Financial Services

FINANCIAL SERVICES INTRODUCTION The increasing role of private sector, market oriented economy, liberalization globalization, competition and efficiency have become the important elements in economic activity of the nation. The main objective of management is to increase the efficiency, productivity and lowest costs and enhancing profits. Hence the business concern is in the area of services. The quality and costs effectiveness will count as pre-requisite for its success. The quality of service depends upon the technology. The analysis of any firm involves the technological relationship between input and outputs. The management of a firm is to see that this relation of inputs and outputs is most up to date modern and cost effective. In Service sector, efficiency and competition are the landmarks of success, management ahs a role to judge. The result, which will be based on cost of service quality and profits. The banks have been forced to enter into new areas of Nonbank financial services. The Chakravarthy and Narasimhan Committee has recommended the need for market oriented financial system. The banks and NBFCs can function with greater autonomy, accountability and efficiency.

The Narasimhan Committee has recommended that all the

institutions which involve in the Capital market should work on sound guidelines within regulatory framework of the SEBI. SEBI is the most powerful organ in promoting better investor protection and widening the pool of savings and investment. Financial deregulation, freeing of interest rates on bank’s lending rates and their practices have helped the growth of financial services. The private sector was permitted to set up mutual funds, banks and financial institutions. Move recently some developments took place to expand the scope of 1

financial services such as inviting FIIS to invest in our country and dilution of FEMA. The following statement reveals the importance of financial services in our economy.

SHARE OF GROSS CAPITAL FORMATION IN GDP (%) Competition of GDP

93-94 94-95

95-96

96-97

97-98

98-99

99-2000

Agricultural, Forestry and Fisheries

1.79

1.71

1.64

1.76

1.55

1.61

1.56

Industry Services

10.66 12.00 8.83 9.72

16.02 8.76

14.29 8.25

12.89 7.72

11.80 7.02

10.55 7.49

SHARE OF AGGREGATE NET CAPITAL STOCK (%) Competition of GDP

93-94 94-95

95-96

96-97

97-98

98-99

99-2000

Agricultural, Forestry and Fisheries

15.29 14.61

13.72

13.71

13.81

13.64

13.53

Industry Services

38.10 39.08 46.61 46.31

40.38 45.90

41.19 45.10

41.63 44.56

41.80 44.56

41.81 44.44

Sources: Economic Times, 26-12.2001, p.10 A well regulated modern financial sector is essential in a globalize economy. Financial innovation contributed to the development. Market based economies have in general done better, because of the constant identification and improved satisfaction of co summer needs, including need of financial products. Rapid technological change creates new possibilities that make it difficult for regulators to keep up. The complexity of modern system is such that controls must give way to self regulation and revelation of information. Innovation ways have been developed to get information from markets. A financial service is one of the elements in Indian financial system. It is an important component of the financial system. It fulfils the needs of financial institution, financial markets and instruments to serve the individual 2

and institutional investors more efficiently. The functioning of the financial system depends on the range of financial services. It includes the services offered by both types of companies such as Asset Management Companies and Liability Management Companies. It not only helps to raise the adequate financial resources but also ensures their efficient deployment. The Asset Management Company includes leasing companies, Mutual funds, Merchant bankers and portfolio Management.

The Liability

Management companies comprise the bill discounting houses, Acceptance houses. Financial services provide efficient management of funds services such as bill discounting, factoring, and parking of short term funds in the money market. The LMCs provides specialized services such as Credit Rating, Venture Capital Financing Housing Finance etc. These services are also provided by a number of various organizations such as NBFCs, Insurance companies, subsidiaries of financial institutions stock exchanges specialized and general financial institutions etc. All these organization are regulated by the securities and Exchange Board of Ind. RBI and the department of Banking and Insurance, Government of India through a number of legislation. It stimulates the velocity of the economic growth and development of a nation.

The Indian economy has to improve the

infrastructure facilities to the investor’s entrepreneurs, Industry and business. Financial services differ in nature from other service sector. The salient features of the financial services are discussed below: (A)

Invisible

(B)

Customer Friendly

(C)

Demarcation

(D)

Dynamism

(E)

Innovation

The services of the finance are intangible.

It smoothens the

functioning of the corporate sector by providing funds within the stipulated period of time without fail. The institutions which supply them have a good 3

image and confidence of the client but they may not succeed. The business concerns have to focus on quality and innovativeness of their services to build their credibility and gain the trust of their clients. Financial services must be consumer friendly. They should provide according to the client needs and convenience.

The provider of such

services should study the requirement of the customer in detail to suggest different financial strategies which reduce the cost and stimulates the profitability of the company.

The providers of such services remain in

constant touch with the market. They offer new variety of products much ahead of need and impending legislation. universal specific projects.

They design innovative and

These services are highly skilful and they

require more talent. At the present day, business concern happen to be different in terms of size, levels of productions profitability and labour forces. The basic function of business is to earn the reasonable return on their investment by producing goods and selling goods. services have to be performed accordingly.

The financial

Hence it needs a perfect

understanding between the service providers and their clients. Financial service is an innovative activity and requires dynamism. It has to be constantly redefined and refined on the basis of economic changes. The economic changes will depend on so many factors such as disposable Income, standard of living and educational changes. These institutions while designing new service must visualize in advance about the requirements of markets and wants to customers.

EVOLUTION OF FINANCIAL SERVICES IN INDIA 4

Financial service is one of the components of the Indian financial system. It is in the process of attaining full bloom. The financial services at present reached through a number of stages mentioned below: (A)

Initial Stage (1960-80)

(B)

Second Stage (1980-90)

(C)

Third Stage (1990-2002)

(A) Initial Stage: Financial services at the initial stage existed between 1960 and 1980.

In this period it introduced many innovative

services such as Merchant banking, Insurance and leasing companies, merchant banking was unknown till 1960. The term merchant banking was used as an umbrella function.

It provides a wide range of service. Its

activities start from project appraisal to arranging funds from the fund suppliers. They provide service like project identifications, preparation of flexibility reports, prepares detailed project reports. It also made marketing financial, managerial and technical analyses.

They also underwrote the

public issues and helped in getting listed in the stock exchanges. Investment companies made their contribution in the initial stage of financial service. The UTI, LIC and GIC initiated to enter into this segment during their period. Leasing activities entered in the year of 1970. Initially leasing companies were engaged in equipment lease financing. Afterwards they have undertaken different kinds of leasing such as financial lease, operating lease and wet leasing.

The No. of leasing concerns has been shot up

during this period. The Initial stage of financial services was crucial period for Indian financial system. (B) Second Stage: Financial services entered the second stage and it covered the period of 10 years approximately. In this period it has introduced many innovative value added services such as O.T.C. share transfers, pledging of shares, mutual funds, factoring, discounting, venture 5

capital and credit rating.

These services were available in the western

countries about 100 years back. Mutual funds provide major fund to the industry anywhere in the developed countries.

The funds have been

innovative in terms of their schemes. They provided better returns to the unit holders.

Their management was transparent.

The small investors

welfare was secured in their hands. Their business goals were such that they created value for their investor. They have their own code of conduct. Credit rating was another important financial service which entered India during this stage. It built investor confidence in the capital market operation. It prevented mal practices in the capital market. Initially they credit rating is applied to debt instruments only. Afterwards the credit rating was applied to the commercial papers and fixed deposits.

Another important financial

service was introduced in this stage “Factoring”.

Factoring means

collection of accounts receivables by a financial intermediary. A number of factoring institutions had entered into the capital market.

They were

Discount and Finance House of India. SBI factors, can bank factors venture capital finance entered in late 1980s. It was a highly specialized service operated by venture capital firms. (C) Third Stage: The third stages in financial services include the setting up of new institutions and instruments. This period started from post liberalization. The depositories, the stock lending scheme, online trading paperless trading, dematerialization, book building aspects were introduced during this period.

Depositories set up in the public sector and many

financial institutions are finding this business more lucrative.

The stock

lending scheme approved by the Central Government in 1997-98.

The

central government initiated steps for the setting up of a separate corporation to deal with trading of the Gilt bonds. It has also taken steps to popularize book building method to help both the investors and fund users. It has also initiated steps to introduce online trading in Bombay stock 6

exchange and Delhi stock exchange. The computerization of NSE acted as the fulcrum for the development of financial services.

These steps had

given a fillip to paperless trading. Paperless trading saved the investors form the onslaught of brokers and jobbers. It also reduced tax evasion. SEBI had been the regulatory authority in the financial environment and issued guidelines to the Merchant bankers in relation to the capital adequacy ratio.

These guidelines ensure the investor protection and

created a differentiation in the market. Establishment of the SEBI was a path breaking development in terms of regulation growth and development of financial services. The efforts to revamp the companies act, Income tax act and other acts had led to the deliverance of effective financial services. The government had taken initiative steps to allow the foreign Institutional investors into the capital market. This situation had been more beneficial to the capital market. The government had also taken steps to bring down the taxes on the capital gains for the FIIs.

