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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
For the quarterly period ended March 31, 2012 OR
For the transition period from to
Commission File Number: 001-33448
JMP Group Inc.
(Exact name of registrant as specified in its charter)
600 Montgomery Street, Suite 1100, San Francisco, California 94111
(Address of principal executive offices)
Registrants telephone number: (415) 835-8900
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of large accelerated filer, accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
The number of shares of the Registrants common stock, par value $0.001 per share, outstanding as of April 30, 2012 was 22,788,019.
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JMP Group Inc. is required to file current, annual and quarterly reports, proxy statements and other information required by the Securities Exchange Act of 1934, as amended (the Exchange Act), with the Securities and Exchange Commission (the SEC). You may read and copy any document JMP Group Inc. files with the SEC at the SECs Public Reference Room located at 100 F Street, N.E., Washington, DC 20549. Information on the operation of the Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330. In addition, the SEC maintains an internet website at http://www.sec.gov, from which interested persons can electronically access JMP Group Inc.s SEC filings.
JMP Group Inc. provides its annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, proxy statements, Forms 3, 4 and 5 filed by or on behalf of directors, executive officers and certain large stockholders, and any amendments to those documents filed or furnished pursuant to the Exchange Act free of charge on the Investor Relations section of its website located at http://www.jmpg.com. These filings will become available as soon as reasonably practicable after such material is electronically filed with or furnished to the SEC.
JMP Group Inc. also makes available, in the Investor Relations section of its website and will provide print copies to stockholders upon request, (i) its corporate governance guidelines, (ii) its code of business conduct and ethics, and (iii) the charters of the audit, compensation, and corporate governance and nominating committees of its board of directors. These documents, as well as the information on the website of JMP Group Inc., are not intended to be part of this quarterly report.
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Consolidated Statements of Financial Condition
(Dollars in thousands, except per share data)
See accompanying notes to consolidated financial statements.
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JMP Group Inc.
Consolidated Statements of Financial Condition - (Continued)
(Dollars in thousands, except per share data)
Assets and liabilities of consolidated variable interest entities (VIE) included in total assets and total liabilities above:
The asset-backed securities issued (ABS) by the VIE are limited recourse obligations payable solely from cash flows of the loans collateralizing them and related collection and payment accounts pledged as security. Accordingly, only the assets of the VIE can be used to settle the obligations of the VIE.
See accompanying notes to consolidated financial statements.
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Consolidated Statements of Operations
(In thousands, except per share data)
See accompanying notes to consolidated financial statements.
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Consolidated Statements of Comprehensive Income
Consolidated Statement of Changes in Equity
See accompanying notes to consolidated financial statements.
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Consolidated Statements of Cash Flows
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JMP Group Inc.
Consolidated Statements of Cash Flows - (Continued)
See accompanying notes to consolidated financial statements.
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Notes to Consolidated Financial Statements
March 31, 2012
1. Organization and Description of Business
JMP Group Inc., together with its subsidiaries (collectively, the Company), is an independent investment banking and asset management firm headquartered in San Francisco, California. JMP Group Inc. completed its initial public offering (IPO) on May 16, 2007, and also completed a corporate reorganization in connection with the IPO. The Company conducts its brokerage business through JMP Securities LLC (JMP Securities), its asset management business through Harvest Capital Strategies LLC (HCS), its corporate credit business through JMP Credit Corporation (JMP Credit), JMP Credit Advisors LLC (JMPCA), Harvest Capital Credit LLC (HCC), formed in the third quarter of 2011, and certain principal investments through JMP Capital LLC (JMP Capital). The above entities are wholly-owned subsidiaries, with the exception of HCC which is a partly-owned subsidiary. JMP Securities is a U.S. registered broker-dealer under the Exchange Act and is a member of the Financial Industry Regulatory Authority (FINRA). JMP Securities operates as an introducing broker and does not hold funds or securities for, or owe any money or securities to customers and does not carry accounts for customers. All customer transactions are cleared through another broker-dealer on a fully disclosed basis. HCS is a registered investment advisor under the Investment Advisers Act of 1940, as amended, and provides investment management services for sophisticated investors in investment partnerships and other entities managed by HCS. Effective April 7, 2009, through JMP Credit, the Company completed the acquisition of 100% of the membership interests of Cratos Capital Partners, LLC (which changed its name to JMP Credit Advisors LLC on July 12, 2010) and its subsidiaries, including Cratos Capital Management, LLC (collectively, Cratos), a manager of collateralized loan obligations (CLO), together with certain securities of Cratos CLO I, Ltd. (Cratos CLO). For further details regarding the ownership of Cratos CLO, see Note 2 - Summary of Significant Accounting Policies in the Companys annual report for year ended December 31, 2011 (the 2011 10-K).
2. Summary of Significant Accounting Policies
Basis of Presentation
These consolidated financial statements and related notes are unaudited and have been prepared in accordance with U.S. generally accepted accounting principles (GAAP) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. These consolidated financial statements should be read in conjunction with the Companys consolidated financial statements and notes thereto included in its 2011 10-K. These consolidated financial statements reflect all adjustments (consisting only of normal recurring adjustments) that are, in the opinion of management, necessary for the fair statement of the results for the interim periods. The results of operations for any interim period are not necessarily indicative of the results to be expected for a full year.
The consolidated accounts of the Company include the wholly-owned subsidiaries, JMP Securities, HCS, JMP Capital, JMP Credit, JMPCA, and the partly-owned subsidiaries Harvest Growth Capital LLC (HGC) (effective April 1, 2010), Cratos CLO and HCC (effective August 18, 2011). All material intercompany accounts and transactions have been eliminated in consolidation. Non-controlling interest on the Consolidated Statements of Financial Condition at March 31, 2012 and December 31, 2011 relate to the interest of third parties in the partly owned subsidiaries.
See Note 2 - Summary of Significant Accounting Policies in the Companys 2011 10-K for the Companys significant accounting policies.
3. Recent Accounting Pronouncements
Accounting Standards Update (ASU) 2011-05: Presentation of Other Comprehensive Income was issued to increase the prominence of other comprehensive income in financial statements, by eliminating the option to report other comprehensive income in the statement of changes in stockholders equity. The standard requires comprehensive income to be reported in either a single statement that presents the components of net income, the components of other comprehensive income, and total comprehensive income, or in two consecutive statements. The standard also required separate line items on the income statement for reclassification adjustments of items out of accumulated other comprehensive income into net income. This standard was scheduled to be effective for periods starting after December 15, 2011. However, ASU 2011-12: Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income deferred the effective date of the requirement to present separate line items on the income statement for reclassification adjustments of items out of accumulated other comprehensive income into net income. The adoption of ASU 2011-05 resulted in the disclosure of other comprehensive income outside the statement of changes in stockholders equity.
ASU 2011-04: Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in GAAP and International Financial Reporting Standards (IFRS). The adoption of ASU 2011-04 gives fair value the same meaning between GAAP and IFRS, and improves consistency of disclosures relating to fair value. As a result of this standard, an entity is required to add more robust disclosures regarding the sensitivity of fair value measurements categorized within Level 3 of the fair value hierarchy. The standard is effective for interim periods beginning after December 15, 2011. The adoption of ASU 2011-04 resulted in additional disclosures.
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4. Fair Value Measurements
The following tables provide fair value information related to the Companys financial instruments at March 31, 2012 and December 31, 2011:
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The following tables provide fair value information related to the Companys other investments at March 31, 2012 and December 31, 2011:
The tables below provide a reconciliation of the beginning and ending balances for the assets held at fair value using significant unobservable inputs (Level 3) for the three months ended March 31, 2012 and 2011.
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Purchases and sales of Level 3 assets shown above were recorded at fair value at the date of the transaction.
