What Obama’s Proposal Could Mean for Private Equity

Earlier today, President Obama outlined some proposals designed to limit risk-taking on Wall Street. For our purposes, here is the operative section:

“We should no longer allow banks to stray too far from their central mission of serving their customers. In recent years, too many financial firms have put taxpayer money at risk by operating hedge funds and private equity funds and making riskier investments to reap a quick reward.

And these firms have taken these risks while benefiting from special financial privileges that are reserved only for banks.

Our government provides deposit insurance and other safeguards and guarantees to firms that operate things. We do so because a stable and reliable banking system promotes sustained growth, and because we learned how dangerous the failure of that system can be during the Great Depression.

But these privileges were not created to bestow banks operating hedge funds or private equity funds with an unfair advantage.

When banks benefit from the safety net that taxpayers provide, which includes lower cost capital, it is not appropriate for them to turn around and use that cheap money to trade for profit. And that is especially true when this kind of trading often puts banks in direct conflict with their customers’ interests.”

It’s good political populism, and may even make for good policy (so argues Felix). That Obama made the statement in the midst of Goldman’s earnings call is theatrical one-upsmanship. What it means for private equity, however, is extremely unclear.

Most, although not all, major banks still have large private equity operations. J.P. Morgan still oversees One Equity Partners, Citi overseas a host of groups including Metalmark Capital, Merrill Lynch has an eponymous unit, Goldman Sachs sponsors the massive GS Capital Partners, Credit Suisse has DLJ Merchant Banking Partners and so on. And this doesn’t even address the scores of funds-of-funds and secondary funds that many of these banks also operate.

At first glance, it would appear that Obama is proposing that all of the above be divested. Certainly not something most banks would want to do, but there at least some logistical precedent for banks spinning out their private equity groups into independent entities. Metalmark, for example, was originally an in-house unit at Morgan Stanley before going independent and subsequently getting scooped up by Citi (I called a Metalmark managing director, but he declined to discuss Obama’s plan).

But it may be much more complicated than that (and not just because most historical spinouts have included new — or continued — cornerstone investments from the former parent).

At the end of his statement, Obama mentions “customers’ interests.” In a corresponding press release, the White House added: “The President and his economic team will work with Congress to ensure that no bank or financial institution that contains a bank will own, invest in or sponsor a hedge fund or a private equity fund, or proprietary trading operations unrelated to serving customers for its own profit.”

This is where it gets very tricky. Goldman and other firms would almost certainly argue that their private equity activities are in their customers’ interests. Moreover, many of their commitments to private equity come from “feeder” pools set up for the expressed purpose of letting a bank’s customers have private equity exposure. Would Obama’s proposal drain such pools, or allow them to continue while only banning investments that originate from a bank’s balance sheet

(Note: A bunch of the same questions also apply to the hedge fund requirement, but there is one important distinctions: PE is almost unable to spark a “run” on the bank, because investors are not allowed to pull out their money midstream. As such, PE is much less of a systemic risk than is hedge).

More questions: Would Obama ban all private equity activity, arguing that carried interest (i.e., profits) off in-house private equity funds is not in its customers’ best interests? Would it grandfather in existing commitments that have not yet been called down? And, if not, how would third-party LPs react to cornerstone investors essentially disappearing (maybe this is where all that excess secondary fund capital can go)? Oh, and would such a move effectively level the playing field for financial sponsor groups, by ending co-investment conflicts?

Actually, that final question is perhaps the most important, because it illustrates how Obama doesn’t actually want to pull banks out of private equity. He just wants to ban them from the “equity” part. Goldman, et. all would still be allowed — in fact, encouraged — to provide leveraged loans to private equity deals. Kind of odd, in that banks have arguably lost far more on PE-related debt than on PE-related equity over the past two years. Moreover, they’ll still make zillions from PE-related advisory/auctioneer work.

Hopefully we’ll get more clarity in the coming days and weeks…