KCG's (KCG) CEO Daniel Coleman on Q4 2015 Results - Earnings Call Transcript

| About: KCG Holdings, (KCG)

KCG Holdings, Inc. (NYSE:KCG)

Q4 2015 Earnings Conference Call

January 29, 2016 09:00 ET

Executives

Jonathan Mairs - Investor Relations

Daniel Coleman - Chief Executive Officer

Steffen Parratt - Chief Financial Officer

Analysts

Rich Repetto - Sandler O’Neill

Ken Hill - Barclays

Chris Allen - Evercore

Ken Worthington - JPMorgan

Chris Harris - Wells Fargo

Operator

Good morning and welcome to KCG’s Fourth Quarter Earnings Conference Call. As a reminder, today’s call is being recorded and will be available by playback. On the line are Chief Executive Officer, Daniel Coleman and Chief Financial Officer, Steffen Parratt. A question-and-answer session will follow remarks on the quarter.

To begin, I will turn the call over to Jonathan Mairs. Please go ahead.

Jonathan Mairs

Good morning. I am Jonathan Mairs. Welcome to KCG’s fourth quarter 2015 earnings call. On the line this morning are CEO, Daniel Coleman and CFO, Steffen Parratt.

Before we begin, please direct your attention to the cautionary terms regarding forward-looking statements in today’s discussion. Certain statements contained herein and the documents incorporated by reference may constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. In addition, take a minute to read the Safe Harbor statement contained in the earnings press release and presentation deck posted at http://investors.kcg.com, which is incorporated herein by reference.

In terms of the agenda for the call, Daniel will open with a few remarks. Steffen will provide details on KCG’s revenues, expenses and overall financial conditions. Daniel will return with a few additional comments before we move to the Q&A.

Now, I will turn the line over to Daniel.

Daniel Coleman

Good morning. Thank you for joining this morning’s call. After a strong Q3 with heightened market volumes and volatility in August, KCG posted revenues below expectations in Q4 through the performance of our market-making businesses. For the full year of 2015, however, KCG’s net revenues declined by approximately 6%. When normalized for the sale of Hotspot in Q1 2015 and our FCM in Q4 2014, our year-over-year net revenues were roughly flat.

In contrast to Q3, broad market conditions were weaker in Q4, consolidated U.S. equity bonds and realized volatility for the S&P declined. In addition, retail U.S. equity market witnessed a combination of strong competition, low dollar volume and tight spreads were significantly impacted results. The Fed decision to delay planned rate hike from September to December contributed in decision among interest rate traders. Relative to Q3 Treasury, future volumes declined 12%. Cash treasuries fell 18%. In November, the 10-year U.S. Treasury future traded on 3.4% volatility, down from an 8% in July before taking back up to 6% after the Fed hike. The environment negatively impacted our rates trading business, which is a significant contributor to non-U.S. equity market-making revenues.

On the other hand, as we approach the Fed meeting in mid-December, we experienced the market with large portfolio liquidations in U.S. equities. For the 6 trading days from December 11 to 18, consolidated volume averaged $354 billion a day and realized volatility ticked up to $24.8 billion, while particularly good for KCG’s institutional business, in particular our ETF business, this period proved difficult for the portfolios we carry to provide liquidity as a market maker. The start of Q1 2016 witnessed a somewhat similar dynamic with the pronounced market declines.

Outside those 6 trading days, consolidated dollar volume averaged about $270 billion a day and volatility averaged about $13.7 million for the remaining 57 days of the quarter. So, most of Q4 was actually quite slow. Outside the U.S. countermeasures enacted to halt a slide of Chinese equity stifle trading in correlated markets and products across Asia and just rounded out the general sluggishness extended to market volumes of FX, while the weakening global economy continue to play out and suppressed commodities prices.

While net revenues were flat from 2014 to 2015 on a like-for-like operating basis, the quarter-to-quarter market-making segment results have been incredibly volatile. And we are aware that revenue volatility is a focus for our analysts and investors. Put it in perspective, the 10 quarters since KCG’s inception, the quarterly mean revenue for market-making in gross terms was $226 million with a standard deviation of about $43 million. If we analyze this with a slightly wider lens, however, we can see somewhat more stable business looking at the average quarterly total revenues on a rolling four-quarter basis for the same period. The mean is $224 million with a standard deviation of $13 million. While the top priority for our revenue producers is to generate greater revenues, management is focused on reducing the overall volatility. We will accomplish this over time by diversifying market-making outside the U.S. equity space and continue to grow commission and fees from agency-based trading. Until that time in my opinion a more measured examination of revenues using data over several quarters is warranted.

