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INTRODUCTION
The banks have been forced to enter into new areas of Non-
bank financial services. The Chakravarthy and Narasimhan Committee has
recommended the need for market oriented financial system. The banks
and NBFCs can function with greater autonomy, accountability and
efficiency. The Narasimhan Committee has recommended that all the
institutions which involve in the Capital market should work on sound
guidelines within regulatory framework of the SEBI. SEBI is the most
powerful organ in promoting better investor protection and widening the pool
of savings and investment.
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and institutional investors more efficiently. The functioning of the financial
system depends on the range of financial services. It includes the services
offered by both types of companies such as Asset Management Companies
and Liability Management Companies. It not only helps to raise the
adequate financial resources but also ensures their efficient deployment.
The Asset Management Company includes leasing companies, Mutual
funds, Merchant bankers and portfolio Management. The Liability
Management companies comprise the bill discounting houses, Acceptance
houses. Financial services provide efficient management of funds services
such as bill discounting, factoring, and parking of short term funds in the
money market. The LMCs provides specialized services such as Credit
Rating, Venture Capital Financing Housing Finance etc. These services are
also provided by a number of various organizations such as NBFCs,
Insurance companies, subsidiaries of financial institutions stock exchanges
specialized and general financial institutions etc. All these organization are
regulated by the securities and Exchange Board of Ind. RBI and the
department of Banking and Insurance, Government of India through a
number of legislation. It stimulates the velocity of the economic growth and
development of a nation. The Indian economy has to improve the
infrastructure facilities to the investor’s entrepreneurs, Industry and
business. Financial services differ in nature from other service sector. The
salient features of the financial services are discussed below: -
(A) Invisible
(B) Customer Friendly
(C) Demarcation
(D) Dynamism
(E) Innovation
The services of the finance are intangible. It smoothens the
functioning of the corporate sector by providing funds within the stipulated
period of time without fail. The institutions which supply them have a good
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image and confidence of the client but they may not succeed. The business
concerns have to focus on quality and innovativeness of their services to
build their credibility and gain the trust of their clients.
(B) Second Stage: Financial services entered the second stage and it
covered the period of 10 years approximately. In this period it has
introduced many innovative value added services such as O.T.C. share
transfers, pledging of shares, mutual funds, factoring, discounting, venture
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capital and credit rating. These services were available in the western
countries about 100 years back. Mutual funds provide major fund to the
industry anywhere in the developed countries. The funds have been
innovative in terms of their schemes. They provided better returns to the
unit holders. Their management was transparent. The small investors
welfare was secured in their hands. Their business goals were such that
they created value for their investor. They have their own code of conduct.
Credit rating was another important financial service which entered India
during this stage. It built investor confidence in the capital market operation.
It prevented mal practices in the capital market. Initially they credit rating is
applied to debt instruments only. Afterwards the credit rating was applied to
the commercial papers and fixed deposits. Another important financial
service was introduced in this stage “Factoring”. Factoring means
collection of accounts receivables by a financial intermediary. A number of
factoring institutions had entered into the capital market. They were
Discount and Finance House of India. SBI factors, can bank factors venture
capital finance entered in late 1980s. It was a highly specialized service
operated by venture capital firms.
(C) Third Stage: The third stages in financial services include the
setting up of new institutions and instruments. This period started from post
liberalization. The depositories, the stock lending scheme, online trading
paperless trading, dematerialization, book building aspects were introduced
during this period. Depositories set up in the public sector and many
financial institutions are finding this business more lucrative. The stock
lending scheme approved by the Central Government in 1997-98. The
central government initiated steps for the setting up of a separate
corporation to deal with trading of the Gilt bonds. It has also taken steps to
popularize book building method to help both the investors and fund users.
It has also initiated steps to introduce online trading in Bombay stock
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exchange and Delhi stock exchange. The computerization of NSE acted as
the fulcrum for the development of financial services. These steps had
given a fillip to paperless trading. Paperless trading saved the investors
form the onslaught of brokers and jobbers. It also reduced tax evasion.
SEBI had been the regulatory authority in the financial environment and
issued guidelines to the Merchant bankers in relation to the capital
adequacy ratio. These guidelines ensure the investor protection and
created a differentiation in the market. Establishment of the SEBI was a
path breaking development in terms of regulation growth and development
of financial services. The efforts to revamp the companies act, Income tax
act and other acts had led to the deliverance of effective financial services.
The government had taken initiative steps to allow the foreign Institutional
investors into the capital market. This situation had been more beneficial to
the capital market. The government had also taken steps to bring down the
taxes on the capital gains for the FIIs. The Mutual funds had been
permitted to exercise voting power which ought to more strengthen. The
Disinvestment of the public enterprises made by the central government
was another realm of financial services. The financial firms have gained
expertise in valuation financial and legal restructuring and making the public
sector firms to be commercial in the market. Financial service firm had
been mobilizing resources from abroad to finance the corporate sector.
