Industry Analysis and History
History of Merchant Banking
In modern history, we know merchant banks grew in the Italian states in the Middle Ages, when Italian merchant houses-generally small, family-owned import-export and commodity trading businesses-began to use their excess capital to finance foreign trade in return for a share of the profits. ‘Europe saw the Medicis of Italy, the Rothschild’s, and for a while, the Hapsburgs of Austria. This often involved sea trade. Thus, the investments were very high risk: war, bad weather, and piracy were constant threats, and by their nature, the investments had to return enough profit to make up for the frequent losses-so straight lending vehicles rarely worked.
As Europe evolved, the center for merchant banking shifted from the Italian states to Amsterdam and then, in the eighteenth century, to London, where immigrants from Prussia, France, Ireland, Russia, and the Italian states formed the core of early British merchant banking. Like the Italian and Dutch houses before them, these British houses were generally small, family-owned partnerships, and most of them continued both to trade for their own businesses and to finance the trading by others. By the end of the eighteenth century, however, the British merchant houses had increased in size and sophistication and began specializing in trade, marketing, or finance. As the nineteenth century opened, virtually no mercantile houses remained focused on both trade and finance. Merchant banks are in fact the original modern banks. These were invented in the Middle Ages by Italian grain merchants. As the Lombardy merchants and bankers grew in stature based on the strength of the Lombard plains cereal crops, many displaced Jews fleeing Spanish persecution were attracted to the trade. They brought with them ancient practices from the Middle and Far East silk routes. Originally intended for the finance of long trading journeys, these methods were applied to finance the production and trading of grain.
In France during the 17th and 18th century, a merchant banker or marchand-banquier was not just considered a trader but also received the status of being an entrepreneur par excellence. Merchant banks in the United Kingdom came into existence in the early 19th century, the oldest being Barings Bank.
Merchant banking progressed from financing trade on one's own behalf to settling trades for others and then to holding deposits for settlement of "billette" or notes written by the people who were still brokering the actual grain. And so the merchant's "benches" (bank is derived from the Italian for bench, banco, as in a counter) in the great grain markets became centers for holding money against a bill (billette, a note, a letter of formal exchange, later a bill of exchange and later still a cheque). These deposited funds were intended to be held for the settlement of grain trades, but often were used for the bench's own trades in the meantime. The term bankrupt is a corruption of the Italian banca rotta, or broken bench, which is what happened when someone lost his traders' deposits. Being "broke" has the same connotation. A sensible manner of discounting interest to the depositors against what could be earned by employing their money in the trade of the bench soon developed; in short, selling an "interest" to them in a specific trade, thus overcoming the usury objection. Once again this merely developed what was an ancient method of financing long-distance transport of goods.
The medieval Italian markets were disrupted by wars and in any case were limited by the fractured nature of the Italian states. And so the next generation of bankers arose from migrant Jewish merchants in the great wheat-growing areas of Germany and Poland. Many of these merchants were from the same families who had been part of the development of the banking process in Italy. They also had links with family members who had, centuries before, fled Spain for both Italy and England. As non-agricultural wealth expanded, many families of goldsmiths also gradually moved into banking. This course of events set the stage for the rise of family banking firms whose names still are known today, such as the Warburgs and Rothschilds.
The rise of Protestantism, however, freed many European Christians from Rome's dictates against usury. In the late 18th century, Protestant merchant families began to move into banking to an increasing degree, especially in trading countries such as the United Kingdom (Barings), Germany (Schroders, Berenbergs) and the Netherlands (Hope & Co., Gülcher & Mulder) At the same time, new types of financial activities broadened the scope of banking far beyond its origins. The merchant-banking families dealt in everything from underwriting bonds to originating foreign loans. For instance, bullion trading and bond issuance were two of the specialties of the Rothschilds. In 1803, Barings teamed with Hope & Co. to facilitate the Louisiana Purchase.
In the 19th century, the rise of trade and industry in the US led to powerful new private merchant banks, culminating in J.P. Morgan & Co. During the 20th century, however, the financial world began to outgrow the resources of family-owned and other forms of private-equity banking. Corporations came to dominate the banking business. For the same reasons, merchant banking activities became just one area of interest for modern banks.
The Art of Merchant Banking
The term merchant banking is generally understood to mean negotiated private equity investment or financing through alternative methods by financial institutions in loans, convertible debt or off balance sheet vehicles, or through unregistered securities of either privately or publicly held companies. Both investment banks, commercial banks, and other companies engage in merchant banking, and the type of security in which they invest is diverse. They may invest in securities with an equity participation feature; these may be convertible preferred stock or subordinated debt with conversion privileges or warrants. Other investment bank services-raising capital from outside sources, advising on mergers and acquisitions, and providing bridge loans while bond financing is being raised in a leveraged buyout (LBO) and are also typically offered by financial institutions or broker dealers engaged in the merchant bank industry. One which is often omitted is the provision of experienced management by the merchant to commercialize ideas, or technology.
