John Mack interview: Morgan Stanley’s reversal of fortunes


Clive Horwood
Published on:

John Mack has the job he always wanted. One of Wall Street’s leading firms has the leader it desperately needed. Morgan Stanley is now the investment bank with momentum. Mack and his senior management tell Clive Horwood how they revived the firm’s fortunes.

Return of the Mack

Morgan Stanley revives asset management

MORGAN STANLEY IS back. In fact, so quick has the turnaround in its fortunes been that you probably didn’t even notice that it had gone away.

When the US investment bank reported its earnings for the second quarter of 2007 in June, it surpassed all expectations. Perhaps the market should not have been so surprised. Morgan Stanley’s full-year 2006 results had been a huge advance on the dark days of 2005. Its Q1 2007 results were a record.

But last month, Morgan Stanley stood out from the rest of Wall Street with the quality of its Q2 earnings – which jumped 40% on the previous year. Once again the firm was the darling of analysts: "We view Morgan Stanley as the clear top performer in its group," said a report from Fox-Pitt Kelton.

More important, Morgan Stanley is once more in favour with its stockholders. Its share price jumped from $60 in June 2006 to $90 a year later; analysts at CIBC World Markets have a target price for the shares of $112.

Crucially, Morgan Stanley is back as an adviser of choice to its global client base. Revenues from key areas such as M&A advisory, and securities sales and trading, have surged ahead. The firm is once again breathing down the neck of its perennial rival, Goldman Sachs.

Most important of all, Morgan Stanley has its culture back. There is a real sense of confidence and pride among its senior managers. It is comfortable in its own skin – not least in the "doctrine of no surprises" approach to increased risk-taking that is, belatedly, driving the firm forward. Morgan Stanley is going places, irrespective of how far it has already come.

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John Mack has achieved a lot in two years as chairman and CEO; and he is in no doubt there is more to come. But is he farther down the road to achieving the goals he set himself and the firm – which in basic terms are to double 2005 pre-tax profits by 2010 and drive a five percentage points improvement in pre-tax profit margin by the same time – than he expected to be at this stage?

Mack’s answer is typically to the point. "My only expectation is that I am going to continue to work my ass off," he says. "We want to maximize our stock price. We want to embed a culture where people work together and stay at the firm. We want people who respect the values of the firm and our clients."

Mack is certainly not one to dwell on past achievements, no matter how good they are. "The last quarter is the last quarter. Now we push on."

How Mack came back

Mack came back to Morgan Stanley in June 2005. It followed an unhappy attempt to recreate the spirit of his alma mater at Credit Suisse First Boston. One of the first things he noticed when he returned in the CEO role he had always craved, and with hindsight he should have been given some years earlier, was how lumbering his formerly nimble group had become. "People who worked here would walk out of meetings with senior managers and then not get a decision on what they wanted for four or five months. Now people walk out of meetings and know where they stand. The answer is yes or no, and they get it quickly."

Insiders who lived through the bad times put it more starkly. "This firm had never been through a situation like it before," says one banker. "It’s happened at others – Merrill with Komansky, the battle at Goldman Sachs between Jon Corzine and Hank Paulson. Our problem was we were in a civil war but the soldiers on the ground didn’t even know who we were fighting. Our competitors loved it. We gave them a present, and they took it."

Competitors weren’t just after business, they were stalking Morgan Stanley’s star performers as well. In the space of 12 months, Morgan Stanley lost 55 of its 270 global managing directors. "It’s a miracle we did as well as we did in 2006, after the turmoil in 2005," the banker says. "Especially in Europe, when our London office was under attack." In fact, Europe was Morgan Stanley’s star performer in 2006, with investment banking revenues growing 70% over 2005. "It shows the inherent strength of our team and our culture, and that we managed to insulate the average guy from what had happened at the top of the business."

It’s clearly a sore period for all those close to Morgan Stanley. Perhaps, with the passing of time and a return to the top tier of the industry, a more sanguine assessment of the difficult times is in order. As one senior insider puts it: "Leaders change because you need different skill sets for different times. The old leaders, under Phil Purcell, were expert in agency business, which was based on commissions. That business used to dominate Morgan Stanley. But our industry migrated to a different model, and it meant that the firm was being run by people who by personality were risk averse at a time when we need to invest our in own capital as well as the client base."

Zoe Cruz perhaps knows Morgan Stanley’s business better than anybody. She first came to the firm as an intern in 1981. Now, as co-president, she oversees its most profitable business – institutional securities – as well as investment banking and the global wealth management business under James Gorman, She also oversees risk management, with chief risk officer Tom Daula reporting directly to her.

