Tuesday, November 13, 2012

Leucadia-Jefferies Merger

So this is what it comes down to.  Leucadia (LUK) buys Jefferies (JEF) and solves some problems with one deal:
  • Succession:  since Handler will become CEO of the post-merger Leucadia, succession is no longer an issue.  Handler is well regarded and is known to be a very solid, conservative manager.  I have no problem with Handler at all.
  • JEF Liquidity Problem:  Actually, I don't think JEF has a liquidity problem and I don't think they had one last year.  But clients and markets have gotten much flakier post-crisis, and ratings agencies seem trigger-happy (and sloppy), so there was a risk that JEF had to manage over-conservatively to compensate for this.  In fact, I think most of the industry is in this situation, and that's why I think the JPM investment bank has higher ROE than the independents (GS, MS etc...).  As long as JEF resides inside of LUK and LUK has plenty of liquidity, this will reduce the risk of "runs" and impact of bad ratings agency opinions. (The fact that LUK is junk rated doesn't matter as long as they have the cash/liquidity)
  • Deferred Tax Assets (DTA):  I didn't do the math on this yet, but this really accelerates the realization of the DTA since JEF earns $300-400 mn/year in operating earnings.  Whatever discount factor we applied to the DTA on the balance sheet can be reduced as it will now be realized much more quickly than before.  I may take a look at that later (but maybe not).
Anyway, here is a presentation on the merger from LUK's website:

Leucadia-Jefferies Merger Presentation

Here are some quick highlights:

The New LUK (no pun intended)
This is what LUK will look like after the merger.

44% of the value (at book) of LUK will be in JEF.  This does change materially the nature of this business.  I know some folks who are fans of BRK, L, LUK and other of these value investing conglomerates don't like investment banks.  So just because of that, I can see why many LUK shareholders are not happy with this deal and would sell their shares.

I am not allergic to investment banks as readers here know.   So I have no problem. 

Past Performance
Here is the long term performance of both of these entities over the long term. 

Since both of these entities are more or less trading near book, stock price is a reasonable proxy of performance (as opposed to looking at something that might have been grossly undervalued at the beginning of the period and way overvalued at the end of the period, like looking at the S&P 500 index performance between 1982 and 2000, for example)

JEF Long Term Performance versus Peers

Of course, one can argue, "but they needed to be bailed out during the crisis...".  They did lose money during the crisis and did get an equity infusion from LUK.  This is true.  But the fact is that they were able to raise the needed capital, and their business model was sound.  Of course it will bother many that they actually needed to raise capital, regardless of how well it was done.  That is enough for some people to not want to be involved in this kind of business.  Fair enough.

BPS Growth Versus the Usual Suspects
So just how good is this guy Handler, though?  He became CEO in 2000/2001 but since we have data for JEF going back to 1996, let's look at how book value per share has grown over that time versus the S&P 500 index, Berkshire Hathaway (BRK) and Leucadia (LUK) itself.  I just put some charts together quickly to take a look.  These are not from the merger presentation.

This chart is the BPS growth (indexed to 100) of the various companies since 1996 (December 1996 - December 2011).  The S&P 500 index figure is just the total return of the index.

It is remarkable how well JEF has done over this time period.  Keep in mind that this chart understates returns because it doesn't include the ITG spinoff from JEF back in 1999.

Judging from this, JEF has done way better than even LUK and BRK.    So it makes sense that this is a sort of reverse takeover of LUK by Handler!

Just to make sure this isn't due coincidentally to two lucky data points, I looked at the same figures starting at the end of 1999 which was the peak of the bubble in the stock market (at least in year-end terms).  Here is how the usual suspects have grown their BPS over that time:

Again, JEF outdoes everyone, including BRK.

I also did the same for the period 2007-2011, but didn't bother with creating a chart.

Here is a table that summarizes the above stuff:

BPS Growth Including Dividends (S&P 500 index is just total return), annualized

Period:                 JEF               BRK          LUK         S&P 500
1996 - 2011:        +15.4%         +11.7%       +9.9%       +5.5%
1999 - 2011:        +13.9%           +8.4%     +11.8%       +0.6%
2007 - 2011:         + 5.6%           +6.4%       +0.2%        -1.6%

It's pretty impressive.  I didn't think I would get this result before I put these charts together.  But there it is.

I read somewhere that LUK is no BRK as BRK would never do such a deal as this or some such.  Well, maybe LUK is better than BRK judging from these figures!

