Merchant Banking

Merchant banks invest their own money into their clients.

Merchant banks invest their own capital into corporate clients. A merchant bank will assess the
value of a company and invest its money into it, sometimes taking a very large ownership interest in
the company. Merchant banks specialize in international finance. Multinational corporations use this
expertise to facilitate their international transactions.

Investment Banking
Investment banks find various sources of capital for their clients.
Investment banks raise outside capital for corporate clients. They handle initial public offerings,
trade securities and facilitate mergers and acquisitions. They also perform research to advise clients
on financial matters prior to their making investment and capitalization decisions.

Commonalities
Neither merchant nor investment banks serve the general public. Instead, both serve publicly and
privately held corporations. Both merchant and investment banks perform underwriting functions
for their corporate clients.

What is ADR
ADR is the short form of American Depository Receipts. This is the recent method adopted by many
large and well respected companies from India to raise funds from American Markets.

How ADR Operates

Indian companies have direct access to raise funds from Indian public by way of issuing Shares,
Debentures etc. However Indian companies cannot do so, in such a direct manner, when it comes to
raising funds from American people. That would entail the Indian companies to adopt US Accounting
Norms which is also called as GAAP, maintain accounting practices as per American Financial Year
(Which starts in January and ends in December of any particular year), as also follow variety of
stringent standards as per American norms. Effectively, it would mean that the Indian company
would have to follow two different set of rules simultaneously, one to comply with the laws of Indian
Companies Act, and the other to comply with the American Laws.

The method to circumvent the American norms, but still raise funds from American people is
available by way of ADR or American Depository Receipts. In this system, the Indian company
deposits certain amount of its Indian shares with designated American Banks. The banks, in turn,
issues receipts that are equivalent in values (And also based on the intrinsic value the Indian
Companys shares would fetch in the American market) to the Indian Company. These receipts
essentially would be in number of receipts. Then these Indian Companies can trade these ADRs or
American Depository Receipts with the American public. These ADRs can be purchased and traded
freely without any encumbrances in the American Stocks and Shares Market. This way the Indian
company is able to enter into the American Stocks and Shares market, and raise funds from the
American public.

The role of the American bank which has issued these receipts is very crucial, since it is they who
stand guarantee to the issued receipts. Hence they do exhaustive study of the Indian company from
all perspectives, and only then issue the ADR to the Indian company.

What is GDR and how it operates

The full form of GDR is Global Depository Receipt. It is not a different financial instrument, as it may
sound, from that of ADR. In fact if the Indian Company which has issued GDRs in the American
market wishes to further extend it to other developed and advanced countries such as Europe, then
they can sell these ADRs to the public of Europe and the same would be named as GDR.

Indian Companies with ADR & GDR

There are quite a lot of successful Indian companies that have now issued ADRs and GDRs. Some
such companies are given underneath.

Dr. Reddys
HDFC Bank
ICICI Bank
Infosys Technologies
MTNL
VSNL
WIPRO

Initial Public Offer

An initial public offeringor IPO as it's most commonly calledis the process by which companies
go from private to public and sell stocks shares in their firm.
IPOs don't happen overnight and take a lot of effort to put together. So here's a look at how the IPO
procedure works, as CNBC explains.
What is an IPO?
If a company wants to sell stock shares to the general public, it conducts an IPO. By doing so, a
company goes from the status of private (no general shareholders) to public (a firm with general
shareholders).
Private companies can have shareholders, but they are few in number and they and the firm are not
subject to regulations by the Securities and Exchange Commission. This changes dramatically with an
IPO, as we'll see later.
An IPO usually takes three to four months from the beginning to the first day's trading on an
exchange.
Why does a company go public?
It's simply a money-making move. The idea is to raise funds and have more liquidity or cash on hand
by selling shares publicly.
The money can be used in various ways, such as re-investing in the company's infrastructure or
expanding the business.
An added benefit from issuing shares is that they can be used to attract top management candidates
through the offer of perks like stock option plans.
Another plus from going public benefit is that stocks can be used in merger and acquisition deals as
part of the payment.
There's also the prestigebragging rights for some firmsof being listed on a major stock exchange
like the NYSE.
What's the first step in an IPO?
The firm going public hires an investment bank, or banks, to handle the IPO. It's possible for a
company to sell shares on its own but, in reality, that never happens.
Investment banks can work alone or together on one IPO, with one taking the lead. They usually
form a group of banks or investors to spread around the fundingand the riskfor the IPO.
Banks submit bids to companies going public on how much money the firm will make in the IPO and
what the bank will walk away with. The process of an investment bank handling an IPO is called
underwriting.