She says that those predicting the demise of Morgan Stanley were sorely mistaken. "Of course 2005 was a difficult period, but it was never as bad as many viewed it from the outside. We were and still are the best brand in the financial services business. Our franchise opens doors; we have excess capital and great human capital. The firm didn’t live up to its full potential across many businesses. When the new management team was put in place, we had some points to prove."

Striking the right balance

One of the accusations that Mack has levelled against Morgan Stanley’s previous leadership is that the institution had been over-conservative. Mack says this charge relates to two areas – not investing enough in the firm’s own businesses, and not being willing to commit the firm’s capital to the needs of its clients.

"We simply weren’t investing in the business," says Mack. "Take the asset management business: it was run purely on a profit basis. We were maintaining good margins and returns but the actual assets under management were shrinking. There was no long-term focus."

Mack also recalls a recent visit to see a client in Japan. "I walked in and the client told me that the last time someone senior from Morgan Stanley had visited him, he had asked us to provide him with capital for an investment he wanted to make. That was in 2003. He was still waiting for an answer."


Regional contributions


Regional PBT growth 2003–2006 (CAGR)

Source: Morgan Stanley

The biggest talking point in investment banking today goes to the heart of the industry: how do firms juggle the sometimes conflicting imperatives of providing a premier service for their clients, and maximizing fees from them, and efficiently using their own capital base to generate excess returns for shareholders? To put the dilemma in its simplest form, where should a CEO position his firm on the spectrum between old-style merchant banking and what is now seen as the Goldman Sachs, principal model?

Read any presentation made by Morgan Stanley’s management in the past 12 months and you’ll see it right there in one of the opening slides. Among the mission statements about "leveraging global scale, franchise and integration across businesses" and "create cohesive ‘one-firm’ culture with the right leadership", one statement stands out: "Strike a better balance between principal and customer activity".

Mack explains the dilemma. "We have to keep our client focus and be the number one firm in the agency business but at the same time look at how we can generate returns through the principal business. In agency trading the commissions and margins are often tiny, even flat. We want to give clients access and do that business but at the same time we need to keep some capital aside for ourselves, whether we use it for trading or for acquisitions. It’s not so much a question of balance but of doing both as well as we can."

Morgan Stanley is aware, however, that the firm’s priorities must appear balanced in the eyes of its clients. As Cruz says: "Principal investing, by its nature, has the potential to cause conflict. Unacceptable levels of conflict get you into trouble. It’s about getting the right level."

The unspoken message is that Morgan Stanley, for all its new risk-taking prowess, won’t be going all the way down the Goldman Sachs route. Of course, that will mean many of its competitors giving Morgan Stanley the "Goldman-lite" tag. The firm’s management have a different take: "We may make lower highs than others, but we’ll make higher lows, and we are comfortable with that," says Cruz.

Analysts and shareholders have expressed some concern about the levels of risk-taking Morgan Stanley is taking on at a time when the market is susceptible to shocks – and every bad piece of news, such as the sub-prime losses in the US, are seen as a harbinger of a full-scale correction in global financial markets. Morgan Stanley has been increasing its exposure to non-investment-grade loans and a significant credit event would leave a lot of these loans on the firm’s balance sheet. Using its own capital to generate returns in the securities markets also has its dangers in the current market – although Morgan Stanley’s numbers in the first two quarters of 2007 showed that the firm had actually profited from, rather than lost out in, the sub-prime correction.

That said, Morgan Stanley’s commitment of risk capital seems well under control for the rewards it is reaping. The firm has increased economic capital usage from $26.7 billion in 2004 to $31.7 billion at the end of 2006; aggregate average trading value at risk rose in absolute terms from $54 million to $61 million over the same period but declined as a percentage to economic value by 0.013 percentage points to 0.181%.

Leveraging traditional strengths

Mack uses an area that has traditionally been seen as one of Morgan Stanley’s strengths, its real estate business, as an example of the new approach. "We’ve always had a great real estate business. But until recently, our firm’s equity in it was less than 10% of the total portfolio. Now it’s over 20%. We’re still making great money for our clients, but our firm is benefiting directly from the expertise of these guys as well."

One of the major focuses of Mack’s new regime has been to turn around the firm’s asset management business. A new management team is in place – created by putting the real estate business inside investment management. Mack says the new team, under Owen Thomas, is already making important strides – but says the credit should go to Thomas and to Cruz.

