Jefferies Group's CEO Discusses Q3 2011 Results - Earnings Call Transcript

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Jefferies Group (JEF) Q3 2011 Earnings Call September 20, 2011 9:00 AM ET

Executives

Peregrine C. de M. Broadbent - Chief Financial Officer, Principal Accounting Officer and Executive Vice President

Brian P. Friedman - Director, Chairman of Executive Committee and President of Jefferies Capital Partners

Richard B. Handler - Executive Chairman, Chief Executive Officer, President and Director of Jefferies

Analysts

Lauren A. Smith - Keefe, Bruyette, & Woods, Inc., Research Division

Christoph M. Kotowski - Oppenheimer & Co. Inc., Research Division

David M. Trone - JMP Securities LLC, Research Division

Michael Holton - Merrill Lynch

K.C. Ambrecht - Millennium Partners

M. Patrick Davitt - BofA Merrill Lynch, Research Division

Daniel F. Harris - Goldman Sachs Group Inc., Research Division

Douglas Sipkin - Ticonderoga Securities LLC, Research Division

Jeffrey Harte - Sandler O'Neill + Partners, L.P., Research Division

Operator

Welcome to the Jefferies 2011 Fiscal Third Quarter Financial Results Conference Call. [Operator Instructions] As a reminder, this conference call is being recorded. A press release containing Jefferies 2011 fiscal third quarter financial results was distributed via Business Wire before the market opened today and can be accessed at jefferies.com.

Some of the comments made in this conference call may include forward-looking statements. These forward-looking statements may contain statements about management's current assumptions, expectations, strategic objectives, growth opportunities, business and prospects. These forward-looking statements are not statements of historical fact and represent only Jefferies's belief as to future performance. They usually include the words continue, will, believe, should, estimate or other similar expressions. Actual results could differ materially from those projected in these forward-looking statements. Please refer to Jefferies's Transition Report on Form 10-K filed with the Securities and Exchange Commission on February 2, 2011, and Jeffries's Form 8-Ks for discussions of important factors that could cause actual results to differ materially from those projected in these forward-looking statements.

I would now like to introduce your host for today's conference, Mr. Richard Handler, Chairman and CEO of Jefferies. Mr. Handler, you may begin your conference.

Richard B. Handler

Good morning, and thank you for joining our discussion of Jefferies's third quarter results. I am Rich Handler, CEO of Jefferies, and with me on the call today are Brian Friedman, Chairman of our Executive Committee; and Peg Broadbent, our Chief Financial Officer.

For the 3 months ended August 31, 2011, Jefferies posted net revenues of $509 million, net income to common shareholders of $68 million and earnings per share of $0.30. It is important to note that our net revenue include a nontaxable onetime accounting gain of about $53 million related to bargain purchase accounting for our Bache acquisition. After certain acquisition-related expenses, this gain has a net -- has a $45 million or $0.20 per share positive impact to our net income for the quarter, which Peg will discuss in detail later.

We believe our core results should be viewed without this impact, which will result in net revenues of $457 million of net income -- and net income of $23 million and earnings per share of $0.10. Our results for the quarter substantially reflect the challenging trading conditions across global markets, which were particularly pronounced in August, and led to significant declines in certain inventory and hedge values during the quarter.

Continued concerns over the deteriorating global economy, combined with the political uncertainty over the U.S. debt ceiling resolution, muted trading activity in June and July. That said, the environment in August was outright brutal. As recently as August 1, we believe we have the opportunity for a satisfactory quarterly result. Beginning in August, however, the ugly reality of the European sovereign debt and bank liquidity crisis drove a period of sustained financial market volatility, as well as interest rates spread widening that led to a significant deterioration in the absolute and relative value of certain assets and hedges.

By the end of August, some fixed-income markets had declined by as much as 15% from May 31 levels, and credit spreads widened significantly. Indeed, August was the third worst month in the history of U.S. credit markets after September and October of 2008, leading to broad-based write-downs in inventory values, which significantly reduced our quarterly fixed income revenues. We will provide further details on our trading results in a few minutes.

Despite the challenging environment and the postponement of several deals, our Investment Banking revenues for the quarter were a solid $294 million, which include record quarterly Capital Markets revenues, and reflected the continuing success we are having in building our firm. Brian will discuss our Investment Banking results in more detail later. As expected and previously announced, we closed on the Bache acquisition on July 1. Our results, therefore, include the impact of 2 months of Jefferies Bache's activities. To date, Jefferies Bache business line of listed commodity derivatives, foreign exchange and metals trading, have performed consistently with our expectations. We are pleased with our team, our platform and our opportunity to significantly grow Jefferies's Bache businesses.

Last month, we closed a $950 million 3-year committed bank revolving credit facility to support Jefferies Bache's day-to-day inventory and liquidity requirements. While still in the fourth -- while we're still early in the fourth quarter, and despite an environment of uncertainty and volatility, our trading results have improved so far in September.

Now I will turn to Peg to discuss our results and financial condition in more detail.

