Item 7. Management’s Discussion and Analysis
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and the notes to those consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data” of this Annual Report on Form 10-K. This discussion contains forward-looking statements that involve significant risks and uncertainties. As a result of many factors, such as those set forth under “Risk Factors” and elsewhere in this Annual Report on Form 10-K, our actual results may differ materially from those anticipated in these forward-looking statements. Please also refer to the section under heading “Special Note Regarding Forward-Looking Statements.”
Overview
We are a leader in the retail financial advice market and the nation’s largest independent broker-dealer. We serve independent financial advisors and financial institutions, providing them with the technology, research, clearing and compliance services and practice management programs they need to create and grow their practices. We enable them to provide objective financial guidance to millions of American families seeking wealth management, retirement planning, financial planning and asset management solutions. Please consult Part I, “Item 1. Business” for additional information related to our business activities.
Executive Summary
Financial Highlights
Results for the year ended December 31, 2020 included net income of $472.6 million, or $5.86 per share, which compares to $559.9 million, or $6.62 per share, for the year ended December 31, 2019.
Asset Growth Trends
Total advisory and brokerage assets served were $903.1 billion as of December 31, 2020, up 18.1% from $764.4 billion as of December 31, 2019. Total net new assets were $60.2 billion for the year ended December 31, 2020, compared to $36.3 billion for the same period in 2019.
Net new advisory assets were an inflow of $52.1 billion for the year ended December 31, 2020, compared to $34.3 billion in 2019. As of December 31, 2020, our advisory assets had grown to $461.2 billion from the prior year end balance of $365.8 billion, an increase of 26.1%, and represented 51.1% of total advisory and brokerage assets served.
Net new brokerage assets were an inflow of $8.1 billion for the year ended December 31, 2020, compared to $2.0 billion in 2019. As of December 31, 2020, our brokerage assets were $441.9 billion, up from $398.6 billion as of December 31, 2019, an increase of 10.9%.
Gross Profit Trends
Gross profit, a non-GAAP financial measure, of $2,103.3 million for the year ended December 31, 2020, decreased 3.2% from $2,172.2 million for the year ended December 31, 2019. Gross profit is calculated as total net revenues, less advisory and commission expenses and brokerage, clearing and exchange fees. Management presents gross profit because we believe that measure may provide useful insight to investors in evaluating the Company’s core operating performance before indirect costs that are general and administrative in nature. See footnote 9 to the Financial Metrics table within the “How We Evaluate Our Business” section for additional information on gross profit.
Shareholder Capital Returns
We returned $229.1 million of capital to shareholders during the year ended December 31, 2020, including $79.1 million of dividends and $150.0 million of share repurchases, representing 1,809,553 shares.
COVID-19 Response
In response to the coronavirus disease 2019 (“COVID-19”) pandemic, we have taken measures to protect the health and safety of our employees, as well as the stability and continuity of our operations. For example, we have equipped and enabled a substantial majority of employees to work remotely, implemented physical distancing and enhanced cleaning protocols throughout our corporate offices, and have worked closely with our vendors to maintain service continuity throughout the increased market volatility and operational volumes that occurred during the year. We also made extra support available to our advisors by extending service hours and providing additional
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resources to enable them to deliver differentiated services to their clients. Please consult the “Risks Related to our Business and Industry” section within Part I, “Item 1A. Risk Factors” for more information about the risks associated with COVID-19.
Our Sources of Revenue
Our revenues are derived primarily from fees and commissions from products and advisory services offered by our advisors to their clients, a substantial portion of which we pay out to our advisors, as well as fees we receive from our advisors for the use of our technology, custody, clearing, trust and reporting platforms. We also generate asset-based revenues through our bank sweep vehicles and money market programs and the access we provide to a variety of product providers with the following product lines:
• Alternative Investments
• Retirement Plan Products
• Annuities
• Separately Managed Accounts
• Exchange Traded Products
• Structured Products
• Insurance Based Products
• Unit Investment Trusts
• Mutual Funds
Under our self-clearing platform, we custody the majority of client assets invested in these financial products, for which we provide statements, transaction processing and ongoing account management. In return for these services, mutual funds, insurance companies, banks and other financial product sponsors pay us fees based on asset levels or number of accounts managed. We also earn interest from margin loans made to our advisors’ clients.
We regularly review various aspects of our operations and service offerings, including our policies, procedures and platforms, in response to marketplace developments. We seek to continuously improve and enhance aspects of our operations and service offerings in order to position our advisors for long-term growth and to align with competitive and regulatory developments. For example, we regularly review the structure and fees of our products and services, including related disclosures, in the context of the changing regulatory environment and competitive landscape for advisory and brokerage accounts.
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How We Evaluate Our Business
We focus on several key metrics in evaluating the success of our business relationships and our resulting financial position and operating performance. In April 2020, we updated our definition of net new assets to make our figures more comparable with other companies. Our updated definition now includes dividends and interest, and subtracts advisory fees. All net new asset figures below align with our new definition. Our key operating, business and financial metrics are as follows:
As of and for the Years Ended December 31,
Operating Metrics (dollars in billions) (1)
2020 2019
Assets
Advisory assets (2)(3)
$ 461.2 $ 365.8
Brokerage assets (2)(4)
441.9 398.6
Total Advisory and Brokerage Assets (2)
$ 903.1 $ 764.4
Advisory Assets % of Total Advisory and Brokerage Assets 51.1 % 47.8 %
Net New Assets
Net new advisory assets (5)
$ 52.1 $ 34.3
Net new brokerage assets (6)
8.1 2.0
Total Net New Assets $ 60.2 $ 36.3
Organic Net New Assets (7)
Net new advisory assets $ 49.6 $ 33.3
Net new brokerage assets 6.6 0.2
Total Organic Net New Assets $ 56.2 $ 33.5
Total Organic Net New Assets Annualized Growth Rate (8)
7.4 % 5.3 %
Client Cash Balances (2)
Insured cash account balances $ 37.3 $ 24.4
Deposit cash account balances 8.2 5.0
Total Bank Sweep Balances 45.5 29.4
Money market account balances 1.5 1.9
Purchased money market fund balances 1.9 2.4
Total Client Cash Balances $ 48.9 $ 33.7
Net Buy (Sell) Activity (9)
$ 34.3 $ 41.4
As of and for the Years Ended December 31,
Business and Financial Metrics (dollars in millions, except per share data) 2020 2019
Advisors 17,287 16,464
Average Total Assets per Advisor (10)
$ 52.2 $ 46.4
Employees 4,756 4,343
Share Repurchases $ 150.0 $ 500.4
Dividends $ 79.1 $ 82.6
% of Capital Returned to Shareholders (11)
44.0 % 96.1 %
Leverage Ratio (12)
2.16 2.05
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For the Years Ended December 31,
2020 2019
Total net revenues $ 5,871.6 $ 5,624.9
Net income $ 472.6 $ 559.9
Earnings per share (“EPS”), diluted $ 5.86 $ 6.62
EPS prior to amortization of intangible assets (13)
$ 6.46 $ 7.17
Gross Profit (14)
$ 2,103.3 $ 2,172.2
EBITDA (15)
$ 908.9 $ 1,036.1
EBITDA as a % of Gross Profit 43.2 % 47.7 %
Core G&A (16)
$ 925.1 $ 868.4
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(1) Totals may not foot due to rounding.
