Project on Investment Banking

L. S. RAHEJA COLLEGE OF ARTS & COMMERCE JUHU ROAD, SANTACRUZ (WEST), MUMBAI 400 054

TITLE OF THE REPORT

INVESTMENT BANKING

PRESENTED BY PRIYANK M. SANDHEL

T.Y. B. COM (BANKING & INSURANCE) Semester V

PROJECT GUIDE PROF. GOVIND SOVANI.

UNIVERSITY OF MUMBAI. ACADEMIC YEAR  2008-2009

L.S. RAHEJA COLLEGE OF ARTS & COMMERCE JUHU ROAD, SANTACRUZ (WEST), MUMBAI 400 054

B.Com in (Banking and Insurance)

INVESTMENT BANKING

Name of Student: Priyank M. Sandhel Seat No: ____________  Date: _____________ 

DECLARATION I, Priyank M. Sandhel , of L. S. Raheja College of Arts & Commerce of T.Y.BBI. , (Semester V) hereby declare that I have completed this project on Investment Banking in the  Academic Year 2008-2009. The information submitted is true and original to the best of my knowledge.

Signature of Student

CERTIFICATE I, Govind Sowani here by certify that SANDHEL PRIYANK PRIYANK of  L. S. Raheja College of T.Y.BBI (Semester V) has completed the project on “Investment Banking” in the Academic Year 2008-2009. The information submitted is true & original.

Co-ordinator

Project Guide

Internal Examiner

Principal

External Examiner

College Seal

ACKNOWLEDGEMNT

It is my proud privilege to express express my sincere gratitude to all all those those who helped helped me direct directly ly or indir indirect ectly ly in comple completio tion n of this this  project report. report. I am greatly indebted to Mr. Govind Sowani my project guide for his support, guidance and valuable suggestions by which this work  has bee been com complet pleteed effec ffecti tive vely ly and and effi effici cieentl ntly . Th Thes esee all all contributions are of immense value. I owe owe than thanks ks to Mr. Mr. Kash Kashya yap p Gana Ganatr traa my co-o co-ord rdin inat ator or for  for   providing the required required data to complete this project. project.

INDEX

Sr. No Topic

Page No.

1. 2. 3.

Executive Summary Introduction Investment Banking and Merchant Banking

1 2 4

4. 5. 6. 7. 8. 9.

Distinguished Evolution of American Investment Banks European Investment Banks Global Industry Structure Business Portfolio of Investment Banks The Indian Scenario Characteristics and Structure of Indian Investment

6 10 12 13 15 19

10. 11.

Banking Industry Service Portfolio of Indian Investment Banks Interdependence be between Di Different Ve Verticals in in

23 29

12. 13. 14. 15. 16. 17.

Investment Banking Regulatory Framework for Investment Banking Regulatory Framework for Merchant Banking Anatomy of Some Leading Indian Investment Banks Recent Trends in Investment Banking The Conflict of Interest Issue Conclusion

31 35 38 51 56 60

EXECUTIVE SUMMARY

1

Introduction

At a very very macr macro o leve level, l, ‘Inv ‘Inves estm tmen entt Bank Bankin ing’ g’ as the the term term sugg sugges ests ts,, is concerned with the primary function of assisting the capital market in its functions of capital intermediation, i.e. the movement of financial resources from those who have them (the Investors), to those who need to make us of  them for generating GDP (the Issuers). As already discussed banking and financial institutions on the one hand and the capital market on the other are the two broad platforms of institutional intermediation for capital flows in the economy. Therefore, it could be inferred that investment banks are those inst instit itu utio tions that that are are the the cou ount nteerpa rparts of bank bankss in the the fun uncctio tion of  intermediation in resource allocation. Nevertheless, it would be unfair to conclude so, as that would confine investment banking to a very narrow sphe sphere re of its its acti activi viti ties es in the the mo mode dern rn worl world d of high high fina financ nce. e. Over Over the the decade decades, s, backed backed by evolut evolution ion and also also fuell fuelled ed by recent recent techno technolog logica icall developments, investment banking has transformed repeatedly to suit the needs of the finance community and thus become one of the most vibrant and exciting segment of financial services. Investment bankers have always enjoyed celebrity status, but at times they have paid the price for excessive flamboyance as well.

To continue from the above, in the words of John F. Marshall and M.E. Ellis, ‘investment banking is what investment banks do’. This definition can  be explained in the context of how investment banks have evolved in their  functionality and how history and regulatory intervention have shaped such as evolution. Much of investment banking in its present form thus owes its

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origin to the financial market in USA, due to which, American investment  banks have been leaders in the American and Euro markets as well. Therefore, the term ‘investment banking’ can arguably be said to be of  American origin. Their counterparts in UK were termed as ‘merchant banks’ since they had confined themselves to capital market intermediation intermediation until the US investment banks entered the UK and European markets and extended the scope of such businesses.

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Investment Banking and Merchant Banking Distinguished

At this stage, it would be relevant therefore, to draw a fine line of distinction  between the terms ‘Investment Banking’ and ‘Merchant Banking’ as both these terms are extensive extensively ly used in this project. project. ‘Merchant ‘Merchant Banking’ Banking’ as the term suggests, is the function of intermediation in the capital market. It consists of assisting issuers to raise capital by placement of securities issued  by them with investors. However, merchant banking is not merely about marketing securities in an agency capacity. 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 an ensure compliance with the law on own account and on behalf of the issuers as well. Therefore, merchant banking is a fee based service management of public offers; popularly know as ‘issue management’ and for private placement of securities in the capital market. In India, the Merchant Banker leading a public offer is also called as the ‘Lead Manager’.

On the the othe otherr hand hand,, the the term term,, ‘Inv ‘Inves estm tmen entt Bank Bankin ing’ g’ has has a mu much ch wide wider  r  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 Th is deve develo lopm pmen entt has has been been driv driven en mo more re by the the way way the the Am Amer eric ican an investment banks have evolved over the past century. Given this situation, investment banking encompasses not merely merchant banking but other  relate related d capita capitall market market activi activitie tiess such such as –stock –stock tradin trading, g, market market making making,, underwriting, broking and asset management as well. Besides the above,

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invest investmen mentt banks banks also also provid providee a hos hostt of specia specializ lized ed corpor corporate ate adviso advisory ry services in the areas of project advisory, business and financial advisory and merg merger erss and and acqu acquis isit itio ions ns.. Th Thee acti activi vity ty prof profil ilee of inve invest stme ment nt bank bankss is discussed in more in detail later in this chapter.

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Evolution of American Investment Banks The earliest events that are relevant for this discussion can be traced to the end of World War I, by which time, commercial banks in the USA were alre alread ady y prep prepar arin ing g for for an econ econom omic ic reco recove very ry and and cons conseq eque uent ntly ly,, to the the significant demand for corporate finance. It was expected that American companies would shift their dependence from commercial banks to stock  and bond markets wherein funds were available at a lower cost and for  longer periods of time. In preparation for a boom in the capital markets in the 1920s, commercial banks started to acquire stock broking businesses in a  bid to have their presence made in such markets. The first of such acquisitions happened when the National City Bank of New York acquired Halsey Stuart and Company in 1916. As in the past, in the entire 1920s, investment banking meant underwriting and distribution of securities.

The stock and bond market boom in 1920s was as opportunity that banks could not miss. But since they could not underwrite and sell securities dire direct ctly ly,, they they owne owned d secu securi rity ty affi affili liat ates es thro throug ugh h ho hold ldin ing g comp compan anie ies. s. However, they were not maintained like water tight compartments. The affiliates were sparsely capitalized as were financed by the parent banks for  their underwriting and other business obligations. While the boom lasted, invest investmen mentt bankin banking g affili affiliate atess made made hug hugee profit profitss as und underw erwrit riting ing fees, fees, specially in the segment called ‘Yankee Bonds’ issued by overseas issuers in US mark market et.. In the the stoc stock k mark market et,, the the bank bankss main mainly ly cond conduc ucte ted d brok brokin ing g operations through their subsidiaries and lent margin money to customers. But with the passage of the McFadden Act in 1927, bank subsidiaries began

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underwriting stock issues as well. National City Bank, Chase Bank, Morgan and Bank of America were the most aggressive banks present at that time.

The stock market got over-heated with investment banks borrowing money from the parent bank in order to speculate in the bank’s stock, mostly for  short selling. Once the general public joined the frenzy, the price-earning ratios reached absurd limits and the bubble eventually burst in October 1929 wiping out millions of dollars of bank depositors’ funds and bringing down with it banks such as Bank of United States/

In order to restore confidence in the banking and financial system, several legislation measure were proposed, which eventually led to the passing of  the Banking Act 1933 (popularly know as Glass-Steagall Act) that restricted commer commercia ciall banks banks from from engagi engaging ng in securi securitie tiess und underw erwrit riting ing and taking taking  positions or acting as agents for others in securities transactions. These activities were segregated as the exclusive domain of investment banks. On the other other hand, hand, invest investmen mentt banks banks were were barred barred from from deposi depositt taking taking and corp corpor orat atee lend lendin ing, g, whic which h were were cons consid ider ered ed the the excl exclus usiv ivee bu busi sine ness ss of  commercial bank. The Act thus provided the water tight compartments that were were needed needed before before.. Since Since the passin passing g of this this Act, Act, invest investmen mentt bankin banking g  became narrowly defined as the basket of financial services associated with the floatation of corporate securities, i.e. the creation of primary market for  securities. It was also extended to mean at a secondary level, secondary market making through securities dealing.