They approached the European Capital market. The service firms learnt the
expertise in raising of GDRs through global market in the digital economy.
This was an excellent development in this sector. It required an
understanding of raising fund abroad and also works together with world
class level financial services institutions. The world standard organizations
such as Lehman brothers, Goldman Schs, Merry Lynch and Morgan Stanley
etc. The global financial markets required a high talent excellent skill and
good infrastructure to deal the affairs more effectively. It was very easy in
Switzerland to approach the capital market which were more flexible in
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terms of procedures and expect lower interest rates. Hence the financial
firms would have to change their approach from syndication to risk finance
aspect. In this period new financial instruments were introduced in the
market. The issue of new financial instruments related to maturity, risk and
interest rate.
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(B) Quality of Services: The survivals of financial services depend
upon the delivery of quality services and products at the right price, and at
the right time. The providers of financial services must use the application
of the appropriate technology in process a large flow of information
according to the needs of the client. The services will be provided on a
fixed fee basis of various activities. The fee is decided by the regulator for
rendering various services. The clients often complaints about the poor
performance and high fee is charged by the service providers. The working
pattern of the Merchant bankers has to be changed. The functioning of
credit rating should build up the confidence in the market. The information
in Finance has to be in the organized form. The data lies in crude stage, it
must be gathered by taking much pains and be stratified according to the
purpose. There is a strong need for conducting research in finance area.
The quality of financial services will only be possible on the basis of
Research activities. Research is the most important factor in innovative
financial products and service. The financial service involves a rapid
change on day by day basis. Hence the quality of service must be improved
and updated at every moment.
(D) Fee and Fund Based: Financial services providers are working
on the basis of either fee based and fund based activities. Some institutions
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provide services for fee basis. Mutual funds, credit Rating, merchant
banking are the best examples for fee based services term lending, housing
finance companies, venture capital, leasing companies are the examples of
fund based services. They provide financial resources to their clients on
interest basis. They charge the interest from their borrowers. Term lending
institutions meet the long term funding needs of industries. Therefore
providing funds to the corporate sector is known as project financing.
Housing finance companies provide funds to the individuals for acquisition
of house property. Venture capital provides funds to the new projects in the
form of equity for innovative products. The providers of financial services
either belong to fund based activities or fee based activities. Some firms
involve in both the aspects.
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Management of Risk in Financial Services
The financial services have introduced several new products and
services. The financial markets have seen a number of bank and insurance
companies’ failure, securities scans and services. The industry is operating
in a risky environment. The success of a financial service provides to a large
extent depends on the manner which it manages the Risk. The business
involves risk, without it there is no existence of business. Risk cannot be
avoided. Risk is the integral part of the financial services industry. The
financial services industry works with the financial claim. Financial claim is
a promise to give a fixed amount under certain specified terms. All financial
claims in general are risky. The financial claim affects the performance of
the company that provides financial services. The risk in financial services
industry is very high. The changes of default by the parties who sell the
financial claims are very high. The default by the concerned parties may
arise due to several reasons. The risks in financial services industry can be
classified as follows:
(A) Internal Risk
(B) External Risk
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the failure of the firms in the service industry. Some of the internal sources
of risk faced by different financial services companies are presented below:
(1) Lending Institutions.
(2) Stock broking service.
(3) Insurance service.
(4) Fee based service companies.
(5) Leasing and Hire purchase.
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Regulatory Framework for Financial Services
The economy will grow with a better financial system of a nation. The
financial system should work on the basis of asset creation better credit flow
to all the sectors and stimulating the per capita income of a nation. The
asset creation is possible only with the efficient primary market the credit
flow to all sectors in the function of banking institutions. The banking
institutions allow the economy to expand more and more. The financial
services industry channels the savings into productive way. It helps the
economic activities to grow without any handles the importance of the
financial services cannot be ignored in the digital economy. This sector is
governed by strict rules and regulations. In a competitive market the
services are required more efficiently and effectively. The financial firms
often take high risk to maximize the return and thus susceptible to default.
There will be a scope that can impart the interest of the investors in this
sector there will be a lot of scope for frauds mismanagement of funds, and
scams. Therefore the regulations are in place of protect the Investor’s
rights. The regulatory frame work to this sector can be categorized in three
forms:
(A) Structural Regulations.
(B) Prudential Norms.
(C) Investor Protection Regulations.
