SVB Financial Group (SIVB) 2017 Q2 法說會逐字稿

Welcome to the SVB Financial Group Q2 2017 earnings call. My name is Allie, and I will be your operator for today's call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. (Operator Instructions) Please note that this conference is being recorded.

I will now turn the call over to Meghan O'Leary. Meghan, you may begin.

Thank you, Allie, and thanks, everyone, for joining us today. Our President and CEO, Greg Becker, and our CFO, Dan Beck, are here to talk about our second quarter 2017 financial results, and we'll be joined by other members of management for the Q&A.

Our current earnings release is available on the Investor Relations section of our website at svb.com. We'll be making forward-looking statements during this call, and actual results may differ materially. We encourage you to review the disclaimer in our earnings release dealing with forward-looking information, which applies equally to statements made in this call.

In addition, some of our discussion may include references to non-GAAP financial measures. Information about those measures, including reconciliation to GAAP measures, may be found in our SEC filings and in our earnings release. We expect the call, including Q&A, to last approximately an hour.

And with that, I will turn the call over to Greg Becker.

Thanks, Meghan, and thanks, everyone, for joining us today. I'll start by commenting on the markets and our business overall, but first I wanted to say that we're excited to have our new CFO, Dan Beck, onboard, and I know you're all looking forward to hearing from him. Since we're only a couple months into the transition process, Mike Descheneaux, our President, who is also with us, may chime in on certain topics during Q&A as needed.

And with that, let's get started. We had a strong quarter, with record earnings per share of $2.32 and record net income of $123.2 million, a more than 20% increase over the first quarter and a more than 30% increase over the same quarter last year. These results reflect the impact of higher short-term rates on our earning asset base, solid credit performance, and healthy levels of activity among our clients.

Highlights of our second quarter included net interest income growth of 10.6%, total client funds growth of 6%, a provision for credit losses of $15.8 million, return on equity of 12.75%, and return on assets of 1.04%, expense growth of 5.7%, and we also received the final 5-year extension for Volcker Rule compliance on our covered funds.

Let me start with our target markets. The innovation ecosystem, and venture capital as a key part of that, is doing well overall, with healthy transaction levels and ample capital for good companies. VCs raised $11 billion in the second quarter, versus $8 billion last quarter. That reflects strong fundraising for first-time funds as well as proven fund managers.

Year-to-date, it appears VCs are on pace to raise more capital in 2017 than in 2016, which was the biggest year in a decade. On top of that, venture capital firms are sitting on record levels of uninvested capital and are motivated to put that capital to work.

Venture investing overall increased 30% quarter-over-quarter, to nearly $22 billion, and also appears to be on pace to exceed 2016 levels. The underlying investment data suggests that the decline in angel and seed stage investing is due to companies bootstrapping or stretching current capital rounds. Overall, entrepreneurship and new company formation are alive and well. Our levels of new client activity support this.

Where the VC markets are challenged is in exits. VC-backed exits declined quarter-over-quarter due to lower levels of M&A, both in terms of overall dollars and the number of deals.

IPOs were a relatively bright spot in this, recovering from their 2016 lows with 19 U.S. VC-backed IPOs in the second quarter alone, compared to 33 for all of 2016. 68%, 13, of those IPOs were SVB clients. Based on the numbers year-to-date, 2017 IPOs appear to be poised to surpass 2016.

While the number of IPOs has increased, recent IPO performance has been disappointing, and the momentum needed to spur more IPOs has not materialized. For now, caution over private company valuations and uncertainty about the prospects for future healthcare, tax or regulatory reforms seem to have put public market investors in a wait-and-see mode, despite a growing pipeline of potential public offerings.

That said, we continue to see healthy activity among our clients. We added more than 1,300 new core commercial clients in the second quarter, a higher pace than usual. We're seeing growth across all client segments and all geographies, particularly in early stage, private equity, global and private bank.

Our net client growth rate in the second quarter was the highest it's been in six quarters. Deal flow has been good across most sectors, with private equity again being the strongest. About a third of our loan growth related to private equity is coming from new client wins. We expect private equity to remain a strong and resilient source of growth over time given the diversity of sub-sectors represented and the ability of PE firms to thrive under varying market conditions.