As I have said in the past, we are focused on what we can control. In terms of revenues, we can impact our revenues over a period of quarters and years. As for cost, we are focused on making the impacts over coming months and quarters. Most recently, we have made progress with respect to compensation expense on an absolute basis as well as a percentage of revenues. We have got roughly $50 million from compensation, excluding the one-time accelerated compensation costs from the spring, lowering the payout ratio to 44.6% of net revenues in 2015. In addition, we cut $10 million from communication and data processing and $5 million from professional fees, excluding our Hotspot deal cost.

Recent cost increases are temporary and attributable to the planned consolidation of our headquarters as well as the refinancing of our debt. Incremental depreciation and amortization from the corporate relocation and real estate consolidation will substantially go away, the incremental amount in 2017. Debt interest expense is up year-over-year from the $500 million offering last March to refinance the smaller, but more expensive 8.25% bonds we had outstanding.

Finally, after a strategic review, we decided to exit option wholesaling. In short, the economics no longer justified the resource commitment of this business. KCG will continue to make markets and options on some exchanges as well as route orders on an agency basis. However, we will wind down wholesaling activities over the next month and sell the associated assets. The decision is part of a more fundamental reengineering of operations, which I will discuss later in the call.

Now, I will hand it over to Steffen to go through the numbers in greater detail.

Steffen Parratt

Thank you, Daniel and good morning everyone. To recap the fourth quarter results, KCG generated a pre-tax loss from continuing operations of $7.1 million and a net loss of $4.6 million or $0.05 per diluted share on 89.2 million weighted average shares outstanding. Pre-tax results included gains of $19.8 million from the sales of investments and $17.4 million of asset write-downs primarily related to assets and businesses held for sale and $3.2 million of write-downs of investments. Putting the impact of these items, KCG’s non-GAAP pre-tax loss from continuing operations was $6.2 million, which roughly equates to a loss of $0.04 per diluted share in operating EPS.

Let’s turn to the segments beginning with market-making. This segment encompasses all direct-to-client and non-client exchange-based market-making across asset classes. During the fourth quarter, market-making generated revenues of $168.2 million and a pre-tax loss of $6.4 million. Negative results for the segment are attributable to the market conditions, macro events and competition. Excluding charges related to write-downs of $15.5 million, market-making generated non-GAAP pre-tax income of $9.1 million.

Among the primary drivers of KCG’s results in market-making, average daily consolidated U.S. equity dollar volume declined 5.5% from the third quarter, while average realized volatility for the S&P 500 decreased from 20.4% to 14.7% quarter-over-quarter. In addition, the retail U.S. equity market was weaker than perhaps indicated by the published direct score Rule 605 share volume.

Industry-wide gross retail dollar volume registered the lowest quarterly total since the second quarter of 2014. Competitive environment, which is centered on execution, quality and price improvement remain difficult. Average industry-wide spreads for retail SEC Rule 605 eligible shares traded tightened quarter-over-quarter. Further, the portfolio liquidations we witnessed late in the quarter affected our models and inventory stocks we used to make markets.

During the fourth quarter, KCG’s total U.S. equity market-making dollar volume traded was $1.8 trillion and revenues were approximately $139 million. The resulting metric for revenue capture per dollar value traded for the quarter was 0.77 basis points. In comparison, during the third quarter, KCG’s U.S. equity market-making dollar volume traded was $2 trillion and revenues were approximately $257 million, resulting in revenue capture of 1.27 basis points. Core market conditions in SEC and Asian equities further impacted results for the quarter. Daniel mentioned market volumes in U.S. Treasuries and related rates products were negatively affected by the delay in the interest rate hike. In Asia trading and markets and products correlated to China declined in some cases precipitously. Trading on FX reporting venues decreased 13% quarter-over-quarter and commodity prices continued to fall amid the weakening global economy. During the fourth quarter, revenues for market making activity outside U.S. equities were approximately $29 million. In comparison, third revenues were approximately $43 million.

