Moelis & Co Q3 FY2023 Earnings Call

Ladies and gentlemen, thank you for being here. My name is Sheryl, and I will be your conference operator today. I would like to welcome you to the Moelis & Company Earnings Conference Call for the Third Quarter of 2023. I will now turn the call over to Mr. Matt Tsukroff. Please proceed.

Good afternoon, and thank you for joining us for Moelis & Company's third quarter 2023 financial results conference call. On the phone today are Ken Moelis, Chairman and CEO; and Joe Simon, Chief Financial Officer. Before we begin, I would like to note that the remarks made on this call may contain certain forward-looking statements, which are subject to various risks and uncertainties, including those identified from time to time in the Risk Factors section of Moelis & Company's filings with the SEC. Actual results could differ materially from those currently anticipated. The firm undertakes no obligation to update any forward-looking statements. Our comments today include references to certain adjusted financial measures. We believe these measures, when presented together with comparable GAAP measures, are useful to investors to compare our results across several periods and to better understand our operating results. The reconciliation of these adjusted financial measures with the relevant GAAP financial information, and other information required by Reg G is provided in the firm's earnings release, which can be found on our Investor Relations website at investors.moelis.com. I'll now turn the call over to Joe.

Thanks, Matt. Good afternoon, everyone. On today's call, I'll go through our financial results, and then Ken will comment further on the business. We reported $278 million of adjusted revenues in the third quarter, an increase of 19% versus the prior year. The revenue increase was driven by our restructuring business and some particularly large restructuring key events. We do not expect this to recur next quarter. Our year-to-date adjusted revenues were $645 million representing a decrease of 16% from the prior year period. The decline in revenues is primarily attributable to a decrease in M&A transaction completions. Moving to expenses, our year-to-date compensation expense was accrued at 83%, which is our best estimate of a full year ratio. Our elevated compensation ratio is a function of a revenue dislocation, driven by the still challenging M&A environment and our decision to aggressively invest in talent during this downturn. Our third quarter adjusted non-comp expenses were $50 million, which includes approximately $8 million of co-advisor and legal fee expense related to completed transactions, which includes our transitional SVB fee sharing agreement related to certain preselected mandates. Our non-compensation expenses are expected to remain elevated through the first quarter of 2024. When our SVB fee sharing agreement terminates, however, the underlying quarterly run rate continued to be approximately $42 million. Based on our updated full year projection of income we accrued tax expense to equal an effective rate of 1.7%. Our non-deductible expenses are large relative to our pre-tax book income. Over the longer term, we expect to reflect the tax rate more consistent with our recent history once normalized productivity can be restored. Regarding capital allocation, the board declared a regular quarterly dividend of $0.60 per share, consistent with the prior period. And lastly, we continue to maintain a strong balance sheet with $297.8 million of cash and no debt. And I'll now turn the call over to Ken.

Thanks, Joe. And good afternoon, everyone. The third quarter marked a significant increase in revenues versus prior quarters. In addition, the pipelines for each of our three product areas continue to grow, and the total pipeline is near record levels. However, M&A completions continue to be challenging, and although our restructuring capital markets business has been quite actively outsized, restructuring contribution is unlikely to repeat in the fourth quarter. Liability management continues to be the main driver of restructuring activity. The team has been a leader in out of court engagements having advised companies on five of the 10 largest restructuring transactions since 2020. If the FED maintains rates at current levels, out of court restructurings will continue to be a significant opportunity for us, in order to help our clients not only grow but also help them address liquidity and maturity issues. Expanding our capital markets business has been a strategic priority for the firm. The team has grown in size and capability, and we're advising clients on a broad range of capital markets transactions. We have significantly enhanced the firm's ability to address the largest sector fee pools. Over the last 12 months, we've hired 27 Managing Directors, while still managing overall headcount through targeted attrition. Although it is difficult to predict when the M&A business will recover, what we do know is that the cycle will turn, and when it does, we are well positioned to capitalize on it for years to come. The investments we're making today have dramatically improved the firm's earnings power. And with that, I'll open it up for questions.

Your first question comes from Devin Ryan with JMP Securities. Devin, you can now proceed with your question.

