Live Oak Bancshares, Inc. Q3 FY2021 Earnings Call

Good afternoon, ladies and gentlemen, and welcome to the Q3 Live Oak Bancshares Inc. Earnings Conference Call. At this time, all participants are in a listen-only mode. We will conduct a question-and-answer session and instructions will follow at that time. As a reminder, this conference call is being recorded. I would now like the conference over to your host, Greg Seward, General Counsel of Live Oak Bancshares. Sir, please go ahead.

Thank you. Good morning, everyone. Welcome to Live Oak's third quarter 2021 earnings conference call. We are webcasting live over the Internet and this call is being recorded. To access the call over the Internet and review the presentation materials and commentary that we will reference on the call, please visit our website at investor.liveoakbank.com and go to today's call on our event calendar for supporting materials. Our third quarter earnings release is also available on our website. Before we get started, I would like to caution you that we may make forward-looking statements during today's call that are subject to risks and uncertainties. Factors that may cause actual results to differ materially from our expectations are detailed in the materials accompanying this call and in our SEC filings. We do not undertake to update the forward-looking statements to reflect the impact of circumstances or events that may arise after the date of today's call. Information about any non-GAAP financial measures referenced, including reconciliation of those measures to GAAP measures, can also be found in our SEC filings and in the presentation materials and commentary. I will now turn the call over to Chip Mahan, our Chairman and Chief Executive Officer.

Thanks, Greg, and good morning to all. For today's kickoff of our best quarter ever, I would be remiss if I failed to acknowledge that this is our first call since we went public without Brett Caines. My excitement over Brett's ability to scratch his entrepreneurial itch is only matched by my enthusiasm for being in business with BJ Losch, who is responsible for this presentation and will take over very shortly. With that, Steve, you and I always talk about safety and soundness, and I was thinking this morning that we have been in the lending business for over 85 years collectively. Tell us what you think?

Thank you, Chip. A rather quiet quarter from a credit perspective. Our credit quality remains strong, evidenced by all the metrics that we like to look at: historically low past dues, stabilized classified assets, nonaccruals, and relatively low charge-off levels. We continue to remain very focused on our servicing efforts, and I'm encouraged by the financial reports that we're receiving from our borrowers. Cash reserves appear to remain strong, and thanks to our diligent servicing focus, we haven't seen many surprises. Most borrowers are now making their own payments without government support or additional payment accommodations from us. In fact, today, we only have 22 loans on deferral, and all of these borrowers appear to be making positive financial progress. So I'd say I remain cautiously optimistic that credit will remain strong. I'm certainly pleased with the health of our portfolio, but I acknowledge that now is not the time to take our eyes off the ball. We will be prepared to deal with any challenges facing these businesses in the quarters to come; we'll remain committed, and we'll remain focused. So again, Chip, a very solid although slightly quiet quarter from a credit perspective.

