SVB Financial Group
Q2 2017 Earnings Call Transcript

Published: 28 Jul 2017

[Operator:]

Welcome to the SVB Financial Group Q2 2017 Earnings Call. My name is Allie and I’ll be your operator for today’s call. [Operator Instructions] Please note that this conference is being recorded. I’ll now turn the call over to Meghan O’Leary. Meghan you may begin.

[Meghan O’Leary:]

Thank you, Allie and thanks everyone for joining us today. Our President and CEO, Greg Becker; and our CFO, Dan Beck are here to talk about our second quarter 2017 financial results and will be joined by other members of management for the Q&A. Our current earnings release is available on the Investor Relations section of our website at svb.com. We’ll be making forward-looking statements during this call and actual results may differ materially. We encourage you to review the disclaimer in our earnings release dealing with forward-looking information which applies equally to statements made in this call. In addition, some of our discussion may include references to non-GAAP financial measures. Information about those measures, including reconciliation to GAAP measures, may be found in our SEC filings and in our earnings release. We expect the call, including Q&A, to last approximately an hour. And with that, I will turn the call over to Greg Becker.

[Greg Becker:]

Thanks, Meghan. And thanks everyone for joining us today. I’ll start by commenting on the markets and our business overall. But first, I want to say that we are excited to have our new, CFO Dan Beck on board and I know you are looking forward to hearing from him. Since we are only a couple months into the transition process, Mike Descheneaux, our President, who is also with us, may chime in on certain topics during Q&A, as needed. And with that let’s get started. We had a strong quarter with record earnings per share of $2.32 and record net income of $123.2 million, and more than 20% increase over the first quarter and more than 30% increase over the same quarter last year. These results reflect the impact of the short-term rates, and on our earning base, solid credit performance and healthy levels of activity among our clients. Highlights of our second quarter included, net interest income growth of 10.6%; total client funds growth of 6%; a provision for credit losses of $15.8 million; return on equity of 12.75% and return on assets of 1.04%; expense growth of 5.7%; and we also received a final five-year extension for Volcker rule compliance on our covered funds. Let me start with our target markets. The innovation ecosystem and venture capital as a key part of that, is doing well overall with healthy transaction levels and ample capital for good companies. VCs raised $11 billion in the second quarter versus $8 billion last quarter. That reflects strong fund raising for first time funds as well as proven fund managers. Year-to-date, it appears VCs are on pace to raise more capital in 2017 than in 2016, which was the biggest year in a decade. On top of that, venture capital firms are sitting on record levels of uninvested capital and are motivated to put that capital to work. Venture investing overall increased 30% quarter-over-quarter to nearly $22 billion, and also appears to be on pace to exceed 2016 levels. The underlying investment data suggests that the decline in angel one [ph] seed stage investing is due to Company’s bootstrapping or stretching current capital realms. Overall, entrepreneurship and new company formation are alive and well. Our levels of new client activity support this. With the VC markets, our challenge is in exits. The VC-backed exits declined quarter-over-quarter due to lower levels of M&A, both in terms of overall dollars and the number of deals. IPOs were relatively bright spot in this, recovering from their 2016 lows with 19 U.S. VC-backed IPOs in the second quarter alone compared to 33 for all of 2016. 68%, 13 of those IPOs were SVB clients. Based on the numbers year-to-date, 2017 IPOs appear to be poised to surpass 2016. While the number of IPOs has increased, recent IPO performance has been disappointing and the momentum needed to spur more IPOs has not materialized. For now, caution for private company valuations and uncertainty about the prospects for future health care, tax, regulatory reform seem to have put public market investors in a wait and see mode, despite a growing pipeline of potential public offerings. That said, we continue to see healthy activity among our clients. We added more than 1,300 new core commercial clients in the second quarter, a higher pace than usual. We are seeing growth across all client segments in all our geographies, particularly in early stage, private equity, global and the private bank. Our net client growth rate in the second quarter was the highest it’s been in six quarters. Deal flow has been good across most sectors with private equity again being the strongest. About a third of our loan growth related to private equity is coming from new client wins. We expect private equity to remain a strong and resilient source of growth over time, given that diversity of sub sectors represented and the ability of PE firms to thrive under varying market conditions. With regard to our technology and life science portfolios, early stage client wins continue to dominate our new client numbers, but activity is healthy in other areas as well. We’re winning new corporate finance clients at a higher pace and we’re improving our ability to engage these clients to encourage them to fully leverage SVB platform. Among our growth stage clients, deal flow has picked up in the first half of 2017 with our strongest ever for newly booked commitments in this segment. Despite new activity, the high pace of M&A among our growth and corporate finance clients and significant amounts of new liquidity have been continued headwinds to a faster pace of loan growth year-to-date. As a result, we’re slightly decreasing our outlook for 2017 loan growth. Nevertheless, our healthy pace of new client wins and new bookings suggest underlying trends remain strong and we believe loan growth among our tech and life science clients will improve in the second half of the year. Looking at the quarter, the rest of 2017 and beyond, we’re optimistic about our business momentum. We’re seeing significant benefit from recent rate increases, consistent with our expectations for asset sensitivity. Client funds are growing at a tremendous pace due to our highly effective client acquisition engine which has been even more successful due to our efforts to expand our client funnel. Fee income is healthy and volumes are growing, even though we’re seeing some pricing compression. Our markets are expanding as our efforts to support our clients and partners. Globally, we have applications underway in Canada and Germany as well as the new investments to support our positive momentum in the UK. Domestically , we’ve recently expanded our offices in New York and have plans to expand in San Francisco to accommodate our growth and the opportunity in those thriving entrepreneurial markets. As I noted at the beginning of my comments, our expenses increased more than expected in the second quarter and we raised our outlook for expense growth as a result. Part of it is incentive compensation related to our ROE performance and our improved bottom line outlook; the rest of it is to support growth. We are a growing company. This is what it takes to support that growth and continue to build on momentum, even as we work to strike optimal balance between investing in growth and being efficient. We’re enhancing partnerships, on-boarding processes and operational support to expand the client funnel I talked about and make sure we remain at the center of the early stage ecosystem. We’re spending on new initiatives, products and enhancing the client experience including the talent required to lead and implement these initiatives. We’re taking steps to boost our fee income growth and putting our credit card penetration making sure our global clients are taking advantage of our foreign exchange products, getting the right off -balance sheet products and ensuring we’re providing clients with access to our products early in their life cycle. And we’re investing in all areas of risk management to support our growth, higher requirements related to compliance and preparation for CCAR and hence prudential standards. Our growth requires systemic efforts to drive our operating leverage and a reduction in our expense growth rates. As a result, we’re focused on a variety of opportunities to simplify and consolidate systems, reduce manual process and deploy enabling technology. Looking ahead, our record results and our momentum as we enter the second half of the year are solid, and we remain positive about our markets, our growth plans and our ability to execute on those. Our clients are raising capital, they’re getting funding and they’re performing well overall. They’re doing all this despite anxiety over the situation of Washington, lower early stage investments and underperforming exit markets. Likewise, SVB is delivering strong growth. We’re investing in our business and maintaining solid asset quality. We’re doing this despite intense competition and M&A-driven turnover in our loan book. We believe our success comes from our focus on things that we excel at, which are building, maintaining lifelong relationships with companies, investors and entrepreneurs; leveraging our unique knowledge, networks and insights to help our clients succeed; and being the best partner to innovators, entrepreneurs and our investors around the world. Ultimately, we believe the growing innovation industry and the convergence of tech and non-tech is going to lead the significant new opportunities in our target markets. We’ll continue to manage our business for the long-term so that we can be a critical part of it. And now, I’d like to turn the call over to our CFO, Dan Beck.

