Goldman, Morgan Stanley PE could be affected by new rules

The firms' decisions to become bank holding companies may present new challenges to keeping their private equity arms under the same roof.

Goldman Sachs and Morgan Stanley say their private equity units will be unaffected by the firms' decisions to become Federal Reserve-regulated bank holding companies. But the change will present new restrictions that could create challenges to keeping the private equity units under one roof.

“Other banks have private equity funds, so why wouldn’t we be able to do the same?” said a spokeswoman for Goldman Sachs. JPMorgan and Citi, both bank holding companies, also have private equity funds.

Similarly, a spokeswoman for Morgan Stanley explained that she did not expect the firm’s private equity business to be re-constituted as a bank holding company or to have its activities curtailed as a result of the new bank holding company structure.

The 1956 US Bank Holding Company Act (BHCA), which governs the activities of bank holding companies, places certain restrictions on such entities, including regulatory capital requirements, minimum leverage ratios and limitations on the kinds of non-banking activities that they and their subsidiaries may engage in.

This can make it difficult to house a myriad of different financial service businesses under one roof. Bank holding companies have a wide range of investment banking and merchant banking activities they can engage in but not exactly in the same way as unregulated securities firms.

For instance, bank holding companies are typically limited to investing between 20 percent and 30 percent of their tier 1 capital in merchant banks, which are exempt from federal limitations on investing no more than 4.9 percent in non-banking businesses. Merchant banks are therefore the home to many bank holding companies' private equity arms.

This effectively limits the amount of space on their balance sheet that bank holding companies can devote to their private equity arms and may lead to spinoffs or winding-down of such activities.

In 2003, for instance, former JPMorgan Chase chief executive officer William Harrison announced that the firm would scale down its equity investment in JPMorgan Partners from 20 percent to 10 percent. Two years later, Chase announced that it would part ways with JPMorgan Partners because the private equity division could best achieve its desired scale independent of the banking giant.

To date, Citi has had at least two private equity groups become independent: Court Square Capital Partners spun out of Citi in 2006 and CVC Capital Partners spun out in 1993.

However, should Goldman Sachs and Morgan Stanley have to follow JPMorgan Chase and Citi in divesting their private equity activities, they would not have to do so anytime soon. Both firms have a two-year window in which to conform their non-banking activities to the standards of the BHCA, with the possibility of three one-year extensions.

In the meantime, although the two firms already have more than $56 billion (€39 billion) in deposits from their BHCA-exempt deposit-taking subsidiaries, industry insiders think that both are likely to go shopping for additional banks.

“I can see them doing an acquisition of a commercial bank just to establish a platform, but that would be one that’s top 50 or top 10 in the country [by size]”, said a principal at a private equity firm that actively invests in the sector and who did not wish to be identified.

He did not foresee either firm being interested in smaller community and regional banks, which have been the traditional niche of private equity firms that specialise in banking sector deals.