Like quiet. Thank you, Steve. Michael, let's go to Slide five. Just a few opening observations before I turn it over to BJ and Huntley. I'd like to touch on our unforeseen lending growth acceleration and operating leverage caused by that growth. What does our bank look like in the future? And what are the advantages of being branchless? I'll admit to you that we did not see this coming. A year ago, we discussed 2021 production to be slightly more than $3 billion. As I look at quarterly production from both a dollar amount and the number of products sold or loans originated, our business has dramatically increased. Just a few highlights looking back: in 2018, about $500 million a quarter; 2019, about the same; 2020, $500 million in Q1, then we had the pandemic in Q2, dropping to $430 million, and then we jumped to $948 million in Q3 and $809 million in Q4. This year, as you know, Q1 was $672 million and $1.1 billion each in Q2 and Q3. And the number of loans more or less parallel that, historically, about 250 loans a quarter, now jumping to over 500 loans a quarter. And what that means in SBA lending, particularly, is that there's a massive amount of infrastructure underneath the architecture of the deal: the underwriters and the closers. I would submit to you that being a closer in the SBA business and certainly at Live Oak Bank is probably the toughest job that we have, trying to manage 148 documents and multiple closings at the same time. Before I get to the punchline, I'm equally excited about what's going on in the general lending group. We hired outside the theory of verticality, folks from other banks with a great deal of experience in SBA lending. Beginning in 2018, we did $90 million worth of business that year, in 2019, $166 million, and in 2020, we did $331 million worth of business, and so far this year, $300 million. And the number of loans has again paralleled that so we've closed 218 loans in the general group in 2020 and 190 year-to-date today. This is a massive amount of work. We faced the PPP euphoria; we stayed up 24/7, and then we got hit with this. The result is actually this in terms of the numbers: one year ago, we had 257 folks in the lending area. We have increased that by 109 to 366 today, and we do not have a bench today; we are going to build a bench. At the end of the day, we are dedicated to treating every customer like the only customer in the bank, and we do not want our people to be working seven days a week, 12 hours a day. So I'm trying to give Huntley and BJ a little runway in terms of increases in noninterest expense that way. This, to me, is the most dramatic thing that's happened in our history. If you look back five or six quarters after you take out all the noise of the investments up and down, all the noise of PPP, we were making about $15 million to $17 million a quarter, and now we're about three times that. The investments that we made in the past and the operating leverage of this business is kicking in. This, to me, is the key slide of what we're going to discuss with you today. All of that has allowed us to maintain and increase our lead. We have been, for the last several years, the number one in SBA lender 7(a) product in the country, and now we are stretching that lead to over $2.3 billion for the fiscal year ending September 30, 2021. Number two is under $1 billion. What does all this mean? Where are we going with all this? These profits will allow us to build never-before-imagined products on a next-generation Finxact Core. The overused term 'embedded banking'—not embedded banking, way more than that. Renato Derraik is going to march across our verticals and figure out how to digitize what our small businesses need to make their life easier. Certainly, payments, loans—again, another overused phrase—buy now, pay later for both our small business customers and potentially their customers, too. But more than that, including, but not limited to, budgeting and financial forecasting, tax preparation, debit and credit card reconciliation. It is exciting, after all of these years, to become a real bank. So let's take it up a notch. What is different about us, and how might we turn these differences to our advantage? First of all, we have no branch infrastructure. Many of you on this call know Tom Brown and his weekly interviews with prominent bank CEOs. Our friend in Canapi, Limited partner Harris Simmons, the CEO of Zions Bank, was on deck last week. Tom writes, 'Harris Simmons knows the community bank model with its focus on small and midsized businesses. That's what differentiates Zions.' He understands very well that activity in the branches is declining and quantified the decline: branch activity is only 9% of what it was several years ago. Consumer transactions are just 7% of what they used to be, but small business transactions are still 27% of prior levels. If you look at Slide eight and nine, you can see what's going on here. I went back and looked it up. The day I went into the banking business on July 9, 1973, there were 13,748 banks in this country. Today, there are less than 4,700 banks as of now, and about 600 of those are publicly traded. The decline in branches fundamentally parallels that. There have been 30 bank acquisitions above $5 billion over the past 36 months, about $3.5 trillion worth of consolidation. We are in an industry with massive overcapacity and poor customer service caused in large part by ancient technology. The average NPS score in our industry is 35; Wells Fargo is negative—that's pitiful. The banking business has to tee it up every day against fintech companies that have attracted enormous amounts of capital from venture firms that have zero expectations of profits anytime soon in this incredibly low-interest-rate environment. Many in our industry believe the answer to the problem is M&A: buy the folks next door, eliminate overlapping expenses. M&A causes disruption and culture change for the acquired; customer service falters. Back in the operating system war years a while ago between Microsoft and Apple, Microsoft used the term FUD—fear, uncertainty, and doubt. That is exactly what happens in the ranks of bank M&A integration; people are nervous. All of the above allows us to be the safe haven for the best and brightest, using next-gen cloud-native API-first technology to build out the nation's premier small business banking platform. We still believe that the regulated bank environment with access to FDIC-insured deposits will win the day for small business America. BJ and Huntley are going to show you how we're going to do that.

Thanks, Chip. Good morning, everybody. It's great to be here at Live Oak and with all of you today. And Chip, thanks for that context for what we're doing over the long term of the company. We've got some very exciting things going on. I am not sure that I could have asked for a better quarter to start with as my first earnings call. Quickly, on highlights on Page ten: $0.76 of diluted EPS. More importantly, and Chip talked about it earlier, 17.5% adjusted PPNR growth from the second quarter to the third, driven by 11% revenue growth from second to third, 64% adjusted PPNR growth year-over-year. So excellent performance. You'll see here is what I would call our opportunity framework that we'll talk about today. Our verticality, which is really our core earnings engine and lending model dedicated to small businesses. And you can see some of the highlights here; Huntley will talk a little bit more about what Chip referred to, which is building out a full-scale bank, building out our platform to serve more customers over time, and we've got exciting things there. And then on the optionality side, building a product factory and innovation with our investments in financial technology and insights that are second to none. Starting on the left side, we talked about $1.1 billion in production. Again, this quarter with what you'll see is broad-based strength across all our different verticals, 7% loan growth from the second quarter to the third quarter, excluding PPP, which is excellent performance in this environment. Steve talked about excellent credit quality, and we'll hit that as well. Lots of exciting things in terms of net new hires, where we're building our businesses, lending and deposits wise. Of course, we will touch on the exciting Finxact conversion of our deposit business. If we go to Page 11, take a look quickly at some earnings highlights. You'll see the adjusted PPNR growth that I talked about, along with the revenue growth; net interest income up 12% quarter-to-quarter, 62% year-over-year on growth, on the balance sheet plus lower deposit costs. Our operating leverage is strong with 11% revenue growth linked quarter versus 7% expense growth. Our margin is at 375 on an adjusted basis, up 12 basis points and 47 basis points year-over-year. All of this performance driving continued improvement in the efficiency ratio that you can see on an adjusted basis is at 56%. Taking a look at balance sheet growth on Slide 12: here, you see the loan and lease portfolio, excluding PPP, growing 7% linked quarter and 32% on a year-over-year basis. On the deposit line, healthy growth continues to support and fund that loan growth with strong retention; we'll talk about that in a minute. Borrowings are down mostly due to PPP liquidity fund pay downs as our PPP loans are running off. And most importantly, at the bottom, top-tier returns on equity assets and very, very healthy tangible book value per share growth, excuse me. Turning at 13, all of this leads to what we see on Slide 13, which is continued favorable comparisons to other banks. If we move to Slide 15, let's talk a little bit about the originations volume in the quarter, which was again an excellent quarter and another $1 billion quarter. You can see the mix in terms of percentage of government-guaranteed loans as a percentage of the total loans originated—about a fifty-fifty split. And on the right-hand side, you'll see from Q3 2020 to 2021, a broadening of the mix that we were producing between SBA 7(a) and conventional loans. Moving to Slide 16: I thought this would be a great view for everyone. Just quickly explain what you're looking at here on the left-hand side. On the x-axis is our 2021 year-to-date originations by vertical. On the y-axis, it's the origination growth year-over-year for those verticals. The size of the bubbles is what our portfolio outstandings are in those verticals, and the colors represent the different types of businesses, whether it's small business banking, energy and infrastructure, or our specialty finance businesses, the more conventional type businesses. You'll see and notice large, broad-based origination growth across all three types of lending, which is very exciting. We're seeing growth in all of the different types of businesses that we want. You'll also notice in the bottom left, the COVID-impacted industries have seen very muted growth, and that's positive for portfolio mix and credit quality. Turning to Slide 17, you'll see how the originations in the quarter, combined with other portfolio changes and our loan sales, show up in our loan outstandings. Key highlights: again, is a 7% loan growth, excluding PPP. And as importantly, if you look at the first four buckets on the waterfall chart, we had 4.2% net growth before loan sales, even with PPP, meaning that our originations and our fund-ups of our existing customer loans offset any prepayments and the significant decline in our PPP balances. The production engine and the earnings engine of our portfolio is very, very strong. Deposit trends are on Slide 18. A couple of different takeaways here: good deposit growth opportunity continues with a favorable mix shift from savings to CDs. In the bottom right, our savings account retention remains very strong, which continues to support our growth. Our 12 basis points of noninterest expense to deposits is in a very efficient platform. Chip talked about our branchless model; well, this demonstrates the very low efficient cost of delivering that kind of deposit growth. Fourth, the continued reduction in our cost of funds from that mix shift is enabling our net interest margin expansion. If you turn to Page 19, speaking of that margin expansion, you'll see that we have relatively stable loan yields over the last few quarters plus those lower deposit costs driving that 12 basis point improvement in the adjusted net interest margin linked quarter and 47 basis point improvement year-over-year. Revenue trends are on Slide 20. Again, very strong performance from balance sheet growth and the gain on sales. You'll see in the bottom right, we sold about half of the loans that became eligible for sale in the third quarter, 25% of the SBA loans that did so in the third quarter. Those sales were about two-thirds fixed or fixed adjusted to lock in some premiums and reduce rate risk on our books. We also sold at lower premiums across the board versus Q2, so there is some pressure on premiums going forward, but we feel very comfortable with the flexibility that we have with our portfolio, and we'll find opportunities to continue to see healthy gains on sale. Expense trends are on Slide 21. As Chip talked about, we will continue to hire, we will continue to invest in technology, but the positive thing here is that our revenue growth is outpacing our expense growth, which will allow us to continue to make our company more efficient. Steve talked about credit trends earlier, so I won't hit those on Slide 22, but you have some more metrics here that he referred to: very, very strong credit quality metrics across the board. Wrapping up on Slide 23 with our credit reserves and capital, you can see in the upper right, our capital ratios remain very strong, and if you look at the 23.5% bubble, we call out the coverage of our unguaranteed portion of our portfolio is over two times higher than any other bank. The strength of our reserves plus our capital relative to our unguaranteed portfolio is unmatched across the industry, which makes us obviously very comfortable with our balance sheet and its strength. With that, I will stop and turn it over to Huntley.