Total gains and losses included in earnings (or changes in net assets) represent the total gains and/or losses (realized and unrealized) recorded for the Level 3 assets and are reported in Principal Transactions in the accompanying Consolidated Statements of Operations.
Transfers between levels of the fair value hierarchy result from changes in the observability of fair value inputs used in determining fair values for different types of financial assets and are recognized at the beginning of the reporting period in which the event or change in circumstances that caused the transfer occurs.
There were no transfers in/out of Level 1 during the three months ended March 31, 2012 and 2011. There were transfers into Level 2 from Level 3 of $0.9 million and $2.4 million for the three months ended March 31, 2012 and 2011, respectively, as a result of the observability of fair value associated with the equity securities in HGC and JMP Capital. There were no other transfers in/out of Level 2 or Level 3 during the three months ended March 31, 2012 and 2011.
The amount of unrealized gains and losses included in earnings attributable to the change in unrealized gains and losses relating to Level 3 assets still held at the end of the period are reported in Principal Transactions in the accompanying Consolidated Statements of Operations.
Included in other investments are investments in partnerships in which one of the Companys subsidiaries is the investment manager and general partner. The Company accounts for these investments using the equity method as described in Note 2Summary of Significant Accounting Policies in the Companys 2011 annual report. The Companys proportionate share of those investments is included in the tables above. In addition, other investments include warrants and investments in funds managed by third parties. The investments in private investment funds managed by third parties are generally not redeemable at the option of the Company. As of March 31, 2012, the Company had unfunded investment commitments of $0.1 million related to private investment funds managed by third parties.
The Company used the following valuation techniques with unobservable inputs when estimating the fair value of the Level 3 assets:
The significant unobservable input used in the fair value measurement of the warrants is the annualized volatility of credit. Significant increases in the rate would result in a significantly higher fair value measurement.
The significant unobservable inputs used in the fair value measurement of the equity securities in HGC and JMP Capital are Revenue, EBITDA and Free Cash Flow multiples, discount for lack of marketability, and control premiums. Significant increases in the multiples in isolation would result in a significantly higher fair value measurement. Increases in the discounts and premium in isolation would result in decreases to the fair value measurement.
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Investments at Cost
On February 11, 2010, the Company made a $1.5 million investment in Class D Preferred Units of Sanctuary Wealth Services LLC (Sanctuary). Sanctuary provides a turnkey platform that allows independent wealth advisors to establish an independent advisory business without the high startup costs and regulatory hurdles. The Class D Preferred Units entitle the Company to receive a preferred dividend with units that are convertible into equity of Sanctuary at the option of the Company prior to the maturity date, which is three years from the investment date. The Company carries its investment in Sanctuary at cost within other investments on the Consolidated Statements of Financial Condition and evaluates the investment for impairment on a quarterly basis. During the fourth quarter of 2010, the Company determined that its investment in Sanctuary was fully impaired and recorded an impairment loss of $1.5 million, which was included in Principal Transactions on the Consolidated Statements of Operations. The carrying value of the Companys investment in Sanctuary was zero at December 31, 2011 and March 31, 2012.
Derivative Financial Instruments
On May 29, 2010, the Company entered into an interest rate cap with City National Bank (the Lender) to effectively lock in or fix the interest rate on its revolving line of credit and term loan from July 1, 2010 through maturity. The interest rate cap will allow the Company to receive payments from the Lender in the event that LIBOR plus 2.25% exceeds 3.75%, limiting the interest rate on the outstanding balance of the line of credit and term loan to such rate. On July 1, 2010, the Company designated the interest rate cap as a cash flow hedge of the interest rate risk of a total of $27.1 million of outstanding borrowings with the Lender as of that date. The notional principal amount of the cap was $17.0 million at March 31, 2012. See Note 7 for additional information pertaining to the Companys borrowing from the Lender.
The interest rate cap is recorded at fair value in other investments on the Consolidated Statements of Financial Condition, with unrealized gains and losses recorded as other comprehensive income. For the three months ended March 31, 2012, the Company recorded $6,477 of other comprehensive loss representing unrealized loss on the interest rate cap. In addition, for the three months ended March 31, 2012, $13,674 was reclassified from accumulated other comprehensive income into interest expense as amortization of the interest cap.
5. Small Business Loans
Small business loans consist of loans held at HCC. HCC was formed in the third quarter of 2011 to generate both current income and capital appreciation by primarily making direct investments in the form of subordinated debt, and, to a lesser extent, senior debt and minority equity investments in small to mid-size companies. As of March 31, 2012, the $13.5 million net loans outstanding were commercial loans. The following table summarizes the components of this small business loan receivable balance:
The Company, at least on a quarterly basis, reviews and evaluates the credit quality of each loan. The review primarily includes the following credit quality indicators with regard to each loan: 1) Moodys rating, 2) current internal rating and 3) performance. The review follows a similar methodology as the review over loans collateralizing asset-backed securities issued. See Note 2Summary of Significant Accounting Policies in the Companys 2011 10-K for the policy and methodology in determining an allowance for loan losses and further descriptions of the credit quality factors analyzed.
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A summary of the activity in the allowance for loan losses for the three months ended March 31, 2012 was as follows:
The Company determined the fair value of small business loans to be $14.0 million and $7.8 million as of March 31, 2012 and December 31, 2011, respectively. The fair value of the loans are calculated using the average market bid and ask quotation obtained from a loan pricing service. Such loans are identified as Level 2 assets. When average market bid and ask quotations are not available, the loans are identified as Level 3 assets. The fair value of these Level 3 loans are calculated internally based on their performance. This analysis incorporates comparable loans traded in the marketplace, the obligors industry, future business prospects, capital structure, and expected credit losses. Significant declines in the performance of the loan would result in decreases to the fair value measurement.
6. Loans Collateralizing Asset-backed Securities Issued and Loans Held for Sale
Loans collateralizing asset-backed securities issued and loans held for sale are commercial loans securitized and owned by Cratos CLO. The loans consist of those loans within the CLO securitization structure at the acquisition date of Cratos and loans purchased by the CLO subsequent to the Cratos acquisition date. The following table presents the components of loans collateralizing asset-backed securities issued and loans held for sale at March 31, 2012 and December 31, 2011:
Loans recorded upon the acquisition of Cratos at fair value reflect a liquidity discount and a credit discount. In addition, most loans purchased subsequent to the acquisition were purchased at a discount to their principal value, reflecting deferred loan fees. The tables below summarize the activity in the loan principal, allowance for loan losses, liquidity discount, credit discount, deferred loan fees and carrying values, net for the impaired loans and non-impaired loans as of and for the three months ended March 31, 2012:
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The tables below summarize the activity in the loan principal, allowance for loan losses, liquidity discount, credit discount, deferred loan fees and carrying values, net for the impaired loans and non-impaired loans as of and for the three months ended March 31, 2011:
Allowance for Loan Losses
The Company recorded general reserves of $0.1 million and $0.2 million during the quarters ended March 31, 2012 and 2011, respectively, on non-impaired loans. A summary of the activity in the allowance for loan losses for loans collateralizing asset-backed securities for the three months ended March 31, 2012 and 2011 is as follows:
A loan is considered to be impaired when, based on current information, it is probable that the Company will be unable to collect all amounts due in accordance with the contractual terms of the original loan agreement, including scheduled principal and interest payments. As of both March 31, 2012 and December 31, 2011, $3.2 million of recorded investment amount of loans collateralizing asset-backed securities issued were individually evaluated for impairment. The remaining $410.9 million and $411.7 million of recorded investment amount of loans collateralizing asset-backed securities issued were collectively evaluated for impairment, as of March 31, 2012 and December 31, 2011 respectively. The entire $2.6 million and $3.0 million of recorded investment amount of loans held for sale were individually evaluated for impairment, as of March 31, 2012 and December 31, 2011, respectively.