Keep in mind that this JEF performance was accomplished in a pretty horrible environment with two big bear markets, financial crisis etc. in an industry that was the epicenter of the crisis.   And of course it includes the loss and equity infusion during the financial crisis.  You will notice that this was done with barely visible damage.

Contrast that with the real bailouts (as opposed to JEF's proactive, preemptive capital raising) of say, Citigroup, Bank of America and AIG.  The book value growth graphs and stock price charts of those would show a very different picture.

Anyway, with JEF, what's not to like?  (unless you are bancophobic)

After the Merger: Different Business

So here's an interesting slide from the presentation.  They actually set parameters for the new LUK.
After the merger, the largest equity investment (excluding JEF) will be no greater than 20% of book value, and no other investment can be greater than 10% of book value at the time of investment.  Also, there is a new leverage limit (as shown above).
This may be due partly to make sure no post Cumming/Steinberg CEO blows LUK up, and partly to stabilize the non-JEF part of LUK as liquidity may be needed to support JEF in times of stress.   
In a sense, this may be the opposite of the Berkshire Hathaway (BRK) model:  BRK owns insurance companies that provide float that BRK can use to make investments while LUK may now have to hold excess cash/liquidity at low returns as reserve in case JEF needs it.
But there would be some advantages from this in terms of capital efficiency that is similar to BRK.  When JEF has business with decent return potential, LUK can inject more capital.  When the opposite is true, they can transfer capital out of JEF into the non-JEF part of LUK.  Of course, this can't be done without the approval of regulators as capital regulations are very strict when it comes to transferring cash in and out of a regulated subsidiary to and from a non-regulated parent.  But this is true with BRK and the heavily regulated insurance companies too.
It is capital efficient in the sense that if JEF was independent and they wanted to maximize capital efficiency, they may buy back a ton of stock during slow times and then have to raise equity capital when things start to pick up.  This can be costly and very inefficient, not to mention the problem of having to raise capital possibly during times of crisis when an independent JEF's stock price may get really cheap (and therefore expensive to raise capital). 
You can get a sense of this capital inefficiency of independents when you listen to Goldman Sachs conference calls.  On the one hand, they want to buy back a ton of stock as they are underutilizing their capital.  But on the other hand, they don't want to be left short of capital when things start moving, the markets come back and business picks up again.  For GS, it's pay dividends and buy back stock, or sit on their capital and wait.
With a JEF/LUK combination, there would be more choices to choose from.  There are more levers to pull in terms of optimizing capital efficiency. 

This added flexibility really does enhance the opportunity for value creation of the combined entity.
LUK is Cheap
Anyway, moving on.  So what happens to LUK post-merger?  If you own LUK stock now, what is it going to be worth after the merger?
After the deal (which includes the pre-merger LUK spinning off Crimson Wine), LUK will have total assets of $42.1 billion, total shareholders equity of $9.3 billion and a book value per share of $24.69/share.
The stock closed today at $20.75.  The above $24.59 post-merger BPS excludes Crimson Wine, which will be spun off before the merger.  That is worth $0.81/share.  I have no idea what Crimson Wine will trade at after the spinoff, but assuming it trades at $0.81/share, the post merger value of LUK and Crimson together would be $25.40/share, so LUK is trading at a 18% discount.
That's pretty cheap.  But to be fair, so are most other financial companies and after the merger, LUK is going to be half an investment bank.
Merger Arb
This is an all stock deal.  JEF shareholders will receive 0.81 shares of LUK and they expect the deal to close in the first quarter of 2013.  Before the deal closes, though, LUK will spin off Crimson Wine, which has a value (at book) of $0.81/LUK share. 
The current LUK price is $20.75, and less $0.81/share (Crimson spin), that gives a value of $19.94/share of LUK that JEF holders will receive.  They get 0.81 shares per JEF share, so that's $16.15/share in value to JEF holders.  JEF closed today at $16.00/share, so that's a $0.15 discount.
LUK has a dividend of $0.25/share and JEF is $0.30/share (both annualized).  Since there will be only one dividend payment (according to last year's dates for JEF), that's a net dividend of $0.0125 for the long JEF/short LUK position.

With 138 days until March 31, 2013, a $0.15 discount plus $0.0125 net dividend works out to a 2.7% annualized return; not much.

If you are an institutional investor and get cheap leverage and can finance this long/short at 40 bps (Fed+20 bps to finance long, receive Fed-20 bps on short) and can get 6x leverage (15% capital), I guess that works out to 13.8% annualized return (2.7% annualized return less 40 bps financing cost times 6x).