Thanks, BJ, and glad to have you onboard for your first earnings call. If you could keep financial performance like this for the foreseeable future, that would be terrific. On Page 25, Chip and BJ both touched on some of the highlights of the quarter, but it was a significant one in a number of ways. We continue to excel on the lending front, booking over 500 new loans, adding 300 new small business customers, retaining our lead as the nation's SBA 7(a) lender for the fourth year in a row, and we continue to bring on excellent new folks across the organization. We reached a couple of notable milestones this quarter: crossing $1 billion of loan production for the second consecutive quarter, as well as over $1 billion in cumulative energy and infrastructure lending, and we crossed $1 billion for our business savings deposits and now have roughly 10,000 accounts in business deposits across the platform, which is really exciting. We're proud to receive an award from Greenwich, the leader in all things customer survey-related, in their small business customer experience category. We're incredibly excited about our deposit conversion that we completed this quarter, and we'll talk about that in a few minutes. Despite these accomplishments, though, we really feel like we're just getting started, and we turn our immediate attention to our checking launch this quarter, enhancements to our loan servicing capabilities and setting the roadmap for additional expansion on our platform. On the horizon, next year is a small balance loan product and the ability to innovate and create specific products to serve small businesses in our industry verticals, like Chip talked about. On Slide 26, our platform has two complementary components: a high-touch and high-tech approach. The roots of this company are in great people with deep domain expertise who serve our small business customers extraordinarily well. We've been fortunate to continue to attract and retain top talent across the banking and technology industries. By investing in and building a next-generation technology stack, we have the ability to deliver innovative products and services for our customers and for our employees. Great teammates paired with great tools allow us to better serve our customers—which at the end of the day is what we're all here to do. That creates a self-reinforcing feedback loop that attracts more great folks who want to be part of this journey and so on. We continue to be really excited about that. On Slide 27, Chip referenced the new technology platform we've been working on and have been talking about for years now, anchored by a cloud-based core Finxact that allows us to innovate in ways that a lot of the industry struggles with. If you were to ask a bank how long it would take for a traditional financial technology vendor to create a new product for them, you would get a groan or an eye roll or something because it takes a long time. On our next-generation platform, we have the flexibility and speed to market to both add new features to existing products and launch new products. Cloud-based architecture gives us the ability to rapidly scale at lower costs. Our data lives in one place with multiple positions in a single account, not siloed in legacy systems. That gives us the ability to better understand our customers, provide them with rich insights, and help them with their financial decisions. The system is also real-time, which further helps customers understand their financial position, enhances our fraud and transaction monitoring, reduces reconciliation work, and allows us to keep pace with all the changes happening in areas such as payments and across the industry. Finally, the open platform architecture allows us to connect with many digital partners and build a best-in-class ecosystem to take advantage of all the innovations coming out of the fintech space, fueled by the venture capital community. If you turn to Page 28, this platform allows us to accomplish something that rarely happens in banking: a successful conversion that exceeded our expectations in terms of speed, accuracy, customer experience, et cetera. I won't go into all of these stats in detail, but our ability on this new platform to establish multiple environments for testing and have real-time access to data for reconciliations helped our incredible teammates flip the switch on 60,000 accounts seamlessly. We showed this slide before and we spend a lot of time with our small business customers, listening to what they want, and we think this slide encapsulates many of those needs: faster access to capital, digital management tools, actionable insights, better payments capabilities, and all in an integrated digital experience. There are a lot of Neobanks that have come online in the last few years that have identified one or two of these problems and built point solutions to target them: think about early payroll or buy now, pay later, expense management—they've done extremely well. Lots of these companies haven't necessarily invented anything new, but they've leveraged a modern technology stack that allows them to innovate more quickly and have data that allows them to possess a deep understanding of digital marketing and customer acquisition costs. We believe we now have all these capabilities in-house, along with an incredible team that understands our customers and is willing to go out of their way to help them. We are just at the beginning of this journey, and with our first use cases live, we're excited about the opportunity ahead and the opportunity this platform creates for us to continue to innovate. Over time, we expect this to result in even better lending experience for our customers, lower deposit costs as we build operating accounts, lower customer acquisition costs, lower attrition rates as we embed our bank within industry verticals, and the opportunity to capitalize on new revenue streams that are emerging. I will now turn it over to Neil to talk about the venture capital space and how our participation in those markets continues to fuel our growth—not just through financial gains, but through intellectual capital and driving our product roadmap.

