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Knight Capital gets US$400m rescue, shares tumble

August 7, 2012

NEW YORK: A group of investors rescued Knight Capital Group Inc in a US$400 million deal that keeps the embattled leader in US equities market-making in business, but comes at a huge cost to existing shareholders.

Chief executive Tom “TJ” Joyce told Reuters the new investors support him and his management team, but it was too early to tell whether the firm would shrink or keep the same strategy it had before last week’s losses.

There were immediate signs the Jefferies Group -led rescue gave Knight back some of the market confidence it had lost, as two large brokerages resumed routing orders through the company and new data showed volumes picking up from last week.

Blackstone Group LP, rival market maker Getco and financial services companies TD Ameritrade Holding Corp, Stifel Nicolaus, Jefferies and Stephens Inc purchased preferred shares for what works out to be a 73% stake in the company, Knight said.

Knight has been the largest US provider of retail market-making in New York Stock Exchange and Nasdaq-listed stocks, buying and selling shares for clients. As a market maker it also provides liquidity to equity markets by stepping in to buy and sell stocks, using its own capital to ensure orderly activity.

Knight shares closed down 24.2% at US$3.07. Those who held Knight shares before yesterday will feel the pain of the company’s rescue the most acutely. The massive dilution that accompanies the deal means their stakes are worth just a fraction of what they were days ago.

Roger Freeman, analyst at Barclays, said the dilution due to the new investment would imply Knight’s value is about US$1 a share. He has a US$3 price target on the stock, but said it was too early to estimate how earnings would be affected in 2013.

Yet Knight co-founder Kenneth Pasternak told Reuters he had no regrets about accumulating hundreds of thousands of shares in the company since last week’s disaster emerged, despite having
lost money as a result of Knight’s rescue. He retired from Knight in 2002.

Breakup coming?

The rescuing companies will buy preferred stock convertible at US$1.50 each with a 2% dividend to save Knight, which was left reeling last week by a software glitch that caused errant trading in dozens of stocks. Knight lost money by selling shares it had inadvertently bought during the day.

The preferred shares are convertible into about 267 million common shares, Knight said in a US Securities and Exchange Commission filing.

Jefferies CEO Richard Handler and executive committee chairman Brian Friedman reached out to Knight last Wednesday, the day of the trading snafu, to offer their services, one source directly familiar with the matter said. The person was not authorised to discuss the issue publicly.

Sandler O’Neill had been tapped by Knight to advise on a deal. But by Friday Jefferies was circulating a term sheet to potential investors based on the same deal format that was later
announced yesterday, sources said. Jefferies backed the deal by making a principal investment itself.

Unlike many private equity firms that snubbed an approach by Knight, Blackstone took an active interest as it was exploring a buyout of the firm. But Blackstone was told to either join the investor group or walk away, according to one of the sources.

“As a financial investment, Knight is a very valuable firm, but it needed liquidity and if it didn’t have liquidity, a lot of that value was going to go away,” Getco CEO Daniel Coleman told Reuters in an interview. “So we thought it was a pretty good bet that by providing liquidity we could preserve that value and perhaps increase it.”

Getco, nominally a Knight rival, gets a strategic advantage via the deal as well – an inside peek at a bigger rival that has some lines of business Getco does not.

Stephens Inc chief operating officer Curt Bradbury, in an interview, said he was long-time friends with Joyce and that his firm approached Knight in that vein last Friday. He said that while there may have been some negotiations by others on terms, Stephens was fine with the term sheet as it was presented.

As part of the deal, the investor group will take three board seats. In a regulatory filing, Knight said Blackstone and Getco parent General Atlantic would each fill one seat, while the board will propose a third member acceptable to Jefferies.

Each retains those rights as long as they hold at least 25% of the preferred shares they purchased in the deal.

JP Morgan analyst Kenneth Worthington, in a client note after the initial reports of the rescue on Sunday night, said the deal presaged Knight’s eventual breakup.

Worthington cited two Knight businesses, the reverse mortgage lender Urban Financial and foreign exchange platform Hotspot FX, as assets that could draw interest, but Joyce said it was too soon to say what would happen to the firm’s assets.

“Right now we kind of like our footprint and we will continue to execute on the strategy we had before the error took place, but as we kind of get back to business and do our annual budgeting and strategic reviews at the end of the year, that will be something that we will have to address,” he said.

Future still uncertain

Vanguard Group, one customer that pulled orders from Knight last week, said yesterday it was again routing there, as did E*Trade Financial Corp.

But even if Knight has been saved for now, the company could face litigation from shareholders.

The potential liability could increase if it were found that Knight violated market rules. The SEC, the top US securities regulator, said last Friday that government lawyers were trying to determine whether Knight violated a new rule designed to protect the markets from rogue algorithmic computer trading programs.

According to those people familiar with the matter, US Securities and Exchange Commission chairman Mary Schapiro spoke with Joyce last Wednesday afternoon from her vacation spot in
Maine. Joyce brought up rules on erroneous trades during the call and expressed hope for some flexibility. But Schapiro did not convey a view on it during the call, the sources said.

Knight’s problems started early last Wednesday, when a software glitch flooded the NYSE with unintended orders for dozens of stocks. That boosted some shares by more than 100% and
left the company holding the shares, causing the trading loss.

Damage swift

The damage to Knight was swift. Whereas Knight once accounted for 20% of the market-making activity in shares of Apple Inc, by midday Friday it was the market maker for 2% of the volume, according to Thomson Reuters AutEx.

But yesterday, AutEx data showed that volume was back up to 19.4%, and it was on the rise for other stocks as well.

Barclays Capital’s Freeman, in a note yesterday, said he assumed that Knight’s overall volumes in 2013 would be about 15% below where they were in the second quarter of 2012.

Sandler O’Neill + Partners and Wachtell, Lipton, Rosen & Katz advised Knight Capital on the bailout. Barclays Plc advised TD Ameritrade on its investment.

– Reuters


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