All impaired loans are classified as cash flow loans. The tables below present certain information pertaining to the impaired loans at March 31, 2012 and December 31, 2011:
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Non-Accrual, Past Due Loans and Restructured Loans
At March 31, 2012, two Cash Flow loans with the aggregate principal amount of $10.7 million and recorded investment amount of $3.2 million were on non-accrual status. At December 31, 2011, two Cash Flow loans with the aggregate principal amount of $10.5 million and recorded investment amount of $3.2 million were on non-accrual status. The Company recognized $37 thousand and $88 thousand in interest income, other than the accretion of liquidity discounts, for the two impaired loans with a weighted average loan balance of $10.7 million and $11.3 million that were on non-accrual status during the three months ended March 31, 2012 and 2011.
Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. At both March 31, 2012 and December 31, 2011, one non-accrual loan in the amount of $2.7 million was over 90 days past due. No other loans were past due at March 31, 2012 or December 31, 2011.
At March 31, 2012 and December 31, 2011, the impaired loans included two Cash Flow loans, with the aggregated recorded investment balance of $0.6 million for both these periods, whose terms were modified in a troubled debt restructuring (TDR). Concessions for these TDRs included a below market interest rate as of December 31, 2011 or receipt of equity interest in the debtor as compensation for reducing the loan principal balance. There were neither new TDR loans nor additional restructuring to existing TDR loans in the three months ended March 31, 2012. No payment defaults in the previous 12 months resulted in any TDRs. At March 31, 2012 and December 31, 2011, there were no remaining commitments to lend funds to debtors whose terms have been modified in a TDR.
Credit Quality of Loans
The Company, at least on a quarterly basis, reviews each loan and evaluates the credit quality of the loan. The review primarily includes the following credit quality indicators with regard to each loan: 1) Moodys rating, 2) current internal rating and 3) performance. The tables below present, by credit quality indicator, the Companys recorded investment in loans collateralizing asset-backed securities issued at March 31, 2012 and December 31, 2011.
The Company determined the fair value of loans collateralizing asset-backed securities to be $428.7 million and $420.1 million as of March 31, 2012 and December 31, 2011, respectively; primarily using the average market bid and ask quotation obtained from a loan pricing service. Such loans are identified as Level 2 assets. When average market bid and ask quotations were not available, the loans are identified as Level 3 assets. The fair value of these Level 3 loans are calculated internally based on their performance. This analysis incorporates comparable loans traded in the marketplace, the obligors industry, future business prospects, capital structure, and expected credit losses. Significant declines in the performance of the loan would result in decreases to the fair value measurement.
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The fair value of the loan held for sale was determined to be $2.6 million and $3.0 million as of March 31, 2012 and December 31, 2011, using similar methodology. Based on the fair value methodology, the Company has identified the loan held for sale as a Level 2 asset.
7. Note Payable
Note payable consists of two term loans related to the Companys Credit Agreement with City National Bank (the Lender), as defined below.
On August 24, 2011, JMP Group LLC, a wholly-owned subsidiary of the Company, entered into Amendment Number Six to Credit Agreement (the Sixth Amendment), which amends certain provisions of the Credit Agreement, dated as of August 3, 2006, by and between the Company and the Lender, as amended by Amendment Number One to Credit Agreement, dated as of December 17, 2007, Amendment Number Two to Credit Agreement, dated as of March 27, 2008, Amendment Number Three to Credit Agreement (the Third Amendment), dated as of December 31, 2008, Amendment Number Four to Credit Agreement and Waiver, dated as of January 28, 2010, and Amendment Number Five (the Fifth Amendment), dated as of April 8, 2011 (collectively, the Credit Agreement).
The Sixth Amendment provided a new line of credit of up to $30.0 million to the extent the aggregate outstanding balance of all facilities does not exceed $55.0 million. The new line of credit will remain available through August 24, 2013. On such date, any outstanding amounts convert to a term loan. The term loan will be repaid in quarterly installments of 3.75% of funded debt for the first two years, 5.00% of funded debt for the next two years, and the remainder due at maturity on August 24, 2017. The Sixth Amendment also permits additional investments. The Company anticipates that the proceeds will be used to fund certain commitments to HCC, to repurchase Company stock and other permitted investments, and for other general working capital purposes. The Companys outstanding balance on this line of credit was $7.7 million as of March 31, 2012.
Under the Fifth Amendment, JMP Securities entered into a $20.0 million revolving line of credit with City National Bank to be used for regulatory capital purposes during its securities underwriting activities. Draws on the revolving line of credit bear interest at the rate of prime and are available through April 8, 2012 on which date, if there is an existing outstanding amount, it converts to a loan that matures on April 8, 2013. There was no borrowing on this line of credit as of March 31, 2012.
The Third Amendment converted the Companys outstanding revolving loans of $8.7 million into a single term loan as of December 31, 2008. The term loan is being repaid in equal quarterly payments of $0.4 million, which commenced on March 31, 2009 and continues through December 31, 2013 and bears interest at LIBOR plus 2.25%. The outstanding balance on this term loan was $3.0 million as of March 31, 2012.
The Third Amendment also provided that of the original $30.0 million revolving line of credit, $21.0 million remained available under the revolving portion of the Credit Agreement and the annual interest rate provisions of the Credit Agreement were increased from the prime rate minus 1.25% to the prime rate and from LIBOR plus 1.25% to LIBOR plus 2.25%. The Lender agreed to continue to provide revolving loans of up to $21.0 million through December 31, 2010, on which date the then existing revolving loans converted into term loans. On December 31, 2010, pursuant to the provisions of the Third Amendment, the outstanding revolving loan of $21.0 million was converted into a single term loan that will fully mature on December 31, 2013. This term loan is being repaid in equal quarterly payments of $1.8 million, which commenced on April 1, 2011 and continues through January 1, 2014. The outstanding balance on this term loan was $14.0 million as of March 31, 2012.
The two term loans had an aggregate outstanding principal amount of $17.0 million and $19.2 million at March 31, 2012 and December 31, 2011, respectively. The following table shows the repayment schedules for the principal portion of the term loans at March 31, 2012:
The Credit Agreement contains financial and other covenants, including, but not limited to, limitations on debt, liens and investments, as well as the maintenance of certain financial covenants. A violation of any one of these covenants could result in a default under the Credit Agreement, which would permit the bank to terminate our note and require the immediate repayment of any outstanding principal and interest. The Third Amendment modified the financial covenants in the Credit Agreement to remove both the minimum requirement of Net Income (as defined in the Credit Agreement) and the minimum requirement of EBITDA (as defined in the Credit Agreement). The Third Amendment also removed the Fixed Charge Coverage Ratio (as defined in the Credit Agreement) and added a new financial covenant regarding the Companys liquidity. The Sixth Amendment added back the Fixed Charge Coverage Ratio requirement and introduced certain leverage ratio requirements. At March 31, 2012, the Company was in compliance with the loan covenants. The term loan is collateralized by a pledge of the Companys assets, including its interests in each of JMP Securities and HCS.
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On May 29, 2010 the Company entered into an interest rate cap with the Lender to effectively fix the interest rate on its revolving line of credit and term loan from July 1, 2010 through maturity. The interest rate cap will allow the Company to receive payments from the counterparty in the event that LIBOR plus 2.25% exceeds 3.75%, limiting the interest rate on the outstanding balance of the term loan to such rate. The cap had an initial notional principal amount of $27.1 million, indexed to LIBOR and amortizes in accordance with the amortization of the revolving line of credit and term loan. The notional principal amount of the cap was $17.0 million at March 31, 2012. See Note 4 for additional information on the interest rate cap.
