What it means
Merchant banks grew out of trading houses that financed cargo shipments and gradually moved into underwriting and advice. That heritage explains the name and the continuing emphasis on trade finance, letters of credit and cross-border transactions.
The defining feature is principal investment. A merchant bank does not only earn fees for advice, because it frequently takes an equity stake in the transactions it arranges, which aligns it with the client but also puts its own balance sheet at risk.
Typical services include advising on mergers and acquisitions, arranging private placements of shares or debt, structuring management buyouts, providing bridge finance and issuing trade instruments for importers and exporters. Clients are mid-market and large private companies rather than retail customers.
Revenue comes mostly from three sources: retainers paid monthly during a mandate, success fees calculated as a percentage of transaction value, and returns on the capital the bank invests itself. Success fee percentages usually step down as deal size rises, so a rate that looks small on a large transaction is still a substantial cash amount.
The distinction from an investment bank is blurred and largely regional. Investment banks tend to be larger, publicly listed and focused on capital markets and trading, while merchant banks are typically smaller, privately held and closer to direct principal investment.
Merchant banking is not commercial banking. There are no current accounts, overdrafts or consumer lending, and funding comes from partners' capital, institutional investors and wholesale markets rather than customer deposits.
In practice
Real-world examples.
Example
A family-owned packaging group wants to sell a non-core division. It appoints a merchant bank that prepares the information memorandum, approaches 40 potential buyers and runs a competitive process. The bank earns a retainer throughout the eight-month project and a success fee on completion.
Example
A specialist textiles importer needs a letter of credit to buy $2,000,000 of fabric from an overseas mill. Its merchant bank issues the instrument, so the mill ships against a bank promise rather than trusting the importer's balance sheet.
Example
A management team wants to buy the division they currently run. A merchant bank structures the buyout, arranges senior debt from a lender, and invests $4,000,000 of its own capital for a minority stake, sitting on the board until an exit.
Formula
Calculation
There is no single merchant bank formula, but the fee structure models easily: total fee = retainers paid over the mandate + (success fee percentage x transaction value), less any agreed retainer credit.
A mid-market manufacturer hires a merchant bank to sell the business. The mandate runs for eight months at a retainer of $25,000 a month, and the success fee is 1.5% of enterprise value on completion, with 50% of retainers credited against that success fee.
Retainers paid come to 8 x $25,000 = $200,000. The company sells for an enterprise value of $80,000,000, so the raw success fee is 1.5% x $80,000,000 = $1,200,000.
The retainer credit is 50% x $200,000 = $100,000, so the completion payment is $1,200,000 - $100,000 = $1,100,000. Total cost to the seller is $200,000 + $1,100,000 = $1,300,000, which works out at $1,300,000 / $80,000,000 = 1.625% of the sale price.Case study
Seen in the real world.
Ashcombe Partners is an invented merchant bank used purely as an illustration. It was engaged by a fictional specialist chemicals maker with revenue of about $60,000,000 that had received an unsolicited approach valuing the business at $70,000,000.
Ashcombe advised against accepting and ran a formal sale process instead, taking a $20,000 monthly retainer for six months plus a 1.75% success fee. Eleven parties were approached, four submitted bids, and the business eventually sold for $92,000,000.
The retainers came to 6 x $20,000 = $120,000 and the success fee to 1.75% x $92,000,000 = $1,610,000, a total of $1,730,000. Set against the $22,000,000 improvement on the original approach, the fee looked cheap in this illustrative case, though had the process failed the seller would still have paid $120,000 in retainers for nothing.
Watch out
Common mistakes.
- Using merchant bank and commercial bank interchangeably. A merchant bank does not take deposits or run current accounts for the general public.
- Assuming the advisory fee is the whole cost of a deal. Legal, accounting, tax and vendor due diligence fees frequently add another substantial layer on top.
- Choosing an adviser on headline percentage alone. A lower rate applied to a badly run process usually costs the seller far more in price than it ever saves in fees.
Questions
People also ask.
What is the difference between a merchant bank and an investment bank?
The functions overlap heavily, but merchant banks are typically smaller, privately owned and more willing to invest their own capital, while investment banks lean towards capital markets, trading and public transactions.
Do merchant banks lend money?
Some provide bridge and mezzanine finance from their own balance sheet, but they are not general lenders and do not offer overdrafts or consumer credit.
When should a company approach a merchant bank?
Usually when contemplating a sale, a significant acquisition, a private capital raise or a cross-border trade arrangement that its ordinary bank cannot structure.
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