Description

The writer of this document, related persons, and / or entities ("Writer") currently holds a long position in this security. The Writer makes no representation that they will continue to hold positions in the securities of the issuer. The Writer is likely to buy or sell securities of this issuer and makes no representation or undertaking that Writer will inform the reader or anyone else prior to or after making such transactions. While the Writer has tried to present facts it believes are accurate, the Writer makes no representation as to the accuracy or completeness of any information contained in this document and disclaims any obligation to update such information. The views expressed in this document are the opinion of the Writer, which may change at any time – This document should not be construed as a recommendation to buy or sell any security. Any person who reads this document (“Reader”) agrees not to invest based on this document and to perform his or her own due diligence and research before taking a position in securities of the issuer. Reader agrees to hold Writer harmless and hereby waives any causes of action against Writer related to this document.

Thesis Summary

Note - Market cap numbers posted in the financial information section above include founder / insider owned shares that constiute 45% economic ownership of Virtu versus only the public Class A float ($1.5bn market cap), which possesses ~55% economic ownership of Virtu. Per share figures (and shares outstanding) in that section correspond to Class A shares.

Despite Virtu (or the “Company”) possessing a durable business model that has existed for centuries (middleman / market making), operating in an industry with extraordinarily high-barriers-to-entry, and generating 120% of its current market cap in earnings over the past 6 years, and returning ~75% of the current market cap to shareholders during this same 6-year period (40% via dividends + 35% via repurchases), Mr. Market is currently affording us with an opportunity to acquire a partial ownership interest in the Company at (i) the lowest absolute price per share since January 2020 (when the market lacked overly strong volumes and volatility leading into COVID) and close to (ii) the lowest forward earnings multiple (~8.5x) in the Virtu’s history as a public company.

I think Virtu is a durable business that trades cheaply on normalized earnings power, has a favorable distribution of outcomes (Heads – I generate a huge IRR from high volatility and volume over the near-to-intermediate term. This often coincides with market weakness and this negative correlation is extremely valuable because it would allow me to recycle the returns generated on Virtu into other assets that have become cheap. Tails – I generate a low double-digit return from ongoing free cash flow and capital returns). Of course, the ultimate downside case in any long investment is getting a zero, but I believe the risk of permanent capital impairment is low here.

I think Virtu shares currently represent a unique and interesting risk-reward due to a combination of fundamental and event-driven factors:

1. Fed Likely to Create Rather than Repress Volatility – I am broadly bearish on the price of equity securities from a “macro” perspective. because the futures market is currently pricing more than four rate cuts from the Federal Reserve this year and I see five broad scenarios playing out from here:
   1. Inflation continues to rage, Fed increases rates – If this occurs, I believe that equity prices would generally suffer and that equity securities will realize both high price volatility and trading volume as investors adjust their positioning.
   2. Inflation and the economy muddle along, Fed holds rates steady (rates stay “higher for longer” than currently expected) – I believe this would largely lead to the same result as the higher rates scenario above (but likely with lower realized volatility and volume).
   3. There is actual evidence of real economic degradation that shows up in data that the Fed cares about and they cut rates one or more times – By the time real economic degradation shows up in data that the Fed cares about, I think equity securities are likely to respond negatively (high realized volatility and volume).
   4. There is an economic or exogenous catastrophe and the Fed cuts rates one or more times – Same as c. above, but the magnitude of the volatility and volume would likely be higher.
   5. “Soft Landing” – Inflation continues to abate, the economy starts to weaken, but the Fed cuts rates proactively, the economy largely stays out of “the tank”, and market participants “keep calm and carry on”, and price volatility and volume of equity securities are largely normal.
      1. I also recognize there is a possibility that volatility of prices and trading volume could be elevated during a soft landing scenario, but I aim to be intellectually honest and explore the actual downside of any investment thesis.
2. Geopolitical Issues Could Introduce Higher Volatility – In four of the five broad scenarios explored above, high price volatility and trading volumes are realized and based on economic history, a soft landing as unlikely. The world is full of geopolitical issues today that could easily introduce higher volatility to markets as well (Middle east conflict, Ukraine conflict, etc.) and it is an election year in the U.S. I do not know many things, but I do think we are in for higher volatility from here.
3. Virtu Is Likely to Capture Explosive Upside in a High Vol Environment – Virtu equity is an outstanding “long volatility” trade because it should benefit from higher volatility and volume (regardless of market direction), while exhibiting positive carry, and possessing less path dependency than derivatives (Virtu equity doesn’t have a time expiry like an options or futures contract).
4. Virtu Equity Currently Prices in a Low Vol Environment and Should do Just Fine if I am Wrong – Herein Lies the Margin of Safety. If I am wrong, and there is a “soft landing to the moon” or QE forever comes back in vogue – I think Virtu will still likely generate a low double digit return from here because I estimate the Company’s conservative earnings power (FCFE) in a typical year is ~$2.00 / share (~12% FCFE yield based on today’s price) and that Virtu will return at least 5.7% per year to shareholders via dividends (the Company has paid the same $0.96 / year dividend to shareholders for a decade) and the rest of cash flow will be used to further accrete value to shareholders via debt amortization or share repurchases.
   1. More specifically, I think the Company is worth at least $22 / share (~24% margin of safety relative to today’s price), because at this price, shareholders would generate 9% returns p.a. based on $2.00 / share of ordinary course FCFE. I think this is conservative because it assumes that Virtu never realized explosive upside gains from large volatility events once or twice a decade.
   2. What is the intrinsic value of a business that generates $2 / share p.a. of FCFE in a typical year and $6.00+ / share of FCFE once a decade, during times of market crisis / turmoil? I think it is likely closer to $25 - $27 / share (~35% margin of safety to today’s price at the mid-point of $26 / share).

