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Volcker Rule Forces Goldman To Shift Focus From Prop Trading To Small-Business Lending

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There's that old line that "hedge funds are a compensation scheme masquerading as an asset class" but the masquerade is getting harder to keep up because you can pay 2 and 20 for just about anything these days. If you wanted to you could pay - well, 1.5 and 20, with a 7% hurdle - to invest in middle-market leveraged loans via Goldman Sachs Liberty Harbor Capital, LLC,1 which is coming to a stock exchange near you as a listed closed-end fund, regulated as a business development company under the Investment Company Act of 1940.

BDCs are I guess all the rage as a way for alternative asset managers to access non-institutional permanent capital; separately, sidling up next to the Volcker Rule and taunting it is kind of all the rage at Goldman Sachs, and this seems to do that too:

Goldman is likely to invest some of its own money in the company and said in the filing that it expects the unit won't be covered by the Volcker Rule, a part of the Dodd-Frank financial regulatory overhaul that restricts banks from making bets with their own funds.

Not sure which motive dominates here - Goldman Sachs Asset Management offers plenty of retail products, and why not have 1.5-and-20 retail products in that mix? - but the Volcker angle is intriguing. Does the Volcker Rule cover proprietary debt investing? Meh: clearly banks are allowed to make loans (right?), clearly they're allowed to trade loans,2 reasonably clearly they're allowed to buy bonds with a 60-plus-day holding period, but ... I guess short-term buying and selling of bonds is problematic. Does the Volcker Rule cover debt investing via a credit fund? The jury is a little out, since no one knows what the rule will actually say; Reuters thinks "it is unlikely that funds that extend loans to businesses will be impacted by the Volcker rule" but Goldman is lobbying anyway.

But since the Volcker Rule pretty clearly doesn't apply to "investment companies" under the '40 Act, and since this Liberty Harbor BDC is a '40 Act investment company, then it's totally fair game to do whatever it wants. Except, maybe, hedge its interest-rate and currency risks.3

Oh also except "do things that make it not a BDC." Some BDC rules tend towards safety - maximum 2x leverage, SEC oversight, various conflict-of-interest-rules - while others tend towards not:

As a business development company, we are generally prohibited from acquiring assets other than qualifying assets, unless, after giving effect to any acquisition, at least 70% of our total assets are qualifying assets. Qualifying assets generally include securities of eligible portfolio companies, cash, cash equivalents, U.S. government securities and high-quality debt instruments maturing in one year or less from the time of investment. Under the rules of the Investment Company Act, “eligible portfolio companies” include (i) private U.S. operating companies, (ii) public U.S. operating companies whose securities are not listed on a national securities exchange (e.g., the New York Stock Exchange) or registered under the Securities Exchange Act of 1934, as amended (the “Exchange Act”) and (iii) public U.S. operating companies having a market capitalization of less than $250 million.

So they're limited to small-cap and private-company debt for 70% of their assets, and in fact 90% of their delightfully cats-and-dogs current investments have double-digit interest rates. For the rest:

In addition to investments in U.S. middle-market companies, we may invest a portion of our capital in opportunistic investments, such as in large U.S. companies, foreign companies, stressed or distressed debt, structured products or private equity. The proportion of these types of investments will change over time given our views on, among other things, the economic and credit environment in which we are operating, although these types of investments generally will constitute less than 30% of our total assets.

Elsewhere they put it as "we also expect to invest a portion of our portfolio in opportunistic investments, which are not our primary focus, but are intended to enhance our risk-adjusted returns to stockholders." I imagine Goldman putting prop traders out to pasture in this BDC. "Just enhance some risk-adjusted returns, whatever."

This is nowhere close to the silliest or most aggressive Volcker workaround we've seen. (For one thing: it really is a bank providing small-business, or smallish-business, loans! Imagine the SEC trying to shut that down!) Still: the Volcker Rule looks pretty patchy, no? You can do private equity investments funded 100% with the bank's money, or funded 0-3% with the bank's money, but not 4-99%, unless you cheat a little. You can sponsor a levered credit fund, and put your own - sorry, "depositors'" - money in it, but it'd better only invest in illiquid high-yield microcap debt.

You could have a theory of financial-regulatory arbitrage that involves evil squids gleefully rubbing their tentacles together as they think up ways to destroy the world financial system, but I don't. My toy theory of this arbitrage goes like this:

  • You work at a bank, or whatever, and think that you're doing mostly good things, for various reasons, some rational, some biased.4
  • Regulators try to stop you from doing some of the things you were doing yesterday.
  • You think that the regulations are ill-conceived, arbitrary and stupid.
  • You're not entirely wrong are you?
  • You think to yourself "I'm smart enough to find a way through these regulations and go back to doing all the good things I was doing yesterday."
  • You're probably right.5
  • So off you go, subverting regulation with your BDC or what-have-you.

I submit to you that the Volcker Rule provides lots of opportunities to put this model to work.

Goldman Launches New Unit to Invest in High-Risk Debt [WSJ]
Goldman Sachs Liberty Harbor Capital, LLC Form N-2 [EDGAR]
Goldman Sachs and the Next New Thing on Wall Street [NetNet / John Carney]

1.Technically I think it is called "Goldman Sachs BDC, Inc.," though prior to yesterday it was called that Liberty Harbor thing:

We were formed as Goldman Sachs Liberty Harbor Capital, LLC on September 26, 2012 and commenced operations on November 15, 2012, using seed capital contributions we received from Group Inc. On March 29, 2013, we elected to become a BDC under the Investment Company Act. On April 1, 2013, we converted from a Delaware limited liability company to a Delaware corporation named Goldman Sachs BDC, Inc. (the “Conversion”). On April 1, 2013, we consummated an offering of $ million of our common stock in a private placement. As a result of the Conversion and upon the consummation of the private placement on April 1, 2013, Group Inc. owned approximately % of our common stock.

2.Try "Step 1: Is It a Principal 'Covered Financial Position'?" here. Loans are okay to trade.

3.What? Here is the prospectus:

We expect and intend that we will not be a covered fund under the Volcker Rule once such rule is fully effective. As a result, we may refrain from engaging in certain activities, including entering into derivative transactions such as interest rate and currency hedging. The proposed rules are highly complex, and many aspects of the Volcker Rule remain unclear. The full impact on us will not be known with certainty until the rules are finalized. Compliance with the Volcker Rule may have a material adverse effect on our operations and share price.

I ... I have no idea? I guess trading derivatives might make you a "commodity pool" and thus take you out of the safety of being an investment company? I dunno. "Step 1: What is a 'Covered Fund'?" here might be helpful. I get all my Volcker everything from Davis Polk, obvs.

4.Rational: you're basically a smart person, you basically mean well, there's an invisible hand. Biased: you only interact with people with similar world views, you spend more time with happy clients than unhappy non-clients, externalities are by definition outside somewhere, you discount downside risk because sort of by definition you haven't experienced serious downside (since if you had you'd have been fired). Etc. Also btw this theory of financial-industry self-image may be empirically wrong.

5.Though in certain degenerate cases you land in jail. Oops!


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: