The deal that made Morgan Stanley’s James Gorman
The acquisition of Smith Barney from Citi was far from the obvious play for Morgan Stanley in 2008. Now, it looks like a masterstroke.
The acquisition of the Smith Barney brokerage business from Citigroup is hailed as one of the transformational moments in Morgan Stanley’s reinvention.
Now, the price that Morgan Stanley paid Citi looks like a steal. At the time, and for some time afterwards, a big bet on wealth management seemed an unlikely path to success for the firm.
Since Gorman had joined Morgan Stanley from Merrill Lynch in 2006 to run the rump of the Dean Witter brokerage that had caused so much management turmoil at the firm, he and then CEO John Mack knew they had two options in wealth management: to get the business into shape and sell it; or to double up through an acquisition.
For some time, Gorman admits, he and Mack thought that the first option would be the most likely. Before the financial crisis, they worried that Citi would strike a killer blow in wealth management by making a play for UBS. They never for a moment thought that buying Smith Barney would be an option.
I knew if we had 15,000 brokers with $2 trillion in assets, then we would always have the foundation of a stable business
Events in 2008 changed all of that. Citi found itself to be one of the first and most badly wounded of the big global banks. Not only that, but the Smith Barney division had its own problems. It was losing around 40 brokers a week.
The two leaders of Citi, CEO Vikram Pandit and president John Havens, were ex-Morgan Stanley investment bankers. They had earlier been the victims of the Morgan Stanley Dean Witter in-fighting under then CEO Philip Purcell and had left the firm angry at their treatment. They were, perhaps, not predisposed towards a brokerage business that reminded them every day of Dean Witter.
The irony, of course, is that the Dean Witter era had left its scars on plenty of people that were still at Morgan Stanley.
Rob Kindler talks like a Morgan Stanley veteran, but he has only been at the firm since 2006. Now global head of M&A and vice-chairman of investment banking, he joined the firm after six years at JPMorgan.
But his connections to Morgan Stanley go deeper and further back than that. Before becoming an investment banker, he was a partner at law firm Cravath, Swaine & Moore, where he specialised in M&A for more than 20 years.
Twice he was part of deals involving the firm he works for today. The first was back in 1994 – a long-forgotten attempt to bring SG Warburg and Morgan Stanley together, which would have then created the world’s biggest investment bank. Kindler was advising SG Warburg. The deal fell apart, and Warburg eventually fell into the hands of Swiss Bank Corp 18 months later. Even now, Kindler thinks the combination would have been a good fit.
Then came the deal that transformed Morgan Stanley in 1996 – the merger with broker/credit card giant Dean Witter Discover, whom Kindler advised. Over a turbulent five years, that merger disrupted Morgan Stanley’s investment bank and helped lead to the problems of the financial crisis.
In brokerage, bigger is better, so you would rather have
Rob Kindler, Morgan Stanley
It’s not one of the deals that Kindler recalls most fondly. “While there was a lot wrong with the Dean Witter Discover deal, there was an important upside: it gave us a retail presence without which James Gorman would not have joined the firm,” he says.
But when Gorman and Mack called Pandit in late October 2008 to ask if Smith Barney might be available, it was an incredibly bold call. For a start, Morgan Stanley had been through its own near-death experience just four weeks earlier. After the collapse of Lehman Brothers, the markets thought Morgan Stanley would be next to suffer a crippling loss of funding and liquidity. The firm had pulled through, thanks to the help of a large stake and capital injection from Japan’s MUFG, but those who lived through that long weekend remain scarred by the experience.
Furthermore, if the proposal had been for a merger of the businesses, Smith Barney would have been the senior partner. Its brokerage was about 50% larger than Morgan Stanley’s.
But Gorman wasn’t proposing a merger; he wanted a takeover. And he read, correctly, that it made strategic sense for Citi to sell up. There was the indifference towards the business of senior management; the haemorrhaging of brokers; and more importantly, Citi had an urgent need for capital to avoid a direct government injection of funds and few big assets that could be sold.
Morgan Stanley also had a clear run at Smith Barney. Both the other natural buyers were consumed by their own crises: UBS had been hit by tens of billions of dollars of credit losses; Merrill Lynch had fallen into the arms of Bank of America, which was only just beginning to understand the burden it had taken on.
Pandit took the bait. Morgan Stanley would be the senior partner in a merged firm, with 51% of the shares. Because, on a like-for-like basis, the ownership should have been 60/40 in Citi’s favour, Morgan Stanley effectively paid Citi a sum of $2.7 billion for 11% of the business. Because the former paid a premium for control, it put a high valuation on the business, which helped Citi stave off a capital injection.
Rob Kindler, Morgan Stanley
Kindler worked on many of the key strategic deals that Morgan Stanley did after he joined in 2006, notably the spin-off of the Discover credit card business. He also worked on the buyout of Smith Barney from Citi.
“In brokerage, bigger is better, so you would rather have 51% of a big business than 100% of a smaller one,” says Kindler. “Many of us were not sure whether we would buy out the remaining 49%. James was the one who was always certain that we would.”
Morgan Stanley negotiated an option to buy the rest of the business in the future. Crucially, the firm was able to pick the time to do it – and was able to choose a moment when, because earnings were lower because of integration issues, the value it paid for the remaining stake was suppressed.
When an option to purchase another 14% stake came due in May 2012, the two sides could not agree on a price. After weeks of back and forth, they agreed to put a value on the joint venture of $13.5 billion. That was $8.5 billion less than Citi’s valuation and $4.5 billion more than Morgan Stanley’s.
It’s become clear since who got the best deal. “James probably pats me on the back two to three times a year about the price we got Smith Barney for,” says a banker who worked on it.
The price for the final 35% stake was set in September 2012. It received regulatory approval and was completed in June 2013. The fact that the acquisition was staggered also allowed Morgan Stanley to comfortably finance it over time.
It wasn’t all plain sailing from there. In 2011, margins in the wealth business were only 7%. Press headlines were calling Gorman’s strategy a failure. Smith Barney financial advisers were enraged by the poor technology platform that Morgan Stanley provided. Plenty were leaving what they thought was a sinking ship, taking their clients with them. Around that time, one even accused president and wealth management head Greg Fleming of being “the captain of the Titanic” at a town hall meeting.
By 2015, the turnaround was clear. Margins in wealth management are a healthy 22%. It is benefitting from the scale that Gorman so desperately wanted. The firm has made a big investment in technology, effectively starting over from scratch.
It now wants to take another chunk out of Citi and its US retail peers by taking on all aspects of clients’ cash management, through current accounts, debit cards, bill-paying and, of course, deposits.
It has 3.5 million US clients with $2 trillion in assets, but just $130 billion of deposits. Fleming says that means “with the build out of our banking services, there’s potentially half a trillion dollars away from us at the moment that we could capture.”
Morgan Stanley thinks it can realistically get the deposit base up to $180 billion in the next couple of years.
The Smith Barney acquisition fundamentally changed Morgan Stanley. “I knew if we had 15,000 brokers with $2 trillion in assets, then we would always have the foundation of a stable business,” says Gorman.
It did something else as well: it changed Gorman’s own standing within Morgan Stanley. Before, he was viewed with suspicion as an outsider. But the rebalancing of the business – and the successful way he had negotiated and integrated the Smith Barney acquisition – made Gorman the natural successor as CEO when John Mack stood down in 2010.