UNIT-IV: Merchant Banking and Underwriting
Q.1 Define merchant banking and explain its origin and growth in
India. Discuss the services rendered by merchant bankers with
example
Concept and Evolution of Merchant Banking
The primary activity of Merchant Banks is to provide fee-based
advice to corporates and governments on the issue of securities.
Merchant banks differ from commercial banks in the sense that
they do not take deposits from individuals or businesses.
Merchant banks these days perform a variety of other activities
such as financing foreign trade, underwriting of equity issues,
portfolio management and undertaking foreign security business as
well as foreign loan business, project appraisal etc. However, not
all merchant banks offer all these services. Since the functions are
very similar to those of Investment Bankers, they are often thought
to be the same. However, an investment banker will also provide
investment advice and deal with securities in secondary market,
unlike a pure Merchant Banker. The difference between merchant
banking and investment banking has been highlighted in the
following section.
Difference between Merchant Banking and Investment
Banking
There is a fine line of distinction between Merchant Banking and
Investment Banking, which we try to highlight in this section.
‘Merchant Banking’ as the term suggests, is the function of
intermediation in the capital market. It helps issuers to raise
capital by placement of securities issued by the issuers with
investors. The merchant banker has an onerous responsibility
towards the investors who invest in such securities. The regulatory
authorities require the merchant banking firms to promote quality
issues, maintain integrity and ensure compliance with the law on
own account and on behalf of the issuers as well. Therefore,
merchant banking is a fee based service for management of public
offers, popularly known as ‘issue management’ and for private
placement of securities in the capital market. In India, the
merchant banker leading a public offer is popularly known as the
‘Lead Manager’.
On the other hand, the term ‘Investment Banking’ has a much
wider connotation and is gradually becoming more of an inclusive
term to refer to all types of capital market activity, both fund based
and non-fund based. This development has been driven more by the
way the American investment banks have evolved themselves over
the past century. Investment banking encompasses not merely
merchant banking but other related capital market activities such
as stock trading, market making and underwriting, stock broking
and asset management as well. Besides the above, investment
banks also provide a host of specialized corporate advisory services
in the areas of project advisory, business and financial advisory and
mergers and acquisitions.
Evolution of International Merchant Banking
Merchant banking originated in Italy then came to France in the
seventeenth and eighteenth centuries. In France, a merchant
banker was a merchant who added the banking business to his
various activities and utilized his accumulated profits better.
Merchant bankers’ activities differed from those of any other
‘money changer’ and involved dealing in bills of exchange with
correspondents abroad and speculated on the rate of exchange.
Merchant banks flourished in the United Kingdom in the late
eighteenth and early nineteenth centuries as England became a
rich trading nation. Profits from colonial trade were diverted into
merchant banking activities and the chief activity was accepting
commercial bills for domestic and international trade. Investment
banks as are called in the United States are one of the most
important participants in the US capital market. They help
businesses and governments sell their new security issues in the
debt or equity markets to raise capital, through primary market
transactions. Once the securities are sold, they also create the
secondary markets for these securities as brokers and dealers. The
Glass-Steagall Act of 1933 differentiated the activities between the
commercial banks and investment banks and prevented
depositories from underwriting. The Securities Exchange Act
(1934) in the United States sought to correct practices in securities
trading with the formation of the Securities Exchange Commission
(SEC). However, the relaxation of the rules set out in Glass Steagall
Act in 1997, led to a wider consolidation in the investment and
commercial banking space. Owing to the growing requirements of
globalisation and growth of financial markets, the Glass Steagall
Act was repealed in 1999 and replaced with a liberal Financial
Modernisation Act 1999. After the exponential growth of
investment banks in the US during the period 1990- 2007 and the
subsequent global financial crisis in 2008, investment banks were
brought under tight regulation again with the passage of the Dodd-
Frank Wall Street Reform and Consumer Protection Act in 2010.
The Act sought to regulate investment advisers, derivative markets,
functioning of credit rating agencies etc. Specific to investment
banking, the Act sought to regulate them by segregating banking
from proprietary trading and asset management (through the
Volcker’s Rule’) as well as to provide for regulatory supervision for
capital adequacy, quantitative limits and other restrictions.
