Awards for Excellence 2017: Morgan Stanley reclaims the investment banking throne
The investment bank has come through more than a decade of difficulties to become the momentum firm on Wall Street once again. The last piece of the puzzle, making its fixed income business fit for purpose, is now in place. Morgan Stanley is working together as a firm better than ever before. Its people have their swagger back. And the architects of this renaissance are determined to press home their advantage with a ruthless approach to deploying the firm’s capital – both financial and human.
Morgan Stanley is all about relationships. Of course, at the heart of its business are the relationships with clients that have made it one of the world’s leading investment banks for close to a century. But Morgan Stanley, for the last two decades at least, has also been defined by the relationships between its senior executives. From 1997 until his resignation in 2005, the key relationship was between then CEO Philip Purcell, formerly of Dean Witter, and most of the senior management of the investment bank his brokerage had merged with. If there was a relationship at all, it was deeply antagonistic. Those Purcell fell out with included John Mack, brought back in 2005 to run the firm just as it entered the financial crisis.
Since Mack handed over the chief executive’s chair in 2010, the most important relationship in the firm has been between James Gorman, the CEO, and his key lieutenant, Colm Kelleher, the firm’s president. Gorman and Kelleher have been a hugely successful double act: they got Morgan Stanley through the crisis and repositioned the firm as the leading wealth manager in the US to provide a counterbalance to the weight of its investment bank.
But they fought a long battle to bring the disparate parts of Morgan Stanley together as one firm. Morgan Stanley operated in silos. The relationships between investment bankers and wealth managers were prickly; the cooperation between advisers and financiers in the institutional securities group (ISG) was sub-standard; and perhaps most difficult of all, there was a long-running feeling of mistrust between the fixed income and equities businesses that had battled for ascendancy for several years.
That, at last, seems to be in the past. Morgan Stanley in 2017 is, clearly, the most joined up it has been in the 20 years since the Dean Witter merger. It has its culture back. People are proud to work for it. They are proud of their history too, and in the process of setting up a long-overdue alumni network.
Senior executives genuinely seem to like each other – they joke about their colleagues from a position of friendship and respect rather than antagonism. Its advisory and financing businesses are working better together than ever before and in doing so, are benefitting themselves and the whole firm. Clever hiring and compensation policies have brought the wealth management, securities and investment banking businesses to a position of mutual respect and collaboration.
And, finally, the markets business that has been the main cause for concern at the firm for the last decade is firing again. And the story of that turnaround depends very much on the relationship between Kelleher and the man he chose to lead the sales and trading business, Ted Pick.
Pick's 100th quarter
Pick is one of many Morgan Stanley lifers. He has just completed his 100th quarter at the firm. He has been head of equities for 33 quarters. And he has now been head of sales and trading across asset classes for seven.
He sits in a small, unremarkable and frankly tired-looking office on the side of the equities trading floor at the firm’s headquarters near Times Square in New York. Two things are immediately apparent – the large number of family photos and drawings by his children on the walls, and the tiered racks of yellow folders that take up much of the sideboard in his office.
But the history of the firm is important to him too, as it is to other Morgan Stanley veterans. From one of the yellow folders, which he locates almost instantly, he pulls out some data on the near 200 managing directors in sales and trading. On average, they have been at the firm for 16 years and have been an MD for seven. Half of all MDs were promoted from within; on top of that, a third of them have always been at the firm.
Pick is clearly proud of this. He explains that the well-lived-in chairs we are sitting on around his cramped meeting table used to belong to Vikram Pandit, who was a mentor to him during his early days in the firm. This used to be Pandit’s office when Pick was a relatively junior ECM banker.
The chairs were found in storage. Next to his desk is an armchair. This used to be in the office of John Havens, Pandit’s right hand man first at Morgan Stanley, then at Citi, and had been put in the tiny reception area that leads to the fifth-floor trading room.