The Mutual funds had been

permitted to exercise voting power which ought to more strengthen. The Disinvestment of the public enterprises made by the central government was another realm of financial services. The financial firms have gained expertise in valuation financial and legal restructuring and making the public sector firms to be commercial in the market. Financial service firm had been mobilizing resources from abroad to finance the corporate sector. They approached the European Capital market. The service firms learnt the expertise in raising of GDRs through global market in the digital economy. This was an excellent development in this sector.

It required an

understanding of raising fund abroad and also works together with world class level financial services institutions. The world standard organizations such as Lehman brothers, Goldman Schs, Merry Lynch and Morgan Stanley etc. The global financial markets required a high talent excellent skill and good infrastructure to deal the affairs more effectively. It was very easy in Switzerland to approach the capital market which were more flexible in 7

terms of procedures and expect lower interest rates. Hence the financial firms would have to change their approach from syndication to risk finance aspect.

In this period new financial instruments were introduced in the

market. The issue of new financial instruments related to maturity, risk and interest rate.

Financial Services and Problems 8

The financial services industry faces a tough competition from its global counter parts. The sector has to increase skills, to integrate itself with the rest of the world. The financial services industry faces a lot of problems constraining growth of the financial services as presented below: (A)

Lack of Skilled Personnel.

(B)

Quality of service.

(C)

Core competence.

(D)

Fee and Fund based business.

(E)

Technology.

(A) Lack of Skilled Personnel: The Indian financial services face a lot of problems. The financial service is involved with skill and talent. It is not like any other service. The availability of suitable personnel is the main constraint faced by the Indian financial system. It requires the right types of people at right place in corporate sector.

The present financial service

industry does not provide much salary where the foreign financial firms offer. The public sector financial services industry is constraint by a number of restrictions imposed on salaries. Therefore, India is facing a manpower problem in finance area. But some of the organizations are making efforts to train the people in finance area specifically. We cannot ignore the efforts made by the Hyderabad based Institute for certified Financial Analyst, Indian Institute to Finance, New-Delhi, Institute for Financial Management Research, Chennai, National Institute of Financial Management Faridabad. All these institutions are conducting training programmes for Finance professionals. They conduct regular post graduate level courses in Finance area. Therefore, in future India does not face the availability of man power problem. There is a strong need to develop the Finance discipline in Academic side.

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(B) Quality of Services: The survivals of financial services depend upon the delivery of quality services and products at the right price, and at the right time. The providers of financial services must use the application of the appropriate technology in process a large flow of information according to the needs of the client. The services will be provided on a fixed fee basis of various activities. The fee is decided by the regulator for rendering various services. The clients often complaints about the poor performance and high fee is charged by the service providers. The working pattern of the Merchant bankers has to be changed. The functioning of credit rating should build up the confidence in the market. The information in Finance has to be in the organized form. The data lies in crude stage, it must be gathered by taking much pains and be stratified according to the purpose. There is a strong need for conducting research in finance area. The quality of financial services will only be possible on the basis of Research activities. Research is the most important factor in innovative financial products and service.

The financial service involves a rapid

change on day by day basis. Hence the quality of service must be improved and updated at every moment. (C) Core Competence: Financial service is a dynamic activity and it must be provided by the providers with a great care and in depth analysis of the problems faced by the clients. They are ready to provide any service in the finance area. The providers can render the services to the needs of client companies. Some financial firms have often got involved in under trade practices through giving unethical advice. The services must be in the form of cast control, cost reduction and review of process and procedure through activities. (D) Fee and Fund Based: Financial services providers are working on the basis of either fee based and fund based activities. Some institutions 10

provide services for fee basis.

Mutual funds, credit Rating, merchant

banking are the best examples for fee based services term lending, housing finance companies, venture capital, leasing companies are the examples of fund based services.

They provide financial resources to their clients on

interest basis. They charge the interest from their borrowers. Term lending institutions meet the long term funding needs of industries.

Therefore

providing funds to the corporate sector is known as project financing. Housing finance companies provide funds to the individuals for acquisition of house property. Venture capital provides funds to the new projects in the form of equity for innovative products. The providers of financial services either belong to fund based activities or fee based activities. Some firms involve in both the aspects. (E) Technology: In the digital age the technology plays an important role in all aspects of the human life.

Technology reduces the cost of

production and stimulates the quality of the products.

Lack of proper

availability of technology has constrained the growth of the financial services industry in India or ex: The dealing of cheques in banks is still not developed. They physical presence is required for every transaction. They time taken to deliver the services is too long for all the transactions. The banks are now introducing ATMs to reduce the operating expenses and stimulating the profits.

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Management of Risk in Financial Services The financial services have introduced several new products and services. The financial markets have seen a number of bank and insurance companies’ failure, securities scans and services. The industry is operating in a risky environment. The success of a financial service provides to a large extent depends on the manner which it manages the Risk. The business involves risk, without it there is no existence of business. Risk cannot be avoided. Risk is the integral part of the financial services industry. The financial services industry works with the financial claim. Financial claim is a promise to give a fixed amount under certain specified terms. All financial claims in general are risky. The financial claim affects the performance of the company that provides financial services. The risk in financial services industry is very high. The changes of default by the parties who sell the financial claims are very high. The default by the concerned parties may arise due to several reasons. The risks in financial services industry can be classified as follows: (A)

Internal Risk

(B)

External Risk

(A) Internal Risk Internal risk means, if the finance company fails to receive the financial claim from the clients. It is also associated with changes in the interest rates in the market that reduces the value of existing financial claims. Therefore the internal risk may be described as failure of Accounts receivables by the finance company.

Usually the financial companies may

disburse the loans to different parties as a routine business activity, but they involve in high risk that affect the company as a whole. They often fail due to their own mistakes. There are several internal factors which contribute to 12

the failure of the firms in the service industry. Some of the internal sources of risk faced by different financial services companies are presented below: (1)

Lending Institutions.

(2)

Stock broking service.

(3)

Insurance service.

(4)

Fee based service companies.

(5)

Leasing and Hire purchase.

(B) External Risk External risk arises due to certain developments that take place outside the purview of the financial service company. The external sources of risk also vary for different services.

The following are the external

sources of risk applicable to various services: (A)

Direct financing Institutions.

(B)

Fee based service companies.

(C)

Leasing and Hire purchase companies.

(D)

Insurance companies.

(E)

Stock broking service.

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Regulatory Framework for Financial Services The economy will grow with a better financial system of a nation. The financial system should work on the basis of asset creation better credit flow to all the sectors and stimulating the per capita income of a nation. The asset creation is possible only with the efficient primary market the credit flow to all sectors in the function of banking institutions.

The banking

institutions allow the economy to expand more and more. The financial services industry channels the savings into productive way. It helps the economic activities to grow without any handles the importance of the financial services cannot be ignored in the digital economy. governed by strict rules and regulations.

This sector is

In a competitive market the

services are required more efficiently and effectively. The financial firms often take high risk to maximize the return and thus susceptible to default. There will be a scope that can impart the interest of the investors in this sector there will be a lot of scope for frauds mismanagement of funds, and scams.

Therefore the regulations are in place of protect the Investor’s

rights. The regulatory frame work to this sector can be categorized in three forms: (A) Structural Regulations. (B) Prudential Norms. (C) Investor Protection Regulations. (A) Structural Regulations: Financial service companies provide fee and fund based services to the clients.

The regulations are meant for

proper working environment by the companies. They control the activities, monitor and review the affairs of concerned. They impose strict rules and regulations to move in a right direction. The objective of these regulations is to be provided and protect safety to the innocent investors. The regulation demarks the lines between activities of financial institutions. The security and exchange Board of India (SEBI) insists that the merchant bankers and 14

stock brokers to separate all their fund based activities. The regulations cover the internal management of financial institutions and other concerns in relation to capital adequacy, liquidity and solvency.

The RBI is the

regulatory authority in the banking service. (B) Prudential Norms: The development of an economy depends upon the efficient financial system. The efficiency of the financial system depends upon the strict rules and regulations imposed by the regulatory bodies. The objective of the prudential norm is to restrict the firms without adequate resources entering into a particular field. These norms could be framed for the smooth functioning of the industry. (C) Investor’s protection Regulations: The main objective of all the regulatory agencies in the financial sector is to protect the interest of the investors. companies.

The innocent investor will be duped by inefficient financial In India the investors are mostly cheated by the finance

companies. CRB capital, pennar Paterson, and other finance companies duped the investors.

Crores of rupees are deposited by middle class

families, low income group levels but their dreams are burnt by the financial parasites. Therefore the investors are the weakest participants of the financial markets, and need a strong protection from malpractice, fraud and scams. The regulatory agencies should step in to protect the interest of the investors. These regulations need larger disclosure of information. The rules and regulations ensure the financial soundness and safety of the financial institutions. They maintain the integrity of the transmission mechanism and protection of clients of the financial services. They ensure to improve the efficiency of the financials companies and provide benefits to the investors and borrowers. At the same time the regulations should not block the development of the financial services industry.

