1. Chapter 13 Merchant Banking

2. Lecture Objectives: 1. Introduction to Merchant Banking 2. To explain the following merchant banking services to corporate clients: Syndicated loans Project finance Contract bonds and guarantees

3. Merchant Banking in the past “ Merchant Bankers ” is a term of English origin. In its earliest form, it was “ Merchants and Bankers. ” It meant that a firm that began as merchant or trader extended its activities by offering credit to its clients. Thereafter, some firms gave up acting as goods merchants and concentrated on trade finance, securities, investment management and venture capital.

4. Category of Merchant Banks 1. Bulge-bracket firms. E.g.Morgan Stanley, Goldman Sachs, Merrill Lynch, Salomon Smith Barney, Credit Suisse First Boston, etc. 2. Major bracket firms. E.g. Lehman Brothers, Prudential- Bache, UBS PaineWebber, etc. 3. Specialized firms: Small firms which are strong in only a few areas. 4. Research firms: Finance houses that make their reputation on the quality of their securities analysts.

5. Organization of a merchant bank 1.Capital Markets (the largest of the four areas) – This includes: Corporate Finance, Securities underwriting, Mergers & Acquisitions (M&A), Leveraged buyouts, Private placements, Money market instruments, Preferred stock, High yield instruments (Junk Bonds), Swaps (interest rate, currency, commodity), Asset management for institutions, Innovative securities Asset-based finance, Real estate finance, Securitization (of accounts receivable), Project finance, Sale & lease back, Venture capital, Public/ municipal finance, Privatization (of government-owned companies), Corporate restructurings, etc.

6. Organization of a merchant bank 2. Consumer Markets  Securities trading  Private banking 3. Research 4. Miscellaneous Products  Commodity trading, insurance, etc.

7. Merchant Banks’ Customers and Fees Major customers of merchant banks are governments, public utilities, corporations and wealthy individuals. The following fees charged for their services are the main sources of income: Retainer fee Success fee Expenses Engagement fee Incentive fee

8. Merchant Banks in Hong Kong In Hong Kong, most merchant banks are registered as restricted licence banks or deposit- taking companies under the Banking Ordinance.

9. Merchant Banks in Hong Kong They provide a wide range of services to corporate customers which include underwriting new equities, arranging loan syndication or project finance and advisory service in business and financial strategies. Some merchant banks are also engaged in financing consumer hire purchases and equipment leasing for business customers.

10. Major Role of Merchant Banks The roles of underwriting equities and financial advisor are the main functions of merchant banks in Hong Kong.

11. Syndicated Loan A syndicated loan is jointly offered by two or more banks, each funding a certain proportion of the loan using common documentation. The loan is arranged and administered by an agent bank which is called the loan manager. The loan is offered to a borrower who gets the same terms and conditions from each lending bank. Repayments are made through the agent bank.

12. The Syndicate The syndicate normally includes the parties who have their own specific expertise beneficial to the project requiring funding.

13. Application for a Syndicated Loan Because of the large size of a syndicated loan, banks would require the syndicate to submit details of the nature of the project, precise financial information and the necessary legal documents. In some specific projects, banks may have their own consultants to evaluate the project in order to identify the possible risks involved.

14. Interest and Fees Syndicated loans may have terms from one to several years. Besides charging interest for the loan, banks also charge service expenses depending on the types of work involved with the syndicate.

15. Project Finance Project financing is the finance for a project wholly or partly on the credit of the project itself, with the project revenue as the sole or primary source of repayment. The project involves the construction of an engineering undertaking, e.g. a road network, a bridge, etc. The terms of financing could be in the form of an open credit or complete finance throughout the life of the project.

16. Non-recourse Project Finance Non-recourse project financing is a true project financing with the cash flow from the project as the sole means of debt services with no direct legal credit support by the sponsors. The risk resides ultimately in successful completion of the project and subsequent cash flow generation sufficient to service the debt commitments.

17. Recourse Project Finance Recourse project financing is s credit- supported project financing. Although the debt portion of the financing is expected to be serviced from the project’s cash flow, if the cash flow is not sufficient, there is a direct legal obligation for the project sponsors or other interested parties to step in and ensure both completeness and timeliness of debt services.

18. Repayment of Project Finance The repayment schedule can be arranged in the form of instalments of fixed payments over periods of time after the project is completed. The bank may also opt for equity sharing instead of a loan-form arrangement. In equity sharing, the bank’s return from financing the project would be similar to profit sharing on capital holding.

19. Contract Bond and Guarantee % of Contract Value 15 10 5 0 Bid Bond Maintenance Bond Performance Bond StartCompletion Time Retention Money Bond Advance Payment Guarantee

20. Guarantee (Bond) A guarantee is basically a contractual agreement in that the bank is to take responsibility for payment of a debt or performance of some obligations if the customer primarily liable fails to comply.

21. Bid Bond A bid bond which guarantees that, if the contractor fails to carry out his obligations, the bank would fulfill the agreement.

22. Advance Payment Guarantee Advance Payment Guarantee is issued when a contract has been awarded and the contractor receives a payment of some of the money in advance. The guarantee is a promise to repay this money if it is not used properly, so as the money is used to pay for work on the contract the amount of the guarantee liability reduces.

23. Performance Bond Performance Bond is a promise to repay if the contract undertaken but not completed properly.

24. Retention Money Bond In some contracts, part of the money payable at each stage of work is kept back by the buyer in case of problems. In order to get this retention money rather than having it kept back the contractor can arrange a Retention Money Bond which promises to repay the money that would otherwise have been kept.

25. Maintenance Bond Maintenance Bond is a kind of continuation of a performance bond after completion of the contract. If the finished construction is faulty, the buyer will be able to claim under the maintenance bond.

26. Application for issuing a guarantee The value of a bond or guarantee becomes the liabilities of the bank issuing it. The bank charges fees for issuing a bond or guarantee. The bank has to consider the nature of the customer’s business and his credit standing, and may request security for issuing a bond or guarantee.