JMP Group LLC
Q3 2018 Earnings Call Transcript

Published: 25 Oct 2018

[Operator:]

Welcome to the JMP Group’s Third Quarter 2018 Earnings Conference Call. Please note that today’s call is being recorded. [Operator Instructions] I’ll now turn the call over to Andrew Palmer, the company’s Head of Investor Relations.

[Andrew Palmer:]

Good morning. With me today are Joe Jolson, JMP Group’s Chairman and Chief Executive Officer; and Ray Jackson, the company’s Chief Financial Officer. We’re joined by Carter Mack, President of JMP Group; and Mark Lehmann, President of JMP Securities. Before we begin, please note that some of this morning’s comments may contain forward-looking statements about future events that are out of JMP’s control. Actual results may differ materially from those indicated or implied. For a discussion of the uncertainties that could affect the company’s future performance, please review the risk factors detailed in our most recent 10-K. With that, I’ll turn things over to JMP’s Chairman and CEO, Joe Jolson.

[Joe Jolson:]

Thanks, Andrew. We had a fairly normal third quarter, with operating earnings of $0.08 a share versus $0.10 a year ago. JMP Securities contributed $0.09 per share compared to a record $0.13 a year ago. Through September of this year, JMP Securities' operating earnings were $0.29 versus $0.19 for the first nine months of 2017, driven by record investment banking revenues that rose 28%. Asset management fee income and investment income combined to contribute $0.10 of operating EPS, up 40% from the third quarter of last year, primarily due to the fully ramped and closing of our fifth CLO in late July. Investment income covered our fixed corporate cost for the second consecutive quarter and earnings of $0.11 at the publicly traded partnership exceeded our third quarter cash distributions by $0.02 a share. Despite recently increased market volatility, including the big selloff yesterday, the fourth quarter is off to a reasonable start at JMP Securities. And with our capital now redeployed in our CLO strategy, our investment income should be more stable going forward, subject to the lumpiness of any particular quarter of credit losses. As we closed out 2018 here, a couple months to go in the year, I thought it was a good time to review our progress in executing on our key initiatives in the last year. First, our primary goal since 2016 has been to organically double our M&A advisory and private-placement business to roughly $15 million of revenues in 2021. Our strategy to accomplish this has been to selectively add senior M&A-focused investment bankers to our platform in order to diversify the sources of production, but also to increase the number of transactions a year, as well as to increase the size of our average fee. To date, in 2018, we have closed 17 transactions, compared to 14 a year earlier, at an average fee of almost $1.4 million, compared to $1 million a year ago. In the past few quarters, we’ve added five senior bankers to JMP Securities, replacing some departures, but also increasing the overall weighting in M&A. The cost of adding these bankers is a modest drag on our earnings this year but, if successful, could position us well to achieve our 2021 goal. The benefits of that, we believe, will be reduced earnings cyclicality, higher operating margins and an improved ROE. Even without any revenue contribution from these new hires, thus far in 2018, we expect to have a record year in our M&A advisory and private placement business with an estimated market share exceeding 1% of advisory fees on transactions below $1 billion in enterprise value. Our second objective is to grow our equity capital markets franchise and its value as one of the few remaining independent investment banking boutiques in the United States. Our market share of all ECM fees in our four industry verticals over the past 12 months was 1.02%, compared to 96 basis points in 2017 and 79 basis points in 2016. Much of the improvement this year has come in our technology vertical. Through September, we were a manager of – or co-manager of 19% of all U.S. technology IPOs compared to 10% in 2014 and 8% in 2007, both peak years of the last two market cycles. After a seasonal slowdown in the third quarter, ECM activity has has picked up, and we have already priced four IPOs in October, with more expected to come to market before year-end. Although this part of our business is cyclical in nature, as demonstrated, we have materially increased our market share over the past decade, which we see as a good indicator of our growing franchise value. Our institutional brokerage business continues to gain share of the shrinking pie, with net commissions down just 2% year-to-date compared to a 7% reduction in market wallet across the industry, according to McLagan. This despite fears of a 20% plus industrywide drop-off due to the adoption of MiFID II in January, which restricted the flexibility of fund managers with operations in the U.K. to pay soft dollars for sell-side research without a defined budget set at the beginning of the year. We think that the situation could evolve further in 2019 as more money managers are now being pressured by consultants and their investors to better define other commission dollars for being allocated. Our third major initiative has been to grow our assets under management and existing fund strategies with excess capacity, while simultaneously looking for attractive partnership opportunities with established managers in order to grow our overall platform. At September 30, sponsored assets under management were $5.8 billion compared to $3.2 billion a year ago. The biggest gainers were Astor, which managed about $2.5 billion compared to $1.8 billion, when we made the investment i n November 2017, and JMP Credit, which managed more than $1.2 billion, up from a low of $355 million in April 2017, after CLOs I and II were called. We recently announced a new $100 million warehouse agreement, which will enable us to continue to grow our credit business, now that the requirement that we put up equity capital equal to 5% of any CLO assets as "skin in the game" under Dodd-Frank has been overturned by the court system. This regulatory change is very significant for us as it could allow us to grow this business more rapidly by redeploying a long-term capital that has been historically tied up in CLO equity into shorter-term warehouse funding facilities at similar risk-adjusted returns. Furthermore, if we can reduce our ownership to less than 10% of the equity of any individual CLO, we would no longer have to consolidate that CLO under GAAP, a requirement that currently materially distorts our financials. On a deconsolidated basis, JMP is rather a simple company. At the end of September, we had just $227 million of assets, mostly invested in our fund strategies and financed with $86 million of long-term, fixed-rate debt and a similar amount of tangible equity. Instead, under GAAP, JMP’s balance sheet balloons up to $1.4 billion financed with $1.2 billion of debt. Our fourth goal has been to redeploy our excess cash, closing CLO V marked the completion of an effort to reinvest roughly $60 million or nearly $2.70 per share in excess cash that was funded with 8% long-term debt and caused a severe headwind for our operating earnings for four or five quarters. We have now more than earned our cash dividend at the publicly traded partnership for two consecutive quarters. Credit cost had been roughly in line with our internal plan for 2018, actually a little bit better at 28 basis points. But as was the case in the third quarter, credit cost can be lumpy in any given period because of the required consolidation of our CLOs. As we look ahead to 2019, we will do our best to make a conservative forecast for the U.S. economic outlook and what our credit cost might be before we consider increasing regular cash distributions. That being said, obviously, it feels much better to outearn the dividend than to not earn it, as was the case during the cash transition and as recently as the first quarter this year. Fifth and finally, we are attempting to simplify our story for the sake of everyone involved, including current and prospective investors. As already mentioned, thanks to regulatory change, we have a potential path to deconsolidate our CLOs over the next few years, albeit in a piecemeal fashion, by raising unaffiliated investor capital equal to at least 90.1% of each deal. We have developed the business plan around this goal, but it’s still early days. Also, we recently announced an agreement in principle to sell Harvest Small Cap Partners to its portfolio manager in an earn-out. The fund has been a great contributor to the success of JMP over many years. But as we all know, it can distort our revenues and compensation ratios materially from quarter-to-quarter depending on the fund’s performance. We continue to evaluate a potential return to C-corp status, given the changes in the tax code this year as well. The conversion could be as much as 20% dilutive to operating earnings since investment income would then be taxed at the corporate level instead of receiving passthrough treatment as it does now. This could lead to a lower dividend – a higher payout, but a lower dividend potentially. However, according to our analysis, the impact to individual shareholders after tax would be much less pronounced, given the significant reduction in the corporate tax rate compared to those in high-tax states', like California and New York, personal tax rates. Closing, I wanted to thank our employees and independent directors for their continued hard work and dedication to the company’s success. With that, operator, I’m happy – our team is happy to answer any questions. Thanks you.