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stock brokers to separate all their fund based activities. The regulations
cover the internal management of financial institutions and other concerns in
relation to capital adequacy, liquidity and solvency. The RBI is the
regulatory authority in the banking service.
The rules and regulations ensure the financial soundness and safety
of the financial institutions. They maintain the integrity of the transmission
mechanism and protection of clients of the financial services. They ensure
to improve the efficiency of the financials companies and provide benefits to
the investors and borrowers. At the same time the regulations should not
block the development of the financial services industry. The financial
services regulations can be divided into four categories:
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(1) Regulation on Banking and financing services.
(2) Regulations on Insurance services.
(3) Regulations on Investment services.
(4) Regulations on Merchant banking and other services.
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Some examples of financial
services given by bank
• Mutual Fund
• Merchant banking
• Venture capital
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MUTUAL FUND
A mutual fund is a professionally managed firm of collective
investments that collects money from many investors and puts it in stocks,
bonds, short-term money market instruments, and/or other securities. The
fund manager, also known as portfolio manager, invests and trades the
fund's underlying securities, realizing capital gains or losses and passing
any proceeds to the individual investors.
According to Weston J. Fred and Brigham, Eugene F., Unit Trusts are
“ corporations which accept dollars from savers and then use these dollars
to buy stocks, long term bonds, short term debt instruments issued by
business or government units; these corporation pool funds and thus reduce
risk by diversification.”
ORIGIN:
In the past decade, Indian mutual fund industry had seen dramatic
improvements, both quality wise as well as quantity wise. Before, the
monopoly of the market had seen an ending phase; the Assets Under
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Management (AUM) was Rs. 67bn. The private sector entry to the fund
family rose the AUM to Rs. 470 bn in March 1993 and till April 2004, it
reached the height of 1,540 bn. Putting the AUM of the Indian Mutual
Funds Industry into comparison, the total of it is less than the deposits of
SBI alone, constitute less than 11% of the total deposits held by the Indian
banking industry.
The main reason of its poor growth is that the mutual fund industry in
India is new in the country. Large sections of Indian investors are yet to be
intellectuated with the concept. Hence, it is the prime responsibility of all
mutual fund companies, to market the product correctly abreast of selling.
History:
Massachusetts Investors Trust (now MFS Investment Management)
was founded on March 21, 1924, and, after one year, it had 200
shareholders and $392,000 in assets. The entire industry, which included a
few closed-end funds represented less than $10 million in 1924.
The stock market crash of 1929 hindered the growth of mutual funds.
In response to the stock market crash, Congress passed the Securities Act
of 1933 and the Securities Exchange Act of 1934. These laws require that a
fund be registered with the Securities and Exchange Commission (SEC)
and provide prospective investors with a prospectus that contains required
disclosures about the fund, the securities themselves, and fund manager.
The SEC helped draft the Investment Company Act of 1940, which sets
forth the guidelines with which all SEC-registered funds today must comply.
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of the key tenets of the industry in his 1951 senior thesis at Princeton
University. It is now called the Vanguard 500 Index Fund and is one of the
world's largest mutual funds, with more than $100 billion in assets. A key
factor in mutual-fund growth was the 1975 change in the Internal Revenue
Code allowing individuals to open individual retirement accounts (IRAs).
Even people already enrolled in corporate pension plans could contribute a
limited amount (at the time, up to $2,000 a year). Mutual funds are now
popular in employer-sponsored "defined-contribution" retirement plans.
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Trustees is Kotak Mahindra Trustee Company Limited and the asset
management company is Kotak Mahindra Asset Management company
Limited. AMC gets management fee annually, based on quantum of funds
managed (1.25% upto Rs. 100 Crores and 1% above that)
With the increase in mutual fund players in India, a need for mutual
fund association in India was generated to function as a non-profit
organisation. Association of Mutual Funds in India (AMFI) was incorporated
on 22nd August, 1995.
Association of Mutual Funds India has brought down the Indian Mutual
Fund Industry to a professional and healthy market with ethical lines
enhancing and maintaining standards. It follows the principle of both
protecting and promoting the interests of mutual funds as well as their unit
holders.
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• It also recommends and promotes the top class business practices
and code of conduct which is followed by members and related people
engaged in the activities of mutual fund and asset management. The
agencies who are by any means connected or involved in the field of
capital markets and financial services also involved in this code of
conduct of the association.
• At last but not the least association of mutual fund of India also
disseminate information’s on Mutual Fund Industry and undertakes
studies and research either directly or in association with other bodies.
Bank Sponsored
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Institutions
Private Sector
AMFI publices mainly two types of bulletin. One is on the monthly basis
and the other is quarterly.
