Analysis: Wall Street still in the hedge fund game

BOSTON/NEW YORK (Reuters) - It appears Wall Street investment banks can stay in the highly-profitable hedge fund business after all.

An overhaul of financial regulations hammered-out by U.S. lawmakers after weeks of negotiation would permit Wall Street banks to continue to manage and sponsor hedge funds along with private equity funds, according to lawyers and Wall Street officials familiar with the massive bill.

For months Wall Street bankers and hedge fund managers have worried that the legislation, which could be signed into law by President Obama within two weeks, would prohibit investment banks from running hedge funds and possibly force them to sell these often very profitable businesses.

But the version of the bill agreed to by lawmakers on Friday morning would not force the draconian changes sought by some critics of the financial industry, said sources familiar with the bill.

Still, Wall Street is not quite ready to celebrate.

That’s because a final language of the financial regulatory reform bill in not yet public and must still be voted on by Senate and the House of Representatives before going to Obama.

But the decision by federal lawmakers to permit banks to continue to manage hedge funds and private equity funds is a big victory for Wall Street because it lets them keep raking in potentially lucrative management fees.

Under the bill, Wall Street investment firms will face a limit on the amount of money they can sink into their hedge funds and private equity funds.

The proposal caps the amount banks’ can invest at 3 percent of an institution’s Tier 1 capital -- the core capital that regulator’s use to judge a bank’s strength.

Right now there is no limitation on the amount of capital a bank can invest in its hedge funds. But the 3 percent limit is actually a concession to the banks because earlier proposals would have prohibited banks from investing any money in hedge funds or private equity funds.

“One sliver of the legislation which was improved in the conference process was the ability to allow banks and other financial institutions to invest up to 3 percent in hedge funds,” said Todd Groome, chairman of hedge fund industry group Alternative Investment Management Association. “And that’s an improvement.”

Still, the cap on bank investment could mean big changes for some institutions.

For instance, Goldman Sachs Group Inc GS.N, according to a securities filing, had $15.5 billion invested in its own funds, including private equity and hedge funds. That was 23 percent of its $68.5 billion in Tier 1 capital at the end of the first quarter.

Under the new rule, with that amount of capital, Goldman could invest only about $2.1 billion in these types of portfolios.

A person familiar with the bill said the proposal will give banks up to five years to meet the investment cap.

The measure also would restrain banks’ abilities to seed start-up hedge funds, which could make it difficult to attract outside investors.

With real information still hard to come by just hours after the deal was hammered out, some of the biggest players on Wall Street are preferring to wait and see before making any public comment or beginning to rethink their business, a source at a major bank said.

Lawyers and bankers said it might take as long as a week to get a real handle on exactly how the overhaul will impact big bank’s businesses.

For the broader hedge fund industry, financial regulatory reform does not appear to be a major event.

The proposal would require large hedge funds to register with U.S. securities regulators but the $1.6 trillion industry had largely conceded that point long ago.

“Until we review the specific language in the bill it is difficult to tell the entirety of the impact on the hedge fund industry,” said Ron Geffner, who works with hedge funds as a partner at law firm Sadis & Goldberg. “But I have reserved optimism based on the information about it that is currently available.”

In a separate development, hedge fund and private equity managers also scored a victory when a plan to tax some of their profits at the higher ordinary income rate in order to help pay for an extension of unemployment benefits collapsed.

The so-called carried interest tax had been bitterly opposed by hedge fund managers and private equity titans, but has been a hot-button issue for many Democrats in Congress. With consideration of the unemployment extension bill having stalled, the fate of this new tax for hedge fund managers is uncertain.

Maybe the most negative thing to come out of the financial regulatory reform proposal for hedge fund managers is a plan to have very large hedge funds contributed to a $19-billion fund designed to help implement the financial overhaul legislation.

As lawyers examined each point more closely, many said the surprise proposal would impact funds with more than $10 billion in assets. Some were angry that mutual funds, for example, seem to not be liable to pay the tax. But the exact terms of the payments to the $19 billion were unclear because a final copy of the bill had yet to be released.

Reporting by Svea Herbst-Bayliss and Matthew Goldstein; Editing by Tim Dobbyn