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FINANCIAL SERVICES

INTRODUCTION

The increasing role of private sector, market oriented economy,


liberalization globalization, competition and efficiency have become the
important elements in economic activity of the nation. The main objective of
management is to increase the efficiency, productivity and lowest costs and
enhancing profits. Hence the business concern is in the area of services.
The quality and costs effectiveness will count as pre-requisite for its
success. The quality of service depends upon the technology. The analysis
of any firm involves the technological relationship between input and
outputs. The management of a firm is to see that this relation of inputs and
outputs is most up to date modern and cost effective. In Service sector,
efficiency and competition are the landmarks of success, management ahs
a role to judge. The result, which will be based on cost of service quality
and profits.

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.

Financial deregulation, freeing of interest rates on bank’s lending rates


and their practices have helped the growth of financial services. The private
sector was permitted to set up mutual funds, banks and financial institutions.
Move recently some developments took place to expand the scope of
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financial services such as inviting FIIS to invest in our country and dilution of
FEMA. The following statement reveals the importance of financial services
in our economy.

SHARE OF GROSS CAPITAL FORMATION IN GDP (%)


Competition of GDP 93-94 94-95 95-96 96-97 97-98 98-99 99-2000
Agricultural, 1.79 1.71 1.64 1.76 1.55 1.61 1.56
Forestry and
Fisheries
Industry 10.66 12.00 16.02 14.29 12.89 11.80 10.55
Services 8.83 9.72 8.76 8.25 7.72 7.02 7.49

SHARE OF AGGREGATE NET CAPITAL STOCK (%)


Competition of GDP 93-94 94-95 95-96 96-97 97-98 98-99 99-2000
Agricultural, 15.29 14.61 13.72 13.71 13.81 13.64 13.53
Forestry and
Fisheries
Industry 38.10 39.08 40.38 41.19 41.63 41.80 41.81
Services 46.61 46.31 45.90 45.10 44.56 44.56 44.44

Sources: Economic Times, 26-12.2001, p.10

A well regulated modern financial sector is essential in a globalize


economy. Financial innovation contributed to the development. Market
based economies have in general done better, because of the constant
identification and improved satisfaction of co summer needs, including need
of financial products.

Rapid technological change creates new possibilities that make it


difficult for regulators to keep up. The complexity of modern system is such
that controls must give way to self regulation and revelation of information.
Innovation ways have been developed to get information from markets.

A financial service is one of the elements in Indian financial system. It


is an important component of the financial system. It fulfils the needs of
financial institution, financial markets and instruments to serve the individual

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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.

Financial services must be consumer friendly. They should provide


according to the client needs and convenience. The provider of such
services should study the requirement of the customer in detail to suggest
different financial strategies which reduce the cost and stimulates the
profitability of the company. The providers of such services remain in
constant touch with the market. They offer new variety of products much
ahead of need and impending legislation. They design innovative and
universal specific projects. These services are highly skilful and they
require more talent. At the present day, business concern happen to be
different in terms of size, levels of productions profitability and labour forces.

The basic function of business is to earn the reasonable return on


their investment by producing goods and selling goods. The financial
services have to be performed accordingly. Hence it needs a perfect
understanding between the service providers and their clients.

Financial service is an innovative activity and requires dynamism. It


has to be constantly redefined and refined on the basis of economic
changes. The economic changes will depend on so many factors such as
disposable Income, standard of living and educational changes. These
institutions while designing new service must visualize in advance about the
requirements of markets and wants to customers.

EVOLUTION OF FINANCIAL SERVICES IN INDIA


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Financial service is one of the components of the Indian financial
system. It is in the process of attaining full bloom. The financial services at
present reached through a number of stages mentioned below: -
(A) Initial Stage (1960-80)
(B) Second Stage (1980-90)
(C) Third Stage (1990-2002)

(A) Initial Stage: Financial services at the initial stage existed


between 1960 and 1980. In this period it introduced many innovative
services such as Merchant banking, Insurance and leasing companies,
merchant banking was unknown till 1960. The term merchant banking was
used as an umbrella function. It provides a wide range of service. Its
activities start from project appraisal to arranging funds from the fund
suppliers. They provide service like project identifications, preparation of
flexibility reports, prepares detailed project reports. It also made marketing
financial, managerial and technical analyses. They also underwrote the
public issues and helped in getting listed in the stock exchanges.
Investment companies made their contribution in the initial stage of financial
service. The UTI, LIC and GIC initiated to enter into this segment during
their period. Leasing activities entered in the year of 1970. Initially leasing
companies were engaged in equipment lease financing. Afterwards they
have undertaken different kinds of leasing such as financial lease, operating
lease and wet leasing. The No. of leasing concerns has been shot up
during this period. The Initial stage of financial services was crucial period
for Indian financial system.

(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.

Financial Services and Problems


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The financial services industry faces a tough competition from its
global counter parts. The sector has to increase skills, to integrate itself
with the rest of the world. The financial services industry faces a lot of
problems constraining growth of the financial services as presented below:

(A) Lack of Skilled Personnel.


