The following information should be read in conjunction with the accompanying unaudited consolidated financial statements and related notes and exhibits included elsewhere in this Quarterly Report on Form 10-Q. Certain statements in this Quarterly Report on Form 10-Q may be considered forward-looking. Statements that are not historical or current facts, including statements about beliefs and expectations, are forward-looking statements. These forward-looking statements include, among other things, statements other than historical information or statements of current conditions and may relate to our future plans and objectives and results, and also may include our belief regarding the effect of various legal proceedings, as set forth under "Legal Proceedings" in Part I, Item 3 of our Annual Report on Form 10-K for the year endedDecember 31, 2019 and in our subsequent reports filed with theSecurities and Exchange Commission ("SEC"). Forward-looking statements involve inherent risks and uncertainties, and important factors could cause actual results to differ materially from those anticipated, including those factors discussed below under "External Factors Impacting Our Business" as well as the factors identified under "Risk Factors" in Part I, Item 1A of our Annual Report on Form 10-K for the year endedDecember 31, 2019 , as updated in our subsequent reports filed with theSEC and under "Risk Factors" in Part II, Item 1A of this Quarterly Report on Form 10-Q. These reports are available at our Web site at www.pipersandler.com and at the SEC Web site at www.sec.gov. Forward-looking statements speak only as of the date they are made, and we undertake no obligation to update them in light of new information or future events.
Explanation of Non-GAAP Financial Measures
We have included financial measures that are not prepared in accordance withU.S. generally accepted accounting principles ("GAAP"). These non-GAAP financial measures include adjustments to exclude (1) revenues and expenses related to noncontrolling interests, (2) interest expense on long-term financing, (3) amortization of intangible assets related to acquisitions, (4) compensation and non-compensation expenses from acquisition-related agreements, (5) acquisition-related restructuring and integration costs and (6) discontinued operations. The adjusted weighted average diluted shares outstanding used in the calculation of non-GAAP earnings per diluted common share contains an adjustment to include the common shares for unvested restricted stock awards with service conditions granted pursuant to the acquisitions ofSOP Holdings, LLC and its subsidiaries, includingSandler O'Neill & Partners, L.P. (collectively, "Sandler O'Neill"), andThe Valence Group ("Valence"). These adjustments affect the following financial measures: net revenues, compensation expenses, non-compensation expenses, income tax expense/(benefit), net income/(loss) applicable to Piper Sandler Companies, earnings/(loss) per diluted common share, non-interest expenses, pre-tax income/(loss) and pre-tax margin. Management believes that presenting these results and measures on an adjusted basis in conjunction with the correspondingU.S. GAAP measures provides the most meaningful basis for comparison of our operating results across periods, and enhances the overall understanding of our current financial performance by excluding certain items that may not be indicative of our core operating results. The non-GAAP financial measures should be considered in addition to, not as a substitute for, measures of financial performance prepared in accordance withU.S. GAAP.
COVID-19 Impacts
The impacts of the novel coronavirus disease ("COVID-19") continue to evolve and present challenges to our business. At this time, it is uncertain how long our business will be impacted by COVID-19, the related economic downturn and changing market environment. We believe the significance of the impact will be directly correlated to the length and severity of the economic slowdown and the stability of the equity and credit markets. Our ability to access the market for working capital and/or short-term and long-term financing may be impacted, perhaps significantly, during periods of economic distress. Our ability to fund operations, make capital investments, maintain compliance with our debt covenants, and fund shareholder dividends or stock repurchases may also be adversely affected, depending on the level and length of disruption to our business. We continue to regularly monitor our capital and liquidity positions, regulatory capital requirements, debt covenants and other contractual obligations in light of the pandemic. See the sections entitled "Outlook for the Remainder of 2020" and "Financial Performance from Continuing Operations" for additional information regarding the impacts of COVID-19 on our business. 41 -------------------------------------------------------------------------------- Table of Contents Executive Overview Our continuing operations principally consist of providing investment banking and institutional brokerage services to corporations, private equity groups, public entities, non-profit entities and institutional investors inthe United States andEurope . We operate through one reportable business segment. Refer to our Annual Report on Form 10-K for the year endedDecember 31, 2019 for a full description of our business, including our business strategy.
Over the last 12 months, we have taken important steps in the execution of our business strategy. These steps include the following:
•OnApril 3, 2020 , we completed the acquisition of Valence, an investment bank offering mergers and acquisitions advisory services to companies and financial sponsors with a focus on the chemicals, materials and related sectors. The transaction adds a new industry sector and expands our presence inEurope . •OnJanuary 3, 2020 , we completed the acquisition ofSandler O'Neill , a full-service investment banking firm and broker dealer focused on the financial services industry. The acquisition ofSandler O'Neill is accretive to our advisory services revenues, diversifies and enhances scale in corporate financings, adds a differentiated fixed income services business, and increases scale in our equity brokerage business. •OnAugust 2, 2019 , we completed the acquisition ofWeeden & Co. L.P. ("Weeden & Co. ").Weeden & Co. is a broker dealer focused on providing institutional clients with global trading solutions, specializing in best execution through the use of high-touch, low-touch and program trading capabilities. The transaction added enhanced trade execution capabilities and scale to our equity brokerage business. Discontinued Operations - Discontinued operations includes the operating results ofAdvisory Research, Inc. ("ARI"), our traditional asset management subsidiary which we sold in the third quarter of 2019. See Note 4 to our unaudited consolidated financial statements for further discussion of our discontinued operations. 42 --------------------------------------------------------------------------------
Table of Contents Financial Highlights Three Months Ended Six Months Ended (Amounts in thousands, except per share June 30, June 30, 2020 June 30, June 30, 2020 data) 2020 2019 v2019 2020 2019 v2019U.S. GAAP Net revenues$ 292,438 $ 172,418 69.6 %$ 528,606 $ 354,960 48.9 % Compensation and benefits 213,560 102,476 108.4 401,684 219,603 82.9 Non-compensation expenses 71,481 49,017 45.8 153,554 91,295 68.2 Net income/(loss) applicable to Piper Sandler Companies 1,454 10,389 (86.0) (13,273) 29,811
N/M
Earnings/(loss) per diluted common share$ 0.10 $ 0.72 (86.1)$ (0.96) $ 2.02 N/M Non-GAAP(1) Adjusted net revenues$ 292,667 $ 162,779 79.8 %$ 537,589 $ 344,908 55.9 % Adjusted compensation and benefits 185,772 101,147 83.7 344,465 215,967
59.5
Adjusted non-compensation expenses 55,128 40,780 35.2 112,344 81,162
38.4
Adjusted net income applicable to Piper Sandler Companies 34,492 18,982 81.7 59,916 41,169
45.5
Adjusted earnings per diluted common share$ 1.93 $ 1.32 46.2$ 3.35 $ 2.83 18.4 N/M - Not meaningful
For the three months ended
•Net revenues were up 69.6 percent from the year-ago period reflecting the investments we have made in our business through the acquisitions ofSandler O'Neill in the first quarter of 2020 andWeeden & Co. in the third quarter of 2019. In the second quarter of 2020, increased revenues in all of our businesses were partially offset by lower investment income. Our corporate financing revenues were driven by favorable market conditions for capital raising and market share gains. •Compensation and benefits expenses increased 108.4 percent compared with the prior-year period due to higher revenues and additional headcount resulting from our acquisitions ofSandler O'Neill ,Weeden & Co. and Valence, as well as higher acquisition-related costs related to restricted consideration and retention awards associated with these acquisitions. •Non-compensation expenses were up 45.8 percent compared to the year-ago period driven by the addition of our recent acquisitions to the platform and intangible asset amortization expense of$11.6 million .
•For the three months ended
43 -------------------------------------------------------------------------------- Table of Contents For the six months endedJune 30, 2020 •Net revenues were up 48.9 percent from the year-ago period as our acquisitions ofSandler O'Neill andWeeden & Co. provided significant franchise and financial diversification, and enhanced our scale and durability across our platform. •Compensation and benefits expenses increased 82.9 percent compared with the prior-year period due to higher revenues, incremental headcount from our recent acquisitions, and higher acquisition-related costs related to restricted consideration and retention awards associated with the acquisitions. We also recorded additional compensation expense for an earnout associated with theWeeden & Co. acquisition related to our expectations of achieving a net revenue target, as our equity brokerage business is outperforming initial projections. •Non-compensation expenses increased 68.2 percent compared to the year-ago period primarily due to our recent acquisitions. Also, in the first quarter of 2020, we recorded higher acquisition-related non-compensation costs due to a$12.1 million fair value adjustment to theWeeden & Co. earnout related to non-employee equity owners. We recorded the full value of the projected earnout for these non-employees as they do not have service requirements. •In the first half of 2020, we recorded$2.6 million of income tax benefits primarily related to new tax provisions in the Coronavirus Aid, Relief, and Economic Security Act (the "CARES Act"), which was enacted by theU.S. federal government onMarch 27, 2020 in response to the COVID-19 pandemic. The CARES Act contains tax provisions allowing a five-year carry back of any net operating losses incurred during federal tax years 2018, 2019 and 2020, to periods when the corporate federal tax rate was 35 percent. The impact of the tax benefit on earnings per diluted common share was$0.19 in the first six months of 2020. •For the six months endedJune 30, 2020 and 2019, we recorded a tax benefit of$0.2 million and$5.1 million , respectively, related to restricted stock vesting at values greater than the grant price. The impact of the tax benefit on earnings per diluted common share was$0.35 in the first six months of 2019. 44
-------------------------------------------------------------------------------- Table of Contents (1)Reconciliation ofU.S. GAAP to adjusted non-GAAP financial information Three Months Ended Six Months Ended June 30, June 30, (Amounts in thousands, except per share data) 2020 2019 2020 2019 Net revenues: Net revenues - U.S. GAAP basis$ 292,438
(2,235) (9,639) 4,301 (10,052) Interest expense on long-term financing 2,464 - 4,682 - Adjusted net revenues$ 292,667
Compensation and benefits: Compensation and benefits -U.S. GAAP basis$ 213,560
(1,329) (57,219) (3,636) Adjusted compensation and benefits$ 185,772
Non-compensation expenses: Non-compensation expenses -U.S. GAAP basis$ 71,481
(992) (1,089) (1,984) (2,118)
Acquisition-related restructuring and integration costs (3,724)
(6,395) (5,626) (6,395) Amortization of intangible assets related to acquisitions (11,637) (753) (21,515) (1,506)
Non-compensation expenses from acquisition-related agreements
- - (12,085) (114) Adjusted non-compensation expenses$ 55,128
Net income/(loss) applicable toPiper Sandler Companies: Net income/(loss) applicable to Piper Sandler Companies - U.S. GAAP basis$ 1,454
Adjustment to exclude net loss from discontinued operations - (2,166) - (2,305) Net income/(loss) from continuing operations$ 1,454
Adjustments:
Compensation from acquisition-related agreements 20,970 1,047 43,313 2,989
Acquisition-related restructuring and integration costs 3,383
4,809 4,802 4,809 Amortization of intangible assets related to acquisitions 8,685 571 16,058 1,141
Non-compensation expenses from acquisition-related agreements
- - 9,016 114 Adjusted net income applicable toPiper Sandler Companies$ 34,492
Earnings/(loss) per diluted common share:
Earnings/(loss) per diluted common share -
$ 0.10
Adjustment to exclude net loss from discontinued operations - (0.15) - (0.16) Income/(loss) from continuing operations$ 0.10
(0.45) - (0.80) - Impact of antidilutive shares in a period of a loss - - 0.04 - Adjustment related to participating shares (2) - - - 0.02$ (0.35)
Adjustments:
Compensation from acquisition-related agreements 1.45 0.07 3.01 0.21
Acquisition-related restructuring and integration costs 0.23
0.34 0.33 0.33 Amortization of intangible assets related to acquisitions 0.60 0.04 1.11 0.08
Non-compensation expenses from acquisition-related agreements
- - 0.62 0.01 Adjusted earnings per diluted common share$ 1.93
Weighted average diluted common shares outstanding:
Weighted average diluted common shares outstanding -
14,476 14,024 14,444 13,778
Adjustment:
Unvested acquisition-related restricted stock with service conditions
3,401 - 3,450 - Adjusted weighted average diluted common shares outstanding 17,877 14,024 17,894 13,778
(2)The adjustment related to participating shares excludes the impact of the annual special cash dividend paid in the first quarter of 2019.