Okay, great. Good afternoon, Kevin and Joe. I guess first question, just want to start on kind of compensation construct? So, I guess first off, Joe, you may have said it. But in terms of just the full year, you're running at 83%? Is that the right way to think about the fourth quarter? Or is 87% I guess the right way? And then I guess the bigger question is just trying to think about this year and appreciating this year as far from normal, if we look at the 83% year-to-date, and compare that to where I think you guys have historically said, comp ratio closer to 60% is quite more normal. The delta is like $150 million in compensation. So, I guess the question is like, is virtually all of that just tied to this kind of elevated recruiting? Or how much is kind of competitive dynamics that I guess everybody should kind of think about? Like where we revert back to any more normal environment? And how much inflation, if you will, and compensation is just in the system? And I think that's a question every firm is getting asked right now. Thanks.

Yeah, so I'll answer the first part of your question, which has to do with the ratio, that 83% is the target for the full year, the 87% for the quarter was basically the catch up for the first two quarters that were accrued for at 80%.

There are two events happening that are connected. One is the decline in revenues due to a tough M&A environment, which would naturally increase the compensation ratio. The second is that we made a strategic decision this year; I have seen similar opportunities during significant disruptions in the banking market three times in the past 40 years. The last time was when we founded the company in the aftermath of the great financial crisis in 2010. In 1990, I moved from Drexel Burnham to DLJ, which was built during a challenging period in the junk bond market and became very valuable over time. UBS also thrived after the tech downturn in 2001. This current situation seems to resemble that, with a major disruption in talent and people's willingness to stay in their roles. We took advantage by hiring 27 people in a year, which is over 20% of our existing Managing Director base. Despite this, the overall headcount increased by only 3% to 4% by year-end, as we actively managed a significant number of departures. We report everything directly in our income statements, unlike others who might account for termination costs separately. While I don’t have the exact figures, I believe the earnings potential of the firm has notably increased. In a typical business cycle, we will likely return to our usual compensation ratio. However, it seems there may be 1% to 2% of the compensation ratio related to junior, non-Managing Directors that may not be recoverable, mainly due to increased compensation for non-managing directors, which I expect could be sticky.

Got it. Okay. Terrific color. Thanks, Ken. Just a quick follow-up on just the M&A market more broadly and just want to get a little more texture around on how you guys are feeling, maybe today relative to three months ago, on one hand, I think October was a better month than we've seen in some time for announcements and some larger deals within that. But the tone has been a bit better at the same time. There's still kind of a fair amount of macro uncertainty. So, love to just get a little defensive, whether you're seeing kind of maybe more activity your sponsors engaging more than they were a few months ago, and just what the general tone is appreciating that, it's still pretty complex and dynamic backdrop. Thanks.

I appreciate your question about how I feel today compared to two days ago. Our backlog is strong, and our pipelines are robust. About a year ago, I mentioned that while we had a decent pipeline, I considered it fragile due to the unfavorable financing market at that time. But now, I truly believe our pipeline is solid. There's a significant amount of deal backlog ready to enter the market. My new analogy for our current situation is inspired by my newfound appreciation for the show "Drive to Survive." It feels like we're at a point in a race where all the cars are lined up, engines revving, and everyone is eager to go, but we're waiting for the signal to start. I sense we're close to that signal, especially after the developments from yesterday, which indicate we're nearing the end of a period. I anticipate that once we receive the final signal, the pipeline will quickly take off, leading to an increase in activity.

Okay great. Got to get back and watch that.

Your next question comes from the line of Ken Worthington with JP Morgan. Ken your line is open.

Hi, good afternoon. Thanks for taking the questions. You're losing money year-to-date; do you expect to lose money for the year? Unless there's a meaningful improvement in deal activity? And does this matter?

I believe we are likely to incur losses. Even if deal activity picks up tomorrow, closings won't be reflected until the first or second quarter. Our current situation will remain relatively stable until year-end, and while it is a concern, we decided to rebuild a firm. Half of our 27 Managing Directors come from technology hires at Silicon Valley Bank, which is a substantial fee pool that will be significant for many years. However, we can't capitalize on this investment. We've potentially acquired talent that represents 20% of our firm, but the associated costs directly impact our income statement. As you can see, we had to let go of a considerable number of employees to maintain our headcount within a 3% to 4% range during this transition. This investment affects our compensation ratio and earnings due to accounting practices. Does it matter? Yes. Was it a challenging decision? Absolutely, and there was considerable debate. I believe this will yield significant returns over time, as it has in past cycles. These franchises can’t just be created whenever; they must be built when the opportunity arises.

Okay, fair enough. And then just maybe moving to the balance sheet, we don't have the queue yet. So talk about the cash balance given the dividend and the compensation accrual. Do you guys think you'll have to draw down on the revolver? Or is there enough cash to kind of meet the dividend in the year-end bonus payouts?