(B) Quality of service.
(C) Core competence.
(D) Fee and Fund based business.
(E) Technology.

(A) Lack of Skilled Personnel: The Indian financial services face a


lot of problems. The financial service is involved with skill and talent. It is
not like any other service. The availability of suitable personnel is the main
constraint faced by the Indian financial system. It requires the right types of
people at right place in corporate sector. The present financial service
industry does not provide much salary where the foreign financial firms
offer. The public sector financial services industry is constraint by a number
of restrictions imposed on salaries. Therefore, India is facing a manpower
problem in finance area. But some of the organizations are making efforts
to train the people in finance area specifically. We cannot ignore the efforts
made by the Hyderabad based Institute for certified Financial Analyst,
Indian Institute to Finance, New-Delhi, Institute for Financial Management
Research, Chennai, National Institute of Financial Management Faridabad.
All these institutions are conducting training programmes for Finance
professionals. They conduct regular post graduate level courses in Finance
area. Therefore, in future India does not face the availability of man power
problem. There is a strong need to develop the Finance discipline in
Academic side.

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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.

(C) Core Competence: Financial service is a dynamic activity and it


must be provided by the providers with a great care and in depth analysis of
the problems faced by the clients. They are ready to provide any service in
the finance area. The providers can render the services to the needs of
client companies. Some financial firms have often got involved in under
trade practices through giving unethical advice. The services must be in the
form of cast control, cost reduction and review of process and procedure
through activities.

(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.

(E) Technology: In the digital age the technology plays an important


role in all aspects of the human life. Technology reduces the cost of
production and stimulates the quality of the products. Lack of proper
availability of technology has constrained the growth of the financial
services industry in India or ex: The dealing of cheques in banks is still not
developed. They physical presence is required for every transaction. They
time taken to deliver the services is too long for all the transactions. The
banks are now introducing ATMs to reduce the operating expenses and
stimulating the profits.

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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

(A) Internal Risk

Internal risk means, if the finance company fails to receive the


financial claim from the clients. It is also associated with changes in the
interest rates in the market that reduces the value of existing financial
claims. Therefore the internal risk may be described as failure of Accounts
receivables by the finance company. Usually the financial companies may
disburse the loans to different parties as a routine business activity, but they
involve in high risk that affect the company as a whole. They often fail due
to their own mistakes. There are several internal factors which contribute to

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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.

(B) External Risk

External risk arises due to certain developments that take place


outside the purview of the financial service company. The external sources
of risk also vary for different services. The following are the external
sources of risk applicable to various services:
(A) Direct financing Institutions.
(B) Fee based service companies.
(C) Leasing and Hire purchase companies.
(D) Insurance companies.
(E) Stock broking service.

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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.

(A) Structural Regulations: Financial service companies provide fee


and fund based services to the clients. The regulations are meant for
proper working environment by the companies. They control the activities,
monitor and review the affairs of concerned. They impose strict rules and
regulations to move in a right direction. The objective of these regulations is
to be provided and protect safety to the innocent investors. The regulation
demarks the lines between activities of financial institutions. The security
and exchange Board of India (SEBI) insists that the merchant bankers and

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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.

(B) Prudential Norms: The development of an economy depends


upon the efficient financial system. The efficiency of the financial system
depends upon the strict rules and regulations imposed by the regulatory
bodies. The objective of the prudential norm is to restrict the firms without
adequate resources entering into a particular field. These norms could be
framed for the smooth functioning of the industry.

(C) Investor’s protection Regulations: The main objective of all the


regulatory agencies in the financial sector is to protect the interest of the
investors. The innocent investor will be duped by inefficient financial
companies. In India the investors are mostly cheated by the finance
companies. CRB capital, pennar Paterson, and other finance companies
duped the investors. Crores of rupees are deposited by middle class
families, low income group levels but their dreams are burnt by the
financial parasites. Therefore the investors are the weakest participants of
the financial markets, and need a strong protection from malpractice, fraud
and scams. The regulatory agencies should step in to protect the interest of
the investors. These regulations need larger disclosure of information.

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.

Definition: The Securities and Exchange of Board of India


Regulations, 1993 defines a Mutual fund as “a fund established in the form
of a trust by a sponsor, to raise monies by the trustees through the sale of
units to the public, under one or more schemes, for investing in securities in
accordance with these regulations”.

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:

The origin of mutual fund industry in India is with the introduction of


the concept of mutual fund by UTI in the year 1963. Though the growth was
slow, but it accelerated from the year 1987 when non-UTI players entered
the industry.

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.

With renewed confidence in the stock market, mutual funds began to


blossom. By the end of the 1960s, there were approximately 270 funds with
$48 billion in assets. The first retail index fund, First Index Investment Trust,
was formed in 1976 and headed by John Bogle, who conceptualized many

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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.

