Goldman Sachs has already changed the way it’s investing in private equity (PE). In a recent deal for PSAV, Reuters reported that the firm underwrote the equity in the deal without using a PE fund to finance it, instead lining up clients who were willing to invest in the deal through separate accounts. It doesn’t appear that the Volcker rule, which is slated to go into effect next July, would prohibit such an arrangement.
President Barack Obama and Paul Volcker (left) speak with General Electric CEO Jeffrey Immelt about economic recovery in 2009. | Photo by The White House
The Volcker rule will limit investment banks from contributing more than 3% of their Tier 1 capital to private equity funds, hedge funds and proprietary trading. The way the law is structured, banks may be allowed to keep making PE investments using their own capital (or their employees’), as long as the capital doesn’t originate from a bank-sponsored PE fund, or a “covered fund.” Wells Fargo is doing pretty much the same thing as Goldman—avoiding outside equity. The San Francisco-based bank is going forward with buyouts and venture capital deals through merchant banking transactions, a somewhat riskier route than traditional PE transactions, but they appear to pass under new regulations. As long as banks are investing alongside third parties instead of covered funds, the new regulations likely won’t affect them.
Wells Fargo and Goldman Sachs won’t have a lot of company going forward. A number of firms have already divested their private equity divisions or are trying to spin them off. JP Morgan is trying to sell its One Equity Partners for as much as $4 billion. Possible buyers of the unit, including AlpInvest Partners, HarbourVest Partners, Pantheon and Lexington Partners, have seen a number of other opportunities pop up from spooked banks. Credit Suisse sold its Customized Fund Investment Group and Strategic Partners secondaries businesses earlier this year, and later agreed to sell its Global Infrastructure Partners division to Lexington. Citigroup inked an agreement to sell Citi Venture Capital International to the Rohatyn Group this past September, and Mizuho Financial Group is set to sell about €250 million worth of buyout stakes it owns to Ardian. Morgan Stanley is hinting that it’s going to start divesting, as well.
Virtue though it is, prudence hasn’t translated into any rewards for those firms yet, even three years after President Obama signed Dodd-Frank into law. Janet Yellen, writing to a Republican congressman recently, made it clear that delaying the Volcker rule even further was a possibility, given “the public interest in granting an extension of the conformance period.” If the delay stretches all the way until July 2015, as some suspect, that would effectively give banks a five-year window since Dodd-Frank was signed to divest their holdings. For some, that’s plenty of time. Goldman, according to Fortune’s Dan Primack, decided when Frank-Dodd was passed not to divest the $20.3 billion PE fund it raised in 2007. The firm thought it had enough time to secure adequate extensions for the fund once the Volcker details were hammered out. If it had to, the firm believed it would be able to liquidate the assets responsibly.
Even in the private equity universe, five years makes for quite a few opportunities, seized or missed. As we covered earlier, 2013 has been a big year for PE exits, evidenced most recently by a blowout third quarter for listed private equity firms. Or take Goldman’s recent third quarter earnings. About $950 million of Goldman’s $1.4 billion in 3Q 2013 earnings came from its private equity and proprietary trading investments. The section that houses that figure accounted for more than a fifth of the firm’s total 3Q revenues. Likewise, Wells Fargo’s PE holdings, listed as “net gains from equity investments” on its income statement, brought in $502 million of income for the firm in the third quarter, up from $164 million reported in 3Q 2012. No wonder these guys aren’t in a rush to sell.
Perhaps the biggest winners in the divestiture party are secondary investors like Ardian, formerly AXA Private Equity. The firm disclosed about $4.3 billion in new buyout fund stakes going back to September 2012, thanks in part to a rising supply of bank-sponsored funds in the market. Ardian doesn’t expect a reduction in the seller pool any time soon, at least in the next five years. Other firms in the secondaries market are also seeing a rise in demand—Neuberger Berman’s NB Secondary Opportunities Fund III recently raised $2 billion to easily eclipse its $1.6 billion target. Ditto for Lexington and HarbourVest, both of which closed secondary funds this July that beat their targets.
Even though details regarding the new regulations haven’t been finalized, its become clear that some are benefiting from the changes and others are finding their exits. Overshadowing the whole discussion, of course, are fresh memories of the 2008 financial crisis, especially the headaches caused by risky, illiquid investments like private equity. It doesn’t look like private equity and its piles of portfolio company debt are threatening the financial system at the moment, as some have feared. But it’s a risky business, particularly for interconnected investment banks that found themselves at the heart of the crisis five years ago.
“Your No. 1 client is the government,” former Morgan Stanley CEO John Mack said recently. Time to cut down on risk a bit, in other words, even if others are forging ahead.