Merchant Banking

CHAPTER 1

To Study Consumer Behaviour on Merchant Banking With Respect To ICICI & Kotak

INTRODUCTION

The term Merchant Banking has its origin in the trading methods of countries in the late eighteenth
and early nineteenth century when trade-taking place was financed by bill of exchange drawn by
merchanting houses. At that time the merchants were merely financing their own activities. As
international trade grew and other lesser-
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known names wanted to import goods from abroad, the established merchants ‘lent their names’ to
the newcomers by agreeing to accept bills of exchange on their behalf. The acceptance houses would
charge a commission for this service and thus there grew up the business of accepting bills of finance
trade not merely of themselves, but of others. Acceptance business thus became and to a degree
always has been hallmark of true Merchant Banks.

The second historical of Merchant Banks was the raising of capital for foreign Government. In many
cases, the Merchant Banks have been trading in the countries concerned and gained the confidence
of Governments and other authorities in those countries. Thus the second principal ingredient of
Merchant Banking became and still is raising of capital through the issue of stocks and bonds.
Therefore, Merchant Banks can be accepting houses or issuing houses or both. Merchant Banking
started in the beginning of 20th century in UK and USA. More recently, the services offered by
Merchant Banks have entered into the other areas of operations. Their role is wide ranging and they
can now provide most of the financial services required by a company, touching almost all aspects of
establishing and running of industrial units on sound financial footing.

Dictionary meaning of ‘merchant bank’ refers to an organization that underwrites corporate

securities and advises such clients on issues like corporate mergers, etc. involved in the ownership of
commercial ventures. This organization may be a bank, corporate body, firm or proprietary concern.

HISTORY OF MERCHANT BANKING

During the seventeenth and most of the eighteenth century international finance was centered on
Amsterdam. Consequently Amsterdam merchants became the first masters of the various financial
techniques and developments which, in the course of time, became identified with the emergent
profession of ‘Merchant Bankers’. Merchant Banking InIndiaz`

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Commercial Banking and Investment Banking are often confused with Merchant Banking. In many
ways, there may be similarities in their functions. However, in certain ways, Merchant Banking is
distinctly different from commercial Banking and Investment Banking.

The primary function of a commercial bank is to receive deposits from the public and lend the same
to others. Commercial Banks can undertake some of the merchant banking activities like Issue
Management whereas Merchant Banking Units can not undertake commercial banking activities.
However, the functions of Merchant Banking may not widely vary from Investment Banking. The
Merchant Banker mainly deals with Issue Management, post issue services, corporate adviser
services etc. the Investment Banker undertaken trading in securities, Investment advises and Bought
out deals which are not the main activities of Merchant Bankers.

In today’s Scenario the Merchant banker and management consultants undertake advisory services
to the corporate sector. The Merchant Banker advices corporation and firms relating to opening of
issues, receiving loans etc, which the management consultants also do. The management consultant
have a wide area operations like production, Marketing, Personnel Relations, of finance etc. but they
lack statutory recognition to undertake capital market related activities which has enabled the
merchant banker to cater to the needs of the Corporate Sector.

A merchant bank may be considered as an institution which centres its operation on all or most of
the following activities.

(1) Corporate financial advice, on such diverse matters as new share and bond issues, capital
reconstructions, mergers and acquisitions;

(2) The taking of deposits and currency, money market operations including foreign exchange
dealing;

(3) Medium-term lending and syndication of loans;

(4) Acceptance credits and all forms of export finance;

(5) The holding and dealing in quoted and unquoted investment; and

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(6) Fund management on behalf of clients, most typically pension funds, unit trust, investment trusts
and wealthy individuals.

DEFINITION

The first authoritative definition for the term ‘Merchant Banker’ has been given in the Rule 2 (e) of
SEBI (Merchant Bankers) Rules, 1922. Accordingly, “A Merchant Banker means any person who is
engaged in the business of Issue Management either by making arrangements regarding selling,
buying or subscribing to Securities as Manager, Consultant, Adviser of rendering Corporate Advisory
Service in relation to such Issue Management”.

