News of a deal by Leucadia National Corp. (LUK) – a conglomerate that has earned the moniker “Baby Berkshire” for the similarity of its value-based approached to building a portfolio of assets – to acquire the largest surviving pure-play investment bank, Jefferies & Co. (JEF), created plenty of Wall Street buzz on Monday.
In part that’s because anything that Jefferies does these days generates curiosity and interest; in the aftermath of the financial crisis, the aggressive Jefferies has a culture that harkens back to the Wall Street glory days of the 1980s and 1990s (its CEO, Richard Handler, cut his teeth as part of the famous junk bond team at Drexel Burnham Lambert).
While other firms have retrenched, cutting operations to curb costs in an era of declining trading revenues and increasing regulatory oversight, Jefferies has been one of a handful of feisty mid-tier investment banks that saw in the crisis an unprecedented opportunity to expand into areas that once it could never have managed to penetrate. In the last five years, its operating expenses have climbed nearly 75 percent as it has invested to open new business divisions and hire top talent like UBS banker Ben Lorello. (In contrast, operating expenses at Goldman Sachs (GS), one of the most resilient of Jefferies’ peers, is up only 22 percent over the same period.)
Handler has proved to be surprisingly adept at steering clear of potential minefields. When MF Global blew itself up by a poorly managed and ill-timed bet on debt securities issued by governments on the “periphery” of the Eurozone, Handler essentially opened Jefferies’ books to analysts and investors in order to demonstrate that his firm had reduced its own exposure to those risks.
The deal, however, is a signal that in an era when size and capital still matters, there may be limits to the ability of a mid-sized firm like Jefferies to go it alone, however aggressive its strategy and however nimble and skillful its managers. Indeed, while Jefferies’ stock price has outpaced that of Goldman Sachs since markets hit bottom in the spring of 2009, rising 18.5 percent compared to 6.3 percent for the latter, Goldman began to outperform its smaller rival this past April.
So far this year, while Goldman Sachs’s stock is 23 percent higher, that of Jefferies had risen only 16.4 percent. Despite its effort, Jefferies has failed to push its way into the ranks of the top 10 in either M&A or stock underwriting league tables, a goal that one Jefferies banker told me back in the summer of 2009 was its post-crisis objective. In 2011, Dealogic did put Jefferies in the No. 12 spot for U.S. M&A rankings, but so far this year it has slipped from that level to rank 15th. When it comes to underwriting domestic stock offerings, it now ranks No. 12, down from No. 11 last year. Globally, it is weaker; not surprising, given that it has been a latecomer to global capital markets.
More worrying is the fact that Moody’s Investors Service cut its rating on Jefferies’s debt to only a single notch above junk bond status, voicing concerns about the company’s ability to maintain a risk management “culture” and managing its risks even as it has gained market share and grown rapidly in the post-crisis environment. Even before the crisis hit, Jefferies had a reputation among investment banks as being a bit of a gunslinger; a firm that was willing to take risks that other investment banks might shy away from. The crisis – and events since then, including JP Morgan’s (JPM) trading losses thanks to the “London Whale” – have served as a reminder of the dangers of that kind of approach.
So far, those fears have proved unfounded: In its most recent fiscal quarter, Jefferies was hit by a trading loss on only a single day, compared to seven trading days at Goldman Sachs and 19 at Morgan Stanley (MS). And its risk-taking may yet reap big dividends. When market-maker Knight Capital (KCG) was hit by a $440 million loss early this year, Jefferies not only earned a $20 million fee advising Knight on its options – the single biggest chunk of its M&A advisory revenues in this third quarter – but became a 45 percent owner of Knight’s shares after it put together a package of rescue financing from an array of Wall Street institutions.
In some ways, Jefferies is behaving the way that Goldman Sachs once did in the days before it abandoned its status as an investment bank. Now the question is whether the Leucadia transaction will give Jefferies the kind of capital it needs to embark on the final stage of that transformation from a second-tier trading firm into the latest generation of white-shoe investment bank.
Analysts calculate that Jefferies will have access to additional $5 billion in cash and short-term securities that could be used to fuel its expansion, which has slowed lately as Jefferies, like other banks, has had to confront the wobbly underwriting and deal-making environment and weak trading volumes that have characterized 2012 and weighed on banking profits.
The biggest question isn’t capital, however, but – as Moody’s pointed out – one of culture. Jefferies’ expansion strategy has been highly opportunistic, resulting in a group of assets and individual banking and trading teams that may now find themselves doing business under the same umbrella, but that haven’t been nurtured within a single banking “culture” and that may have little sense of loyalty to Jefferies as an institution.
That has long been one of Goldman Sachs’s key assets, even though it has come under siege in the post-IPO period and been criticized even by insiders like disgruntled banker Greg Smith as being honored more in word than by deed. The other big winner in the post-crisis period, JPMorgan Chase, also has benefitted from an unusually cohesive group of key employees and – despite the “London Whale” snafu – an intense focus on risk management.
There is room for Jefferies to move into the big leagues, particularly if the growing calls for a breakup of the big banks by influential voices like former FDIC head Sheila Bair result in some movement on than front. Having access to a larger and more stable source of capital will undoubtedly help it achieve that objective, but in order to accomplish that feat, Jefferies also will require a cultural transformation.
The difficulty of predicting whether that is possible or likely means that it’s difficult today to do more than guess whether the Leucadia merger means that Jefferies will emerge as simply a larger version of its current self, or as a transformed entity that potential clients view as akin to the Goldman Sachs, Morgan Stanley, Merrill Lynch or Lehman Brothers of the pre-crisis era.