With regard to our technology and life science portfolios, early stage client wins continued to dominate our new client numbers, but activity is healthy in other areas as well. We're winning new corporate finance clients at a higher pace, and we're improving our ability to engage these clients to encourage them to fully leverage the SVB platform.

Among our growth stage clients, deal flow has picked up, and the first half of 2017 was our strongest ever for newly booked commitments in this segment. Despite new activity, the high pace of M&A among our growth and corporate finance clients and significant amounts of new liquidity have been continued headwinds to a faster pace of loan growth year-to-date.

As a result, we are slightly decreasing our outlook for 2017 loan growth. Nevertheless, our healthy pace of new client wins and new bookings suggest underlying trends remain strong, and we believe loan growth among our tech and life science clients will improve in the second half of the year.

Looking at the quarter, the rest of 2017 and beyond, we are optimistic about our business momentum. We're seeing significant benefit from recent rate increases, consistent with our expectations for asset sensitivity. Client funds are growing at a tremendous pace due to our highly effective client acquisition engine, which has been even more successful due to our efforts to expand our client funnel.

Fee income is healthy, and volumes are growing, even though we're seeing some pricing compression. Our markets are expanding as are our efforts to support our clients and partners. Globally, we have applications under way in Canada and Germany, as well as new investments to support our positive momentum in the U.K.

Domestically, we've recently expanded our offices in New York and have plans to expand in San Francisco to accommodate our growth and the opportunity in those thriving entrepreneurial markets.

As I noted at the beginning of my comments, our expenses increased more than expected in the second quarter, and we raised our outlook for expense growth as a result. Part of it is incentive compensation related to our ROE performance and our improved bottom line outlook. The rest of it is to support growth. We are a growing company. This is what it takes to support that growth and continue to build our momentum, even as we work to strike the optimal balance between investing in growth and being efficient.

We're enhancing partnerships, onboarding processes, and operational support to expand the client funnel I talked about and make sure we remain at the center of the early stage ecosystem. We're spending on new initiatives, products, and enhancing the client experience, including the talent required to lead and implement these initiatives.

We're taking steps to boost our fee income growth, improving our credit card penetration, making sure our global clients are taking advantage of our foreign exchange products, getting clients into the right off-balance sheet products, and ensuring we're providing clients with access to our products early in their lifecycle. And we're investing in all areas of risk management to support our growth, higher requirements related to compliance, and preparation for CCAR enhanced prudential standards.

Our growth requires systemic efforts to drive our operating leverage and a reduction in our expense growth rates. As a result, we are focused on a variety of opportunities to simplify and consolidate systems, reduce manual processes, and deploy enabling technology.

Looking ahead, our record results and our momentum as we enter the second half of the year are solid, and we remain positive about our markets, our growth plans, and our ability to execute on those. Our clients are raising capital, they're getting funded, and they're performing well overall. They're doing all this despite anxiety over the situation in Washington, lower early stage investments, and underperforming exit markets.

Likewise, SVB is delivering strong growth. We're investing in our business and maintaining solid asset quality. We're doing this despite intense competition and M&A-driven turnover in our loan book.

We believe our success comes from our focus on things that we excel at, which are building and maintaining lifelong relationships with companies, investors and entrepreneurs; leveraging our unique knowledge, networks and insights to help our clients succeed; and being the best partner to innovators, entrepreneurs and our investors around the world.

Ultimately, we believe the growing innovation industry and the convergence of tech and non-tech is going to lead to significant new opportunities in our target markets. We'll continue to manage our business for the long term so that we can be a critical part of it.

And now I'd like to turn the call over to our CFO, Dan Beck.

Thank you, Greg. Good afternoon. It's great to be here and to join this exceptional team. We delivered a good quarter, with a strong increase in net income due to healthy revenue growth and continued stable credit performance, while expense growth remains an area of focus.

Highlights of the quarter included, 1, strong growth in net interest income driven by higher interest rates and a larger balance sheet; 2, stable credit, with notable improvements in underlying trends; 3, strong capital and liquidity; 4, improved warrant gains related to valuation increases; 5, solid core fee income growth, driven by client investment fees, albeit somewhat below our expectations; and 6, higher expenses related to higher people costs, including incentive compensation, infrastructure, and operational costs along with risk- and compliance-related expenses.