The net asset value, or NAV, is the current market value of a fund's
holdings, less the fund's liabilities, usually expressed as a per-share
amount. For most funds, the NAV is determined daily, after the close of
trading on some specified financial exchange, but some funds update their
NAV multiple times during the trading day. The public offering price, or POP,
is the NAV plus a sales charge. Open-end funds sell shares at the POP and
redeem shares at the NAV, and so process orders only after the NAV is
determined. Closed-end funds (the shares of which are traded by investors)
may trade at a higher or lower price than their NAV; this is known as a
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premium or discount, respectively. If a fund is divided into multiple classes
of shares, each class will typically have its own NAV, reflecting differences
in fees and expenses paid by the different classes.
Some mutual funds own securities which are not regularly traded on
any formal exchange. These may be shares in very small or bankrupt
companies; they may be derivatives; or they may be private investments in
unregistered financial instruments (such as stock in a non-public company).
In the absence of a public market for these securities, it is the responsibility
of the fund manager to form an estimate of their value when computing the
NAV. How much of a fund's assets may be invested in such securities is
stated in the fund's prospectus.
Usage:
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Most mutual funds' investment portfolios are continually adjusted
under the supervision of a professional manager, who forecasts cash flows
into and out of the fund by investors, as well as the future performance of
investments appropriate for the fund and chooses those which he or she
believes will most closely match the fund's stated investment objective. A
mutual fund is administered under an advisory contract with a management
company, which may hire or fire fund managers.
Turnover:
25
In Canada, under NI 81-106 (required disclosure for investment funds)
turnover ratio is calculated based on the lesser of purchases or sales
divided by the average size of the portfolio (including cash).
CLASSIFICATION OF FUNDS:
MUTUAL FUND
On the basis On the basis of yield and investment pattern
of execution
and operation
Close Open Income Growth Balance Specialized Money Taxation
ended ended fund fund fund fund Market Fund
Under the scheme, the corpus of the fund and its duration are
prefixed. In other words, the corpus of the fund and the number of units are
determined in advance. Once the subscription reaches the pre-determined
level, the entry of investors is closed. After the expiry of the fixed period,
the entire corpus is disinvested and the proceeds are distributed to the
various units holders in proportion to their holding. Thus, the fund cases to
be a fund, after the final distribution.
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• The main object of this fund is capital appreciation.
• From the investors’ point of view, it may attract more tax since the
entire capital appreciation is realized into at one stage itself.
• The period and /or the target amount of the fund is definite and fixed
beforehand.
• Generally, the prices of closed-end-scheme units are quoted at a
discount of up-to 40 per cent below their Net
Asset Value (NAV).
• Once the period is over and/or the target is reached, the door is
closed for the investors. They cannot purchase any more units.
• If the market condition is not favourable, it may also affect the investor
since he may not get the full benefit of capital appreciation in the value
of the investment.
• At the time of redemption, the entire investment pertaining to a closed-
end scheme is liquidated and the proceeds are distributed among the
unit holders.
• These units are publicly traded through stock exchange and generally,
there is no repurchase facility by the fund.
• The whole fund is available for the entire duration of the scheme and
these will not any redemption demands before its maturity. Hence,
the fund manager can manage the investments efficiently and
profitably without the necessity of maintaining any liquidity.
It is just the opposite of close ended funds. Under this scheme, the
size of the fund and the period of the fund is not pre-determined. The
investors are free to buy and sell any number of units at any period of time.
For instance, the Unit Scheme (1964) of the Unit Trust of India is an open-
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ended one, both in terms of period and target amount. Anybody can but his
unit at any time and sell it also at any time at his discretion.
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(A) Income Fund:
As the very name suggest, this fund aims at generated and
distributing regular income to the members on periodical basis. It
concentrates more on the distribution of regular income and it also sees that
the average return is higher than that of the income from bank deposit.
Unlike the income funds, growth funds concentrate mainly one long
run gains i.e. Capital appreciation. They do not offer regular income and
they aim at Capital appreciation in the long run. Hence, they have been
described as “Nest Eggs” investments.
These funds are basically open handed mutual funds and as such
they have all the features of the open ended fund. But, they invest in highly
liquid and save securities like commercial papers, banks acceptance,
certificates of deposits, treasury bill. These instruments are called money
market instruments. They take place of share, debenture and bonds in the
Capital market. They pay money market rates of interest. These funds are
called ‘money funds’ in the USA and they have been functioning since 1972.
Investors generally used it as a “Parking Place” or stop gap arrangements
for their cash resources till they finally decide about the proper avenue for
their investment i.e., long term financial assets like bonds and stocks. Since
MMMFs are anew concept in India, the RBI has laid down certain stringent
regulations. For instance, the entry to MMMFs is restricted only to
scheduled commercial bank and their subsidiaries.