When an investment bank, like Goldman Sachs or Morgan Stanley is eventually hired, the company
and the investment bank talk about how much money they think they will raise from the IPO, the
type of securities to be issued, and all the details in the underwriting agreement.
What happens next?
After the company and investment bank agree to an underwriting deal, the bank puts together a
registration statement to be filed with the Securities Exchange and Commission(SEC).
This statement has detailed information about the offering and company info such as financial
statements, management background, any legal problems, where the money is to be used, and who
owns any stock before the company goes public.
The SEC will investigate the company to make sure all the information submitted to it is correct and
that all relevant financial data has been disclosed.
If everything is OK, the SEC will work with the company to set a date for the IPO. After SEC approval
for the IPO, the underwriter must put together a prospectus; that is, all financial information on the
company that's doing the IPO.
How do underwriters make their money?
A bank or group of banks put up the money to fund the IPO and 'buys' the shares of the company
before they are actually listed on a stock exchange. The banks make their profit on the difference in
price between what they paid before the IPO and when the shares are officially offered to the
public.
Competition among investment banks for handling an IPO can be fierce, depending on the company
that's going public and the money the bank thinks it will make on the deal.

Investment banking includes set of activities, which

can be classified into three main areas:
1. Core or traditional investment banking, which can be further broken down into: (a) underwriting
services, which consist in assisting firms raising capital on financial markets and (b) advisory services,
which consist in assisting firms in transactions such as mergers, acquisitions, debt restructuring, etc.
2. Trading and brokerage: it consists in purchasing and selling securities by using the banks money
(proprietary trading) or on behalf of clients (brokerage).
3. Asset management: it is a very heterogeneous area itself. Generally speaking, it consists in
managing investors money. It can be broken down into two main categories: (a) traditional asset
management (i.e., open end mutual funds) and (b) alternative asset management, which includes
real estate funds, hedge funds, private equity funds, and any other vehicle investing in alternative
asset classes.
Relevant to all the three areas is the research activity, which support investment decisions (trading
& brokerage, and asset management), as well as the core investment banking business.

However, because of the possible conflicts of inter- ests (e.g., recommending an issuer simply
because it is a client), the research activity is normally organizationally separated by the core
investment banking (by the so called Chinese walls).
Underwriting and advisory services are the core investment banking activities, i.e., the object of
this book.
With underwriting services an investment bank helps firms to raise funds by issuing securities in the
financial markets. These securities can include equity, debt, as well as hybrid securities like
convertible debt or debt with warrants attached. Investment banks structure the transactions by
verifying financial data and business claims, performing due diligence and, most importantly, pricing
claims. These services are labeled underwriting because investment banks actually purchase
securities from the issuer and then resale them to the market.
In the case of equity, this is done through Initial Public Offerings (IPOs). IPO is a rather generic term,
but there are several alternative offering structures depending on the kind of shares being sold,
where the company is listed, to whom the offer is addressed, etc. Investment banks also structure
seasoned equity offerings (SEOs) and rights offerings, which are transactions through which listed
firms can raise equity capital.
IPO
The direct costs of IPOs are the fees paid to lawyers, accountants, consultants, but most importantly,
investment banks. Investment banking fees vary according to country, the IPO size, and many other
factors. However, a 27% of the amount raised (i.e., the proceeds) is a reasonable range. Indirect
costs, are probably more relevant, at least because more subtle. IPOs are usually underpriced, i.e.,
the first-day return is in general positive. Although there are exceptions, the presence of an average
underpricing is consistent across country and over time.

3.4 Price-Setting Mechanisms

The IPO process takes on average four to six months. The steps of this process, in particular the final
ones, are strictly related to the price-setting mechanism chosen by the issuer and its investment
banks. Therefore, lets first take a look to the different mechanisms to price an equity offering and
then discuss the whole IPO process. Further details about price-setting mechanisms will be discussed
in Chap. 5.

There are three main mechanisms to price and

distribute securities:

(a) open price (book-building), (b) fixed price, and (c) auctions. In open-priced offerings the
investment bank canvasses potential investors and then sets an offer price. In contrast, in fixed-price
offerings the offer price is set prior to requests of shares being submitted. In auctions a market
clearing price is set after bids are submitted.
Open price (Book-building): The issue is presented to institutional investors during a roadshow,
that takes on average a couple of weeks. A price range is suggested to investors. Based on the
roadshow presentation, investors are asked to provide non-binding indications of interest (bids). The
book is built from the bids, and, based on the information provided by the book, the terms of the
offerings are finalized shortly before allocation of shares. One of the key features of the open price
approach is that allocation of shares among institutional investors is decided by the investment bank
on a discretionary basis. In their pitch book (i.e., the presentation investment banks prepare to
get the mandate) investment banks claim that this discretion helps to allocate shares only to
selected buy and hold investors, that is investors who do not flip the shares the very next day. At
the closing of the book-building period, the investment banks underwrite the shares. Therefore, they
are at risk for a short period (usually 24 h), between the closing and the allocation of shares. The
bids are non-binding; however, because of the repeated nature of the relationship between
investors and the investment bank, it is very rare for any investor to renege on a bid. Moreover, the
book is closed only when there is sufficient demand at the offer price.4 The offer would be pulled
otherwise In a hard-underwritten IPO the investment bank commits to guarantee a minimum offer
price at the beginning of the book-building period. A hard-underwritten IPO offers the issuers
the
.e., abandoned). To summarize, there is very little underwriting risk. Nonetheless, to protect
themselves from adverse change, banks use the clause force majeure, which allows them to cancel
the transaction under certain conditions.
The open price mechanism is the US standard approach, but it has become
increasingly used worldwide.
Fixed price: It was the standard practice in Europe, but it has been in decline for many years,
especially for larger offerings. The key feature of the fixed price approach is that the issuer and its
investment bank set the price before bids are submitted. In other words, the price is fixed with
information about the market demand. There are two kind of fixed-priced offerings: (a) firm
commitment (or underwritten) and (b) best effort (non-underwritten). In the first case (the most
common case) the investment bank underwrites the offer, thus guaranteeing the full proceeds to
the issuer, regardless of the actual demand. In the second case, the bank just puts its best effort to
sell the shares, with no underwriting. Often a minimum offer size is set and if at closing there is no
sufficient demand, the offer is pulled. It is evident that the firm commitment is much riskier for the
investment bank in terms of underwriting risk.
Auction: Historically, it is the least common price-setting mechanism. It was frequently used only in
France. Nonetheless, an increasing number of issuers decide to use this approach (note the
remarkable case of Googles IPO in 2004). In an auction investors are invited to bid for shares, and
once the offering is covered, shares are allocated at a single clearing price. As for book-building, the
price is set after bids are submitted. The crucial difference between the two techniques, is that in

