The Bankruptcy of Lehman Brothersand its Acquisition by Nomura

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

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

May 2009

Abstract

In September 2008, Lehman Brothers filed for bankruptcy and proved to be the mostprominent victim of the US subprime financial crisis. With over $600 billion in assetsand 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 No-mura, only days after the bankruptcy filing, was a bold move and its value to Nomura’sshareholders was questioned to be justifiable.

A retrospective on the events and circumstances leading to the bankruptcy filingand the study of the US bankruptcy law show that Lehman was disadvantageously hitby missing governmental involvement to rescue the bank and by the Bankruptcy AbusePrevention and Consumer Protection Act amendments to the bankruptcy law, whichcaused a meltdown of Lehman’s assets immediately after the bankruptcy filing.

An assessment of the long-term value of Lehman’s subsequent acquisition for No-mura’s shareholders is provided by quantitative and qualitative analyses: A Net PresentValue analysis gives a negative value of -$668 million, especially caused by promisedhigh salaries and bonuses to ex-Lehman staff. As Nomura made the deal with futurestrategic moves in mind, trying to gain advantage by synergies from complimentarybusinesses and clients, a Real Option analysis shows that a value in the range of $1billion could be added to the NPV value. This value proves to be very sensitive to theunderlying assumptions, however, the Real Option analysis demonstrates an alternativeway to value the deal and provides a clearer picture on Nomura’s investment. Com-paring these results to how the market reacted through a Share Price analysis showsthat the it valued the deal with $2.2 billion. To capture issues like corporate culture,potential synergies and future difficulties in merging the two businesses, and to put thequantitative results in relation with strategic and qualitative insights, a SWOT analysisand a study of the two companies’ previous core businesses confirm that the acquisitioncould generate great synergies and transform Nomura into a top player in the globalbanking industry. However, general experience with mergers and acquisitions affirmsthat huge acquisitions by companies not used to it tend to destruct shareholder value;especially cultural differences tend to hamper huge acquisitions. As Nomura has neitherexperience with such a big acquisition nor a compatible corporate culture with Lehman’sone, these issues are going to be the greatest challenges for Nomura in the future.

ii

Contents

Abstract ii

Introduction vii

1 Lehman Brothers 11.1 The History of Lehman Brothers . . . . . . . . . . . . . . . . . . . . . . 11.2 Lehman’s Big Man: Dick Fuld . . . . . . . . . . . . . . . . . . . . . . . . 21.3 Lehman and the Subprime Mortgage Market . . . . . . . . . . . . . . . 21.4 The Role of Lehman’s Risk Management . . . . . . . . . . . . . . . . . . 31.5 The Beginning of the End . . . . . . . . . . . . . . . . . . . . . . . . . . 3

2 The Bankruptcy of Lehman Brothers 52.1 Heading towards the Weekend of September 14 . . . . . . . . . . . . . . 52.2 The Bankruptcy Law in the United States . . . . . . . . . . . . . . . . . 7

2.2.1 Chapter 11 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92.2.2 Bankruptcy Abuse Prevention and Consumer Protection Act . . 9

2.3 Lehman’s Bankruptcy Filing . . . . . . . . . . . . . . . . . . . . . . . . . 102.3.1 Major Asset Dispositions . . . . . . . . . . . . . . . . . . . . . . 112.3.2 The Chapter 11 Process and Lehman’s Estate . . . . . . . . . . . 11

2.4 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

3 Nomura 133.1 The History of Nomura . . . . . . . . . . . . . . . . . . . . . . . . . . . 133.2 Nomura’s Acquisition of Lehman Brothers . . . . . . . . . . . . . . . . . 14

3.2.1 The New Workforce Resources . . . . . . . . . . . . . . . . . . . 143.2.2 Nomura’s Key Strategy . . . . . . . . . . . . . . . . . . . . . . . 143.2.3 The Client Base . . . . . . . . . . . . . . . . . . . . . . . . . . . 153.2.4 Transition: The Road to Revenue . . . . . . . . . . . . . . . . . . 16

4 Share Price Analysis 184.1 Idea . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

4.1.1 Assumptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 184.2 Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

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CONTENTS

5 Net Present Value Analysis 205.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 205.2 Salaries and Bonuses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 205.3 Idea . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

5.3.1 Assumptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 215.4 Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22

6 Real Option Analysis 236.1 Idea . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

6.1.1 The MacDonald and Siegel Model . . . . . . . . . . . . . . . . . 236.1.2 Assumptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24

6.2 Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

7 Strategic Analysis 267.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267.2 SWOT Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267.3 Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27

Conclusion 28

Bibliography 28

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List of Figures

3.1 New Workforce Resources . . . . . . . . . . . . . . . . . . . . . . . . . . 153.2 Synergies in Client Business . . . . . . . . . . . . . . . . . . . . . . . . . 153.3 Synergies in Asset Management . . . . . . . . . . . . . . . . . . . . . . . 163.4 Synergies in Investment Banking . . . . . . . . . . . . . . . . . . . . . . 163.5 The Road to Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

4.1 Share Price Nomura Jan 08 – Oct 08 . . . . . . . . . . . . . . . . . . . . 18

7.1 SWOT Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27

vi

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’sbankruptcy filing was the largest in US corporate history, as its assets far surpassedthose of previous bankrupt giants such as WorldCom and Enron. At the time of thecollapse, Lehman was the fourth-largest US investment bank, with 25,000 employeesworking 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 mortgage-induced financial crisis that swept through global financial markets in 2008. Lehman’scollapse was a seminal event that greatly intensified the 2008 crisis and contributed tothe erosion of close to $10 trillion in market capitalisation from global equity markets inOctober 2008, the biggest monthly decline on record at the time. Lehman’s bankruptcywas the prelude to the armageddon observed in money and equity markets betweenSeptember 2008 and January 2009. From one day to another, money markets froze upand for the first time since the Great Depression the fear of a systemic crisis evolved. Thesystemic fear should last well into 2009 while equities markets only reached their bottomin March of 2009. While writing these lines the bankruptcy of Lehman is receding inmarket participants’ mind and does no longer directly impact the markets. 3-monthUSD Libor, used to set borrowing costs on about $360 trillion of financial productsglobally, 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 77basis points, which is below its pre-crisis level of 2007. Similar observations can be madefor 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 havediminished, Nomura, however, is now in the crucial phase of integrating the formerLehman Brothers operations. Managerial skills, personnel, market conditions and com-petitors will decide on success or failure of Nomura’s big move. This report has themodest objective to find out whether this big move of last September was justifiable atthe time. We aim to provide quantitative as well as qualitative analytics and rigourouslyassess 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 Ger-man immigrant. Henry Lehman of Rimpar, northern Bavaria, settled in Montgomery,Alabama in 1844 and opened a small general store. Only in 1850, Henry Lehman andhis brothers, Emanuel and Mayer, founded Lehman Brothers, which at this time was acotton trading company. Until the late 19th century Lehman Brothers remained focusedon the cotton market. The Lehman brothers moved the firm to New York after the civilwar 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 theCoffee Exchange. Four years later, in 1887, Lehman became a member of the New YorkStock Exchange.

Lehman expanded into the profitable equity underwriting business which was stronglylinked to the rapid industrialisation of the United States. In 1899, it underwrote its firstpublic offering, the preferred and common stock of the International Steam Pump Com-pany and subsequently developed to one of the most active equity underwriters. Whilethe firm prospered over the following decades as the US economy grew into an inter-national powerhouse, Lehman had to contend with plenty of challenges over the years.Lehman survived them all - the railroad bankruptcies of the 1800s, the Great Depres-sion of the 1930s, two world wars, a capital shortage when it was spun off by AmericanExpress 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 andthe 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 housingmarket ultimately brought Lehman Brothers to its knees, as its headlong rush into thesubprime mortgage market proved to be a disastrous step. However, even at the time ofthe bankruptcy most units of Lehman were profitable and Lehman’s last CEO, RichardFuld, had spent most of his tenure with diversifying the company, making sure it wouldhave other businesses to depend on if one collapsed. Equity trading accounted for one-third of Lehman’s revenue in 2006, and the firm was the largest trader of stocks onthe London Stock Exchange and Euronext. It ranked as high as No. 5 among mergersand acquisitions advisers in 2007, when it had a role in one-fifth of all corporate take-overs. Its research teams in equities and fixed income had ranked at the top of surveys

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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 atthe 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 highlycompetitive and keeping a straight face. In 1993, he became CEO of what was then theLehman Brothers unit of American Express. When American Express spun off Lehmanas a public company in 1994, Fuld became its first chief executive. That was widelyperceived as a signal of the rising power of traders on Wall Street. Until the mid 1990sbankers were the dominant force on the street but with the inception of liquid derivativesmarkets in both fixed income and equities, the balance changed as the majority of profitson Wall Street was made in trading.

Fuld, at the time of the bankruptcy the longest-serving CEO on Wall Street, waswidely known as a driven decider, not hesitating in taking immediate action when thecrisis in the US housing market began to bite Lehman’s earnings. In July 2007, whenLehman’s shares had fallen 70% in the previous six months, Fuld did not duck. Nor didhe 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 onshort-term funding to create a buffer against a possible bank run. When none of thosemeasures worked, he replaced Lehman’s No. 2, Joseph Gregory, his trusted lieutenantof 30 years, with a younger man known for his cautious approach to risk taking. And hemoved aside Lehman’s high-profile Chief Financial Officer (CF0) Erin Callan, who hada 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 mortgagelenders, including Irvine, California-based subprime lender BNC Mortgage, which lentto homeowners with poor credit or heavy debt loads and Aurora Loan Services, whichspecialised in Alt-A loans (a notch above subprime, to more-creditworthy borrowers whodo not provide full documentation for their assets). In the first quarter of 2006, BNCwas lending more than $1 billion a month, while Aurora was originating more than $3billion a month of such loans in the first half of 2007.

Lehman’s acquisitions at first seemed prescient; record revenues from Lehman’s realestate businesses enabled revenues in the capital markets unit to surge 56% from 2004to 2006, a faster rate of growth than other businesses in investment banking or assetmanagement. The firm securitized $146 billion of mortgages in 2006, a 10% increasefrom 2005. Lehman reported record profits every year from 2005 to 2007. In 2007, thefirm reported net income of a record $4.2 billion on revenue of $19.3 billion. At the timeLehman was the biggest underwriter of US bonds backed by mortgages, accumulatingan $85 billion portfolio, 44% more than Morgan Stanley and almost four times the $22.5

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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 marketcapitalisation of close to $60 billion. However, by the first quarter of 2007, cracksin the US housing market were already becoming apparent as defaults on subprimemortgages rose to a seven-year high. On March 14, 2007, a day after the stock had itsbiggest one-day drop in five years on concerns that rising defaults would affect Lehman’sprofitability, the firm reported record revenues and profit for its fiscal first quarter. In thepost-earnings conference call, Lehman’s CFO said that the risks posed by rising homedelinquencies 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 therest of the housing market or hurting the US economy. Prices of securities backed bytheir mortgages sank, ultimately forcing Bear Stearns, Lehman’s main competitor insubprime underwriting, to tell investors in two of its hedge funds, which bet heavily onhome loans, that their investments had been wiped out.

Toward the end of 2006, people familiar with Lehman’s risk management operationssay, executives at the firm started seeing trouble in the mortgage market. The securitiza-tion division raised rates on its bonds to reflect higher risk, which meant higher intereston the loans Lehman’s mortgage units made to home owners. When that did not slowborrowing, lending standards were tightened, a decision that was met with resistance byBNC and Aurora executives, whose fees depended on volume, the people say [4].

By the end of 2006, Lehman started hedging against its mortgage exposure. Sometraders were allowed to bet against the prices of home loans by shorting indexes tiedto mortgage securities. Still, Lehman President Gregory did not move fast enough toreduce risk, the people say. And at least two executives who urged caution were pushedaside.

One was Madelyn Antoncic, 55, head of risk, who was moved to a government re-lations job in September 2007. Two months later, at a risk management conferencein 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 attaking 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 hedgefunds, Lehman’s stock fell sharply. Lehman Brothers became the first firm on WallStreet to close its subprime-lending unit and laid off 2500 employees of the BNC andother mortgage related units. Against the statements of the CFO from March 2007,shuttering BNC Mortgage LLC would cut third-quarter earnings by $52 million Lehmancalculated at the time. BNC made about $2 billion of loans in the first quarter of2007, already down 40% from a year earlier, according to industry newsletter NationalMortgage News. BNC had 23 offices in eight states of which all were closed [3].

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CHAPTER 1. LEHMAN BROTHERS

In addition, it also closed offices of Alt-A lender Aurora in three states. Even asthe correction in the US housing market gained momentum, Lehman continued to bea major player in the mortgage market. In the fourth quarter of 2007, Lehman’s stockrebounded, as global equity markets reached new highs and prices for fixed-income assetsstaged a temporary rebound. However, the firm did not take the opportunity to trim itsmassive 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 firstquarter of 2008 though. While the firm wrote down the value of mortgage-related assetsby 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 byprivate equity firms and others for buyouts. The firm was stuck with the loans, whichthey had aimed to package and sell, when the leveraged buyout market froze in thesecond half of 2007.

Fuld used the temporary recovery of credit markets in the first quarter of 2008 tooffload one-fifth of the firm’s leveraged-loan portfolio. Yet he also tried to gain marketshare by borrowing against the firm’s capital to trade other fixed-income products forLehman’s clients, people say. That increased Lehman’s risk in the event of a reneweddownturn, as did its growing inventory of Alt-A loans. Fuld had bet the wrong way: InMarch, markets tumbled as defaults by homeowners surged, housing prices fell furtherand the US headed toward a recession. Reversing course, he ordered his associatesto hunker down, people say. Traders were told to sell troubled assets or buy creditprotection for further potential losses, which meant that if prices were to recover, Lehmancouldn’t benefit. In other words, things weren’t going to turn around anytime soon [5].

4

Chapter 2

The Bankruptcy of LehmanBrothers

“My goodness. I’ve been in the business 35 years, and these are themost 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, whichwere mainly caused by the subprime crisis, hit Lehman particularly hard: Pulling outBNC Mortgage of business and thus eliminating 2500 jobs in August 2007 was just partof 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 increasinglyvulnerable to deteriorating market conditions. On March 17, 2008, following the near-collapse 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 firmto fail. Confidence in the company returned to some extent in April, after it raised $4billion through an issue of preferred stock that was convertible into Lehman shares at a32% premium to its price at the time. However, the stock resumed its decline as hedgefund managers began questioning the valuation of Lehman’s mortgage portfolio.

Throughout the year 2008 Lehman had to suffer bigger and bigger losses caused bylower-rated mortgage-backed securities, culminating in $2.8 billion losses and a declineof 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 andits first loss since being spun off by American Express. It also arranged a $6 billion sharesale.

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CHAPTER 2. THE BANKRUPTCY OF LEHMAN BROTHERS

“As painful as this quarterly loss has been, now is the time to look forward,” Fuldwrote to employees. “In past down cycles, the firm has always emerged stronger. Wehave done it before, and we will do it again.” The firm also said that it had boosted itsliquidity pool to an estimated $45 billion, decreased gross assets by $147 billion, reducedits exposure to residential and commercial mortgages by 20%, and cut down leveragefrom a factor of 32 to about 25. However, selling $147 billion of assets in a jittery marketmeant taking significant losses. On top of that, people familiar with the transactionssay, some of the hedges did not work. For example, Lehman bet against the CMBXindex, a gauge of bonds backed by commercial mortgage bonds, to hedge its residentialmortgage portfolio. In the second quarter, the index improved - the cost of protectingagainst 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 bothsides of the trade.

However, the above described measures were perceived as being too little and toolate. Over the summer of 2008, Lehman’s management made unsuccessful overturesto a number of potential partners. The stock should plunge 77% in the first week ofSeptember 2008, amid plummeting equity markets worldwide, as investors questionedCEO Richard Fuld’s plan to keep the firm independent by selling part of its asset man-agement 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 alreadylaid off more than 6000 workers since June 2007, this round of Lehman’s head-countreductions should not only affect its mortgage origination and securitization businesses.Now, as business was stumbling from one sombre quarter to the next, jobs in investmentbanking and trading were also in jeopardy [13].

In August 22, 2008 investor’s confidence in Lehman should reach a small peak afterthe state-run South Korean firm Korea Development Bank announced it was consideringbuying 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 sharplyby 45% to mediocre $7.79 on September 9, when the Korean bank had to report to holdthe negotiations due to “difficulties pleasing regulators and attracting partners for thedeal” [15].

On that day the fresh concerns on Lehman’s stability and investor’s worries thatLehman could have major difficulties in finding new sources of capital pulled down theDow Jones by 300 points and the S&P by 3.4% [16]. This decline more than wipedout the market’s revival on the day before, after the Bush administration rescued themortgage giants Fannie Mae and Freddie Mac. The outlook and fear that the governmentmight 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 toLehman, leading to a 45% plunge in the stock and a 66% spike in credit-default swapson the company’s debt. The company’s hedge fund clients began pulling out, while itsshort-term creditors cut credit lines.

On September 10, Lehman’s share further dropped by 41% to $4.22, as it had toannounce a loss of $3.9 billion and indicated its intention to sell its prized investmentmanaging division, including Neuberger Berman. Among the potential buyers wereBarclays of Britain, the Bank of America and private equity firms. At this point, Lehman

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CHAPTER 2. THE BANKRUPTCY OF LEHMAN BROTHERS

was already in a calamitous condition where it was trying to buy time to reach theweekend and complete a deal. As the potential buyers were seeking assistance from theFederal 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 InvestorService announced that it was reviewing Lehman’s credit ratings, and also said thatLehman would have to sell a majority stake to a strategic partner in order to avoid arating downgrade. These developments led to a 42% plunge in the stock on September11.

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 theirfinancial exposures to Lehman and work out plans over the possibility that the govern-ment 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 collapseof Long Term Capital Management (LTCM), a hedge fund firm that dealt with esotericsecurities, when Bear Stearns, the hedge fund’s clearing broker, refused to contributein an investment saving the fund. Besides Henry M. Paulson Jr., the Treasury Secre-tary, executives of all major investment banks and two foreign banks were present, butLehman representatives were absent of the talks. At the meeting Messrs. Paulson andGeithner had to announce that the government was not willing to assure the potentialbuyers, as they were worried its help could establish a situation of moral hazard, andargued they were seeking an industry wide solution to stabilise Lehman. On the otherhand, the Wall Street banks involved in this meeting argued that Lehman overreachedand brought its troubles on itself. If a buyer of Lehman could not be found, they couldcollect their collateral and liquidate Lehman’s assets [19].

Finally, after nervous around-the-clock negotiations over the weekend, on SundaySeptember 14, Merrill Lynch agreed to sell itself to Bank of America. Lehman announcedBarclays has ended the bid to buy all or part of Lehman and a deal to rescue thebank could not be settled. Bank of America, also rumoured to be involved in biddingfor Lehman, had to reject its interests, too, as the regulators declined a governmentalinvolvement in Lehman’s sale [20].

It was finally on that day when Lehman reached its nadir by announcing to file forbankruptcy 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 andcodified in Title 11 of the United States Code, commonly known as “The BankruptcyCode”. The Code has been amended several times, especially in 2005 through theBankruptcy Abuse Prevention and Consumer Protection Act, BAPCPA, which has par-ticular significance for the financial industry.

Bankruptcy cases are filed in US Bankruptcy Courts and governed under federallaw, but state laws play usually a major role in bankruptcy cases, because these areoften 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 remainingchapters provide rules to govern these petitions.

