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 raise questions about whether they would keep their merchant banking operations over the long term.

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.

Goldman Sachs has a much greater presence in the asset class than Morgan Stanley. Through its GS Capital Partners unit, Goldman Sachs invests in the United States, Europe and Asia. Since 1992, it has raised seven funds, including its most recent vehicle, GS Capital Partners VI, which closed with $20.3 billion in commitments in 2007.

GS Mezzanine Partners, which the firm bills as the largest mezzanine fund family worldwide, is currently raising its fifth fund with an estimated size of $20 billion. Overall, that unit has invested more than $17 billion since 1996.

Goldman Sachs Private Equity Group is the company’s fund of funds operation, 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.

“We’re not expecting any change to our business,” says a spokesperson for Goldman Sachs.

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.

Morgan Stanley has been involved with private equity since the mid-1980s, investing more than $6 billion in equity since that time, according to its website.

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 June in a deal worth about $700 million; McKechnie Aerospace, a Los Angeles-based maker of aerospace components; and supermarket operator Tops, which operates in the upstate New York region.

The firm’s private equity fund of funds unit, based in 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,” says Marie Ali, a company spokeswoman.

Still, according to industry observers, the firms will face restrictions in how hands-on they can be with the management of any portfolio companies in businesses outside of financial services. —Michael Baron