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The Volcker Rule and Private Equity

Chris Barker

In the aftermath of the recent financial crisis, risk levels taken by financial firms came under greater scrutiny and in 2010 Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act. One of the most controversial elements of this legislation was the Volcker Rule, which barred American banks from making speculative investments with their own money. In preparation for the rule’s implementation this year, banks are making adjustments to their investment strategies.

Under the Volcker Rule, banks are required to significantly cut their stakes in private equity units, or be rid of them altogether, by 2015 (Dezember). With the rule set to take effect in April, banks are finding ways to comply with this private equity provision.

Generally speaking, private equity firms raise their capital by generating demand among investors and committing successful sales pitches to those investors. Before the Volcker Rule, however, banks had private equity divisions that did not have to do this. These entities simply invested the funds of the banks. Starting in April, this will no longer be a legal practice. From now on, private equity firms like Ridgemont Equity Partners, previously connected to Bank of America Corp., will have to generate their capital just like any other private equity firm.

A common criticism of the rule is that it restricts the behavior of American institutions, hampering them competitively in international capital markets in which foreign firms are still engaging in such proprietary trading. For example, England’s Barclays will be able to participate in private equity, sweetening their bottom line, whereas America’s J.P. Morgan Chase will not be able to. This line of argument follows that investors will flock to foreign institutions, harming American institutions.

Another impact of the rule, however, will be on competitive practice in the American private equity markets. Previously, private equity units of big banks, such as Ridgemont, had an obvious built-in advantage over independent private equity firms like Apollo Global Management, LLC. Apollo needed to commit resources to raising capital, whereas Ridgemont simply extracted capital from Bank of America. This line of argument follows that investors interested in private equity used to commit their capital to banks like Bank of America, despite the possibility that Apollo was making better returns. The difference between the two firms’ returns may not have exceeded Apollo’s marketing costs. This meant that capital was being allocated inefficiently.

One thing is for sure, and that is the foundation of private equity in America is about to shift. Ridgemont was ahead of the game; Bank of America spun that unit off in 2010. So far, Ridgemont has made the adjustment in stride; executives sealed $735 million from new investors in the last eighteen months (Dezember). In the coming years, it will be interesting to monitor how Ridgemont’s counterparts such as J.P. Morgan Chase’s One Equity Partners will adjust to the new costs they will incur.

 

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Dezember, Ryan. “New Rules Put Buyout Firms Out On Own.” The Wall Street Journal. 10 Feb. 2014. C1, C4. Print.

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