Business Overview

Virtu has two segments:

1. Market-Making / Wholesaling (60 – 65% of Revenue) – Virtu acts as a dealer (trades as a principal investor, for its own account) that facilitates various markets. The Company generates revenue and profitability from matching buy and sell orders in the market and capturing the bid-ask spread. They compete on providing quality execution to customers / counterparties, which consists of providing competitive spreads / prices, sufficient speed, and size desired by market participants (i.e. filling buy / sell orders at fair prices quickly). Virtu’s business is primarily focused on equity markets (mostly U.S. but also Asia) – This includes serving customers from retail brokers clients (they pay some retail brokers for order flow) and Virtu is also one of the largest authorized participants in the ETF ecosystem (authorized participants create and redeem shares of ETFs in accordance with market participants’ buy / sell orders). Virtu also is an active market-maker in commodities and FX markets, is ramping up its market making operations in options (including single name securities), cryptocurrencies, and has very nascent growth initiatives in credit (treasuries, corporate) and interest rate products. Revenue is driven by both volume (they need to trade to make money) and volatility (they make more money when bid-ask spreads are wide). Therefore, this business is episodic and volatile.
2. Agency / execution trading (35-40% of Revenue) – 75% of this segment was acquired by Virtu through their 2019 acquisition of ITG. It is a more stable business in which Virtu provides software and services that assist large financial market participants execute trades effectively (quickly and with low market impact) and efficiently (cost effectively). Revenue is primarily driven by volume, but it tends to be more stable due to the nature of institutional asset flows.

Market-making in particular is a volatile business. Furthermore, cash equities are extremely competitive and operate on incredibly tight spreads. Virtu’s primary competitors are Citadel and Susquehanna, but also Jane Street, Wolverine Trading, Hudson River Trading, Two Sigma, and large banks like Morgan Stanley / UBS / Citi in both cash equities and options. Vast scale and best-in-class technology / IP (including scarce and valuable human capital / know-how) is necessary to run a successful market-making operation in cash equities, which is why their hasn’t been a new market entrant for many years. Increased regulation has accrued additional benefits to scale players and increased barriers-to-entry as well. The arms race of technology and speed and competition for volume (in a high fixed cost business with scant marginal costs) has driven spreads tighter over time, which has decreased profitability at the unit economics level (although it is spread across fewer players, so aggregate profitability at scale players has likely increased). I believe Virtu is the #2 player in cash equities (Citadel is #1), although it is pretty close. However, Citadel is much larger in the aggregate given their huge market share in options and other markets (I believe Susquehanna is smaller than Virtu in cash equities, but larger in the aggregate as well (they are known for their options market-making operation), but it is difficult to know for sure given Citadel and Susquehanna are both private).