Kelleher got close to Pick during the financial crisis when the former was CFO of the firm and Morgan Stanley’s very existence was in doubt. He describes Pick as “my go-to guy on capital and funding” at the time. A close bond was forged in that crisis, so when Kelleher became co-president and head of the institutional securities division (the Morgan Stanley equivalent of a corporate and institutional bank) in 2009, one of his first decisions was to appoint Pick as head of equities.
“We had to shake the equities division out of its complacency,” says Kelleher. “It was a former number two firm trending to number four from 2008 to 2010. Ted brought in his focus on nine boxes and quickly turned it around. He has a ruthless attention to detail.” Morgan Stanley’s global equities business is now the clear global leader, ranked number one by revenue for 13 of the last 16 quarters, with a market share consistently around the 20% mark.
The running sore at Morgan Stanley, however, was its fixed income division (FID, known more generally in the markets as fixed income, currencies and commodities or FICC). The firm was seriously underperforming its rivals in this area and it was weighing heavily on the group’s overall returns. Some outside the firm questioned if it was fit for purpose.
Kelleher’s most difficult and most important task was to fix FICC. And to do so, he turned to Pick.
“It’s true that our FID was battered and, in parts, broken,” says Kelleher. “We were always committed to the business, but the markets didn’t believe us.”
In the end, in the third quarter of 2015, Morgan Stanley went further than any other big Wall Street firm in reorganizing its fixed income business. That coincided with one of the low points in fixed income for the firm – in that quarter, its market share among the top nine firms globally had slumped to just 4.2%. And that was not the only problem.
“By then it had become clear that fixed income was a business in structural decline – that over the next three years total revenue would not be more than $100 billion,” says Kelleher. “That meant the whole of the industry – and not just Morgan Stanley – was too big.”
Kelleher says of the decision to re-size fixed income: “We had to cut back far enough to show people we were big enough to exist in the business, but also to get the activists and the naysayers off our backs.” In the end, that meant a 25% reduction in headcount, a 40% reduction in capital and a 12.5% reduction in overall costs.
Kelleher gives credit to the previous co-heads of fixed income, Rob Rooney (now chief executive of Morgan Stanley International) and Michael Heaney (who chose to retire) for beginning the restructuring of the business in difficult circumstances. But their moves opened a gap to put Pick in charge of all sales and trading across fixed income and equities.
Bringing the fixed income and equities franchises together was not easy. First, there is an assumption that the cross-over between the two is limited. “You can’t simply ‘equitize’ fixed income product,” says Pick. “But there are some areas where you can adapt things that work well in equities.”
And there was quite a lot of history between the two asset classes. In 2005 Pandit, by then head of the institutional securities division of Morgan Stanley, and Havens, who was running equities, left the firm after falling out with then CEO Purcell. The trigger was the appointment of fixed income veteran Zoe Cruz as co-president of the firm. Pandit had built the most respected part of Morgan Stanley’s markets franchise at the time, its hedge fund and derivatives business. But this was the era when fixed income in all its sub-prime and CDO-shaped guises was king.
Within three years, that fixed income bubble had burst, leading to the global financial crisis. But the simmering tensions between the equities and fixed income divisions only grew – the fixed income losses came close to bringing the entire firm down in 2008. That had a knock-on effect on Morgan Stanley’s once-leading equities business. By 2010, the firm was not even one of the top three global equities firms.
When Pick was asked to add the FID franchise to his equities responsibilities in 2015, having brought the equities business back to the top, he worked closely with Kelleher on the strategy.
“Perhaps fixed income is not as natural an asset class to us as it is to some of our competitors,” says Pick. “But it is a natural fit in terms of fixed income being part of the value chain of delivery in an investment bank. We have to be part of that cycle. And while the new regulatory world has hit large parts of the fixed income business, there are still plenty that will continue to exist and in which you can make a high enough return.”
There were still some very good people in FID. Pick had to be careful not to disenfranchise them. It was not going to just be a question of adding fixed income to the business cards of the senior equities guys.
That said, the poor performance of the fixed income franchise had taken its toll on morale. Pick was annoyed to see fixed income staff walking around without ties – some even in T-shirts and jeans.