By 1935, investment banking became one of the most heavily regulated industries in USA. The Securities Act, 1933 provided for the first time the 7

 preparation of offer documents and registration of new securities with the fede federa rall go gove vern rnme ment nt.. Th Thee Secu Securi riti ties es Ex Exch chan ange ge Act, Act, 19 1934 34 led led to the the establishment of the Securities Exchange Commission. The Maloney Act of  1938 led to the formation of the NASDAQ, the Investment Company Act, 1940, which brought mutual funds within the regulatory ambit and the Inve Invest stme ment nt Advi Advise sers rs Act, Act, 19 1940 40 whic which h also also regu regula late ted d the the bu busi sine ness ss of  investment advisers and wealth managers.

After the passing of the Glass-Streagall Act of the 1930s, until the beginning of the 21st century, investment banking had been through several phases of  transformation which had broken down the water tight compartments to a great extent. Due to the 1973 Arab oil embargo, world economies were under pressure and inflation and interest rate volatility became disturbing. It was was at this this time time that that inst instit itut utio iona nall inve invest stor orss madd madder er thei theirr adve advent nt into into securities markets. It was also the time when the industrial and financial serv servic icee sect sector orss were were begi beginn nnin ing g to expa expand nd and and glob global aliz ize. e. Due Due to thes thesee develo developme pments nts,, invest investmen mentt bankin banking g and commer commercia ciall bankin banking g once once again again  became constrained by the very legislation that was meant to clean up the system in the 1930s. This led to several relaxations over the years such as the Securities Acts Amendments, 1975 which had permitted commercial  banks to have subsidiaries (called section 20 subsidiaries) that were allowed to underwrite and trade in securities. In 1990, J.P. Morgan was the first bank  to open a section 20 subsidiary. Since the Glass-Streagall Act did not apply to foreign subsidiaries of US banks, they continued to underwrite in the Euro Eu robo bond nd mark market et and and by 19 1984 84,, they they had had a 52 52% % mark market et shar sharee in that that  business. But there was stiff competition from Japanese banks in this market and by 1987, they underwrote only 25% of the Eurobond issuances. 8

During the economic growth and globalization of the 1980s, investment  banking expanded to several new areas and services which had included curren currency cy tradi trading, ng, real real estate estate,, financ financial ial future futures, s, bridg bridgee loans, loans, mortga mortgagege backed securities and several others. But the stock market crash of 1987 once again brought the focus back to core areas of specialization. Similarly, the ambitious expansion that took place on a global scale was also halted to some extent. However due to technological advancements in the 1990s and the availability of global access through the revolution in communication tech techno nolo logi gies es fuel fuelle led d the the glob global al grow growth th agai again. n. But But this this time time thou though gh,, investment banking is no more restricted to underwriting new issuances and securi security ty dealin dealing. g. The shift shift is mo more re toward towardss provid providing ing expert expertise ise in new  products and risks. Apart from these activities, investment banking also encompasses a considerable spectrum of advisory services in the areas of  corporate restructuring, mergers and acquisitions and LBOs, fund raising and privat privatee equity equity.. On the dealin dealing g and tradin trading g side, side, invest investmen mentt banks banks  participate in derivatives market, arbitrage and speculation. In the area of  struct structure ured d financ finance, e, invest investmen mentt banks banks also also provid providee financ financial ial engine engineeri ering ng through securitization deals and derivative instruments.

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European Investment Banks In continental Europe (excluding UK), the concept of a ‘Universal Bank’ had been the undercurrent since the late nineteenth century, when most of  thes thesee bank bankss were were set set up up.. Th Thee term term ‘uni ‘unive vers rsal al bank bankin ing’ g’ mean meantt the the cocoexistence of commercial banking (lending activity) along with investment  banking (investment and distribution activity). Their universality was in the sense of harnessing the vast retail customer base that these banks enjoyed to market security issuances by their investment banking arms. These issues were mostly in the local markets designated in the local currencies. France’s Banques d’affiars and Germany’s Universalbanken Universalbanken are good examples.

The United Kingdom, which is considered as Europe’s largest investment  banking market, had its own structure evolved from history. The oldest merc mercha hant nt bank bank in Lo Lond ndon on was was Bari Baring ngss Brot Brothe hers rs whic which h had had play played ed a  prominent role in the nineteenth century. Securities distribution was the function of stock brokers, secondary market trading was held by jobbers and advisory services were provided by merchant bank. The term ‘merchant  bank’ was evolved so as to distinguish between commercial banks and those that provided capital market advice. However, the breaking down of such  barriers in 1986 by allowing banks to own broking outfits led to a consolidation and most of the broking firms got absorbed by larger and diversified entities. Around the same time, the US too was witnessing the disappearance of distinction between pure broking entities restricted to the second secondary ary market marketss and invest investmen mentt bankin banking g entiti entities es involv involved ed with with the  primary markets. The US investment banks with their integrated global  business model entered UK and Europe and later into Japan. The 10

introduction of the Euro currency in 1999, helped the US invasion further by neutralizing the local currency advantages enjoyed by European universal  banks. By 2001, the US bulge group garnered 29.7% of the investment  banking fee generated in Europe as compared to 16.3% by the European universal banks.

Post-1 Post-1986 986,, the mercha merchant nt banks and commerc commercial ial banks banks in UK could not match up to the US onslaught which ultimately led to the sale of SG Warb Warbur urg, g, the the merc mercha hant nt bank bank to Swis Swisss Bank Bank Corp Corpor orat atio ion n (whi (which ch was was acquired by UBS later) in 1995. In 1997, Natwest Bank and Barclays Bank  exited investment banking business. Morgan Grenfell, a merchant bank was sold to Deutsche Bank in 1990. In this upheaval, niche players such as Drexel Burnham and Barings Bank also collapsed with internal deficiencies. This led to cross border M&A between European banks inter-se and their  American counterparts to create bigger investment banks. UBS Warburg was born out of merger of UBS and Swiss Bank Corporation which had earlier acquired SG Warburg. Deutsche Bank acquired Bankers Trust.

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Global Industry Structure The investment banking industry on a global scale is oligopolistic in nature ranging from the global leaders (known as the ‘Global Bulge Group’) to ‘Pure’ investment banks and ‘Boutique’ investment banks. The bulge group consisting of eight investment banks has a global presence and these firms dominate the league tables in key business segments. The top ten global firms in terms of their fee billing as in 2001 are listed in Table T able

Within the listing given in the table referred to above are the top ‘pure’ investment banks, i.e. which do not have commercial banking connections, which are Merrill Lynch, Goldman Sachs and Morgan Stanley Dean Witter. Listed therein are also the leading European Universal Banks that are called so due to their role in both commercial and investment banking. The five leading universal banks in the world and their important group affiliates are given in Table

Ther Th eref efor ore, e, the glob global al inve invest stme ment nt bank bankin ing g indu indust stry ry rang ranges es form orm the the acknowledged global leaders to a larger number of mid-sized competitors at a national or regional level and the rear end is supported by boutique firms or advisory and sectoral specialists.

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Business Portfolio of Investment Banks Globally, investment banks handle significant fund-based business of their  own in the capital market along with their non-fund service portfolio which is offered to clients. However, these distinct segments are handled either on the same balance sheet or through subsidiaries and affiliates depending upon the regulatory requirements in the operating environment of each country. All these these activi activitie tiess are segmen segmented ted across across three three broad broad platf platform ormss –equit –equity y market activity, debt market activity and merger and acquisition (M&A) acti activi vity ty.. In addi additi tion on,, give given n the the stru struct ctur uree of the the mark market et,, ther theree is also also a segmentation based on whether a particular investment bank belongs to a  banking parent or is a stand-alone pure investment bank. Figure represents the broad spectrum of global investment acitivity.

From From this this diag diagra ram, m, it may may be appr apprec ecia iate ted d that that inve invest stme ment nt bank bankin ing g encompasses a wide area of capital market based businesses and services and has a signif significa icant nt financ financial ial exposu exposure re to the capita capitall market market.. Though Though investment banks also earn a significant component of their income from non-fund based activity, it is their capacity to support clients with fund based services, which distinguishes them from pure merchant banks. In the US capital market, investment banks underwrite issues or buy them outright and and sell sell them them late laterr to reta retail il inve invest stor orss ther thereb eby y taki taking ng up upon on them themse selv lves es significant financial exposure to client companies. Besides, being such large financ financial ial power power hou houses ses themse themselve lves, s, the global global invest investmen mentt banks banks play play a major role as institutional investors in trading and having large holdings of  capital market securities. As dealers they take positions and make a market for many securities both in equity and derivative segments. They hold large 13

inventories and therefore influence the direction of the market. Goldman Sachs, Salomon Brothers, Merrill Lynch, Schroeders, Rothschild and other  significant Market Investors both on their own account and on behalf of the  billions dollars of of funds under their their management.

The global mergers and acquisitions business is very large and measures up to trillions of dollars annually. Investment banks play a lead advisory role in this booming segment of financial advisory business. Besides, they come in as investors in management buy-outs and management buy-in transactions. On other occasions, wherein investment banks manage private equity funds, they also represent their investors in such buy-out deals.

