Lehman-Nomura

The Bankruptcy of Lehman Brothers and its Acquisition by Nomura

F. Cassim, R. Klein Rivera, R. Rebib, T. Reuber, K. Wannaprapa

Advanced Corporate Finance II – Prof. Dr. Michel Habib University of Zurich/Swiss Federal Institute of Technology Zurich

May 2009

Abstract In September 2008, Lehman Brothers filed for bankruptcy and proved to be the most prominen prominentt victim of the US subprime subprime financial crisis. With over over $600 billion in assets and in debt, Lehman’s bankruptcy filing was by far the largest in US corporate history. The acquisition of Lehman’s Europe and Asia Pacific franchises by the Japanese Nomura, only days after the bankruptcy filing, was a bold move and its value to Nomura’s shareholders was questioned to be justifiable. A retrospective on the events and circumstances leading to the bankruptcy filing and the study of the US bankruptcy law show that Lehman was disadvantageously hit by missing governmental involvement to rescue the bank and by the Bankruptcy Abuse  Prevent Prevention ion and Consumer Consumer Prote Protection ction Act  Act  amendments to the bankruptcy law, which caused a meltdown of Lehman’s assets immediately after the bankruptcy filing. An assessment of the long-term value of Lehman’s subsequent acquisition for Nomura’s shareholders is provided by quantitative and qualitative analyses: A Net Present Value analysis gives a negative value of -$668 million, especially caused by promised high salaries salaries and bonuses bonuses to ex-Lehman ex-Lehman staff. staff. As Nomura made the deal with future strategic strategic moves in mind, trying to gain advantage advantage by synergies synergies from complimen complimentary tary businesses and clients, a Real Option analysis shows that a value in the range of $1 billion billion could be added added to the NPV value. value. This value value proves proves to be very sensitive sensitive to the underlying assumptions, however, the Real Option analysis demonstrates an alternative way way to value value the deal and provides provides a clearer picture on Nomura’s Nomura’s investmen investment. t. Comparing these results to how the market reacted through a Share Price analysis shows that the it valued valued the deal with $2.2 billion. To capture issues like corporate corporate culture, potential synergies and future difficulties in merging the two businesses, and to put the quantitative results in relation with strategic and qualitative insights, a SWOT analysis and a study of the two companies’ previous core businesses confirm that the acquisition could generate great synergies and transform Nomura into a top player in the global banking banking industry. industry. Howeve However, r, general general experience experience with mergers mergers and acquisitions acquisitions affirms that huge acquisitions by companies not used to it tend to destruct shareholder value; especially cultural differences tend to hamper huge acquisitions. As Nomura has neither experience with such a big acquisition nor a compatible corporate culture with Lehman’s one, these issues are going to be the greatest challenges for Nomura in the future.

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Contents Abstract

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Introduction

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1 Lehman Brothers 1.1 The History of Lehman Brothers . . . . . . . 1.2 Lehman’s Big Man: Dick Fuld . . . . . . . . . 1.3 Lehman and the Subprime Mortgage Market 1.4 The Role of Lehman’s Risk Management . . . 1.5 The Beginning of the End . . . . . . . . . . .

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1 1 2 2 3 3

2 The Bankruptcy of Lehman Brothers 2.1 Heading towards the Weekend of September 14 . . . . . . . . . . . . . . 2.2 The Bankruptcy Law in the United States . . . . . . . . . . . . . . . . . 2.2.1 Chapter 11 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.2.2 Bankruptcy Abuse Prevention and Consumer Protection Act . . 2.3 Lehman’s Bankruptcy Filing . . . . . . . . . . . . . . . . . . . . . . . . . 2.3.1 Major Asset Dispositions . . . . . . . . . . . . . . . . . . . . . . 2.3.2 The Chapter 11 Process and Lehman’s Estate . . . . . . . . . . . 2.4 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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3 Nomura 3.1 The History of Nomura . . . . . . . . . . 3.2 Nomura’s Acquisition of Lehman Brothers 3.2.1 The New Workforce Resources . . 3.2.2 Nomura’s Key Strategy . . . . . . 3.2.3 The Client Base . . . . . . . . . . 3.2.4 Transition: The Road to Revenue .

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4 Share Price Analysis 4.1 Idea . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.1.1 Assumptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.2 Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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CONTENTS 5 Net 5.1 5.2 5.3

Present Value Analysis Introduction . . . . . . . . Salaries and Bonuses . . . Idea . . . . . . . . . . . . 5.3.1 Assumptions . . . 5.4 Results . . . . . . . . . . .

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7 Strategic Analysis 7.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.2 SWOT Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.3 Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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Conclusion

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6 Real Option Analysis 6.1 Idea . . . . . . . . . . . . . . . . . . . . . 6.1.1 The MacDonald and Siegel Model 6.1.2 Assumptions . . . . . . . . . . . . 6.2 Results . . . . . . . . . . . . . . . . . . . .

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List of Figures 3.1 3.2 3.3 3.4 3.5

New Workforce Resources . . . . Synergies in Client Business . . . Synergies in Asset Management . Synergies in Investment Banking The Road to Revenue . . . . . .

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4.1

Share Price Nomura Jan 08 – Oct 08 . . . . . . . . . . . . . . . . . . . .

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SWOT Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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Introduction On September 15, 2008, Lehman Brothers, one of the most storied Wall Street firms, filed for bankruptcy. With $639 billion in assets and $613 billion in debt, Lehman’s bankruptcy filing was the largest in US corporate history, as its assets far surpassed those of previous bankrupt giants such as WorldCom and Enron. At the time of the collapse, Lehman was the fourth-largest US investment bank, with 25,000 employees working in investment banking, equity and fixed-income sales, research and trading, investment management, private equity, and private banking. Lehman Brothers was the most prominent victim of the US subprime mortgageinduced financial crisis that swept through global financial markets in 2008. Lehman’s collapse was a seminal event that greatly intensified the 2008 crisis and contributed to the erosion of close to $10 trillion in market capitalisation from global equity markets in October 2008, the biggest monthly decline on record at the time. Lehman’s bankruptcy was the prelude to the armageddon observed in money and equity markets between September 2008 and January 2009. From one day to another, money markets froze up and for the first time since the Great Depression the fear of a systemic crisis evolved. The systemic fear should last well into 2009 while equities markets only reached their bottom in March of 2009. While writing these lines the bankruptcy of Lehman is receding in market participants’ mind and does no longer directly impact the markets. 3-month USD Libor, used to set borrowing costs on about $360 trillion of financial products globally, according to the BBA, rose to 4.82% in October 2008, after Lehman’s failure; on May 19, while finishing this report, Libor is continuing its decline and reached 77 basis points, which is below its pre-crisis level of 2007. Similar observations can be made for the Libor-OIS spread, a measure for pure credit risk of banks. Even though the impact of Lehman’s failure on the daily market moves may have diminished, Nomura, however, is now in the crucial phase of integrating the former Lehman Brothers operations. Managerial skills, personnel, market conditions and competitors will decide on success or failure of Nomura’s big move. This report has the modest objective to find out whether this big move of last September was justifiable at the time. We aim to provide quantitative as well as qualitative analytics and rigourously assess the long-term value of the deal for Nomura’s shareholders.

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Chapter 1

Lehman Brothers 1.1

The History of Lehman Brothers

Like its most aggressive rival Goldman Sachs, Lehman’s history traces back to a German immigrant. Henry Lehman of Rimpar, northern Bavaria, settled in Montgomery, Alabama in 1844 and opened a small general store. Only in 1850, Henry Lehman and his brothers, Emanuel and Mayer, founded Lehman Brothers, which at this time was a cotton trading company. Until the late 19th century Lehman Brothers remained focused on the cotton market. The Lehman brothers moved the firm to New York after the civil war and were involved in the foundation of the New York Cotton Exchange in 1870. Only in 1883 Lehman went on to enter the coffee market, becoming a member of the Coffee Exchange. Four years later, in 1887, Lehman became a member of the New York Stock Exchange. Lehman expanded into the profitable equity underwriting business which was strongly linked to the rapid industrialisation of the United States. In 1899, it underwrote its first public offering, the preferred and common stock of the International Steam Pump Company and subsequently developed to one of the most active equity underwriters. While the firm prospered over the following decades as the US economy grew into an international powerhouse, Lehman had to contend with plenty of challenges over the years. Lehman survived them all - the railroad bankruptcies of the 1800s, the Great Depression of the 1930s, two world wars, a capital shortage when it was spun off by American Express in 1994 and losses had depleted shareholder equity to less than 2% of assets, the Long Term Capital Management collapse, the Russian debt default of 1998 and the 2001 attack on the World Trade Center where Lehman had 3 floors of office space. However, despite its ability to survive past disasters, the collapse of the US housing market ultimately brought Lehman Brothers to its knees, as its headlong rush into the subprime mortgage market proved to be a disastrous step. However, even at the time of  the bankruptcy most units of Lehman were profitable and Lehman’s last CEO, Richard Fuld, had spent most of his tenure with diversifying the company, making sure it would have other businesses to depend on if one collapsed. Equity trading accounted for onethird of Lehman’s revenue in 2006, and the firm was the largest trader of stocks on the London Stock Exchange and Euronext. It ranked as high as No. 5 among mergers and acquisitions advisers in 2007, when it had a role in one-fifth of all corporate takeovers. Its research teams in equities and fixed income had ranked at the top of surveys 1

CHAPTER 1. LEHMAN BROTHERS of money managers conducted by Greenwich Associates, an industry consulting firm. Non-US revenue accounted for half of the total in 2007 for the first time.

1.2

Lehman’s Big Man: Dick Fuld

The last CEO of Lehman Brothers was Richard S. Fuld, Jr. who joined the company at the age of 23 and spent his entire 39-year career at Lehman, the last 15 in the top job. Fuld was considered as a trader by nature and nurture and was described as highly competitive and keeping a straight face. In 1993, he became CEO of what was then the Lehman Brothers unit of American Express. When American Express spun off Lehman as a public company in 1994, Fuld became its first chief executive. That was widely perceived as a signal of the rising power of traders on Wall Street. Until the mid 1990s bankers were the dominant force on the street but with the inception of liquid derivatives markets in both fixed income and equities, the balance changed as the majority of profits on Wall Street was made in trading. Fuld, at the time of the bankruptcy the longest-serving CEO on Wall Street, was widely known as a driven decider, not hesitating in taking immediate action when the crisis in the US housing market began to bite Lehman’s earnings. In July 2007, when Lehman’s shares had fallen 70% in the previous six months, Fuld did not duck. Nor did he absent himself at bridge tournaments, like his counterpart at Bear Stearns, James   “Jimmy” Cayne. Instead, he raised $14 billion of capital, sold $147 billion of assets, increased cash holdings and reduced the fourth-largest US securities firm’s reliance on short-term funding to create a buffer against a possible bank run. When none of those measures worked, he replaced Lehman’s No. 2, Joseph Gregory, his trusted lieutenant of 30 years, with a younger man known for his cautious approach to risk taking. And he moved aside Lehman’s high-profile Chief Financial Officer (CF0) Erin Callan, who had a spat with hedge fund manager David Einhorn, a short seller of Lehman stock.

1.3

Lehman and the Subprime Mortgage Market

In 2003 and 2004, with the US housing market soaring, Lehman acquired five mortgage lenders, including Irvine, California-based subprime lender BNC Mortgage, which lent to homeowners with poor credit or heavy debt loads and Aurora Loan Services, which specialised in Alt-A loans (a notch above subprime, to more-creditworthy borrowers who do not provide full documentation for their assets). In the first quarter of 2006, BNC was lending more than $1 billion a month, while Aurora was originating more than $3 billion a month of such loans in the first half of 2007. Lehman’s acquisitions at first seemed prescient; record revenues from Lehman’s real estate businesses enabled revenues in the capital markets unit to surge 56% from 2004 to 2006, a faster rate of growth than other businesses in investment banking or asset management. The firm securitized $146 billion of mortgages in 2006, a 10% increase from 2005. Lehman reported record profits every year from 2005 to 2007. In 2007, the firm reported net income of a record $4.2 billion on revenue of $19.3 billion. At the time Lehman was the biggest underwriter of US bonds backed by mortgages, accumulating an $85 billion portfolio, 44% more than Morgan Stanley and almost four times the $22.5 2

CHAPTER 1. LEHMAN BROTHERS billion of shareholder equity Lehman had as a buffer against losses.

1.4

The Role of Lehman’s Risk Management

In February 2007, Lehman’s stock reached a record $86.18, giving Lehman a market capitalisation of close to $60 billion. However, by the first quarter of 2007, cracks in the US housing market were already becoming apparent as defaults on subprime mortgages rose to a seven-year high. On March 14, 2007, a day after the stock had its biggest one-day drop in five years on concerns that rising defaults would affect Lehman’s profitability, the firm reported record revenues and profit for its fiscal first quarter. In the post-earnings conference call, Lehman’s CFO said that the risks posed by rising home delinquencies were well contained and would have little impact on the firm’s earnings. He also said that he did not foresee problems in the subprime market spreading to the rest of the housing market or hurting the US economy. Prices of securities backed by their mortgages sank, ultimately forcing Bear Stearns, Lehman’s main competitor in subprime underwriting, to tell investors in two of its hedge funds, which bet heavily on home loans, that their investments had been wiped out. Toward the end of 2006, people familiar with Lehman’s risk management operations say, executives at the firm started seeing trouble in the mortgage market. The securitization division raised rates on its bonds to reflect higher risk, which meant higher interest on the loans Lehman’s mortgage units made to home owners. When that did not slow borrowing, lending standards were tightened, a decision that was met with resistance by BNC and Aurora executives, whose fees depended on volume, the people say [4]. By the end of 2006, Lehman started hedging against its mortgage exposure. Some traders were allowed to bet against the prices of home loans by shorting indexes tied to mortgage securities. Still, Lehman President Gregory did not move fast enough to reduce risk, the people say. And at least two executives who urged caution were pushed aside. One was Madelyn Antoncic, 55, head of risk, who was moved to a government relations job in September 2007. Two months later, at a risk management conference in New York, she said that hedging mortgage positions had curtailed Lehman’s profit, which was difficult for top management to accept. The second was Michael Gelband, 49, who ran fixed income and was pushed out altogether in May 2007 after he balked at taking more risk, people familiar with the situation say.

1.5

The Beginning of the End

As the credit crisis erupted in August 2007 with the failure of two Bear Stearns hedge funds, Lehman’s stock fell sharply. Lehman Brothers became the first firm on Wall Street to close its subprime-lending unit and laid off 2500 employees of the BNC and other mortgage related units. Against the statements of the CFO from March 2007, shuttering BNC Mortgage LLC would cut third-quarter earnings by $52 million Lehman calculated at the time. BNC made about $2 billion of loans in the first quarter of  2007, already down 40% from a year earlier, according to industry newsletter National Mortgage News. BNC had 23 offices in eight states of which all were closed [3]. 3

CHAPTER 1. LEHMAN BROTHERS In addition, it also closed offices of Alt-A lender Aurora in three states. Even as the correction in the US housing market gained momentum, Lehman continued to be a major player in the mortgage market. In the fourth quarter of 2007, Lehman’s stock rebounded, as global equity markets reached new highs and prices for fixed-income assets staged a temporary rebound. However, the firm did not take the opportunity to trim its massive mortgage portfolio, which in retrospect, would turn out to be its last chance. Lehman’s hedges helped offset some losses in the second half of 2007 and the first quarter of 2008 though. While the firm wrote down the value of mortgage-related assets by more than $10 billion, the net reduction to profit was only $3.3 billion. Some of Lehman’s losses in that period were from leveraged loans, which are used by private equity firms and others for buyouts. The firm was stuck with the loans, which they had aimed to package and sell, when the leveraged buyout market froze in the second half of 2007. Fuld used the temporary recovery of credit markets in the first quarter of 2008 to offload one-fifth of the firm’s leveraged-loan portfolio. Yet he also tried to gain market share by borrowing against the firm’s capital to trade other fixed-income products for Lehman’s clients, people say. That increased Lehman’s risk in the event of a renewed downturn, as did its growing inventory of Alt-A loans. Fuld had bet the wrong way: In March, markets tumbled as defaults by homeowners surged, housing prices fell further and the US headed toward a recession. Reversing course, he ordered his associates to hunker down, people say. Traders were told to sell troubled assets or buy credit protection for further potential losses, which meant that if prices were to recover, Lehman couldn’t benefit. In other words, things weren’t going to turn around anytime soon [5].

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Chapter 2

The Bankruptcy of Lehman Brothers

“My goodness. I’ve been in the business 35 years, and these are the  most extraordinary events I’ve ever seen”  Peter G. Peterson, co-founder of Blackstone Group, and former head of Lehman

2.1

Heading towards the Weekend of September 14

The difficulties the financial services industry was facing during the year 2008, which were mainly caused by the subprime crisis, hit Lehman particularly hard: Pulling out BNC Mortgage of business and thus eliminating 2500 jobs in August 2007 was just part of Lehman’s decline, which should reach its nadir at the weekend of September 14, 2008 [12]. Lehman’s high degree of leverage - the ratio of total assets to shareholders equity - was 31 in 2007, and its huge portfolio of mortgage securities made it increasingly vulnerable to deteriorating market conditions. On March 17, 2008, following the nearcollapse of Bear Stearns - the second-largest underwriter of mortgage-backed securities - Lehman shares fell as much as 48% on concern it would be the next Wall Street firm to fail. Confidence in the company returned to some extent in April, after it raised $4 billion through an issue of preferred stock that was convertible into Lehman shares at a 32% premium to its price at the time. However, the stock resumed its decline as hedge fund managers began questioning the valuation of Lehman’s mortgage portfolio. Throughout the year 2008 Lehman had to suffer bigger and bigger losses caused by lower-rated mortgage-backed securities, culminating in $2.8 billion losses and a decline of its stock value of 73% at the end of the second fiscal year, announced on June 9. Lehman’s second-quarter losses, four times more than the worst analyst estimate and its first loss since being spun off by American Express. It also arranged a $6 billion share sale. 5

CHAPTER 2. THE BANKRUPTCY OF LEHMAN BROTHERS   “As painful as this quarterly loss has been, now is the time to look forward,” Fuld wrote to employees. “In past down cycles, the firm has always emerged stronger. We have done it before, and we will do it again.” The firm also said that it had boosted its liquidity pool to an estimated $45 billion, decreased gross assets by $147 billion, reduced its exposure to residential and commercial mortgages by 20%, and cut down leverage from a factor of 32 to about 25. However, selling $147 billion of assets in a jittery market meant taking significant losses. On top of that, people familiar with the transactions say, some of the hedges did not work. For example, Lehman bet against the CMBX index, a gauge of bonds backed by commercial mortgage bonds, to hedge its residential mortgage portfolio. In the second quarter, the index improved - the cost of protecting against losses on commercial mortgage bonds narrowed to 100 basis points from 150 while the prices of residential mortgages continued to drop, resulting in losses on both sides of the trade. However, the above described measures were perceived as being too little and too late. Over the summer of 2008, Lehman’s management made unsuccessful overtures to a number of potential partners. The stock should plunge 77% in the first week of  September 2008, amid plummeting equity markets worldwide, as investors questioned CEO Richard Fuld’s plan to keep the firm independent by selling part of its asset management unit and spinning off commercial real estate assets. In August 2008, shortly before the third-quarter announcements in mid-September, Lehman made public to lay off 1500 jobs, being 6% of its workforce. Having already laid off more than 6000 workers since June 2007, this round of Lehman’s head-count reductions should not only affect its mortgage origination and securitization businesses. Now, as business was stumbling from one sombre quarter to the next, jobs in investment banking and trading were also in jeopardy [13]. In August 22, 2008 investor’s confidence in Lehman should reach a small peak after the state-run South Korean firm Korea Development Bank announced it was considering buying Lehman [14]. On that day Lehman’s stock value appreciated by 5% and 16% over the week. After this short moment of euphoria Lehman’s shares finally fell sharply by 45% to mediocre $7.79 on September 9, when the Korean bank had to report to hold the negotiations due to “difficulties pleasing regulators and attracting partners for the deal” [15]. On that day the fresh concerns on Lehman’s stability and investor’s worries that Lehman could have major difficulties in finding new sources of capital pulled down the Dow Jones by 300 points and the S&P by 3.4% [16]. This decline more than wiped out the market’s revival on the day before, after the Bush administration rescued the mortgage giants Fannie Mae and Freddie Mac. The outlook and fear that the government might not come to rescue Lehman and that it may have to solve its problems on its own, finally lead to the market decline on that day [17]. The news was a deathblow to Lehman, leading to a 45% plunge in the stock and a 66% spike in credit-default swaps on the company’s debt. The company’s hedge fund clients began pulling out, while its short-term creditors cut credit lines. On September 10, Lehman’s share further dropped by 41% to $4.22, as it had to announce a loss of $3.9 billion and indicated its intention to sell its prized investment managing division, including Neuberger Berman. Among the potential buyers were Barclays of Britain, the Bank of America and private equity firms. At this point, Lehman 6

CHAPTER 2. THE BANKRUPTCY OF LEHMAN BROTHERS was already in a calamitous condition where it was trying to buy time to reach the weekend and complete a deal. As the potential buyers were seeking assistance from the Federal Reserve in form of assurances guaranteeing a part of Lehman’s troubled assets, it was still unclear whether the Fed would help [18]. The same day, Moody’s Investor Service announced that it was reviewing Lehman’s credit ratings, and also said that Lehman would have to sell a majority stake to a strategic partner in order to avoid a rating downgrade. These developments led to a 42% plunge in the stock on September 11. On Friday September 12, the New York Federal Reserve’s president Timothy F. Geithner summoned the heads of major Wall Street firms, so they could review their financial exposures to Lehman and work out plans over the possibility that the government had to co-ordinate an orderly liquidation of Lehman’s assets the next Monday. The meeting was very reminiscent to the meeting held ten years ago before the collapse of Long Term Capital Management (LTCM), a hedge fund firm that dealt with esoteric securities, when Bear Stearns, the hedge fund’s clearing broker, refused to contribute in an investment saving the fund. Besides Henry M. Paulson Jr., the Treasury Secretary, executives of all major investment banks and two foreign banks were present, but Lehman representatives were absent of the talks. At the meeting Messrs. Paulson and Geithner had to announce that the government was not willing to assure the potential buyers, as they were worried its help could establish a situation of moral hazard, and argued they were seeking an industry wide solution to stabilise Lehman. On the other hand, the Wall Street banks involved in this meeting argued that Lehman overreached and brought its troubles on itself. If a buyer of Lehman could not be found, they could collect their collateral and liquidate Lehman’s assets [19]. Finally, after nervous around-the-clock negotiations over the weekend, on Sunday September 14, Merrill Lynch agreed to sell itself to Bank of America. Lehman announced Barclays has ended the bid to buy all or part of Lehman and a deal to rescue the bank could not be settled. Bank of America, also rumoured to be involved in bidding for Lehman, had to reject its interests, too, as the regulators declined a governmental involvement in Lehman’s sale [20]. It was finally on that day when Lehman reached its nadir by announcing to file for bankruptcy protection on Monday September 15.

2.2

The Bankruptcy Law in the United States

Bankruptcy in the United States of America is permitted by the US Constitution and codified in Title 11 of the United States Code, commonly known as “The Bankruptcy Code”. The Code has been amended several times, especially in 2005 through the Bankruptcy Abuse Prevention and Consumer Protection Act, BAPCPA, which has particular significance for the financial industry. Bankruptcy cases are filed in US Bankruptcy Courts and governed under federal law, but state laws play usually a major role in bankruptcy cases, because these are often applied in property rights issues. Title 11 of the Code consists of nine chapters, six of which provide for filing a petition seeking relief. Depending on the circumstances, entities filing for petition chose under which chapter they file, while the three remaining chapters provide rules to govern these petitions. 7

CHAPTER 2. THE BANKRUPTCY OF LEHMAN BROTHERS

• Chapter 7: Liquidation

Liquidation under this chapter involves the selling of non-exempt property of the debtor and the distribution of the proceedings to his creditors. Most Chapter 7 cases are no-asset cases, i.e. the debtor keeps all his essential property.

• Chapter 9: Reorganisation for municipalities

This chapter is only available to municipalities and is a form of reorganisation, e.g. Orange County in 1994.

• Chapter 11: Reorganisation

This chapter will be discussed more in depth further down.

• Chapter 12: Reorganisation for family farmers/fishermen

This chapter is very similar to Chapter 13, but only available in certain situations.

• Chapter 13: Reorganisation for consumers

Bankruptcy under Chapters 11-13 is a complex form of reorganisation and allows the debtor to keep part or all of his property and use future earnings to pay off  his creditors.

• Chapter 15: Cross-border insolvency

BAPCPA added this chapter to deal with foreign companies with US debts.

Bankruptcy cases are either voluntary, where debtors petition the court, or involuntary, where creditors file the petition, e.g. to force a company into bankruptcy to enforce their rights. Voluntary cases are by far the majority of all bankruptcy cases. All bankruptcy cases commence with the establishment of the debtor’s estate, which consists of all property interests at the time of the case commencement, subject to certain exclusions. The bankruptcy estate of a company, partnership and other collective entities is for federal income tax purposes not a separate taxable entity from the debtor, contrary to individuals filing under Chapters 7 or 11, where the estate is separate. In particular, the estate is the net worth of an individual or company, being the sum of the assets (legal rights, interests and entitlements to property of any kind available for distribution to the creditors) less all liabilities, and is administered by a trustee in bankruptcy. At the moment the petition for bankruptcy is filed, an automatic stay is imposed. An automatic stay is an injunction, which prohibits the commencement, enforcement and appeal of actions and judgements by creditors against the debtor for the collection of a claim. Actions and proceedings towards the estate itself are prohibited, too. Violations of the automatic stay are treated as void ab initio or voidable, depending on the circuit 1 . In any case, violations of the stay, which give rise to damages, are assessed against the violator and may be excused without penalty or the violator made liable for punitive damages. 1

A circuit in the US is one of thirteen United States Courts of Appeals, historically organised by region and territory.

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CHAPTER 2. THE BANKRUPTCY OF LEHMAN BROTHERS 2.2.1

Chapter 11

Chapter 11 of the Bankruptcy Code allows reorganisation of any business, with the basic rationale behind, that a reorganised business is more valuable as a going-concern than the value of its parts in case of liquidation. In most cases the debtor remains in control of its business operations as a debtor in possession and is subject to the oversight of  a jurisdiction of the court. The rights and interests of the owners of companies filing under Chapter 11 with debts exceeding its assets are ended and the creditors are left with ownership of the newly reorganised company. Chapter 11 features tools and mechanisms to facilitate the debtor to restructure its business. The debtor in possession may acquire financing and loans on a favourable basis, providing the lender first priority on the earnings obtained by his advances. The priority scheme in Chapter 11 is the same as in the other chapters of Title 11, i.e. giving secured creditors (with security interest or collateral in the debtor’s property) higher priority than unsecured creditors, e.g. giving then employees higher priority than others. Each priority level has to be paid off in full before the next lower one can be served. The debtor can also obtain the permit to cancel or reject executory contracts, such as labour union contracts, supply/operating contracts or real estate leases, in case it would be favourable to the company and its creditors. The Chapter 11 plan for reorganization, with the goal to emerge debtors from the bankruptcy within months or years, is voted upon by the interested creditors. A confirmed plan becomes binding and identifies the treatment of debts and business operations. Debtors have the exclusive right to propose a plan for a specific duration (in most cases 120 days), after which creditors may also propose a plan. In case the involved parties cannot confirm a plan, the bankruptcy case may be converted into Chapter 7 liquidation or dismissed to return to the status quo before the bankruptcy filing, allowing the creditors to claim their rights by use of non-bankruptcy law. If a publicly listed company files under Chapter 11, its stocks are immediately delisted from the stock exchange, but remain very often listed as over-the-counter (OTC) stock, or in many cases the confirmed Chapter 11 plans render the shares of the company valueless. 2.2.2

Bankruptcy Abuse Prevention and Consumer Protection Act

The Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) gave many changes to the bankruptcy law, and hence often called “The New Bankruptcy Law”. Especially the changes concerning the financial industry, aimed to insulate banks from collapse of big clients, were significant, but also criticised. The changes made clear that certain derivatives and financial transactions are exempt from provisions in the Bankruptcy Code that freeze a failed company’s asset until a court decides how to apportion them among creditors. Notably, the BAPCPA enabled a non-debtor party without any limitation to terminate, liquidate or accelerate its securities contracts, commodity contracts, forward contracts, repurchase agreements, swap agreements or master netting agreements with the debtor. Interestingly, or unfortunately, with that terminology the Act expanded the scope and definition of financial transactions not covered by the Bankruptcy Code to products that were widely used by Lehman (and also Bear Stearns) and accelerated in that way Lehman’s collapse [23]. 9

CHAPTER 2. THE BANKRUPTCY OF LEHMAN BROTHERS In other words, by that, regulators expected to insulate financial companies from failure of very large derivative counterparties by making it easier for them to orderly terminate transaction agreements and retrieve collateral, and thus avoiding a domino effect initiated by these large counterparties, such as hedge funds. With the new law the counterparties are thus able to put themselves in front of the line ahead of other creditors in bankruptcy proceedings. Ironically, the policy makers never expected that the collapse could start from the other end [24]. In the end the BAPCPA effectively excludes financial services firms from the benefits of bankruptcy: “The Act’s extension of the Code’s protections for the financial services industry to include a broader array of financial contracts, all in the name of reducing systemic risk is a mistake,” according to Edward Morrison and Franklin Edwards from Columbia University. They argue a better, efficiency-based reason for treating derivatives contracts differently arises naturally from the economics theory underlying the automatic stay, i.e. derivative contracts are rarely needed to preserve a firm’s goingconcern surplus [15]. 2

2.3

Lehman’s Bankruptcy Filing

Lehman filed on Monday September 15, 2008 for bankruptcy protection under Chapter 11 of Title 11 of the United States Code. The case is in re Lehman Brothers Holdings Inc. (LBHI), US Bankruptcy Court, Southern District of New York (Manhattan), being by far the largest corporate bankruptcy in history, listing a total of $639 billion in assets, $613 billion in bank debt and $155 billion in bond debt. As only the holding filed, Lehman further announced that its subsidiaries would continue to operate business as usual. The way that Lehman filed for Chapter 11 shows that its executives hired the bankruptcy attorney as late as possible to avoid hints to its employees and to the markets, that bankruptcy was in consideration. Hence, there was no well-planned contingency plan to allow a seamless transition to the Chapter 11 state and to avoid a financial meltdown during the first days after the bankruptcy filing. But -possibly- a better plan wouldn’t have changed much since the BAPCPA added provisions that affected Lehman in a per se unfortunate manner. Actually, Lehman filed only three, non-substantial motions to open the bankruptcy case [15]: 3

• First motion asks the court to enforce the automatic stay provisions. • Second motion asks the court to extend the time to file required lists and schedules. • Third motion asks the court to waive the requirement that a filing include the list of creditors.

2

As a short side note: The Securities Industry and Financial Markets Association and the International Swaps and Derivatives Association, the bodies which lobbied for the 2005 changes never acknowledged the criticism, by arguing the changes “enhance legal certainty for contracts, (and) reduce legal risk ... and systemic risk” and “provided legal certainty by clarifying existing federal policy”. 3 A curious motion since the Southern District of New York is part of exactly the United States Court of Appeals for the Second Circuit, which treats violations against the automatic stay as void ab inito.

10

CHAPTER 2. THE BANKRUPTCY OF LEHMAN BROTHERS Lehman’s broker dealer unit received on the same day and the day after Federal Reserve-backed advances of a total of $138 billion from JPMorgan Chase & Co. to settle Lehman’s securities transactions with customers and its clearance parties, with the intention to stabilise the financial markets. As approved by the bankruptcy court, the advances provided by JPMorgan Chase were covered by existing collateral agreements with Lehman and its affiliates. JPMorgan Chase itself held $17 billion in collateral to secure the money it advanced [14]. The Dow Jones closed down just over 500 points, which was the largest drop on a single day since the September 11 attacks. 2.3.1

Major Asset Dispositions

On September 20, 2008, a revised proposal to sell the brokerage part of Lehman was approved by the bankruptcy court. Barclays was to acquire the Manhattan core business of Lehman for $1.35 billion, with the responsibility of around 9000 employees. With the deal, Barclays absorbed assumed $47.4 billion in securities and $45.5 billion in trading liabilities. The fact that only the real estate, which was acquired with the deal, was worth $1.29 billion (including the Manhattan headquarters skyscraper) shows the exceptional nature of the deal. Finally, on September 22 and 23, Nomura’s agreement to buy Lehman’s franchise in Japan, Hong Kong and Australia and its intentions to buy Lehman’s investment banking and equities businesses in Europe and Middle East were announced, and the deal became legally effective on October 13. 2.3.2

The Chapter 11 Process and Lehman’s Estate

Lehman’s estate is under administration of Alvarez & Marsal, having six asset teams in place, with the task to maximise the recovery value of the assets, mitigate potential liability, reconcile claims and meet the needs of the court, trustee and unsecured creditors committee. Since the in re LBHI commencement date, the chaotic state of Lehman’s estate came to stability by the beginning of the year 2009. Melting asset issues, loss of all accounting systems, a lack of asset inventory, loss of operational support and a major head-count loss to Barclays were difficulties for the estate administration. Cash positions in the Americas rose from $3.3 billion to $7 billion and the head-count could be stabilised.

2.4

Conclusion

Lehman’s collapse roiled global financial markets for weeks, given the size of the company and its status as a major player in the US and internationally. Many questioned the US government’s decision to let Lehman fail, as compared to its tacit support for Bear Stearns (which was acquired by JPMorgan Chase) in March 2008. Lehman’s bankruptcy led to more than $46 billion of its market value being wiped out. Its collapse also served as the catalyst for the purchase of Merrill Lynch by Bank of America. Less than a week later, on September 21, the Wall Street that had shaped the financial world for two decades ended, when Goldman Sachs Group Inc. and Morgan Stanley became bank 11

CHAPTER 2. THE BANKRUPTCY OF LEHMAN BROTHERS holding companies concluding that there were no future in remaining investment banks as investors had determined the model is broken. [6]

12

Chapter 3

Nomura 3.1

The History of Nomura

The Nomura Group has been founded in 1919 in Osaka by Tokushichi Nomura II, a wealthy Japanese stockbroking tycoon. Everything begun much earlier with Tokushichi II’s father, Tokushich Nomura. His father created a money changer business in Osaka in 1872, the Nomura Shoten. His son first helped him in his business and then went on to start in a new business in Japan at that time, stock brokering. This led Tokushichi Nomura II to found the nowadays called Nomura Group based on the idea that a long and sound customer relationship is the key to a successful business. The Nomura Group is the financial institution of a wider conglomerate named Nomura Holding. This conglomerate is based on the Japanese business model Keiretsu. Companies in a Keiretsu have strong and interwoven relationships but stay independent in their management. Those business groups are usually organized around a bank which lent to Keiretsu companies, hold equities in them and bail Keiretsu members out if needed [1]. Nomura Holding is a horizontal Keiretsu with companies present in many industries from oil and gas to construction, chemicals and foodstuffs [2]. The bank in this case is Nomura Group with a noteworthy group member named Nomura Securities (NSC). NSC is Japan’s most internationally famous stock brokerage firm. It has been established in 1925 in Osaka, when it spun off from Nomura Group. It was first a bond trading firm and became famous for inventing the conduit commercial mortgage. It was actually NSC, which should acquire the European and Asian operations of Lehman Brothers. NSC has managed throughout the 20th century to take advantage of political and economical difficult situations like the end of the Second World War, the 1965 Japanese recession or the oil shocks. This was made possible by the visionary company beliefs, always one step ahead of the industry competitors. The Economist once wrote “What Nomura does this morning, the rest of the Japanese securities industry will do after lunch”. For example in 1965, guided by the belief that economics and technology would be closely intertwined in the future, NSC founded an independent research institute to serve Nomura’s needs but those of Japan as well. Today Nomura Research Institute is one of the leading research organizations in Japan and the company’s belief at that time has been proved to be correct. During the 1980s, a cutting edge computer system was 13

CHAPTER 3. NOMURA one of the competitive advantages Nomura had on the market. NSC was the first Japanese company to be listed on an American stock exchange (Boston) in 1969 and the first Japanese company to be listed on the New York Stock Exchange in 1981. However they never really succeeded in taking a significant part on the American securities market. They founded the very successful European branch in the 1970s with its headquarters in Frankfurt. At the beginning of the 1990s during the Japanese economy crash, things started to get nasty. NSC faced many scandals and market troubles. However, they managed to stay financially sound and took the crisis as an opportunity to restructure their business and management model to become competitive again [7].

3.2

Nomura’s Acquisition of Lehman Brothers

Nomura started to move to acquire Lehman Brothers after the company filing for bankruptcy. After one week of decision, on September 22, Nomura declared the acquisition of Lehman Brothers’ franchise in the Asia Pacific region, including Japan and Australia. On September 23, Nomura acquired Lehman’s European and Middle Eastern equities and investment banking divisions. On October 7, Nomura moved further to hire former Lehman Brothers fixed income staff. Then on October 14, Nomura completely integrated the acquisition of three companies in Lehman’s eleven services platform in India which are LB Services India, LB Financial Services (India), and LB Structured Financial Services. 3.2.1

The New Workforce Resources

The new world-class human capital came from the former Lehman employees, which were around 8,000 people. Approximately 2,650 employees worked in equities, investment banking and fixed income in Europe. Approximately 1,100 people worked in the former Japan franchise. Approximately 1,500 people worked in Asia Pacific (ex-Japan), and around 2,900 worked in the subsidiary in India. The acquisition will give access to a broad range of clients and be complimentary in the business areas. Through the India acquisition, Nomura will also gain the strength of Lehman’s IT platform, being a crucial element for global business operations, i.e one of Lehman’s strengths was the high-velocity trading engine, which allowed Lehman to trade the stocks and bonds significantly fast. This is highly beneficial to the customers such as hedge funds. 3.2.2

Nomura’s Key Strategy

The key strategy behind the acquisition is to quickly overhaul the wholesale business by enhancing the product and service delivery as well as significantly expanding the international franchise and client base. Nomura also aims to create substantial value to the customers by investing in the infrastructure system. Another strategy is to reduce the cost of operation due to the acquisition and powerful infrastructure model. The last key strategy is to promote the world-class management structure in terms of organisation, management bodies, and corporate systems. 14

CHAPTER 3. NOMURA

Europe & ME

Japan

Acqu i sit ion of equ iti es and bank ing opera ti ons

Acqu ired Japan franch ise

inves t men t

Approx. 1 , 100peop l e Approx . 2, 500peop l e

H ired ex-Lehman fixe d s t a ff

Ind i a

income

Acqu ired t hree subs i di ar i es Approx . 150peopl e To t a l o f approx. 2, 900peop l e In t eres t ra t e , cred it, and currency li nked opera tions As i a (ex-Japan) Acqu ired As i a Pac if ic franch ise Approx. 1 , 500peop l e (ex-Japan)

