Merchant Banking Services: Role and Functions, Regulation, Issues

Merchant Banking Service

A merchant bank is a financial institution which provides capital to companies in the form of share ownership instead of loans. A merchant bank also provides advisory on corporate matters to the firms they lend to. In the USA, the term “merchant bank” refers to an investment bank. Merchant banking is a fee-based business, where the bank assumes market risks but no long-term credit risk.

In other words, a Merchant Bank may be defined as a financial institution conducting money market activities and lending, underwriting and financial advice, and investment services for a corporate enterprise or an individual in marketable securities by deciding the quantum, timing and the type of security to be bought.

Securities & Exchange Board of India (Merchant Bankers) Rules, 1992 defined 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 securities as manager, consultant, advisor or rendering corporate advisory service in relation to such issue management”. In this definition, a person means a legal person including a company.

Role and Functions of Merchant Banking

Although merchant banking in India was imitated about three decades ago, it was in 1992 when SEBI was formed and the rules and regulations, regarding merchant banking activities, were made. As we understand that merchant banking is a service-oriented industry.

Merchant banks all over the world carry out the same set of activities. Exhibits 1 and 2 give a snapshot of the variety of merchant banking services rendered by SBI and PNB, two leading commercial banks in India.

Following are the role and functions of merchant banking:

  1. Corporate Counselling
  2. Project Counselling and Pre-Investment Studies
  3. Advisory Service for Capital Restructuring
  4. Credit Syndication and Project Finance
  5. Issue Management and Underwriting
  6. Portfolio Management
  7. Working Capital Finance
  8. Bill Discounting and Acceptance Credit
  9. Mergers and Acquisitions
  10. Venture capital Financing
  11. Lease Financing
  12. Foreign Currency Finance
  13. Project Appraisal

Corporate Counselling

The activities that are undertaken to ensure the efficient and smooth running of a business enterprise are known as corporate counselling. It may include the reviving of old companies and ailing units, and guiding the existing units in identifying the areas or activities for growth and diversification.

The merchant banker guides the clients on various aspects like the location of the business, organizational size, operational scale, choice of product, market survey, cost analysis, cost reduction, allocation of resources, investment decision and pricing decision etc. The following set of activities form part of corporate counselling:

  1. Providing guidance in the areas of diversification based on the Government’s policies.
  2. Undertaking appraisal of product lines, analyzing their growth and profitability and forecasting future trends of the business.
  3. Reviving old companies and ailing sick units by appraising their technology and process assessing their requirements and restructuring their capital based.
  4. Conducting diagnostic studies for the industry or business unit.
  5. Assessment of the revival prospects and planning for rehabilitation through modernization and diversification and restructuring of the financial and organizational structure.
  6. Arranging for the approval of the financial institutions/banks for schemes of rehabilitation involves financial relief, etc.
  7. Providing assistance in getting soft loans from financial institutions for capital expenditure, and the requisite credit facilities from the bank.
  8. Exploring the possibilities for the takeover of sick units and providing assistance in making consequential arrangements and negotiations with financial institutions/ banks and other interests/authorities involved.

Project Counselling and Pre-Investment Studies

Project counselling refers to the preparation of project reports; decision making on the financial pattern of the projects; appraisal of projects and arranging of funds for the project. Pre-investment studies relate to the activities that are concerned with making a detailed feasibility exploration to evaluate alternative avenues of capital investment in terms of growth and profit prospects.

The following are important activities which constitute part of the Project counselling and pre-investment studies:

  1. Undertaking the general review of the project ideas/project profile.

  2. Providing advice on procedural aspects of project implementation.

  3. Conducting a review of the technical feasibility of the project on the basis of the report prepared by own exerts or by outside consultants.

  4. Assisting in the selection of a Technical consultancy Organization (TCO) for preparing project reports and market surveys, or review of the project report or market survey reports prepared by TCO.

  5. Assisting in the preparation of project report from a financial angle, and advising and acting on various procedural steps including obtaining government consent for the implementation of the project.

  6. Assisting in obtaining approvals/licenses/permissions/grants, etc. from government agencies in the form of a letter of intent, industrial license and registration, government approval (FIPB) for foreign collaboration etc.

  7. Providing guidance to Indian entrepreneurs for making investments in Indian projects in India and in Indian joint ventures overseas. h. Identification of potential investment avenues.

  8. Exploring the market for the proposed product.

  9. Carrying out precise capital structuring and shaping the pattern of financing.

  10. Arranging and negotiating foreign collaborations, amalgamations, mergers, and takeovers.

Advisory Service for Capital Restructuring

Merchant bankers assist the corporate enterprise in structuring their capital in such a way that it would minimize the cost of capital and maximize its return on capital invested or shareholder value. Capital restructuring covers the following services:

  1. Examining the existing capital structure of the client company to determine the extent of capitalization required.

  2. Preparing a comprehensive memorandum for the SEBI and securing consent where the capitalization takes place through the issue of bonus shares.

  3. Suggesting an alternative capital structure conforming to legal requirements, viz., the extent of capitalization on reserve and quantum of disinvestments by ‘offer for sale’ and/or fresh issues of corporate securities such as equity share, and preference share in the case of FEMA companies.

  4. Preparing a memorandum covering the valuation of shares and justifying the level of premium applied.

Credit Syndication and Project Finance

Credit syndication refers to the activities connected with credit procurement and project financing, aimed at raising Indian and foreign currency loans from banks and financial institutions. Basically, credit syndication is the outcome of the project counselling process through which various sources of funds can well be traced to arrange required finance.

Activities covered under credit syndication are as follows:

  1. Estimating the total cost of the project to be undertaken.
  2. Drawing up a financing plan for the total project cost which conforms to the requirements of the promoters and their collaborators, financial institutions and banks, government agencies and underwriters.
  3. Preparing loan applications for financial assistance from term lenders/financial institutions/banks, and monitoring their progress, including pre-sanction negotiations.
  4. Selecting institutions and banks for participation in financing.

Generally, credit syndication services overlap with the activities of project counselling and project finance. But, the loan or credit syndication also includes the preparation of applications for financial assistance from financial institutions/banks.

Issue Management and Underwriting

Issue management and underwriting concerns with the activities relating to the management of the public issues of corporate securities, viz. equity shares, preference shares, and debentures or bonds, and are aimed at mobilization of money from the capital market for the corporate.

Following are some of the popular services provided by merchant bankers in this regard:

  1. Preparation of an action plant.
  2. Preparation of budget for the local expenses for the issues.
  3. Preparation of SEBI application and assisting in obtaining consent/ acknowledgement.
  4. Drafting of a prospectus.
  5. Selection of institutional and broker underwriters for syndicating/underwriting arrangements.
  6. Selection of issues Houses and advertising agencies for undertaking pre and post-issue publicity.
  7. Obtaining the approval of institutional underwriters and stock exchanges for publication of the prospectus

Portfolio Management

Portfolio refers to investment in different kinds of securities such as shares, and debentures issued by different companies. It is a combination of assets but a carefully blended asset combination. Portfolio management refers to maintaining a proper combination of securities in a manner that gives maximum return Investors are interested in the safety, liquidity and profitability of their investment but they can’t choose the appropriate securities.

So, merchant bankers help their investors in choosing the shares. They conduct regular market and economic surveys. Portfolio management also includes making decisions for the investment of cash resources of a corporate enterprise in marketable securities by deciding the quantum, timing and the type of security to be bought. The services covered under portfolio management are:

  1. Undertaking investment in securities.
  2. Undertaking investment for non-resident Indians, on both repatriation and non-repatriation basis.
  3. Undertaking review of Provident fund investment, Trust investment, etc.
  4. Safe custody of securities in India and overseas.
  5. Providing advice on the selection of investments.
  6. Carrying out a critical evaluation of the investment portfolio.
  7. Collecting and remitting interest and dividend on investment.

Working Capital Finance

The finance required for meeting the day-to-day expenses of an enterprise is known as ‘Working Capital finance’. Working capital is needed to ensure that fixed assets are utilised at their best capacity. Inadequate working capital may attract liquidity problems for the business and may lead to business failure.

Merchant banks help in arranging the working capital for the corporate. The services rendered by merchant banks under working capital finance include:

  1. Assessment of working capital requirements.
  2. Preparing the necessary application to negotiations for the sanction of appropriate credit facilities.
  3. Assisting, co-coordinating and expediting documentation and other formalities for disbursement.
  4. Advising on the issue of debentures for augmenting long-term requirements of working capital.

