Earnings Call Transcript - HLI Q2 2024

Charles Yamarone, Chief Compliance Officer

Thank you, operator, and hello everyone. By now, you should all have access to our second quarter fiscal year 2024 earnings release, which can be found on the Houlihan Lokey website at www.hl.com in the Investor Relations section. Before we begin our formal remarks, we need to remind everyone that the discussion today will include forward-looking statements. These forward-looking statements, which are usually identified by the use of words such as will, expect, anticipate, should, or other similar phrases, are not guarantees of future performance. These statements are subject to numerous risks and uncertainties that could cause actual results to differ materially from what we expect. And therefore, you should exercise caution when interpreting and relying on them. We refer all of you to our recent SEC filings for a more detailed discussion of the risks that could impact our future operating results and financial condition. We encourage investors to review our regulatory filings, including the Form 10-Q for the quarter ended September 30, 2023, when it is filed with the SEC. During today's call, we will discuss non-GAAP financial measures, which we believe can be useful in evaluating the company's financial performance. These measures should not be considered in isolation or as a substitute for our financial results prepared in accordance with GAAP. A reconciliation of these measures to the most directly comparable GAAP measures is available in our earnings release and our investor presentation on the hl.com website. Hosting the call today, we have Scott Beiser, Houlihan Lokey's Chief Executive Officer; and Lindsey Alley, Chief Financial Officer of the company. They will provide some opening remarks, and then we will open the call to questions.

Scott Beiser, CEO

Thank you, Chuck. Welcome everyone to our second quarter fiscal 2024 earnings call. We ended the quarter with revenues of $467 million and adjusted earnings per share of $1.11. Revenues were down 5% and adjusted earnings per share were down 7% from the quarter a year earlier. However, in comparison to the June quarter, revenues were up 12% and adjusted earnings per share were up 25%. Over the last seven quarters and during a challenging time in the world's financial markets, our diversified business model has enabled us to produce steady results, with quarterly revenues consistently in a range of $416 million to $490 million. Our business activity and financial results have shown consistent improvement since April, and we enter our third fiscal quarter with measured optimism. The market environment for our Corporate Finance and Financial and Valuation Advisory business is improving, but at a pace that is likely to result in a slow exit from this market environment. Consistent with their commentary in the previous quarter, we continue to experience improvement in client confidence as a result of improving capital markets. We see some improvement in deal momentum, in M&A, and a renewed interest from our clients in testing current market conditions after sitting on the sidelines for more than 18 months. However, recent events, including rising interest rates, a stalled stock market and the war in Israel have slowed some of the momentum we experienced in late spring and early summer. Looking forward, we remain optimistic that market conditions will continue to improve, but we are realistic about the macro pressures that exist today. Our Corporate Finance business produced $282 million in revenues for the quarter. This was a decline from the prior year period but an increase from last quarter. For several months, we have continued to experience a solid level of new business opportunities. Financial sponsors are showing increased interest in taking their portfolio of companies to market; this is a result of improving availability of debt capital, a resilient stock market, pressure from limited partners seeking liquidity and the desire by PE managers to get back into the deal business versus maintenance business. Strategic buyers and sellers are also slowly coming back buoyed by improving equity markets and continued stable financial performance. This increased interest to transact is still tempered by a fickle M&A market, resulting in a longer time to close transactions and deeper due diligence. With respect to our Capital Markets business, our revenues are up year-over-year, driven by improvements in availability of credit, particularly in the mid-cap space. Also, capital is harder to access than it was in calendar 2021, which has increased our value proposition for this service line. Historically, in a business rebound, we see capital markets improving first, then M&A activity follows. We expect this rebound to follow a similar path. Our Financial Restructuring business had another strong quarter, producing revenues of $115 million. While the Restructuring business continues to benefit from higher interest rates and a fast-approaching debt maturity wall, the growth in new business slowed during the quarter, likely a result of improving capital markets. While the U.S. restructuring market has leveled off a bit, causing a slowdown in new business activity, we have seen continued strength in our restructuring business in Europe, Asia, and South America, where we believe our brand and market presence is second to none. As we have said on previous calls, since this restructuring cycle is not the result of a one-off crisis, we expect to experience elevated revenues over the next couple of years versus a significant revenue spike and subsequent drop as we experienced in previous cycles. Financial and Valuation Advisory produced $71 million in quarterly revenues, down from the same quarter last year, but higher than anything we have reported for FVA in the last three quarters. Our market neutral service lines continue to perform well in this environment, while our service lines that are tied to the M&A markets are lagging previous year results. If the slow but general improvements we are seeing in Corporate Finance and the overall M&A markets produce an increase in M&A closings, we would expect FVA to see positive revenue momentum in calendar 2024. Although we resumed share repurchases this quarter, we continue to take a conservative approach to excess cash in order to give us plenty of balance sheet flexibility to take advantage of acquisitions that may arise. Also during the quarter, we had two new Managing Directors start and believe that the market for hiring senior bankers remains attractive. Over the last seven quarters, our senior hires, acquisitions and geographic expansions have resulted in significant value being added to our investment banking platform. We believe we are well positioned for growth as market conditions continue to improve, and we are well prepared to maximize that opportunity for the benefit of our employees and shareholders. And with that, I'll turn the call over to Lindsey.

