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Merchant Banking explained by RYS & Co.

Early History
Current
Looking Forward

Definition and Early History of Merchant Banking

Although not defined in U.S. federal banking and securities laws, the term merchant banking is generally understood to mean negotiated private equity investment by financial institutions in the unregistered securities of either privately or publicly held companies. Both investment banks and commercial banks engage in merchant banking, and the type of security in which they most commonly invest is common stock. They also 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)—are also typically offered by financial institutions engaged in merchant banking.

Merchant banks first arose in the Italian states in the Middle Ages,1 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. This trade generally consisted of lengthy sea voyages. Thus, the investments were very high risk: war, bad weather, and piracy were constant threats, and by their nature the voyages were long-term and illiquid.

Later, 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.

Valentine V. Craig
Read more by Valentine V. Craig

Domestic Merchant Banking Modern Practices

The definition of merchant banking has changed greatly since the days of the Rothschilds. The great merchant banking families dealt in everything from underwriting bonds to originating foreign loans. Bullion trading and bond issuing were some of the specialties of the Rothschild family. The modern merchant banks, however, tend to advise corporations and wealthy individuals on how to use their money. The advice varies from counsel on mergers and acquisitions to recommendation on the type of credit needed. The job of generating loans and initiating other complex financial transactions has been taken over by investment banks and private equity firms.

Today there are many different classes of merchant banks. One of the most common forms is primarily utilized in America. This type initiates loans and then sells them to investors. Even though these companies call themselves "merchant banks," they have few if any of the characteristics of former merchant banks. (A bank that deals mostly in (but is not limited to) international finance, long-term loans for companies and underwriting. Merchant banks do not provide regular banking services to the general public.)

The Next Generation

The Merchant Banks of the old world where the engines that drove commerce and in some cases built nations supporting the flow of free commerce which was the true beginning of a global economics. In more modern times the goals and visions of the Merchant Bank have been blurred to accommodate geopolitical agendas and by over regulation restricting free commerce. The results were the creation of Commercial Banking, insurance companies, Broker Dealers and the conversion of Merchant Banking to Investment Banking all of these risking someone else’s money. The blurring of the lines has led to numerous financial down turns, outright collapses of financial systems and the sacrifice of the rules of law for political expedience by government’s (Too Big To Fail). When you couple these factors with the lack of corporate and government accountability the concept of responsible commerce has been eroded.

RYS & CO. considers itself to be the next generation of Merchant Bank based on accountability to its partners, they to each other, risk its capital based on commitments to free commerce and the growth of independently owned businesses to build wealth.

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