Leucadia rescues Jefferies, which rescued Knight

The acquisition will help the struggling investment bank ride out the storms on Wall Street.

By TheStreet Staff Nov 12, 2012 3:12PM

Life ring copyright Blend Images, Jupiterimages, JupiterimagesBy  Antoine Gara


When trading firm Knight Capital (KCG) needed a rescue in August, it called Jefferies (JEF) to arrange a last-minute deal with a handful of investors.


Now, only a few months later, Jefferies is getting its own capital injection by way of a sale to Leucadia National (LUK), which values the struggling investment bank at roughly $3.6 billion.


The Monday morning merger with Leucadia National isn't the last-minute call for capital that put Knight Capital into the hands of Jefferies and a handful of other investors, however, the low price of the deal signals Jefferies was in need of a balance sheet injection to withstand a bleak Wall Street outlook.


In the merger, Leucadia National -- already a 28.6% shareholder in Jefferies -- will offer 0.81 of its shares for each outstanding Jefferies share in a stock deal that's valued at roughly $3.6 billion as of Friday's close.


After the deal is completed, Jefferies chief executive Richard Handler will become CEO of the combined companies and Jefferies will be Leucadia's largest business among a span of insurance and finance operations that make some consider it a mini Berkshire Hathaway (BRK.A).


A press release announcing the deal keyed in on capital and the $9 billion in shareholder equity that the combined companies will now have.


Leucadia's co-founder Joseph Steinberg will become chairman of the combined company and Ian M. Cumming, another co-founder, will retire but remain a director.


Jefferies' merger with Leucadia comes at a time when the firm's investment banking and trading units face pressure from a weak economic outlook, the burden of expansion efforts and new regulations that make it more costly to do business.


Meanwhile, Jefferies status as an independent Wall Street dealer a fraction of the size of competitors like Goldman Sachs (GS) and Morgan Stanley (MS) caused ratings agencies like Moody's and independent analysts to downgrade the firm's bond ratings just above investment grade levels that are crucial to survival.


Just over a year ago, trading firm MF Global filed for bankruptcy after an outsized position in European government bonds caused ratings agencies to question the firm's capital and cut its bond ratings to junk. In the aftermath of MF Global's demise, investors and some analysts questioned whether Jefferies would be next.


While the Monday deal staves off any lingering comparison to MF Global, it gives fresh evidence of the struggles gripping Wall Street, as even large players like UBS (UBS) exit key trading areas.


For Jefferies employees, the deal may be a relief. On a conference call with analysts, Jefferies CEO Handler said business is expected to be as usual at the investment bank on Monday and there are no expected layoffs to go with the merger. Meanwhile, all Jefferies employee stock grants will convert to Leucadia units at the terms of the all stock transaction.


A key part of the deal is the assumption that the ongoing profitability of Jefferies will create the earnings to utilize a large net operating loss held on Leucadia's balance sheet, converting it into tangible capital that could bolster future trading and banking business.


Monday's deal completes a frenetic year for Jefferies. In early November 2011, independent ratings firm Egan Jones cut Jefferies bond ratings to BBB- citing the bank's near $3 billion exposure to European government debts, which it said represented 77% of the firm's shareholder equity.


Shares plummeted 20% and prompted Jefferies and its long-time chief executive Jeffrey Handler to liquidate the firm's European debt position by the end of 2011, in a quick move that cut against some of the worst-case scenarios Egan Jones had expressed.


Jefferies started 2012 on new footing and without analysts predicting its demise. After taking a 22.8% stake in and advising Knight Capital on its rescue efforts, Jefferies posted record third quarter results in September. Still underlying the firm's record profit - largely due to its Knight Capital stake -- were weak results in its core trading and investment banking business that augured poorly for its future.


Excluding the stake in Knight Capital, Jefferies missed profit expectations, according to analysts polled by Thomson Reuters, as core investment banking and trading businesses showed a slowing in revenue over the course of 2012.


While Handler saw results as evidence of "the best nine-month period in our firm's history," and a balance sheet in record-strong position, according to a statement released with earnings, investors and ratings agencies saw differently.


In mid-October, Moody's cut Jefferies bond ratings to a step above junk, citing the firm's increasing need of capital as it expands trading and investment banking businesses.


"Since the onset of the financial crisis in 2007, Jefferies has grown significantly and opportunistically," Moody's said. "This growth also introduces risks as the firm integrates the people and operations that it has acquired, and establishes long-term discipline around risk-taking."


The downgrade and Jefferies subsequent deal with Leucadia in a matter of weeks indicates that the investment bank was in need of capital or a strategic partner to survive a new trading environment on Wall Street of higher capital costs and diminished revenue opportunities.


In the financial crisis, investment banks like Bear Stearns and Merrill Lynch fell into the arms of larger players like JPMorgan and Bank of America. Meanwhile, other independent Wall Street players like Lehman Brothers and MF Global fell to bankruptcy.


Earlier in November, financial sector advisory company KBW (KBW) said it will be acquired by St. Louis-based investment firm Stifel Financial (SF) for $575 million, in a deal that had little premium attached to it.


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