"It was Zoe’s idea to take real estate out of the institutional securities business. She said to me: ‘John, this is an asset management business.’ At the same time, Owen was saying: ‘If asset management is so important to you, why is real estate located outside it?’" (See Morgan Stanley revives asset management for an in-depth report on Morgan Stanley’s asset management and real estate businesses.)

One of the first outward signs of the new regime under Mack was the whirlwind acquisitions of stakes in three major externally owned hedge funds in 2006: strategic stakes in Avenue Capital and Lansdowne Partners, and the outright purchase of FrontPoint Partners.

"The asset management business had not been invested in – in fact, there was even disinvestment," says Mack. "We were short of products for the global wealth management business. We had exited the private equity business. We needed to do something quickly."

The hedge fund acquisitions "gave us ownership of some of the best of breed in the alternative space – these are first class investment managers," says Mack. He says the acquisition of FrontPoint brought further benefits: "Buying FrontPoint also brought back into the fold a number of great former Morgan Stanley employees who understand what makes this firm great, and have the DNA to help us rebuild our business in the way we want to."

Assets under management are growing quickly, both at Morgan Stanley and at the other hedge funds, where Mack says the funds have benefited from their association with the investment bank’s brand. The stakes that Stanley took also look like a good investment in their own right. "We bought these stakes before Fortress floated. They look like pretty good investments right now," says Mack.

Changing the DNA of ISG

Mack has also effected a major reorganization of the reporting lines of the institutional securities business. This comes from a position of strength. The institutional securities group (ISG), overseen by Cruz, is the main contributor to Morgan Stanley’s profits and revenues. In the second quarter of 2007, institutional securities posted revenues of $7.4 billion, up 39% year on year.

Walid Chammah, Morgan Stanley

"We’re a very proud firm, and yet some of our own people were saying that we have to re-establish ourselves. That helped lift our competitive spirit and led us to rediscover our appetite for risk and for winning. Our deals are now innovative and aggressive"
Walid Chammah, Morgan Stanley

Of course it still lags behind the undisputed sales and trading leader, Goldman Sachs, but the gap is narrowing. Fixed-income sales and trading revenues rose to $2.9 billion from a year earlier, a 34% jump, halving the fixed-income revenue gap to Goldman to just 18%. Mack and his team hope a new organizational structure will first close the gap, and then result in Morgan Stanley taking the lead.

Cruz says that the structure shows how the firm is capable of adapting to changing conditions in all markets. "We have to re-engineer some of our businesses in North America and western Europe," she says. "These are mature markets which have allocation and efficiency issues. We need to realign our business to reflect the multi-asset class world. The biggest growth in the US hedge fund industry is in multi-asset funds. The previous boundaries between fixed income and equities often no longer exist."

The next push forward for the ISG is being driven by two of Morgan Stanley’s gilded veterans. Neil Shear, who used to run global fixed income, now oversees a trading division that comprises both equity and debt; and Jerker Johansen, former global head of equities, has control of the clients and services group.

"We expect to see excellent results from the new structure, which reflects the way much of our business is done today," says Mack. "Previously, we’d send three different derivatives guys in to see the same hedge fund. Ninety percent of the time we’re talking to the same portfolio manager there. He doesn’t want to see three different people from the same firm: a derivative is a derivative, whatever the underlying security."

Cruz says that the aim is to replicate the traditional investment banking model, with one coverage officer dealing with the client, supported by a team of product specialists. "Matrix-based organizational structures are very difficult to put in place but if you get it right it is the best way to run a large and complex organization," says Cruz.

There are other benefits to the firm as well. "We can get a much better picture of what is happening across all asset classes, and also have a much clearer idea of where to allocate our risk capital," says Mack.

The ISG is also benefiting from Morgan Stanley’s reassessment of how it uses its own capital. Cruz takes up the story. "We have to have our capital aligned with our key businesses. Our firm’s fixed overheads are big: and manufacturing and distribution of product is a client-driven business. That machine develops products across diversified asset classes. We can generate a big uplift in earnings if we put capital to work in the right way."

The importance of leveraging ISG to the full is clear – the division contributed $21.6 billion, or 63%, of full-year revenue in 2006; and 75% of the firm’s profit before taxes – $11 billion.