book-building the price and allocation rules are not transparent (because they are discretionary): the
bank does not have to allocate to highest bidders and may also ignore them at all.
Currently the most used price-setting mechanism is book-building, at least for institutional tranches.
Retail investors are frequently allowed to place orders in the retail tranche, but the price is set by
the institutional tranche. In other words, most IPOs use a hybrid approach, combining fixed-price
retail offers with book-building. This hybrid approach can be either sequential or simultaneous. In
the sequential hybrid approach the price is set with book-building prior than retail offer is opened:
retail investors thus know exactly the price they will pay. In the simultaneous hybrid approach
institutional and retail offerings are run at the same time, thus retail investors bid without knowing
the exact price they will pay. A mid-way solution is also possible. During book-building (before the
book is closed) a maximum price is announced and the retail offer is launched: retail investors do not
know the exact price, but just the maximum they will pay. The next paragraph describes the typical
IPO process where this approach is employed.
3.6.2 Rights Offerings
In many jurisdictions a capital increase requires the company to issue the new capital in the form of
rights to protect existing shareholders from the dilution of their ownership stake.8
Shareholders are therefore entitled to purchase new shares in the proportion that they hold at the
time of the offering. The rights are issued to the existing share- holders at a certain ratio and at
discount relative to the current market price. Moreover, the rights trade on the same stock
exchange as the shares. If a share- holder does not exercise his rights during the subscription period
(usually two weeks), the issuer will still receive some proceeds through the so called rump
placement, where unexercised rights are sold to investors. The rump is priced at current prevailing
market levels and not at the subscription price. The firm receives proceeds up to the subscription
price and the investors who did not exercise their rights will receive the balance.

Regulatory Framework for Investment Banking in

India Investment Banking in India is regulating in its various facets under separate legislations or
guidelines issued under statute. The Regulatory powers are also distributed between different
regulators depending upon the constitution and status of Investment Bank. Pure investment banks
which do not have presence in the lending or banking business are governed primarily by the capital
market regulator (SEBI). However, Universal banks and NBFC investment banks are regulated
primarily by the RBI in their core business of banking or lending and so far as the investment banking
segment is concerned, they are also regulated by SEBI. An overview of the regulatory framework is
furnished below:
1. At the constitutional level, all invest banking companies incorporated under the Companies Act,
1956 are governed by the provisions of that Act.

2. Investment Banks that are incorporated under a separate statute such as the SBI or IDBI are
regulated by their respective statute. IDBI is in the process of being converted into a company under
the Companies Act.
3. Universal Banks that are regulated by the Reserve Bank of India under the RBI Act, 1934 and the
Banking Regulation Act which put restrictions on the investment banking exposures to be taken by
banks.
4. Investment banking companies that are constituted as non-banking financial companies are
regulated operationally by the RBI under sections 45H to 45QB of Reserve Bank of India Act, 1934.
Under these sections RBI is empowered to issue directions in the areas of resources mobilization,
accounts and administrative controls.
5. Functionally, different aspects of investment banking are regulated under the Securities and
Exchange Board of India Act, 1992 and guidelines and regulations issued there under.
6. Investment Banks that are set up in India with foreign direct investment either as joint ventures
with Indian partners or as fully owned subsidiaries of the foreign entities are governed in respect of
the foreign investment by the Foreign Exchange Management Act, 1999 and the Foreign Exchange
Management (Transfer or issue of Security by a person Resident outside India) Regulations, 2000
issued there under as amended from time to time through circulars issued by the RBI.
7. Apart from the above specific regulations relating to investment banking, investment banks are
also governed by other laws applicable to all other businesses such as tax law, contract law,
property law, local state laws, arbitration law and the other general laws that are applicable in India.