Peregrine C. de M. Broadbent

Thank you, Rich. As Rich mentioned, our net revenues include a gain of $52.5 million, connected with our acquisition of Bache. Accounting Standards Codification 805, which includes the GAAP guidance on acquisition accounting, requires that upon acquisition we recognize all Bache's net assets at fair value, including any intangible assets that were not previously included on the balance sheet. To the extent that the acquired net assets including intangibles exceed the purchase price, then GAAP requires us to record the difference referred to as a bargain purchase gain in our results of operations.

The fair value of the Bache net assets acquired was $475 million which exceeded our cash purchase price of $422 million. The excess value acquired or so-called bargain purchase gain of $52.5 million is not taxable and has been recorded in our other income line. It should be noted that, as we amortize approximately $27 million in related intangible assets and incur future compensation expense for future retention and stock replacement awards, they will impact future periods' net income by about $27 million. The net impact of these future expenses to each of our next 14 quarters will be less than $0.01 per share per quarter based on our current share count.

Now for the results, which as Rich mentioned, should be viewed without the purchase accounting gain in order to reflect the actual results of our core operating activities and be comparable with other periods. Without the impact of the Bache items, net revenues would have been $457 million, a reduction of 12% from the third quarter of 2010, net income of $23 million and earnings per share of $0.10. These items are outlined on the supplemental schedule provided in our earnings release.

Equities net revenues for our third quarter were $127 million, up 16% from the third quarter of 2010. Fixed income net revenues, which include 2 months of Bache activities, were $33 million, down significantly from our third quarter 2010 results of $161 million. Investment Banking revenues were $294 million, an increase of 19% over the third quarter of 2010. Also $294 million, Capital Markets revenues were a record $187 million, and advisory revenues were $170 million.

Asset Management revenues for the quarter were $3 million compared to the near 0 net revenues reported for the third quarter of last year. Our non-compensation expenses, which include 2 months of Jefferies's Bache expenses, were $169 million versus $160 million for the second quarter without Bache.

Our all-in compensation accruals for the third quarter and the 9 months ended 31st of August were 58.8% and 58.9%, respectively. Adjusting net revenues for the impact of the purchase accounting gain and adjusting compensation expense for the compensation charges associated with acquisition, our adjusted compensation expense accrual for the third quarter was 63.6%, bringing our 9 months ended August 31 to 60%. The compensation charges associated with the acquisition include 2 months of amortization obligations we described earlier.

The adjusted third quarter rate should be compared to the 59.4% recorded in the second quarter. We repurchased 3.1 million shares during the quarter for an average price of $17.61. There remain roughly 6.7 million shares authorized for future repurchases.

Book value per share was $15.85 at quarter end based on 200 million shares outstanding. Adjusted book value per share was $14.90 based on 225 million shares outstanding, including restricted stock units. We estimate that our total assets were about $45 billion at August 31, including the Jefferies's Bache assets which were about $5 billion. We estimate that our average balance sheet during the most recent quarter was about 15% higher than the quarter-end amount.

We estimate our quarter-end Level 3 assets, after accounting for noneconomic interests, were approximately $576 million, and continue to be about 3.5% of total assets at fair value. We estimate that our average VaR for the quarter will decrease approximately to $10.5 million from the $12.7 million reported in the second quarter. The impact of the increased market volatility during the quarter was more than offset by some diversification benefits derived from the Jefferies's Bache businesses, as well as reducing our risk exposure in certain businesses.

Our tax rate for our third quarter was 2.2%. Adjusting profits before taxes for the impact of the purchase accounting gain, our tax rate for the quarter was 38.9%. As with the adjusted compensation rate, the adjusted tax rate should be used for comparisons to other quarters, including the second quarter, when the tax rate was 35.1%.

As mentioned before, the tax rate for any given quarter is derived from our then current estimates of total pretax profits for the full current year and the expected mix of those profits by business and tax jurisdiction. The quarter-over-quarter increase in normalized tax rate is attributable to any change in our now anticipated full year mix of taxable profits by business line and region.

At quarter end, we had a total of 3,842 employees, a net increase of 620 people since the end of the second quarter. 2/3 of our new Jefferies partners for the period joined us through our Bache acquisition.

Brian will now address in more detail our Investment Banking results.

Brian P. Friedman

As Peg indicated, Investment Banking net revenues were $294 million, an increase of 19% from the $246 million generated during the comparable quarter last year. Our Capital Markets revenues were a record $187 million, nearly twice the $97 million we reported in the comparable period a year ago.

Debt capital markets generated $128 million, and equity capital markets $59 million. Despite the volatility in the secondary markets, debt capital markets continue to be open for much of the third quarter with attractive financing terms generally attainable for issuers. Our backlog of both debt and equity capital markets deals remain strong and broad-based, but conversion and realization of this backlog is, as ever, subject to market conditions and other factors.

During the quarter, we completed 129 Capital Markets transactions. 100 of these were debt deals, 57 of which were bookrun. The other 29 were equity offerings or placements, of which 24 or 83% were bookrun.

Some notable deals we completed using our broad product platform included: in the healthcare sector, our serving as joint lead arranger for the $2.1 billion senior credit facility for Alere; in the consumer sector, our acting as both joint lead arranger on a $230 million senior secured term loan for Clement Pappas and as sole financial advisor to Lassonde in their $390 million acquisition of Clement Pappas; and in the media sector, we served as both joint lead arranger of a $450 million credit facility for SymphonyIRI Group and as joint financial advisor to SymphonyIRI in its $800 million sale to New Mountain Capital.

In the investment-grade bond area, we acted as sole bookrunner for MF Global's inaugural debt offering of $325 million in 5-year senior notes, and we acted as sole manager of a $600 million Fannie Mae residential mortgage securitization. In public finance, among our significant transaction, we acted as joint bookrunner for $520 million of New York State Environmental Facilities Corporation water and sewer revenue bonds; joint bookrunner for $610 million State of Utah general obligation bonds; and sole bookrunner for $280 million of Texas Public Finance Authority, also geo bonds.

We continue to be active in equity capital markets, including acting as joint bookrunners of both Francesca's Collections' $196 million IPO and Chefs' Warehouse's $155 million IPO; and acting sole bookrunner for 3Legs Resources' GBP 86 million IPO and Velti plc's $172 million follow-on offering in the United States.

Our M&A and advisory revenues were $107 million for the third quarter. Notable M&A deals included our acting as joint financial advisor to Radiant Systems, a global provider of innovative technology and services to the hospitality and retail industries, in their $1.2 billion sale to NCR Corporation, our acting as sole financial advisor to Carmel Pharma on their sale to Becton, Dickinson and our acting as joint financial advisor to Talisman Energy in their more than $1 billion joint venture with Sasol Ltd.

Now Rich will comment on our trading results before we take questions.

Richard B. Handler

Thanks, Brian. Our fixed income revenues were $33 million for the quarter, down significantly as compared to the $161 million a year ago. Our poor fixed income results for the third quarter are results of more muted customer activity in June and July and, more significantly, the extremely difficult conditions prevailing in August. We suffered significant pain, particularly in our U.S. and international credit sales and trading businesses, including our high-yield effort and, to a lesser extent, in mortgages.

During the quarter, and particularly in August, credit spreads widened significantly which impacted us in 2 main ways. First, the U.S. Treasury hedges used to offset the interest rate risk in our high-grade inventory increased in value significantly due to a flight to quality, which resulted in significant losses. Second, we incurred significant write-downs in the value of some of our long inventory positions, including high-yield, distressed and some mortgage inventory. We lost about 4% for the quarter in Jefferies high-yield trading, a high-yield distressed trading platform. This compares to a decrease of roughly 6% for most high-yield indices. While we are still positive for the year, we did reduce risk significantly and quickly in this area, which resulted in some realized losses.

We reduced assets and, hence, the risk inherent in our credit-related positions during the quarter. It is important to note that a material portion of the net losses incurred during the quarter are unrealized and could potentially reverse if prices and hedge relationships revert. In addition, it should be noted that our losses reflect a broad repricing of risk assets, and no individual position represented a meaningful loss for us in the third quarter.

Our equity revenues were $127 million for the quarter, up from the $109 million reported in the third quarter of 2010, but down compared to the $165 million reported in the second quarter this year. Our equity revenues are sensitive to trading volumes which were very lackluster during June and July, but picked up significantly in August, along with market volatility. Our equity derivatives business, which benefit from the volatile environment, performed well during the quarter.

While we are disappointed with our third quarter trading results, we are extremely pleased with the overall position of our firm today. We believe our third quarter results reflect a unique period of dislocation and are not indicative of where our firm is positioned today. Our common shareholders equity has increased by 80% since March 2008, and now stands at $3.2 billion versus $1.8 billion back then.

Additionally, during this period, we have raised in aggregate an additional of $2.5 billion of long-term debt capital at a blended average rate of 5.91% and an average maturity exceeding 8 years. Our recently placed $950 million Jefferies Bache committed credit facility gives us added flexibility in times of uncertainty. Clearly, we have all worked very hard this past 3 years to enhance the overall foundation of our firm.

Today, we have approximately $2 billion of cash in the bank. Our leverage ratio is reasonable and consistent with historic levels and our Level 3 assets were at the same low ratio that allowed us to navigate the 2008 period. More important than any ratios, we have a significantly more diversified global business in 2011, which enjoys an enhanced competitive position. Most important of all, we also enjoy a culture that embodies ownership, integrity and transparency. We do not know when the volatility in the financial system will normalize, but eventually it will. With our diversified and strong platform, we will continue to prudently move forward with our business plan to best serve our clients, shareholders and employees.

We are now available for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Lauren Smith of KBW.

Lauren A. Smith - Keefe, Bruyette, & Woods, Inc., Research Division

Maybe as a little more color, Rich, on FIC. Even if it's just roughly what was maybe as a percentage of impact of secondary trading versus prop and then inventory marks, even if it's just generally speaking. I mean, is one disproportionately impactful than any other?

