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, 2021 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, 2021 , 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. 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 from net revenues, (3) amortization of intangible assets related to acquisitions, (4) compensation expenses from acquisition-related agreements, (5) acquisition-related restructuring and integration costs and (6) the income tax expense allocated to the adjustments. 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 all acquisitions sinceJanuary 1, 2020 . These adjustments affect the following financial measures: net revenues, compensation expenses, non-compensation expenses, income tax expense, net income applicable toPiper Sandler Companies , earnings per diluted common share, total non-interest expenses, pre-tax income 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. 36 -------------------------------------------------------------------------------- Table of Contents Executive Overview Our business principally consists 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, 2021 for a full description of our business, including our business strategy.
During the first half of 2022, we have announced or completed the following acquisitions as part of our growth strategy:
•OnJuly 6, 2022 , we announced a definitive agreement to acquireDBO Partners , a technology investment banking firm. The transaction is expected to close in the fourth quarter of 2022, subject to obtaining required regulatory approvals and other customary closing conditions.
•On
•OnFebruary 4, 2022 , we completed the acquisition ofCornerstone Macro Research LP , including its subsidiary,Cornerstone Macro LLC (collectively, "Cornerstone Macro"), a research firm focused on providing macro research and equity derivatives trading to institutional investors. The transaction adds a macro research platform and increases the scale of our equity brokerage operations. Financial Highlights Three Months Ended Six Months Ended (Amounts in thousands, except per June 30, June 30, 2022 June 30, June 30, 2022 share data) 2022 2021 v2021 2022 2021 v2021U.S. GAAP Net revenues$ 352,191 $ 508,648 (30.8) % $ 702,836$ 937,255 (25.0) % Compensation and benefits 239,917 325,252 (26.2) 487,816 605,580 (19.4) Non-compensation expenses 75,114 69,336 8.3 142,223 134,748 5.5 Income before income tax expense 37,160 114,060 (67.4) 72,797 196,927
(63.0)
Net income applicable to Piper Sandler Companies 21,390 69,821 (69.4) 58,041 119,280
(51.3)
Earnings per diluted common share
(69.4) $ 3.39 $ 7.14 (52.5) Ratios and margin Compensation ratio 68.1 % 63.9 % 69.4 % 64.6 % Non-compensation ratio 21.3 % 13.6 % 20.2 % 14.4 % Pre-tax margin 10.6 % 22.4 % 10.4 % 21.0 % Effective tax rate 25.3 % 23.7 % 28.0 % 22.5 % Non-GAAP(1) Adjusted net revenues$ 345,642 $ 492,673 (29.8) % $ 707,435$ 906,424 (22.0) % Adjusted compensation and benefits 216,787 298,835 (27.5) 442,908 553,103
(19.9)
Adjusted non-compensation expenses 68,323 57,364 19.1 128,794 114,112 12.9 Adjusted operating income 60,532 136,474 (55.6) 135,733 239,209 (43.3) Adjusted net income applicable to Piper Sandler Companies 44,066 98,569 (55.3) 100,620 174,048
(42.2)
Adjusted earnings per diluted common share$ 2.47 $ 5.37 (54.0) $ 5.59 $ 9.51 (41.2) Adjusted ratios and margin Adjusted compensation ratio 62.7 % 60.7 % 62.6 % 61.0 % Adjusted non-compensation ratio 19.8 % 11.6 % 18.2 % 12.6 % Adjusted operating margin 17.5 % 27.7 % 19.2 % 26.4 % Adjusted effective tax rate 25.2 % 26.6 % 24.1 % 25.8 %
See the "Results of Operations" section for additional information.
37 -------------------------------------------------------------------------------- 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) 2022 2021 2022 2021 Net revenues: Net revenues - U.S. GAAP basis$ 352,191 $ 508,648 $ 702,836 $ 937,255 Adjustments: Revenue related to noncontrolling interests (8,174) (18,192) 1,349 (35,335) Interest expense on long-term financing 1,625 2,217 3,250 4,504 Adjusted net revenues$ 345,642
Compensation and benefits: Compensation and benefits - U.S. GAAP basis$ 239,917 $ 325,252 $ 487,816 $ 605,580 Adjustment: Compensation from acquisition-related agreements (23,130) (26,417) (44,908) (52,477) Adjusted compensation and benefits$ 216,787
Non-compensation expenses: Non-compensation expenses - U.S. GAAP basis$ 75,114 $ 69,336 $ 142,223 $ 134,748 Adjustments: Non-compensation expenses related to noncontrolling (4,259) (2,028) interests (1,789)
(1,019)
Acquisition-related restructuring and integration costs (1,609)
(3,433) (2,856) (3,568) Amortization of intangible assets related to (6,314) (15,040) acquisitions (3,393)
(7,520)
Adjusted non-compensation expenses$ 68,323
Income before income tax expense: Income before income tax expense - U.S. GAAP basis$ 37,160 $ 114,060 $ 72,797 $ 196,927 Adjustments: Revenue related to noncontrolling interests (8,174) (18,192) 1,349 (35,335) Interest expense on long-term financing 1,625 2,217 3,250 4,504 Non-compensation expenses related to noncontrolling 4,259 2,028 interests 1,789
1,019
Compensation from acquisition-related agreements 23,130 26,417 44,908 52,477
Acquisition-related restructuring and integration costs 1,609
3,433 2,856 3,568 Amortization of intangible assets related to 6,314 15,040 acquisitions 3,393
7,520
Adjusted operating income$ 60,532 $ 136,474 $ 135,733 $ 239,209 Interest expense on long-term financing (1,625) (2,217) (3,250) (4,504)
Adjusted income before adjusted income tax expense
Income tax expense: Income tax expense - U.S. GAAP basis$ 9,385 $ 27,066 $ 20,364 $ 44,340 Tax effect of adjustments: Compensation from acquisition-related agreements 4,470 6,142 9,504 12,205
Acquisition-related restructuring and integration costs 176
871 443 894 Amortization of intangible assets related to 1,552 3,218 acquisitions 810 1,609 Adjusted income tax expense$ 14,841 $ 35,688 $ 31,863 $ 60,657 Net income applicable toPiper Sandler Companies : Net income applicable to Piper Sandler Companies - U.S.$ 58,041 $ 119,280 GAAP basis$ 21,390
Adjustments:
Compensation from acquisition-related agreements 18,660 20,275 35,404 40,272
Acquisition-related restructuring and integration costs 1,433
2,562 2,413 2,674 Amortization of intangible assets related to 4,762 11,822 acquisitions 2,583
5,911
Adjusted net income applicable to Piper Sandler Companies$ 44,066 $ 98,569 $ 100,620 $ 174,048 38
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Table of Contents Three Months Ended Six Months Ended June 30, June 30, (Amounts in thousands, except per share data) 2022 2021 2022 2021
Earnings per diluted common share:
Earnings per diluted common share -
$ 4.12 $ 3.39 $ 7.14
Adjustment for inclusion of unvested acquisition-related (0.14)
(0.45) (0.29) (0.91) stock$ 1.12 $ 3.67 $ 3.10 $ 6.23 Adjustments: Compensation from acquisition-related agreements 1.11 1.20 2.07 2.41
Acquisition-related restructuring and integration costs 0.08
0.15 0.14 0.16 Amortization of intangible assets related to 0.16 0.35 0.28 0.71
acquisitions
Adjusted earnings per diluted common share$ 2.47 $ 5.37 $ 5.59 $ 9.51
