02/12/96 MORGAN STANLEY'S GLOBAL GAMBLE

MORGAN STANLEY'S GLOBAL GAMBLE
The investment bank is charging into the Third World. Will it get burned?
The 90-year-old landmark building is anything but prepossessing--here in the Fort section of Bombay. The elevator is broken, forcing visitors to walk up the dilapidated stairs. But on the fourth floor is a modern office, with its own power and telecommunications lines and Indian employees working at computers. Welcome to fortress Morgan Stanley, a key beachhead on the subcontinent for the prestigious investment bank. Since 1992, Morgan Stanley Group has invested $25 million and recruited 62 employees, with plans to expand to 150 by 1998.
Despite India's ragged infrastructure--phones in this city of 14 million are unreliable, and the Bombay Stock Exchange is swamped by mountains of paper-- Morgan Stanley is now the largest American investment bank in India. The firm's goal is to capitalize on the dramatic expansion of the Indian economy unleashed by extensive reforms. Morgan is convinced that it is getting in on the ground floor. ``The advantage of being first is you can help shape things and events,'' says Pradip Darooka, executive vice-president of Morgan Stanley Trust Co.
India is far from the only place Morgan Stanley is planting its banner. The firm has been opening offices, raiding local talent, and scrambling for deals from Beijing to Johannesburg to Sao Paulo. Morgan is betting that the capitalist revolution sweeping through much of the world is irreversible and that newly minted free markets will generate red-hot economic growth and, eventually, profits. ``High growth rates create wealth,'' says Richard B. Fisher, Morgan Stanley's chairman. ``Wealth is what generates business for us.''
SMALL TOWN. Leading the attack is Morgan Stanley's hard-charging president, John J. Mack. Lately, he has been skiing with Mexican clients, setting up a joint venture in Beijing, and angling for a role in the privatization of Indonesia's phone system in Jakarta. Mack, 51, hardly fits the mold for the quintessential white-shoe firm and lacks the pedigree one associates with Morgan Stanley. The son of Lebanese immigrants, he grew up in a small North Carolina town and worked throughout boyhood and college. A former bond trader, Mack is pushing Morgan Stanley to change its conservative culture, to become bolder and more aggressive. ``It's grow or die,'' says Mack. ``The biggest risk is not to invest.''
Morgan Stanley's new Times Square headquarters symbolizes the transformation. It's an attention-getting glass box wrapped with neon bands of real-time currency quotes and stock prices. Inside is a high-tech hub of emerging-market information. Morgan Stanley staff have access from their desktop personal computers to an online database with exhaustive information on 65 countries. And Morgan Stanley Capital International, based in Geneva, creates and maintains 3,500 different international-market indexes that are the standard for the industry.
``MOST DARING.'' Morgan is not alone in betting on the Third World. It is waging a fierce battle with such U.S. archrivals as Merrill Lynch, Goldman Sachs, J.P. Morgan, and too many foreign banks and brokers to mention. Some are ahead of Morgan in certain markets, such as CS First Boston in Russia. Merrill Lynch has been lead manager of more large privatizations. But while it's hard to evaluate the extent of a firm's global presence, Morgan Stanley earns kudos for its all-around leadership position. ``They are the premier emerging-markets firm,'' says J. Mark Mobius, president of Templeton Emerging Market Funds, a client and rival. ``They are the broadest in scope and the most daring to move into new places, and they have a very large commitment.''
That commitment is driven by the need to develop new sources of high-margin business. In 1995 Morgan had a banner year, earning $600 million and ranking third in worldwide underwriting and first in U.S. and international mergers and acquisitions, says Securities Data Corp. But in the U.S., margins on such activities as underwriting are under extreme pressure. New markets are by nature more inefficient and thus more profitable than mature markets. Morgan Stanley is trying to repeat the success it had in Tokyo in the 1980s: Along with other U.S. securities firms, it reaped handsome profits with superior technology and sophisticated financial products.
In the process, Morgan Stanley could emerge as an important architect of modern financial markets in countries such as India and China. As such, it would have considerable impact there. Morgan Stanley now acts as these nations' link to the world capital markets, which helps foster economic growth. For example, Morgan Stanley is pushing to set up a better system for clearing trades in Bombay and is building the first Chinese investment bank (page 68)--in much the same way it pioneered country funds, which brought long-term capital into developing countries.
