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.

US President Barack Obama is calling for major banks to reduce their risk taking and investors in financial stocks are clearly alarmed. Goldman Sachs Group shares have fallen more than seven per cent since Wednesday, before the proposal was leaked, and JP Morgan Chase & Co shares have fallen more than nine per cent.

Banks account for five per cent of investors in US private equity funds by number and represent nine per cent 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 specialising in private equity.

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

Sanford C 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, said Hintz, assuming that the law ends up separating commercial banking businesses from investment banking ones.

"There's a real concern for the commercial banks," said Hintz. Banks are likely to spin private equity businesses off to shareholders rather than trying to sell them off piecemeal, said experts.

"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 one per cent of total revenue, said a spokesman for Bank of America.

Banks have for several years been reducing private equity investments, said David de Weese, partner at specialist secondary firm Paul Capital, and that will likely continue as it remains hard to strike leveraged buyout deals of significant size.

In addition, the Basel II accords which came into force in Europe and Japan last year and are to take effect in the United States by 2012 boost the amount of capital that banks have to hold against their private equity investments, making holding on to these assets much more costly, he added.

Industry executives expect banks would be able to keep their hedge funds of funds operations where the institutions operate as middlemen in helping their clients invest with hedge funds.

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