[Dan Beck:]

Thank you, Greg. Good afternoon. It’s great to be here and to join this exceptional team. We delivered a good quarter with strong increase in net income due to health revenue growth and continued stable credit performance, while expense growth remains an area of focus. Highlights of the quarter included, one, strong growth in net interest income, driven by higher interest rates and a larger balance sheet; two, stable credit with notable improvements in underlying trends; three, strong capital and liquidity; four, improved warrant gains related to valuation increases; five, solid core fee income growth, driven by client investment fees, albeit somewhat below our expectations; and six, higher expenses related to higher people costs including incentive compensation, infrastructure and operational costs along with risk and compliance related expenses. Overall, we continue to see healthy growth and positive momentum in our pipe line. I’ll walk you through some specifics and discuss the few changes to our full year outlook. Let me start with the balance sheet, where we see healthy growth overall. Average loans increased by $439 million or 2.2% to $20.5 billion driven by private equity and the private bank. The pace of M&A among our clients, which included some large deals in the second quarter, the abundance of liquidity in our ecosystem, and heavy VC investment are constraining faster loan growth for now especially in the technology and life sciences portfolio. However, as Greg pointed out, new loan commitments are strong and our pipeline looks stood. So, we feel positive about our loan growth opportunities moving forward. Based on our balances at midyear, we’re trimming our full year 2017 loan growth outlook from the high teens to the mid teens. This amounts to a reduction of approximately $500 million. Turning to client funds. Average total client funds grew by $5.1 billion or 6% to $91.2 billion. This increase reflected strong average deposit growth of $2.1 billion or 5.5% driven by robust new client acquisition and healthy equity funding for our clients. These trends and the significant amounts of dry powder available for investment suggest deposit growth will remain strong. As a result, we’re raising our full year deposit growth guidance from the mid single digits to the high single digits. Average off -balance sheet client investment funds also grew strongly by $3 billion or 6.5% due to strong equity funding for investor backed clients and active secondary public offerings among our larger life science clients. Despite the slow recovery of the IPO markets, secondary public offerings remained a robust source of liquidity. Average assets increased $2.2 billion or 5% to $47.5 billion. We crossed the $50 billion asset level for two days during the quarter and expect to reach the threshold that requires SIFI compliance by early 2019, which would make us subject to public CCAR reporting in early 2020. Moving to capital. Capital on liquidity remains strong. Tier 1 leverage ratios at the Bank and holding company remained well within our target ranges, despite a modest decline at the Bank level driven by strong deposit growth and dividend form the bank to the holding company. Now, I would like to turn to the income statement. Net interest income grew strongly by $32.7 million or 10.5% to $343 million, driven mainly by the benefit of the December and March fed funds increases and increasing balances on both loans and investment securities as well as one extra day in the quarter. In total, we had increases of $17.1 million in interest on loans, $10.3 million in cash and investment securities interest income, and $5.8 million in loan fees, mostly from early repayments. Total yields increased by 30 basis points which primarily reflected the impact of short-term rate increases. As we discussed last quarter, we are seeing approximately 60% to 70% of each increase in fed funds translate to improvement in loan yields. We also saw a small increase of our deposit cost of 2 basis points in the quarter. Higher short-term interest rates drove an increase of 12 basis points in our net interest margin to 3%, consistent with our expectations. We are raising our full year 2017 outlook for net interest income growth from the high teens to a range of the high teens to low 20s. This accounts for the expected full impact of the March and June rate increases along with the higher investment in cash balances due to robust deposit growth. This does not include any future rate increases. Likewise, we are refining our expectations for our net interest margin towards the top half of our previous range. We now expect net interest margin to be between 3.0% and 3.1%. Now, I would like to turn to credit quality, which was stable with a number of notable improvements in the quarter. Our allowance for loan losses was $236.5 million at the end of the second quarter or 1.12% of total gross loans, a decrease of $6.6 million or 6 basis points compared to the first quarter, reflective of a decrease in reserves for nonperforming loans as well as improved overall credit quality in our performing loan portfolio. Our provision for credit losses was $15.8 million compared to the $30.7 million in the first quarter, this consisted of a provision for loan losses to $15.2 million. The provision for loan losses reflects $12.7 million and specific reserves for net new nonaccrual loans and $5 million for loan growth offset by a $2.5 million benefit related to the continued increase in capital call lines and lower criticized loan balances. Net charge-offs increased by $10.3 million to $22.5 million or 44 basis points of total average loans. This figure reflects gross charge-offs of $25.1 million including two loans to software clients totaling $13 million with the rest primarily from early stage software and life science companies. 87% of net charge-offs had prior reserves. Nonaccrual loans decreased by $18.6 million to $120.2 million or 57 basis points of total loans. This decrease reflects charge-offs of $22.8 million and repayments of $17.8 million. New nonperforming loans of $22 million were primarily from companies in our software portfolio and represent a substantial drop from prior quarters. While liquidity and valuation still pose a risk for early stage credits, we’re seeing good overall performance across the portfolio and solid trends in underlying credit metrics. We’re maintaining our full year credit outlook for 2017. Now, I’d like to turn to non-interest income which is primarily composed of core fee income and net gains from warrants and private equity and venture capital related investments. GAAP non-interest income was $128.5 million, up $10.8 million or 9.2% over the first quarter. Non-GAAP, non-interest income, net of non-controlling interest, was $119 million, an increase of $7.9 million or 7.1% over the first quarter. Increase was primarily related to better warrant gains and an increase in core fee income due to higher client investment fees. Let me review the components. Equity warrant gains were $10.8 million in the second quarter, up $4.1 million or 61.1%. These were driven primarily by valuation increases from new funding rounds which are unrealized gains. This compares to gains of $6.7 million in the first quarter, primarily due to realized gains from M&A activities. Non-GAAP net gains on investment securities net of non-controlling interests were $8.2 million, a decline of $1.3 million or 13.7% from the first quarter. This reflects approximately $6.2 million of distribution from our strategic investments and $2.7 million of valuation increases associated with our managed funds of funds. Moving to core fee income. Overall, we’re seeing growth from strong volumes with some price compression. Core fee income increased $4.7 million or 5.7% to $87.3 million, primarily driven by higher client investment fees. Client investment fees increased by $4 million or 44% to $13 million due to higher spreads and an additional $3 billion in off-balance sheet client fund balances. Credit card fees were roughly flat at $18.1 million. This is an area where we’re seeing higher client penetration and transaction volumes offset by lower spreads due to competition. Fees from foreign exchange transactions were also flat at $26.1 million which reflects an increase of 14% in overall transaction volumes offset by lower spreads and lower global currency volatility. As a result of pricing pressure on credit card fee income and lower spreads on foreign exchange transactions, we’re decreasing our full year 2017 outlook for core fee income growth from the high teens to the mid teens. In dollar terms, this amounts to a reduction of between $7 million and $10 million pretax on an annual basis in our fee income expectations. Turning to expenses. Non-interest expense was $251.2 million, an increase of $13.6 million or 5.7%. Taking into consideration seasonal increases of $5.9 million in the first quarter, non-interest expenses increased by $19.5 million or 8.2%. Included in these numbers are approximately $8 million of expense items that we do not expect to recur. As a result, we are increasing our full year 2017 expense growth outlook from the low double digit to the low teens. To put it into perspective, this is an increase of approximately $17 million to $20 million pretax on an annual basis, half of which is accounted for in the second quarter. We expect expenses in the Q3 and Q4 to be relatively consistent with Q2 levels. While approximately $8 million of our Q2 expense increase was for one-time -- or for items we do not expect to recur, we do not anticipate a corresponded reduction in future quarters due to our plans to add people and infrastructure to build our business and to support our growth. Again, this is considered in our outlook. The second quarter increase came from investments and growth enhancing initiatives that Greg referred to in his comments. With that in mind, the increase was primarily attributable to three factors. First was higher people related cost of $7.7 million, excluded the Q1 seasonal expenses mentioned above. This was evenly split between staffing and compensation increases to support revenue and growth enhancing initiatives along with incentive compensations related to ROE relative to peers due to improving bottom line results. Included in this figure are approximately $4 million of non-recurring items. I would like to point out that we’ve reached the ceiling on our peer-related ROE incentive compensation for the year. The second category was infrastructure and operationally oriented investments totaling $7.8 million in business development projects, systems and technology to support our continued strong growth and related initiatives as well as other operating costs. Of this amount, approximately $3 million relates to items that are not expected to recur. The third category was investments of approximately $2.7 million in enhancements to our risk and compliance infrastructure, again to support our momentum as we grow into a larger, more global organization. Finally a note on taxes. We recognized the $7 million tax benefit related to new accounting guidance for share-based compensation that we implemented, last quarter. This tax benefit equated to approximately $0.13 per share. As a reminder, the magnitude of this tax impact of the employee share-based transactions is a function of one, the vesting date for restricted stock units; two, the amount of in the money stock options that are exercised; and three, the change in our stock price relative to the grant date values of the share-based compensation awards. I would like to point out that the tax benefits are expected to be lower in the second half of 2017. In closing, we are pleased with our performance this quarter. We delivered record earnings, strong balance sheet growth and solid credit quality. Capital and liquidity remain strong to support our continued growth. We are wining new clients at a rapid pace and continue to see healthy deal activity backed by a solid pipeline, despite persistent competition and elevated M&A activity among our clients. Our clients are performing well overall, and are able to access funding and liquidity as evidenced by our robust deposit franchise. We remain focused on expanding our clients’ asset base, penetration, product offering and global footprint while delivering high-quality growth and stable credit quality. And lastly, we continue to invest prudently to enhance our infrastructure to support our growth and meet increasing regulatory requirements. Thank you. And I’ll ask the operator to open the line for Q&A.

[Operator:]

[Operator Instructions] And our first question comes from Ken Zerbe from Morgan Stanley. Your line is open.

[Ken Zerbe:]

I guess maybe a question for Dan, just in terms of -- if I heard your SIFI comments correctly, I think you said that you plan to cross over or sort of be eligible, if you will, in the first part of 2019. I just want to make sure I understand the process and everything correctly, because I have your $48 billion plus in total assets currently. And I certainly have you crossing over $50 billion well on the four-quarter trailing basis well before 2019. Can you just walk us through sort of what am I missing here, why don’t you cross over on four-quarter average earlier than early 2019? Thanks.