45 -------------------------------------------------------------------------------- Table of Contents External Factors Impacting Our Business Performance in the financial services industry in which we operate is highly correlated to the overall strength of economic conditions and financial market activity. Overall market conditions are a product of many factors, which are beyond our control, often unpredictable and at times inherently volatile. These factors may affect the financial decisions made by investors, including their level of participation in the financial markets. In turn, these decisions may affect our business results. With respect to financial market activity, our profitability is sensitive to a variety of factors, including the demand for investment banking services as reflected by the number and size of advisory transactions, equity and debt corporate financings, and municipal financings; the relative level of volatility of the equity and fixed income markets; changes in interest rates and credit spreads (especially rapid and extreme changes); overall market liquidity; the level and shape of various yield curves; the volume and value of trading in securities; and overall equity valuations. Factors that differentiate our business within the financial services industry also may affect our financial results. For example, our capital markets business focuses on specific industry sectors while serving principally middle-market clientele. If the business environment for our focus sectors is impacted adversely, our business and results of operations could reflect these impacts. In addition, our business, with its specific areas of focus and investment, may not track overall market trends. Given the variability of the capital markets and securities businesses, our earnings may fluctuate significantly from period to period, and results for any individual period should not be considered indicative of future results. 46 -------------------------------------------------------------------------------- Table of Contents Outlook for the Remainder of 2020 OnMarch 11, 2020 , theWorld Health Organization characterized the COVID-19 outbreak as a global pandemic. The COVID-19 pandemic has affected major economic and financial markets, and businesses and governments are facing challenges associated with the economic conditions resulting from efforts to address it. Global macroeconomic conditions have been significantly impacted by the government-mandated closure of businesses and the gradual reopening of the economy with new protocols for social interaction, supply chain and production disruptions, job losses, reduced consumer spending and sentiment, and a myriad of other factors. TheU.S. federal government passed legislation attempting to mitigate some of the economic hardship caused by the COVID-19 pandemic, with the potential for more legislation and stimulus measures in the future. TheU.S. Federal Reserve has taken extraordinary steps to provide liquidity in the financial markets, including cutting the short-term benchmark interest rate to zero and launching a new round of quantitative easing. After historic volatility in the first quarter of 2020, equity markets rebounded and fixed income markets stabilized, aided by the record levels of federal monetary and fiscal support. Geopolitical and macroeconomic risks, such as uncertainties surrounding trade policy, negotiations regarding Brexit and other global economic conditions, remain in the background and will continue to have an ongoing impact to theU.S. and global economy. The 2020 U.S. presidential election may also influence the volatility or direction of markets based on investors' assessment of the outcome and the overall political outlook in theU.S.
The uncertainty associated with COVID-19 continues to influence advisory services activity market-wide, as evidenced by the decline in the number of announced deals in the market. Many engagements have been put on hold until business conditions become more clear. We expect that our advisory services revenues in the second half of 2020 will be lower compared to the second quarter, reflecting this pause in activity.
Market conditions were favorable for corporate capital raising in the second quarter of 2020 as both public and private companies completed transactions to strengthen their balance sheets. Our pipeline remains strong and we expect capital raising activity will continue as long as market conditions remain favorable. In our equity brokerage business, equity market volumes and volatility remain elevated from historical levels as clients seek liquidity in the changing market environment. We believe that client activity and our equity brokerage revenues will decline from levels in the first half of 2020 as volatility has started to subside and the market historically experiences a slowdown during the summer months. We believe that our revenues will continue to follow institutional trading volumes and the uncertainty of the current market conditions could lead to further spikes in volatility and volumes in future periods. The actions taken by theU.S. Federal Reserve to inject liquidity into the market toward the end of March helped to stabilize the fixed income markets in the second quarter of 2020. Fixed income client activity remained strong for taxable and tax-exempt products. We believe that our fixed income services revenues will remain strong as clients continue to reposition in a changing market. Our public finance underwriting business benefited from market stability, low yields and strong investor demand in the second quarter of 2020. We expect revenues in the third quarter to moderate from these levels. Volatility, rate stability and client demand will impact the level of municipal finance activity going forward. 47 -------------------------------------------------------------------------------- Table of Contents Results of Operations
Financial Summary for the three months ended
The following table provides a summary of the results of our operations on a
As a Percentage of Net Revenues for the Three Months Ended Three Months Ended June 30, June 30, 2020 (Amounts in thousands) 2020 2019 v2019 2020 2019 Revenues: Investment banking$ 199,827 $ 118,739 68.3 % 68.3 % 68.9 % Institutional brokerage 89,339 32,204 177.4 30.5 18.7 Interest income 3,065 6,863 (55.3) 1.0 4.0 Investment income 3,733 17,605 (78.8) 1.3 10.2 Total revenues 295,964 175,411 68.7 101.2 101.7 Interest expense 3,526 2,993 17.8 1.2 1.7 Net revenues 292,438 172,418 69.6 100.0 100.0 Non-interest expenses: Compensation and benefits 213,560 102,476 108.4 73.0 59.4 Outside services 9,899 8,451 17.1 3.4 4.9 Occupancy and equipment 13,269 8,425 57.5 4.5 4.9 Communications 11,096 6,849 62.0 3.8 4.0 Marketing and business development 2,588 8,089 (68.0) 0.9 4.7 Deal-related expenses 11,204 6,725 66.6 3.8 3.9 Trade execution and clearance 4,312 1,017 324.0 1.5 0.6 Restructuring and integration costs 3,724 6,395 (41.8) 1.3 3.7 Intangible asset amortization 11,637 753 N/M 4.0 0.4 Other operating expenses 3,752 2,313 62.2 1.3 1.3 Total non-interest expenses 285,041 151,493 88.2 97.5 87.9 Income from continuing operations before income tax expense/(benefit) 7,397 20,925 (64.6) 2.5 12.1 Income tax expense/(benefit) 4,700 (180) N/M 1.6 (0.1) Income from continuing operations 2,697 21,105 (87.2) 0.9 12.2 Discontinued operations: Loss from discontinued operations, net of tax - (2,166) N/M - (1.3) Net income 2,697 18,939 (85.8) 0.9 11.0 Net income applicable to noncontrolling interests 1,243 8,550 (85.5) 0.4 5.0 Net income applicable toPiper Sandler Companies$ 1,454 $ 10,389 (86.0) 0.5 % 6.0 % N/M - Not meaningful 48
-------------------------------------------------------------------------------- Table of Contents For the three months endedJune 30, 2020 , we recorded net income from continuing operations applicable to Piper Sandler Companies of$1.5 million . Net revenues from continuing operations for the three months endedJune 30, 2020 were$292.4 million , a 69.6 percent increase compared to$172.4 million in the year-ago period, reflecting the impact of our acquisitions ofSandler O'Neill andWeeden & Co. In the second quarter of 2020, investment banking revenues were$199.8 million , up 68.3 percent compared with$118.7 million in the prior-year period, driven by robust corporate financing revenues, as well as higher municipal financing and advisory services revenues. For the three months endedJune 30, 2020 , institutional brokerage revenues increased 177.4 percent to$89.3 million , compared with$32.2 million in the second quarter of 2019, due to the acquisitions ofWeeden & Co. andSandler O'Neill , as well as elevated levels of trading volumes. For the three months endedJune 30, 2020 , net interest expense was$0.5 million , compared to net interest income of$3.9 million in the prior-year period. Net interest expense resulted from a decline in interest income on our long inventory positions combined with incremental interest expense on our long-term financing arrangements, which consist of our fixed rate senior notes issued onOctober 15, 2019 , and the unsecured promissory notes we entered into onApril 3, 2020 to fund a portion of the Valence purchase price. In the second quarter of 2020, we recorded investment income of$3.7 million , compared with$17.6 million in the prior-year period. In the current quarter, we recorded lower gains on our investment and the noncontrolling interests in the merchant banking funds that we manage. Non-interest expenses from continuing operations were$285.0 million for the three months endedJune 30, 2020 , up 88.2 percent compared to$151.5 million in the prior-year period, driven by higher compensation and non-compensation expenses resulting from the acquisitions ofSandler O'Neill ,Weeden & Co. and Valence.