Lindsey Alley, CFO

Thank you, Scott. Revenues in Corporate Finance were $282 million for the quarter, down 11% when compared to the same quarter last year. We closed 117 transactions this quarter compared to 114 in the same period last year. Although our transaction count increased, our average transaction fee was lower for the quarter versus the same quarter last year. This was a result of deal mix and not the result of any trends in transaction value or fee size. Financial Restructuring revenues were $115 million for the quarter, a 17% increase versus the same period last year. We closed 31 transactions in the quarter compared to 24 in the same period last year, but our average transaction fee on closed deals declined slightly. In Financial and Valuation Advisory, revenues were $71 million for the quarter, an 8% decrease from the same period last year. We had 852 fee events during the quarter compared to 890 in the same quarter last year. Turning to expenses. Our adjusted compensation expenses were $287 million for the quarter versus $301 million for the same quarter last year. Our only adjustment was $9.3 million for deferred retention payments related to certain acquisitions. Our adjusted compensation expense ratio for the second quarter in both fiscal 2024 and fiscal 2023 was 61.5%. We do not expect a change to our long-term target of 61.5% for our adjusted compensation expense ratio. Our adjusted non-compensation expenses were $75 million for the quarter, an increase of $3 million over the same period last year, but flat from the previous quarter. This resulted in an adjusted non-compensation expense ratio of 16.1% for the quarter compared to an adjusted non-compensation expense ratio of 14.8% for the same quarter last year. On a per employee basis, our adjusted non-compensation expense was $29,000 per employee this quarter versus $30,000 per employee for the same quarter last year. We typically see some seasonality in our adjusted non-compensation expenses, with the second half normally coming in modestly higher than the first half. We expect that trend to continue this year. For the quarter, we adjusted out of our non-compensation expenses, $3.4 million in noncash acquisition-related amortization, the majority of which was related to the GCA transaction, and $1.5 million for acquisition-related costs, primarily related to the Seven Mile acquisition, which is expected to close during our third fiscal quarter. Our adjusted other income and expense decreased for the quarter, to income of approximately $2.5 million versus an expense of approximately $1.2 million in the same period last year. The improvement in this category was driven by higher interest income on our cash balances across the globe as a result of higher interest rates. We adjusted out of our other income and expense, a gain of $816,000 related to the payment of an earn-out on a previous acquisition. Our adjusted effective tax rate for the quarter was 28.4%, compared to 27.9% for the same quarter last year. We maintain our long-term range for our effective tax rate of between 27% and 29%, but we expect that our effective tax rate for the year will be at the higher end of that range. Turning to the balance sheet, as of the quarter end, we had approximately $525 million of unrestricted cash and equivalents and investment securities. As a reminder, we will pay the deferred cash bonus related to compensation in fiscal year 2023 to employees in November, which will significantly reduce our balance sheet cash. In this past quarter, we repurchased approximately 239,000 shares at an average price of $104.33 per share as part of our share repurchase program. We continue to take a conservative approach to share repurchases as we are prioritizing balance sheet strength and flexibility to be able to take advantage of acquisition and hiring opportunities in this market. And with that, operator, we can open the line for questions.