8. Asset-backed Securities Issued
On May 17, 2007, Cratos CLO completed a $500.0 million aggregate principal amount of notes (the Notes) on-balance sheet debt securitization and obtained $455.0 million of third-party financing. The Notes will be repaid from the cash flows generated by the loan portfolio owned by the CLO. The Notes were issued in seven separate classes as set forth in the table below. The Company owns approximately 94.0% of the unsecured subordinated notes and $13.8 million of Class C, D and E notes ($2.0 million of Class C, $4.1 million of Class D and $7.7 million of Class E notes). These unsecured subordinated notes and the Class C, D and E notes owned by the Company are eliminated upon consolidation of JMP Credit, and therefore, are not reflected on the Companys consolidated statement of financial condition at March 31, 2012 and December 31, 2011.
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The secured notes and subordinated notes are limited recourse obligations payable solely from cash flows of the CLO loan portfolio and related collection and payment accounts pledged as security. Payment on the Class A-1 notes rank equal, or pari-passu, in right of payment with payments on the Class A-2 notes and payment on the Class A-1 and Class A-2 notes rank senior in right of payment to the other secured notes and the subordinated notes. Payment on the Class B, Class C, Class D and Class E notes generally rank subordinate in right of payment to any other class of notes which has an earlier alphabetical designation. The subordinated notes are subordinated in right of payment to all other classes of notes and will not accrue interest. Interest on the secured notes is payable quarterly at a per annum rate equal to LIBOR plus the applicable spread set forth in the table above. Payment of interest on the Class C, Class D and Class E notes is payable only to the extent proceeds are available under the applicable payment priority provisions. To the extent proceeds are not so available, interest on the Class C, Class D and Class E notes will be deferred. As of March 31, 2012 and December 31, 2011, all interest on the secured notes was current. The CLO is also required to pay a commitment fee of 0.18% on the unused portion of the funding commitments of the Class A-1 notes. As of March 31, 2012 and December 31, 2011, all of the Class A-1 notes were drawn. The secured notes are secured by the CLO loan portfolio and the funds on deposit in various related collection and payment accounts. The terms of the debt securitization subject the loans included in the CLO loan portfolio to a number of collateral quality, portfolio profile, interest coverage and overcollateralization tests. Total interest expense related to the asset-backed securities issued for the three months ended March 31, 2012 and 2011 was $9.4 million and $8.4 million, respectively, which comprised cash coupon of $1.3 million and $1.1 million and a liquidity discount amortization of $8.1 million and $7.3 million, respectively. As of March 31, 2012 and December 31, 2011, accrued interest payable on the Notes was $0.6 million and $0.5 million, respectively.
The Notes recorded upon the acquisition of Cratos in April 2009 at fair value reflect a liquidity discount. The activity in the note principal and liquidity discount for the three months ended March 31, 2012 comprised the following:
The activity in the note principal and liquidity discount for the three months ended March 31, 2011 comprised the following:
The Company determined the fair value of asset-backed securities issued to be $388.9 million and $375.9 million as of March 31, 2012 and December 31, 2011, respectively. Based on the fair value methodology, the Company has identified the asset backed securities issued as Level 2 liabilities.
9. Stockholders Equity
Stock Repurchase Program
In each of August and November 2007, the Companys board of directors authorized a 1.5 million share repurchase program, both of which were fully executed as of January 18, 2008. On March 10, 2008, the Companys board of directors authorized the repurchase of an additional 2.0 million shares during the subsequent eighteen months, the repurchase of an additional 0.5 million shares during the subsequent twelve months on March 3, 2009, the repurchase of an additional 1.0 million shares during the subsequent eighteen months on May 4, 2010, the repurchase of an additional 0.5 million shares during the subsequent twelve months on May 3, 2011, and the repurchase of an additional 1.0 million shares during the subsequent eighteen months on November 1, 2011. During the three months ended March 31, 2012 and 2011, the Company repurchased 597,143 and 218,799 shares, respectively, of the Companys common stock at an average price of $7.08 per share and $8.32 per share, respectively, for an aggregate purchase price of $4.2 million and $1.8 million, respectively. 581,228 shares repurchased during the three months ended March 31, 2012 were deemed to have been repurchased in connection with employee stock plans, whereby the Companys shares were issued on a net basis to employees for the payment of applicable statutory withholding taxes and therefore such withheld shares are deemed to be purchased by the Company. The remaining shares were repurchased in the open market. All shares repurchased during the three months ended March 31, 2011 were deemed to have been repurchased in connection with employee stock plans, whereby the Companys shares were issued on a net basis to employees for the payment of applicable statutory withholding taxes and therefore such withheld shares are deemed to be purchased by the Company.
The timing and amount of any future open market stock repurchases will be determined by JMP management based on its evaluation of market conditions, the relative attractiveness of other capital deployment activities, regulatory considerations and other factors. Any open market stock repurchase activities will be conducted in compliance with the safe harbor provisions of Rule 10b-18 of the Exchange Act, or in privately negotiated transactions. Repurchases of common stock may also be made under an effective Rule 10b5-1 plan which permits common stock to be repurchased when the Company may otherwise be prohibited from doing so under insider trading laws. This repurchase program may be suspended or discontinued at any time.
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10. Stock-Based Compensation
On March 26, 2007, the board of directors adopted the JMP Group Inc. 2007 Equity Incentive Plan (JMP Group 2007 Plan), which was approved by the stockholders on April 12, 2007. The board reauthorized this plan and it was approved by our stockholders on June 6, 2011. JMP Group Inc. authorized the issuance of 4,000,000 shares of its common stock under this Plan. This amount is increased by any shares JMP Group Inc. purchases on the open market, or through any share repurchase or share exchange program, as well as any shares that may be returned to the JMP Group 2007 Plan or the JMP Group LLC 2004 Equity Incentive Plan (JMP Group 2004 Plan) as a result of forfeiture, termination or expiration of awards; not to exceed a maximum aggregate number of shares of 2,960,000 shares under the JMP Group 2004 Plan. The Company will issue shares upon exercises or vesting from authorized but unissued shares or from treasury stock.
There was no stock option activity for the three months ended March 31, 2012. The following table summarizes the stock options outstanding as well as stock options vested and exercisable as of March 31, 2012:
The Company recognizes stock-based compensation expense for stock options over the graded vesting period of the options using the accelerated attribution method. The Company recognized compensation expense related to stock options of zero for both the three months ended March 31, 2012 and 2011.
As of March 31, 2012, there was no unrecognized compensation expense related to stock options.
Restricted Stock Units and Restricted Shares
Under the JMP Group 2007 Equity Incentive Plan, the Company has granted restricted stock units (RSUs) to employees and non-employee directors at no cost to the recipient. An RSU entitles the recipient to receive a share of common stock after the applicable restrictions lapse. These awards are generally subject to vesting schedules and continued employment with the Company. Some of these awards are also subject to post vesting lockup restrictions. In the event of a change in control or corporate transactions, or if the vesting of all or certain of the RSUs are otherwise accelerated, the RSUs will vest immediately prior to the effective date of such an event.
The following table summarizes the RSU activity for the three months ended March 31, 2012:
The aggregate fair value of RSUs vested during the three months ended March 31, 2012 was $9.8 million. For the three months ended March 31, 2012, the income tax benefits realized from the vested RSUs were $4.0 million.
The Company recognizes compensation expense over a graded vesting period using the accelerated attribution method. For the three months ended March 31, 2012 and 2011, the Company recorded compensation expense of zero and $0.3 million, respectively, related to RSUs awarded in connection with the IPO. In addition, for both the three months ended March 31, 2012 and 2011, the Company recorded compensation expense of $0.2 million and $0.1 million for RSUs granted after the IPO. For both the three months ended March 31, 2012 and 2011, the Company recognized income tax benefits of $0.1 million and $0.2 million, related to the compensation expense recognized for RSUs. As of March 31, 2012, there was $8.2 million of unrecognized compensation expense related to RSUs expected to be recognized over a weighted average period of 2.68 years.