Consolidated Non-Interest Expenses from Continuing Operations
Compensation and Benefits - Compensation and benefits expenses, which are the largest component of our expenses, include salaries, incentive compensation, benefits, stock-based compensation, employment taxes, income associated with the forfeiture of stock-based compensation and other employee-related costs. A portion of compensation expense is comprised of variable incentive arrangements, including discretionary incentive compensation, the amount of which fluctuates in proportion to the level of business activity, increasing with higher revenues and operating profits. Other compensation costs, primarily base salaries and benefits, are more fixed in nature. The timing of incentive compensation payments, which generally occur in February, has a greater impact on our cash position and liquidity than is reflected on our consolidated statements of operations. We have granted restricted stock and restricted cash with service conditions as a component of our acquisition deal consideration, which is amortized to compensation expense over the service period. For the three months endedJune 30, 2020 , compensation and benefits expenses increased 108.4 percent to$213.6 million , compared with$102.5 million in the corresponding period of 2019. The increase in compensation and benefits expenses was driven by higher revenues and incremental headcount from the acquisitions ofSandler O'Neill and Valence in the first half of 2020 andWeeden & Co. in the third quarter of 2019, along with higher acquisition-related compensation related to restricted consideration and retention awards associated with these acquisitions. Compensation and benefits expenses as a percentage of net revenues was 73.0 percent in the second quarter of 2020, compared with 59.4 percent in the second quarter of 2019. The compensation ratio was impacted by increased acquisition-related compensation related to our recent acquisitions. Outside Services - Outside services expenses include securities processing expenses, outsourced technology functions, outside legal fees, fund expenses associated with our consolidated alternative asset management funds and other professional fees. Outside services expenses increased 17.1 percent to$9.9 million in the second quarter of 2020, compared with$8.5 million in the corresponding period of 2019. The increase was primarily due to higher securities processing fees resulting from higher trading volumes due to the addition ofWeeden & Co. onto our platform and higher levels of trading volatility during the quarter resulting from the economic impacts of the COVID-19 pandemic. The increase was also due to incremental expenses related to the acquisition ofSandler O'Neill and higher professional fees. Occupancy and Equipment - For the three months endedJune 30, 2020 , occupancy and equipment expenses increased to$13.3 million , compared with$8.4 million for the three months endedJune 30, 2019 . The increase was primarily the result of incremental occupancy and software maintenance expenses related to our recent acquisitions. Communications - Communication expenses include costs for telecommunication and data communication, primarily consisting of expenses for obtaining third party market data information. For the three months endedJune 30, 2020 , communication expenses increased 62.0 percent to$11.1 million , compared with$6.8 million for the three months endedJune 30, 2019 due to increased market data services expenses resulting from incremental headcount related our recent acquisitions. 49 -------------------------------------------------------------------------------- Table of Contents Marketing and Business Development - Marketing and business development expenses include travel and entertainment costs, advertising and third party marketing fees. For the three months endedJune 30, 2020 , marketing and business development expenses decreased 68.0 percent to$2.6 million , compared with$8.1 million in the corresponding period of 2019. The decrease was driven by lower travel and entertainment costs. Deal-Related Expenses - Deal-related expenses include costs we incurred over the course of a completed investment banking deal, which primarily consist of legal fees, offering expenses, and travel and entertainment costs. For the three months endedJune 30, 2020 , deal-related expenses were$11.2 million , compared with$6.7 million for the three months endedJune 30, 2019 . The amount of deal-related expenses is principally dependent on the level of deal activity and may vary from period to period as the recognition of deal-related costs typically coincides with the closing of a transaction. Trade Execution and Clearance - For the three months endedJune 30, 2020 , trade execution and clearance expenses were$4.3 million , compared with$1.0 million in the corresponding period of 2019. The increase in trade execution and clearance expenses was reflective of higher trading volumes driven by the addition ofWeeden & Co. onto our platform and higher levels of trading volatility during the quarter. Restructuring and Integration Costs - For the three months endedJune 30, 2020 , we incurred acquisition-related restructuring and integration costs of$3.7 million primarily related to the acquisitions ofSandler O'Neill and Valence. The expenses consisted of$2.2 million of transaction costs,$2.0 million of severance benefits and$0.1 million for vacated leased office space. These expenses were partially offset by a credit of$0.6 million related to previously accrued contract termination costs that were settled favorably. We expect to incur additional restructuring and integration costs in the third quarter of 2020. For the three months endedJune 30, 2019 , we incurred acquisition-related restructuring and integration costs of$6.4 million related to the acquisitions ofWeeden & Co. andSandler O'Neill . The expenses consisted of$2.8 million of contract termination costs,$2.5 million of transaction costs and$1.1 million of severance benefits. Intangible Asset Amortization - Intangible asset amortization includes the amortization of definite-lived intangible assets consisting of customer relationships, internally developed software and the trade name that we acquired fromSimmons & Company International . For the three months endedJune 30, 2020 , intangible asset amortization was$11.6 million , compared with$0.8 million for the three months endedJune 30, 2019 . The increase was due to incremental intangible amortization expense related to identifiable intangible assets associated with the acquisitions ofSandler O'Neill ,Weeden & Co. and Valence. Other Operating Expenses - Other operating expenses include insurance costs, license and registration fees, expenses related to our charitable giving program and litigation-related expenses, which consist of the amounts we reserve and/or pay out related to legal and regulatory matters. Other operating expenses were$3.8 million in the second quarter of 2020, compared with$2.3 million in the corresponding period in 2019. The increase was primarily due to higher expense related to our charitable giving program and increased insurance costs. Income Taxes - For the three months endedJune 30, 2020 , our provision for income taxes was$4.7 million , which included$3.2 million of income tax expense related to the reversal of income tax credits taken in the first quarter of 2020 related to the tax provisions in the CARES Act. The CARES Act contains tax provisions allowing a five-year carry back of any net operating losses incurred during federal tax years 2018, 2019 and 2020, to periods when the corporate federal tax rate was 35 percent. Given our improved performance in the second quarter, we reduced some of these tax credits. Excluding this impact and noncontrolling interests, our effective tax rate was 24.9 percent. For the three months endedJune 30, 2019 , our benefit from income taxes was$0.2 million , which included a$3.5 million tax benefit related to stock-based compensation awards vesting at values greater than the grant price. Excluding the impact of this benefit and noncontrolling interests, our effective tax rate was 26.5 percent. 50
-------------------------------------------------------------------------------- Table of Contents Financial Performance from Continuing Operations
Our activities as an investment bank and institutional securities firm constitute a single business segment.
Throughout this section, we have presented results on both aU.S. GAAP and non-GAAP basis. Management believes that presenting results and measures on an adjusted, non-GAAP basis in conjunction with the correspondingU.S. GAAP measures provides a more meaningful basis for comparison of its operating results and underlying trends between periods, and enhances the overall understanding of our current financial performance by excluding certain items that may not be indicative of our core operating results. The non-GAAP results should be considered in addition to, not as a substitute for, the results prepared in accordance withU.S. GAAP. The adjusted financial results exclude (1) revenues and expenses related to noncontrolling interests, (2) interest expense on long-term financing, (3) amortization of intangible assets related to acquisitions, (4) compensation and non-compensation expenses from acquisition-related agreements and (5) acquisition-related restructuring and integration costs. ForU.S. GAAP purposes, these items are included in each of their respective line items on the consolidated statements of operations. 51 --------------------------------------------------------------------------------
Table of Contents
The following table sets forth the adjusted, non-GAAP financial results and
adjustments necessary to reconcile to our consolidated
Three Months Ended June 30, 2020 2019 Adjustments (1) Adjustments (1) Total Noncontrolling Other U.S. Total Noncontrolling Other U.S. (Amounts in thousands) Adjusted Interests Adjustments GAAP Adjusted Interests Adjustments GAAP Investment banking Advisory services$ 85,569 $ - $ -$ 85,569 $ 75,238 $ - $ -$ 75,238 Corporate financing 83,448 - - 83,448 25,718 - - 25,718 Municipal financing 30,810 - - 30,810 17,783 - - 17,783 Total investment banking 199,827 - - 199,827 118,739 - - 118,739 Institutional brokerage Equity brokerage 40,644 - - 40,644 15,468 - - 15,468 Fixed income services 48,695 - - 48,695 16,736 - - 16,736 Total institutional brokerage 89,339 - - 89,339 32,204 - - 32,204 Interest income 3,065 - - 3,065 6,863 - - 6,863 Investment income 1,498 2,235 - 3,733 7,966 9,639 - 17,605 Total revenues 293,729 2,235 - 295,964 165,772 9,639 - 175,411 Interest expense 1,062 - 2,464 3,526 2,993 - - 2,993 Net revenues 292,667 2,235 (2,464) 292,438 162,779 9,639 - 172,418 Non-interest expenses 240,900 992 43,149 285,041 141,927 1,089 8,477 151,493 Pre-tax income$ 51,767 $ 1,243 $ (45,613) $ 7,397 $ 20,852 $ 8,550 $ (8,477) $ 20,925 Pre-tax margin 17.7 % 2.5 % 12.8 % 12.1 % (1)The following is a summary of the adjustments needed to reconcile our consolidatedU.S. GAAP financial results to the adjusted financial results: Noncontrolling interests - The impacts of consolidating noncontrolling interests in our alternative asset management funds are not included in our adjusted financial results. Other adjustments - The following items are not included in our adjusted financial results: Three Months Ended June 30, (Amounts in thousands) 2020 2019 Interest expense on long-term financing$ 2,464 $ - Compensation from acquisition-related agreements 27,788 1,329 Acquisition-related restructuring and integration costs 3,724 6,395 Amortization of intangible assets related to acquisitions 11,637 753 43,149 8,477 Total other adjustments$ 45,613 $ 8,477 Net revenues on aU.S. GAAP basis were$292.4 million for the three months endedJune 30, 2020 , compared with$172.4 million in the prior-year period. For the three months endedJune 30, 2020 , adjusted net revenues were$292.7 million , compared with$162.8 million in the second quarter of 2019. The variance explanations for net revenues and adjusted net revenues are consistent on both aU.S. GAAP and non-GAAP basis unless stated otherwise. Investment banking revenues comprise all of the revenues generated through advisory services activities, which includes mergers and acquisitions, equity private placements, debt and restructuring advisory, and municipal financial advisory transactions, as well as equity and debt corporate financing activities and municipal financings. 52 -------------------------------------------------------------------------------- Table of Contents In the second quarter of 2020, investment banking revenues increased 68.3 percent to$199.8 million , compared with$118.7 million in the corresponding period of the prior year. For the three months endedJune 30, 2020 , advisory services revenues were$85.6 million , up 13.7 percent compared to$75.2 million in the second quarter of 2019. Revenues for the second quarter of 2020, which reflect the addition ofSandler O'Neill to our platform, increased year-over-year due to more completed transactions. The uncertainty associated with COVID-19, and the potential near- and long-term impacts on the economy, continue to influence advisory services activity market-wide, as evidenced by the decline in the number of announced deals in the market. We expect this dynamic to continue for the remainder of 2020. The uneven distribution of the number and size of deals results in revenue fluctuations from quarter to quarter. For the three months endedJune 30, 2020 , corporate financing revenues were a record$83.4 million , up significantly compared with$25.7 million for the three months endedJune 30, 2019 , due to more completed and book run equity deals, and the addition ofSandler O'Neill to our platform, which book ran debt offerings for financial services companies. Following a substantial halt to capital raising activity in March, market conditions became favorable for capital raising during the second quarter of 2020 driven by a sharp rebound in valuations combined with lower volatility. We expect capital raising activity will continue as long as market conditions remain favorable. Municipal financing revenues for the three months endedJune 30, 2020 were$30.8 million , up 73.3 percent compared to$17.8 million in the prior-year period, driven by robust issuance activity within the governmental space, which benefited from low interest rates and strong investor demand in a more stabilized market environment.