Costs are basically all fixed (headcount, technology / communications infrastructure, and G&A), so when volume increases and volatility spikes (spreads blow out) on their fixed cost base – free cash flow screams higher and Virtu literally prints money (similar to hard markets in the insurance industry, but even more skewed). Expenses are more sticky than revenue, which has obvious drawbacks, but the business is attractive from an ROIC / ROE perspective and the high variability and lean years acts as an additional barrier-to-entry. I mentioned the Company’s growth initiatives, which I think are real and will help grow and make the business more stable over time (they’ll be more diversified, trading different products), but I think the inherent volatility will persist and diversification will be a slow burn, also akin to the insurance industry (it is difficult to expand in a new market / trading initiative quickly, just like it is difficult to expand into writing a new line of business or business in a new country within the insurance industry. Tuition usually has to be paid in the form of losses to gain the know-how and data to price properly).

Regulation

I think I would be remiss to gloss over the topic of regulation on this business. Regulation is one of the largest risks to Virtu (similar to other large financial institutions and seemingly any other business that interacts with individual consumers in the U.S. these days) and in my view, regulatory actions and litigation are considered a normal cost of doing business. This is a constant overhang on one hand, but also represents a real barrier-to-entry and reinforces scale advantages.

Payment-for-order-flow (FPOF) has been a hot topic and political punching bag ever since Flash Boys was released in 2014. However, PFOF is embedded in the system and facilitates market participation by most retail investors (given most have low account balances) and therefore it is unlikely to be banned. Citadel is a staunch opponent of abolishing PFOF and Ken Griffin is one of the largest taxpayers and political donors in the U.S. which also likely mitigates this risk. PFOF is one of Virtu’s expenses. If PFOF was banned, some retail brokers would need to restructure their business model, which could reduce retail trading volume (if they had to go back to charging customer commissions). However, I also believe Virtu would become a crown jewel M&A target for banks and brokerages under this regime (in order for them to best internalize their orders). If they weren’t acquired, the benefit or harm to Virtu would rest on the difference between 1. lower gross trading income (from lower volume) and 2. the elimination of PFOF costs. It could be negative to Virtu, but it would not be a death knell either since superior execution and liquidity will always be needed and many retail brokers / wealth managers in the country already send their volume to Virtu for free (no PFOF). At any rate, a ban on PFOF is unlikely to be enacted.

In my opinion, the largest regulatory risk to Virtu relates to mandatory lowering of tick sizes / bid-ask increments on equities, because it could hurt Virtu’s profitability by lowering spreads that Virtu pockets on transactions. However, I don’t even think this would have much of a negative effect on Virtu because if enacted, it would only effect ~50% of equity volume and market makers will likely just lower the amount of liquidity they make available at each “tick” in order to protect themselves (by creating less spread per transaction for market makers, the market makers will likely just react by creating more transaction opportunities to capture spread because tick sizes are smaller). By trying to make an extra half-a-penny of price discovery available on a limited amount of shares (due to lower liquidity offered by market makers), retail and long-term oriented institutional investors would end up being harmed by: reduced liquidity and lower execution quality (as discussed above), higher transaction intensity and costs (as discussed above, plus market-makers would require more infrastructure costs to accommodate higher messaging / communication intensity and would likely pass this on), less stable quotes (as alluded to above), and higher market fragmentation that would simply create more arbitrage opportunities for HFTs and market-makers’ low latency technology to capture at the expense of retail and institutional investors. Given that the benefits would not be meaningful for investors and these costs could be materially harmful to market function, I do not believe that there will be widespread adoption of lower mandatory tick sizes. I do think that lower tick sizes will be adopted on certain large, liquid stocks, but I don’t think it will have a negative effect on scale players like Virtu, especially over the long run (it will likely lead to even more concentration because it probably will not make economic sense for relatively smaller firms to undertake the required infrastructure upgrades, which will lead to them exiting the market).