[Operator:]

[Operator Instructions] We have a question from the line of Alex Paris from Barrington Research. Your line is open.

[Alex Paris:]

Good morning guys.

[Joe Jolson:]

Hi, Alex.

[Alex Paris:]

Just a couple of questions. First, with the strategic advisory business, private placements, you added five new bankers year-to-date on a gross basis. First question is, how many on a net basis? And then on a base of what, how much have we grown this M&A adviser force?

[Joe Jolson:]

Well, Carter probably has some color on that. So I’ll pass it off to him.

[Carter Mack:]

Yes, I think it’s three on a net basis, meaning there was a couple of people that replaced folks that left at different times. But we don’t really look at it that way. I mean, all of our senior bankers are calling and looking to do strategic advisory business, so you can assume that all of our MDs are the folks out there generating strategic advisory business. We have a head of M&A who is focused in technology but really is doing deals across the platform with different bankers. But all of our bankers are focused on the M&A product.

[Alex Paris:]

So focused on M&A, but also on capital-raising as well?

[Joe Jolson:]

Yes, I think that we’ve tried to make an effort, I guess, over the last four or five years when hiring people to hire people that have a more balanced business plan and with a history of being involved in M&A transactions as opposed to just capital markets. So I think that it’s hard to quantify exactly, Alex, but I think that the weighting is shifted within the calling effort more to M&A in the last four or five years, in particular with public companies.

[Carter Mack:]

Yes, there are certain factors that we focus more on M&A, health care services, we added a health care IT banker that is a medical device banker. That’s an area that does a fair amount of M&A.

[Joe Jolson:]

Cybersecurity.