The following table provides investment banking deal information:
Three Months Ended June 30, (Dollars in billions) 2020 2019 Advisory services Aggregate transaction value$ 7.8 $ 4.8 Total transactions 55 46 Corporate financings Total equity transactions 42 22 Book run equity transactions 30 15 Total debt and preferred transactions 21 - Book run debt and preferred transactions 16 - Municipal negotiated issues Aggregate par value$ 5.9 $ 3.1 Total issues 223 134 Institutional brokerage revenues comprise all of the revenues generated through trading activities, which consist of facilitating customer trades, executing competitive municipal underwritings and our strategic trading activities in municipal bonds. Our results may vary from quarter to quarter as a result of changes in trading margins, trading gains and losses, net interest spreads, trading volumes, the timing of payments for research services, and the timing of transactions based on market opportunities. For the three months endedJune 30, 2020 , institutional brokerage revenues were$89.3 million , compared with$32.2 million in the prior-year period. Equity brokerage revenues were$40.6 million in the second quarter of 2020, up 162.8 percent compared with$15.5 million in the corresponding period of 2019, as market-wide volumes and volatility remained elevated from historical levels. Additionally, our results in the second quarter of 2020 reflect our expanded client base with the acquisitions ofSandler O'Neill andWeeden & Co. , execution expertise and product capabilities. For the three months endedJune 30, 2020 , fixed income services revenues were$48.7 million , up 191.0 percent compared with$16.7 million in the prior-year period. Revenues in the second quarter of 2020 were driven by the addition ofSandler O'Neill to our platform and strong client activity for taxable and tax-exempt products. The financial services team acquired withSandler O'Neill contributed strong revenues as they leveraged their expertise with banks to provide strategic advice on repositioning balance sheets, maximizing yields and managing risk. Interest income represents amounts earned from economically hedging and holding long inventory positions. For the three months endedJune 30, 2020 , interest income decreased to$3.1 million , compared with$6.9 million for the three months endedJune 30, 2019 , reflecting lower long inventory balances. We have focused on only carrying inventory where clients need liquidity within our areas of expertise. 53 -------------------------------------------------------------------------------- Table of Contents Investment income includes realized and unrealized gains and losses on investments, including amounts attributable to noncontrolling interests, in our merchant banking and energy funds, as well as management and performance fees generated from those funds. For the three months endedJune 30, 2020 , we recorded investment income of$3.7 million , compared with$17.6 million in the corresponding period of 2019. In the second quarter of 2020, we recorded lower gains on our investment and the noncontrolling interests in the merchant banking funds that we manage. Excluding the impact of noncontrolling interests, adjusted investment income was$1.5 million and$8.0 million for the three months endedJune 30, 2020 and 2019, respectively. Interest expense represents amounts associated with financing, economically hedging and holding short inventory positions, including interest paid on our long-term financing arrangements, as well as commitment fees on our line of credit and revolving credit facility. For the three months endedJune 30, 2020 , interest expense was$3.5 million , compared with$3.0 million in the prior-year period. In the second quarter of 2020, we recorded incremental interest expense on our long-term financing arrangements, which consist of the$175 million of fixed rate senior notes we issued onOctober 15, 2019 , and$20 million of unsecured promissory notes we entered into onApril 3, 2020 to fund a portion of the Valence purchase price. The increase was partially offset by a decline in interest expense resulting from lower average short inventory balances. Excluding the impact of interest expense on long-term financing, adjusted interest expense was$1.1 million for the three months endedJune 30, 2020 . Pre-tax margin for the three months endedJune 30, 2020 was 2.5 percent, compared with 12.1 percent for the corresponding period of 2019. The decrease in pre-tax margin was primarily due to an increased compensation ratio resulting from higher acquisition-related compensation. Adjusted pre-tax margin for the three months endedJune 30, 2020 was 17.7 percent, up compared with 12.8 percent for the corresponding period of 2019, reflecting the operating leverage in our business at higher revenue levels. 54 -------------------------------------------------------------------------------- Table of Contents Financial Summary for the six months endedJune 30, 2020 andJune 30, 2019
The following table provides a summary of the results of our operations on a
As a Percentage of Net Revenues for the Six Months Ended Six Months Ended June 30, June 30, 2020 (Amounts in thousands) 2020 2019 v2019 2020 2019 Revenues: Investment banking$ 358,825 $ 259,800 38.1 % 67.9 % 73.2 % Institutional brokerage 178,482 67,169 165.7 33.8 18.9 Interest income 9,130 14,430 (36.7) 1.7 4.1 Investment income/(loss) (10,093) 19,197 N/M (1.9) 5.4 Total revenues 536,344 360,596 48.7 101.5 101.6 Interest expense 7,738 5,636 37.3 1.5 1.6 Net revenues 528,606 354,960 48.9 100.0 100.0 Non-interest expenses: Compensation and benefits 401,684 219,603 82.9 76.0 61.9 Outside services 18,338 17,022 7.7 3.5 4.8 Occupancy and equipment 25,507 16,774 52.1 4.8 4.7 Communications 22,730 14,714 54.5 4.3 4.1 Marketing and business development 12,627 14,827 (14.8) 2.4 4.2 Deal-related expenses 16,144 11,453 41.0 3.1 3.2 Trade execution and clearance 11,463 2,823 306.1 2.2 0.8 Restructuring and integration costs 5,626 6,395 (12.0) 1.1 1.8 Intangible asset amortization 21,515 1,506 N/M 4.1 0.4 Other operating expenses 19,604 5,781 239.1 3.7 1.6 Total non-interest expenses 555,238 310,898 78.6 105.0 87.6 Income/(loss) from continuing operations before income tax expense/(benefit) (26,632) 44,062 N/M (5.0) 12.4 Income tax expense/(benefit) (7,074) 4,012 N/M (1.3) 1.1 Income/(loss) from continuing operations (19,558) 40,050 N/M (3.7) 11.3 Discontinued operations: Loss from discontinued operations, net of tax - (2,305) N/M - (0.6) Net income/(loss) (19,558) 37,745 N/M (3.7) 10.6 Net income/(loss) applicable to noncontrolling interests (6,285) 7,934 N/M (1.2) 2.2 Net income/(loss) applicable to Piper Sandler Companies$ (13,273) $ 29,811 N/M (2.5) % 8.4 % N/M - Not meaningful
Except as discussed below, the description of non-interest expenses and net revenues as well as the underlying reasons for variances to prior year are substantially the same as the comparative quarterly discussion.
55 -------------------------------------------------------------------------------- Table of Contents For the six months endedJune 30, 2020 , we recorded a net loss from continuing operations applicable to Piper Sandler Companies of$13.3 million . Net revenues from continuing operations for the six months endedJune 30, 2020 increased 48.9 percent to$528.6 million , compared with$355.0 million in the year-ago period, as the acquisitions ofSandler O'Neill andWeeden & Co. have provided diversification, scale and durability across our platform. In the first half of 2020, investment banking revenues increased 38.1 percent to$358.8 million , compared with$259.8 million the prior-year period, primarily due to higher corporate and municipal financing revenues. For the six months endedJune 30, 2020 , institutional brokerage revenues increased 165.7 percent to$178.5 million , compared with$67.2 million in the first half of 2019. The increase was due to the acquisitions ofWeeden & Co. andSandler O'Neill , as well as higher volatility in the financial markets, particularly in the first quarter of 2020, driving higher trading volumes. In the first six months of 2020, net interest income decreased to$1.4 million , compared with$8.8 million in the prior-year period, driven by a decline in interest income on our long inventory positions and incremental interest expense on our long-term financing arrangements. For the six months endedJune 30, 2020 , we recorded an investment loss of$10.1 million , compared with income of$19.2 million in the prior-year period. In the first half of 2020, we recorded unrealized losses on our investment and the noncontrolling interests in the merchant banking funds that we manage. Non-interest expenses from continuing operations were$555.2 million for the six months endedJune 30, 2020 , up 78.6 percent compared with$310.9 million in the year-ago period, primarily due to higher compensation and non-compensation expenses resulting from our recent acquisitions.
Consolidated Non-Interest Expenses from Continuing Operations
Compensation and Benefits - For the six months endedJune 30, 2020 , compensation and benefits expenses increased 82.9 percent to$401.7 million , compared with$219.6 million in the corresponding period of 2019. The increase in compensation and benefits expenses was driven by increased revenues and incremental headcount from our recent acquisitions, as well as higher acquisition-related compensation related to restricted consideration and retention awards associated with these acquisitions. We also recorded additional compensation expense for an earnout associated with the acquisition ofWeeden & Co. related to our expectations of achieving a net revenue target, as our equity brokerage business is outperforming initial projections. Compensation and benefits expenses as a percentage of net revenues was 76.0 percent in the first half of 2020, compared with 61.9 percent in the corresponding period of 2019. The compensation ratio was impacted by increased acquisition-related compensation related to our recent acquisitions. Other Operating Expenses - For the six months endedJune 30, 2020 , other operating expenses were$19.6 million , compared with$5.8 million in the corresponding period of 2019. In the first quarter of 2020, we recorded a$12.1 million fair value adjustment related to the earnout for former Weeden & Co. equity ownerswho did not transition to our platform. We are required to record the full value of the projected earnout as the non-employee equity owners do not have service requirements. Income Taxes - For the six months endedJune 30, 2020 , our provision for income taxes was a benefit of$7.1 million , which included$2.6 million of income tax benefits related to new tax provisions in the CARES Act. Excluding the impact of these benefits and noncontrolling interests, our effective tax rate was 22.2 percent. For the six months endedJune 30, 2019 , our provision for income taxes was$4.0 million . In the first half of 2019, we recorded a$5.1 million tax benefit related to stock-based compensation awards vesting at values greater than the grant price. Excluding the impact of this benefit and noncontrolling interests, our effective tax rate was 25.3 percent. 56 -------------------------------------------------------------------------------- Table of Contents Financial Performance from Continuing Operations
The following table sets forth the adjusted, non-GAAP financial results and
adjustments necessary to reconcile to our consolidated
Six Months Ended June 30, 2020 2019 Adjustments (1) Adjustments (1) Total Noncontrolling Other U.S. Total Noncontrolling Other U.S. (Amounts in thousands) Adjusted Interests Adjustments GAAP Adjusted Interests Adjustments GAAP Investment banking Advisory services$ 196,795 $ - $ -$ 196,795 $ 190,117 $ - $ -$ 190,117 Corporate financing 108,624 - - 108,624 39,234 - - 39,234 Municipal financing 53,406 - - 53,406 30,449 - - 30,449 Total investment banking 358,825 - - 358,825 259,800 - - 259,800 Institutional brokerage Equity brokerage 88,497 - - 88,497 31,374 - - 31,374 Fixed income services 89,985 - - 89,985 35,795 - - 35,795 Total institutional brokerage 178,482 - - 178,482 67,169 - - 67,169 Interest income 9,130 9,130 14,430 14,430 Investment income/(loss) (5,792) (4,301) - (10,093) 9,145 10,052 - 19,197 Total revenues 540,645 (4,301) - 536,344 350,544 10,052 - 360,596 Interest expense 3,056 - 4,682 7,738 5,636 - - 5,636 Net revenues 537,589 (4,301) (4,682) 528,606 344,908 10,052 - 354,960 Non-interest expenses 456,809 1,984 96,445 555,238 297,129 2,118 11,651 310,898 Pre-tax income/(loss)$ 80,780 $ (6,285) $ (101,127) $ (26,632) $ 47,779 $ 7,934 $ (11,651) $ 44,062 Pre-tax margin 15.0 % (5.0) % 13.9 % 12.4 % (1) The following is a summary of the adjustments needed to reconcile our consolidatedU.S. GAAP financial results to the adjusted financial results: Noncontrolling interests - The impacts of consolidating noncontrolling interests in our alternative asset management funds are not included in our adjusted financial results. Other adjustments - The following items are not included in our adjusted financial results: Six Months Ended June 30, (Amounts in thousands) 2020 2019 Interest expense on long-term financing$ 4,682 $ - Compensation from acquisition-related agreements 57,219 3,636 Acquisition-related restructuring and integration costs 5,626 6,395 Amortization of intangible assets related to acquisitions 21,515 1,506 Non-compensation expenses from acquisition-related agreements 12,085 114 96,445 11,651 Total other adjustments$ 101,127 $ 11,651 Net revenues on aU.S. GAAP basis were$528.6 million for the six months endedJune 30, 2020 , compared with$355.0 million in the prior-year period. In the first half of 2020, adjusted net revenues were$537.6 million , compared with$344.9 million in the first half of 2019. The variance explanations for net revenues and adjusted net revenues are consistent on both aU.S. GAAP and non-GAAP basis unless stated otherwise. 57 -------------------------------------------------------------------------------- Table of Contents In the first half of 2020, investment banking revenues were$358.8 million , up 38.1 percent compared with$259.8 million in the corresponding period of the prior year. For the six months endedJune 30, 2020 , advisory services revenues were$196.8 million , up slightly compared with$190.1 million in the first half of 2019. Incremental revenues from the addition ofSandler O'Neill to our platform offset the decline in revenues resulting from market-wide decreases in completed and announced deals, which reflects a pause in advisory services activity as companies evaluate the changing and uncertain environment due to COVID-19. For the six months endedJune 30, 2020 , corporate financing revenues were$108.6 million , an increase of 176.9 percent compared with$39.2 million in the prior-year period, due to more completed and book run equity deals, and the addition ofSandler O'Neill to our platform. In the first half of 2020, our revenues on equity offerings in the sub-$5 billion fee pool were up approximately 144 percent compared to approximately 46 percent for the overall market. Additionally, activity in the first quarter of 2019 was impacted by theU.S. federal government shut-down. Municipal financing revenues for the six months endedJune 30, 2020 were$53.4 million , up 75.4 percent compared with$30.4 million in the year-ago period. Despite a rapid decline in the level of activity in March due to significant volatility in the fixed income markets, our results in the first half of 2020 were driven by robust new issuance and refunding activity as interest rates remained low. The par amount of our negotiated municipal issuances increased approximately 98 percent in the first half of 2020, compared to an increase of approximately 34 percent for the industry.
