Reuters has a delightful story today about Wells Fargo’s merchant banking business, Norwest Equity Partners, which owns among other things the quite horribly named rifle maker Savage Sports. I can’t get too worked up about the likelihood that a fifty-year-old, smallish ($3.7bn), carefully managed, moderately gun-toting, otherwise wholesome private equity business will bring down the global financial system, but then I’m not Sheila Bair:
“Is that really what you want institutions that have safety net support doing? Is that an appropriate use for a government backstop?” she told Reuters.
I dunno, Sheila. Who is “you”? What do you want institutions doing? Something, right?
The point of the Reuters story is mainly that the Volcker Rule is expected to limit banks’ ability to invest in private equity funds, but that Norwest’s business is likely to be exempt because it runs only Wells’ own money. If you put bank money in a separate PE fund with outside investors it’s caught up in the Volcker Rule, but if you just make private-equity-type investments on your own it is not. This is no way to run a railroad:
The merchant banking that Wells Fargo is embracing is riskier than investing in private equity funds with outside investors, where a bank shares any losses with others. Some critics warn that the Volcker Rule is banning the safer of the two activities, and allowing the one that could lead to bigger losses for a bank.
Those critics sure sound right, though I suppose one could for sport make some counterarguments.1 One could also, for more profitable sport, try to build a more complete Volcker Rule private equity loophole around the merchant banking exemption.2 Those sporting activities are in footnotes.
Up here let’s talk about Sheila Bair’s question: what is it that you want federally insured banks to do with their money? The Volcker Rule lives in an unbearable tension between, on the one hand, “we want banks to do only safe things,” and on the other hand, “we want banks to do only traditional banking things.” The traditional banking things are the riskiest things. Making the bid/ask on opaque derivatives, charging fees to run hedge funds, securitizing your credit risk, prop trading with an under-60-day holding period: these are good ways to limit your risk. If you want to lose money fast, lend it to small businesses and new homeowners.
Or give it to them as an equity investment, which is surely riskier than just lending it to them. It’s also, I suppose, a less traditional line of commercial banking than old-fashioned 3-6-3 lending, though it’s in the same ballpark. Isn’t financing companies’ businesses, in the way that best meets their needs, exactly what you want your government supported banking businesses to do?
It’s what clients want, I suppose, which might also be important. However constrained banks are by Volcker and new capital regulations and so forth, one bright spot for the future is cross-selling, finding ways to get clients of one area of the bank to use products from all areas. So Morgan Stanley wants to sell more IBD structured products and IPOs to wealth management clients, BofA uses its commercial banking business to cross-sell 401(k) services, and Wells uses its in-house private equity as a way to get underwriting business:
The lure of private equity to companies like Wells Fargo is not only profitable investment returns, but also new business for other parts of the bank. The funds work with small- and mid-sized companies that often also need loans, treasury management, and other financing and services, former CEO Kovacevich said.
In January 2012, for example, Norwest Equity Partners bought rifle maker Savage Sports, teaming up with the company’s management. Wells Fargo also arranged senior debt financing for the purchase, which according to Crain’s Detroit Business cost the buyers more than $100 million.
Business can go the other way, too – companies that borrow from Wells Fargo can get equity from Norwest Equity Partners.
This sounds weird if you think of banking as just “providing loans.” But clients expect banks, at least big banks, to be supermarkets: if you ask your bank to provide treasury management services, bond underwriting, tax advice, FX trades, interest-rate swaps, or even an equity investment, you expect them to have an answer. If they repeatedly don’t, you stop asking them questions.
The broader the menu of services a bank offers to clients, the better its chances of getting the call when the client is looking for services that the bank can provide lucratively and at low risk.3 Even if some of those services are, say, private equity, the result might end up being something that even Sheila Bair could live with.
1. The counterargument goes something like: managing outside private equity capital is a very profitable capital-light business, since you get 2 and 20 or whatever on a big pool of off-balance-sheet money, with no downside risks. Managing your own merchant banking investments is not; you just get the profits on whatever you can do profitably, and the losses on whatever you can’t. So “running private equity” is more attractive, and at scale, than “making private equity investments.” So you’ll do, like, 10x as much of it, if you can, and you’ll make riskier investments since you share a lot more of the profits than you do of the losses. And since LPs in bank private equity funds demand that the bank have skin in the game via a substantial co-investment, you’ll end up running a $10X fund with $3X of your own money instead of an $X fund with $X of your own money, while also making riskier investments.
For a given size of bank private equity operation, 100% internally funded merchant banking sure sounds riskier than ~70% externally funded private equity. If you don’t hold size constant, though … I dunno I find the counterargument moderately compelling.
2. I thought I could, but now I think I can’t. (I think?) The loophole I had in mind was:
- You start a private equity fund in which you are the GP (and take your 2 and 20 compensation) but have no or a de minimis ownership interest (<3%, which seems to be the Volcker maximum).
- You start a separate merchant banking business in which you take no outside investors.
- You do buyout deals in which the merchant banking business and the private equity fund co-invest, calling them “club deals” and having market-standard arms’-length agreements between the two separate investors, just like KKR and Carlyle might have, though I guess without the antitrust concerns.
- And you kind of nod and wink with the PE investors that you have skin in the game because you plan to keep co-investing from your MB division.
This struck me as a good devious plan but, per Davis Polk’s Volcker Rule flowchart, it appears they’ve already thought of that. Note the right-hand column on that page: investments by an affiliate of the bank (i.e. the merchant banking division) “Acting in concert with a covered fund organized and offered by the banking entity” (i.e. the PE fund) in a portfolio company counts against the Volcker Rule’s limits on private equity. Oh well. I tried.
3. And the more uncorrelated lines of business it ends up being in.