Project By Shelani Agarwal

THE HISTORY

To understand Merchant Banks, you should know something of their history. Modern merchant
banking started in Italy during the 7th Century. The banking practices evolved from the financing structure
of the Silk Road Trading that predates the Roman Empire. The basic financing structure was the advance
payment for goods by merchant bankers at a great discount to the delivery value of those goods. In the case
of Italy and then Germany, wheat was the product. The merchant banks purchased the wheat soon after
planting. They accepted the risk of crop failure. They profited when they sold the wheat. In most countries
today, the national government accepts the risk through government crop insurance.

In late 17th and early 18th century Europe, the largest companies of the world were merchant
adventurers. Supported by wealthy groups of people and a network of overseas trading posts, the collected
large amounts of money to finance trade across parts of the world. For example, The East India Trading
Company secured a Royal Warrant from England, providing the firm with official rights to lucrative trading
activities in India. This company was the forerunner in developing the crown jewel of the English Empire.
The English colony was started by what we would today call merchant bankers, because of the firm's
involvement in financing, negotiating, and implementing trade transactions.

The colonies of other European countries were started in the same manner. For example, the Dutch
merchant adventurers were active in what is now Indonesia; the French and Portuguese acted similarly in
their respective colonies. The American colonies also represent the product of merchant banking, as
evidenced by the activities of the famous Hudson Bay Company. One does not typically look at these
countries' economic development as having been fueled by merchant bank adventurers. However, the
colonies and their progress stem from the business of merchant banks, according to today's accepted sense of
the word. The colonies of other European countries were started in the same manner. For example, the Dutch
merchant adventurers were active in what is now Indonesia; the French and Portuguese acted similarly in
their respective colonies. The American colonies also represent the product of merchant banking, as
evidenced by the activities of the famous Hudson Bay Company. One does not typically look at these
countries' economic development as having been fueled by merchant bank adventurers. However, the
colonies and their progress stem from the business of merchant banks, according to today's accepted sense of
the word.

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 Project By Shelani Agarwal

 The Historical Merchant Bank

Merchant Banking, as the term has evolved in Europe from the 18th century to today, pertained to
an individual or a banking house whose primary function was to facilitate the business process between a
product and the financial requirements for its development. Merchant banking services span from the earliest
negotiations from a transaction to its actual consummation between buyer and seller. In particular, the
merchant banker acted as a capital sources whose primary activity was directed towards a commodity
trader/cargo owner who was involved in the buying, selling, and shipping of goods. The role of the merchant
banker, who had the expertise to understand a particular transaction, was to arrange the essary capital and
ensure that the transaction would ultimately produce "collectable" profits. Often, the merchant banker also
became involved in the actual negotiations between a buyer and seller in a transaction.

 The Modern Merchant Bank

During the 20th century, however, European merchant banks expanded their services. They
became increasingly involved in the actual running of the business for whom the transaction was conducted.
Today, merchant banks actually own and run businesses for their own account, and that of others. Since the
18th century, the term merchant banker has, therefore, been considerably broadened to include a composite
of modern day skills. These skills include those inherent in an entrepreneur, a management advisor, a
commercial and/or investment banker plus that of a transaction broker. Today a merchant banker is who has
the ability to merchandise -- that is, create or expand a need -- and fulfill capital requirements. The modern
European merchant bank, in many ways, reflects the early activities and breadth of services of the colonial
trading companies

Most companies that come to a U.S. merchant bank are looking to increase their financial stability
or satisfy a particular, immediate capital need.
Professional merchant bankers must have:
1) an understanding of the product, its industry and operational management;
2) an ability to raise capital which might or might not be one's own (originally merchant bankers
supplied their own capital and thereby took an equity interest in the transaction);
3) and most importantly, effective skills in concluding a transaction - the actual sale of the product
and the collection of profit. Some people might question whether or not there are many individuals or
organizations who have the abilities to fulfill all three areas of expertise.

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INTRODUCTION TO MERCHANT BANKING

There is no statutory or any authoritative definition for the term Merchant Banking. For many, it
just means management of capital issues of companies. Some confuse this with investment banking and an
issue house. Yet another group of persons mean it to what a merchant banker does. In this situation, let us try
to settle for a workable definition of this term.

It is an activity of financial intermediation which matches the entities that need capital with those that
have capital. As per the Securities Exchange Board of India (SEBI), which regulates the Indian Merchant
Banking activity, a Merchant Banker (MBR) is defined as a person who is engaged in the business of the
issue management either by making arrangements regarding selling, buying of, or subscribing to securities
as Manager, Consultant, Advisor or rendering Corporate Advisory Services in relation to such issue
management.

Normally, banks are categorised either as commercial banking or investment banking. Commercial
banking activities primarily consist of taking deposits from and granting loans to the public, corporations,
and municipalities. Investment banking, on the other hand, is involved in the underwriting and distribution
of securities, portfolio management, information gathering for security analysis, trading securities, and
advising corporate finance strategies. Although these two types of activities differ in some substantial ways,
such as how they obtain funds and the types of financing services they provide, they do share the common
characteristic of being a pure intermediary. Both are simply acting as a financial middleperson; they do not
risk their own capital on either side of financial transactions.

A third type of banking activities that is receiving increased attention and importance in recent years
is often classified under the rubric of merchant banking? A merchant bank could be a converted traditional
investment bank, a subsidiary of a commercial bank holding company, or a specialized institution organized
for a certain type of transactions, e.g., leverage buyout. The merchant bank provides its own capital with a
bundle of the usual pure intermediary services such as arranging financing, advising, underwriting. Because
it commits its own capital, as a principal investing in the equity of the client, for a certain duration, the
merchant bank is no longer a pure intermediary. On the other hand, because it derives substantial revenues
(fees) from the bundle of services that are inseparable from the capital it committed to the transaction, it is
not a pure investment company either. Thus, the merchant bank is at best described as a quasi-intermediary
(or a quasi-investment company).

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 Project By Shelani Agarwal

NATURE AND SCOPE

 Nature of MB

MB facilitates the process of flow of capital in the Market by intermediating between the issuers of
capital and the ultimate investors who purchase the securities. MB channelizes the financial surplus of the
society into productive investment avenues. MBR has to ensure that only quality paper emanates from his
firm. He is required to exercise due diligence to ensure the adequacy and appropriateness of the disclosures
made in the offer document. He is also required to guide and co-ordinate the activities of the Registrar,
Bankers, Advertising Agency, Printers, Underwriters, Brokers, etc. to the issue. MBR has also to ensure the
compliance of all laws and regulations governing the securities issue, and also in developing regulatory
framework for orderly growth of capital markets.

 Scope of MB

The scope of MB in India covers the following:-

i. Management of Debt and Equity Issues: Designing the Instrument, Pricing the Issue, Registration of
Offer Document, Underwriting & Marketing the Issue, Allotment, Refund and Listing on SEs.

ii. Placement and Distribution of Investment Proposals: Placement of the Issue and Distribution thru the
network of Institutional Investors like MFs, FIIs, Banks, Domestic and Multilateral FIs, Pvt. Equity
and Pension Funds, etc. (of various financial products viz. equity shares, debt instruments,
commercial products) and retail investors (of MF products, FDs and Insurance products).

iii. Corporate Advisory Services: Offer of customized solutions to the financial problems of the clients
such as (1) Financial restructuring, (2) Refinancing, (3) Working capital finance, (4) Rehabilitation
and turnaround management, (5) Securitization of receivables, (6) Management of risk, and (7)
Deployment of short term resources.

iv. Project Advisory Services: Offer project related services such as conceptualization of the project
idea, preparation of feasibility report and detailed project report and even project appraisal.

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v. Loan Syndication: It involves tying up of loans, analyzing cash flows, preparation of loan
memorandum containing loan parameters and preparation of loan documentation.

vi. Venture Capital & Mezzanine Financing: It involves preliminary screening of the venture capital
firm, identifying the venture funds, conducting due diligence, valuation of the company, structuring
the terms of the deal like pricing, divestment, and follow up on financial aspects & handling
divestment.
Mezzanine financing refers to the late stage (when co. is in operation and may be profit
making) financing in respect of those companies which need fresh induction of capital for growth
plans, but the IPO market may not be favorable. Some venture Funds and Private Equity Funds offer
mezzanine finance to potential IPO companies which acts as waterhouse (bridge finance) for
investments and later divest their stake through a public offering.

vii. Mergers & Acquisitions: The policy of decentralization, liberalization and globalization has exposed
the companies to domestic and international competition and necessitated them to consolidate their
operations in areas of their core competence and divest those businesses where they do not have any
competitive advantage. Here, mergers and acquisitions help in effectively combining two entities by
identifying the synergies and value drivers, ultimately to maximize the wealth of the shareholders.
Following are some of the factors which will make an acquisition a potential tool for wealth
maximization:-