Merchant banking has been a very lucrative-and a highly risky-endeavor for the small number of bank holding companies and banks that have engaged in it under existing law, and for private equity investors. Banking law legislation has expanded the merchant-banking activity that is permissible to commercial banks and has spurred interest in this lucrative specialty on the part of a some institutions, however, limitations exist and have scared many banks away from the markets after the Lehman collapse and the resulting fallout with JP Morgan, Bank of America and the big bank Wall Street bailout. Although for much of the past half-century commercial banks have been permitted (subject to certain restrictions) to engage in merchant banking activities, their continued role is limited by the conservatism of the regulators and their Boards.
Evolution of the Private Equity Market
Given its history, merchant banking is often thought of as a European, and especially British, financial specialty, and British institutions continue to maintain a major presence in this area. Since the 1800s and even earlier, however, U.S. firms (such as J.P. Morgan) also have been active in merchant banking. However, although both investment banks and commercial banks, as well as other types of businesses, have been authorized to engage in private equity investment in the United States, financial institutions have not been major providers of private equity.
Until the 1950s, U.S. investors in private equity were primarily wealthy individuals and families. In the 1960s and 1970s, corporations and financial institutions joined them in this type of investment. (In the 1960s, commercial banks were the major providers of one kind of private equity investing, venture-capital financing.) Through the late 1970s, wealthy families, industrial corporations, and financial institutions, for the most part investing directly in the issuing firms, constituted the bulk of private equity investors.
In the late 1970s, changes in the Employee Retirement Income Security Act (ERISA) regulations, in tax laws, and in securities laws brought new investors into private equity. In particular, the Department of Labor's revised interpretation of the "prudent man rule" spurred pension fund investment in private equity capital. Currently, the major investors in private equity in the United States are pension funds, endowments and foundations, corporations, and wealthy investors; financial institutions-both commercial banks and investment banks-represent approximately 20 percent of total private equity capital, divided approximately equally between the two. The U.S. Department of the Treasury (Treasury) estimated that at year-end 1999, commercial banks accounted for approximately $35 billion to $40 billion, and investment banks for approximately another $40 billion, of the $400 billion total investment in the private equity market.
At $400 billion as of year-end 1999, the private equity market was approximately one-quarter the size of the commercial and industrial bank-loan market and the commercial-paper market. In recent years, funds raised through private equity have approximately equaled and sometimes exceeded funds raised through initial public offerings and public high-yield corporate bond issuance. The market also has grown dramatically in recent years, increasing from approximately $4.7 billion in 1980 to its 1999 figure. Despite this tremendous growth, the private equity market was extremely small compared with the public equity market, which was approximately $17 trillion at year-end 1999.
Since 1999, the markets have been through a number of cycles and the differentiation between investment banking and merchant banking has not been kept clear and statistics have been difficult to collect for reliable data.
Typical Uses of Private Equity
Private equity financing is an alternative to raising public equity, issuing public debt, or arranging a private placement of debt or bank loan. The reasons companies seek private equity financing are varied. For example, other forms of financing may be unavailable or too expensive because the company's track record is either nonexistent or poor (that is, the company is in financial distress). Or a private company may want to expand or change its ownership but not go public. Or a firm may not want to take on the fixed cost of debt financing.
Public firms may seek private equity financing when their capital needs are very limited and do not warrant the expense, time, and regulatory paperwork required for a public issue. They also may seek private equity to keep a planned acquisition confidential or to avoid other public disclosures. They may use the private equity market because the public market for new issues in general is bad or because the public equity market is temporarily unimpressed with their industry's prospects. Finally, very often in recent years, managements of large public firms have felt their firms will benefit from a change in capital structure and ownership and will choose to go private by means of a leveraged buyout (LBO).
Although companies seek private equity for all these reasons, most private equity funding has been used for one of two purposes: to fund start-up or early-stage companies (venture capital) or to bring large public companies private in LBOs.
Of the $400 billion in outstanding private equity investment at year-end 1999, venture-capital investments accounted for approximately $125 billion and non-venture capital investments for approximately $275 billion. LBOs were by far the most common use of nonventure-capital private equity.
Forms Taken by Investments
Currently, more than 80 percent of private equity investments are made by limited partnerships or limited liability companies, with professional private equity managers acting on behalf of institutional investors. In a limited partnership, the professional equity managers serve as general partners, and the institutional investors serve as limited partners. The general partners or managers manage the investment and contribute an insignificant part of the investment, generally approximately 1 percent. These entities have a contractually fixed life, usually ten years. The investments are highly illiquid over the entity's life, with a return not expected until the entity's later years, when the business is sold through a public offering or a private sale, or interest or the shares are repurchased by the company. Banks (through subsidiaries) often act as limited partners in private equity limited partnerships, and infrequently as general partners.