In the case of universal banks such as the Citigroup or UBS Warburg, loan  products form a significant part of the debt market business portfolio. Pure invest investmen mentt banks banks such such as Goldma Goldman n Sachs, Sachs, Merril Merrilll Lynch Lynch and Morgan Morgan Stanley Dean Witter do not have commercial banking in their portfolio and therefore, do not offer loan products. Besides the larger firms, there are a host ho st of othe otherr do dome mest stic ic play player erss pres presen entt in each each coun countr try y and and midmid-si size zed d investment banks, which either specialize in local markets or in certain  product segments.

Some investment banks in the overseas markets also specialize in niche segments such as –management of hedge funds, bullion trade, commodity hedges, real estate and other exotic markets.

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The Indian Scenario

Origin In India, though the existence of this branch of financial services can be traced to over three decades, investment banking was largely confined to merchant banking services. The forerunners of merchant banking in India were were the the fore foreig ign n bank banks. s. Grin Grindl dlay ayss Bank Bank (now (now merg merged ed with with Stan Standa dard rd Chartered Bank in India) began merchant banking operations in 1967 with a license obtained from the RBI followed by the Citibank in 1970. These two  banks were providing services for syndication of loans and raising of equity apart from other advisory services.

It was in 1972, that the Banking Commission Report asserted the need for  merchant banking services in India by the public sector banks. Based on the American experience which led to the passing of the Glass-Streagall Act, the Commission recommended a separate structure for merchant banks so as to distinct them from commercial banks and financial institutions. Merchant  banks were meant to manage investments investments and provide advisory advisory services.

Following the above recommendations, the SBI set up its merchant banking division in 1972. Other banks such as the –Bank of India, Central Bank of  India, Bank of Baroda, Syndicate Bank, Punjab National Bank, Canara Bank  also followed suit to set up their merchant banking outfits. ICICI was the first financial institution to set up its merchant banking division in 1973. The later entrants were IFCI and IDBI with the latter setting up its merchant

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 banking division in 1992. However, by the mid eighties and early nineties, most of the merchant banking divisions of public sector banks were spun off  as separate subsidiaries. SBI set up SBI Capital Markets Ltd. in 1986. Other  such banks such as –Canara Bank, BOB, PNB, Indian Bank and ICICI created separate merchant banking entities.

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Growth Merchant banking in India was given a shot in the arm with the advent of  SEBI in 1988 and the subsequent introduction of free pricing of primary market equity issues in 1992. However, post 1992, the merchant banking industry was largely driven by issue management activity which fluctuated with the trends in the primary market. These have been phases of hectic activity followed by a severe setback in business. SEBI started to regulate the mercha merchant nt bankin banking g activi activity ty in 199 1992 2 and a majori majority ty of the mercha merchant nt  bankers who registered with SEBI were either in issue management or  associ associate ated d activi activity ty such such as und underw erwrit riting ing or adviso advisorsh rship. ip. SEBI SEBI had four  four  categories of merchant bankers with varying eligibility criteria based on their networth. The highest number of registered merchant bankers with SEBI was seen in the mid-nineties, but the numbers have dwindled since, duee to the du the inac inacti tivi vity ty in the the prim primar ary y mark market et.. Th Thee nu numb mber er of regi regist ster ered ed merchant bankers with SEBI as at the end of March 2003 was 124, from a  peak of almost a thousand in the nineties. In the financial year 2002-03 itself, the number decreased by 21.

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Constraints in Investment Banking

Due to the over dependence on issue management activity in the initial years, most merchant banks perished in the primary market downturn that followed later. In order to stabilize their businesses, several merchant banks diversified to offer a broader spectrum of capital market services. However, other than a few industry leaders, the other merchant banks have not been able to transform themselves into full service investment banks. Going by the service portfolio of the leading full service investment banks in India, it may may be said said that that the the indu indust stry ry in Indi Indiaa has has seen seen mo more re or less less simi simila lar  r  development as its western counterparts, though the breadth available in the overseas capital market is still not present in the Indian capital market. Secondly, due to the lack of institutional financing in a big way to fund capital market activity, it is only the bigger industry players who are in investment banking. The third major deterrent has also been the lack of  depth in the secondary market, especially in the corporate debt segment.

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Char Charac acte teri rist stic icss and and Stru Struct ctur uree of Indi Indian an Inve Invest stme ment nt Bank Bankin ing g Industry

Investment banking in India has evolved in its own characteristics structure over the years both due to business realities and the regulatory regime.

On the regulatory front, the Indian regulatory regime does not allow all investment banking functions to be performed under one entity for two reasons–(a) to prevent excessive exposure to business risk under one entity and (b) (b) to prescr prescribe ibe and mo monit nitor or capita capitall adequa adequacy cy and risk risk mitiga mitigatio tion n mechanisms. Therefore bankruptcy remoteness is a key feature in structuring the business lines of an investment bank so that the risks and rewards are defined for the investors who provide resources to the investment banks. In addition, the capital adequacy requirements and leveraging capability for  each business line have been prescribed differently under relevant provisions of law. On the same analogy, commercial banks in India have to follow the  provisions of the Banking Regulation Act and the RBI regulations, which  prohibit them from exposing themselves to stock market investments and lending against stocks beyond certain specified limits.

Theref Therefore ore,, Indian Indian invest investmen mentt banks banks struct structure ure their their bus busine iness ss segmen segments ts in different corporate entities to be able to meet regulatory norms. For e.g. it is desirable to have merchant banking is a separate company as it requires a separate merchant banking license from the SEBI. Merchant bankers other  than banks and financial institutions are also prohibited from undertaking any other business other than that in the securities market. However, since

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 banks are subject to the Banking Regulation Act, they cannot perform invest investmen mentt bankin banking g to a large large extent extent on the same balanc balancee sheet. sheet. Ass Asset et management business in the form of a mutual fund requires a three-tier  structure under the SEBI regulations. Equity research should be independent of the merchant banking business so as to avoid the kind of conflict of  interest as faced by American investment banks. Stock broking has to be sepa separa rate ted d into into a diff differ eren entt comp compan any y as it requ requir ires es a stoc stock k exch exchan ange ge member membershi ship p apart apart from from SEBI SEBI regist registrat ration ion.. A comple complete te overvi overview ew of the regulatory framework for investment banking is furnished later.

Investment banking in India has also been influenced by business realities to a large extent. The financial services industry in India till the early 1980s was driven largely by debt services in the form of term financing from financial institutions and working capital financing by commercial banks and non-banki non-banking ng financial financial companies companies (NBFCs). (NBFCs). Capital Capital market market services services were mostly restricted to stock broking activity which was driven by a noncorp corpor orat atee un unor orga gani nize zed d bo body dy indu indust stry ry.. Merc Mercha hant nt bank bankin ing g and and asse assett management services came up in a big way only with the opening up of the capital markets in the early nineties. Due to the primary market boom during that period, many financial business houses such as financial institutions,  banks and NBFCs entered the merchant banking, underwriting and advisory  business. While most institutions and commercial banks floated merchant  banking divisions and subsidiaries, NBFCs combined their existing business with that of merchant banking.

Over the subsequent years, two developments have taken place. Firstly, with the downturn in the capital markets, the merchant banking industry has seen 20

a tremendous shake out and only about a 10% of them remain in serious  business as pointed out earlier. The other development is that due to the gradual regulatory developments in the capital markets, investment banking activities have come under regulations which require separate registration, licensing and capital controls.

Due to the above reasons, the Indian investment banking industry has a heterogeneous structure. The bigger investment banks have several group entities in which the core and non-core business segments are distributed. Others have either one or more entities depending upon the activity profile.

The hetero heterogen geneou eouss and fragme fragmente nted d struct structure ure is eviden evidentt even even if Indian Indian investment banks are classified on the basis of their activity profile. Some of  them such as –SBI, IDBI, ICICI, IL & FS, Kotak Mahindra, Citibank and othe others rs offe offerr almo almost st the the enti entire re gamu gamutt of inve invest stme ment nt bank bankin ing g serv servic ices es  permitted in India. Among these, the long term financial institutions are gradua gradually lly transf transform orming ing themse themselve lvess into into full full servic servicee commer commercia ciall banks banks (calle (called d ‘unive ‘universa rsall bankin banking’ g’ in the Indian Indian contex context). t). They They also also have have full full service investment banking under their fold. Other entities such as NBFCs or  subsidiaries of public sector banks mainly offer merchant banking and other  capital market services. There are also several others who are providing only corp corpor orat atee advi adviso sory ry serv servic ices es bu butt pref prefer er to ho hold ld merc mercha hant nt bank bankin ing g or  underwriting registrations.

Presently, there are no global Indian investment banks although there is a  bulge bracket of investment investment banks in India that have some overseas presence presence to serve Indian issuers and their investors. At the middle level are several 21

niche players including the merchant banking subsidiaries of some public sector banks. Some of these subsidiaries have been either shut down or sold off in the wake of two securities scam seen in 1993 and in 2000. However, certain banks such as Canara Bank and Punjab National Bank have had successful merchant banking activities. Among the middle level players are also merchant banks structured as non-banking financial services companies such as Rabo India Finance Ltd, Alpic Finance etc. There are also in the middle level, some pure advisory firms such as –Lazard Capital, Ernst & Young, KPMG, Price Waterhouse Coopers etc. At the lower end are several niche players and boutique firms, which focus on one or more segments of  the investment banking spectrum.

