Wall Street faces pain from buyout cutback

A street sign on Wall Street outside the New York Stock Exchange in New York April 18, 2007.

NEW YORK/BOSTON (Reuters) - 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.

U.S. President Barack Obama is calling for major banks to reduce their risk taking and investors in financial stocks are clearly alarmed. Goldman Sachs Group Inc shares have fallen more than 7 percent since Wednesday, before the proposal was leaked, and JPMorgan Chase & Co shares have fallen more than 9 percent.

Banks account for 5 percent of investors in U.S. private equity funds by number and represent 9 percent 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 specializing in private equity.

While banks are relatively small direct investors in hedge funds, representing 0.9 percent, 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, Bank of America and presumably Barclays North American operations, Hintz said.

Overall, commercial banks could suffer the most from the proposals, Hintz said, assuming that the law ends up separating commercial banking businesses from investment banking ones.

"There's a real concern for the commercial banks," Hintz said.

Banks are likely to spin private equity businesses off to shareholders rather than trying to sell them off piecemeal, experts said.

"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 and Barclays were 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 1 percent of total revenue, a spokesman for Bank of America said.

THE DEVIL YOU KNOW

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 that banks would be able to keep their so-called hedge funds of funds operations where the institutions essentially operate as middlemen in helping their clients invest with hedge funds.

So-called funds of funds groups have been lucrative for both asset managers like Legg Mason and banks like JP Morgan Chase where its Highbridge Capital Management LLP invests $21 billion in hedge funds on behalf of wealthy clients.

Banks like JP Morgan would be able to keep these units and only have to pull out their own money if any is invested, but in-house hedge funds run by institutions like Goldman Sachs would be more problematic, observers say.

"The most likely outcome is that funds currently owned by banks will be spun off as independent entities," said Kenneth Heinz, President of industry tracking group Hedge Fund Research.

But putting this legislation together will be a long process, and the outcome is anything but certain, analysts cautioned.

"The devil's in the details on this," said Paul Miller, analyst, FBR Capital Markets. "There's a potential for a big impact on banks, and there's a potential for almost no impact at all, but it adds a layer of uncertainty to their operations."

(additional reporting by Dan Wilchins; editing by Carol Bishopric)