Friday, November 16, 2012

Jefferies: Comfortable in its Niche

In finance circles, Jefferies, the mid-sized, New York-based investment bank, is a "tweener"--too big and mature to be a young upstart, but not  large or imposing enough to earn the label "bulge bracket" or "too big too fail." Like a Knight Capital or MF Global, if Jefferies were in danger of sliding into oblivion, government regulators and market counterparties would let it go.

Amidst all the post-election squabble about "fiscal cliffs" and recent stomach-churning market volatility, Jefferies quietly slipped into the business news this month. It agreed to be acquired by its minority owner, the conglomerate holding company Leucadia.  The transaction won't shake the broker/dealer world. It may hardly move anybody in any way.

But it brings to mind the consistent, stable performance of a niche investment bank, one that has always been too small to be a threat of any kind to behemoths Morgan Stanley, Goldman Sachs and JPMorgan. Yet it is one that is a bit too large to be called a specialized boutique (like Greenhill or Evercore) and too broad in scope to be a Lazard.  The quiet acquisition reminds us how one firm through decades of incarnations and shake-ups has survived when others (bigger and better known) like Bear Stearns and Lehman couldn't.

MBA students interested in banking and finance usually don't know the firm as well as it should. Jefferies is not widely known to criss-cross the country to visit top business schools and make flashy corporate presentations, hungry to recruit the best MBAs. And some might rate its diversity  record slightly less than satisfactory.  Bankers and traders across the globe are from various ethnic groups, many backgrounds and countries. The board of directors and executive committee, however, appear to be a club of long-time Jefferies executives--with virtually no representation from under-represented groups (women and minorities).  

The firm, which used to promote itself the go-to investment bank for the "middle market," has endured its share of troubles, problems and scares. When the dust often settles--whether they were insider-trading problems years ago or European-debt turmoil of a year ago, Jefferies appears to wipe itself off and proceed with its normal course. Or it sometimes swoops in to purchase the valued pieces left behind by other firms that failed.

The acquisition by Leucadia will come with synergies and provide a resource for more capital, if and when it needs it. (Leucadia, known also to be a "Baby Berkshire," manages private investments in multiple industries.) Jefferies will continue its business as usual. In times when capital is king, Jefferies likely decided that it should have a parent that could provide capital at a moment's notice--without it having to fall into the hands of the big boys like JPMorgan or Credit Suisse. Jefferies can now have access to capital, but still be Jefferies after all.

The bank manages a diverse array of businesses (sales & trading, investment banking, equities, fixed-come, precious metals, and brokerage) with a $3.3 billion capital base--too large to be called a pure-advisory boutique like Greenhill or Moelis, too small to be in the league of Goldman or Morgan Stanley.  To its credit, it has never aspired to go head-to-head with Morgan Stanley in most of its business lines.

Years ago it pronounced itself as the favorite investment bank for middle-market clients, seizing upon a niche that even the boutiques and bulge-brackets often ignored.  Growing, middle-market companies are enterprises that issue modest amounts of new equity and high-yield debt to support growth. Jefferies elected, too, to tap aggressively into the high-yield niche, when boutiques couldn't do so and the bulge-brackets wavered about their commitment to "junk bonds."

The bank has certainly withstood its share of storms. Its founder, Boyd Jefferies, got caught in the whirlwind of insider-trading scandals of the 1980s. At the time, the firm was better known as a "third market" trading firm, making markets in equities after normal trading hours. More recently, as the financial crisis unfurled, the firm got caught with excessive amounts of high-yield and mortgage securities on its balance sheet (just like its larger peers). 

Last year, when the whole world watched the crumbling state of finances in Greece and Spain, market watchers turned suddenly to Jefferies and wondered whether the firm was overloaded with European debt or other related exposures.  Rumors swirled, and its stock price tanked. When MF Global collapsed, partly because of excessive Europe exposures, financial markets wondered if Jefferies would be next. Markets always play a guessing game of who's-next. Some made unfair, ungrounded accusations about what toxic waste might be hiding on Jefferies' balance sheet.

Somehow Jefferies escaped that tumult and pulled through to have a stellar, profitable year in 2011.  In 2012, it's on its way to a $250-million-plus earnings year (good enough for a respectable 8-10% ROE).

Every other year, there are industry shake-outs. While firms like DLJ, Drexel Burnham, A.G. Edwards, Alex Brown, Hambrecht & Quist, Montgomery Securities and L.F. Rothschild have disappeared to the back financial history books, Jefferies plods along. Richard Handler is its CEO, who roared often when others claimed the firm was overloaded with Greek exposure, and will also become the head of Leucadia.

A strategy of remaining comfortable and aggressive within its niche, allowing itself to seize pockets of opportunity when they arise, has probably made the difference. It would, however, be nice to see it do better in diversity at its top rungs.