[Dan Beck:]

It’s a great question. That calculation is based on our end of period asset figures, as we report in our regulatory filing. We don’t expect to reach the four-quarter average of that end up period amount until we get to the second quarter of 2019. So, it’s really reflective of that four-quarter average. And our predictions at this point that we’ll be there by the second quarter of 2018.

[Greg Becker:]

Yes, clarified, the 2018.

[Ken Zerbe:]

Sorry, just to be super clear, four-quarter rolling look back, 12 months look back, is fourth quarter, sorry -- second quarter of 2018?

[Dan Beck:]

Second quarter of 2018.

[Ken Zerbe:]

Got it, okay. And then that’s when you are eligible in 2019 and then you have to file CCAR in 2020?

[Dan Beck:]

You are right. Yes.

[Ken Zerbe:]

Okay. That makes sense. And then, second question just in terms of the expenses, I get that you did have some of the onetime items in there, but how much of your spending currently does go towards CCAR preparation versus other items? I’m just wondering how much more of the CCAR prep that we need to be thinking about.

[Dan Beck:]

When we look at the increase in expenses that we talked about in our outlook, included in our guidance, we don’t have a significant increase in the CCAR expenses. We are spending roughly $11 million to $13 million a year on CCAR. And the thing that that is going to get us to the right level in 2017 as we look ahead to 2018, we have been increasing that amount by $3 million to $5 million a year. And we think that that will probably get us there on the CCAR related expenses.

[Greg Becker:]

This is Greg. The only thing I would add to that is that it’s more where you can tangibly connect it to CCAR, SIFI and hence potential standards, but there are clearly other areas in the organization in areas of risk that we still have to raise our gain. Now, how much of that relates to CCAR or SIFI versus just prudent risk management and the bar being raised, it’s hard to distinguish, but we have more money obviously that we are going to be putting into the infrastructure and risk management as well.

[Operator:]

And our next question comes from Ebrahim Poonawala from Bank of America. Your line is open.

[Ebrahim Poonawala:]

Thanks. Good afternoon, guys. I just wanted to touch based on the fee revenue outlook, I guess the guidance there has bumped a little bit over the last few quarters. Just wanted to get your sort of big picture thoughts, Greg, in terms of where have you seen some of the biggest delta, operationally in the first six months relative to when we started out the year. Was it lower ForEx fees and why lower card fees and why -- any color would be extremely helpful.

[Greg Becker:]

Sure. I will start and Dan or others may want to add into it. But, I’d break it down into two buckets and the areas you described, it is FX and it is cards. I will start with FX. To think about FX, the volumes remain strong. And there is really kind of a couple of components to saying why wouldn’t the revenue follow that. So, one is, there are some larger transactions in there and larger transactions on the spot trades, so they have lower margins, that’s number one. Number two, you have lower volatility in the FX markets. And where that’s impacted actually relates to forwards and options. So that’s a higher margin business. And so, since the volatility is down, you tend to have the net overall lower FX revenue despite the volumes being up. So, we don’t know obviously where volatility will play out in the second half of the year, but that was the main driver. And so, we’re expecting more of a consistent growth from volumes and some margin improvement. But, we’re not expecting volatility to come back. If it does come back, we’ll see some upside in FX. That’s one piece. Second piece is on the cards. Again, much like FX, we’ve seen very nice volume growth. The margins impacted for a few different areas, one is mixed but I’ll give you an example where margin compressions come down and it’s not in our control. So, our clients, as you would expect, have a lot of credit card purchases for Google ads and Facebook ads. What happens is Google and Facebook work with MasterCard and Visa to negotiate lower interchange fees because of the volumes going through. What happens, we get impacted more than other players because more of our clients are spending on those ads. So, that actually creates some compression and interchange in margin related specifically to our clients. Now, we can’t predict those are the areas that will occur, those are the two biggest ones and we believe that probably [ph] negotiated longer term arrangements for that. So, we think the margins will stabilize and the volumes will pick up, so we expect to see some growth in the latter half of the year which is built into our outlook. So that -- but you do see that interchange coming down, that was the main driver. So, volume is good, some impact on the margin.

[Ebrahim Poonawala:]

How big of a component in your growth outlook is adding new clients for both these services or is it mostly activity levels times margin and that’s what the growth is?

[Greg Becker:]

Yes. And there is two different pieces, right, so one was on FX. FX is -- it’s mainly selling to our existing clients, including some new with the private equity et cetera, but it’s mainly to existing clients and it is penetration, right. So, we still have more penetration of our existing clients where we have clients that are sending international wires, then they are sending it U.S. dollars and the transactions being traded on FX on the opposite side. We believe we can provide our clients a better service and actually at lower price in the FX if it’s traded on the front end, so there is an opportunity there to continue to growth with existing clients. With credit cards, again it’s penetration related, so we have more upside there. And then, that is an area where you do have sometimes some larger new clients where that actually does create a material bump on a company-by-company basis. But, I’d say, if you broke the two apart, the majority is going to come from existing client penetration.

[Ebrahim Poonawala:]

Understood. And just switching gears in terms of competition on lending, I got the color what you talked about in terms of what drove slower loan growth for the quarter. But, there is a fair chatter post just last quarter’s earnings around pricing competition, I think loan spreads. Just wanted to get some color in terms of how competition stacks up today versus three or six months ago? And incrementally, as we think about the June rate hike and maybe another rate hike in December, is your expectation that the sensitivity of the margin to every future rate hikes should be similar to what we’ve seen so far this cycle?