Richard B. Handler

I think if you look at it, as June and July were progressing, due to a relatively slow period, if you recall, it was during the beginning of the negotiations for the debt ceiling. And the fixed income side, the activity itself was relatively light. That being said, it wasn't so light that we're going to have a quarter like we had. It felt like it would just going to be a relatively modest fixed income period. Once August hit, the events that I mentioned -- we carry inventory to facilitate trading with our clients, and effectively, the market for most of those asset classes just went a little bit haywire in August. We had markdowns in high-yield. We had markdowns in mortgages. We had the spread widening in the corporate high-grade business. And clearly, we operate generally on a pre-hedge basis with treasuries, and that generally works unless you are in a period of extreme volatility, which in case it didn't work. So it was really a blend of all those. And as we said in the call, there was no particular area or position that really drove this. It was really across the board.

Lauren A. Smith - Keefe, Bruyette, & Woods, Inc., Research Division

Okay. That's helpful. And would it be reasonable to assume that the $14.7 million noncontrolling interest net loss would largely be associated with the high-yield JV?

Richard B. Handler

Yes, that's correct.

Lauren A. Smith - Keefe, Bruyette, & Woods, Inc., Research Division

Okay. And then Level 3 assets, I know on a percentage basis, have remained pretty -- relatively flat, but on an absolute they did tick up. But I recall you guys saying that the Pru Bache, there were no Level 3 assets associated with that, is that correct?

Peregrine C. de M. Broadbent

Actually, they ended up being about a $20 million Bache Level 3 asset pertaining to a German pension fund. So a part of the increase is -- a small -- a relatively small increase is actually attributable to Bache.

Richard B. Handler

But you are right, we did say we thought they were all Level 1 and Level 2, there was $20 million.

Lauren A. Smith - Keefe, Bruyette, & Woods, Inc., Research Division

Okay. And then just one last for me, on the comp ratio, I mean, clearly jumped up in the quarter, revenues were down. For the 9 months, it's about 60%. I mean, if we assume, hope not, but sort of static level of revenues going forward. Is the 3Q absolute number of comp kind of sticky? I mean...

Richard B. Handler

Look, first of all, we hope the period of August does not continue. As I said, September has started off better than August, clearly. We don't stick to any specific number. We strive to pay competitively, but we're very mindful that we want to have a good return for the shareholders.

Operator

Your next question comes from Daniel Harris of Goldman Sachs.

Daniel F. Harris - Goldman Sachs Group Inc., Research Division

Can you talk a little bit specifically about the Pru Bache acquisition? How much did it add in revenues in the quarter? I think you guys have talked about a $50-plus million run rate when you acquired it on a quarterly basis. And then also, where did that show up? Was it largely in equities or interest income? And then on the expense side, where it hit comp?

Brian P. Friedman

You're right that we had said that it was a $220 million annual revenue business, so your $50-plus million for the quarter is right. We had it for 2 months, so you can do the math on that. We also just said before that the performance was in line with our expectations. Virtually, 100% of that is in our fixed income commodities and currency lines. So in the FIC line is where essentially 100% of Bache would be found.

Peregrine C. de M. Broadbent

And from a GAAP income statement standpoint, the Bache results was spread between commission income and net interest for the most part.

Daniel F. Harris - Goldman Sachs Group Inc., Research Division

Okay. Coming back to some of the commentary around what you guys are seeing thus far in September. You said that fixed income feels a little bit better. Now is that largely on volumes or the fact that the inventory marks aren't as negative as what we've seen in the August period?

Brian P. Friedman

You got to be -- let's be very careful because the month of September included several days before Labor Day that were truly end of Summer slow. You then have the coming out of Labor Day week. You had last week which had a good tone to it, as things seem to solidify. And you have the current week, which is a little bit choppier. Definitively, we're not seeing the scale or breadth of asset and inventory issues that came up particularly in August. So it's, at the moment, a bit tamer than that. Activity levels are not robust, but there is activity.

Richard B. Handler

I would say it's similar to a seasonally better June and July. While there is muted activity it's seasonally better though, and the sheer panic in the whipsaws are not going on. But obviously, it's all subject to change.

Brian P. Friedman

Yes. I mean, a combination of our having experienced what we saw in August, coupled with the massive macros that hang over all of us right now, we're not ready to venture a prognostication.

Daniel F. Harris - Goldman Sachs Group Inc., Research Division

And then last for me. I think this is, at least, the second quarter in a row, Peg, you mentioned that the average balance sheet size was very different from quarter-end size. So what is it that's happening at quarter end that's driving that end-of-period number down?

Peregrine C. de M. Broadbent

It's all in what time your quarter ends, it's what's happening during the course of the quarter. I mean, with the volatile markets both here in the domestic U.S. and in Europe, our Rates business was able to take advantage of that in some cases and accommodate client requirements, as well as their obligations from a primary dealer standpoint. So the Rates balance sheet can go up or down at any particular point in time given that the events of the market, and that's what tends to drive fluctuations in our balance sheet intraquarter.