Thank you, Huntley, and welcome aboard, BJ. Let’s start off with macro first, and I think we all have heard about this, but seeing it on this chart, it's just amazing what's happening in fintech: both the valuation and the amount of capital that's going into it. I tend to oversimplify this; in my view, it falls into two categories: those that are bank-friendly and those that compete directly with banks. On the latter, massive amounts of capital are going into these companies, and it's going directly to marketing and customer acquisition costs to the tune of hundreds of millions. We get to look at the income statements of these companies, and it's going into R&D, and all of them are using best-in-class metrics like lifetime value of customers, customer acquisition costs, and tuning and optimizing all the way. That's why the search for the right bank-friendly, cloud-native API-first fintech has continually been so important to us from the start. Moving on to the next slide, this is a good slide that embodies the evolution of fintech investing in Live Oak Bank, and you can tell we've been on this mission for quite some time. By now, everybody knows the nCino story, I'm sure, but under the banner of Live Oak Ventures, we incubated and invested in companies that help further revolutionize the entire bank tech stack, much like the fintech competition I was referring to earlier. Any of the logos listed in bold mean that we're using them at Live Oak Bank. They're either live or in an active project in implementation, and that's ultimately how we define the ultimate resolution between Live Oak Ventures and Canapi. If we use the software under service, then it's been a big win. The evolution of our mission became more formal when we launched the first fintech fund of its kind, $650 million in capital, for 40 banks, the ABA, and the ICBA. We spent the last three years combing through thousands of companies only to find the best, which, again, we intend to implement at Live Oak Bank. The mission will continue as we work to launch Canapi Fund II. Moving on to the next slide, you've seen some of this before, but this shows an aggregate view over time of the Live Oak Ventures Companies through a financial lens. The previous slide broke down the investment amount, carrying value, and value if it were priced at the last round. While the original intent to incubate these companies was for strategic value, the economic benefit has a meaningful impact, as you've seen in recent quarters, and we certainly hope these trends will continue.

Let's open it up to Q&A.

[Operator Instructions]. Our first question comes from the line of Steven Alexopoulos from JPMorgan.

Hey, good morning, everyone. And BJ, I think we're as excited as Chip and the team to have you on the call, so welcome. Chip, I wanted to start—so you said when you kicked off the call that you guys didn't see this coming in terms of the loan originations. Can you drill down for us so we can better understand what exactly is coming in even better than you expected? And second, do you feel like we could now—I know I asked you this last quarter, but now there were two quarters above $1 billion—do you think we could stay above there in terms of originations?

I just knew that you were going to ask some forward questions, Steve, I really did. I think it's a couple of things, and then Huntley and the team will weigh in. I mean, certainly, the 90% guarantee in the 7(a) space has helped. The government picking up what usually we pick up on behalf of our customers, and the 55 BPS—that's helped. Subsidies have helped, as Steve mentioned earlier. I don't know, Huntley, it's a little early for us to predict next year, but it feels okay. How would you go with that one?