Overall, we continue to see healthy growth and positive momentum in our pipeline. I'll walk you through some specifics and discuss a few changes to our full year outlook. Let me start with the balance sheet, where we see healthy growth overall. Average loans increased by $439 million, or 2.2%, to $20.5 billion, driven by private equity and the private bank.

The pace of M&A among our clients, which included some large deals in the second quarter, the abundance of liquidity in our ecosystem, and heavy VC investment are constraining faster loan growth for now, especially in the technology and life sciences portfolio. However, as Greg pointed out, new loan commitments are strong, and our pipeline looks good, so we feel positive about our loan growth opportunities moving forward.

Based on our balances at midyear, we are trimming our full year 2017 loan growth outlook from the high teens to the mid-teens. This amounts to a reduction of approximately $500 million.

Turning to client funds, average total client funds grew by $5.1 billion, or 6%, to $91.2 billion. This increase reflected strong average deposit growth of $2.1 billion, or 5.5%, driven by robust new client acquisition and healthy equity funding for our clients. These trends and the significant amounts of dry powder available for investment suggest deposit growth will remain strong. As a result, we are raising our full year deposit growth guidance from the mid-single digits to the high single digits.

Average off-balance sheet client investment funds also grew strongly, by $3 billion, or 6.5%, due to strong equity funding for investor-backed clients and active secondary public offerings among our larger life science clients. Despite the slow recovery of the IPO markets, secondary public offerings remained a robust source of liquidity.

Average assets increased $2.2 billion, or 5%, to $47.5 billion. We crossed the $50 billion asset level for 2 days during the quarter and expect to reach the threshold that requires SIFI compliance by early 2019, which would make us subject to public CCAR reporting in early 2020.

Moving to capital, capital and liquidity remain strong. Tier 1 leverage ratios at the bank and holding company remain well within our target ranges despite a modest decline at the bank level driven by strong deposit growth and dividends from the bank to the holding company.

Now I'd like to turn to the income statement. Net interest income grew strongly, by $32.7 million, or 10.5%, to $343 million, driven mainly by the benefit of the December and March fed funds increases and increasing balances on both loans and investment securities, as well as one extra day in the quarter.

In total, we had increases of $17.1 million in interest on loans, $10.3 million in cash and investment securities interest income, and $5.8 million in loan fees, mostly from early repayments. Total yield increased by 30 basis points, which primarily reflected the impact of short-term rate increases.

As we discussed last quarter, we are seeing approximately 60% to 70% of each increase in fed funds translate to improvement in loan yields. We also saw a small increase of our deposit cost of 2 basis points in the quarter. Higher short-term interest rates drove an increase of 12 basis points in our net interest margin to 3%, consistent with our expectations.

We are raising our full year 2017 outlook for net interest income growth from the high teens to a range of the high teens to low 20s. This accounts for the expected full impact of the March and June rate increases, along with the higher investment and cash balances due to robust deposit growth. This does not include any future rate increases.

Likewise, we are refining our expectations for our net interest margin towards the top half of our previous range. We now expect net interest margin to be between 3.0% and 3.1%.

Now I'd like to turn to credit quality, which was stable, with a number of notable improvements in the quarter. Our allowance for loan losses was $236.5 million at the end of the second quarter, or 1.12% of total gross loans, a decrease of $6.6 million, or 6 basis points, compared to the first quarter, reflective of a decrease in reserve for nonperforming loans as well as improved overall credit quality in our performing loan portfolio.

Our provision for credit losses was $15.8 million, compared to $30.7 million in the first quarter. This consisted of a provision for loan losses of $15.2 million. The provision for loan losses reflects $12.7 million in specific reserves for net new non-accrual loans and $5 million for loan growth, offset by a $2.5 million benefit related to the continued increases in capital call lines and lower criticized loan balances.

Net charge-offs increased by $10.3 million to $22.5 million, or 44 basis points of total average loans. This figure reflects gross charge-offs of $25.1 million, including 2 loans to software clients totaling $13 million, with the rest primarily from early stage software and life science companies. 87% of net charge-offs had prior reserves.