30
Capital market limited is the best example for the domestic type.
UTI’s US$ 60 million Indian fund, based in the USA, is an example for the
foreign type.
Other classification:
These funds are also called borrowed funds since they are used
preliminary to increase the size of the value of portfolio of a mutual fund.
When the value increases, the earning capacity of the fund also increases.
The gains are distributed to the unit holders.
Off shore mutual funds are those funds which are meant for non-
residential investors. In other words, the sources of investments for these
funds are from abroad so they are regulated by the provision of the foreign
country where those funds are registered.
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This is a special kind closed ended fund. It provides a single
investment opportunity for two different types of investors. For this
purpose, it sells two types of investments stocks viz. income shares and
capital shares. Those investors whose seek current investments income
can purchase income shares.
This fund have portfolio consisting mainly of fixed income security like
bonds. The main thrust of these funds is mostly on income rather than
capital gains.
These funds are just the opposite of bond funds. These funds are
capital gains oriented and thus the thrust area of these funds is ‘Capital
gains’. Hence, these funds are generally invested in speculative stocks.
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concession. For instance, under section 80L of the Income Tax
Act, a sum of Rs.10,000/- received as a dividend (Rs.13,000/- to
UTI) from a MF is deductible from the gross total income. Some
funds operate 88 A funds where 20% of the amount invested is
allowed to be deducted from the tax payable under the wealth tax
act, investments in MF are exempted up to Rs.5,00,000/-.
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• Promoting industrial development: The economic
development of any nation depends upon its industrial
advancement and agricultural developments. All industrial units
have to raise their funds by resorting to the capital market by the
issue of shares and debentures.
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Public Offering to the mutual funds and thus they are saved from
the marketing cost of such issues.
The Indian Mutual fund is perhaps the best example of the customer
focused, well managed and regulated financial industry in India and may be
in the world. The professionals in the industry are uniformly of high calibre
and bring great dedication and drive to their task.
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LIMITATIONS:
• The investors are likely to come in difficulties if the mutual fund is
not managed efficiently. The rate of return will go down and the
investment may become risky.
36
Let us discuss with the following table:
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• Trying to curb the late trading practices.
• Introduction of Financial Planners who can provide need based
advice.
Changed Environment:
While the spread and penetration of mutual funds has been relatively
low in the past, things are changing at a rapid pace now.
One of the important drivers of this change has been the change in
demographic profile of the country where greater sophistication has meant
some shift away from a saving culture to an investment culture.
To serve this changing trend, the financial distribution and the financial
advisory infrastructure has been evolving at a rapid pace. The recently
witnessed uptrend in the equities market and the consequent value creation
for investors in equity. Mutual funds have also led to an improvements in
sentiments towards these products .
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The popularity of mutual funds is fast growing in India. The number of
such funds is increasing and are getting popular support from the investing
class. Investors prefer to give their savings to mutual funds for the safety of
their funds and also for securing the benefits of diversified investment.
These funds take appropriate investment to the investors.
Mutual funds are also popular as they have introduced various open-
ended schemes in order to offer convenience to all categories of investors.
The professional management of mutual funds is also one important reason
of their popularity. Small investors do not have substantial amount to invest,
sufficient time to study various avenues available for investment and finally
necessary knowledge, experience and skills to find out the most secured
and profitable avenue for investment. However, these problems can be
solved by investing money in mutual funds. The mutual funds relieve the
investors from the entire botheration about secured and profitable
investment and also offer the benefits of secured and diversified investment
to the investors. In this sense, mutual fund acts as a boon to investors in
general and small investors in particular.
Merchant Banking
Introduction:
In banking, a merchant bank is a financial institution primarily engaged
in international finance and long-term loans for multinational corporations
and governments. It can also be used to describe the private equity
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activities of banking. This article is about the history of banking as
developed by merchants, from the Middle Ages onwards.
History:
Merchant banks, now so called, are in fact the original "banks". These
were invented in the Middle Ages by Italian grain merchants. As the
Lombardy merchants and bankers grew in stature based on the strength of
the Lombard plains cereal crops, many displaced Jews fleeing Spanish
persecution were attracted to the trade. They brought with them ancient
practices from the middle and far east silk routes. Originally intended for the
finance of long trading journeys, these methods were now utilized to finance
the production of grain.
The Jews could not hold land in Italy, so they entered the great trading
piazzas and halls of Lombardy, alongside the local traders, and set up their
benches to trade in crops. They had one great advantage over the locals.
