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Here's Why Wells Fargo's PE Unit Will Flourish Despite The Volcker Rule

By: Trefis
Posted: 2/26/2013 1:07:00 PM
Referenced Stocks: GS;JPM;MS;NVP;WFC

Quick Take

Like the Goldman Sachs ( GS ), the risk-averse and traditional-banking focused Wells Fargo ( WFC ) has also figured out loopholes in the Volcker Rule, to ensure that cash continues flowing into its coffers (see Goldman's Volcker Rule Policy: Creative And Profitable Compliance ). Wells Fargo has also done its research on the fine print of this restrictive rule, and the bank plans to not only sustain, but also grow its private equity (PE) business. Ironically, the fact that Wells Fargo's PE business is funded 100% by its own cash is what will allow it to go around the 3% limit imposed by the Volcker Rule, on a bank's use of its own cash in a private equity fund. The law  states that by keeping external investors out, Wells Fargo is actually indulging in 'merchant banking' - an activity specifically exempted under the current format of the Volcker Rule.

We maintain a $38 price estimate for Wells Fargo's stock , which is about 5% ahead of current market prices.

See our complete analysis of Wells Fargo here

Wells Fargo's Private Equity Business At A Glance

One of the lesser known businesses of Wells Fargo's diversified business model is its private equity business - something it acquired as a part of its merger with the Norwest Bank in 1998. The two business units Norwest Equity Partners (NEP) and Norwest Venture Partners ( NVP ), look for suitable investment opportunities in small companies and manage capital worth $5 billion and $3.7 billion respectively.

So how much does the business affect bottom line figures for the country's fourth biggest bank? To put things in perspective, Norwest Equity Partners sold off Becker Underwood to Germany-based chemical firm BASF last November for a tidy sum of $1.02 billion, booking a pre-tax gain of $715 million on the deal. That's nearly 10% of Wells Fargo's $7.2 billion pre-tax income for Q4 2012.

Wells Fargo reports its PE revenue under the "net gains from equity investments" head in its income statement. For our analysis of the bank, we include these revenues as part of "other revenues," represented in the chart below.

But Despite The Risks, The Business Is Set To Grow In The Future

The Volcker Rule has a clear reasoning for clamping down on banks' PE activity - the business offers high returns, but comes with very high risk, and the rule understands that bank customers would definitely be better off without this risk. For example, Wells Fargo's PE business lost $1.27 billion over the 2008-2009 period. And deals like the Becker Underwood sell-off can only be materialized once every couple of years, if at all.

Wells Fargo is not Goldman Sachs. While the former has just a fraction of its assets set aside for the Norwest funds, private-equity and merchant banking assets for Goldman form at least a quarter of the investment bank's assets. So we can safely say that as far as Wells Fargo is concerned, the risks of the private equity business are largely contained, and it does look like a good option for the bank to continue growing this business in light of the stable economic outlook for the future.

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