News Column

HFF, INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

May 12, 2014

The following discussion summarizes the financial position of the Company and its subsidiaries as of March 31, 2014, and the results of our operations for the three month period ended March 31, 2014, and should be read in conjunction with (i) the unaudited consolidated financial statements and notes thereto included elsewhere in this Quarterly Report on Form 10-Q and (ii) the consolidated financial statements and accompanying notes to our Annual Report on Form 10-K for the year ended December 31, 2013.



Overview

Our Business

We are, based on transaction volume, one of the largest full-service commercial real estate financial intermediaries in the U.S. providing commercial real estate and capital markets services to both the consumers and providers of capital in the U.S. commercial real estate industry. We operate out of 22 offices nationwide with approximately 654 associates including approximately 260 transaction professionals as of March 31, 2014. Substantially all of our revenues are in the form of capital markets services fees collected from our clients, usually negotiated on a transaction-by-transaction basis. We also earn fees from commercial loan servicing activities. We believe that our multiple product offerings and platform services, diverse client mix, expertise in a wide range of property types and national platform create a diversified revenue stream within the U.S. commercial real estate sector.



We operate in one reportable segment, the commercial real estate financial intermediary segment, and offer debt placement, investment sales, equity placements, investment banking and advisory services, loan sales and loan sale advisory services, commercial loan servicing.

Our business may be significantly affected by factors outside of our control, particularly including:

• Economic and commercial real estate market downturns. Our business is

dependent on international and domestic economic conditions and the demand

for commercial real estate and related services in the markets in which we

operate. A slow-down, a significant downturn and/or recession in either the

global economy and/or the domestic economy, including but not limited to even

a regional economic downturn, could adversely affect our business. A general

decline in acquisition and disposition activity, as well as a general decline

in commercial real estate investment activity, can lead to a reduction in

fees and commissions for arranging such transactions, as well as in fees and

commissions for arranging financing for acquirers and property owners that

are seeking to recapitalize their existing properties. Such a general decline

can also lead to a significant reduction in our loan servicing activities,

due to increased delinquencies and defaults and lack of additional loans that

we would have otherwise added to our loan servicing portfolio.



• Global and domestic credit and liquidity issues. Global and domestic credit

and liquidity issues have in the recent past led to an economic downturn,

including a commercial real estate market downturn. This downturn in turn led

to a decrease in transaction activity and lower values. Restrictions on the

availability of capital, both debt and/or equity, created significant

reductions, and could in the future cause, further reductions of the

liquidity in and the flow of capital to the commercial real estate markets.

These restrictions also caused, and could in the future cause, commercial

real estate prices to decrease due to the reduced amount of equity capital

and debt financing available which could lead to a reduction in our revenues.

• Decreased investment allocation to commercial real estate class. Allocations

to commercial real estate as an asset class for investment portfolio

diversification may decrease for a number of reasons beyond our control,

including but not limited to poor performance of the asset class relative to

other asset classes or the superior performance of other asset classes when

compared with the performance of the commercial real estate asset class. In

addition, while commercial real estate is now viewed as an accepted and valid

class for portfolio diversification, if this perception changes, there could

be a significant reduction in the amount of debt and equity capital available

in the commercial real estate sector which could, therefore, result in decreased transactional volume. 21



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• Fluctuations in interest rates. Significant fluctuations in interest rates as

well as steady and protracted movements of interest rates in one direction

(increases or decreases) could adversely affect the operation and income of

commercial real estate properties as well as the demand from investors for

commercial real estate investments. Both of these events could adversely

affect investor demand and the supply of capital for debt and equity

investments in commercial real estate. In particular, increased interest

rates may cause prices to decrease due to the increased costs of obtaining

financing and could lead to decreases in purchase and sale activities,

thereby reducing the amounts of investment sales and loan originations and

related servicing fees. If our debt placement and investment sales

origination and servicing businesses are negatively impacted, it is likely

that our other lines of business would also suffer due to the relationship

among our various capital markets services.

