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Morgan Stanley has announced that it will be buying 14% of its Morgan Stanley Smith Barney joint venture from Citi in a sort of glacially negotiated way. MS currently owns 51% of MSSB (plus $5.5bn of preferred interests), and Citi owns the other 49% (plus $2bn of preferred). You can read how they’re going to figure out the price here. Basically they each hire an advisor to value MSSB like a public company, and then get together and see how close they are. If they’re within 10% of each other, they average their prices; if not, they hire a third advisor to figure out who got closer to the right answer. Don’t get too excited about pitching to be one of those advisors, though, at least not in the first round:
Morgan Stanley and Citigroup each will engage one investment bank or financial advisory firm of national standing and with experience in the valuation of securities of financial services companies (an “Appraiser”) for purposes of estimating FMV. All fees and disbursements of the first two Appraisers shall be the responsibility of the party that engaged such Appraiser. Either or both of the first two Appraisers may be an affiliate of the party engaging such Appraiser, and Morgan Stanley has engaged Morgan Stanley Investment Banking as its Appraiser.
MSSB’s net income was about $300mm last year*, and recent Morgan Stanley Investment Banking valuation precedents suggest about a 100x P/E, so I’ll go ahead and predict we’ll see a $30bn-ish valuation from them, no? (Too easy? Actually, ha, it’s not that wildly off; press reports suggest a $15bn bid from MS and a $23bn offer from Citi.) Here’s how they’ll do their math:
Under the LLC Agreement, FMV will (i) not include any control premium, (ii) not include any discount due to the illiquid nature of the Membership Interests or any discount relating to the fact that MSSBH is not a public company, (iii) take into account (A) the prospects of MSSBH, (B) the value of the estimated future earnings of MSSBH, (C) the size of MSSBH, (D) the public market trading values of comparable companies, (E) the business mix of MSSBH relative to comparable companies and (F) such other factors as the Appraisers (as defined below) deem relevant, (iv) be based on (A) the valuation of MSSBH and its subsidiaries taken as a whole, (B) an assumption that MSSBH will remain independent and have the continued ownership of its subsidiaries and (C) an assumption that the then existing contractual relationships among Morgan Stanley, Citigroup and MSSBH and their respective controlled affiliates shall remain in full force and effect and continue in accordance with their terms (other than certain transaction documents that terminate in accordance with their terms), (v) take into account whether or not any items are non-recurring and (vi) assume that all funding contribution obligations and obligations to make any delayed contributions of certain businesses to MSSBH have been satisfied or made and all delayed distributions of certain businesses from MSSBH to Morgan Stanley and Citigroup have been effected.
Which seems fine – ignore the nebulosity of control premiums and liquidity discounts, and otherwise basically “do what a sensible M&A banker would do.” So why spell it out? When I sold equity derivatives sometimes people expressed interest in buying or selling calls with a strike price to be set equal to the market price at the time of exercise, and it was always fun to explain why that was not of much interest to anyone. Exercise for reader etc. to prove why that call option is normally worth something right around zero.
But sometimes it’s worth something! This is a good example. It seems pretty likely that Morgan Stanley wants as much MSSB as it can get (subject to some capital and funding concerns) at pretty much any reasonable price, as it would be accretive to earnings and helpful to a story of “hi we are a client-centered brokerage and have no plans to blow ourselves up whaling.” Similarly Citi should want out of MSSB at any reasonable price, as it would be accretive to capital, which Citi needs, and helpful to a story of “hi we are a commercial bank and not an amalgam of random minority stakes in things we ended up thinking better of.” So the range of market-clearing prices in this two-player market is pretty wide, and it makes sense to narrow that range with some sort of appraiser-driven process rather than just posture-y negotiations.
Lots of M&A deals have a similar dynamic, though, with a motivated buyer and seller and a wide valuation gap, and those deals get resolved not by financial advisors submitting their best guess and averaging them, but by those advisors (and their principals) negotiating with each other – by arguing rationally and/or irrationally about the most appropriate inputs to use in considering the factors that the LLC agreement here painstakingly spells out. Existing JVs are more likely to have arrangements like these, as a way to deal with the difficult dynamics in advance – but it’s a little tempting to view the detailed arrangement here as in part the cynicism of two banks who know how a negotiation would go. Arguments about the right discount rate to use in valuing the JV are unlikely to sway people used to making those arguments in a mercenary way for their clients – and who are now evaluating them in light of their own self-interest. So why not put your faith in game-theoretic approaches to choosing and persuading the third appraiser, rather than in trying to convince a counterparty who’s heard it all before?
There are alternatives to the appraisal process, I guess. One way to get to a fair price with less gamesmanship might be to do a market check – shop the stake and see if anyone is willing to pay more than Morgan Stanley. But that, of course, would be silly for lots of reasons, including the fact that there’s unlikely to be much of a market. Who would want to buy several billion dollars worth of minority interest in a controlled business where they have no management rights?
Morgan Stanley Aims To Raise Stake In Brokerage Joint Venture [Dow Jones]
Morgan Stanley 8-K and press release [EDGAR]
* See page 66 here – MS doesn’t break out MSSB from the rest of its wealth management business, but attributes $146mm of net income to the 49% noncontrolling interests, which means that total net income for the JV should be $298mm. Here are estimates from a GS research note from March; they valued the thing then at about $17bn based on DCF but $12.5bn based on public comparables:
Citigroup currently carries its 49% interest in MSSB at $10bn, which implies a valuation for the total joint venture at slightly over $20bn. Morgan Stanley does not disclose the carrying value of Citigroup’s minority stake, but we do know that total non-controlling interests on the balance sheet is $8bn, which implies that the most MS could be valuing the total joint venture is just over $16bn (i.e., a valuation gap of $4bn vs. Citigroup’s). However, as we believe this includes other non-MSSB minority interests, we estimate MS carries MSSB at $15bn, leaving the valuation gap at close to $5bn.
** Freestanding footnote re the headline: yes I know that they don’t actually allocate clients based on equity ownership – the MSSB clients are all clients of MSSB; C and MS just divide the income; MS is not actually roping in 14% more clients. Whatever.