Non-accrual loans decreased by $18.6 million to $120.2 million, or 57 basis points of total loans. This decrease reflects charge-offs of $22.8 million and repayment of $17.8 million. New nonperforming loans of $22 million were primarily from companies in our software portfolio and represent a substantial drop from prior quarters.

While liquidity and valuations still pose a risk for early stage credits, we are seeing good overall performance across the portfolio and solid trends in underlying credit metrics. We are maintaining our full year credit outlook for 2017.

Now I'd like to turn to non-interest income, which is primarily composed of core fee income and net gains from warrant and private equity and venture capital related investments. GAAP non-interest income was $128.5 million, up $10.8 million, or 9.2%, over the first quarter. Non-GAAP non-interest income net of non-controlling interest was $119 million, an increase of $7.9 million, or 7.1%, over the first quarter. The increase was primarily related to better warrant gains and an increase in core fee income due to higher client investment fees.

Let me review the components. Equity warrant gains were $10.8 million in the second quarter, up $4.1 million, or 61.1%. These were driven primarily by valuation increases from new funding rounds, which are unrealized gains. This compares to gains of $6.7 million in the first quarter, primarily due to realized gains from M&A activities.

Non-GAAP net gains on investment securities net of non-controlling interests were $8.2 million, a decline of $1.3 million, or 13.7%, from the first quarter. This reflects approximately $6.2 million of distribution from our strategic investments and $2.7 million of valuation increases associated with our managed funds of funds.

Moving to core fee income, overall, we are seeing growth from strong volumes, with some price compression. Core fee income increased $4.7 million, or 5.7%, to $87.3 million, primarily driven by higher client investment fees. Client investment fees increased by $4 million, or 44%, to $13 million due to higher spreads and an additional $3 billion in off-balance sheet client fund balances.

Credit card fees were roughly flat at $18.1 million. This is an area where we are seeing higher client penetration and transaction volumes offset by lower spreads due to competition. Fees from foreign exchange transactions were also flat, at $26.1 million, which reflects an increase of 14% in overall transaction volumes, offset by lower spreads and lower global currency volatility.

As a result of pricing pressure on credit card fee income and lower spreads on foreign exchange transactions, we are decreasing our full year 2017 outlook for core fee income growth from the high teens to the mid-teens. In dollar terms, this amounts to a reduction of between $7 million and $10 million pre-tax on an annual basis in our fee income expectations.

Turning to expenses, non-interest expense was $251.2 million, an increase of $13.6 million, or 5.7%. Taking into consideration seasonal increases of $5.9 million in the first quarter, non-interest expenses increased by $19.5 million, or 8.2%. Included in these numbers are approximately $8 million of expense items that we do not expect to recur.

As a result, we are increasing our full year 2017 expense growth outlook from the low double digits to the low teens. To put it into perspective, this is an increase of approximately $17 million to $20 million pre-tax on an annual basis, half of which is accounted for in the second quarter.

We expect expenses in Q3 and Q4 to be relatively consistent with Q2 levels. While approximately $8 million of our Q2 expense increase was for one-time -- for items we do not expect to recur, we do not anticipate a corresponding reduction in future quarters due to our plans to add people and infrastructure to build our business and to support our growth. Again, this is considered in our outlook.

The second quarter increase came from investments and growth-enhancing initiatives that Greg referred to in his comments. With that in mind, the increase was primarily attributable to three factors.

First was higher people-related costs of $7.7 million, excluding the Q1 seasonal expenses mentioned above. This was evenly split between staffing and compensation increases to support revenue and growth-enhancing initiatives, along with incentive compensation related to our ROE relative to peers due to improving bottom line results. Included in this figure are approximately $4 million of non-recurring items. I would like to point out that we've reached the ceiling on our peer-related ROE incentive compensation for the year.

The second category was infrastructure and operationally-oriented investments totaling $7.8 million in business development projects, systems and technology to support our continued strong growth and related initiatives, as well as other operating costs. Of this amount, approximately $3 million relates to items that are not expected to recur.

The third category was investment of approximately $2.7 million in enhancements to our risk and compliance infrastructure, again, to support our momentum as we grow into a larger, more global organization.

Finally, a note on taxes. We recognized a $7 million tax benefit related to new accounting guidelines for share-based compensation that we implemented last quarter. This tax benefit equated to approximately $0.13 per share.