The factors discussed above have adversely affected and continue to be a risk to our business, as evidenced by the effects of the significant recent disruptions in the global capital and credit markets, and in particular the domestic capital markets. While conditions in 2011 through year to date 2014 have generally improved, the global and domestic credit and liquidity issues, coupled with the global and domestic economic recession/slow down as well as other global and domestic macro events beyond our control, could reduce in the future the number of acquisitions, dispositions and loan originations, as well as the respective number of transactions and transaction volumes. This has had, and may have in the future, a significant adverse effect on our capital markets services revenues (including but not limited to our servicing revenues). The significant balance sheet issues of many of the CMBS lenders, banks, life insurance companies, mortgage REITS and debt funds, captive finance companies and other financial institutions have adversely affected, and could again in the future adversely affect the global and domestic economies and the flow of commercial mortgage debt to the U.S. capital markets, and, in turn, could potentially adversely affect all of our capital markets services platforms and resulting revenues. Other factors that may adversely affect our business are discussed under the heading "Forward-Looking Statements" and under the caption "Risk Factors" in this Quarterly Report on Form 10-Q. 22



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Results of Operations

Following is a discussion of our results of operations for the three months ended March 31, 2014 and March 31, 2013. The table included in the period comparisons below provides summaries of our results of operations. The period-to-period comparisons of financial results are not necessarily indicative of future results. For a description of the key financial measures and indicators included in our consolidated financial statements, refer to the discussion under "Management's Discussion and Analysis of Financial Condition and Results of Operations - Key Financial Measures and Indicators" in our Annual Report on Form 10-K for the year ended December 31, 2013. For the Three Months Ended March 31, 2014 2013 Total Total % of % of Dollar Percentage Dollars Revenue Dollars Revenue Change Change (dollars in thousands, unless percentages) Revenues Capital markets services revenue $ 75,141 98.8 % $ 52,964 97.7 % $ 22,177 41.9 % Interest on mortgage notes receivable 425 0.6 % 845 1.6 % (420 ) (49.7 )% Other 465 0.6 % 406 0.7 % 59 14.5 % Total revenues 76,031 100.0 % 54,215 100.0 % 21,816 40.2 % Operating expenses Cost of services 46,074 60.6 % 34,842 64.3 % 11,232 32.2 % Personnel 13,941 18.3 % 8,732 16.1 % 5,209 59.7 % Occupancy 2,351 3.1 % 2,136 3.9 % 215 10.1 % Travel and entertainment 2,996 3.9 % 2,319 4.3 % 677 29.2 % Supplies, research and printing 1,398 1.8 % 1,130 2.1 % 268 23.7 % Other 5,453 7.2 % 5,177 9.5 % 276 5.3 % Total operating expenses 72,213 95.0 % 54,336 100.2 % 17,877 32.9 % Operating (loss) income 3,818 5.0 % (121 ) (0.2 )% 3,939 NM Interest and other income, net 2,910 3.8 % 4,187 7.7 % (1,277 ) (30.5 )% Interest expense (7 ) (0.0 )% (9 ) (0.0 )% 2 22.2 % (Increase) decrease in payable under tax receivable agreement 501 0.7 % - 0.0 % 501 100.0 % Income before income taxes 7,222 9.5 % 4,057 7.5 % 3,165 78.0 % Income tax expense 3,515 4.6 % 1,741 3.2 % 1,774 101.9 % Net income $ 3,707 4.9 % $ 2,316 4.3 % $ 1,391 60.1 % Adjusted EBITDA (1) $ 11,834 15.6 % $ 6,860 12.7 % $ 4,974 72.5 % NM - not meaningful