Organisation of a Mutual Fund:


There are many entities involved and the diagram below illustrates the
organisational set up of a mutual fund:

The institution commonly referred to as ‘Mutual Funds’ is a company


called as ‘Asset Management Company’ (AMC). Its sole business is to
manage funds as mutual fund. AMC is controlled by Trustees. AMC is
promoted by and Trustees are appointed by the entity which starts Mutual
fund. This entity is referred to as ‘Sponsor’. For example, for Kotak
Mahindra Mutual Fund, the Sponsor is Kotak Mahindra Finance Limited; the

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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)

ASSOCIATION OF MUTUAL FUNDS IN INDIA:

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.

AMFI is an apex body of all Asset Management Companies (AMC)


which has been registered with SEBI. Till date all the AMCs are that have
launched mutual fund schemes are its members. It functions under the
supervision and guidelines of its Board of Directors.

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.

The objectives of Association of Mutual Funds in India:

The Association of Mutual Funds of India works with 30 registered


AMCs of the country. It has certain defined objectives which juxtaposes the
guidelines of its Board of Directors. The objectives are as follows:

• This mutual fund association of India maintains high professional and


ethical standards in all areas of operation of the industry.

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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.

• AMFI interacts with SEBI and works according to SEBIs guidelines in


the mutual fund industry.

• Association of Mutual Fund of India does represent the Government of


India, the Reserve Bank of India and other related bodies on matters
relating to the Mutual Fund Industry.

• It develops a team of well qualified and trained Agent distributors. It


implements a programme of training and certification for all
intermediaries and other engaged in the mutual fund industry.

• AMFI undertakes all India awareness programme for investors in


order to promote proper understanding of the concept and working of
mutual funds.

• 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.

The sponsorers of Association of Mutual Funds in India:

Bank Sponsored

• SBI Fund Management Ltd.


• BOB Asset Management Co. Ltd.
• Canbank Investment Management Services Ltd.
• UTI Asset Management Company Pvt. Ltd.

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Institutions

• GIC Asset Management Co. Ltd.


• Jeevan Bima Sahayog Asset Management Co. Ltd.

Private Sector

• Bench Mark Asset Management Co. Pvt. Ltd.


• Cholamandalam Asset Management Co. Ltd.
• Credit Capital Asset Management Co. Ltd.
• Escorts Asset Management Ltd.
• JM Financial Mutual Fund
• Kotak Mahindra Asset Management Co. Ltd.
• Reliance Capital Asset Management Ltd.
• Sahara Asset Management Co. Pvt. Ltd
• Sundaram Asset Management Company Ltd.
• Tata Asset Management Private Ltd.

AMFI publices mainly two types of bulletin. One is on the monthly basis
and the other is quarterly.

Net asset value:

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:

Since the Investment Company Act of 1940, a mutual fund is one of


three basic types of investment companies available in the United States.

Mutual funds can invest in many kinds of securities. The most


common are cash instruments, stock, and bonds, but there are hundreds of
sub-categories. Stock funds, for instance, can invest primarily in the shares
of a particular industry, such as technology or utilities. These are known as
sector funds. Bond funds can vary according to risk (e.g., high-yield junk
bonds or investment-grade corporate bonds), type of issuers (e.g.,
government agencies, corporations, or municipalities), or maturity of the
bonds (short- or long-term). Both stock and bond funds can invest in
primarily U.S. securities (domestic funds), both U.S. and foreign securities
(global funds), or primarily foreign securities (international funds).

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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.

Mutual funds are subject to a special set of regulatory, accounting,


and tax rules. In the U.S., unlike most other types of business entities, they
are not taxed on their income as long as they distribute 90% of it to their
shareholders and the funds meet certain diversification requirements in the
Internal Revenue Code. Also, the type of income they earn is often
unchanged as it passes through to the shareholders. Mutual fund
distributions of tax-free municipal bond income are tax-free to the
shareholder. Taxable distributions can be either ordinary income or capital
gains, depending on how the fund earned those distributions. Net losses are
not distributed or passed through to fund investors.

Turnover:

Turnover is a measure of the fund's securities transactions, usually


calculated over a year's time, and usually expressed as a percentage of net
asset value.
This value is usually calculated as the value of all transactions
(buying, selling) divided by 2 divided by the fund's total holdings; i.e., the
fund counts one security sold and another one bought as one "turnover".
Thus turnover measures the replacement of holdings.

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

Mutual fund scheme can broadly be classified into many times as


given below:

On the basis of execution and operation:

(A) Close-ended funds:

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.

Features of Close-Ended Funds:

26
• 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.

(B) Open-ended Funds:

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-

27
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.