Shifting over to the Global Execution Services segment, which comprises agency trading and venues, during the fourth quarter GES generated revenues of $70.2 million and a pre-tax loss of $1.1 million. Negative results for the segment is largely attributable to flat revenues quarter-over-quarter, a write-down of goodwill and increased professional fees. Excluding the write-down of $900,000, Global Execution Services generated a non-GAAP pre-tax loss of $200,000. On the agency trading side, KCG Electronic Trading which consists of algorithmic execution and order routing reported average daily U.S. equity share volume of $311.7 million in the fourth quarter, which represented approximately 4.4% of consolidated U.S. equity share volume. Part of a firm-wide focus on strategic clients, KCG Electronic Trading has been actively cultivating the leading U.S. asset managers. During the fourth quarter, KCG Electronic Trading increased its average daily U.S. equity share volume from the 25 largest U.S. asset managers, 37% year-over-year.

KCG sales trading teams in the U.S and London performed well, given the operating environment and the ETF trading team performed particularly well in garnering a series of large client trades and rebalances before year end. Please note that starting with the January 2016, trade volumes, which will be published on the 10th business day of February, we will reconfigure the trade volumes disclosed each month, to better reflect client trading activity of KCG Electronic Trading and sales trading. Presently we report average daily U.S. equity share volume from algorithmic execution and order routing which includes volumes from internal clients on KCG trading desk using the firm’s algorithms. Beginning in 2016, we will remove volumes generated from internal sources and add trade volumes from sales trading in single stocks and ETFs. KCG believes the reconfigured trade volumes will be a more accurate gauge of commission and fee generating activity. We will provide historical monthly volumes for comparison purposes.

Turning to the venues, KCG BondPoint set a new quarterly record for average daily par value traded of $150.7 million. The total represents a rise of 15.1% from the prior quarter. Result is attributable to greater volumes from strategic clients among the leading U.S. brokers and a slight rise industry wide in inter-dealer corporate bond transactions under 250 bonds quarter. KCG MatchIt recorded average daily U.S. equity share volume of $33.7 million in the fourth quarter, which accounted for approximately 2.8% of dark liquidity according to data from Rosenblatt. Bidding venues tracked by Rosenblatt accounted for approximately 16.4% of consolidated U.S. equity share volume in the fourth quarter.

Turning now to expenses, total expenses for the quarter were $269.8 million. Adjusted for the asset write-downs of $17.4 million, expenses for the quarter were $252.4 million. In terms of our primary expense, employee compensation and benefits declined to $67.8 million for the fourth quarter, as a result of lower revenues, lower discretionary bonus accruals and headcount. During the quarter, compensation was 43.4% of net revenues, up $156.3 million. As a reminder, we define net revenues as total revenues less execution and clearance fees, payments for order flow and collateralized financing interest as well as any one-time gains or losses. For the full year 2015, ratio of compensation to net revenues was 44.6% which hit management’s target. Running through a series – running through a few of the bigger movers quarter-to-quarter under expenses, depreciation and amortization rose $1.3 million from the third quarter, primarily due to CapEx and accelerated depreciation of older trading technologies. Professional fees rose $1.4 million for increased audit tax and legal fees. Other expenses declined $1.8 million due to a decrease in recruiting expenses and other expenses.

Among transaction based expenses, execution and clearance fees declined nearly $900,000. Payments for order flow decreased $2.7 million and collateralized financing interest rose just over $100,000. Transaction based expenses fluctuate with KCG trade volumes, fees paid to exchanges and ECMs, financing costs and other factors. Excluding transaction based expenses and non-operating charges disclosed in our Reg G table, consolidated expenses totaled $162.5 million. A brief reminder on depreciation as previously disclosed, we will continue to record added expenses of approximately $4.5 million to $5 million per quarter in 2016 due to the planned corporate relocation and real estate consolidation. In addition, we expect to incur added occupancy costs of approximately $2.5 million per quarter in 2016 for duplicative rents until the relocation is complete.

Turning to our balance sheet, at December 31, KCG had cash and cash equivalents of $581.3 million and debt of $495.6 million. In addition the firm had $24.7 million in assets of businesses held for sale which represents the fair value of certain non-core businesses we are seeking to divest or exit. At December 31, the firm’s debt to tangible equity ratio was 0.37 to 1. KCG had $1.4 billion in stockholders’ equity, a book value of $0.16 per share and a tangible book value of $14.89 per share based on 90.2 million shares outstanding including restricted stock units at the end of 2015. During the quarter KCG repurchased 2.3 million shares of Class A common stock for $29.4 million and 2.6 million warrants for $4.4 million. As of December 31, $23.9 million remained in the share repurchase program. KCG had $15 million in annual capacity at the start of 2016 under our debt covenant. However, based on the fourth quarter financial results KCG currently has no additional repurchase capacity beyond the $15 million.

