NEW YORK: A group of investors rescued Knight Capital Group Inc in a $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 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 US 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 fell 23 percent to $3.11 in afternoon trade. 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.
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 US Securities and Exchange Commission filing.
As part of the deal, the investor group will take three board seats, with TD Ameritrade and Blackstone expected to get one each, a source familiar with the situation said, adding that details were still being worked out.
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 US 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 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.
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. When trading began, the computers poured orders into the market.
For about 10 minutes it was unclear where the orders were originating. After NYSE officials pinpointed Knight, it took another 10 minutes for the company to figure out the source.
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 yesterday, 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.