Yeah, we obviously are pretty attentive to that area. We do not expect to have to draw on the line, we expect to have adequate cash to service the dividend as well as the compensation at the end of the year.

Okay, great. Thank you very much.

Your next question comes from James Yaro with Goldman Sachs. James, your line is open.

Good afternoon, and thanks for taking my questions. I take your point on the strong restructuring this quarter not repeating but how is the challenging macro backdrop affecting the medium-term trajectory for restructuring?

We had a strong restructuring quarter, and our restructuring business is looking good for the future. This quarter's performance was exceptional for us, with our backlog in restructuring remaining solid. I'm optimistic about the future because our out-of-court expertise is highly sought after. Recently, most deals have been financed with a larger amount of equity compared to previous downturns. Consequently, the path for these transactions is often through capital markets to extend runway and liquidity, and we've enhanced our capital markets for this purpose and for liability management to create flexibility. The significant equity backing the debt capital allows for innovative solutions without needing to go to court. Therefore, I believe the restructuring business will remain strong. While many firms may struggle with higher interest rates, they still have options and flexibility to manage those challenges.

Okay, that's very clear. Maybe we can just turn to your hiring plans, I guess should we expect you to continue to hire at an elevated pace into next year? I'd imagine it obviously won't be at the level you've been hiring at, especially earlier in this year. But will it remain elevated into next year?

I believe we have made significant strides in addressing key sectors, particularly technology, which accounted for over half of our Managing Directors. We formed an Energy Transition Team in response to the IRA, identifying it as a market we wanted to engage with prominently, and we assembled a strong team for that purpose. The situation at Credit Suisse allowed us to acquire some outstanding talent in industrials, which we leveraged. Previously, we were also proactive in the healthcare sector about a year ago. I feel that we have effectively positioned ourselves in the areas we aimed to focus on as we approach the next M&A cycle. While I won’t disclose specifics, we are considering one more sector, though it won’t be of the same scale as our previous efforts. We believe we have established a solid base of talent to navigate the markets.

And if the fifth light goes off, you're going to have the opportunity, right?

It's just, I have to wait for them to all watch drive to survive, or else I can't continue with the analogy. But yes, if that happens, I do think we’d slow down as well.

All right, well, we'll have to watch the newest season. Thanks so much.

Your next question comes from the line of Steven with Wolfe Research. Steven, your line is open.

Good afternoon. This is Brendan O'Brien filling in for Steven, I guess to start just on the M&A outlook commentary, your views on how quickly activity could ramp next year was maybe a bit more optimistic than what we've heard from some of your peers, which have indicated that this would be more of a stop-start recovery. Want to get a sense as to whether you're saying that we could see a ramp in activity that is similar to what we saw during COVID. And I guess, circling back to the drive to survive reference, what is that fifth light in your view that could kickstart activity?

That's a good question, and you're right. The reason is that yesterday felt significant to me. I might not have had the same perspective if this call had happened five days ago. I happened to take this call after the FED meeting, and it seemed to me like they were suggesting that the impact of rates hasn't been fully captured in the data available. Companies are facing considerable challenges, although some consumer spending has helped keep GDP up. There are significant issues related to the higher rates. I read yesterday that we are starting to consider whether these rates are causing problems that we haven't fully identified yet. I want to emphasize that my commentary might have been different before. It feels like we could be close to the end of the current economic cycle. There are various factors that could trigger this, but it probably won't resemble the COVID situation, which was characterized by sharply low interest rates and an influx of capital. However, I believe activity could pick up quickly. Remember, the pandemic only postponed transactions for about three to four months. There is now a backlog of two years’ worth of investors seeking capital and sponsors looking to engage in buying or selling. Although this situation isn't the same as COVID in terms of reduced borrowing costs, that backlog could lead to similar levels of transaction activity.

That's right. Thanks. And I guess my follow-up, restructuring was a big driver of the results this quarter. And I know that Joe indicated that you don't expect this to repeat next quarter. I just wanted to get a sense as to how we should be thinking about, what was typically a seasonally stronger quarter and 4Q. And whether that's an indication that we should expect some decline in revenues. And if you could give some context around how large of a contributor restructuring was to this quarter's results, that'd be great?