[Greg Becker:]

Yes. I’ll start, Ebrahim, and then Marc may want to add something. I’ll start with the last question first, which is what do we expect in the future. I’d say, generally speaking, we would expect that same margin sharing to occur, which is roughly 60% to 70% of rate increases would be brought down. You have a mix question though, right. So, we continue to grow lower margin loans. But, so, you have to take that into consideration, but the net number, 60% to 70% is right. Now just competition in general. It is competitive, it’s a very competitive. We’re seeing it from both banks and non-banks. I would say slightly more competitive than it was, but it’s not a dramatic change, it’s how I would describe it. Much like we’ve talked about in prior quarters, there is three different ways to look at competition. You can look at pricing, you can look at size of loans and you can look at structure. We look at the deal, we look at the overall risk, and we may be willing to drop pricing a little bit depending upon how quality it is. We may be willing to do a larger loan if it has structure. Where we see again some pressure is the structure as well and that’s an area we really want to be disciplined on. Mike has talked in the past about smart growth, we would put it in the smart growth category. That being said, the one last point I’d make is, we as I described, had a very strong pipeline, we had very strong level of booked commitments and our hope is that we’ll give guidance or give future loan growth in the second half of the year. So, with that I’ll pause and see Marc, if you have anything to add.

[Marc Cadieux:]

No, you covered it.

[Operator:]

And our next question comes from Jennifer Demba from SunTrust Robinson. Please go ahead.

[Jennifer Demba:]

Ebrahim, pretty much just covered my question. But, could you just go into, as much color as you can on the reasons for the tampering the loan growth outlook for the rest of the year?

[Greg Becker:]

Yes. Jennifer, I’ll start. And it is mainly driven because of what we saw in the first and the second quarter, because you’re talking to deal with averages. And so, if you see that being lower than what we thought, obviously that plays out for the balance of the year, number one. Number two, we do look at it and say despite what I said, we do believe the second half will be stronger than the first half, especially in the tech and second life science portfolio. We still believe, it’s going to be very competitive and we still believe we’re going to have to be smart about where we do want to lean in and where we want to back away. So, I wouldn’t read anything into it more than that.

[Operator:]

And our next question comes from Jared Shaw from Wells Fargo. Please go ahead.

[Jared Shaw:]

Just on the expense side, when you spoke about the $7.7 million incremental growth in expenses quarter-over-quarter compensation, did I hear you right that a third of that is roughly, call it revenue producing personnel, a third is support, and a third is due to the ROE adjustment, was that correct?

[Dan Beck:]

It’s generally correct. If we look at it we get the $7.7 million worth of increase, $4 million of that is non-recurring items, a half of that relates to the ROE plans as well as some other onetime items related to benefit cost. So, rest, the 3.7 is really people related and growth related people cost.

[Jared Shaw:]

And then on the -- looking at third quarter with the expectation -- third and fourth quarter with the expectation that expenses are flat. Where else -- so that $8 million is not recurring, it’s going to be distributed in other categories. Is that still going to be increased hiring or should we expect to see, is it professional services, as you are ramping up maybe new systems? Maybe just a little color on where that $8 million gets reallocated.

[Greg Becker:]

This is Greg. Jared, it’s going to be across the board. It is going to be in additional hiring. And again, go back to the fact that whether it is expanding into different markets, supporting our growth, so we are adding people in a variety of different areas, number one. Number two, it is about systems and infrastructure, as I talked about. We do have to make investments in that area. And it will be front-end loaded and quite honestly, we will be seeing that for a while where we have to invest in systems to improve the manual processes and procedures that we do have. And so, you will see it in a variety of areas. But, we try to give you enough color to give you a little more clarity on expectations on absolute numbers in the third and the fourth quarter which is why Dan shared the commentary about we expect third and fourth quarter to be generally in the range on an absolute basis at the level of Q2.

[Jared Shaw:]

And then, on the investments in these systems, ultimately are these more people heavy or is it more software heavy where we should see as we look out maybe in 2018 more operating -- positive operating leverage coming from those investments or is it really as the business grows, the pace of growth with these new investments have to maintain or keep up with that?

[Greg Becker:]

I would love to make it a simple answer and say it’s just one area and it’s going to be all about efficiency. But there is systems that we have that we’ve had for a while that we just have quite honestly there end of life and we have to upgrade. And so, there isn’t going to be a material cost savings when those get implemented. So, the others really are about looking at manual process and procedures whether it’s a client on-boarding, it’s such a simple one where the way we have it today, we have a really great front-end that it makes easy for our clients. But the back-end side of it is an incredibly manual intensive process. We have got to make that automated end to end to create more efficiency. So that would be an example of one that would create efficiencies and scalability but there is others that truly are end of life or it just is an area that we just actually need system capabilities that we don’t have today. So, it’s an incremental add.

[Operator:]

And our next question comes from Steven Alexopoulos from J.P. Morgan. Please go ahead.

[Steven Alexopoulos:]

I want to make sure I fully understand this. So, if we look at the updated expense outlook, is the increased guidance primarily tied to higher incentive comp or since last quarter, have you also decided now to accelerate the pace of investment?

[Greg Becker:]

This is Greg, Steve. So, it’s a little bit of catch up in the second quarter on incentive compensation. And obviously we look it for the whole year and so that incentive compensation will be built in. And we’re going to be spending more money on different infrastructure and growth initiatives. So, it’s a combination of both.

[Steven Alexopoulos:]

Okay, got you. Thank you. And then, on the total client funds, you guys had almost growth [ph] in total client fund this quarter that you had all last year. Could you give more color what’s driving this growth? Do you see more rounds, are there larger rounds, what is it?

[Greg Becker:]

Yes. It’s again variety of different things, one is you saw the numbers in the quarter I talked about and it was an incredibly strong quarter for venture capital activity. We saw a number of rounds that were pretty amazing. The number of $100 million rounds that were closed, was truly astonishing and we’re winning the majority of those client funds, a 100% almost, all those dollars are coming to us. We had another client that raised in the UK a massive amount of money and again we got the majority of those funds. And so, it is about large rounds. But the second part is about increasing our funnel and adding a lot of new clients. So, we, as I said we had 13 new core commercial clients. And so that was -- that is good. And the other part is, one of the areas we’ve done an off-balance sheet is that we have gone after what I’ll call prospects that they are not clients of ours but they have their larger net excess cash and targeting them to start with actually selling our off-balance sheet product for cash management and then looking at buildings bringing them in as clients. So, it’s still strategy combined with just very strong market growth, market liquidity right now.