Sec/5 (b) of the Banking Regulation Act, 1949 defines Banking as “accepting, for the purpose of
lending or investment of deposits of money from the public, repayable on demand or otherwise and
withdraw able by cheque, draft, order or otherwise”.

The Notification of the Ministry of Finance defines a merchant banker as, “any person who is
engaged in the business of issue management either by making arrangements regarding selling,
buying or subscribing to the securities as manager, consult, adviser or rendering corporate advisory
service in relation to such issue management”.

Merchant bankers and market making

Many successful public issues get listed on the stock exchanges but later do not see any trade i.e
liquidity in the market. Listing remains a formality only and investors practically cannot buy/sell
shares of that company for lack of liquidity (volume). In well organized markets, there is a system of
market makers who offer two way quotes on any scrip, so that continuous liquidity is provided to all
scrips. Market making means that a trader or a company puts both buy and sell orders into the
market, and wait for people to trade with him on either sides. Market making could be made
compulsory at least for a period of six to twelve months after listing of issues. Most merchant
bankers and brokers are significantly undercapitalized to perform Merchant Banking InIndiaz`

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CHAPTER 2

RESEARCH METHODOLOGY

India has entered the 21st century as one of the Asia’s most dynamic economies. This is the part of
the assessment made by International Financial and Capital Market Institutions based on India’s
economic and financial reforms initiated in 1991 and brought to fruition in various budget.

The progress of any economy mainly depends on the efficient financial system of the country. Indian
economy is no exception financial system of the country. The importance of the financial sector
reforms affirms an effective means for solving the problems of economic, financial and social in India
and elsewhere in the developing nations of the world. The progress of the Securities Industry of any
country depends mainly on the flow of funds. In fact, capital generation is the lifeblood of the capital
market without which the health and soundness of the financial system cannot be geared and for
which well-developed capital market as well as money market is essential.

India’s capital market is among the largest in the developing world. The market is comprised of 24
stock exchanges transacting long-term debt; debentures and equity shares both electronic and
physical forms. Derivatives financial instruments are also be added to the market shortly. The
number of firms listed on the Indian Stock Exchange is more than the USA. Market Capitalization of
listed firms is 1980s was similar to Brazil, Malaysia, Singapore and Denmark. Merchant Banking
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The capital market of the country, however, underwent dramatic changes since the beginning of
1980s basically because of a progressive realization that the command economy on which the
emphasis was placed could not lead to higher levels of economic development and that a slant
towards a market-oriented economy is necessary.

It is in the context of fast expanding economy and a liberalized and deregulated atmosphere that the
growth of the Indian Stock Market activities has to be viewed. No wonder that the markets have
registered a quantum jump judge by any standards.
In India prior to the enactment of Indian Companies Act, 1956,managing agents acted as issue
houses for securities, evaluated project reports, planned capital structure andMerchant Banking
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to some extent provided venture capital for new firms. Few share broking firms also functioned as
merchant bankers.

The need for specialized merchant banking services was felt in India with the rapid growth in the
number and size of the issues made in the primary market. The merchant banking services were
started by foreign banks, namely the National Grindlays Bank in 1967 and the City Bank in 1970.
The Banking Commission in its report in 1972 recommended the setting up of merchant banking
institutions. This marked the beginning of specialized merchant banking in India.

To begin with, merchant banking services were offered along with other traditional banking services.
In the mid-Eighties, the Banking Regulation Act was amended permitting commercial banks to offer a
wide range of financial services through the subsidy rule. The State Bank of India was the first India
Bank to set up merchant Banking division in 1972. Later ICICI set up its Merchant Banking division
followed by Bank of India, Bank of Baroda, Canada Bank, Punjab National Bank and UCO Bank. The
merchant banking gained prominence during 1983-84 due to new issue boom.