Christians were strictly forbidden the sin of usury. The Jewish newcomers,
on the other hand, could lend to farmers against crops in the field, a high-
risk loan at what would have been considered usurious rates by the Church,
but did not bind the Jews. In this way they could secure the grain sale rights
against the eventual harvest. They then began to advance against the
delivery of grain shipped to distant ports. In both cases they made their
profit from the present discount against the future price. This two-handed
trade was time consuming and soon there arose a class of merchants, who
were trading grain debt instead of grain.
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season). He would underwrite (insure) the delivery of the crop (through crop
or commodity insurance) to the merchant wholesaler who was the ultimate
purchaser of the farmer’s harvest. And he would make arrangements to
supply this buyer through alternative sources (the merchant function) of
supply (such as grain stores or alternate producer markets), should any
particular farming district suffer a seasonal crop failure. He could also keep
the farmer (or other commodity producer) in business during a drought or
other crop failure, through the issuance of a crop (or commodity) insurance
against the hazard of failure of his crop.
It was a short step from financing trade on their own behalf to settling trades
for others, and then to holding deposits for settlement of "billete" or notes
written by the people who were still brokering the actual grain. And so the
merchant's "benches" (bank is a corruption of the Italian for bench, as in a
counter) in the great grain markets became centers for holding money
against a bill (billette, a note, a letter of formal exchange, later a bill of
exchange, later still, a cheque).
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overcoming the usury objection. Once again this merely developed what
was an ancient method of financing long distance transport of goods.
The medieval Italian markets were disrupted by wars and in any case
were limited by the fractured nature of the Italian states. And so the next
generation of bankers arose from migrant Jewish merchants in the great
wheat growing areas of Germany and Poland. Many of these merchants
were from the same families who had been part of the development of the
banking process in Italy. They also had links with family members who had,
centuries before, fled Spain for both Italy and England.
This course of events set the stage for the rise of banking names
which still resonate today: Schroders, Warburgs, Rothschilds, even the ill-
fated Barings, were all the product of the continental grain trade, and
indirectly, the early Iberian persecution of Jews. It may be defined as, “ an
institution which covers a wide range of activities such as management of
customer services, portfolio management, credit syndication, acceptance
credit, counseling and insurance etc., The merchant banks are also known
as “ accepting and Issuing houses” in UK and as “Investment Banks” in US.
They offer a package of financial services for fee mostly in new issues
market.
Modern practices:
Today there are many different classes of merchant banks. One of the
most common forms is primarily utilized in the United States. This type
[3]
initiates loans and then sells them to investors. Even though these
companies call themselves "merchant banks," they have few, if any, of the
characteristics of former merchant banks.
Venture Capital
Introduction:
Venture capital (also known as VC or Venture) is a type of private
equity capital typically provided to immature, high-potential, growth
43
companies in the interest of generating a return through an eventual
realization event such as an IPO or trade sale of the company. Venture
capital investments are generally made as cash in exchange for shares in
the invested company.
History:
With few exceptions, private equity in the first half of the 20th century
was the domain of wealthy individuals and families. The Vanderbilts,
Whitneys, Rockefellers and Warburgs were notable investors in private
companies in the first half of the century. In 1938, Laurance S. Rockefeller
44
helped finance the creation of both Eastern Air Lines and Douglas Aircraft
and the Rockefeller family had vast holdings in a variety of companies. Eric
M. Warburg founded E.M. Warburg & Co. in 1938, which would ultimately
become Warburg Pincus, with investments in both leveraged buyouts and
venture capital.
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well. ARDC is credited with the first major venture capital success story
when its 1957 investment of $70,000 in Digital Equipment Corporation
(DEC) would be valued at over $355 million after the company's initial public
offering in 1968 (representing a return of over 500 times on its investment
and an annualized rate of return of 101%). Former employees of ARDC
went on to found several prominent venture capital firms including Greylock
Partners (founded in 1965 by Charlie Waite and Bill Elfers) and Morgan,
Holland Ventures, the predecessor of Flagship Ventures (founded in 1982
by James Morgan). ARDC continued investing until 1971 with the retirement
of Doriot. In 1972, Doriot merged ARDC with Textron after having invested
in over 150 companies.
J.H. Whitney & Company was founded by John Hay Whitney and his
partner Benno Schmidt. Whitney had been investing since the 1930s,
founding Pioneer Pictures in 1933 and acquiring a 15% interest in
Technicolor Corporation with his cousin Cornelius Vanderbilt Whitney. By
far Whitney's most famous investment was in Florida Foods Corporation.
The company developed an innovative method for delivering nutrition to
American soldiers, which later came to be known as Minute Maid orange
juice and was sold to The Coca-Cola Company in 1960. J.H. Whitney &
Company continues to make investments in leveraged buyout transactions
and raised $750 million for its sixth institutional private equity fund in 2005.