Mack and Fisher are not betting the ranch. If Morgan Stanley's entire emerging-markets business dried up, the damage would be limited: It accounted for only 10%-15% of 1995 revenues, by one estimate. Morgan Stanley's strategy is to build for the long term in a focused, gradual, and cost-conscious manner. For instance, the firm opens an office only when a specific U.S. business unit, such as asset management or commodity trading, agrees to pay for its startup. Other businesses are then added gradually. In parts of the world where Morgan Stanley has no offices, it relies on frequent visits by bankers and analysts based in New York, Hong Kong, or London. ``You can't look at it on a year-to-year basis,'' says Mack. ``It's a marathon, not a race.''
Nevertheless, Mack and Fisher are taking a big gamble with significant risks. Emerging markets are complex and treacherous. Most immediate is the financial impact. To build for the future, the firm is accepting lower earnings. Morgan's 17% growth in overseas personnel in 1994 cost the firm four percentage points in return on equity: Its ROE was 8.8%, instead of 12.8% in 1994.
TURBULENCE. The external risks are also huge. Business could dry up if U.S. pension, hedge, and mutual funds get cold feet about investing in emerging markets. When emerging-markets mutual funds fell 5% in 1995, many investors switched their investments to other funds. The firm itself could incur big trading losses in turbulent emerging markets, which it did in 1994. And there's the constant danger of political instability stalling market reforms. Many foreign financial markets are decades behind the U.S. and lack legal and regulatory protections, accounting systems, and clearing mechanisms. They can also be rife with fraud and corruption.
Perhaps Morgan Stanley's biggest risk is harm to its vaunted reputation. In 1994, to loud fanfare, Morgan launched India's first mutual fund. But the launch was rocky, and the fund's performance mediocre. In 1995, the Bombay index fell 20.8% while the fund was down 28.2%. The effect was to tarnish Morgan Stanley's image in India (page 70). ``Emerging markets are very imprimatur-conscious, and Morgan Stanley is a name they all understand,'' says Samuel B. Hayes III, a professor at the Harvard business school. ``If they lose their good name, they're in trouble.''
Fisher believes the risks are manageable. ``We would not hesitate to change course if the situation changed,'' he says. ``But everything we see as we get into these businesses convinces us we're right.''
Morgan Stanley has a history of transforming itself to adapt to change. The firm was formed in 1935, after the government forced commercial banks to shed their investment banking arms. Howard Stanley and Henry S. Morgan, son of J.P., resigned from J.P. Morgan & Co. and formed Morgan Stanley. Until the 1970s, Morgan Stanley was a private partnership. In the 1970s, it began a trading operation and by the late 1980s had built a major presence in London and Tokyo. The firm went public in 1986. Yet Morgan Stanley is 40% employee-owned, and it retains its partnership culture.
The commitment to emerging markets comes right from the top. Fisher is the father of the firm's globalization push, but it took Mack's management muscle to break down fiefdoms within the firm to carry out the plan. Mack has worked for Fisher for his entire 21-year tenure at the firm, and the two are extremely close. While both visit clients, Mack runs the firm day-to-day, and Fisher concentrates on strategy. Fisher, 59, is a measured, private, Princeton man who is viewed as the firm's best salesman. ``Dick makes you feel like you're the only person he has to see that day. There's a tremendous grace to that,'' says Robert Matschullat, ex-head of global investment banking at Morgan Stanley and now vice-chairman of Seagram Co.
By contrast, Mack is impatient, willing to trust his instincts, and runs a tight ship. Mack was furious when a budget for Morgan Stanley's Chinese joint venture, requested in August, 1995, hadn't been delivered by December. With the O.K. of his Chinese partners, he quickly replaced the head of the joint venture, Edwin Lim, even though Lim was the architect of the venture. ``Running the bank was never really part of my assignment,'' Lim insists.
TIGHT SHIP. Mack is also known for bluntness. After moving to New York in 1968, he met broadcaster Charlie Rose and Rose's then wife, Mary, at a party. Mack's first question upon meeting Mary was, ``Do you have a sister?'' It turned out she had a sister named Christy, whom Mack later married.
Mack, the youngest of six boys, grew up in Mooresville, N.C. (pop. 11,000). His father ran a wholesale grocery business. Mack went to Duke University on a football scholarship and worked at a small brokerage--earning $325 a month.