I don't do this sort of thing, usually, so I may have missed something in the above calculation.  It looks pretty tight.  If you can only make 14% with 6x leverage, that's not very exciting.

In any case, this isn't the main point of this post.  

Why All Stock Deal?
Of course the question is going to be, why would LUK issue cheap shares (below book value) to pay for JEF (at book value, or over tangible book).  

The reason they would do this is as a stock transaction is that it would be tax free to JEF shareholders (Richard Handler being one of the large ones) and it will allow JEF shareholders to benefit from the future value creation of the combined entity.

LUK went out of it's way to liquify their portfolio before announcing the deal, so it seems they are more comfortable with the deal with this excess liquidity.  This means that they wouldn't have considered the deal if they were going to issue debt costing 8%, or if they had to use up all of their cash and liquidity to pay for the deal.

OK, Fine. But How Dilutive Is This Deal?
From page 32 of the presentation, we can see that LUK had BPS as of the end of September of $26.71/share.  After the merger, LUK will have BPS of $24.69/share.  Adjusting the first figure for the Crimson Wine spinoff, you get a September-end BPS of $25.90/share.  So that's a $1.21/share dilution to current LUK shareholders.  That's a 4.7% dilution right there.

Is it worth it?  Well, like anything else, you will have plenty of varying opinions.

I think the big thing about this deal is the succession issue.  Richard Handler is a highly regarded CEO and this would seem to be a small price to pay to get this deal done and in such a way that many JEF shareholders will roll into LUK.

Given that Handler helped find some of LUK's investments in the past (Fortescue etc.), he may be instrumental in finding other ideas.  Which leads to the next question:

Potential Conflicts?
Now, I do think this is a great deal and LUK shareholders, unless they are allergic to financials, should be comfortable.  People who hate investment banks and financials in general should probably sell out (maybe at a better price once this cliff nonsense clears).

But having said that, I do wonder about the issue of conflicts here.  LUK was a client of JEF; JEF brought ideas to LUK for them to look at.  I am thinking about the potential conflicts that people raise with Goldman Sachs.  On the one hand, they have investment bankers looking for deals and matching buyers with sellers.  And on the investment side, GS have their own people looking for deals to do too.  When a deal is found, how do you decide if it's OK for GS to go ahead and buy, or do they have to show it to a client that was looking for something like it before doing the deal themselves?

In the case of GS, I guess you can make the case that the private equity funds inside GS operate independently and the CEO doesn't see these deals.   At least there is some sort of Chinese wall there.  (There have always been walls between trading and investment banking even though many seem to believe they don't actually exist.  In my experience, they actually do exist even though it may leak from time to time).

But if Handler is CEO of both JEF the investment bank and LUK the opportunistic value investor where the CEO plays a major role, how do you reconcile this conflict?

When an energy company client is talking to JEF investment bankers, how do they know or not know what information Handler will get to use for LUK's energy business, acquisition opportunities etc.?

At big banks like GS and JPM, the CEO is not involved as key decision makers in deals that the private equity arms do.  They may know what's going on, but they are not the deal makers.  At the new LUK, it seems like Handler will be the key decision maker on deals at the non-JEF LUK, basically replacing Cumming as CEO.

I don't have any doubt about the honesty and integrity of the folks at LUK and JEF so this is not a question about that.  It's just a practical question that comes to my mind.

So What Do I think?
My first impression from looking at all this stuff on first pass is that I like it.  I understand that many probably won't.  There may be some disappointment that the merger is with an investment bank that is prone to the booms and busts we have seen recently, and that is not something to look forward to.

One great thing is that if investment banking is in fact dead and won't ever recover, this deal can still work out because Handler can reallocate capital out of the investment bank into other LUK areas, just like BRK does with their insurance business.  This internal capital fluidity, I think, is a huge advantage.  In that sense, owning the combined LUK/JEF is probably better than owning an independent investment bank.

I like and respect all of the parties involved and see no problem with the people, intent of the deal or anything like that. 

I do own LUK and will be looking to buy more (maybe through JEF) as I do think it's cheap.  JEF is also small and nimble enough to be able to take advantage of the changes going on in the industry (European banks scaling back etc.)


  1. I agree on the potential (at least optically) conflict of interest. I'm not sure if you have any knowledge connection in investment banking, but do you think JEF's clients might choose a different adviser because of this? Just trying to better quantify that risk.