The following table provides investment banking deal information:
Six Months Ended June 30, (Dollars in billions) 2020 2019 Advisory services Aggregate transaction value$ 15.4 $ 16.7 Total transactions 112 81 Corporate financings Total equity transactions 54 34 Book run equity transactions 41 22 Total debt and preferred transactions 29 - Book run debt and preferred transactions 19 - Municipal negotiated issues Aggregate par value$ 9.5 $ 4.8 Total issues 371 218 For the six months endedJune 30, 2020 , institutional brokerage revenues increased 165.7 percent to$178.5 million , compared with$67.2 million in the prior-year period. Equity brokerage revenues increased 182.1 percent to$88.5 million in the first half of 2020, compared with$31.4 million in the corresponding period of 2019. In the first quarter of 2020, the increased volatility market-wide drove a significant increase in volumes as investors repositioned in response to market uncertainty and fund outflows. Volatility and volumes remained at elevated levels in the second quarter of 2020, albeit down from the significant levels experienced in the first quarter. Additionally, we continue to leverage our expanded client base, execution expertise and product capabilities. For the six months endedJune 30, 2020 , fixed income services revenues were$90.0 million , up 151.4 percent compared with$35.8 million in the prior-year period, due to the addition ofSandler O'Neill to our platform. Additionally, in the first quarter of 2020, the historically volatile quarter and higher volumes in municipals drove client activity as we provided liquidity to municipal bond funds which saw significant outflows by identifying buyerswho took advantage of meaningfully higher yields. The strong client activity was partially offset by trading losses in municipal securities due to the sharp and sudden market dislocation. Interest income for the six months endedJune 30, 2020 decreased 36.7 percent to$9.1 million , compared with$14.4 million in the prior-year period, reflecting lower levels of long inventory positions. 58 -------------------------------------------------------------------------------- Table of Contents For the six months endedJune 30, 2020 , we recorded an investment loss of$10.1 million , compared with income of$19.2 million in the year-ago period. In the first six months of 2020, we recorded unrealized losses on our investment and the noncontrolling interests in the merchant banking funds that we manage. Lower equity valuations and an uncertain and challenging operating environment for some of our portfolio companies drove the fair value adjustments in our merchant banking portfolio. Excluding the impact of noncontrolling interests, adjusted investment loss was$5.8 million for the six months endedJune 30, 2020 , compared with adjusted investment income of$9.1 million for the six months endedJune 30, 2019 . Interest expense for the six months endedJune 30, 2020 was$7.7 million , up compared with$5.6 million in the prior-year period, driven by incremental interest expense from our long-term financing arrangements. Long-term financing consists of our fixed rate senior notes issued onOctober 15, 2019 and the unsecured promissory notes we entered into onApril 3, 2020 to fund a portion of the Valence purchase price. The increase was partially offset by a decline in interest expense resulting from lower average short inventory balances. Excluding the impact of interest expense on long-term financing, adjusted interest expense was$3.1 million for the six months endedJune 30, 2020 . Pre-tax margin for the six months endedJune 30, 2020 was a negative 5.0 percent, compared with 12.4 percent for the corresponding period of 2019. The negative pre-tax margin for the six months endedJune 30, 2020 primarily resulted from higher acquisition-related compensation and non-compensation expenses, and intangible asset amortization. Adjusted pre-tax margin for the six months endedJune 30, 2020 was 15.0 percent, compared with 13.9 percent for the corresponding period of 2019. Adjusted pre-tax margin increased driven by the scale of our platform and cost synergies realized through theSandler O'Neill andWeeden & Co. acquisitions.
Discontinued Operations
Discontinued operations includes our traditional asset management subsidiary, ARI, which we sold in the third quarter of 2019. For the three and six months endedJune 30, 2019 , we recorded a loss from discontinued operations, net of tax, of$2.2 million and$2.3 million , respectively. See Note 4 to our unaudited consolidated financial statements for further discussion of our discontinued operations.
Recent Accounting Pronouncements
Recent accounting pronouncements are set forth in Note 2 to our unaudited consolidated financial statements, and are incorporated herein by reference.
Critical Accounting Policies
Our accounting and reporting policies comply withU.S. GAAP and conform to practices within the securities industry. The preparation of financial statements in compliance withU.S. GAAP and industry practices requires us to make estimates and assumptions that could materially affect amounts reported in our consolidated financial statements. Critical accounting policies are those policies that we believe to be the most important to the portrayal of our financial condition and results of operations and that require us to make estimates that are difficult, subjective or complex. Most accounting policies are not considered by us to be critical accounting policies. Several factors are considered in determining whether or not a policy is critical, including whether the estimates are significant to the consolidated financial statements taken as a whole, the nature of the estimates, the ability to readily validate the estimates with other information (e.g., third party or independent sources), the sensitivity of the estimates to changes in economic conditions and whether alternative accounting methods may be used underU.S. GAAP.
We believe that of our significant accounting policies, the following are our critical accounting policies:
•Valuation of Financial Instruments •Goodwill and Intangible Assets •Compensation Plans •Income Taxes See the "Critical Accounting Policies" section and Note 2 to our consolidated financial statements included in our Annual Report on Form 10-K for the year endedDecember 31, 2019 for further information on our critical accounting policies. 59 -------------------------------------------------------------------------------- Table of Contents Liquidity, Funding and Capital Resources Liquidity is of critical importance to us given the nature of our business. Insufficient liquidity resulting from adverse circumstances contributes to, and may be the cause of, financial institution failure. Accordingly, we regularly monitor our liquidity position and maintain a liquidity strategy designed to enable our business to continue to operate even under adverse circumstances, although there can be no assurance that our strategy will be successful under all circumstances. The majority of our tangible assets consist of assets readily convertible into cash. Financial instruments and other inventory positions owned are stated at fair value and are generally readily marketable in most market conditions. Receivables and payables with brokers, dealers and clearing organizations usually settle within a few days. As part of our liquidity strategy, we emphasize diversification of funding sources to the extent possible while considering tenor and cost. Our assets are financed by our cash flows from operations, equity capital and our funding arrangements. The fluctuations in cash flows from financing activities are directly related to daily operating activities from our various businesses. One of our most important risk management disciplines is our ability to manage the size and composition of our balance sheet. While our asset base changes due to client activity, market fluctuations and business opportunities, the size and composition of our balance sheet reflect our overall risk tolerance, our ability to access stable funding sources and the amount of equity capital we hold.
Certain market conditions can impact the liquidity of our inventory positions, requiring us to hold larger inventory positions for longer than expected or requiring us to take other actions that may adversely impact our results.
A significant component of our employees' compensation is paid in annual discretionary incentive compensation. The timing of these incentive compensation payments, which generally are made in February, has a significant impact on our cash position and liquidity. Our capital and liquidity positions remain strong, our leverage is low, and our risk posture remains conservative. We have reduced inventory levels and remain prudent in allocating capital as we continue to adapt and respond to the changing market conditions. Our dividend policy is intended to return between 30 percent and 50 percent of our adjusted net income from the previous fiscal year to shareholders. This includes the payment of a quarterly and an annual special cash dividend, payable in the first quarter of each year. Our board of directors determines the declaration and payment of dividends on an annual and quarterly basis, and is free to change our dividend policy at any time. Although the quarterly cash dividend of$0.30 per share declared by our board of directors onJuly 31, 2020 increased compared to the previous quarter, it is lower compared to our 2019 quarterly dividends, as we prudently manage capital and maintain our balance sheet strength and flexibility during this challenging environment. Our board of directors declared the following dividends on shares of our common stock: Dividend Declaration Date Per Share Record Date Payment Date February 1, 2019 (1)$ 1.010 February 25, 2019 March 15, 2019 February 1, 2019$ 0.375 February 25, 2019 March 15, 2019 April 26, 2019$ 0.375 May 24, 2019 June 14, 2019 July 26, 2019$ 0.375 August 23, 2019 September 13, 2019 October 30, 2019$ 0.375 November 22, 2019 December 13, 2019 January 31, 2020 (2)$ 0.750 March 2, 2020 March 13, 2020 January 31, 2020$ 0.375 March 2, 2020 March 13, 2020 May 1, 2020$ 0.200 May 29, 2020 June 12, 2020 July 31, 2020$ 0.300 August 28, 2020 September 11, 2020 (1) Represents the annual special cash dividend based on our fiscal year 2018 results. (2) Represents the annual special cash dividend based on our fiscal year 2019 results. 60 -------------------------------------------------------------------------------- Table of Contents EffectiveJanuary 1, 2020 , our board of directors authorized the repurchase of up to$150.0 million in common shares throughDecember 31, 2021 . During the six months endedJune 30, 2020 , we repurchased 128,865 shares of our common stock at an average price of$71.58 per share for an aggregate purchase price of$9.2 million related to this authorization. AtJune 30, 2020 , we had$140.8 million remaining under this authorization. We also purchase shares of common stock from restricted stock award recipients upon the award vesting or as recipients sell shares to meet their employment tax obligations. During the first half of 2020, we purchased 98,136 shares or$8.3 million of our common stock for these purposes.
