(Bloomberg) -- Knight Capital Group Inc. received a $400 million cash infusion through the sale of convertible securities after trading losses spurred by a software failure drove the market maker to the brink of bankruptcy.
Investors agreed to buy preferred stock that will be convertible into approximately 267 million common shares, according to a company filing today. Getco LLC, the automated trading firm backed by General Atlantic LLC, Blackstone Group LP, brokerages Stifel Nicolaus & Co. and TD Ameritrade Holding Corp., and the investment banks Stephens Inc. and Jefferies Group Inc. are investing, according to two people with direct knowledge of the matter, who asked not to be named because the agreements aren't public.
Knight shares plunged 32 percent to $2.76 before being halted in trading before the open of U.S. exchanges. Knight, whose market-making unit executes about 10 percent of U.S. shares, has been fighting for survival since a computer breakdown spewed orders through stock exchanges Aug. 1 and led to a $440 million loss. The mishap spurred calls in Congress to examine whether increasing automation is damaging the integrity of the U.S. equity market, the world's largest with $16.4 trillion in share value.
Customer Rescue
"It's not too surprising that among the sources of financing for Knight in their emergency are some of their customers," David Whitcomb, founder of Automated Trading Desk LLC, a competitor of Knight that is owned by Citigroup Inc., said in a phone interview from Honolulu. "Their customers want to keep a diverse set of market makers going so as to maintain a high level of competition."
The new investors in Knight will own about 73 percent of the company once the 2 percent preferred shares are converted into common stock, according to data compiled by Bloomberg.
While owners of Knight stock saw the value of their shares shrinking after last week's 61 percent plunge, the bailout averted a threat to the equity market where it is one of the biggest partners for smaller traders. The company accounted for 29 percent of the average monthly volume in U.S. equity trading by individuals in the first quarter, according to a June 7 presentation.
'Very Little'
The dilution to its equity leaves "very little" for existing shareholders, while likely ensuring the company's survival, according to analysts at JPMorgan Chase & Co., who predicted the company may be broken up.
"We expect investors will look to value the KCG pieces, expecting the parts to be divested at more opportunistic times," the JPMorgan analysts wrote in a note.
Market Orders
Stifel Nicolaus sent 38 percent of its market orders in New York Stock Exchange-listed shares to Knight last quarter, and TD Ameritrade did 9 percent, according to a public execution disclosure statement. Knight is the dominant firm in equity wholesaling, the business of executing orders off exchanges primarily for retail brokerages, according to Larry Tabb, chief executive officer of research firm Tabb Group LLC in New York.
The New York Stock Exchange and NYSE MKT temporarily switched custodial responsibility for approximately 524 NYSE and 156 NYSE MKT-listed securities from Knight's designated market maker unit to Getco, according to a statement today. The reassigned securities will be returned to Knight after the completion of its recapitalization plan, NYSE Euronext said.
Obtaining additional capital to fund businesses such as market making was viewed as necessary to keep Knight afloat. Analysts at CLSA Credit Agricole Securities wrote last week that bankruptcy was a possibility if the firm failed to get financing.
Cash Overwhelmed
Knight's trading loss was bigger than the $365 million cash balance it reported as of June 30 and exceeded its market value of $398 million as of Aug. 3, data compiled by Bloomberg show.
The sale of convertible securities dilutes existing shareholders because they can be exchanged for stock at a preset price. The deal allows investors to buy new shares in Knight at about $1.50 apiece, according to a person familiar with the plan who asked that his name not be used because details of the transaction haven't been made public.
Share Plunge
Knight was working with advisers to line up financing after its shares plunged 75 percent over two days last week to $2.58 in the biggest drop since it went public in 1998. The stock climbed 57 percent the next day to $4.05 as some customers said they were routing stock orders back to the firm.
"This is a confidence-inspiring group, so that's a good thing to begin with," Michael Holland, chairman of New York- based Holland & Co., said in a phone interview. His firm oversees $4 billion. "These businesses really fund overnight. If you don't have the confidence, you don't have the funding."
The share decline brought the company's market value to $253 million on Aug. 2, compared with a peak of $4.8 billion in 2000, data compiled by Bloomberg show.