Many banks entered merchant banking in the 1960s to take advantage of the economies of scope
produced when private equity investing is added to other bank services, particularly commercial
lending. As lenders to small and medium-sized companies, banks become knowledgeable about
individual firms’ products and prospects and consequently are natural providers of direct private
equity investment to these firms. As mentioned above, commercial banks were the largest providers
of venture capital in the 1960s. In the middle to late 1980s, the decision to enter Merchant Banking
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merchant banking was thrust on other banks and bank holding companies by unforeseen events. In
those years, as a result of the LDC (less-developed-country) debt crisis, many banks received private
equity from developing nations in return for their defaulted loans. At that time, many of these banks
set up merchant banking subsidiaries to try to get some value from this private equity.

Also at about that time, most commercial banks began refocusing their private equity investments to
middle-market and public companies (often low-tech, already profitable companies) and, rather than
providing seed capital, financed expansion or changes in capital structure and ownership. Most
particularly, they took equity positions in LBOs, takeovers, or recapitalizations or provided
subordinated debt in the form of bridge loans to facilitate the transaction. Often they did both.
Commercial banks financed much of the LBO activity of the 1980s.Then, in the mid-1990s; major
commercial banks began once again focusing on venture capital, where they had substantial
expertise from their previous exposure to this kind of investment. Some of these recent venture-
capital investments have been spectacularly successful. For example, the Internet search engine
Lycos was a 1998 investment of Chase Manhattan’s venture-capital arm. Commercial banks are
permitted to report either realized or unrealized gains on their merchant-banking portfolios, as long
as they are consistent in the reporting. This option makes it difficult for one to compare different
entities’ financial results and could lead to an overly liberal reporting of profits. Merchant Banking
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SCOPE OF SERVICE OF

MERCHANT BANKING

 LOAN SYNDICATION

It refers to assistance rendered by merchant banks to get mainly term loans for projects. Such loans
may be obtained from a single development finance institution or a syndicate or consortium as in the
case of large term loans. Merchant banks can also help corporate clients to raise syndicated loans
from commercial banks.

Once the client company has decided about the project proposed to be undertaken, the next step is
looking for the sources wherefrom funds could be procured to implement the project. The
responsibility of locating the sources of finance, approaching these sources by putting in requisite
prescribed applications and complying with all the formalities involved in the sanction and disbursal
of loan rests with the merchant bankers who provide the service of loan/credit syndication.

Loan syndication in the case of domestic borrowing is undertaken with the institutional lenders and
the banks. Amongst institutional lenders the following institutions are the main suppliers of the long
and medium term funds with which the merchant bankers contact, liaison and arrange loans working
for and on behalf of their clients.

1. All India financial institutions

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i. Industrial Finance Corporation of India (IFCI)

ii. Industrial Development Bank of India (IDBI)

iii. Industrial Credit & Investment Corporation of India Ltd (ICICI)

2. State level financial bodies

i. State Financial Corporation’s (SFCs)

ii. State Industrial Development Corporations (SIDCs)

iii. State Industrial & Investment Corporations (SIICs)

3. All India level investment institutions

i. Life Insurance Corporation of India (LIC)

ii. Unit Trust of India (UTI)

iii. General Insurance Corporation of India (GIC) & its subsidiary companies.

4. Commercial banks: Commercial banks join in consortium loan being provided by the above
institutions.

5. Mutual Funds & Venture Capital Funds: these funds generally invest in equity but mutual funds
contribute to the issues of Debentures/Bonds on private placement basis as well as subscribe to
public issues.

 RESTRUCTURING SERVICES

Merchant bankers assist the management of the client company to successfully restructure various
activities, which include mergers and acquisitions, divestitures, management buyouts, joint venture
among others.

To help companies achieve the objectives of these restructuring strategies, the merchant banker
participates in different activities at various stages which include understanding the objectives
behind the strategy (objectives could be either to obtain financial, marketing, or production
benefits), and help in searching for the right partner in the strategic decision and financial valuation
of the proposal. Merchant Banking InIndiaz`

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SIGNIFICANCE

 Important reason for the growth of merchant banking is due to exerting excess demand on the
sources of funds forever expanding industry and trade.

 Corporate sector had the only alternative to avail of the capital market services for meeting their
long-term financial requirements through capital issues of equity and debentures.