Leverage
The following table presents total assets, adjusted assets, total shareholders' equity and tangible shareholders' equity with the resulting leverage ratios: June 30, December 31, (Dollars in thousands) 2020 2019 Total assets$ 1,710,908 $ 1,628,719 Deduct: Goodwill and intangible assets (383,080)
(104,335)
Deduct: Right-of-use lease asset (91,929)
(40,030)
Deduct: Assets from noncontrolling interests (69,067) (76,516)
Adjusted assets$ 1,166,832 $
1,407,838
Total shareholders' equity$ 813,712 $
806,528
Deduct:Goodwill and intangible assets (383,080)
(104,335)
Deduct: Noncontrolling interests (67,756)
(75,245)
Tangible common shareholders' equity$ 362,876 $ 626,948 Leverage ratio (1) 2.1 2.0 Adjusted leverage ratio (2) 3.2 2.2 (1)Leverage ratio equals total assets divided by total shareholders' equity. (2)Adjusted leverage ratio equals adjusted assets divided by tangible common shareholders' equity. Adjusted assets and tangible common shareholders' equity are non-GAAP financial measures.Goodwill and intangible assets are subtracted from total assets and total shareholders' equity in determining adjusted assets and tangible common shareholders' equity, respectively, as we believe that goodwill and intangible assets do not constitute operating assets that can be deployed in a liquid manner. The right-of-use lease asset is also subtracted from total assets in determining adjusted assets as it is not an operating asset that can be deployed in a liquid manner. Amounts attributed to noncontrolling interests are subtracted from total assets and total shareholders' equity in determining adjusted assets and tangible common shareholders' equity, respectively, as they represent assets and equity interests in consolidated entities that are not attributable, either directly or indirectly, to Piper Sandler Companies. We view the resulting measure of adjusted leverage, also a non-GAAP financial measure, as a more relevant measure of financial risk when comparing financial services companies. Our adjusted leverage ratio increased fromDecember 31, 2019 primarily due to the goodwill and intangible assets related to our acquisitions ofSandler O'Neill and Valence.
Funding and Capital Resources
The primary goal of our funding activities is to ensure adequate funding over a wide range of market conditions. Given the mix of our business activities, funding requirements are fulfilled through a diversified range of short-term and long-term financing. We attempt to ensure that the tenor of our borrowing liabilities equals or exceeds the expected holding period of the assets being financed. Our ability to support increases in total assets is largely a function of our ability to obtain funding from external sources. Access to these external sources, as well as the cost of that financing, is dependent upon various factors, including market conditions, the general availability of credit and credit ratings. We currently do not have a credit rating, which could adversely affect our liquidity and competitive position by increasing our financing costs and limiting access to sources of liquidity that require a credit rating as a condition to providing the funds. 61 -------------------------------------------------------------------------------- Table of Contents Our day-to-day funding and liquidity is obtained primarily through the use of our clearing arrangement withPershing LLC ("Pershing"), commercial paper issuance, a prime broker agreement, and a bank line of credit, and is typically collateralized by our securities inventory. These funding sources are critical to our ability to finance and hold inventory, which is a necessary part of our institutional brokerage business. The majority of our inventory is liquid and is therefore funded by short-term facilities. Certain of these short-term facilities (i.e., committed line and commercial paper) have been established to mitigate changes in the liquidity of our inventory based on changing market conditions. In the case of our committed line, it is available to us regardless of changes in market liquidity conditions through the end of its term, although there may be limitations on the type of securities available to pledge. Our commercial paper program helps mitigate changes in market liquidity conditions given it is not an overnight facility, but provides funding with a term of 27 to 270 days. Our funding sources are also dependent on the types of inventory that our counterparties are willing to accept as collateral and the number of counterparties available. Funding is generally obtained at rates based upon the federal funds rate or the London Interbank Offered Rate ("LIBOR"). Pershing Clearing Arrangement - We have established an arrangement to obtain financing from Pershing related to the majority of our trading activities. Under our fully disclosed clearing agreement, the majority of our securities inventories and all of our customer activities are held by or cleared through Pershing. Financing under this arrangement is secured primarily by securities, and collateral limitations could reduce the amount of funding available under this arrangement. Our clearing arrangement activities are recorded net from trading activity and reported within receivables from or payables to brokers, dealers and clearing organizations. The funding is at the discretion of Pershing (i.e., uncommitted) and could be denied without a notice period. Our fully disclosed clearing agreement includes a covenant requiringPiper Sandler & Co. , ourU.S. broker dealer subsidiary, to maintain excess net capital of$120 million . AtJune 30, 2020 , we had$0.2 million of financing outstanding under this arrangement. Commercial Paper Program -Piper Sandler & Co. issues secured commercial paper to fund a portion of its securities inventory. This commercial paper is currently issued under the CP Series II A program, and is secured by different inventory classes, which is reflected in the interest rate paid. The program can issue commercial paper with maturities of 27 to 270 days. CP Series II A includes a covenant that requiresPiper Sandler & Co. to maintain excess net capital of$100 million . We retired the CP Series A program onJanuary 2, 2020 .
The following table provides information about our CP Series II A program at
(Dollars in millions) CP
Series II A
Maximum amount that may be issued $
200.0
Amount outstanding
50.0
Weighted average maturity, in days 6 Weighted average maturity at issuance, in days 32 Prime Broker Arrangement - We have established an overnight financing arrangement with a broker dealer related to our convertible securities inventories. Financing under this arrangement is secured primarily by convertible securities and collateral limitations could reduce the amount of funding available. The funding is at the discretion of the prime broker and could be denied subject to a notice period. This arrangement is reported within receivables from or payables to brokers, dealers and clearing organizations, net of trading activity. AtJune 30, 2020 , we had$99.5 million of financing outstanding under this prime broker arrangement. Committed Line - Our committed line is a one-year$125 million revolving secured credit facility. Advances under this facility are secured by certain marketable securities. The facility includes a covenant that requiresPiper Sandler & Co. to maintain a minimum regulatory net capital of$120 million , and the unpaid principal amount of all advances under the facility will be due onDecember 11, 2020 . This credit facility has been in place since 2008 and we renewed the facility for another one-year term in the fourth quarter of 2019. AtJune 30, 2020 , we had no advances against this line of credit. Revolving Credit Facility - Our parent company, Piper Sandler Companies, has an unsecured$50 million revolving credit facility withU.S. Bank N.A. The credit agreement will terminate onDecember 20, 2022 , unless otherwise terminated, and is subject to a one-year extension exercisable at our option. AtJune 30, 2020 , we had advances of$50 million against this credit facility. Early in the third quarter of 2020, we repaid$25 million related to this credit facility. 62 -------------------------------------------------------------------------------- Table of Contents This credit facility includes customary events of default and covenants that, among other things, requirePiper Sandler & Co. to maintain a minimum regulatory net capital of$120 million , limit our leverage ratio, require maintenance of a minimum ratio of operating cash flow to fixed charges, and impose certain limitations on our ability to make acquisitions and make payments on our capital stock. AtJune 30, 2020 , we were in compliance with all covenants.
The following table presents the average balances outstanding for our various funding sources by quarter for 2020 and 2019:
Average Balance for the Three Months Ended (Amounts in millions) June 30, 2020 Mar. 31, 2020 Funding source: Pershing clearing arrangement$ 17.7 $ 117.8 Commercial paper 50.0 50.0 Prime broker arrangement 81.9 72.3 Revolving credit facility 50.0 7.1 Total$ 199.6 $ 247.2 Average Balance for the Three Months Ended (Amounts in millions) Dec. 31, 2019
$ 22.9 $ 94.6 $ 170.2 $ 82.1 Commercial paper 50.0 50.0 50.0 50.0 Prime broker arrangement 99.7 68.0 77.1 106.4 Total$ 172.6 $ 212.6 $ 297.3 $ 238.5 The average funding in the second quarter of 2020 decreased to$199.6 million , compared with$247.2 million during the first quarter of 2020 and$297.3 million during the second quarter of 2019, due to lower inventory balances during the current quarter, as well as the accumulation of cash from operations. The decrease was offset by borrowings under our revolving credit facility, which we drew on to finance the upfront cash consideration of our acquisition of Valence, which closed onApril 3, 2020 . The following table presents the maximum daily funding amount by quarter for 2020 and 2019: (Amounts in millions) 2020 2019 First Quarter$ 642.1 $ 362.7 Second Quarter$ 378.3 $ 427.1 Third Quarter$ 416.0 Fourth Quarter$ 330.7 Long-term Financing Senior Notes - OnOctober 15, 2019 , we entered into a note purchase agreement ("Note Purchase Agreement") under which we issued unsecured fixed rate senior notes ("Notes") in the amount of$175 million . The initial holders of the Notes are certain entities advised by Pacific Investment Management Company ("PIMCO"). The Notes consist of two classes, Class A Notes and ClassB Notes , with principal amounts of$50 million and$125 million , respectively. The Class A Notes bear interest at an annual fixed rate of 4.74 percent and mature onOctober 15, 2021 . The ClassB Notes bear interest at an annual fixed rate of 5.20 percent and mature onOctober 15, 2023 . Interest on the Notes is payable semi-annually. The unpaid principal amounts are due in full on the respective maturity dates and may not be prepaid. The Note Purchase Agreement includes customary events of default and covenants that, among other things, requirePiper Sandler & Co. to maintain a minimum regulatory net capital, limit our leverage ratio and require maintenance of a minimum ratio of operating cash flow to fixed charges. AtJune 30, 2020 , we were in compliance with all covenants. 63 -------------------------------------------------------------------------------- Table of Contents Valence Notes - OnApril 3, 2020 , we entered into unsecured promissory notes as part of the acquisition of Valence totaling$20 million (the "Valence Notes"). The Valence Notes bear interest at an annual fixed rate of 5.0 percent and mature onOctober 15, 2021 . Interest is payable quarterly in arrears.
