Goldman Sachs, Morgan Stanley Face Limits On Merchant Banking

Goldman Sachs and Morgan Stanley plan to stay the course in private equity. At least for the moment. But restrictions that they face as bank holding companies do raise questions as to whether they would keep their merchant banking operations, as presently constitutued, over the long term.

Goldman Sachs has a much greater presence in the asset class than does Morgan Stanley. Through its GS Capital Partners unit, the company makes investments in a range of industries in the United States, Europe and Asia. Since 1992, it’s raised seven funds, the most recent being GS Capital Partners VI, which closed with commitments of $20.3 billion in 2007. GS Capital has investment targets from $200 million to $800 million and it invests across a range of industries in the Americas, Europe and Asia.

GS Mezzanine Partners, which the company bills as the largest mezzanine fund family in the world, is currently raising its fifth fund with an estimated size of $20 billion. In total, that unit has invested more than $17 billion since 1996. Goldman Sachs Private Equity Group is the company’s fund-of-funds business, which managed more than $24.3 billion in primary commitments, co-investments and secondary-market investments as of Dec. 31. Of that total, $1.9 billion was invested by the company and its employees. Goldman Sachs also makes real estate investments through its Whitehall Funds’ operations.

A spokesperson for Goldman Sachs told Buyouts: “We’re not expecting any change to our business,” and that will certainly be true in the near-term. Both Goldman Sachs and Morgan Stanley have a two-year period to make sure all of their businesses are compliant with the Federal Reserve’s requirements. And even then, after that period, the Fed would have the option of granting up to three one-year extensions.

For its part, Morgan Stanley has been involved with private equity since the mid-eighties, investing more than $6 billion in equity since that time, according to its Web site. The current Morgan Stanley Private Equity unit targets investments of between $100 million and $500 million with what’s termed an “opportunistic multi-sector” approach. Current portfolio companies include Breitenfeld AG, an Austrian steel maker, Learning Care Group, a provider of early education and care services acquired in a deal worth roughly $700 million back in June; McKechnie Aerospace, a Los Angeles-based maker of aerospace components; and supermarket operator Tops, which operates in the upstate New York region. The company’s private equity fund-of-funds business, which is run out of West Conshohoken, Pa., has about $7 billion in assets under management.

Morgan Stanley also doesn’t expect the shift in status to have a tangible impact. “The Firm does not expect significant adverse tax or accounting effects from this new status, nor does the Firm expect there to be limitations on its activities that would have a material impact on Morgan Stanley’s overall business,” said Marie Ali, a company spokeswoman.

Still, according to industry observers, the companies will face restrictions in how hands-on they can be with the management of any portfolio companies in businesses outside of financial services. Bank holding companies are able to invest in private equity through the “merchant banking exception” that allows them to form non-bank subsidiaries to engage in the practice. Those subsidiaries face a 10-year maximum holding limit, and the running of the business must be left to managers outside the merchant banking arm, although some influence, such as a presence on the board of a portfolio company is acceptable. The fund-of-funds businesses are less likely to be impacted because of their inherent distance from the day-to-day operations of portfolio companies.

Under these rules, other bank holding companies have maintained modest private equity operations. JPMorgan Chase, for example, operates One Equity Partners, which it inherited as part of the Bank One acquisition in 2004. The unit manages about $8 billion in investments and commitments for the parent company, which is its sole general partner. But JPMorgan also had a private equity presence prior to the Bank One deal, J.P. Morgan Partners LLC. That group was spun out from JPMorgan in the summer of 2006, forming CCMP Capital Advisors LLC, an independent entity.

Citigroup also has a presence through its Citi Alternative Investments unit. As of June 30, this group had more than $54 billion in un-levered capital under management, including the hedge fund, real estate, global fixed income and infrastructure asset classes as well as private equity. About 22 percent of that, or $11.9 billion, was proprietary capital from Citigroup. The company’s private equity business consists of Citi Private Equity, which oversees more than 300 limited partnership investments and upwards of 75 direct investments, and its strategic relationship with Metalmark Capital, a New York-based shop with a strategic focus on platform investing. Ironically, Metalmark Capital has its roots in Morgan Stanley. The firm was founded by former principals of Morgan Stanley Capital Partners in 2004 and it still acts as subadvisor for certain related funds.

Michael Wolitzer, a partner with Simpson Thacher & Bartlett LP who focuses on private investing, noted that both companies will have plenty of time to sort things out.

“It will be interesting to see if the laws evolve, given the circumstances,” Wolitzer said. “The Federal Reserve has already reacted with changes to the restrictions on bank ownership. There may be more that needs to be clarified.”