Weighted average diluted common shares outstanding: Weighted average diluted common shares outstanding - 16,920
16,951 17,106 16,709U.S. GAAP basis Adjustment: Unvested acquisition-related restricted stock with 937 1,409 886 1,598 service conditions Adjusted weighted average diluted common shares 17,857 18,360 17,992 18,307 outstanding
External Factors Impacting Our Business
Performance in the financial services industry in which we operate is highly correlated to the overall strength of macroeconomic conditions, financial market activity and the effect of geopolitical events. 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 a 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. 39 -------------------------------------------------------------------------------- Table of Contents Outlook for the Remainder of 2022 We believe that theU.S. economy will continue to slow for the remainder of 2022 with a heightened risk of economic recession. Additionally, the financial markets continued to experience increased uncertainty resulting from macroeconomic and geopolitical risks, such as the war inUkraine , persistent inflation, supply and demand imbalances, labor shortages and higher energy prices. These risks contributed to increased market volatility and have resulted in a subdued economic outlook. Future legislative actions and policies by theU.S. federal government, including on levels of taxation and spending, may also impact economic growth. We believe the tightening of theU.S. monetary policy will continue to be a critical factor impacting the economy and financial markets. TheU.S. Federal Reserve increased its short-term benchmark interest rate by 75 basis points in both June and July of 2022 and is expected to raise rates further this year with its primary near-term focus to slow inflation. Additionally, theU.S. Federal Reserve began its quantitative tightening measures during the second quarter of 2022 by reducing its holdings of securities.
The overall market for equity capital raising remains largely shut down driven by high levels of market volatility, declining equity valuations and a more cautious investor outlook stemming from economic concerns and geopolitical risks. It remains unclear when the equity capital markets will reopen.
We experienced a lower level of advisory services activity in the second quarter of 2022 driven by macroeconomic uncertainty delaying transaction timelines and increasing deal risk, as well as a decline in CEO confidence and weaker business performance and valuations. While our pipeline across industry teams is strong, the current environment has introduced a level of uncertainty in our outlook that we have not experienced in the last 18 months. Equity brokerage revenues in the second quarter of 2022 reflected a full quarter with Cornerstone Macro on our platform and elevated volatility and volumes. As integration activities progress, we expect to execute on cross-selling opportunities and realize market share gains. We believe these market share gains will offset the expected decrease in the research and trading services fee pool for 2022 resulting from the significant year-to-date decline in the equity markets. Also, the equity market historically experiences a slowdown during the summer months. Our fixed income services business navigated volatile interest rates during the second quarter of 2022, as clients assessed the impact of inflation, tightening monetary policy and the economic outlook, to record results consistent with the first quarter. We believe our broad product offerings and diverse client base will help deliver consistent results across market environments. Our municipal financing revenues in the second quarter of 2022 reflected solid contributions from both our governmental business and specialty sectors, which we expect to continue in the second half of 2022. We believe overall municipal market issuance levels to continue to moderate driven by a decline in refinancing activity. Our specialty sector pipeline is strong, however execution will be dependent on market conditions. 40 -------------------------------------------------------------------------------- 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, 2022 (Amounts in thousands) 2022 2021 v2021 2022 2021 Revenues: Investment banking$ 234,132 $ 387,147 (39.5) % 66.5 % 76.1 % Institutional brokerage 104,942 95,830 9.5 29.8 18.8 Interest income 4,536 1,673 171.1 1.3 0.3 Investment income 10,936 26,694 (59.0) 3.1 5.2 Total revenues 354,546 511,344 (30.7) 100.7 100.5 Interest expense 2,355 2,696 (12.6) 0.7 0.5 Net revenues 352,191 508,648 (30.8) 100.0 100.0 Non-interest expenses: Compensation and benefits 239,917 325,252 (26.2) 68.1 63.9 Outside services 14,429 10,593 36.2 4.1 2.1 Occupancy and equipment 15,562 13,720 13.4 4.4 2.7 Communications 13,215 10,026 31.8 3.8 2.0 Marketing and business development 12,238 5,114 139.3 3.5 1.0 Deal-related expenses 8,308 8,710 (4.6) 2.4 1.7 Trade execution and clearance 5,891 4,207 40.0 1.7 0.8 Restructuring and integration costs 1,609 3,433 (53.1) 0.5 0.7 Intangible asset amortization 3,393 7,520 (54.9) 1.0 1.5 Other operating expenses 469 6,013 (92.2) 0.1 1.2 Total non-interest expenses 315,031 394,588 (20.2) 89.4 77.6 Income before income tax expense 37,160 114,060 (67.4) 10.6 22.4 Income tax expense 9,385 27,066 (65.3) 2.7 5.3 Net income 27,775 86,994 (68.1) 7.9 17.1 Net income applicable to noncontrolling interests 6,385 17,173 (62.8) 1.8 3.4 Net income applicable to Piper Sandler Companies$ 21,390 $ 69,821 (69.4) % 6.1 % 13.7 % 41
-------------------------------------------------------------------------------- Table of Contents For the three months endedJune 30, 2022 , we recorded net income applicable toPiper Sandler Companies of$21.4 million . Net revenues for the three months endedJune 30, 2022 were$352.2 million , a 30.8 percent decrease compared with$508.6 million in the year-ago period. In the second quarter of 2022, investment banking revenues were$234.1 million , down 39.5 percent compared to$387.1 million in the prior-year period, resulting from lower advisory services and corporate financing revenues. For the three months endedJune 30, 2022 , institutional brokerage revenues increased 9.5 percent to$104.9 million , compared with$95.8 million in the second quarter of 2021, as higher equity brokerage revenues were partially offset by lower fixed income services revenues. For the three months endedJune 30, 2022 , net interest income was$2.2 million , compared to net interest expense of$1.0 million in the prior-year period. In the second quarter of 2022, we recorded investment income of$10.9 million , compared to$26.7 million in the second quarter of 2021. In the current quarter, we recorded lower gains on our investments and the noncontrolling interests in the merchant banking funds that we manage. Non-interest expenses were$315.0 million for the three months endedJune 30, 2022 , down 20.2 percent compared with$394.6 million in the prior-year period, primarily due to decreased compensation expenses resulting from lower revenues.