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CHAPTER 2. THE BANKRUPTCY OF LEHMAN BROTHERS

• Chapter 7: Liquidation

Liquidation under this chapter involves the selling of non-exempt property of thedebtor and the distribution of the proceedings to his creditors. Most Chapter 7cases 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 allowsthe debtor to keep part or all of his property and use future earnings to pay offhis 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 invol-untary, where creditors file the petition, e.g. to force a company into bankruptcy toenforce 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, whichconsists of all property interests at the time of the case commencement, subject to certainexclusions. The bankruptcy estate of a company, partnership and other collective entitiesis for federal income tax purposes not a separate taxable entity from the debtor, contraryto 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 distributionto 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. Anautomatic stay is an injunction, which prohibits the commencement, enforcement andappeal of actions and judgements by creditors against the debtor for the collection of aclaim. Actions and proceedings towards the estate itself are prohibited, too. Violationsof the automatic stay are treated as void ab initio or voidable, depending on the circuit1.In any case, violations of the stay, which give rise to damages, are assessed against theviolator and may be excused without penalty or the violator made liable for punitivedamages.

1A circuit in the US is one of thirteen United States Courts of Appeals, historically organised byregion 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 basicrationale behind, that a reorganised business is more valuable as a going-concern thanthe value of its parts in case of liquidation. In most cases the debtor remains in controlof its business operations as a debtor in possession and is subject to the oversight ofa jurisdiction of the court. The rights and interests of the owners of companies filingunder Chapter 11 with debts exceeding its assets are ended and the creditors are leftwith ownership of the newly reorganised company.

Chapter 11 features tools and mechanisms to facilitate the debtor to restructure itsbusiness. The debtor in possession may acquire financing and loans on a favourablebasis, providing the lender first priority on the earnings obtained by his advances. Thepriority 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 thanothers. Each priority level has to be paid off in full before the next lower one can beserved. 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 caseit would be favourable to the company and its creditors.

The Chapter 11 plan for reorganization, with the goal to emerge debtors from thebankruptcy within months or years, is voted upon by the interested creditors. A con-firmed plan becomes binding and identifies the treatment of debts and business opera-tions. Debtors have the exclusive right to propose a plan for a specific duration (in mostcases 120 days), after which creditors may also propose a plan. In case the involvedparties cannot confirm a plan, the bankruptcy case may be converted into Chapter 7liquidation or dismissed to return to the status quo before the bankruptcy filing, allowingthe creditors to claim their rights by use of non-bankruptcy law.

If a publicly listed company files under Chapter 11, its stocks are immediately de-listed 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 companyvalueless.

2.2.2 Bankruptcy Abuse Prevention and Consumer Protection Act

The Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) gave manychanges to the bankruptcy law, and hence often called “The New Bankruptcy Law”.Especially the changes concerning the financial industry, aimed to insulate banks fromcollapse of big clients, were significant, but also criticised.

The changes made clear that certain derivatives and financial transactions are ex-empt from provisions in the Bankruptcy Code that freeze a failed company’s asset untila court decides how to apportion them among creditors. Notably, the BAPCPA en-abled a non-debtor party without any limitation to terminate, liquidate or accelerateits securities contracts, commodity contracts, forward contracts, repurchase agreements,swap agreements or master netting agreements with the debtor. Interestingly, or unfor-tunately, with that terminology the Act expanded the scope and definition of financialtransactions not covered by the Bankruptcy Code to products that were widely used byLehman (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 fromfailure of very large derivative counterparties by making it easier for them to orderlyterminate transaction agreements and retrieve collateral, and thus avoiding a dominoeffect initiated by these large counterparties, such as hedge funds. With the new lawthe counterparties are thus able to put themselves in front of the line ahead of othercreditors in bankruptcy proceedings. Ironically, the policy makers never expected thatthe collapse could start from the other end [24].

In the end the BAPCPA effectively excludes financial services firms from the benefitsof bankruptcy: “The Act’s extension of the Code’s protections for the financial servicesindustry to include a broader array of financial contracts, all in the name of reducingsystemic risk is a mistake,” according to Edward Morrison and Franklin Edwards fromColumbia University. They argue a better, efficiency-based reason for treating deriva-tives contracts differently arises naturally from the economics theory underlying theautomatic stay, i.e. derivative contracts are rarely needed to preserve a firm’s going-concern surplus [15].2

2.3 Lehman’s Bankruptcy Filing

Lehman filed on Monday September 15, 2008 for bankruptcy protection under Chapter11 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 byfar 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 asusual.

The way that Lehman filed for Chapter 11 shows that its executives hired thebankruptcy attorney as late as possible to avoid hints to its employees and to the mar-kets, that bankruptcy was in consideration. Hence, there was no well-planned contin-gency plan to allow a seamless transition to the Chapter 11 state and to avoid a financialmeltdown during the first days after the bankruptcy filing. But -possibly- a better planwouldn’t have changed much since the BAPCPA added provisions that affected Lehmanin a per se unfortunate manner. Actually, Lehman filed only three, non-substantialmotions to open the bankruptcy case [15]:

• First motion asks the court to enforce the automatic stay provisions.3

• 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 listof creditors.

2As a short side note: The Securities Industry and Financial Markets Association and the Interna-tional Swaps and Derivatives Association, the bodies which lobbied for the 2005 changes never acknowl-edged the criticism, by arguing the changes “enhance legal certainty for contracts, (and) reduce legalrisk ... and systemic risk” and “provided legal certainty by clarifying existing federal policy”.

3A curious motion since the Southern District of New York is part of exactly the United States Courtof 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 FederalReserve-backed advances of a total of $138 billion from JPMorgan Chase & Co. tosettle Lehman’s securities transactions with customers and its clearance parties, withthe intention to stabilise the financial markets. As approved by the bankruptcy court, theadvances provided by JPMorgan Chase were covered by existing collateral agreementswith Lehman and its affiliates. JPMorgan Chase itself held $17 billion in collateral tosecure the money it advanced [14].

The Dow Jones closed down just over 500 points, which was the largest drop on asingle 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 wasapproved by the bankruptcy court. Barclays was to acquire the Manhattan core businessof Lehman for $1.35 billion, with the responsibility of around 9000 employees. With thedeal, Barclays absorbed assumed $47.4 billion in securities and $45.5 billion in tradingliabilities. 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 exceptionalnature of the deal.

Finally, on September 22 and 23, Nomura’s agreement to buy Lehman’s franchise inJapan, Hong Kong and Australia and its intentions to buy Lehman’s investment bankingand equities businesses in Europe and Middle East were announced, and the deal becamelegally 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 teamsin place, with the task to maximise the recovery value of the assets, mitigate potentialliability, reconcile claims and meet the needs of the court, trustee and unsecured creditorscommittee.

