E*Trade announced last week that they are selling their G1X equity market making business to options market maker Susquehanna. Since E*Trade is a public company, the details of the transaction are public and provide an updated view into the current economics of market making.
First, the details from E*Trade’s press release
E*TRADE also announced today that it has entered into a definitive agreement to sell its market making business, G1 Execution Services, to an affiliate of Susquehanna International Group, LLP for $75 million. The transaction is subject to regulatory approvals and other customary closing conditions and is expected to close in three to six months. In addition, the Company will enter into an order flow arrangement whereby E*TRADE agrees, subject to best execution standards, to route 70 percent of its customer equity order flow to G1 Execution Services over the next five years.
From the press release, one would assume E*Trade would receive $75 million in return for the G1X business and a guarantee to send 70% of their order flow over 5 years to Susquehanna. The most recent SEC 8-k filing shows the G1X business as generating $55.5 million in revenue for Q1-Q3 2013, down over 15% from the $67.6 million in revenue for Q1-Q3 2012. In the most recent quarter, G1X had a capture rate of $0.142 per 1,000 shares traded and over 90% of the shares were Bulletin Board shares. E*Trade currently sends only about 30% of their non-directed orders to G1X, meaning E*Trade will be forced to more than double the percentage of orders they send to G1X to make good on the 70% guarantee.
Assuming E*Trade is the largest current client of G1X, it seems reasonable to assume that more than doubling the number of orders sent to G1X would increase their revenue to a run rate closer to ~$80+ million per year, valuing the sale to Susquehanna at just a little under 1x revenue. E*Trade does not break out the profitability of G1X so we can’t use any type of profitability valuations. But what we can do is compare these metrics to a large public market maker, KCG (the combination of Knight Capital Group and GETCO). KCG has a current market cap of ~$110 million and trailing twelve months revenue of ~$490 million for a revenue valuation multiple of only 0.22.
Given the market’s low valuation placed on market makers (for good reason, see Knight’s August of 2012 disaster), why would Susquehanna agree to pay over 4x the current market multiple for G1X? Like many things on Wall Street, the answer is embedded in an SEC filing footnote.
(1) The $75 million sale price is based on the tangible capital in G1 Execution Services as of September 30, 2013 as well as $27 million of additional purchase price. The amount of tangible capital in the business could change through the closing of a sale which could impact the final sales price.
This footnote provides more details on how the market making unit is priced. The real cost is $27 million, not $75 million. Susquehanna will also pay E*Trade cash equal to the amount of tangible capital (cash and cash equivalents) at the time of close, which is expected to be ~$48 million for a total sales “price” of ~$75 million. Paying cash for cash equivalents is merely an equal swap and does not “cost” Susquehanna anything.
Taking the new $27 million number and dividing it into an expected $80 million revenue run rate yields a much more reasonable 0.33 revenue valuation multiple for G1X. The combination of G1X no longer being owned by a competing retail broker dealer and Susquehanna’s strong position in options market making will also provide many opportunities to rapidly increase G1X revenue and bring the revenue valuation multiple down even more.