Daniel F. Harris - Goldman Sachs Group Inc., Research Division

Okay. And so even though it's happened a few quarters in a row, it's really just about what clients were looking to transact?

Richard B. Handler

Look, we clearly like to make sure we know what's on our balance sheet, and it's busting up to take -- to get down. And so we put pressure on everybody on a regular basis to have a clean balance sheet. And at quarter end's a good period of time to measure by, so we clearly go through. But that being said, we see opportunities throughout the quarter, and we take advantage of it.

Operator

Your next question comes from Patrick Davitt of Bank of America Merrill Lynch.

M. Patrick Davitt - BofA Merrill Lynch, Research Division

With the understanding you probably can't say much in regards to this NASDAQ lawsuit, can you just give us an idea of when those losses occurred, and what the magnitude was?

Brian P. Friedman

Yes. The cost to us associated with the matters that underlie that lawsuit aggregated approximately $24 million over time. It was reflected almost equally over the last 3 quarters, including the third quarter. So through mark-to-market and normal process, that's already been reflected over the 3 quarters. It wasn't material to any one of the 3 quarters. So from our perspective, whatever the hurt was, it's 100%, the net impact has been absorbed, and if we're to be successful in the lawsuit, that would be a recoup.

M. Patrick Davitt - BofA Merrill Lynch, Research Division

Okay. Great. And can you kind of give us an idea of how much, I guess, of your compensation number now is made up of amortization of RSUs and deferred comp?

Peregrine C. de M. Broadbent

Yes. I think you can see from our last 10-K, we have about $180 million worth of unvested restricted stock and restricted stock units. Broadly speaking, it's going to be in the order of about, if you assume that on average about 3-year vesting period, take that $180 million, divide it by 3 and divide it by 4, that will give you an idea as to how much we're charging each quarter.

M. Patrick Davitt - BofA Merrill Lynch, Research Division

Okay. All right. And then you've made good progress in Investment Banking, obviously, and can you give us an idea of how many kind of senior banker hires you still have, and kind of that ramp-up period where you've got them on the books but they're not generating any activity yet?

Brian P. Friedman

I would say roughly that about 1/4 of our senior investment bankers have been with us for less than one year, and probably north of 1/3 have been with us for less than 18 to 24 months. I would say that the former group, the ones that have been with us for less than one year in particular, are likely to be on an ongoing ramp. The ramp is typically at least one year and tends to be in the 1 to 2. And it's not the they're not productive in that first year, it's just that they tend to join us having left wherever they departed their backlog, and there's a period where that backlog builds, and then subject to market conditions environment, et cetera, we convert that backlog. So I think it's safe to say that we don't believe that we are yet getting 100% benefit of the breadth of our banking capability.

Operator

Your next question comes from Chris Kotowski of Oppenheimer & Co.

Christoph M. Kotowski - Oppenheimer & Co. Inc., Research Division

Yes. You gave us in the revenues by type disclosure, you have showed us the $74 million of losses and principal transactions. And I know that's kind of a net number, but is it fair to say that the preponderance of that is high-yield? Or can you characterize the split between high-yield and mortgage and other?

Brian P. Friedman

I mean, it is fixed income, but it really is a blend of high-yield. In order, I would say, high-yield and corporates are at similar level and mortgages were 1/3.

Christoph M. Kotowski - Oppenheimer & Co. Inc., Research Division

Okay. And then earlier in the year you highlighted the growth of your European business and had a conference call there. And I wonder, can you characterize the performance of that through all this turmoil, and discuss flow versus -- flow and agency business versus principal, and to the extent that you have principal exposure, is it overwhelmingly corporate credit-related exposure versus sovereign? Or what is the mix of business there?

Richard B. Handler

It is a pretty well diversified book of business over there. Our rates business has perform particularly well in Europe. Our credit business has performed similarly to the United States, in terms of having some losses for the quarter, but consistent with what we've been seeing in the United States, and our mortgage desk had a reasonable quarter, but they suffered some pain as well. I would add that we've had some good inroads on the banking side in Europe. And the fact that we have attracted a number of key people in addition to our existing people, we feel like we've got a lot of momentum on the banking side. Obviously, the markets are very choppy over there.

Christoph M. Kotowski - Oppenheimer & Co. Inc., Research Division

Yes. Okay. And on the banking side, you talked about the need for markets to cooperate and all that. Is there any advice you would give us all, who model out the quarter? How much of the backlog -- given all the market turmoil, how much of the VaR backlog is getting pushed out of, say, 2011?

Brian P. Friedman

It's really -- it's a difficult data to suggest what the answer is. Traditionally, historically, there's an effort by corporates and other issuers to get things done in their fiscal year before they get into their requirements for yet another audit and delay and whatever. So if you'd asked this question last week on Wednesday, Thursday, when markets were coming together better, you'll get a little more optimistic view of -- there could be a fair amount of issuance in October and November. Today is a little less certain, but not too uncertain. So the answer is, we don't know yet. I mean, that we will have a better picture in October. Clearly, right now, you're not looking at robust markets in the next 2, 3 months, but history says that could change very significantly, very rapidly.

