Merchant Banking

The Advanced Learners Dictionary defines the term merchant banker as 'a key
intermediary in the financial market'. He facilitates the issuers of securities
(companies) to raise capital in the financial market by selling the securities. He
offers a package of services related to the capital raising activity. Right from
drafting of prospectus to listing of shares in the stock exchange, merchant
bankers offer a range of services.
That is the reason why merchant banking is often identified with capital issue
activities of companies. According to SEBI, ‘a merchant banker is one who is
engaged in the business of issue management either by making arrangements
regarding selling, buying or subscribing to the securities as manager; consultant,
advisor or rendering corporate advisory services in relation to such issue
management'.
But merchant banking, contrary to popular notions, is not just handling of public
issues alone, it is a task that involves a broader range of services such as project
financing, corporate valuations, deal making in mergers and takeovers,
syndication of loans, organizing venture capital, portfolio management services,
delisting, share buy-backs, etc.
A merchant banker is a resource mobiliser as well as an advisor to the
companies. He assists the companies to raise capital by placing securities with
the investors. He does all the drafting and printing of offer documents and
appoints other market intermediaries to ensure the successful marketing of the
issues.

Categories of Merchant Bankers

Originally, as per SEBI regulations, merchant bankers were required to get
authorisation to act as an issue manager, underwriter or advisor. This
authorisation was granted by SEBI based on the net worth limits,
professional competence, experience in the business, general reputation and
the Past performance record. Accordingly, four categories of merchant
bankers were:
1. Category I — Capital adequacy of Its 5 crores.
2. Category II — Capital adequacy of Its 50 lakhs.
3. Category III — Capital adequacy of Rs 20 lakhs.
4. Category IV — No capital adequacy requirement.
The functions rendered by these four categories were also stipulated by SEBI.
Category I merchant bankers could act as an issue manager, underwriter,
advisor, consultant and portfolio manager. Although the advisory or consultancy
function could be performed by all the four categories, it was not possible for
Categories III and IV merchant bankers to act as an issue manager or portfolio
manager.

Existing Scenario
The demarcation of activities according to the four categories described above
has lost its relevance now due to the changes made by SEBI in September 1997.
SEBI has done away with the four categories of merchant bankers. At present,
only one category (Category I) could function as the merchant banker. As of
September 2015, there are 189 merchant bankers in India registered with SEBI.

Merchant Banking Functions

As stated earlier, a merchant banker is a financial intermediary in the capital
market. He is positioned between the companies who want to raise capital and
the investors who want to invest in the securities. The merchant banker facilitates
the process of raising capital in the capital market. He undertakes all the work
connected with the issue of securities on behalf of the client companies. A
merchant banker is not merely an issue manager. The scope of his activities
extends beyond issue management. He undertakes new responsibilities such as
syndication of project financing or global fund raising, designing new financial
instruments, deal making in corporate takeovers, and offering opinions on
valuation in the case of mergers and acquisitions.
■ Corporate Finance Services
The most visible function of a merchant banker is the function of mobilizing
funds for the companies. Starting from public issue of securities, it extends to
private placements, bought-out-deals, Euro-issues and corporate valuations.
Generally, companies are not willing to handle the public issue of capital
themselves because the merchant bankers' services are available for a fee. The
merchant bankers are good at the nuances of the public issue process. Merchant
bankers undertake the legal, administrative and the marketing responsibilities of a
public issue.
■ Project Finance Services
The second major activity of a merchant banker is project financing services.
Project financing requires appraisal of the projects. He should carry out an
independent appraisal of a project. Besides advising clients on project
feasibility, they also find the best package of financing mix necessary for such a
project. A merchant banker should be closely associated with the project right
from its inception. He will be able to provide the expertise in determining the
project size, capital structuring, amount of capital to be mobilized, sourcing of
funds, the type of instruments to be issued and providing inputs on when to raise
the resources.
■ International Financing Services
Companies have gone to overseas capital markets to raise capital. GDRs,
American Depository Receipts (ADRs) and FCCBs are issued foreign investors.
External Commercial Borrowings (ECBs) are also found to be common among
the companies. In this, the domestic merchant bankers and foreign investment
banks play a major role. Large merchant banking outfits in India have entered
strategic alliances with international investment bankers and tapped the
international markets for resources.

