Island Expected to Come of Age With Datek Spinoff Plan

Updated from 3:19 p.m. EST

Datek Online Holdings and its Island ECN electronic trading system have put together a $700 million deal that ransoms the brokerage from the oft-investigated founders of their predecessor firm, Datek Securities, and potentially clears the way for Island to gain full exchange status.

Bain Capital, TA Associates and Silver Lake Partners are pumping a combined $700 million into privately held Datek Online and Island, which Datek plans to spin off when the deal officially closes. Roughly $500 million of the money will go to buy the stakes held by trusts for Jeffrey Citron and Sheldon Maschler, two Datek Securities founders who are reportedly under investigation by the Securities and Exchange Commission and Department of Justice.

The investigations had cast a pall over both Datek Online's past capital-raising attempts and Island's application for exchange status.

"In order to move forward, we had to move beyond our predecessor organization," Ed Nicoll, Datek Online's chairman and CEO, said in a conference call. "It's a transformative event for our company."

Rekindling

It may have the most "transformative" effect on Island, the second-largest electronic communications network, or alternative trading system. Island has been pushing for exchange status since 1999, and, according to Matt Andresen, president and CEO, its separation from Datek will rekindle that process.

"The concentration [of ownership] was one of [the SEC's] concerns," Andresen said. The commission wants to maintain that "no organization regulated by an exchange controls the exchange." Datek as a majority shareholder in Island and a brokerage firm that would fall under its regulatory auspices was in exactly that position.

With the spinoff, that concentration concern evaporates and, Andresen said, the firm will quickly update its SEC filing.

The Datek-Island cord won't be totally severed. Island's board will consist of current management and representatives from Bain, TA Associates and Silver Lake. Datek's current 85% ownership position in Island will be reduced to less than 10% after the deal closes.

Still, Datek sends more than 50% of its customers' orders to Island for execution, according to Nicholl. Andresen said that order flow accounts for 10% of Island's total and about 5% of its revenue. Those numbers should remain relatively stable, depending on market conditions, Nicoll said.

Chris Eklund, who heads the electronic brokerage M&A practice at boutique investment bank Berkshire Capital, said the Datek deal "was the most anyone has paid for a pure online brokerage play. On a relative basis, it's a rich valuation. But if its clients are very active traders, it might be a better valuation than it appears."

With Datek reporting that it has 620,000 accounts, the $700 million price tag translates into a customer acquisition cost of roughly $1,100 per customer. That gilt isn't likely to touch the rest of the online brokerage sector and help pull those stock prices back to their previously lofty levels. "I don't see a huge impact on other electronic trading firms," Eklund says. "They've been under severe pressure and I don't see that abating in the near term."

The Future

Datek Online, according to Nicoll, will now be able to undertake several plans that weren't possible before, including the possibility of a future initial public offering. Nicoll said the remaining $200 million would be used for general corporate purposes but that the firm would explore joint ventures and international expansion plans.

Datek's sketchy lineage contributed to it losing a potential investment from Paul Allen's Vulcan Ventures in July 1999 and had hung over the company's attempts to grow. (TheStreet.com (TSCM Quote), publisher of this Web site, has received financial backing from Vulcan.)

But online trading has slowed in the market's recent downturn, putting it far below its heyday in 1999. Recently, Datek said its third-quarter trades fell about 6% to 97,638 a day from 103,825 in the second quarter as retail investors pulled back with the market's slide.

"It's been brutal. Customers have lost a lot of money," Nicoll said. Still, both Datek and Island are profitable, he added, without disclosing any figures.

Steve Pagliuca, a managing director at Bain Capital, said his firm sees the online brokerage arena -- regardless of market gyrations -- as one that's "underpenetrated. There's still an enormous amount of growth there."

Datek Securities founders Citron, who stepped down as chairman and chief executive about one year ago, and Maschler were associated with an investigation into whether Datek took part in a money-laundering operation. There were questions about offshore transactions and trading practices at the firm when its main business was daytrading. The Citron and Maschler trusts that held the ownership stakes in Datek will retain small stakes but have no voting stock.