Volcker impact sends shivers through banks

Speculation continues to grow as to which Wall Street bank will be looking to get out of proprietary trading or the private equity business in order to comply with new financial regulatory reform legislation.

But despite recent moves by Bank of America, Morgan Stanley and Goldman Sachs on that front, most banks will be able to pare back investments in risky ventures without making dramatic changes to their structure.

The new Volcker rule, named for former Federal Reserve chairman Paul Volcker, restricts banks from proprietary trading and sets new limits on the size of private equity or hedge fund investments.

It means they cannot hold more than 3% of their Tier 1 capital in private equity or hedge fund investments. Tier 1 capital is a measure of a company''s financial strength.

Some, like Bank of America, hover near their 3% cap, and will need to make only minor adjustments to comply. Others, like Goldman Sachs, will need to be more aggressive.

Still, banks have several years to reduce their holdings -- meaning that even institutions with significant private equity holdings are likely to be able to keep units.

"They (financial institutions) have time to adjust," said Mark Nuccio, partner at Ropes & Gray in Boston. "I don't think there's any intention on behalf of the regulators to create economic dislocation at financial institutions."

Goldman Sachs is considering two options for its main proprietary trading group as it tries to comply with the rule, sources familiar with the process said.

Meanwhile, Citigroup Inc agreed to sell its private equity business in July. In 2009, the bank had moved that unit into its Citi Holdings repository for assets it considers unrelated to its main businesses.

Citigroup still has a capital advisors hedge fund business, which manages about $14 billion overall, including about 5% -- or $5 billion -- of its Tier 1 capital.

While the new rules might be forcing some banks to rethink their business, for others it comes as a welcome excuse to move ahead with plans to divorce themselves from unwanted hedge or private equity funds, experts said.

"If you were leaning toward a strategic change anyway then now is a good time to reevaluate the business because you have a regulator saying you shouldn't be in this business anyway," said Thomas Whelan, chief execuive of Greenwich Alternative Investments.

That is especially true at some banks that raced to acquire hedge fund operations at the height of the industry boom when having a hedge fund was a necessary part of the strategic mix.

But after 2008, when hedge funds posted their worst-ever returns and clients raced to redeem assets, that calculus changed for many banks, industry experts said.

Case in point may be Morgan Stanley's expected decision to spin-off hedge fund FrontPoint Partners. While the discussions might be seen to have been driven by the Volcker rule, Morgan Stanley has been disenchanted with its 2006 acquisition of the hedge fund for quite some time, industry experts said. A Morgan Stanley spokesperson declined to comment on the matter.

Similarly, Bank of America's decision to shed its private equity group had been in the works before President Obama signed the financial regulatory reform measure into law even though the move to spin out the group will help the Charlotte, NC bank come into compliance with the new law's regulatory capital requirements.

Also Wachovia Capital Partners split from Wells Fargo in March and renamed itself Pamlico Capital before the government raised its voice.

"The biggest impact is certainly strategic," said Nuccio. "If financial institutions in general are being told -- don't make big private equity bets, big hedge fund bets, it is more (a decision) about whether it is a business they want to be in.

Under the rules, up to 3% of a bank's Tier 1 capital can be invested in private equity and hedge funds. Banks have four years to reduce their positions.

Goldman Sachs, for example, is likely to reduce its bank's own position in private equity over time rather than spinning its Goldman Sachs Capital Partners and other units out, said a source familiar with the situation.

The long run-up to having to exit also means that firms' private equity funds could likely be invested and closed by the time they have to exit.

For example, Goldman Sachs' $20.3 billion global buyout fund it is currently investing was raised in 2007, so by the time the rules and exceptions kick in, it may not have to sell anything.

On the hedge fund side, investors are debating whether Goldman will actually spin anything out and whether it will make much of a difference to them.

Considering the firm's long history in growing talented traders who then left, ranging from Daniel Och to Eric Mindich to Dinakar Singh to Mark Carhart, a move to push its internal hedge funds out the door might not have a big impact.

"So many of those former Goldman Sachs partners now have their own hedge funds anyway that it really wouldn't make a difference from the investing side," said Chris Tobe, a senior consultant at Breidenbach Capital Consulting.

Complying with the so-called Volcker rule, Tobe said, will make a difference for the banks and their investors but not the clients who seek out hedge fund investments.

"Whether they are under Goldman's umbrella or outside of it does not matter at all at a time there is so much more supply than demand anyway," he said.

Some banks are likely to be little impacted.

Credit Suisse has European hedge funds and owns DLJ Merchant Banking, a fund of funds business and its secondary private equity business Credit Suisse Strategic Partners.

A spokesperson for Credit Suisse said the bank is not planning on selling any of its hedge fund or private equity businesses as a result of the Volcker rule.

Similarly, JP Morgan will not have to part with its private equity arm One Equity Partners, a source familiar with the situation said.

UBS said it has no need to spinoff or make an exit from any of its fund of hedge funds because those investment vehicles operate solely with outside money. A spokesperson said the same is true of the private equity funds offered by the firm.