Definition of Merchant Banker
In the SEBI (Merchant Bankers) Regulations, 1992, a Merchant
Banker is defined as “any person who is engaged in the business of
issue management either by making arrangements regarding
selling, buying or subscribing to securities or acting as manager,
consultant, adviser or rendering corporate advisory service in
relation to such issue management”
Services Rendered by
Merchant Bankers
Merchant bankers provide a wide range of financial services to businesses,
governments, and individuals, primarily focusing on corporate finance, capital raising,
and advisory services. Their expertise helps companies navigate complex financial
decisions, ensuring smooth transactions in various domains. Below are the key
services provided by merchant bankers, along with examples for better understanding.
1. Issue Management (IPO & FPO
Management)
Merchant bankers assist companies in raising capital by managing the process of
Initial Public Offerings (IPOs) and Follow-on Public Offerings (FPOs). They
handle everything from drafting prospectuses to marketing the issue and ensuring
regulatory compliance.
Example: When Zomato launched its IPO in 2021, merchant bankers like Kotak
Mahindra Capital, Morgan Stanley, and Credit Suisse played a crucial role in
managing and underwriting the issue.
2. Underwriting Services
Underwriting involves merchant bankers guaranteeing a minimum subscription for a
public issue. If investors do not subscribe to the full issue, the merchant banker
purchases the remaining shares. This reduces the risk for the issuing company.
Example: In the Reliance Jio Financial Services demerger, merchant bankers such as
ICICI Securities and Axis Capital helped underwrite the deal to ensure financial
stability.
3. Corporate Advisory Services
Merchant bankers advise companies on mergers, acquisitions, takeovers, and
restructuring. They conduct due diligence, negotiate deals, and ensure regulatory
compliance.
Example: When Tata Motors acquired Jaguar Land Rover in 2008, leading merchant
bankers like JPMorgan and Citigroup facilitated the deal by providing advisory and
financial structuring support.
4. Project Finance & Syndication of
Loans
They help businesses secure funds for large projects by arranging syndicated loans
from multiple banks and financial institutions.
Example: Adani Group’s large infrastructure projects, such as airports and energy
plants, have been financed with the help of merchant bankers like SBI Capital
Markets and Standard Chartered Bank.
5. Private Placements of Shares &
Debentures
Merchant bankers assist companies in raising funds from private investors, such as
venture capitalists and institutional investors, instead of public offerings.
Example: Before Flipkart’s acquisition by Walmart, the company raised several
rounds of funding through private placements handled by merchant bankers like
Goldman Sachs and Morgan Stanley.
6. Venture Capital & Private Equity
Advisory
Startups and high-growth companies often seek funding from venture capitalists
(VCs) and private equity (PE) firms. Merchant bankers help these companies secure
investments, structure deals, and negotiate terms.
Example: Paytm raised billions of dollars from SoftBank and Alibaba in its early
days with the help of merchant bankers who facilitated negotiations and due
diligence.
7. Foreign Exchange and Trade Finance
They provide advisory services related to foreign exchange risk management,
hedging strategies, and trade finance solutions for companies involved in
international trade.
Example: Infosys, a global IT giant, manages its foreign exchange risks through
merchant banks like Citibank and HSBC, which help hedge currency fluctuations.
8. Portfolio Management & Investment
Advisory
High-net-worth individuals (HNIs) and institutions rely on merchant bankers for
investment advisory services to manage their portfolios and maximize returns.
Example: Asset management firms like BlackRock and Kotak Wealth Management
offer tailored investment strategies to HNIs, guiding them on equity, debt, and
alternative investments.
9. Corporate Restructuring & Debt
Management
When companies face financial distress, merchant bankers help in debt
restructuring, loan renegotiation, and turnaround strategies to revive businesses.
Example: During the financial crisis, Jet Airways underwent debt restructuring with
the help of merchant bankers like SBI Capital Markets and EY.
10. Compliance & Regulatory Advisory
Merchant bankers ensure that companies comply with SEBI (Securities and Exchange
Board of India), RBI (Reserve Bank of India), and other regulatory requirements
while conducting financial transactions.
Example: LIC’s IPO in 2022 was handled by merchant bankers like SBI Capital and
Goldman Sachs, ensuring compliance with SEBI regulations.
2. What is underwriting? Discuss its recent trends in India
and its importance in the financial market. Highlight the
advantages and disadvantages of underwriting.
What Is an Underwriter?
An underwriter is any party, usually a member of a financial organization, that
evaluates and assumes another party’s risk in mortgages, insurance, loans, or
investments for a fee, usually in the form of a commission, premium, spread, or
interest.