“We are at our best when we are a client-facing firm,” he says, and he wanted sales and trading staff to reflect that in their appearance. But there was no edict. Pick and his senior colleagues wore suits and ties. Eventually, most of the fixed income team got the message. Now, he says, in a recent review 95% of the team said they were proud to work for the firm.
“We couldn’t go to the people in fixed income and just tell them we got it right in equities and they got it wrong,” says Pick. “Remember it took us four years to get equities back from a firm struggling to make the top three in 2010 to being the number one franchise in the world.”
But big changes would need to be made. “We knew we needed to strike a balance: on the one hand, we had to make some big cuts to FID, but not so much that there would continue to be an existential discussion about whether it was worth staying in FID at all,” says Pick. “At the end of the day, fixed income is a limb that the body of an investment bank needs in order to function.”
Striking a balance was not easy. A 10% cut in fixed income headcount seemed too low, a 40% cut too high; a compromise level of 25% seemed about right. Pick admits that in making such large cuts, it is inevitable that some mistakes were made, but it was important to move quickly and to move on.
At the same time, Matt Berke, who was COO of the equities division, took on an expanded role across all sales and trading activities. That allows the firm to manage risk across all of its markets businesses, balancing the steadier returns of equities with the more unpredictable cycles in fixed income. It also allows Pick to manage the business to achieve the best operating leverage overall: “In equities, we have a 20% market share. How do we get to 22%? We call that offensive defence. In fixed income, it’s important to grow market share from 7%, as long as we’re not gaining one percentage point at a 5% ROE. To optimize our resourcing, we need a cross-asset behavioural mentality.
“We used to spend our time focusing on revenues. Now we’re focused on returns,” explains Pick. “We look at our return on assets and returns on equity per client. But the key to making that work is to have a sales and trading mentality.”
What he means by that is having a holistic view of the relationships with both individual clients and the client base as a whole. “There’s a danger in being too focused on return metrics,” he says, “which can make you have a myopic view of what businesses to allocate capital to. If you’re not careful, you can spend so much time looking at the numbers that you actually forget to talk to the clients. So it makes absolute sense to have one sales and trading team across asset classes. By and large, we see that the broader the client coverage we have, and the broader the remit of our discussions, the better off we are as a firm.”
That all makes sense, Pick says, as long as one crucial factor is in place: “It works because the management team here gets along well.”
And the numbers are making sense too. Taken as a whole, Morgan Stanley’s sales and trading businesses secured a market share of 12.7% globally among the top nine firms in the four most recent quarters. That represents a 146 basis point gain in market share over the previous 12 months.
Kelleher uses the phrase “ruthless attention to detail” in how the fixed income business is run today. That ruthless approach involves analyzing basis and gap risk, something the old Morgan Stanley might have been big enough to ride until the market bailed it out, but not the new-look fixed income division. He uses inventory management as another example. “Fixed income always has thousands of tail risk positions,” he says. “If you tighten that inventory management up to the same standards as we have in the equities division, you can save $1 million to $2 million a day.” It might not sound much in a business with $35 billion in annual revenues, but it certainly adds up and helps to improve returns on the fixed income side. The fixed income turnaround seems to be working. From the second quarter of 2016 to the first quarter of 2017, Morgan Stanley’s share of revenues among the top nine firms globally in fixed income rose from 5.7% to 8.4% over the previous 12 months, as the market overall rose by 23%. That is a dramatic increase in wallet share of 272bp and a big increase in revenues, from just $3.2 billion for Q2 2015 to Q1 2016 to $5.9 billion over the four most recent quarters.
Pick is quick to point out that no one at the firm is celebrating those numbers: “We need to continue to apply a high level of focus on our credit inventory, foreign exchange and rates businesses, the appropriate risk-adjusted returns and absolutely not trying to be a flow monster.”
He says he sees the return of a hiring battle for talent in fixed income after a series of better quarters, and that some in the market might be starting to focus more closely on revenues again. “But the metric of measuring success for us is and will remain the level of return we generate on the bank’s capital, as well as the happiness and productivity of our human capital.”