Consolidated Non-Interest Expenses
Compensation and Benefits - Compensation and benefits expenses, which are the largest component of our expenses, include salaries, incentive compensation, benefits, stock-based compensation, employment taxes, reversal of expenses associated with the forfeiture of stock-based compensation and other employee-related costs. A significant portion of compensation expense is comprised of variable incentive arrangements, including discretionary incentive compensation, the amount of which fluctuates in proportion to the level of business activity, increasing with higher revenues and operating profits. Other compensation costs, primarily base salaries and benefits, are more fixed in nature. The timing of incentive compensation payments, which generally occur in February, has a greater impact on our cash position and liquidity than is reflected on our consolidated statements of operations. In conjunction with our acquisitions, we have granted restricted stock and restricted cash with service conditions, which are amortized to compensation expense over the service period. We have also entered into forgivable loans with service conditions, which are amortized to compensation expense over the loan term. Additionally, expense estimates related to revenue-based earnout arrangements entered into as part of our acquisitions are amortized to compensation expense over the service period. The following table summarizes our future acquisition-related compensation expense for restricted stock, restricted cash and forgivable loans with service conditions, as well as expense estimates related to revenue-based earnout arrangements: (Amounts in thousands) Remainder of 2022$ 47,154 2023 40,494 2024 29,382 2025 10,710 2026 3,568 Thereafter 692 Total$ 132,000 For the three months endedJune 30, 2022 , compensation and benefits expenses decreased 26.2 percent to$239.9 million , compared with$325.3 million in the corresponding period of 2021, due to lower revenues. Compensation and benefits expenses as a percentage of net revenues was 68.1 percent in the second quarter of 2022, compared to 63.9 percent in the second quarter of 2021. Excluding the impact of noncontrolling interests, our compensation ratio increased to 69.7 percent in the second quarter of 2022, compared with 66.3 percent in the second quarter of 2021 due to lower net revenues. 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 36.2 percent to$14.4 million in the second quarter of 2022, compared with$10.6 million in the corresponding period of 2021. Excluding the portion of expenses from non-controlled equity interests in our consolidated alternative asset management funds, outside services expenses increased 33.1 percent, primarily due to higher professional fees associated with recruiting as well as higher legal fees. Occupancy and Equipment - For the three months endedJune 30, 2022 , occupancy and equipment expenses increased 13.4 percent to$15.6 million , compared with$13.7 million in the corresponding period of 2021, primarily due to incremental occupancy costs related to our acquisition of Cornerstone Macro as well as office space expansion. 42 -------------------------------------------------------------------------------- Table of Contents 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, 2022 , communication expenses increased 31.8 percent to$13.2 million , compared with$10.0 million in the corresponding period of 2021, due to higher market data services expenses in part resulting from incremental costs related to our acquisition of Cornerstone Macro. 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, 2022 , marketing and business development expenses increased to$12.2 million , compared with$5.1 million in the corresponding period of 2021. The increase was due to higher travel expenses driven by an acceleration of activity and overall inflationary impact on costs. With the end of pandemic-related travel restrictions, our travel costs have reverted to more normalized levels in 2022. 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, 2022 , deal-related expenses were$8.3 million , compared with$8.7 million for the three months endedJune 30, 2021 . 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, 2022 , trade execution and clearance expenses increased 40.0 percent to$5.9 million , compared with$4.2 million in the corresponding period of 2021. The increase in trade execution and clearance expenses is reflective of higher trading volumes compared with the second quarter of 2021. Restructuring and Integration Costs - For the three months endedJune 30, 2022 , we incurred acquisition-related restructuring and integration costs of$1.6 million , primarily consisting of transaction costs related to our acquisitions ofCornerstone Macro and Stamford Partners and the announced acquisition ofDBO Partners . We expect to incur additional restructuring and integration costs for the remainder of 2022. For the three months endedJune 30, 2021 , we incurred acquisition-related restructuring and integration costs of$3.4 million , primarily related to vacated leased office space associated with our acquisitions ofThe Valence Group andTRS Advisors LLC . Intangible Asset Amortization - Intangible asset amortization includes the amortization of definite-lived intangible assets consisting of customer relationships and internally developed software. For the three months endedJune 30, 2022 , intangible asset amortization was$3.4 million , compared to$7.5 million for the three months endedJune 30, 2021 . The decrease was due to lower intangible asset amortization expense associated with our 2020 acquisitions, partially offset by incremental intangible asset amortization expense associated with our 2022 acquisitions. Beginning in the fourth quarter of 2022, we anticipate incurring additional intangible asset amortization expense related to the acquisition ofDBO Partners .
The following table summarizes the future aggregate amortization expense of our intangible assets with determinable lives:
(Amounts in thousands) Remainder of 2022$ 7,406 2023 10,981 2024 9,069 2025 7,832 2026 7,202 Thereafter 6,105 Total$ 48,595 Other Operating Expenses - Other operating expenses primarily 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$0.5 million in the second quarter of 2022, compared with$6.0 million in the corresponding period in 2021. The decrease was primarily due to lower expense related to our charitable giving program driven by lower operating profits. 43 -------------------------------------------------------------------------------- Table of Contents Income Taxes - For the three months endedJune 30, 2022 , our provision for income taxes was$9.4 million . Excluding the impact of noncontrolling interests, our effective tax rate was 30.5 percent. The higher effective tax rate was driven by the impact of non-deductible expenses. For the three months endedJune 30, 2021 , our provision for income taxes was$27.1 million . Excluding the impact of noncontrolling interests, our effective tax rate was 27.9 percent. Financial Performance
Our activities as an investment bank and institutional securities firm constitute a single business segment.