11. Net Income (Loss) per Share of Common Stock
Basic net income (loss) per share for the Company is calculated by dividing net income (loss) by the weighted average number of common shares outstanding for the reporting period. Diluted net income (loss) per share is calculated by adjusting the weighted average number of outstanding shares to reflect the potential dilutive impact as if all potentially dilutive stock options or RSUs were exercised or converted under the treasury stock method. However, for periods that the Company has a net loss the effect of outstanding stock options or RSUs is anti-dilutive and, accordingly, is excluded from the calculation of diluted loss per share.
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The computations of basic and diluted net income per share for the three months ended March 31, 2012 and 2011 are shown in the tables below:
Stock options to purchase 1,704,665 and 1,796,865 shares of common stock for the three months ended March 31, 2012 and 2011, respectively, were anti-dilutive and, therefore, were not included in the computation of diluted weighted-average common shares outstanding. Restricted stock units for 24,676 and 1,040 shares of common stock for the three months ended March 31, 2012 and 2011, respectively, were anti-dilutive and, therefore, were not included in the computation of diluted weighted-average common shares outstanding.
12. Employee Benefits
All salaried employees of the Company are eligible to participate in the JMP Group 401(k) Plan after three months of employment. Participants may contribute up to the limits set by the U.S. Internal Revenue Service. There were no contributions by the Company during the three months ended March 31, 2012 and 2011.
13. Income Taxes
The Company is subject to U.S. federal and state income taxes. For the three months ended March 31, 2012 and 2011, the Company recorded a tax expense of $0.3 million and $2.5 million, respectively.
The components of the Companys income tax expense for the three months ended March 31, 2012 and 2011 are as follows:
A reconciliation of the statutory U.S. federal income tax rate to the Companys effective tax rate for the three months ended March 31, 2012 and 2011 is as follows:
The Company determined that a valuation allowance against deferred tax assets was not necessary as of March 31, 2012 and December 31, 2011 based on the assessment of future ordinary income and capital gains and that the deferred tax assets will, more-likely-than-not, be realized. The 20.72% decrease in the effective tax rate for the three months ended March 31, 2012 compared to the same periods in 2011 was primarily attributable to the income associated with HGC which is consolidated for financial reporting purposes but not for tax purposes.
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The Company adopted the accounting principles related to uncertainty in income taxes on May 16, 2007, the date the Company became subject to federal and state income taxes. The Company has analyzed the filing positions in its federal and state income tax returns for all open tax years, which are 2008 through 2011 for federal income tax purposes and 2007 through 2011 for state income tax purposes. The Company does not anticipate any tax adjustments that will result in a material adverse effect on the Companys financial condition, results of operations, or cash flow. Therefore, the Company recorded no liability for uncertain income tax positions at March 31, 2012. In addition, the Company did not record a cumulative effect adjustment related to the adoption of the amended accounting principles related to the accounting for uncertainty in income taxes, and no liabilities for uncertain income tax positions have been recorded pursuant to the amended accounting principles.
The Companys policy for recording interest and penalties associated with the tax audits or unrecognized tax benefits, if any, is to record such items as a component of income before taxes. Penalties, if incurred, would be recorded in administration and interest paid or received would be recorded in interest and dividend expense in the Consolidated Statements of Operations.
14. Commitments and Contingencies
The Company leases office space in California, Illinois, Georgia, Massachusetts, Minnesota and New York under various operating leases. Rental expense for the three months ended March 31, 2012 and 2011 was $0.8 million and $0.7 million, respectively.
The California, Illinois, Minnesota and New York leases included a period of free rent at the start of the lease. Rent expense is recognized over the entire lease period uniformly net of the free rent savings. The aggregate minimum future commitments of these leases are:
In the normal course of business, the Company enters into underwriting commitments. Settlement of transactions relating to such underwriting commitments, which were open at March 31, 2012 and December 31, 2011, had no material effect on the consolidated financial statements.
The marketable securities owned and the restricted cash, as well as the cash held by the clearing broker, may be used to maintain margin requirements. At March 31, 2012 and December 31, 2011, the Company had $0.2 million and $0.3 million of cash on deposit with JMP Securities clearing broker, respectively. Furthermore, the marketable securities owned may be hypothecated or borrowed by the clearing broker.
Unfunded commitments are agreements to lend to a borrower, provided that all conditions have been met. As of March 31, 2012 and December 31, 2011, the Company had unfunded commitments of $8.5 million and $3.2 million, respectively, in the Corporate Credit segment.
15. Regulatory Requirements
JMP Securities is subject to the SECs Uniform Net Capital Rule (Rule 15c3-1), which requires the maintenance of minimum net capital, as defined, and requires that the ratio of aggregate indebtedness to net capital, both as defined, shall not exceed 15 to 1. JMP Securities had net capital of $22.0 million and $38.0 million, which were $21.0 million and $37.0 million in excess of the required net capital of $1.0 million at March 31, 2012 and December 31, 2011, respectively. JMP Securities ratio of aggregate indebtedness to net capital was 0.52 to 1 and 0.26 to 1 at March 31, 2012 and December 31, 2011, respectively.
Since all customer transactions are cleared through another broker-dealer on a fully disclosed basis, JMP Securities is not required to maintain a separate bank account for the exclusive benefit of customers in accordance with Rule 15c3-3 under the Exchange Act.
16. Related Party Transactions
The Company earns base management fees and incentive fees from serving as investment advisor for various affiliated entities, including corporations, partnerships, limited liability companies, and offshore investment companies. The Company also owns an investment in most of such affiliated entities. As of March 31, 2012 and December 31, 2011, the aggregate fair value of the Companys investments in the affiliated entities for which the Company serves as the investment advisor was $27.9 million and $36.0 million, respectively, which consisted of general partner investments in hedge and other private funds of $27.8 million and $25.6 million, respectively, general partner or other principal investments in funds of funds of $0.1 million for both periods, and an
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investment in New York Mortgage Trust, Inc. NYMT common stock of zero and $10.3 million, respectively. Base management fees earned from these affiliated entities were $2.4 million and $2.3 million for the quarters ended March 31, 2012 and 2011, respectively. Also, the Company earned incentive fees of $1.0 million and $0.9 million, from these affiliated entities for the three months ended March 31, 2012 and 2011, respectively. As of March 31, 2012 and December 31, 2011, the Company had incentive fees receivable from these affiliated entities of $0.4 million and $2.1 million, respectively.
JMP Securities has agreed to indemnify its clearing broker for losses that the clearing broker may sustain from the accounts of customers introduced by JMP Securities. Should a customer not fulfill its obligation on a transaction, JMP Securities may be required to buy or sell securities at prevailing market prices in the future on behalf of its customer. JMP Securities obligation under the indemnification has no maximum amount. All unsettled trades at March 31, 2012 and December 31, 2011 have subsequently settled with no resulting material liability to the Company. For the three months ended March 31, 2012 and 2011, the Company had no material loss due to counterparty failure, and has no obligations outstanding under the indemnification arrangement as of March 31, 2012 and December 31, 2011.
The Company is engaged in various investment banking and brokerage activities whose counterparties primarily include broker-dealers, banks and brokerage or investment banking clients. In the event counterparties do not fulfill their obligations, the Company may be exposed to risk. The risk of default depends on the creditworthiness of the counterparty or issuer of the instrument. It is the Companys policy to review, as necessary, the credit standing of each counterparty with which it conducts business.
The Company is involved in a number of judicial, regulatory and arbitration matters arising in connection with our business. The outcome of matters the Company has been and currently is involved in cannot be determined at this time, and the results cannot be predicted with certainty. There can be no assurance that these matters will not have a material adverse effect on our results of operations in any future period and a significant judgment could have a material adverse impact on our financial condition, results of operations and cash flows. The Company may in the future become involved in additional litigation in the ordinary course of our business, including litigation that could be material to our business.