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Service Portfolio of Indian Investment Banks

Core Services Merchant Banking, Underwriting and Book Running

The primary market which was quite small in India, was revitalized with the abolition of the Capital Issues (Control) Act 1947 and the passing of the Securities and Exchange Board of India Act, 1992. The SEBI functions as the regulator for the capital markets similar to its counterpart, the SEC in USA. SEBI vide its guidelines dated June 11, 1992 introduced free pricing of securities in public offers for the first time in India. Over the last ten years, there have been two distinct phases of primary market boom –the first  between 1992-1996 and the second between 1998-2001. The third wave of   primary market issues could shape up in the near future. This market is very closely regulated by SEBI. In the days when the public offers market is very vibr vibran ant, t, this this area area of serv servic icee form formss the the main main acti activi vity ty for for mo most st Indi Indian an investment banks. In the past few years, though public offers have been very few, the private placement market especially in the debt segment has been very active and has served as an important source of funds for prime-rated corpor corporate ates. s. Notabl Notablee among among such such offeri offerings ngs are relat related ed privat privately ely placed placed debe debent ntur ures es issu issued ed by pu publ blic ic sect sector or corp corpor orat atio ions ns and and lead leadin ing g priv privat atee compan companies ies.. Financ Financial ial instit instituti utions ons have have been been raisin raising g funds funds via the pub public lic offers and hand holding them in the private placements as well. Once the  private placement markets also come under regulatory stipulations, investment banks would have a wider role to play in such issuances.

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Mergers and Acquisitions Advisory The mergers and acquisitions industry was pretty nascent in India prior to 1994 19 94 and and cont contin inue uess to be tiny tiny comp compar ared ed to the the glob global al scal scalee of such such transactions. However, two main features that have given a big push to this industry are:

•

The forces of liberation and globalization that have forced the Indian industry to consolidate.

•

The institutionalization of corporate acquisitions by SEBI through its guidelines, popularly known as the Takeover Code.

One of the cream activities of investment banks has always been M&A advisory. The larger investment banks specialize in M&A as a core activity. While some of them provide pure advisory services in relation to M&A, others holding valid merchant banking licenses from SEBI also manage the open offers arising out of such corporate events.

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Corporate Advisory

Investment banks in India also have a large practice in corporate advisory servic services es relati relating ng to proje project ct finan financin cing, g, corpor corporate ate restru restructu cturin ring, g, capita capitall restructuring through equity repurchases (including management of buyback  offers offers und under er sectio section n 77A of the Compan Companies ies Act, Act, 195 1956), 6), raisin raising g privat privatee equity, structuring joint-ventures and strategic partnerships and other such value added specialized areas.

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Support services and Businesses

Secondary Market Activities Most of the universal banks such as ICICI, IDBI and Kotak Mahindra have their broking and distribution firms in both the equity and debt segments of  the secondary market. In addition several other investment banks such as the IL & FS and pure investment banks such as DSP Merrill Lynch and JM Morgan Stanley have a strong presence in this area of activity. In the past few years, the derivatives segment has been introduced in Indian capital mark market et and and this this prov provid ides es an addi additi tion onal al aven avenue ue of spec specia iali liza zati tion on for  for  invest investmen mentt banks. banks. Deriva Derivativ tives es tradin trading, g, risk risk manag manageme ement nt and struct structur ured ed  products offerings are the new segments that are fast becoming the areas of  future potential for Indian investment banks. The securities business also  provides extensive research offerings and guidance to investors. The seco second ndar ary y mark market et serv servic ices es cate caterr to bo both th the the insti nstitu tuti tion onal al and and no nonninstitutional investors.

Asset Management Services Most of the top financial groups in India which have investment banking  businesses such as the –ICICI, the IDBI, Kotak Mahindra, DSP Merrill Lynch, JM Morgan Stanley, SBI and IL & FS also have their presence in the asset management business through separate entities. As per the three layer  structure propounded by SEBI, the parent organization acts as the sponsor of  the fund and the fund itself is constituted as a trust. The trust is managed by

26

an asset asset manage managemen mentt compan company y and a separa separate te trust trustee ee compan company y which which oversees the interests of the unit holders in the Mutual Fund. The whole structure has as arm’s length distance from the sponsor’s other businesses and entities.

Wealth Management Services (Private Banking) Many Many repute reputed d invest investme ment nt banks banks nurtur nurturee a separa separate te servic servicee segmen segmentt to manage the portfolio of high networth individuals, households, trusts and other types of non-institutional investors. This can be structured either as a  pure advisory service wherein the investment manager does not have any access to the funds or as a fund management service wherein the investment manager is given charge of the funds. In the former case, it becomes a nondiscretionary portfolio and in the latter case, it becomes a discretionary  portfolio. Such activity is regulated under the SEBI guidelines as already discussed. In other cases, wealth management may be restricted to a research  based activity wherein the investor is provided good investment recommendations from time to time.

Institutional Banking

Institutional investors have been a recent phenomenon in the Indian capital market, which till then had the presence of a handful of public financial institutions such as the UTI and the insurance companies. The term lending institutions such as the IDBI and IFCI did not participate in secondary market dealing as a matter of policy. With the advent of liberalization, there

27

are presen presently tly a large large num number ber of dom domest estic ic instit instituti utiona onall invest investors ors in the secondary market apart from approved foreign institutional investors. In addition, institutional investments have risen significantly in the primary markets through venture capital and private equity investments by investors in both the domestic and non-domestic categories. Several of the leading investment banks either have dedicated venture funds or private equity funds that invest in primary market. In addition they make proprietary investments investments in the secondary market through their dealing and market activities. The  business portfolio of Indian Investment Banks has been briefly discussed in Fig.

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Inte Interd rdep epen ende denc ncee betw betwee een n Diff Differ eren entt Vert Vertic ical alss in Inve Invest stme ment nt Banking As is evident evident from Figure Figure

, there are differen differentt verti verticals cals in investmen investmentt

 banking and they do enjoy synergies with one another. While some of the service or business segments form the core of investment banking, others  provide invaluable support. This inter-dependence inter-dependence and complementary existence has been explained below.

While merchant banking largely relates to management of public floatations of securi securitie tiess or revers reversee floata floatatio tions ns such such as buy backs backs and open open offer offers, s, underw und erwrit riting ing is an inhere inherent nt part part of mercha merchant nt bankin banking g for for pub public lic issues issues.. Similarly, bought out deals and market making are a part of the process of  floating issues on the OTC Exchange of India. The concept of market making has now been introduced for listing of certain scrips in the main stock exchanges as well. Advisory and transaction service have a close link linkag agee with with merc mercha hant nt bank bankin ing g as mo more re ofte often n than than no not, t, such such serv servic ices es culminate in a merchant banking assignment for a public issue or a reverse floatation. Such services also help in maintaining an enduring relationship with clients during those times when merchant banking is not a hot activity due to depressed market conditions. The other segment of primary market activity, i.e. venture capital and private equity has equal synergies with merc mercha hant nt bank bankin ing. g. Bein Being g in vent ventur uree capi capita tall bu busi sine ness ss whic which h enab enable less identification of potential IPO candidates quite early, which helps not only in generating good fee income from merchant banking services, but also good in capital gains for the venture capital invested at earlier rounds of 

29

financing in such companies. Similarly, being in private equity business helps in harnessing the potential offered by later stage and listed companies, which may approach an investment bank primarily for merchant banking services.

The support business vertical in the secondary market operations also have synergies with those in the primary equity and debt market segment as far as investment banking is concerned. Stock broking and primary dealership in debt markets nurture institutional, corporate and retail clients who can be tapped effectively for asset management, portfolio management, and private equity business. In addition, presence in the equity derivative and foreign exchange derivatives segments can help in offering solutions in treasury management to clients. In addition, the advisory and transaction services vertic vertical al can draw draw expert expertise ise from from such such segmen segments ts in provi providin ding g struct structure ured d financing solutions to its clients. All these verticals are driven by support services such as sales and distribution and also equity research and analysis. Lastly but more importantly, the capability in sales and distribution also determines the success of the merchant banking vertical.

Thus, it may be seen that the growth and success of an investment bank  depends on its strengths in each vertical and how well it combines them for  synergies. To sum up, investment banking is a business that is very sensitive to the economic and capital market scenario and therefore, the broader the  platform of its operations, the more is likelihood of an investment bank  surviving business cycles and sudden shocks from the market.

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Regulatory Framework for Investment Banking As discussed discussed above, investment investment banking in India is regulate regulated d in its various facets under separate legislations or guidelines issued under statute. The regu regula lato tory ry po powe wers rs are are also also dist distri ribu bute ted d betw betwee een n diff differ eren entt regu regula lato tors rs depending upon the constitution and status of the 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 also 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 the cons consti titu tuti tion onal al leve level, l, all all inve invest stme ment nt bank bankin ing g comp compan anie iess incorporated under the Companies Act, 1956 are governed by the  provisions of that that Act.