As a reminder, the magnitude of this tax impact of the employee share-based transactions is a function of, 1, the vesting date for restricted stock units; 2, the amount of in-the-money stock options that are exercised; and 3, a change in our stock price relative to the grant date values of the share-based compensation awards. I would like to point out that the tax benefits are expected to be lower in the second half of 2017.

In closing, we are pleased with our performance this quarter. We delivered record earnings, strong balance sheet growth, and solid credit quality. Capital and liquidity remain strong to support our continued growth.

We are winning new clients at a rapid pace and continue to see healthy deal activity backed by a solid pipeline, despite persistent competition and elevated M&A activity among our clients. Our clients are performing well overall and are able to access funding and liquidity, as evidenced by our robust deposit franchise.

We remain focused on expanding our client base, penetration, product offerings, and global footprint while delivering high-quality growth and stable credit quality. And lastly, we continue to invest prudently to enhance our infrastructure to support our growth and meet increasing regulatory requirements.

Thank you, and I'll ask the operator to open the line for Q&A.

(Operator Instructions) And our first question comes from Ken Zerbe from Morgan Stanley.

I guess maybe a question for Dan, just in terms of if I heard your SIFI comments correctly, right, I think you said that you plan to cross over -- or sort of be eligible, if you will, in the first part of 2019. I just want to make sure I understand the process and everything correctly, because I have you at 48 -- call it $48 billion-plus in total assets currently, and I certainly have you crossing over $50 billion well -- on a 4 quarter trailing basis, well before 2019. Can you just walk us through -- what am I missing here? Why don't you sort of cross over on a 4 quarter average earlier than early 2019? Thanks.

It's a great question. That calculation is based on our end of period asset figures as we report in our regulatory filings. We don't expect to reach the 4-quarter average of that end of period amount until we get to the second quarter of 2019, so it's really reflective of that 4-quarter average, and our predictions at this point is that we'll be there by the second quarter of 2018.

Yes, clarified to 2018.

'18.

Sorry, fourth -- sorry, just to be super clear, 4-quarter rolling look back, 12-month look back, is fourth -- sorry, second quarter of 2018.

Second quarter of 2018.

Got it. Okay, that totally makes -- and then that's when you're eligible, in '19, and then you have to file CCAR is 2020.

You're right. Yes.

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

So when we look at the increase in expenses that we talked about in our outlook and included in our guidance, we don't have a significant increase in the CCAR expenses. We're spending roughly $11 million to $13 million a year on CCAR, and I think that that is going to get us to the right level in 2017. As we look ahead to 2018, we've been increasing that amount by $3 million to $5 million a year, and we think that that'll probably get us there on the CCAR-related expenses.

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

And our next question comes from Ebrahim Poonawala from Bank of America.

I just wanted to touch base on sort of the fee revenue outlook. I guess the guidance there has bombed a little bit over the last 3 quarters. I just wanted to get your sort of big-picture thoughts, Greg, in terms of where have you seen sort of the biggest delta operationally in the first 6 months relative to when we started out the year? Was it lower FX fees, and why lower card fee and why -- any color would be extremely helpful.

Sure. I will start, and Dan or others may want to add to it, but I'd break it down into two buckets in the areas you described. It is FX, and it's cards. I'll start with FX. If you think about FX, the volumes remain strong, and there are really kind of a couple components to saying why wouldn't the revenue follow that, right? So one is there are some larger transactions in there, and larger transactions on the spot trades tend to have lower margins. That's #1. #2, you have lower volatility in the FX markets, and where that's impacted actually relates to forwards and options, and so that's a higher-margin business. And so since the volatility is down, you tend to have then net overall lower FX revenue, despite the volumes being up. So we don't know, obviously, where volatility will play out in the second half of the year, but that was the main driver, and so we're expecting more of a consistent growth from volumes and some margin improvement, but we're not expecting volatility to come back. If it does come back, we'll see some upside in FX. That's one piece. The second piece is on cards. Again, much like FX, we've seen very nice volume growth. The margin is impacted for a few different areas. One is mix, but I'll give you an example where margin compression comes down and it's not in our control. So our clients, as you would expect, have a lot of credit card purchases for Google ads and Facebook ads. Well, what happens is Google and Facebook work with MasterCard and Visa to negotiate lower interchange fees because of the volumes going through. What happens, we get impacted more than other players, because more of our clients are spending on those ads, so that actually creates some compression in interchange margin related specifically to our clients. Now, we can't predict that there are other areas where that will occur. Those are the two biggest ones, and we believe they probably have negotiated longer-term arrangements for that. So we think the margins will stabilize and the volumes will pick up, so we expect to see some growth in the latter half of the year, which is built into our outlook. So that -- but you do see that interchange coming down. That was the main driver. So volume is good, some impact on the margin.