Since the in re LBHI commencement date, the chaotic state of Lehman’s estate cameto stability by the beginning of the year 2009. Melting asset issues, loss of all accountingsystems, a lack of asset inventory, loss of operational support and a major head-countloss to Barclays were difficulties for the estate administration. Cash positions in theAmericas 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 companyand its status as a major player in the US and internationally. Many questioned theUS government’s decision to let Lehman fail, as compared to its tacit support for BearStearns (which was acquired by JPMorgan Chase) in March 2008. Lehman’s bankruptcyled to more than $46 billion of its market value being wiped out. Its collapse also servedas the catalyst for the purchase of Merrill Lynch by Bank of America. Less than aweek later, on September 21, the Wall Street that had shaped the financial world fortwo 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 banksas 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, awealthy Japanese stockbroking tycoon. Everything begun much earlier with TokushichiII’s father, Tokushich Nomura. His father created a money changer business in Osakain 1872, the Nomura Shoten. His son first helped him in his business and then went onto start in a new business in Japan at that time, stock brokering. This led TokushichiNomura II to found the nowadays called Nomura Group based on the idea that a longand sound customer relationship is the key to a successful business.

The Nomura Group is the financial institution of a wider conglomerate named No-mura Holding. This conglomerate is based on the Japanese business model Keiretsu.Companies in a Keiretsu have strong and interwoven relationships but stay indepen-dent in their management. Those business groups are usually organized around a bankwhich lent to Keiretsu companies, hold equities in them and bail Keiretsu members outif needed [1]. Nomura Holding is a horizontal Keiretsu with companies present in manyindustries from oil and gas to construction, chemicals and foodstuffs [2]. The bank inthis 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 es-tablished in 1925 in Osaka, when it spun off from Nomura Group. It was first a bondtrading firm and became famous for inventing the conduit commercial mortgage. Itwas actually NSC, which should acquire the European and Asian operations of LehmanBrothers.

NSC has managed throughout the 20th century to take advantage of political andeconomical difficult situations like the end of the Second World War, the 1965 Japaneserecession 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 “WhatNomura does this morning, the rest of the Japanese securities industry will do afterlunch”. For example in 1965, guided by the belief that economics and technology wouldbe closely intertwined in the future, NSC founded an independent research institute toserve Nomura’s needs but those of Japan as well. Today Nomura Research Institute isone of the leading research organizations in Japan and the company’s belief at that timehas 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 StockExchange in 1981. However they never really succeeded in taking a significant part onthe American securities market. They founded the very successful European branchin the 1970s with its headquarters in Frankfurt. At the beginning of the 1990s duringthe Japanese economy crash, things started to get nasty. NSC faced many scandalsand market troubles. However, they managed to stay financially sound and took thecrisis as an opportunity to restructure their business and management model to becomecompetitive again [7].

3.2 Nomura’s Acquisition of Lehman Brothers

Nomura started to move to acquire Lehman Brothers after the company filing forbankruptcy. After one week of decision, on September 22, Nomura declared the ac-quisition of Lehman Brothers’ franchise in the Asia Pacific region, including Japan andAustralia. On September 23, Nomura acquired Lehman’s European and Middle Easternequities and investment banking divisions. On October 7, Nomura moved further to hireformer Lehman Brothers fixed income staff. Then on October 14, Nomura completelyintegrated the acquisition of three companies in Lehman’s eleven services platform inIndia which are LB Services India, LB Financial Services (India), and LB StructuredFinancial Services.

3.2.1 The New Workforce Resources

The new world-class human capital came from the former Lehman employees, which werearound 8,000 people. Approximately 2,650 employees worked in equities, investmentbanking and fixed income in Europe. Approximately 1,100 people worked in the formerJapan franchise. Approximately 1,500 people worked in Asia Pacific (ex-Japan), andaround 2,900 worked in the subsidiary in India.

The acquisition will give access to a broad range of clients and be complimentary inthe business areas. Through the India acquisition, Nomura will also gain the strengthof Lehman’s IT platform, being a crucial element for global business operations, i.e oneof Lehman’s strengths was the high-velocity trading engine, which allowed Lehman totrade the stocks and bonds significantly fast. This is highly beneficial to the customerssuch as hedge funds.

3.2.2 Nomura’s Key Strategy

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

14

CHAPTER 3. NOMURA

4

4

A cquisition O utline – Summary1

India

Acquired three subsidiaries

Tota l of approx. 2,900 people

LB Services IndiaIT , G loba lS erv ic ing

LB F inancia l Services (India) Research services

LB Structured F inance ServicesC apita l Markets Support andAna lytics

Europe & ME

Acquisition of equities and investment banking operations

Approx. 2,500 people

H ired ex-Lehman fixed income staff

Approx. 150 people

Interest ra te , credit, and currency linked operations

Japan

Acquired Japan franchise

Approx. 1,100 people

Asia (ex-Japan)

Acquired Asia Pacific franchise

Approx. 1,500 people (ex-Japan)

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 in-vestors such as pension funds and mutual funds. Lehman’s strength lies on hedge fundsand other similar clients due to its competitive execution services (see Figure 3.2).

8

8

Synergies – Solid Client Base2

Synergies in client businesses: Perfect complementary relationship

Global Equity

DomesticFixed Income

Overseas IB

Others

Traditional

Japanese

Niche

Retail & HNW

Hedge Funds

Overseas

Broad

Wholesale

L e h m a n

Note: Please refer to Appendix for synergies of each divisions.

Nomura’s global strength lies in Japanese equity products and services for traditional investors such as pension funds and mutual funds based on our competitive research. Lehman’s strength is with hedge funds and other similar clients due to its competitive execution services.

By acquiring Lehman’s European equity operations, we have been able to add European equities to our product lineup. In the domestic fixed income business, our strength lies with domestic investors, while Lehman is focused on international investors. For instance, in JGB underwriting, we hold the top share for domestic investors, and Lehman holds the top position for international investors.

In investment banking, we maintain the top market share in Japan, with a niche coverage in emerging markets such as India and eastern Europe. Lehman, meanwhile, is a top player in Asia and Europe with a broad client base. We can expect to see this complementary relationship deliver results in the growing area of cross-border M&A.

In addition, we have a substantial base of customers including high-net-worth investors in the retail business in Japan and the rest of Asia. Lehman’s client base is in the wholesale business.

So as you can see, there is a perfectly complementary relationship between Nomura and Lehman Brothers in terms of clients and products and services. We will maximize these synergies to rapidly expand our client-facing businesses.

Please turn to the next page.

Lehman

Figure 3.2: Synergies in Client Business

The acquisition of Lehman will help Nomura to increase the number of internationalinvestors. While Nomura holds a top share of JGB underwriting for domestic investors,Lehman holds a top rank for international investors. Furthermore, the Lehman in-vestment banking branches in Asia and Europe will complement the client base, sinceLehman is a top player in this market. Nomura can still maintain a top share in Japanand emerging markets such as India and Eastern Europe (see Figures 3.3 & 3.4).