Bill Discounting and Acceptance Credit

Bill discounting and acceptance credit connotes the activities relating to the acceptance and the discounting of bills of exchange, besides the advancement loans to business concerns on the strength of such instruments, which are collectively known as ‘Acceptance Credit and Bill of discounting.

In order that the bill accepting and discounting to take place on sound lines, it is necessary that the firm involved command a good reputation and financial standing.

Mergers and Acquisitions

This is a specialized service provided by the merchant banker who arranges for negotiating acquisitions and mergers by offering expert valuation regarding the quantum and the nature of considerations, and other related matters. The various functions that form part of this activity are as follows:

  1. Undertaking management audits to identify areas of corporate strength and weakness in order to help formulate guidelines and directions for future growth.

  2. Conducting exploratory studies on a global basis to locate overseas markets, foreign collaborations and prospective joint venture associates.

  3. Obtaining approvals from shareholders, depositors, creditors, government, and other authorities.

  4. Monitoring the implementation of merger and amalgamation schemes.

  5. Identifying organizations with matching characteristics.

  6. Merchant bankers provide advice on acquisition propositions after careful examination of all aspects, viz, financial statements, articles of associations, provisions of companies act, rules and guidance of trade chambers, the issuing house associations, etc.

Venture capital Financing

Venture capital is the equity financing for high-risk and high-reward projects. The concept of venture capital originated in the USA in the 1950s, when business magnates like Rockefeller financed new technology companies.

The concept became more popular during the sixties and seventies when several private enterprises undertook the financing of high-risk and high reward projects.

Lease Financing

Leasing is an important alternative source of financing a capital outlay. It involves letting out assets on lease for use by the lessee for a particular period of time. Following are the important services provided in regard to leasing:

  1. Providing advice on the viability of leasing as an alternative source for financing capital investment projects.
  2. Providing advice on the choice of a favourable rental structure.

In India, leasing is a non-banking financial activity. Commercial banks like the State Bank of India and Canara Bank also provide lease financing by forming subsidiaries under the amended Banking Regulations Act of 1949.

Foreign Currency Finance

Foreign currency finance is the fund provided for foreign trade transactions. It may take the form of export-import trade finance, euro currency loans to Indian joint ventures abroad or foreign collaborations. The main areas that are covered in this type of merchant activity are as follows:

  1. Providing assistance for carrying out the study of turnkey and construction contract projects.
  2. Providing assistance in applications to working groups, liaison with RBI, ECGD and other institutions.

  3. Providing assistance in opening and operating bank accounts abroad.
  4. Providing assistance in obtaining export credit facilities from the EXIM bank for the export of capital goods, and arranging for the necessary government approvals and clearance.
  5. Providing guidance on forwarding cover for exchange risk.

Project Appraisal

The evaluation of industrial projects in terms of alternative variants in technology, raw materials, production capacity and location of the plant is known as ‘Project Appraisal’. Project appraisal may fall into the following categories:

  1. Financial appraisal: Financial appraisal involves assessing the feasibility of a new proposal for setting up a new project or the expansion of existing production facilities. A financial appraisal is undertaken through an analysis which takes into account the financial features of a project, including sources of financing. Financial analysis helps trace the smooth operation of the project over its entire life cycle.

  2. Technical Appraisal: Technical appraisal is primarily concerned with the project concept in terms of technology, design, scope and content of the plant, as well as inputs are infrastructure facilities envisaged for the project, Basically, the project should be able to deliver a marketable product from the resources deployed, at a cost which would leave a margin that would be adequate to service the investment, and also plough back a reasonable amount into the project to enable the enterprise to consolidate its positions.

  3. Economic Appraisal: Economic appraisal of a project deals with the impact of the project on economic aggregates. These may be classified under two broad categories. The first deals with the effect of the project on employment and foreign exchange, and the second deals with the impact of the project on net social benefits or welfare.