(2) Advisory and brokerage assets consists of assets that are custodied, networked and non-networked and reflect market movement in addition to new assets, inclusive of new business development and net of attrition. Insured cash account balances, deposit cash account balances, money market account balances and purchased money market fund balances are also included in total advisory and brokerage assets.
(3) Advisory assets consists of total advisory assets under custody at our broker-dealer subsidiary, LPL Financial LLC (“LPL Financial”). Please consult the “Results of Operations” section for a tabular presentation of advisory assets.
(4) Brokerage assets consists of brokerage assets serviced by advisors licensed with LPL Financial.
(5) Net new advisory assets consists of total client deposits into custodied advisory accounts less total client withdrawals from custodied advisory accounts, plus dividends, plus interest, minus advisory fees. We consider conversions from and to brokerage accounts as deposits and withdrawals, respectively. Figures for net new advisory assets reported prior to April 2020 did not include dividends and interest or subtract advisory fees. The figure previously reported for the year ended December 31, 2019 was an inflow of $30.0 billion.
(6) Net new brokerage assets consists of total client deposits into brokerage accounts less total client withdrawals from brokerage accounts, plus dividends, plus interest. We consider conversions from and to advisory accounts as deposits and withdrawals, respectively. Figures for net new brokerage assets reported prior to April 2020 did not include dividends and interest. The figure previously reported the year ended December 31, 2019 was an outflow of $3.4 billion.
(7) Consists of net new assets excluding the acquisitions of Lucia Securities, LLC and E.K. Riley Investments, LLC. Acquired assets include $2.5 billion of net new assets related to E.K. Riley Investments, LLC in November 2020, $1.5 billion of net new assets from Lucia Securities, LLC in October 2020 and $2.8 billion of net new assets from Allen & Company in August 2019.
(8) Calculated as annualized current period organic net new assets divided by preceding period total advisory and brokerage assets.
(9) Represents the amount of securities purchased less the amount of securities sold in client accounts custodied with LPL Financial. Reported activity does not include any other cash activity, such as deposits, withdrawals, dividends received or fees paid.
(10) Calculated based on the end-of-period total advisory and brokerage assets divided by end-of-period advisor count.
(11) Percentage of capital returned to shareholders is calculated as the ratio of total shareholder capital returns per diluted share count to EPS prior to amortization of intangible assets. EPS prior to amortization of assets is a non-GAAP financial measure. For a reconciliation of EPS prior to amortization of intangible assets to the Company’s GAAP EPS for the periods presented, see footnote 13.
(12) A financial covenant from our credit agreement calculated as consolidated total debt to consolidated EBITDA. Please consult the “Debt and Related Covenants” section for more information.
(13) EPS prior to amortization of intangible assets is a non-GAAP financial measure defined as GAAP EPS plus the per share impact of amortization of intangible assets. The per share impact is calculated as amortization of intangible assets expense, net of applicable tax benefit, divided by the number of shares outstanding for the applicable period. The Company presents EPS prior to amortization of intangible assets because management believes that the metric can assist investors in comparing our performance to that of other companies on a consistent basis without regard to certain items which do not directly affect our ongoing operating performance. EPS prior to amortization of intangible assets is not a measure of the Company's financial performance under GAAP and should not be considered as an alternative to GAAP EPS or any other performance measure derived in accordance with GAAP. Below is a reconciliation of EPS prior to amortization of intangible assets to the Company’s GAAP EPS for the periods presented:
Years Ended December 31,
EPS Reconciliation (in millions, except per share data) 2020 2019
GAAP EPS $ 5.86 $ 6.62
Amortization of intangible assets $ 67.4 $ 65.3
Tax benefit $ (18.9) $ (18.3)
Amortization of intangible assets, net of tax benefit $ 48.5 $ 47.0
Diluted share count 80.7 84.6
EPS impact $ 0.60 $ 0.56
EPS prior to amortization of intangible assets $ 6.46 $ 7.17
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(14) Set forth below is a calculation of gross profit, calculated as total net revenues less advisory and commission expenses and brokerage, clearing and exchange fees. All other expense categories, including depreciation and amortization of fixed assets and amortization of intangible assets, are considered by management to be general and administrative in nature. Because our gross profit amounts do not include any depreciation and amortization expense, we consider our gross profit amounts to be non-GAAP financial measures that may not be comparable to those of others in our industry. We believe that gross profit amounts can provide investors with useful insight into our core operating performance before indirect costs that are general and administrative in nature.
Years Ended December 31,
Gross Profit (in millions) 2020 2019
Total net revenues $ 5,871.6 $ 5,624.9
Advisory and commission expense 3,697.1 3,388.2
Brokerage, clearing and exchange fees 71.2 64.4
Gross Profit (†)
$ 2,103.3 $ 2,172.2
____________________
(†) Totals may not foot due to rounding.
(15) EBITDA is a non-GAAP financial measure defined as net income plus interest and other expense, income tax expense, depreciation and amortization, and amortization of intangible assets. The Company presents EBITDA because management believes that it can be a useful financial metric in understanding the Company’s earnings from operations. EBITDA is not a measure of the Company's financial performance under GAAP and should not be considered as an alternative to net income or any other performance measure derived in accordance with GAAP, or as an alternative to cash flows from operating activities as a measure of profitability or liquidity. In addition, the Company’s EBITDA can differ significantly from EBITDA calculated by other companies, depending on long-term strategic decisions regarding capital structure, the tax jurisdictions in which companies operate, and capital investments. Below is a reconciliation of EBITDA to net income for the periods presented:
Years Ended December 31,
EBITDA Reconciliation (in millions) 2020 2019
Net income $ 472.6 $ 559.9
Non-operating interest expense and other 105.8 130.0
Provision for income taxes 153.4 182.0
Depreciation and amortization 109.7 95.8
Amortization of intangible assets 67.4 65.3
Loss on extinguishment of debt — 3.2
EBITDA $ 908.9 $ 1,036.1
(16) Core G&A is a non-GAAP financial measure. Core G&A consists of total operating expenses, excluding the following expenses: advisory and commission, regulatory charges, promotional, employee share-based compensation, depreciation and amortization, amortization of intangible assets, and brokerage, clearing and exchange. Management presents Core G&A because it believes Core G&A reflects the corporate operating expense categories over which management can generally exercise a measure of control, compared with expense items over which management either cannot exercise control, such as advisory and commission expenses, or which management views as promotional expense necessary to support advisor growth and retention, including conferences and transition assistance. Core G&A is not a measure of the Company’s total operating expenses as calculated in accordance with GAAP. Below is a reconciliation of Core G&A against the Company’s total operating expenses for the periods presented:
Years Ended December 31,
Operating Expense Reconciliation (in millions) 2020 2019
Core G&A $ 925.1 $ 868.4
Regulatory charges 29.4 32.3
Promotional 208.3 205.5
Employee share-based compensation 31.6 29.9
Total G&A 1,194.4 1,136.1
Advisory and commission 3,697.1 3,388.2
Depreciation and amortization 109.7 95.8
Amortization of intangible assets 67.4 65.3
Brokerage, clearing and exchange 71.2 64.4
Total operating expenses $ 5,139.8 $ 4,749.9
Legal and Regulatory Matters
As a regulated entity, we are subject to regulatory oversight and inquiries related to, among other items, our compliance and supervisory systems and procedures and other controls, as well as our disclosures, supervision and reporting. We review these items in the ordinary course of business in our effort to adhere to legal and regulatory requirements applicable to our operations. Nevertheless, additional regulation and enhanced regulatory enforcement has resulted, and may result in the future, in additional operational and compliance costs, as well as increased costs in the form of penalties and fines, investigatory and settlement costs, customer restitution and
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remediation related to regulatory matters. For additional information, see the “Risks Related to Our Regulatory Environment” and the “Risks Related to Our Business and Industry” sections within Part I, “Item 1A. Risk Factors”. In the ordinary course of business, we periodically identify or become aware of purported inadequacies, deficiencies and other issues. It is our policy to evaluate these matters for potential legal or regulatory violations, and other potential compliance issues. It is also our policy to self-report known violations and issues as required by applicable law and regulation. When deemed probable that matters may result in financial losses, we accrue for those losses based on an estimate of possible fines, customer restitution and losses related to the repurchase of sold securities and other losses, as applicable. Certain regulatory and other legal claims and losses may be covered through our wholly-owned captive insurance subsidiary, which is chartered with the insurance commissioner in the state of Tennessee. For more information, see Note 2 - Summary of Significant Accounting Policies - “ Commitments and Contingencies,” within the notes to the consolidated financial statements.
