Earlier this month, Goldman Sachs (NYSE:GS) announced the launch of Liberty Harbor Capital – a unit created as a business development company (BDC) with the aim of investing in small U.S. companies.  The unit will use its funds to buy high-yield debt issued by such companies – usually without any credit rating, as well as to make and buy loans. Shares of the new unit will be up for grabs soon with Goldman looking to raise at least $600 million, a figure that will likely include a sizable contribution from the investment bank itself.
At this point, if you are getting the feeling that we are talking about something similar to a private equity (PE) fund, you are on the right track. So why call it a “BDC,” you ask. Simple. Because the Volcker Rule which seeks to clamp down on risky funds by imposing a restriction for a bank’s infusion of its own cash in PE and hedge funds, provides BDCs a free hand with no such restriction. While fundamentally being the same business in terms of risks and returns, the preferential treatment for a BDC is what prompted Goldman to form one in a bid to make up for some of the revenues it will lose once the Volcker Rule is implemented.
We maintain a $146 price estimate for Goldman’s stock, which is about 5% below current market prices.
Like all other Wall Street banks, Goldman has kept itself busy in the last couple of years, trying to make changes to its business model so as to accommodate the stringent Volcker Rule. This includes shuttering various proprietary trading desks and limiting investments in various funds.
But unlike the other banks, Goldman has also been thinking outside the box the whole time to find ways to carry on some of these (highly profitable) businesses by working around the provisions laid down in the rule as it stands now. This is what gave Goldman the idea of structuring Liberty Harbor as a BDC, as they are specifically exempted from the Volcker Rule’s purview.
Here’s how Liberty Harbor’s business would work: Goldman would most likely pump in a quarter of the unit’s $600 million funds, i.e. a good $150 million thanks to there being no restrictions on the bank’s use of its own funds. Now BDCs have a good track record when it comes to return on investment with returns around 10% considered quite normal. Using this 10% benchmark, we can assume that Goldman will be able to annually generate about $15 million in gross revenues from the unit on an average, which is definitely not a bad deal. And add to this the fact that the business is easily scalable – either by increasing the size of the fund’s assets or by opening more such units; albeit at increased risk.
So, ironically, Goldman uses the Volcker Rule to continue making money through investments which it would have been forced to discontinue because of the Volcker Rule.
The unit will be managed as a part of Goldman’s asset management business. While this particular unit only marginally increases the size of Goldman’s assets under management, any success in the model will soon spawn clones that will grow the asset base quicker over the years to come.Notes:
- Goldman Launches New Unit to Invest in High-Risk Debt, The Wall Street Journal, Apr 1 2013 [↩]