15

CHAPTER 3. NOMURA

14

14

6 .8%

74 .2 %

19 .0 %

H e d g e F u n d s

M u tu a l F u n d s

O th e r s

N o m ura %

- 18 . 3%

- 24 . 9%

- 56 . 8% He d g e F u n d s

M ut u a l F u n d s

O th e r s

L e h m a n %

Synergies – A sia E quity2

Nomura depends on mutual funds whereas Lehman depends on hedge funds

A sia E quity B usiness by C lient Type

* F igures are based on top 30 clients of Nomura and Lehman’s top 40 clients in F Y07.

Figure 3.3: Synergies in Asset Management

16

16

Synergies – Investment B anking2

E quityUnderwriting

E urope & ME A sia-Pacific Japan

M&A

11,523

(Bookrunner)

(F inancia l Advisor)

1,499

(63) (19)

33,952

(30) (12) (3) (214)

4825,161 2,712

(154) (29) (24) (29) (13) (348)

17,544

552,983

76,535

3,894

19,2576,794

(Jan . 2006 – Sept. 2008)

Proceeds (US$ mil.)

(# of Issues)

(# of Dea ls)

Lehman N OMUR A

Rank Va lue (US$ mil.)

Source: Thomson Reuters

Investment banking businesses a lso highly complementary

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).

9

9

Transition – The Road to Revenue3Increased costs in initial phases; revenue expansion from next fiscal year

Revenue

C ost

Profit

Phase 1 Phase 2 Phase 3 Phase 4

Transform

Crea te synergies

Crea te synergies

Promoteefficiency Promote

efficiency S tart

joint opera tionsS tart

joint opera tionsEx-Lehman sta ff

join Nomura Ex-Lehman sta ff

join Nomura

Asia-Pacific Approx. 2,600Europe & ME Approx. 2,650IT pla tform Approx. 2,900

EquityH igh ve locity trading engine

Broad client reach

New products

G loba l footprint

World-class people

World-class products & services

Enhanced IT pla tform

F ixed IncomeG loba l interest rates & currencies

Investment BankingBroader coverage

Note: This slide is for illustra tive purposes as of October 28, 2008. No representa tions or warranties are made regarding accuracy, comple teness, current, or future earnings. Forecasts are interna l and subject to change without notice .

This shows an outline of the road to revenue . Phase one is a lready comple te . We are now in phase two working on ge tting the acquired businesses up and running aga in. In some businesses, transactions with clients have a lready started, both in Japan and overseas. We have a globa l coordina ted e ffort to ge t the businesses fully opera tiona l as soon as possible . In the third phase , we will promote e fficiencies in the combined organiza tion and infrastructure . And in the fourth phase , we can expect revenues to be genera ted from synergies during next fisca l year.

In addition, we recently announced a new management structure which a llows our increasingly diverse pool of managers to be appointed as Senior Managing D irectors. This move positions us to enhance our business execution structure in response to the increasingly sophistica ted na ture of the financia l services industry. The introduction of this new management structure led to three non-Japanese managers be ing appointed Senior Managing D irectors.

In another management move , we recently announced tha t the positions of Head of Equity, Europe , the Middle E ast, and A frica , and Head of Equity, Asia Pacific, including Japan will be filled by former Lehman managers. As we work to build an opera ting structure for the combined organiza tions, we will appoint whoever is the right person for the job.

Figure 3.5: The Road to Revenue

16

CHAPTER 3. NOMURA

The first phase is to acquire Lehman and offer the former Lehman employees to joinNomura. The second phase is to start the joint operations, integrate infrastructure andrun up the business. The third phase is to promote the efficiency in the combined oper-ation and infrastructure. And in the last phase, Nomura can expect revenues generatedfrom 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 theperformance of management to support the sophisticated nature of financial business.Under the new management structure, the three non-Japanese managers are appointedto be the Senior Managing Directors. Furthermore, Nomura tries to promote the rightpersons for each job and not only Japanese bankers.

In the medium to long term, Nomura wants to become a world class player in invest-ment banking. The benefit from the acquisition will dramatically help Nomura in manyways such as having world-class human resources, world-class services and solutions, anda world-class client base. In addition, a well structured synergy and the integration ofinfrastructure will provide Nomura to become a world-class investment bank in the nearfuture.

17

Chapter 4

Share Price Analysis

4.1 Idea

We make an analysis both over two trading days after the announcement of the firstacquisition 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 September22 and the acquisition of the European business one day later. The two day analysis ismade to capture a rough proxy of the value that Nomura shareholders attributed to thebusinesses acquired. The analysis over one month shall give a more precise value sinceduring that period Nomura shareholders received more details about the acquisition (seeFigure 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 aperiod of five years relative to the Topix Banking index, the benchmark index for theJapanese 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 Brothersshould be priced in over that period. However, the ordinary performance of Nomuraover that period is not a correct proxy since it is biased by the beta effect, i.e. the co-movement with the general market. To neutralise that effect we calculated the differenceof the two day performance of Nomura and the product of the beta and the two dayperformance 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 theperiod of September 22-24 that cannot be explained by the movement of the benchmarkindex and should therefore reflect the idiosyncratic news Nomura was exposed to. Thatnews 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 thenumber of shares of Nomura and the closing price on September 22 into account wecompute an increment in value of U160,296,740,624 which at the time was - using theJPY/USD FX rate - $1,519,069,213. That value gives us the ad-hoc valuation thatNomura shareholders assigned to the parts acquired on September 24.

We can refine this value by observing a one month period after September 22 ratherthan just two days. That procedure is meant to reflect the additional informationabout the businesses acquired that shareholders of Nomura received over one monthafter the announcements. We calculated the arithmetic mean daily performance overthe period of September 22 – October 22 of both Nomura and the benchmark. Thenwe adjusted the performance of Nomura to obtain a beta neutral value according to theabove equation. This value was computed as 0.2496% and thus gives monthly return of5.74%. That translates into an increment of value of U218,466,727,995 or $2,198,269,954.That procedure reflects the more information available in the market one month afterthe acquisition announcement but is biased by the idiosyncratic information not relatedto the acquisition. We assume here that the market impact of that kind of informationis negligible since there was no major news release not related to the Lehman franchisepurchase.