Kelleher thinks the business is now in the right shape and at the right size. “Our fixed income business is now sized to produce an average of $1 billion in revenues per quarter, and in the last four quarters it has produced between $1 billion and $1.75 billion. That’s in the context of a firm-wide annual revenue base of around $35 billion. We’re comfortable with the resized business and are simply not going to be an $8 billion fixed income business again.”
Perennial battle for the crown
The attention given to Morgan Stanley’s markets business over the last few years has detracted from what most rivals and clients consider to be its core franchise: traditional investment banking, advising clients and helping them to raise capital.
Morgan Stanley is in a perennial battle with Goldman Sachs for the crown of being the world’s best traditional investment bank, while the likes of JPMorgan and Bank of America Lynch throw down a growing challenge across financing and, increasingly, advisory.
For all that was good about Morgan Stanley’s investment bank, it needed to do more: win more business from the biggest clients, do better in providing them with finance and act more cohesively as one firm presenting to its customers.
One of Kelleher’s big areas of focus has been on winning more revenues in the firm’s advisory business. The revenue gap to Goldman Sachs has always been a sore point at Morgan Stanley, often as high as $2 billion a year. That is a big difference between the number one and two firms competing on a similar platform. That closed last year to around $700 million.
Two areas have been targeted: the first, getting better access to chief executives and boardrooms; and the second, a shift in mentality. Goldman covered clients; Morgan Stanley sold products to them.
“Our focus was too much on taking ideas around M&A, or IPOs, or debt capital markets, rather than a strategic dialogue with the CEO or the board,” says Kelleher. “If you look at the sell-side mandates we have picked up over the past couple of years, you can clearly see we have become much better at that. We had some top people in some industry groups, but not in enough. Now, most of the top CEOs that are important to us have a close relationship with the Morgan Stanley banker that covers them.”
Colleagues say Kelleher is at the heart of such changes, making sure that from the top down his bankers are self-critical about the way they run their businesses and have a surgeon’s precision when it’s time to cut a client or an area that simply does not work. Colleagues also point to how important it is that senior investment bankers are paid through a global compensation pot, which makes them think cross-border and prevents the unseemly arguments about compensation allocation that afflicts many other investment banks.
Of course, any advances that Morgan Stanley is making already are from a position of strength. The firm has some clear leading market franchises. One of them is arguably in the hottest sector of recent years – technology.
“We have a killer franchise in tech,” says Rob Kindler, global head of M&A. “It’s the same team we have had for many years – the guys who did the Google and Facebook IPOs. The market is not just tech buying tech any more. You have to look beyond the traditional ecosystem for these deals. You see companies from other sectors and sponsor buyers. To be successful today, you have to be in the strategic dialogue behind the scenes.” A list of the deals is in itself impressive. In advisory for example, the lead sell-side mandate on the $64 billion sale of EMC to Dell and Microsoft’s $28 billion acquisition of LinkedIn, where Morgan Stanley acted as sole adviser to Microsoft. In equities, the landmark $3.9 billion IPO of Snap Inc, on which the firm was lead left bookrunner and in which it was awarded over 20% more fees than any other underwriter. Since 2015, Morgan Stanley has a lead left market share of US tech IPOs more than 150% higher than the second-ranked bank. In debt, the firm led Alphabet’s $2 billion bond offering, its first since being restructured as the holding company for Google, having previously been sole lead dealer manager on a like-for-like exchange offer worth $1.6 billion between the two companies.
The growing closeness of those C-suite and board relationships is notably seen in two areas. First, in the number of times Morgan Stanley wins a mandate as the sole adviser on the buy side. From April 1, 2016, to March 31, 2017, Morgan Stanley acted on $109 billion of sole-advised deals, $30 billion ahead of second-ranked JPMorgan, according to Dealogic. Goldman Sachs ranked fourth.
