Within weeks of signing the second-biggest deal of his career, Morgan Stanley boss James Gorman was recovering from Covid-19 in his Manhattan apartment and watching the world’s economies lurch towards a coronavirus-driven recession.
Some might have fretted about committing to pay $13bn for online brokerage ETrade at such a perilous time. But within months, Mr Gorman was already thinking about another big play, the $7bn acquisition of investment manager Eaton Vance, announced last week.
“Timing is a funny thing,” says Mr Gorman, who argues that both deals were “strategically obvious over many years” and made just as much sense in the Covid world as before it.
The 62-year-old Australian has a history of crisis-time acquisitions, having wrested control of brokerage Smith Barney from Citigroup in the aftermath of the financial crisis in 2008. It was a $13.5bn deal that would prove transformative, delivering stable income to smooth volatile investment bank earnings and stable funding to Morgan Stanley’s balance sheet. It ultimately laid the foundations for 22 per cent revenue growth from Morgan Stanley’s pre-crisis high to 2019, and a recent string of record results.
With ETrade, an online brokerage popular with millennials, and Eaton Vance, Mr Gorman is doubling down on his original bet that Morgan Stanley’s brightest growth prospects lie in helping individuals and companies to manage their money.
The decision to go “very deep in the things we understand and know” and avoid the rest further widens the gap between Morgan Stanley and Goldman Sachs, a once-similar Wall Street powerhouse that is now chasing growth in new businesses including cash management and credit cards.
But ETrade and Eaton Vance will tilt the balance of earnings, and arguably of power, at Morgan Stanley away from the investment bank which has long been described as the “DNA” of the 85-year-old institution but which would have contributed just 42 per cent to 2019’s pre-tax profits, based on the combined accounts of Morgan Stanley, ETrade and Eaton Vance.
“We want to make sure that in very difficult times, Morgan Stanley is steady in the water,” Mr Gorman told analysts on Thursday. “A decade ago, our asset management and wealth management businesses had bright spots in them, but they weren’t big enough . . . [to] provide real stability to the rest of the organisation. This gives us unbelievable balance.”
Yet, for all their textbook logic the acquisitions have done little to lift Morgan Stanley’s share price, which at around $49 still trades at a slight discount to the value of the firms’ assets. “The market can be really stupid,” Mr Gorman says of the level the stock currently trades at.
Analysts, however, point out that the fallout from the Covid crisis means interest rates will stay lower for longer, restraining ETrade’s profitability. They also question whether Morgan Stanley can make good on its hopes of converting ETrade clients to its main businesses, and some express frustration at how long the bank will have to wait for a pay-off from its investment.
As for the Eaton Vance acquisition, the almost 40 per cent premium that Morgan Stanley paid raised eyebrows, despite general appreciation for a deal which takes the bank into the league of $1tn-plus investment managers, adds new product areas and offers a broader distribution network across the US.
There are broader questions about whether the deals will be enough to maintain the momentum built up by Mr Gorman and his team.
“Morgan Stanley was probably my best stock call of the last decade,” says veteran Wall Street analyst Mike Mayo of Wells Fargo. “But now we actually don’t recommend it. We’re not negative, we’re just trying to figure out what’s left [for them to do], especially since the jury is out on its acquisitions.”
It is hard to overstate the impact of the 2008 financial crisis on Morgan Stanley, the corporate finance house spun off from JPMorgan in 1935 to satisfy the Glass Steagall Act’s requirement for a church and state-style separation between banks that dabbled in high finance and those that safeguarded household deposits.
“On a personal level, lots of people were worried about [survival],” says Clare Woodman, head of Morgan Stanley’s Europe, Middle East and Africa business. Hedge funds were pulling their balances from Morgan Stanley at an alarming rate, funding markets seized up and the value of the bank’s trading assets plummeted.
A $9bn investment from Japanese bank MUFG in September 2008 bought the bank time. “When we came out of the crisis, it was very clear what we had to fix,” says Jon Pruzan, Morgan Stanley’s finance boss.
Top of the list was cutting the bank’s leverage. Its assets were more than 30 times its equity in late 2007 — a figure that has been cut to 13 times, it has also exited illiquid positions, almost halved its assets in the two years to mid 2009 and reduced its outsized reliance on market funding due to its lack of ordinary depositors.
Smith Barney, for whom Morgan Stanley struck a joint venture with Citi in 2009 before buying in full four years later, offered the potential to make the wealth management division “big enough and durable and stable enough to meaningfully change the profile of the company”, says Mr Gorman.
“It gave us the space to tackle the challenges inside the institutional business [the investment bank], some of which was working beautifully and some which clearly needed to be fixed,” he adds.
Mr Gorman, hired from Merrill Lynch in 2006, had long coveted such an asset. “I didn’t have any doubt,” he says. Investors, however, were less convinced. The memory of Morgan Stanley’s fraught merger with brokerage Dean Witter in the late 1990s that left a legacy of legal issues and internal divisions still smarted. Adding another 40,000 people in the wake of the crisis was “a bridge too far” for some, Mr Gorman says, adding that although he was initially “bewildered” by their scepticism he now understands the “scar tissue” that investors were nursing.
He was quickly vindicated. Wealth management has grown from less than a third of group revenues pre-crisis to more than 40 per cent and Morgan Stanley has become America’s largest wealth manager by assets under management. That shift has created a general halo around Morgan Stanley, and a perception that it has fared far better than rival Goldman Sachs since the crisis, even though Goldman’s returns have beaten Morgan Stanley’s for six of the past 10 years.
Taming the investment bank, whose pre-crisis profits were often built on big bets with the bank’s own capital, was the other critical part of Morgan Stanley’s post-crisis reinvention and another area where the bank won praise for beating Goldman.