4.2 Results

Using the one month approach rather than the ad-hoc two day procedure we get a valueof close to $2.2 billion for the Lehman operations acquired. We have to challenge thisvalue with our own NPV and real options analysis to check whether Nomura shareholderswere 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 earningsstatement/report from Lehman Brothers published only several days before Lehmanwas forced to file for Chapter 11 bankruptcy [26]. The report classified the earnings andnet revenues (revenues minus interest expenses) by region as well as by activity, but notby region and activity which would have been ideal for our case study. Therefore we hadto estimate them by separating the revenues from each activity by giving weights to eachregion that we obtained by dividing the region’s total revenue by the total revenue forLehman. We ignored revenues of the fixed income department since it was not part of thedeal. As we can see, despite large falls in revenues of equities, investment banking andinvestment management stayed positive throughout 2008 which cannot be said for thefixed 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 inorder to get profits by activity and region. Quarterly revenues in 2008 in equities werehalf those in 2007 but revenues from investment banking and investment managementwere still pretty stable in the first quarter of 2008 before slightly decreasing in the quarterending on August 31. Therefore the departments Nomura bought in Lehman EMEAwere still generating nice revenues in 2008. So why did Nomura buy Lehman EMEA foronly a nominal value?

5.2 Salaries and Bonuses

Nomura’s bid was approved and favoured over its competitors’ bids because Nomuraagreed to employ no less than 8000 former Lehman employees and guarantee theirsalaries and bonuses for years 2008 and 2009 at 2007 levels. The average bonus of aLehman employee in those divisions stood at $332,000. This sums up to $2.65 billionin bonuses only. Nomura’s management insisted that this move was necessary to keepLehman’s stars satisfied and loyal to their new employer.

Did this really make sense in the September 2008 environment? Was competition tohire Lehman “star” employees really that tough? Most investment banks were experienc-ing 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 guaranteedbonuses and salaries almost twice as high as those of their “old” Nomura employees withsimilar jobs. This might be a potential problem in the integration process and shall beaddressed 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 questionslingered over the deal. Nomura either expected revenues to attain their pre 2007 levelsfast or they had a plan to lay off a sizeable portion of their ex-Lehman workforce in thefuture. Assuming the latter is the case, Nomura deliberately guaranteed jobs for 8000employees for the years 2008 and 2009 knowing many of them would not be with themany more in 2010. Still assuming this hypothesis, regardless of whether Nomura wouldprofit from the deal or not, we can already safely say that the biggest winners in thedeal were the ex-Lehman employees. Not only were their astronomical 2007 bonusesguaranteed 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 busi-ness given different hypotheses. In other words, we will try to evaluate future revenuesthat would make the deal break-even for Nomura and then give our opinion whethersuch a forecast is plausible or not. The break-even value would in fact be positive forNomura because of the effects of synergies but here we will only concentrate on thefuture of Lehman alone and determine its stand-alone value.

After extracting the revenue figures, the second step would be to evaluate the non-interest expenses. Page 12 in [26] gives us quarterly costs for the whole firm. Onceagain we shall assume that EMEA and Asia Pacific represent 52% of those costs andsubtract costs linked to the fixed income business which we shall assume to account for25% of total costs. We arrive at a figure of $2 billion for annual non-interest and non-compensation expenses. Salaries plus benefits and bonuses amount to about $4 billionfor the European and Asian business. This gives us total costs in the region of $6 billionwhereas total revenues stand at only $2.5 billion. The acquisition will therefore costNomura about $3.5 billion in the first year assuming market conditions stay the sameas in Q4 2008. The “real” price Nomura paid for Lehman is therefore these $3.5 billionplus all further losses attributed to Lehman in the years to come. Even if we find theNPV to be positive, the investment requires a down-payment of at least $3.5 billion inthe first year of the acquisition. Given the liquidity and credit conditions in September2008, it is easy to see why there was a shortage of bidders for Lehman EMEA and AsiaPacific.

5.3.1 Assumptions

We shall assume that Nomura will be able to reduce non-interest and non compensationcosts by 10% in the years 2009, 2010 and 2011 and that they remain constant in thefollowing years. We shall also assume that Nomura will lay off approximately 10% oftheir work force each year in years 2010, 2011 and 2012 and thus lower compensationcosts. 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 faras net revenues are concerned, we predict a gloomy 2009 with negative growth, a smallcomeback in 2010 and then a larger one in 2011, 2012, and 2013 before a stable periodwith approximately 10% growth rates in the following years. We regard these as ratheroptimistic assumptions. We shall assume that interest rates stay low for quite some timebefore gradually increasing in the middle of the next decade. We also assume a beta of1.7.

5.4 Results

With these assumptions we come up with an NPV of -$668 million. Lehman would be-come profitable only after 2014. On the other hand, Nomura is confident that they canturn around Lehman and become profitable before 2012. Their revenue growth assump-tions are therefore more optimistic than ours or they envisage cutting their workforcemore than 10% in the first three years. Another possibility is that they value the syner-gies brought by the deal at more than $668 million plus the $200 million they paid forLehman Asia Pacific. We shall try to put a number on those synergies in the real optionsanalysis (see Chapter 6) and discuss it in a qualitative way in the strategic analysis (seeChapter 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 haveto reduce their workforce by 20% in 2010 and 15% in 2011 in order for the acquisitionto break-even. This sums up to approximately the same number of employees as in thesituation 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 actboldly 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 followingtheir acquisition of Lehman Brothers. As we saw in Chapter 3.2, one of the reasonswhy Nomura chose to buy Lehman EMEA and Asia Pacific is that it would provideNomura to become a global investment bank and gain a significant market share in theEMEA and Asia Pacific regions including its home country Japan. Indeed, as we shallsee Lehman and Nomura operate complementary businesses. The acquisition thereforegives Nomura the opportunity to expand its traditional business in EMEA and AsiaPacific because it will already have its brand name and reputation consolidated in thoseregions. They would then be slowly be able to expand into businesses such as fixedincome which they will not have at first. This can be seen as an option to expand. Thisoption therefore has some value and should be considered in our valuation. There arenumerous studies on how to value such an option, one of them is the MacDonald andSiegel (1986) model which we will use in this section [25]. The value of the acquisitioncan be seen as:

Vacquisition = NPV + C

where C is the option value.

6.1.1 The MacDonald and Siegel Model

We will denote by Vt the present value of future revenues if the option is exercised attime t. If it were today, V0 would be nothing else than the NPV of the newly establishedfixed income business and others. We will also denote Ht the present value of the costsassociated with the expansion. And we shall assume that Vt and Ht follow the followingstochastic rules:

dVtVt

= α1 · dt+ σ1 · dW1,t

dHt

Ht= α2 · dt+ σ2 · dW2,t

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

23

CHAPTER 6. REAL OPTION ANALYSIS

note: Vt = E(∫∞

0 e−r(u−t)Ru du|Ft) where Ru are the revenues at time u.The option value is given as

C = supτEP ((Vτ −Hτ )+e−rτ )

The preceding equation is correct because Nomura will exercise its option, which willyield Vτ −Hτ in present value terms at time τ , therefore we have to discount it back totoday. τ is therefore a stopping time.