A. Production: Horizontal or vertical integration and new technology acquisition.

B. Marketing: Elimination/reduction of competition, enhancement of market share,
diversification reducing risk and growth without creating surplus capacity.
C. Finance: tax benefits, restructuring and strengthening balance sheet, profits from
leveraged buyouts, investment of surplus cash, and reduction of volatility of earnings in
a cyclical industry.

viii. Divestitures of Assets: This involves sale of business assets or units (entities). The assets may be
tangible (manufacturing or product line) or intangible (brand, distribution network. The entities
include entire unit. The reasons for divestitures include: Opportunity like high price, forced
circumstances due to liquidity crunch; and planned strategic decision due to competition, shrinking
margins, losses, poor business prospects, exiting the industry, etc.
The MB has also to advise the company on the sale strategy (negotiated sale or auction
sale), valuation of the assets/business, drafting of offer memorandum containing the contents (such

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as executive summary, sale procedure, background, operations, marketing, HR, Finance, etc.),
identifying the potential buyers, negotiating and closing the deal, etc.

ix. Takeover Defense Activities: MBRs carry out defensive audit for companies to assess their
vulnerability to takeovers, mainly hostile takeovers. MBR can suggest companies for taking
corrective action like pre-emptive defensive actions (like increasing promoters stake, equity buy-
back, corporate restructuring like asset sale and spin off, etc.) to reduce the vulnerability of the
company.

x. Financial Engineering: It involves design, development and implementation of innovative financial

instruments and processes and the formulation of creative solutions to the problems in finance.
Factors like interest and exchange rate and price volatility, regulatory and tax changes, globalization
of markets, increased competition among investment bankers, etc. have accelerated the process of
financial innovation.

The Merchant Banking industry hitherto used to deal with issue management and underwriting only.
MBRs have started diversifying into new functions (M&A), new products (risk management tools), new
techniques (securitization) and new markets (global).

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REGULATORY FRAMEWORK OF MB ACTIVITY

Earlier, MB Activity was both (i) Fund based (Leasing, Hire-Purchase, Bills Discounting, Factoring, etc.)
and (ii) Fee based (Issue Management, Underwriting, Advisory Services, etc.). Earlier, MBRs were carrying
both the above activities. While RBI regulated the fund-based activities, the fee-based activities were
regulated by SEBI, which resulted in a single entity being regulated by two different regulatory authorities.
With effect from 1st July 1988, a MBR is disallowed from carrying on any business other than those related
to the securities market i.e. MBR has to discontinue activities other than those relating to the securities
market i.e. discontinue fund-based activities or the merchant banking activities should be hived off to a
separate company.
All MBRs will have to register with the Securities Exchange Board of India (SEBI), which is the
regulator for merchant banking activity. SEBI as a regulator with statutory powers will –
 Deal with all matters relating to development and regulation of securities market and investor
protection, and advise Government on these matters;
 Prepare a comprehensive legislation for the regulation and development of the securities market;
 Carry out such functions as may be delegated to the Board/Chairman by the Central Government for
the development and regulation of securities market.

SEBI shall perform the following functions -

• Regulating the business of stock exchanges and any other securities markets.
• Registering and regulating the working of stock brokers, sub-brokers, share transfer agents, bankers
to the issue, trustees of trust deeds, registrars to the issue, merchant bankers, underwriters, portfolio
managers, investment advisers and such other intermediaries who may be associated with securities
markets in any manner.
• Registering and regulating the work of collective investment schemes including mutual funds.
• Prohibiting fraudulent and unfair trade practices relating to securities markets.
• Promoting investor’s education and training of intermediaries of securities markets.
• Prohibiting insider trading in securities.
• Regulating substantial acquisition of shares and takeover of companies.
• Calling for information from undertaking inspection, conducting inquiries and audits of the stock
exchanges and intermediaries and self-regulatory organizations in the securities market.

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• Performing such functions and exercising such powers under the provisions of the Securities
Contracts (Regulations) Act, 1956, as may be delegated to it by the Central Government.
• Levying fees or other charges for carrying out the purpose of the Act.

• Conducting the research for the above purposes and performing such other functions as prescribed.

SEBI has powers towards Stock Exchanges to: -

 Grant recognition
 Withdraw recognition
 Direct any SE to amend rules relating to its constitution, admission / readmission of new or
other members, qualifications, suspension, expulsion, etc.
 Supersede governing body
 Suspend or Supersede business
 Declare contracts as void
 Prohibit contracts in certain cases
 Powers to issue directions

Other Powers of SEBI: -

 Stock-brokers, sub-brokers, share transfer agents, bankers to an issue, trustees of trust deeds,
registrars to an issue, merchant bankers, underwriters, portfolio managers, investment advisers,
and such other intermediaries who may be associated with securities market shall buy, sell or
deal in securities in accordance with the conditions of a certificate of registration obtained from
SEBI under the regulations made under the Act.
 All depositories, participants, custodians of securities; foreign institutional investors (FIIs);
credit rating agencies; venture capital funds; mutual funds, or any other collective investment
schemes in the securities market shall also register with SEBI and abide by its rules and
regulations.