“Fixed income was always a hot mess,” says Glenn Schorr, an analyst at Evercore ISI, describing how it had “kept trying to chase Goldman . . . and be something that they weren’t” in a division that included everything from government bonds to bespoke interest rate derivatives and commodities.
The bank went through a string of fixed-income trading bosses and other senior executives. Then in 2015 it cut around 25 per cent or 1,200 people from its fixed income staff, exited areas where it did not have the scale to compete, including some global currencies, and slashed a bloated trading balance sheet by cutting exposures and selling some businesses.
The slimmed-down division was set a goal of quarterly revenues of $1bn, 25 per cent less than its 2015 level. By 2016, it was already averaging $1.28bn. Goldman Sachs, meanwhile, was being hammered by investors for its bet that the changes to the fixed income business were temporary rather than permanent, a position it clung to until 2019 when it began cutting back.
As the fixed income division’s return on equity improved from around 2 per cent in 2015 to above the 6 per cent to 8 per cent threshold set by the bank, Morgan Stanley began quietly rebuilding. Around half of the 2015 job cuts have been added back since then. In the second quarter of 2020, as banks across Wall Street were buoyed by a mammoth trading period, Morgan Stanley’s fixed income business rose by more than anyone else’s, delivering $3bn in revenues.
“We were running a profitable business that was meeting our target threshold,” says Mr Gorman. “We’d be stupid not to take advantage of that.”
Yet Morgan Stanley’s loftiest growth ambitions have in recent years been focused elsewhere: buying investment manager Mesa West for several hundred million dollars; the $900m acquisition of workplace stock plans manager Solium, ETrade and now Eaton Vance.
The latest acquisition brings $500bn of assets to Morgan Stanley Investment Management, bringing its total assets under management to $1.2tn and putting it in a position to turbocharge growth at a division that traditionally accounts for less than 10 per cent of Morgan Stanley’s revenue.
“They fill gaps and give us scale in fixed income,” says Dan Simkowitz, MSIM’s head, adding that Eaton Vance also brings a strong business of environmental, social and governance (ESG) investing as well as a broad US distribution network to complement Morgan Stanley’s international reach.
Mr Schorr believes the rationale for the deal was sound and that while some investors might “think they have overpaid by around $1bn”, that was “the price . . . for a quality growing company and not overly material for a company with a circa $90bn market capitalisation”.
As for ETrade, Mr Gorman says investors are much more comfortable with that deal than they were with Smith Barney, recognising the strategic rationale of having a stake in the online-only brokerage world. ETrade has attracted an additional $32bn of retail clients’ funds this year, as individuals piled into the stock market rally.
“[ETrade] gives us a growth business in the digital space that is extremely complimentary to everything we do,” he says, describing how the deal will accelerate the digitisation of Morgan Stanley’s own wealth business, improve its capital ratios and potentially open doors to 800-plus companies whose stock plans are managed by ETrade.
The deal also brings 5.2m mostly younger clients from ETrade’s main trading business — a potential pipeline for Morgan Stanley’s core wealth management division where the average client age is around 58. In the short term it hopes to offer them mortgages and loans for trading.
Outsiders offer a cooler assessment. Jeff Harte, analyst at Piper Sandler, says it is “not obvious” that Morgan Stanley will succeed in winning much of the $3.2tn of assets that ETrade’s customers hold in other institutions. Another question is “how long earnings will be diluted for” to offset the extra Morgan Stanley shares created to buy ETrade.
Mr Mayo remains sceptical about the $400m of synergies promised from the deal over the next three years and says Morgan Stanley has grown its assets under management by less than its rivals and less than the S&P 500 over the past decade, though the bank argues that their wealthy clients’ sophisticated demands mean they invest in a more diverse range of assets and would not benefit as much from a pure equities rally. Buying the brokerage also makes the bank more vulnerable to low interest rates since ETrade will be making less on its client balances, and some of those who joined ETrade this year may just as easily depart when equities markets turn, he adds.
Brian Kleinhanzl, analyst at KBW, says JPMorgan, Bank of America, Wells Fargo and Goldman all have strategies to “develop these feeder systems for the wealth management businesses — they are all trying to grow and they’re all doing it in slightly different ways.”
He adds: “It remains to be seen whether any of them will be truly successful.”
Focus on competition
Hours after the ETrade deal closed on October 2, rating agency Moody’s upgraded Morgan Stanley to A2, one of its highest tiers, praising the firm’s “resilient” business mix. “We celebrated with clients, we said, ‘we clawed our way back, thank you for being there with us’,” says Ted Pick, who runs the investment bank. He sees the upgrade as a powerful endorsement from a rating agency that threatened a three-notch downgrade in 2012 before settling on two notches.
He and other executives insist there is plenty of growth to come, especially in investment and wealth management, where clients are looking for solutions and advice to navigate the pandemic’s unpredictable fallout, and also in some parts of its more traditional Wall Street businesses.
A business mix shift like the one under way at Morgan Stanley can lead to vying factions. “People can see who’s in the ascendancy,” says an executive at a rival bank. “At the margin, people do care about these things.”
The task for Morgan Stanley executives is to make sure their traders, bankers, wealth advisers and investment managers continue to swear allegiance to the bank, not their individual fiefdoms.
“I’m not going to be judged based on ETrade or Smith Barney or Solium or Mesa West or restructuring fixed income or selling physical commodities or shutting down our prop businesses,” says Mr Gorman. “All these things are just part of the galaxy of steps you take.
“[The real question is] how did we do relative to our competitors? Better or worse? Did we make the right strategic choices, and did we execute on those?’ That's how we should be judged.”
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