And how big of a component in your growth outlook is adding new clients to both these services? Or is it mostly activity levels times margin and that's what the growth is?

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

Understood. And just switching gears in terms of competition on lending, I got the color, what you talked about in terms of what drove sort of slower loan growth for the quarter, but there's a fair bit of chatter post your last quarter's earnings on pricing competition between loan spreads. I just wanted to get some color in terms of how competition stacks up today versus 3 or 6 months ago. And incrementally, as we think about the June rate hike and maybe another rate hike in December, is your expectation that the sensitivity of the margin to every future rate hike should be similar to what we've seen so far this cycle?

Yes, I'll start, Ebrahim, and then Marc may want to add something. I'll start with the last question first, which is what do we expect in the future, and I would say, generally speaking, we would expect that same margin sharing to occur, which is roughly 60% to 70% of rate increases would be brought down. Now, you have a mix question, though, right, and so we continue to grow lower-margin loans, but -- so you have to take that into consideration, but the net number of 60% to 70% is right. Now, just competition in general, it is competitive. It's very competitive. We're seeing it from both banks and non-banks. I would say it's slightly more competitive than it was, but it's not a dramatic change, is how I would describe it. Much like we've talked about in prior quarters, there are 3 different ways to look at competition. You can look at pricing, you can look at the size of loans, and you can look at structure. We look at the deal, we look at the overall risk, and we may be willing to drop pricing a little bit, depending upon how quality it is. We may be willing to do a larger loan if it has structure. Where we see, again, some pressure is the structure as well, and that's an area we really want to be disciplined on. Mike has talked in the past about smart growth. We would put it in the smart growth category. That being said, the one last point I would make is we, as I described, have a very strong pipeline. We had a very strong level of booked commitments, and our hope is that we'll give guidance or give future loan growth in the second half of the year. So that -- I'll pause and see, Marc, if you have anything to add.

No, nothing to add. You covered it.

And our next question comes from Jennifer Demba from SunTrust Robinson.

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

Yes, Jennifer, I'll start, and it is -- it's mainly driven because of what we saw in the first -- kind of the second quarter, right, because you're talking dealing with averages, and so if you see that being lower than what we thought, obviously that plays out for the balance of the year, #1. #2, we do look at it and say, despite what I said, that we do believe the second half will be stronger than the first half, especially in our tech and life science portfolio. We still believe it's going to be very competitive, and we still believe we're going to have to be smart about where we do want to lean in and where we want to back away. So I wouldn't read anything into it more than that.

And our next question comes from Jared Shaw from Wells Fargo.

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

It's generally correct. If we look at it, we get the $7.7 million worth of increase. $4 million of that is non-recurring items. Half of that relates to the ROE plan as well as some other one-time items related to benefit costs. The rest, the $3.7 million, is really people-related and growth-related of people (inaudible).

Okay. And then on the -- but when we're looking at third quarter with the expectation -- third and fourth quarter with the expectation that expenses are flat, where else -- so that $8 million that's non-recurring is going to be distributed in other categories. Is that still going to be increased hiring, or should we expect to see -- is it professional services as you're ramping up maybe some new systems? Maybe just a little color on where that $8 million gets reallocated.

Yes, this is Greg, and, Jared, it's going to be across the board. It is going to be in additional hiring, and again, just go back to the fact that -- whether it's expanding into different markets, supporting our growth, so we are adding people in a variety of different areas, #1. #2, it is about systems and infrastructure. As I talked about, we do have to make investments in that area, and it'll be front end-loaded, and quite honestly, we'll be seeing that for a while where we have to invest in systems to improve the manual processes and procedures that we do have, and so you'll see it in a variety of areas. But we wanted to try to give you enough color to give you a little more clarity on expectations on absolute numbers in the third and the fourth quarter, which is why Dan shared kind of the commentary about we expect the third and fourth quarter to be generally in the range, on an absolute basis, at the level of Q2.