Throughout this section, we have presented results on both aU.S. GAAP and non-GAAP basis. Management believes that presenting results and measures on an adjusted, non-GAAP basis in conjunction with the correspondingU.S. GAAP measures provides a more meaningful basis for comparison of its operating results and underlying trends between periods, and enhances the overall understanding of our current financial performance by excluding certain items that may not be indicative of our core operating results. The non-GAAP results should be considered in addition to, not as a substitute for, the results prepared in accordance withU.S. GAAP. The adjusted financial results exclude (1) revenues and expenses related to noncontrolling interests, (2) interest expense on long-term financing from net revenues, (3) amortization of intangible assets related to acquisitions, (4) compensation expenses from acquisition-related agreements and (5) acquisition-related restructuring and integration costs. ForU.S. GAAP purposes, these items are included in each of their respective line items on the consolidated statements of operations.
The following table sets forth the adjusted, non-GAAP financial results and
adjustments necessary to reconcile to our consolidated
Three Months Ended June 30, 2022 2021 Adjustments (1) Adjustments (1) Total Noncontrolling Other U.S. Total Noncontrolling Other U.S. (Amounts in thousands) Adjusted Interests Adjustments GAAP Adjusted Interests Adjustments GAAP Investment banking Advisory services$ 169,660 $ - $ -$ 169,660 $ 248,668 $ - $ -$ 248,668 Corporate financing 29,237 - - 29,237 102,401 - - 102,401 Municipal financing 35,235 - - 35,235 36,078 - - 36,078 Total investment banking 234,132 - - 234,132 387,147 - - 387,147 Institutional brokerage Equity brokerage 51,375 - - 51,375 34,873 - - 34,873 Fixed income services 53,567 - - 53,567 60,957 - - 60,957 Total institutional brokerage 104,942 - - 104,942 95,830 - - 95,830 Interest income 4,536 - - 4,536 1,673 - - 1,673 Investment income 2,762 8,174 - 10,936 8,502 18,192 - 26,694 Total revenues 346,372 8,174 - 354,546 493,152 18,192 - 511,344 Interest expense 730 - 1,625 2,355 479 - 2,217 2,696 Net revenues 345,642 8,174 (1,625) 352,191 492,673 18,192 (2,217) 508,648 Total non-interest expenses 285,110 1,789 28,132 315,031 356,199 1,019 37,370 394,588 Pre-tax income$ 60,532 $ 6,385 $ (29,757) $ 37,160 $ 136,474 $ 17,173 $ (39,587) $ 114,060 Pre-tax margin 17.5 % 10.6 % 27.7 % 22.4 % 44
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Table of Contents
(1)The following is a summary of the adjustments needed to reconcile our
consolidated
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) 2022 2021 Interest expense on long-term financing $
1,625
Compensation from acquisition-related agreements 23,130 26,417 Acquisition-related restructuring and integration costs 1,609 3,433 Amortization of intangible assets related to acquisitions 3,393 7,520 28,132 37,370 Total other adjustments$ 29,757 $ 39,587 Net revenues on aU.S. GAAP basis were$352.2 million for the three months endedJune 30, 2022 , compared with$508.6 million in the prior-year period. For the three months endedJune 30, 2022 , adjusted net revenues were$345.6 million , compared with$492.7 million in the second quarter of 2021. The variance explanations for net revenues and adjusted net revenues are consistent on both aU.S. GAAP and non-GAAP basis unless stated otherwise.
The following table provides supplemental business information:
Three Months EndedJune 30, 2022 2021 Advisory services Completed M&A and restructuring transactions 49
59
Completed capital advisory transactions 22
40
Corporate financings Total equity transactions priced 11
48
Book run equity transactions priced 9
30
Total debt and preferred transactions priced 10
19
Book run debt and preferred transactions priced 5
11
Municipal negotiated issues Aggregate par value of issues priced (in billions)$ 4.4 $ 5.0 Total issues priced 160 280 Equity brokerage Number of shares traded (in billions) 2.8
2.4
Investment banking revenues comprise all of the revenues generated through advisory services activities, which includes mergers and acquisitions ("M&A"), equity and debt private placements, debt and restructuring advisory, and municipal financial advisory transactions. Collectively, debt advisory transactions and equity and debt private placements are referred to as capital advisory transactions. Investment banking revenues also include equity and debt corporate financing activities and municipal financings. 45 -------------------------------------------------------------------------------- Table of Contents In the second quarter of 2022, investment banking revenues decreased 39.5 percent to$234.1 million , compared with$387.1 million in the prior-year period. For the three months endedJune 30, 2022 , advisory services revenues were$169.7 million , down 31.8 percent compared to$248.7 million in the second quarter of 2021, due to fewer completed transactions and lower average fees driven by delayed transaction closings. For the three months endedJune 30, 2022 , corporate financing revenues were$29.2 million , down 71.4 percent compared with$102.4 million for the three months endedJune 30, 2021 , as the overall market for equity capital raising continues to remain largely shut as the result of market volatility, declining valuations and a cautious investor outlook stemming from economic concerns and geopolitical risks. Activity for us during the second quarter of 2022 was principally in the financial services and healthcare sectors. Municipal financing revenues for the three months endedJune 30, 2022 were$35.2 million , compared to$36.1 million in the prior-year period. Our revenues were essentially flat relative to an approximate 12 percent decline in the overall market based on the par value of municipal negotiated issuances driven by less refinancing activity. Our results in the second quarter of 2022 reflect solid performance within our governmental business, as well as our specialty sectors. Institutional brokerage revenues comprise all of the revenues generated through trading activities, which consist of facilitating customer trades and executing competitive municipal underwritings, as well as fees received for our research services. 