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With the growing demand for funds there was pressure on capital market that enthused the
commercial banks, share brokers and financial consultancy firms to enter into the field of merchant
banking and share the growing capital market.

 In India have opened their merchant banking windows and are competing in this field, and also
doing advisory functions as merchant bankers as well as managing public issues in syndication with
other merchant bankers.

 Merchant banks can play highly significant role in mobilizing funds of savers to investible channels
assuring promising return on investments activity.

 With the growth of merchant banking profession corporate enterprises in both public and private,
sectors would be able to meet the growing requirements for the funds for establishing new
enterprises, undertaking expansion/modernization/diversification of the existing enterprises.

 Merchant banks have been procuring impressive support from capital market for the corporate
sector for financing their projects.

 In view of multitude of enactments, rules and regulations, guidelines and offshoot press release
instructions brought out by the Government from time to time imposing statutory obligations upon
the corporate sector to comply with all those requirements prescribed therein, the need of skilled
agency existed which could provide counseling.

 Merchant bankers advise the investors of the incentives available in the form of tax relief’s, other
statutory relaxations, good return on investment and capital appreciation in such investment to
motivate them to invest their savings in securities.

ROLE OF MERCHANT BANKERS

The role of merchant banker is dynamic in the wake of diverse nature of merchant banking services.
Merchant banker’s dynamism lies in promptly attending to the corporate problems and suggests
ways and means to solve it. The nature of merchant banking services is development oriented and
promotional to help the industry and trade to grow and survive. Merchant banker is, therefore,
dedicated to achieve this objective through his dynamism. He is always awake to renew his skills,
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expertise in new areas so as to equip himself with the knowledge and techniques to deal with
emerging new problems of corporate business world. He has to keep pace with the changing
environment where Government rules, regulations and policies affecting business conditions
frequently change; where science and technology create new innovations in production processes of
industries envisaging immediate renovations, diversification, modernizations or replacements of
existing plant and machinery or other equipments putting new demands for finances and
necessitating overhauling of the capital structure of the firms.
Merchant banker has to think and devise new instruments of financing industrial projects. He has to
assume wider responsibilities of saving industrial units from going sick and guiding industries to be
set up industrially backward areas to eliminate regional imbalances in industrial development of the
country. He has to guide the wider section of the community possessing surplus money to invest in
corporate securities and other productive investment channels. He has to help the industry in
different forms to ensure that it runs risk free and devoid of uncertainty by assisting the has to watch
the interest and win over the confidence of the Government, its agencies, along with the
entrepreneurs, the investors and the whole community. He must bridge the communication gap
between different sections and resolve the problem being faced in different areas concerned with
the business world.

To discharge the above role, a merchant banker has t be dynamic. For this reason, a merchant banker
is sometimes, called M.B i.e. Moving Bottom, i.e., one who never sits at one place, always moving-
attending meetings and meeting clients and constituents, doing business and getting business by
attending meetings and conferences, imparting knowledge to others and acquiring new knowledge
to maintain his supremacy in possession of latest information. His role depicts a personality cult,
which is unique and envious to be followed by others.

In the days ahead, merchant bankers have very significant role to play tuning their activities to the
requirements of the growth pattern of corporate sector, the industry and the economy as a whole,
which is, in it, a challenging task and to meet these challenges merchant bankers will have to be
more vigorous and strategic in playing their role. They will have also to adopt new ways and means in
discharging their role. Merchant Banking InIndiaz`

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MERCHANT BANKERS COMMISSION

As determined by the Finance Ministry, Government of India, Merchant Bankers are eligible to
charge commission / fee from their clients as detailed below :

(i) A Merchant Banker can charge 0.5% as the maximum as commission for whole of the issue.

(ii) They can charge project appraisal fees.

(iii) A lead manager can claim a commission of 0.5% up to Rs.25 crore and 0.2% in excess of Rs.25
crore.

(iv) Underwriting Commission.

Type of Security On amount On amount

Devolving on subscribed by
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