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Sand Hill Road in Menlo Park, California, where many Bay Area
venture capital firms are based
During the 1960s and 1970s, venture capital firms focused their
investment activity primarily on starting and expanding companies. More
often than not, these companies were exploiting breakthroughs in electronic,
medical or data-processing technology. As a result, venture capital came to
be almost synonymous with technology finance.
It was also in the 1960s that the common form of private equity fund,
still in use today, emerged. Private equity firms organized limited
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partnerships to hold investments in which the investment professionals
served as general partner and the investors, who were passive limited
partners, put up the capital. The compensation structure, still in use today,
also emerged with limited partners paying an annual management fee of 1-
2% and a carried interest typically representing up to 20% of the profits of
the partnership.
It was not until 1978 that venture capital experienced its first major
fundraising year, as the industry raised approximately $750 million. With the
passage of the Employee Retirement Income Security Act (ERISA) in 1974,
corporate pension funds were prohibited from holding certain risky
investments including many investments in privately held companies. In
1978, the US Labor Department relaxed certain of the ERISA restrictions,
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under the "prudent man rule," thus allowing corporate pension funds to
invest in the asset class and providing a major source of capital available to
venture capitalists.
The public successes of the venture capital industry in the 1970s and
early 1980s (e.g., Digital Equipment Corporation, Apple, Genentech) gave
rise to a major proliferation of venture capital investment firms. From just a
few dozen firms at the start of the decade, there were over 650 firms by the
end of the 1980s, each searching for the next major "home run". While the
number of firms multiplied, the capital managed by these firms increased
only 11% from $28 billion to $31 billion over the course of the decade.
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The venture capital boom and the Internet Bubble
(1995 to 2000):
By the end of the 1980s, venture capital returns were relatively low,
particularly in comparison with their emerging leveraged buyout cousins,
due in part to the competition for hot startups, excess supply of IPOs and
the inexperience of many venture capital fund managers. Growth in the
venture capital industry remained limited through the 1980s and the first half
of the 1990s increasing from $3 billion in 1983 to just over $4 billion more
than a decade later in 1994.
The late 1990s were a boom time for the venture capital, as firms on
Sand Hill Road in Menlo Park and Silicon Valley benefited from a huge
surge of interest in the nascent Internet and other computer technologies.
Initial public offerings of stock for technology and other growth companies
were in abundance and venture firms were reaping large windfalls.
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The technology-heavy NASDAQ Composite index peaked at 5,048 in
March 2000, reflecting the high point of the dot-com bubble.
The Nasdaq crash and technology slump that started in March 2000
shook virtually the entire venture capital industry as valuations for startup
technology companies collapsed. Over the next two years, many venture
firms had been forced to write-off their large proportions of their investments
and many funds were significantly "under water" (the values of the fund's
investments were below the amount of capital invested). Venture capital
investors sought to reduce size of commitments they had made to venture
capital funds and in numerous instances, investors sought to unload existing
commitments for cents on the dollar in the secondary market. By mid-2003,
the venture capital industry had shriveled to about half its 2001 capacity.
Nevertheless, PricewaterhouseCoopers' MoneyTree Survey shows that total
venture capital investments held steady at 2003 levels through the second
quarter of 2005.
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Venture capital firms are typically structured as partnerships, the
general partners of which serve as the managers of the firm and will serve
as investment advisors to the venture capital funds raised. Venture capital
firms in the United States may also be structured as limited liability
companies, in which case the firm's managers are known as managing
members. Investors in venture capital funds are known as limited partners.
This constituency comprises both high net worth individuals and institutions
with large amounts of available capital, such as state and private pension
funds, university financial endowments, foundations, insurance companies,
and pooled investment vehicles, called fund of funds or mutual funds.
Although the titles are not entirely uniform from firm to firm, other
positions at venture capital firms include:
Most venture capital funds have a fixed life of 10 years, with the
possibility of a few years of extensions to allow for private companies still
seeking liquidity. The investing cycle for most funds is generally three to five
years, after which the focus is managing and making follow-on investments
in an existing portfolio. This model was pioneered by successful funds in
Silicon Valley through the 1980s to invest in technological trends broadly but
only during their period of ascendance, and to cut exposure to management
and marketing risks of any individual firm or its product.
In such a fund, the investors have a fixed commitment to the fund that
is initially unfunded and subsequently "called down" by the venture capital
fund over time as the fund makes its investments. There are substantial
penalties for a Limited Partner (or investor) that fails to participate in a
capital call.
