On the ropes, Knight Capital seeks buyers

As loss pressure grows, battered firm opens books to potential suitors

Aug 3, 2012 @ 10:26 am

By Bloomberg

Knight Capital Group Inc. (KCG) opened its books to potential buyers, including private-equity firms and at least one securities-industry rival, as it seeks an investment or takeover to survive after a $440 million trading loss, said two people with knowledge of the matter.

Knight is working with Goldman Sachs Group Inc. (GS) and Sandler O'Neill & Partners LP as advisers in the rescue talks, said one of the people, who spoke on condition of anonymity because the discussions are private. The company is under pressure to strike a deal within days, the people said.

“They need to do something fast,” said Peter Lenardos, an analyst at RBC Capital Markets in London. “There is a desperate need for capital, as Knight themselves acknowledge,” he said. “It might be private equity, it could be a big sell-side bank, it could be a peer like Citadel.”

Bank of America Corp. was among several potential partners that was in talks with Knight yesterday, said a person with knowledge of the matter. John Yiannacopoulos, a Bank of America spokesman, declined to comment.

Jersey City, New Jersey-based Knight, one of the biggest American market makers, is exploring strategic and financial alternatives as a software malfunction cost the company almost four times what it earned last year. The firm's shares lost 75 percent in two days after its computers flooded the market with unintended trades, sending dozens of stocks into spasms.

`Black Swan'

“You can see how that one black swan event can literally take this company out,” Tim Hartzell, chief investment officer at Houston, Texas-based Sequent Asset Management LLC, which oversees about $350 million, said in a phone interview. “Maybe this is the new chapter for program trading and algorithm trading. We'll have to go back and re-evaluate.”

A representative for Goldman Sachs declined to comment. Spokespeople for Sandler O'Neill and Knight didn't immediately return calls seeking comment.

Knight fought to preserve its business as concern grew about its solvency. Analysts at CLSA Credit Agricole Securities said bankruptcy was a possibility if it failed to get financing. The trading fault, which caused stocks to swing as much as 151 percent, left the firm with a “large error position,” Knight Chief Executive Officer Thomas Joyce told Bloomberg Television's “Market Makers” program with Erik Schatzker and Stephanie Ruhle yesterday.

`Severely Impacted'

While the company's balance sheet was “severely impacted,” its broker/dealer subsidiaries are in compliance with capital requirements, according to a statement.

“We're talking to a lot of capable people, people who are in touch with situations like this,” Joyce said. “This was an anomaly, not one we're proud of.”

Knight shares plunged as investors speculated about the company's future. Joyce declined to elaborate on the discussions during the interview, saying “you might imagine during the day- to-day activity, it's kind of hard to comment.”

Katie Spring, a spokeswoman for Chicago-based Citadel LLC, the investment firm run by Ken Griffin, declined to comment. Citadel's electronic-trading and market-making business is a unit of Citadel Securities which says it executes about 10 percent of U.S. equity volume, according to its website, a similar amount to Knight.

“The businesses they are in are attractive to other players,” Justin Schack, managing director for market-structure analysis at Rosenblatt Securities Inc., said in a phone interview. “The likely candidates include banks that have an equity capital markets business and firms that want to get into market making.”

Convertible notes

Knight had $365 million of cash as of the end of June, with about $70 million in its revolving credit line, Robert Rutschow, a New York-based analyst with CLSA, wrote in a report. He said there's a risk it will break loan covenants and cut his rating on the stock to sell from outperform.

Investors hold $375 million of Knight convertible notes and can demand repayment if there's a “fundamental change,” including a sale, according to a 10-K filing. The biggest owners of the notes are Goldman Sachs, Oaktree Capital Management, Invesco Ltd. and Citadel Advisors LLC, according to data compiled by Bloomberg. The bonds lost 16.125 cents to 67 cents on the dollar, sending the yield up to 20 percent.

“Without finding a buyer, it's going to be tough to have the working capital to keep the firm afloat for much more than a week,” Matthew Heinz, a St. Louis, Missouri-based analyst at Stifel Nicolaus & Co., said in a phone interview. “You may be able to secure some emergency funding to hold them off before a buyer can come in. That's the game plan for Knight right now.”

Programming Bug

Knight's shares plunged 63 percent to $2.58 yesterday after tumbling 33 percent on Aug. 1. The stock peaked at $78.47 in 1999, data compiled by Bloomberg show. About 155 million shares changed hands yesterday, making it the most-actively traded stock on U.S. exchanges, according to data compiled by Bloomberg on companies with a market value of at least $50 million.