The Company reviews the need for any loss contingency reserves and establish reserves when, in the opinion of management, it is probable that a matter would result in liability and the amount of loss, if any, can be reasonably estimated. The Company was named as a defendant in a purported securities class action complaint with respect to a company for which JMP Securities served as an underwriter in a public offering, and recorded an accrual based on its portion of the estimated legal expenses. A loss contingency has not been booked as a range of loss cannot be reasonably estimated at this time. Generally, given the inherent difficulty of predicting the outcome of matters the Company is involved in, particularly cases in which claimants seek substantial or indeterminate damages, it is not possible to determine whether a liability has been incurred or to reasonably estimate the ultimate or minimum amount of that liability until the case is close to resolution. For these matters, no reserve is established until such time, other than for reasonably estimable legal fees and expenses. Management, after consultation with legal counsel, believes that the currently known actions or threats will not result in any material adverse effect on the Companys financial condition, results of operations or cash flows.
19. Financial Instruments with Off-Balance Sheet Risk, Credit Risk or Market Risk
The majority of the Companys transactions, and consequently the concentration of its credit exposure, is with its clearing broker. The clearing broker is also a significant source of short-term financing for the Company, which is collateralized by cash and securities owned by the Company and held by the clearing broker. The Companys securities owned may be pledged by the clearing broker. The receivable from the clearing broker represents amounts receivable in connection with the trading of proprietary positions.
The Company is also exposed to credit risk from other brokers, dealers and other financial institutions with which it transacts business. In the event that counterparties do not fulfill their obligations, the Company may be exposed to credit risk.
The Companys trading activities include providing securities brokerage services to institutional clients. To facilitate these customer transactions, the Company purchases proprietary securities positions (long positions) in equity securities. The Company also enters into transactions to sell securities not yet purchased (short positions), which are recorded as liabilities on the Consolidated Statements of Financial Condition. The Company is exposed to market risk on these long and short securities positions as a result of decreases in market value of long positions and increases in market value of short positions. Short positions create a liability to purchase the security in the market at prevailing prices. Such transactions result in off-balance sheet market risk as the Companys ultimate obligation to satisfy the sale of securities sold, but not yet purchased may exceed the amount recorded in the Consolidated Statements of Financial Condition. To mitigate the risk of losses, these securities positions are marked to market daily and are monitored by management to assure compliance with limits established by the Company.
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In connection with Cratos CLO, the Company is party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include unfunded commitments to lend and standby letters of credit. The instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheet of the Company.
Unfunded commitments are agreements to lend to a borrower, provided that all conditions have been met. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since certain commitments may expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each borrowers creditworthiness on a case by case basis.
Standby letters of credit are conditional commitments issued by the Company to guarantee the performance by a borrower to a third party. The Companys exposure to credit loss in the event of nonperformance by the other party to the financial instrument for standby letters of credit is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on balance sheet instruments. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loans to borrowers. In its Corporate Credit segment, the Company had unfunded commitments of $8.5 million and $0.2 million and standby letters of credit of $0.4 million and $0.2 million at March 31, 2012 and December 31, 2011, respectively.
20. Business Segments
The Companys business results are categorized into the following four business segments: Broker-Dealer, Asset Management, Corporate Credit and Corporate. The Broker-Dealer segment includes a broad range of services, such as underwriting and acting as a placement agent for public and private capital markets raising transactions and financial advisory services in M&A, restructuring and other strategic transactions. The Broker-Dealer segment also includes institutional brokerage services and equity research services to our institutional investor clients. The Asset Management segment includes the management of a broad range of pooled investment vehicles, including the Companys hedge funds, hedge funds of funds, as well as the Companys principal investments in public and private securities. The Corporate Credit segment includes the management of collateralized loan obligations, small business loans and certain principal investments through JMP Capital and HCC. The Corporate segment includes revenues and expenses related to JMP Group Inc., the holding company, and JMP Group LLC, and is mainly comprised of corporate overhead expenses and interest expense related to the Companys credit facility with City National Bank. The accounting policies of the segments are consistent with those described in the Summary of Significant Accounting Policies in Note 2 in the 2011 10-K.
Revenue generating activities between segments are eliminated from the segment results for reporting purposes. These activities include fees paid by the Broker-Dealer segment to the Asset Management segment for the management of its investment portfolio as well as fees paid by the Corporate Credit segment to the Asset Management segment for co-management of its investment portfolio.
The Companys segment information for the three months ended March 31, 2012 and 2011 were prepared using the following methodology:
The Company evaluates segment results based on revenue and segment operating income before non-controlling interest and taxes.
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Segment Operating Results
Management believes that the following information provides a reasonable representation of each segments contribution to revenues, income (loss) before non-controlling interest and income tax expense (benefit) and assets:
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21. Summarized Financial Information for Equity Method Investments
The tables below present summarized financial information of the hedge funds which the Company accounts for under the equity method. The financial information below represents 100% of the net assets, net realized and unrealized gains (losses) and net investment income (loss) of such hedge funds as of the dates and for the periods indicated.
22. Subsequent Events
In April 2012, the Companys investment in Sanctuary, which was fully impaired as of December 31, 2010, completed its restructuring, resulting in an anticipated $0.9 million recovery.
On April 18, 2012, the Company met the contingent advisory obligations outlined in the December 31, 2011 termination agreement with NYMT. This will result in an expected income of $2.0 million.
On May 1, 2012, the Companys board of directors declared a cash dividend of $0.035 per share of common stock for the first quarter of 2012 to be paid on June 1, 2012, to common stockholders of record on May 18, 2012.
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The following Managements Discussion and Analysis of Financial Condition and Results of Operations (MD&A) should be read together with the unaudited consolidated financial statements and the related notes included elsewhere in this report. For additional context with which to understand our financial condition and results of operations, see the MD&A for the fiscal year ended December 31, 2011 contained in our Annual Report on Form 10-K (the 2011 10-K) filed with the SEC on March 12, 2012, as well as the Consolidated Financial Statements and Notes contained therein.
Cautionary Statement Regarding Forward Looking Statements
This MD&A and other sections of this report contain forward looking statements. We make forward-looking statements, as defined by the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, and in some cases, you can identify these statements by forward-looking words such as if, shall, may, might, will likely result, should, expect, plan, anticipate, believe, estimate, project, intend, goal, objective, predict, potential or continue, the negative of these terms and other comparable terminology. These forward-looking statements, which are based on various underlying assumptions and expectations and are subject to risks, uncertainties and other unknown factors, may include projections of our future financial performance based on our growth strategies and anticipated trends in our business. These statements are only predictions based on our current expectations and projections about future events that we believe to be reasonable. There are or may be important factors that could cause our actual results, level of activity, performance or achievements to differ materially from the historical or future results, level of activity, performance or achievements expressed or implied by such forward-looking statements. These factors include, but are not limited to, those discussed under the caption Risk Factors in our 2011 10-K. In preparing this MD&A, we presume that readers have access to and have read the MD&A in our 2011 10-K, pursuant to Instruction 2 to paragraph (b) of Item 303 of Regulation S-K. We undertake no duty to update any of these forward-looking statements after the date of filing of this report to conform such forward-looking statements to actual results or revised expectations, except as otherwise required by law.
JMP Group Inc., together with its subsidiaries (collectively, the Company, we or us), is a full-service investment banking and asset management firm headquartered in San Francisco, California. We have a diversified business model with a focus on small and middle-market companies and provide:
Components of Revenues
We derive revenues primarily from fees earned from our investment banking business, net commissions on our trading activities in our sales and trading business, asset management fees in our asset management business and interest income on collateralized loan obligations and small business lending we manage. We also generate revenues from principal transactions, interest, dividends, and other income.