Richard B. Handler

And the fact that we have a diversified platform in terms of products, service and industries, it's a positive for us.

Operator

Your next question comes from Douglas Sipkin of Ticonderoga.

Douglas Sipkin - Ticonderoga Securities LLC, Research Division

Just more of like a strategic type of question. I'm just curious, I mean, how critical is the big fixed income trading effort for Investment Banking? And the reason I say it, it just feels like you guys have done so well in Investment Banking, and you have a really good equity trading business. It's volatile, and I acknowledge that's not always the highest profitable business, but it just feels like the big push that you guys have made into fixed income trading has actually hurt the stock more that it's helped it. So I'm just wondering, is that part of the process for the longer-term story, or maybe I'm just thinking too much about it?

Richard B. Handler

I think you're thinking too much about it. If you think about it, our corporate high-grade business, our mortgage business, our muni business, all have direct capabilities of new issue business. And on top of that, our secondary trading business with the exception of this quarter -- and emerging markets as well, with the exception this quarter which was a -- literally one of the 3 worst trading quarters in history, has performed extremely well. We've got a great group of talent, a great -- we've got market share throughout all the biggest buy-side relationships on the globe, and we have a very important part of our firm. So -- look, obviously, in periods like this you wish you didn't have a fixed income business because there's no way to make money, but in the same token, it's completely core to our business, and we're very thankful we do.

Brian P. Friedman

Also, I think if you look at events in our industry in the last few weeks again, and we're not in our view done with the aftermath of the crisis and the regulatory and other changes that are taking place. So when you look at an industry that may yet face additional consolidation, we think having the breadth and depth of capabilities we have, and having them under one roof in our model, still has have a great deal of benefit and upside.

Douglas Sipkin - Ticonderoga Securities LLC, Research Division

Okay. That's helpful. And then secondly, obviously, you guys continue to invest, obviously, the Prudential acquisition, everyone sees the press releases. I mean, what are you guys thinking about that? Are you still sort of putting your foot on the gas there in terms of trying to pick people? It seems like while it's a great time, given all that's going on in the industry and competitors, I mean, you may have to balance the fact that, hey, if things are like these for the next 6 to 12 months, it maybe a different story. So I mean, how are you thinking about hiring plans right now?

Richard B. Handler

You're exactly right. In times like these, it's the best time to hire people, and it's the hardest time to hire people. I think the way we are thinking about it is we are very happy with our platform, our human capital base and all that we have to do to work on the platform today. That said, when we do see a situation where there's the right person, we will continue to add, but we're going to make sure we do it in the mindset of having a relatively tough operating environment out there so that we'll be very prudent. The good news is, a lot of people want to come work here more so than ever. They want to come on reasonable terms more so than ever, and we can be more selective.

Operator

Your next question comes from K.C. Ambrecht of Millennium Partners.

K.C. Ambrecht - Millennium Partners

Two for you. X the Pru Bache, ROE for the quarter looked around 3% to 4%, 5%. Jeffries looks like it has cost capital of 12%. So back of the envelope math, looks like the assets got up to around $59 billion during the quarter. Why not just shrink your balance sheet versus taking this risk if you're not covering your cost of capital?

Richard B. Handler

Well, it's hard to basically run a business based on one month in the middle of the storm. And if you want to have a long-term platform, the long-term permanent shareholder value for a long-term investor, you're going to have to go through to some tough periods of time.

K.C. Ambrecht - Millennium Partners

Okay. And then just back to the deferred comp. In December of 2008, Jefferies took a $440 million hit, it's about 24%, I guess, on a noncash basis to tangible book. And in the press release, you guys said that future comp expenses would closely match the economic comp to the period in which related services were performed. Since 4Q '08, it looks like Jefferies has $416 million of unrecognized comp, $181 million of RSU that one analyst brought up, and also $235 million of deferred cash. Can you just talk about that, and what the strategy, like where you're taking this?

Brian P. Friedman

I think what we said in 2008 when we took a noncash charge -- let's put it in perspective. In 2008, the worst period of the financial crisis, we lost about -- as an organization, we lost about $170 million worth of cash, and we raised $450 million worth of equity before anybody else did to draw a line in the sand. And what we said at that time was we're going to have all compensation aside from sign-on compensation will be expensed in the year it was earned, that's what we did. And that's what we've continue to do. So if you go through and look at the math today, we are nowhere near the same position where there's a bunch of legacy composition. We have grown. We have hired people, and when we hire people and replace some of their shares, there's a vesting period, it's sign-on, and we're consistent what we said to people we would do back in 2008.

Brian P. Friedman

And if you take into account the amortization period that Peg indicated before for the average duration of sign-on that's on our balance sheet, the annual amortization would be a relatively modest amount compared to our total annual compensation cost.

Richard B. Handler

Our firm has more than doubled its size since then.

K.C. Ambrecht - Millennium Partners

But what's the difference between the deferred cash award and an RSU?

Brian P. Friedman

The difference is one is cash and one is in stock. It simply represents that...

K.C. Ambrecht - Millennium Partners

But it's on record as comp expense, right?