The financial

services regulations can be divided into four categories: 15

(1) Regulation on Banking and financing services. (2) Regulations on Insurance services. (3) Regulations on Investment services. (4) Regulations on Merchant banking and other services.

16

Some

examples

of

financial

services given by bank • Mutual Fund • Merchant banking • Venture capital

17

MUTUAL FUND A mutual fund is a professionally managed firm of collective investments that collects money from many investors and puts it in stocks, bonds, short-term money market instruments, and/or other securities. The fund manager, also known as portfolio manager, invests and trades the fund's underlying securities, realizing capital gains or losses and passing any proceeds to the individual investors. Definition: The Securities and Exchange of Board of India Regulations, 1993 defines a Mutual fund as “a fund established in the form of a trust by a sponsor, to raise monies by the trustees through the sale of units to the public, under one or more schemes, for investing in securities in accordance with these regulations”. According to Weston J. Fred and Brigham, Eugene F., Unit Trusts are “ corporations which accept dollars from savers and then use these dollars to buy stocks, long term bonds, short term debt instruments issued by business or government units; these corporation pool funds and thus reduce risk by diversification.”

ORIGIN: The origin of mutual fund industry in India is with the introduction of the concept of mutual fund by UTI in the year 1963. Though the growth was slow, but it accelerated from the year 1987 when non-UTI players entered the industry. In the past decade, Indian mutual fund industry had seen dramatic improvements, both quality wise as well as quantity wise. Before, the monopoly of the market had seen an ending phase; the Assets Under 18

Management (AUM) was Rs. 67bn. The private sector entry to the fund family rose the AUM to Rs. 470 bn in March 1993 and till April 2004, it reached the height of 1,540 bn.

Putting the AUM of the Indian Mutual

Funds Industry into comparison, the total of it is less than the deposits of SBI alone, constitute less than 11% of the total deposits held by the Indian banking industry. The main reason of its poor growth is that the mutual fund industry in India is new in the country. Large sections of Indian investors are yet to be intellectuated with the concept. Hence, it is the prime responsibility of all mutual fund companies, to market the product correctly abreast of selling.

History: Massachusetts Investors Trust (now MFS Investment Management) was founded on March 21, 1924, and, after one year, it had 200 shareholders and $392,000 in assets. The entire industry, which included a few closed-end funds represented less than $10 million in 1924. The stock market crash of 1929 hindered the growth of mutual funds. In response to the stock market crash, Congress passed the Securities Act of 1933 and the Securities Exchange Act of 1934. These laws require that a fund be registered with the Securities and Exchange Commission (SEC) and provide prospective investors with a prospectus that contains required disclosures about the fund, the securities themselves, and fund manager. The SEC helped draft the Investment Company Act of 1940, which sets forth the guidelines with which all SEC-registered funds today must comply. With renewed confidence in the stock market, mutual funds began to blossom. By the end of the 1960s, there were approximately 270 funds with $48 billion in assets. The first retail index fund, First Index Investment Trust, was formed in 1976 and headed by John Bogle, who conceptualized many 19

of the key tenets of the industry in his 1951 senior thesis at Princeton University. It is now called the Vanguard 500 Index Fund and is one of the world's largest mutual funds, with more than $100 billion in assets. A key factor in mutual-fund growth was the 1975 change in the Internal Revenue Code allowing individuals to open individual retirement accounts (IRAs). Even people already enrolled in corporate pension plans could contribute a limited amount (at the time, up to $2,000 a year). Mutual funds are now popular in employer-sponsored "defined-contribution" retirement plans.

Organisation of a Mutual Fund: There are many entities involved and the diagram below illustrates the organisational set up of a mutual fund:

The institution commonly referred to as ‘Mutual Funds’ is a company called as ‘Asset Management Company’ (AMC). Its sole business is to manage funds as mutual fund.

AMC is controlled by Trustees. AMC is

promoted by and Trustees are appointed by the entity which starts Mutual fund. This entity is referred to as ‘Sponsor’. For example, for Kotak Mahindra Mutual Fund, the Sponsor is Kotak Mahindra Finance Limited; the 20

Trustees is Kotak Mahindra Trustee Company Limited and the asset management company is Kotak Mahindra Asset Management company Limited. AMC gets management fee annually, based on quantum of funds managed (1.25% upto Rs. 100 Crores and 1% above that)

ASSOCIATION OF MUTUAL FUNDS IN INDIA: With the increase in mutual fund players in India, a need for mutual fund association in India was generated to function as a non-profit organisation. Association of Mutual Funds in India (AMFI) was incorporated on 22nd August, 1995. AMFI is an apex body of all Asset Management Companies (AMC) which has been registered with SEBI. Till date all the AMCs are that have launched mutual fund schemes are its members. It functions under the supervision and guidelines of its Board of Directors. Association of Mutual Funds India has brought down the Indian Mutual Fund Industry to a professional and healthy market with ethical lines enhancing and maintaining standards. It follows the principle of both protecting and promoting the interests of mutual funds as well as their unit holders.

The objectives of Association of Mutual Funds in India: The Association of Mutual Funds of India works with 30 registered AMCs of the country. It has certain defined objectives which juxtaposes the guidelines of its Board of Directors. The objectives are as follows: •

This mutual fund association of India maintains high professional and ethical standards in all areas of operation of the industry.

21

•

It also recommends and promotes the top class business practices and code of conduct which is followed by members and related people engaged in the activities of mutual fund and asset management. The agencies who are by any means connected or involved in the field of capital markets and financial services also involved in this code of conduct of the association.

•

AMFI interacts with SEBI and works according to SEBIs guidelines in the mutual fund industry.

•

Association of Mutual Fund of India does represent the Government of India, the Reserve Bank of India and other related bodies on matters relating to the Mutual Fund Industry.

•

It develops a team of well qualified and trained Agent distributors. It implements a programme of training and certification for all intermediaries and other engaged in the mutual fund industry.

•

AMFI undertakes all India awareness programme for investors in order to promote proper understanding of the concept and working of mutual funds.

•

At last but not the least association of mutual fund of India also disseminate information’s on Mutual Fund Industry and undertakes studies and research either directly or in association with other bodies.

The sponsorers of Association of Mutual Funds in India: Bank Sponsored •

SBI Fund Management Ltd.

•

BOB Asset Management Co. Ltd.

•

Canbank Investment Management Services Ltd.

•

UTI Asset Management Company Pvt. Ltd. 22

Institutions •

GIC Asset Management Co. Ltd.

•

Jeevan Bima Sahayog Asset Management Co. Ltd.

Private Sector •

Bench Mark Asset Management Co. Pvt. Ltd.

•

Cholamandalam Asset Management Co. Ltd.

•

Credit Capital Asset Management Co. Ltd.

•

Escorts Asset Management Ltd.

•

JM Financial Mutual Fund

•

Kotak Mahindra Asset Management Co. Ltd.

•

Reliance Capital Asset Management Ltd.

•

Sahara Asset Management Co. Pvt. Ltd

•

Sundaram Asset Management Company Ltd.

•

Tata Asset Management Private Ltd.

AMFI publices mainly two types of bulletin. One is on the monthly basis and the other is quarterly.

Net asset value: The net asset value, or NAV, is the current market value of a fund's holdings, less the fund's liabilities, usually expressed as a per-share amount. For most funds, the NAV is determined daily, after the close of trading on some specified financial exchange, but some funds update their NAV multiple times during the trading day. The public offering price, or POP, is the NAV plus a sales charge. Open-end funds sell shares at the POP and redeem shares at the NAV, and so process orders only after the NAV is determined. Closed-end funds (the shares of which are traded by investors) may trade at a higher or lower price than their NAV; this is known as a 23

premium or discount, respectively. If a fund is divided into multiple classes of shares, each class will typically have its own NAV, reflecting differences in fees and expenses paid by the different classes. Some mutual funds own securities which are not regularly traded on any formal exchange. These may be shares in very small or bankrupt companies; they may be derivatives; or they may be private investments in unregistered financial instruments (such as stock in a non-public company). In the absence of a public market for these securities, it is the responsibility of the fund manager to form an estimate of their value when computing the NAV. How much of a fund's assets may be invested in such securities is stated in the fund's prospectus.

Usage: Since the Investment Company Act of 1940, a mutual fund is one of three basic types of investment companies available in the United States. Mutual funds can invest in many kinds of securities. The most common are cash instruments, stock, and bonds, but there are hundreds of sub-categories. Stock funds, for instance, can invest primarily in the shares of a particular industry, such as technology or utilities. These are known as sector funds. Bond funds can vary according to risk (e.g., high-yield junk bonds or investment-grade corporate bonds), type of issuers (e.g., government agencies, corporations, or municipalities), or maturity of the bonds (short- or long-term). Both stock and bond funds can invest in primarily U.S. securities (domestic funds), both U.S. and foreign securities (global funds), or primarily foreign securities (international funds).