We earn investment banking revenues from underwriting securities offerings, arranging private capital market transactions and providing advisory services in mergers and acquisitions and other strategic advisory assignments.
We earn underwriting revenues from securities offerings in which we act as an underwriter, such as initial public offerings and follow-on equity offerings. Underwriting revenues include management fees, underwriting fees, selling concessions and realized and unrealized net gains and losses on equity positions held in inventory for a period of time to facilitate the completion of certain underwritten transactions. We record underwriting revenues, net of related syndicate expenses, at the time the underwriting is completed. In syndicated underwritten transactions, management estimates our share of transaction-related expenses incurred by the syndicate, and we recognize revenues net of such expense. On final settlement by the lead manager, typically 90 days from the trade date of the transaction, we adjust these amounts to reflect the actual transaction-related expenses and our resulting underwriting fee. We receive a higher proportion of total fees in underwritten transactions in which we act as a lead manager.
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Strategic Advisory Revenues
Our strategic advisory revenues primarily include success fees on closed merger and acquisition transactions, as well as retainer fees, earned in connection with advising both buyers and sellers transactions. We also earn fees for related advisory work and other services such as providing fairness opinions and in valuation analyses. We record strategic advisory revenues when the transactions or the services (or, if applicable, separate components thereof) to be performed are substantially completed, the fees are determinable and collection is reasonably assured.
Private Capital Market and other Revenues
We earn agency capital market and other fees in non-underwritten transactions such as private placements of equity securities, private investments in public equity (PIPE) transactions, Rule 144A private offerings and trust preferred securities offerings. We record private placement revenues on the closing date of these transactions.
Since our investment banking revenues are generally recognized at the time of completion of each transaction or the services to be performed, these revenues typically vary between periods and may be considerably affected by the timing of the closing of significant transactions.
Our brokerage revenues include commissions paid by customers from brokerage transactions in exchange-listed and over-the-counter (OTC) equity securities. Commissions are recognized on a trade date basis. Brokerage revenues also include net trading gains and losses that result from market-making activities and from our commitment of capital to facilitate customer transactions. Our brokerage revenues may vary between periods, in part depending on commission rates, trading volumes and our ability to continue to deliver research and other value-added services to our clients. The ability to execute trades electronically, through the Internet and through other alternative trading systems has increased pressure on trading commissions and spreads. We expect this trend toward alternative trading systems and pricing pressures in our brokerage business to continue. We are, to some extent, compensated through brokerage commissions for the value of research and other value added services we deliver to our clients. These soft dollar practices have been the subject of discussion among regulators, the investment banking community and our sales and trading clients. In particular, commission sharing arrangements have been adopted by some large institutional investors. In these arrangements, institutional investors concentrate their trading with fewer execution brokers and pay a fixed amount for execution with an additional amount set aside for payments to other firms for research or other brokerage services. Accordingly, we may experience reduced (or eliminated) trading volume with such investors but may be compensated for our research and sales efforts through allocations of the designated amounts. Depending on the extent to which we adopt this practice and depending on our ability to reach arrangements on terms acceptable to us, this trend would likely impair the revenues and profitability of our commission business by negatively affecting both volumes and trading commissions in our commission business.
Asset Management Fees
Asset management fees for hedge funds, hedge funds of funds, private equity funds and Harvest Capital Credit LLC (HCC) include base management fees and incentive fees earned from managing investment partnerships sponsored by us. Earned base management fees are generally based on the fair value of assets under management or aggregate capital commitments and the fee schedule for each fund and account. We also earn incentive fees based upon the performance of investment funds and accounts. For most of the funds, such fees are based on a percentage of the excess of an investment return over a specified highwater mark or hurdle rate over a defined performance period. For private equity funds, incentive fees are based on a specified percentage of realized gains from the disposition of each portfolio investment in which each investor participates, and we earn after returning contributions by the investors for that portfolio investment and for all other portfolio investments in which each such investor participates that have been disposed of at the time of distribution.
As of March 31, 2012, the contractual base management fees earned from each of these investment funds ranged between 1% and 2% of assets under management or were 2% of aggregate committed capital. The contractual incentive fees were generally (i) 20%, subject to highwater marks, for the hedge funds; (ii) 5% to 20%, subject to high-water marks or a performance hurdle rate, for the funds of funds; (iii) 20%, subject to high-water marks, for Harvest Growth Capital LLC (HGC). Our asset management revenues are subject to fluctuations due to a variety of factors that are unpredictable, including the overall condition of the economy and the securities markets as a whole and our core sectors. These conditions can have a material effect on the inflows and outflows of assets under management, and the performance of our asset management funds. For example, a significant portion of the performance-based or incentive revenues that we recognize are based on the value of securities held in the funds we manage. The value of these securities includes unrealized gains or losses that may change from one period to another. As we consolidate HCC and HGC, the management fees earned at HCS from HCC and HGC are eliminated on consolidation.
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Asset management fees for the collateralized loan obligations (CLOs) we manage currently consist only of senior and subordinated base management fees. For one of the CLOs, we earn incentive fees in the event that specified cumulative investment returns are achieved, but such investment returns have not been achieved yet. We recognize base management fees for the CLOs on a monthly basis over the period in which the collateral management services are performed. The base management fees for the CLOs are calculated as a percentage of the average aggregate collateral balances for a specified period. As we consolidate Cratos CLO, the management fees earned at JMP Credit Advisors LLC (JMPCA) from Cratos CLO are eliminated on consolidation in accordance with accounting principles generally accepted in the United States (GAAP). At March 31, 2012, the contractual base management fees earned from the CLOs ranged from 0.40% to 0.50% of the average aggregate collateral balance for a specified period.
The following tables present certain information with respect to the investment funds managed by HCS and CLOs managed by JMPCA:
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Principal transaction revenues includes realized and unrealized net gains and losses resulting from our principal investments, which includes investments in equity and other securities for our own account and as the general partner of funds managed by us, warrants we may receive from certain investment banking assignments, as well as limited partner investments in private funds managed by third parties. In addition, we invest a portion of our capital in a portfolio of equity securities managed by HCS and in side-by-side investments in the funds managed by us. In certain cases, we also co-invest alongside our institutional clients in private transactions resulting from our investment banking business. Principal transaction revenues also include unrealized gains and losses on the private equity securities owned by HGC, a private equity fund managed by HCS which is consolidated in our financial statements, as well as unrealized gains and losses on the investments in private companies sponsored by HCS and JMP Capital LLC (JMP Capital).
Gain on Sale and Payoff of Loans
Gain on sale and payoff of loans consists of gains from the sale and payoff of loans collateralizing asset-backed securities at JMP Credit Corporation (JMP Credit). Gains are recorded when the proceeds exceed our carrying value of the loan. Gain on sale and payoff of loans also consists of lower of cost or market adjustments arising from loans held for sale. Losses are recorded when the carrying value exceeds fair value.
Gain on Repurchase of Asset-Backed Securities Issued
Gain on repurchase of asset-backed securities issued primarily consists of gains from repurchases of our ABS from third parties. Gains are recorded when the repurchase price is less than the carrying value of the ABS.
Net Dividend Income
Net dividend income comprises dividends from our investments offset by dividend expense for paying short positions in our principal investment portfolio.
Other income includes loan restructuring fees at JMP Credit and revenues from fee sharing arrangements with, and fees earned to raise capital for third-party investment partnerships, or funds.
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Interest income primarily consists of interest income earned on loans collateralizing asset backed securities issued, small business loans, and loans held for investment. Interest income on loans comprises the stated coupon as a percentage of the face amount receivable as well as accretion of accretable or purchase discounts and deferred fees. Interest income is recorded on the accrual basis in accordance with the terms of the respective loans unless such loans are placed on non-accrual status.