In capital markets, one of the Morgan Stanley success stories is the structured finance business. Morgan Stanley bought mortgage originator Saxon Capital in December 2006 for $706 million. It followed the purchase of Advantage Home Loans in the UK in 2005. The results have been impressive: for the first five months of 2007, Morgan Stanley ranked third overall in ABS volumes, with a 7.7% market share; and fifth in MBS volumes, with a 6.6% share. Cruz describes structured finance at Morgan Stanley as a world-class business, and says the market plays to the firm’s strengths. "As our former CEO, Dick Fisher, once said, ‘complexity is our friend’. The more complex a market is, the better we are."

Back at the top

Perhaps the most dramatic turnaround in Morgan Stanley’s fortunes has been in the M&A business. In May 2006, the firm stood a lowly eighth in the global M&A rankings. By the end of the year, it had risen to a lofty second place overall. The story has been even better in 2007; for the first five months of the year, Morgan Stanley stood top of the rankings for completed M&A transactions, according to figures from Dealogic, with 145 deals totalling $390 billion – well in advance of second-placed Goldman Sachs, with $309 billion of business.

With business comes profit. Revenues from investment banking rose 65% year on year. Advisory revenues grew 99% over the same period, to $725 million.

"We came together because everybody at the firm wanted to succeed," says Walid Chammah, Morgan Stanley’s global head of investment banking. We’re a very proud firm, and yet some of our own people were saying that we have to re-establish ourselves. That helped lift our competitive spirit and led us to rediscover our appetite for risk and for winning. Our deals are now innovative and aggressive"

Morgan Stanley has played a key role in many of the landmark transactions of the past 12 months, such as Blackstone’s $39 billion acquisition of real estate firm EOP; the largest healthcare LBO in history, HCA; General Motors’ sale of a 51% stake in GMAC to a Cerberus-led consortium; and the sales of Arcelor to Mittal Steel, and of Scottish Power to Iberdrola.

The firm showed its newly found confidence with its lead role in executing the mandate for the listing of a new Kohlberg Kravis Roberts fund. It was the largest IPO of 2006 in the US. It pioneered an innovative structure that allowed funds to be used as independent equity investments, simultaneous investments alongside the parent fund KKR or opportunistic investments in other attractive assets and securities. One banker who worked on the deal says that Morgan Stanley almost lost its role on the deal because it insisted that the original structure was too much balanced towards the issuer and not the investor. "We nearly walked away from a lot of money," the banker says. In the end, the structure came out closer to Morgan Stanley’s template – and KKR raised an unprecedented $5 billion, 233% more than initially marketed, making KKR Private Equity Investors the fourth-largest IPO in US history.

Chammah is unsure how long the current merger and leverage finance mania can last. "Several months ago we became concerned about leverage and confidence levels in the marketplace and as a result we have become more discerning."

Cruz adds: "To the extent that there remains more money to put to work than there is product available then you could say there is not enough leverage in the market. But at the more opaque, illiquid end of the spectrum, there is not enough of a risk premium. We have said no to some product, because we don’t think it is right for our clients. It’s created some tension internally, but it is the right thing to do."

On the international attack

Mack has been no less busy building Morgan Stanley’s international network of businesses. At the moment, about 60% of Morgan Stanley’s revenues derive from the US; sooner rather than later, Morgan Stanley’s CEO expects that proportion of the firm’s business will be generated from international operations. For Mack, the rationale is simple: "We have to be where the highest growth in GDP will be."

And the list of acquisitions, build-outs and joint ventures that Morgan Stanley has accumulated in the past 24 months shows that Mack has no intention of being left behind again in growing markets. This incorporates asset classes the firm already has a leading position in, such as commodities, where recent acquisitions include TransMontaigne, Heidmar Group and Olco Petroleum; but the main focus is on developing markets.


Institutional securities business mix


Fiscal 2004–2006 ISG net revenue compound annual growth rates


Profit before tax of $11 bln

Source: Morgan Stanley

Mack describes China as "being one of our loves for ever. We bought a bank to get a banking licence. We’d love to have a securities licence as well." Morgan Stanley bought Nan Tung Bank in China when its joint venture with China International Capital Corporation unravelled; it has also applied to the Chinese regulators for a renminbi financing licence.

In India, Morgan Stanley separated from its joint venture partner JM Financial in February this year. The deal involved the US firm taking full control of the venture’s institutional equities sales, trading and research platform in India but cedes control of the investment banking, fixed-income and retail operations. Morgan Stanley paid a net consideration of $425 million to unwind the partnership and will now build out its own investment banking and fixed-income businesses organically. It was a high price to pay, in line with Merrill Lynch’s decision to increase its stake in partner DSP from 40% to 90% for $500 million, but Morgan Stanley advisers believe the firm needs an independent platform in India – not just for today’s markets, but for those 20 years down the line.