Tracy Williams

See also

CFN:  MF Global and Its Collapse, 2011
CFN:  Knight Capital's Darkest Day, 2012

Monday, November 5, 2012

UBS Throws in the IB Flag

UBS, the Zurich-based global financial institution, announced last week that it plans to dismiss 10,000 employees as it continues, like most big banks, to review, revamp and re-scale its business units around the world.  That's not an unusual news item. In financial services, that's a news blurb we see almost every other day.

UBS provided more details.  Most of the dismissals will come in its investment-banking group.  More specifically, its fixed-income businesses will suffer the most.  The dismissals, the down-scaling and shrinkage are unfortunate. The announcements are, nonetheless, not shocking, since they are a common event in the business press.

This might, however, be the first wave of dismissals in finance, where the bank stepped up to admit  blame solely on its inability to justify business lines because of hefty capital requirements from the new wave of regulation. UBS says new regulation (in Switzerland and from the reforms of Basel II, II.5, and III, and new Dodd-Frank and Volcker rules) will require substantial increases in its equity capital base just to continue doing existing business. And barring any spectacular periods of revenue growth, the increases in capital will push down returns on equity to levels that can't be explained to shareholders.  About as simple as that.

(See CFN on Basel III, 2010 for more background on Basel regulation. In effect, the combination of Basel and Dodd-Frank would virtually double the capital requirements at large banks (those commonly thought to be "too big to fail") between now and 2019. The requirements will step up in increments over the years.)

For all practical purposes, UBS has decided to withdraw from huge-scale investment banking after having decided years ago to attempt to be a bulge-bracket bank.  It has decided it can't make the numbers make sense for it to be a Top-10 investment bank.  Sure, it will continue in certain niches--equities, research, brokerage, and investment management.  But it will not try to compete head-to-head with Goldman Sachs, JPMorgan, Deutsche Bank, and Morgan Stanley.

UBS, through the years, had built up its investment-banking practice through acquisitions, corporate-banking relationships, the reputation of its investment-management and private-banking businesses and the heft of its capital base. Some may recall how in two decades it penetrated U.S. borders by acquiring the well-known retail brokerage Paine Webber and the boutique firm Dillon Read. It absorbed those operations years ago and used them as a base to compete in the U.S. in many areas.

UBS's rationale makes some sense.  It articulates that it seeks to generate a return on equity (ROE) from 12-17 percent. That varies with business cycles and market volatility. On average, it strives to seek returns of 15 percent.

New regulation throws a thorn into its side.  The bank must, as it has done the past year or so, reduce leverage, get rid of bad assets, and push costs down significantly. It also had to deal with the $2 billion loss of a rogue trader, repair risk management and trading operations and improve controls.  While sprucing up controls and balance sheet, new regulation comes along and adds the burden of boosting capital and taking leverage down even more.

If it decides that it must boost capital by 10-20 percent, then ultimately it would need to increase net earnings by 20 percent or more. Increasing net earnings in the current environment--one of uncertainty, volatility and fierce competition from the other big banks--might be near impossible, unless UBS decided to cut costs vigorously.

So where do you cut costs? You do so in businesses where regulation will require big increases in capital, where profit margins are already slim or vulnerable and where costs can be cut swiftly.  Its fixed-income businesses (corporate bonds, municipal bonds, government bonds, interest-rate derivatives, corporate lending) became the first target of deep cuts. This includes (within fixed-income units) corporate-advisory activity, underwriting, trading and market-making.

Senior management may have deduced that, at best, ROE would hover around 5-7 percent in those businesses. ROE in the range of 0-5 percent for a business that already uses up significant amounts of capital would be a certain drag on the bank's overall ROE.  An unsatisfactory result for shareholders, who too dream of earnings growth, stock-price increases and a nice, reliable dividend.

UBS Investment Banking won't go away. It requires a certain amount of investment banking (underwriting, market-making, securities distribution and equity research) to complement other profitable or growing business lines:  investment management, private banking, brokerage, and corporate banking. Yet with massive departures in London and in fixed-income activities, there will be minimal activity in corporate bonds, short-term instruments, mortgage securities, structured securities, private placements, subordinated debt, mezzanine debt, interest-rate swaps, and any of the products and activities that fall under the fixed-income spectrum.

UBS in its announcements hints this is not a cowardly business act. It claims to be making a tough business decision (at the expense, unfortunately, of thousands who must seek employment elsewhere) that all of its old peers must inevitably make over the next few years. It is patting itself for making that decision now.

Tracy Williams

See also:

CFN:  Basel III and Capital Cushion, 2010
CFN:  Big Banks and Dreadful Downgrades, 2012
CFN:  JPMorgan Chase and Regulatory Rants, 2012
CFN:  Big Banks and Where Do We go from Here? 2010

CFN:  The Volcker Rule, 2010
CFN:  The Volcker Rule, Part 2, 2011