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

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

And our next question comes from Steven Alexopoulos from JP Morgan.

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

So this is Greg, Steve. So it's a little bit -- so we had a little bit of catch-up in the second quarter on incentive compensation, and obviously we look at the whole year, and so that incentive compensation will be built in, and we are going to be spending more money on different infrastructure and growth initiatives, so it's a combination of both.

Okay, got you. Thank you. And then on the total client funds, you guys had almost as much growth in total client funds this quarter that you had all of last year. Could you give more color what's driving this growth? Are you seeing more rounds? Are they larger rounds? What is it?

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

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

We're not changing our view. We're not pushing clients any way. Right now, I actually feel that we've got a really good balance to our product set, and so they're going at the right place. They're going the place that they should. When you see these large rounds get closed, the vast majority should be going off-balance sheet, so I think it's a good mix right now. But, no, the short answer is we're not pushing anyone because we're getting close to $50 billion.

And our next question comes from Chris McGratty from KBW.

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

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

Just to add to that, Greg, our cash balance guides around $2 billion to $3 billion. That's the level that we've been operating around, and we're replacing about 800 -- we're running off about $800 million per quarter on the securities portfolio. We did add within the quarter, because of the increased cash balances, though, close to $2 billion worth of investment securities at an overall average blended yield of 2.4%, around that range, so it is a pickup for us on those balances.

So just so I got that, the new reinvestment rate was 240 in the quarter? Did I hear that right?

Yes. Yes.

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

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

And our next question comes from John Pancari from Evercore ISI.

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

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

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

Yes, so when you think about it -- so as we were growing over the last 2, 3, 4 years, right, we continued to invest in a variety of different areas, but we continued to add what I'll expertise from people that actually have been there and done it and actually managed larger programs, and so when we look at -- if you look at our risk function overall, risk includes our compliance department, it includes our enterprise-wide risk management, it includes BSA, AML, it includes loan review, it includes credit review or model risk management, all those areas. And if you look across the board and just look at what I'll call other institutions and what they're hearing and what feedback they're getting from the regulators and just our own risk management levels, we're having to invest across all those areas, and it is both people and it's technology. And for us, this really, I would say, is less about CCAR, although part of it would be. It's more about we just have to up our game as we get bigger as an institution, as we become more global, as we have more transaction processing, all those things, and so I wouldn't say it's one part of risk management. It is actually across all areas that we need to raise our game.

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

Yes, so I'll start. So for '18, usually what we end up talking about is in the kind of October call, we start to give guidance out to '18, and we'll do that again. I just wanted to talk about '18 first. Dan was going to comment on the balance of '17.

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

And our next question comes from Brett Rabatin from Piper Jaffray.

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

Yes, I'll start at a high level, and then Marc will comment on it in more detail. Q2 was a really strong quarter from a credit quality perspective, and our view is we feel good about that. We feel good about the outlook, and we think a lot of what we experienced in '16 as far as the recalibration is behind us. That being said, we are -- we've been in this business long enough to know that one quarter does not a trend make, and that you end up in a position where we feel good about where we are, but we don't feel that we have the clarity yet to kind of change our guidance. So I'll leave it at that and turn it over to Marc.

Yes, so I'll pick up with early stage, and so there, as Greg mentioned, following what we saw in the first half of 2016 -- we've now seen 4 consecutive quarters of what I would characterize as pretty typical credit quality performance in the early stage segment, which is reassuring. Again, it's not necessarily predictive of the future, and we do continue to hear of companies that are struggling to raise that series B round of financing, for example, but, again, our credit quality in the early stage segment continues to be stable. You referenced new guidance. We've heard some questions about that, I think stemming from the earnings release of another bank. We are unaware and, in fact, have confirmed that there is no new guidance related to lending to pre-profit companies, either interagency or from any of the agencies independently, and therefore are not expecting any change in credit quality in pre-profit driven by regulatory change. Obviously, if there were to be guidance, we'd have to incorporate that in our thinking, and presumably, if we thought it was going to have any impact, we'd be talking about it.