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, 2022 , institutional brokerage revenues increased 9.5 percent to$104.9 million , compared with$95.8 million in the prior-year period. Equity brokerage revenues were$51.4 million in the second quarter of 2022, up 47.3 percent compared with$34.9 million in the corresponding period of 2021, due to the addition of Cornerstone Macro to our platform as well as elevated volatility driving increased client activity. For the three months endedJune 30, 2022 , fixed income services revenues were$53.6 million , down 12.1 percent compared to$61.0 million in the prior-year period due to lower client activity resulting from interest rate volatility and expectations for continued tightening of monetary policy. Interest income represents amounts earned from holding long inventory positions. For the three months endedJune 30, 2022 , interest income increased to$4.5 million , compared with$1.7 million for the three months endedJune 30, 2021 . Average inventory balances are largely consistent with the prior-year period, however higher yields are driving the increase in interest income. Investment income includes realized and unrealized gains and losses on investments, including amounts attributable to noncontrolling interests, in our merchant banking and healthcare funds, as well as management and performance fees generated from those funds. For the three months endedJune 30, 2022 , we recorded investment income of$10.9 million , compared with$26.7 million in the corresponding period of 2021. In the second quarter of 2022, we recorded lower gains on our investments and the noncontrolling interests in the merchant banking funds that we manage. Excluding the impact of noncontrolling interests, adjusted investment income was$2.8 million for the three months endedJune 30, 2022 , compared with$8.5 million for the three months endedJune 30, 2021 . 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, 2022 , interest expense decreased to$2.4 million , compared with$2.7 million in the prior-year period. The decrease was primarily due to lower interest paid on long-term financing as we repaid the$50 million of Class A unsecured senior notes upon maturity onOctober 15, 2021 . Excluding the impact of interest expense on long-term financing, adjusted interest expense increased to$0.7 million for the three months endedJune 30, 2022 , compared with$0.5 million for the three months endedJune 30, 2021 . Pre-tax margin for the three months endedJune 30, 2022 decreased to 10.6 percent, compared to 22.4 percent for the corresponding period of 2021 driven by lower net revenues and a higher compensation ratio. Adjusted pre-tax margin for the three months endedJune 30, 2022 decreased to 17.5 percent, compared with 27.7 percent for the corresponding period of 2021 due to lower adjusted net revenues and higher adjusted non-compensation expenses. 46 -------------------------------------------------------------------------------- Table of Contents Financial Summary for the six months endedJune 30, 2022 andJune 30, 2021
The following table provides a summary of the results of our operations on a
As a Percentage of Net Revenues for the Six Months Ended Six Months Ended June 30, June 30, 2022 (Amounts in thousands) 2022 2021 v2021 2022 2021 Revenues: Investment banking$ 491,634 $ 683,221 (28.0) % 70.0 % 72.9 % Institutional brokerage 209,504 205,318 2.0 29.8 21.9 Interest income 8,392 3,730 125.0 1.2 0.4 Investment income/(loss) (2,138) 50,462 N/M (0.3) 5.4 Total revenues 707,392 942,731 (25.0) 100.6 100.6 Interest expense 4,556 5,476 (16.8) 0.6 0.6 Net revenues 702,836 937,255 (25.0) 100.0 100.0 Non-interest expenses: Compensation and benefits 487,816 605,580 (19.4) 69.4 64.6 Outside services 25,605 18,268 40.2 3.6 1.9 Occupancy and equipment 30,098 27,742 8.5 4.3 3.0 Communications 25,640 21,834 17.4 3.6 2.3 Marketing and business development 20,870 7,181 190.6 3.0 0.8 Deal-related expenses 13,852 21,141 (34.5) 2.0 2.3 Trade execution and clearance 9,926 8,387 18.3 1.4 0.9 Restructuring and integration costs 2,856 3,568 (20.0) 0.4 0.4 Intangible asset amortization 6,314 15,040 (58.0) 0.9 1.6 Other operating expenses 7,062 11,587 (39.1) 1.0 1.2 Total non-interest expenses 630,039 740,328 (14.9) 89.6 79.0 Income before income tax expense 72,797 196,927 (63.0) 10.4 21.0 Income tax expense 20,364 44,340 (54.1) 2.9 4.7 Net income 52,433 152,587 (65.6) 7.5 16.3 Net income/(loss) applicable to noncontrolling interests (5,608) 33,307 N/M (0.8) 3.6 Net income applicable to Piper Sandler Companies$ 58,041 $ 119,280 (51.3) % 8.3 % 12.7 % 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.
47 -------------------------------------------------------------------------------- Table of Contents For the six months endedJune 30, 2022 , we recorded net income applicable toPiper Sandler Companies of$58.0 million . Net revenues for the six months endedJune 30, 2022 decreased 25.0 percent to$702.8 million , compared with$937.3 million in the year-ago period. In the first half of 2022, investment banking revenues decreased 28.0 percent to$491.6 million , compared with$683.2 million in the prior-year period, primarily driven by lower corporate financing as well as lower advisory services revenues. For the six months endedJune 30, 2022 , institutional brokerage revenues increased to$209.5 million , compared with$205.3 million in the first half of 2021. In the first six months of 2022, net interest income was$3.8 million , compared to net interest expense of$1.7 million in the prior year period. For the six months endedJune 30, 2022 , we recorded an investment loss of$2.1 million , compared to investment income of$50.5 million in the prior-year period. In the first six months of 2022, we recorded unrealized losses on our investments and the noncontrolling interests in the merchant banking funds that we manage. Non-interest expenses were$630.0 million for the six months endedJune 30, 2022 , down 14.9 percent compared to$740.3 million in the year-ago period, primarily due to decreased compensation expenses resulting from lower revenues.