Brian P. Friedman

I'm sorry, when we hire someone from another organization, and for whatever reason, it's appropriate for us to give them something upfront. The mix of that can be in both cash and in equity deferred over periods of time. And again, cash would be cash and equity in equity, and that's what you're seeing.

Peregrine C. de M. Broadbent

From an expense standpoint, it makes no difference.

Brian P. Friedman

Yes. I mean, it's expense over its vesting period.

K.C. Ambrecht - Millennium Partners

Okay. But this went from 0 to now $415 million. I mean this is over 2 years worth of net income depending on what periods you look at.

Peregrine C. de M. Broadbent

I don't have those numbers in front of me right now. When I get back to my desk, I'd be happy...

K.C. Ambrecht - Millennium Partners

But it's becoming a big number. That's the one...

Brian P. Friedman

First of all, recognize that, that's a pretax number. So if you're going to compare it to net income, you have to tax-effect it. Again, as Peg indicated, it amortizes out over some number of years, and the net income numbers that you're may be referring to are net income numbers after our full comp, which includes that amortization. So you can't kind of multi-count the same number.

Operator

Your next question comes from Mike Holton of The Boston Company.

Michael Holton - Merrill Lynch

I've got 2 quick ones. On headcount, in the past quarter, using what you all said you added from the acquisition, it looked like you added about 200 people. And, Rich, in listening to you, it sounds like you can be selective and you can get good people, but likely over the next quarter, you'll continue to hire, is that correct?

Richard B. Handler

I think during the summer period, there are a number of MBAs and analysts out of the class that might have distorted the increase this year. This for this period. And I think what you can read into me saying is we are very, very cognizant of a very tough environment. We are going to look to hire people, but we're going to be more selective than ever.

Brian P. Friedman

Probably, a give or take, 100-person number in our investment bank. That's once a year kind of event, and then there's some attrition over time.

Michael Holton - Merrill Lynch

Okay. So in taking those into account, should we expect headcount to be up at the end of the next quarter? It could be up by one person; it could be up by 75. But given you guys have been hiring, can we expect it to be up?

Richard B. Handler

I would guess it's going to be up. I would guess the rate of that increase is probably going to slow. And I think you'll watch us be very mindful of the environment. Balancing that with the fact that we have really good people who want to join us who will be good fits, but we can't hire everybody.

Michael Holton - Merrill Lynch

Yes, of course. And kind of a follow-up to that, you've been talking about fixed income trading, did you say for overall fixed income, that a great proportion of the hit you took on inventory marks were unrealized in the past quarter?

Richard B. Handler

It's hard to go through it exactly, but I would say the majority was unrealized. We did take down a good portion of our risk in a few areas where we just didn't want to ride out the storm, but there is significant amount of unrealized. And obviously, you have a treasury position that's upside down, which we made it smaller but we still have to hedge our book. And historically, this has been the right way to hedge it.

Michael Holton - Merrill Lynch

Okay. So -- and just thinking about FIC over the next couple of months, who knows what direction market goes, but if the market gets better, you guys do fine. If the market remains tough, you're going to have significantly subpar ROEs again.

Richard B. Handler

I think that if the market does better, we will be fine. If the market does poorly, we won't do as poorly as we did in August, but we're not going to be doing spectacularly.

Operator

Your next question comes from David Trone of JMP Securities.

David M. Trone - JMP Securities LLC, Research Division

So going back to the deferred comp issues. So are you implying that the 181 plus the 235 is strictly new hire pickup equity and pickup deferred, is that right? So in other words, none of that was granted to, like I say, employees?

Peregrine C. de M. Broadbent

The vast majority of that was -- it's -- it relates to new hires.

David M. Trone - JMP Securities LLC, Research Division

Okay. And so since the end of '08, you added about 1,500 people. So that's, on average, about 270 -- if it were 100% then it would be 277K for newly hired employees, is that about right?

Richard B. Handler

Obviously, the average doest really mean a lot. When you're hiring Senior Managing Directors, it will distort the average of it. But obviously, on the street, when people hire people, and it's not unique to Jefferies, you generally make up for what they leave behind.

David M. Trone - JMP Securities LLC, Research Division

Another question. If you look at '08, you took a lot of losses. In '09, you've benefited from the wide spreads thereafter. Obviously, we're not looking at anything of that type of magnitude here. But on a smaller scale, could you have the same dynamic where you -- you've taken your pain on the big shift in the market, but if spreads stay wide, you could do better than you otherwise would?

Richard B. Handler

You also have to remember, 2010 was not exactly -- '09 was a very unique period in fixed income just about anybody who could, could make money in fixed income. 2010 was not the easiest period in time, and our guys gain market share and actually did a very good job. And the first half of this year was relatively good, not great, but relatively good in a challenging environment. August was terrible, there's no way around it.

David M. Trone - JMP Securities LLC, Research Division

Right. But the question really centers on going forward. Are the spreads still wide enough that you could benefit...