And our next question comes from Geoffrey Elliott from Autonomous Research.

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

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

Got it. Thank you. And then in terms of growth on the technology and life sciences and also your healthcare loan book, just help us understand what you think that should look like over the next few years. I mean, do we get back to the sort of pace that we've seen in the past, or is it going to be slower from now on just given some of the competitive facts that you've called out?

When I think about -- this is Greg, and Marc will probably add some color. When I think about the tech and life science portfolio, you've got a couple things going on. One is you do have -- with a lot of the loan products that we have, they amortize, and so you start out the day with amortization in a given quarter, in a given year that you then have to replace to get back to 0, to get a start there. The second part then is just the liquidity in the market. We're at a point right now where, with the high liquidity that we have, that you have lines of credit that aren't utilized or they just don't take debt to the same level because they have $50 million, $100 million, $200 million worth of cash on their balance sheet, and why would they want to pay for something that is just adding more cash to that balance sheet they may not need or probably won't need? That being said, when we look at the market, we view it as still a robust market. It's a growing market. Our win rate is very strong, despite it being competitive, and that's part of the reason that we're optimistic. Now, what does that look like from a growth rate percentage? It's hard to predict. My take, if you look out in the future, is you're going to be looking at in the single digits. Mid to high single digits is probably where I would end up, with volatility on a given quarter and even on a given year, depending upon where venture capital flow is and what the level of M&A in our client base is.

And our next question comes from Aaron Deer from Sandler O'Neill & Partners.

One of the highlights of the quarter was the client investment fees, no doubt stemming from the large inputs that you had there, but I would imagine you also got a benefit from higher rates and the fees being affected by that. Can you give us a sense of where those fees stood, maybe on a basis point level, at June 30 relative to March 31, and what kind of uptick we might get from the rate hikes that were intra-quarter?

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

Okay. And then just a quick one on the tax rate and the impact of the shared comp. Looking out to '18, do you expect, based on the timing of the issuances, that it's going to be another kind of front-loaded year in terms of the tax benefit and then have it fade, or is it more tied to the price of the stock? It seems like the issuance seemed to be the bigger driver, but you can correct me if I'm wrong.

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

And our next question comes from Chris York from JMP Securities.

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

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

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

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

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

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

I think you might be confusing between sponsored buyouts, perhaps, and regular capital call lines of credit.

So, Chris, I'll give you -- so the private equity capital call loans we've been doing forever, and now with sponsor-led buyouts, even that has been around for -- now you're looking at almost --

11 years.

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

And our next question comes from Matt Keating from Barclays.

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

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

Right. Now, is the Germany and Canada expansion -- are those still in the works right now and you expect to bring those online over the next couple of years? Is that a fair timeline?

Obviously, I'll start with subject to regulatory approval, we would expect that in the -- hopefully in the first half of '18, we'll be able to start getting some traction in those markets. But, again, just to take a step back, with either of those markets, you're going to go from -- you have a very low base that you're starting from, or no base in one case, and you're going to be building on that, so it will take a while. How I describe it is you've got the core loan growth from the areas that we described, and a Germany or a Canada is going to be icing on the cake.

And our next question comes from John Pancari from Evercore ISI.

I have one more quick follow-up. You mentioned the ROE rationale on your comp versus peers. Who is your peer group that you were talking about?

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

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

Great. Thanks. So in closing, I just want to say thanks to everyone for joining us today. When we look at the overall markets that we serve, the second quarter was a really, really strong quarter in fundraising, venture funds, in investing, deployment of capital, soft on the exit side, but, again, what we see in our portfolio is there are companies that are performing really well, so we feel good about, again, our target market. We had a record quarter. We're seeing the benefit, after many, many years, of rising rates coupled with strong fundamentals and feel good that we've got a solid outlook for the balance of '17, so feel really good about where we are. We really, as we always do, just want to thank our clients for their trust and support in us. We know we have a lot to live up to and totally appreciate their business, and thank all of our employees for what they do. We just have a real strong team here, love working with and feel really good about what we've built. And then, finally, I want to thank Dan Beck for joining the team. I thought he did a great job on his first inaugural earnings call, and great addition to the team. So thank you all, and have a great day.

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