Look, I agree; I mean, momentum feels really solid. I think that part of what happened over the last 18 months is that our brands and sort of success sometimes feed on that. The PPP work we did, we worked with small business customers, we work for referral sources, and some of these associations that we spend time with, and we served them well. We're getting a fair amount of word-of-mouth referrals now until things are coming in. I think the macro trends that we see are still quite positive regarding the aging population of small business owners and M&A in that space, some macro trends around industries like health care and veterinary services, etc. So all of those feel good, and it feels like we're continuing to attract good people in that space as we grow. I think Chip's right; we may see some headwind as it relates to the SBA enhancements going away, but the pipeline still feels really solid right now, so we're kind of taking it as it comes.

And one other thing. As of last night, right, in the $3.5 trillion reconciliation bill, the 90% guarantee extending for five years, plus other enhancements is in that. I don't think anyone sitting around this table at Live Oak Bank and Wilmington, North Carolina, thinks that we'll make the cut. We'll probably go back to what we were used to, so we would not be factoring any of that into the future.

Okay, that's helpful. And Chip, I wanted to ask about expenses. You mentioned at one point the need to build a bigger bench, and Huntley and BJ, giving you a little more runway. What does that mean for us? Like what should we be thinking from an expense growth viewpoint?

That's probably more for you, BJ. I just want—Steve, I just want to make sure we have been pushing our people the last 12 months. They wake up every day and try really hard to treat every customer like they're the only customer, spending three months working 18 hours a day trying to help out PPP and this massive volume because we doubled the volume of the business. They're trying their best, going home at night and staying up to 8:00, working every Saturday and Sunday, and I don't want that. I do not want that to continue, and if we need to build a bench to do that, we are going to do that. Now how that gets into noninterest expense, BJ, that's up to you.

Yeah, so, Steve, what I would say is just look at this quarter, right? We had 11% linked quarter revenue growth on 7% expense growth. I think that kind of revenue versus expense should likely continue, right? There are going to be continued heavy investments. Like Chip said, we had about 70% of our year-to-date hires in lender or lender support, probably much more weighted towards lender support than it was even on the lender side itself. We're making continued investments in technology and the technology platform, not just Finxact, but checking rollout in the fourth quarter, and loan servicing enhancements. Huntley referred to small ticket lending coming next year. We continue to be on a journey to build out the platform, so expenses will continue to go up commensurate with revenue, but our expectation is that PPNR trend continues to be on a steady climb upwards.

And just one quick other thing on this issue, right, Steve. I think we now have 22 lenders that are from other banks not part of the theory of verticality. In the future, Huntley, we're going to get ahead of that by bringing the infrastructure with them in terms of underwriters or closers. You may want to just comment on that because that's going to affect us.

Yeah, I mean, Chip, we have had great success in finding these experienced lenders. We've tended to hire them and then scrambled a bit to provide the support behind them. We're just going to flip that order so that as we grow that business, we'll start with incremental underwriting, credit, and closing support and then layer those people on because we still see great opportunity to continue along that strategy.

That's helpful. And then final question on the checking launch that's coming this quarter: will this be initially a pilot in select verticals, or is this going out more broadly across all of the verticals?

Yes, I'll start. I mean, we've got a pilot in place for our employees, and that's already planned. What we will launch is a product that has base capabilities for small businesses; it won't be vertical-specific yet—that will be the enhancements that we'll layer on. So the base product, I think, will be a very good product broadly applicable for small businesses, and then we'll start to get more specific over time.

Thank you, good morning. Let me follow up on one of Steve's questions: based on your pipeline today and what you're seeing in October, do you think you could see another $1 billion origination quarter in the fourth quarter?

Hard to say at this point, but I would say close, Jennifer. You people are relentless on this, I certainly acknowledge that, but business is pretty good.

Okay. And on Slide 16, you have the breakdown of small business lending versus specialty lending and energy and infrastructure. How do you think the loan mix evolves over time, Chip, when you look at those three? Are there more types to come later?

Okay, Jennifer, I'll take that. I think we see really good opportunities across all three. Trying to figure out exactly which one is going to grow the fastest is a bit tricky. We've had a great run on the small business side, and I think you could continue to see a little bit more weighting to the other two. Some of these specialty finance businesses, we're really just getting started, so I think we have a lot of white space to run. Given all the tailwinds in renewable energy, it feels like we've just begun to continue to have a massive opportunity there to grow as well.

