Morgan Stanley Seeks Growth In Private Investments Despite Volcker Rule Restrictions

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Morgan Stanley

Morgan Stanley (NYSE:MS) recently announced that it has raised roughly $1 billion for a new private equity-type credit fund. [1] The cash was secured by a subsidiary of the investment bank’s Merchant Banking & Real Estate Investing business, and will be used to target corporate mezzanine debt and other similar instruments issued by middle market companies in North America and Western Europe. The fund is the second one of its type for Morgan Stanley, with the first one raising $956 million in 2011. [2] Notably, the bank also raised $1.7 billion as a part of its Asia private equity fund last July – its first such offering since the economic downturn of 2008. [3]

The increasing level of activity by Morgan Stanley in the private equity (PE) and private debt industry – even as the Volcker Rule imposes restrictions on the involvement of banks in hedge funds and private equity funds – appears quite confusing. After all, the country’s largest investment banks, including Goldman Sachs (NYSE:GS) and JPMorgan (NYSE:JPM), have shrunk their presence in the private equity business significantly over recent years and continue to look for ways to divest their stakes in private investment vehicles. But interestingly, Morgan Stanley has been expanding in the industry while sticking to the 3% limit laid out under the Volcker Rule for a bank’s use of its own money in any private fund. The investment bank is actually capitalizing on the strong revenue opportunities that exist in private equity funds in the form of management fees and performance fees to boost its top-line figures while still staying within the letter of the law. [4]

We maintain a $38 price estimate for Morgan Stanley’s stock, which is slightly below the current market price.

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The Volcker Rule, which was implemented as a part of the Dodd-Frank Act, brought into effect a series of restrictions on several risky activities undertaken by U.S. banks – most notable among them being a ban on proprietary trading and a 3% limit on the amount of cash a bank can pump into hedge funds or private equity funds. The legislation has a clear reasoning for clamping down on banks’ PE activity – the business offers high returns but comes with high risk, and the rule emphasizes that bank customers would be better off without this risk.

Before the economic downturn of 2008, the largest U.S. banks bet billions of their own money through funds they managed – something that resulted in huge losses over 2008-2010. In view of the regulatory clampdown, most of the banks slashed their presence in the private equity business considerably since 2011. Many of them also resorted to alternatives such as the use of merchant banking and business development companies rather than structuring investment vehicles as private equity or debt funds and hedge funds to avoid the Volcker Rule completely (see Here’s Why Wells Fargo’s PE Unit Will Flourish Despite The Volcker Rule and Goldman’s Volcker Rule Policy: Creative And Profitable Compliance).

But Morgan Stanley had adopted a completely different approach – choosing to pursue the profits that exist in the private equity industry in terms of management fees rather than looking for potential gains on investments themselves. As a bank is entitled to a management fee irrespective of the performance of the fund itself, the downside risk to Morgan Stanley’s approach is negligible. At the same time, a notable upside potential exists in the form of performance-related incentives which can allow Morgan Stanley to generate a return on equity in excess of 10% on these investments. [4]

We capture the impact of Morgan Stanley’s private investment revenue on its share value as a part of the “Principal Investments and Other Revenue” driver in our analysis of the bank as shown below. You can see how a better-than-expected increase in these revenues helps the bank’s share price by making changes here.

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  1. Morgan Stanley Raises $1 Billion for Second Mezzanine Debt Fund, Morgan Stanley Press Releases, Jan 8 2015 []
  2. Morgan Stanley Raises $956 Million for Mezzanine Credit Fund, Bloomberg, Jan 12 2011 []
  3. Morgan Stanley Asia Private-Equity Fund Raises $1.7 Billion, The Wall Street Journal, Jul 7 2014 []
  4. Morgan Stanley uses client cash to chase private equity profits, Reuters, Oct 9 2014 [] []