2. Investmen Investmentt banks that are incorpo incorporate rated d under a separate separate statute statute such as the SBI or the IDBI are regulated by their respective statute. IDBI is in the the proc proces esss of bein being g conv conver erte ted d into into a comp compan any y un unde derr the the Companies Act.

3. Universal Universal Banks Banks are regulat regulated ed by the Reserve Reserve Bank of India India under under the RBI Act 1934 and the Banking Regulation Act which put restrictions on the investment banking exposures to be taken by banks. The RBI has relaxed the exposure limits for merchant banking subsidiaries of  commercial banks. Till now, such companies were restricting their  31

exposure to a single entity through the underwriting business and other fund based commitments such as standby facilities etc to 25% of  their net owned funds (NOF). Therefore these companies are now on  par with other investment banks which can do so up to 20 times their   NOF.

4. Invest Investmen mentt bankin banking g compan companies ies that are consti constitut tuted ed as non non-ba -banki nking ng financ financial ial compan companies ies are regula regulated ted operat operation ionall ally y by the the RBI und under  er  Chapter IIIB (sections 45H to 45QB) of the Reserve Bank of India Act, 1934. Under these sections RBI is empowered to issue directions in the area area of resour resource ce mob mobili ilizat zation ion,, accoun accounts ts and admini administr strati ative ve controls. The following directions directions have been issued by the RBI so far: •

 Non-Banking Financial Companies Acceptance of Deposits (Reserve Bank) Directions, 1998.

•

 NBFCs Prudential Norms (Reserve Bank) Bank) Directions, Directions, 1998.

5. Functi Functiona onally lly,, differ different ent aspects aspects of invest investmen mentt bankin banking g are are regula regulated ted under the Securities Exchange Board of India Act, 1992 and the guidelines and regulations issued there under. These are listed below: •

Merchant banking business consisting of management of public offers is a licensed and regulated activity under the Securities and Exchange Board of India (Merchant Bankers) Rules 1992 and Securities Exchange Board of India (Merchant Bankers) Regulations 1992.

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•

Underwriting

business

is

regulated

under

the

SEBI

(Und (Under erwr writ iter ers) s) Rule Ruless 19 1993 93 and and the the SEBI SEBI (Und (Under erwr writ iter ers) s) Regulations 1993. •

The activity of the secondary market operations including stock   broking are regulated under the relevant by-laws of the stock  exchange and the SEBI (Stock Brokers and Sub Brokers) Rules 1992 and the (Stock Brokers and Sub Brokers) Regulations 1992. Besides, for curbing unethical trading practices, SEBI has  promulgated the SEBI (Prohibition of Insider Trading) Regulations 1992 and the SEBI (Prohibition of Fraudulent and Unfa Unfair ir Trad Tradee Prac Practi tice cess Rela Relati ting ng to Secu Securi riti ties es Mark Market ets) s) Regulations 1995.

•

The business of asset management as mutual funds is regulated under the SEBI (Mutual Funds) Regulations 1996.

•

The business of portfolio management is regulated under the SEBI (Portfolio Managers) Rules, 1993 and the SEBI (Portfolio Managers) Regulations, 1993.

•

The bus busine iness ss of ventur venturee capita capitall and privat privatee equity equity by such such funds that are incorporated in India is regulated by the SEBI (Venture Capital Funds) Regulations, 1996 and by those that are incorp incorpora orated ted outsid outsidee India India is regul regulate ated d und under er the SEBI SEBI (Foreign Venture Capital Funds) Regulations 2000.

•

The business of institutional investing by foreign investment  banks and other investors in Indian secondary markets is gove go vern rned ed by the the SEBI SEBI (For (Forei eign gn Inst Instit itut utio iona nall Inve Invest stor ors) s) Regulations 1995.

33

34

6. Inv nves estm tmen ents ts ban banks that that are set up in Indi Indiaa with ith forei oreig gn direct rect 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. Apar Apartt from from the the abov abovee spec specif ific ic regu regula lati tion onss rela relati ting ng to inve invest stme ment nt  banking, investment banks are also governed by other laws applicable to all other businesses such as the –tax law, property law, state laws, arbitration law and other general laws that are applicable in India.

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Regulatory Framework for Merchant Banking Merchant Bankers are governed by the SEBI (Merchant Bankers) Rules 1992 and SEBI (Merchant Bankers) Regulations 1992. According to the SEBI (Merchant Bankers) Rules 1992 a Merchant Banker means ‘a person who is engaged in the business of issue management either by making arrang arrangeme ements nts regar regardin ding g sellin selling, g, buy buying ing or sub subscr scribi ibing ng to securi securitie tiess as manage manager, r, consul consultan tant, t, adviso advisorr or rende renderin ring g corpor corporate ate adviso advisory ry servic servicee in relation to such issue management’.

Given the fact that Merchant Bankers are entrusted with the responsibility of  issue management by law, the regulatory framework is designed to ensure that they sufficient competence and exercise diligence in their work such that the issuers comply with all statutory requirements concerning the issue. At the same time, the merchant banker shall have high levels of integrity so that quality issues alone are brought to the primary market. Keeping these objectives in mind and investor protection as the paramount objective, the SEBI SEBI has has laid laid emph emphas asis is on ensu ensuri ring ng that that merc mercha hant nt bank banker erss fulf fulfil il the the eligib eligibili ility ty criter criteria ia on an on-goi on-going ng basis basis and has there therefor foree provid provided ed for  compulsory registration every three years. All Merchant Bankers need to have a valid registration certificate under the said rules to perform the role of  Merchant Bankers to issues. In considering the application for registration, SEBI shall pay regard to the professional qualification in finance, law or   business management, adequate office space, manpower, office equipment and other infrastructure, at least two support staff members who have the competence to be in the field of merchant banking business, existence of 

36

minimum stipulated capital and previous experience to investor grievance redressal.

Thee acti Th activi viti ties es that that a Merc Mercha hant nt Bank Banker er is auth author oriz ized ed to do are are issu issuee mana manage geme ment nt and and asso associ ciat ated ed acti activi viti ties es such such as advi advisi sing ng or prov provid idin ing g consultancy or marketing services for the issue, underwriting of issues and  portfolio management, though portfolio management alone requires additional registration under the relevant regulations. Merchant Bankers are  precluded from carrying on any business or fund-based activity other than that associated with the securities market. Merchant Bankers are also bound  by the Code of Conduct prescribed under the Regulations. In addition, Mer Merchan chantt Bank ankers ers hav have to comp comply ly with with gene eneral ral ob obli lig gati ation onss and responsibilities under the Regulations.

Presently there is only one category of Merchant Bankers prescribed by SEBI (Category I) and the minimum stipulated networth for such Merchant Bankers is Rs.five crore. Such Merchant Bankers holding valid certificates of registration are alone qualified to manage public offers. SEBI levies a one-time authorization fee, an annual fee and a renewal fee from each Merchant Banker.

Under the regulations, Merchant Bankers have also to submit periodical returns and any other additional information that SEBI might seek from time to time. SEBI also has a right of inspection of the books of account, records and documents of the merchant banker at any time if required. SEBI may suo moto conduct an enquiry or launch an investigation into the working of  a Merchant Banker or on receipt of a complaint against such Merchant 37

Banker. SEBI may even appoint an external auditor to inspect the books and repo report rt to SEBI SEBI.. Base Based d on the the find findin ings gs,, SEBI SEBI is empo empowe were red d to take take appropriate action to award penalty points to the erring Merchant Banker   based on the degree of the default or contravention in accordance with the SEBI (Procedure for Holding Enquiry by Enquiry Officer and Imposing Penalty) Regulations 2002. The aggrieved Merchant Banker may prefer to appe appeal al the the Cent Centra rall Gove Govern rnme ment nt un unde derr the the SEBI EBI (App (Appea eall to Cent Centra rall Government) Rules 2003. It may also be mentioned here that a Merchant Banker is deemed to be a connected person to the issuer under the SEBI (Prohibition of Insider Trading) Regulations, 1992.

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Anatomy of Some Leading Indian Investment Banks.

ICICI Securities Ltd. (I-Sec). I-Sec is a part of the ICICI group whose parent company is the ICICI Bankm which till recently was a financial institution that converted itself into a universal bank by it merger with its own commercial bank, the ICICI Bank  in 2003. I-Sec, which was initially a joint venture with J.P. Morgan of the US, US, beca became me full fully y owne owned d by ICIC ICICII afte afterr J.P. J.P. Mo Morg rgan an exit exited ed from from the the  business.

I-Sec is a full service investment bank that provides services across all the segments spanning –debt market, equity market, derivatives and corporate adviso advisory ry servic services. es. It has sup suppor portt servic services es in resear research ch and brokin broking. g. The advi adviso sory ry bu busi sine ness ss focu focuse sess on merg merger er and and acqu acquis isit itio ions ns,, cros crosss bo bord rder  er  acquisitions, equity and bidding for a number of reputed companies. The equity business offers research, sales and execution services to institutional investors in the secondary market and capital market related services such as exec execut utio ion n of pu publ blic ic offe offeri ring ngs, s, stru struct ctur urin ing g and and regu regula lato tory ry and and lega legall documentation services.