Issue Management ***

SEBI definition of the term merchant banking, as stated earlier, has emphasized
the activity of issue management. Among all the functions of a merchant banker,
issue management is the dominant one. The merchant banker has to comply with
many legal formalities and has to work in strict adherence to a prescribed
timeline.
Once a merchant banker is chosen by the issuing company, the issue management
activity starts immediately. As the capital issues are mostly based on the
book-building method, the merchant banker acts as the BRLM or, simply, the
Lead Manager to the Issue. There could be other merchant bankers who are
associated with the issue management process as Co-managers and the number of
such Co-managers depends on the amount of the capital involved in the issue. To
bring out the specific responsibilities of the merchant banker regarding the issue
management process, we present three stages in this task:
1. Pre-issue Activities
In the pre-issue stage, the BRLM has to deal with the stock exchange, SEBI and
the Registrar of Companies (RoC) for filing the draft prospectus [known as 'Red
Herring Prospectus' (RHP)]. A Red Herring Prospectus is prepared in accordance
with the provisions of the Companies Act and SEBI Regulations. It does not
specify the issue price and the quantity of shares offered to the public. RHP is
filed with the RoC three days before the opening date of the bid and it will
become Prospectus upon filing with the RoC after the issue is closed and the
final cut-off price is arrived at.
The prospectus is prepared by the merchant banker by getting all the information
from the company management. For this purpose, the company annual reports,
and other records and documents have to be perused by the merchant banker.
Discussions with the management and personal visits to the plant are done to
gather information. This job is considered to be a crucial one for the merchant
banker because he issues the due diligence certificate after verification of the
documents, financial statements and other records. Therefore, the role of
merchant bankers in the preparation of offer documents is very crucial.
The BRLM appoints the syndicate members who act as the marketers of the
securities. The syndicate consists of other merchant banks, QIBs, stock broking
firms and sub-brokers. Further, the Registrars to the Issue, underwriters and the
bankers to the issue are appointed by the BRLM. Arrangements with the printers
have to be made for the printing of the application forms (bid forms). The
advertising agencies have to be fixed up for the advertisement of the public
issue.
The merchant banker obtains an in-principle approval from the stock exchange
for the issue to be made. The 'Draft Red Herring Prospectus' has to be filed with
SEBI along with the required fees. A due diligence certificate by the merchant
banker has to be sent to MM. An agreement with the Registrars to the issue and
the depositories is also entered into by the merchant banker.
After the Red Herring Prospectus is filed with the RoC, the BRLM proceeds to
finalize the bidding centers as well as the issue time table. Floor price and the
price band for the shares to be issued are finalized with the consultation of the
issuing company. Applications are then made to the stock exchanges for the
book-building process.
The 'road shows' or the publicity campaign starts for the promotion of the public
issue. The logistics involving transportation and distribution of the application
forms and the brochures to various bid-ding centers is another major task.
Simultaneously, arrangements are made with the bankers and an escrow
agreement is signed with them. The advertisement of the issue begins
announcing the opening of the issue for subscription.

2. During the Issue

Once the public issue is on, fill in application forms (bid forms) along with the
cheques and drafts arc received by the syndicate members from the investors.
The details of the forms received are informed to the BRLM. The electronic
book is built with the details of the number of forms received and the amount of
bids.
The bankers to the issue collect the physical forms from the syndicate
members. The cheques and drafts are sent for clearance. The banker to the
issue informs the Registrar and the physical forms are then sent to the
Registrar. The Registrar to the Issue reconciles the data which have been
gathered with that of the BRLM. While the issue is open, the BRLM monitors
the response and the status of the number of bids received is ascertained.

3. Post-issue
The public issue closes on the stipulated closing date. Subsequently, the BRLM
and the issuing company finalized the price. The prospectus will be updated with
the mention of the final price of the shares. The finalized prospectus will be
issued to QIBs. After making allotment to the QIBs on the discretionary portion,
the basis of allotment for the retail investors will be finalized by the issuer,
Registrar, BRLM, stock exchange and a public representative.
The basis of allotment is communicated to the stock exchange. After this, the
refund orders are sent to the applicants. Arrangements for crediting the allotted
shares are done with the depositories. Application for listing of the shares
allotted is made to the stock exchange with the necessary fees and once listing is
permitted, trading in shares begins in the stock exchanges. The merchant banker
who acts as the lead manager is responsible till this final stage of listing of
shares.

Escrow Account
Escrow Account services are provided by the banks. As an escrow agent, the
bank provides escrow account services for various types of transactions. For
example, in an IPO, the collecting bank may serve as escrow collection banker.
The money collected during the public issue is put in the "IPO account" of the
issuing company and is not mingled with other accounts of the issuer. Once the
allotment is done and listing is completed, then only the issuing firm will have
access to the proceeds of public issue. Therefore, an escrow account is a
temporary pass through account. It ensures that transactions are operated as per
terms of the underlying agreement.

Eligibility for being a Merchant Banker **

1. The applicant must be a corporate body.
2. The applicant should not carry on a business other than the securities

market business. 3. He should have the necessary infrastructure in terms

of office space and experienced man-power. 4. The associate company or
the group company should not have been a registered merchant banker. 5.
The applicant should not have been involved in security scams.