[Steven Alexopoulos:]

Got you. And I think you partially answered this, but if we look at 60% of the client funds moving of balance sheet, I was wondering are you guys pushing that harder, given coming up on $50 billion or are clients preferring that now that rates are higher?

[Greg Becker:]

We’re not changing our view. We’re not pushing clients anyway. Right now, I actually feel that we’ve got a really good balance to our product set. And so, they are going at the right place, they are going to place they should. And when you see these large ones, rounds get closed, those vast majority should be going off balance sheet. So, I think it’s a good mix right now but short answer is we’re not pushing anyone because we’re getting close to $50 billion.

[Operator:]

And our next question comes from Chris McGratty from KBW. Please go ahead.

[Chris McGratty:]

Maybe on the margin guide. What’s the assumption that’s being made that related to cash balances which obviously had tremendous growth in the quarter? What’s the assumption for deployment in the back half of the year?

[Greg Becker:]

Chris, this is Greg. I’ll start. So, when you think about the cash balances, we’re trying to keep anywhere from 1 to $1.5 billion of cash, maybe a little bit more than that. And so, you’ll see spikes on a given basis, that’s why you have period end balances that will be higher. But, you can look at that now. Again, the rest of it is just the model, how much money we have coming off that’s actually being reinvested, and Dan may have those numbers better than I do. But, we’re effectively rolling off, I want to say it’s roughly $800 million quarter. And so that’s getting reinvested, obviously at higher rates than they were at before, which is very helpful to the margin.

[Dan Beck:]

Yes, just to add to that Greg. Our cash balance guidance is around $2 million to $3 million; that’s the level that we’ve been operating around. And we’re replacing about $800 million -- running off about $800 million per quarter on the securities portfolio. We did add within the quarter because of the increased cash balances, close to $2 billion worth of investment securities at an overall average -- 2.4%, around that range. So, it is a pickup for us on those balances.

[Chris McGratty:]

So, just so I got it, the new reinvestment rates, was 240 in the quarter, is that right?

[Dan Beck:]

Yes.

[Chris McGratty:]

Okay. In terms of the second half tax rate, should we -- backing out last two quarters, just kind of go back to where it was last year, maybe full year is a good proxy for the back half?

[Dan Beck:]

There is a lot of volatility in that tax rate because it’s driven by exercise on the stock compensation side. That being said, we expect fewer exercises in Q3 and Q4 and if that happens, and we’ll be back to the 2016 rate.

[Operator:]

And our next question comes from John Pancari from Evercore ISI. Please go ahead. Your line is open.

[John Pancari:]

Just on the expense topic again. In terms of the higher incentive comp component, I know you indicated that in part it relates to the improving ROE. However, if you look at your ROE over the past several years, I guess going back to few years, there is not a real notable increase, and same thing with the ROA. So, I’m just -- give us a little bit of color what exactly you’re anchoring that to?

[Dan Beck:]

So, I’ll start and others might jump in. What we’re doing is we’re targeting on a portion of our incentive compensation plan, our ROE relative to peers. So, a third of our overall incentive compensation plan is driven by that pure benchmarking. You’ve seen over the last few quarters and in particular this quarter an improvement in that ROE that puts us very close to the top 3 to 5 of the pure benchmark in ROE for our peer sets. So, that’s truly driving component of the overall incentive compensation. If we take a step back on expenses, let’s just look at things from a guidance perspective where we started the year. We started the year in the high single digits and now we’re effectively sitting in the low teens. What that means to us just overall is anywhere between $40 million and $45 million increase in the overall expense outlook on an annualized basis. Stepping back from there, about $30 million of that relates to improved performance, which includes this component of the compensation plan tied to ROE. So, that’s a big driver of the overall number. The addition to that is the investments in operations as well as regulatory and compliance area but preponderance of what’s happening here relates to a performance relative -- and in particular relative to this ROE plan.

[John Pancari:]

And then, on the risk and compliance investments. Can you help me out again in terms of on the risk compliance side, what investments are these that differ from what you’ve already accomplished, as you approach the $50 billion. I know, you indicated, Greg, that there is more you can do on that side, beyond what you did. But can you talk about what is it that the regulators have not yet been on about improving but now it’s the time to do it?

[Greg Becker:]

We think about it. So, as we were growing over the last two, three, four years, we continued to invest in a variety of different areas. But, we continue to add what I’ll call, expertise for people that actually have been there and done it and actually managed larger programs. And so, if you look at our risk functional overall, risk includes, it includes our compliance department; it includes our enterprise wide risk management; it includes BSA AML; it includes loan review; it includes credit review or model risk management, all those areas. If you look across the board and just look at what I’ll call other institutions and what they are hearing and what feedbacks are getting from the regulators and just our own risk management levels, we are having to invest across all those areas, and it is both people and its technology. And for us, this really I would say is less about CCAR, although I guess part of it would be -- it’s more about we just have to up our game as we get bigger as an institution, as we become more global, as we have more transaction processing all those things. So, I wouldn’t say it’s one part of risk management it is actually across all areas that we need to raise our game.

[John Pancari:]

If I could ask just one more, efficiency ratio expectation, could you talk about that little bit for 2018?

[Dan Beck:]

So, as we…

[Greg Becker:]

Yes. So, I’ll start. So, for 2018, usually what we end up talking about is in the October call, we start to give guidance out to 2018 and we will do that again. I just want to talk about 2018 first, Dan is going to comment on the balance of 2017.

[Dan Beck:]

Yes. What I was going to say is obviously so much of that is dependent upon rate outlook expectations and there is a lot of variability that goes into that. So, it’s hard to comment on exactly where things are going to end up, but with the improvement -- or the increase in June, the expectation is that it would be slightly better, but again still dependent upon what happens from rate perspective.