Regulation of Merchant Banking in India

Schedule 2 of Securities and Exchange Board of India (Merchant Bankers) Regulations, 1992 outlines the requirement for the registration of Merchant Bankers in India. Following are silent requirements for registration as Merchant Banker:

  1. Application for Grant of Certificate
  2. Application to Conform to the Requirements
  3. Consideration of Application
  4. Capital Adequacy Requirement
  5. Grant of Certificate of Initial Registration
  6. Grant of Certificate of Permanent Registration

Application for Grant of Certificate

An application by a person for grant of a certificate [of initial registration] shall be made to the Board in Form A of SEBI regulations related to Merchant Banker.

[(1A) An application for registration made under sub-regulation (1) shall be accompanied by a non-refundable application fee as specified in Schedule II of Regulation.]

The application under sub-regulation (1) shall be made for any one of the following categories of the merchant banker namely:

[(2A) Notwithstanding anything contained in this regulation, with effect from 9th December 1997:

  1. An application under sub-regulation (2) can be made only for carrying on the activities mentioned in clause (a) therein.
  2. An applicant can carry on the activity as portfolio manager only if he obtains a separate certificate of registration under the provisions of the Securities and Exchange Board of India (Portfolio Manager) Regulations, 1993.]

Notwithstanding anything contained in sub-regulation (1) any application made by a merchant banker prior to coming into force of these regulations containing such particulars or as near thereto as mentioned in Form A shall be treated as an application made in pursuance of sub-regulation (1) and dealt with accordingly.

Application to Conform to the Requirements

Subject to the provisions of sub-regulation (3) of regulation 3, any application, which is not complete in all respects and does not conform to the instructions specified in the form shall be rejected: Provided that, before rejecting any such application, the applicant shall be given an opportunity to remove within the time specified such objections as may be indicated by the Board.

Consideration of Application

The Board shall take into account for considering the grant of a certificate, all matters which are relevant to the activities relating to merchant bankers and in particular the applicant complies with the following requirements, namely:

  1. The applicant has in his employment a minimum of two persons who have the experience to conduct the business of merchant bankers.

  2. A person directly or indirectly connected with the applicant has not been granted registration by the Board.

  3. The applicant fulfils the capital adequacy requirement specified in the regulation.

  4. The applicant, his partner, director or principal officer is not involved in any litigation connected with the securities market which has an adverse bearing on the business of the applicant.

  5. The applicant, his director, partner or principal officer has not at any time been convicted for any offence involving moral turpitude or has been found guilty of any economic offence.

  6. The applicant has the professional qualification from an institution recognised by the Government in finance, law or business management; (gg) the applicant is a fit and proper person; grant of certificate to the applicant is in the interest of investors.

Capital Adequacy Requirement

The capital adequacy requirement referred to in clause (d) of regulation 6 shall be a net worth of not less than five crore rupees.

Explanation: For the purposes of this regulation, “net worth” means the sum of paid-up capital and free reserves of the applicant at the time of making an application under sub-regulation (1) of regulation 3.]

Grant of Certificate of Initial Registration

Following are regulations related to the grant of certificate of initial registration:

  1. The Board, on being satisfied that the applicant is eligible, shall grant a certificate of initial registration in Form B and shall send an intimation to the applicant.

  2. The certificate of initial registration granted under sub-regulation (1) shall be valid for a period of five years from the date of its issue to the applicant.

  3. The merchant banker who has already been granted the certificate of registration by the Board, prior to the commencement of the Securities and Exchange Board of India (Merchant Bankers) (Amendment) Regulations, 2011, and has not completed a period of three years, shall be deemed to have been granted a certificate of initial registration for a period of five years from the date of its certificate of registration, subject to payment of the fee for the remaining period of two years, as prescribed in Schedule II of these regulations.

  4. On the grant of a certificate of initial registration, the merchant banker shall be liable to pay the fee in accordance with Schedule II of these regulations.

Grant of Certificate of Permanent Registration

  1. The merchant banker who has been granted or deemed to have been granted a certificate of initial registration under regulation 8, may, three months before the expiry of the period of the certificate of initial registration, make an application for grant of a certificate of permanent registration in Form A.

  2. The merchant banker who has already been granted a certificate of registration by the Board and has completed a period of five years, on the date of commencement of the Securities and Exchange Board of India (Merchant Bankers) (Amendment) Regulations, 2011, may, three months before the expiry of the validity of the certificate of registration or before, make an application for grant of a certificate of permanent registration in Form A.

