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14 FDIC Banking Rev. 29 (2001)
Merchant Banking: Past and Present

handle is hein.journals/fdicbnkrv14 and id is 31 raw text is: by Valentine V. Craig* erchant banking has been a very lucrative- and risky-endeavor for the small number of bank holding companies and banks that have engaged in it under existing law. Recent legisla- tion has expanded the merchant-banking activity that is permissible to commercial banks and is therefore likely to spur interest in this lucrative specialty on the part of a greater number of such institutions. Although for much of the past half-century commercial banks have been permitted (subject to certain restrictions) to engage in merchant-banking activities, the term mer- chant banking itself is undefined in U.S. banking and securities laws and its exact meaning is not always clearly understood. This article begins by defining merchant banking and provides a short history of it. The article then looks at the private equity market in the United States, examining that market in terms of its evolu- tion, typical uses of funds, and forms taken by the investments. (In examining the private equity mar- ket, one needs to be aware that the private equity mar- ket is, in fact, private. Data are limited and could be subject to error.) Discussed next is commercial bank involvement in merchant banking: the structure of commercial bank involvement, the evolution of that involvement, and the recent track record. The major provisions of the Gramm-Leach-Bliley Act of 1999, legislation which authorizes financial holding compa- nies to engage in merchant banking, is looked at next. The final section focuses on the relationship among merchant banking, risk, and the regulators. MrchatBnking Although not defined in U.S. federal banking and securities laws, the term merchant banking is general- ly understood to mean negotiated private equity invest- ment 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 war- rants. Other investment bank services-raising capital from outside sources, advising on mergers and acquisi- tions, 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 com- modity 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 * Valentine V. Craig is a Chartered Financial Analyst in the FDIC's Division of Research and Statistics. The author gratefully acknowl- edges the comments of the FDIC's Legal Division in preparing this article. Much of the history of merchant banking is derived from Banks (1999). 29

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