Goldman Sachs announced today that it would invest $1.27 billion (Yen 150.3 billion) in the Sumitomo Mitsui Financial Group (SMFG). This can be read as the re-payment of a favour (back in 1986 Sumitomo Bank saved Goldman the risk of going public by investing $500 million in the investment bank) or a vote of confidence in the recovery of the Japanese banking system.
In fact, it is probably neither. The investment will secure Goldman a handsome fee income from helping Sumitomo Mitsui clean up its balance sheet, which is weighed down by troubled property and construction loans. “Goldman Sachs and SMFG have agreed to expand their cooperative activities,” says a Goldman press release. “The two organizations will work together on the disposition of non-performing assets, on SMFG’s financial restructuring and in other areas where Goldman Sachs’ expertise can be of use.” And the terms on which Goldman has made its investment – in convertible preferred stock paying an annual 4.5% cash dividend, with voluntary conversion rights running from 2005 to 2030 – .are by any standards extremely cautious.
Both of which suggest that Goldman is not so much convinced of the recovery of the Japanese banking system as keen to make a profitable play on it. Indeed, the capital iIt has even secured from Sumitomo Mitsui credit loss protection to support Goldman Sachs’s lending activities. As part of the agreement, SMFG will provide Goldman Sachs with up to an aggregate of $1 billion in first loss protection to mitigate risks associated with extending credit to Goldman Sachs’ investment grade clients. In other words, SMFG will absorb losses incurred by Goldman up to $1 billion in value. If requested by Goldman Sachs, SMFG will provide additional second loss protection, which will also be rated investment grade.
So the real purpose of the deal from the point of view of Goldman Sachs is (as in 1986) to avoid mortgaging its independence – to, say, a commercial bank – while expanding its ability to do investment banking business in general, and in particular to compete with better capitalised rivals. The risk is offset by the lure of restructuring fees – a business in which Goldman is already well-entrenched in Japan – and a relatively generous coupon on the preference shares. SMFG is well-chosen, for it is not as if the Japanese banking group was in a strong position to dictate terms to Goldman: $1.27 billion translates into an improvement in the capital base of the bank of less than half of one per cent. Yet it needed help, with a Financial Services Agency review of bad loans in train already.
“While new regulatory guidelines announced by the Japanese FSA may increase SMFG’s credit costs substantially, we believe the costs will be manageable,” says Yoshifumi Nishikawa, President and Chief Executive Officer of SMFG. “Given our enhanced capital base, earnings capacity and focus on the disposition of non-performing loans and rehabilitation of borrowers through our recently established Asset Restructuring Unit, we are confident that the steps we have taken will expedite meeting our goals of long-term earnings growth and improved asset quality. We welcome Goldman Sachs as an investor, and look forward to extending the ties between our firms. This investment, coupled with other initiatives, will strengthen the financial position of SMFG and enable us to accelerate our program to improve asset quality, an effort that Goldman Sachs’ expertise will certainly facilitate.”
Hank Paulson, Chairman and Chief Executive Officer of Goldman Sachs, added: “Today’s agreement serves to mark our commitment to Japan and to SMFG, one of Japan’s largest and most prominent financial groups. We view this as an important opportunity to deepen Goldman Sachs’s participation in Japan and its markets, and the next step in the long and successful relationship between our organizations. We are looking forward to working with SMFG on all the initiatives outlined in this transaction, and on its program to achieve its financial objectives. We believe the benefits of today’s agreement to both organizations and their shareholders will be significant.”