Knight Capital Group Inc. (KCG:US)’s decision to pursue a takeover by Getco LLC gives its shareholders, mostly Wall Street firms, an opportunity for stock appreciation while surrendering the certainty of cash.
Knight, pushed to the brink of bankruptcy in August by a trading error, chose Getco’s proposal yesterday over a competing offer from Virtu Financial LLC, three people with direct knowledge of the matter said yesterday. The Chicago-based high- frequency trader offered $3.75 a share for Knight, one-third of it in stock, for a total value of $1.4 billion, according to a statement from Knight today. Virtu’s offer was all-cash.
An acquisition would end the 17-year independence of Jersey City, New Jersey-based Knight, a company propelled by the explosion in electronic trading in American stock markets. While joining with Getco preserves Knight’s listing and expands its reach, it also means the company’s value will depend on the view of markets, where Getco has never traded.
“There’s an uncertainty,” Sachin Shah, a special situations and merger arbitrage strategist at Tullett Prebon Plc, said in a telephone interview. “Shareholders want to know that getting stock is attractive because it can appreciate. They need to articulate the future opportunity of the combined company. That will to some extent reduce the uncertainty so shareholders feel comfortable that it is not just paper, it’s valuable paper.”
Knight shares increased 5.9 percent to $3.53 as of 2:46 p.m. in New York.
Knight lost more than $450 million in August when improperly installed software caused it to bombard stock exchanges with unintended orders. Getco and five other financial firms provided $400 million to restore Knight’s capital in return for convertible securities representing more than 70 percent of its equity.
Other rescuers were Blackstone Group LP, brokerages Stifel Nicolaus & Co. and TD Ameritrade Holding Corp. and investment banks Stephens Inc. and Jefferies Group Inc. (JEF:US) Virtu does not have a stake in the company.
The priority now is building a team to work on integration plans, Getco Chief Executive Officer Daniel Coleman, who will head the combined company, said in a phone interview. He and Knight CEO Thomas Joyce, who will be executive chairman, will lead the group, he said. No asset sales are currently planned.
“We’re putting these two firms together because of the businesses they have,” Coleman said. “Knight has some great business that from time to time people want to buy, but that’s because they’re great businesses.” Asked about potential staff reductions, Coleman said that while any merger has overlaps, “this is more about the revenue potential than it is about ripping out cost synergies.”
Joyce, who helped build a market-making unit that executes orders for individual investors sent by about 700 retail brokers and expanded into institutional services and currency and fixed- income trading, said the takeover unites complementary businesses. Getco, known for its financial technology, is a global electronic market maker across asset classes and, more recently, a provider of trading services to institutions.
“There’s certainly going to be an element of me being Mr. Outside, if you will, on the road a little more often, out in front of clients,” Joyce said about his role at the combined firm. Coleman as CEO will be “Mr. Inside” running the company’s day-to-day business, he said.
The valuation of the combined firm depends on Getco, which is private and has made few financial disclosures, Patrick O’Shaughnessy, a New York-based analyst for Raymond James Financial Inc., wrote in a note to clients. While that makes the deal hard to evaluate, the price is more than owners would have received had no bidding contest occurred, he wrote.
“Knight’s intermediate-term earnings (KCG:US) power was significantly harmed due to share dilution related to its Aug. 1 trading error as well as depressed industrywide trading volumes,” he wrote. “As a result, we believe that an acquisition price of $3.75 per share greatly surpasses what Knight would likely have garnered (KCG:US) over the next year as stand- alone entity.”
Virtu had a fully funded offer at $3.20 a share to take Knight private with equity financing from Silver Lake Management LLC and debt and equity financing from Cerberus Capital Management LP, according to one of the people.
Gemma Hart, a spokeswoman for Silver Lake at Brunswick Group LLP, declined to comment, as did Alan Sobba, a spokesman for Virtu. Peter Duda, a spokesman for Cerberus at Weber Shandwick, said he couldn’t immediately comment when reached after normal business hours.