Knight turned to Goldman Sachs Group Inc. on Aug. 1 to buy the firm out of trading positions acquired when a computer program malfunctioned, a person with knowledge of the matter said. It has until the close of business today to complete the transaction.
Unintended Trades
Knight's computers flooded the market with unintended trades on Aug. 1, sending dozens of stocks into spasms. The fault caused shares to swing as much as 151 percent and left the firm with a "large error position," Chief Executive Officer Thomas Joyce told Bloomberg Television's "Market Makers" program with Erik Schatzker and Stephanie Ruhle last week.
People trickled in and out of Knight's Jersey City headquarters yesterday, with polo shirts and khakis outnumbering business suits. None would comment on the record to Bloomberg News. Around noon, platters of sandwiches and salads from Vito's Italian Deli in Hoboken were delivered.
Knight made it to the weekend after receiving short-term financing for market making, according to a person familiar with the matter who requested anonymity. TD Ameritrade and Scottrade Inc., which sent trades elsewhere for execution after Knight's software failure, said Aug. 3 they were routing orders back.
Vanguard, Fidelity
Vanguard Group Inc. in Valley Forge, Pennsylvania, continued to avoid processing brokerage orders through Knight, according to an Aug. 3 e-mail from spokesman John Woerth. Boston-based Fidelity Investments, the second-largest mutual- fund company, is sending business elsewhere, according to a person familiar with the matter, who asked not to be identified because the information is private.
TD Ameritrade, the third-largest U.S. retail brokerage by client assets, helped found Knight with a group of brokers as a way to get better order execution in 1995 with an investment of about $700,000 and held on to a 7 percent stake after Knight's initial stock offering in 1998. The broker, advised by Barclays Plc in yesterday's transaction, exited the Knight investment in January 2006, according to regulatory filings.
'Pretty Happy'
"I was curious to see whether it might be one of the original founders" that invested, Mike Shea, a managing partner at New York-based brokerage firm Direct Access Partners LLC, said in a telephone interview. Shea worked at Knight from 1995 to 2002 as an assistant market maker and sales trader. "Anybody that was able to make this deal with Knight is going to be pretty happy with it down the road."
Before the trading error last week, Knight posted an 81 percent drop in second-quarter net income after saying it lost $35 million in Facebook Inc.'s initial public offering. Revenue from the market-making unit dropped 52 percent last quarter in the third straight decline, and even without the Facebook loss, sales from that business fell 4 percent to $139 million, Joyce said in a July 18 analyst call.
'Large Bug'
Knight's problems were triggered by "a large bug" in software, Joyce said in an Aug. 2 interview on Bloomberg Television. "Technology breaks. It ain't good. We don't look forward to it."
The software malfunction was the latest black eye for the computer infrastructure of an equity market still haunted by the May 2010 market crash, Facebook's botched share offering, and the failed IPO of Bats Global Markets Inc.
MF Global Holdings Ltd., the holding company for the broker-dealer run by ex-Goldman Sachs co-chairman Jon Corzine, filed the eighth largest U.S. bankruptcy in October, days after a $6.3 billion trade on its own behalf on bonds of some of Europe's most indebted nations led to credit downgrades and margin calls.
Regulatory Response
Securities and Exchange Commission Chairman Mary Schapiro, whose agency in Washington is the main market overseer, described the Knight event as "unacceptable," and promised to issue regulations to help prevent similar mishaps.
Representative Maxine Waters of California, a senior Democrat on the House Financial Services Committee, said the panel should hold hearings to get to the bottom of the turmoil.
"Though we don't yet know precisely what caused the problem with Knight Capital, with a drumbeat of financial market snafus continuing, it's clear that the industry, with guidance from regulators, needs to strengthen their internal controls," Waters said.
Knight's investment came one day after the death of John Phelan, the former chairman and president of the New York Stock Exchange, who warned of an equity market "meltdown" spurred by trading technology one year before the crash of October 1987.
"From an overall market perspective, it would be helpful to not have yet another firm blow up," Walter Todd, who oversees about $930 million as chief investment officer of Greenwood Capital in Greenwood, South Carolina, said in a telephone interview. "If they can come in and structure a deal to allow the firm to continue to operate and eventually get back on its feet, that's a better outcome for the market."
