On December 19, shares of Knight Capital Group (KCG), the leading wholesale market maker in U.S. equity securities, rose on news of the company’s acceptance of an acquisition bid from competing market-making firm, Getco LLC, which valued the company at about $1.4 billion. Under the terms of the merger, which must still gain approval from shareholders and regulators, current Knight stockholders would exchange their shares for $3.75 per share (up from the $3.50 that had originally been offered), or for an equal number of shares in the newly merged company. Knight’s board preferred the agreement to a competing acquisition bid from another market-making firm, Virtu Financial LLC. The Virtu offer would have been an all-cash transaction, with all of Knight’s shares being purchased up front at about $3.00 per share.
The merger marks the latest twist in the Knight story, after the company was overwhelmed by a massive trading error in August that led to colossal losses for shareholders. A bug in computer software, which had been dormant, was activated by the installation of a new trading platform. The glitch led Knight to unintentionally buy millions of shares within minutes of the market-open on that day. Amazingly, the errant trades apparently continued for over a half-hour before they were stopped. The shares were largely bought at huge premiums to their pre-open prices since the errant trades had bid up the stocks involved. Once the smoke had cleared, Knight Capital worked with Goldman Sachs (GS) to unwind the massive positions it had taken, selling the shares to Goldman at a discount in exchange for much-needed capital. Fortunately, no clients had were affected by the incident.
In the past, such errant trades had often been cancelled. However, in this instance the New York Stock Exchange and the Securities and Exchange Commission denied the company’s cancellation requests due to strict rules that were implemented in the aftermath of the 2010 flash crash. As a result, Knight Capital had to close out the errant positions at a $440 million loss.
Rather than suffer further financial reversal, the company received a lifeline in the form of a cash infusion from a broad investor group, which included competitors such as market-making firm Getco LLC, investment firms such as Jefferies Group (JEF) and Blackstone Group LP, and online broker TD Ameritrade (AMTD).
While the cash infusion seems to have fully replenished Knight Capital’s liquidity and capital, it came at an immense cost to shareholders. The investment came in the form of convertible preferred securities that may be converted into common stock at $1.50 per share. The number of shares that could be issued as a result would be a multiple of the share count before the debacle. This effectively leaves the majority of decision-making power in the hands of the investor group, which made a breakup or buyout of the company highly likely. Indeed, the significant stake that Getco took as a result of its participation may have been a factor that leaned in favor of its buyout proposal.
In the months since, the SEC has been investigating not only the incident itself, but also Knight Capital’s risk-control procedures and compliance with market-access rules meant to prevent erroneous trades from high-frequency trading operations. In particular, the SEC seems skeptical as to whether Knight adequately tested its systems after installing the new code.
Despite the risks, potential acquirers saw value in Knight’s continuing operations. The company has four operating segments: market making, institutional sales and trading, electronic execution services, and corporate/other services. While all four segments contribute to revenues, the market-making segment has traditionally accounted for the vast majority of Knight’s earnings. Indeed, the newly merged company will likely be the biggest market-maker of U.S. stocks by a significant margin.
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.