In Russia, Morgan Stanley has a long track record in investment banking. As Jonathan Chenevix-Trench, chairman of Morgan Stanley International, says: "We’ve been in Russia since 1994. We stayed through the crisis of 1998. We believe we have the premier investment banking franchise in the country."

Other international landmarks include the acquisition of CityMortgage in Russia; the purchase of the Capital Group in Saudi Arabia, which received regulatory approval in June; a joint venture in Vietnam; and the opening of local offices in countries such as Turkey and Dubai.

The Middle East is a particular area of focus for the firm. It’s certainly not alone in that regard – every big investment bank is rushing to get their share of the finance riches in the region. Chenevix-Trench explains why he thinks his firm will reap the rewards in the long term. "We admit that our thoughtful approach had led to us not always being as fast as others in getting into new countries. But we think our model as a trusted advisor to clients will differentiate our firm over the long term."

"We have to re-engineer some of our businesses in North America and western Europe. These are mature markets which have allocation and efficiency issues. We need to realign our business to reflect the multi-asset class world. The biggest growth in the US hedge fund industry is in multi-asset funds. The previous boundaries between fixed income and equities often no longer exist"
Zoe Cruz, Morgan Stanley

Zoe Cruz, Morgan Stanley
Cruz says, as does Mack, that a global firm of the future will have to be successful in Brazil, Russia, India and China, as well as Mexico. Each needs a different approach. "India and China are both hugely exciting but the way you approach them is different," says Cruz. "India is a capital markets-driven economy; China is bank driven. Our job is to ensure that we put the users and providers of capital together."

In India, of course, it is not easy for a firm such as Morgan Stanley to have the resources in place on the ground to pick up all of the new market flows. Cruz says this is why the global footprint is so important. "The firm that is closest to the client base makes the lion’s share of the fees. So local firms make money locally. But we can make stay ahead of the competition if we can link the capital markets globally, and by remaining in the vanguard of the marquee transactions."

However, Cruz says that the market that excites her most over the next three years is Japan. "There’s huge potential to develop a derivatives-based market in Japan. We see Tokyo as a key financial centre with huge opportunities for investment."

Mack continues to hunt for more opportunities to add to the Morgan Stanley mix. "If we can find the right businesses, I have a big appetite for more acquisitions," he says.

Last of the De-Witterization

But as Euromoney went to press, the next big corporate event on the horizon was the divestment of Discover Financial Services, the credit card company acquired as part of Morgan Stanley’s acquisition of Dean Witter.

Previous CEO Philip Purcell had announced plans to spin off Discover shortly before he was ousted in 2005. One of Mack’s first actions on taking over the business was to shelve the sale – perhaps a surprise given his focus on investment banking, and the falling out he had with the Dean Witter management in 2001.

But insiders say it wasn’t a question of if Discover should be sold, but when. Mack did not want the distraction of a Discover sale when he had many other priorities. The importance of Discover to the overall business has been diluted by growth in other business areas: Discover contributed just 9% of net revenues, which were down 13% year on year.

Although Discover offered business diversification, most analysts and stockholders are more interested in synergies in today’s business environment, and feared that Morgan Stanley’s breadth of product mix would act as a constraint on performance. After the spin-off, the powerhouse institutional business will make up 68% of the firm’s revenues.

The spin-off of Discover will be an important moment for many at Morgan Stanley. It marks the final step in what insiders call the ‘De-Witterization’ of the business. The rebuilding of the firm’s retail brokerage business remains a work in progress. It is led by James Gorman, and Mack has a clear plan to restore its scale and profitability, which he believes will take three to five years – although he stresses that the division is making "tremendous strides forward".

With so many plans still in the works, it’s no wonder Mack doesn’t share the sense of impending doom that many in the market – but few in investment banking – worry that an end to the current market cycle will bring.

When Euromoney spoke to him in late June, Mack had just completed a two-week tour of Morgan Stanley’s main businesses and clients across the globe. "One thing I have learnt for sure: if the US goes into recession, it is not simply going to bring the rest of the world with it. There’s tremendous wealth in the world, and importantly in developing nations people are now looking to invest it in real assets. Of course there are geopolitical risks, and a rise in inflation would slow markets down. And the current boom in leverage in the US and western Europe can’t continue at this pace for ever. But there remains huge potential for global growth in underdeveloped markets."