In order to assist/provide corporate clients and institutional investors with inve invest stme ment nt bank bankin ing g serv servic ices es in the the USA. USA. I-Se I-Secc set set up two two US base based d subsidiaries namely ICICI Securities Holding Inc and ICICI Securities Inc. ICICI ICICI Securi Securitie tiess Inc regist registere ered d itself itself with with the Nation National al Ass Associ ociati ation on of 

39

Security Dealers Inc as a broker-dealer, broker-dealer, empowering it to engage in a variety of securities transactions in the US market.

ICIC ICICII Brok Broker erag agee Serv Servic ices es Limi Limite ted, d, a memb member er of the the Nati Nation onal al Stoc Stock  k  Exchange of India Limited, is the domestic broking subsidiary of I-Sec’s distri distribut bution ion and second secondary ary market market servic services es are handle handled d by the brokin broking g company.

DSP Merrill Lynch Ltd.

Originally incorporated as DSP Financial Consultants Ltd, its name was changed to DSP Merrill Lynch (DSP-ML) in 1996 following its conversion into a joint venture with Merrill Lynch of USA, a leading international capital raising financial management and advisory company. Merrill Lynch has a 40% equity stake in DSP-ML. DSP-ML is a part of the DSP group which has been in the securities and brokerage business for 130 years in the Indian market, thus pre-dating even the Bombay Stock Exchange. E xchange.

DSP-ML is a leading full service Investment Bank that provides services across debt market, equity market and corporate advisory segments. It also  provides services to private customers on equity and debt products and wealth management. It has a full fledged research team serving the needs of   both its institutional and retail clients. The company is among the major   players on proprietary account in the debt and equity markets and is also a registered primary dealer in government securities.

40

The functional divisions at DSP-ML consist of the –Investment Banking Group, the Equity Sales Group, the Equity Trading and Dealing Group, Debt Sales Group, the Mergers and Acquisitions Group, the Research Group and the Private Client Group. The investment banking group generates equity and debt products emerging from IPOs, secondary issues and debt market issues as well as private placements. It is also a leading underwriter in both equity and debt products. These products are distributed through the equity sales group and the debt sales group. Both the marketing groups serve a cross section of institutional clients, other non-institutional clients such as trusts and investment companies, retail clients and overseas investors. The sales groups also distribute apart from their own products, the products emerging from other entities such as DSP Merrill Lynch Mutual Fund and other mutual funds. The sales groups are supported by a national distribution networking networking comprisin comprising g of approxim approximately ately 8000 sub-brok sub-brokers ers and alliance alliance  partners.

The trading and dealing groups support the broking activity in equities and the primary dealership activities in the debt market. DSP-ML, is one of the largest institutional broking firms in India. It is a founding member of The Stock Exchange, Mumbai (BSE) and is an active member of the National Stoc Stock k Ex Exch chan ange ge (NSE (NSE)) of Indi Indiaa in bo both th the the equi equity ty segm segmen entt and and the the wholesale debt market segment. It is an accredited primary dealer with the RBI and an active participant in the Government Securities/Treasury bill markets. As a primary dealer, it makes a market for debt securities by offering to buy and sell quotes. These quotes are also available on wire serv servic ices es like like Reut Reuter ers, s, Cris Crisil il Mark Market et wire wire,, Bloo Bloomb mber erg g and and Dow Dow Jone Joness  Newswires. 41

The mergers and acquisitions advisory has been structured as a separate specialist group that offers their clients financial advice and assistance in restructuring, divestures, acquisitions, de-mergers, spin-offs, joint ventures,  privatization and takeover defense mechanisms. The research group offers  products such as –sectoral reports, company reports and special theme analyses, daily, weekly and monthly market views as well as specific policy forecasts. The private client group offers depository, broking and investment advisory services to high net worth individuals, professionals and promoters of business groups, corporate executives, trusts and private companies.

In 1996, the DSP group floated a separate equity broking company called DSP Securities Ltd. which is a member of the BSE.

42

JM Morgan Stanley Pvt. Ltd. JM Morgan Stanley (JMMS) is a joint venture between the JM Financial Group and Morgan Stanley Dean Witter of the USA. In 1997, Morgan Stanley which was established in New York in 1935, had acquired Dean Witter, an investment bank founded in 1924 in San Francisco. JM Morgan Stanley commenced operations in April 1999. However, the association of  the two partners is limited only to the investment banking area. Both of them have separate asset management companies in India which run independent of mutual fund businesses.

Unlike DSP-ML and I-Sec which have an integrated structure, the JM Group has separate companies handling various components of the capital market  business. The core functions of investment banking are performed by JMMS. This company focuses on capital raising, mergers and acquisitions,  private equity and advisory work for Indian corporations in both the international and domestic capital markets. The function of distribution and marketing securities is handled by two of its wholly owned subsidiaries –JM Morgan Stanley Retail Services Pvt. Ltd. (JMRS) and JM Morgan Stanley Fixed Income Securities Pvt. Ltd. (JMFI). JMRS provides equity distribution serv servic ices es for for prim primar ary y mark market et prod produc ucts ts,, mu mutu tual al fund funds, s, equi equity ty sale saless and and marketing support for the group broking activity and wealth management and portfo portfolio lio manage managemen mentt servic services es to high high net worth worth indivi individua duals. ls. JMFI JMFI offers similar services in fixed income (debt) securities. A third company, JM Morgan Stanley Securities Pvt. Ltd. handles all the broking operations for the group and provides services to institutional clients and others. It also  provides research support support for both FII and Indian institutional clients. clients. 43

SBI Capital Markets Ltd Founded in 1986 as a hive-off of the SBI Merchant Banking division, SBI Capital Markets Ltd. (SBI Caps) is amongst the oldest players in the Indian capital market. It is a full service investment bank that provides investment, advisory and financial services. In 2001, SBI Caps started its sales and distribution activity along with equity and debt broking services.

SBI Caps provides services across the following spectrum: •

Mergers Mergers and Acquisiti Acquisitions ons: This group provides advisory services

with regard to disinvestment of the government, valuations, mergers and and acqu acquis isit itio ions ns in the the corp corpor orat atee sect sector or,, fina financ ncia iall and and bu busi sine ness ss restructuring and other areas. •

Project advisory and structure finance : It is arguably one of the

lead leadin ing g grou groups ps in the the comp compan any y that that prov provid ides es serv servic ices es such such as restructur restructuring ing and privatiza privatization tion advisory advisory for public public utilities utilities,, policy policy advisory to Central and State Governments, regulatory bodies and government departments and organizations, project structuring and advisory to the private sector and arranging finance for such projects. SBI Caps has been a major player in governmental work and in the infrastructure sector. The project advisory services consist of handholding from the concept to commissioning stage involving project structuri structuring, ng, contract contract structur structuring, ing, financial financial modeling, modeling, preparat preparation ion of  info inform rmat atio ion n memo memora rand ndum um,, synd syndic icat atio ion n of debt debt and and equi equity ty and and assist assistanc ancee in docume documenta ntatio tion n and finan financia ciall closur closure. e. Other Other servic services es include appraisals for green-field and brown-field projects, techno-

44

econ econom omic ic appr apprai aisa sall from from bank bankss and and fina financ ncia iall inst instit itut utio ions ns for  for  establishing the viability of corporate restructuring plans, and vetting of contracts, loan documents, project documentation etc. •

Capital market: This group provides merchant banking services in

connection with public issues, rights issues and public offers for buy backs and open offers. It also advises clients on the private  placements, ADR and GDR issues and overseas bond issues by the SBI. •

Treasury and Investments: This group deals with the proprietary

investment of the company in the equity, debt and money markets. Resource mobilization and management is also undertaken by this group. •

Broking of Equity and Debt : SBI Caps is a registered broker and a

member of the NSE in the equity and wholesale debt segments and is also a member in the equity segment. The broking group caters to the secondary market needs of financial institutions, FIIs, mutual funds,  banks, other corporates, high net worth individuals, non-resident investors and retail investors. The company commenced wholesale debt market broking in 2001. The company expects to have a strong  presence in institutional broking. The company plans to open a derivative trading desk soon. •

Sales and Distribution of equity and mutual fund products : SBI

Caps has been a leading mobilizer of funds both for public offers and  private placements. placements. •

Research: This This group group provi provides des the resear research ch sup suppor portt for in-hou in-house se

departments and for institutional clients. Besides regular updates on

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comp compan anie iess and and indu indust stri ries es,, the the rese resear arch ch grou group p brin brings gs ou outt Indi Indiaa Strategy, Strategy, Debt Market Market Review Review and Daily Debt Market review which which are circulated to SBI Caps investment banking and broking clients.

In its annual report for the year ending March 31, 2002, SBI Caps repo report rted ed that that is has has two two bu busi sine ness ss segm segmen ents ts –(a) –(a) Fee Fee base based d segm segmen entt  providing

merchant

banking

and

advisory

services

like

issue

managemen management, t, underwri underwriting, ting, arranger arranger,, project project advisory advisory and structure structured d finance. (b) Fund based segment which undertakes deployment of funds in leasing, hire purchase and securities dealing. However, as a result of  SEBI SEBI direct directive ives, s, fresh fresh lendin lending g und under er leasin leasing g and hirehire-pur purcha chase se was stopped from 1 st July 1998. For the period 2001-02, SBI Caps was ranked first among issue managers by PRIME database.