Commercial Bank Involvement in Merchant Banking Commercial banks have historically utilized Small Business Investment Corporations (SBICs) or "5 percent subs" (defined below) for their domestic private equity investments, and Edge Act Corporations or foreign subsidiaries to make their foreign private equity investments. Several very large bank holding companies have come to dominate merchant banking, directing as much as 10 percent of their capital to these activities. For the most part, reported earnings from these merchant-banking activities have been very good.
Before passage of the Gramm-Leach-Bliley Act (GLBA), commercial banks and bank holding companies (BHCs) had two primary vehicles for making private equity investments in domestic corporations. They could make these investments through SBICs and/or through "5 percent subs." Typically, banks engaged in domestic merchant banking have used both of these vehicles; for equity investments in foreign companies, they have used foreign subsidiaries or Edge Act Corporations. As mentioned above, although these subsidiaries have sometimes organized limited partnerships in which they acted as general partners, more often they have invested directly in private equity or have acted as limited partners in a partnership.
5 Percent Subs. The Bank Holding Company Act of 1956 permitted bank holding companies to make passive equity investments in nonfinancial companies. Specifically, the legislation allowed bank holding companies to own a maximum of 5 percent of the voting shares (hence the "5 percent sub" designation) and a maximum of 25 percent of the total equity of companies engaged in any activity. There is no limit on the total amount of equity that a BHC can invest through all of its 5 percent subs.
Because these investments are passive equity interests only, bank holding companies often have used unregulated independent general partners to oversee them. And because of the 5 percent sub investment 16 limits, in the case of growing businesses 5 percent subs often have been forced to raise outside capital and limit their role to that of a minority investor or agent. Therein, management believes, lies opportunity for BlackStar Enterprise.
A few very large BHCs have dominated large merchant banking, directing as much as 10 percent of their capital to these activities. Citigroup, Chase, Bank of America, FleetBoston, J.P. Morgan, Goldman Sachs and Wells Fargo have had large presence in this area over the years. No exact figures are available, but Chase, FleetBoston, Wells Fargo, J.P. Morgan, and First Union have aggregate investment of many billions in venture-capital investments, and they expect to continue to expand this area of their business.
Many banks entered merchant banking in the 1960s to take advantage of the economies of scope produced when private equity investing is added to other bank services, particularly commercial lending. As lenders to small and medium-sized companies, banks become knowledgeable about individual firms' products and prospects and consequently are natural providers of direct private equity investment to these firms. As mentioned above, commercial banks were the largest providers of venture capital in the 1960s.
In the middle to late 1980s, the decision to enter merchant banking was thrust on other banks and bank holding companies by unforeseen events. In those years, as a result of the LDC (less-developed-country) debt crisis, many banks received private equity from developing nations in return for their defaulted loans. At that time, many of these banks set up merchant-banking subsidiaries to try to get some value from this private equity.
Also at about that time, most commercial banks began refocusing their private equity investments to middle-market and public companies (often low-tech, already profitable companies) and, rather than providing seed capital, financed expansion or changes in capital structure and ownership. Most particularly, they took equity positions in LBOs, takeovers, or recapitalizations or provided subordinated debt in the form of bridge loans to facilitate the transaction. Often they did both. Commercial banks financed much of the LBO activity of the 1980s
Then, in the mid-1990s, major commercial banks began once again focusing on venture capital, where they had substantial expertise from their previous exposure to this kind of investment. Some of these recent venture-capital investments have been spectacularly successful. For example, the Internet search engine Lycos was a 1998 investment of Chase Manhattan's venture-capital arm.
We do not compete in the area of these ultra large merchant banks, or even large or mid-market banks.
Historical Track Records
The merchant-banking subsidiaries of Chase, Wells Fargo, J.P. Morgan, First Union, and FleetBoston reported in the aggregate $5 billion in net income for 1999. Chase's merchant-banking subsidiary Chase Capital Partners reported $2.5 billion in net income in 1999-22 percent of Chase's total reported net income. Wells Fargo's merchant-banking activities accounted for 13 percent of its 1999 reported income; J.P. Morgan's for 15 percent; First Union's for 8 percent; and FleetBoston's for 9 percent, in 1999,
While reported earnings have been good over time, earnings have been adversely affected when major melt downs occurred in the economy.
With the long bull market in stocks-and a particularly hot IPO market for technology stocks BHC merchant-banking subsidiaries have increased their venture-capital investments in recent years.
JP Morgan, Goldman Sachs, Tudor Pickering and Holt are current examples of very large to small merchant Banks.