Unit 4:

Merchant Banking

A merchant bank may be defined as an institution or an organisation which

provides a number of services including management of securities issues, portfolio
services, underwriting of capital issues, insurance, credit syndication, financial
advices, project counselling etc.

In India merchant banking services were started only in 1967 by National

Grindlays Bank followed by Citi Bank in 1970. The State Bank of India was the
first Indian Commercial Bank having set up separate Merchant Banking Division
in 1972. In India merchant banks have been primarily operating as issue houses
than full- fledged merchant banks as in other countries.

Merchant banking is regulated by the regulations framed by SEBI. These

regulations may be called the Securities and Exchange Board of India, (Merchant
Bankers) Regulations, 1992.

Merchant Banking

Banking Services Consultancy Services

To help the It helps the manager

businessman to run in financial, legal,
the business and managerial and
how to raise finance marketing

Functions of Merchant Banks:

The basic function of a merchant banker is marketing corporate and other
securities. Now they are required to take up some allied functions also.
The functions of merchant banking are listed as follows:
1. Raising Finance for Clients : Merchant Banking helps its clients to raise
finance through issue of shares, debentures, bank loans, etc. It helps its
clients to raise finance from the domestic and international market. This
finance is used for starting a new business or project or for modernization or
expansion of the business.
2. Broker in Stock Exchange : Merchant bankers act as brokers in the stock
exchange. They buy and sell shares on behalf of their clients. They conduct
research on equity shares. They also advise their clients about which shares
to buy, when to buy, how much to buy and when to sell. Large brokers,
Mutual Funds, Venture capital companies and Investment Banks offer
merchant banking services.
3. Project Management : Merchant bankers help their clients in the many
ways. For e.g. Advising about location of a project, preparing a project
report, conducting feasibility studies, making a plan for financing the
project, finding out sources of finance, advising about concessions and
incentives from the government.
4. Advice on Expansion and Modernization : Merchant bankers give advice
for expansion and modernization of the business units. They give expert
advice on mergers and amalgamations, acquisition and takeovers,
diversification of business, foreign collaborations and joint-ventures,
technology up-gradation, etc.
5. Managing Public Issue of Companies : Merchant bank advice and manage
the public issue of companies. They provide following services:
a. Advise on the timing of the public issue.
b. Advise on the size and price of the issue.
c. Acting as manager to the issue, and helping in accepting applications and
allotment of securities.
d. Help in appointing underwriters and brokers to the issue.
e. Listing of shares on the stock exchange, etc.
6. Handling Government Consent for Industrial Projects : A businessman
has to get government permission for starting of the project. Similarly, a
company requires permission for expansion or modernization activities. For
this, many formalities have to be completed. Merchant banks do all this
work for their clients.
7. Special Assistance to Small Companies and Entrepreneurs : Merchant
banks advise small companies about business opportunities, government
 policies, incentives and concessions available. It also helps them to take
advantage of these opportunities, concessions, etc.
8. Services to Public Sector Units : Merchant banks offer many services to
public sector units and public utilities. They help in raising long-term
capital, marketing of securities, foreign collaborations and arranging long-
term finance from term lending institutions.
9. Revival of Sick Industrial Units : Merchant banks help to revive (cure)
sick industrial units. It negotiates with different agencies like banks, term
lending institutions, and BIFR (Board for Industrial and Financial
Reconstruction). It also plans and executes the full revival package.
10.Portfolio Management : A merchant bank manages the portfolios
(investments) of its clients. This makes investments safe, liquid and
profitable for the client. It offers expert guidance to its clients for taking
investment decisions.
11.Corporate Restructuring : It includes mergers or acquisitions of existing
business units, sale of existing unit or disinvestment. This requires proper
negotiations, preparation of documents and completion of legal formalities.
Merchant bankers offer all these services to their clients.
12.Money Market Operation : Merchant bankers deal with and underwrite
short-term money market instruments, such as:
Government Bonds.
Certificate of deposit issued by banks and financial institutions.
Commercial paper issued by large corporate firms.
Treasury bills issued by the Government (Here in India by RBI).
13.Leasing Services : Merchant bankers also help in leasing services. Lease is
a contract between the lessor and lessee, whereby the lessor allows the use
of his specific asset such as equipment by the lessee for a certain period. The
lessor charges a fee called rentals.
14.Management of Interest and Dividend : Merchant bankers help their
clients in the management of interest on debentures / loans, and dividend on
shares. They also advise their client about the timing (interim / yearly) and
rate of dividend.
A merchant banker provides Promotional, Issue Management, Credit syndication,
Portfolio Management, Leasing & Finance and other specialist services to the
clients.
Difference Merchant Bank & Investment bank

