KCG cost of capital calculation

I will warn this is a very dry post.

The merger arbitrage spread with KCG has narrowed considerably.

When the $20 cash merger was announced the shares were trading at $19.75. There is little chance of the deal falling through or there being a superior offer.

Today KCG is trading at $19.88. The estimated close of the merger was reported to be “3rd quarter 2017”. The assumption is the mid-range, or August 15, 2017.

So there are 3.5 months until the deal closes.

12 cents appreciation is 0.6% over 3.5 months, which over the course of 3.5 months implies a 2.1% annualized rate, not compounding. This also excludes trading costs.

Because I had a small cash deficit in my USD account and a surplus in CAD, I’ve sold some shares at $19.88 to make up the shortfall. I placed it at the ask to minimize trading costs, which turned out to be 29 cents per 100 shares.

What’s interesting is my trade got hammered away, 100 shares at a time, approximately 2-4 seconds apart per trade. Interesting algorithms at play here.

I also believe Virtu (Nasdaq: VIRT) will have a more difficult time with the integration of KCG than they originally anticipate. The company cultures are significantly different and while the merger makes sense on paper, in practice it is going to be quite different. KCG was also dealing with a non-trivial data migration program on their own, from New Jersey to New York City and these sorts of technical details require highly skilled individuals to pull off without causing trading blow-ups. It might take them a year to get things stabilized after the merger is finished. KCG had huge growing pains of its own after it was reverse-takeovered by GetCo.

KCG Holdings: Bought out

KCG Holdings (NYSE: KCG) looks like it will finally be bought out by Virtu (Nasdaq: VIRT) for US$20/share, cash. They also announced their first quarter results, and according to my scorecard they did better than expected – while their bottom-line net income was slightly negative, they were significantly better on trading revenues than I was expecting. I was expecting a very lacklustre quarter due to incredibly low market volatility in the quarter. Interactive Brokers (Nasdaq: IBKR) is a regular conference call I read and they can attest to the impact of low market volatility on trading.

My investment history with KCG is quite fascinating. I did not disclose things here until October 2016, but I have been trading the stock at various times since 2013, which resulted in material performance gains, especially in 2013 (I took a fairly heavy call option position at the second half of the year). It has exhibited a narrow price range since its merger with GetCo after their August 2012 trading blow-up. The company has generally been off the radar of most investors as it received little analyst coverage and was treated like toxic trash.

Virtu has a plan to raise $1.65 billion in debt financing for the merger and also has sold $750 million in equity at $15.60/share, which should make the buyers happy considering they are now trading at $16.40/share – the market believes this will be quite valuable for Virtu. KCG’s existing 25% shareholder has consented to the agreement, which makes it very unlikely that the deal will not pass through KCG shareholder approval. Given the highly strategic nature of the acquisition, I also doubt there will be other competitors for KCG. Thus, this merger looks like a done deal.

Current trading is at US$19.75. The expected closing is in the third quarter of 2017. As the current spread between market and US$20.00 is around 127 basis points, this would imply a merger arbitrage spread of about 3.8% annualized, so I am in no rush to sell as I have nothing else to deploy my capital into.

The only other issue of concern is KCG’s senior secured debt, maturing on March 15, 2020. According to the fine print, the notes can presently be called off at 103.438 cents on the dollar and there is a required offer for 101 cents on the dollar due to the change of control (which would be redundant since the notes are trading over this in the marketplace). I would suspect Virtu would be eager to get these notes off the books as quickly as possible as they contain covenants that would otherwise restrict the KCG entity. I’ll hold onto these as long as possible but do not think they will survive much longer.

April options on KCG Holdings

The April options cycle expires on Friday, April 21. Not including today, this leaves 3 days of trading before expiry.

KCG Holdings (NYSE: KCG) is hovering around US$17.50 and their April 18 call options have a substantial bid of 16 cents, which puts them at an implied volatility of about 48%. Their historical volatility has been much less than this (typical options have been trading at around 20-25%, depending).

This is somewhat unusual, and probably instigated by the previous unsolicited buyout proposal at US$18-20/share prompted by Virtu (Nasdaq: VIRT) last month. Will there be a more solid proposal that will be made public soon?

Q1-2017 Performance Report

Portfolio Performance

My very unaudited portfolio performance in the first quarter of 2017, the three months ended March 31, 2017 is approximately +18.6%.

My 135 month compounded annual growth rate performance is +18.6% per year, an identical number that is strict coincidence.

