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Virtu aims for new revenue mix with second billion-dollar deal in 2 years

Virtu Financial Inc.'s blueprint for integrating Investment Technology Group Inc. may already be in place.

The New York-based trading giant agreed to acquire the independent agency brokerage known as ITG for $30.30 per share, or approximately $1.00 billion. The deal is Virtu's second large-scale purchase in as many years and the latest sign that proprietary trading companies are still exploring scale acquisitions, new business lines and cost-cutting measures to stay afloat and find consistent growth, something Virtu believes it has in ITG.

"This is a win-win," said Virtu CEO Doug Cifu during a Nov. 7 call with analysts. "[This transaction] will mute some of the volatility in terms of our earnings to bring us real consistency in our results, hopefully in 2019 and beyond."

After rising to prominence as a proprietary trading company and market maker over the last decade, Virtu, along with many of its peers, has seen revenue opportunities dry up due to the lack of consistent market volatility, which tends to lead to higher revenues for proprietary traders.

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Virtu first ventured outside of its traditional business model in 2017 when it acquired rival trading company KCG Holdings Inc. for $1.42 billion, its largest purchase ever. Known as a sizable market-making competitor to Virtu, KCG also ran a retail trading business that handled orders from everyday investors.

By adding ITG, Virtu believes it will be able to expand its already existent agency brokerage business and its presence outside the U.S.

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The vast majority of Virtu's adjusted net trading income has historically come from making markets in equities, options and fixed income. Prior to the KCG deal, 96% of Virtu's trading income came from market making. Since that deal, the company's market-making business has accounted for 90% of its adjusted net trading income, which totaled $177.9 million in the third quarter.

Virtu expects the ITG deal to provide an even bigger shift in its trading revenues. When the deal is completed, Virtu projects that market making will represent 63% of its adjusted net trading income, with the remaining 37% coming from workflow technology and execution services.

But the biggest opportunity for Virtu to gain higher profits with ITG may lie in its ability to slash costs, a strategy it has deployed during its integration of KCG.

"Virtu will be looking to see what they can do to create synergies in the acquisition," Greenwich Associates analyst Richard Johnson said in an interview. "What Virtu did with KCG formed at least some sort of template for how to approach this acquisition."

Since its purchase of KCG, Virtu has undergone a series of cost-cutting moves such as reducing the combined company's headcount by more than half to 512. Those moves are expected to lead to cost savings of 58% on a net basis from the KCG deal, CFO Joseph Molluso said on the call.

The ITG acquisition, if completed, is projected to bring about $123 million in annual net cost savings, which Virtu hopes to reach in 2020. Those savings will likely come from the integration of ITG's and Virtu's technology systems, support functions, real estate and other costs, Virtu said.

The deal to acquire ITG does carry some risk reputational risk, though.

In 2015, ITG admitted that it had operated a secret proprietary trading desk that used client information to trade. The incident sparked a backlash among many of ITG's customers at the time. Now, with the prospect of ITG being acquired by a proprietary trader, those clients could switch their business to other agency brokerages such as Instinet Inc. and Liquidnet Inc.

On Nov. 7, ITG also reached a $12 million settlement with the SEC over claims that it had misled customers and investors about operations within its dark pool between 2010 and 2015. The company previously disclosed in August that it was engaged in settlement talks with the SEC. Spokespeople for Virtu and ITG declined to comment on the finalized settlement.

Virtu expects to see about $10 million in costs tied to customers walking away from ITG, which was a "fairly aggressive" estimate, according to Compass Point analyst Chris Allen. In a Nov. 7 research report, Allen wrote that he expected pretax revenue dis-synergies to range between $84 million and $141 million, a figure he revised to $75 million later in the day.

But Cifu was optimistic that the company will be able to persuade its new customers to stay with Virtu.

"I will do my best to be out there and to be transparent and talk to customers, as will our entire institutional team," he said.

Shares for both ITG and Virtu climbed after the merger was announced. As of 2:51 p.m. ET, ITG shares were up 8.27% to $30.04, while Virtu's stock had risen 3.63% to $25.55.