Please note that share repurchases are subject to several factors including KCG’s financial condition, debt covenants, available liquidity in the stock, blackouts and so forth. As such, we can provide no insurance that any further repurchases will actually occur. Finally, headcount was 1,006 full-time employees as of December 31, compared to 1,033 employees as of September 30.

That concludes my report on the quarter. Now, I will turn it back over to Daniel.

Daniel Coleman

Thank you, Steffen. As I indicated on our last earnings call, we initiated more fundamental reengineering of our support functions and operations. The efforts are driven by I believe, that we must not simply integrate legacy systems and incrementally update them, rather we must evaluate our business. From the standpoint of a new entrant and understand where we can streamline, improve or outsource past processes to better position the firm for the future. The efforts will require significant attention from me, the management team and the organization in the coming year. To that end, we can talk to the strategic review of our businesses to evaluate where we are dedicating time and energy. The review resulted in the sales of investments, exit of option wholesaling and designation of certain other assets as held for sale.

As we redesign internal infrastructure, we are focusing on the businesses we believe to be not only core the firm, but scalable as well, businesses that are overly complex or they don’t lend themselves to expansion through technology are less attractive to the firm at this point. The priorities for KCG in the coming years – year are simple. Number one, we are looking to drive down our costs. Number two, we are looking to increase scale, so that we can grow revenues in ‘17 and ‘18 without growing fixed costs. And number three, when possible we are looking to continue to return capital to shareholders. While revenues are contingent to a certain extent on the operating environment, the management team set updated targets for expenses, things that we can control. For the full year of 2016, we expect the ratio of compensation to net revenues to fall to between 40% and 42%, fully anticipating the ratio in the first quarter will be higher than 42% due to 401(k) matches and taxes on the annual awards. We project non-transaction based non-compensation expenses to fall within the range of $355 million to $365 million, with approximately a $135 million allocated to communications in data processing.

And lastly, we estimate total non-transaction based expenses of approximately $700 million, which represents a 5% decrease from the full year of 2015. In the event, revenues are significantly higher. The target of course will be breached given that we manage compensation as a ratio of net revenues. This is a problem we all hope we have. The target for 2016 expenses, are part of a plan to attain a double-digit return on equity in 2017. To achieve this target, we need to grow annual net revenues by mid to low single-digits in 2016 and in 2017. We need to drive down total expenses by another 7% or so in 2017 aided by the drop-off in accelerated depreciation when the corporate relocation is complete at the end of 2016.

As this year, we are assuming a tax rate of 38%. We will continue to return capital to stockholders whenever possible, but we anticipate maintaining a book value of close to $1.5 billion. We will benefit from expenses set to fall away at the start of 2017 related to the corporate relocation, real estate consolidation and duplicative rents, which amounted to roughly $9 million in 2015 excluding the non-recurring Reg G items and are projected to reach up to $30 million in 2016.

As with any estimate target or plan, the actual results are subject to some measure to the operating environment. While we don’t forecast revenues, I think the projected growth is moderate, considering the organic opportunities at hand. And I think the target expense reductions are achievable given the potential to consolidate efficiencies from building new trading systems and reengineering in our processes and support functions. We spent the last 2.5 years building KCG. During this time, we have returned more than $470 million to shareholders. We have streamlined our businesses to focus solely on the buying and selling of liquid assets. And now we are at the point where we can see the end results of reengineering our businesses to make it cost-competitive and scalable.

As we work to get this result, we will continue to return capital to shareholders, increasing the upside leverage our shareholders will experience when our returns are in the double-digits. In the meantime, we appreciate your patience.

And now, Steffen and I would be glad to answer any questions you might have.

Question-and-Answer Session

Operator

Thank you. [Operator Instructions] And we will take our first question from Rich Repetto with Sandler O’Neill.

Rich Repetto

Yes, good morning Daniel. Good morning, Steffen. First, very interesting quarter and thank you for the expense guidance as well as the roadmap on the 10% ROE. Daniel, I guess my question is, if we – we have had a chance to run the numbers here and they would imply – if you have flat revenues in ‘16 and ‘17, upside to consensus estimates and if you executed on the expense guidance. But I guess my question is seeing where what happened in the revenue side on this quarter and I understand this is what you consider uncontrollable, but what assurances – and revenues were down 6% in 2015 – as you go through these expense reductions, how can we feel comfortable, our investors feel comfortable with the revenue picture, is stable and we are not going to see more declines, never mind the low single-digit increases that get you to the 10% ROE?