Assessing the probability of a loss occurring and the timing and amount of any loss related to a regulatory matter or legal proceeding, whether or not covered by our captive insurance subsidiary, is inherently difficult and requires judgments based on a variety of factors and assumptions. There are particular uncertainties and complexities involved when assessing the adequacy of loss reserves for potential liabilities that are self-insured by our captive insurance subsidiary, which depends in part on historical claims experience, including the actual timing and costs of resolving matters that begin in one policy period and are resolved in a subsequent period.
Our accruals, including those established through our captive insurance subsidiary at December 31, 2020, include estimated costs for significant regulatory matters or legal proceedings, generally relating to the adequacy of our compliance and supervisory systems and procedures and other controls, for which we believe losses are both probable and reasonably estimable. For example, on May 1, 2018, we agreed to a settlement structure with the North American Securities Administrators Association that related to our historical compliance with certain state “blue sky” laws and resulted in aggregate fines of $26.4 million, the majority of which were covered by our captive insurance subsidiary loss reserves. As part of the settlement structure, we engaged independent third party consultants to conduct a historical review of securities transactions and an operational review of our systems for complying with blue sky securities registration requirements. We also agreed to offer customers remediation in the form of reimbursement for any actual losses, plus interest, and these costs were not material.
The outcome of regulatory or legal proceedings could result in legal liability, regulatory fines or monetary penalties in excess of our accruals and insurance, which could have a material adverse effect on our business, results of operations, cash flows or financial condition. For more information on management’s loss contingency policies, see Note 14 - Commitments and Contingencies, within the notes to the consolidated financial statements.
In June 2018, the U.S. Court of Appeals for the Fifth Circuit invalidated regulations previously enacted by the U.S. Department of Labor (“DOL”) that expanded the definition of “fiduciary” and would have resulted in significant new prohibited transaction exemption requirements for our servicing of certain retirement plan accounts subject to the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), and individual retirement accounts (“IRAs”). In December 2020, the DOL finalized a new investment advice fiduciary prohibited transaction exemption with regard to such accounts that became effective on February 16, 2021. Because ERISA plans and IRAs comprise a significant portion of our business and we continue to expect that compliance with current and future laws and regulations with respect to retail retirement savings and reliance on prohibited transaction exemptions under such laws and regulations will require increased legal, compliance, information technology and other costs and could lead to a greater risk of class action lawsuits and other litigation.
In June 2019, the SEC adopted a new standard of conduct applicable to retail brokerage accounts (“Regulation BI”) with a compliance date of June 30, 2020. Regulation BI requires that broker-dealers act in the best interest of retail customers without placing their own financial or other interests ahead of the customer’s and imposes new obligations related to disclosure, duty of care, conflicts of interest and compliance. Certain state securities and insurance regulators have also adopted, proposed or are considering adopting similar laws and regulations. In addition, it is unclear how and whether other regulators, including banking regulators and state securities and insurance regulators, may respond to or attempt to enforce similar issues addressed by the newly proposed DOL Rule and Regulation BI. As of June 30, 2020, we implemented new procedures in accordance with Regulation BI.
Future laws and regulations, including the new rule proposed by the DOL and state rules relating to the standards of conduct applicable to both retirement and non-retirement accounts, may affect our business in ways that cannot be anticipated or planned for, and may have negative impacts on our products, services and results of operations.
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Acquisitions, Integrations and Divestitures
We continuously assess the competitive landscape in connection with our capital allocation framework as we pursue acquisitions, integrations and divestitures. These activities are part of our overall growth strategy, but can distort comparability when reviewing revenue and expense trends for periods presented. Our recent acquisitions are as follows:
• Waddell & Reed Financial, Inc. (“Waddell & Reed”) - In December 2020, we entered into an agreement with Macquarie Management Holdings, Inc. (“Macquarie”) to acquire the wealth management business of Waddell & Reed upon completion of Macquarie’s acquisition of all of the issued and outstanding common shares of Waddell & Reed. The transaction is expected to close in the middle of 2021, subject to satisfaction of closing conditions.
• Blaze Portfolio Systems LLC (“Blaze”) - In October 2020, we acquired Blaze, a technology company that provides an advisor-facing trading and portfolio rebalancing platform.
• E.K. Riley Investments, LLC (“E.K. Riley”) - In August 2020, we acquired business relationships with advisors from E.K. Riley, a broker-dealer and registered investment adviser (“RIA”).
• Lucia Securities, LLC (“Lucia”) - In August 2020, we acquired business relationships with advisors from Lucia, a broker-dealer and RIA firm.
• Allen & Company of Florida, LLC (“Allen & Company”) - In August 2019, we acquired Allen & Company, an RIA. Allen & Company advisors and staff became employees of the Company.
• AdvisoryWorld - In December 2018, we acquired AdvisoryWorld, a technology company that provides proposal generation, investment analytics and portfolio modeling capabilities in the wealth management industry.
See Note 4 - Acquisitions , within the notes to the consolidated financial statements for further detail.
Economic Overview and Impact of Financial Market Events
Our business is directly and indirectly sensitive to several macroeconomic factors and the state of the U.S. financial markets. Global economic conditions in the fourth quarter of 2020 continued to be dominated by the COVID-19 pandemic and the economic impact of containment efforts. Significant mitigation efforts through supportive central bank policy (monetary stimulus) and government spending (fiscal stimulus) have helped the global and U.S. economies take meaningful steps toward recovery, but the results have been uneven and uncertainty remains elevated in the near term. The fall / winter surge in cases slowed fourth quarter growth after a strong rebound in the U.S. economy in the third quarter, but the start of vaccine distribution increases the prospects of a more durable recovery emerging by the middle of 2021.
