More on conflicts of interest in investment banking

Interesting article in the FT on how Goldman Sachs is courting Silicon Valley unicorns in the hope of winning transactions advisory business (on future IPOs etc). It also exposes certain underlying conflicts of interest and interpretation of existing rules like the Volcker Rule, the thin line that investment banks like Goldman have navigated with much success, 

As fast-growing tech companies such as Uber and Airbnb stay in private ownership for longer, bankers must come up with more ways to ingratiate themselves in advance of a public stock offering... A case in point is a $1.6bn private debt raising that Goldman ran for Uber earlier this year, giving its private clients access to equity in Uber in advance of an IPO. They paid a 4 per cent fee for debt that converts to equity at an 18 per cent discount to the IPO price, if the IPO occurs within one year. The discount grows more generous with time, rising to 30.5 per cent if the IPO happens after three and a half years.

Goldman has also been investing small amounts of its own money in tech start-ups, and it is a small shareholder in Uber after participating in the company’s 2011 fundraising. The bank has made about 50 investments in start-ups so far this year, or double the number it made during the same period in 2012... Goldman says its activities are compliant with the Volcker rule, which curbed proprietary trading and placed limits on banks’ investments in in-house private equity and hedge funds. Under the rule, banks were allowed to continue using their own money to buy stock in private companies, so long as they planned to hold the investments for more than 60 days.

Two things stand out. One, the pricing of such issuances give Goldman ample flexibility to curry favor with their unicorn clients at the cost of its investors. And we know that Goldman is not averse to doing so. During the sub-prime mortgage boom, it sold the infamous Abacus 2007-AC1 synthetic collateralized debt obligations of mortgages to its investors even while using its proprietary capital to bet against the same mortgages. And the favors can cut in the other direction, benefiting preferred institutional investors and high net worth investors, as ZipCar and LinkedIn found out during their IPOs. Second, the concern about proprietary trading, which was sought to be curtailed by the Volcker Rule, also underlines the limitations of prescriptive rules in regulating such trades. 

Such conflicts of interest are likely to deepen in the years ahead as Goldman's (and others) traditional cash driver, fixed income sales and trading, looks set to decline on the face of the bottomed-out bond yields, and financial advisory (advising companies on mergers and acquisitions and fundraising) becomes an increasingly important contributor to revenues.