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Kotak Mahindra Capital Company Born in 1995 as part of a corporate re-organization as an unlimited comp compan any. y. Th Thee Kota Kotak k Mahi Mahind ndra ra Capi Capita tall Comp Compan any y (KMC (KMCC) C),, is the the investment banking entity belonging to the Kotak Mahindra Group. It is a strategic joint venture between Kotak Mahindra Bank Limited (KMBL) and the Goldman Sachs Group LLP of USA. KMCC is a full service investment bank whose core business centers on equity issuances and fixed income securities, mergers and acquisitions and advisory services. As an investment bank, KMCC is registered with SEBI and is also registered as a non-banking financial company with RBI. It is also an active member of the association of Merchant Bankers of India (AMBI). KMCC has two wholly owned subsidiaries –(a) Kotak Mahindra (UK) Limited, which is registered with the Securities and Futures Association, UK and regulated by the Financial Services Authority, UK and (b) Kotak  Mahindra Inc based in USA, which is registered with the Securities and Exchange Commission, USA. KMCC is the first Indian investment bank  to have sought such regulations in USA and UK. A third company called Kotak Mahindra (International) Limited., based in Mauritius provides distribution and other client services to non-resident investors.

In KMCC, the Equity Capital Markets group focuses on structuring and executing diverse equity financing transactions in the public and private markets for corporates, banks, financial institutions and the Government. Prod Produc ucts ts incl includ udee init initia iall pu publ blic ic offe offeri ring ngss (IPO (IPOs) s),, righ rights ts offe offeri ring ngs, s, convertible offerings, private placements and private equity for unlisted and listed companies. In the advisory business, the Structured Finance 47

(Proj (Project ect Financ Financee & Adviso Advisory ry Busine Business) ss) Group Group provi provides des expert expertise ise in various vertical segments in the infrastructure infrastructure sector including power, oil, gas, ports, automobiles, steel & metals and hotels by offering structured financ financee soluti solutions ons to client clients. s. The Fixed Fixed Income Income Securi Securitie tiess Group Group at KMCC advises advises PSUs, PSUs, Governme Government nt companies companies,, financia financiall instituti institutions, ons,  banks and corporates on raising capital by way of public or private  placement of debt. KMCC is credited with innovating on some bond structures in the Indian market. The advisory group on mergers and acqu acquis isit itio ions ns prov provid ides es comp comple lete te solu soluti tion onss on stra strate tegy gy form formul ulat atio ion n identification of targets or buyers, valuation, negotiations and bidding, capi capita tall

stru struct ctur urin ing, g,

tran transa sact ctio ion n

stru struct ctur urin ing, g,

assi assist stan ance ce

in

lega legall

documentation and acquisition financing strategies and implementation. implementation.

KMCC is supported in its functions by Kotak Securities Ltd, a broking firm incorporated in 1995 that is also a joint venture with Goldman Sachs which handles all the broking, distribution and research business of the group. Kotak Securities is a member of the debt segment of the NSE and is also a member of the National Stock Exchange Members Association. Kotak Securities offers services to investors, financial institutions, mutual funds, funds, religi religious ous and charit charitabl ablee trusts trusts,, insura insurance nce compan companies ies,, etc. etc. The institutional business division has a comprehensive research cell with sectoral sectoral analysts covering covering all the major major areas of the Indian economy. economy. In the intern internati ationa onall arena, arena, it provid provides es broker brokerage age servic services es on the India Indian n securities to institutional and other investors who are based outside India. Due to its overseas presence, the company has marketing interests in Indian GDR and ADR issues as well.

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The research products brought out by Kotak Securities include: •

For the instit instituti utiona onall client clients, s, a produc productt called called AKSESS AKSESS,, which which  primarily covers secondary market broking. It caters to the needs of foreign and Indian institutional investors in Indian equities (both local shares and GDRs).

•

The Daily Forex Monitor which tracks the Indian and international foreign exchange markets and opines on currency strategies on a daily basis.

•

The Weekly Money Market Update which gives the details of the developments in markets and provides a short-term interest rate view along with indicative pricing for Triple A credits.

•

The CURRENCY WATCH captures the monthly developments in the Indian foreign exchange markets, analyses the key influencing issu issues es,, asse assess ss futu future re ou outl tloo ook k and and also also reco recomm mmen ends ds hedg hedgin ing g strategies.

•

Monthly FINSEC and FINSEC Focus.

Kotak Securities is also a registered primary dealer with the RBI in the government securities market. As a primary dealer, the company acts as a mark market et make makerr and and also also prov provid ides es two two way way qu quot otes es,, acts acts as reta retail iler er and and marketing agent, provides underwriting support on government securities issues and participates in auctions held by the RBI.

Besi Beside des, s, the the abov abovee comp compan anie ies, s, the the Kota Kotak k Grou Group p incl includ udes es the the Kota Kotak  k  Mahindra Bank which was formerly a non-banking finance company that has recently been converted into a bank, the Kotak Mahindra Mutual Fund

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which is managed by the Kotak Mahindra Asset Management Co. Ltd and the OM Kotak Life Insurance, which is a joint venture with Old Mutual Plc of UK and the Kotak Mahindra Venture Capital Co. which manages the  private equity fund fund of the group. group.

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Recent Trends in Investment Banking One of the trends that has been developing in the past few years in the global and Indian investment banking arena, is the strong emergence of  universal banks ahead of pure investment banks as market leaders. These universal banks have the additional financial muscle of their banking arms that add to their investment banking strengths. Pure investment  banks have found it unmanageable to maintain leadership positions due to difficult market conditions and the economic downturn. The year 2002 has been dubbed as the watershed year in investment banking for over a decade. Globally, universal banks such as the –Citigroup, JP Morgan Chase and Deutsche Bank are emerging strongly against pure investment  banks such as Goldman Sachs and Morgan Stanley. This trend could  probably reappear in India as well with the emergence of SBI, ICICI, IDBI and Kotak Mahindra Bank as strong universal banks. However, in 2002 20 02,, pu pure re inve invest stme ment nt bank bankss such such as JM Mo Morg rgan an Stan Stanle ley y and and DSP DSP Merril Merrilll Lynch Lynch still still occupi occupied ed top pos positi itions ons in the invest investmen mentt bankin banking g league tables.

Some Some rece recent nt deve develo lopm pmen ents ts in the the inve invest stme ment nt bank bankin ing g indu indust stry ry as reported in some financial dailies and other press clippings are listed  below: International •

The Wall Street IPO market has seen the fewest number of issues since 1978 in the calendar year 2003, with just five in the first

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quarte quarter. r. These These have have mos mostly tly been been from from insura insurance nce and finan financia ciall services firms and four of them were IPOs. •

In 2002, there was a drop of 28% in global equity and equity related related issuances issuances according according to Thomson Thomson Financial Financial.. IPOs were the main causality with a drop of 34% to $60.6 billion. European mark markeet saw a dro drop of 53% drop in IPO IPOs and 54 54% % dro drop in convertible bond issuances. In Europe, the market focus shifted from from fund fund rais raisin ing g thro throug ugh h IPOs IPOs and and pu publ blic ic issu issues es to mo more re restructuring deals. These are termed as ‘rescue finance’ deals such as righ rights ts issu issuee and and full fully y conv conver erti tibl blee bo bond nd issu issues es by trou troubl bled ed companies. companies. Ericsson, Ericsson, Sonera Sonera and Zurich Zurich Financial Financial Services are some companies that made rights issues in 2002. According to Dealogic, the volume of rights issues in Europe rose from $20.7  billion to $21.5 billion in 2002. The most popular instrument in USA and Europe Europe has been been the ‘m ‘mand andato atory ry conver convertib tible’ le’ (full (fully y convertible) bond which is considered as a forward share sales which is superior in nature to a rights issue.

•

The Citigroup was Wall Street’s top stock and bond underwriter in 2002. Citigroup affiliates Salomon Smith Barney arranged $414  billion of offerings with a 10.6% market share according to Thomson Financial. Merrill Lynch and CSFB were ranked second and third respectively. However, the total underwriting pie fell by 5% during the same year.

•

The top IPO investment bank in 2002 was Salomon Smith Barney followed by Goldman Sachs. Goldman arranged the largest IPO of 

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2002, the $4.6 billion CIT Group Inc. (Tyco International Ltd) unit. •

The reported fee of American Investment banks fell by 21% in 2002 to $14.1 billion. Salomon took the highest fee of around $2  billion followed by the other two with around $1.2 billion each. Since April 2001, 78000 jobs were slashed in this industry in USA accounting for about 10% of the total strength.

•

Global M&A market was also dull in 2002 witnessing a sharp fall of 47% to stand at $996 billion from $1887 billion in the previous year year.. Th Thee bigg bigges estt deal dealss in 20 2002 02 were were HP-C HP-Com ompa paq, q, Am Amge gennImmunex Corp, AOL Time Warner-AOL Europe, Bayer-Aventis Crop Crop

Scien ciencce,

Com omca casst

Petroleum-Conoco

and

Corp Corp-A -AT& T&T T Siemens

Broad roadb band and, Robert

Phil hilips ips

Bosch-Atccs

Mannesmann. •

Some of the big universal banks such as JP Morgan Chase took  major hits in their private equity businesses due to the technology meltdown. Incidentally, JP Morgan, which is one of Wall Street’s largest private equity operators with a fund base of $28 billion, genera generated ted $13 $130 0 millio million n in revenu revenues es in privat privatee equity equity in 200 2001 1 fuelled mainly by the IPO market boom in technology stocks. Due to the meltdown, many investment banks have felt it necessary to spin off their private equity operations into separate entities. BNP Paribas, Deutsche Bank, HSBC and Zurich Financial Services are some of these banks.

