What is a Merchant Bank?

A merchant bank is like a specialty store that sells tools to construction companies…

Many consumers find themselves needing to buy tools and hardware for small projects they’re working on at home. But certain buyers, such as construction companies, have different needs than the average homeowner. Those companies might visit a specialty store that sells products that a construction company would need. Similarly, merchant banks provide services to customers who need more than what their local consumer bank can offer.

A merchant bank is a financial institution that generally works with private companies to provide banking services. Though there’s no actual definition of a merchant bank in U.S. law, the term generally describes institutions that engage in private equity investing. Private equity is a type of investing that involves buying ownership in private companies. Merchant banks also often offer other services such as advising on mergers and acquisitions and helping companies to raise capital from other sources.

Merchant banks date back to the Middle Ages. Italian businesses began using their extra money to invest in foreign trade in exchange for a cut of the profit. These entities, known at the time as merchant houses, were usually small, family-owned businesses. Because of the international component, these investments were generally considered high-risk at the time. Ships carrying goods had to cross seas and oceans, risking bad weather, war, and piracy.

Over the years, merchant banking spread to other parts of Europe. By the 18th century, cities like Amsterdam and London had become hubs for merchant banking. As with the merchant houses in Italy, merchant banks in later centuries were usually small, family-owned businesses that invested in trade for a share of the profit.

Merchant banking as it exists in the United States didn’t really become popular until the 1960s and 1970s, when financial institutions became an important player in the private equity market. Prior to those decades, it was mostly just wealthy individuals engaging in private equity. Now, many companies turn to merchant banks, which are often divisions of commercial or consumer banks and investment banks (which are those that help publicly-traded companies with capital raising).

Merchant banks and commercial banks with merchant banking divisions generally work with businesses that need cash flow to grow, but aren’t quite ready to (or don’t want to) issue public shares.

The primary role of merchant banks is to provide funding for these companies in exchange for partial ownership. Merchant banking generally involves the purchase of common stock, which is a type of stock that comes with voting rights in the company. It also may or may not come with dividends (meaning a share of the profits).

Merchant banks come in many different forms, but here are two of the most common structures:

1. Merchant banking might be just one division of a large financial institution. Companies such as JP Morgan Chase, Wells Fargo, and Bank of America serve companies through merchant banking divisions, while also serving consumers through a separate part of the business.
2. Institutions that provide merchant banking services that aren’t also commercial banks are most often limited partnerships. This type of partnership generally has one general partner, who oversees the daily operations of the company. The general partner also takes on most of the risk, as they’re responsible for the firm’s financial obligations. Limited partnerships also have one or more limited partners, who have part ownership in the company without as much risk.

The primary function of a merchant bank is to give money to companies in the form of private equity (meaning investment in exchange for part ownership). In addition to getting partial ownership, the merchant bank may also get a share of the profits.

Merchant banks have other functions as well, including:

• Helping clients raise capital from other sources
• Advising on mergers and acquisitions
• Providing bridge financing in a leveraged buyout (a buyout financed primarily through debt — bridge financing is a type of temporary loan to hold the company over through the purchase)

A commercial bank is a financial institution chartered at either the federal or state level that offers services to businesses and consumers. These entities provide basic banking services, such as deposit accounts, mortgages, and other consumer loans. They also provide services to businesses, helping them to issue securities (investments with the chance of a financial return).

Commercial banks generally act as intermediaries in the financial industry. They find people with money and match them with people who need money. Consumers participate in these transactions, even if they don’t realize it. For example, someone might open a savings account at a commercial bank. When another person comes in looking for a mortgage, the bank uses the money that people have put into savings accounts to lend to borrowers.

Commercial banks also match lenders with companies. Suppose a business wanted to raise capital by issuing bonds (a type of debt security). The bank may find people who want to buy the bonds and make money in the form of interest payments from the company.

Merchant banking and commercial banking differ not only in the services they offer, but also in the customers they serve. Commercial banks serve both businesses and individuals, while merchant banks work only with businesses. And rather than lending money to companies like a commercial bank, merchant banks instead often invest in the companies for a share of the ownership.

An investment bank is an entity that offers financial services to companies (primarily publicly traded corporations). A primary function of investment banking is to help companies raise capital, either through taking on more debt or equity.

When a company takes on debt, it often does so by issuing debt securities such as bonds. A company takes on equity by selling shares of stock, which investors then purchase for ownership (aka equity) in the company. Investment banks also help clients with initial public offerings (IPOs), which is when companies issue public shares for the first time.

Investment banks help their clients with other financial services as well. Another major responsibility that these banks have is to advise companies through the mergers and acquisitions (M&A) process. When a company is merging with another, buying a company, or being bought by another company, it would likely hire an investment bank to help guide it through the process.

Investment banks are similar to merchant banks, in that they both help companies to raise capital. But while investment banks usually serve publicly traded companies, merchant banks serve private ones. And while investment banks help companies find other investors, the merchant banks are often the ones investing in their customers’ businesses.

Private equity refers to the act of investing in businesses for a share of the ownership and possibly profits. Private equity investments are a way for companies to raise capital without turning to options such as taking on debt or issuing public shares. The companies benefiting from private equity are often small to medium-sized businesses that aren’t ready to go public yet. Private equity is a popular choice for start-ups. And while these companies start with private equity, many become publicly-traded corporations down the road.

Private equity is one of the primary functions of merchant banking. These institutions often invest in companies for a share of the ownership and possibly some of the profits. But merchant banks do a lot more than just private equity. They may also help clients raise capital from other sources, advise on mergers and acquisitions, and more.

Merchant banking, as with many segments of the financial world, comes with both upsides and downsides. Merchant banks serve their clients in a critical way, by giving funding and advice to companies who need it. The companies working with merchant banks are often too small for the services of an investment bank and aren’t quite ready to go public. Merchant banks can help take them to the next level.

Merchant banking also has its downsides, though. Companies usually have to give up partial ownership of their business when they take money from a merchant bank. Since these institutions engage in private equity, they generally take a share of the company in exchange for their investment.

Merchant banking serves a particular subset of the business community. While investment banks help to serve large companies that are publicly-traded, merchant banks serve companies that aren’t quite at that level yet. Merchant banks provide the stepping stone those companies need by giving them the capital and expertise to take their firms to the next level.