Sharing Our Experience With Our Clients First, As Always

To Our Clients

For most of last quarter, we at Jefferies chose to ‚bare it all? in what was for us an uncharacteristically public fashion. We entered November focused as ever on serving you, our clients, and immediately found ourselves facing a gauntlet of serious challenges that we felt we needed to address full force and head on. This experience was incredibly stressful and, while we can now see we will be a better firm because of it, there is no doubt it will have a lasting effect on how we look at ourselves and how we operate Jefferies. While you may already have heard more than you need from us and the media about this subject, since Jefferies is in the business of advising both investors and companies, we thought we would share with you some of the major lessons we learned from our recent experience. We hope you can gain something of value from our experience that will help you be better investors and leaders of companies as you navigate increasingly volatile and complex global economies and markets.

Please keep in mind that none of these comments or observations represent anything resembling a victory lap or a proclamation of any type of success. We too are learning every day, as there is no road map or manual for building a company in today’s uncharted new world. While this experience has affected all of us deeply, we are thankful that the truth has been accepted and we can get back to building our firm and serving you, our clients. We would be remiss if we did not ask you to consider Jefferies’ focus and determination over these past two months and what these efforts say about our firm, as well as our capability and passion to serve you and your needs.

Here are some of the more significant lessons and observations we would like to share with you:

1. Relationships Matter. Today’s world moves very fast — faster than we ever realized. The media, old and new, social networking, electronic communication and execution, and high-frequency trading all operate at a pace that requires laser-focused, real-time responses. One can come to work on any given day and find oneself in the center of a hurricane that was not visible in its formation and for which one may not be prepared. Research analysts and rating agencies (genuine professionals and others), television, print and electronic reporters, bloggers, chat-room participants and competitors can feed instantly upon each other in a manner that compounds exponentially and ultimately can lead to panic. They can attack your financial condition, your product or service, your customers, your team or you personally. This combination can turn a company with decades of minimal press coverage and modest average daily trading volume into a major corporate news story and one of the most active stocks around. Shareholder bases can change quickly, and, in this world of viral communication, random and even unprofessional opinion makers can have as much clout as experienced and historically trusted professionals. This can happen to any company in any industry. The lesson here is that there is no substitute for true long-term relationships. The major rating agencies need to have real relationships with the most senior members of the management team and there must be a bond of trust. All that trust will buy you is the possibility they will actually take the time to do the work, rather than panic like everyone else. For the same reason, there must be a degree of trust with as many stockholders and bondholders as possible. There is nothing like a long-term quality shareholder and bondholder base to build upon and protect a company in moments of extreme stress. The same goes for clients, counterparties and suppliers ” one must constantly build trust with every constituency, so that you have a basis for rational discussion and consideration in times of fear and panic. It takes relentless effort to achieve this trust and it can be jeopardized in one moment if it is taken for granted or abused. (Please note that the point we are making here is not a knock on legitimate short sellers who can provide a very important function.)
2. The Environment Matters. One must pay very close attention to developments in the macro environment, even when it doesn’t appear to be directly relevant. MF Global wasn’t one of our top competitors. So many aspects of our firm are so different from MF Global — in fact, how we operated our respective businesses were night and day. Yet, we erred by not realizing this didn’t matter, given the skittishness of the world today and the magnitude of damage that can be inflicted by the players we mentioned above when they feed uncontrollably upon each other. In unstable times, correlation can be very high, and you must understand everything possible about the landscape in which you operate and be aware of all forces from which media/bloggers/investors/customers will extrapolate. One can’t be aware enough about the environment and its impact.
3. There Is No Substitute For A Strong Capitalization. If you have adequate long term capital, a solid balance sheet, ample liquidity, a contingency plan and a business model that is sound, you can survive a bad storm. If this is not the case, you are highly vulnerable. There is obviously a tradeoff between returns to shareholders and an unduly strong balance sheet, but without a firm foundation, the shareholders may never see a dime. There is a time to raise equity and a time to buy back shares. The same is true for loans, bonds, preferreds and convertible securities. There is also a time to do absolutely nothing to your capitalization. Making the right decisions at the right time on capital structure will allow one to absorb the unavoidable mistakes along the way without drastic consequences. It may not sound like a brilliant concept, but everything will be OK so long as one gets the big decisions right, and having adequate capital is a critical first decision. If your company is built on a solid foundation, it can endure almost anything.
4. There Are Times to Just Play Defense. Sometimes, the goal is simply to protect your shareholders’ equity at all costs, versus optimizing results or returns. We focused this past quarter on making sure our very significant equity base was protected for the benefit of our shareholders and all who depend on us. That was our number one, two and three priorities. We will always be highly focused on delivering the very best long-term returns possible for our shareholders ” that goes without saying. However, there are periods of time that shareholders will not get rewarded for any incremental risk or aggressiveness, and one must recognize those inflection points and act accordingly.
5. Stay Humble and Transparent. Never allow a drop of arrogance into your organization. We have always operated with the firm belief that we are ‚not too big to fail.? That is why we chose the route of aggressive transparency to assure the truth about Jefferies is well known. We cannot expect clients, the real rating agencies, shareholders, bondholders or counterparties to give us the benefit of the doubt, if we do not give you and them all the ammunition we would need if we were in your and their places. Similarly, we could have fought the fight by insisting that we had the exact same approximately 12.9:1 leverage we had for the past several years, so why can’t we continue to operate as we did before, given our mix of liquid assets and strong operating businesses. Further, we knew our sovereign bond market making positions were truly hedged, so why make changes there? In our opinion, that would have been arrogant. Instead, we embraced that the world has changed (at least for now) and decided we should be an example of how to operate in the new environment, with a year-end balance sheet reduction of nearly 25% and a huge reduction in the relevant bond positions. We chose to become the most transparent, least levered and still full service investment banking firm, with the goal of a solid long term return on equity based on our customer-focused model.
6. Bond Prices Matter. One must always pay attention to the price of a company’s bonds, as that is the greatest barometer of investor trust. That is why credit default swaps are so dangerous, as they can often trade in a very thin market that is easily moved and can have a direct impact on bondholder sentiment. We committed significant capital to allow our traders to make an orderly market in our bonds because we saw liquidity from others drying up when misinformation permeated the market. This has implications for every company when selecting underwriters, as one is really choosing a long-term partner and not just a placement agent.
7. The Right Board of Directors Matters. Why would one ever invest in a company that doesn’t have a fully engaged, fully informed, heavily invested and pro-active Board of Directors? Why would any CEO not want to surround himself/herself with people far smarter and more experienced than the CEO? The Board of Directors is crucial to a company’s effectiveness, especially during challenging times.
8. Never Stop Communicating Internally. One cannot have too much transparent communications with everyone in your company during times of stress. Our team is the backbone of our firm, and we kept them fully abreast of all matters so that we could all deliver the message and deliver upon our promise to serve our clients. In return, we received instant and vital communication and feedback from those in the trenches that were closest to our clients, shareholders and bondholders.
9. Teammates Matter. One cannot have a weak link in one’s senior leadership team. During times of stress, people either rally to the challenge or fail because it just becomes “too much.? One weak link will cause the entire team to fail, as business is a team sport. In this regard, we can say without any hesitation that every one of our key links is now battle tested and proven to be titanium strong — and we greatly appreciate it. We also learned that the number of key links (people) upon whom one must rely in times of stress goes far deeper throughout our firm than we ever understood.
10. Culture Matters. Institutions define themselves during periods of extreme stress. While nobody seeks an experience like we just went through, there is nothing like an all-out crisis to remind everyone how much they value their job/career/co-workers/equity and how much we appreciate a platform that allows us to truly serve our clients. If the culture has a rich fabric and is genuine, that becomes the glue that ultimately allows an organization to emerge stronger as the result of overcoming a painful challenge.

These are just some of our observations/lessons/thoughts/emotions as we enter 2012. We share them with you hoping you might see something that you can relate to or learn from, hopefully without any one of you having to go through a period like the one we just experienced. Please forgive us if this note sounds ‚preachy,? but we have just been through a very real experience and thought an honest and direct note to our clients would be more useful than a typical New Year message.

We close with one final thought: You, our clients, stuck with us during this most challenging period and we want you to know that this has meant the world to both of us personally, as well as to our entire firm. We had a tremendous outreach of support and we heard/felt the bleachers filled with you cheering us on as many of you went out of your way to do businesses with us when the noise level was the loudest. Our promise back to you is to continue to keep our platform strong, as we do our best to serve each of you to the best of our abilities every single day.

With appreciation and less leverage,

Rich and Brian