Knight Holders Face Funding Options in Hotspot, Direct Edge
The investors who bailed out Knight Capital Group Inc. (KCG) may wring more value from the firm by selling its currency platform and stake in Direct Edge Holdings LLC.
Hotspot FX, the foreign-exchange trading system acquired in 2006, would get as much as $300 million in a sale, according to JPMorgan Chase & Co. Its 19.9 percent of Direct Edge Holdings LLC may be worth $80 million, said Raymond James & Associates Inc. While the company’s U.S. broker-dealer has $300 million in excess capital, Knight can’t rule out more losses from lawsuits and diminished business, it said yesterday in a filing.
Chairman and Chief Executive Officer Thomas Joyce avoided insolvency with an agreement to sell convertible securities to six investors for $400 million, a “permanent solution” for Knight’s funding issues, he said in a telephone interview Aug. 6. The six investors, whose stake is worth more than $800 million on paper, may find it tempting to boost the payout even more with sales.
“Management will probably take a fresh look at the company beyond just internal controls,” Michael Wong, a Chicago-based analyst with Morningstar Inc., said in a phone interview. “There is the potential for them to sell off some assets.”
Knight, whose market-making unit executes about 10 percent of U.S. equity volume, said in a government filing that last week’s mishap may spur more losses. Should its customers and trading partners lose confidence, Knight’s reputation and business may suffer, the firm said. Lawsuits and regulatory probes may also cost money, it said.
“Knight resolved its capital needs through the transaction announced Monday,” Kara Fitzsimmons, a spokeswoman for Knight, said in an e-mail yesterday. “It is sufficiently capitalized.”
The stock has tumbled 72 percent from its $10.33 closing price before the Aug. 1 software malfunction caused it to spew out orders into the market, triggering a trading loss that will total $270 million after tax, according to a filing. The stock slid 5.5 percent to $2.90 in New York today.
Among Knight’s rescuers, Jefferies Group Inc. (JEF) bought $125 million of convertible stock, according to a regulatory filing by Knight. Automated trading firm Getco LLC and Blackstone Group LP (BX), a private equity company, bought $87.5 million each. Broker TD Ameritrade Holding Corp. (AMTD) got $40 million, and investment bank Stephens Inc. and brokerage Stifel Nicolaus & Co. took $30 million each, the filing showed.
“We saw the Knight opportunity as a good strategic investment for our company,” Kim Hillyer, a spokeswoman at TD Ameritrade, said in an e-mail. “Beyond that, we think it’s premature to speculate about what we might or might not do in the future.”
Richard Khaleel, a spokesman at Jefferies, declined to comment. Stifel bought its stake because it was an “attractive” financial investment, said Ronald J. Kruszewski, chairman, president and CEO of Stifel Financial Corp. (SF), said in a conference call Aug. 8. Getco invested because Knight is a “very valuable company,” Daniel Coleman, its chief executive officer, said in a phone interview Aug. 6.
Peter Rose, a spokesman for Blackstone, said in an e-mail, “Any comment at this stage would be premature.” Frank Thomas, a spokesman for Stephens, didn’t immediately return a call seeking comment.
Knight spent the last decade expanding from a market maker that mainly handled orders from individuals sent by brokers to a financial services company with institutional clients, electronic trading services, and businesses in fixed income and currencies. The company provides research and asset management and got into the reverse mortgage business in 2010.
The trading malfunction raises concern about risk control and may limit how much investors are willing to pay for shares relative to earnings, JPMorgan analyst Kenneth B. Worthington wrote in a note. Stock in Knight was valued at 6.8 times annual profit on July 31, according to data compiled by Bloomberg.
“The company was already trading in the mid-single digits given the lack of transparency, and valuations as a going concern will likely fall meaningfully,” he wrote in the Aug. 6 note. “Given this perspective, we expect investors will look to value the Knight pieces, expecting the parts may be divested at more opportune times.”
Businesses Knight acquired over the last seven years may be worth $600 million, including $300 million for Hotspot FX based on the valuations of its competitors and taking into account increased trading volume, which has tripled since 2006 when Knight bought the business for $77.5 million, according to Worthington.
Sandler O’Neill & Partners LP’s Richard Repetto estimated in an Aug. 7 note that Hotspot’s value could be about half Worthington’s figure. The currency platform reported $28 billion in average daily volume in the first half of 2012, he wrote. Assuming this could lead to about $48 million in revenue and $10.3 million in post-tax profit this year, Repetto said Hotspot would be worth $155 million after applying a 15 times multiple on earnings.
Knight’s stake in Direct Edge may be worth as much as $100 million in cash, Repetto wrote. The exchange was valued at $390 million in 2008 when International Securities Exchange Holdings Inc. bought a 31.5 percent stake in the company, according to Repetto. Assuming the sale price could be as much as $500 million, this could generate up to $60 million in an accounting gain, he said.
Retail brokers including TD Ameritrade have a “vested interest” in Knight’s survival to ensure that the amount of payment for order flow they receive from wholesalers doesn’t decrease, Patrick O’Shaughnessy, a Chicago-based analyst at Raymond James, wrote in a note to clients dated Aug. 6.
Selling some of Knight’s “non-core” businesses, including Direct Edge, its EdgeTrade unit and BondPoint, may generate almost $300 million, O’Shaughnessy wrote in a separate note, adding that it was a “very rough guess.”
Knight’s investors are making too much money from the transaction to be considering deals now, said Jeffrey Meyerson, market maker and senior managing director at Sunrise Securities Corp., in a phone interview.
“I’d be surprised if they have a concentrated strategy to break the firm up,” Meyerson said in phone interview. “The investors made a very shrewd deal and got some very cheap equity. They’ll want to grow the company to sell their stock.”
The rescue was probably more of a “buy low opportunity” than a plan to eventually split up the company, Larry Tabb, chief executive officer of research firm Tabb Group LLC in New York, said in a phone interview.
“There’s a high likelihood they’re not breaking up, given the investors that they have,” Tabb said. “If it had been bought by one or two private equity guys, I would say it would get broken up. But you’ve got a whole consortium of different people,” he said. “They would have a really hard time splitting up all the Knight assets.”
Knight hadn’t done any new strategic planning as of Aug. 6, Joyce said in an interview. Budgets and strategies would be set over the normal schedule toward the end of the year. The “footprint” of the company would “remain intact for a while,” he said.
“Once the internal review of the trading error is completed, we would expect the board and management to re- evaluate the model and strategic direction,” Christopher Allen, an analyst at Evercore Partners Inc. in New York, wrote in an e- mail yesterday. “We would not be surprised if there was increased scrutiny of any businesses that generate only marginal profitability relative to their capital usage.”
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