Operator, Operator

Thank you. We will now be conducting a question-and-answer session. The first question comes from the line of Brennan Hawken with UBS. Please go ahead.

Brennan Hawken, Analyst

Good afternoon. Thanks for taking my question, guys. I wanted to start with the comments on the Corporate Finance market. So, totally appreciate the environment has been challenging and somewhat fluid. But I'm curious about your perspective on sponsors. We're hearing that sponsors have been a bit slow to return to the M&A market. And I'm curious about what you're seeing there. And with this, maybe a little bit of caution added to the more positive outlook, do you think that it's reasonable to expect some seasonality here this year in the Corporate Finance line?

Scott Beiser, CEO

Brennan, well, I think there's two questions there. I'll take at least the first one on the sponsors. I think we've continued to see, really over the last several months, an improved interest by sponsors to start doing things with their portfolio companies. We see that in terms of number of pitches that we have participated in. We've seen that in their attendance in our various industry conferences. We've seen that in terms of them asking us to get started in processes. We continue to hear from them that there is some nudging by LPs to start returning capital. And there's issues, I think, from the employee base of sponsors that they eventually need to start getting back into what we call the deal business. Having said all that, they're still not going at the pace that I think we all experienced in the industry three years ago, five years ago, seven years ago. So, I wouldn't quite say they're exactly at the normal pace yet, but we do think it's improved from where they were three, six, nine months ago. And on your question on seasonality, for as long as I could remember except for calendar 2022, the December quarter is always the best quarter for the industry and not too dissimilar for Houlihan Lokey either. Calendar 2022, the December quarter did not stand out like other quarters, there's maybe a host of reasons. And once again, kind of unclear where the lawyers and bankers and accountants and all the other service providers, are they going to be pushing for various probably compensation or tax-related reasons to get something done by this quarter. Or will they be more motivated to slip things where they do have control into the next quarter? I don't know. We know what historically has happened, and we also know that calendar 2022 was unique. And I guess we'll find out pretty soon what calendar 2023 holds.

Brennan Hawken, Analyst

Okay, that's fair. And when we think about the MD count in Corporate Finance, I noticed that it was down quarter-over-quarter. Could you maybe speak to what drove that decline and whether or not you'd expect that to continue? Or what was behind that slip?

Scott Beiser, CEO

In our typical process, as a company aligned with the fiscal year ending on March 31, we often engage with a small group of our Managing Directors to evaluate their performance, especially if they seem mismatched to our platform or not meeting our expected performance levels. This can lead to some involuntary departures, which usually happen in the June or September quarter. This is part of our usual year-end adjustments. In contrast, we have also promoted several Managing Directors in April and added new ones in the June and September quarters. Like many others in the industry, we have accepted offers from new hires who have not yet started. Overall, our headcount has remained relatively stable over the past year, reflecting the usual transitions of some departures balanced by promotions and new hires.

Brennan Hawken, Analyst

Great. Thanks for the color.

Operator, Operator

Thank you. Next question comes from the line of James Yaro with Goldman Sachs. Please go ahead.

James Yaro, Analyst

Good afternoon Scott and Lindsey. Maybe we could just start with restructuring, which was a little bit weaker in the quarter than I think the quarter before, but against this, obviously, rates continue to rise. So, how do you think about the move in the long end of the curve and its impact on restructuring? And do you think the opportunity set has improved?

