Companies overview
Virtu Financial Inc (NYSE:VIRT)
Virtu Financial Inc is a financial firm whose main businesses are market making and high-frequency trading based in New York. It was born in 2008, when Vincent Viola (a former chairman the New York Mercantile Exchange) and Douglas Cifu, a former partner in an international law firm.
A market maker is a company that quotes both a sell and buy price for a financial instrument, allowing every investor to buy or sell at the quoted price. Virtu’s main strength is the technology and its aim is to automate market making. One of the main advantage of automated market making is to provide liquidity to the system at every moment and not to fall in human errors in pricing (law of one price). A particular fact about automated market maker is that they make the market more efficient and therefore the volatility goes down (although that is not the only factor responsible for a decrease in volatility), making it more difficult for them to generate profit. In fact, a decrease in volatility has negatively impacted Virtu’s trading income, which diminished quite a lot from 2016 to 2017 taking in consideration for example the first quarter. In fact, they have gone down from $186.3mln to $139.6mln, 25.1%. See the graph comparing trading profit in the second quarter of 2016 and 2017 below.
For Virtu Financial market making and high frequency trading are very related. In fact by quoting both sides you can still buy or sell at a specified price i.e. trade in high frequency. High frequency trading in a very simplistic way is a software that executes a large number of transaction very fast based on algorithms which take into account several parameters. The faster the execution the more profitable the business, all else being equal. The profoundly technological soul of the company is also represented by the number of employees before the merger, 148. It has to be said however that a few people were fired after the merger.
As the industry become more competitive, one option is to become bigger and that seems one of the most decisive factor for Virtu’s merger with KCG. After the merger one in five US equity will pass through Virtu. Moreover, as stated in Virtu’s Q3-17 presentation the main business will be split into market making/high frequency trading and execution for other companies.
KCG Holding, Inc.
KCG was born in July 2013 out of a merger of two companies, Getco LLC and Knight Capital Group.
During August 2012 Knight lost more than $400mln in less than an hour putting it at the risk of default. At the end of the year is was acquired by Getco LLC. The process was completed with the new corporate identity KCG Holdings being announced. Getco’s core business was electronic market making/high frequency trading; it was founded by ex floor traders. Whereas Knight had its main business in market making for retail brokerages, still it provided other services such as execution. This service is offered mainly to banks, brokers and asset managers. In particular banks have tried to outsource the execution to independent company as the profit in trading decreased. After the merger the execution department has witnessed some difficult time, as witnessed by the firing of the head of European client execution at KCG Holdings.
A comparison could be made between the current situation of Virtu and the one Getco was in: in fact, both are technology oriented business trying to enter a more customer based business model.
Industry Overview
As previously described Virtu’s and KCG’s main activities can be split into market making and execution services both based on high-frequency trading techniques. The nature of this business model entails that the companies are more profitable on high volumes (they earn a spread per trade) and high volatility (higher spreads). Both of these factors are related to each other as volumes tend to be high when volatility is high and vice versa.
In the last quarters markets have observed both falling volatility and falling volumes across all asset classes, with the VIX (a proxy for US stock market volatility) hitting the lowest level in 20 years in October this year. Further headwinds to the industry have come from increasing fees for market data.
The resulting pressure on the industry has created a wave of consolidation. Teza Technologies has sold some technology assets to Quantlab Financial this year, Chopper Trading has sold parts of its business to DRW in 2015 and others, such as Mocho Trading, shut down their business for good.
However, it is widely believed that this period of low volatility is coming to an end and profits for the industry are going to grow again. The main reasons behind this are the Fed’s decision to end its ultra-loose monetary policy and the mean reversion of volatility. Historically policy tightening has increased volatility and markets expect this to be the case this time again. Moreover, since volatility is at an historical low, observers expect volatility to reverse back to its mean and increase. perhaps violently.
Financial Structure
In March 2018, Virtu offered a staggering 20$ per KCG stock, valuing the company at 1.4 bln. Before the announcement of the deal, the stock traded at around 13.7$, implying a 45% premium, quite high considering we are talking about a struggling industry.
The purchase was financed through a combination of $1.65bn of debt and the sale of $750m of new equity (priced at $15.60 per share). The investors in the equity stake were:
- Temasek and GIC, two Singapore sovereign wealth funds;
- PSP Investments, one of Canada’s largest pension funds;
- North Island, a private equity firm, led by Glenn Hutchins (co-founder of US private equity firm Silver Lake) and Bob Greifeld (chairman of Nasdaq).
Furthermore, Virtu sold BondPoint, KCG’s bonds platform, for $400 millions to pay off debt, and forecasted $208 millions synergies in 2 years from the acquisition. As we will see later in the report, they were able to extract even more value.
Strategic Rationale
How can Virtu justify a 45% premium on the stock price? Where are the synergies coming from? Bottom Line Up: at a time in which profits are eroded by low volatility and strengthening competition, Virtu wants to create value by:
- exporting its trading technology to KCG wholesale business and
- cutting costs and inefficiencies.
Furthermore, the company aims at diversifying away from high-frequency algorithm trading, into KCG’s customer-facing wholesale trading business. If on one hand Citadel has spent five years and probably more than $1.4B in organically building its own customer business, on the other, Virtu is taking an aggressive stand and wants to accelerate the process via acquisitions.
As stated earlier in this article, Virtu and KCG focus on two segments of the same industry. Although they do have some overlapping services, they only partially compete against each other. On one hand, there is Virtu, technology based, with fewer than 150 employees, doing algorithmic, high-frequency, trading on its own behalf. On the other, KCG, more people based, with over 1000 employees, with a focus on executing trades on behalf of its large client base. Virtu has fewer than 10 customers, while KCG has hundreds. The bottom line is that the deal is not a merger of identical companies merely aimed at cost cutting. Rather, it is the integration of two complementary businesses. Virtu aims at taking over KCG franchise to complement the company’s client services with its stronger technology.
This marks a major strategy shift for Virtu, posing strong cultural and integration risks. Observers were sceptical about how much the customer business could be made more efficient, especially after GETCO acquisition of Knight Capital, did not deliver on investors’ expectations. Still at the time when it got acquired by Virtu, KCG was a dualistic entity, which had failed at integrating GETCO technology into Knight Capital wholesale business.
However, after Virtu reported results in Q3 2017 for the first time since the purchase closed, the stock soared more than 18%. In the earnings call, Cifu said KCG’s technology was a mess, it lacked discipline around capital allocation, had multiple unprofitable units, and missed opportunities to expand in areas of strength. Point being, Virtu did not just fire people, but it also spent a great effort on integrating the two businesses. As a matter of fact, since the deal closed, Virtu has:
- Integrated tech, moving to a single pan-asset, class, and geography integrated technology platform. KCG was formed when two trading firms, Knight and Getco, merged in 2013. According to Cifu the merger translated into redundancies four years later, since from an operational and trading perspective, the legacy Getco and Knight systems were essentially unaware of each other.
- Sold off KCG’s $400 million bond business to ICE, the owner of the New York Stock Exchange, with the proceeds being used to pay down debt.
- Cut staff almost in half from 1250 total employees (1,100 from KCG and 150 from Virtu) to just 648.
- Shut down units and offices in Asia and in Europe that were losing money.
- Realized $14 millions of incremental annualized adjusted net trading income from growth initiatives, with aim of realizing many times this number.
Virtu excepts $262 million in gross synergies in 2018, adding that headcount reductions the firm has undertaken will have little impact on revenues as many of the departed employees worked in redundant cost centers or offices that generated little revenue, or even lost money.
In conclusion, Virtu emerged rather successful from this acquisition. As the CEO said, the company has managed to keep fixed cost under control, while also proving the ability to generate net trading revenue in a muted volatility environment. As volatility is poised to pick soon, the company is positioned to generate a handsome profit.
J.P. Morgan Securities LLC is acting as lead financial advisor to Virtu, and has committed to provide debt financing for the acquisition. Sandler O’Neill + Partners is acting as financial advisor to Virtu with Paul, Weiss, Rifkind, Wharton & Garrison LLP serving as Virtu’s legal counsel. Goldman, Sachs & Co. is financial advisor for KCG Holdings with Sullivan & Cromwell LLP serving as its legal counsel. Centerview Partners LLC is serving as exclusive financial advisor to North Island. Wachtell, Lipton, Rosen & Katz is acting as legal advisor to North Island, Sidley Austin LLP is acting as legal advisor to GIC, and Weil, Gotshal & Manges LLP is acting as legal advisor to PSP Investments. Ernst & Young provided transaction due diligence services to North Island, GIC and PSP Investments. Shearman & Sterling LLP is serving as Temasek’s legal counsel.
Sources and References: Mergermarket, Bloomberg, Investor presentations (Virtu Financial), Financial Times, Wilmott
To contact the authors:
Davide Martintoni davide.martintoni@studbocconi.it
Edoardo del Vecchio edoardod@usc.edu
Niklas Müller (editor) niklas.mueller@studbocconi.it
Bocconi Students M&A Circle 
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