The Bizarre Merger Of Jefferies And Leucadia

By Stephen D. Simpson, CFA | November 12, 2012 AAA

Mergers and Acquisitions (M&A) play a large role in business today. While many recent merger/acquisitions announcements have made quite a bit of sense for both parties, Monday's announcement that Leucadia (NYSE:LUK) will acquire the remainder of mid-tier investment bank Jefferies (NYSE:JEF) breaks that mold. Although this deal brings some fairly clear benefits for Jefferies, I'm not really sure that Leucadia shareholders should be celebrating this deal.

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The Terms of the Deal
Leucadia and Jefferies announced that Leucadia will acquire the roughly 71% of Jefferies that it doesn't own through a stock-for-stock merger worth about $3.6 billion. Each Jefferies shareholder will get 0.81 shares of Leucadia for each share they own. At the time of the announcement, that worked out to $17 a share, or a 12% premium to Friday's close.

At this price, Jefferies is barely getting any premium to its reported book value and only about a 20% premium to its tangible book value. Unimpressive as that may sound, a quick look at other mid-tier banks like Cowen (Nasdaq:COWN) and Piper Jaffray (NYSE:PJC) will show that mid-tier investment banks just aren't going for much in terms of valuation these days, as investors worry about their ability to withstand tougher competition for trading business from major banks like Morgan Stanley (NYSE:MS) and ECNs.

SEE: Mergers And Acquisitions: Understanding Takeovers

Why Do This Deal? The Jefferies Side
If good deals are supposed to be those that benefit both parties, I'm not sure this one qualifies. While I can see the benefits to Jefferies, it is not so clear to me that Leucadia is getting much in the deal.

While Jefferies is a quality mid-tier bank, the company had what you might call a "near death" experience when MF Global collapsed in 2011. Jefferies managed a sale of over $600 million in debt securities for MF Global just before scandals (related in large part to how it valued its European debt holdings) hammered that company, and Jefferies then came under intense scrutiny for its own balance sheet.

Although Jefferies stabilized after that episode (helped in part by a 1 million-share investment from Leucadia in November 2011), the writing was arguably on the wall. Regulatory changes have arguably hurt banks like Jefferies the most, and it is definitely up for debate as to whether banks like Jefferies and Cowen can continue to compete where margins keep shrinking and the cost of capital is higher than it used to be.

In any case, merging with Leucadia gives Jefferies breathing room and access to a larger balance sheet, even though Jefferies' credit rating is actually a bit higher. What's more, adding its investment banking capabilities to an investment conglomerate often compared to Berkshire Hathaway (NYSE:BRK.A) should create some solid long-term opportunities and could be part of a transformation towards an old-style merchant bank operation.

SEE: The Wonderful World Of Mergers

Why Do This Deal? The Leucadia Side
But what does Leucadia gain? I don't see how folding Jefferies into Leucadia alters the fundamental changes in investment banking nor addresses its long-term profitability challenges. Aside from the fact that Jefferies can probably leverage over $4 billion in tax benefits, it doesn't seem like Leucadia is likely to earn a major return here, unless there really are synergies in having a captive investment bank to help invest in/acquire new businesses and/or if the future for mid-tier banks is better than I think.

It's also worth noting that the CEO of Jefferies (Handler) will become the CEO of Leucadia once the deal is complete, as Ian Cumming (LUK's CEO) intends to retire. While bringing in a new leader (and one with Handler's capabilities) is a positive for Leucadia, I'm not sure they needed to do a multi-billion dollar deal to secure a high-quality CEO.

The Bottom Line
Although some Jefferies investors likely will grouse about the valuation of this deal, the reality is that there just aren't many willing buyers looking for mid-tier investment banks and this deal will shore up and de-risk the situation. At the same time, Jefferies shareholders will end up owning about one-third of Leucadia after the deal and that's arguably a trade-up.

For Leucadia shareholders, this is more of a head-scratcher. I suppose it may be true that the market currently undervalues Jefferies, and that eventual stability in the global financial markets will lead to higher returns. Likewise, it's worth noting that Berkshire Hathaway has made a few curious deals over the years (there was a lot of skepticism and criticism over the Burlington Northern buy), but most have worked out. That said, arguably the best things that can be said about this deal for Leucadia is that it gives them a younger management team and that the company is not paying much of a premium over book value, but that's pretty scant praise on balance.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

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