Moving to New York, Mack took his first Wall Street job at Smith Barney, as a municipal bond trader and salesman. In 1972, Fisher, then head of fixed-income, hired him at Morgan Stanley. Mack made his name building Morgan Stanley's bond-trading operation, which became hugely profitable in the late 1980s. Mack earned respect as a tough, sometimes brutal manager. In 1993, he replaced investment banker Robert Greenhill as president.
Despite the $2.5 million Mack made in 1994 in salary and bonus, he remains down-to-earth. He lives in Westchester County, N.Y., with his wife and three children and has houses in North Carolina and Utah. His office is dominated by a large, realistic painting of a woman swimming underwater, and he keeps the TV on CNBC with the sound off. Mack enjoys hobnobbing with all types, from Senator Jesse Helms (R-N.C.) to Argentine President Carlos Menem to IBM CEO Louis V. Gerstner Jr. ``For the head of a corporation, he doesn't surround himself with a lot of the trappings,'' says New York Police Commissioner William J. Bratton, a friend.
Morgan Stanley's push into emerging markets began in earnest when Mack became president. At the time, several rivals were cutting back. Mack decided this was just the moment to push hard. And he didn't want to repeat a 1989 blunder: The firm cut staff in Hong Kong by 50 and deactivated its seat on the Hong Kong Stock Exchange, only to build back up in 1993. Competitors still love to remind clients of Morgan's fickleness. ``In 1989, we decided to take our chips off the table in Hong Kong,'' says Mack. ``We realized it was a mistake.''
Asia is clearly Morgan Stanley's top priority: From 1990 to 1995, the number of employees in Asia outside Japan soared from 90 to 540. Staff costs alone total $200 million a year.
INFLUENTIAL FRIENDS. A key to Morgan's success so far has been its ability to adapt to local unwritten business rules, which are infused by relationships and politics. A good example is Morgan Stanley's campaign in Indonesia. Initially, the firm lost the 1994 competition to underwrite the privatization of PT Telkom, Indonesia's local phone system, to four other Wall Street firms. Although Morgan said it could raise $2 billion, its rivals promised an impossibly large $3 billion. The deal, which raised only $1.7 billion, was a fiasco.
Morgan Stanley had to settle for a secondary role--of financial adviser to PT Telkom--but it won points with government officials for giving more realistic advice. That helped Morgan proceed with a longstanding plan to set up a joint venture with two well-connected, local partners. The partners are a holding company owned by Siti Hardiyanti Rukmana, a daughter of President Suharto, who has held power for three decades, and PT Makindo, an Indonesian brokerage. The venture will be capitalized at $10 million and should be up and running this year. If all goes well, Morgan Stanley will underwrite lucrative initial public offerings as the government gears up to privatize 50 of the companies it owns.
Morgan is also gaining entree to developing countries by using its established global businesses. Take Morgan Stanley Asset Management (MSAM), which manages $100 billion. Morgan is a top manager of institutional and retail emerging-markets funds: Its only serious Wall Street competitor is Merrill Lynch. In emerging-markets assets, it ranks fourth--after Templeton, Fidelity, and Capital Guardian--with $5.2 billion. In Thailand and Indonesia, being in early with country funds gave Morgan an edge in winning investment-banking deals. ``Our presence through MSAM in traded financial markets is clearly the most important advantage we have,'' says Fisher.
LOQUACIOUS. MSAM's chairman is Barton Biggs, who played a key role in giving Morgan Stanley a headstart in emerging markets. Biggs worked with International Finance Corp., an arm of the World Bank, in the mid-1980s to get Morgan Stanley to launch some of the first country funds, such as the Malaysia Fund in 1985. Some of Biggs's calls have been wrong, and others have landed the firm in hot water with local authorities. Yet the persuasive Biggs gets credit for popularizing investing in emerging markets. For years, he has been promoting such remote places as Myanmar and Vietnam. He has a following among a group of influential U.S. and foreign institutional investors who accompany him on his annual trip to different emerging markets. ``He moves markets, so you have to listen to him,'' says one money manager.
MSAM is not the only unit that gives Morgan Stanley great on-the-ground intelligence on emerging markets. Morgan Stanley Capital Partners, the firm's merchant-banking fund, has $100 million invested in three Chinese and Indonesian firms. Its global custody business, the mundane business of clearing and settling trades for clients in 64 countries, provides Morgan with an intimate familiarity with the nuts and bolts of each nation's markets. Morgan Stanley is the only U.S. investment bank in this business, where it competes with U.S. commercial banks. It ranks 11th, with $117 billion worth of assets in custody. Morgan Stanley executes trades through a worldwide network of banks and a sophisticated computer system.