Contractual Obligations
Our contractual obligations have not materially changed from those reported in Part II, Item 7 of our Annual Report on Form 10-K for the year endedDecember 31, 2019 , except for our operating lease obligations, purchase commitments and long-term financing. In conjunction with our acquisitions ofSandler O'Neill and Valence, we acquired various leases and agreements related to new purchase commitments. Additionally, we entered into the Valence Notes, which are included in long-term financing on the consolidated statements of financial condition. Remainder of 2021 2023 2025 and (Amounts in millions) 2020 - 2022 - 2024 thereafter Total Operating lease obligations$ 12.8 $ 44.5 $ 33.4 $ 35.4 $ 126.1 Purchase commitments 12.7 23.2 7.6 8.8 52.3 Long-term financing - 70.0 125.0 - 195.0 Purchase commitments include agreements to purchase goods or services that are enforceable and legally binding and that specify all significant terms, including fixed or minimum quantities to be purchased, fixed, minimum or variable price provisions, and the approximate timing of the transaction. Purchase commitments with variable pricing provisions are included in the table based on the minimum contractual amounts. Certain purchase commitments contain termination or renewal provisions. The table reflects the minimum contractual amounts likely to be paid under these agreements assuming the contracts are not terminated. Capital Requirements As a registered broker dealer and member firm of theFinancial Industry Regulatory Authority, Inc. ("FINRA"),Piper Sandler & Co. is subject to the uniform net capital rule of theSEC and the net capital rule ofFINRA . We have elected to use the alternative method permitted by the uniform net capital rule which requires that we maintain minimum net capital of$1.0 million . Advances to affiliates, repayment of subordinated liabilities, dividend payments and other equity withdrawals are subject to certain approvals, notifications and other provisions of the uniform net capital rules. We expect that these provisions will not impact our ability to meet current and future obligations. AtJune 30, 2020 , our net capital under theSEC's uniform net capital rule was$153.4 million , and exceeded the minimum net capital required under theSEC rule by$152.4 million . Although we operate with a level of net capital substantially greater than the minimum thresholds established byFINRA and theSEC , a substantial reduction of our capital would curtail many of our capital markets revenue producing activities. Our committed short-term credit facility, revolving credit facility and senior notes with PIMCO include covenants requiringPiper Sandler & Co. to maintain a minimum regulatory net capital of$120 million . Secured commercial paper issued under CP Series II A includes a covenant that requiresPiper Sandler & Co. to maintain excess net capital of$100 million . Our fully disclosed clearing agreement with Pershing also includes a covenant requiringPiper Sandler & Co. to maintain excess net capital of$120 million . AtJune 30, 2020 ,Piper Sandler Ltd. , our broker dealer subsidiary registered in theU.K. , was subject to, and was in compliance with, the capital requirements of thePrudential Regulation Authority and theFinancial Conduct Authority pursuant to the Financial Services Act of 2012.Piper Sandler Hong Kong Limited is licensed by theHong Kong Securities and Futures Commission , which is subject to the liquid capital requirements of the Securities and Futures (Financial Resources) Rule promulgated under the Securities and Futures Ordinance. AtJune 30, 2020 ,Piper Sandler Hong Kong Limited was in compliance with the liquid capital requirements of theHong Kong Securities and Futures Commission . 64 -------------------------------------------------------------------------------- Table of Contents Off-Balance Sheet Arrangements In the ordinary course of business we enter into various types of off-balance sheet arrangements. The following table summarizes the notional contract value of our off-balance sheet arrangements for the periods presented: Expiration Per Period atDecember 31 , Total
Contractual Amount
2023 2025 June 30, December 31, (Amounts in thousands) 2020 2021 2022 - 2024 - 2026 Later 2020 2019 Customer matched-book derivative contracts (1) (2)$ 22,840 $ 6,930 $ 24,150 $ 139,670 $ 15,160 $ 1,800,203 $ 2,008,953 $ 2,197,340 Trading securities derivative contracts (2) 105,400 12,000 - - - 9,375 126,775 110,875 Equity option derivative contracts (2) 4,910 5,183 - - - - 10,093 - Investment commitments (3) - - - - - - 70,857 70,953 (1)Consists of interest rate swaps. We have minimal market risk related to these matched-book derivative contracts; however, we do have counterparty risk with one major financial institution, which is mitigated by collateral deposits. In addition, we have a limited number of counterparties (contractual amount of$171.9 million atJune 30, 2020 )who are not required to post collateral. The uncollateralized amounts, representing the fair value of the derivative contracts, expose us to the credit risk of these counterparties. AtJune 30, 2020 , we had$27.5 million of credit exposure with these counterparties, including$23.2 million of credit exposure with one counterparty. (2)We believe the fair value of these derivative contracts is a more relevant measure of the obligations because we believe the notional or contract amount overstates the expected payout. AtJune 30, 2020 andDecember 31, 2019 , the net fair value of these derivative contracts approximated$20.2 million and$16.3 million , respectively. (3)The investment commitments have no specified call dates. The timing of capital calls is based on market conditions and investment opportunities.
Derivatives
Derivatives' notional or contract amounts are not reflected as assets or liabilities on our consolidated statements of financial condition. Rather, the fair value of the derivative transactions are reported on the consolidated statements of financial condition as assets or liabilities in financial instruments and other inventory positions owned and financial instruments and other inventory positions sold, but not yet purchased, as applicable. For a discussion of our activities related to derivative products, see Note 5 in the notes to our unaudited consolidated financial statements.
Investment Commitments
We have investments, including those made as part of our merchant banking activities, in various limited partnerships or limited liability companies that provide financing or make investments in companies. We commit capital and/or act as the managing partner of these entities. We have committed capital of$70.9 million to certain entities and these commitments generally have no specified call dates.
Replacement of Interbank Offered Rates ("IBORs"), including LIBOR
Central banks and regulators in a number of major jurisdictions (e.g.,U.S. ,U.K. ,European Union ,Switzerland andJapan ) have convened working groups to find, and implement the transition to, suitable replacements for IBORs.The U.K. Financial Conduct Authority , which regulates LIBOR, has announced that it will not compel panel banks to contribute to LIBOR after 2021. We have a limited number of contractual agreements which use LIBOR. We do not expect the transition from LIBOR to a replacement rate to have a significant impact on our operations. 65 -------------------------------------------------------------------------------- Table of Contents Risk Management Risk is an inherent part of our business. The principal risks we face in operating our business include: strategic risk, market risk, liquidity risk, credit risk, operational risk, human capital risk, and legal and regulatory risks. The extent to which we properly identify and effectively manage each of these risks is critical to our financial condition and profitability. We have a formal risk management process to identify, assess and monitor each risk and mitigating controls in accordance with defined policies and procedures. The risk management functions are independent of our business lines. Our management takes an active role in the risk management process, and the results are reported to senior management and the Board of Directors. The audit committee of the Board of Directors oversees management's processes for identifying and evaluating our major risks, and the policies, procedures and practices employed by management to govern its risk assessment and risk management processes. The nominating and governance committee of the Board of Directors oversees the Board of Directors' committee structures and functions as they relate to the various committees' responsibilities with respect to oversight of our major risk exposures. With respect to these major risk exposures, the audit committee is responsible for overseeing management's monitoring and control of our major risk exposures relating to market risk, credit risk, liquidity risk, legal and regulatory risks, operational risk (including cybersecurity), and human capital risk relating to misconduct, fraud, and legal and compliance matters. Our compensation committee is responsible for overseeing management's monitoring and control of our major risk exposures relating to compensation, organizational structure, and succession. Our Board of Directors is responsible for overseeing management's monitoring and control of our major risk exposures related to our corporate strategy. Our Chief Executive Officer and Chief Financial Officer meet with the audit committee on a quarterly basis to discuss our market, liquidity, and legal and regulatory risks, and provide updates to the Board of Directors, audit committee, and compensation committee concerning the other major risk exposures on a regular basis. We use internal committees to assist in governing risk and ensure that our business activities are properly assessed, monitored and managed. Our executive financial risk committee manages our market, liquidity and credit risks; oversees risk management practices related to these risks, including defining acceptable risk tolerances and approving risk management policies; and responds to market changes in a dynamic manner. Membership is comprised of senior leadership, including but not limited to, our Chief Executive Officer, President, Chief Financial Officer, Treasurer, Head of Market and Credit Risk, and Head of Fixed Income Trading. Other committees that help evaluate and monitor risk include underwriting, leadership team and operating committees. These committees help manage risk by ensuring that business activities are properly managed and within a defined scope of activity. Our valuation committee, comprised of members of senior management and risk management, provide oversight and overall responsibility for the internal control processes and procedures related to fair value measurements. Additionally, our operational risk committees address and monitor risk related to information systems and security, legal, regulatory and compliance matters, and third parties such as vendors and service providers. With respect to market risk and credit risk, the cornerstone of our risk management process is daily communication among traders, trading department management and senior management concerning our inventory positions, including those associated with our strategic trading activities, and overall risk profile. Our risk management functions supplement this communication process by providing their independent perspectives on our market and credit risk profile on a daily basis. The broader objectives of our risk management functions are to understand the risk profile of each trading area, to consolidate risk monitoring company-wide, to assist in implementing effective hedging strategies, to articulate large trading or position risks to senior management, and to ensure accurate fair values of our financial instruments. Risk management techniques, processes and strategies may not be fully effective in mitigating our risk exposure in all market environments or against all types of risk, and any risk management failures could expose us to material unanticipated losses.
Strategic Risk
Strategic risk represents the risk associated with executive management failing to develop and execute on the appropriate strategic vision which demonstrates a commitment to our culture, leverages our core competencies, appropriately responds to external factors in the marketplace, and is in the best interests of our clients, employees and shareholders. Our leadership team is responsible for managing our strategic risks. The Board of Directors oversees the leadership team in setting and executing our strategic plan. 66 -------------------------------------------------------------------------------- Table of Contents Market Risk Market risk represents the risk of losses, or financial volatility, that may result from the change in value of a financial instrument due to fluctuations in its market price. Our exposure to market risk is directly related to our role as a financial intermediary for our clients, to our market-making activities and our strategic trading activities. Market risks are inherent to both cash and derivative financial instruments. The scope of our market risk management policies and procedures includes all market-sensitive financial instruments.
Our different types of market risk include:
Interest Rate Risk - Interest rate risk represents the potential volatility from changes in market interest rates. We are exposed to interest rate risk arising from changes in the level and volatility of interest rates, changes in the slope of the yield curve, changes in credit spreads, and the rate of prepayments on our interest-earning assets (e.g., inventories) and our funding sources (e.g., short-term financing) which finance these assets. Interest rate risk is managed by selling shortU.S. government securities, agency securities, corporate debt securities and derivative contracts. See Note 5 of our accompanying unaudited consolidated financial statements for additional information on our derivative contracts. Our interest rate hedging strategies may not work in all market environments and as a result may not be effective in mitigating interest rate risk. Also, we establish limits on the notional level of our fixed income securities inventory and manage net positions within those limits. Equity Price Risk - Equity price risk represents the potential loss in value due to adverse changes in the level or volatility of equity prices. We are exposed to equity price risk through our trading activities primarily in the U.S. market. We attempt to reduce the risk of loss inherent in our market-making and in our inventory of equity securities by establishing limits on the notional level of our inventory and by managing net position levels within those limits. Foreign Exchange Risk - Foreign exchange risk represents the potential volatility to earnings or capital arising from movement in foreign exchange rates. A modest portion of our business is conducted in currencies other than theU.S. dollar, and changes in foreign exchange rates relative to theU.S. dollar can therefore affect the value of non-U.S. dollar net assets, revenues and expenses. A change in the foreign currency rates could create either a foreign currency transaction gain/loss (recorded in our consolidated statements of operations) or a foreign currency translation adjustment (recorded to accumulated other comprehensive income/(loss) within the shareholders' equity section of our consolidated statements of financial condition and other comprehensive income/ (loss) within the consolidated statements of comprehensive income). Value-at-Risk ("VaR") We use the statistical technique known as VaR to measure, monitor and review the market risk exposures in our trading portfolios. VaR is the potential loss in value of our trading positions, excluding noncontrolling interests, due to adverse market movements over a defined time horizon with a specified confidence level. We perform a daily VaR analysis on substantially all of our trading positions, including fixed income, equities, convertible bonds, mortgage-backed securities and all associated economic hedges. These positions encompass both customer-related and strategic trading activities. A VaR model provides a common metric for assessing market risk across business lines and products. Changes in VaR between reporting periods are generally due to changes in levels of risk exposure, volatilities and/or correlations among asset classes and individual securities. We use a Monte Carlo simulation methodology for VaR calculations. We believe this methodology provides VaR results that properly reflect the risk profile of all our instruments, including those that contain optionality, and also accurately models correlation movements among all of our asset classes. In addition, it provides improved tail results as there are no assumptions of distribution, and can provide additional insight for scenario shock analysis. Model-based VaR derived from simulation has inherent limitations including: reliance on historical data to predict future market risk; VaR calculated using a one-day time horizon does not fully capture the market risk of positions that cannot be liquidated or offset with hedges within one day; and published VaR results reflect past trading positions while future risk depends on future positions. The modeling of the market risk characteristics of our trading positions involves a number of assumptions and approximations. While we believe that these assumptions and approximations are reasonable, different assumptions and approximations could produce materially different VaR estimates. When comparing our VaR numbers to those of other firms, it is important to remember that different methodologies, assumptions and approximations could produce significantly different results. 67 -------------------------------------------------------------------------------- Table of Contents The following table quantifies the model-based VaR simulated for each component of market risk for the periods presented, which are computed using the past 250 days of historical data. When calculating VaR we use a 95 percent confidence level and a one-day time horizon. This means that, over time, there is a one in 20 chance that daily trading net revenues will fall below the expected daily trading net revenues by an amount at least as large as the reported VaR. Shortfalls on a single day can exceed reported VaR by significant amounts. Shortfalls can also accumulate over a longer time horizon, such as a number of consecutive trading days. Therefore, there can be no assurance that actual losses occurring on any given day arising from changes in market conditions will not exceed the VaR amounts shown below or that such losses will not occur more than once in a 20-day trading period. June 30, December 31, (Amounts in thousands) 2020 2019 Interest Rate Risk$ 254 $ 428 Equity Price Risk 50 52 Diversification Effect (1) (37) (37) Total Value-at-Risk$ 267 $ 443 (1)Equals the difference between total VaR and the sum of the VaRs for the two risk categories. This effect arises because the two market risk categories are not perfectly correlated.
