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Leucadia's Upside-Down Acquisition of Jefferies

Source: Jefco.com

Try as I might, I cannot make sense of Leucadia buying Jefferies.

The deal only makes sense if you think of it the other way—Jefferies taking over Leucadia . Which, actually, is what's happening, even if technically the deal is structured the other way.

The chief executive of Jefferies, Dick Handler, will become the CEO of Leucadia while somehow keeping his job as CEO of Jefferies. Brian Friedman, the current chairman of Jefferies' executive committee, keeps that job and becomes Leucadia's president, and gets a seat on the board.

Meanwhile, the two most important guys at Leucadia are being sidelined.

(Read more: Leucadia to Buy Jefferies in a $3.7 Billion Deal)

Ian Cumming, the current chief executive of Leucadia and one of its largest shareholders, is retiring from the company he's led for years (he'll remain on the board of directors). Joseph Steinberg, currently Leucadia's president, will become chairman of the board while remaining in an executive role of some sort.

The reason the deal doesn't really make sense from Leucadia's standpoint is simply that Leucadia had all the exposure it needed to Jefferies, owning close to 30 percent of the company and investments in Jefferies' high-yield funds. If investors in Leucadia wanted more exposure to Jefferies they could buy the stock directly.

The synergies here are quite minimal. Supposedly, Leucadia will have greater access to Jefferies' research and investment-banking network. But these were available for hire from Jefferies without the cost of an acquisition.

If Leucadia were a triple-A credit firm with a huge balance sheet, the deal might make sense on the theory that Jefferies could perform better under the parent company's umbrella. After all, access to cheap funding and a balance sheet to leverage have helped make a lot of Wall Street firms extremely wealthy. But, as Matt Levine of DealBreaker points out, that isn't what's happening here. Leucadia has a lower credit rating than Jefferies—and its balance sheet is smaller.

But if you look at it from the point of view of the executives of Jefferies, especially Handler, the deal makes more sense. It allows them to escape the limitations of running a mid-tier investment bank in the post-financial crisis era. As the firm's near-death experience following the MF Global fiasco made clear, the market makes running an investment bank that is not "Too Big To Fail" quite a constrained operation these days. Go after higher returns by buying assets that are too risky or too illiquid and you may find yourself cut off from funding and under regulatory scrutiny.

Gone are the days when an investment bank could set up its own private equity arm or operate as a hedge fund within a bank—and with them the huge paychecks for the top executives. The upside is limited for these firms now, crushing dreams of becoming a Master of the Universe.

So Handler flipped the script. Instead of launching a special executions group from within Jefferies, he's hoisted Jefferies into the Leucadia conglomerate. From there he will presumably be able to have all the fun of taking companies private, engaging in illiquid investments, and still running an investment bank. Think of it like an upside-down cake of pre-crisis Wall Street. But notice that Handler still gets to have a cake.

What Leucadia really gets out of this deal is a CEO. This is no small thing for the company. Cumming is 72 years old and Steinberg is 68. Both have a substantial amount of their own wealth wrapped up in Leucadia and every incentive to see that it does well after their own retirement. So they might well have been willing to pay the price of acquiring Jefferies to get Handler—just 51 years old—running their company.

To put it differently, Leucadia's big investment in Jefferies prior to the acquisition put it in a difficult spot when it came to bringing Handler on. If they had hired Handler out of Jefferies without an acquisition, it's very likely that the value of Jefferies's stock would have plummeted. So there was a large cost attached to acquiring Handler—with or without Jefferies.

- by CNBC Senior Editor John Carney

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