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Most mutual funds' investment portfolios are continually adjusted under the supervision of a professional manager, who forecasts cash flows into and out of the fund by investors, as well as the future performance of investments appropriate for the fund and chooses those which he or she believes will most closely match the fund's stated investment objective. A mutual fund is administered under an advisory contract with a management company, which may hire or fire fund managers. Mutual funds are subject to a special set of regulatory, accounting, and tax rules. In the U.S., unlike most other types of business entities, they are not taxed on their income as long as they distribute 90% of it to their shareholders and the funds meet certain diversification requirements in the Internal Revenue Code. Also, the type of income they earn is often unchanged as it passes through to the shareholders. Mutual fund distributions of tax-free municipal bond income are tax-free to the shareholder. Taxable distributions can be either ordinary income or capital gains, depending on how the fund earned those distributions. Net losses are not distributed or passed through to fund investors.

Turnover: Turnover is a measure of the fund's securities transactions, usually calculated over a year's time, and usually expressed as a percentage of net asset value. This value is usually calculated as the value of all transactions (buying, selling) divided by 2 divided by the fund's total holdings; i.e., the fund counts one security sold and another one bought as one "turnover". Thus turnover measures the replacement of holdings.

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In Canada, under NI 81-106 (required disclosure for investment funds) turnover ratio is calculated based on the lesser of purchases or sales divided by the average size of the portfolio (including cash).

CLASSIFICATION OF FUNDS: MUTUAL FUND On the basis of yield and investment pattern

On the basis of execution

and operation Close Open Income Growth Balance Specialized Money Taxation ended ended

fund

fund

fund

fund

Market

Fund

Mutual fund scheme can broadly be classified into many times as given below:

On the basis of execution and operation: (A) Close-ended funds: Under the scheme, the corpus of the fund and its duration are prefixed. In other words, the corpus of the fund and the number of units are determined in advance. Once the subscription reaches the pre-determined level, the entry of investors is closed. After the expiry of the fixed period, the entire corpus is disinvested and the proceeds are distributed to the various units holders in proportion to their holding. Thus, the fund cases to be a fund, after the final distribution.

Features of Close-Ended Funds: 26

• The main object of this fund is capital appreciation. • From the investors’ point of view, it may attract more tax since the entire capital appreciation is realized into at one stage itself. • The period and /or the target amount of the fund is definite and fixed beforehand. • Generally, the prices of closed-end-scheme units are quoted at a discount

of

up-to

40

per

cent

below

their

Net

Asset Value (NAV). •

Once the period is over and/or the target is reached, the door is closed for the investors. They cannot purchase any more units.

• If the market condition is not favourable, it may also affect the investor since he may not get the full benefit of capital appreciation in the value of the investment. • At the time of redemption, the entire investment pertaining to a closedend scheme is liquidated and the proceeds are distributed among the unit holders. • These units are publicly traded through stock exchange and generally, there is no repurchase facility by the fund. • The whole fund is available for the entire duration of the scheme and these will not any redemption demands before its maturity. Hence, the fund manager can manage the investments efficiently and profitably without the necessity of maintaining any liquidity.

(B) Open-ended Funds: It is just the opposite of close ended funds. Under this scheme, the size of the fund and the period of the fund is not pre-determined. The investors are free to buy and sell any number of units at any period of time. For instance, the Unit Scheme (1964) of the Unit Trust of India is an open27

ended one, both in terms of period and target amount. Anybody can but his unit at any time and sell it also at any time at his discretion.

Feature of Open-Ended Fund: • The main objective of this fund is income generation. The investors get dividend, rights or bonuses as rewards for their investment. • The fund manager has to be very careful in managing the investments because he has to meet the redemption demands at any time made during the life of the scheme. • There is complete flexibility with regard to one’s investments or disinvestment. In other words there is free entry and exit of investors in an open-ended fund. There is no time limit. • Since the units are not listed on the stock market, their prices are linked to the Net Asset Value (NAV) of the units.

The NAV is

determined by the fund it varies from time to time. • These units are not publicly traded but, the fund is ready to repurchase and re-sell at any time. • The investor is offer instant liquidity in the sense that the unit can be sold on any working day to the fund. In fact, the fund operator just like a bank-account wherein one can get cash across the counter for any number of units sold. • Generally, the listed prices are close to their Net Asset Value. The fund fixes a different price for their purchases and sell.

On the Basis of Yield and Investment Patter: 28

(A) Income Fund: As the very name suggest, this fund aims at generated and distributing regular income to the members on periodical basis.

It

concentrates more on the distribution of regular income and it also sees that the average return is higher than that of the income from bank deposit.

(B) Pure Growth Fund (Growth Oriented Fund): Unlike the income funds, growth funds concentrate mainly one long run gains i.e. Capital appreciation. They do not offer regular income and they aim at Capital appreciation in the long run. Hence, they have been described as “Nest Eggs” investments.

(C) Balanced funds: This is otherwise called “income-cum-growth” fund. It is nothing but a combination of both income and growth funds. It aims at distributing regular income as well as capital appreciation. This is achieved by balancing the investment between the high growth equity shares and also the fixed income earning securities.

(D) Specialised Funds: Besides the above, a large of specialized funds are in existence abroad. They offer special schemes so as to meet the specific needs of specific categories of people like pensioners, widows, etc. There are also funds for investments in security of specified area.

For instance Japan

Fund, South Korea Fund, etc. Again, certain funds may be confined to one particular sector or industry like fertilizer, auto mobiles, petroleum, etc.

These funds carry

heavy risks since the entire investment is in one industry. But, there are 29

higher risk taking investors who prefers this type of fund, of course, in such cases, the rewards may commensurate with the risk taken.

The best

example of this type Petroleum Industry Funds in USA.

(E) Money Market Mutual Funds (MMMFs): These funds are basically open handed mutual funds and as such they have all the features of the open ended fund. But, they invest in highly liquid and save securities like commercial papers, banks acceptance, certificates of deposits, treasury bill.

These instruments are called money

market instruments. They take place of share, debenture and bonds in the Capital market. They pay money market rates of interest. These funds are called ‘money funds’ in the USA and they have been functioning since 1972. Investors generally used it as a “Parking Place” or stop gap arrangements for their cash resources till they finally decide about the proper avenue for their investment i.e., long term financial assets like bonds and stocks. Since MMMFs are anew concept in India, the RBI has laid down certain stringent regulations. For instance, the entry to MMMFs is restricted only to scheduled commercial bank and their subsidiaries.

(F) Taxation Funds: A taxation fund is basically a growth-oriented fund. But, it offers tax rebates to he investors either in the domestic or foreign capital market. It is suitable to salaries people who want to enjoy tax rebates particularly during the month of February and March. In India, at present the law relating to tax rebates in covered under Sec. 88 of the Income Tax Act, 1961. An investor is entitled to get 20% rebates in Income Tax for investments make under this fund subject a maximum of Rs.10,000/- per annum. The tax saving Magnum of SBI

30

Capital market limited is the best example for the domestic type. UTI’s US$ 60 million Indian fund, based in the USA, is an example for the foreign type.

Other classification: (A) Leveraged Funds: These funds are also called borrowed funds since they are used preliminary to increase the size of the value of portfolio of a mutual fund. When the value increases, the earning capacity of the fund also increases. The gains are distributed to the unit holders.

(B) Index Funds: Index fund refers to those funds where the portfolio is designed in such a way that they reflect the composition of some broad based market index.

(C) Off Shore Mutual Funds: Off shore mutual funds are those funds which are meant for nonresidential investors. In other words, the sources of investments for these funds are from abroad so they are regulated by the provision of the foreign country where those funds are registered.

(D) Dual Funds:

31

This is a special kind closed ended fund.

It provides a single

investment opportunity for two different types of investors.

For this

purpose, it sells two types of investments stocks viz. income shares and capital shares. Those investors whose seek current investments income can purchase income shares.

(E) Bond Funds: This fund have portfolio consisting mainly of fixed income security like bonds. The main thrust of these funds is mostly on income rather than capital gains.

(F) Aggressive Ground Funds: These funds are just the opposite of bond funds. These funds are capital gains oriented and thus the thrust area of these funds is ‘Capital gains’. Hence, these funds are generally invested in speculative stocks.

Importance/Advantages of Mutual Funds: •

Offering wide portfolio investment: Small and medium investors used to burn their fingers in stock exchange operations with a relatively modest outlay. If they invest a select few shares, some may even sink without a trace never to rise again. Now, these investors can enjoy the wide portfolio of the investment held by the mutual fund.

•

Offering tax benefits: Certain funds offer tax benefits to its costumers.

Thus, apart from dividend, interest and capital

appreciation, investors also stands to get the text benefits 32

concession. For instance, under section 80L of the Income Tax Act, a sum of Rs.10,000/- received as a dividend (Rs.13,000/- to UTI) from a MF is deductible from the gross total income. Some funds operate 88 A funds where 20% of the amount invested is allowed to be deducted from the tax payable under the wealth tax act, investments in MF are exempted up to Rs.5,00,000/-. •

Supporting Capital Market: Mutual fund plays a vital role in supporting the development of capital market. The mutual funds make the capital market active by the means of providing a sustainable domestic source of demand for capital market instruments.