(1) The Company defines Adjusted EBITDA as net income before (i) interest

expense, (ii) income tax expense, (iii) depreciation and amortization,

(iv) stock-based compensation expense, which is a non-cash charge, (v) income

recognized on the initial recording of mortgage servicing rights that are

acquired with no initial consideration, which is also a non-cash income

amount that can fluctuate significantly based on the level of mortgage

servicing right volumes, and (vi) the increase (decrease) in payable under

the tax receivable agreement, which represents changes in a liability

recorded on the Company's consolidated balance sheet determined by the

ongoing remeasurement of related deferred tax assets and, therefore, can be

income or expense based in the Company's consolidated statement of income in

any individual period. The Company uses Adjusted EBITDA in its business

operations to, among other things, evaluate the performance of its business,

develop budgets and measure its performance against those budgets. The

Company also believes that analysts and investors use Adjusted EBITDA as a

supplemental measure to evaluate its overall operating performance. However,

Adjusted EBITDA has material limitations as an analytical tool and should not

be considered in isolation, or as a substitute for analysis of the Company's

results as reported under U.S. generally acceptable accounting principles

(GAAP). The Company finds Adjusted EBITDA as a useful tool to assist in

evaluating performance because it eliminates items related to capital

structure and taxes, including the Company's tax receivable agreement. Note

that the Company classifies the interest expense on its warehouse lines of

credit as an operating expense and, accordingly, it is not eliminated from

net income in determining Adjusted EBITDA. Some of the items that the Company

has eliminated from net income in determining Adjusted EBITDA are significant

to the Company's business. For example, (i) interest expense is a necessary

element of the Company's costs and ability to generate revenue because it

incurs interest expense related to any outstanding indebtedness, (ii) payment

of income taxes is a necessary element of the Company's costs, and

(iii) depreciation and amortization are necessary elements of the Company's

costs. 23



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Any measure that eliminates components of the Company's capital structure and costs associated with the Company's operations has material limitations as a performance measure. In light of the foregoing limitations, the Company does not rely solely on Adjusted EBITDA as a performance measure and also considers its GAAP results. Adjusted EBITDA is not a measurement of the Company's financial performance under GAAP and should not be considered as an alternative to net income, operating income or any other measures derived in accordance with GAAP. Because Adjusted EBITDA is not calculated in the same manner by all companies, it may not be comparable to other similarly titled measures used by other companies. Set forth below is a reconciliation of consolidated net income attributable to controlling interest to Adjusted EBITDA for the Company for the three months ended March 31, 2014 and 2013: Adjusted EBITDA for the Company is calculated as follows: (dollars in thousands) For the Three Months Ended March 31, 2014 2013 Net income $ 3,707$ 2,316 Add: Interest expense 7 9 Income tax expense 3,515 1,741 Depreciation and amortization 2,053



1,588

Stock-based compensation (a) 4,745



2,530

Initial recording of mortgage servicing rights (1,692 ) (1,324 ) Increase (decrease) in payable under the tax receivable agreement (501 ) - Adjusted EBITDA $ 11,834$ 6,860



(a) Amounts do not reflect expense associated with the stock component of

estimated incentive payouts under the Company's firm profit participation

bonus plan or office profit participation bonus plans that are anticipated to

be paid in respect of the applicable year. Such expense is recorded as

incentive compensation expense within personnel expenses in the Company's

consolidated statements of income during the year to which the expense

relates. Following the award, if any, of the related incentive payout, the

stock component expense is reclassified as stock compensation costs within

personnel expenses. See Note 2 to the Company's consolidated financial

statements for further information regarding the Company's accounting

policies relating to its firm profit participation bonus plan and office

profit participation bonus plans. Stock-based compensation expense for the

three months ended March 31, 2014 reflects $0.5 million expense recognized

during such period that was associated with restricted stock granted in March

2014 under the Company's firm profit participation bonus plan or office

profit participation bonus plans in respect of 2013. Stock-based compensation

expense for the three months ended March 31, 2013 reflects $0.3 million

expense recognized during such period that was associated with restricted

stock granted in March 2013 under the Company's firm profit participation

bonus plan or office profit participation bonus plans in respect of 2012.

Stock-based payments under such plans were first made in 2012 in respect of

2011. See Note 3 to the Company's consolidated financial statements for

further information regarding the Company's accounting policies relating to

its stock compensation.

Revenues. Our total revenues were $76.0 million for the three months ended March 31, 2014 compared to $54.2 million for the same period in 2013, an increase of $21.8 million, or 40.2%. Revenues increased primarily due to a 40.7% increase in total production volumes as compared to the first quarter of 2013.

• The revenues we generated from capital markets services for the three months

ended March 31, 2014 increased $22.2 million, or 41.9%, to $75.1 million from

$53.0 million for the same period in 2013. The increase is primarily

attributable to an increase in the total production volume during the first

quarter of 2014 compared to the first quarter of 2013. 24



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• The revenues derived from interest on mortgage notes receivable were $0.4

million for the three months ended March 31, 2014 compared to $0.8 million

for the same period in 2013, a decrease of approximately $0.4 million.

Revenues decreased primarily as a result of a decrease in the average loan

size and fewer transactions in the first quarter of 2014 compared to the

first quarter of 2013 in connection with our services as a Freddie Mac

Multifamily Program Plus® Seller/Servicer. • The other revenues we earned, which include expense reimbursements from



clients related to out-of-pocket costs incurred and vary on a

transaction-by-transaction basis, were approximately $0.5 million for the

three month period ended March 31, 2014 and $0.4 million for the three month

period ended March 31, 2013, an increase of approximately $0.1 million, or

14.5%.