SEBI’s Achievements:
1. Guidelines on Disclosure and Investor Protections with several subsequent clarifications.
2. Proper disclosures to investors through prospectus made obligatory.
3. Insider trading regulations.
4. Stock Brokers and Sub-Brokers Rules
5. Guidelines to Merchant Bankers.
6. Guidelines to Mutual Funds
7. Advertising Code for Mutual Funds

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8. Takeover Code
9. Guidelines to share transfer agents and registrars to an issue
10. Portfolio management service rules and regulations
11. Stockinvest scheme to eliminate delayed funds
12. Set up self-regulatory organizations like Association of Merchant Bankers
13. Regulations for Foreign Institutional Investors (FIIs) for portfolio investments in India.

STRUCTURE OF THE MB INDUSTRY

Just as the other industries, the MB industry also functions in an environment which includes both internal
and external factors, such as the level of competition within the industry, the technology level, government
policy, etc. which might affect the ability of the industry to function well. These forces and the interplay
amongst them constitute the structure of the industry.

Porter’s Five Forces Model

Study of the structural analysis of the MB industry with the help of the above model suggests that the
IB industry in India has low entry barriers leading to high competition and high bargaining power of
customers. Further, the pressure from substitute options like new innovations in raising funds such as screen-
based automated computerized operations (through NSE and OTC windows) is fast growing. As such the
success of an MB firm depends on the relationship with clients of the firm and the quality of the services
offered. To control the trend of ever increasing the number of the MBRs in India, SEBI had come up with
stricter guidelines like increasing net worth requirements, making a rational fees structure, and so on.
The above conclusions may be made from the following Porter’s Analysis diagram:-

Threat of potential (new) entrants is

high due to low Entry Barriers like
Econs. of Scale, Product
Differentiation, Capital
Requirements, Switching Costs,
Distribution Channels, Govt.
Policies, Employee Efficiency,
Good Relations with Customers.

Less Bargaining High Bargaing.

Power of Suppliers
(like registrars,
bankers, printers,
underwriters, legal
advisors etc
are many.
Competition among MBRs (based on Power of Buyers
pricing, advt., goodwill, product ( proms. &
innovation, after(Threat
sales service etc.) is high investrs for
Substitutes of substitute max/min premia
products and services – like new but MBR tries for
innovations in raising funds viz. a reasonable price)
screen-based automated
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computerized through NSE and
OTC windows is not very high)
 Project By Shelani Agarwal

PRIMARY MARKET IN INDIA AND ABROAD

 Primary Market In India

An essential feature of Primary Market is that it has to be driven by fresh issues of securities (equity or
debt or both) by different issuers. Each issue made adds to the floating stock of such securities in the
secondary market. Unlike the Primary Market, the Secondary Market is driven by deals (purchases and/or
sales) in floating stock of securities. They are described below:-

 Primary Equity Market Segment

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Primary Equity Market

Investors
(Institutional/Other large/retail)

Issuers
(Companies under Companies Act/Other Statutory Corp.)

Public Instruments
Rights Private Boughtout
Issues (Equity/Preference/Convertibles/Units
Issues Placementsof Mutual Funds)
Deals
Intermediaries
(MBRs/Registrars/Bankers/Underwriters/Brokers)

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 Primary Debt Market Segment

Unlike the primary equity market, the debt market is driven by a predominance of government securities
and bonds floated by Public FIs, Public sector Corporations, Local Authorities and Government
Companies.

Primary Debt Market

Public Rights Private Boughtout

Issues Issues Placements Deals

Investors
(Institutional/Other large/retail)

Issuers
(Companies under Companies Act/Other Statutory
Corporations/Government)

Instruments
(Corporate Debt: Debentures/Bonds/Convertibles;
and Government Debt)

Intermediaries
(MBRs /Underwriters/Brokers)

Features of Debt Instruments

 Coupon Rate (Interest Rates: Fixed and Floating Rates)

 Yield (IRR)
 Tenor (Maturity Period)

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 Cash Flows
 Primary Market abroad (Overseas Capital Market Issues

This deals exclusively with fund raising by Indian corporates with floats of debt, equity offerings in
international capital markets, the features of overseas bond markets and the mechanism of Depository
Receipts for equity issues, the Regulatory Framework in India for International Capital Market offerings, the
process flow for an international capital offering and the role of the Merchant Banker in this respect.
International Capital Market (ICM) is only a part of the larger International Financial Market (IFM),
which is a financial market that transcends national geographical boundaries. In IFM, funds are raised from
lenders or investors in a country by borrowers or issuers from another country or conduct transactions in
currencies other than the domestic currencies of respective countries. IFM can be outside the regulatory
purview of any single country. The ICM consists of:-

(a) Global Bond Markets (including convertibles) (b) Global Equity Markets
(c) Global Derivatives Markets (Stocks, Commodities, Foreign Currencies, etc.)