Portfolio Percentages

At March 31, 2017 (change from Q4-2016):

24% common equities (-24%)
20% preferred share equities (-7%)
38% corporate debt (-6%)
3% net equity options (+2%)
15% cash (+35%)

Percentages may not add to 100% due to rounding.

USD exposure: 50% (+8%)

Portfolio is valued in CAD (CAD/USD 0.7508);
Other values derived per account statements.

Portfolio commentary

Needless to say this was a good quarter for me. Normally posting a return like this would be good for a year’s performance. Although I do not invest for relative performance, relative to the S&P 500 (+6% for the quarter) and the TSX (+2%) my portfolio had a smashingly good quarter.

I will warn this performance will not be matched in the next 9 months of this year. The upside potential of the current portfolio components is limited. My estimate of this potential, assuming an above-average ideal of things going correct, is 8%. This means about 2-3% a quarter for the next three quarters, and of course things never run that smoothly in portfolio management, unless if you invested in GICs.

In terms of buying activity, this quarter was relatively inactive (less than a percent of the portfolio). On the selling side, my two largest equity components (TSX: MIC, NYSE: KCG) had considerable rises in price, and as such, I did some significant trimming. They are now down to reasonable proportions of the portfolio. I also trimmed some preferred shares. Also assisting the +15% cash position was the maturity of Pengrowth Energy’s debentures (my initial post about them was here). My portfolio now has a positive cash balance for the first time in about a year.

In contrast, I ended 2016 with a -20% cash balance (i.e. a margin position of 20% of the equity of the portfolio). As you can see, it was time to cash some chips. Cashing in some chips results in capital gains taxes to be paid in the next year, but this is the cost of profitable portfolio management. Taxes are a secondary consideration in trading decisions – valuation is the primary driver. I am relatively happy to see the capital gains inclusion rate did not change in Budget 2017, but I do not take the government at its word at all that it will keep this rate steady.

The other corporate debt in the portfolio has an weighted average remaining term of slightly less than 3 years. The corporate debt will collect interest income and will otherwise sit there collecting dust until maturity or being called. At par value, I am not interested in liquidating them until maturity (or if they are called away). Given the short duration, I do not care if risk-free rates rise.

Portfolio Outlook

The decision to play safe this quarter (and likely for the remainder of the year) is obvious to me. Markets have risen significantly in the Trump honeymoon and I do not believe that risks (specifically the so-called “unknown unknowns“) are being truly appreciated at the moment. Everything is seemingly looking good. Things are comfortable. Look at what happened to the S&P 500 implied volatility after Donald Trump got elected (November 8, 2016):

When everybody thinks things are comfortable, this is a formula for future loss when less optimistic scenarios bakes into market pricing. I am not sure when negative sentiment will pervade throughout the market, but these things will always manifest themselves later than one expects – I am probably too early.

It is psychologically difficult to sell yielding securities for non-yielding cash (why sell something that gives away money for something that just sits there and earns zero?), but I must reload my ammunition for when the market truly decides to go into a tailspin. I don’t know the specific reason for the next tailspin will be (or when), but these things usually do occur when people least expect them. The future is always difficult to predict, but right now when I am looking microscopically across the markets for opportunities, I am drawing so many blanks that I need to crawl to a safe place. It might look foolish to duck into the shelter before there is even an inkling of a hurricane or tornado coming in the horizon, but this is how I feel, so I will bunker down.

I had written earlier in my 2016 year-end report that if everything goes well this year I should probably see a low-teens performance. Because of some unexpectedly positive developments in my two largest portfolio components, I have already made a year’s worth of gains in a single quarter. I will repeat that while one can extrapolate this quarter’s performance to future quarters, I would advise it would be a significant error to do so – there is no way this can continue. As I continue to cash up, it will continue to cap my performance gains. If markets rise to my additional sell points, the amount of cash can go 50%, which is a ridiculously high amount. I am also content to hold cash or cash-like instruments for extended periods of time.

Just imagine showing up to work in a finance firm as an asset manager and telling your bosses that you’re holding cash and going to watch movies until the markets drop. While I am not that lazy (I do run occasional stock/bond screens and try to look at the microscopic parts of publicly traded securities which are less prone to overall market fluctuations), when I do some detailed due diligence, it mostly ends up flat. Even worse yet are the IPO and secondary offerings that are hitting the market – there’s a lot of junk being shoved out the door to yield-hungry investors. It reminds me of what they did with the income trusts in the early 2000’s (most of them blew up and lost a lot of people money, other than investment banks and management insiders).

Sadly, market conditions and the selling nature of my portfolio at present means my writing will become more boring until things become more volatile. I recognize this is my shortest quarterly commentary in quite some time – I’m finding little to invest in.

My next challenge is to find a good location to park cash.

Some macroeconomic outlooks

I do have a few convictions that surround my decision-making (or lack thereof). One is that I am of the belief that the US dollar is undervalued and should perform relatively well against other world currencies, including the Canadian dollar. I have generally maintained a policy of keeping the US dollar exposure of the portfolio between 30-70%.

The other conviction I have is that I believe crude oil will continue to be a mediocre performer and indeed, in any sign of any world economic malaise, will take a tailspin from their existing price band. This makes Canadian oil producers (especially in the existing hostile federal and provincial environments) relatively prone if they have debt pressure, especially those contingent on higher oil pricing. At present, a lot of these companies have “value trap” written all over them. A good example will be Cenovus (TSX: CVE), who decided to leverage up, but just imagine the stress their shareholders will feel at US$40/barrel instead of US$50/barrel today. There will be a time to invest in fossil fuels, but not now.

Political outlook

My home province of British Columbia is having an election. Although I project the incumbent party is going to continue to win another majority government, there is a strong anti-incumbency undercurrent which appears to be brewing, which will make motivational aspects of elections (i.e. turnout) crucial. I am not nearly as certain as the result as I was at the beginning of this year when I projected the existing government would cruise to an easy victory.

The main opposition party, the BC NDP, still doesn’t appear to have their act together (I don’t see them focusing on issues that will actually win them the election), but this campaign is going to be quite volatile since the public is only going to pay attention during two weeks of the election period before deciding who they will vote for.

It doesn’t matter how incompetent the BC NDP have looked in the past, it matters how competent they look in exactly those two weeks when the public care.

Portfolio - Q1-2017 - Historical Performance

Performance and TSX Composite is measured in CAD$; S&P 500 is measured in US$. Total returns indices are with dividends reinvested at time of receipt.
YearDivestor PortfolioS&P 500 (Price Return)S&P 500
(Total Return)
TSX Comp. (Price Return)TSX Comp.
(Total Return)
11.25 Years (CAGR):+18.6%+5.8%+8.1%+2.9%+5.8%

KCG Holdings – Takeover bid from Virtu

The Q1-2017 report is going to be shockingly positive. Genworth MI (TSX: MIC) used to be my largest holding, but I have trimmed the position (mainly for diversification and deleveraging reasons). It still is a decent size of the portfolio, but not as prominent as it used to be.

My largest position after Genworth MI was KCG Holdings (NYSE: KCG).

Yesterday, near the close of trading, they confirmed that they received an unsolicited takeover proposal of US$18.50-20.00 per share from Virtu (Nasdaq: VIRT), another (very credible) high frequency trading firm. KCG did not file with the SEC.

Virtu filed 8-K with the SEC confirming they “made a preliminary, non-binding proposal to acquire KCG”.

Both entities have been quite silent otherwise. There is likely a lot of backroom jockeying going on.

KCG’s stock shot up from about $13.60 a share to $18/share today on over 6 million shares of volume. The company has about 66.4 million shares outstanding, and Jefferies (a wholly owned subsidiary of Leucadia (NYSE: LUK)) owns 15.41 million shares, and insiders own another 3 million shares, leaving a float of about 48 million shares that can be actively traded. 6.65 million shares traded today and suffice to say there is quite a large amount of speculation about what is going to happen.

My take on the matter is the following (in no particular order):

1. Tangible book value of KCG Holdings is $18.71/share as reported in their 10-K filing. A US$18.50 takeover price would allow Virtu to effectively take over KCG for free. This is the primary reason why I wouldn’t think this takeover would go anywhere as-is. My guess is that if Virtu was serious they would have to offer some equity as well, or some sort of premium to book value.

2. Virtu is a logical strategic acquirer to KCG – the synergies are quite obvious to both businesses. There might even be anti-trust issues with this acquisition.

3. Even though the acquisition at the low price range would be “free” for Virtu, it leaves the question of how they would immediately finance it.

4. The Jefferies control block is vital to the situation – if they can be persuaded to sell out, then management will likely have to follow. The question is whether they are motivated to sell out or not – obviously they will at the right price, but US$18.50 is too low.

5. The CEO was granted a huge amount of options at $22.50/share (priced well out-of-the-money at the time of the grant) and probably doesn’t have much of an incentive at this point to selling out the company for cheap.

6. Operationally, KCG is treading water in terms of cash flow, but this is because of unprecedented low market volatility conditions that is practically the worst environment for the firm (and also Virtu). In more normal conditions, one could easily estimate a value of US$25-30/share for the firm which is where I think management is targetting. They’ll probably sell out at 24ish if the bid got there.

7. Who leaked this unsolicited offer? Obviously KCG did – probably trying to drum up any counter-proposals out there as there are some other financial institutions that would be interested in acquiring the business. Perhaps management knows the end-game is nearing and this was a last ditch attempt to prevent a forced merger.

The decision forward is a high-stakes game for a lot of participants!

Disclosure: I own common shares of KCG, call options, and also their senior secured debt. Sometimes you really do hit the lottery in the marketplace.

KCG Holdings – Significant share buyback

KCG Holdings (NYSE: KCG) I’ve identified as a fairly good risk-reward candidate last month.

Yesterday they announced they came to an agreement with one of their major shareholders (whom were part of the recapitalization/reverse takeover of the predecessor firm after their major trading glitch on August 1, 2012) and have swapped 8.9 million shares of BATS for 18.7 million shares of KCG stock and 8.1 million at-the-money (roughly) warrants.

After this transaction, KCG still has 2.3 million shares of BATS – they did liquidate about 2 million shares on the open market over the past month.

This transaction has a positive double-whammy for book value – not only are the BATS shares accounted for at less than market value (which means the transaction will cause an accounting gain), but the KCG shares are being bought back for well under book value. Even when accounting for the not insignificant tax bill that will result (about a hundred million!), the final book value of KCG would be around $18.79/share after the transactions.

KCG will have about 67.5 million shares outstanding and 5.1 million warrants outstanding (strike prices of $11.70, $13.16, and $14.63, with each about 1/3rds of the warrants). These are likely to be exercised and shares sold in time – each of these warrants expire in July 2017, 2018 and 2019, respectively.

The corporation is trading slightly more than 20% underneath tangible book value. They have historically made money, especially in volatile conditions. The word “volatile” is also used to describe the new President-Elect. Needless to say, this has potential.

The other note is that CEO Daniel Coleman owns 1,487,907 common shares, or about 2.2% of the company, which is not a trivial amount of capital. He also owns 161,132 warrants, and 1.7 million stock options at a strike price of $11.65/share (making the effective ownership about 4.8% assuming the exercise of warrants and options), plus stock appreciation awards at $22.50/share, due to expire in July 2018. There is some serious incentive for him to get the stock price higher.

KCG Holdings – very inexpensive risk-reward ratio

KCG Holdings (NYSE: KCG) is probably best known as previously being “Knight Capital”, which was one of the top-tier US market-making firms back in the days when the Nasdaq traded in quotations of 1/16ths.

The second reason why they are well-known is because due to a badly botched software upgrade on August 1, 2012, where their algorithms managed to incur $440 million in 30 minutes of trading losses before technicians were able to pull the plug. I am quite confident with an unlimited amount of equity on my Interactive Brokers account I could not manage to lose that much money using my fingertips and mouse.

The company was forced to recapitalize and what incurred after was a reverse-takeover by the algorithmic trading firm GETCO. The existing shareholders were massively diluted and this functionally served as a way for GETCO shareholders to liquidate their holdings (backed by General Atlantic). The combined entity was renamed “KCG” (yet another example of a firm acronym-ing their name) and what ensued was an internal purge of legacy Knight Capital personnel. The transition at this time is more or less complete.

The corporation still makes the bulk of their money through market making and related trade execution services. Their prime competitors include other high-frequency trading firms, including the newly public Virtu (Nasdaq: VIRT). In general, the firm makes money when market conditions are volatile and they operate at a loss when volatility is quite muted.


The July to September quarter was a disaster for KCG (and other market-making entities, including Interactive Brokers), while the April to June quarter was quite profitable (think about Brexit!).

Since the last quarter’s results, KCG shares have tail-spinned:


The business, quarter by quarter, is highly volatile. In the Q2-2016, they reported operating revenues of $280 million, and in Q3-2016 they reported $200 million. As you might tell by this seasonality, it creates volatility in the stock as quantitative algorithms that purchase and sell shares on fundamental data generally go wild with companies like these.

Profitability also varies. The corporation is still trying to cut costs and become lean and mean (like Virtu), but it is taking them time to get to that position where they can be profitable in a very low volatility environment like the last quarter. On the aggregate, they are profitable in the medium run, which means I do not regard them as much of a risk at this moment (unless if their programmers decide to botch up another software upgrade like what happened in August 1, 2012).

The balance sheet is a little more interesting.

Its tangible book value is $15.54/share at the end of September. The underlying corporation has $508 million in cash, and a whole host of financial instruments that vary from quarter to quarter as they maintain an inventory for market making purposes (13F-HR form attached for illustration). In addition, they also own 13.1 million shares of BATS (Nasdaq: BATS), which is presently in the middle of getting acquired by the CBOE (Nasdaq: CBOE) sometime in 2017. The BATS stake is worth a pre-tax amount of about US$380 million at current market value.

Where my accounting experience comes in handy is how this is reported. You would think that owning US$380 million in a publicly traded entity would be reflected as US$380 million on the balance sheet, but this is not the case with KCG’s BATS stake. Instead, it is reported under the equity method of accounting. I will leave out the complications and state that it is reported as $94 million at present on the balance sheet. As KCG sells their BATS shares, the differential between sale price and their carrying value on the asset side will be reported as a gain (subtracting a provision for income tax).

So there is actually about $285 million of pre-tax money that is bottled up and waiting to escape. After taxes, this will be about $200 million leftover (using 30% as a basis – the actual rate may be higher).

You can see why most people do not have the time or patience to go through this minutiae.

On the liability side, we have one significant liability – $465 million face value outstanding of secured senior debt, with an 6.875% coupon maturing March 2020. The debt restricts the corporation to repurchasing shares at a fraction of KCG’s income (if you care to read the fine print, it is available on this 8-K filing) in addition to other nitty gritty details that I will omit from this post.

KCG initially issued $500 million in debt, but decided to repurchase debt at a discount to market earlier this year, when their debt was trading at about 89 cents on the dollar.

Readers of this site perhaps would not be surprised to know that I decided to purchase a decent-sized block of debt at around 90 cents earlier this year. My first disclosure of that purchase is in this post. Unless if the corporation decides to do an August 1, 2012-style blow-up, I regard it as virtually impossible that they will be unable to pay back this debt.

The company has also been actively engaged with the repurchase of its equity (and warrants related to the GETCO merger) at values that have been below book. They conducted a dutch-auction tender last year with excess capital, and they have not made sufficient amounts of money this year to conduct further stock repurchases – their authorization after the previous quarter was a paltry $2 million. However, they can liquidate BATS shares and use those proceeds for equity buyback purposes.

Considering the firm is now trading at a 15% discount to tangible book value, any equity repurchases would be accretive to their book value, in addition to being an EPS boost whenever the markets are volatile enough for them to make money.

So this is a compelling business with a relatively wide moat (market-making is not as easy as initial perceptions may seem), a decent balance sheet, and reasonable prospects for much better business conditions (did I say anything about Donald Trump in my previous post?). It is a company that would find better business conditions when there are higher amounts of market volatility, and assuming they can keep some sort of competitive business edge on the algorithmic side of things, they should be able to generate positive cash flows.

In other words, the downside appears limited, but the upside is less defined.

A question of what their terminal value would be is an interesting study – one would think that if they decided to go private (which would be a legitimate avenue considering everything presented above) that they could do so at a share price obviously above the US$13.10 they closed at today. Management has made promotions of aiming for a “double digit return on equity” in 2017, which I believe is generous, especially on the operating side, but if they get anywhere close to this (or even half of it), the market should value this well north of US$13.10.

So I’m in. Both the equity and debt.

Electronic trading perils

One aspect of trading electronically is that you better make sure your algorithms are correct, otherwise you are going to make stupid trades and suffer losses. Knight (NYSE: KCG) is the victim of their own electronic infrastructure, taking a 22% hit.

During the flash crash a bunch of trades were busted, but my personal opinion is that the only way to prevent these sorts of things happening is by depriving those that made the errant orders of their capital. Perhaps it will give a bit more incentive toward those that actually program their systems correctly, or heaven forbid, give it a little bit of human manual intervention before sending a billion-dollar order that has 10 minutes to get rammed through the markets.