We often mention that restructuring capital markets represents 20% to 25%. For this year, we're likely at the upper end, around 25% or more. In this quarter, it was nearly 50% higher than that. However, analyzing revenues by just one quarter is not a great approach, as they fluctuate between periods. I've assessed our contributions as a firm, and it seems we're exceeding 25%. Including capital markets in the mix, it might be close to a third for the year. I mention capital markets because they serve as an alternative for many of these capital raises, helping companies in restructuring or seeking liquidity. For the fourth quarter, I suggest taking the average run rate from the first nine months. I won’t provide specific guidance, but if you smooth out the quarters, it seems that the overall run rate for the year is indicating a certain trend.

I think the idea was that we just didn't want you to extrapolate the third quarter to the four that, we have an unusual multiple when you guys look at deal logic, that that's probably a bad way to look at it for the fourth quarter.

That's exactly what I was getting on. So, thanks for taking my questions.

Your next question comes from the line of Brennan Hawking with UBS. Brennan, your line is open.

Good afternoon. I appreciate you answering my questions. Ken, thank you for clarifying the holiday gift, which seemed to be related to a Formula One team and a company known for weed killer. On a serious note, we all acknowledge that the environment is challenging. The compensation ratio is indeed high, and it's clear that significant hiring is taking place. However, you aim to reduce the compensation ratio back to the 60% level we've become accustomed to. What kind of revenue environment do you need to achieve that, considering the additional fixed expenses you've incurred?

You can observe our performance from the lowest point to the highest point in the cycle. The average revenue per Managing Director has ranged from about 8 million to 12 million, or even as low as 7.5 million to 12 million throughout the cycle. This reflects the range from the bottom to the top, without considering personnel changes. For instance, when you hire 27 Managing Directors, who might average their start time in June, significant revenue contributions from them won't materialize immediately. However, they are included in the compensation pool. We have around 150 Managing Directors, and I believe we have one of the strongest client-facing teams we've ever assembled. While different metrics can suggest various outcomes, any typical numbers that reflect a standard M&A cycle would likely bring the firm back to a 60% compensation ratio. The focus has been on ensuring we're adequately addressing the fee pools that will drive this growth, particularly in technology and healthcare industrials, which are among the largest sectors. I believe we have successfully repositioned the firm to achieve this without incurring substantial M&A costs. However, the downside is we cannot capitalize on the expenses. Nevertheless, I believe this investment strategy is far more efficient and will yield a higher return on invested capital for everyone involved. Also, I want to clarify that I’m not particularly knowledgeable about Formula One; I just enjoy watching the show, similar to how one might feel after staying at a Holiday Inn Express, but my expertise in this area is limited.

Let's not let the truth interfere with a good story, Ken. That's understandable. Looking back at the last year, 2021 was quite remarkable. You were at 12.5. However, for 2022, we're typically seeing eight, and 7.5 projected for 2026, similar to 2019 at 7.5 and 6.7. If we take the upper end of the 2021 range and estimate 7.5, that gives us about one and a quarter billion. Are you suggesting that at that level, you could return to a 60% comp ratio?

Yes, I think we can do better than that. We have addressed better fee pools, significantly improved the brand of the firm, and enhanced our go-to-market strategy. If we achieve that, I believe we could reach a 60% compensation ratio.

Yeah, we have. Mind you, though, I think that's true broadly, but there is elevated fixed costs that are going to go into next year as well. So, it might be a couple of points different. But material, you're on the right track, and certainly 25 for sure.

Understood. When considering the impact of the new commitments from our active recruitment efforts, we need to think carefully about the cash costs involved. I did some quick calculations and wonder if it's reasonable to assume that the recruitment commitments could essentially double the size of our cash incentive pool compared to what it would have been without this unique opportunity.

No, we are pretty disciplined. We want partners, we hire partners. If you're asking did we guarantee we are calm. We hold pretty closely to making sure that the people entering our system are getting comp, the same way as our existing group. We like to have equity partners, people who want to see the value of the firm go up, so we're pretty disciplined on that.

Okay, but I believe that the recruiting would indeed put upward pressure on what the cash incentive pool would look like without the recruiting efforts.

Yes, whatever the incentive pool would look like we've hired 27 more of them. And yeah –

Why we're at 83.

And that's what yeah and that is why we're – one of the main reasons we’re at 83?

Yeah. Okay. And then just last one on that point like, given that you're going to have some liquidity drain, as typically happens in the beginning of next year as the incentive gets better. Should we continue? You had a nice liquidity building in this quarter. Should we continue to expect liquidity to build in the year-end, so that you're in a position to cover those demands?

