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Don't Worry About Goldman, They'll Figure Out This Volcker Rule Thing

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The saddest part of this job is discovering a beautiful thing that someone has created as a way around financial regulation, and then watching philistine regulators destroy it. But the happiest part is dreaming up a come-on-that-could-never-work ploy to get around some financial regulation, and then finding out that someone's actually doing it. Extra points if the someone is Goldman Sachs.

Two weeks ago I thought I'd concocted a way around the Volcker Rule's porous and silly restrictions on banks running private equity funds. My solution involved (1) having a merchant banking business that took no outside investors (which the Volcker Rule does not restrict), (2) having a private equity fund that took no bank money (since the Volcker Rule limits banks to owning 3% of such funds), and (3) having your merchant bank and your private equity arm co-invest in deals. Since that doesn't quite work,1 I later modified it a bit to have the outside investors co-invest directly, rather than through a private equity fund, and give the bank its management fee in the form of better economics to the merchant bank in each investment.

Today Reuters has this:

Goldman Sachs Group Inc is trying to work around a financial reform regulation to keep investing in the profitable, albeit risky, business of buying and selling companies ....

In a bid to pool money for deals without raising a private equity fund, the Wall Street bank has been lining up clients who are willing to put money into accounts set up to invest in private equity-style deals, the sources said. Goldman would also set aside some of its own money and partner capital into separate accounts for the same purpose, they said.

Under the new plan, Goldman would then make investments in a syndicate fashion, contributing investor money, along with its own capital and partner dollars, the sources said. ... The details of the new structure, including whether Goldman would still get fees for managing client money and how profits would be taxed, could not be learned.2

So, yeah, like I said. Perhaps my prize will be a job at Goldman. Wait no not that.

It's worth saying that of course of course of course Goldman is doing this, not only because they're a squid after my own heart (or vice versa) but also because this is their business. The Volcker Rule is a mess, but it either says "we want traditional banks to do traditional banking things" or "we don't want banks gambling with your insured deposits" or some combination thereof. And so the Citis of the world are cutting back on Volcker-restricted investment-bank-type activities like running hedge funds

But Goldman really can't. Goldman is a not a traditional bank and is not all that into your deposits; it's been an investment bank its whole history and now sits pretty uncomfortably with the commercial banks at the Volcker Rule table. It currently has $133 billion in AUM of "alternative investments," meaning hedge funds and private equity funds that would be impacted by the Volcker Rule, and about $70 billion of deposits. Those numbers are up from $114 billion and nothing, respectively, in 2005.3 This is not a deposit-taking bank with a risky sideline in alternative investments; this is an alternative investment manager (and market maker and prop trader and M&A adviser etc., but just go with me here) with a recent and annoying sideline in taking deposits.

Why would new rules applicable to deposit-taking banks make Goldman give up on its private equity and hedge fund businesses without a fight? If anything, Goldman would probably rather give up its deposit-taking businesses and live in un-Volcker'ed peace, though that option doesn't really seem to be on the table. So a little more creativity is required. Fortunately, they seem to be up for it.

Goldman eyes Volcker workaround for buyouts [Reuters]

1.The rule forbids a bank from having more than a 3% interest in a "covered fund," including a private equity fund. (But a 100%-owned merchant bank is okay: the forbidden zone is 3% < x < 100%.) The 3% is calculated in a broad way that includes investments by bank affiliates in portfolio companies in which the bank's covered fund also invests, if the affiliate is "acting in concert with a covered fund organized and offered by the banking entity." So you can't use a merchant bank alongside a "covered fund." But you can use a merchant bank alongside third parties. And if you bring in the third parties why shouldn't you charge them some sort of transaction fee?

2.But I'll tell you:

  • Goldman will get fees but investment-by-investment rather than fund-wide. Probably no fees on undrawn capital (because that won't really be a thing). But probably transaction fees on making the investment, maybe monitoring fees during its life, and probably in effect an incentive fee on other investors' returns (but written into the waterfall on the investment rather than a fund structure).
  • The taxes are gonna be like private equity. Transaction fees are ordinary income, returns to investors are capital gains. If the waterfall gives Goldman effectively an incentive fee, that'll be capital gains too.

I mean, I'm guessing, but this doesn't seem like a big leap, no?

3.Alternatives are on page 6, deposits on page 119, of Goldman's 2012 10-K. Alternatives are on page 10, deposits on page 16, of the 2005 10-K. The 2005 deposit number is approximate; it's not broken out but evidently quite small.


The Volcker Rule Will Come Too Late For Kaufman Bros.

If you're a more or less regular consumer of efficient markets hypothesis Kool-Aid then a fun activity is to handicap the probability of various public policy things based on market reaction.* So for instance Obama's budget is going to reduce the tax deductibility of munis! And the muni market didn't care! So, no, Obama is not going to reduce the tax deductibility of munis. You heard it here first, or last, or whatever. (Exercise for the reader: is Obama going to raise the tax rate on dividends?) Since today seems to be Volcker Day hangover it's worth pondering this: