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Knight Capital Group, Inc. (NYSE:KCG) nearly averted bankruptcy after posting a $440 million trading loss due to a blamed "error" in its software. The company was able to find last-minute financing from several institutions. The injection of capital helped the company stay afloat and stop the death spiral the stock was experiencing. The stock is down more than 70% since the news was announced.

While shareholders should be relieved they did not lose everything, they should not be thrilled about the terms of the financing. The market has stopped the bleeding, but it seems the future upside for the company is limited.

The Deal

A group of companies including Blackstone (NYSE:BX) and Jefferies (JEF) made a last minute deal to save Knight Capital. The deal would allow the consortium of companies to get preferred shares in Knight. The shares would be convertible into common at a $1.50, which is half the price of the current market price. In addition to this, the preferreds will carry a 2% interest rate. The preferreds will account for more than 70% of the shares outstanding. This means that common shareholders will be diluted heavily.

Common Shareholders In Trouble

Blackstone, Jefferies, and the other institutions will make a sweet profit on the preferreds. However, while the company will survive, shareholders will experience minimal returns if any. When conversions begin to happen, shares will become more and more diluted at a much cheaper price than the current market price.

The common shareholders will see very little upside at least for the next three-five years. The preferreds and their conversion options will keep current market prices depressed for sometime. Not only is there massive dilution, but it's happening at a 50% discount to current prices.

Conclusion

Investors should not believe that Knight's shares are undervalued. Even though the problems have passed, the fact is that the deal was very costly for the company. The common shareholders should expect very little upside and it's even possible that the stock could still fall, based on how the conversions will occur. At $3 a share, Knight is just far too expensive for anyone looking to purchase its common shares. The word "undervalued" and "Knight" will more than likely not be seen in the same sentence, at least not anytime soon.

Source: Knight Capital's Preferred Shares Leave Little Hope For Common Shareholders