Total Operating Expenses. Our total operating expenses were $72.2 million for the three months ended March 31, 2014 compared to $54.3 million for the same period in 2013, an increase of $17.9 million, or 32.9%. Expenses increased primarily due to increased cost of services and increased personnel costs resulting primarily from an increase in capital markets services revenue and increased headcount.



• The cost of services for the three months ended March 31, 2014 increased

$11.2 million, or 32.2%, to $46.1 million from $34.8 million for the same period in 2013. The increase is primarily the result of the increase in



commissions and other incentive compensation directly related to the increase

in capital markets services revenues. Also contributing to the increase in

cost of services are higher salary and fringe benefit costs from increased

headcount. Cost of services as a percentage of capital markets services

revenues was approximately 61.3% and 65.8% for the three month periods ended

March 31, 2014 and March 31, 2013, respectively.



• Personnel expenses that are not directly attributable to providing services

to our clients increased $5.2 million, or 59.7%, to $13.9 million for the

three months ended March 31, 2014 from $8.7 million for the same period in

2013. The increase is primarily related to an increase in salaries and

incentive compensation costs of $0.5 million, an increase in profit

participation costs of $1.9 million, equity compensation costs of $0.7

million for newly granted awards and the mark-to-market adjustment on the

existing restricted stock awards accounted for as liability awards which are

revalued each quarter and resulted in increased expense of $1.4 million

during the first quarter 2014 as compared to the first quarter 2013.

Personnel expenses are also impacted quarterly by the adjustments made to

accrue for the estimated expense associated with the performance-based firm

and office profit participation plans. Both the firm and office profit

participation plans allow for payments in the form of both cash and

share-based awards based on the decision of the Company's board of directors.

The stock compensation cost included in personnel expenses was $4.7 million

and $2.5 million for the three months ended March 31, 2014 and 2013,

respectively. The increase in stock compensation costs is primarily due to

the mark-to-market adjustment on existing restricted stock awards accounted

for as liability awards which resulted in $3.3 million of expense (or a $1.4

million increase as compared to the first quarter of 2013). At March 31,

2014, there was approximately $23.3 million of unrecognized compensation cost

related to share based awards. The weighted average remaining contractual

term of the unvested restricted stock units is 4.2 years as of March 31,

2014. The weighted average remaining contractual term of the vested options

is 4.5 years as of March 31, 2014.



• Occupancy, travel and entertainment and supplies, research and printing

expenses for the three months ended March 31, 2014 increased $1.2 million, or

20.8%, to $6.7 million compared to the same period in 2013. These increases

are primarily due to increased travel and entertainment costs stemming from

the increase in headcount and production volumes, increased occupancy costs

from office expansions and increased supplies, research and printing costs

from the increase in production volumes and the number of transactions.

• Other expenses, including costs for insurance, professional fees,



depreciation and amortization, interest on our warehouse line of credit and

other operating expenses, were $5.5 million in the three months ended

March 31, 2014, an increase of $0.3 million, or 5.3%, versus $5.2 million in

the three months ended March 31, 2013. This increase is primarily related to

increased amortization of $0.4 million due to a higher balance of mortgage

servicing rights and higher professional fees. These costs were slightly

offset by lower other operating costs.

Net Income. Our net income for the three months ended March 31, 2014 was $3.7 million, an increase of $1.4 million versus $2.3 million for the same fiscal period in 2013. This increase is primarily due to the increase in revenue as described above.



• Interest and other income, net for the three months ended March 31, 2014 was

$2.9 million, a decrease of $1.3 million as compared to $4.2 million for the

same fiscal period in 2013 primarily due to lower gains on sale of servicing

rights on certain loans and lower securitization compensation from the sale of servicing rights. 25



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• The interest expense we incurred in of the three months ended March 31, 2014

and 2013 was $7,000 and $9,000, respectively.



• (Increase) decrease in payable under the tax receivable agreement reflects

the change in the estimated tax benefits owed to HFF Holdings under the tax

receivable agreement. The $0.5 million decrease in payable under the tax

receivable agreement for the three month period ended March 31, 2012

represents 85% of the decrease in the related deferred tax asset of $0.6

million.



• Income tax expense was approximately $3.5 million for the three months ended

March 31, 2014, as compared to $1.7 million in the three months ended

March 31, 2013. This increase is primarily due to the higher income before

income taxes during the three months ended March 31, 2014 compared to the

same period of the prior year. During the three months ended March 31, 2014,

the Company recorded a current income tax expense of $0.1 million and

deferred income tax expense of $3.4 million.

