Under the Volcker Rule, signed into law July 21 as part of financial reform legislation, a bank does have the ability to sponsor private equity and hedge funds, and to commit up to 3 percent of its Tier 1 capital (equity capital plus disclosed reserves) across the lot of them. But a little digging reveals that it will be practically impossible for banks to continue managing merchant banking funds as before.
Consider Goldman Sachs, which has an estimated $68 billion in Tier 1 Capital, according to law firm Debevoise & Plimpton. Three percent of that figure comes to roughly $2 billion. According to Buyouts, the investment bank contributed far more than that — $9 billion of its own capital, including contributions from employees — to its sixth merchant banking fund, closed in 2007 at $20.3 billion. And that’s just one of many merchant banking funds under management at
Even without the limit on Tier 1 capital, the Volcker Rule explicitly prevents banks from holding more than a 3 percent ownership interest in a merchant banking fund within a year of it being set up. It also forbids employees outside of the fund from having an ownership interest. All this might seem manageable: Banks simply have to cut way back on their commitments to their sponsored funds. Then outside investors will make up the balance, right?
But that ignores the fact that the often-substantial commitment made by the house to merchant banking funds is what makes them palatable to outside investors in the first place. Such investors realize the many potential conflicts of interest posed by merchant banking funds. Consider, for example, that some of the best clients of investment bankers are buyout firms. Who are these bankers going to show a proprietary deal to first — the in-house buyout group, or a favored buyout firm client? Another question potential investors ask: Would the merchant bank acquire a company simply to produce investment banking fees for its parent company?
To get past these concerns, investors have traditionally liked to see both a substantial commitment by the parent bank, as well as by employees outside the fund, such as investment bankers. That helps to ensure everyone’s interests are aligned toward maximizing profts in the fund.
If you still aren’t convinced the era of big merchant banks is nearly history, consider one final requirement imposed by the Volcker Rule on banks that wish to sponsor funds. Although the language is somewhat ambiguous, some attorneys interpret the rule to require merchant banks to have an existing fiduciary relationship, or investment advisory relationship, with investors in the fund. Such a requirement would severely limit the amount of marketing the merchant bank could do. The merchant bank might also have a duty to ensure that the investment was well-suited to each client, in light of the client’s other holdings, tax objectives and related characteristics.
In related bad news, the Volcker Rule prohibits bank holding companies outright from having passive investments in private equity and hedge funds. The immediate upshot is that banks will have to start thinking about divesting their holdings. Longer term, they will have to come to terms with how this will impact their relationships with their buyout firm clients, since fund commitments have been one way they show their gratitude for sending business their way. Nothing prohibits merchant banks from co-investing their own money alongside their clients in deals, and agreeing to pay fees and carried interest for the privilege. However, the legislation does have anti-evasion prohibitions that prevent banks from circumventing the intent of the new rules.
Banks do get quite a long runway to prepare for the new rules. The Federal Reserve and other regulators have up to two years to craft final regulations stemming from the Volcker Rule, and it would be at least another two years beyond that before banks have to comply. The law also provides for two sets of extensions beyond that — three one-year extensions, and a separate five-year extension provided the assets at issue are illiquid. (It’s not clear yet whether the two sets of extensions would run concurrently or not.) Altogether, bank holding companies could have as long as nine to 12 years to come into compliance.
Those grasping for good news also have the November elections to look forward to. A big Republican win could lead to a whole new political climate that would be more favorable to banks, and one that could influence how the final regulations get written.
Banks also could seek to shed their bank holding company status. But after all this work on the financial reform legislation, politicians won’t be eager to see banks slip from their regulatory grasp.