Interest expense primarily consists of interest expense incurred on asset-backed securities issued and note payable. Interest expense on asset-backed securities is the stated coupon payable as a percentage of the principal amount as well as amortization of the liquidity discount which was recorded at the acquisition date of Cratos. Interest expense is recorded on the accrual basis in accordance with the terms of the respective asset-backed securities issued and note payable.
Provision for Loan Losses
Provision for loan losses includes provision for losses recognized on our loan notes and non-revolving credit agreements at JMP Capital (collectively, loans held for investment), on loans collateralizing ABS at JMP Credit, and on small business loans at HCC to record them at their estimated net realizable value. We maintain an allowance for loan losses that is intended to estimate loan losses inherent in its loan portfolio. A provision for loan losses is charged to expense to establish the allowance for loan losses. The allowance for loan losses is maintained at a level, in the opinion of management, sufficient to offset estimated losses inherent in the loan portfolio as of the date of the financial statements. The appropriateness of the allowance and the allowance components are reviewed quarterly. Our estimate of each allowance component is based on observable information and on market and third party data that we believe are reflective of the underlying loan losses being estimated.
An allowance is provided for loans that are considered impaired. A loan is considered impaired when it is probable that we will be unable to collect all amounts due according to the contractual terms of the loan agreement. We measure impairment of a loan based upon either the present value of expected future cash flows discounted at the loans effective interest rate, the loans observable market price or the fair value of the collateral securing the loan if the loan is collateral dependent, depending on the circumstances and our collection strategy. For those loans held by Cratos at the date of acquisition by JMP Credit, and deemed impaired at that date or a subsequent date, allowance for loan losses is calculated considering two further factors. For loans deemed impaired at the date of acquisition, if there is a further decline in expected future cash flows, this reduction is recognized as a specific reserve in the current quarter in accordance with above. For those loans deemed impaired subsequent to the acquisition date, if the net realizable value is lower than the current carrying value then the carrying value is reduced and the difference is booked as provision for loan losses. If the total discount from unpaid principal balance to carrying value is larger than the expected loss at the date of assessment, no provision for loan losses is recognized.
In addition, we provide an allowance on a loan by loan basis at JMP Credit for loans that were purchased after the Cratos acquisition. We employ internally developed and third party estimation tools for measuring credit risk (loan ratings, probability of default and exposure at default), which are used in developing an appropriate allowance for loan losses. We perform periodic detailed reviews of our loan portfolio to identify risks and to assess the overall collectability of loans.
Loans which are deemed to be uncollectible are charged off and the charged-off amount is deducted from the allowance.
Components of Expenses
We classify our expenses as compensation and benefits, administration, brokerage, clearing and exchange fees, travel and business development, communications and technology, professional fees, impairment loss on purchased management contract and other expenses. A significant portion of our expense base is variable, including compensation and benefits, brokerage clearing and exchange fees, travel and business development and communication and technology expenses.
Compensation and Benefits
Compensation and benefits is the largest component of our expenses and includes employees base pay, performance bonuses, sales commissions, related payroll taxes, medical and benefits expenses, as well as expenses for contractors, temporary employees and equity-based compensation. Our employees receive a substantial portion of their compensation in the form of individual performance-based bonuses. As is the widespread practice in our industry, we pay bonuses on an annual basis, which for senior professionals typically make up a large portion of their total compensation. Bonus payments may have a greater impact on our cash position and liquidity in the periods in which they are paid than would otherwise be reflected in our Consolidated Statements of Operations. We accrue for the estimated amount of these bonus payments ratably over the applicable service period.
Compensation is accrued using specific ratios of total compensation and benefits to total revenues based on revenue categories, as adjusted if, in managements opinion, such adjustments are necessary and appropriate to maintain competitive compensation levels.
Administration expense primarily includes the cost of hosted conferences, non-capitalized systems and software expenditures, insurance, business tax (non-income), office supplies, recruiting and regulatory fees.
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Brokerage, Clearing and Exchange Fees
Brokerage, clearing and exchange fees include the cost of floor and electronic brokerage and execution, securities clearance, and exchange fees. We clear our securities transactions through J.P. Morgan Clearing Corp. Changes in brokerage, clearing and exchange fees fluctuate largely in line with the volume of sales and trading activity.
Travel and Business Development
Travel and business development expense is net of expenses reimbursed by clients.
Communications and Technology
Communications and technology expense primarily relates to communication and information processing as well as the subscription of certain market data.
Professional fees primarily relate to legal and accounting professional services.
Impairment Loss on Purchased Management Contract
Impairment loss on purchased management contract relates to a CLO management contract we purchased from Princeton Advisory Group, Inc. on September 8, 2010 for $3.8 million. Because a single investor had previously acquired control of the right to transfer the management contract without cause at any time with 90 days notice, we initially recorded an impairment charge of $2.8 million for the quarter ended September 30, 2010 and an additional impairment charge of $0.7 million in the quarter ended March 31, 2011. The CLO began liquidation proceedings in December 2011. The remaining assets will be distributed in 2012. See Note 9 in the 2011 10-K for further information.
Other operating expenses primarily include occupancy, depreciation and CLO administration expense at JMP Credit.
Non-controlling interest for three months ended March 31, 2012 includes the interest of third parties in Cratos CLO, HGC, and HCC, partially-owned subsidiaries consolidated in our financial statements. Non-controlling interest for the three months ended March 31, 2011 includes the interest of third parties in Cratos CLO and HGC, partially-owned subsidiaries consolidated in our financial statements.
We follow the authoritative guidance under GAAP regarding the determination of whether a general partner, or the general partners as a group, controls a limited partnership or similar entity when the limited partners have certain rights. Such guidance applies when a general partner controls a limited partnership and is required to consolidate the limited partnership in its financial statements. Under the guidance, the general partner in a limited partnership is presumed to control the limited partnership regardless of the extent of the general partners ownership interest in the limited partnership. If the limited partners have either (a) the substantive ability to liquidate the limited partnership or otherwise remove the general partner without cause or (b) substantive participating rights, the general partner does not control the limited partnership.
The limited liability company agreements of HGC do not provide for the right of the members to remove the manager by a simple majority vote of the non-affiliated members and therefore the manager (with a minority interest in the limited liability company) is deemed to control HGC. As a result, we consolidated HGC from its inception on April 1, 2010.
On August 6, 2010, along with individual employee security holders (the Unitholders) of JMP Credit, we entered into an Exchange Agreement providing for, among other things, an offer to buy the minority interest units and shares in JMP Credit held by the Unitholders in exchange for a combination of (i) restricted common stock of the Company par value $.001 per share, (ii) cash and (iii) certain Cratos CLO subordinated notes. In connection with the Exchange Agreement, we issued an aggregate of 381,310 shares of restricted stock and transferred 109 subordinated notes to the Unitholders and we received all the remaining units and shares of JMP Credit that we did not previously own. The restricted stock and the Cratos CLO notes are subject to limitations on transfer and our repurchase rights in the event of certain terminations of the Unitholders employment with the Company or its affiliates through June 1, 2013. As a result of the aforementioned transaction, we own 100% of JMP Credit and approximately 94% of the subordinated notes of Cratos CLO.
On August 18, 2011, HCS formed HCC to make direct investments in the form of subordinated debt and, to a lesser extent, senior debt and minority equity investments, in privately-held U.S. small to mid-size companies. HCS acts as its investment advisor, earning a base management fee equal to 2% annually of the gross assets acquired with equity. HCS does not charge a base management fee on assets funded through the Companys line of credit. JMP Credit Advisors provides HCC with its administrative services, and is reimbursed its expenses, including the allocable percentage of the compensation costs for the employees performing services under the agreement. The Company consolidates HCC into its consolidated financial statements.
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Results of Operations
The following table sets forth our results of operations for the three months ended March 31, 2012 and 2011 and is not necessarily indicative of the results to be expected for any future period.