Feature of Open-Ended Fund:

• The main objective of this fund is income generation. The investors


get dividend, rights or bonuses as rewards for their investment.
• The fund manager has to be very careful in managing the
investments because he has to meet the redemption demands at
any time made during the life of the scheme.
• There is complete flexibility with regard to one’s investments or
disinvestment. In other words there is free entry and exit of
investors in an open-ended fund. There is no time limit.
• Since the units are not listed on the stock market, their prices are
linked to the Net Asset Value (NAV) of the units. The NAV is
determined by the fund it varies from time to time.
• These units are not publicly traded but, the fund is ready to re-
purchase and re-sell at any time.
• The investor is offer instant liquidity in the sense that the unit can
be sold on any working day to the fund. In fact, the fund operator
just like a bank-account wherein one can get cash across the
counter for any number of units sold.
• Generally, the listed prices are close to their Net Asset Value. The
fund fixes a different price for their purchases and sell.

On the Basis of Yield and Investment Patter:

28
(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.

(B) Pure Growth Fund (Growth Oriented Fund):

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.

(C) Balanced funds:

This is otherwise called “income-cum-growth” fund. It is nothing but a


combination of both income and growth funds. It aims at distributing regular
income as well as capital appreciation. This is achieved by balancing the
investment between the high growth equity shares and also the fixed
income earning securities.

(D) Specialised Funds:

Besides the above, a large of specialized funds are in existence


abroad. They offer special schemes so as to meet the specific needs of
specific categories of people like pensioners, widows, etc. There are also
funds for investments in security of specified area. For instance Japan
Fund, South Korea Fund, etc.

Again, certain funds may be confined to one particular sector or


industry like fertilizer, auto mobiles, petroleum, etc. These funds carry
heavy risks since the entire investment is in one industry. But, there are
29
higher risk taking investors who prefers this type of fund, of course, in such
cases, the rewards may commensurate with the risk taken. The best
example of this type Petroleum Industry Funds in USA.

(E) Money Market Mutual Funds (MMMFs):

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.

(F) Taxation Funds:


A taxation fund is basically a growth-oriented fund. But, it offers tax
rebates to he investors either in the domestic or foreign capital market. It is
suitable to salaries people who want to enjoy tax rebates particularly during
the month of February and March. In India, at present the law relating to tax
rebates in covered under Sec. 88 of the Income Tax Act, 1961. An investor
is entitled to get 20% rebates in Income Tax for investments make under
this fund subject a maximum of Rs.10,000/- per annum. The tax saving
Magnum of SBI

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:

(A) Leveraged Funds:

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.

(B) Index Funds:

Index fund refers to those funds where the portfolio is designed in


such a way that they reflect the composition of some broad based market
index.

(C) Off Shore Mutual Funds:

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.

(D) Dual Funds:

31
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.

(E) Bond Funds:

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.

(F) Aggressive Ground Funds:

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.

Importance/Advantages of Mutual Funds:


• Offering wide portfolio investment: Small and medium investors
used to burn their fingers in stock exchange operations with a
relatively modest outlay. If they invest a select few shares, some
may even sink without a trace never to rise again. Now, these
investors can enjoy the wide portfolio of the investment held by the
mutual fund.

• Offering tax benefits: Certain funds offer tax benefits to its


costumers. Thus, apart from dividend, interest and capital
appreciation, investors also stands to get the text benefits

32
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/-.

• Supporting Capital Market: Mutual fund plays a vital role in


supporting the development of capital market. The mutual funds
make the capital market active by the means of providing a
sustainable domestic source of demand for capital market
instruments. In other words, a saving of the people are directed
towards investments in capital market through these mutual funds.

• Channelising savings for investment: Mutual funds act as


a vehicle in galvanizing the savings of the people by offering
various schemes suitable to the various classes of customers for
the development of the economy as a whole. A number of scheme
are being offered by mutual fund so as to meet the varied
requirements of the masses, and thus, savings are directed
towards capital investment directly.

• Providing better yields: The pooling of funds from a large


number of customers enables the funds to have large funds at its
disposal. Due to these large funds, mutual funds are able to buy
cheaper and sell dearer than the small land medium investors.
Thus, they are able to command better market rates and lower
rates of brokerage. So as they provide better yield to their
costumers. They also enjoy the economies of large scale and
reduce the cost of capital market participation.

33
• 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.

• Rendering expertise investment services a low cost:


The management of the fund is generally assigned to professional
who are well trained and have adequate experience in the field of
investment. The investment decision of these professional are
always backed by informed judgement and experienced. Thus,
investors are assured of quality services in their best interest.

• Providing research services: A mutual fund is able to


command vast resources and hence it is possible for it to have in
depth study and carry out research on corporate securities. Each
fund maintains a large research team which constantly analysis the
companies and the industries, recommends the fund to buy or sell
a particulars share.

• Introducing flexible investment schedule: Some mutual


funds have permitted the investors to exchange their units from one
scheme to another and this flexibility is a great boom to investors.
Income units can be changed from growth units depending upon
the performance of the funds.

• Reducing the marketing cost of new issues: Moreover


the mutual funds help to reduce the marketing cost of the new
issues. The promoters used to allot a major share of the Initial

34
Public Offering to the mutual funds and thus they are saved from
the marketing cost of such issues.

• Simplified record keeping: An investor with just an


investment in 500 shares or so in 3 or 4 companies has to keep
proper records of dividend payments, bonus issues, price
movements, purchase or sale instruction, brokerage and other
related items. It is very tedious and consumes a lot of time. One
may even forget to record the rights issue and may have to forfeit
the same. Thus, record keeping is the biggest problem for small
and medium investors.