In other words, a saving of the people are directed

towards investments in capital market through these mutual funds. •

Channelising savings for investment: Mutual funds act as a vehicle in galvanizing the savings of the people by offering various schemes suitable to the various classes of customers for the development of the economy as a whole. A number of scheme are being offered by mutual fund so as to meet the varied requirements of the masses, and thus, savings are directed towards capital investment directly.

•

Providing better yields: The pooling of funds from a large number of customers enables the funds to have large funds at its disposal. Due to these large funds, mutual funds are able to buy cheaper and sell dearer than the small land medium investors. Thus, they are able to command better market rates and lower rates of brokerage. costumers.

So as they provide better yield to their

They also enjoy the economies of large scale and

reduce the cost of capital market participation. 33

•

Promoting

industrial

development

of

any

development:

nation

depends

The

upon

advancement and agricultural developments.

its

economic industrial

All industrial units

have to raise their funds by resorting to the capital market by the issue of shares and debentures. •

Rendering expertise investment services a low cost: The management of the fund is generally assigned to professional who are well trained and have adequate experience in the field of investment.

The investment decision of these professional are

always backed by informed judgement and experienced.

Thus,

investors are assured of quality services in their best interest. •

Providing research services: A mutual fund is able to command vast resources and hence it is possible for it to have in depth study and carry out research on corporate securities. Each fund maintains a large research team which constantly analysis the companies and the industries, recommends the fund to buy or sell a particulars share.

•

Introducing flexible investment schedule: Some mutual funds have permitted the investors to exchange their units from one scheme to another and this flexibility is a great boom to investors. Income units can be changed from growth units depending upon the performance of the funds.

•

Reducing the marketing cost of new issues: Moreover the mutual funds help to reduce the marketing cost of the new issues. The promoters used to allot a major share of the Initial 34

Public Offering to the mutual funds and thus they are saved from the marketing cost of such issues. •

Simplified record keeping: An investor with just an investment in 500 shares or so in 3 or 4 companies has to keep proper records of dividend payments, bonus issues, price movements, purchase or sale instruction, brokerage and other related items. It is very tedious and consumes a lot of time. One may even forget to record the rights issue and may have to forfeit the same. Thus, record keeping is the biggest problem for small and medium investors.

•

Acting as substitute for initial public offerings (IPO’s): In most cases investors are not able to get allotment in IPO’s of companies because they are often oversubscribed many times. Moreover, they have to apply for a minimum of 500 shares which is very difficult particularly for small investors. But, in mutual funds, allotment is more or less guaranteed.

•

Keeping the money market active: An individual investor cannot have any access to money market instruments since the minimum amount of investment is out of his reach. On the other hand, mutual funds keep the money market instruments active by investing money on the money market.

The Indian Mutual fund is perhaps the best example of the customer focused, well managed and regulated financial industry in India and may be in the world. The professionals in the industry are uniformly of high calibre and bring great dedication and drive to their task. 35

LIMITATIONS: • The investors are likely to come in difficulties if the mutual fund is not managed efficiently. The rate of return will go down and the investment may become risky. • The investors have no direct control on their investment as the investment policies are decided by the trustees. • Investors of mutual fund are not given adequate information about the functioning of their mutual fund. They get the information about irregularities, etc. when it is too late to introduce remedial measures. • The future of mutual fund investor is linked with the future of mutual fund. An investor may suffer because of mismanagement of the mutual fund. • The expectations of investors are fast growing in the case of mutual funds but the managers of mutual funds find it hard to meet such high expectations of investors.

FUTURE OF MUTUAL FUNDS IN INDIA: By December 2004, Indian mutual fund industry reached Rs 1,50,537 crore. It is estimated that by 2010 March-end, the total assets of all scheduled commercial banks should be Rs 40,90,000 crore. The annual composite rate of growth is expected 13.4% during the rest of the decade. In the last 5 years we have seen annual growth rate of 9%. According to the current growth rate, by year 2010, mutual fund assets will be double.

36

Let us discuss with the following table: Aggregate deposits of Scheduled Com Banks in India (Rs. Crore) Month/Year Mar-98 Mar-00 Mar-01 Mar-02 Deposits

Mar-03

Mar-04 Sep-04

605410 851593 989141 1131188 1280853 -

Change in % over last year

15

14

13

4-Dec

1567251 1622579

12

-

18

3

Month/Year Mar-98 Mar-00 Mar-01 Mar-02

Mar-03

Mar-04 Sep-04

MF AUM's 68984 93717 83131 94017

75306

137626 151141 149300

Change in % over last year

25

45

Mutual Fund AUM’s Growth

26

13

12

9

4-Dec

1

Some facts for the growth of mutual funds in India • 100% growth in the last 6 years. US based, with over US$1trillion assets under management worldwide. • Our saving rate is over 23%, highest in the world. Only channelizing these savings in mutual funds sector is required. • We have approximately 29 mutual funds which is much less than US having more than 800. There is a big scope for expansion. • 'B' and 'C' class cities are growing rapidly. Today most of the mutual funds are concentrating on the 'A' class cities. Soon they will find scope in the growing cities. • Mutual fund can penetrate rural like the Indian insurance industry with simple and limited products. • SEBI allowing the MF's to launch commodity mutual funds. • Emphasis on better corporate governance. 37

• Trying to curb the late trading practices. • Introduction of Financial Planners who can provide need based advice.

Changed Environment: While the spread and penetration of mutual funds has been relatively low in the past, things are changing at a rapid pace now. One of the important drivers of this change has been the change in demographic profile of the country where greater sophistication has meant some shift away from a saving culture to an investment culture. This shift in turn is being aided by benefits including taxation benefits given to the investors. Decline in the yield on alternative investment instruments such as bonds and government sponsored savings products and the overall decline in interest rates have also aided the focus on ownership of assets. To serve this changing trend, the financial distribution and the financial advisory infrastructure has been evolving at a rapid pace. The recently witnessed uptrend in the equities market and the consequent value creation for investors in equity. Mutual funds have also led to an improvements in sentiments towards these products . Mutual funds have also attempted to innovate and position products appropriate to investors needs and requirements. Over the past five years the basket of products available to investors has increased significantly.

Growing Popularity of Mutual Funds:

38

The popularity of mutual funds is fast growing in India. The number of such funds is increasing and are getting popular support from the investing class. Investors prefer to give their savings to mutual funds for the safety of their funds and also for securing the benefits of diversified investment. These funds take appropriate investment to the investors. Mutual funds are also popular as they have introduced various openended schemes in order to offer convenience to all categories of investors. The professional management of mutual funds is also one important reason of their popularity. Small investors do not have substantial amount to invest, sufficient time to study various avenues available for investment and finally necessary knowledge, experience and skills to find out the most secured and profitable avenue for investment. However, these problems can be solved by investing money in mutual funds. The mutual funds relieve the investors from the entire botheration about secured and profitable investment and also offer the benefits of secured and diversified investment to the investors. In this sense, mutual fund acts as a boon to investors in general and small investors in particular.

Merchant Banking Introduction: In banking, a merchant bank is a financial institution primarily engaged in international finance and long-term loans for multinational corporations and governments. It can also be used to describe the private equity

39

activities of banking. This article is about the history of banking as developed by merchants, from the Middle Ages onwards.

History: Merchant banks, now so called, are in fact the original "banks". These were invented in the Middle Ages by Italian grain merchants. As the Lombardy merchants and bankers grew in stature based on the strength of the Lombard plains cereal crops, many displaced Jews fleeing Spanish persecution were attracted to the trade. They brought with them ancient practices from the middle and far east silk routes. Originally intended for the finance of long trading journeys, these methods were now utilized to finance the production of grain. The Jews could not hold land in Italy, so they entered the great trading piazzas and halls of Lombardy, alongside the local traders, and set up their benches to trade in crops. They had one great advantage over the locals. Christians were strictly forbidden the sin of usury. The Jewish newcomers, on the other hand, could lend to farmers against crops in the field, a highrisk loan at what would have been considered usurious rates by the Church, but did not bind the Jews. In this way they could secure the grain sale rights against the eventual harvest. They then began to advance against the delivery of grain shipped to distant ports. In both cases they made their profit from the present discount against the future price. This two-handed trade was time consuming and soon there arose a class of merchants, who were trading grain debt instead of grain. The Jewish trader performed both finance (credit) and an underwriting (insurance) functions. He would derive an income from lending the farmer money to develop and manufacture (through seeding, growing, weeding and harvesting) his annual crop (the crop loan at the beginning of the growing 40