And then there are defence mandates, where Morgan Stanley is pushing hard to take Goldman’s crown as the best on the street. Two deals stand out: its defence of Unilever from a bid from Kraft Heinz; and the defence of Norfolk Southern from a $36 billion acquisition play from Canadian Pacific Railway. Morgan Stanley helped Norfolk stave off multiple bids from Canadian Pacific, rising to $85 a share. Its defence not only called into question the value of the bids, the firm’s bankers were also able to cast doubt on whether or not it would receive regulatory approval. The bid went away. Shareholders have done rather well out of it – Norfolk shares were trading around $125 by mid June.
The activist defence group is led by David Rosewater, a former partner in law firm Schulte Roth & Zabel, who joined the firm in 2015 after a career advising activists such as Trian and Elliott. The poacher-turned-gamekeeper is said to be a master at providing tactical advice.
Often missed in the story Morgan Stanley’s recent evolution is the improvement in its financing business, and its contribution to the overall investment bank. In 2012, Kelleher brought capital markets into the investment bank and made the respective heads of M&A and capital markets, Mark Eichorn and Franck Petitgas, the co-heads of the business. It is another personal relationship that seems to work well, five years on. They sing from the same hymn sheet, certainly, when it comes to deployment of capital – but of a different kind. “We have reoriented the way the management team think about our activity,” says Eichorn. “Capital markets and investment banking are one and the same team. And we have to maximize the return on capital of our team. The capital is principally human capital – in other words, we must maximize the return on the investment of our time and effort.”
Maximizing the return on human capital requires focusing more on wallet share and less on league tables, says Eichorn. “All investment banks miss business. So the question should be: ‘Did we miss that piece of business on purpose?’ We have limited human capital; consequently we cannot afford to deploy it where we are not winning business.”
All the senior executives Euromoney spoke to for this story say that the firm had, effectively, ‘fired’ a number of big clients that were not giving them enough business. One talks of meeting the CEO of a $50 billion company and telling him they would have to stop coverage of the client. The CEO was flummoxed – after all, he was paying the firm around $2 million a year. But that did not meet the return thresholds for the new, focused Morgan Stanley.
And they add that such an approach is paying dividends.
“If you look at our momentum over the past 18 months or so, you will clearly see we are gaining wallet share,” says Eichorn. “The key is: this is good business with good returns and success is not just a question of gaining or preserving market share. That approach is a waste of time versus gaining wallet share and maximizing returns.”
“I’m in no doubt that we are executing our business in a better way,” says Petitgas. “We demonstrate an enlightened discipline in everything we do. The whole firm is working very well as a team. The investment we have made over the past few years is paying off. I think our position now is stronger than it has ever been.”
Mo Assomull, head of global markets, adds: “The last 12 months have played to our strengths. Our unique capital markets model allows us to be product-agnostic, and that’s becoming increasingly important to clients.”
The advisory business has also benefited from the fixed income problems no longer weighing so heavily on the whole group. Simon Smith, head of investment banking for EMEA, talks about a big European client that his team had been discussing a deal with for almost two years.
“The mandate looked like a toss-up between us and another firm,” says Smith. “The client told us he chose us not just because he liked the team and our knowledge of his sector, but also because we were the momentum firm on Wall Street.”
And the improvement in Morgan Stanley’s financing business has had a clear benefit to its advisory arm. On those sole mandates, Morgan Stanley – often with the added heft of the balance sheet of its Japanese partner MUFG (which owns a 22% stake in Morgan Stanley, as well as having a joint venture in Japanese investment banking) – can put big financings in place. Clients value the combination; in confidential situations, leaks are less likely to happen.
“Our aim is to be in the room with the client from the beginning,” says Eichorn. “Banks that lead with financing often get into the room late. Today, with MUFG on our team, we are able to speak for a financing commitment as large as just about any other firm. This capability helps keep a transaction confidential and provides our clients with maximum optionality.”
And of course, it allows Morgan Stanley to keep a much larger slice of the financing fees (and advisory economics) that flow from such deals.
