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Volcker Rule Weighs On Goldman Sachs Earnings Growth

NEW YORK ( TheStreet) -- Goldman Sachs (GS - Get Report) on Tuesday reported a surprise 10% rise in profits , as revenue at the bank exceeded $10 billion for the first time in two years.

Still, the earnings beat, which hinged on about $1 billion in private equity investment gains and another $1 billion in write-ups of principal debt and equity trading positions, proved to be a mixed bag for investors as shares sold off about 2% in early afternoon trading.

Wall Street analysts discounted the $2.1 billion in revenue Goldman earned from the bank's so-called "Investing & Lending" unit as a result of uncertainty surrounding future earnings of the business as new regulations such as the 2010 Dodd Frank Act take hold.

For Goldman, the Volcker Rule, a crucial piece of the Act, limits the amount of capital the firm can put into private equity and hedge funds, creating a challenge to the sustainability of revenue from units such as Investing & Lending.

Currently, the Investing & Lending unit holds $57.2 billion in assets, according to Goldman's most recent 10-K filing with the Securities and Exchange Commission.

In light of regulations such as the Volcker Rule, however, it's unclear whether those high-earning investments will eventually run off of Goldman's balance sheet or be replaced with a new slate of investments and trading positions.

As a result, analysts said on Tuesday, the market may have discounted Goldman's income from private equity investments and proprietary trading positions, which at $2.1 billion, accounted for about 21% of quarterly revenue.

Morgan Stanley analyst Betsy Graseck wrote in a note to clients that Goldman's earnings beat was driven by write-ups to private equity investments amid rising markets. Still, Graseck questioned the pace of asset wind-downs in the unit and whether current investments could be replaced with Volcker-compliant investments.

"We continue to manage our existing private equity funds, taking into account the transition periods under the Volcker Rule. With respect to our hedge funds, we currently plan to comply with the Volcker Rule by redeeming certain of our interests in the funds," Goldman said in its 10-K.

Goldman noted that since March 2012, the firm has redeemed 10% of certain hedge funds' total redeemable units per quarter. It expects to continue that pace through June 2014, while also limiting its overall private equity and hedge fund exposure to just 3% of an initial fund investment.

According to Goldman's 10-K, assets in the Investing & Lending unit increased between 2011 and 2012, likely driven by rising asset values.

While quarterly earnings still reflected a sharp rise in investment banking fees on record debt underwriting revenue and a 60%-plus rise in equity underwriting fees, the extent of the Goldman's earnings beat may be overstated just looking at top and bottom-line numbers.

For the quarter, Goldman reported a profit of $2.26 billion, on revenue of $10.09 billion, beating adjusted estimates of $1.97 billion and $9.65 billion respectively.

Earnings per share of $4.29 surpassed an adjusted estimate of $3.86 a share, according to analyst forecasts compiled by Bloomberg.

Goldman Sachs shares fell less than 1% to $144.96 in early Tuesday trading.

"We think the market will largely ignore the investment gains but the strong [investment banking] fees and lower compensation ratio should be taken positively," Richard Staite, a banking analyst at Atlantic Equities, wrote in a note to clients.
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