season). He would underwrite (insure) the delivery of the crop (through crop or commodity insurance) to the merchant wholesaler who was the ultimate purchaser of the farmer’s harvest. And he would make arrangements to supply this buyer through alternative sources (the merchant function) of supply (such as grain stores or alternate producer markets), should any particular farming district suffer a seasonal crop failure. He could also keep the farmer (or other commodity producer) in business during a drought or other crop failure, through the issuance of a crop (or commodity) insurance against the hazard of failure of his crop. Thus in his underlying financial function the merchant banker (trader) would ensure the continuous smooth flowing of the commodity (crop, wool, salt; salt-cod, etc.) markets by providing both credit and insurance. It was a short step from financing trade on their own behalf to settling trades for others, and then to holding deposits for settlement of "billete" or notes written by the people who were still brokering the actual grain. And so the merchant's "benches" (bank is a corruption of the Italian for bench, as in a counter) in the great grain markets became centers for holding money against a bill (billette, a note, a letter of formal exchange, later a bill of exchange, later still, a cheque). These deposited funds were intended to be held for the settlement of grain trades, but often were used for the bench's own trades in the meantime. The term bankrupt is a corruption of the Italian banca rotta, or broken bench, which is what happened when someone lost his traders' deposits. Being "broke" has the same connotation. A sensible manner of discounting interest to the depositors against what could be earned by employing their money in the trade of the bench soon developed; in short, selling an "interest" to them in a specific trade, thus 41

overcoming the usury objection. Once again this merely developed what was an ancient method of financing long distance transport of goods. Islamic banking has the same constraints against usury as Christianity. The medieval Italian markets were disrupted by wars and in any case were limited by the fractured nature of the Italian states. And so the next generation of bankers arose from migrant Jewish merchants in the great wheat growing areas of Germany and Poland. Many of these merchants were from the same families who had been part of the development of the banking process in Italy. They also had links with family members who had, centuries before, fled Spain for both Italy and England. This course of events set the stage for the rise of banking names which still resonate today: Schroders, Warburgs, Rothschilds, even the illfated Barings, were all the product of the continental grain trade, and indirectly, the early Iberian persecution of Jews. It may be defined as, “ an institution which covers a wide range of activities such as management of customer services, portfolio management, credit syndication, acceptance credit, counseling and insurance etc., The merchant banks are also known as “ accepting and Issuing houses” in UK and as “Investment Banks” in US. They offer a package of financial services for fee mostly in new issues market.

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 42

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 the United States. This type initiates loans and then sells them to investors.

[3]

Even though these

companies call themselves "merchant banks," they have few, if any, of the characteristics of former merchant banks.

Venture Capital Introduction: Venture capital (also known as VC or Venture) is a type of private equity capital typically provided to immature, high-potential, growth 43

companies in the interest of generating a return through an eventual realization event such as an IPO or trade sale of the company. Venture capital investments are generally made as cash in exchange for shares in the invested company. Venture capital typically comes from institutional investors and high net worth individuals and is pooled together by dedicated investment firms. A venture capitalist (also known as a VC) is a person or investment firm that makes venture investments, and these venture capitalists are expected to bring managerial and technical expertise as well as capital to their investments. A venture capital fund refers to a pooled investment vehicle (often an LP or LLC) that primarily invests the financial capital of third-party investors in enterprises that are too risky for the standard capital markets or bank loans. Venture capital is most attractive for new companies with limited operating history that are too small to raise capital in the public markets and are too immature to secure a bank loan or complete a debt offering. In exchange for the high risk that venture capitalists assume by investing in smaller and less mature companies, venture capitalists usually get significant control over company decisions, in addition to a significant portion of the company's ownership (and consequently value).

History: With few exceptions, private equity in the first half of the 20th century was the domain of wealthy individuals and families. The Vanderbilts, Whitneys, Rockefellers and Warburgs were notable investors in private companies in the first half of the century. In 1938, Laurance S. Rockefeller 44

helped finance the creation of both Eastern Air Lines and Douglas Aircraft and the Rockefeller family had vast holdings in a variety of companies. Eric M. Warburg founded E.M. Warburg & Co. in 1938, which would ultimately become Warburg Pincus, with investments in both leveraged buyouts and venture capital.

Origins of modern private equity: Before World War II, venture capital investments (originally known as "development capital") were primarily the domain of wealthy individuals and families. It was not until after World War II that what is considered today to be true private equity investments began to emerge marked by the founding of the first two venture capital firms in 1946: American Research and Development Corporation. (ARDC) and J.H. Whitney & Company.

A VAX-11/780 system created by Digital Equipment Corporation, the first major venture capital success story ARDC was founded by Georges Doriot, the "father of venture capitalism" (former dean of Harvard Business School), with Ralph Flanders and Karl Compton (former president of MIT), to encourage private sector investments in businesses run by soldiers who were returning from World War II. ARDC's significance was primarily that it was the first institutional private equity investment firm that raised capital from sources other than wealthy families although it had several notable investment successes as 45

well. ARDC is credited with the first major venture capital success story when its 1957 investment of $70,000 in Digital Equipment Corporation (DEC) would be valued at over $355 million after the company's initial public offering in 1968 (representing a return of over 500 times on its investment and an annualized rate of return of 101%). Former employees of ARDC went on to found several prominent venture capital firms including Greylock Partners (founded in 1965 by Charlie Waite and Bill Elfers) and Morgan, Holland Ventures, the predecessor of Flagship Ventures (founded in 1982 by James Morgan). ARDC continued investing until 1971 with the retirement of Doriot. In 1972, Doriot merged ARDC with Textron after having invested in over 150 companies. J.H. Whitney & Company was founded by John Hay Whitney and his partner Benno Schmidt. Whitney had been investing since the 1930s, founding Pioneer Pictures in 1933 and acquiring a 15% interest in Technicolor Corporation with his cousin Cornelius Vanderbilt Whitney. By far Whitney's most famous investment was in Florida Foods Corporation. The company developed an innovative method for delivering nutrition to American soldiers, which later came to be known as Minute Maid orange juice and was sold to The Coca-Cola Company in 1960. J.H. Whitney & Company continues to make investments in leveraged buyout transactions and raised $750 million for its sixth institutional private equity fund in 2005.

Early venture capital and the growth of Silicon Valley:

46

Sand Hill Road in Menlo Park, California, where many Bay Area venture capital firms are based One of the first steps toward a professionally-managed venture capital industry was the passage of the Small Business Investment Act of 1958. The 1958 Act officially allowed the U.S. Small Business Administration (SBA) to license private "Small Business Investment Companies" (SBICs) to help the financing and management of the small entrepreneurial businesses in the United States. During the 1960s and 1970s, venture capital firms focused their investment activity primarily on starting and expanding companies. More often than not, these companies were exploiting breakthroughs in electronic, medical or data-processing technology. As a result, venture capital came to be almost synonymous with technology finance. It is commonly noted that the first venture-backed startup is Fairchild Semiconductor (which produced the first commercially practical integrated circuit), funded in 1959 by what would later become Venrock Associates. Venrock was founded in 1969 by Laurance S. Rockefeller, the fourth of John D. Rockefeller's six children as a way to allow other Rockefeller children to develop exposure to venture capital investments. It was also in the 1960s that the common form of private equity fund, still in use today, emerged. Private equity firms organized limited 47

partnerships to hold investments in which the investment professionals served as general partner and the investors, who were passive limited partners, put up the capital. The compensation structure, still in use today, also emerged with limited partners paying an annual management fee of 12% and a carried interest typically representing up to 20% of the profits of the partnership. The growth of the venture capital industry was fueled by the emergence of the independent investment firms on Sand Hill Road, beginning with Kleiner, Perkins, Caufield & Byers and Sequoia Capital in 1972. Located, in Menlo Park, CA, Kleiner Perkins, Sequoia and later venture capital firms would have access to the burgeoning technology industries in the area. By the early 1970s, there were many semiconductor companies based in the Santa Clara Valley as well as early computer firms using their devices and programming and service companies. Throughout the 1970s, a group of private equity firms, focused primarily on venture capital investments, would be founded that would become the model for later leveraged buyout and venture capital investment firms. In 1973, with the number of new venture capital firms increasing, leading venture capitalists formed the National Venture Capital Association (NVCA). The NVCA was to serve as the industry trade group for the venture capital industry. Venture capital firms suffered a temporary downturn in 1974, when the stock market crashed and investors were naturally wary of this new kind of investment fund. It was not until 1978 that venture capital experienced its first major fundraising year, as the industry raised approximately $750 million. With the passage of the Employee Retirement Income Security Act (ERISA) in 1974, corporate pension funds were prohibited from holding certain risky investments including many investments in privately held companies. In 1978, the US Labor Department relaxed certain of the ERISA restrictions, 48

under the "prudent man rule," thus allowing corporate pension funds to invest in the asset class and providing a major source of capital available to venture capitalists.