Underwriters try to determine the likelihood that a borrower will pay as promised and
that enough collateral is available if there's a default. In the case of insurance,
underwriters seek to assess a policyholder's health and other factors and spread the
potential risk among as many people as possible.
What Do Underwriters Do?
Underwriters play a critical role in many industries in the financial world, including
the mortgage industry, the insurance industry, equity markets, and some common
types of debt securities trading. An individual in the position of a lead underwriter is
sometimes called a book runner.
Modern-day underwriters play a variety of roles, depending on the industry in which
they work. In general, underwriters are tasked with determining the level of risk
involved in a transaction or other kind of business decision. Risk is the likelihood that
an outcome or investment’s actual gains will differ from an expected outcome or
return.
Investors rely on underwriters because they determine if a business risk is worth
taking. Underwriters also contribute to sales-type activities. For example, in an initial
public offering (IPO), the underwriter might purchase the entire IPO issue and sell it
to investors. An IPO is a process through which a previously privately owned
company sells its shares on a public stock exchange for the first time.
History of Underwriters
The term “underwriter” first emerged in the early days of marine insurance.
Shipowners sought insurance for a ship and its cargo to protect themselves if the boat
and its contents were lost. Shipowners would prepare a document that described their
ship and its contents, crew, and destination.
An agreed-upon rate and terms were set out in the paper. Businesspeople who wished
to assume some obligation or risk would sign their name at the bottom and indicate
how much exposure they were willing to accept. These businesspeople became known
as underwriters.
Types of Underwriters
Mortgage Underwriters
The most common type of underwriter is a mortgage loan underwriter. Mortgage
loans are approved based on a combination of an applicant’s income, credit history,
debt ratios, and overall savings.
Mortgage loan underwriters ensure that a loan applicant meets all of these
requirements, and they subsequently approve or deny a loan. Underwriters also
review a property’s appraisal to ensure that it is accurate and that the home is worth
the purchase price and loan amount.
Mortgage loan underwriters have final approval for all mortgage loans. Loans that
aren't approved can go through an appeal process, but the decision requires
overwhelming evidence to be overturned.
According to the U.S. Bureau of Labor Statistics, employment of insurance
underwriters is projected to decline 4% from 2021 to 2031.
Insurance Underwriters
Insurance underwriters, like mortgage underwriters, review applications for coverage
and accept or reject an applicant based on risk analysis. Insurance brokers and other
entities submit insurance applications on behalf of clients, and insurance underwriters
review the application and decide whether to offer insurance coverage.
Insurance underwriters advise on risk management issues, determine available
coverage for specific individuals, and review existing clients for continued coverage
analysis.
Equity Underwriters
Underwriters administer the public issuance and distribution of securities—in the
form of common or preferred stock—from a corporation or other issuing body in the
equity markets. Perhaps the most prominent role of an equity underwriter is in the
IPO process.
IPO underwriters are financial specialists who work closely with the issuing body to
determine the initial offering price of the securities, buy the securities from the issuer,
and sell the securities to investors via the underwriter’s distribution network.
IPO underwriters are typically investment banks that have IPO specialists on staff.
These investment banks work with a company to ensure that all regulatory
requirements are satisfied.
To gauge interest in the investment, the IPO specialists contact a large network of
investment organizations—such as mutual funds and insurance companies. The
amount of interest received by these large institutional investors helps an underwriter
set the IPO price of the company’s stock.
The underwriter also guarantees that a specific number of shares will be sold at that
initial price and purchase any surplus.
Debt Security Underwriters
Underwriters purchase debt securities—such as government bonds, corporate bonds,
municipal bonds, or preferred stock—from the issuing body (usually a company or
government agency) to resell them for a profit. This profit is known as the
underwriting spread.
An underwriter may resell debt securities directly to the marketplace or to dealers
(who will then sell them to other buyers). When the issuance of debt security requires
more than one underwriter, the resulting group of underwriters is known as an
underwriter syndicate.
Why Are Underwriters Important?
Investors need underwriters to determine if a business risk is worth investing in. In
addition, underwriters also contribute to the success of sales activities.
Recent Trends in Merchant Banking in
India
Merchant banking in India has evolved significantly due to economic growth,
regulatory changes, and increasing corporate financial needs. Some of the key trends
shaping the industry include:
1. Rise in IPO and FPO Activity
India has witnessed a surge in Initial Public Offerings (IPOs) and Follow-on Public
Offerings (FPOs) as companies seek to raise capital from public markets. With
record-breaking IPOs like Zomato, Paytm, and LIC, merchant bankers play a crucial
role in managing these offerings.
