Leucadia National Corp., which EDGAR tells me is in the “Lumber & Wood Products (No Furniture)” business but which also processes beef, drills for oil, owns a Mississipi casino and develops biopharmaceuticals, is getting out of one business:
Leucadia National Corporation (NYSE: LUK) and Jefferies Group, Inc. (NYSE: JEF) today announced that the Boards of Directors of both companies have approved a definitive merger agreement under which Jefferies’ shareholders (other than Leucadia, which currently owns approximately 28.6% of the Jefferies outstanding shares) will receive 0.81 of a share of Leucadia common stock for each share of Jefferies common stock they hold. …
Leucadia will continue to operate in its current form, except that the merger agreement contemplates that Leucadia’s Crimson Wine Group, with a book value of $197 million, will be spun out in a distribution that is intended to be tax-free to current Leucadia shareholders prior to the completion of the merger.
I assumed that the spinoff was driven by some sort of regulatory impediment (alcoholic or financial), though on the analyst call for the merger Jefferies said that Crimson was just “less synergistic” to the combined business than … I guess, than the casino or the slaughterhouse? Still, I like it: you can combine a casino and a wine business, or a casino and an investment bank, but not a wine business and an investment bank. Do you think the investment bankers are prudes, or the winemakers?
What are the investment bankers up to anyway? It makes a lot of sense for a low-investment-grade wee investment bank who recently overcame a near-death experience re: Eurozone sovereign bonds to sell itself to a highly rated financial conglomerate – a “baby Berkshire Hathaway” no less – with a big balance sheet that can provide cheap funding for its bond-market misadventures. But this isn’t that: Leucadia’s rating is 2-3 notches lower than Jefferies’, and its balance sheet is smaller, though Moody’s is talking about upgrading Leucadia on the deal.
Moody’s also noted that the merger will allow Jefferies to warehouse illiquid risks from time to time within other legal entities in the Leucadia family (subject to Leucadia’s new investment guidelines). Jefferies historical avoidance of less liquid assets has been a key feature supporting the current Baa3 rating. Therefore an increase in the firm’s appetite to underwrite or warehouse illiquid risks (regardless of the “ability” to book them elsewhere in the Leucadia family) could suggest an increase in Jefferies’ overall risk tolerance and put pressure on Jefferies’ ratings.
And here is the Jefferies/Leucadia merger deck on that topic:
Jefferies’ investment banking and trading platforms periodically originate investment opportunities that offer the opportunity to earn outsized returns over the medium horizon
- Leucadia will leverage Jefferies’ 700 investment bankers across 8 industry verticals in offices worldwide, as well as Jefferies’ research and trading platforms
- For example, Leucadia’s investment in Fortescue emanated from a Jefferies introduction
- Opportunistic intermediate term (six months to two+ years) marketable securities investments emanating from Jefferies’ trading flow and market knowledge (such as recent investment in Knight Capital)
Why would you want to run an independent investment bank nowadays? One answer could be that you love the thrill of the M&A business and the feeling of satisfaction that comes from your clients’ confidence in you, and maybe some boutique bankers think that. That explanation is somewhat perilous – there’s, like, no M&A – but in any case it probably does not explain Jefferies; here is a June Goldman research note:
So that leaves you with: you are a trader. You like buying low and selling high, without the Volcker and G-SIFI constraints that your larger, more cheaply funded brethren face. But if you’re Jefferies you’re increasingly running up against other constraints. Turns out nobody likes a 12x levered independent investment bank, or over-reliance on short-term funding, or, umm, Europe, which means that you’re increasingly stuck funding a low-risk, not-too-frightening market-making business with a long-term, expensive balance sheet.1 This is not a recipe for having fun as a trader.2
If you can’t expand risks by levering up a short-term balance sheet, and if the market doesn’t love it when you expand risk by just buying riskier stuff, what does that leave you? The last big risk dimension is time: you can take longer-term risks. You can be a merchant banker. In a strange part of the merger call this morning, Jefferies CEO – and soon-to-be Leucadia CEO – Richard Handler revealed that was his lifelong dream. A Sandler O’Neill analyst asked how long this merger had been in the works, and Handler said something like “you’re not going to like this answer, but I’ve been planning for this my whole career.” He admires the Leucadia team – they’re investors, they spot value, they buy low and sell high, etc. – and he wants to be them.
So he ran an investment bank, because once upon a time that was a good place to do that. Now it’s not: post MF Global, it’s hard to put much of anything long-term on your balance sheet without freaking out the markets. So why not take over a … a beef-processing-timber-cutting-biopharma-developing conglomerate? Anything you buy in Jefferies will be scrutinized closely; anything you buy in Leucadia, given that hodgepodge background, will fit right in. Except I guess a winery.
1. From that same Goldman note:
Or take leverage: per Bloomberg, Common Equity/Total Assets was 6.75% at the end of 2010; now it’s 9.79%.
2. Nor is it necessarily a recipe for high returns on equity for shareholders. As has often been noted, there is significant alignment between what is fun for bankers and what is good for shareholders. Not total alignment, but significant.