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The merchant banking vision: deploying entrepreneurial capital effectively

The book “Transforming Financial Institutions” argues that specialisation and service integration are core drivers of the financial industry’s ongoing strategic repositioning and reorganisation effort. There is a gap to be filled in the market by specialised new entrants, the “challengers”, but also for large-scale incumbent players, the “established financial institutions”. The incumbents remain under pressure to adjust their business models amid the rapidly changing market and regulatory environment. On the one hand, utility-like banking products and services can effectively only be delivered via operational scale and efficiency, while making sure that the regulatory requirements are fulfilled. On the other hand, there is inherent value and a business case for specialised risk-transfer and distribution capabilities via new market entrants. In order to facilitate their success and to implement this inclusive growth and transformation agenda, open-architecture and embedded services are essential for providing the required technology-enabled operating platform.


Small and mid-size enterprises (SME) are the backbone of all major European economies. Yet, as a target group, they represent today an underserved segment in the coverage strategy of the incumbent banking players. Accelerated by cost cutting and regulatory pressure, this situation has led to funding shortfalls for SME across a range of key industry sectors in several European countries. Against this backdrop, a technology-enabled merchant-banking platform with a specialised alternative lending programme, and effective capital allocation and service integration can make a key difference. Such a platform with its dedicated coverage model for the SME segment is well placed to close the market gap through innovative lending structures and by providing SME an inclusive service package through embedded services.


The following article outlines the vision of a digital merchant banking platform as part of the evolving legislative and regulatory agenda for open finance*.


The funding gap

Financial institutions have retreated from a range of core financing-market segments, including cash-flow based (non-investment grade) corporate lending, but also real-asset lending such as real estate, infrastructure and renewables, shipping, and aviation debt. In addition, capital requirements under Basel IV have made lending to growth companies via venture debt, provision of subordinated capital via mezzanine or hybrid financings largely impossible. Consequently, certain traditional customer segments such as European SME have been neglected and underserved by incumbent financial institutions. The funding gap is estimated to reach several trillions Euros for the European banking industry alone. SME borrowers and sponsors are engaging nonbank providers and frequently seeking holistic financing solutions and execution certainty in this changing environment. These developments have led to an influx of new specialty-finance players and rise of private debt as a dedicated alternative asset class.


Specialty finance and alternative capital

Specialty finance is defined as any financing activity that takes place outside the traditional financial system. Most specialty finance businesses have been established as alternative direct lending and investing platforms, targeting market segments that have difficulties to obtain financing through traditional channels. These specialty-finance players provide risk-transfer business models that target consumer and commercial segments with dedicated and tailored lending propositions. Traditionally backed by institutional capital and, as of late, increasingly also private wealth capital, their approach is focused on the risk-adjusted performance of the underlying asset, and funding often provided through innovative investment vehicles and structures. A thorough level of underwriting allows them to provide tailored debt, hybrid and equity financing in special situations, often declined by traditional lenders. These players obtain a premium price to cover their in-depth analysis and the risk taken. SME are an excellent example for such a market segment. Under the Alternative Investment Fund Managers Directive (AIFMD), alternative investment managers can provide banking services such as lending under a defined regulatory framework by the European Union. A banking licence is no longer required to serve these customers.


The merchant-banking approach

The term merchant bank has traditionally been used for banks that deal in commercial loans and equity ownership, combined with advice on corporate matters. Co-investing in the firms they work with has been a crucial distinction to their approach. Merchant banks got their name from dealing with mediaeval merchants. They were the first modern banking organisation that evolved for accelerated economic growth through innovation. A course of historical events in the 18th century led to the rise of banking dynasties such as Rothschild and Warburg, followed by the move of merchant families into banking such as Barings, Schroders, and Berenberg mainly in Germany and the United Kingdom. At the same time, new types of financial activities broadened the scope of banking far beyond its origins. In the 19th century, the rise of trade and industry led to powerful merchant banks in the United States such as J.P. Morgan & Co and Kuhn, Loeb & Co. Jacob Schiff and Siegmund Warburg were amongst the last traditional merchant banking figures of the 20th century.