Okay. And my final question is on—BJ, can you just talk about what you see for net interest income and the net interest margin when Fed funds do start to go up?

Sure, Jennifer. We continue to think that net interest income is going to climb materially, particularly over the near term from continued deposit cost declines over the next maybe quarter or two, but then also, obviously, adding all this production and net loan growth is going to continue to move NII higher. In the near term as well, we do think the margin could benefit incrementally from those two things. I think spreads are still pretty good and stable on the loan side, and on the deposit side, the cost of funds continues to trickle down. Longer-term, we are not as asset sensitive as others, but we do have about 50% of our loan portfolio levered to the shorter end of the curve. We will see some modest improvement as rates start to rise, but more of our net interest income will be driven by increases in volume.

Hey guys, good morning, thanks for taking my questions. I wanted to start—I kind of had a question around the debenture investments. I was curious if you guys could maybe spend a minute refreshing us on how those write-ups or gains actually flow through Live Oak's consolidated income statement? For example, I saw in the third quarter in September that Alloy completed its Series C; I think the valuation was up four times on the $100 million raise. I'm pretty sure Canapi led that Series B, so I imagine there's a pretty sizable ownership. I'm just curious if you can maybe just refresh us on how those types of gains flow through moving forward as we probably get a little bit more line of sight on some of these companies that you have investments in as they raise their valuations.

Yeah, I'll start and then turn it over to BJ for more clarity. I think it's important to look at Live Oak Ventures, which are direct investments, and every time there's a raise, there's a mark as compared to Canapi, which is a fund. We at Live Oak Bank invested $20 million in that fund, but we're also subject to management fees. More importantly, the carry. That indeed is also marked to market but would have a much smaller impact on income as it flows through than a Live Oak Ventures direct investment. I'm going to turn it over to you to clean all that up.

No, you got it, Neal. The venture investments are a variety of equity security methods, and so some are market-to-market and some are more flow-through. As Neil said, anything that's in Canapi, we are an investor in the fund. Our stake in that will have value once those things start to get marked and realized, but it will be a much smaller impact for us just given the size of our investment in the fund itself. We've got some performance fees that over time may flow their way through as well.

Got it. So something like Alloy, the actual impact felt in the financials would be far less than something like Greenlight where the majority is held within Live Oak Ventures.

Yep, that's right. It is a competitive market; there's no question about it, and great folks have a ton of options where they want to work. We've got to be competitive in all facets: in the mission, what we're doing there, how we treat people, compensation, and a bunch of other stuff, too. We're out every day trying to find folks, and the best ones can work wherever they want. That's especially true in the technology sector. To convince folks like Renato and others to come join us is fun; it's actually fun to go out and recruit and see what we can build here, but it is competitive, there's no doubt about it.

Just an extension of that: hiring other lenders has not been a problem, nor do I foresee that being a problem in the future with them bringing their infrastructure staff with them. Renato, you may want to comment on—I know that you've done a couple of searches recently for senior people in your organization, and it's seemingly gone reasonably well.

Yes, incredibly well. There is an incredible amount of excitement from folks who are having dialogues with us about the future state architecture, access to fintech, and the culture of this place, which makes it incredibly special. So we are fortifying and continuing to build our capabilities in the technology space and had no issues at all attracting incredible talent from across the industry, including some announcements that will be made really soon.

Yeah, Michael, you'll remember that years ago when we started nCino, people used to tell me, like, there's no way in hell you could attract technology talent in Wilmington, North Carolina. I think nCino has 1,200 people across town today, so something is going right.

Yes, I think if you're looking at it on a gross basis, if you will, with the PPP and the benefit that we've had there, yes. On an adjusted basis, I do think, like we talked about, there still is a little bit of margin expansion, and there is quite a bit more net interest income growth from the production that we've already put on the balance sheet. We've got flexibility on gain on sale because of the kind of portfolio we have that is eligible for sales, so we can be discerning in how we pick our spots on when and how we sell. All of that should more than cover the increases in expenses related to hiring and investment in technology. I think the revenue engine is incredibly helpful and supportive in continuing to pay for our expense growth over the next several quarters.

Good morning, everyone. I appreciate you taking the questions here. One for Steve about the boring credit quality: using the phrases 'not out of the woods' and 'not taking our eyes off the ball.' Is—and Chip, I'm going to be another sell-side analyst asking a forward-looking question here— is there any point in the coming quarters where you think you might be able to relax a little bit? Or just with the pandemic and the macro situation, it's going to be tough to really relax for a while?