    1. Hi, I don't know. That's a good question that I don't think came up in the conference call, but may come up in future calls.

      Banking is a relationship thing, especially good banking, so it shouldn't impact the business too much as long as JEF explains how they operate clearly. I think Handler has a reputation as being a straight shooter, transparent, honest and all that, so frankly I don't think clients would really worry much about it.

      I would still like to hear from them, eventually, how they will deal with this.

  2. Why are they spinning the Crimson Wine Group as a part of this deal? Seems random.

    1. Hi, it does seem random. On the conference call, they said they looked at what the business would look like after the deal, the business lines etc... and Crimson didn't really fit or something like that.

      Maybe the business was just too far out compared to other things they do, or maybe it was a Cumming/Steinberg 'pet' project that Handler didn't want to have anything to do with, who knows...

      But why they would have to spin it out before closing the deal, I don't know.

  3. Hi good post thanks ! I do not like that Handler admired, worked and was trained by Michael Milken. Any thoughts on that ?

    1. Yes, I don't have a problem with that. Milken had problems, but at the time he really had some very smart people working with him and they did work very hard, tore apart balance sheets and really had a lot of good things going other than what we read about.

      Also, even if we don't like that whole Drexel thing, it has been a very long time since then and Handler has created a track record and reputation that stands on it's own that I am totally comfortable with.

  4. Ok, nice analysis BUT I think you are missing 2 very BIG points here:

    1. If the predicate for this deal really is succession then
    a. There are MANY MANY far more qualified private equity/deal maker/lbo/executives out there that
    are and were available for a HELLUVA lot less than 4.7% immediate dilution, handing over 44% of
    the company AND tying the future of LUK to Handler's "skill". I can name at least 5 of these guys
    off the top of my head that would have GLADLY come into LUK for a LOT LESS than what LUK paid.

    b. Who else was vetted for this role? Who else was passed over, LUK is a PUBLIC company not a
    private entity. That this was not even mentioned makes me leery of the succession angle.

    2. The chart of JEF vs. its "peer" group is LAUGHABLE. Not Handler, nor Steinberg will ever convince
    any intelligent investor that running JEF for share, profit and ROE is or was anything remotely
    resembling the task of running GS, MS or JPM. That logic and thus the chart are absurd.
    Consequently, what the LUK shareholder is 'getting' is an unproven deal maven in the form of Handler
    AND immediate dilution to boot. I have nothing against investment banks, but my guess here is that
    Steinberg got "sold" on Handler, this happens a lot in business and especially when the time comes
    to pass the reigns over or onto the next generation. If anyone in their right mind believes LUK+JEF
    will somehow out maneuver or out play the boys at Cerberus, Apollo, Lightyear, CVC, Jana, TPG, or
    Leonard Green to name a few, they should be put out to pasture.

    1. Thanks for the post. I appreciate opposing views.

      All I can say is that I have no problem with Handler. They have known each other and worked together for a very long time, and frankly, I prefer this sort of thing than having a 'board' of independent directors hire executive search firms and try to find the right candidate (like HPQ, YHOO in the past etc...).

      I would much rather have Cumming/Steinberg pick their successor the way they did than any other way I have seen be tried in corporate America.

      And yes, this is a public company, but like BRK, L and others like it, this stock is a bet on the people. If people can't trust Cumming/Steinberg's judgement, they shouldn't be in the stock in the first place.

      In any case, the shareholders will vote and we shall see how the shareholders feel.

      The chart for JEF is what it is. I don't know what's so laughable about it. Increasing book value is increasing book value. Good performance is good performance. I don't care if the business is simple or complex. I would actually prefer simple, of course.

      Nobody said anything about JPM, MS or GS. I didn't even put up those guys in my charts.

      I just compared JEF to BRK, LUK and the S&P 500 index, I think. And that's because I think a company that is valued based on book value should outdo the S&P over time, at least. And if they can do better than LUK and BRK, two other companies that are often valued at book, that's great.

      There is no bonus points for complexity or difficulty, so to say that managing JPM, MS or GS is much harder than managing JEF, it doesn't matter.

      So that's an irrelevant argument. If someone can compound BPS in double digits without complexity, that's actually much better for me. I'm not gonna say, gee, but that's too easy! I'm not going to value this person cuz he didn't jump over a higher hurdle.

      As for competing with the boys at Cerberus and other private equity houses, that's also irrelevant as they are in a different business.

      The business of the private equity firms are to raise capital, lever it up and earn management and incentive fees.