= supτEP (Hτ (

VτHτ− 1)+e−rτ )

= supτEP (H0e

(α2−σ22/2)τ+σ2W2,τ (

VτHτ− 1)+e−rτ )

= H0 supτEP (e−(r−α2)τ−σ2

2τ/2+σ2W2,τ (VτHτ− 1)+)

= H0 supτEQ(e−(r−α2)τe−σ

22τ/2+σ2W2,τ (

VτHτ− 1)+ dP

dQ)

We choose Q such that e−σ22τ/2+σ2W2,τ · dPdQ = 1

therefore dQdP = e−σ

22τ/2+σ2W2,τ and W2,t − σ2t; t ≥ 0 is a Q Brownian motion.

C = H0 supτEQ((

VτHτ− 1)+e−(r−α2)τ )

Using the optimal stopping theorem, Laplace transform, Ito formula and orthogonaldecomposition theorem this equation gets us to:

C = H0(Lc − 1)(V0H0

Lc)θ

where Lc = θθ−1 , θ = −α+

√α2+2(r−α2)

Σ , α = α1−α2−Σ2/2Σ , and Σ =

√σ2

1 + σ22 − 2ρσ1σ2

6.1.2 Assumptions

We shall assume that the revenue in the first year R0 would be $300 million (approx-imately one sixth of what Lehman was earning through its fixed income business inEMEA and Asia Pacific) and that it would grow at a growth rate of α1 = 0.1. ThereforeV0 = R0

r−α1= 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. Weassume a high growth rate of costs to represent wage increases and to artificially offsetthe anomaly where one can wait for a long time and then exercise the option with hugeprofits and low costs in the first year of the project. This gives us H0 = K0

r−α2= 2.142

billion dollars. We assume σ1 to be 0.20 and σ2 to be 0.05 given the uncertain natureof revenues and the contrary for costs. We also assume the correlation between thetwo Wiener processes to be ρ = 0.5, which could represent bonuses for good years andcutting costs for bad years.

24

CHAPTER 6. REAL OPTION ANALYSIS

6.2 Results

Plugging in the values we get C = 963 million USD. Therefore the acquisition canbe valued as the NPV plus these $963 million. This value is very sensitive to ourassumptions and we cannot precisely predict the revenues of the expansion nor thecosts, however the goal of this chapter was not so much to give an exact price as itwas to show an alternative way to value Nomura’s investment and give us a clearerpicture of the deal. It is worth noting that the figure we got is not that far away fromV0 − H0 = 858 million USD. This implies that there is value in waiting rather thanexpanding immediately but given the high cost of equity the exercise time is not thatfar from today. Our cost of equity estimate probably was high due to low interest rateswe 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 tothe 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 thepotential synergies that this acquisition could provide. This dimension is very hard toassess quantitatively. Hence, this chapter will provide a qualitative and strategic analysisof the acquisition to complement the previous quantitative investigations.

Before September 2008, Nomura was a bank mainly focused on Japanese equityproducts 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 andmostly present in the USA and Europe. When looking at their core competencies, wesee 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 qualitativearguments 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 thisacquisition. This goal was defined by Nomura as “becoming a world class investmentbank” by “maximising synergies using competitive resources” and having a “verticallyintegrated international wholesale business”. Once this goal is defined, we first assesswhat are the present strengths and weaknesses of Lehman. Then from this assessment,we evaluate what are the potential future opportunities and threats this deal wouldcreate for Nomura (see Figure 7.1).

This analysis shows that the acquisition has the potential to create great synergiesdue to economies of scale and complementary businesses. In the banking industry sizeplays an important role to be competitive. Buying the European and Asian activitiesof Lehman will give Nomura the opportunity to become a competitive player on thosemarkets, which was not the case so far.

Lehman also possesses powerful IT and R&D departments developing platforms likehigh velocity trading machines. Acquiring those departments and merging them withthe present IT and R&D departments at Nomura could also produce great innovationsand a potential cost-leadership position on the market. This is the reason why Nomura

26

CHAPTER 7. STRATEGIC ANALYSIS

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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, Nomurapromised to keep the bonuses at the same level for 2008 and 2009. This represents ahuge cost of $2.65 billion that cannot be cut as developed in the NPV analysis. Thisis a necessary move in order to retain Lehman’s best employees, which represent a keycompetitive advantage in this industry. With this offer, Nomura succeeded to retainmore than 95% of former Lehman employees.

Nomura and Lehman are two very different companies. On the product and marketside 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. Theemployees are usually employed lifelong with great job security but low salary. On theother 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, highcompetition and intense work. Merging those two cultures is a great challenge and couldcreate big frictions in the future. With hindsight we know that in Europe Lehman’sculture took over Nomura’s culture. Hence, on a business cultural level, we could saythat Lehman acquired Nomura in Europe. In Japan, Nomura employees were offered tochoose between their old job scheme or a “Lehman style scheme” offering them highersalary 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 toperform to employees coming from both worlds in order to gain advantage by creatingsynergies through both cultures.

27

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 theEuropean equities and investment banking division for a price as ridiculous as $2. OurNPV analysis gives an insight on how the new Nomura should restructure itself in orderto 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 theoption of waiting and expanding in EMEA and Asia Pacific makes the deal interestingfor Nomura.

Comparing this analysis to how the market reacted shows that our analysis is morepessimistic but still comparable. The Share Price analysis shows that the market valuedthis acquisition at $2.2 billion.

These quantitative insights have to be put into perspective with a strategic andqualitative analysis capturing issues like corporate culture issues and potential synergies.A SWOT analysis and an investigation of the two companies’ previous core businessesshows that this acquisition could generate great synergies and transform Nomura intoa key player in the global banking industry. This was precisely Nomura’s goal whenacquiring part of Lehman Brothers. This paper shows how complementary the twobanks are in terms of products, customers and geographical locations.

However, history in merger & acquisition shows that huge acquisitions by companiesnot used to it tend to destruct shareholder value. Great cultural difference tends to makethe acquisition fail as well. Nomura combines both of those weaknesses. The culturalissues, as discussed in the Strategic analysis, are most probably the greatest challengefor Nomura in the future.

Hence, we see so far that the decision whether this acquisition is a good move byNomura or not is not obvious. The opportunities are huge but the challenges on all levelsare great. However, given the amplitude and uniqueness of the crisis, which lead LehmanBrother to bankruptcy, and given that Nomura was financially strong at that time, theacquisition was probably a good move. As Nomura said, “this is the opportunity ofonce in a life time”. We conclude that this acquisition is a risky bet for Nomura but, ifmanaged carefully and properly, still a good one.

28

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