[Operator:]

And our next question comes from Brett Rabatin from Piper Jaffray. Please go ahead. Your line is open.

[Brett Rabatin:]

I wanted to ask a non-expense question. I wanted to ask about credit. And if I kind of heard your tone right, it sounds like you are maybe a little more comfortable with your outlook, even though you haven’t changed the specific guidance around charge-offs. I’m just curious to hear how you see the environment shaping up, Greg, and then does the new guidance around pre-profit technology companies, does that going to have any effect on how you criticize the asset levels?

[Greg Becker:]

I’ll start at a high level and then Marc will comment on it in more detail. 2Q was a really strong quarter from a credit quality perspective. And our view is we feel good about that, we feel good about the outlook and we think a lot of what we experienced in 2016 as far as the recalibration is behind us. That being said, we’ve been in this business long enough to know that one quarter is not a trend make and that you end up in a position where we feel good about where we are, but we don’t feel that we have the clarity yet to kind of change our guidance. So, I’ll leave it at that and turn it over to Marc.

[Marc Cadieux:]

Yes. So, I’ll pick up with early stage. And so, there as Greg mentioned, following the -- what we saw on the first half of 2016, we have now seen four consecutive quarters of what I would characterize as pretty typical credit quality performance in the early stage segment which is reassuring. Again, it’s not necessarily predictive of the future and we do continue to hear companies that are struggling to raise that series B round of financing for example. But again, our credit quality in early stage segment continues to be stable. You referenced new guidance. We’ve heard some questions about that I think stemming from the earnings release of another bank. We’re unaware and in fact have confirmed that there is no new guidance related to lending to pre-profit companies, either inter agency or from any of the agencies independently and therefore not expecting any change in credit quality in pre-profit driven by regulatory change. Obviously, if there were to be guidance, we’d have to incorporate that in our thinking and presumably if we thought it was going to have any impact, we’d be talking about it.

[Operator:]

And our next question comes Geoffrey Elliott from Autonomous Research. Please go ahead.

[Geoffrey Elliott:]

I wondered if you could help tie together a couple of things that you said earlier. In the prepared remarks at the beginning, you talked about the exit environment being tougher, less M&A taking place specifically. But then when you were talking about your client base, you mentioned M&A as being something which is being negative to loan growth. So, I am assuming that means some of your clients getting acquired. So, just curious, why you think your client base is different from the industry overall, if actually that’s the case?

[Greg Becker:]

Yes, this is Greg. So, when you think about the numbers and what people are paying attention to in the market, we’re now looking at exit, they are talking about the very, very large exits, that’s what the attention is paid to; that’s the headline news. When we’re talking about loan balances where you’ve got $5 million, $10 million $15 million, you are looking at acquisitions that are actually on the lower end. And those acquisitions do then retire all the debt that we have. Typically if a company is being sold for hundreds if not billions of dollars, they probably have a lot of cash, a lot of liquidity, they probably raised a lot of money, so kind of borrowing that much at the end of the day. So, we just -- what we say is this is what we’re experiencing. The headline news in the market is that M&A is on the softer side relative to what it was a year ago. But what we’ve experienced, we look at pay downs in the second quarter. M&A clearly was a catalyst for that.

[Geoffrey Elliott:]

And then, in terms of growth on the technology and life sciences, and also your healthcare loan book, just help us understand what you think that should look like over the next few years? Do we get back to the pace that we’ve seen in the past or is it going to be slower from now on, just given some of the competitive factors you’ve rolled out?

[Greg Becker:]

Yes. When I think about -- this is Greg, and Marc will probably add some color. When I think about the tech and life science portfolio, you got couple of things going on. One is you do have with a lot of the loan products that we have, they amortize and so you start out the day with amortization in a given quarter, in a given year that you then have to replace to get back to zero. So, you get start there. The second part then is just liquidity in the market. We’re at a point right now, where with the high liquidity that we have, you have lines of credit that aren’t utilized or they just don’t take that to the same level, because they have $50 million or $100 million or $200 million worth of cash on their balance sheet and why would they want to pay for something that’s just adding more cash to that balance sheet, they may not need or probably won’t need. That being said, when we look at the market, we view it as still a robust market, it’s a growing market. Our win rate is very strong, despite it being competitive. And that’s part of the reason that we’re optimistic. Now what does that look like from a growth rate percentage? It’s hard to predict. My take, if you look out in the future, you’re going to be looking at in the single digits, mid to high single digit is where I would end up with the volatility on a given quarter and even on a given year depending upon where venture capital flow is and what the level of M&A in our client base is.

[Operator:]

And our next question comes from Aaron Deer from Sandler O’Neill & Partners. Please go ahead.

[Aaron Deer:]

One of the highlights for quarter was the client investment fees. No doubt it’s coming from the large input that you have there. But I would imagine, you also got a benefit from higher rates in the fees being affected by that. Can you give us a sense of where those fees stood, maybe on a basis-point level at June 30th relative to March 31st and what kind of uptick we might get from the rate hikes that were inter quarter?

[Greg Becker:]

Yes. We’re roughly -- Aaron, this is Greg, roughly around 10 basis points of yield on the overall off-balance sheet management. And as you know, we were as low as 12 months ago at roughly 5 basis points. So, the rate increases that we’ve seen have allowed us to go to that 10 basis points. And I think just a good rule of thumb -- obviously we don’t have this factored into our outlook. But a good rule of thumb would be, right now, given the level that we’re at, it’s probably about a basis point per 25 basis points of increases that you would see out into the future. We talked before about maybe being as much as 1 to 2 basis points, but since we’ve already gone up to 10, obviously it will start to slow down that growth with future rate increases. So, rule of thumb, 1 basis point for 25 basis points of future increases.

[Aaron Deer:]

Okay. And then, just a quick one on the tax rate and the impact of the share comp. Looking out to 2018, do you expect, based on the timing of the issuances that it’s going to be another kind of front-loaded here in terms of the tax benefit? And then, that would fade or is it more tied to the price of the stack? It seems like -- issuances seem to be the bigger driver, but you can correct me, if I’m wrong.