• Acting as substitute for initial public offerings (IPO’s):


In most cases investors are not able to get allotment in IPO’s of
companies because they are often oversubscribed many times.
Moreover, they have to apply for a minimum of 500 shares which is
very difficult particularly for small investors. But, in mutual funds,
allotment is more or less guaranteed.

• Keeping the money market active: An individual investor


cannot have any access to money market instruments since the
minimum amount of investment is out of his reach. On the other
hand, mutual funds keep the money market instruments active by
investing money on the money market.

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.

35
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.

• The investors have no direct control on their investment as the


investment policies are decided by the trustees.
• Investors of mutual fund are not given adequate information about
the functioning of their mutual fund. They get the information about
irregularities, etc. when it is too late to introduce remedial
measures.
• The future of mutual fund investor is linked with the future of mutual
fund. An investor may suffer because of mismanagement of the
mutual fund.
• The expectations of investors are fast growing in the case of mutual
funds but the managers of mutual funds find it hard to meet such
high expectations of investors.

FUTURE OF MUTUAL FUNDS IN INDIA:


By December 2004, Indian mutual fund industry reached Rs 1,50,537
crore. It is estimated that by 2010 March-end, the total assets of all
scheduled commercial banks should be Rs 40,90,000 crore.

The annual composite rate of growth is expected 13.4% during the


rest of the decade. In the last 5 years we have seen annual growth rate of
9%. According to the current growth rate, by year 2010, mutual fund assets
will be double.

36
Let us discuss with the following table:

Aggregate deposits of Scheduled Com Banks in India (Rs. Crore)


Month/Year Mar-98 Mar-00 Mar-01 Mar-02 Mar-03 Mar-04 Sep-04 4-Dec
Deposits 605410 851593 989141 1131188 1280853 - 1567251 1622579
Change in
% over last 15 14 13 12 - 18 3
year

Mutual Fund AUM’s Growth


Month/Year Mar-98 Mar-00 Mar-01 Mar-02 Mar-03 Mar-04 Sep-04 4-Dec
MF AUM's 68984 93717 83131 94017 75306 137626 151141 149300
Change in
% over last 26 13 12 25 45 9 1
year

Some facts for the growth of mutual funds in India

• 100% growth in the last 6 years. US based, with over US$1trillion


assets under management worldwide.
• Our saving rate is over 23%, highest in the world. Only
channelizing these savings in mutual funds sector is required.
• We have approximately 29 mutual funds which is much less than
US having more than 800. There is a big scope for expansion.
• 'B' and 'C' class cities are growing rapidly. Today most of the
mutual funds are concentrating on the 'A' class cities. Soon they
will find scope in the growing cities.
• Mutual fund can penetrate rural like the Indian insurance industry
with simple and limited products.
• SEBI allowing the MF's to launch commodity mutual funds.
• Emphasis on better corporate governance.

37
• 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.

This shift in turn is being aided by benefits including taxation benefits


given to the investors.

Decline in the yield on alternative investment instruments such as


bonds and government sponsored savings products and the overall decline
in interest rates have also aided the focus on ownership of assets.

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 .

Mutual funds have also attempted to innovate and position products


appropriate to investors needs and requirements. Over the past five years
the basket of products available to investors has increased significantly.

Growing Popularity of Mutual Funds:

38
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

39
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.

The Jewish trader performed both finance (credit) and an underwriting


(insurance) functions. He would derive an income from lending the farmer
money to develop and manufacture (through seeding, growing, weeding and
harvesting) his annual crop (the crop loan at the beginning of the growing

40
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.

Thus in his underlying financial function the merchant banker (trader)


would ensure the continuous smooth flowing of the commodity (crop, wool,
salt; salt-cod, etc.) markets by providing both credit and insurance.

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).

These deposited funds were intended to be held for the settlement of


grain trades, but often were used for the bench's own trades in the
meantime. The term bankrupt is a corruption of the Italian banca rotta, or
broken bench, which is what happened when someone lost his traders'
deposits. Being "broke" has the same connotation.

A sensible manner of discounting interest to the depositors against what


could be earned by employing their money in the trade of the bench soon
developed; in short, selling an "interest" to them in a specific trade, thus

41
overcoming the usury objection. Once again this merely developed what
was an ancient method of financing long distance transport of goods.

Islamic banking has the same constraints against usury as Christianity.

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:

The definition of merchant banking has changed greatly since the


days of the Rothschilds. The great merchant banking families dealt in
everything from underwriting bonds to originating foreign loans. Bullion
trading and bond issuing were some of the specialties of the Rothschild
42
family. The modern merchant banks, however, tend to advise corporations
and wealthy individuals on how to use their money. The advice varies from
counsel on mergers and acquisitions to recommendation on the type of
credit needed. The job of generating loans and initiating other complex
financial transactions has been taken over by investment banks and private
equity firms.