Scott Beiser, CEO

I think it's pretty hard to make a case that things do not look good for the restructuring industry for at least the next couple of years just on where certain businesses are performing, where interest rates are, just the maturity wall, a whole host of dynamics. We've always found that, that business, at least for us, is probably the most lumpy or sometimes you get more sizable projects that may close in one quarter versus another. We did note in our remarks, there was a bit of a slowdown in new business activity, albeit it was only in the United States. And I think it continues to ramp up in other parts outside of the United States, and we expect that we will be operating at this higher level for the foreseeable future. And as you mentioned, yes, a continuation of the theme now, probably on interest rates, which might be higher for longer, net-net is good for the restructuring environment.

James Yaro, Analyst

Thank you. As a follow-up, it seems that M&A activity may be recovering and increasing gradually. This could potentially create opportunities for additional acquisitions, especially considering that some smaller firms have not yet seen a revenue rebound. Could you share your thoughts on the possibility of making more bolt-on acquisitions from this point forward?

Scott Beiser, CEO

Lindsey, do you want to cover that? You've been talking to a number of the acquisition targets we've been pursuing.

Lindsey Alley, CFO

Sure. Look, I think the pipeline is as robust as it's ever been. I think the longer this M&A recession, if you want to call it that, continues, as you suggested, the tougher it is on smaller firms that don't have a restructuring practice in particular. But I think for us, it's very important we don't rush it. Our acquisition process is usually a long one. We like to get to know the management teams. We like to make sure that there's a good cultural fit. And there's normally a process of, for lack of a better word, dating, that we go through, and we're doing that. And we're not rushing it given the circumstances. So I think acquisitions will continue to be an important part of our nonorganic growth. It does provide some opportunities in a market like this, but we do have to move at a speed that makes sense for both parties and we continue to do that.

James Yaro, Analyst

That’s very clear. Thank you.

Operator, Operator

Thank you. Next question comes from the line of Devin Ryan with JMP Securities. Please go ahead.

Alex Jenkins, Analyst

Hey guys. This is Alex Jenkins stepping in for Devin Ryan. I hope you guys are doing well. I guess just to follow up on the restructuring question. Obviously, we've been talking a lot about the maturity wall coming in 2024 and 2025. Can you just talk about how you're proactively getting ahead of clients and what the catalyst is going to be for them to take action, meaning, should we expect a flurry of activity leading up to that? Or will we see a step-up function of activity as time kind of runs out? Thank you.

Scott Beiser, CEO

I believe, as we've mentioned, this isn't a crisis situation; it's more about catching up and adapting to a higher interest rate environment. We can expect a more consistent flow of business, with some companies being proactive early on to address challenges before facing maturity issues, while others may take longer to respond. The key difference now compared to the past couple of years is the availability of refinancing options that weren’t accessible six to twelve months ago, though these options come with higher interest rates and don’t necessarily solve their challenges. We continue to discuss with companies that may face difficulties in their business plans, financial performance, and balance sheets, which, given the current interest rates, require them to seek solutions. This is why I anticipate the industry will experience elevated restructuring efforts and results over the next few years.

Alex Jenkins, Analyst

Sure. That makes sense. Thanks for that color. I guess as a follow-up, just on the expenses, you guys have been able to hold the line on expense ratios, particularly relative to your non-middle market peers. If the M&A market doesn't recover, do you see a scenario where you might have to take that comp ratio structurally higher? Or is this just an example of the differences in your business models? Thanks for the time.

Lindsey Alley, CFO

I think it's probably the latter. I mean, we do have some structural differences that allow us some flexibility in how we run the compensation ratio. And in market conditions like the one we're in, we're clearly confident enough to suggest on the earnings call that we have no plans to change that. Are there market conditions that might impact our compensation ratio? Of course, there is. Are we in one now? No. And so I think we are still comfortable suggesting that we won't change our target, and we've been pretty consistent over the last certainly the last several years at maintaining this tighter range.

Scott Beiser, CEO

The firm has been operating for 50 years, experiencing both strong and weak market cycles. Our approach to managing the business, along with its diversity and the level of deferrals, contributes to maintaining a relatively stable compensation payout ratio. Over the past several quarters, this ratio has remained consistent, and we expect it will continue that way in the near future. While there are unpredictable factors that could lead to a change in our approach to managing the business, we are currently satisfied with our operations. The compensation payout ratio we have maintained for several quarters seems appropriate for our situation.