According to the most recent estimate by the U.S. Bureau of Economic Analysis, the U.S. economy contracted an annualized 31.4% in the second quarter of 2020, extending the recession that began in the first quarter, but then rebounded strongly, growing at an annualized 33.4% in the third quarter of 2020. Data received during the fourth quarter of 2020 suggests that the U.S. economy continued to expand, but at a much slower rate. Despite growth slowing, there are continued signs of progress. The unemployment rate, which had spiked to 14.8% in April 2020, has declined steadily to 6.7% in December 2020. Consumer spending on goods has rebounded sharply, although spending on the services industries most impacted by COVID-19 remains depressed. Business investment has continued to rebound and industrial production has strengthened but remains below pre-pandemic levels. The Federal Reserve’s (“Fed”) most recent median gross domestic product projections, released following its December 15-16, 2020 policy meeting, saw the economy contracting 2.4% for all of 2020, a meaningful improvement from its September projection of a 3.7% contraction, followed by 4.2% growth in 2021.
Equity markets posted solid gains in the fourth quarter. The S&P 500 Index returned 12.2% for the quarter, bringing the full-year return to 18.4%. Small cap stocks had a particularly strong quarter, as the Russell 2000 Index returned 31.4%. Non-U.S. stocks outperformed their U.S. counterparts in the fourth quarter, led by emerging markets’ 19.8% return compared to 16.1% for developed international equities, based on the MSCI EM and MSCI EAFE Indexes. The Bloomberg Barclays U.S. Aggregate Bond Index returned 0.7% during the quarter, with rising interest rates weighing on returns but narrowing credit spreads helping corporate bonds. The 10-year Treasury yield rose 0.24% over the fourth quarter, to end the quarter at 0.93%. Nevertheless, 2020 was a solid year for bonds overall, with the U.S. Aggregate Bond Index climbing 7.5%. More economically sensitive bonds were rewarded in the fourth quarter, with the Bloomberg Barclays U.S. High Yield Index climbing 6.5%.
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Our business is also sensitive to current and expected short-term interest rates, which are largely driven by Fed policy. During the fourth quarter, Fed policymakers maintained the target range for the federal funds rate at 0.0 to 0.25%. According to projection materials released following the conclusion of the December 15-16, 2020 policy meeting, the median expectation among meeting participants was that the Fed will not begin raising rates until after 2023, although one participant projected the Fed raising rates as early as 2022 and several in 2023. The Fed also enhanced guidance on how long it would continue its bond purchase program at current levels, highlighting the need for “substantial further progress” toward inflation and unemployment goals. The updated language signaled extended potential support for the economy.
Please consult the “Risks Related to Our Business and Industry” section within Part I, “Item 1A. Risk Factors” for more information about the risks associated with significant interest rate changes, and the potential related effects on our profitability and financial condition.
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Results of Operations
A discussion of changes in our results of operations during the year ended December 31, 2019 compared to the year ended December 31, 2018 has been omitted from this Annual Report on Form 10-K, but may be found in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2019, filed with the SEC on February 21, 2020.
The following discussion presents an analysis of our results of operations for the years ended December 31, 2020 and 2019.
Years Ended December 31,
(Dollars in thousands) 2020 2019 % Change
REVENUES
Advisory $ 2,327,519 $ 1,982,869 17.4 %
Commission 1,906,560 1,892,407 0.7 %
Asset-based 1,044,517 1,165,979 (10.4) %
Transaction and fee 506,071 480,328 5.4 %
Interest income, net of interest expense 29,412 46,508 (36.8) %
Other 57,561 56,765 (1.4) %
Total net revenues
5,871,640 5,624,856 4.4 %
EXPENSES
Advisory and commission 3,697,147 3,388,186 9.1 %
Compensation and benefits 609,257 556,128 9.6 %
Promotional 208,250 205,537 1.3 %
Depreciation and amortization 109,732 95,779 14.6 %
Amortization of intangible assets 67,358 65,334 3.1 %
Occupancy and equipment 166,389 136,163 22.2 %
Professional services 57,067 73,887 (22.8) %
Brokerage, clearing and exchange 71,185 64,445 10.5 %
Communications and data processing 52,399 49,859 5.1 %
Other 101,018 114,546 (11.8) %
Total operating expenses
5,139,802 4,749,864 8.2 %
Non-operating interest expense and other 105,765 130,001 (18.6) %
Loss on extinguishment of debt — 3,156 100.0 %
INCOME BEFORE PROVISION FOR INCOME TAXES
626,073 741,835 (15.6) %
PROVISION FOR INCOME TAXES
153,433 181,955 (15.7) %
NET INCOME
$ 472,640 $ 559,880 (15.6) %
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Revenues
Advisory
Advisory revenues primarily represent fees charged to clients of our advisors for the use of our corporate RIA advisory platform, and are based on the value of their advisory assets. Advisory fees are billed to clients in advance, on a quarterly basis, and are recognized as revenue ratably during the quarter. The majority of our client accounts are on a calendar quarter and are billed using values as of the last business day of the preceding quarter. The value of the assets in an advisory account on the billing date determines the amount billed, and accordingly, the revenues earned in the following three-month period. Advisory revenues collected on our corporate advisory platform are proposed by the advisor and agreed to by the client and averaged 1.0% of the underlying assets for the year ended December 31, 2020.
We also support separate investment adviser firms (“Hybrid RIAs”), through our hybrid advisory platform, which allows advisors to engage us for technology, clearing and custody services, as well as access to the capabilities of our investment platforms. The assets held under a Hybrid RIA’s investment advisory accounts custodied with LPL Financial are included in total advisory assets and net new advisory assets. The advisory revenue generated by a Hybrid RIA is not included in our advisory revenues. We charge separate fees to Hybrid RIAs for technology, clearing, administrative, oversight and custody services, which are included in our transaction and fee revenues in our consolidated statements of income. The administrative fees collected on our hybrid advisory platform vary and can reach a maximum of 0.2% of the underlying assets as of December 31, 2020.
The following table summarizes the composition of advisory assets for the periods presented (dollars in billions):
December 31,
2020 2019 $ Change % Change
Corporate platform advisory assets
$ 291.9 $ 228.3 $ 63.6 27.9 %
Hybrid platform advisory assets
169.3 137.5 31.8 23.1 %
Total advisory assets
$ 461.2 $ 365.8 $ 95.4 26.1 %
Net new advisory assets in a particular quarter drive advisory revenues in future quarters, due to billing quarterly in advance. Therefore, the full impact of net new advisory assets to advisory revenues is not realized in the same period. The following table summarizes activity in advisory assets for the periods presented (in billions):
Years Ended December 31,
2020 2019
Beginning balance at January 1 $ 365.8 $ 282.0
Net new advisory assets (1)
52.1 34.3
Market impact (2)
43.3 49.5
Ending balance at December 31 $ 461.2 $ 365.8
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(1) Net new advisory assets consists of total client deposits into custodied advisory accounts less total client withdrawals from custodied advisory accounts, plus dividends, plus interest, minus advisory fees. We consider conversions from and to brokerage accounts as deposits and withdrawals, respectively. Previously reported figures for net new advisory assets did not include dividends and interest or subtract advisory fees. The figure previously reported for the year ended December 31, 2019 was an inflow of $30.0 billion.
(2) Market impact is the difference between the beginning and ending asset balance less the net new asset amounts, representing the implied growth or decline in asset balances due to market changes over the same period of time.