Top 5 merchant banking institutions in India

 a. Kotak
b. Axis
c. Citi
d. ICICI
e. JP Morgan

Kotak Mahindra Bank has topped IPO (initial public offering) rankings for
2015-16, with a market share of 12 per cent. The private lender managed seven
IPOs and a volume of Rs 1,589 crore. Some transactions were of InterGlobe
Aviation and Coffee Day Enterprises. Meanwhile, rankings of equity capital
market (ECM, which includes IPO) were topped by US-based Goldman Sachs,
on the back of big-ticket share deals such as that of Sun Pharmaceutical. A total
of Rs 13,647 crore has been raised by 67 IPOs in 2015-16, while ECM volume
is Rs 86,714 crore. In 2014-15, Rs 3,039 crore was raised through IPOs and
ECM volume stood at Rs 85,021 crore, say data compiled by Bloomberg.

Underwriting

Underwriting is a type of financial service wherein an individual or an institution

undertakes the risk associated with a venture, an investment, or a loan in lieu of a
premium. Once the underwriting agreement is struck, the underwriter bears the risk
of being unable to sell the underlying securities, and the cost of holding them on its
books until such time in the future that they may be favorably sold.

In today’s financial world, underwriting is done at three levels:

a. Underwriting in Insurance:
In the insurance world, underwriters determine whether an insurance agency
should undertake the risk of insuring a client. They determine
 The risk and exposure of clients
 How much insurance should be granted to a client
 How much they should pay for it
 Whether or not to offer an insurance policy to the client in the first
place.
b. Underwriting in Stock Market:
In the securities market, underwriting involves determining the risk and
price of a particular security. It is a process seen most commonly during
 initial public offerings, wherein investment banks first buy or underwrite the
securities of the issuing entity and then sell them in the market. This ensures
that the issuers of the security can raise the full amount of capital while
earning the underwriters a premium in return for the service.

Investors benefit a lot from the underwriting process as the information

provided by an underwriting agency can help them take a more informed
buying decision. An underwriter who holds a large chunk of the securities of
a particular company or is the market maker for such a security provides the
core liquidity for the security and enhances price stability and distribution.
c. Underwriting in Banking
Before banks agree to loan money, bank loan underwriters review each
customer's credit history to determine whether the bank will grant the loan.

In the Indian financial market, there are 5 major underwriting agencies

a. Brokers
Private brokers underwrite the issue of securities on ad hoc basis ie the
issues suiting their risk & return profile. Brokers are usually interested in
short Term gains so they do not wish to be invested in the security for long
term while they would sell the securities to the promoters at the earliest.
b. Private Investment and Insurance Companies
The nature of underwriting services undertaken by private investment
companies is very similar to that of brokers and they are the major sub-
underwriters in the market.
c. Commercial Banks
Commercial banks do not have funds at their disposal to act as underwriter
so there share is also not substantial in underwriting. Commercial banks are
also, usually, not interested in holding for a long-period the underwritten
shares or debentures.
d. Development Banks and Other Financial Institutions
The institutions are engaged both in direct financing as well as underwriting.
The purpose of these underwriters is not on marketability of the securities
while their emphasis is on the long term viability of the issuing company.
These institutions help the enterprises by holding the underwritten shares or
debentures not taken up by public for a long period.
e. Consortium Underwriting
When one single financial institution do not have the capacity of
underwriting the issue, capital issues are underwrite through consultations
and collaborations.
d. Housing Finance:
e. Leasing:
In order to enhance the operating efficiency of the organization, financial
institutions provide funding as well as non funding services. Under funding
services, funds are provided to the organizations to purchase the assets, meet
the daily expenditure as well as to meet their liabilities. Non funding
services are the services where funds are not provided to the firms while
they are provided with the consultation and rental services.
Leasing & Hire Purchase are the two types of Non Funding services. These
two services are Leasing & Hire Purchase. Both the techniques are used to
finance the long term assets. The two techniques can be differentiated on viz.
ownership of the asset, depreciation, rental payments, duration, tax impact,
repairs and maintenance of the asset and the extent of finance.
The two techniques are useful when the entrepreneur or a small organization
fear of investing funds in capital intensive assets, as well the assets which
are not frequently used by the firm.

i. Lease:
In simple words, Lease is a financial contract between the business
customer (user) and the equipment supplier (normally owner) for using a
particular asset/equipment over a period of time against the periodic
payments called “Lease rentals”.