Alex Jenkins, Analyst

Great. Thank you. We appreciate it.

Operator, Operator

Thank you. Next question comes from the line of Ken Worthington with JPMorgan. Please go ahead.

Ken Worthington, Analyst

Hi, good afternoon, and thank you for the opportunity to ask a question. I wanted to follow up on how higher long-term rates are impacting middle market mergers and acquisitions. First, could you clarify what percentage of these deals is financed through debt and loans as opposed to equity? How does this financing structure compare to large-scale mergers and acquisitions? Are the smaller middle market deals financed in a different way? You mentioned earlier that the availability of financing is improving. However, considering that financial costs are significantly higher than they were five or six months ago, and even a year ago, do you see any indications that these increased financing costs are or will possibly have a more persistent negative effect on deal activity in the next six to twelve months? I know there’s a lot to unpack here, but I’m eager to hear your insights.

Scott Beiser, CEO

Sure. Good question, Ken. First of all, I think in all the statistics that we've seen, when others do these kinds of surveys. In a higher interest rate world or a tougher to access debt capital, sponsors are putting in more equity than they normally would. So, the percentage of the capital structure now has more equity on a percentage basis than we've seen in some previous years. So that would be the first comment. The second comment then tied into that is all things being equal in a higher interest rate world, you are going to achieve lower IRRs from kind of a principal standpoint that obviously has some impact on what buyers and sellers think the valuation is. What we find, and especially in the mid-cap space that we participate in, is there is a growing number of nontraditional banks that are providing that financing. And when you look at the amount raised by sponsors in this, we'll call it, private debt capital environment. It is substantially greater today than it ever was several years ago. So, we're getting new entrants into the marketplace. Yes, it comes with a higher interest rate. Yes, therefore, it should have some impact on IRRs and valuations. But ultimately, as time goes on, I do believe that buyers and sellers and lenders and borrowers just get closer and closer to seeing the world through the same vantage point. And that's what ultimately gets deals done when they have completely different vantage points, that's when deals kind of stalled. And so all of those reasons, I think we've tried to describe in previous quarterly calls, do suggest that people are getting closer and closer to that equilibrium point. And therefore, we do see the activity level is increasing still, like I said, not probably at the pace that maybe we expected based upon the prior periods, but it is improving.

Lindsey Alley, CFO

And one thing I would add, Ken, is if you take a look at the typical Houlihan Lokey transaction, the type of leverage versus equity. I'm not sure it's any different than what our publicly traded peers are doing in terms of levels. I think that the significant difference is the participants. The larger transactions are likely either high yield or a bank syndicate market, versus the private credit market, and all three behave very differently. And the private credit market in this environment has just been more robust than either the public debt markets or the bank syndicate market. And I think that's why you might be hearing slightly different views on how the capital markets are doing from a Houlihan Lokey versus a firm that does $3 billion, $4 billion, $5 billion, $6 billion transactions.

Ken Worthington, Analyst

Perfect. Okay. Thanks very much.

Operator, Operator

Thank you. Next question comes from the line of Ryan Kenny with Morgan Stanley. Please go ahead.

Ryan Kenny, Analyst

Hi, good afternoon. Thanks for taking my question. So, on the non-comp side, there's a comment around expecting non-comp to be seasonally higher in the second half of the year. Any color on the puts and takes there and how high it could get, how we should think about the run rate heading into the next fiscal year?

Lindsey Alley, CFO

I don't want to give specifics. I mean, there's a fair amount of public information. If you look at over the last five or six years, you'll get a sense, COVID was a little unique. And the breakdown of non-comps, and maybe throughout one or two years, they are 2020 and 2021. But when you look at pre-COVID, then even last year and take a look at the non-comp ratio first half versus second half, and that's not a bad proxy.