Financial Condition

Total assets decreased to $377.5 million at March 31, 2014 from $488.2 million at December 31, 2013, primarily due to:

• A decrease in cash and cash equivalents of $96.5 million primarily due to a

dividend payment of $68.2 million and the payment of incentive compensation

that was accrued as of December 31, 2013. • A decrease in mortgage notes receivable of $16.7 million due to a lower



number of loans pending sale to Freddie Mac at March 31, 2014, compared to

December 31, 2013.

These decreases in assets were partially offset by increases in prepaid taxes of $2.3 million and prepaid expenses and other assets of $1.1 million.

Total liabilities decreased to $253.7 million at March 31, 2014 from $312.6 million at December 31, 2013, primarily due to:

• A decrease in amounts outstanding under the warehouse lines of credit of

$16.7 million due to a lower number of loans pending sale to Freddie Mac at

March 31, 2014, compared to December 31, 2013.



• A decrease in accrued compensation and related taxes of $31.9 million

primarily due to the payment of incentive compensation that was accrued as of

December 31, 2013 and a decrease in other current liabilities of $9.4 million

primarily from the payment of federal, state and local income taxes.



Cash Flows

Our historical cash flows are primarily related to the timing of receipt of transaction fees, the timing of distributions to members of HFF Holdings and payment of commissions and bonuses to employees.

First Three Months of 2014

Cash and cash equivalents decreased $96.5 million in the three months ended March 31, 2014. Net cash of $22.5 million was used in operating activities, primarily resulting from a $18.7 million decrease in accrued compensation and related taxes, a $9.4 million decrease in other accrued liabilities, a $3.4 million increase in prepaid taxes, prepaid expenses and other current assets and a $1.6 million increase in accounts receivable. These uses of cash were partially offset by $3.7 million of net income. Cash of $0.4 million was used for investing in property and equipment. Financing activities used $68.2 million primarily due to a dividend payment that we made to holders of our Class A common stock on February 6, 2014. Additionally, payments on certain capital leases used $0.1 million, $6.3 million was used to purchase shares of Class A common stock in connection with the minimum employee statutory tax withholdings and we recognized a $1.0 million excess tax benefit related to share-based award activities. First Three Months of 2013 Cash and cash equivalents decreased $18.1 million in the three months ended March 31, 2013. Net cash of $16.6 million was used in operating activities, primarily resulting from a $13.4 million decrease in accrued compensation and related taxes, a $7.4 million decrease in other accrued liabilities, a $2.6 million increase in prepaid taxes, prepaid expenses and other current assets and a $0.5 million decrease in accounts payable. These uses of cash were partially offset by $2.3 million of net income and a decrease of $0.7 million in accounts receivable. Cash of $0.2 million was used for investing in property and equipment. Financing activities used $0.1 million for the payments on certain capital leases, $1.7 million to purchase shares of Class A common stock in connection with employee tax withholdings and we recognized a $0.5 million excess tax benefit related to share-based award activities. 26



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Liquidity and Capital Resources

