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(Reuters) - When former Wells Fargo & Co (WFC.N) Chief Executive Dick Kovacevich joined Norwest Bank in 1986, he had reservations about its private equity investments as he did not think it was the kind of business a bank needed to be in. He got over it.
"I was skeptical, met with the people and became convinced that they absolutely knew what they were doing and that this was a business we could manage and do well," said Kovacevich, who became CEO of Wells Fargo when it merged with Norwest in 1998, and retired as chairman of the fourth-largest U.S. bank in 2009.
U.S. lawmakers shared Kovacevich's skepticism about private equity when they crafted the Dodd-Frank financial reform bill in 2010. In a section of the law known as the "Volcker Rule," they blocked banks from making big bets with their capital, including sizable investments in private equity funds, fearing taxpayers would be left on the hook when wagers soured.
The fine print of the Volcker Rule - named for former Federal Reserve Chairman Paul Volcker - is expected to be finalized as soon as this year. Major banks such as Bank of America Corp (BAC.N) and Citigroup Inc (C.N) are already pulling back from private equity investments ahead of the rules.
But Wells Fargo is taking a different path. The bank invests in buyouts and venture capital deals largely on its own, with capital only from Wells Fargo itself and some employees. By avoiding equity from outside investors, the bank is considered to be engaging in "merchant banking," an activity that is likely to be exempt under the Volcker Rule, lawyers and people familiar with the matter said.
Wells Fargo's private equity investments show how even button-down, staid banks are looking for loopholes in financial regulations as they seek to boost their profits.
Their decisions may run counter to rulemakers' efforts to make the financial system safer. 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.
Some argue that banks should be blocked from any form of private equity investing. Sheila Bair, the former chairman of the Federal Deposit Insurance Corp, which guarantees the deposits of banks like Wells Fargo, said private equity and merchant banking are too far removed from regular banking.
"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.
Wells Fargo declined to comment for this story, noting that the regulations are not yet final. But the bank has said publicly it expects to continue to back its main private equity-type funds - Norwest Equity Partners and Norwest Venture Partners - that buy stakes in or take over smaller companies.
"We believe that we will continue to be able to invest, and we continue to invest today, in Norwest Venture Partners and Norwest Equity Partners, which we believe will be allowed under the Volcker Rule," Wells Fargo Chief Financial Officer Tim Sloan said on a recent conference call.
The Norwest funds account for most of the bank's $3.7 billion of private equity assets, which represent a little more than 3 percent of the bank's Tier 1 regulatory capital.
In the fourth quarter, private equity was a key business for the bank, earning about $715 million before taxes and boosting the bottom line by about 10 percent. The above-average gain came from selling a seed treatment company to chemical maker BASF (BASFn.DE) for $1.02 billion.
Other banks are looking at ways around the Volcker Rule, too. Goldman Sachs Group Inc (GS.N), for example, had about $16.8 billion of private equity investments as of September 30, representing about a quarter of its regulatory capital. Some assets are merchant banking investments, meaning Goldman may use the same Volcker loophole as Wells Fargo. A Goldman spokesman declined to comment.
Wells Fargo's private equity business is small relative to the bank's overall assets, but it grew 8 percent in 2012 from the prior year, and is more than double its level in 2005. Norwest is still making investments using funds it received from Wells in 2008, and the bank contributed another $250 million to a Norwest pool in 2011, a person familiar with the funds said.
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.
"It's good for the bank, and it's good for the economy," Kovacevich said. "If you do something well for 50 years why would you not continue doing it?" The funds were founded in 1961.
The business can be good for the bank's shareholders — Wells Fargo's private equity unit has produced gains every quarter for the last three years — but it can also be a negative. In 2008 and 2009, Wells Fargo took $1.27 billion in losses from its private equity holdings over the course of three quarters as the financial crisis hit hard and it absorbed assets from Wachovia.
Some Norwest investments have also turned out badly more recently. Norwest turned over Deep Rock Water Co to the bottled water company's creditors before it was sold in 2011, the person familiar with the funds said. The Savage Sports deal may also end up performing poorly, the person added, after the Newtown, Connecticut, school shootings in December hit gun makers' shares. Savage and Deep Rock Water did not return calls seeking comment.
Losses in individual companies are not unusual for a private equity business, but during tough times, the value of the whole portfolio can drop. Bank of America, JPMorgan Chase & Co (JPM.N), and others took big charges on their private equity portfolios in the third quarter of 2011 as stock markets sank.
The Volcker Rule says that banks cannot hold more than 3 percent of their Tier 1 capital in private equity funds, but the details of the regulations are still being finalized and banks could have as many as 10 years to comply with the regulations.
Inside the Norwest funds, some employees wonder whether regulators will be sanguine about the business as it grows, the source familiar with the funds said.
Tim Keehan, senior counsel with the American Bankers Association, said it appears merchant banking won't be covered by the rule, but it's still unclear until the rules are final.
"The reason it still is a concern is we don't have any sense of boundaries on these definitions," Keehan said. "That's why I think you're seeing some banks go one way, and some banks go the other way."
Kovacevich said Wells Fargo's private equity business has had a solid track record, but the bank should be careful.
"I would never want it to be big," he said. "I don't consider it something you must be in if you are a commercial bank or should be in if you don't know what you're doing. It's got risk to it."
Reporting By Rick Rothacker in Charlotte, North Carolina; Additional reporting by Lauren Tara LaCapra in New York and Douwe Miedema in Washington; Editing by Dan Wilchins, Paritosh Bansal, Martin Howell and Claudia Parsons