We’ve moved a major step towards a done deal here. Good news is that this remains far from a done story. Easy access to financial and operational data about the outer extremes of technical leverage in the global financial services sector provides great fodder for a story that will continue to inform and fascinate. Along those lines, and in addition to the updated deal news, both parties disclosed results from the most recent quarter today. With that, I thought it would be timely to update our ongoing analysis to see if the evidence confirms or alters the findings we have been showcasing to date.
Here’s where we started a little over a month ago on March 15 when Virtu made its unsolicited bid for KCG: “In the chart below, average daily adjusted net trading revenue for Q4-2016 returns to levels not seen since late 2013 / early 2014. Chances are quite high that persistent low volatility during Q1-2017 … has caused these figures to fall back to pre-2013 levels.”
And then there is this additional comment: “A situation like that needs a good distraction; something that can change the narrative and allow for lots of financial restructuring and restatements. Voila! Try to take out one of your nearest competitors…” (Remember: The purpose for what is essentially a prop shop to have public shares is 1) for founders and senior management to be able to take some chips off the table, and 2) to develop a “currency” with which to protect, if possible, any leadership or incumbency that has been earned. The key, however, is to protect the value of that currency. Weakening fundamentals tend to necessitate transactions – like what we are seeing here – in order to protect that value.)
Got it? Ok. Here’s what we learned today:
First, Daniel Coleman, Chief Executive Officer of KCG, confirmed today in conjunction with its earnings release: “The first quarter of 2017 was marked by historic low market volatility. Realized intraday volatility for the S&P 500 posted the lowest quarterly average in 55 years while U.S. equity market volumes and bid-ask spreads contracted from a year ago.”
Couple this with an update to the previous chart using the latest Q1-2017 data, we get a picture that confirms our initial hypothesis: “Chances are quite high that persistent low volatility during Q1-2017 … has caused these figure to fall back to pre-2013 levels.” This is exactly what happened (see Exhibit below) – and as far as I’m concerned, remains the primary blunt reason for the timing of the bid. The complementary fit of the businesses legitimizes the narrative, but is still secondary. If fundamentals are strong, none of these deals happen.Speaking of fundamentals, weakness in the latest quarter was pervasive. Both Virtu and KCG experienced declines that take our many of our measurements back to pre-2013 levels, as we speculated at the outset. Much like the marriage of Knight Capital and GETCO, this combination also includes weak – or, at least, weakening – counterparties. Based on the numbers, that they would seek shelter together from the lack of vol makes sense. And, though many of these metrics are down, the “technical leverage gap” that was highlighted previously (amounting to about $2 million in adjusted net trading revenue per employee) continues to persist, thereby truly giving Virtu accretive potential from merging both trading operations onto a single platform (see Exhibit below).
Until we find another example of such extreme levels of technical leverage (in the financial arena), we will continue to follow this story closely. The names may change, but the application of intelligence and technology here continues to be nothing short of impressive…