Under the terms of the agreement today, existing Knight shareholders can receive $3.75 per share in cash or one share in the combined firm. The payout will be pro-rated if shareholders elect to receive more than $720 million in cash. Jefferies, which provided financing to Getco, agreed to limit the cash portion to 50 percent of their Knight shares, according to the statement.
The Knight board “unanimously concluded that a merger between Knight and Getco provides the best possible value creation opportunity for Knight’s shareholders,” Joyce said in the statement. “The transaction provides near-term certainty in the form of cash, while also allowing shareholders to benefit from participation in the future success of the firm.”
Getco will receive 233 million shares in the new company and retire the 57 million shares of Knight it currently owns. It will also receive warrants for 75 million additional shares with staggered strike prices.
“If I were a shareholder (KCG:US), I’d want it to continue on and would take a deal that allowed me to own some upside in a publicly traded security,” Kenneth Pasternak, who co-founded Knight in 1995, said in a phone interview from Ridgefield Park, New Jersey. “If you didn’t want to continue with Getco you could take the cash and sell the stock and probably get as much as Virtu is giving you.”
Automated market-maker Virtu in New York had asserted in talks with Knight that its offer was more attractive than Getco’s because it was for all of Knight’s shares and was more likely to be completed, according to a person familiar with the matter. Virtu had sought to convince directors that Knight and its employees would be better off if the firm was restructured as a private company. Virtu would go public later, the person said.
“The most bang for the buck will be with Getco,” Ben Schwartz, the Chicago-based chief market strategist at broker Lightspeed Financial Inc., said in a phone interview. “They can consolidate as liquidity providers and they will be able to bring their technologies together to create a more efficient market.”
Knight had more than 1,545 employees at the end of September, it said in a regulatory filing. Getco had more than 400 in June after eliminating 40 jobs, according to a person with knowledge of the matter. Virtu has about 150 employees.
Getco, Knight and Virtu are designated market makers, or DMMs, on the New York Stock Exchange or NYSE MKT. The takeover will make Getco the largest with more than 1,400 NYSE companies, surpassing Barclay Plc, which has 1,200, based on data from the end of October. Getco became a Big Board market maker in 2010. Virtu has the most companies on NYSE MKT, formerly known as the American Stock Exchange.
Barclays represents 12 NYSE-listed companies in the Dow Jones Industrial Average, followed by Getco with 10 and Goldman Sachs Group Inc. with 5, according to data from NYSE.
Getco is committed to being a large DMM on the NYSE floor and maintaining Knight’s market-making business for over-the- counter equity securities, Coleman said. The firms will review the dark pools, or private venues that don’t display orders and quotations, they each operate in the next few months and decide whether clients would benefit if they’re combined, Coleman said.
Acquiring Knight speeds up by five years Getco’s plans to expand into new businesses following a strategic review, said Coleman, who was named CEO in February. He joined Getco as a managing director focused on business development in September 2010 and later became global head of equities and client services. He previously was global head of equities at UBS AG.
Knight shares (KCG:US) were above $10 before the trading malfunction and bailout, which diluted existing owners by more than 70 percent.
In the first half of this year, Knight’s market-making unit posted pretax earnings (KCG:US) of $51.1 million, or 86 percent of the company’s total, according to a statement. Institutional sales and trading generated $7.2 million in the first six months of this year. Electronic execution services had pretax earnings of $23.6 million while the company’s corporate division had a loss of $22.5 million before taxes.
Knight has transformed (KCG:US) over the last decade from mainly handling orders by individuals sent by brokers into a financial services company with institutional clients, electronic trading and businesses in fixed income and currency. It owns the Hotspot FX and BondPoint platforms, provides research and asset management and got into the reverse mortgage business in 2010.
“Getco was one of the six that bought Knight and they probably have insights into the company as part of that due diligence,” said Pasternak, who now works in the private equity industry. “An acquirer always thinks the acquired company is undervalued (KCG:US) and they could do things differently that could enhance the value of the enterprise.”
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