Virtu is currently facing litigation from the SEC regarding the improper administration of information barriers to safeguard customer information. This was pumped up in the headlines, but my research indicates this is a “nothingburger” and that Virtu is likely to prevail outright or agree to a settlement in the low tens of millions of dollars (based on historical settlements of similar regulatory actions toward other firms who actually abused sensitive customer information, which Virtu is not alleged to have done). Bloomberg has good research and commentary on this. All regulatory actions and litigation are not the same, but unfortunately many regulators seem to have pivoted from professionals that provide and police clear rules of the road to activists focused on punishing market participants in accordance with extreme philosophical / political viewpoints over the past few years, so I am much more skeptical of the authenticity of regulatory actions than I used to be (the CFTC brought a market manipulation suit and pursued a lifetime ban of DRW’s founder from the securities industry for five years based on DRW purchasing an undervalued instrument and pushing it closer to what DRW believed to be its true / fair value. Thankfully the suit was dismissed with scorching written criticism from a district court judge who likened the CFTC’s denial of basic facts to flat earthers).

On the balance, I think Virtu is more likely to benefit than be harmed by regulation and value chain modifications in the intermediate term. Exchanges have increased their data and access fees by exorbitant amounts over the past decade and I think this is rife for regulatory action. Virtu has also collaborated with other market participants to create new market infrastructure (e.g. Members Exchange – a new options exchange created by Virtu, Citadel, Optiver, Jane Street, Schwab, Fidelity, BofA, etc.) that could lower costs and become a valuable hidden asset. Lowering of tick sizes in options contracts could benefit Virtu because this is a small part of Virtu’s current business (it would harm other competitors businesses much more) and potentially provide a quicker avenue for Virtu to enter the space, because M&A candidates would increase – Virtu has been an adept acquirer and integrator of distressed and / or sub-scale assets in the past (KCG). M&A is rare due to how IP / trade secret intensive the industry is, so regime changes are typically required in order to present opportunistic acquisition opportunities.

Capital Allocation

Huh? The Company recently returned 35% of its current market cap to shareholders via buybacks, yet the stock price is at an all-time low? Before someone calls the capital allocation police on me. Yes – Virtu’s public Class A shares currently trade for $16.78 / share, Virtu’s $1.12bn of buybacks that began in 2021 were executed at an average price of $25.38 / share, and public Class A shareholders only own ~55% of the underlying Virtu operating companies (insiders / employees own the remaining ~45%). Ouch! In hindsight, shareholders would’ve been better off receiving special dividends rather than the buyback.

Based on today’s share price, the buyback was value destructive. However, I think there is some real silver lining here though – This Company is massively cash generative and has underearned due to substantial growth investment initiatives that require several years of upfront investment prior to generating revenue, let alone breaking even (options market making, investment in a new options exchange with other market participants, crypto market making, digitization of fixed income trading (treasuries and corporate credit), rates trading initiatives, expanding geographically into the Asia, etc.). It is also worth mentioning that Virtu acquired ITG in late 2018 for $1.0bn. Although this acquisition was funded with a term loan rather than through internally generated capital, I think it is important to note that Virtu’s balance sheet was clean enough to fund the deal completely with debt (~$250mm of projected synergies also probably helped: ~$125mm of cost reductions + ~$125mm of capital releases). How many companies do you know of that could have generated enough capital over the last 6 years to: 1. Return 75% of their current market cap to shareholders via dividends and share repurchases 2. heavily invest in organic growth initiatives, and 3. complete a $1bn acquisition? ($1bn is 2/3 of the current market cap). The potentially logical rebuttal here is that COVID and meme stock mania was an anomaly and they are not going to generate this much cash ever again. That might indeed be correct, but there is always a crisis somewhere and they occur more often than you think – As Virtu expands into more markets, they will be able to capitalize on volume and volatility wherever it rears its head. Furthermore, because of the share repurchases, Virtu could generate similar per share earnings power from a materially smaller spike in volume and volatility compared to COVID.

Select Major / Key Risks

• Negative regulatory changes
• QE forever – Financial repression returns and market volatility disappears
• Fat finger / blow up risk (KCG)
• Self-dealing / over indulgent employee comp and SBC at the expense of minority investors (probably not a good look for a market-maker, but it is possible)

Catalyst

Market volatility

New growth initiatives ramp up faster than the slow and steady pace (unlikely other than potentially in cryptocurrencies products which were approved earlier this year)

M&A – Company is an adept acquirer and integrator and synergy potential in the industry is enormous. M&A in the industry is relatively rare, but changes in regulatory and market regimes can lead to distressed / sub-scale consolidation opportunities and Virtu has taken advantage of these in the past