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Goldman: Into the Private Equity Stratosphere

A key source of profits for Goldman Sachs (NYSE: GS  ) is its private equity fund, GS Capital Partners. So it's good news that -- according to a story in The Wall Street Journal -- it looks like the next fund will be $19 billion. There are certainly risks, such as conflicts of interest, but this megafund should be quite lucrative, at least in the short run.

While other major investment banks, like Morgan Stanley (NYSE: MS  ) and Merrill Lynch (NYSE: MER  ) , have moved in and out of the private equity game, Goldman has been a steady player since the mid-1980s. Buyouts are a big part of the investments, although the investment focus has been broad in terms of industries, geographies, and types of transactions.

So far this year, GS Capital Partners has been quite busy. Some of the deals include the $6.4 billion purchase of Triad Hospitals (NYSE: TRI  ) and the $1.4 billion acquisition of USI Holdings (Nasdaq: USIH  ) .

Some issues
There are some major risk factors. After all, Goldman receives large advisory fees from private equity firms. Might GS Capital Partners anger them if it competes on a deal?

Competition with corporate clients is another potential conflict. For example, suppose GS Capital Partners is investing in a buyout in which Goldman Sachs is also providing advisory services. In this case, is the corporate client getting sound counsel? It's definitely complex. But for the most part, Goldman has been able to manage these conflicts fairly well.

However, perhaps the biggest risk is investing in a bad deal. Even the best firms blunder. Take a look at KKR, which almost came undone because of its RJR Nabisco deal in the late 1980s. With about half the capital from Goldman Sachs' balance sheet and its employees, there is certainly a large degree of risk exposure.

One thing is clear: A $19 billion fund will result in a nice payday for Goldman Sachs. Generally, a private equity fund gets about a 2% management fee. Thus, Goldman could generate a tidy $380 million annual annuity.

Next, a private equity fund gets a "carry" -- about 20% to 25% of the profits. For example, let's say the GS Capital Partners fund increased by 10%, or $1.9 billion. The take for Goldman will be a cool $475 million (assuming a 25% carry). On many of these deals, Goldman Sachs also gets advisory fees. There may even be fees for structuring the debt financing.

In other words, Goldman's $19 billion fund could be a big help in moving profits forward. As a result, it should be no surprise that other investments, such as Lehman Brothers (NYSE: LEH  ) and Morgan Stanley, are aggressively raising their own megafunds.

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Fool contributor Tom Taulli does not own shares mentioned in this article. He is currently ranked 1,735 out of 22,413 in CAPS. The Fool's disclosure policy comes in tall, grande, venti, and mega.

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