The growth in advisory revenues from 2019 to 2020 was due to net new advisory assets resulting from the acquisitions and our recruiting efforts and strong advisor productivity, as well as market gains as represented by higher levels of the S&P 500 Index.
Commission
We generate two types of commission revenues: sales-based commissions and trailing commissions. Sales-based commission revenues, which occur when clients trade securities or purchase various types of investment products, primarily represent gross commissions generated by our advisors. The levels of sales-based commission revenues can vary from period to period based on the overall economic environment, number of trading days in the reporting period and investment activity of our advisors’ clients. Trailing commission revenues, which are paid over time, are recurring in nature and are earned based on the market value of investment holdings in trail-eligible
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assets. We earn trailing commission revenues primarily on mutual funds and variable annuities held by clients of our advisors. See Note 3 - Revenues, within the notes to the consolidated financial statements for further detail regarding our commission revenues by product category.
The following table sets forth our commission revenues included in our consolidated statements of income (dollars in thousands):
Years Ended December 31,
2020 2019 $ Change % Change
Sales-based $ 770,764 $ 782,852 $ (12,088) (1.5) %
Trailing
1,135,796 1,109,555 26,241 2.4 %
Total commission revenues
$ 1,906,560 $ 1,892,407 $ 14,153 0.7 %
The decrease in sales-based commission revenues in 2020 compared to 2019 was primarily driven by the low interest rate environment impacted by the COVID-19 pandemic, which led to a decrease in sales of annuities, partially offset by an increase in sales of equities.
The increase in trailing commission revenues in 2020 compared to 2019 was primarily due to the increase in value of annuities as a result of the market increases during the second half of the year, partially offset by the decline in value of other trail eligible assets as a result of the market downturn during the first quarter of 2020.
The following table summarizes activity in brokerage assets for the periods presented (in billions):
Years Ended December 31,
2020 2019
Beginning balance at January 1 $ 398.6 $ 346.0
Net new brokerage assets (1)
8.1 2.0
Market impact (2)
35.2 50.6
Ending balance at December 31 $ 441.9 $ 398.6
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(1) Net new brokerage assets consists of total client deposits into brokerage accounts less total client withdrawals from brokerage accounts, plus dividends, plus interest. We consider conversions from and to advisory accounts as deposits and withdrawals, respectively. Previously reported figures for net new brokerage assets did not include dividends and interest or subtract advisory fees. The figure previously reported for the year ended December 31, 2019 was an outflow of $3.4 billion.
(2) Market impact is the difference between the beginning and ending asset balance less the net new asset amounts, representing the implied growth or decline in asset balances due to market changes over the same period of time.
We are uncertain, as of the date of this Annual Report on Form 10-K, of the effect of the COVID-19 pandemic on our future commission revenues. We cannot predict how the ongoing COVID-19 pandemic and foreign and domestic responses to it will impact our future sales-based or trailing commission revenues. While domestic equity markets have started to recover, COVID-19 cases remain widespread in the United States and many other parts of the world, and significant market disruptions and volatility remain possible.
Asset-Based
Asset-based revenues consist of fees from omnibus processing and networking services (collectively referred to as “recordkeeping”), our sponsorship programs with financial product manufacturers and fees from our client cash programs. Omnibus processing revenues are paid to us by mutual fund product sponsors and are based on the value of custodied assets in advisory accounts and the number of brokerage accounts in which the related mutual fund positions are held. Networking revenues on brokerage assets are correlated to the number of positions we administer and are paid to us by mutual fund and annuity product manufacturers. We receive fees from certain financial product manufacturers in connection with sponsorship programs that support our marketing and sales education and training efforts. Client cash-based revenues are generated on advisors’ clients’ cash balances in insured bank sweep accounts and money market programs. Pursuant to contractual arrangements, we receive fees based on account type and invested balances for administration and recordkeeping.
Asset-based revenues for the year ended December 31, 2020 decreased by $121.5 million compared to 2019, primarily due to decreased revenues from our client cash programs, partially offset by an increase in recordkeeping revenues and sponsorship programs.
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Revenues for our recordkeeping and sponsorship programs for the year ended December 31, 2020, which are largely based on the market value of the underlying assets, increased compared to 2019 due to the impact of market appreciation on the value of the underlying assets.
Client cash revenues for the year ended December 31, 2020 decreased compared to 2019 due to the impact of a lower federal funds effective rate, partially offset by higher average client cash balances. For the year ended December 31, 2020, our average client cash balances increased to $44.7 billion compared to $31.0 billion for the year ended December 31, 2019.
Transaction and Fee
Transaction revenues primarily include fees we charge to our advisors and their clients for executing certain transactions in brokerage and fee-based advisory accounts. Fee revenues primarily include IRA custodian fees, contract and licensing fees and other client account fees. In addition, we host certain advisor conferences that serve as training, education, sales and marketing events, for which we charge a fee for attendance.
Transaction and fee revenues for the year ended December 31, 2020 increased by $25.7 million compared to 2019, primarily due to increased transaction volume in response to the market volatility caused by the COVID-19 pandemic, partially offset by a decrease in conference service revenues as a result of advisor-related conferences being cancelled or held in a virtual format in 2020 in response to the COVID-19 pandemic.
Interest Income, Net of Interest Expense
We earn interest income from client margin loans and cash equivalents, net of interest expense. Period-over-period variances correspond to changes in the average balances of margin loans and cash equivalents as well as changes in interest rates. Interest income, net of interest expense for the year ended December 31, 2020 decreased by $17.1 million compared to 2019, primarily due to lower average interest rates.
Other
Other revenues primarily include mark-to-market gains or losses on assets held by us in our advisor non-qualified deferred compensation plan and model research portfolios, marketing allowances received from certain financial product manufacturers, primarily those who offer alternative investments, such as non-traded real estate investment trusts and business development companies and other miscellaneous revenues.
Other revenues for the year ended December 31, 2020 increased by $0.8 million compared to 2019, primarily due to realized and unrealized gains on assets held in our advisor non-qualified deferred compensation plan, which are based on the market performance of the underlying investment allocations chosen by advisors in the plan, partially offset by decreases in dividend income on assets held in our advisor non-qualified deferred compensation plan.
Expenses
Advisory and Commission
Advisory and commission expenses consist of the following: base payout amounts that are earned by and paid out to advisors and institutions based on advisory and commission revenues earned on each client’s account; production based bonuses earned by advisors and institutions based on the levels of advisory and commission revenues they produce; the recognition of share-based compensation expense from equity awards granted to advisors and financial institutions based on the fair value of the awards at grant date; and the deferred advisory and commissions fee expenses associated with mark-to-market gains or losses on the non-qualified deferred compensation plan offered to our advisors.
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The following table shows the components of our payout ratio, which is a statistical or operating measure:
Years Ended December 31,
2020 2019 Change
Base payout rate (1)
82.22 % 83.05 % (83) bps
Production based bonuses 3.90 % 3.22 % 68 bps
Total payout ratio (2)
86.12 % 86.27 % (15) bps
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(1) Our base payout rate is calculated as advisory and commission expenses less production based bonuses and mark-to-market gains or losses on the non-qualified deferred compensation plan, divided by advisory and commission revenues.
(2) Totals may not foot due to rounding.