We have closely examined our situation and we have no concerns. We will have $300 million in cash by the end of the year, and we have thoroughly tested this in various scenarios. We are secure with our dividend and our bonus pool. We have several options available to us, and we believe we are in excellent condition. The lowest point for our liquidity will be when we pay bonuses, and we are confident we will manage that well.

All right, thank you for taking my questions.

Our final question comes from the line of Ryan Kenny with Morgan Stanley. Ryan, your line is open.

Hi, this is Connell Schmitz filling in for Ryan Kenny. So, I guess we just want to go back to the sponsor question. We've heard a lot on the narrative on why sponsors will ultimately go back to transacting and come off the sidelines. But can you just give an update on how sponsors are feeling in this environment? And what like, what the next catalyst is to see sponsors transact and what kind of pressure they're seeing from LPs at the moment? And just any color you can give, that would be helpful.

So, the answer is yes, we do think there is a large bit of pressure on distributing proceeds to LPs. If people want to raise a new fund, they're going to have to return some of the old investments. Most investments that were targeted for disposition as of about 20 months ago have been on hold. And so those might be 2016 investments, 2017 and 2018 investments, but they're certainly not supposed to be held for 10 years. So, the pressure is out there to do transactions to recognize where the market is, you might have thought you had five times return on the asset. And it might only be three times return. And we think people are getting to that point where they're facing the fact that the realization of what they might have to take slightly different pricing and peak pricing. And we see it in the fact and when I talk about our pipeline is that there is a serious amount of allocated transactions pending a market to go-to-market on and I think that that market is when the FED says we're done. I don't think we need a rate cut, obviously that would be extremely helpful. But it's starting to feel like this might have been the last cut or very close to it. And when that happens, I think there'll be a lot of transactions that will go to market, the amount of capital, let me say one thing, the amount of capital that is accumulating in the private credit system, and the creation of funding mechanisms around the banks, is also reaching a significant proportion. And so the ability to finance is coming back up with multiple bidders to put forth financing. And the last thing I'll say about my optimism for the next five years, and why I'm happy to build into it is, I do think that the large banks are going to continue to face a regulatory challenge of being in the let's give out below market funding in order to get advice business. And if they are put out of that business, your regulations, and I think the new Basel negotiations and the regulatory environment, are pointing to that more and more. As a result of what happened with Credit Suisse and Silicon Valley Bank. I think the regulators are again starting to believe that the government guaranteeing deposits of large institutions so that they can speculate in all kinds of businesses, not the right structure for capital markets. And I think it'd be very healthy, to have private credit build up that's not leveraged 10 to one but is levered one on one, and is not free to use the government backed deposit base to go compete with FinTech companies and independent advisory companies using the government guaranteed money. And that will be very positive for us. And I think that's a long-term structural tailwind that we'll see over the next 10 years that will continue to drive. I believe a wedge between advisory businesses, and the ability for those institutions to use below market lending to generate business. And has to redound to the benefit of the independent investment banks.

That's really helpful color. I guess, on your point on rates in the near term, though, like, can you just speak to like volatility and in yields over the past few weeks? Like has that impacted the pipeline and elongated deals more so? And has that affected financing conditions, any color on that will be helpful?

Deals were slow to get out of the gate. I mean, again, I think there's -- there might have been a signal in the last 24 hours from the FED that that you can move from having a toe in the water to a full leg. But yeah, before that, and again, it's only been 24 hours. So, I can't say I've seen anything change in our go-to-market on these transactions. But yes, things were -- what was happening is transactions were being assigned. Work was beginning. And the idea was, we want to be ready when the market’s ready for us and a substantial amount of transactions have that sort of structure around them. And so as I see the market get ready to accept those deals, either via the FED. Either way, I think the turning of the year will be, most people between about Thanksgiving and Christmas just try to keep their jobs versus take risk. And then in the beginning of the year, they think about how to create capital. So, I think there could be a lot of momentum around the FED decision markets turn to the year, New Year, a lot of those things might come. But this could all change. There's a lot of macro events out there that could change that. But as of right now, it feels like we're heading to that type of transition in the market.

Thank you.

I will now turn the call back over to Ken for closing remarks.

Thank you. I have one recommendation: I think Drive to Survive is an entertaining show. Maybe after listening to this call, you'll get a better understanding of what I was trying to convey. I'm looking forward to our next conversation after you've all had a chance to watch the three to four seasons. Best of luck, and thank you.

Ladies and gentlemen, that concludes today's call. You may now disconnect. Have a great day.