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.

Venture capital typically comes from institutional investors and high


net worth individuals and is pooled together by dedicated investment firms.

A venture capitalist (also known as a VC) is a person or investment


firm that makes venture investments, and these venture capitalists are
expected to bring managerial and technical expertise as well as capital to
their investments. A venture capital fund refers to a pooled investment
vehicle (often an LP or LLC) that primarily invests the financial capital of
third-party investors in enterprises that are too risky for the standard capital
markets or bank loans.

Venture capital is most attractive for new companies with limited


operating history that are too small to raise capital in the public markets and
are too immature to secure a bank loan or complete a debt offering. In
exchange for the high risk that venture capitalists assume by investing in
smaller and less mature companies, venture capitalists usually get
significant control over company decisions, in addition to a significant
portion of the company's ownership (and consequently value).

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.

Origins of modern private equity:

Before World War II, venture capital investments (originally known as


"development capital") were primarily the domain of wealthy individuals and
families. It was not until after World War II that what is considered today to
be true private equity investments began to emerge marked by the founding
of the first two venture capital firms in 1946: American Research and
Development Corporation. (ARDC) and J.H. Whitney & Company.

A VAX-11/780 system created by Digital Equipment Corporation, the


first major venture capital success story

ARDC was founded by Georges Doriot, the "father of venture


capitalism" (former dean of Harvard Business School), with Ralph Flanders
and Karl Compton (former president of MIT), to encourage private sector
investments in businesses run by soldiers who were returning from World
War II. ARDC's significance was primarily that it was the first institutional
private equity investment firm that raised capital from sources other than
wealthy families although it had several notable investment successes as

45
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.

Early venture capital and the growth of Silicon Valley:

46
Sand Hill Road in Menlo Park, California, where many Bay Area
venture capital firms are based

One of the first steps toward a professionally-managed venture capital


industry was the passage of the Small Business Investment Act of 1958.
The 1958 Act officially allowed the U.S. Small Business Administration
(SBA) to license private "Small Business Investment Companies" (SBICs) to
help the financing and management of the small entrepreneurial businesses
in the United States.

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 is commonly noted that the first venture-backed startup is Fairchild


Semiconductor (which produced the first commercially practical integrated
circuit), funded in 1959 by what would later become Venrock Associates.
Venrock was founded in 1969 by Laurance S. Rockefeller, the fourth of
John D. Rockefeller's six children as a way to allow other Rockefeller
children to develop exposure to venture capital investments.

It was also in the 1960s that the common form of private equity fund,
still in use today, emerged. Private equity firms organized limited

47
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.

The growth of the venture capital industry was fueled by the


emergence of the independent investment firms on Sand Hill Road,
beginning with Kleiner, Perkins, Caufield & Byers and Sequoia Capital in
1972. Located, in Menlo Park, CA, Kleiner Perkins, Sequoia and later
venture capital firms would have access to the burgeoning technology
industries in the area. By the early 1970s, there were many semiconductor
companies based in the Santa Clara Valley as well as early computer firms
using their devices and programming and service companies. Throughout
the 1970s, a group of private equity firms, focused primarily on venture
capital investments, would be founded that would become the model for
later leveraged buyout and venture capital investment firms. In 1973, with
the number of new venture capital firms increasing, leading venture
capitalists formed the National Venture Capital Association (NVCA). The
NVCA was to serve as the industry trade group for the venture capital
industry. Venture capital firms suffered a temporary downturn in 1974, when
the stock market crashed and investors were naturally wary of this new kind
of investment fund.

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,

48
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.

Venture capital in the 1980s:

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.

The growth the industry was hampered by sharply declining returns


and certain venture firms began posting losses for the first time. In addition
to the increased competition among firms, several other factors impacted
returns. The market for initial public offerings cooled in the mid-1980s before
collapsing after the stock market crash in 1987 and foreign corporations,
particularly from Japan and Korea, flooded early stage companies with
capital.

In response to the changing conditions, corporations that had


sponsored in-house venture investment arms, including General Electric
and Paine Webber either sold off or closed these venture capital units.
Additionally, venture capital units within Chemical Bank and Continental
Illinois National Bank, among others, began shifting their focus from funding
early stage companies toward investments in more mature companies.
Even industry founders J.H. Whitney & Company and Warburg Pincus
began to transition toward leveraged buyouts and growth capital
investments.

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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.

After a shakeout of venture capital mangers, the more successful


firms retrenched, focusing increasingly on improving operations at their
portfolio companies rather than continuously making new investments.
Results would begin to turn very attractive, successful and would ultimately
generate the venture capital boom of the 1990s. Former Wharton Professor
Andrew Metrick refers to these first 15 years of the modern venture capital
industry beginning in 1980 as the "pre-boom period" in anticipation of the
boom that would begin in 1995 and last through the bursting of the Internet
bubble in 2000.

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.

