For those who favor quick and brutal justice for market misdeeds, the travails of Knight Capital Group (NYSE:KCG) ought to offer some measure of satisfaction. While Knight's technology problem led to only about an hour of chaos in about 140 stocks, the costs to the company have been swift and severe. While Knight has secured a capital injection that will keep it in the game, the long-term viability of this business is still uncertain at best.
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A Huge Error Nearly Overwhelms the Company
Knight Capital operates largely behind the scenes of the stock market - offering electronic trading, market-making and various broker-dealer services, as well as engaging in businesses like reverse mortgages. Knight found itself shoved into the limelight quite suddenly, though, when a technology "glitch" on August 1 interfered with the trading of 140 stocks.

SEE: Is A Reverse Mortgage Right For You?

The stock market quickly returned to equilibrium, but the impact to the company was devastating. In less than an hour, the company racked up a pre-tax loss of $440 million, or 30% of the company's shareholder equity as of the last quarter.

A Capital Lifeline
Not surprisingly, a 30% hit to equity and a greater than 40% hit to tangible assets is not sustainable, and questions immediately arose regarding the company's viability. Keep in mind, Knight's business is a business of counterparties and if those other financial institutions doubt the company's viability and pull away, it can become a self-fulfilling prophecy of doom.

That left Knight with few options and little time to shore up its capital. While Knight does have some business units that it could look to sell to raise capital (including Knight Hotspot FX and Urban Financial), those sales are difficult to finalize in a short amount of time. Instead, the company turned to a capital injection from other financial firms in the form of 400,000 shares of convertible preferred stock deal. Jefferies (NYSE:JEF), Blackstone (NYSE:BX), GETCO LLC, Stephens, Stifel Financial (NYSE:SF) and TD Ameritrade (NYSE:AMTD) joined together in the transaction and will earn a 2% dividend on the shares.

SEE: Introduction To Convertible Preferred Shares

Assuming full conversion (the shares convert to common shares at a price of $1.50), this deal represents 75% dilution for common shareholders. That is indeed steep, if not devastating, but it is simply the cost of doing business (or rather, staying in business). It's still very much unknown if the company's order flow can return to its pre-glitch levels, or whether the company can retain valuable employees, but this deal was essential if Knight wanted to stay in the game.

The Bottom Line
Knight Capital is now trading below book value, but valuation is not going to drive these shares in the near-term. At a minimum, institutional investors are going to want to see order flow trends stabilizing or recovering before considering the shares. Informed by past experiences with companies like Bear Stearns and Lehman Brothers, counterparties are more cautious than before and the company's stated book value isn't necessarily going to convince companies to continue doing business with Knight.

This mess is also a good reminder of how opaque and vulnerable financial companies can be. There's a saying within the industry that a trader is only as good as his or her last trade, and that is broadly true for financial companies as well - when a single "rogue trade" or "technology glitch" can wipe out hundreds of millions (if not billions) of capital in a moment, investors can never rest entirely certain that they understand all of the risks of a given financial company and are discounting them properly.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.



Tickers in this Article: KCG, AMTD, JEF, BX

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