Cazenove’s yield may muddy JP Morgan deal

September 23, 2009

As your friendly neighbourhood investment bank rarely tells you, something like 80 percent of deals don’t pay off. So why do one if you don’t have to?

That is the question facing the mighty City of London firm of Cazenove. Five years after Caz poured its investment banking business into a joint venture with the U.S. bank, JP Morgan, it has to decide whether to go the whole hog and sell the remainder — or to hang on.

Technically the shares are the subject of a put and call arrangement — JP Morgan can force Caz’s investors to sell and vice versa. But it is hard to imagine the Americans obliging the shareholders to sell if they clearly don’t want to.

Which raises the question: why would they want to?

A deal has certain attractions for JP Morgan. The bank’s UK business would be simpler if it owned 100 percent of its UK investment banking operations. The current set-up is quite advantageous for Caz. Not least it gives it access to JP Morgan’s deep pockets and client list.

But these are also good reasons for Caz shareholders to hang on. Most commentators have focused on the cultural reasons for leaving the joint venture intact and these are indeed potent. But there are also good financial reasons to leave things where they are. Take the fact that the joint venture perches on JP Morgan’s mega balance sheet. This gives it the best of both worlds. It can use the U.S. bank’s financial heft to haul in equity capital markets business but it doesn’t carry the risk. Any duff underwritings land on JP Morgan’s plate.

This means the JV hardly needs any capital. Caz itself is a shell these days — its only asset is its near 50 percent stake in the joint venture. That in turn means almost all its profits are flushed through as dividends. Caz’s share of the joint venture’s after-tax profit last year was 46 million pounds, all of which was paid to its own shareholders (plus a further 3 million generated by Caz itself).

Caz’s shares trade intermittently on an internal market. The last traded price was 240 pence per share. On the basis of last year’s dividend of 26 pence a share, the stock yields about 11 percent.

This year the joint venture will probably do even better, given the general hunger for equity rather than debt (which is Caz’s stock in trade) and reduced competition in the investment banking business. But that is not the whole point. Essentially, Caz is a sort of money machine geared to the performance of markets and appetite for the sort of investment banking services it provides. Not only is it highly profitable when things are going well, but most of that profit is distributed to shareholders. That is quite an attractive asset.

The question ultimately is what sort of exit yield might tempt Caz’s owners — half of whom are former partners who no longer work at the firm — to cash in their stock and invest elsewhere. Assume the dividend rises 30 percent this year and investors sought an exit yield equivalent to the yield on the FTSE100, currently 3.45 percent. That would equate to a price of about 900 pence per Caz share or a valuation of 1.7 billion pounds — implying a total value for the joint venture of 3.4 billion pounds.

That might look like a wildly overblown number. After all the entire joint venture was only valued at about 700 million pounds when Caz sold half its business to JP Morgan in 2004. It would also be extremely hard for JP Morgan to justify paying a price earnings multiple of over 25 for the business. After all, Goldman Sachs trades on just 11 times.

Of course, some of Caz’s owners might accept a lower price: after all, a JP Morgan takeover is the only way to exit what is otherwise a highly illiquid investment. If there’s a deal to be done, the answer is probably somewhere between the two extremes of the very low internal market price and the very high price justified by Caz’s dividend stream. That wide gap also explains why agreement may be harder to find that it first appears.

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