Our total payout ratio decreased slightly for the year ended December 31, 2020 compared to 2019, primarily due to a decrease in base payout rate, which was driven by increases in the sale of equities and a shift from brokerage to advisory business, each of which results in lower payouts, partially offset by an increase in production based bonuses, which was driven by broader price reductions on our corporate advisory platform.
Compensation and Benefits
Compensation and benefits include salaries, wages, benefits, share-based compensation and related taxes for our employees, as well as compensation for temporary employees and contractors. The following table sets forth our average number of employees for the year ended December 31, 2020 as compared to 2019.
Years Ended December 31,
2020 2019 % Change
Average number of employees 4,560 4,327 5.4%
Compensation and benefits for the year ended December 31, 2020 increased by $53.1 million compared to 2019, primarily due to an increase in salary and employee benefit expenses resulting from an increase in headcount.
Promotional
Promotional expenses include business development costs related to advisor recruitment and retention, costs related to hosting certain advisory conferences that serve as training, sales and marketing events and other costs that support advisor business growth. For the year ended December 31, 2020 promotional expenses increased by $2.7 million compared to 2019, primarily due to an increase in costs associated with advisor loans, which are driven by larger recruitment and retention, partially offset by a decrease in advisor conference expenses due to conferences being cancelled or held in a virtual format in 2020 in response to the COVID-19 pandemic.
Depreciation and Amortization
Depreciation and amortization relates to the use of fixed assets, which include internally developed software, hardware, leasehold improvements and other equipment. Depreciation and amortization for the year ended December 31, 2020 increased by $14.0 million compared to 2019, primarily due to an increase in internally developed software.
Amortization of Intangible Assets
Amortization of intangible assets relates to intangible assets established through our acquisitions. Amortization of intangible assets for the year ended December 31, 2020 remained relatively flat compared to 2019.
Occupancy and Equipment
Occupancy and equipment expenses include the costs of leasing and maintaining our office spaces, software licensing and maintenance costs and maintenance expenses on computer hardware and other equipment. For the year ended December 31, 2020 occupancy and equipment expenses increased by $30.2 million compared to 2019, primarily due to an increase in costs related to software licensing fees in support of our service and technology investments.
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Professional Services
Professional services expenses include costs paid to outside firms for assistance with legal, accounting, technology, regulatory, marketing and general corporate matters, as well as non-capitalized costs related to service and technology enhancements. Professional services expenses for the year ended December 31, 2020 decreased by $16.8 million compared to 2019, primarily due to the Company temporarily bringing certain services in-house as a result of the COVID-19 pandemic.
Brokerage, Clearing and Exchange Fees
Brokerage, clearing and exchange fees include expenses originating from trading or clearing operations as well as any exchange membership fees. These fees fluctuate largely in line with the volume of sales and trading activity. Brokerage, clearing and exchange fees increased by $6.7 million for the year ended December 31, 2020 compared to 2019, primarily due to an increase in the volume of sales and trading activity.
Communications and Data Processing
Communications and data processing expenses consist primarily of the cost of voice and data telecommunication lines supporting our business, including connectivity to data centers, exchanges and markets as well as customer statement processing and postage costs. Communications and data processing expenses remained relatively flat for the year ended December 31, 2020 compared to 2019.
Other
Other expenses include the costs of the investigation, settlement and resolution of regulatory matters (including customer restitution and remediation), licensing fees, insurance, broker-dealer regulator fees, travel-related expenses and other miscellaneous expenses. Other expenses will depend in part on the size and timing of resolving regulatory matters and the availability of self-insurance coverage, which depends in part on the amount and timing of resolving historical claims. There are particular uncertainties and complexities involved when assessing the potential costs and timing of regulatory matters, including the adequacy of loss reserves for potential liabilities that are self-insured by our captive insurance subsidiary. Other expenses for the year ended December 31, 2020 decreased by $13.5 million compared to 2019, primarily due to a decrease in travel expenses as a result of the COVID-19 pandemic and lower costs associated with the investigation of regulatory matters.
Non-Operating Interest Expense and Other
Non-operating interest expense and other represents expenses from our senior secured credit facilities, senior unsecured notes, finance leases and other non-operating expenses. Non-operating interest expense and other for the year ended December 31, 2020 decreased by $24.2 million compared to 2019, primarily due to a lower outstanding principal balance and a lower interest rate on our senior secured term loan, partially offset by the issuance of additional senior unsecured notes in 2019.
Loss on Extinguishment of Debt
On November 12, 2019, we closed a refinancing transaction and accelerated the recognition of $3.2 million of unamortized debt issuance costs as a loss on extinguishment of debt. There were no refinancing transactions during the year ended 2020.
Provision for Income Taxes
Our effective income tax rate remained consistent at 24.5% for the year ended December 31, 2020 and 2019.
COVID-19 Impact
On March 11, 2020, the World Health Organization designated the spread of the COVID-19 as a pandemic. As of the date of this Annual Report on Form 10-K, the COVID-19 pandemic has had a significant impact on global financial markets, and we continue to monitor its effects on the overall economy and our operations. We are not yet able to determine the full impact of the pandemic; however, should it continue, there could be a material and adverse financial impact to our results of operations. Please consult the “Risks Related to our Business and Industry” section within Part I, “Item 1A. Risk Factors” for more information about the risks associated with the COVID-19 pandemic.
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Liquidity and Capital Resources
Senior management establishes our liquidity and capital policies. These policies include senior management’s review of short- and long-term cash flow forecasts, review of capital expenditures and daily monitoring of liquidity for our subsidiaries. Decisions on the allocation of capital are based upon, among other things, projected profitability and cash flow, risks of the business, regulatory capital requirements and future liquidity needs for strategic activities. Our Treasury department assists in evaluating, monitoring and controlling the business activities that impact our financial condition, liquidity and capital structure. The objectives of these policies are to support our corporate business strategies while ensuring ongoing and sufficient liquidity.
A summary of changes in cash flow data is provided as follows (in thousands):
Years Ended December 31,
2020 2019
Net cash flows provided by (used in):
Operating activities $ 789,941 $ 623,871
Investing activities (187,499) (180,987)
Financing activities (275,186) (533,225)
Net increase (decrease) in cash, cash equivalents and restricted cash
327,256 (90,341)
Cash, cash equivalents and restricted cash — beginning of year 1,471,778 1,562,119
Cash, cash equivalents and restricted cash — end of year $ 1,799,034 $ 1,471,778
Cash requirements and liquidity needs are primarily funded through our cash flow from operations and our capacity for additional borrowing.
Net cash flows provided by operating activities includes net income and adjustments for non-cash expenses; changes in operating assets and liabilities, including balances related to the settlement and funding of client transactions; receivables from product sponsors; and accrued advisory and commission expenses due to our advisors. In addition to net income, operating assets and liabilities that arise from the settlement and funding of transactions by our advisors’ clients are the principal cause of changes to our net cash from operating activities and can fluctuate significantly from day to day and period to period depending on overall trends and clients’ behaviors.
The increase in cash flows provided by operating activities for 2020 compared to 2019 was primarily due to increases in inflows to receivables from and payables to clients, partially offset by a decrease in net income.
The increase in cash flows used in investing activities for 2020 compared to 2019 was primarily attributable to increases in acquisition costs and purchases of held-to-maturity securities.
The decrease in cash flows used in financing activities for 2020 compared to 2019 was primarily attributable to the suspension of repurchases of our common stock, partially offset by repayments of our revolving line of credit.
