Wall Street Faces Pain From Buyout Cutback

If major banks give up their private equity and hedge fund investments, their bottom lines could take a real hit because these investments also are a key source of underwriting and advisory fees.

President Barack Obama is calling for major banks to reduce their risk taking and investors in financial stocks are clearly alarmed. Goldman Sachs Group Inc. shares have fallen more than 7 percent since Jan. 20, before the proposal was leaked, and JPMorgan Chase & Co. shares have fallen more than 9 percent.

Banks account for 5 percent of investors in U.S. private equity funds by number and represent 9 percent of the capital invested, data from London research firm Preqin show. The lion’s share of that number is capital managed on behalf of clients rather than invested from banks’ own balance sheets.

“For most of the investment banks, the main benefits of having private equity programs probably comes less from the extraordinary returns they’ve got, and more from the fact it opened the door to getting clients from private equity groups,” said Josh Lerner, a Harvard Business School professor specializing in private equity.

While banks are relatively small direct investors in hedge funds, representing 0.9 percent, for some big banks, their internal hedge funds and private equity investments provide crucial trading, underwriting, and advisory revenue.

Sanford Bernstein analyst Brad Hintz calculates that every $1 invested by a securities firm into its own merchant banking fund, can add up to another 47 cents of transaction revenue and investment gains over time.

The banks that would suffer most from such limitations are Goldman Sachs, Morgan Stanley, JPMorgan Chase, and Bank of America, Hintz said.

Overall, commercial banks could suffer the most from the proposals, Hintz said, assuming that the law ends up separating commercial banking businesses from investment banking ones.

“There’s a real concern for the commercial banks,” Hintz said.

Banks are likely to spin private equity businesses off to shareholders rather than trying to sell them off piecemeal, experts said.

“I think we’ll see controlled spin-outs rather than dumping assets,” said Lerner.

A Goldman Sachs spokeswoman declined to comment on the White House plan for banks and what it might mean for private equity and hedge fund units. A spokeswoman for JPMorgan Chase was not immediately available for comment.

Morgan Stanley was not immediately available for comment.

Bank of America said it does not operate a hedge fund. It does operate BAML Capital Partners, a private equity business, and a proprietary trading unit. Analysts said those units could be affected.

Proprietary trading accounts for less than 1 percent of total revenue, a spokesman for Bank of America said.

(By Megan Davies and Svea Herbst-Bayliss. Additional reporting by Dan Wilchins)