[Carter Mack:]

Cybersecurity is an area that we focus pretty heavily on the M&A front. So there’s sectors within each of our industry groups that are more heavily weighted to M&A.

[Alex Paris:]

Okay, understood. And then looking at the revenue that’s coming out of that line, strategic advisory and private placement, and as you said, you’re well on your way of having a record year this year – looks like you’re $33 million on a trailing 12 basis – your previous best year was $31 million in 2016. With regard to your target of $50 million by 2021, do you think you have what you need in terms of bankers? Or is that going to require adding additional bankers? I realized you’ve raised your minimum fee and things like that. So that’s my question.

[Carter Mack:]

I would guess over the next couple of years we’ll add a few more senior bankers. We’ve had good productivity in adding people, and it’s a great way to grow our business. If we can get a banker onboard that has a chance to do $5 million to $10 million of M&A revenues after they’re fully ramped on a platform that’s set up to do that, we think that’s a great investment. So – but saying that, we have increased our average fee. We’ve been taking on larger transactions. We’ve been getting each year bigger deals closed. So you only need a handful of large transactions that can really boost the growth of your M&A business. We should have a couple of those this year and that’s really the focus.

[Joe Jolson:]

And I think, it’s not that complicated of a model to project out. It’s kind of number of transactions and average fee. Now within that, there’s lots of efforts going on to drive both of those kind of things. So part of the effort is as you add more people’s time, focused on M&A and maybe some – a few M&A-more-focused bankers, the number of transactions should rise. But also, it will be more diversified through the industry groups, because some of these areas could be cyclical. And then on top of that, obviously, as Carter mentioned, we’re focused on some larger transactions as well. That’s been a specific effort, and I think that could surpass there. It’s hard to get great statistics, Alex, but we use the Dealogic enterprise value of $1 billion or less just to track kind of where we are. And it’s running like in a volume of deals, I don’t know, maybe $300 billion, and if you just assume the average fee there is 1% and it may be less than that – certainly, on the larger end of that enterprise value – we’re over 1% market share right now before these adds this year. And that’s pretty valuable, we think. That’s a pretty good market share that we see quite a bit of upside for going forward. So I think we’re definitely at scale at this point in that business. Alexander

[Alex Paris:]

Well, great. One other question comes to mind. Your comment about Harvest Small Cap partners, that’s new information. You haven’t – this is the first time you’ve discussed, at least publicly, that you have sold that in principle for an earn-out. How big of a business was that, and when do you expect that deal to close?

[Joe Jolson:]

Well, we put out an 8-K, I think, a month or two ago. So, I mean, it was disclosed. Once again, it hasn’t been principle and if it happens in line with the handshake agreement that it’s – it will close at year-end, and it’ll be like a six-month transaction period. The – our small-cap fund has had one of the top two or three track records in equity hedge funds, especially market-neutral equity hedge funds over a decade. So he’s done a great job. The – when he has a good year, which he’s had many, most – he get – he and his team get the lion’s share of the incentive fees. And the result of that is it lifts our revenues materially and distorts our ratios in terms of comp and stuff like that, and I think that – so from the standpoint of revenues, it’ll be a much bigger potential impact than it would be in terms of the earnings impact. And the earn-out is about – is earnings neutral. It could be slightly positive, depending on his performance in any given year, but the revenue impact would be more pronounced because it’s – most of the incentive fees that we have shown historically in asset management have been driven by the fund strategies there.

[Alex Paris:]

All right. So this, again, while it does contribute lumpy revenue, there’s not a big earnings hit? And this is part of the simplification strategy I presume, right?

[Joe Jolson:]

Yes, I mean, it’s also strategically, as I’m sure everyone – you’ve noticed and others have, we’ve not started a new hedge fund in many years, and we have been rationalizing some of the smaller ones, and this isn’t one of those funds. It’s a very profitable strategy, but I think that in terms of how it fits with everything else we do, there’s conflicts of interest that are pretty high in terms of running an investment bank boutique and running a long/short equity hedge fund type of thing, and we – historically that business has been totally walled off. But other than it’s a good earnings contributor, it hasn’t been an overall kind of synergistic business model with everything else we’re doing. And we’re more focused in terms of trying to grow funds that have more leverage across the franchise. You saw us start a real estate fund business, a credit-opportunities fund, we have some venture funds. And those areas leverage a lot of the senior talented people we have across the franchise. And so there’s opportunity where one plus one can equal a lot more than two from doing it that way.

[Alex Paris:]

Okay. Well, thank you very much. I appreciated the additional color.

[Operator:]

There are no further questions at this time. Please continue.

[Joe Jolson:]

Great. Well, we appreciate everyone’s interest and look forward to updating you on the fourth quarter results in February, late February, I guess. Thank you.

[Operator:]

This concludes today’s conference call. Thank you for your participation. You may now disconnect.