LB Serv ices Ind i a IT , G l ob a l Serv i c i ng LB F inanci a l Serv ices (Ind i a) Research servi ce s LB S truc tured F i nance Serv ice s C ap it a l Marke ts Support and An a l y ti cs

Figure 3.1: New Workforce Resources 3.2.3

The Client Base

Nomura’s strength is on the Japanese equity products and services for traditional investors such as pension funds and mutual funds. Lehman’s strength lies on hedge funds and other similar clients due to its competitive execution services (see Figure 3.2). L eh m an Lehman

Global Equity

Traditional

Hedge Funds

Domestic Fixed Income

Japanese

Overseas

Niche

Broad

Retail & HNW

Wholesale

Overseas IB Others

Figure 3.2: Synergies in Client Business The acquisition of Lehman will help Nomura to increase the number of international investors. While Nomura holds a top share of JGB underwriting for domestic investors, Lehman holds a top rank for international investors. Furthermore, the Lehman investment banking branches in Asia and Europe will complement the client base, since Lehman is a top player in this market. Nomura can still maintain a top share in Japan and emerging markets such as India and Eastern Europe (see Figures 3.3 & 3.4).

15

CHAPTER 3. NOMURA Lehman %

Nomura % Hedge Funds

-

6.8%

M u tu a l F u n d s

Hedge Funds

56 . 8%

74 .2%

Others

-

19 .0%

*

-

18 . 3%

Mutual Funds

24 . 9%

Others

F igures are based on t op 30 c li en ts o f Nomura and Lehman s top 40 c li en ts in FY07 . ’

Figure 3.3: Synergies in Asset Management (Jan. 2 0 06 – S e p t. 2008)

E uro p e & ME

Equity Underwriting

A sia-P acific

Jap a n

33 , 952

Proceeds (US$ m il . )

11 , 523 1 , 499

(Bookrunner) (6 3)

5 , 161

2 , 712

482

(30)

(12)

(3)

( 19 )

(214)

(# o f Issues)

552 , 983

M& A (F inanc i a l Adv isor)

19 , 257

17 , 544

76 , 535

Rank Va lue (US$ m il . )

(348)

(# o f De a ls)

6 , 794 3 , 894

(154)

(29)

Source: Thomson Reu t ers

(24)

(29)

Leh man

(13) N O MU R A

Figure 3.4: Synergies in Investment Banking 3.2.4

Transition: The Road to Revenue

There are four phases to finish the integration of Lehman (see Figure 3.5). Phase 1

P h as e 2

Phase 3

Phase 4

World-class products & services

E qu it y H i gh ve loc it y tra d i ng engine F ixed Income G lob a l in t erest ra t es & currenc i es Invest me n t Banking

Broad cli en t reach

Broader coverage

New product s

Profit

Wo rld-c l ass peopl e G l ob a l f oo t pr in t

Revenue

Enhanced IT pl a tf orm As i a-Pac ific

Cost

Approx. 2 , 60 0

Europe & ME Approx. 2 , 65 0 IT p l a tf orm Approx . 2 , 90 0

Ex-Lehman Ex-Lehmansst at affff j oj oi ni nNomura Nomura

t art t SSt ar j oj oi ni nt topera operat iton i onss

Promo Promot et e eeffffici ci ency i ency

Crea Creat et e synerg synergi es i es

Figure 3.5: The Road to Revenue

16

Transform

CHAPTER 3. NOMURA The first phase is to acquire Lehman and offer the former Lehman employees to join Nomura. The second phase is to start the joint operations, integrate infrastructure and run up the business. The third phase is to promote the efficiency in the combined operation and infrastructure. And in the last phase, Nomura can expect revenues generated from the synergies in the next fiscal year. In addition, in the management structure, Nomura will allow to increase the diverse pool of management. This will enhance the performance of management to support the sophisticated nature of financial business. Under the new management structure, the three non-Japanese managers are appointed to be the Senior Managing Directors. Furthermore, Nomura tries to promote the right persons for each job and not only Japanese bankers. In the medium to long term, Nomura wants to become a world class player in investment banking. The benefit from the acquisition will dramatically help Nomura in many ways such as having world-class human resources, world-class services and solutions, and a world-class client base. In addition, a well structured synergy and the integration of  infrastructure will provide Nomura to become a world-class investment bank in the near future.

17

Chapter 4

Share Price Analysis 4.1

Idea

We make an analysis both over two trading days after the announcement of the first acquisition of parts of Lehman Brothers on September 22, 2008 and over one month. The acquisition of the Asia-Pacific franchise of Lehman was made public on September 22 and the acquisition of the European business one day later. The two day analysis is made to capture a rough proxy of the value that Nomura shareholders attributed to the businesses acquired. The analysis over one month shall give a more precise value since during that period Nomura shareholders received more details about the acquisition (see Figure 4.1).

Figure 4.1: Share Price Nomura Jan 08 – Oct 08

4.1.1

Assumptions

We proceed as follows: After having calculated a beta of 0.9179 for Nomura over a period of five years relative to the Topix Banking index, the benchmark index for the Japanese banking industry, we compared the two day performance over September 22-24 18

CHAPTER 4. SHARE PRICE ANALYSIS of Nomura and the benchmark. The notion is that the acquisition of Lehman Brothers should be priced in over that period. However, the ordinary performance of Nomura over that period is not a correct proxy since it is biased by the beta effect, i.e. the comovement with the general market. To neutralise that effect we calculated the difference of the two day performance of Nomura and the product of the beta and the two day performance of the Topix Banking Index to obtain an adjusted performance Radj = rNomura

− β  · rTopix.

which is computed as 4.21%. This figure reflects the performance of Nomura over the period of September 22-24 that cannot be explained by the movement of the benchmark index and should therefore reflect the idiosyncratic news Nomura was exposed to. That news is clearly the announcement of the acquisitions of several parts of Lehman Brothers. Using the 4.21% for the increment in value due to the acquisition and taking the number of shares of Nomura and the closing price on September 22 into account we compute an increment in value of  160,296,740,624 which at the time was - using the JPY/USD FX rate - $1,519,069,213. That value gives us the ad-hoc valuation that Nomura shareholders assigned to the parts acquired on September 24. We can refine this value by observing a one month period after September 22 rather than just two days. That procedure is meant to reflect the additional information about the businesses acquired that shareholders of Nomura received over one month after the announcements. We calculated the arithmetic mean daily performance over the period of September 22 – October 22 of both Nomura and the benchmark. Then we adjusted the performance of Nomura to obtain a beta neutral value according to the above equation. This value was computed as 0.2496% and thus gives monthly return of  5.74%. That translates into an increment of value of  218,466,727,995 or $2,198,269,954. That procedure reflects the more information available in the market one month after the acquisition announcement but is biased by the idiosyncratic information not related to the acquisition. We assume here that the market impact of that kind of information is negligible since there was no major news release not related to the Lehman franchise purchase.

4.2

Results

Using the one month approach rather than the ad-hoc two day procedure we get a value of close to $2.2 billion for the Lehman operations acquired. We have to challenge this value with our own NPV and real options analysis to check whether Nomura shareholders were too optimistic about the profitability of the acquisition.

