June 21 (The following statement was released by the rating agency)
Fitch Ratings believes that the strategic merger of Knight Capital Group, Inc. (Knight) and GETCO Holding Company, LLC (GETCO) has potential long-term benefits. However, the combined entity will face near-term earnings, leverage and liquidity challenges before synergies can be fully realized.
On Dec. 19, 2012, Knight and GETCO announced a business combination to create a financial services firm providing proprietary market-making and trade execution services across a broad array of asset classes. The combined entity, KCG Holdings, Inc. (KCG), will benefit from the amalgamation of GETCO's technology and operations and Knight's customer franchise, while seeking to realize cost efficiencies and generate additional revenues.
However, Fitch believes the transaction has meaningful execution risks including increased initial leverage levels and near-term liquidity risks, which set against the backdrop of depressed trading volumes and regulatory scrutiny, combine to result in a highly speculative credit profile at this time.
Fitch does not rate the newly formed company and the following analysis is based solely on publicly available information, primarily including the Form S-4 Registration Statement (S-4) filed with the SEC on May 24, 2013.
INCREASED LEVERAGE LEVELS:
Fitch calculates that KCG could have initial gross debt/adjusted EBITDA leverage as high as 5x, based on annualized 1Q13 earnings and the assumption that current equity holders exercise their maximum right to take cash as opposed to equity in the new entity. The increased debt burden for the combined entity comes at a time of lower trading volumes and volatility, which could create further pressure on leverage levels.
To fund the $1.3 billion merger, which is scheduled to close on July 1, 2013, KCG will issue a $535 million senior secured first lien credit facility (maturing four years and six months from its close) and has pre-funded a $305 million senior secured second lien note at 8.25% with a five-year term. Per the S-4, the first lien term loan is required to maintain a maximum leverage ratio of 1.75x in order to be in compliance with its covenants. The S-4 does not indicate how the leverage ratio is calculated, and the final covenant levels of the first lien credit facility may differ from those outlined in the document.
Fitch believes that KCG's combined 2013 operating results will continue to be challenged by depressed trading volumes, a slow U.S. economic recovery, higher expenses associated with the completion of the merger, pending regulatory reforms, technology upgrades, and increased legal fees and associated settlement expenditures for pending lawsuits. Knight and GETCO each reported poor financial results in 1Q13, following weak performance in 2012. Financial underperformance has been due to lower trading volumes and volatility, and in the case of Knight, the August 2012 technology glitch as well as goodwill and intangibles write-offs.
NEAR-TERM LIQUIDITY RISKS:
Per the terms of the debt documents, KCG is also required to make a $235 million principal payment on the senior secured first lien term loan one year after the close. While earnings generation and cash on hand (pro forma minimum of $405.7 million at March 31, 2013) could be the primary sources of repayment, Fitch believes KCG's current profitability challenges and other potential uses of cash may constrain its ability to generate sufficient funds from operations to meet this obligation. Otherwise, absent material asset sales and/or favorable refinancing conditions, Fitch believes there is substantial liquidity risk associated with this repayment requirement.
KCG has announced that it is exploring the potential sale of Urban Financial Group, Inc. (Urban), a reverse mortgage lender, and non-core business. In Fitch's view, this could provide additional capital to KCG, which otherwise is restricted for Urban's operations. The consolidation of certain other duplicative operating entities, in Fitch's view, could yield additional capital that KCG can deploy for cash flow demands.
If KCG is able to navigate its near-term earnings, leverage and liquidity challenges its longer-term credit profile will be influenced by its ability to develop and implement a business strategy that incorporates the market-making and execution strengths of Knight and GETCO, maintain the company's diversified client base and realize potential cost synergies in a timely manner. Successful execution on these fronts will be counterbalanced, in Fitch's view, by the continual need for technology re-investment, operational/reputational risks, balance sheet risk associated with mid-frequency trading, intensifying regulatory scrutiny, and potential competitive pressures.