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* Getco sweetens offer to beat out rival Virtu
* With cash-and-stock offer, Getco to merge into Knight
* Offer is two-thirds cash, values Knight at $3.75 per share
* Deal comes after near-fatal trading error in August
By John McCrank and Jessica Toonkel and Jed Horowitz
NEW YORK, Dec 18 (Reuters) - Getco Holding Company LLC will buy Knight Capital Group for about $2 billion after sweetening its offer for the equities market-making firm to beat out rival Virtu Financial LLC, people close to the deal said.
Getco clinched the deal after it increased the amount of cash in its cash-and-stock offer that will essentially see it merge into Knight to create a new publicly traded company, the sources said.
The deal seals a whirlwind five months for Knight after a near-fatal trading error on Aug. 1. The company, which executes about 10 percent of U.S. equity trading volume, making it a vital cog in the stock trading system, had to be rescued by a $400 million injection from a group of investors led by Jefferies Group Inc and including Chicago-based Getco.
The deal is two-thirds cash and values Knight at $3.75 a share, the sources said.
Getco, an electronic trading firm that often competes against Knight, will borrow $1 billion to execute the deal, they said, adding that Knight's board had accepted the terms after the markets closed on Tuesday.
Knight and Virtu declined to comment.
Getco had originally offered $3.50 a share for Knight in an unsolicited bid that was 50 percent cash, and was helped by an infusion from private equity firm General Atlantic, one of its biggest investors.
Knight shares rose 5.1 percent to $3.50 in after-hours trading on the New York Stock Exchange after closing at $3.33.
"We never dreamed this would come about so quickly," said Curt Bradbury, chief operating officer of Stephens, a Little Rock Arkansas broker-dealer that took part in Knight's rescue.
"On the surface, the deals looks good, and I'm looking forward to taking a closer look. We appreciate the board's effort at sorting this out."
Jefferies, which agreed earlier this year to be bought by Leucadia National Corp, worked with Getco on the deal and is helping it with financing. At one point during the negotiations, Jefferies' role raised concerns among some at Knight about whether the investment bank was trying to push a sale to make a quick buck. A Jefferies spokesman declined to comment.
Other investors involved in the rescue included Blackstone Group LP, TD Ameritrade Holding Corp, Stifel Financial. General Atlantic, Blackstone and TD Ameritrade took seats following the rescue on Knight's board.
Both Getco and Virtu coveted Knight's U.S. market-making business, which uses computer models to match buy and sell orders in stocks and options. Knight's market-making has remained profitable despite a market-wide slump in equities volume, though its profits have been eroded by ventures into other areas.
Knight also runs bond and foreign exchange trading platforms, and owns a reverse mortgage lender as well as a stake of about 20 percent in Direct Edge, the No. 4 U.S. cash equities exchange.
Getco is expected to divest most of Knight's noncore assets, the sources said.
The latest discussions started after Getco made an unsolicited bid late last month for Knight, which was followed by Virtu's bid, also unsolicited. Under Getco's proposal, Knight Chief Executive Thomas Joyce will step down from that role, but will remain as executive chairman of the combined company. Getco's Daniel Coleman will become the CEO of the combined firm.
Knight's board was initially split on the relative merits of the competing bids, the sources said.
Virtu this week boosted its all-cash bid to $3.20 a share, one of the sources said, leaving Knight to weigh the value of cash against what stock in a newly combined Getco-Knight would be worth.
Knight's directors were also divided over the future management and financial health of the company, sources said.
The board questioned Getco's motivations, worrying that, with its profit down 60 percent this year, it was scrambling to find a stronger partner, one source said.
The board also had questions about Virtu's debt load, another source said. Virtu had lined up some financing for its bid from private equity firm Silver Lake, a Virtu investor.
One concern for brokerages such as TD Ameritrade was whether the new owner would continue to pay discount brokers to route orders through Knight in order to create liquidity for the market, the sources said. That also became a point of discussion for Knight's board as it debated the rival bids, they said.
On Aug. 1, Knight's errant software sent millions of unintentional orders in almost 150 stocks in the opening 45 minutes of the U.S. trading session.
Knight ended up selling the shares it purchased at a large discount to Goldman Sachs Group Inc, leading to a $461.1 million loss that overwhelmed the $365 million of cash on its books. In the wake of the debacle, its stock, which had traded at a high of $13.59 this year, fell to as low as $2.58.