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Goldman’s private equity problem is getting bigger

Goldman Sachs Group Inc. signage.Goldman Sachs Group Inc. signage.

The Volcker Rule may be causing Goldman Sachs to become greedy in the short-term as well.

The investment bank, which has long claimed to be focused on the long-term, beat Wall Street’s estimates in its second quarter. But those better-than-expected results came with a caveat. About $1.2 billion of the firm’s revenue, or nearly 15%, came from investment gains in the shares of private and public companies. That was $800 million more than a year before.

Goldman beat analyst estimates by $500 million. Without those equities gains, Goldman would not have beaten estimates. And Goldman will soon have to make do without those gains, much of which have come from its investments in private equity funds. PE funds, after all, are not Volcker-compliant.

Analysts and investors have known for a while that Goldman will eventually have to dump its private equity portfolio, which was valued at $8 billion at the end of the first quarter. On top of that, Goldman has another $2.4 billion in unfunded commitments, money it has pledged to private equity funds but has yet to contribute. It also has almost $5 billion in hedge funds and funds that invest in debt.

Under the Volcker Rule, big banks are not allowed to have more than 3% of their capital invested in private equity, hedge funds, and other investment funds. At Goldman, at the end of the third quarter, those investments equalled about 21%. So, the bank has a lot to sell.

It’s all a matter of timing. The Volcker Rule does not officially go into effect for another year. And Goldman can get an extension so it can hold on to some investments until 2017. So far, Goldman has been slowly selling its investments in hedge funds over the past three years, which are also not allowed under Volcker. But it’s mostly held onto its private equity portfolio. That may now be changing. When Goldman reports its official quarterly numbers to the SEC in the next week or so, a number of analysts expect to see a drop in its PE portfolio.

Goldman declined to comment for this article. In the past, the firm has given no firm timeline on the exit from its private equity positions. And the firm has said it will continue to manage private equity funds for outside investors. And it is reportedly looking for new ways to make private equity investments outside of specific funds. That might be a Volcker loophole. Still, the firm will have to exit much of its current private equity positions.

In theory, selling its PE investments shouldn’t affect its profits much. Goldman marks all of its investments to market, meaning that it takes any gains it has each quarter, not when it eventually sells. But if the bank ends up selling for more than it thinks its investments are worth, that difference would show up as a gain. That’s more likely to happen when Goldman exits the shares of private companies, because the value of those stakes are harder to estimate.

Goldman’s principal investment line on its balance sheet tends to be choppy, so it’s not unusual for it to jump around. And the second quarter’s earnings could have been a blimp. The $1.25 billion gain it registered from equity investments is the biggest it has had from that business in years.

The problem is those gains are coming at a time when earnings from Goldman’s traditional driver of profits—trading—has slumped, dragging down the firm’s overall profitability. Goldman’s return on equity in its most recent quarter was nearly 11%. Goldman’s ROE used to regularly top 20%. When the firm’s highly profitable private equity investment gains dry up, that ROE could drop even further.

But the bigger issue is determining what Goldman will do with the cash it gets after selling its positions. The lower ROE suggests that Goldman is having trouble finding places to put its cash that can generate higher returns. But that may not be a problem. Analyst Matthew Burnell of Wells Fargo says Goldman can give its cash back to shareholders if it can’t find high return investments for it. And the firm appears to be doing that. Burnell estimates that Goldman will pay out 85% of its earnings this year in dividends or buybacks to shareholders. That’s a much proportional pay out than what other large banks are doing, where payout ratios are averaging around 50%.

At the same time, handing money back to shareholders means that Goldman will have less capital to invest when Wall Street profitability does rebound. What’s more, all those payouts to shareholders doesn’t seem to be helping much. Shares of Goldman, which have been up recently, are basically flat for the year. Greed, no matter what Gordon Gecko says, doesn’t always work.