Morgan Stanley: A Big Bet on Hedge Funds

Buying FrontPoint is just one step in a push to modernize its entire business, says the company's head of alternative investments

Amid the rapid growth of hedge funds—assets under management have increased 21% this year, to $1.3 trillion, according to Hedge Fund Research—big Wall Street banks are jockeying for a piece of this steadily expanding sector (see, 10/13/06, "What's Driving the Hedge Fund Boom?"). On Oct. 31, Morgan Stanley (MS) announced that it's buying the hedge fund FrontPoint Partners. Just one day earlier, the investment bank announced plans to enter a strategic alliance with another hedge fund, Avenue Capital Group.

The deals were the result of efforts that had been in the works for several months at Morgan Stanley. And according to the firm's Head of Alternative Investments, Stuart Bohart, they're part of an effort to "evolve" its asset management business by bringing new managers and new fund products to the Morgan Stanley stable. And there will likely be more hedge-fund deals in the future.

Bohart spoke with BusinessWeek Associate Editor Emily Thornton about the strategic thinking behind the latest purchases—and potential deals down the road. Here are excerpts from their conversation:

What does Morgan Stanley hope to achieve by buying hedge funds?

The goal is to evolve our entire investment management business, which is a $500 billion business. We don't view hedge funds as an asset class. We view them as a form of active management in equity or fixed income that tailors risk, uses unique tools, and has fewer restrictions on how the managers pursue returns.

The goal is to bring in new managers and new products and to modernize the broad business. We won't have a sexy, fast-alternatives business in one corner and a traditional one in another. We're going to modernize the entire business by bringing in new talent, new ways of running money, new products, and a much more consultative approach to our clients.

Why was Morgan Stanley interested in FrontPoint specifically?

FrontPoint is part of our strategy to build out our internal capabilities. It's a 100% purchase, and it's a firm we feel comfortable with culturally. Twenty people at FrontPoint are former Morgan Stanley people. We see the FrontPoint people as an important step to bringing in new products and new skills.

What attracted us to FrontPoint was the cultural fit, the exceptional management, and the strength of the team. Their $6 billion in assets provide a significant jump start for Morgan Stanley in the space. The personal relationships are very strong. This is a group that we can really connect with, so it was a home run from every angle.

Will Morgan Stanley buy any more hedge funds outright, as in the case of FrontPoint?

FrontPoint was truly one of a kind. You're not going to see any other 100% large-size purchases from us. We may buy small funds of around the size of $200 million. But we're filling in the edges now. We've covered most of the bases. We have 15 [hedge funds] covering most of the sectors. It would be too much overlap.

What about minority stakes, like the one you have taken in Avenue Capital Group?

[The FrontPoint deal] is distinct from what we will be doing with our partnership programs, where we own between 15% and 20% of outside firms. That goal there is to participate in the growth of firms that are on the cusp of going from being a hedge fund to an investment-management firm. The deals we do will be characterized by firms with multiple products and very solid controls that seek Morgan Stanley's distribution and infrastructure support and can offer our clients capacity in their underlying funds.

We want people to hold Morgan Stanley out as the investment-management firm that can offer access to the world's best portfolio managers. Some of those will work here. And some of them will be outside. We'll have access to both.

Are you planning to take minority stakes in more hedge funds?

We will do four or five more. In my view, there are 15 truly great hedge-fund firms in the world that are on the cusp of going from hedge funds to investment-management firms. I would expect one-third to one-half of them to have an affiliation with a major distribution channel, like Morgan Stanley, in the next couple of years. Those firms will be more interested in having closer relationships with a partner that can support them in their growth.

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