6. The minimum net worth of the applicant firm should be Rs 50 million.

Obligations of Merchant Bankers

In the conduct of his business, a merchant banker is supposed to observe certain
codes of conduct. SEBI has issued some guidelines for regulating the merchant
banking activities and the code of conduct for the merchant banks is specified
in the Schedule III of the SEBI (Merchant Banking) Regulations 1992.
1. High standards: In dealing with the clients, the merchant bankers are
expected to keep high standards of integrity and fairness in all their dealings.
2. Due diligence: The merchant bankers have to render high standards of set
vice, exercise due diligence, ensure proper care and exercise professional
judgment in delivering their service. They should disclose to clients all
possible sources of conflict of duties and interests.

3. Dealing with competing merchant bankers: In the course of their business,

competition with other merchant bankers is inevitable. During the process of
prospecting for clients or during the execution of their services to a client, a
merchant banker should not make a statement harmful to other merchant banks
or is likely to place the other merchant banker in a disadvantageous position.
4. Not all claims: While dealing with the clients, a merchant banker shall not
make an exaggerated statement, either orally or in a written form, about his
capabilities to render certain service or about his achievements with regard to
services rendered to other clients.
5. Cost-effective service: A merchant banker shall always endeavor to do the best
possible advice to clients. He should ensure that all professional dealings are
affected in a prompt, efficient and cost-effective manner.
Factoring

Factoring is a continuing arrangement between a financial intermediary known

as the factor and a business concern (the client) whereby the factor purchases
the client’s accounts receivable/book debts either with or without recourse to
the client. This relation enables the factor to control the credit extended to the
customer and administer the sales ledger.
Factoring is a collection and finance service designed to improve the client’s
(seller’s) cash flow by turning his credit sales invoices into ready cash. In very
simple terms, factoring is an activity of managing the trade debts of a business
concern. The factor controls the credit extended to the customers and administers
the sales ledger.
Besides purchase of accounts receivables, a factor may provide a wide
range of services, such as the following.
 Credit management and covering the credit risk involved.
 Provision of prepayment of funds against the debts it agreed to buy.
 Arrangement for collection of debts.
 Administration of the sales ledger.

Types
1. Recourse factoring:
In recourse factoring, the factor purchases trade debts and essentially renders
collection service and maintains sales ledgers. But, in case of default or
non-payment by a trade debtor, the client refunds the amount to the factor.
Hence, recourse factoring does not include bad debts protection. It is popular in
developing countries.
2. Non-recourse factoring:
Under non-recourse factoring, the factor’s obligation to the client becomes
absolute on the due date of the invoice, irrespective of the payment made or not
made by the trade debtor. In other words, if the trade debtor fails to make a
payment, the factor cannot recover this amount from the client. In non-recourse
factoring, factor charges are high as they offer the client protection against
bad-debts. The loss arising out of irrecoverable receivables is borne by the
factor. This type of factoring arrangement is found in developed countries such
as the UK and USA, where reliable credit rating services are available.
3. Advance factoring:
Sometimes, the factor and the client make an arrangement whereby the factor
pays a pre-specified portion of the factored receivables in advance to the client
on submission of necessary documents. This type of arrangement is known as
advance factoring. The balance portion is paid upon collection or on the
guaranteed payment date. Generally, factoring is advance factoring and factor
pays 80 percent of the invoice amount in advance.
4. Maturity factoring:
Under maturity factoring no advance payment is made by the factor but payment
is made only on the guaranteed payment date or on the date of collection.
Maturity factoring is also known as collection factoring.

5. Cross-border factoring/International factoring:

In domestic factoring, three parties are involved, namely, customer (buyer), client (seller), and
factor (financial institution or intermediary) while in international factoring there are four
parties, namely, exporter (client), importer (customer), export factor, and import factor. Thus,
in international business transactions, factoring services are provided by factors of both
countries, that is, the exporter country’s factor and the importer country’s factor. This is
known as cross-border factoring or international factoring.
6. Invoice discount:
Invoice discount is a variant of factoring. It provides finance against invoices backed by
letters of credit of banks. The factor provides finance once the letter of credit opening bank
confirms the due date of payment.
Sum 1
The following facts related to the Avon Industries Ltd. (AIL). A proposal of Factoring
arrangement is also under consideration.
1. In- House Arrangement
• Annual Credit turnover in the current financial year ₹1200 Million on credit term
2/10 net 30
• 30% of debtors avails the discount and for remaining Average Collection Period 60
days
• Bad Debts 2% of the Total Sales
• Financing in Receivable is a mix of Bank and Long term in a ratio of 2:1
• Cost of Funds Bank 22% and Long Term 30%
• Annual Credit and collection Expenditure ₹ 250 million of which three-fourth is
avoidable
2. Factoring Arrangement (30 Days Guarantee)
Recourse Non- Recourse
• Advance 80% • 21%
• Discount Rate 22% • Commission 4% (Up
• Commission 2% (Up front) front)
• Advance 85%

