Jefferies Seen Reaping Leucadia Tax Assets to Boost Capital

Jefferies Group Inc.’s sale to Leucadia National Corp. is Richard Handler’s attempt to solve a puzzle every mid-size securities firm is facing: How to spur earnings without ratcheting up on leverage.

The deal lets Jefferies curb tax and dividend payouts so it can tap profits to boost capital, said analysts including Doug Sipkin at Susquehanna Financial Group LLLP. Building the stockpile helps Jefferies make use of trading businesses and an army of bankers that Chief Executive Officer Handler has been expanding since the financial crisis.

Jefferies has pared assets by 24 percent in the past year amid investor concern that stand-alone investment banks are vulnerable to Europe’s sovereign-debt crisis and market upheaval. Like other Wall Street firms, Jefferies is under pressure to cut costs amid a trading slump that has forced smaller firms to close.

“By combining with Leucadia, they’ll be able to grow capital faster,” Sipkin said. “They’ll probably get more perceived support by the diversity of some of Leucadia’s businesses.”

Jefferies said yesterday it agreed to be acquired by its biggest shareholder in a $2.8 billion deal. Handler, 51, will become CEO of the combined company after the transaction is completed in the first quarter, according to a statement. Brian Friedman, chairman of Jefferies’s executive committee, will become president of Leucadia, an investment firm with stakes in beef processors, mining companies and auto retail.

‘Market Dislocations’

The transaction will also help Jefferies guard against “market dislocations,” the firms said yesterday in the statement. The investment bank will benefit from Leucadia’s resources as the acquiring firm had $8.74 billion in assets supported by $6.19 billion in equity as of Sept. 30, according to a quarterly filing.

“One of the things they certainly had as an objective was a much stronger balance sheet, and I think that’s what they get out of this deal,” said Joseph Schenk, Jefferies’s chief financial officer from 2000 to 2007, and now a senior adviser at Carlyle Group LP. “The way of the world at this point is bigger is still better.”

Smaller investment banks and trading firms, facing pressure on profits from lower deal and trading volumes, are searching for stability and risk shuttering operations.

Tax Assets

KBW Inc., the investment bank focused on the financial-services industry, agreed to sell itself to Stifel Financial Corp., the St. Louis-based brokerage, after reporting losses in five of the past six quarters. Rodman & Renshaw LLC, which acquired brokerage Hudson Holding Corp. last year, stopped trading in September. ThinkEquity LLC, the San Francisco-based investment bank, shut last month, Harriet Britt, its chief compliance officer, said last week.

“The balance sheets of these smaller firms need to get stronger,” Sipkin said.

Jefferies’s earnings will help the combined company make use of Leucadia’s deferred-tax assets, a benefit held over from previous losses that reduces tax liabilities. Leucadia has about $1.4 billion in tax assets, adjusted for the spinout of a wine business, according to a presentation from the firms.

Earnings from Jefferies and other Leucadia businesses “should rapidly convert Leucadia’s substantial tax-loss carry forwards into cash over the next several years and our job will be to then redeploy this cash in smart ways,” Friedman said in a conference call after the announcement.

Risk, Return

Jefferies shareholders are trading a high-risk, high-return stock for stability, said Jeffrey Bronchick, who manages about $400 million, including Jefferies shares, for Los Angeles-based Cove Street Capital LLC.

“I close my eyes, and it’s two years out from now, and there’s a reasonable environment to be a deal person -- then I’m going to sure as heck wish Jefferies was stand-alone,” Bronchick said yesterday in a phone interview. “It’s not jump up and down for joy as a Jefferies shareholder.”

Mergers-and-acquisitions volume dropped 21 percent in the first nine months of 2012 from a year earlier as the European sovereign-debt crisis and the U.S. fiscal cliff, which would trigger $607 billion in spending cuts and tax increases starting Jan. 1, stalled deal closings. Average daily equity trading on major U.S. exchanges was about 6.47 billion this year through yesterday, 19 percent less than the same period in 2011, according to data compiled by Bloomberg.

‘Another Team’

Investors will get 0.81 Leucadia share for each Jefferies share they own, minus 81 cents a share for the spinout of the wine business, the companies said in the presentation. That gives Jefferies investors $17.01 for each of their shares, valuing the entire firm at $3.78 billion, according to the presentation.

Jefferies climbed 14 percent to $16.27 yesterday in New York and has advanced 18 percent this year. Leucadia dropped 3 percent to $21.14.

Jefferies’s investors may miss out on a resurgence in investment banking, said Byron Snider, co-founder of West Oak Capital LLC, which owned about 1.5 million shares in the firm as of Sept. 30.

“If you’d let them keep playing, you’d have seen greatness out of Jefferies,” said Snider, whose firm is based in Westlake Village, California. “But they’re going to be playing as part of another team now.”

Chairman and CEO Ian Cumming didn’t plan to request a renewal of his employment contract, the company said in an April regulatory filing. Cumming, 71 at the time of the filing, has run Leucadia with President Joseph Steinberg, then 68, since the 1970s.

MF Global

“It’s clear that with their relationship with Jefferies that they became very comfortable with the top couple people there in terms of managing a large-scale financial intermediary,” Charles Akre, CEO of Middleburg, Virginia-based Akre Capital Management LLC, said in a phone interview. Akre managed about 1.6 million Leucadia shares as of June 30, according to data compiled by Bloomberg.

“We would expect to see Jefferies be part of the Leucadia world for a long, long time to come,” Friedman said in the conference call.

Jefferies faced investor scrutiny after MF Global Holdings Ltd., which was run by former New Jersey Governor and Goldman Sachs Group Inc. co-Chairman Jon Corzine, revealed a $6.3 billion bet on the bonds of Europe’s most indebted nations. Jefferies shares plunged 18 percent in the week following MF Global’s Oct. 31, 2011, bankruptcy, and Handler sought to assure shareholders by releasing at least six statements detailing his firm’s market positions.

‘Finest Hour’

Cumming and Steinberg called Jefferies executives’ response to the crisis “their finest hour,” the two wrote in a letter to investors in April.

Jefferies cut assets to $34.4 billion as of Aug. 31, from $45.1 billion a year earlier, and reduced its leverage ratio, the measure of total assets divided by stockholders’ equity, to 9.3-to-1 from 12.9-to-1. Jefferies wouldn’t have to expand its leverage ratio to boost earnings, Handler said earlier this year. Investors probably wouldn’t reward Jefferies if it generated earnings by increasing leverage, Joel Jeffrey, an analyst at KBW Inc., said in March.

“Maybe they are more nervous of the world as we see it,” Cove Street Capital’s Bronchick said. “This deal takes that off the table.”

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