How the Market Punished Knight Capital

If there's one thing we do know for sure about the outcome of the Knight Capital (NYSE: KCG  ) debacle, it's that Knight itself got brutally punished for its trading-software mishap. As such, I was a little surprised when my fellow Fool Michael Lewis lamented that Knight didn't experience "a true loss."

Right off the top, Knight's debacle left it holding huge amounts of stock -- reportedly $7 billion at one point -- that it never intended to buy. In order to maintain the liquidity that it needed to continue facilitating trades -- that is, keep its business running -- Knight needed to sell that stock. Because it needed the liquidity in a hurry, rather than try to offload all of that stock on its own, it sold it all to Goldman Sachs, in a block trade at a discount. This left Knight with a gaping $440 million loss. That hurts. No, wait ... that really hurts.

Because Knight didn't have that kind of scratch laying around, let alone that plus extra cash to continue operating its business as normal, it had to raise money from the outside. As you might assume, because Knight was in a precarious position, potential investors had a ton of bargaining power. The deal that ended up being struck involved Jefferies (NYSE: JEF  ) , Blackstone (NYSE: BX  ) , Getco, Stephens, Stifel Financial (NYSE: SF  ) , and TD Ameritrade (Nasdaq: AMTD  ) buying $400 million of 2% convertible preferred stock with a conversion price of $1.50 per share.

That's a little heady, so let's unpack that last part. The new investors stepping in are getting:

  1. A 2% dividend (there is no dividend on Knight common stock).
  2. The option to convert their preferred shares to common at $1.50 per share.
  3. Liquidation preference over common shareholders -- that is, if something further goes wrong, they get paid out before any of the previous shareholders.

With around 93 million shares of Knight stock previously outstanding, the 267 million new convertible preferred shares give the new owners the primary ownership stake. Or 73%, if you want to be exact.

In all, this is really a dreadful outcome for Knight shareholders -- a group that includes CEO Tom Joyce, whose stake was worth about $16 million prior to the disaster. As the stock stands today, it's down about 70% from its pre-crisis closing price. But even the current (as of this writing) price of $3.07 may face pressure as investors digest the cost of the new convertible preferred dividend and the dilution.

And that doesn't even touch on the incredible reputational damage that Knight has sustained and the further fallout that could come if it's sanctioned, fined, or otherwise punished by the SEC or the NYSE.

So when Lewis writes: "For once, a market player like Knight needs to experience what the retail investor and the gambler experience -- a true loss," I emphatically agree with the spirit of what he's saying. But I'd point out that we don't have to wait for a player like Knight to experience such a loss, because Knight itself experienced just that awful loss.

Motley Fool newsletter services have recommended buying shares of Goldman Sachs Group and NYSE Euronext. Motley Fool newsletter services have recommended creating a write puts position in TD Ameritrade Holding. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Matt Koppenheffer owns shares of Blackstone, but does not have a financial interest in any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or Facebook. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.


Read/Post Comments (5) | Recommend This Article (2)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 10, 2012, at 12:49 PM, JohnMaxfield37 wrote:

    Ironically, like ripping off a band-aid, Knight's liquidation probably would have been more pleasant for Joyce et al, as they could have opened up a new shop down the street. As it is, however, for at least the foreseeable future, they're effectively indentured servants.

  • Report this Comment On August 10, 2012, at 2:43 PM, TMFKopp wrote:

    John-

    I think it may be possible that you're underestimating the scope of Knight. This is a company with around 1,500 employees and a (as of 6/30 at least) $9 billion balance sheet. They have offices throughout the U.S. and in London, Zurich, etc. Not to mention an incredible amount of infrastructure set up to be able to do what they do.

    That's not to say that a "new Knight" couldn't be created, but this isn't like a five-person hedge fund that can simply grab new capital and start over fresh.

    Also, being an effective CEO of an existing company and having an entrepreneur-type drive to build a brand new company from the ground up don't always overlap. I wouldn't take it for granted that Joyce would have the skill / interest to build a new trading operation from scratch.

    Matt

  • Report this Comment On August 10, 2012, at 3:05 PM, JohnMaxfield37 wrote:

    True. He couldn't replicate Knight, at least not over night -- what an inexcusable pun.

    However, as you intimated, though probably not for this reason, he could start a hedge fund or other type of HFT or market-making operation. Given his success, recent events aside, it seems reasonable to assume that he'd have backers. Look at the guys from LTCM. They've been able to reinvent themselves, some multiple times over. Or, assuming no criminality surfaces, which there doesn't appear to be evidence of, he could set up shop more on his own terms with a bigger house.

    For the time being, however, he's lost his autonomy. He now has a number of bosses, none of which likely have reputations for being gentle. And that hurts folks that are accustomed to ruling the roost.

  • Report this Comment On August 11, 2012, at 9:24 PM, neamakri wrote:

    Sorry I'm such a simple person.

    If Knight had a $7 billion bundle of stock, and they needed $400 million to get going (just 6% of the bundle) then why didn't they just sell $400 million of that bundle?

    Is it that obvious?

  • Report this Comment On August 13, 2012, at 1:19 PM, TMFKopp wrote:

    @neamakri

    Some of the details on all of this are a bit murky, but Knight needed the cash infusion to be able to settle with Goldman for selling the chunk of stock. Knight needed liquidity and it needed it fast, so it offloaded the pile of stock to Goldman (http://www.fool.com/investing/general/2012/08/11/once-again-....

    Goldman, of course, didn't handle that out of the goodness of it's own heart, so Knight needed to turn around and pay the piper.

    Or, at least, that's how the details seem to be shaking out at this point.

    Matt

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