The programming bug swept through the market at the open of exchanges on a day when Joyce, a 57-year-old Harvard College graduate known as TJ, limped into work following knee surgery. Joyce said that while the bug sent “a ton of orders, all erroneous” into the market as the firm prepared to trade with the NYSE's new so-called retail liquidity program, it had “nothing to do” with the NYSE.

“Technology breaks,” Joyce told Bloomberg TV. “It ain't good. We don't look forward to it.” He added that the problem is mainly one for his firm, and “we did not harm individual investors, we got them out of the way.”

Software fixed

Knight's market-making unit executed a daily average of $19.5 billion worth of equities in June, according to its website. The unit traded 711 million exchange-listed shares a day in June, according to data compiled by the company and Bloomberg.

The software was fixed, he said, and some clients of the market-making business were executing with the firm by the end of Aug. 1 after Knight told them initially to go elsewhere.

Citigroup, the third-largest U.S. bank, refrained from routing some trades through Knight, according to a person with direct knowledge of the matter. Vanguard Group is steering brokerage orders through other vendors, a company spokesman, John Woerth, said in an e-mailed statement.

TD Ameritrade Holding Corp. has not yet started routing to Knight again, spokeswoman Kim Hillyer said.

“We are testing,” she said in a phone interview. “We want to make sure the client experience remains good.”

Scottrade Inc. has several market makers and is not utilizing Knight “at this point in time” for equity execution, spokesman Whitney Ellis said in an e-mail. Scottrade routed 41 percent of its market orders for NYSE securities to Knight during the second quarter, according to a filing.

140 stocks

Knight spokeswoman Kara Fitzsimmons said she did not have “any confirmation or comment” about other clients still sending trades elsewhere. Stephen Austin, a spokesman at Fidelity Investments in Boston, declined to comment.

The NYSE reviewed trading in 140 stocks from Molycorp Inc. (MCP) to AT&T Inc. as the market's Aug. 1 open was disrupted. Trades that occurred during the height of the volatility were canceled in six securities, where prices swung at least 30 percent in the first 45 minutes. Trades in all of the other stocks were allowed to stand.

The software malfunction was the latest black eye for the computer infrastructure of an equity market still haunted by the May 2010 market crash, the botched initial public offering of Facebook Inc. and failed IPO of Bats Global Markets Inc.

`Weak Testing'

“It appears Knight and other firms reliant on software to execute trades do not have the testing and quality-assurance function figured out yet,” said Bruce Weber, dean of the Lerner College of Business and Economics, who co- wrote “The Equity Trader Course” with Robert Schwartz and Deutsche Boerse CEO Reto Francioni. “As we've seen the consequences of weak testing and bugs that slip through is enormous.”

Democratic U.S. Representative Maxine Waters of California said in an e-mailed statement that she is seeking hearings on the matter as a “drumbeat” of errors in stock markets shows the need for stronger controls.

Study group

The incident shows regulation is “broken” and a study group should be convened to review technology and market structure, Arthur Levitt, former chairman of the Securities and Exchange Commission, said in an interview. Regulators would have been able to stop incidents such as yesterday's breakdown if they didn't face a lack of resources, he said.

“The ability of regulators to do their job has never been weaker than it is today because of the failure of the oversight process,” Levitt, 81, said yesterday in an interview. Levitt serves as a consultant to Getco LLC and Goldman Sachs Group Inc. and is a director of Bloomberg LP, parent of Bloomberg News. “Congress has a greater responsibility for what we're seeing today than any regulator or any particular part of the industry. They've allowed this to happen.”

Kevin Callahan, a spokesman with the SEC, said in an e-mail that regulators are monitoring the situation and in continuous contact with the NYSE and other market participants.

Market Value

Knight's $440 million loss compares with net income of $115.2 million in 2011 and is more than the company's market value of $253 million at the close yesterday, data compiled by Bloomberg show. The company was worth as much as $4.8 billion in 2000 and valued at more than $1 billion before yesterday, according to data compiled by Bloomberg.

The loss represents about 40 percent of Knight's book value and would “exhaust” the firm's cash, according to CLSA Credit Agricole Securities, which said Knight should consider selling itself.

“We believe Knight Capital is at risk of bankruptcy following the loss and so we are lowering our rating to sell,” Robert Rutschow, a New York-based analyst with CLSA who had an outperform rating on the stock, wrote in a note yesterday. He also cut the price estimate to $3 from $9. “The company's best option at this point is a sale.”

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