End of the John Mack Era at Morgan Stanley

Morgan Stanley’s decision to spin-off the hedge fund FrontPoint Partners may have come after the Dodd-Frank financial reform bill was enacted but the process was kick-started by management changes at the top ranks of the bank, according to people familiar with the matter.

Morgan Stanley
Oliver P. Quillia for cnbc.com
Morgan Stanley

CNBC reported yesterday that Morgan Stanley is planning to spin off FrontPoint. A spokesperson for Morgan Stanley declined to comment on the matter.

The unwinding of the 2006 acquisition of FrontPoint has been under consideration for several months, these people said. The trigger was the resignation of John Mack as CEO and the elevation of James Gorman to the chief executive spot. Gorman named Greg Fleming head of the investment management division in February. Mack is now chairman of Morgan Stanley's board.

Fleming’s elevation was followed several months later by the departure of the former co-heads of the investment management division, Stephen Trevor and Stuart Bohart. Bohart was a former FrontPoint partner who had come to Morgan Stanley prior to the acquisition. He was closely involved in the 2006 FrontPoint deal, a person familiar with the matter said. For the past few months he served as an advisor to Fleming but had no day to day responsibilities for running the division.

With Mack out of the CEO post, the support for Morgan Stanley’s relationship with FrontPoint began to whither. The elevation of Fleming into the position formerly held Bohart and Trevor left the FrontPoint relationship “hanging in the wind,” a person close to the matter said.

“The Volcker rule in FinReg might be a convenient reason to cut FrontPoint loose. But this cake was baked when Gorman and Fleming took over,” another person familiar with the situation said.

Morgan Stanley bought FrontPoint during a late 2006 hedge fund buying spree by then-chief executive John Mack. In the course of three days, Morgan Stanley announced that it was buying stakes in Greenwich, Connecticut-based FrontPoint, New York-based Avenue Capital Management and London-based Landsdowne Capital.

The acquisition of FrontPoint was perhaps the most important of these deals. In the first place, it was the only deal in which Morgan Stanley bought a controlling stake of the hedge fund manager. More importantly, the deals left FrontPoint executives in prominent roles within Morgan Stanley. Many of the FrontPoint partners were Morgan Stanley veterans, and on their return the investment management division was remade around them.

FrontPoint Chairman and co-founder Philip Duff, a former chief financial officer of Morgan Stanley, reported directly to Mack as a consultant on strategy. Co-founder Gil Caffray was named vice-chairman of Morgan Stanley’s investment management division.

FrontPoint’s chief operating officer, Joanne Pace, became the division’s operations chief. Daniel Waters, who was a managing director at Morgan Stanley before joining FrontPoint, became the head of institutional sales for the division. FrontPoint partner Mike Kelley became the chief investment officer of the absolute returns strategies group in the division. Arthur Lev was tapped to be general counsel of the division, a job he held prior to joining FrontPoint.

Many of these executives have since left the firm or been replaced in these positions. Duff left in late 2007 to become chief executive of Duff Capital Advisors. Caffray left last year to join Touradji Capital Management. Earlier this year Fleming brought in Ed Moriarty, recently of Merrill Lynch, as chief operating officer, replacing Pace. Kelley and Waters lost their titles at Morgan Stanley when Fleming came in, although both remain at FrontPoint.

Morgan Stanley discloses almost nothing about FrontPoint now. It is not clear, for instance, how much money FrontPoint has under management. At the time of the acquisition, Morgan Stanley said FrontPoint had $5.5 billion AUM.

The precise arrangements for the spin-off are still being negotiated.

One source familiar with the situation at FrontPoint said that partners are squabbling about the structure of the separation deal. Lower level employees are said to be nervous about whether their positions will survive the spin-off.

FrontPoint played a prominent role in Michael Lewis’s book "The Big Short: Inside The Doomsday Machine." FrontPoint portfolio manager Steven Eisman, a one-time mentor to well-known banking sector analyst Meredith Whitney, made bearish bets on housing that resulted in a lucrative payoff for FrontPoint.

Under Gorman, Morgan Stanley has been extensively restructuring its investment management division. The division reported its first quarterly profit in over two years in the first quarter of this year but returned to loss-making in the second quarter.

On the second quarter earnings call Gorman indicated that changes were coming to the division, saying that Fleming was examining the “structure associated with the various hedge fund stakes we have.”

Even before Fleming came on, the company was restructuring the investment management division to focus on institutional clients. The retail mutual fund business, Van Kampen, was sold to Investco in a deal that was finalized in June. News reports have said that the company is mulling a possible sale of its property business, including whether to sell it. Other changes are likely in the works, insiders at Morgan Stanley say.

“What we’re seeing is the end of the era of John Mack,” a former Morgan Stanley employee told CNBC.