Ryan Kenny, Analyst

Thanks. And then on the comments around the pace of Corporate Finance expecting to be a slow exit from this environment. Is it fair for us to hear that as a more negative tone shift from last quarter? And if so, where are you seeing the most hesitation among your client group? Is there a certain segment or geography?

Scott Beiser, CEO

I would describe the situation as one where for several quarters, there has been a sense that each next quarter would bring meaningful improvement, but that expectation keeps getting pushed further out. Improvements are occurring; they are simply taking longer to materialize, and the rate of progress appears to be slower than what many anticipated when forecasting a year ago. We believe we reached the low point in this cycle last spring and have seen improvements since then. Discussions with our peers and legal professionals indicate that there are significant pipeline backlogs, and the challenge now is determining how quickly these can be completed. We are not seeing an unusual number of deals that we would label as dead or significantly stalled; they are simply taking longer to move from engagement to closure. This reflects our current view of the markets, which is not drastically different from what it was a quarter ago.

Ryan Kenny, Analyst

So, pipeline's building, but lags are longer.

Scott Beiser, CEO

Yes.

Operator, Operator

Thank you. Next question comes from the line of Steven Chubak with Wolfe Research. Please go ahead.

Brendan O'Brien, Analyst

Good afternoon. This is Brendan O'Brien filling in for Steven. I guess to start, I just wanted to follow up on the last question. It's encouraging and it feels like we're at the bottom or the worst is behind us in terms of M&A activity, and that's consistent with what we've been hearing from peers. But as we think about that exit rate or exit growth rate from here, I know it's a bit of a tough question, but based on what you know today, I wanted to get a sense as to when you think that we can get back to what you would characterize as normal activity levels?

Scott Beiser, CEO

If we truly knew the answer to that, we might be in a different business. From my perspective, during the summer of 2020, there was a noticeable improvement that lasted about a year or a year and a half, roughly from the low caused by COVID to the peak in December 2021. It's difficult to pinpoint exactly what triggered the shift from a declining situation to one that was improving, and then rapidly improving. We believe a similar pattern is emerging now, indicating that we are in a phase of improvement and will continue to see progress. However, comparing the growth from the low in 2020 to the peak in December 2021, we don't anticipate that level of rapid growth this time around. Our outlook suggests we recognize some parallels in emerging from this current downturn, but the recovery won't happen at the same exceptionally fast pace as it did three years ago.

Brendan O'Brien, Analyst

That's helpful context. Regarding restructuring, I understand you have previously indicated that a run rate of around $120 million is expected for the next year. However, you mentioned in your prepared remarks that activity has decreased, which aligns with the recent improvements in capital markets. I would like to know if significant improvements in the capital markets could pose a risk to maintaining that $120 million run rate. Alternatively, are the debt maturities related to the earlier discussed dynamics sufficient to support that level into 2024 and beyond?

Scott Beiser, CEO

I would highlight two points. First, we find it puzzling that there has been a slowdown in new restructuring activities in the U.S., as we believe the macro factors affecting it remain consistent. There hasn’t been a significant change. On the topic of capital market improvements, the situation is challenging for Corporate Finance when capital markets are closed. We believe they are open now, but this isn’t necessarily beneficial for restructuring activities. Even though capital markets are opening up more, the interest rates remain higher than the rates people would typically refinance at. Therefore, I don't anticipate that the current condition of capital markets, which we expected to return to normal, will negatively affect the restructuring environment due to the prevailing interest rates. However, if there were a substantial decrease in interest rates, akin to what we saw two years ago—which is unlikely according to current expectations—our perspective on restructuring would shift significantly.

Brendan O'Brien, Analyst

Got it. That makes sense. Thank you for taking my questions.

Operator, Operator

Thank you. This concludes today's question-and-answer session. I would like to turn the floor back over to Scott Beiser for closing comments.

Scott Beiser, CEO

I want to thank you all for participating in our second quarter fiscal year 2024 earnings call, and we look forward to updating everyone on our progress when we discuss our third quarter results for fiscal 2024 this coming winter.

Operator, Operator

Thank you. This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.