Consolidated Non-Interest Expenses
Income Taxes - For the six months endedJune 30, 2022 , our provision for income taxes was$20.4 million , which included a$4.6 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 31.9 percent. The higher effective tax rate was driven by the impact of non-deductible expenses. For the six months endedJune 30, 2021 , our provision for income taxes was$44.3 million , which included a$1.4 million tax benefit related to stock-based compensation awards vesting at values greater than the grant price. Excluding the impact of this benefit and noncontrolling interests, our effective tax rate was 28.0 percent. 48 -------------------------------------------------------------------------------- Table of Contents Financial Performance
The following table sets forth the adjusted, non-GAAP financial results and
adjustments necessary to reconcile to our consolidated
Six Months Ended June 30, 2022 2021 Adjustments (1) Adjustments (1) Total Noncontrolling Other U.S. Total Noncontrolling Other U.S. (Amounts in thousands) Adjusted Interests Adjustments GAAP Adjusted Interests Adjustments GAAP Investment banking Advisory services$ 380,559 $ - $ -$ 380,559 $ 401,517 $ - $ -$ 401,517 Corporate financing 48,423 - - 48,423 218,537 - - 218,537 Municipal financing 62,652 - - 62,652 63,167 - - 63,167 Total investment banking 491,634 - - 491,634 683,221 - - 683,221 Institutional brokerage Equity brokerage 101,180 - - 101,180 78,107 - - 78,107 Fixed income services 108,324 - - 108,324 127,211 - - 127,211 Total institutional brokerage 209,504 - - 209,504 205,318 - - 205,318 Interest income 8,392 - - 8,392 3,730 - - 3,730 Investment income/(loss) (789) (1,349) - (2,138) 15,127 35,335 - 50,462 Total revenues 708,741 (1,349) - 707,392 907,396 35,335 - 942,731 Interest expense 1,306 - 3,250 4,556 972 - 4,504 5,476 Net revenues 707,435 (1,349) (3,250) 702,836 906,424 35,335 (4,504) 937,255 Total non-interest expenses 571,702 4,259 54,078 630,039 667,215 2,028 71,085 740,328 Pre-tax income$ 135,733 $ (5,608) $ (57,328) $ 72,797 $ 239,209 $ 33,307
Pre-tax margin 19.2 % 10.4 % 26.4 % 21.0 %
(1) The following is a summary of the adjustments needed to reconcile our
consolidated
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) 2022 2021 Interest expense on long-term financing $
3,250
Compensation from acquisition-related agreements 44,908 52,477 Acquisition-related restructuring and integration costs 2,856 3,568 Amortization of intangible assets related to acquisitions 6,314 15,040 54,078 71,085 Total other adjustments$ 57,328 $ 75,589 Net revenues on aU.S. GAAP basis were$702.8 million for the six months endedJune 30, 2022 , compared with$937.3 million in the prior-year period. In the first half of 2022, adjusted net revenues were$707.4 million , compared with$906.4 million in the first half of 2021. The variance explanations for net revenues and adjusted net revenues are consistent on both aU.S. GAAP and non-GAAP basis unless stated otherwise. 49 -------------------------------------------------------------------------------- Table of Contents The following table provides supplemental business information: Six Months Ended June 30, 2022 2021 Advisory services Completed M&A and restructuring transactions 103
108
Completed capital advisory transactions 49
69
Corporate financings Total equity transactions priced 15
119
Book run equity transactions priced 11
79
Total debt and preferred transactions priced 21
25
Book run debt and preferred transactions priced 12
12
Municipal negotiated issues Aggregate par value of issues priced (in billions)$ 7.5 $ 8.1 Total issues priced 314 493 Equity brokerage Number of shares traded (in billions) 5.6
5.4
In the first half of 2022, investment banking revenues were$491.6 million , down 28.0 percent compared to$683.2 million in the corresponding period of the prior year. For the six months endedJune 30, 2022 , advisory services revenues were$380.6 million , down 5.2 percent compared with$401.5 million in the first half of 2021, due to fewer completed transactions. For the six months endedJune 30, 2022 , corporate financing revenues were$48.4 million , down 77.8 percent compared to$218.5 million in the prior-year period, as the market for equity capital raising remains largely shut down. Activity for us during the first half of 2022 was primarily in the financial services sector. Municipal financing revenues for the six months endedJune 30, 2022 were$62.7 million , compared to$63.2 million in the year-ago period. Our increase in average issuance size from 2021 drove revenues despite the decline in issuance activity resulting from higher nominal interest rates and increased interest rate volatility. In the first half of 2022, our results were driven by solid issuance activity in our governmental business and specialty sectors. For the six months endedJune 30, 2022 , institutional brokerage revenues increased to$209.5 million , compared with$205.3 million in the prior-year period. Equity brokerage revenues increased 29.5 percent to$101.2 million in the first half of 2022, compared with$78.1 million in the corresponding period of 2021, due to the addition of Cornerstone Macro to our platform. For the six months endedJune 30, 2022 , fixed income services revenues were$108.3 million , down 14.8 percent compared to$127.2 million in the prior-year period, as a result of lower client activity driven by interest rate volatility and expectations for inflation, tightening of monetary policy and the economic outlook.
Interest income for the six months ended
For the six months endedJune 30, 2022 , we recorded an investment loss of$2.1 million , compared to investment income of$50.5 million in the year-ago period. In the first six months of 2022, we recorded unrealized losses on our investments and the noncontrolling interests in the merchant banking funds that we manage that reflect lower equity market valuations. Excluding the impact of noncontrolling interests, adjusted investment loss was$0.8 million for the six months endedJune 30, 2022 , compared with adjusted investment income of$15.1 million for the six months endedJune 30, 2021 . Interest expense for the six months endedJune 30, 2022 was$4.6 million , compared with$5.5 million in the prior-year period. The decrease was primarily due to lower interest paid on long-term financings as we repaid the$50 million of Class A unsecured senior notes upon maturity onOctober 15, 2021 . Excluding the impact of interest expense on long-term financing, adjusted interest expense was$1.3 million and$1.0 million for the six months endedJune 30, 2022 and 2021, respectively. 50 -------------------------------------------------------------------------------- Table of Contents Pre-tax margin for the six months endedJune 30, 2022 was 10.4 percent, compared to 21.0 percent for the six months endedJune 30, 2021 . Adjusted pre-tax margin for the six months endedJune 30, 2022 decreased to 19.2 percent, compared with 26.4 percent for the corresponding period of 2021. In the first six months of 2022, the decrease in pre-tax margin on both aU.S. GAAP and adjusted basis was driven by lower revenue levels and a higher compensation ratio. Additionally, adjusted pre-tax margin decreased due to higher adjusted non-compensation expenses.
Recent Accounting Pronouncements
Recent accounting pronouncements are set forth in Note 2 to our unaudited consolidated financial statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q, 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, 2021 for further information on our critical accounting policies.
Liquidity, Funding and Capital Resources
We regularly monitor our liquidity position, which is of critical importance to our business. Accordingly, we 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. Insufficient liquidity resulting from adverse circumstances contributes to, and may be the cause of, financial institution failure. 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. 51 --------------------------------------------------------------------------------
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Our acquisition of
Our dividend policy is intended to return between 30 percent and 50 percent of our fiscal year adjusted net income to shareholders. Our board of directors determines the declaration and payment of dividends and is free to change our dividend policy at any time. Our board of directors declared the following dividends on shares of our common stock: Declaration Date Dividend Per Share Record Date Payment Date Related to 2020: February 4, 2021 (1) $ 1.85 March 3, 2021 March 12, 2021 Related to 2021: February 4, 2021 $ 0.40 March 3, 2021 March 12, 2021 April 30, 2021 $ 0.45 May 28, 2021 June 11, 2021 July 30, 2021 $ 0.55 August 27, 2021 September 10, 2021 October 29, 2021 (1) $ 3.00 November 23, 2021 December 10, 2021 October 29, 2021 $ 0.55 November 23, 2021 December 10, 2021 February 10, 2022 (1) $ 4.50 March 2, 2022 March 11, 2022 Related to 2022: February 10, 2022 $ 0.60 March 2, 2022 March 11, 2022 April 29, 2022 $ 0.60 May 27, 2022 June 10, 2022 July 29, 2022 $ 0.60 August 26, 2022 September 9, 2022
(1)Represents a special cash dividend.