Our current assets typically have consisted primarily of cash and cash equivalents and accounts receivable in relation to earned transaction fees. At March 31, 2014, our cash and cash equivalents of approximately $104.8 million were invested or held in a mix of money market funds and bank demand deposit accounts at two financial institutions. Our liabilities have typically consisted of accounts payable and accrued compensation. We regularly monitor our liquidity position, including cash level, credit lines, interest and payments on debt, capital expenditures and other matters relating to liquidity and to compliance with regulatory net capital requirements. Over the three month period ended March 31, 2014, we used approximately $22.5 million of cash for operations. Our short-term liquidity needs are typically related to compensation expenses and other operating expenses such as occupancy, supplies, marketing, professional fees and travel and entertainment. For the three months ended March 31, 2014, we incurred approximately $72.2 million in total operating expenses. A large portion of our operating expenses are variable, highly correlated to our revenue streams and dependent on the collection of transaction fees. During the three months ended March 31, 2014, approximately 56.3% of our operating expenses were considered variable expenses. Our cash flow generated from operations historically has been sufficient to enable us to meet our objectives. However, if the economy deteriorates at the rate it did during 2008 and 2009, we may be unable to generate enough cash flow from operations to meet our operating needs and therefore we could use all or substantially all of our existing cash reserves on hand to support our operations. We currently believe that cash flows from operating activities and our existing cash balance will provide adequate liquidity and are sufficient to meet our working capital needs for the foreseeable future. Our tax receivable agreement with HFF Holdings entered into in connection with our initial public offering provides for the payment by us to HFF Holdings of 85% of the amount of cash savings in U.S. federal, state and local income tax that we actually realize as a result of the increases in tax basis and as a result of certain other tax benefits arising from our entering into the tax receivable agreement and making payments under that agreement. We have estimated that future payments that will be made to HFF Holdings will be $145.1 million, of which approximately $10.8 million is anticipated to be paid in 2014. Our liquidity needs related to our long term obligations are primarily related to our facility leases. Additionally, for the three months ended March 31, 2014, we incurred approximately $2.4 million in occupancy expenses and approximately $7,000 in interest expense. We are a party to an uncommitted $350 million financing arrangement with PNC Bank, N.A. (PNC) and an uncommitted $125 million financing arrangement with The Huntington National Bank (Huntington), to fund our Freddie Mac loan closings. Pursuant to these arrangements, PNC or Huntington funds the multifamily Freddie Mac loan closings on a transaction-by-transaction basis, with each loan being separately collateralized by a loan and mortgage on a multifamily property that is ultimately purchased by Freddie Mac. The PNC and Huntington National Bank financing arrangements are only for the purpose of supporting our participation in Freddie Mac's Program Plus Seller Servicer program and cannot be used for any other purpose. As of March 31, 2014, we had outstanding borrowings of $76.9 million under the PNC/Huntington arrangements and a corresponding amount of mortgage notes receivable. Although we believe that our current financing arrangements with PNC and Huntington are sufficient to meet our current needs in connection with our participation in Freddie Mac's Program Plus Seller Servicer program, in the event we are not able to secure financing for our Freddie Mac loan closings, we will cease originating such Freddie Mac loans until we have available financing.



Critical Accounting Policies; Use of Estimates

We prepare our financial statements in accordance with U.S. generally accepted accounting principles. In applying many of these accounting principles, we need to make assumptions, estimates and/or judgments that affect the reported amounts of assets, liabilities, revenues and expenses in our consolidated financial statements. We base our estimates and judgments on historical experience and other assumptions that we believe are reasonable under the circumstances. These assumptions, estimates and/or judgments, however, are often subjective and our actual results may change negatively based on changing circumstances or changes in our analyses. If actual amounts are ultimately different from our estimates, the revisions are included in our results of operations for the period in which the actual amounts become known. We believe the following critical accounting policies could potentially produce materially different results if we were to change underlying assumptions, estimates and/or judgments. See the notes to our consolidated financial statements for a summary of our significant accounting policies. 27