Venture capital in the 1980s: The public successes of the venture capital industry in the 1970s and early 1980s (e.g., Digital Equipment Corporation, Apple, Genentech) gave rise to a major proliferation of venture capital investment firms. From just a few dozen firms at the start of the decade, there were over 650 firms by the end of the 1980s, each searching for the next major "home run". While the number of firms multiplied, the capital managed by these firms increased only 11% from $28 billion to $31 billion over the course of the decade. The growth the industry was hampered by sharply declining returns and certain venture firms began posting losses for the first time. In addition to the increased competition among firms, several other factors impacted returns. The market for initial public offerings cooled in the mid-1980s before collapsing after the stock market crash in 1987 and foreign corporations, particularly from Japan and Korea, flooded early stage companies with capital. In response to the changing conditions, corporations that had sponsored in-house venture investment arms, including General Electric and Paine Webber either sold off or closed these venture capital units. Additionally, venture capital units within Chemical Bank and Continental Illinois National Bank, among others, began shifting their focus from funding early stage companies toward investments in more mature companies. Even industry founders J.H. Whitney & Company and Warburg Pincus began to transition toward leveraged buyouts and growth capital investments. 49

The venture capital boom and the Internet Bubble (1995 to 2000): By the end of the 1980s, venture capital returns were relatively low, particularly in comparison with their emerging leveraged buyout cousins, due in part to the competition for hot startups, excess supply of IPOs and the inexperience of many venture capital fund managers. Growth in the venture capital industry remained limited through the 1980s and the first half of the 1990s increasing from $3 billion in 1983 to just over $4 billion more than a decade later in 1994. After a shakeout of venture capital mangers, the more successful firms retrenched, focusing increasingly on improving operations at their portfolio companies rather than continuously making new investments. Results would begin to turn very attractive, successful and would ultimately generate the venture capital boom of the 1990s. Former Wharton Professor Andrew Metrick refers to these first 15 years of the modern venture capital industry beginning in 1980 as the "pre-boom period" in anticipation of the boom that would begin in 1995 and last through the bursting of the Internet bubble in 2000. The late 1990s were a boom time for the venture capital, as firms on Sand Hill Road in Menlo Park and Silicon Valley benefited from a huge surge of interest in the nascent Internet and other computer technologies. Initial public offerings of stock for technology and other growth companies were in abundance and venture firms were reaping large windfalls.

The bursting of the Internet Bubble and the private equity crash (2000 to 2003): 50

The technology-heavy NASDAQ Composite index peaked at 5,048 in March 2000, reflecting the high point of the dot-com bubble. The Nasdaq crash and technology slump that started in March 2000 shook virtually the entire venture capital industry as valuations for startup technology companies collapsed. Over the next two years, many venture firms had been forced to write-off their large proportions of their investments and many funds were significantly "under water" (the values of the fund's investments were below the amount of capital invested). Venture capital investors sought to reduce size of commitments they had made to venture capital funds and in numerous instances, investors sought to unload existing commitments for cents on the dollar in the secondary market. By mid-2003, the venture capital industry had shriveled to about half its 2001 capacity. Nevertheless, PricewaterhouseCoopers' MoneyTree Survey shows that total venture capital investments held steady at 2003 levels through the second quarter of 2005. Although the post-boom years represent just a small fraction of the peak levels of venture investment reached in 2000, they still represent an increase over the levels of investment from 1980 through 1995. As a percentage of GDP, venture investment was 0.058% percent in 1994, peaked at 1.087% (nearly 19x the 1994 level) in 2000 and ranged from 51

0.164% to 0.182 % in 2003 and 2004. The revival of an Internet-driven environment in 2004 through 2007 helped to revive the venture capital environment. However, as a percentage of the overall private equity market, venture capital has still not reached its mid-1990s level, let alone its peak in 2000. However, venture capital funds, which were responsible for much of the fundraising volume in 2000 (the height of the dot-com bubble), raised only $25.1 billion in 2006, a 2% percent decline from 2005 and a significant decline from its peak.

Venture capital firms and funds:

Diagram of the structure of a generic venture capital fund

Structure of Venture Capital firms:

52

Venture capital firms are typically structured as partnerships, the general partners of which serve as the managers of the firm and will serve as investment advisors to the venture capital funds raised. Venture capital firms in the United States may also be structured as limited liability companies, in which case the firm's managers are known as managing members. Investors in venture capital funds are known as limited partners. This constituency comprises both high net worth individuals and institutions with large amounts of available capital, such as state and private pension funds, university financial endowments, foundations, insurance companies, and pooled investment vehicles, called fund of funds or mutual funds.

Roles within venture capital firms: Within the venture capital industry, the general partners and other investment professionals of the venture capital firm are often referred to as "venture capitalists" or "VCs". Typical career backgrounds vary, but broadly speaking venture capitalists come from either an operational or a finance background. Venture capitalists with an operational background tend to be former founders or executives of companies similar to those which the partnership finances or will have served as management consultants. Venture capitalists with finance backgrounds tend to have investment banking or other corporate finance experience. Although the titles are not entirely uniform from firm to firm, other positions at venture capital firms include: •

Venture partners - Venture partners are expected to source potential investment

opportunities

("bring

in

deals")

and

typically

are

compensated only for those deals with which they are involved. •

Entrepreneur-in-residence (EIR) - EIRs are experts in a particular domain and perform due diligence on potential deals. EIRs are engaged by venture capital firms temporarily (six to 18 months) and 53

are expected to develop and pitch startup ideas to their host firm (although neither party is bound to work with each other). Some EIR's move on to executive positions within a portfolio company. •

Principal - This is a mid-level investment professional position, and often considered a "partner-track" position. Principals will have been promoted from a senior associate position or who have commensurate experience in another field such as investment banking or management consulting.

•

Associate - This is typically the most junior apprentice position within a venture capital firm. After a few successful years, an associate may move up to the "senior associate" position and potentially principal and beyond. Associates will often have worked for 1-2 years in another field such as investment banking or management consulting.

Structure of the funds: Most venture capital funds have a fixed life of 10 years, with the possibility of a few years of extensions to allow for private companies still seeking liquidity. The investing cycle for most funds is generally three to five years, after which the focus is managing and making follow-on investments in an existing portfolio. This model was pioneered by successful funds in Silicon Valley through the 1980s to invest in technological trends broadly but only during their period of ascendance, and to cut exposure to management and marketing risks of any individual firm or its product. In such a fund, the investors have a fixed commitment to the fund that is initially unfunded and subsequently "called down" by the venture capital fund over time as the fund makes its investments. There are substantial penalties for a Limited Partner (or investor) that fails to participate in a capital call.

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Compensation: Venture capitalists are compensated through a combination of management fees and carried interest (often referred to as a "two and 20" arrangement: •

Management fees – an annual payment made by the investors in the fund to the fund's manager to pay for the private equity firm's investment operations. In a typical venture capital fund, the general partners receive an annual management fee equal to up to 2% of the committed capital.

•

Carried interest - a share of the profits of the fund (typically 20%), paid to the private equity fund’s management company as a performance incentive. The remaining 80% of the profits are paid to the fund's investors Strong Limited Partner interest in top-tier venture firms has led to a general trend toward terms more favorable to the venture partnership, and certain groups are able to command carried interest of 25-30% on their funds. Because a fund may run out of capital prior to the end of its life, larger

venture capital firms usually have several overlapping funds at the same time; this lets the larger firm keep specialists in all stages of the development of firms almost constantly engaged. Smaller firms tend to thrive or fail with their initial industry contacts; by the time the fund cashes out, an entirely-new generation of technologies and people is ascending, whom the general partners may not know well, and so it is prudent to reassess and shift industries or personnel rather than attempt to simply invest more in the industry or people the partners already know.

Venture capital funding: 55

Venture capitalists are typically very selective in deciding what to invest in; as a rule of thumb, a fund may invest in one in four hundred opportunities presented to it. Funds are most interested in ventures with exceptionally high growth potential, as only such opportunities are likely capable of providing the financial returns and successful exit event within the required timeframe (typically 3-7 years) that venture capitalists expect. Because investments are illiquid and require 3-7 years to harvest, venture capitalists are expected to carry out detailed due diligence prior to investment. Venture capitalists also are expected to nurture the companies in which they invest, in order to increase the likelihood of reaching a IPO stage when valuations are favourable. Venture capitalists typically assist at four stages in the company's development: •

Idea generation;

•

Start-up;

•

Ramp up; and

•

Exit

There are typically six stages of financing offered in Venture Capital, that roughly correspond to these stages of a company’s development. Seed Money: Low level financing needed to prove a new idea (Often provided by "angel investors") •

Start-up: Early stage firms that need funding for expenses associated with marketing and product development

•

First-Round: Early sales and manufacturing funds

•

Second-Round: Working capital for early stage companies that are selling product, but not yet turning a profit

•

Third-Round: Also called Mezzanine financing, this is expansion money for a newly profitable company 56

•

Fourth-Round: Also called bridge financing, 4th round is intended to finance the going public process Because there are no public exchanges listing their securities, private

companies meet venture capital firms and other private equity investors in several ways, including warm referrals from the investors' trusted sources and other business contacts; investor conferences and symposia; and summits where companies pitch directly to investor groups in face-to-face meetings, including a variant know as "Speed Venturing", which is akin to speed-dating for capital, where the investor decides within 10 minutes whether s/he wants a follow-up meeting. Mass High Tech, September 5, 2008 This need for high returns makes venture funding an expensive capital source for companies, and most suitable for businesses having large upfront capital requirements which cannot be financed by cheaper alternatives such as debt. That is most commonly the case for intangible assets such as software, and other intellectual property, whose value is unproven. In turn this explains why venture capital is most prevalent in the fast-growing technology and life sciences or biotechnology fields. If a company does have the qualities venture capitalists seek including a solid business plan, a good management team, investment and passion from the founders, a good potential to exit the investment before the end of their funding cycle, and target minimum returns in excess of 40% per year, it will find it easier to raise venture capital.