The bursting of the Internet Bubble and the


private equity crash (2000 to 2003):

50
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.

Although the post-boom years represent just a small fraction of the


peak levels of venture investment reached in 2000, they still represent an
increase over the levels of investment from 1980 through 1995. As a
percentage of GDP, venture investment was 0.058% percent in 1994,
peaked at 1.087% (nearly 19x the 1994 level) in 2000 and ranged from
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0.164% to 0.182 % in 2003 and 2004. The revival of an Internet-driven
environment in 2004 through 2007 helped to revive the venture capital
environment. However, as a percentage of the overall private equity market,
venture capital has still not reached its mid-1990s level, let alone its peak in
2000.

However, venture capital funds, which were responsible for much of


the fundraising volume in 2000 (the height of the dot-com bubble), raised
only $25.1 billion in 2006, a 2% percent decline from 2005 and a significant
decline from its peak.

Venture capital firms and funds:

Diagram of the structure of a generic venture capital fund

Structure of Venture Capital firms:

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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.

Roles within venture capital firms:


Within the venture capital industry, the general partners and other
investment professionals of the venture capital firm are often referred to as
"venture capitalists" or "VCs". Typical career backgrounds vary, but broadly
speaking venture capitalists come from either an operational or a finance
background. Venture capitalists with an operational background tend to be
former founders or executives of companies similar to those which the
partnership finances or will have served as management consultants.
Venture capitalists with finance backgrounds tend to have investment
banking or other corporate finance experience.

Although the titles are not entirely uniform from firm to firm, other
positions at venture capital firms include:

• Venture partners - Venture partners are expected to source potential


investment opportunities ("bring in deals") and typically are
compensated only for those deals with which they are involved.
• Entrepreneur-in-residence (EIR) - EIRs are experts in a particular
domain and perform due diligence on potential deals. EIRs are
engaged by venture capital firms temporarily (six to 18 months) and
53
are expected to develop and pitch startup ideas to their host firm
(although neither party is bound to work with each other). Some EIR's
move on to executive positions within a portfolio company.
• Principal - This is a mid-level investment professional position, and
often considered a "partner-track" position. Principals will have been
promoted from a senior associate position or who have commensurate
experience in another field such as investment banking or
management consulting.
• Associate - This is typically the most junior apprentice position within a
venture capital firm. After a few successful years, an associate may
move up to the "senior associate" position and potentially principal
and beyond. Associates will often have worked for 1-2 years in
another field such as investment banking or management consulting.

Structure of the funds:

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.

54
Compensation:

Venture capitalists are compensated through a combination of


management fees and carried interest (often referred to as a "two and 20"
arrangement:

• Management fees – an annual payment made by the investors in the


fund to the fund's manager to pay for the private equity firm's
investment operations. In a typical venture capital fund, the general
partners receive an annual management fee equal to up to 2% of the
committed capital.
• Carried interest - a share of the profits of the fund (typically 20%), paid
to the private equity fund’s management company as a performance
incentive. The remaining 80% of the profits are paid to the fund's
investors Strong Limited Partner interest in top-tier venture firms has
led to a general trend toward terms more favorable to the venture
partnership, and certain groups are able to command carried interest
of 25-30% on their funds.

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.

Venture capital funding:

55
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.

Because investments are illiquid and require 3-7 years to harvest,


venture capitalists are expected to carry out detailed due diligence prior to
investment. Venture capitalists also are expected to nurture the companies
in which they invest, in order to increase the likelihood of reaching a IPO
stage when valuations are favourable. Venture capitalists typically assist at
four stages in the company's development:

• 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

Because there are no public exchanges listing their securities, private


companies meet venture capital firms and other private equity investors in
several ways, including warm referrals from the investors' trusted sources
and other business contacts; investor conferences and symposia; and
summits where companies pitch directly to investor groups in face-to-face
meetings, including a variant know as "Speed Venturing", which is akin to
speed-dating for capital, where the investor decides within 10 minutes
whether s/he wants a follow-up meeting. Mass High Tech, September 5,
2008

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.

If a company does have the qualities venture capitalists seek including


a solid business plan, a good management team, investment and passion
from the founders, a good potential to exit the investment before the end of
their funding cycle, and target minimum returns in excess of 40% per year, it
will find it easier to raise venture capital.

Main alternatives to venture capital:

57
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.

Furthermore, many venture capital firms will only seriously evaluate an


investment in a start-up otherwise unknown to them if the company can
prove at least some of its claims about the technology and/or market
potential for its product or services. To achieve this, or even just to avoid the
dilutive effects of receiving funding before such claims are proven, many
start-ups seek to self-finance until they reach a point where they can
credibly approach outside capital providers such as venture capitalists or
angel investors. This practice is called "bootstrapping".

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.

In industries where assets can be securitized effectively because they


reliably generate future revenue streams or have a good potential for resale
in case of foreclosure, businesses may more cheaply be able to raise debt
to finance their growth. Good examples would include asset-intensive

58
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.