The aggregate VaR as of
We view average VaR over a period of time as more representative of trends in the business than VaR at any single point in time. The table below illustrates the daily high, low and average VaR calculated for each component of market risk during the six months endedJune 30, 2020 and the year endedDecember 31, 2019 . (Amounts in thousands) High Low Average For the Six Months EndedJune 30, 2020 Interest Rate Risk$ 918 $ 229 $ 556 Equity Price Risk 63 41 51 Diversification Effect (1) (40) Total Value-at-Risk$ 930 $ 191 $ 567 (Amounts in thousands) High Low Average For the Year EndedDecember 31, 2019 Interest Rate Risk$ 792 $ 181 $ 432 Equity Price Risk 69 42 54 Diversification Effect (1) (41) Total Value-at-Risk$ 808 $ 191 $ 445 (1)Equals the difference between total VaR and the sum of the VaRs for the two risk categories. This effect arises because the two market risk categories are not perfectly correlated. Because high and low VaR numbers for these risk categories may have occurred on different days, high and low numbers for diversification effect would not be meaningful.
Trading losses exceeded our one-day VaR on 17 occasions during the first half of 2020.
In addition to VaR, we also employ additional measures to monitor and manage market risk exposure including net market position, duration exposure, option sensitivities, and inventory turnover. All metrics are aggregated by asset concentration and are used for monitoring limits and exception approvals. In times of market volatility, we also perform ad hoc stress tests and scenario analysis as market conditions dictate. Unlike our VaR, which measures potential losses within a given confidence level, stress scenarios do not have an associated implied probability. Rather, stress testing is used to estimate the potential loss from market moves outside our VaR confidence levels.
Liquidity Risk
Liquidity risk is the risk that we are unable to timely access necessary funding sources in order to operate our business, as well as the risk that we are unable to timely divest securities that we hold in connection with our market-making, sales and trading, and strategic trading activities. We are exposed to liquidity risk in our day-to-day funding activities, by holding potentially illiquid inventory positions and in our role as a remarketing agent for variable rate demand notes. 68 --------------------------------------------------------------------------------
Table of Contents See the section entitled "Liquidity, Funding and Capital Resources" for information regarding our liquidity and how we manage liquidity risk.
Our inventory positions, including those associated with strategic trading activities, subject us to potential financial losses from the reduction in value of illiquid positions. Market risk can be exacerbated in times of trading illiquidity when market participants refrain from transacting in normal quantities and/or at normal bid-offer spreads. Depending on the specific security, the structure of the financial product, and/or overall market conditions, we may be forced to hold a security for substantially longer than we had planned or forced to liquidate into a challenging market if funding becomes unavailable. Credit Risk Credit risk refers to the potential for loss due to the default or deterioration in credit quality of a counterparty, customer, borrower or issuer of securities we hold in our trading inventory. The nature and amount of credit risk depends on the type of transaction, the structure and duration of that transaction and the parties involved. Credit risk also results from an obligor's failure to meet the terms of any contract with us or otherwise fail to perform as agreed. This may be reflected through issues such as settlement obligations or payment collections.
Our different types of credit risk include:
Credit Spread Risk - Credit spread risk arises from the possibility that changes in credit spreads will affect the value of financial instruments. Credit spreads represent the credit risk premiums required by market participants for a given credit quality (e.g., the additional yield that a debt instrument issued by a AA-rated entity must produce over a risk-free alternative). Changes in credit spreads result from potential changes in an issuer's credit rating or the market's perception of the issuer's credit worthiness. We are exposed to credit spread risk with the debt instruments held in our trading inventory, including those held for strategic trading activities. We enter into transactions to hedge our exposure to credit spread risk through the use of derivatives and certain other financial instruments. These hedging strategies may not work in all market environments and as a result may not be effective in mitigating credit spread risk. Deterioration/Default Risk - Deterioration/default risk represents the risk due to an issuer, counterparty or borrower failing to fulfill its obligations. We are exposed to deterioration/default risk in our role as a trading counterparty to dealers and customers, as a holder of securities, and as a member of exchanges. The risk of default depends on the creditworthiness of the counterparty and/or issuer of the security. We mitigate this risk by establishing and monitoring individual and aggregate position limits for each counterparty relative to potential levels of activity, holding and marking to market collateral on certain transactions. Our risk management functions also evaluate the potential risk associated with institutional counterparties with whom we hold derivatives, TBAs and other documented institutional counterparty agreements that may give rise to credit exposure. Collections Risk - Collections risk arises from ineffective management and monitoring of collecting outstanding debts and obligations, including those related to our customer trading activities and margin lending. Our client activities involve the execution, settlement and financing of various transactions. Client activities are transacted on a delivery versus payment, cash or margin basis. Our credit exposure to institutional client business is mitigated by the use of industry-standard delivery versus payment through depositories and clearing banks. Credit exposure associated with our customer margin accounts in theU.S. is monitored daily. Our risk management functions have credit risk policies establishing appropriate credit limits and collateralization thresholds for our customers utilizing margin lending. Concentration Risk - Concentration risk is the risk due to concentrated exposure to a particular product; individual issuer, borrower or counterparty; financial instrument; or geographic area. We are subject to concentration risk if we hold large individual securities positions, execute large transactions with individual counterparties or groups of related counterparties, or make substantial underwriting commitments. Concentration risk can occur by industry, geographic area or type of client. Securities purchased under agreements to resell consist primarily of securities issued by theU.S. government or its agencies. The counterparties to these agreements typically are primary dealers ofU.S. government securities and major financial institutions. Inventory and investment positions taken and commitments made, including underwritings, may result in exposure to individual issuers and businesses. Potential concentration risk is carefully monitored through review of counterparties and borrowers and is managed through the use of policies and limits established by senior management. 69 -------------------------------------------------------------------------------- Table of Contents We have concentrated counterparty credit exposure with five non-publicly rated entities totaling$27.5 million atJune 30, 2020 . This counterparty credit exposure is part of our matched-book derivative program related to our public finance underwriting business, consisting primarily of interest rate swaps. One derivative counterparty represented 84.1 percent, or$23.2 million , of this exposure. Credit exposure associated with our derivative counterparties is driven by uncollateralized market movements in the fair value of the interest rate swap contracts and is monitored regularly by our financial risk committee. We attempt to minimize the credit (or repayment) risk in derivative instruments by entering into transactions with high-quality counterparties that are reviewed periodically by senior management.
Operational Risk
Operational risk is the risk of loss, or damage to our reputation, resulting from inadequate or failed processes, people and systems or from external events. We rely on the ability of our employees and our systems, both internal and at computer centers operated by third parties, to process a large number of transactions. Our systems may fail to operate properly or become disabled as a result of events that are wholly or partially beyond our control. In the event of a breakdown or improper operation of our systems or improper action by our employees or third party vendors, we could suffer financial loss, a disruption of our businesses, regulatory sanctions and damage to our reputation. We also face the risk of operational failure or termination of our relationship with any of the exchanges, fully disclosed clearing firms, or other financial intermediaries we use to facilitate our securities transactions. Any such failure or termination could adversely affect our ability to effect transactions and manage our exposure to risk. Our operations rely on secure processing, storage and transmission of confidential and other information in our internal and outsourced computer systems and networks. Our computer systems, software and networks may be vulnerable to unauthorized access, computer viruses or other malicious code, internal misconduct or inadvertent errors and other events that could have an information security impact. The occurrence of one or more of these events, which we have experienced, could jeopardize our or our clients' or counterparties' confidential and other information processed and stored in, and transmitted through, our computer systems and networks, or otherwise cause interruptions or malfunctions in our, our clients', our counterparties' or third parties' operations. We take protective measures and endeavor to modify them as circumstances warrant. In order to mitigate and control operational risk, we have developed and continue to enhance policies and procedures that are designed to identify and manage operational risk at appropriate levels throughout the organization. We also have business continuity plans in place that we believe will cover critical processes on a company-wide basis, and redundancies are built into our systems as we have deemed appropriate. These control mechanisms attempt to ensure that operational policies and procedures are being followed and that our various businesses are operating within established corporate policies and limits. We operate under a fully disclosed clearing model for all of our clearing operations. In a fully disclosed clearing model, we act as an introducing broker for client transactions and rely on Pershing, our clearing broker dealer, to facilitate clearance and settlement of our clients' securities transactions. The clearing services provided by Pershing are critical to our business operations, and similar to other services performed by third party vendors, any failure by Pershing with respect to the services we rely upon Pershing to provide could cause financial loss, significantly disrupt our business, damage our reputation, and adversely affect our ability to serve our clients and manage our exposure to risk. Human Capital Risk Our business is a human capital business and our success is dependent upon the skills, expertise and performance of our employees. Human capital risks represent the risks posed if we fail to attract and retain qualified individualswho are motivated to serve the best interests of our clients, thereby serving the best interests of our company. Attracting and retaining employees depends, among other things, on our company's culture, management, work environment, geographic locations and compensation. There are risks associated with the proper recruitment, development and rewards of our employees to ensure quality performance and retention. 70 -------------------------------------------------------------------------------- Table of Contents Legal and Regulatory Risk Legal and regulatory risk includes the risk of non-compliance with applicable legal and regulatory requirements and loss to our reputation we may suffer as a result of failure to comply with laws, regulations, rules, related self-regulatory organization standards and codes of conduct applicable to our business activities. We are generally subject to extensive regulation in the various jurisdictions in which we conduct our business. We have established procedures that are designed to ensure compliance with applicable statutory and regulatory requirements, such as public company reporting obligations, regulatory net capital requirements, sales and trading practices, potential conflicts of interest, anti-money laundering, privacy and recordkeeping. We have also established procedures that are designed to require that our policies relating to ethics and business conduct are followed. The legal and regulatory focus on the financial services industry presents a continuing business challenge for us. Our business also subjects us to the complex income tax laws of the jurisdictions in which we have business operations, and these tax laws may be subject to different interpretations by the taxpayer and the relevant governmental taxing authorities. We must make judgments and interpretations about the application of these inherently complex tax laws when determining the provision for income taxes. Effects of Inflation Because our assets are liquid and generally short-term in nature, they are not significantly affected by inflation. However, the rate of inflation affects our expenses, such as employee compensation, office space leasing costs and communications charges, which may not be readily recoverable in the price of services we offer to our clients. To the extent inflation results in rising interest rates and has adverse effects upon the securities markets, it may adversely affect our financial position and results of operations.
© Edgar Online, source