Daniel Coleman

Okay. Rich, that’s an important question obviously. In some ways, it’s difficult. But let me frame an answer that will revert back to and work with over the coming quarters. If we look at our businesses on a like-for-like basis, ‘16 to ‘15 – I mean ‘15 to ‘14 on a net revenue basis, so we take out Hotspot and take out the SCM our revenues were within 1% of being flat. And this is in an environment while we are not prepared to quantify the cost of price improvement, but it was very significant over a year. So, in fact in many parts of our businesses, we had an improved revenues year-over-year.

And we are not anticipating necessarily that this price improvement issue is going to abate. But we feel pretty confident that the work we have done over the past 2.5 years and there has been a lot going on in the past 2.5 years to get cost in line. The work we have done will lead to growth in various parts of our businesses. But the pros in the putting and I understand the question, but I do want to frame it that, it was a very difficult environment for one of our key businesses, wholesale market-making year-over-year that significantly hurt the revenues of that business. And that said we managed to stay as a firm in our like-for-like businesses flat year-over-year. So, that’s our starting position. We think that while we don’t anticipate the environment changing, we think a lot of investment in other businesses can help us grow organically our revenues and we are talking about – we are not talking about a huge amount in the low to mid single-digits.

Rich Repetto

Got it. The price improvement issue, I acknowledge that, you are right, that’s good to point out. So, the next question, Daniel is you shed some businesses, the small, I guess, investment in options, house and there is a potential monetization event in another investment you have. And I guess the question is what will you do, if you do – can monetize, how would you – a commitment, what would be the use of the cash, I guess, the liquidity? Okay. And then the other thing...

Daniel Coleman

Employing the best.

Rich Repetto

Yes, I am restrictive. So, I can’t mention anything.

Daniel Coleman

Oh, okay. I was just wondering that I get the question every quarter. We didn’t even have to name the exchange. I am sorry, Rich, what was the second half of the question?

Rich Repetto

Well, the use of the liquidity plus you also shutdown your options market-making, so is there any capital relief there as well?

Daniel Coleman

Right, okay. We will start with a potential monetization event in early Q2 for BATS, which is a holding of ours. And I will just point to a few things. One, our ability to use the proceeds after-tax proceeds of BATS are pretty much free and clear from our covenants of our debt, so that we are free to return that cash to shareholders in the most effective way possible and that’s our intent. We will see, where things are, their share price, but where it is here I would say, I would be pounding the table to do it via buyback, but we will just see what happens. I probably – I may not know as much as you do about a timing or a likelihood of an event in Q2, but everything I know is based on what has been published and basically as long as the markets are there, I anticipate an IPO sometime in Q2.

As far as options growth, it wasn’t a huge business. It does drip a little bit of capital. I wouldn’t say, it’s material enough to really talk about extensively. I would say this. Other than BATS and the proceeds we are receiving from the sale of Hotspot, which are both outside of our basket from a covenant point of view. If we do free up capital on our business, our ability to return that capital is limited by the covenants of our debt, which is limited to effectively 50% of our after-tax or earnings plus a $50 million adjustment every year and that’s approximately right, there is also some non-cash comp in there. But so, it’s not materials, but the best way to say it, if we do free up capital in lot of our businesses and we do feel like we don’t need it we would of course explore deploying it in ways, where it could benefit our shareholders. But even in that sense, we are limited by the covenants of our bonds.

Rich Repetto

Okay. Thank you for taking the questions and all the info. Thanks.

Daniel Coleman

Thank you, Rich.

Operator

We will take our next question from Ken Hill with Barclays.

Ken Hill

Hi, good morning everyone.

Daniel Coleman

Good morning, Ken.

Ken Hill

So, I had a question on the regulatory focus here. It seems like coming back in the news as it relates to the payment for order flow, ideas being tossed around about SEC looking at maybe prohibiting or passing some of the benefit on the customers or even enhancing some of the disclosures around. I was hoping you guys could comment on how you are seeing that discussion evolve and any input you might have to the SEC on it?