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American investors poured more money into debt mutual funds in

•

2002 accounting to $133 billion and there were few takers for   public issues of equity equity junk bonds and convertible convertible bonds.

National •

During the year 2001, JM Morgan Stanley which acted as adviser to M&A deals worth Rs.16022 crore was rated the top investment bank  in Indi India. a. Th Thee othe otherr play player erss in the the big big leag league ue were were ABNABN-Am Amro ro (Rs. (Rs.10 1046 460 0 cror crore) e),, DSP DSP Merr Merril illl Ly Lync nch h (Rs. (Rs.71 7130 30 cror crore) e),, Arth Arthur  ur  Ande Anders rsen en (now (now part part of E& E&Y, Y, Rs.3 Rs.353 532 2 cror crore) e),, Kota Kotak k Mahi Mahind ndra ra (Rs. (Rs.17 1719 19 cror crore) e),, Rabo Rabo Indi Indiaa Fina Financ ncee (Rs. (Rs.83 833 3 cror crore) e) and and Laza Lazard rd Capita Capitall (Rs.53 (Rs.536 6 crore crore)) –(as –(as repor reported ted in the Econom Economic ic Times Times 21 st  November 2001). 2001).

•

In 2002, there was only one GDR/ADR issue as compared to 6 in 2001 and 9 in 2000. This was made by Mascon Global which raised $10 million through issue of 2.5 million GDRs which are listed at Luxe Lu xemb mbou ourg rg Stoc Stock k Ex Exch chan ange ge.. In this this mark market et,, Citi Citiba bank nk was was the the leading depository banks according to Instanex Capital Consultants. This was followed by Bank of New York, Deutsche Bank and JP Morgan.

•

In the M&A market, the year 2002 saw an increase of around 5% in the value of M&A deals in Inda. Among these, more than 50% were cros cross-b s-bor orde derr deal dealss acco accord rdin ing g to a surv survey ey cond conduc ucte ted d by KPMG KPMG Corporate Finance. The deals were mostly in the SME segment with average size not exceeding $25 million. The banking, finance and

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insurance sectors contributed almost one-third of the total volume. Privatization deals also played a significant part. •

DSP-ML DSP-ML de-lis de-listed ted from from the stock stock exchan exchange ge since since its promot promoters ers,, Hemendra Kothari and Merrill Lynch together held more than 90% of  the shares. DSP was rated the ‘The Best Domestic Investment Bank’ in Indi Indiaa for for 20 2000 00 by Fina Financ ncee As Asia ia.. Eu Euro romo mone ney y vo vote ted d it ‘Bes ‘Bestt Domestic M&A House in India’ as well as ‘Best Domestic Equity House in India’ in 2000. This distinction has returned for three years in a row with DSP-ML being named as the ‘Best Domestic Securities House’ House’ and ‘Best ‘Best Domest Domestic ic Invest Investmen mentt Bank’ Bank’ for 200 2002-2 2-2003 003 by Asiamoney (May 2003 issue) and The Asset (January 2003 issue) magazine respectively.

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The Conflict of Interest Issue The most burning global issue in the investment banking industry is that of  conflict of interest between investment bankers and their research analysis divisions. In the wake of the Enron, Worldcom and other corporate disasters, the the issu issuee has has gain gained ed some some sign signif ific ican ance ce.. Th Thee Secu Securi riti ties es and and Ex Exch chan ange ge Commission in the USA (SEC) have initiated investigations investigations into instances of  investment banks issuing over-optimistic research and steering shares in hot IPOs to important clients for vested interests. In such investigations some of  the banks have been imposed fines. Merrill Lynch paid up fines to the extent of $1 $100 00 mill millio ion n in regu regula lato tory ry proc procee eedi ding ngss in 20 2002 02 brou brough ghtt agai agains nstt its its misleading research reports. Citigroup’s Salomon Smith Barney is also in the dock and may find itself paying the heaviest fines. CSFB also finds itself  in trouble with the regulators. Most of the other top investment banks such as –Goldm –Goldman an Sachs, Sachs, Lehman Lehman Brothe Brothers, rs, Bear Bear Sterns Sterns,, Deutsc Deutsche he Bank, Bank, JP Morgan Chase and others also found their names in the fines list in 2002. CSFB was fined for misleading investors on offerings in technology shares. JP Morgan on the other hand, has been under a cloud for its role in the infamous off-balance sheet partnership it had crafted for Enron.

Besides, investment banks have also been the target of several lawsuits filed  by aggrieved investors. In late 2002, the French luxury goods leader LVMH filed a 100 million euro lawsuit against Morgan Stanley alleging that its research report on LVMH was biased because of the investment bank’s close advisory relationship with LVMH’s arch rival Gucci Group NV. Morgan Stanley was also the underwriter of Gucci’s IPO in 1995.

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Both the NYSE and NASDAQ came out with ‘research analysts’ conflict of  interest rules’ in May 2002 which was subsequently approved by SEC. Market observers have felt that this is a good development from the point of  view of addressing conflict of interest, currently a burning issue in the industry. While an investment bank may be advising a client on a buy out, its private equity arm may be in the fray for its purchase. An example of this was the sale of the power storage business of Invensys in 2001 wherein Morgan Stanley was the advisor in the $505 million sale to EnerSys a company owned by Morgan Stanley Capital Partners (Morgan Stanley’s  private equity firm). firm).

So how does the conflict of interest really arise? Most investment banks have have in-h in-hou ouse se rese resear arch ch divi divisi sion onss whic which h act act as a supp suppor ortt func functi tion on as discussed earlier. The research divisions perform vital function of tracking corporates and making recommendations to their clients in the secondary market operations or to their own dealing rooms. They also issue reviews and ratings to new issuances hitting the market. The conflict could arise if  the research analyst promotes a share, the public offering for which is being handled by the merchant bank. Alternatively, it could also be that the analyst is privy to insider information being provided by their merchant banking divi divisi sion on and and ther theree up upon on issu issuee reco recomm mmen enda dati tion onss that that coul could d amou amount nt to fraudulent deceit of investors or gains for select few. Over the years, the ethi ethica call wall wall betw betwee een n merc mercha hant nt bank banker erss and and rese resear arch ch anal analys ysts ts melt melted ed especially in the heat of the IPO and the internet boom. The compensation  patterns of the investment bankers and research analyst were also getting complementary to an extent thus undermining their independence.

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A study was conducted by the SEC in 2001on ‘full service investment  banks’ in Wall Street focusing on these conflicting relationships. The study disclosed two main areas of conflict–(a) research recommendations tending to become marketing tools for merchant banking assignments by the same  bank and analysts getting paid share of such investment banking gains, (b) owne owners rshi hip p of stoc stocks ks by rese resear arch ch anal analys ysts ts in the the comp compan anie iess that that they they recommend or research. The study disclosed that analysts leveraged their   position in pumping up recommendations recommendations in companies that they are interested in when they went public.

In the revised dispensation, one of the main provisions is that analysts have to disclose their interests in their recommendations. In addition, there is sought to be a water tight compartment in the working of the merchant  banking departments and research divisions. The third area has been the regulation of compensatory structures for research analysts based on the  profits of the merchant banking divisions. The developments in the USA have also resulted in precautionary amendments to regulations made in India  by SEBI though such instances of conflict of interest have not surfaced so far. SEBI has amended the regulations that have been in place for Merchant Bankers, Underwriters and for the prohibition of insider trading. As a result, analysts are barred from private trading in shares they analyze. There is still room for more regulation in future in this area of importance for the survival of the investment banking industry.

In conclusion, it can be said that the investment banking industry has been through difficult times. On one hand, the economic slow down and the crash of the markets that were propelled to dizzy heights by the new economy 58

stocks have battered their bottom lines and led to a large scale cut back in staf stafff and and op oper erat atio ions ns.. On the the othe otherr hand hand,, role role of inve invest stme ment nt bank bankss in corporate scandals and their questionable business practices and ethics have taken a toll on their reputation and image. A large scale cleaning up has to take place in their methods of working and service offerings. Similarly, a major resurrection of their confidence is required through resurgence of the markets, whenever that happens. In the meantime, the industry has to live up to the challenge through appropriate restructuring and consolidation.

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Conclusion Given the scope for investment banking in India, the future looks bright for  the industry as a whole in India. Many more pure investment banks and advisory firms could convert themselves into full service investment banks that would broaden the market and make the service delivery much more efficient. In addition, the technological and market developments shaping the capital market as discussed would also provide an added impetus to growth of investment banking. Better regulatory supervision and stricter  enforcement of the code of conduct of market intermediaries would ensure that better quality issuers come to the market and existing issuers would follow enhanced standards of corporate governance. In the long run, all these developments would ensure fair return to investors, and bring back investor  support to the market. This would augur well for the capital market in general and investment banking in particular.

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