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Goodwill. We evaluate goodwill for potential impairment annually or more frequently if circumstances indicate impairment may have occurred. Changes in accounting standards, which were adopted by the Company in 2013, provide the option to qualitatively assess goodwill for impairment before completing a quantitative assessment. Under the qualitative approach, if, after assessing the totality of events or circumstances, including macroeconomic, industry and market factors and entity-specific factors, the Company determines it is likely (more likely than not) that the fair value of a reporting unit is greater than its carrying amount, then the quantitative impairment analysis is not required. The Company performs the required annual goodwill impairment evaluation in the fourth quarter of each year. No impairment of goodwill was determined to exist for the years ended December 31, 2013 or 2012. Intangible Assets. Our intangible assets primarily include mortgage servicing rights under agreements with third party lenders. Servicing rights are recorded at the lower of cost or market. Mortgage servicing rights do not trade in an active, open market with readily available observable prices. Since there is no ready market value for the mortgage servicing rights, such as quoted market prices or prices based on sales or purchases of similar assets, the Company determines the fair value of the mortgage servicing rights by estimating the present value of future cash flows associated with servicing the loans. Management makes certain assumptions and judgments in estimating the fair value of servicing rights. The estimate is based on a number of assumptions, including the benefits of servicing (contractual servicing fees and interest on escrow and float balances), the cost of servicing, prepayment rates (including risk of default), an inflation rate, the expected life of the cash flows and the discount rate. The cost of servicing, prepayment rates and discount rates are the most sensitive factors affecting the estimated fair value of the servicing rights. Management estimates a market participant's cost of servicing by analyzing the limited market activity and considering the Company's own internal servicing costs. Management estimates the discount rate by considering the various risks involved in the future cash flows of the underlying loans which include the cancellation of servicing contracts, concentration in the life company portfolio and the incremental risk related to large loans. Management estimates the prepayment levels of the underlying mortgages by analyzing recent historical experience. Many of the commercial loans being serviced have financial penalties for prepayment or early payoff before the stated maturity date. As a result, the Company has consistently experienced a low level of loan runoff. The estimated value of the servicing rights is impacted by changes in these assumptions. As of March 31, 2014, the fair value and net book value of the servicing rights were $20.7 million and $16.7 million, respectively. The most sensitive assumptions in estimating the fair value of the mortgage servicing rights are the level of prepayments, discount rate and cost of servicing. If the assumed level of prepayments increased 92%, the discount rate increased 41% or if there is a 5% increase in the cost of servicing at the stratum level, the estimated fair value of the servicing rights may result in the recorded mortgage servicing rights being potentially impaired and would require management to measure the amount of the impairment charge. The effect of a variation in each of these assumptions on the estimated fair value of the servicing rights is calculated independently without changing any other assumption. Servicing rights are amortized in proportion to and over the period of estimated servicing income which results in an accelerated level of amortization. We evaluate amortizable intangible assets on an annual basis, or more frequently if circumstances so indicate, for potential impairment. Income Taxes. The Company accounts for income taxes under the asset and liability method. Deferred tax assets and liabilities are recognized for future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, and for tax losses and for tax credit carryforwards, if any. Deferred tax assets and liabilities are measured using tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period of the tax rate change. In assessing the realizability of deferred tax assets, the Company considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. Our effective tax rate is sensitive to several factors including changes in the mix of our geographic profitability. We evaluate our estimated tax rate on a quarterly basis to reflect changes in: (i) our geographic mix of income, (ii) legislative actions on statutory tax rates, and (iii) tax planning for jurisdictions affected by double taxation. We continually seek to develop and implement potential strategies and/or actions that would reduce our overall effective tax rate. 28