19

Chapter 5

Net Present Value Analysis 5.1

Introduction

The document, which was the basis to undertake the NPV analysis, is an earnings statement/report from Lehman Brothers published only several days before Lehman was forced to file for Chapter 11 bankruptcy [26]. The report classified the earnings and net revenues (revenues minus interest expenses) by region as well as by activity, but not by region and activity which would have been ideal for our case study. Therefore we had to estimate them by separating the revenues from each activity by giving weights to each region that we obtained by dividing the region’s total revenue by the total revenue for Lehman. We ignored revenues of the fixed income department since it was not part of the deal. As we can see, despite large falls in revenues of equities, investment banking and investment management stayed positive throughout 2008 which cannot be said for the fixed income department. EMEA and Asia represented 52% (35% for EMEA and 17% for Asia) of total non fixed income revenues and therefore we attributed those weights in order to get profits by activity and region. Quarterly revenues in 2008 in equities were half those in 2007 but revenues from investment banking and investment management were still pretty stable in the first quarter of 2008 before slightly decreasing in the quarter ending on August 31. Therefore the departments Nomura bought in Lehman EMEA were still generating nice revenues in 2008. So why did Nomura buy Lehman EMEA for only a nominal value?

5.2

Salaries and Bonuses

Nomura’s bid was approved and favoured over its competitors’ bids because Nomura agreed to employ no less than 8000 former Lehman employees and guarantee their salaries and bonuses for years 2008 and 2009 at 2007 levels. The average bonus of a Lehman employee in those divisions stood at $332,000. This sums up to $2.65 billion in bonuses only. Nomura’s management insisted that this move was necessary to keep Lehman’s stars satisfied and loyal to their new employer. Did this really make sense in the September 2008 environment? Was competition to hire Lehman “star” employees really that tough? Most investment banks were experiencing big problems themselves and considering hefty layoffs in all departments. It is also

20

CHAPTER 5. NET PRESENT VALUE ANALYSIS worth mentioning that former Lehman employees in their Japan branch were guaranteed bonuses and salaries almost twice as high as those of their “old” Nomura employees with similar jobs. This might be a potential problem in the integration process and shall be addressed in the strategic analysis (see Chapter 7). With annual bonuses amounting to $2.65 billion and total revenues being only $2.6 billion, it was clear why many questions lingered over the deal. Nomura either expected revenues to attain their pre 2007 levels fast or they had a plan to lay off a sizeable portion of their ex-Lehman workforce in the future. Assuming the latter is the case, Nomura deliberately guaranteed jobs for 8000 employees for the years 2008 and 2009 knowing many of them would not be with them any more in 2010. Still assuming this hypothesis, regardless of whether Nomura would profit from the deal or not, we can already safely say that the biggest winners in the deal were the ex-Lehman employees. Not only were their astronomical 2007 bonuses guaranteed but some of them were offered jobs when in fact their work was redundant (given their salaries).

5.3

Idea

Our task in this chapter is to determine the value of the Lehman EMEA and Asia business given different hypotheses. In other words, we will try to evaluate future revenues that would make the deal break-even for Nomura and then give our opinion whether such a forecast is plausible or not. The break-even value would in fact be positive for Nomura because of the effects of synergies but here we will only concentrate on the future of Lehman alone and determine its stand-alone value. After extracting the revenue figures, the second step would be to evaluate the noninterest expenses. Page 12 in [26] gives us quarterly costs for the whole firm. Once again we shall assume that EMEA and Asia Pacific represent 52% of those costs and subtract costs linked to the fixed income business which we shall assume to account for 25% of total costs. We arrive at a figure of $2 billion for annual non-interest and noncompensation expenses. Salaries plus benefits and bonuses amount to about $4 billion for the European and Asian business. This gives us total costs in the region of $6 billion whereas total revenues stand at only $2.5 billion. The acquisition will therefore cost Nomura about $3.5 billion in the first year assuming market conditions stay the same as in Q4 2008. The “real” price Nomura paid for Lehman is therefore these $3.5 billion plus all further losses attributed to Lehman in the years to come. Even if we find the NPV to be positive, the investment requires a down-payment of at least $3.5 billion in the first year of the acquisition. Given the liquidity and credit conditions in September 2008, it is easy to see why there was a shortage of bidders for Lehman EMEA and Asia Pacific. 5.3.1

Assumptions

We shall assume that Nomura will be able to reduce non-interest and non compensation costs by 10% in the years 2009, 2010 and 2011 and that they remain constant in the following years. We shall also assume that Nomura will lay off approximately 10% of  their work force each year in years 2010, 2011 and 2012 and thus lower compensation costs. From then on we will assume that compensation will represent approximately 21

CHAPTER 5. NET PRESENT VALUE ANALYSIS 50% of total revenues as was the standard in investment banking in recent years. As far as net revenues are concerned, we predict a gloomy 2009 with negative growth, a small comeback in 2010 and then a larger one in 2011, 2012, and 2013 before a stable period with approximately 10% growth rates in the following years. We regard these as rather optimistic assumptions. We shall assume that interest rates stay low for quite some time before gradually increasing in the middle of the next decade. We also assume a beta of  1.7.

5.4

Results

With these assumptions we come up with an NPV of -$668 million. Lehman would become profitable only after 2014. On the other hand, Nomura is confident that they can turn around Lehman and become profitable before 2012. Their revenue growth assumptions are therefore more optimistic than ours or they envisage cutting their workforce more than 10% in the first three years. Another possibility is that they value the synergies brought by the deal at more than $668 million plus the $200 million they paid for Lehman Asia Pacific. We shall try to put a number on those synergies in the real options analysis (see Chapter 6) and discuss it in a qualitative way in the strategic analysis (see Chapter 7), but a priori they are not enough to compensate for the $868 million. Will Lehman have to reduce their workforce by more than 15%? They would have to reduce their workforce by 20% in 2010 and 15% in 2011 in order for the acquisition to break-even. This sums up to approximately the same number of employees as in the situation where they would have to cut the workforce by 10% in 2010, 2011, and 2012. Fast restructuring is therefore vital and it is in our opinion that Nomura should act boldly in reducing their workforce as soon as the year 2010.

22

Chapter 6

Real Option Analysis 6.1

Idea

In this section we shall try to quantify the opportunities given to Nomura following their acquisition of Lehman Brothers. As we saw in Chapter 3.2, one of the reasons why Nomura chose to buy Lehman EMEA and Asia Pacific is that it would provide Nomura to become a global investment bank and gain a significant market share in the EMEA and Asia Pacific regions including its home country Japan. Indeed, as we shall see Lehman and Nomura operate complementary businesses. The acquisition therefore gives Nomura the opportunity to expand its traditional business in EMEA and Asia Pacific because it will already have its brand name and reputation consolidated in those regions. They would then be slowly be able to expand into businesses such as fixed income which they will not have at first. This can be seen as an option to expand. This option therefore has some value and should be considered in our valuation. There are numerous studies on how to value such an option, one of them is the MacDonald and Siegel (1986) model which we will use in this section [25]. The value of the acquisition can be seen as: V acquisition = N P V  + C 

where C  is the option value. 6.1.1

The MacDonald and Siegel Model

We will denote by V t the present value of future revenues if the option is exercised at time t. If it were today, V 0 would be nothing else than the NPV of the newly established fixed income business and others. We will also denote H t the present value of the costs associated with the expansion. And we shall assume that V t and H t follow the following stochastic rules: dV t = α1 dt + σ1 dW 1,t V t

·

·

dH t = α2 dt + σ2 dW 2,t H t

·

·

and let ρ represent the correlation between the two Wiener processes. 23

CHAPTER 6. REAL OPTION ANALYSIS note: V t = E ( 0 e r(u t) Ru du F t ) where Ru are the revenues at time u. The option value is given as

 

∞

−

|

−

C  = sup E P ((V τ  τ 

− H τ )+e

−

rτ 

)

The preceding equation is correct because Nomura will exercise its option, which will yield V τ  H τ  in present value terms at time τ , therefore we have to discount it back to today. τ  is therefore a stopping time.

