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WIKI ANALYSIS
Knight Capital Group (NASDAQ: NITE) executes stock trades (ie, completes the buy or sell) for asset management companies such as mutual funds, hedge funds, and retail brokerages. NITE executes both U.S. and international trades in securities such as equities, futures, options, fixed income on both US and foreign exchanges. NITE profits from this line of business from both flat fees for its services and from investments NITE makes when it makes a market for a client.
The company's Asset Management division consists of a 51% stake in the Deephaven family of hedge funds [1]. Deephaven Capital Management runs hedge funds for wealthy individuals, institutions, and fund of funds. These funds have different strategies and have the freedom to invest in any security. NITE earns money both from management fees that are collected on its assets under management and from the incentive fees which are charged when the funds outperform.
NITE has been acquiring firms to increase the services NITE is able to provide to clients. On May 6, 2008, NITE announced their purchase of Libertas Holdings, LLC, a fixed income brokerage firm[2]. This takeover will let NITE provide better proprietary research on target companies to their clients, which is a strength of Libertas[3]. On August 22, 2008, Direct Edge ECN, a 19.9% NITE owned stock trading venue, took over the ISE stock exchange to become the fourth largest U.S. equities venue[4]. Conversely, Deephaven has had to downsize due to market conditions. On January 31, 2008, investments in their $780 million Event Fund were returned to investors after many redemptions[5].
Company Overview
Knight Capital Group was created in January 2000 resulting from the Knight/Trimark Group, Inc. and Roundtable Partners, LLC[7]. NITE is headquartered in Jersey City, NJ and employs 868 full-time employees with 10% in the United Kingdom and the remainder in the United States [8]. Since 2005, the company's total revenues have risen 42.6% and net income has also increased 84.2%[9]. The largest growth has come from the trade execution (Global Markets) division, while the asset management and corporate divisions have declined.[10]
Business Segments
- Global Markets (83% Consolidated Revenue, 89.7% Pre-Tax Earnings) [11] provides trade execution services to clients such as mutual funds, hedge funds, asset managers, and broker-dealers[12]. NITE also makes markets for their clients in NASDAQ, OTC, AMEX, and NYSE securities if necessary, putting their own capital at risk[13]. 45% of the Global Markets revenue comes from the buy side and 55% comes from the sell side, showing a fair balance[14]. Additionally, none of their clients accounted for over 10% of their total U.S. equity dollar value traded[15]. All of the business for the Global Markets group takes place in the U.S.[16]
NITE has expanded its Global Markets division through several acquisitions since 2006. In April 2006, NITE purchased Hotspot, a foreign exchange marketplace with a sophisticated ECN (Electronic Communication Networks) based platform, for $77.5 million in cash [17]. In October 2006, NITE acquired Knight BondPoint for $18.2 million in cash, which provides electronic trade execution in the fixed income markets [18]. In November 2007, EdgeTrade, which provides algorithmic software, was purchased by NITE for $59.5 million, $29.5 million in cash and 2.3 million shares of stock[19].
| August 2008 | July 2008 | July 2007 | |
| Total Average Daily Trades (in thousands) | 2,002 | 2,484 | 2,001 |
| Total Average Daily Shares (in millions) | 5,509 | 5,232 | 3,733 |
| Average Daily Dollar Value Traded (in millions) | $15,830 | $20,039 | $18,234 |
- Asset Management (13.1% Consolidated Revenue, 8.2% Pre-Tax Earnings) consists solely of a 51% investment in Deephaven Capital Management[21]. Deephaven manages a family of hedge funds for investment by funds of funds, large institutional investors, and wealthy individuals. In 2007, Deephaven returned a 6.8% annual return to its investors and finished the year with $3.9 billion of assets under management (AUM) down from a 22.8% return and $4.2 billion in 2006[22]. Their largest hedge fund is the Global Multi-Strategy (GMS) Fund which accounts for 58% of the AUM of Deephaven[23]. Deephaven also manages an assortment of other single-strategy funds[24]. One investor in Deephaven accounts for over 10% of their AUM, which would be disastrous if he were to redeem his investment[25]. In January 2008, Deephaven decided to close its $780 million Event Fund and return all of the money to its investors due to a lack of attractive investments in that strategy[26]. While this shows discipline by the portfolio managers at Deephaven to return money to investors, making it attractive for investors in Deephaven, investors in Knight will receive less earnings from fees.
