The Exchange

Jefferies Squeezes Through Graceful Exit

The Exchange

In a conference call this morning to discuss Jefferies & Co.'s (JEF) freshly struck deal to be acquired by its largest shareholder Leucadia Corp. (LUK), Jefferies' longtime chief executive Richard Handler told investors, "I've thought about this my entire career."

There is no reason to doubt the remark by Handler, who shares a commitment to opportunistic deal-making and long-term growth of capital with the founders of Leucadia, a financial conglomerate commonly dubbed a miniature Berkshire Hathaway Inc. (BRK-A)

Yet the tough financial-market conditions now plaguing small and mid-sized brokerage firms must also have something to do with Jefferies decision to sell Leucadia the 71% of the company it doesn't already own. At about $17 per share, the cash and stock deal represents a 12% premium over Jefferies closing share price Friday; still, it's lower than the stock traded as recently as March.

In this respect, Jefferies has become the second mid-tier investment bank in a week to sell for a price below its public value of last spring. KBW Inc. (KBW), the parent of financial-stock specialist Keefe Bruyette & Woods, last week agreed to be acquired by broker Stifel Financial Corp. (SF) for $17.50 a share, a discount to its March peak above $19. Both firms are selling at slim premiums to their book value, the main gauge of a brokerage firm's net worth.

Jefferies reached its deal less than a month after Moody's Investors Service downgraded Jefferies' debt rating to one notch above "junk" status. This move threatened to squeeze trading profits and pressed the standing question of whether there is a place in today's financial environment for an independent, mid-sized trading powerhouse.

These deals are part of a gathering rationalization of the securities industry, four years after the financial crisis climaxed and more than two years after a clutch of ambitious smaller shops set plans to expand, seeing an opportunity as the huge "bulge-bracket" banks grappled with massive losses, tougher capital requirements and new regulatory pressure.

The recent move by Swiss banking giant UBS AG (UBS) to exit the bond business and lay off 10,000 employees is only a more dramatic version of this process operating among the global banks as well.

Related: UBS's Pain…Goldman's Gain?

Most of the upstart firms — emboldened by the huge, one-time surge in financing and trading activity in 2009 as markets recovered — have struggled to remain sufficiently profitable as stock-trading volumes have sagged, corporate merger activity has stayed subdued and the cost of competing for trading volume with powerful electronic platforms financed by the largest firms has risen. Shares of FBR Inc. (FBRC), Cowen & Co. (COWN) and Gleacher & Co. (GLCH) have all been cut in half, or worse, in the last three years, even as stock values have climbed and bond issuance has been strong.

The industry is now cleaving into three, slimmer layers. There are the surviving, dominant global giants including Goldman Sachs Group (GS), JP Morgan Chase & Co. (JPM) and Morgan Stanley (MS), with Bank of America Corp. (BAC), Citigroup (C) and a couple of large European banks sticking close.

Three-Tiered Industry

The industry giants are resigned to holding more expensive capital, trading less with their own money and accepting lesser returns than they were used to. But once new regulations are settled, they stand in good position to facilitate the flow of capital around the world from wealthy investors and institutions to the fast-growing enterprises of the emerging economies.

The next tier, made up of full-service firms seeking to serve somewhat smaller companies and act as a traditional broker for fund-manager clients, is best represented by Jefferies, which will now operate as a division of Leucadia. Both Jefferies and Leucadia will be run by Handler.

At the bottom are standalone firms left wishing for rising markets to energize retail trading activity, mutual-fund inflows and initial public offering volume to a degree that hasn't happened yet, three and a half years since the bear market and recession ended. Some will become tightly focused boutiques, others will seek a buyer or band together with one another.

In some respects, the union of Leucadia and Jefferies resembles a very old model of "merchant bank," such as J.P. Morgan or Rothschilds operated 100 years ago, both owning non-financial companies as long-term investments and acting as broker and banker to others. Leucadia is in several respects a poster child for the "financial engineering" era of the last 30 years, using public capital to buy distressed assets and companies, returning investors more than 13% annualized since 1990. Its subsidiaries now include a large beef processor, real estate ventures and mining and lumber interests.

Jefferies' roots are as a nimble broker of large or difficult blocks of stock in the days when trading "upstairs" from the New York Stock Exchange was a maverick's game. Under Handler, a former Drexel Burnham Lambert junk-bond trader, it has grown into a lean and resourceful integrated investment bank, punching above its weight in trading, scooping up banker teams and whole firms when other firms hit rough times.

Along the way it made a somewhat awkward arrangement with Leucadia to jointly own a bond-trading unit and share the profits, a concession to how Jefferies' ambitions outran its financial heft. Last year, Jefferies' perceived exposure to struggling European government debt of the sort that sank MF Global forced Handler to curtail trading risk and open the firm's books to skeptical investors, ultimately reassuring the Street that the company was sound -- but not before the stock sank from $20 to near $10 over four months.

With large ownership of the firm by Handler and other top executives, and little benefit to being an independent publicly traded broker these days, Jefferies move to become part of a larger, more capital rich company makes sense. Many of its smaller competitors, though, won't likely find so comfortable a home in the new, less prosperous Wall Street.

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