Bankers in Issue Management

Designing of Capital Structure 


As the 'Issue Managers' of their corporate clients, merchant bankers also undertake the planning of their capital framework. This activity is considered as the core function of a merchant banker. Capital framework of a company is nothing but the pattern of its capitalization, including the owners funds (capital, reserves, etc.) and various-long sources of funds, e.g. institutional borrowings and market borrowings in the form of equity/debt issues. Merchant bankers take the responsibility of raising the funds from all the above external sources. They also provide tailor-made solutions to the financial problems faced by their clients, including the financial restructuring.

Financial structuring envisages assessment of the appropriate debt-equity ratio and gearing ratio for the project, and formulation of suitable capital structure theory, Merchant bankers evaluate each refinancing options available and finalize the cheapest source of finance for the project. In the cases of sick industrial units, they tender. expert advice on the management of rehabilitation and turn around. Merchant bankers also facilitate preparation of a revival package for the rehabilitation of such units in consultation with banks and financial institutions. Their expert advice in the area of risk management (use of hedging instruments and formulation of risk management policies) is valuable for their clients.

Funds requirements for a project undertaken by a corporate need to be assessed and their financing arrangements need to be chalked out in a meticulous manner. Appropriate finance-mix (combination of different sources of finance) assumes a lot of significance in view of the fact that it is capable of influencing the valuation exercise. Merchant bankers help the company's management in deciding such capital framework, which may lead to maximum value. Generally, an appropriate mix/combination of debt and equity as a source of finance is considered as ideal framework. If the option of debt route for fund-raising is exercised, a liability is created as a consequence, which needs to be serviced from time to time, irrespective of the success or failure of the project. As a result, this route is associated with cash flow problems. As regards equity route, there are cash flow issues, and as such it is less risky. However, this route results in dilution of ownership and earnings. The cost of equity is comparatively high to that of debt, and as such equity route of financing likely to have an increase in hurdle rate, which may nullify any decrease in cash flow risk.

Appraisal of Projects


Project appraisal, also commonly referred to as "feasibility study", forms a significant phase of project progression. It is extremely essential that various available options are considered seriously and risks associated therewith are properly recognized/evaluated, especially if the data is not available.

Project appraisal may be defined as the method of evaluating, through certain steps, the case for going ahead with a proposal of a project. As part of the appraisal exercise, available options are compared making use of various techniques, like economic appraisal and decision analysis. Its objective is to help the client in taking a final decision with regard to the options available with him, keeping in view the nature and level of investment in the project and subsequent implementation thereof.

Project appraisal is considered as one of the most important services offered by a merchant bank. It includes (i) preparation of project report, (ii) taking a final view with regard to the financing pattern for meeting the cost of the project, and (iii) approaching the financial institutions with project report for their consideration for granting loans. Merchant bankers take the responsibility of supporting their clients during different phases of the project, right from the beginning till the successful completion thereof. They help their clients even in perceiving the idea of project. a conceptualization of an idea is followed by undertaking the feasibility studies to ensure viability of the perceived project idea.

The objective behind the preparation of a project report is (i) to get necessary authorization from the Government, (ii) to get financial support from banks/financial institutions/private investors, (iii) to ensure market share for the proposed product, and (iv) to plan for the public issues, etc. The most crucial part of the project appraisal relates to the financing of the project cost. There are two possible sources of finance for a company planning to venture for a new project, (i) internal (owner's funds), in the form of promoter's contribution and retained earnings, and (ii) external, in the form of borrowings from banks, private investors and financial institutions. Alternatively, a company may borrow from public by issuing debt instruments like debentures or bonds.

Merchant bankers are required to take a decision with regard to the financing-mix, i.e. a combination of internal sources and external sources of funds to be raised for financing the project, keeping in view various internal and external factors, e.g. the rules, regulations and norms stipulated by the government/term lending financial institutions/other regulators. They are also responsible for ensuring the appropriateness of various aspects of the project such as the nature of project, its location, and technical/commercial/financial viability, before filling the application form of the financing institution and approaching them.

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