      The business of LUK is to use their own money to make investments. It's a totally different business model.

      So again, I have no problem with this.

      It's true that this deal would have been better if it was accretive or at least non-dilutive. But you know, you aren't going to have everything you want.

      Anyway, thanks for the contrary viewpoint. It is always appreciated!

  5. Hello KK,

    I've just recently found out about your beautiful blog, thank you for taking the time and effort to put it all down in words. I'm starting from the first post in 2011 to learn better and have what you write in context, if I were to leave a comment on an older posts would you be able to see them/have time to reply?

    Many thanks again


    1. Hi,

      Thanks for the comment. Yeah, I do get a notice when a comment is posted.


  6. the dilution may turn out to be insignificant. perhaps cumming/steinberg feel that the intrinsic value of JEF is much higher than the current price accounting for the dilution and LUK's current valuation. these guys have opportunistically issued and repurchased stock, and their own debt. i'm certain that they considered the intrisic value of both businesses before okaying the deal and deciding to use stock.

  7. Just thanking you for your post. Thought it was well-written, as usual.

  8. Thanks for the post. It seems to me the new book value per share of LUK is calculated using the JEF BV based on the offer price from LUK -- ie the new LUK BV includes the premium generated from LUK's own offer. Is that a fair way of looking at it and does it overstate book given tangible book is less?

    1. Good point. I assumed the acquisition price was more or less around book value, but on an all adjusted basis, that's not the case. Common BPS was around $16.59 or some such at quarter-end, but the adjusted BPS was $15.63.

      So for post-deal analytical purposes, you may want to look at BPS using this. To adjust for it, knock off $0.81 or so from the post-deal adjusted BPS for LUK on the presentation (why does 81 keep coming up in this deal? $0.81 value for wine, 0.81 exchange ratio etc...).

      On the other hand, after the deal, JEF will as you say sit on LUK's book at 'book' with some goodwill (how much depends on the final price).

      Thanks for pointing it out.

    2. By the way, having thought about this a little more, it is conservative to look at this deal without goodwill from the LUK acquisition. But on the other hand, there is no need really to force this thing to be fixed at book either.

      Why? When JEF was partially owned, it was trading in the market at various levels versus book and when we valued LUK, we didn't mark down the value of JEF to book value; we just used market price.

      So from that point of view, if the valuation of JEF is reasonable at the time of the deal, there is no problem valuing LUK at stated book value. The merger proxy should give us insight into the valuation of JEF.

      Of course, in this case, LUK's purchase pushed up the price of JEF so this may not be a perfect analogy to marking stockholdings at market value.

      It's just an argument against the need to mark JEF upon consummation of the deal at book.

      (This may be similar to when BRK bought Burlington Northern and maybe the JPM/Bank One deal (goodwill is still on JPM's books from that deal; it's OK to value JPM at book including good will as long as you look at ROE including goodwill).

  9. Hi, enjoy your blog very much. I tend to agree with much of your analysis on Leucadia and Jefferies...though, as a LUK shareholder, I still harbor serious doubts about the addition of an investment bank with questionable value on a go-forward basis to a much different, largely industrial/raw materials franchise (nonetheless realizing that JEF's historical BV growth has been stellar and that Handler is an adept manager).

    Of note, I find most interesting your point (which I have not seen addressed anywhere else) regarding the potential for conflicts of interest as the new, combined LUK-JEF entity evaluates potential acquisitions/corporate actions for itself and clients.

    Just a short time after you made that observation, as I am sure you are aware, First Quantum bid to acquire Inmet Mining, in which LUK is the largest shareholder. It just so happens that First Quantum is being advised by JEF, which LUK is in the process of acquiring. It has been less than a month and this conflict that you proposed has already presented itself in a very large way (pertaining to one of LUK's largest investments)...was curious to hear your expanded thoughts on this. Thanks, and keep up the great writing.

    1. Hi, thanks for the comments.

      The conflict is an interesting issue. As for Inmet, I don't see a problem with it at this point. JEF has been involved in LUK deals before and I'm sure FQ is aware that JEf and LUK has a long history of working together.

      So this deal in particular doesn't seem like an issue to me at all.

      I think going forward, especially when LUK wants to buy something it may come up as an issue.

      But we shall see. These people know what they are doing so I'm sure they will address these issues. It may be on a client-by-client basis, which means that we shareholders may not hear too much about how they deal with it. But I'm sure JEF would explain to clients how the relationship will work etc... I hope to see something, though...


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