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The net deferred tax asset of $158.6 million at March 31, 2014 is comprised mainly of a $154.9 million deferred tax asset related to the Section 754 of the Internal Revenue Code ("Section 754") election tax basis step up. The net deferred tax asset related to the Section 754 election tax basis step up of $154.9 million represents annual pre-tax deductions on the Section 754 basis step up and payments under the tax receivable agreement of approximately $32.8 million in 2014, then increasing to $53.0 million in 2021 and then decreasing over the next nine years to approximately $0.1 million in 2030. In order to realize the anticipated pre-tax benefit of approximately $32.8 million in 2014, the Company needs to generate approximately $268 million in revenue, assuming a constant cost structure. In the event that the Company cannot realize the annual pre-tax benefit each year, the shortfall becomes a net operating loss that can be carried back two years to offset prior years' taxable income, if any, or carried forward twenty years to offset future taxable income. During 2008 and 2009, based on the decline in production volume and corresponding impact on operating results, we did not realize the entire benefit of the annual deduction. Currently, $7.4 million of this cumulative benefit is characterized as a net operating loss and can be carried forward for periods that begin to expire in 2028. The net operating loss limitation does not impact the Company's ability to fully utilize the net operating loss before its expiration. In evaluating the realizability of these deferred tax assets, management makes estimates and judgments regarding the level and timing of future taxable income, including projecting future revenue growth and changes to the cost structure. Based on this analysis and other quantitative and qualitative factors, management believes that it is currently more likely than not that the Company will be able to generate sufficient taxable income to realize the net deferred tax assets. Based on revenue and taxable income generated through March 31, 2014, management currently expects to realize the entire $32.8 million anticipated pre-tax benefit. If it is more likely than not that the Company would not be able to generate a sufficient level of taxable income through the carryforward period, a valuation allowance would be recorded as a charge to income tax expense and a proportional reduction would be made in the payable under the tax receivable agreement which would be recorded as income in the consolidated statements of income. The trend in revenue growth over the next few years and through the amortization and carryforward periods is a key factor in assessing the realizability of the deferred tax assets. Leases. The Company leases all of its facilities under operating lease agreements. These lease agreements typically contain tenant improvement allowances. The Company records tenant improvement allowances as leasehold improvement assets, included in property and equipment, net in the consolidated balance sheet, and related deferred rent liabilities and amortizes them on a straight-line basis over the shorter of the term of the lease or useful life of the asset as additional depreciation expense and a reduction to rent expense, respectively. Lease agreements sometimes contain rent escalation clauses or rent holidays, which are recognized on a straight-line basis over the life of the lease in accordance with ASC 840, Leases (ASC 840). Lease terms generally range from one to ten years. An analysis is performed on each equipment lease to determine whether it should be classified as a capital or operating lease according to ASC 840. Share Based Compensation. The Company estimates the grant-date fair value of stock options using the Black-Scholes option-pricing model. For restricted stock awards, the fair value of the awards is calculated as the difference between the market value of the Company's Class A common stock on the date of grant and the purchase price paid by the employee. The Company also has restricted stock awards that are accounted for as liability awards and require remeasurement to fair value at the end of each reporting period. The Company's awards are generally subject to graded or cliff vesting schedules. Compensation expense is adjusted for estimated forfeitures and is recognized on a straight-line basis over the requisite service period of the award. Forfeiture assumptions are evaluated on a quarterly basis and updated as necessary. Employment / Non-compete Agreements. The Company has entered into arrangements with newly-hired producers whereby these producers would be paid additional compensation if certain performance targets are met over a defined period. Some of these agreements contain provisions that the payments will be made to the producers only if they enter into an employment agreement at the end of the performance period. Payments under these arrangements, if earned, would be paid in fiscal years 2016 through 2018. The Company begins to accrue for these payments when it is deemed probable that payments will be made; therefore, on a quarterly basis, the Company evaluates the probability of each of the producers achieving the performance targets and the probability of each of the producers signing an employment agreement, if applicable. As of March 31, 2014, no accrual has been made for these arrangements. Firm and Office Profit Participation Plans. The Company's firm and office profit participation plans provide for payments in cash and share-based awards if certain performance targets are achieved during the year. The expense associated with the plans is included in personnel expenses in the consolidated statements of income. The expense recorded for these plans is estimated during the year based on actual results at each interim reporting date and an estimate of future results for the remainder of the year. The plans allow for payments to be made in both cash and share-based awards, the composition of which is determined in the first calendar quarter of the subsequent year. Cash and share-based awards issued under these plans are subject to vesting conditions over the subsequent year, such that the total expense measured for these plans is recorded over the period from the beginning of the performance year through the vesting date. Based on an accounting policy election, the expense associated with the share-based component of the estimated incentive payout is recognized before the grant date of the stock due to the fact that the terms of the profit participation plans have been approved by the Company's board of directors and the employees of the Company understand the requirements to earn the award. Prior to the grant date, the share-based component-related expense is recorded as incentive compensation expense within personnel expenses in the Company's consolidated statements of income. Following the award, if any, the related incentive payout, the share-based component expense is reclassified as stock compensation costs with personnel expenses.



Certain Information Concerning Off-Balance Sheet Arrangements

We do not currently invest in any off-balance sheet vehicles that provide liquidity, capital resources, market or credit risk support, or engage in any leasing activities that expose us to any liability that is not reflected in our consolidated financial statements. 29



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Seasonality

Our capital markets services revenue has historically been seasonal, which can affect an investor's ability to compare our financial condition and results of operation on a quarter-by-quarter basis. This seasonality has caused our revenue, operating income, net income and cash flows from operating activities to be lower in the first six months of the year and higher in the second half of the year. The typical concentration of earnings and cash flows in the last six months of the year has historically been due to an industry-wide focus of clients to complete transactions towards the end of the calendar year. However, given the recent disruptions, write-offs and credit losses in the global and domestic capital markets, the liquidity issues facing all global capital markets, and in particular the U.S. commercial real estate markets, this historical pattern of seasonality may or may not continue. For example, the seasonality described above did not occur in 2007 or 2008, causing historical comparisons to be even more difficult to gauge.



Effect of Inflation and/or Deflation

Inflation and/or deflation, or both, could significantly affect our compensation costs, particularly those not directly tied to our transaction professionals' compensation, due to factors such as availability of capital and/or increased costs of capital. The rise of inflation could also significantly and adversely affect certain expenses, such as debt service costs, information technology and occupancy costs. To the extent that inflation and/or deflation results in rising interest rates and has other effects upon the commercial real estate markets in which we operate and, to a lesser extent, the securities markets, it may affect our financial position and results of operations by reducing the demand for commercial real estate and related services which could have a material adverse effect on our financial condition. See Part II, Item 1A, "Risk Factors" in this Quarterly Report on Form 10-Q. 30



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