We repurchase our common stock as part of our capital management strategy in order to offset the dilutive effect of our employee stock-based compensation awards over time and return capital to shareholders. We had two share repurchase authorizations in place as ofJune 30, 2022 . EffectiveMay 6, 2022 , our board of directors authorized the repurchase of up to$150.0 million in common shares throughDecember 31, 2024 . AtJune 30, 2022 , we had$150.0 million remaining under this authorization. EffectiveJanuary 1, 2022 , our board of directors authorized the repurchase of up to$150.0 million in common shares throughDecember 31, 2023 . During the six months endedJune 30, 2022 , we repurchased 1,068,387 shares of our common stock at an average price of$133.79 per share for an aggregate purchase price of$142.9 million related to this authorization. AtJune 30, 2022 , we had$7.1 million remaining under this authorization, for a combined$157.1 million remaining under both current authorizations. 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 2022, we purchased 139,073 shares or$21.3 million of our common stock for these purposes. 52 -------------------------------------------------------------------------------- Table of Contents Leverage The following table presents total assets, adjusted assets, total shareholders' equity and tangible common shareholders' equity with the resulting leverage ratios: June 30, December 31, (Dollars in thousands) 2022 2021 Total assets$ 1,950,972 $ 2,565,307
Deduct:Goodwill and intangible assets (378,316)
(347,286)
Deduct: Right-of-use lease asset (98,584)
(71,341)
Deduct: Assets from noncontrolling interests (184,797) (168,675)
Adjusted assets$ 1,289,275 $
1,978,005
Total shareholders' equity$ 1,177,635 $
1,226,855
Deduct:Goodwill and intangible assets (378,316)
(347,286)
Deduct: Noncontrolling interests (180,996)
(164,645)
Tangible common shareholders' equity$ 618,323 $ 714,924 Leverage ratio (1) 1.7 2.1 Adjusted leverage ratio (2) 2.1 2.8
(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, toPiper 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 decreased fromDecember 31, 2021 , due to a decline in cash and cash equivalents driven by annual incentive compensation payments in the first quarter of 2022 and repurchases of our common stock during the first six months of 2022.
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. Our day-to-day funding and liquidity is obtained primarily through the use of our clearing arrangement withPershing LLC ("Pershing"), a clearing arrangement with bank financing, 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. Our committed line has been established to mitigate changes in the liquidity of our inventory based on changing market conditions, and 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 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"). 53 -------------------------------------------------------------------------------- Table of Contents 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, all of our securities inventories with the exception of convertible securities, 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, 2022 , we had less than$0.1 million of financing outstanding under this arrangement. Clearing Arrangement with Bank Financing - In the second quarter of 2021, we established a financing arrangement with aU.S. branch of Canadian Imperial Bank of Commerce ("CIBC") related to our convertible securities inventories. Under this arrangement, our convertible securities inventories are cleared through a broker dealer affiliate of CIBC, and held and financed by CIBC. Our convertible securities inventories are generally economically hedged by the underlying common stock or the stock options of the underlying common stock. 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 CIBC 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, 2022 , we had$70.0 million of financing outstanding under this arrangement. Prime Broker Arrangement - We previously had an overnight financing arrangement with a broker dealer related to our convertible securities inventories. In the second quarter of 2021, we replaced this arrangement with the clearing arrangement with bank financing. Committed Line - Our committed line is a one-year$100 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 9, 2022 . This credit facility has been in place since 2008 and we renewed the facility for another one-year term in the fourth quarter of 2021. AtJune 30, 2022 , we had no advances against this line of credit. Revolving Credit Facility - Our parent company,Piper Sandler Companies , has an unsecured$65 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, 2022 , there were no advances against this credit facility. This credit facility includes customary events of default and covenants that, among other things, requiresPiper Sandler & Co. to maintain a minimum regulatory net capital of$120 million , limits our leverage ratio, requires maintenance of a minimum ratio of operating cash flow to fixed charges, and imposes certain limitations on our ability to make acquisitions and make payments on our capital stock. AtJune 30, 2022 , we were in compliance with all covenants.
The following table presents the average balances outstanding for our various funding sources by quarter for 2022 and 2021:
Average Balance for the Three Months Ended (Amounts in millions) June 30, 2022 Mar. 31, 2022 Funding source: Pershing clearing arrangement$ 19.7
$ 3.8
Clearing arrangement with bank financing 83.3 110.3 Prime broker arrangement - - Total$ 103.0 $ 114.1 54
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Average Balance for the Three Months Ended (Amounts in millions) Dec. 31, 2021 Sept. 30, 2021 June 30, 2021 Mar. 31, 2021 Funding source: Pershing clearing arrangement$ 4.1 $
12.1 $ 5.2 $ 6.9 Clearing arrangement with bank financing
92.7 84.2 49.9 - Prime broker arrangement - - 8.0 57.2 Total$ 96.8 $ 96.3 $ 63.1 $ 64.1 The average funding in the second quarter of 2022 increased to$103.0 million , compared with$63.1 million during the second quarter of 2021, primarily driven by our clearing arrangement with bank financing. The average funding decreased compared with$114.1 million during the first quarter of 2022, primarily due to lower average balances of convertible securities inventories. The following table presents the maximum daily funding amount by quarter for 2022 and 2021: (Amounts in millions) 2022 2021 First Quarter$ 366.3 $ 141.5 Second Quarter$ 409.5 $ 306.2 Third Quarter$ 228.1 Fourth Quarter$ 170.3 Long-Term Financing Our long-term financing consists of$125 million of Class B unsecured fixed rate senior notes ("ClassB Notes "). The initial holders of the ClassB Notes were certain entities advised by Pacific Investment Management Company ("PIMCO"). The ClassB Notes bear interest at an annual fixed rate of 5.20 percent and mature onOctober 15, 2023 . Interest is payable semi-annually. The unpaid principal amount is due in full on the maturity date and may not be prepaid. The ClassB Notes include 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, 2022 , we were in compliance with all covenants. 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, 2022 , our net capital under theSEC's uniform net capital rule was$243.1 million , and exceeded the minimum net capital required under theSEC rule by$242.1 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 ClassB Notes include covenants requiringPiper Sandler & Co. to maintain a minimum regulatory net capital of$120 million . Our fully disclosed clearing agreement with Pershing includes a covenant requiringPiper Sandler & Co. to maintain excess net capital of$120 million . AtJune 30, 2022 ,Piper Sandler Ltd. , our broker dealer subsidiary registered in theU.K. , was subject to, and was in compliance with, the capital requirements of thePrudential Regulation Authority and theFinancial Conduct Authority pursuant to the Financial Services Act of 2012. 55 -------------------------------------------------------------------------------- Table of ContentsPiper Sandler Hong Kong Limited is licensed by theHong Kong Securities and Futures Commission , which is subject to the liquid capital requirements of the Securities and Futures (Financial Resources) Rule promulgated under the Securities and Futures Ordinance. AtJune 30, 2022 ,Piper Sandler Hong Kong Limited was in compliance with the liquid capital requirements of theHong Kong Securities and Futures Commission .
