Wells Fargo & Company (NYSE:WFC) is aggressively increasing its investments in private equity in a bid to boost profits and without infringing the Volcker rule. The San Francisco based bank is allegedly exploiting a loophole in the former Federal Reserve Chairman, Paul Volcker’s rule that bars commercial banks from using client money to invest in the private equity sector.
It is believed that Wells Fargo is using its own money to invest in private equity something which qualifies the exercise as Merchant banking. The Volcker rule has no restrictions on Merchant banking.
Wells Fargo & Company (NYSE:WFC), which merged with Norwest in 1998, has been switching from conventional banking over the last few years to hedge funds, investment banking and now private equity. This comes at a time when Basel III rules on tier-1 capital begin to kick in as implementation gathers momentum.The Volcker Rule says that banks cannot hold more than 3 percent of their Tier 1 capital in private equity funds.
It is not clear whether Wells Fargo plans to completely switch from commercial banking to investment banking and private equity. However, this could also signal a future spin-off if the Volcker rule is reassessed to consider Merchant banking.
Other major banks such as Bank of America Corp (NYSE:BAC), and Citigroup Inc. (NYSE:C) are already pulling out their investments in private equity, as the Volcker Rule is set for finalization this year.
Reuters noted lawyers and people familiar with the matter saying, “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.”
This statement seeks to justify the safety of investors’ money, but a closer examination of the statement could prove that the bank is indeed taking too much risk, than if investors’ money was involved. In a nut shell, Wells Fargo would incur any losses associated with investments in private equity; had the bank used some of the investors’ money, then the risk would be spread on a pro-rata basis.
Wells Fargo lost about $1.27 billion through investments in private equity in 2008/2009, during the worst of the global financial crisis. JPMorgan Chase & Co. (NYSE:JPM) also suffered a similar fate most recently losing about $2 billion in the money markets.
The company is investing in private equity and venture capital because of the likely upside in the industry. However, we do understand that high returns are usually attached to high risk. A majority of the returns would come from the acquisition of very small companies, which in most circumstances, have no clear information or accounting history. That said, Wells Fargo is now following in the footsteps of Goldman Sachs Group, Inc. (NYSE:GS), which had about $16.8 billion worth of private equity investments as of September 30, 2012.
Wells Fargo’s Chief Financial Officer Tim Sloan was quoted in a recent conference call saying, “”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 investments in private equity account for about 3 percent of the company’s tier-1 regulatory capital. The company reported $715 million in pretax profits from investment in private equity following the sale of a seed treatment company to chemical maker BASF for $1.02 billion.
The bank has been consistently investing in private equity via its merger partner since 2005, with a contribution of $250 million made in 2011. The company’s investment in private equity grew by about 8 percent in 2012 as it acquired rifle company Savage Sports in January. While Wells Fargo continues to increase its investments in private equity and other money market funds, this has paid dividend to the company’s shareholders in the recent past, profit-wise. However, when disaster strikes, the more investments the company makes in these vehicles, the higher the risk of loss.
Wells Fargo & Company (NYSE:WFC) opened at $35.33 on Thursday, up 0.66 percent from Wednesday’s close.