Morgan Stanley bankers talk about how the senior management team across institutional securities works closely together and how that has helped quick decision-making and the ability to commit capital to win block trades and big event financings that it may have missed in the past. Not that they would admit it, but there are shades of the Goldman Sachs playbook here. At its arch-rival, Goldman’s senior partner committee has often been seen as one of its key differentiators, with its ability to act on opportunities and commit capital at short notice.
But Morgan Stanley bankers also point to two big advantages their firm has over Goldman and every other global investment bank – its wealth management business, which gives the firm a big distribution lead in the US, and the breadth and strength of relationships through its equities market franchise.
“When you’re a $150 billion company, you know very well that you can raise large sums in the debt markets,” says Petitgas. “But an important question in the boardroom is: how will the shareholders react? And if you have better relationships with the big fund managers that hold their stock than anyone else, clearly you have a big advantage in advising your clients in that regard.”
"No more excuses"
Gorman has spoken recently about Morgan Stanley “living in the same realities as our competitors”. His mantra on taking over the CEO role was “no more mistakes”. The mantra now could be “no more excuses”. The firm’s crises are long consigned to history. Morgan Stanley is on the right footing, and it is a strong one. Its investment bankers have to deliver.
Bankers in New York, London and Hong Kong sense Morgan Stanley is in a good position. There is a spring in their step. There is a confidence about the present and the future, rather than a focus on the past. As one investment banker says: “When clients see you winning, that matters.”
Kelleher is certainly not the type who will ever declare victory; and to him winning means getting the right returns. He thinks Morgan Stanley can do just that.
“We’re confident that with our current business mix our targets can be achieved,” says Kelleher.
“Consistent returns on equity of 9% to 11% are in reach. We’re a top-two advisory house, the leading global equities business, a growing force in financing, a right-sized fixed income business and in wealth we’re close to our target margin of 25% profit before tax. We now have terrific cross-selling both within ISG and between ISG and wealth management, and that will continue to improve. And we have a great culture with good people who have got their swagger back.”
Equities: the business that Morgan Stanley's rivals covet
Ted Pick made his reputation at Morgan Stanley turning around the global equities business. He did such a good job that not only did it lead him to taking on the entire sales and trading business for the firm, he is also touted by many insiders as a leading candidate for the chief executive’s role when James Gorman steps down.
When Pick took over equities in 2009, Morgan Stanley was not a top-three firm globally. He proudly points out that for 11 of the last 13 quarters the firm has been the global leader. Many firms claim to dominate certain business lines; in global equities, Morgan Stanley actually does.
The turnaround was in large part thanks to a focus on what Morgan Stanley calls its ‘nine-box strategy’. The nine boxes encompass three broad business lines – cash equities, derivatives and prime brokerage – across the main geographic regions of the US, Europe and Asia. Each box must be a leader and the focus on making them so is described by insiders as “rigorous and relentless”.
Getting to the top in global equities is important. A general rule of thumb among market participants is that the top three global firms make good money, the next three break even and the three after that lose money. And although barriers to entry are high, and any build-out takes time and a lot of investment, Morgan Stanley bankers are well aware that little more than five years ago they themselves were only in the break-even group.
Everyone at Morgan Stanley is proud of the achievement – although Kelleher and Pick are not the types to let hubris set in. Indeed, Kelleher admits the firm is “paranoid” about maintaining its leadership in equities, saying the three keys to this are continued investment and leadership in electronic trading, which its state-of-the-art Morgan Stanley Electronic Trading (MSET) platform provides; having the leading prime brokerage platform; and continuity in the senior team. Morgan Stanley also commits more capital to equities than any of its big Wall Street peers, according to those competitors that jealously observe the business, especially to the strong relationships it has with strategic arbitrage firms and systematic traders.
Morgan Stanley has been growing market share in a declining overall market. From the second quarter of 2016 to the first quarter of 2017, the firm increased its market share to 20.4% – a rise of 166 basis points over the previous 12 months, even as the total market share for the top nine firms declined by 7%.
Kelleher believes the market will improve. “We’ve had a 25-year reallocation from equities to fixed income, fuelled by unprecedented central bank policy. We’re coming close to the end of that. The equities revenue pool will grow long term.”