COMMENT: Volcker shock

David Snow ponders what a proposed US banking rule would mean for captive private equity and private equity real estate firms.

Beyond death and taxes, there are few certainties in life. But here are two more: First, if you are a captive private investment firm in a bank, you will eventually spin out.
Second, while you are a captive entity, you will extol the benefits of your parent company’s “vast network” and “world-class resources”, but after you have flown the corporate coop you will declare that life is much better as an independent firm, after all.
The list of independent private equity firms begat by banks is too long to list here, but it includes some major names as well as names that have faded in heft. The list of firms still owned by US banks is much shorter than it used to be owing to the aforementioned, preordained spinouts. But if a new banking rule proposed by the Obama administration is enacted, the manifest destiny of independence will be accelerated dramatically.

David Snow

Last week, in an announcement that shocked many already shell-shocked market observers, the president declared his intention to pursue the “Volcker Rule” – named after the former US Federal Reserve chairman who formulated and promoted it. Among the details revealed are that “banks will no longer be allowed to own, invest, or sponsor hedge funds, private equity funds, or proprietary trading operations”, Obama said. “These firms should not be allowed to run these hedge funds and private equities funds while running a bank backed by the American people”.
Setting aside whether or not this constitutes good policy, as well as what the precise meaning of “own, invest or sponsor” is, if some form of this rule becomes reality, there are quite a few people and assets that will need to strenuously extract themselves from one place and move to another place, often under a different name. But these groups will have a number of options in dealing with the new regulations. Let’s look at a few of these groups and, while we admittedly are still in a fog of uncertainty, ponder their options:

Goldman Sachs Principal Investment Area – this is the second-largest private equity firm in the world, having raised some $49 billion for direct investment over the past 5 years, according to our PEI 300 ranking. As with many things, there’s a Goldman exception to the captive spin-out rule. The firm’s Principal Investment Area has proved amazingly impervious to the forces that have expelled many other private equity divisions from banks. Can Goldman withstand the Volcker Rule? Yes – by throwing away its bank holding company status, which it reluctantly converted to in September 2008 while under intense pressure from the Fed. If Goldman (and Morgan Stanley) elect to cease being bank holding companies their proprietary investment activities will be secure. Any part of this large group going independent would be the Mother of All Spinouts.
One Equity Partners – this division of JPMorgan Chase manages some $8 billion, including a sizeable chunk of its parent company’s balance sheet.  There is no chance that JP Morgan Chase will give up its banking charter. However it the investment bank and commercial bank were broken in two, One Equity could continue to operate from within JP Morgan. However it would also be a prime candidate to spin out as an independent, and fairly substantial, private equity firm.
Citi Private Equity – this group manages direct, mezzanine and fund commitments, both on a proprietary basis and for clients. This mix would present something of a mess if the Volcker Rule were enacted. The team would have to decide which parts to sell, which parts to spin out, and, if Citi were to jettison its investment bank, which parts would follow the reborn Smith Barney. With regard to the private equity fund commitments on Citi’s balance sheet, let’s just say that secondaries buyers are licking their chops.
It is unclear if a group – like a captive fund of funds housed in the asset management division of an investment bank – that merely advises on fund commitments without investing any of the bank’s capital would be deemed to “own” a private equity fund.
The good news is that, for the right team at the right price, spin-out capital is abundant in the private equity market, as are the many standard sunny explanations as to why ditching a bank parent is a positive thing.