Example: In 2023, Tata Technologies' IPO saw overwhelming investor demand,
managed by merchant bankers like JM Financial and Axis Capital.
2. Growth of Private Equity and Venture Capital Deals
The Indian startup ecosystem has attracted significant investments from private
equity (PE) and venture capital (VC) firms. Merchant bankers assist in structuring
these deals and conducting due diligence.
Example: In 2023, Zepto, a quick-commerce startup, raised $200 million in a funding
round facilitated by merchant bankers.
3. Increase in Mergers and Acquisitions (M&A)
With globalization and consolidation, mergers and acquisitions (M&A) have
increased across industries. Merchant bankers help companies navigate complex
financial and regulatory frameworks in these deals.
Example: The merger of HDFC Bank and HDFC Ltd. in 2023 was one of the largest
deals in India, managed by leading merchant banks like Morgan Stanley and Kotak
Mahindra Capital.
4. Digital Transformation in Financial Services
Technology-driven merchant banking services have gained momentum, with AI and
blockchain being integrated into investment advisory, risk management, and financial
transactions.
Example: SBI Capital Markets has adopted AI-driven investment advisory to
enhance efficiency and accuracy in deal structuring.
5. Increased Regulatory Oversight
SEBI has introduced stricter regulations for merchant bankers to enhance
transparency and investor protection. Compliance with guidelines related to due
diligence and corporate governance has become crucial.
Example: The SEBI (Issue of Capital and Disclosure Requirements) Regulations,
2023, have improved disclosure standards for IPO-bound companies.
6. Rising Role in Debt Market Advisory
With increasing corporate debt issuances and government bond sales, merchant
bankers are playing a larger role in advising companies on debt financing and bond
market participation.
Example: The Indian government’s Green Bond issuance in 2023 was managed by
merchant bankers like ICICI Securities and HSBC India.
Importance of Merchant Banking in the
Financial Market
Merchant banking plays a vital role in the financial ecosystem by facilitating capital
formation, improving market efficiency, and providing advisory services.
1. Facilitates Capital Raising for Businesses
Merchant bankers help companies raise funds through IPOs, private placements,
and debt financing, ensuring smooth access to capital markets. This is essential for
economic growth and business expansion.
2. Strengthens Corporate Governance and Compliance
By ensuring regulatory compliance and conducting due diligence, merchant bankers
enhance transparency and investor confidence in financial markets.
3. Supports Mergers, Acquisitions, and Restructuring
They play a critical role in structuring M&A deals, helping businesses expand,
consolidate, or restructure debt, which enhances market stability and corporate
growth.
4. Enhances Liquidity and Market Efficiency
By underwriting securities and managing financial instruments, merchant bankers
contribute to increased liquidity and stability in financial markets.
5. Encourages Foreign Investments
Through advisory services on Foreign Direct Investment (FDI) and foreign
exchange management, merchant bankers help Indian businesses attract international
investments.
6. Boosts the Debt and Bond Market
They assist corporations and governments in issuing bonds and debt instruments,
diversifying funding sources beyond traditional bank loans.
Advantages and disadvantages of underwriting:
Aspect Advantages Disadvantages
Risk Reduces the issuer's Underwriters bear financial
Managemen risk by ensuring capital risk if the issue is not
t is raised. subscribed.
Enhances investor May lead to overpricing of
Market
confidence in the securities, affecting market
Confidence
offering. response.
Ensures liquidity in the
Liquidity High underwriting fees
market by guaranteeing
Support increase the cost of issuance.
share sales.
Aspect Advantages Disadvantages
Helps companies raise If the underwriter misjudges
Quick
funds faster without market demand, they may
Fundraising
delays. suffer losses.
Ensures adherence to Complex legal and regulatory
Regulatory
SEBI and stock market requirements can slow down
Compliance
regulations. processes.
Prevents drastic price In case of low demand,
Price
fluctuations in new underwriters may be forced
Stability
issuances. to hold unsold securities.
Underwriters have a Potential conflict of interest
Market
vast network to attract if underwriters promote
Reach
investors. weak issues.
Facilitates capital In weak markets,
Boosts
formation, aiding underwriting firms may
Economy
economic growth. hesitate to take risks.