Richard B. Handler

The bid-ask spreads are starting to get wider again. We've taken a good share of our write-down, we've taken all of our write-downs that we felt were appropriate, and the bid-ask spread is wider. Customer activity is still relatively muted, but we think that's a temporary phenomenon.

David M. Trone - JMP Securities LLC, Research Division

Okay. Great. And then one last question. I know you've touched on a lot, but I didn't quite get exactly if you have if any -- and if so, how much it is to directly to European banks?

Richard B. Handler

We...

Peregrine C. de M. Broadbent

From an overall credit exposure standpoint, our exposure to European banks is relatively small, obviously, hugely focused as well on our -- from a funding perspective, on how much funding we get from European banks, which if the diversified nature of our funding sources, we're pretty comfortable with the exposure we have from that standpoint.

Richard B. Handler

I think the answer is from an inventory position, we're extremely comfortable. And we're pretty well diversified from all of our sources of funding.

Operator

Your next question comes from Jeff Harte of Sandler O'Neill.

Jeffrey Harte - Sandler O'Neill + Partners, L.P., Research Division

Looking at the investment income or loss from invested funds. Given how tough a quarter it seemed to be in converts, it was a big asset class for you. I'm surprised that we only see $41 million of losses there. Was there something else? I mean, how should we think of that line?

Peregrine C. de M. Broadbent

Let me just get the specific line. I think that -- are you talking about the investment line within the asset management?

Jeffrey Harte - Sandler O'Neill + Partners, L.P., Research Division

Yes. The investment income from managed funds within asset management.

Peregrine C. de M. Broadbent

Excuse me whilst I just identify...

Brian P. Friedman

That's $41,000.

Jeffrey Harte - Sandler O'Neill + Partners, L.P., Research Division

I apologize. Not million, $41,000.

Brian P. Friedman

That's why we were stunned.

Jeffrey Harte - Sandler O'Neill + Partners, L.P., Research Division

And I guess my question really is...

Brian P. Friedman

That is $41,000. We may have missed. Sorry.

Jeffrey Harte - Sandler O'Neill + Partners, L.P., Research Division

The relative size of that loss, given what happened to the market, especially the convertibles markets, is a surprise to me. I thought you would have had bigger losses there.

Richard B. Handler

You know what, we've had big-enough losses for us, so I appreciate the thought.

Jeffrey Harte - Sandler O'Neill + Partners, L.P., Research Division

Okay. But I mean -- okay. I guess why weren't the losses bigger if you're a big convert investor and convertibles got killed in the quarter?

Brian P. Friedman

First of all, you're making an assumption there which I'm not sure was right. We are not -- we are a large manager of convertibles. Remember that, that is substantially a long-only convertible business. We have a comparatively modest amount of investment in some of the product there. So the convertible is not a large driver of that number. We also have some capital in our commodity asset strategies, and we also have some in 1 or 2 other areas. Frankly, the sum of it is that number, it's not a material number.

Jeffrey Harte - Sandler O'Neill + Partners, L.P., Research Division

Okay. It's not a material number, but given the way the market has performed, I thought it would have been a more material number.

Peregrine C. de M. Broadbent

As Brian said, we have other -- some other funds including commodities funds. And whilst there were a few write-downs in some of the -- our own investments in our convertible fund, a, it wasn't huge; and b, it was offset by some other investments in a completely different market.

Jeffrey Harte - Sandler O'Neill + Partners, L.P., Research Division

Okay. And as we think about the Prudential acquisition, kind of looking forward, I tend to think of that as a fairly asset-sensitive business, and we've seen short-term rates kind of go down again. And the Fed indicating, they're going to be lower for a longer period of time. How big an impact should we think of that having on Prudential, on Prudential Bache?

Brian P. Friedman

I mean, basically, has been living in a ultra-low rate environment now for a fairly long period of time. So really, it's the opposite, which is if and when rates were to begin to rise, that business, all else being the same, should benefit meaningfully. The minor, frankly, reduction or change at this point is not a meaningful element. There's not a lot of spread there right now.

Jeffrey Harte - Sandler O'Neill + Partners, L.P., Research Division

Yes. I get it. And then just as we look at the comp ratio, and given how low revenues came in, I think that the flexibility proved pretty good. But as you said, comp to date for the first 3 quarters, are you making assumptions as to what kind of environment you'll be in the fourth quarter? I guess what I'm asking is, does the comp to date assume the fourth quarter is going to get a lot better than the third quarter? Or do you deal with that when the fourth quarter comes?

Richard B. Handler

I think it's safe to assume, we think it would be better than the third quarter, but we're also a realist in the environment.

Peregrine C. de M. Broadbent

And our comp rates in any given quarter like our tax rate does have to take into account an estimate of what we think revenues would look like for the full year.

Operator

And at this time, I'm showing no further questions. I'll turn the conference back to Mr. Handler for any or further remarks.

Richard B. Handler

Thank you for listening to our call today. We appreciate your interest and your support. Thank you.

Operator

And ladies and gentlemen, that concludes the Jefferies 2011 Fiscal Third Quarter Financial Results Conference Call. We appreciate your time. You may now disconnect.

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