What Is a Merchant Bank?

Merchant Banks Explained

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A merchant bank is a type of non-depository financial institution that primarily offers services in lending, financial advisory, and investing. Their main customers are private companies, but some wealthy individuals also use a merchant bank’s services.

Let’s look at how merchant banks work, how customers can benefit from their services, and what the relationship with investment banking looks like.

Definition and Examples of Merchant Banks

Sometimes focusing on a specific industry, merchant banks play a major role in helping customers raise the capital needed for their growth plans. This often includes moving forward with a private equity investment in which the bank provides funding to the customer in exchange for company stock and sometimes part of their future profits. 

With this arrangement, the merchant bank would get partial ownership in the company seeking funding. At the same time, merchant banks can assist with offering business loans and other types of fundraising options.

Merchant banks tend to target smaller private companies rather than larger public companies like investment banks do. 

Merchant banks usually also play a key role in helping wealthy individuals and companies make strategic financial decisions. Their advisory role might include helping a U.S. company decide whether to merge with or acquire an international company or whether to sell off some of their assets. They can also help customers decide how best to raise private capital for their needs. 

Due to their dual role as advisors and investors, merchant banks can help facilitate the various steps for important financial transactions for companies. For example, when a company considers acquiring another company, the merchant bank would help understand the financial implications and viability of the move first. It would then help the company look at potential financing options and proceed with the financing transaction to make the acquisition possible.

How Does a Merchant Bank Work?

Merchant banks operate as non-depository financial institutions that don’t offer services to the general public. This means they’re not like typical retail and commercial banks that allow customers to sign up for savings accounts and deposit money with the institution. Instead, merchant banks focus on providing lending, investment, and financial advisory services to wealthy people and private companies. These banks often operate at a multinational level and may exist as segments of larger commercial or investment banks such as Rothschild & Co. and Goldman Sachs.

State statutes specify the activities that merchant banks can perform, and prohibit them from taking deposits from customers.

Often, a merchant bank’s customers are companies that want to raise capital but need an alternative to the highly regulated initial public offerings (IPOs) that larger companies might pursue. Merchant banks can help such customers by privately investing in them in exchange for an ownership stake in shares of their company’s stock. The ownership interest can be as much as 100%, and the merchant bank may also get dividends and request a portion of future profits. Providing this funding to the customer might involve the merchant bank tapping into its own money or using its network of investors and entrepreneurs to obtain it.  

Merchant banks will perform research and thoroughly evaluate the customer before extending any private equity deal. They will take into account the level of risk and the potential return in deciding which customers to invest in. 

In addition to offering private equity investment, a merchant bank can help customers find alternative financing for transactions such as acquisitions and mergers. For example, they may assist companies that mount a leveraged buyout and need to obtain a loan to do so by offering “bridge” financing—a type of temporary loan to hold the company over through the purchase. They also can provide general business loans needed for other purchases. The financial advisory services offered will guide customers on which options to consider as well as the feasibility of the strategic decision.

As an example of a business taking advantage of a merchant bank’s services and expertise, consider that a U.S. technology company is interested in expanding and opening a new location in Germany. The following steps might take place:

  • The American company consults a merchant bank to get financial advice on whether the new German location would be a good move. 
  • After evaluating the business’s strategic goals and finances, the merchant bank advises to proceed with the expansion, and the company agrees.
  • Together, the merchant bank and the U.S. company look at different capital-raising options such as private equity financing and business loans
  • Once a financing decision is made, the merchant bank and company would decide on a share of ownership for private equity financing, and the underwriting process would occur for any business loans taken out.
  • The merchant bank would continue to help execute the acquisition process.

Merchant Bank vs. Investment Bank

Merchant Bank Investment Bank
Serves smaller private companies and wealthy individuals  Serves larger public companies and wealthy individuals
Helps with raising capital and offering advice Helps with raising capital and offering advice
Offers private equity investment Assists as an intermediary with finding suitable investors
Helps with private placement Helps with IPOs
Doesn’t take deposits Doesn’t take deposits

Merchant banks and investment banks can seem very similar because both types of financial institutions help their customers with raising funds, making investment decisions, and general financial advice. Neither institution will take customers’ deposits as non-depository financial institutions. 

But while merchant banks focus on smaller private companies and frequently deal with private equity investment decisions, investment banks focus on larger public companies and assist with locating other investors who are interested in the customer. Further, investment banks often help with IPOs for larger companies, while smaller companies turn to merchant banks for the less complex alternative of a private placement. As a company grows, however, its needs might shift from the capabilities of a merchant bank to an investment bank.

Key Takeaways

  • Merchant banks are non-depository financial institutions serving businesses and wealthy individuals who need to raise funds, get financial advice, or make investment decisions.
  • These banks often provide private equity financing to customers who give the bank a portion of ownership interest in exchange for the necessary funding.
  • Merchant banks target smaller companies interested in a private placement rather than an IPO.
  • Businesses often go to a merchant bank to get advice on whether to acquire or merge with another company, as well as learn of available financing options for the transaction.
  • While merchant and investment banks have a similar role, they differ in terms of the target customer and investment method used.