Main alternatives to venture capital:

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Because of the strict requirements venture capitalists have for potential investments, many entrepreneurs seek initial funding from angel investors, who may be more willing to invest in highly speculative opportunities, or may have a prior relationship with the entrepreneur. Furthermore, many venture capital firms will only seriously evaluate an investment in a start-up otherwise unknown to them if the company can prove at least some of its claims about the technology and/or market potential for its product or services. To achieve this, or even just to avoid the dilutive effects of receiving funding before such claims are proven, many start-ups seek to self-finance until they reach a point where they can credibly approach outside capital providers such as venture capitalists or angel investors. This practice is called "bootstrapping". There has been some debate since the dot com boom that a "funding gap" has developed between the friends and family investments typically in the $0 to $250,000 range and the amounts that most Venture Capital Funds prefer to invest between $1 to $2M. This funding gap may be accentuated by the fact that some successful Venture Capital funds have been drawn to raise ever-larger funds, requiring them to search for correspondingly larger investment opportunities. This 'gap' is often filled by angel investors as well as equity investment companies who specialize in investments in startups from the range of $250,000 to $1M. The National Venture Capital association estimates that the latter now invest more than $30 billion a year in the USA in contrast to the $20 billion a year invested by organized Venture Capital funds. In industries where assets can be securitized effectively because they reliably generate future revenue streams or have a good potential for resale in case of foreclosure, businesses may more cheaply be able to raise debt to finance their growth. Good examples would include asset-intensive 58

extractive industries such as mining, or manufacturing industries. Offshore funding is provided via specialist venture capital trusts which seek to utilize securitization in structuring hybrid multi market transactions via an SPV (special purpose vehicle): a corporate entity that is designed solely for the purpose of the financing. In addition to traditional venture capital and angel networks, groups have emerged which allow groups of small investors or entrepreneurs themselves to compete in a privatized business plan competition where the group itself serves as the investor through a democratic process.

Geographical differences: Venture capital, as an industry, originated in the United States and American firms have traditionally been the largest participants in venture deals and the bulk of venture capital has been deployed in American companies. However, increasingly, non-US venture investment is growing and the number and size of non-US venture capitalists have been expanding. Venture capital has been used as a tool for economic development in a variety of developing regions. In many of these regions, with less developed financial sectors, venture capital plays a role in facilitating access to finance for small and medium enterprises (SMEs), which in most cases would not qualify for receiving bank loans.

United States: 59

Venture capitalists invested some $6.6 billion in 797 deals in U.S. during the third quarter of 2006, according to the MoneyTree Report by PricewaterhouseCoopers and the National Venture Capital Association based on data by Thomson Financial. A recent National Venture Capital Association survey found that majority (69%) of venture capitalists predict that venture investments in U.S. will level between $20-29 billion in 2007.

Canada: Canadian technology companies have attracted interest from the global venture capital community as a result, in part, of generous tax incentive through the Scientific Research and Experimental Development (SR&ED) investment tax credit program. The basic incentive available to any Canadian corporation performing R&D is a non-refundable tax credit that is equal to 20% of "qualifying" R&D expenditures (labour, material, R&D contracts, and R&D equipment). An enhanced 35% refundable tax credit of available to certain (i.e. small) Canadian-controlled private corporations (CCPCs). Because the CCPC rules require a minimum of 50% Canadian ownership in the company performing R&D, foreign investors who would like to benefit from the larger 35% tax credit must accept minority position in the company - which might not be desirable. The SR&ED program does not restrict the export of any technology or intellectual property that may have been developed with the benefit of SR&ED tax incentives. Canada also has a fairly unique form of venture capital generation in its Labour Sponsored Venture Capital Corporations (LSVCC). These funds, also known as Retail Venture Capital or Labour Sponsored Investment Funds (LSIF), are generally sponsored by labor unions and offer tax breaks from government to encourage retail investors to purchase the funds. 60

Generally, these Retail Venture Capital funds only invest in companies where the majority of employees are in Canada. However, innovative structures have been developed to permit LSVCCs to direct in Canadian subsidiaries of corporations incorporated in jurisdictions outside of Canada.

Europe: Europe has a large and growing number of active venture firms. Capital raised in the region in 2005, including buy-out funds, exceeded €60mn, of which €12.6mn was specifically for venture investment. The European Venture Capital Association includes a list of active firms and other statistics. In 2006 the top three countries receiving the most venture capital investments were the United Kingdom (515 minority stakes sold for €1.78bn), France (195 deals worth €875m), and Germany (207 deals worth €428m) according to data gathered by Library House. European venture capital investment in the second quarter of 2007 rose 5% to 1.14 billion Euros from the first quarter. However, due to bigger sized deals in early stage investments, the number of deals was down 20% to 213. The second quarter venture capital investment results were significant in terms of early-round investment, where as much as 600 million Euros (about 42.8% of the total capital) were invested in 126 early round deals (which comprised more than half of the total number of deals).

India: The investment of capitalists in Indian industries in the first half of 2006 is $3 billion and is expected to reach $6.5 billion at the end of the year. Most VC firms in India are either divisions or subsidiaries of Silicon Valley funds. They are primarily centered in Bangalore and Mumbai. Some VCs also operate from Delhi and other parts of the National Capital Region. 61

China: In China, venture funding more than doubled from $420,000 in 2002 to almost $1 million in 2003. For the first half of 2004, venture capital investment rose 32% from 2003. By 2005, led by a wave of successful IPOs on the NASDAQ and revised government regulations, China-dedicated funds raised US$4 million in committed capital.

Vietnam: In Vietnam, venture funding has been increasing rapidly as Vietnamese

overseas

returnees

and

Vietnamese

ex-managers

of

multinational companies increasingly establish new companies with ambitious growth plans. Firms such as Mekong Ventures, IDG Vietnam Ventures and DFJ-VinaCapital have pioneered investments in seed-stage and start-up stage companies in Vietnam. The $20 Million Challenge is Vietnam's first business plan contest for local entrepreneurs.

Confidential information: Unlike public companies, information regarding an entrepreneur's business is typically confidential and proprietary. As part of the due diligence process, most venture capitalists will require significant detail with respect to a company's business plan. Entrepreneurs must remain vigilant about sharing information with venture capitalists that are investors in their competitors. Most venture capitalists treat information confidentially, however, as a matter of business practice, do not typically enter into Non Disclosure Agreements because of the potential liability issues those agreements entail. Entrepreneurs are typically well-advised to protect truly proprietary intellectual property.

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Limited partners of venture capital firms typically have access only to limited amounts of information with respect to the individual portfolio companies in which they are invested and are typically bound by confidentiality provisions in the fund's limited partnership agreement.

Popular culture: Robert von Goeben and Kathryn Siegler produced a comic strip called The VC between the years 1997-2000 that parodied the industry, often by showing

humorous

exchanges

between

venture

capitalists

and

entrepreneurs. Von Goeben was a partner in Redleaf Venture Management when he began writing the strip. Mark Coggins' 2002 novel Vulture Capital features a venture capitalist protagonist who investigates the disappearance of the chief scientist in a biotech firm in which he has invested. Coggins also worked in the industry and was co-founder of a dot-com startup. Drawing on his experience as reporter covering technology for the New York Times, Matt Richtel produced the 2007 novel Hooked, in which the actions of the main character's deceased girlfriend, a Silicon Valley venture capitalist, play a key role in the plot.

Conclusion 63

The world landscape is changing fast and a growing and India is at the center of that new world and expects India to take a leading role in world economic affairs in the coming years. India’s human and natural resources, language and IT skills, and geographical positions- as well as its entrepreneurial base, grounded in the world’s largest democracy- make it well suited for further growth, especially in the Asia Pacific region. Internationalization brings commercial and financial success and India will benefit from using international firms to further raise its access to global market place.

Bibliography 64

•

Text book of financial services

• Book published by Himalayan publication on financial services in India • Introduction to venture capital and private Equity Finance (Encyclopedia) • Merchant Banking: Past and Present (Encyclopedia) • Sources of information investment (Encyclopedia) •

www.finance.com

•

www.sec.gov.com

•

www.wikipedia.com

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