| 2007 | 2006 | 2005 | |
| Year End AUM | $3.9 Billion | $4.2 Billion | $2.9 Billion |
| Annual Return to Investors | 6.8% | 22.8% | 7.2% |
- Corporate (3.9% Consolidated Revenue, 2.1% Pre-Tax Earnings) consists of the company's private investments [28], mostly in specific Deephaven funds[29]. Corporate also includes overhead expenses such as executive compensation and public relations expenses[30].
Key Trends and Forces
Market Downturn Hurts Returns and Fees
The current struggles of the financial markets will lead to negative consequences for all 3 of NITE's divisions. The Global Markets division has been hurt by reduced trading by broker dealers in the current markets [31]. With reduced liquidity and volume, market making will also become a less profitable business[32]. This was shown during the market difficulties of August when average daily trades decreased by 19.4% since July [33]. Equity trade volume had been rising dramatically up over 50% since April 2008[34].Moreover, Deephaven will see reduced returns by its hedge funds as was seen in 2007 with the current market conditions[35]. Reduced returns for their investors leads to redemptions and further struggles for Deephaven's funds. As investors redeem, Deephaven has to sell off assets, which are usually their most liquid investments, leaving Deephaven with its most illiquid investments. Since the Corporate division has company investments in Deephaven's funds, this would lead to further losses for NITE.
Consolidation has increased fragmentation
Regional exchanges and broker-dealers have been joining together to provide their own alternative trading systems to compete with OTC and listed trading venues [36]. Moreover, more broker-dealers are offering their own internal crossing networks [37]. These moves are increasing the fragmentation in the market and making it more difficult to gain market share [38]. Moreover, this has led to market makers charging explicit commissions for OTC securities and these commissions have also decreased due to the increased competition [39]. Thus, the consolidation has raised the competition due to increasing the number of firms who can alone fulfill all the needs of their clients.
More Hedge Funds Leads to More Business and Competition
Since 1990, the number of hedge funds has risen from 610 to 10,096 [40]. This is both good and bad for NITE. The Global Markets division benefits from an increase in hedge funds because it increases the number of potential buy side clients. The increase in potential clients has also attracted more companies which has decreased what NITE is able to charge for its services[41]. Thus, it has presented a double edged sword where the increase in hedge funds has given it more potential clients but also increased the competition for said clients. However, this will also provide more competition for Deephaven to gain the investments dollars of hedge fund investors[42]. Deephaven is somewhat shielded from some of this competition since it has been in existence much longer than the average hedge fund and has a track record of high returns [43].
Competition
The Global Markets division is in a competitive industry with ever changing technology and an increased international presence[44]. Similar products as NITE's are being offered by exchanges, broker dealers, ECNs, alternative trading systems, and crossing networks[45]. The NASDAQ market makers who are involved in the most program trading are Goldman Sachs, Merrill Lynch , and Morgan Stanley [46]. Hedge funds, such as Renaissance and Citadel, have become increasingly involved in market making under the name of statistical arbitrage [47]. This makes it difficult to fully understand the market breakdown since the market making of these billion dollar hedge funds are not accounted for in market share data[48]. Direct Edge ECN, partially owned by NITE, is the fourth largest U.S. equities venue[49]. Companies in this industry compete based on the types of services they offer clients, fees, and the speed of trade execution[50].
Deephaven competes with other asset management companies than run hedge funds. The companies Deephaven competes with run hedge funds with multi-strategy, credit, long-short equity, event driven, and volatility driven strategies [52]. Due to the very private nature of the hedge fund business, it is very difficult to get the market share data for the industry. Also few hedge fund firms are publicly traded. Och Ziff Capital Management, GLG Partners, and Lazard are examples of asset management firms that are traded publicly. Investors in hedge funds do significant due diligence and examine many aspects of not only the strategies of the funds but also the past performance of funds run by the portfolio managers. Investors also examine the risk management systems of hedge funds to make sure that the fund has systems in place to protect against a blow up. Ultimately, the reputation of an asset management company is very influential in the decision making of the investor and can make all the difference[53].
References
- ↑ NITE 2007 10-k pg. 7
- ↑ zacks.com (June 15, 2008). Knight Capital: Estimates on the Rise.
- ↑ zacks.com (June 15, 2008). Knight Capital: Estimates on the Rise.
- ↑ Phil Wahba and Jonathan Spicer (August 22, 2008). UPDATE 2-Direct Edge lands deal for ISE Stock Exchange.
- ↑ Jenny Strasburg (January 31, 2008). Deephaven Shuts Hedge Fund After Redemption Requests (Update3).
- ↑ NITE 2007 10-k pg. 5
- ↑ NITE 2007 10-k pg. 7
- ↑ NITE 2007 10-k pg. 15
- ↑ NITE 2007 10-k pg. 29
- ↑ NITE 2007 10-k pg. 31
- ↑ NITE 2007 10-k pg. 5
- ↑ NITE 2007 10-k pg. 11
- ↑ NITE 2007 10-k pg. 9
- ↑ NITE 2007 10-k pg. 11
- ↑ NITE 2007 10-k pg. 11
- ↑ NITE 2007 10-k pg. 31
- ↑ NITE 2007 10-k pg. 10
- ↑ NITE 2007 10-k pg. 10
- ↑ NITE 2007 10-k pg. 10
- ↑ Volume Statistics.
- ↑ NITE 2007 10-k pg. 7
- ↑ NITE 2007 10-k pg. 6
- ↑ NITE 2007 10-k pg. 8
- ↑ NITE 2007 10-k pg. 8
- ↑ NITE 2007 10-k pg. 7
- ↑ Jenny Strasburg (January 31, 2008). Deephaven Shuts Hedge Fund After Redemption Requests (Update3).
- ↑ NITE 2007 10-k pg. 6
- ↑ NITE 2007 10-k pg. 13
- ↑ NITE 2007 10-k pg. 13
- ↑ NITE 2007 10-k pg. 13
- ↑ NITE 2007 10-k pg. 15
- ↑ NITE 2007 10-k pg. 15
- ↑ Volume Statistics.
- ↑ Total Monthly Trade.
- ↑ NITE 2007 10-k pg. 13
- ↑ NITE 2007 10-k pg. 33
- ↑ NITE 2007 10-k pg. 33
- ↑ NITE 2007 10-k pg. 33
- ↑ NITE 2007 10-k pg. 33
- ↑ NITE 2007 10-k pg. 9
- ↑ NITE 2007 10-k pg. 12
- ↑ NITE 2007 10-k pg. 9
- ↑ Statement of the Financial Economists Roundtable on Hedge Funds.
- ↑ NITE 2007 10-k pg. 11
- ↑ NITE 2007 10-k pg. 11
- ↑ HL Camp & Company. Program Trading Firms.
- ↑ Harry Kat. Hedge funds or market makers?.
- ↑ Harry Kat. Hedge funds or market makers?.
- ↑ Phil Wahba and Jonathan Spicer (August 22, 2008). UPDATE 2-Direct Edge lands deal for ISE Stock Exchange.
- ↑ NITE 2007 10-k pg. 11
- ↑ Ned Phillips. Is Trading in Asia About to Go Dark?.
- ↑ NITE 2007 10-k pg. 15
- ↑ NITE 2007 10-k pg. 8
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