After the second world war, traditional merchant banks were replaced by bulge bracket investment banks with global service offerings. The financial needs during the period of accelerated globalisation outgrew the resources of privately-owned financial institutions in the traditional legal structures of merchant banks. Merchant banking activities became just one area of interest for these large-scale global banks. Today, the merchant-banking terminology is used for a mixture of different financial services packages. At the core of the proposition however stands the idea of serving corporations with entrepreneurial endeavours through financing across the capital structure and corporate advice such as M&A. The traditional merchant banking model was based on close relationships of bankers with their entrepreneurial counterparts, coupled with a focus on shared risk-taking and co-investing. This merchant-banking business approach and entailling entrepreneurial mindset have been diminished in today’s modern banking environment. The banking industry's large-scale business models that operate in complex and multilateral ecosystems with high regulatory scrutiny is focused on standardised and efficiency-driven services in their client-coverage approach. The traditional merchant-banking approach and mindset are required though – likely more than ever before, in response to the current funding challenges of today’s SME lending markets.


Open architecture and embedded finance

Embedded finance technologies in combination with open architecture has become a key differentiator in implementing this technology-enabled merchant-banking vision. Legislative efforts such as Open Banking and Open Finance provide the regulatory toolset to make this approach a reality today.


At the core of this model sits the risk-taking appetite and capabilities across the capital structure. On the credit side, it includes direct lending activities, often tailored to specific needs (e.g., organic growth investments, acquisitions, shareholder changes, succession topics, ...) and special situations (e.g., corporate reorganisations and restructurings, including short-term liquidity issues), backed by specific collateral requirements. It can also include hybrid (debt and equity) or pure equity financings and co-investing in accordance with the client's specific capital requirements. After the boom in private equity, private credit has as an asset class expanded significantly over the last few years. Non-bank or alternative lenders have emerged first in the US more than two decades ago, in the UK more widely after the global financial crisis (GFC) and now most recently across Western Europe. However, certain large economies such as Germany are still exhibit a relatively low penetration. Direct lending is corporate borrowing by a private-credit provider. It is the most common form of private corporate credit. Direct lending originates and facilitates a deal, either bilaterally, but often involving a club deal with a small group of direct lenders and/or in combination with banks. Direct lending firms were able to seize significant market share from incumbent banks through their flexible approach to deal structuring and speed of execution. The total assets managed by private credit is estimated today between $1.5 and 2tn with expectations that this amount doubles in the years to come.


A next step in the industry's development is through open-technology architecture. Embedded services such as payments, accounting, interest-rate and foreign-exchange hedging are offered as a package on an integrated basis by alternative-capital platforms. The operational data received through those services can be used to assess credit risk and tailor an overall risk-management approach for lending and other investing activities. A fully automated lending offering, supported by big-data and machine-learning techniques, can be offered for smaller loans, targeting the small and lower mid-markets for their working-capital needs. Technology enables alternative capital players to establish agile operating platforms with integrated databases at their core, supported by quantitative algorithms and high computational power for operational efficiency. This allows to integrate these package offerings in the wider ecosystem of incumbent banking players through a collaborative approach and mindset.


The rapid changes in the SME lending markets represent a significant opportunity for a new generation of market players. Those able to combine a merchant-banking approach with alternative capital and open-technology architecture will win the race.


*See guest essay on "Open Finance as an Innovation for the Financial Industry" in finews from March 2023 for an in-depth perspective on the regulatory and strategic agenda.


This article concludes the four blog series that were launched after the publication of the book “Transforming Financial Institutions” in early 2022. The build-up of a technology-enabled merchant banking has been a core strategic focus for the author under the umbrella of Evolve Enterprise Solutions (EES) across a number of corporate and transactional situations. The article picks up the book's key hypothesis on technology-enabled service specialisation. It further integrates the experience gained over the last few years in appreciation and gratitude for the entrepreneurs and innovators that have been driving the SME lending and servicing topic with a pan-European vision. [Joerg Ruetschi in December 2023]

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