Due to Factoring arrangement the Sales team will work only on sales promotion and
as a result the sales will increase by ₹ 50 Million, the gross margin on the sales has
been 20%.
Before taking any decision on the proposal, The Board of Directors of AIL seeks your
advice, as a financial consultant, on the course of action. What Advice would you
give? Why?
Solution:
Calculation of cost to collection
1. In House Management
Particulars Amount
in millions

Discount Allowed 2% to 30% of 1200 7.2

1200 X 30 X 2
100 X 100

Bad Debts 2% 1200 X 2% 24

 Cost of Funds 37
1. Bank 2/3 of 1200 for 45 days @ 22% = 22 2.
Long 1/3 of 1200 for 45 days @30% = 15

Collection Expenses 3/4 187.5

Total Cost

Average Collection Period = 30% pays in 10 days + 70% pays in 60 days

ACP = 10 X 30% + 60 X 70%
ACP =3+42 =45 Days
2. Factoring Arrangement
(a): Factoring (Recourse) for Sales 1250 Mill
Particulars Amount
in millions

Advance 80% 0f 1250 =1000

Amount due for advance 1000-25 = 975
Advance paid 975-18.33= 956.67

Commission 2% of 1250 Million 25

Discount charges 1000 X 22% X 30 days 18.33

Bad Debts 2% of 1250 25
Cost of funds 6.02
1. Bank 2/3 of 293.33 for 30 days @22% =3.58 2.
Long 1/3 of 293.33 for 30 days @30% = 2.44

Total Cost

Less: Additional Profits 10

Net Factoring cost (Recourse)
Fund blocked =1250-956.67 =293.33

(b): Factoring (Non- Recourse) for Sales 1250 Mil

Particulars Amount
in millions

Advance 85% 0f 1250 =1062.5

Amount due for advance 1062.5-50 = 1012.5
Advance paid 1012.5-18.59= 993.91

Commission 4% of 1250 Million 50

Discount charges 1062.5 X 21% X 30 days 18.59
Cost of funds 5.26
1. Bank 2/3 of 256.09 for 30 days @22% =3.13 2.
Long 1/3 of 256.09 for 30 days @30% =2.13

Total Cost

Less: Additional Profits 10

Net Factoring cost (Recourse)

Fund blocked =1250-993.91 =256.09

Analysis
Cost of In house =255.7
Cost of Fac (Rec)=64.35
Cost of Fac (Non Rec.) =63.85
As from above calculation we can see that the cost of Factoring arrangement
non-recourse is minimum among all options so we will go for it.
Credit Rating

With increased activity in the Indian financial sector both existing and new
companies are opting for finance from the capital market. The competition
among firms for a slice of the savings cake has increased. New instruments have
been designed by companies to attract investors to subscribe to their issues. The
market is flooded with a variety of new and complex financial products. These
new instruments are embodied with complex features very difficult for an
ordinary investor to understand and analyze. Besides this, investors no longer
evaluate the creditworthiness of the borrowers by their names or size. Credit
rating agencies have come into existence to assist the investors in their
investment decisions, by assessing the creditworthiness of the borrowers.
Credit rating is the assessment of a borrower’s credit quality. Credit rating
performs the function of credit risk evaluation reflecting the borrower’s expected
capability to repay the debt as per terms of issue.
Credit rating is merely an indicator of the current opinion of the relative capacity
of a borrowing entity to service its debt obligations within a specified time
period and with particular reference to the debt instrument being rated. Credit
rating is not a recommendation to buy, hold or sell. It is a well-informed opinion
made available to the public, and might influence their investment decisions.
An agency that performs the rating of debt instruments is known as a credit rating
agency. At present, the scope of a credit rating agency is not limited to rating of
debts. Credit rating agencies now undertake financial analysis and assessment of
financial products, individuals, institutions, and governments.

Importance
 Credit rating helps in the development of financial markets. Credit rating
agencies play a key role in the infrastructure of the modern financial
system.
 It saves the investors time and enables them to take a quick decision and
provides them better choices among available investment opportunities
based on their risk-return preferences.
 Issuers with a high credit rating can raise funds at a cheaper rate thereby lowering their
cost of capital.
 It acts as a marketing tool for the instrument, enhances the company’s
reputation and recognition, and enables even lesser known companies to
raise funds from the capital market.
 Credit rating is a tool in the hands of financial intermediaries, such as
banks and financial institutions that can be effectively employed for taking
decisions relating to lending and investments.
 Credit rating helps the market regulators in promoting stability and
efficiency in the securities market. Ratings make markets more efficient
and transparent.
 Ratings and rating changes influence the pricing of financial instruments.
 Ratings have assumed a much larger role in the global financial markets.
Sovereign ratings affect the quantum of financial and investment flows to
a country.