−

= sup E P (H τ ( τ 

= sup E P (H 0 e(α

2−

V τ  H τ 

σ22 /2)τ +σ2 W 2,τ 

τ 

= H 0 sup E P (e

−

− 1)+e (

rτ 

−

V τ  H τ 

(r−α2 )τ −σ22 τ /2+σ2 W 2,τ 

τ 

= H 0 sup E Q (e

(r−α2 )τ 

−

−

e

σ22 τ /2+σ2 W 2,τ 

τ 

We choose Q such that e therefore

dQ dP 

=e

−

(

)

− 1)+e (

V τ  H τ 

V τ  H τ 

rτ 

−

)

− 1)+)

dP  − 1)+ dQ )

σ22 τ /2+σ2 W 2,τ 

−

σ22 τ /2+σ2 W 2,τ 

· dP  dQ = 1 and W 2,t − σ2 t; t ≥ 0 is a Q Brownian motion.

C  = H 0 sup E Q (( τ 

V τ  H τ 

− 1)+ e

(r−α2 )τ 

−

)

Using the optimal stopping theorem, Laplace transform, Ito formula and orthogonal decomposition theorem this equation gets us to: C  = H 0 (Lc

where Lc = 6.1.2

θ

1, θ =

θ−

−

√α +2(r

α+

2

Σ

α2 )

−

V 0 H 0 θ

− 1)( Lc )

,α=

α1 −α2 −Σ2 /2 , Σ

and Σ =

σ12 + σ22

 

− 2ρσ1σ2

Assumptions

We shall assume that the revenue in the first year R0 would be $300 million (approximately one sixth of what Lehman was earning through its fixed income business in EMEA and Asia Pacific) and that it would grow at a growth rate of  α1 = 0.1. Therefore V 0 = r Rα = 3 billion dollars assuming the average cost of equity to be 0.20. We shall assume the first year costs to be $300 million and growing at a rate of  α2 = 0.06. We assume a high growth rate of costs to represent wage increases and to artificially offset the anomaly where one can wait for a long time and then exercise the option with huge profits and low costs in the first year of the project. This gives us H 0 = r K α = 2.142 billion dollars. We assume σ1 to be 0.20 and σ2 to be 0.05 given the uncertain nature of revenues and the contrary for costs. We also assume the correlation between the two Wiener processes to be ρ = 0.5, which could represent bonuses for good years and cutting costs for bad years. 0

−

1

0

−

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2

CHAPTER 6. REAL OPTION ANALYSIS

6.2

Results

Plugging in the values we get C  = 963 million USD. Therefore the acquisition can be valued as the NPV plus these $963 million. This value is very sensitive to our assumptions and we cannot precisely predict the revenues of the expansion nor the costs, however the goal of this chapter was not so much to give an exact price as it was to show an alternative way to value Nomura’s investment and give us a clearer picture of the deal. It is worth noting that the figure we got is not that far away from V 0 H 0 = 858 million USD. This implies that there is value in waiting rather than expanding immediately but given the high cost of equity the exercise time is not that far from today. Our cost of equity estimate probably was high due to low interest rates we are experiencing today. For a cost of equity of  0.18 we get a value of $1021 million. The low interest rates are therefore a blessing for Nomura and give even more value to the option to wait and expand their business in EMEA and Asia Pacific.

−

25

Chapter 7

Strategic Analysis 7.1

Introduction

The main argument Nomura had when acquiring part of Lehman Brothers was the potential synergies that this acquisition could provide. This dimension is very hard to assess quantitatively. Hence, this chapter will provide a qualitative and strategic analysis of the acquisition to complement the previous quantitative investigations. Before September 2008, Nomura was a bank mainly focused on Japanese equity products and services for traditional investors such as mutual funds and pension funds. On the other hand, Lehman was an investment bank with strengths in hedge funds and mostly present in the USA and Europe. When looking at their core competencies, we see that those two banks have very complementary businesses.

7.2

SWOT Analysis

We use a SWOT analysis to base our strategic analysis and assess with qualitative arguments whether buying part of Lehman was a good move for Nomura. In order to do the SWOT analysis, we have to first define the main goal of this acquisition. This goal was defined by Nomura as “becoming a world class investment bank” by “maximising synergies using competitive resources” and having a “vertically integrated international wholesale business”. Once this goal is defined, we first assess what are the present strengths and weaknesses of Lehman. Then from this assessment, we evaluate what are the potential future opportunities and threats this deal would create for Nomura (see Figure 7.1). This analysis shows that the acquisition has the potential to create great synergies due to economies of scale and complementary businesses. In the banking industry size plays an important role to be competitive. Buying the European and Asian activities of Lehman will give Nomura the opportunity to become a competitive player on those markets, which was not the case so far. Lehman also possesses powerful IT and R&D departments developing platforms like high velocity trading machines. Acquiring those departments and merging them with the present IT and R&D departments at Nomura could also produce great innovations and a potential cost-leadership position on the market. This is the reason why Nomura

26

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Figure 7.1: SWOT Analysis also acquired three IT subsidiaries based in India. However, this acquisition presents great challenges that could offset the presented strengths and opportunities. First, in order to retain Lehman’s employees, Nomura promised to keep the bonuses at the same level for 2008 and 2009. This represents a huge cost of $2.65 billion that cannot be cut as developed in the NPV analysis. This is a necessary move in order to retain Lehman’s best employees, which represent a key competitive advantage in this industry. With this offer, Nomura succeeded to retain more than 95% of former Lehman employees. Nomura and Lehman are two very different companies. On the product and market side this is a strength as analysed before. On the cultural side this represents a threat. Nomura is a Japanese company with a very conservative and risk adverse strategy. The employees are usually employed lifelong with great job security but low salary. On the other hand, Lehman is a Wall Street bank with a very aggressive and risk taking strategy. Working for this bank implies high salary and bonuses but also high job insecurity, high competition and intense work. Merging those two cultures is a great challenge and could create big frictions in the future. With hindsight we know that in Europe Lehman’s culture took over Nomura’s culture. Hence, on a business cultural level, we could say that Lehman acquired Nomura in Europe. In Japan, Nomura employees were offered to choose between their old job scheme or a “Lehman style scheme” offering them higher salary but lower job security.

7.3

Results

What has been done so far looks like a good strategy to hedge those cultural problems. Nomura has to redefine itself and find a new corporate culture that gives incentives to perform to employees coming from both worlds in order to gain advantage by creating synergies through both cultures.

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Conclusion Putting together all the analyses done in this paper following conclusions can be drawn: Given all the conditions of the acquisition, especially on the salary issue, the NPV is negative at -$668 million. This explains why Nomura had the opportunity to buy the European equities and investment banking division for a price as ridiculous as $2. Our NPV analysis gives an insight on how the new Nomura should restructure itself in order to become profitable again as soon as possible. Doing only an NPV analysis does not reflect the true value of the acquired company. The Real Option analysis shows that $1 billion could be added to the NPV value. Although very sensitive to the underlying assumptions, this analysis affirms that the option of waiting and expanding in EMEA and Asia Pacific makes the deal interesting for Nomura. Comparing this analysis to how the market reacted shows that our analysis is more pessimistic but still comparable. The Share Price analysis shows that the market valued this acquisition at $2.2 billion. These quantitative insights have to be put into perspective with a strategic and qualitative analysis capturing issues like corporate culture issues and potential synergies. A SWOT analysis and an investigation of the two companies’ previous core businesses shows that this acquisition could generate great synergies and transform Nomura into a key player in the global banking industry. This was precisely Nomura’s goal when acquiring part of Lehman Brothers. This paper shows how complementary the two banks are in terms of products, customers and geographical locations. However, history in merger & acquisition shows that huge acquisitions by companies not used to it tend to destruct shareholder value. Great cultural difference tends to make the acquisition fail as well. Nomura combines both of those weaknesses. The cultural issues, as discussed in the Strategic analysis, are most probably the greatest challenge for Nomura in the future. Hence, we see so far that the decision whether this acquisition is a good move by Nomura or not is not obvious. The opportunities are huge but the challenges on all levels are great. However, given the amplitude and uniqueness of the crisis, which lead Lehman Brother to bankruptcy, and given that Nomura was financially strong at that time, the acquisition was probably a good move. As Nomura said, “this is the opportunity of  once in a life time”. We conclude that this acquisition is a risky bet for Nomura but, if  managed carefully and properly, still a good one.

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