We actively monitor changes to our liquidity needs caused by general business volumes and price volatility, including higher margin requirements of clearing corporations and exchanges, and stress scenarios involving a sustained market downturn and the persistence of current interest rates, which include the impacts of the COVID-19 pandemic. We believe that based on current levels of operations and anticipated growth, our cash flow from operations, together with other available sources of funds, which include six uncommitted lines of credit, the revolving credit facility established through our senior secured credit agreement (the “Credit Agreement”) and the committed revolving credit facility of LPL Financial, will provide us with adequate liquidity to satisfy our working capital needs, the payment of all of our obligations and the funding of anticipated capital expenditures for the foreseeable future.
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The following table presents our external lines of credit at December 31, 2020 (dollars in millions):
Description Borrower Maturity Date Outstanding Available
Senior secured, revolving credit facility LPL Holdings, Inc. November 2024 $ — $ 750
Broker-dealer revolving credit facility LPL Financial LLC July 2024 $ — $ 300
Secured, uncommitted lines of credit LPL Financial LLC March 2022 $ — $ 75
Unsecured, uncommitted lines of credit LPL Financial LLC September 2021 $ — $ 75
Unsecured, uncommitted lines of credit LPL Financial LLC September 2021 $ — $ 50
Unsecured, uncommitted lines of credit LPL Financial LLC None $ — $ 75
Secured, uncommitted lines of credit LPL Financial LLC None $ — unspecified
Secured, uncommitted lines of credit LPL Financial LLC None $ — unspecified
We regularly evaluate our existing indebtedness, including potential refinancing opportunities, based on a number of factors, including our capital requirements, future prospects, contractual restrictions, the availability of refinancing on attractive terms and general market conditions. The earliest principal maturity date for our long-term borrowings is 2025 and our revolving credit facilities mature in 2024, which makes us less dependent on capital markets in the near-term.
We have certain capital adequacy requirements related to our registered broker-dealer subsidiary and bank trust subsidiary. As of December 31, 2020, we were in compliance with all such requirements.
Share Repurchases
We engage in share repurchase programs, which are approved by our board of directors (the “Board of Directors”), pursuant to which we may repurchase our issued and outstanding shares of common stock from time to time. Purchases may be effected in open market or privately negotiated transactions. We suspended share repurchases in early 2020 in light of the business and financial uncertainties created by the COVID-19 pandemic. The resumption, timing and amount of future share repurchases, if any, will be determined at our discretion within the constraints of our Credit Agreement, the indentures governing our senior unsecured notes (the “Indentures”) and consideration of our general liquidity needs. See Note 15 - Stockholders’ Equity , within the notes to the consolidated financial statements for additional information regarding our share repurchases.
Dividends
The payment, timing and amount of any dividends are subject to approval by the Board of Directors as well as certain limits under our Credit Agreement and the Indentures. See Note 15 - Stockholders’ Equity , within the notes to the consolidated financial statements for additional information regarding our dividends.
Operating Capital Requirements
Our primary requirement for working capital relates to funds we loan to our advisors’ clients for trading conducted on margin and funds we are required to maintain for regulatory capital and reserves based on the requirements of our regulators and clearing organizations, which also consider client balances and trading activities. We have several sources of funds that enable us to meet increases in working capital requirements that relate to increases in client margin activities and balances. These sources include cash and cash equivalents on hand, cash segregated under federal and other regulations, the committed revolving credit facility of LPL Financial and proceeds from repledging or selling client securities in margin accounts. When an advisor’s client purchases securities on margin or uses securities as collateral to borrow from us on margin, we are permitted, pursuant to the applicable securities industry regulations, to repledge, loan or sell securities, up to 140% of the client’s margin loan balance, that collateralize those margin accounts.
Our other working capital needs are primarily related to advisor loans and timing associated with receivables and payables, which we have satisfied in the past from internally generated cash flows.
We may sometimes be required to fund timing differences arising from the delayed receipt of client funds associated with the settlement of client transactions in securities markets. These timing differences are funded either with internally generated cash flows or, if needed, with funds drawn on our uncommitted lines of credit at LPL Financial or under one of our revolving credit facilities.
LPL Financial is subject to the Securities and Exchange Commission’s (“SEC”) Uniform Net Capital Rule, which requires the maintenance of minimum net capital. LPL Financial computes net capital requirements under the
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alternative method, which requires firms to maintain minimum net capital equal to the greater of $250,000 or 2% of aggregate debit balances arising from client transactions. At December 31, 2020, LPL Financial had net capital of $119.0 million with a minimum net capital requirement of $11.1 million.
LPL Financial’s ability to pay dividends greater than 10% of its excess net capital during any 35-day rolling period requires approval from the Financial Industry Regulatory Authority (“FINRA”). In addition, payment of dividends is restricted if LPL Financial’s net capital would be less than 5% of aggregate customer debit balances.
LPL Financial also acts as an introducing broker for commodities and futures. Accordingly, its trading activities are subject to the National Futures Association’s (“NFA”) financial requirements and it is required to maintain net capital that is in excess of or equal to the greatest of NFA’s minimum financial requirements. The NFA was designated by the Commodity Futures Trading Commission as LPL Financial’s primary regulator for such activities. Currently, the highest NFA requirement is the minimum net capital calculated and required pursuant to the SEC’s Net Capital Rule.
Our subsidiary, The Private Trust Company, N.A. (“PTC”), is also subject to various regulatory capital requirements. Failure to meet the respective minimum capital requirements can result in certain mandatory and discretionary actions by regulators that, if undertaken, could have substantial monetary and non-monetary impacts on PTC’s operations.
Debt and Related Covenants
The Credit Agreement and the Indentures contain a number of covenants that, among other things, restrict, subject to certain exceptions, our ability to:
• incur additional indebtedness or issue disqualified stock or preferred stock;
• declare dividends, or other distributions to stockholders;
• repurchase equity interests;
• redeem indebtedness that is subordinated in right of payment to certain debt instruments;
• make investments or acquisitions;
• create liens;
• sell assets;
• guarantee indebtedness;
• engage in certain transactions with affiliates;
• enter into agreements that restrict dividends or other payments from subsidiaries; and
• consolidate, merge or transfer all or substantially all of our assets.
Our Credit Agreement and the Indentures allow us to pay dividends and distributions or repurchase our capital stock only when certain conditions are met. In addition, our revolving credit facility requires us to be in compliance with certain financial covenants as of the last day of each fiscal quarter. The financial covenants require the calculation of Credit Agreement EBITDA, as defined in, and calculated by management in accordance with, the Credit Agreement. The Credit Agreement defines Credit Agreement EBITDA as “Consolidated EBITDA,” which is Consolidated Net Income (as defined in the Credit Agreement) plus interest expense, tax expense, depreciation and amortization, and further adjusted to exclude certain non-cash charges and other adjustments (including unusual or non-recurring charges) and gains, and to include future expected cost savings, operating expense reductions or other synergies from certain transactions.
