NEW YORK (Reuters) - A group of investors rescued Knight Capital Group Inc in a $400 million (256.4 million pounds) deal that keeps the embattled leader in U.S. equities market-making in business, but comes at a huge cost to existing shareholders.
Chief Executive Tom “TJ” Joyce told Reuters the new investors supported 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.
Yet there were immediate signs the 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’s lows.
Blackstone Group LP, rival market maker Getco and financial services companies TD Ameritrade Holding Corp, Stifel Nicolaus, Jefferies Group Inc and Stephens Inc purchased preferred shares for what works out to be a 73 percent stake in the company, Knight said.
Knight was the largest U.S. provider of retail market-making in New York Stock Exchange and Nasdaq-listed stocks, buying and selling shares for clients. 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 percent at $3.07. Those who held Knight shares before Monday 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.
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.
Roger Freeman, analyst at Barclays, said the dilution due to the new investment would imply Knight’s value is about $1 a share. He has a $3 price target on the stock, but said it was too early to estimate how earnings would be affected in 2013.
The rescuing companies will buy preferred stock convertible at $1.50 each with a 2 percent dividend to save Knight, which was brought to its knees last week by a software glitch that caused errant trading in dozens of stocks.
The preferred shares are convertible into about 267 million common shares, Knight said in a U.S. Securities and Exchange Commission filing.
“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.”
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 on 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 percent of the preferred shares they purchased.
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.
“We don’t expect investors to value Knight as an ongoing entity given its technology glitch generated a pretax loss equal to (about) 30 percent of shareholders equity and nearly wiped out the company in just 30-45 minutes of trading,” he said.
Worthington cited 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.
The New York Stock Exchange said it would temporarily transfer Knight’s market-making responsibilities on more than 500 stocks -- and related Knight employees -- to Chicago-based Getco, until the recapitalization is complete.
The NYSE consulted with securities regulators about transferring those responsibilities, according to people familiar with the matter, amid regulators’ intense focus on ensuring the markets were not more broadly impacted. The sources declined to be named because they are not authorized to speak to the media.
Vanguard Group, one customer that pulled orders from Knight last week, said Monday 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 top U.S. securities regulator said on 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, U.S. 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.
Knight’s problems started early Wednesday, when a software glitch flooded the NYSE with unintended orders for dozens of stocks, boosting some shares by more than 100 percent and leaving the company with the trading loss.
Knight’s computers had been loaded with new software on Tuesday that was designed to accommodate a change on the NYSE, according to people familiar with the matter. They declined to be named because they were not authorized to discuss the situation with the media. When trading began, the computers poured orders into the market.
The damage to Knight was swift. Whereas Knight once accounted for 20 percent of the market-making activity in shares of Apple Inc, by midday Friday it was the market maker for 2 percent of the volume, according to Thomson Reuters AutEx.
But on Monday, AutEx data showed, that volume was back up to 19.4 percent, and it was on the rise for other stocks as well.
Barclays Capital’s Freeman, in a note Monday, said he assumed that Knight’s overall volumes in 2013 would be about 15 percent 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.
Reporting by John McCrank, Carrick Mollenkamp, Edward Krudy, Jessica Toonkel, Nick Brown, Rodrigo Campos, Paritosh Bansal and Greg Roumeliotis in New York, Angela Moon in Jersey City, Ben Berkowitz in Boston, Rick Rothacker in Charlotte and Sarah N. Lynch in Washington; writing by Ben Berkowitz; editing by Jeffrey Benkoe, Dale Hudson and Phil Berlowitz