  3. An application under sub-regulation (1) or sub-regulation (2) shall be accompanied by a non-refundable application fee as specified in Schedule II of these regulations.

  4. The application for grant of a certificate of permanent registration shall be accompanied by details of the changes that have taken place in the information that was submitted to the Board while seeking initial registration or renewal, as the case may be, and a declaration stating that no changes other than those as mentioned in such details have taken place.

  5. The application for permanent registration made under sub-regulation (1) or (2) shall be dealt with in the same manner as if it were a fresh application for grant of a certificate of initial registration.

  6. The Board, on being satisfied that the applicant is eligible, shall grant a certificate of permanent registration in Form B and shall send intimation to the applicant.

  7. On the grant of a certificate of permanent registration, the merchant banker shall be liable to pay the fee in accordance with Schedule II of these regulations.

Merchant Banks and Investment Banks

Merchant banking and investment banking are interchangeable terms, but the practices and procedures followed in the USA for selling the securities distinguish it from the rest of the world. Merchant banking is the function of intermediation in the capital market and is purely a fee-based activity (except underwriting) whereas, investment banking is both fee and fund based activity.

Merchant bankers assist issuers to raise capital and are responsible for the successful management of capital issues. They have also the responsibility toward investors. The regulatory authorities require the merchant banking firms to observe a code of conduct and ensure compliance with the law on the account and on behalf of the issuer.

Investment banking, however, is a wider term. It provides capital by buying whole issues of securities and distributing them to the public. Thus, they perform the function of a middleman as the originator of new issues, wholesaler of securities and responsible for sharing risk through underwriting operations.

Investment banks also provide a host of specialized corporate advisory services in the area of project counselling, business and financial counselling and merger and acquisitions.

Issue Management in Merchant Banking

The public issue of corporate securities involves basically three functions, namely (1) origination of the issue (2) risk-bearing and risk averting and (3) marketing of the securities. The public issues are managed by the involvement of various intermediaries like underwriters, registrar to the issue, bankers to the issue, brokers, advertising agencies, printers and legal advisers.

Merchant banker as ‘ issue manager’ to the public issue plan, coordinate and control the entire issue activities and direct different intermediaries to contribute to the success of the issue.

As merchant bankers play the role of apex intermediary in the issue management process, they are called the lead managers (s) or lead merchant bankers. In the case of the book-building mechanism, the merchant banker has the primary responsibility of preparing and maintaining records of the book-building process.

The procedure for the managing the public issue by a merchant banker is divided into two phases:

  1. Pre Issue Management
  2. Post Issue Management

Pre Issue Management

The steps required to be undertaken for pre-issue management are as follows:

  1. Memorandum of Understanding with the issuer.
  2. Obtaining stock exchange approval.
  3. Acting as per SEBI guidelines.
  4. Appointment of other intermediaries like Registrar to the issue, Bankers to the issue, Underwriter, Advertising agency and Printers etc.
  5. Drafting the prospectus and application form.

  6. Obtaining approvals of the draft prospectus from the company’s legal advisers, underwriters, financial institutions/banks.
  7. Appointment of Compliance Officer.
  8. Filing the draft prospectus with SEBI.
  9. Incorporating the suggestions/ comments of SEBI in the prospectus.
  10. Finalisation of prospectus.
  11. Filing the final prospectus with SEBI and Registrar of Companies.
  12. Agreement with Depositories for dematerialization of securities.
  13. Grading the IPO from the credit rating agency.
  14. Publicity of the issue with roadshows and advertisements.
  15. Due diligence certificate.
  16. Fixing the dates for opening and closing the issue.
  17. Dispatch of issue material.
  18. Filing no complaints certificate with SEBI.
  19. Opening the subscription list.

Post Issue Management

Post issue management activities of merchant bankers can be stated as follows:

  1. Confirmation of minimum subscription (90% of total issue amount) including devolvement from underwriters.
  2. Supervision and coordination of allotment procedure.
  3. Ensuring dispatch of allotment letters and refund orders.
  4. Listing of securities with stock exchange(s).
  5. To attend to the investors’ grievances regarding the public issues.
  6. Submission of post-issue monitoring reports to SEBI.

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