Off-Balance Sheet Arrangements
In the ordinary course of business we enter into various types of off-balance sheet arrangements. The following table summarizes the notional contract value of our off-balance sheet arrangements for the periods presented: Expiration Per Period atDecember 31 ,
Total Contractual Amount
2025 2027 June 30, December 31, (Amounts in thousands) 2022 2023 2024 - 2026 - 2028 Later 2022 2021 Customer matched-book derivative contracts (1) (2)$ 8,430 $ 1,080 $
17,930
1,576,572$ 1,630,056 Trading securities derivative contracts (2) 124,200 77,750 - - - 9,375 211,325 65,925 Investment commitments (3) - - - - - - 73,839 80,562 (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$156.3 million atJune 30, 2022 ) 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, 2022 , we had$14.0 million of credit exposure with these counterparties, including$9.1 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, 2022 andDecember 31, 2021 , the net fair value of these derivative contracts approximated$14.4 million and$19.8 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 4 to our unaudited consolidated financial statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q.
Investment Commitments
We have investments, including those made as part of our alternative asset management activities, in various limited partnerships or limited liability companies that make direct or indirect equity or debt investments in companies. We commit capital and/or act as the managing partner of these entities. We have committed capital of$73.8 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. OnMarch 5, 2021 , theU.K. Financial Conduct Authority , which regulates LIBOR, formally announced the dates after which LIBOR will cease publication. The publication of certain USD LIBOR tenors and all non-USD LIBOR tenors ceased afterDecember 31, 2021 , which did not impact our operations. The remaining USD LIBOR tenors will continue publication untilJune 30, 2023 . Our limited number of contractual agreements, which use the remaining USD LIBOR tenors, are primarily within our customer matched-book derivatives portfolio. Substantially all of these instruments mature afterJune 30, 2023 and use interest rates based on LIBOR.The International Swaps and Derivatives Association ("ISDA") created the IBOR Fallback Protocol to facilitate amending references to benchmark interest rates in derivative contracts governed by Master ISDA Agreements. If a benchmark interest rate is no longer published, it will "fall back" to a new benchmark interest rate in those contracts where both counterparties have agreed to adhere to the protocol. We are working with our clients to ensure adherence to the protocol. As a result, we do not expect the transition from the remaining USD LIBOR tenors to a replacement rate to have a significant impact on our operations. 56 -------------------------------------------------------------------------------- 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 and Risk. 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 committees, 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 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. 57 -------------------------------------------------------------------------------- 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 and to our market-making activities. The scope of our market risk management policies and procedures includes all market-sensitive cash and derivative 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 4 to our unaudited consolidated financial statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q 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 our long fixed income securities inventory, monitor these limits on a daily basis and manage within those limits. Our limits include but are not limited to the following: position and concentration size, dollar duration (i.e., DV01), credit quality and aging. We estimate that a parallel 50 basis point adverse change in the market would result in a decrease of approximately$0.3 million in the carrying value of our fixed income securities inventory as ofJune 30, 2022 , including the effect of the hedging transactions.
We also measure and monitor the aging and turnover of our long fixed income securities inventory. Turnover is evaluated based on a five-day average by category of security. The vast majority of our fixed income securities inventory generally turns over within three weeks.
In addition to the measures discussed above, we monitor and manage market risk exposure through evaluation of spread DV01 and the MMD basis risk for municipal securities to movements inU.S. treasury securities. All metrics are aggregated by asset concentration and are used for monitoring limits and exception approvals. In times of market volatility, we may also perform ad hoc stress tests and scenario analysis as market conditions dictate. 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 our long inventory, monitoring these limits on a daily basis, 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. 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 and sales and 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. Our inventory positions 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. 58 --------------------------------------------------------------------------------
Table of Contents See the section entitled "Liquidity, Funding and Capital Resources" for information regarding our liquidity and how we manage liquidity risk.
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. A key tenet of our risk management procedures related to credit risk is the daily monitoring of the credit quality of our long fixed income securities inventory. These rating trends and the credit quality mix are regularly reviewed with the executive financial risk committee. The following table summarizes the credit rating for our long corporate fixed income, municipal (taxable and tax-exempt), andU.S. government and agency securities as a percentage of the total of these asset classes as ofJune 30, 2022 : AAA AA A BBB BB Not Rated Corporate fixed income securities - % 1.1 % 0.6 % 0.4 % - % - % Municipal securities - taxable and tax-exempt 10.9 % 57.7 % 13.3 % 1.2 % - % 3.6 %U.S. government and agency securities - % 11.0 % 0.1 % - % - % 0.1 % 10.9 % 69.8 % 14.0 % 1.6 % - % 3.7 %
Convertible and preferred securities are excluded from the table above as they are typically unrated.
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 creditworthiness. We are exposed to credit spread risk with the debt instruments held in our trading inventory. We enter into transactions to hedge our exposure to credit spread risk with 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. 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. Our risk management functions have credit risk policies establishing appropriate credit limits and collateralization thresholds for our customers and counterparties. 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. Potential concentration risk is monitored through review of counterparties and borrowers and is managed using policies and limits established by senior management. 59 -------------------------------------------------------------------------------- Table of Contents We have concentrated counterparty credit exposure with four non-publicly rated entities totaling$14.0 million atJune 30, 2022 . This counterparty credit exposure is part of our matched-book derivative program related to our public finance business, consisting primarily of interest rate swaps. One derivative counterparty represented 65.0 percent, or$9.1 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. Important aspects of these policies and procedures include segregation of duties, management oversight, internal control over financial reporting and independent risk management activities within such functions as Risk Management, Compliance, Operations, Internal Audit,Treasury , Finance, Information Technology and Legal. Internal Audit oversees, monitors, evaluates, analyzes and reports on operational risk across the firm. 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 securities inventories with the exception of convertible securities, and for all of our client clearing activities. 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 individuals who 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. 60 -------------------------------------------------------------------------------- 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, communications charges and travel costs, 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.
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