HIGH HURDLES. Will Morgan Stanley's global bet pay off? The firm has done a solid job entrenching itself around the world, but it faces many hurdles because of primitive financial infrastructures in many countries. In Russia, for example, stockholders don't legally own stock until their names are written on a list maintained by the companies' registrar. This means that to process trades, Morgan agents must travel to the registrars to make sure the names are on the lists. In India, it takes 12 days for a trade to clear, and a stack of paper a foot high is generated to clear one trade.
The firm must deal with cultural challenges as well. Some 34% of its employees are locals in their respective countries--and they span 20 different nationalities. This makes it more difficult to maintain high standards and its cohesive WASP culture, which dictates even where headquarters staff should live, namely, Greenwich, Conn., or Rye, N.Y. ``We have to work hard to demonstrate we're not a bunch of white guys from Greenwich,'' says Thomas DeLong, Morgan Stanley's chief development officer.
More serious, though, is its vulnerability to well-heeled rivals. For example, in December, 1995, it lost to Merrill Lynch in vying for the job of selling Brazilian mining giant Companhia Vale do Rio Doce (CVRD)--likely to be Latin America's largest privatization ever. One miscue was Morgan's bidding strategy: It went from a front-runner to being disqualified because its bid was too low even to be considered.
But that was only part of the problem. Morgan Stanley has strong Latin American credentials, with its team led by Francisco Gros, former president of the central bank of Brazil. He and other Morgan bankers and analysts in New York frequently visit Latin American clients. But Merrill Lynch, which won the $5 billion CVRD mandate and could take in the bulk of a juicy $95 million fee, has nearly 100 employees in Brazil and is highly visible in local financial circles. Rivals say Morgan lost because it lacks local presence and experience. ``Your level of understanding is different when you're here,'' says Eduardo Saad, managing director of Merrill Lynch in Sao Paulo.
Morgan Stanley faces tough competition from commercial banks with investment-banking capabilities. In 1994, for example, Morgan Stanley won over 40% of all Mexico's equity issues. But in December, 1994, when the new government devalued the peso and plunged the country into recession, Morgan Stanley's business dried up overnight. Mexican company stocks plummeted, and the international markets snapped shut.
But commercial banks with investment banking arms as well, particularly J.P. Morgan and CS First Boston, were able to offer corporate clients emergency bridge loans during the crisis, a capability Morgan just announced in January, 1996. Grateful clients rewarded those banks with their first international debt issues when capital markets reopened six months later. ``The banks that wear two hats [investment and commercial] are in a particularly advantageous position in Mexico today,'' says Peter T. Hutchison, who was chief financial officer of Grupo Alfa, a Monterrey conglomerate. Even the recent privatization plums have gone elsewhere: J.P. Morgan is advising the government on the petrochemical sell-off, and CS First Boston beat out Morgan for the government contract for the railroads.
With so many businesses, Morgan Stanley must be careful about potential conflicts between its own and its customers' interests. In Europe, Morgan Stanley is fighting accusations about its conflicting roles in the collapse last year of the $120 million Global Opportunity Fund, registered in the Cayman Islands. Morgan Stanley's Luxembourg operation was the fund's custodian and administrator. While Morgan's London office lent $34 million to the fund's investors, 20 investors claimed losses of $70 million and are suing the firm in a Luxembourg court for gross negligence, mainly over Morgan Stanley's inflated valuations of the fund. Investors also say that when the fund tanked, Morgan Stanley's first priority was to recover the $34 million. A firm spokesperson denies this and blames the collapse on the fund manager, saying he misled them on the fund's value and made unauthorized trades.
Given the hazards of the markets in which it is playing, Morgan Stanley could well stumble as often as it succeeds. It believes, though, that it is taking intelligent, cost-conscious risks. ``I think we have the most resources and the most conviction,'' says Fisher. ``We could be wrong. We won't know for five years whether we are right.''
BY LEAH NATHANS SPIRO IN NEW YORK, WITH SHARON MOSHAVI IN BOMBAY, MICHAEL SHARI IN JAKARTA, IAN KATZ IN SaO PAULO, HEIDI DAWLEY IN LONDON, GERI SMITH IN MEXICO CITY, AND DAVE LINDORFF IN HONG KONG