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Goldman Sachs Sends a Message With Facebook Deal: The Magic Model is Back

Goldman Sachs Group Inc.’s stake in Facebook Inc. and plan to offer shares to wealthy clients shows how Chief Executive Officer Lloyd Blankfein’s model of investing the firm’s own capital continues to pay off.

While the financial crisis led rivals such as Morgan Stanley to scale back principal risk-taking, Blankfein, 56, hewed to the firm’s strategy of serving as a co-investor as well as an adviser and financier to clients. The Facebook deal demonstrates that new U.S. financial regulations and proposed international capital requirements haven’t changed that yet.

“The take-away is that the model is not broken,” said Roger Freeman, an analyst at Barclays Capital in New York who has an “equal-weight” recommendation on Goldman Sachs. “When the dust settles a lot of the prior activities are still permissible.”

Principal investing -- in which Goldman Sachs uses its own money, instead of clients’ money, to buy stakes in companies or real estate -- generated a total of $9.4 billion for the firm since the end of 2001, company filings show. The business can be volatile. In 2007 the unit contributed $3.8 billion in revenue and the next year it lost $3.9 billion, company filings show.

One of Goldman Sachs’s top successes was the firm’s January 2006 investment in Industrial & Commercial Bank of China Ltd., nine months before ICBC went public in what was the world’s largest initial public offering. Goldman booked a $949 million profit on the investment in the quarter of the offering and went on to reap a total of $3.5 billion in gains over the next four years. ICBC is the world’s biggest bank and the world’s seventh most valuable company, according to data compiled by Bloomberg.

Partners May Invest

Goldman Sachs invested in ICBC alongside Goldman Sachs private-equity funds, enabling clients and the firm’s employees to share in the purchase.

The investment bank is pursuing a similar model with Facebook, in which the firm is buying $450 million of stock that isn’t publicly traded and offering clients in its private wealth management division an opportunity to invest about $1.5 billion, according to people familiar with the matter. All Goldman Sachs partners are clients of the division, meaning they may also have a chance to invest.

Some funds within Goldman Sachs Asset Management, such as Goldman Sachs Investment Partners, are also likely to get some of the Facebook stock, according to two people familiar with the matter. Goldman Sachs Investment Partners is a hedge fund run by former members of the firm’s proprietary trading group known as principal strategies.

Charging Fees

Clients of the wealth management division are being offered the opportunity to invest as much as $2 million apiece in Facebook, and Goldman Sachs will take a 4 percent placement fee, 5 percent of any investment profits and charge an annual servicing fee, according to two clients who were offered shares.

Stephen Cohen, a Goldman Sachs spokesman, declined to comment.

Goldman Sachs didn’t get a role in underwriting Beijing- based ICBC’s IPO in 2006. Still, it did win business arranging follow-on share sales in 2009 and 2010.

Facebook hasn’t announced plans to go public. Some analysts expect Goldman Sachs is first in line to win that mandate.

“From Goldman’s point of view, this is a way of ensuring it wins the lead underwriting position when Facebook goes public,” said Brad Hintz, an analyst at Sanford C. Bernstein & Co. who rates the firm “outperform.” “Facebook will likely be a cult stock that retail investors will pursue when it’s offered in its IPO and pursue aggressively when it begins to trade.”

Won’t Change Tune

Goldman Sachs’s success with investments like ICBC led firms like Merrill Lynch & Co., Lehman Brothers Holdings Inc. and Morgan Stanley to follow suit by making bigger bets with their own capital, a strategy that backfired for all of them during the financial crisis. Lehman Brothers filed the biggest bankruptcy in U.S. history in 2008 in part because of losses related to its principal investments in real estate and real estate companies.

Even after the financial crisis put Lehman Brothers out of business, caused Merrill Lynch to agree to an emergency sale to Bank of America Corp., and led Morgan Stanley to commit to reduce principal risk-taking, Blankfein made it clear he had no intention of changing his tune.

“We are not forsaking our position as a pre-eminent adviser, financier and co-investor as we pursue additional opportunities as a bank holding company,” Blankfein told investors on Nov. 11, 2008, less than a month after taking $10 billion from the U.S. Treasury Department. “We remain committed to generating industry-leading returns over the cycle.”

Fueling Profits

Principal investment may be an important tool to enable Goldman Sachs to continue to generate average return on equity of 20 percent over the economic cycle, Barclays Capital’s Freeman said. Blankfein said at an investor conference on Nov. 16 that he doesn’t think the firm has to revise that target, even though many analysts question how the firm can achieve those kinds of returns after reducing the amount it borrows, known as leverage.

“How do you get there?” Freeman said. “How did they generate some of the really high, 30 percent-plus returns in prior years? It was significant principal gains.”

One executive at a rival company, speaking on the condition of anonymity because he’s not authorized to speak publicly, said that his firm and others will be watching this year to see if Goldman Sachs’s strategy continues to pay off and, if so, they may find it tempting to follow suit once again.

Dodd-Frank Act

Although the Dodd-Frank Act passed last year in the U.S. aims to limit banks’ ability to take risks through proprietary trading or through stakes in hedge funds or private equity funds, Barclays Capital’s Freeman said the law doesn’t set any specific limits on principal investments.

“One of the ironies of Dodd-Frank is that the long-dated investments that got other firms into trouble are not prohibited under Dodd-Frank,” said Freeman, who worked at Lehman Brothers before it was acquired by Barclays.

Although new capital requirements established by the Basel Committee on Banking Supervision could make such investments less appealing, the rules don’t take effect for a couple of years. Even then, some principal investments may be lucrative enough to proceed with even if returns are somewhat diminished by the need to hold more capital.

“The Facebook investment sends a message to institutional investors that Dodd-Frank and Basel III have not hobbled Goldman’s business model and that the magic remains,” said Bernstein’s Hintz.

To contact the reporter on this story: Christine Harper in New York at charper@bloomberg.net

To contact the editor responsible for this story: David Scheer at dscheer@bloomberg.net.

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