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Compensation:
Because a fund may run out of capital prior to the end of its life, larger
venture capital firms usually have several overlapping funds at the same
time; this lets the larger firm keep specialists in all stages of the
development of firms almost constantly engaged. Smaller firms tend to
thrive or fail with their initial industry contacts; by the time the fund cashes
out, an entirely-new generation of technologies and people is ascending,
whom the general partners may not know well, and so it is prudent to
reassess and shift industries or personnel rather than attempt to simply
invest more in the industry or people the partners already know.
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Venture capitalists are typically very selective in deciding what to
invest in; as a rule of thumb, a fund may invest in one in four hundred
opportunities presented to it. Funds are most interested in ventures with
exceptionally high growth potential, as only such opportunities are likely
capable of providing the financial returns and successful exit event within
the required timeframe (typically 3-7 years) that venture capitalists expect.
• Idea generation;
• Start-up;
• Ramp up; and
• Exit
There are typically six stages of financing offered in Venture Capital, that
roughly correspond to these stages of a company’s development.
Seed Money: Low level financing needed to prove a new idea (Often
provided by "angel investors")
• Start-up: Early stage firms that need funding for expenses associated
with marketing and product development
• First-Round: Early sales and manufacturing funds
• Second-Round: Working capital for early stage companies that are
selling product, but not yet turning a profit
• Third-Round: Also called Mezzanine financing, this is expansion
money for a newly profitable company
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• Fourth-Round: Also called bridge financing, 4th round is intended to
finance the going public process
This need for high returns makes venture funding an expensive capital
source for companies, and most suitable for businesses having large up-
front capital requirements which cannot be financed by cheaper alternatives
such as debt. That is most commonly the case for intangible assets such as
software, and other intellectual property, whose value is unproven. In turn
this explains why venture capital is most prevalent in the fast-growing
technology and life sciences or biotechnology fields.
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Because of the strict requirements venture capitalists have for
potential investments, many entrepreneurs seek initial funding from angel
investors, who may be more willing to invest in highly speculative
opportunities, or may have a prior relationship with the entrepreneur.
There has been some debate since the dot com boom that a "funding
gap" has developed between the friends and family investments typically in
the $0 to $250,000 range and the amounts that most Venture Capital Funds
prefer to invest between $1 to $2M. This funding gap may be accentuated
by the fact that some successful Venture Capital funds have been drawn to
raise ever-larger funds, requiring them to search for correspondingly larger
investment opportunities. This 'gap' is often filled by angel investors as well
as equity investment companies who specialize in investments in startups
from the range of $250,000 to $1M. The National Venture Capital
association estimates that the latter now invest more than $30 billion a year
in the USA in contrast to the $20 billion a year invested by organized
Venture Capital funds.
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extractive industries such as mining, or manufacturing industries. Offshore
funding is provided via specialist venture capital trusts which seek to utilize
securitization in structuring hybrid multi market transactions via an SPV
(special purpose vehicle): a corporate entity that is designed solely for the
purpose of the financing.
Geographical differences:
United States:
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Venture capitalists invested some $6.6 billion in 797 deals in U.S.
during the third quarter of 2006, according to the MoneyTree Report by
PricewaterhouseCoopers and the National Venture Capital Association
based on data by Thomson Financial.
Canada:
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Generally, these Retail Venture Capital funds only invest in companies
where the majority of employees are in Canada. However, innovative
structures have been developed to permit LSVCCs to direct in Canadian
subsidiaries of corporations incorporated in jurisdictions outside of Canada.
Europe:
India:
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China:
Vietnam:
Confidential information:
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Limited partners of venture capital firms typically have access only to
limited amounts of information with respect to the individual portfolio
companies in which they are invested and are typically bound by
confidentiality provisions in the fund's limited partnership agreement.
Popular culture:
Robert von Goeben and Kathryn Siegler produced a comic strip called
The VC between the years 1997-2000 that parodied the industry, often by
showing humorous exchanges between venture capitalists and
entrepreneurs. Von Goeben was a partner in Redleaf Venture Management
when he began writing the strip.
Conclusion
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The world landscape is changing fast and a growing and India is at the
center of that new world and expects India to take a leading role in world
economic affairs in the coming years. India’s human and natural resources,
language and IT skills, and geographical positions- as well as its
entrepreneurial base, grounded in the world’s largest democracy- make it
well suited for further growth, especially in the Asia Pacific region.
Internationalization brings commercial and financial success and India will
benefit from using international firms to further raise its access to global
market place.
Bibliography
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• Text book of financial services
• Book published by Himalayan publication on financial services in
India
• Introduction to venture capital and private Equity Finance
(Encyclopedia)
• Merchant Banking: Past and Present (Encyclopedia)
• Sources of information investment (Encyclopedia)
• www.finance.com
• www.sec.gov.com
• www.wikipedia.com
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