As of December 31, 2020, we were in compliance with both financial covenants, a maximum Consolidated Total Debt to Consolidated EBITDA Ratio (as defined in the Credit Agreement) or “Leverage Ratio” and a minimum Consolidated EBITDA to Consolidated Interest Expense Ratio (as defined in the Credit Agreement) or “Interest Coverage”. The breach of these financial covenants would be subject to certain equity cure rights. The required ratios under our financial covenants and actual ratios were as follows:
December 31, 2020
Financial Ratio Covenant Requirement Actual Ratio
Leverage Ratio (Maximum) 5.0 2.16
Interest Coverage (Minimum) 3.0 9.81
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See Note 11 - Long-term and Other Borrowings , within the notes to the consolidated financial statements for further detail regarding the Credit Agreement and the Indentures.
Off-Balance Sheet Arrangements
We enter into various off-balance-sheet arrangements in the ordinary course of business, primarily to meet the needs of our advisors’ clients. These arrangements include Company commitments to extend credit. For information on these arrangements, see Note 14 - Commitments and Contingencies and Note 21 - Financial Instruments with Off-Balance-Sheet Credit Risk and Concentrations of Credit Risk, within the notes to the consolidated financial statements.
Contractual Obligations
The following table provides information with respect to our commitments and obligations as of December 31, 2020 (in thousands):
Payments Due by Period
Total < 1 Year 1-3 Years 3-5 Years > 5 Years
Operating leases (1)
$ 185,905 $ 22,025 $ 44,799 $ 43,748 $ 75,333
Finance leases (2)
269,480 9,735 17,379 17,606 224,760
Purchase obligations (3)
105,528 47,187 44,755 13,258 328
Long-term borrowings (4)
2,359,300 10,700 21,400 921,400 1,405,800
Interest payments (5)
502,855 90,279 179,950 179,137 53,489
Commitment and other fees (6)
11,397 3,002 6,005 2,390 —
Total contractual cash obligations $ 3,434,465 $ 182,928 $ 314,288 $ 1,177,539 $ 1,759,710
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(1) Represents future payments under operating leases. See Note 12 - Leases, within the notes to the consolidated financial statements for further detail.
(2) Represents future payments under finance leases. See Note 12 - Leases , within the notes to the consolidated financial statements for further detail.
(3) Includes future minimum payments under service, development and agency contracts, and other contractual obligations. See Note 14 - Commitments and Contingencies , within the notes to the consolidated financial statements for further detail on obligations under noncancelable service contracts.
(4) Represents principal payments under our Credit Agreement. See Note 11 - Long-term and Other Borrowings , within the notes to the consolidated financial statements for further detail.
(5) Represents interest payments under our Credit Agreement, which include a variable interest payment for our senior secured credit facilities and a fixed interest payment for senior unsecured notes. Variable interest payments assume the applicable interest rates at December 31, 2020 remain unchanged. See Note 11 - Long-term and Other Borrowings , within the notes to the consolidated financial statements for further detail.
(6) Represents commitment fees for unused borrowings on the revolving credit facility under our Credit Agreement. See Note 11 - Long-term and Other Borrowings , within the notes to the consolidated financial statements for further detail.
As of December 31, 2020, we have a liability for unrecognized tax benefits of $54.4 million, which we have included in income taxes payable in the consolidated statements of financial condition. This amount has been excluded from the contractual obligations table because we are unable to reasonably predict the ultimate amount or timing of future tax payments.
Fair Value of Financial Instruments
We use fair value measurements to record certain financial assets and liabilities at fair value and to determine fair value disclosures. See Note 5 - Fair Value Measurements, within the notes to the consolidated financial statements for a detailed discussion regarding our fair value measurements.
Critical Accounting Policies and Estimates
Our consolidated financial statements are prepared in accordance with GAAP, which requires management to make estimates, judgments and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. We believe that of our critical accounting policies, the following are noteworthy because they require management to make estimates regarding matters that are uncertain and
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susceptible to change where such change may result in a material adverse impact on our financial position and reported financial results.
Revenue Recognition
Revenues are recognized when control of the promised service is transferred to customers, in an amount that reflects the consideration that we expect to be entitled to in exchange for those services. Management exercises judgment to estimate revenue accruals. In particular, our trailing commission revenues, included in commission revenues on the consolidated statements of income, are generally received in arrears and therefore require our management to estimate accrued amounts based on revenues received in prior periods, market performance and payment frequency of each product type or sponsor. See Note 2 - Summary of Significant Accounting Policies and Note 3 - Revenues , within the notes to the consolidated financial statements for more details on our policies and disclosures related to revenues.
Commitments and Contingencies
Liabilities related to loss contingencies, are recognized when we believe it is probable a liability has occurred and the amount can be reasonably estimated by management. We have established an accrual for those legal proceedings and regulatory matters for which a loss is both probable and the amount can be reasonably estimated.
We also accrue for losses at our captive insurance subsidiary for those matters covered by self-insurance. Our captive insurance subsidiary records losses and loss reserve liabilities based on actuarially determined estimates of losses incurred, as well as specific reserves for proceedings and matters that are probable and estimable. Assessing the probability of a loss occurring and the timing and amount of any loss related to a legal proceeding or regulatory matter is inherently difficult and requires management to make significant judgments. For additional information, see Note 2 - Summary of Significant Accounting Policies and Note 14 - Commitments and Contingencies - “Legal & Regulatory Matters,” within the notes to the consolidated financial statements.
Valuation of Goodwill and Other Intangible Assets
Goodwill is recognized as a result of business combinations and is measured as the excess of the purchase price over the fair value of the net assets acquired. The valuation of goodwill and other intangible assets requires management to apply judgment and assumptions when estimating future earnings and performance. Management also applies judgment when testing for impairment of goodwill and other indefinite-lived intangible assets, including estimating fair values. Goodwill and other indefinite-lived intangible assets are tested annually for impairment in the fourth fiscal quarter and between annual tests if certain events occur indicating that the carrying amounts may be impaired.
Intangible assets that are deemed to have definite lives are amortized over their useful lives, or the estimated period the intangible asset will provide economic benefit. Definite-lived intangible assets are reviewed for impairment when there is evidence that events or changes in circumstances indicate that the carrying amount may not be recoverable. For additional information on our policies and disclosures related to goodwill and other intangible assets, see Note 2 - Summary of Significant Accounting Policies and Note 9 - Goodwill and Other Intangible Assets , within the notes to the consolidated financial statements.
Income Taxes
In preparing the consolidated financial statements, we estimate income tax expense based on various jurisdictions where we conduct business. This requires management to estimate current tax obligations and to assess temporary differences between the financial statement carrying amounts and the tax basis of assets and liabilities. These temporary differences result in deferred tax assets and liabilities, which we must then assess the likelihood that the deferred tax assets will be realized. A valuation allowance is established to the extent that it is more likely than not that such deferred tax assets will not be realized. Changes in the estimate of tax assets and liabilities occur periodically due to changes in the tax rates, changes in the business operations, implementation of tax planning strategies, resolution with taxing authorities of issues where we had previously taken certain tax positions and newly enacted statutory, judicial and regulatory guidance. For more information on our policies and disclosures related to taxes, see Note 2 - Summary of Significant Accounting Policies and Note 13 - Income Taxes , within the notes to the consolidated financial statements.
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Recently Issued Accounting Pronouncements
Refer to Note 2 - Summary of Significant Accounting Policies, within the notes to the consolidated financial statements for a discussion of recent accounting pronouncements or changes in accounting pronouncements that are of significance, or potential significance, to us.
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