[Dan Beck:]

Yes. Issuances as well as where the overall stock price is, are the big drivers. So, we can’t say with certainty what’s going to happen next year. But, when we look at where our options and where restricted stock vest is more heavily weighted to the front part of the year. So, obviously it depends on the overall stock price. But assuming it would increase, it would be more heavily weighted to the front part of the year.

[Operator:]

Next question comes from Chris York from JMP Securities.

[Chris York:]

So, Greg, you said in your prepared remarks that loan growth was positively affected in the private equity business. Now, I think that loan type is clumped in with VC in the Q, so could you tell us what the growth was in dollars quarter-over-quarter and then maybe what the period end portfolio size is?

[Greg Becker:]

So, I’m going to let Marc to give you a little more color on the Q. The one thing I would say, when we took the PES, our private equity services, it is call loans for both private equity and venture capital, and the vast majority of any growth that we see is coming from private equity not from venture capital. But Marc anymore color you want to add to it?

[Marc Cadieux:]

Yes. So, loans went up in that broader type of private equity services, roughly $500 million quarter-over-quarter. This quarter was actually type of what Greg said, because that is generally a bit anomalous this quarter and that we actually had more growth from VC segment than we did from the PE segment.

[Chris York:]

And maybe as a follow-up. So, can you remind us of the go-to-market strategy, maybe with sponsors as they are raising a lot new money here? And then, potentially the weighted average yield on your private equity service facilities?

[Dan Beck:]

So, in terms of yields and from interest-only standpoint, the venture capital segment of private equity services is around 4% for interest only yield. Private equity is a bit less than that in the mid 3s.

[Chris York:]

And then, maybe just a little color on the strategy and how sponsors are reacting to the new product -- I mean not new but relatively new for you guys?

[Dan Beck:]

I think you might be confusing between sponsored buyouts perhaps and maybe their private equity capital call lines of credit.

[Greg Becker:]

So, Chris, the private equity capital calls loans we’ve been doing for ever and now with sponsor led buy-outs, even that has been around for -- now you are looking at almost 11 years. I would say that neither one would that in the category on new. But if you -- I’ll focus on assuming you are talking about sponsor-led buyouts. So, there have been a lot of new funds raised, which is why part of our private equity services business is doing so well. We are very targeted, we are looking at -- and our sponsor-led buyout technology, mostly software buyout as well as some healthcare services deals. So, we take the large private equity market and our market, target market gets much more narrow. Our go-to-market is defined the right sponsors, the ones that we have worked with or the ones that have built up a good track record that we want to partner with. And we are looking at putting in the senior credit facilities for them. The strategy hasn’t changed a whole lot. I would tell you that it is definitely one area that’s gotten more competitive less so from banks, more from non-banks who have raised a lot of debt funds going to go larger on the structure and size side of the equation.

[Operator:]

And our next question comes from Matt Keating from Barclays. Please go ahead.

[Matt Keating:]

Yes, thank you. Just one quick question on the international operations. I am just curious if you are seeing the same levels of more muted growth in the traditional software, hardware, life sciences practices internationally that you might be overall, are you seeing faster growth there than the U.S. at this point in those categories?

[Greg Becker:]

Yes, this is Greg. We’re seeing a little bit faster growth. It’s still competitive less so from banks, more so from the non-banks that are out there. But because you don’t have -- I mean you’re adding newer clients at a faster pace as a percentage of the portfolio, you don’t have the same level of turnover. And therefore, those balances can build more quickly than what you see in the U.S. So, we’re seeing nice growth in the global markets, I mean UK specifically for tech and life sciences. But it is definitely competitive.

[Matt Keating:]

Right. And now, Germany and Canada expansion, are those still in the works right now and expect to bring those on line over the next couple of years, is that a fair timeline?

[Greg Becker:]

Yes. Obviously, I’ll start with subject to regulatory approval. We would expect that in the hopefully in the first half of 2018, we’ll be able to start getting some traction in those markets. But again, just to take a step back, either of those markets are going to go from very little base that you’re starting from or no base in one case, and you’re going to be building on that. So, it will take a while. How I describe it is, you’ve got the core loan growth from the areas that we describe and Germany or Canada is going to be icing on the cake.

[Operator:]

And the next question comes from John Pancari from Evercore ISI. Please go ahead.

[John Pancari:]

Hi. Sorry to queue back in, I’d one more quick follow-up. You mentioned, the ROE rationale on your comp and versus peers. Who is your peer group that you’re talking about?

[Greg Becker:]

Yes, I think it’s in our proxy and it’s pretty clearly outlined. So, I don’t know all the names off the top of my head and I don’t want to spend time on the call going through it, but you can look it up on the proxy.

[John Pancari:]

That’s what I just wanted to confirm, it’s within the proxy. Okay. All right, thanks.

[Operator:]

And that concludes our question-answer-session. I will turn the call now back over to Greg Becker for final remarks.

[Greg Becker:]

Great, thanks. So, in closing, I just want to say thanks to everyone for joining us today. When we look at the overall markets that we serve, second quarter was a really, really strong quarter in fund raising, venture funds, in investing, deployment of capital; soft on the exit side but again, what we see in our portfolio, there is companies that are performing really well. So, we feel good about again our target market. We had a record quarter. We’re seeing the benefit after many, many years of rising rates coupled with strong fundamentals and feel good that we’ve got a solid outlook for the balance of 2017. So, feel really good about where we are. Really as we always do, just want to thank our clients for their trust and support in us. We know we have a lot to live up to and totally appreciate their business. And thank all our employees for what they do. And just have a real strong team here, love working with and feel really good about what we’ve built. And then finally, I want to thank Dan Beck for joining the team. He did a great job on his first inaugural earnings call and great addition to the team. So, thank you all and have a great day.

[Operator:]

Thank you, ladies and gentlemen. This concludes today’s conference. Thank you for participating. You may now disconnect.