Global/Foreign Bonds
Foreign Bonds are issued within the domestic market of a country by a foreign issuer for subscription
exclusively by domestic investor. For instance, ICICI Bank can issue a dollar denominated bond in the US
market or Euro market for subscription, say, by local investors in USA or Euro countries, it is a foreign bond
in those markets. The main requirement for the issue of these bonds is that the local regulations of the host
country need to permit such issues. They are called by different names in different countries as follows:-
• Yankee Bonds (in USA)
• Samurai Bonds (thru public issue), Shibosai Bonds (thru private Placement) and Shogun Bonds
(Non-Yen dominated) – in Japan.
• Bull Dogs (in UK)
• Matador Bonds (in Spain)
If Yankee Bonds are floated in US by a company belonging to some other country, say India, then the
company is required to comply with the local listing requirements of the SEC in US, which include stringent
disclosure requirements apart from compliance with US GAAP accounting. An alternative to the public
issue of Yankee Bond in US is through Rule 144A adopted by SEC, which is a safe haven for bonds issued
on a private placement basis to the QIBs (investors that have invested not less than a $100 mn in non-
affiliate investments). Bonds issued under 144A route can be traded between QIBs under the permitted
dealing systems of the NYSE (System 144A), NASDAQ (Portal) and the AMEX (Situs). The US market for
foreign bonds both through a public issue and 144A route offers long tenors and access to huge fund base

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with US investors. Though this being a primary market though for high quality paper, the appetite for such a
paper is small in the emerging markets.

RECENT CHANGES IN REGULATORY FRAMEWORK

 One of the important new regulations stipulates that a MB has to discontinue (w.e.f. 1.7.’98) the fund
based activities or the MB activities should be hived off to a separate company. The segregating of MB
and fund based operations is expected to facilitate greater accountability and better monitoring.
However, this regulation is not applicable to Banks and FIs.
 Abolition of the existing multiple categories (I, II, III and IV) and there will be only one category i.e.
Merchant Banker. All the norms applicable to the erstwhile Category I merchant bankers are now
applicable to all the Merchant Bankers.

PROFESSIONAL ETHICS & CODE OF CONDUCT IN MB

Recent events have raised the level of ethics awareness and concern all around the world. Companies with
deficient corporate ethics are being held accountable. Ethics policies and procedures need to be clear and all
people in the organization need to understand them. Ethical issues need to be dealt with promptly and
properly, for a MBR and with any company it advises or invests in. A MBR’s ethical tasks will be to:

 Maintain the highest standard of personal and professional conduct in its dealings with clients and
investors.Conduct all business dealings with fairness, honesty and integrity.
 Maintain loyalty to the investors and to the clients who hires it, that it will pursue their objectives in
ways that are consistent with their best interests and legal obligations.
 Maintain the confidentiality of privileged information entrusted to it by its clients and their employees.
 Protect from loss, theft, and misuse of all information and resources available to it.
 Always communicate with the investors and the clients in a truthful and accurate manner.
 Serve as a reliable source of information on matters pertaining to business advice and consulting.
 Encourage and promote the highest level of ethical and professional conduct within the organization.
 Recognize and engage the responsibility to uphold all laws and regulations governing the policies and
activities of their profession.
 Avoid even the appearance of conflict of interest or any other impropriety.
 Treat fellow employees fairly, with dignity and respect.
 Promote and reward company personnel for their special responsibilities, contributions, and sacrifices;
to promote a sense of mutual trust and shared responsibility.

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 Provide professional services to all qualified candidates regardless of race, color, creed, religion,
national origin, gender, age, income level or physical handicap.
 Respect the rights and interests of our competitors.
 Help create and sustain an atmosphere conducive to the spirit of this code.

SOURCES AND REFERENCES

Websites of

Press reports from:

http://www.economictimes.com

http://www.livemint.com

http://www.moneycontrol.com

http://www.theindiastreet.com

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