The lease generally involves two parties i.e. the lessor (owner) and the lessee
(user). Under this arrangement, the lessor transfers the right to use to the
lessee in return of the lease rentals agreed upon. A lease agreement can be
made flexible enough to meet the financial requirements of both the parties.

ii. Hire Purchase:

Hire Purchase is a kind of installment purchase where the businessman
(hirer) agrees to pay the cost of the equipment in different installments over
 a period of time. This installment covers the principal amount and the
interest cost towards the purchase of an asset for the period the asset is
utilized. The hirer gets the possession of the asset as soon as the hire
purchase agreement is signed. The hirer becomes the owner of the
equipment after the last payment is made. The hirer has the right to
terminate the agreement any time before taking the title or the ownership of
the asset.
Difference between leasing & Hire Purchase
Leasing Hire Purchase
Ownership of the asset Ownership right is with The hirer has the option
the lessor, lessee does to purchase. The hirer
not have the option to becomes the owner of
purchase the asset the asset/equipment
immediately after the
last installment is paid.
Depreciation Claimed by the lessor Claimed by the Hirer
Duration Longer period and Shorter period and
assets with high value assets with less value
Eg: land, building Eg: machinery, car
Repairs & Lessee Hirer
maintenance
Tax Impact Lessor makes the
payment as rentals and
indicate them as
expenditures
Extent of Finance Fully financed 20- 25% of down
payment is required to
be paid by the hirer

f. Venture Capital:
Big & Profitable organizations can arrange funds for themselves by
exhibiting their trend of profitability but the smaller firms and the
entrepreneurs with new ideas are not able to convince the financers about the
sustainability of their product or idea.
In such a situation, a new breed of financers named as Venture Capitalist
agrees to sponsor a new but viable and profitable idea.
The country's fast growing startups are in desperate need of expert
mentoring in scaling their business ideas and solving complex business
problems, beyond the disruptive world of technology-enabled services.

Urban Ladder: Tata’s

Paytm: Alibaba
Bookmyshow: Accel Partners, SAIF partners
OYO: Innoven Capital, Softbank,
Pepperfry: Goldman Sachs and Zodius
Ola: Accel, Helium

Features
1. High risk capital
2. Involvement is in the form of equity participation
3. Can be an individual or a private equity firm
4. Participate in the management of the organization
5. Medium to long term investment
6. Returns are in the form of capital gains
7. Management advises and technique to run business are provided by the
venture capitalist
8. There is no obligation to repay the money
9.

Process:

1. Idea Generation: Detailed business proposal with indicative profits,

review of exiting and expected business scenario, market potential and
size
2. Start Up: testing the proposal in the market, suitability analysis,
3. Ramp up
4. Exit

Type of Venture Capital Financing

1. Seed Financing
 2. Expansion Financing
3. Acquisition or Buyout Financing

g. Factoring:
It is one of the forms of financial service provided in the financial system.
Within financial system, the deficit units are provided with different
alternatives to raise finance to meet their funds requirement.

Factoring is a way of short term finance, it is a facility provided by the

financial service provider to maintain the books of accounts related to
debtors.
Features
1. The organization sells its books of debts to a financial institution at a
discount.
2. The factor maintains the books of accounts “Sales Ledger” of the
organization, updates the books and be after the debtors to recover the
amount.
3. Factoring agency accepts the service only after quality check of the
debtors of the organization. Commission charges are according to the
quality of the debtors
4. The factor manages the credit control of the organization.
5. The factor pays maximum amount in advance to the organization while
the balance after recovery from the debtors
6. Three parties are involved: Factor, Debtor and Client
7. Two Types of factoring Recourse and Non Recourse
8. No guiding Act
9. Financer gets interest for the financial service and commission for other
allied service

Bill Discounting “Invoice Discounting”, is a financial service under which

the bills of exchange ie the Bills Receivable is traded with the financer,
trading is done at a price less than the face value. The entire bill is
discounted or paid when the transaction takes place. It involves only
recourse funding. It is guided through the Negotiable Instrument Act 1881.