Chip, I can take it. This is Steve, Chris; I'm paid not to relax, so I won't. My point is we will never be complacent. We'll never spike the ball, and that's what's been successful and worked for us, and we'll continue to do so. We're fully aware that we need to focus on inflation, supply chain, and the political environment; we need to train our folks to work with our borrowers, ask the right questions, so we have a very good pulse on our borrowers and how they're doing, and we react to that and try to be as proactive as we can. Again, I think we've been in a really, really good place, much better placed than I would have first thought when the pandemic first hit. That has a lot to do with the type of portfolio that we've built over the last more than a decade, and we'll just continue to do what works for us going forward, and we won't shy away from the challenges that might or may not be in front of us.

Okay. And then, Steve, just to follow up on that one: when I look at the loan origination graphic on Slide 16 with the year-to-date originations and year-on-year origination growth, it must filter into that. Can you just talk about how it does with inflation concerns, supply chain concerns, and all the other recent developments beyond the pandemic?

Yeah, I'll make a couple of comments. First of all, our model is incredibly powerful and it allows us to expand and contract in various industries based on the pressures in front of them. We do that also; our domain expertise in many of these areas is incredibly powerful to give us a very close pulse on what's facing those businesses in those areas. Also, I'll make a comment that we manage risk through participations, which has been very successful for us, and we've put a lot of investments in growing that capacity over the years. You can look at senior housing, you can look at middle-market where we're making really good inroads; however, about 50% of what you see there, we manage risk through participations, and that also gives us a very good tool to control our risk tolerance as well.

Hi, thanks for taking my question. Maybe like to just try to put a bow on the expense line of questioning. If we kind of just think about the comments that you made about some investments in people, I believe in the press release, you talked about T&E starting to normalize, etc. Some expense pressures there but revenue growth driving continued operating leverage. If we think about it from an efficiency ratio perspective, maybe just help us think about any current interest rate environment where efficiency could trend to in the next year and a half to two years?

Let's kind of put aside PPP and runoff and all those types of things, right? Just think about where we sit in the third quarter at a 56% efficiency ratio on an adjusted basis. That's been trended down given our strong PPNR growth. If we can continue to generate PPNR growth, which, as you know, is simply revenues minus expenses, we're going to inherently spend less to make $1, and the efficiency ratio will improve. Over the next couple of quarters, I can think about it continuing to trend down a couple hundred basis points over that time, and our longer-term goal would be to continue to move that even further down as we build the earnings in here.

Okay, thank you. That's helpful. And then, there have been a couple of comments made about the premiums on loan sales being under pressure a little bit, correct me if I'm wrong, the incentives ended at the beginning of this quarter, correct? If that's the case, can you just talk a little bit about how premiums have trended quarter-to-date?

Yes, we really started to see a change in the premiums actually back in mid-quarter of this quarter. Premiums are going to be different for products, but on balance, maybe 150 to 200 basis points lower. We did a little bit of work in the third quarter to sell a little bit more on the longer fixed-rate side, taking advantage of what we saw with historically higher premiums. We'll look this quarter to be a little more opportunistic in terms of looking at premiums and the mix between FDA and USDA going forward. Premiums are going to continue to be under pressure because of the reintroduction of the SBA fees and dealer excess inventory that's out there, particularly going into the year-end. All of that said, we have better insights arguably than anybody in this industry regarding SBA and premium trends and what’s going on in the secondary market. The flexibility we have with the guaranteed portfolio and our ability to pick our spots on when and how to sell are going to be really helpful to us.

Okay, thank you. And then my last question, you had a slide, I think it's Slide 28, that just gave some stats around how successful the conversion to Finxact was. I'm wondering if you could just provide us with any updates on how the beta testing is going with several of the larger banks.

I think it's going pretty well, don't you, Neil? I don't know how much Frank would want to disclose.

Yeah, but I think having Live Oak as the first bank that's live has actually done a conversion from the old core is a meaningful inflection point. He’s got over 12 banks in the implementation right now. It just bodes well for the velocity and momentum of that company and their product-market fit.

Thank you, ma'am. We enjoyed today's call, and we enjoyed the questions. We'll see you in 90 days.

This concludes today's conference call. Thank you for participating. You may now disconnect.