In addition to traditional venture capital and angel networks, groups


have emerged which allow groups of small investors or entrepreneurs
themselves to compete in a privatized business plan competition where the
group itself serves as the investor through a democratic process.

Geographical differences:

Venture capital, as an industry, originated in the United States and


American firms have traditionally been the largest participants in venture
deals and the bulk of venture capital has been deployed in American
companies. However, increasingly, non-US venture investment is growing
and the number and size of non-US venture capitalists have been
expanding.

Venture capital has been used as a tool for economic development in


a variety of developing regions. In many of these regions, with less
developed financial sectors, venture capital plays a role in facilitating access
to finance for small and medium enterprises (SMEs), which in most cases
would not qualify for receiving bank loans.

United States:

59
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.

A recent National Venture Capital Association survey found that


majority (69%) of venture capitalists predict that venture investments in U.S.
will level between $20-29 billion in 2007.

Canada:

Canadian technology companies have attracted interest from the


global venture capital community as a result, in part, of generous tax
incentive through the Scientific Research and Experimental Development
(SR&ED) investment tax credit program. The basic incentive available to
any Canadian corporation performing R&D is a non-refundable tax credit
that is equal to 20% of "qualifying" R&D expenditures (labour, material, R&D
contracts, and R&D equipment). An enhanced 35% refundable tax credit of
available to certain (i.e. small) Canadian-controlled private corporations
(CCPCs). Because the CCPC rules require a minimum of 50% Canadian
ownership in the company performing R&D, foreign investors who would like
to benefit from the larger 35% tax credit must accept minority position in the
company - which might not be desirable. The SR&ED program does not
restrict the export of any technology or intellectual property that may have
been developed with the benefit of SR&ED tax incentives.

Canada also has a fairly unique form of venture capital generation in


its Labour Sponsored Venture Capital Corporations (LSVCC). These funds,
also known as Retail Venture Capital or Labour Sponsored Investment
Funds (LSIF), are generally sponsored by labor unions and offer tax breaks
from government to encourage retail investors to purchase the funds.

60
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:

Europe has a large and growing number of active venture firms.


Capital raised in the region in 2005, including buy-out funds, exceeded
€60mn, of which €12.6mn was specifically for venture investment. The
European Venture Capital Association includes a list of active firms and
other statistics. In 2006 the top three countries receiving the most venture
capital investments were the United Kingdom (515 minority stakes sold for
€1.78bn), France (195 deals worth €875m), and Germany (207 deals worth
€428m) according to data gathered by Library House.

European venture capital investment in the second quarter of 2007


rose 5% to 1.14 billion Euros from the first quarter. However, due to bigger
sized deals in early stage investments, the number of deals was down 20%
to 213. The second quarter venture capital investment results were
significant in terms of early-round investment, where as much as 600 million
Euros (about 42.8% of the total capital) were invested in 126 early round
deals (which comprised more than half of the total number of deals).

India:

The investment of capitalists in Indian industries in the first half of


2006 is $3 billion and is expected to reach $6.5 billion at the end of the year.
Most VC firms in India are either divisions or subsidiaries of Silicon Valley
funds. They are primarily centered in Bangalore and Mumbai. Some VCs
also operate from Delhi and other parts of the National Capital Region.

61
China:

In China, venture funding more than doubled from $420,000 in 2002 to


almost $1 million in 2003. For the first half of 2004, venture capital
investment rose 32% from 2003. By 2005, led by a wave of successful IPOs
on the NASDAQ and revised government regulations, China-dedicated
funds raised US$4 million in committed capital.

Vietnam:

In Vietnam, venture funding has been increasing rapidly as


Vietnamese overseas returnees and Vietnamese ex-managers of
multinational companies increasingly establish new companies with
ambitious growth plans. Firms such as Mekong Ventures, IDG Vietnam
Ventures and DFJ-VinaCapital have pioneered investments in seed-stage
and start-up stage companies in Vietnam. The $20 Million Challenge is
Vietnam's first business plan contest for local entrepreneurs.

Confidential information:

Unlike public companies, information regarding an entrepreneur's


business is typically confidential and proprietary. As part of the due
diligence process, most venture capitalists will require significant detail with
respect to a company's business plan. Entrepreneurs must remain vigilant
about sharing information with venture capitalists that are investors in their
competitors. Most venture capitalists treat information confidentially,
however, as a matter of business practice, do not typically enter into Non
Disclosure Agreements because of the potential liability issues those
agreements entail. Entrepreneurs are typically well-advised to protect truly
proprietary intellectual property.

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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.

Mark Coggins' 2002 novel Vulture Capital features a venture capitalist


protagonist who investigates the disappearance of the chief scientist in a
biotech firm in which he has invested. Coggins also worked in the industry
and was co-founder of a dot-com startup.

Drawing on his experience as reporter covering technology for the


New York Times, Matt Richtel produced the 2007 novel Hooked, in which
the actions of the main character's deceased girlfriend, a Silicon Valley
venture capitalist, play a key role in the plot.

Conclusion

63
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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