The Decision to Spin Off a Private Equity Unit Could Impact Investors in a Big Way

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JP Morgan Chase (NYSE: JPM) recently announced its intention to divest its private equity arm in response to long-awaited regulatory changes and volatile swings in profitability. Known as One Equity Partners, the private equity division has been a longstanding point of contention for JP Morgan's management team, as well as members of the broader investment community. It appears that opponents of the division's continued attachment to JP Morgan have finally won the day. 

Although retail investors will probably be unable to throw in their lots with the new company, this deal could have important ramifications for JP Morgan's organizational structure and future growth plans. It could also presage similar moves by other big banks. In fact, a rush to comply with the provisions of the so-called Volcker rule and some additional pieces of regulation has led to private-equity divestitures across the industry. Investors with interest in large-cap banks would do well to remain informed about this transaction.

JP Morgan and the Competition at a Glance

As one of the largest U.S.-based banks in existence, JP Morgan competes with other highly diversified "household name" banks like Bank of America (NYSE: BAC) and Citigroup (NYSE: C). With enormous revenue figures and globe-spanning operational structures, these firms are alike in many important ways. Until recently, market-watchers deemed JP Morgan to be the strongest and most stable of the bunch.

For starters, their market capitalization figures are all comfortably in the 11-figure range. With a valuation of nearly $205 billion, JP Morgan leads the pack. With a market capitalization of just under $153 billion, Citigroup is not too far behind. Bank of America's shares are worth around $142 billion in the aggregate.

Revenues and profits tell a similar story. In 2012, JP Morgan earned a solid $21.4 billion on revenues of about $92 billion. This compares quite favorably with Citigroup's take of $8.4 billion on revenues of $61 billion. Bank of America had a much narrower margin: it took in about $78 billion in revenue but posted a profit of just over $3.5 billion. Fortunately, all three of these firms appear to be in good financial shape. Bank of America's debts add up to about $618 billion and offset a cash hoard of just over $500 billion. JP Morgan and Citigroup enjoy similar ratios.

How the Deal Will Happen

Few hard details about this spin-off have been released. However, JP Morgan's CEO has indicated that One Equity will no longer raise capital from JP Morgan's clients or accept infusions of cash from its former parent company. Although the firm will receive limited support during its transition to full independence, it will have its own internal management team. Meanwhile, JP Morgan will completely exit the private equity business to focus on its core banking and trading operations.

Although JP Morgan has not provided explicit guidance on the structure of the newly independent One Equity Partners, it appears that the firm will not trade as a public company. Rather, it appears likely that it will solicit large-scale investments from institutional clients like other private equity firms, hedge funds and pension funds. However, it would be foolish to assume that a public offering is off the table for the foreseeable future. As such, investors would be wise to keep an eye on One Equity.

Good or Bad for JPM?

This deal will represent a major change for JP Morgan. On the positive side, the bank will divest a volatile asset that has seen its share of troubles over the past decade. Of course, it will also sacrifice potential revenue from well-structured deals. Operationally, the company will be a bit more streamlined and may be able to put the cash that it would set aside One Equity to use in other ways. Overall, JP Morgan will emerge from this spin-off as a more conservative company that fully complies with the confusing mix of new banking regulations to which it and its peers are required to adhere.

Are Other Banks Vulnerable?

One of this deal's drivers is the Volcker rule. Since the rule prohibits mainstream banks like JP Morgan from providing more than 3 percent of their private equity divisions' capital reserves, it more or less renders such associations unworkable. While it is theoretically possible for a bank to maintain a private equity division under the terms of the Volcker rule, most banking executives are electing to avoid the problem altogether by spinning off these units. Many similar transactions have already occurred, and it would be reasonable for investors to expect more big banks to follow JP Morgan's lead.

Possible Plays and Long-Term Outlook

Although investors cannot play this deal directly, an independent One Equity Partners might turn out to be a boon for JP Morgan. By releasing its private equity arm, the company may be able to cut costs in other areas. Moreover, its operational structure will become easier to understand and present less risk to everyday investors. Those who might normally be reluctant to jump into the still-recovering banking industry should be heartened by these developments.

Investors who wish to play this deal can do so with a long position in JP Morgan. The company's stock has fallen slightly since the announcement of the spin-off and may be at an attractive buy-in price. Once the effects of the deal have worked their way through JP Morgan's balance sheet, the company's multiples could improve by a noticeable margin. Of course, interested investors should always perform supplemental research before playing a deal of this magnitude.

With big finance firms still trading at deep discounts to their historic norms, investors everywhere are wondering if this is the new normal, or if finance stocks are a screaming buy today. The answer depends on the company, so to help figure out whether JPMorgan is a buy today, check out The Motley Fool's premium research report on the company. Click here now for instant access!

Mike Thiessen has no position in any stocks mentioned. The Motley Fool recommends Bank of America. The Motley Fool owns shares of Bank of America, Citigroup Inc , and JPMorgan Chase & Co.. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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