Daniel Coleman

Well, I think you are referring to the topics sent out by the SEC to their advisory group, which mentioned reviewing best execution and best execution for institutions and mentioned the conflicts payment for order flow. And as well, I would argue it should be focusing on the conflicts of access fees, because access – competitive access fees, there is a conflicts right there is exactly the same as payment for order flow. I think for us, I haven’t heard a lot on this issue frankly in the last few quarters. It is – it always comes up, because it’s a very transparent conflicts, they noted in that letter that you could have non-transparent conflicts replace it. I have always said in the past that a payment for order flow went away I don’t think we would have a material impact on our business and I don’t think it would be beneficial necessarily to us. I would say that you see the payment for order flow numbers in our quarterly statements. It is not a growing number. And when option business leaves, it will be even smaller. I think the fact is that price improvement is such a bigger factor to us and to the clients, the payment for order flow is just simply not the issue, it might have been 2 years or 3 years ago. But from my personal point of view, as far as conflicts in our industry, as obvious as this one can seem to be its not as big as many others. And I think the best way to deal with conflicts is through transparency to the end client and ensuring they get what they are bargaining for which is really good execution.

Ken Hill

Okay. Just, I wanted to follow-up on DMM business for you guys, I know some firms have exited it and I know there has been some headlines around you guys with some of your relationships changing over the course of the year, how are you guys thinking about that business longer term and maybe the strategic advantages it provides you guys?

Daniel Coleman

With all of our business we will review them, I think the DMM business is a business that’s provided value for us in the past. But the only thing I would say, it’s not a big business for us and with all of our businesses we have been reviewing them. The issue that you referred to before really doesn’t have an impact in any decisions we would have with the DMM, but as with every business we have conducted a review. So that’s what all I can say on that one.

Ken Hill

Great. Thanks for taking my questions.

Operator

And we will take our next question from Chris Allen with Evercore.

Chris Allen

Good morning, guys.

Daniel Coleman

Good morning, Chris.

Chris Allen

Dan, you noted the, I think its 16 December which sounds like it’s a very challenging stretch for you guys. Just wondering maybe if you could give us some color in terms of what maybe the capture rate would look like in U.S. market, if we shift those six days out?

Daniel Coleman

I don’t have it in hand and I would be hesitant to break that down. And I would say that the six days for the portfolios were tough, but they were tough, they weren’t great before that. I will frame it a little differently. October was fine, no issues. Towards the end of November, things got a little more difficult and then at the end of December they got quite difficult. But I actually don’t have the numbers Chris and I don’t think – I think it gives a little too much detail in the core parts of our business for non-investors, I would have to say.

Chris Allen

Sure. And then any color in terms of how the environment is in January so far. I mean we are seeing volumes up in equities, in rates, which should be a positive for you guys. I am just wondering if you are seeing some of your Asia-Pac businesses recover as well, any color there will be helpful.

Daniel Coleman

We don’t give forward-looking revenue numbers. I would just make couple of comments. The first couple of weeks, we saw more of what December was like and then it dissipated. So it feels like a more normal environment the last week-and-a-half of January and so the more normal metrics of volume and volatility seem to be holding true the last couple of weeks.

Chris Allen

Got it. And then just on your guidance for next year moving forward and on the competition side implies a decline in absolute – obviously be dependent on where the revenues kind of come in. Do you – I mean do you have to – do you foresee additional headcounts, you have been reducing FTEs over the course of ‘15 or is it just kind of you are there for the most part, obviously with the exception of exiting a couple of businesses, just wondering what further actions need to be taken on this front?

Daniel Coleman

I think there is going to be – we mentioned option business and obviously have assets held for sale, so there will be heads attached to that. But as we consolidate processes and technologies, there will be some headcount reduction. I wouldn’t expect a large reduction of force or anything like that, but I expect that most of what we are doing on the asset sales side should be done by the end of this quarter. And at the end of this quarter, we will have fewer heads at the end of this year than we did at the end of this quarter. And that is clearly one of the ways we are able to manage this compensation expense, not looking to pay our people less, but we will have fewer heads.

Chris Allen

Got it. I will get back into queue. Thanks.

Operator

We will take our next question from Ken Worthington with JPMorgan.

Ken Worthington

Hey, good morning.

Daniel Coleman

Good morning.

Ken Worthington

So can you talk a little bit about risk management and market-making and maybe how it’s evolving or you would like it to evolve? So maybe first given the weakness in 4Q either inside the U.S. or outside the U.S. could changes in risk management have helped the results during the quarter? And then as you think about maybe how to use risk management, is it possible that may be more aggressive usage of risk management could smooth revenues somewhat or would that just basically harm the business?

Daniel Coleman

I mean, it’s – I understand where you are coming from. I don’t think there is a risk management issue. I think that when you carry portfolios on behalf of clients, certain times those portfolios will have to by definition move against you. I do think there may be a diversification issue in our businesses. And I think it will be important to grow our businesses outside of U.S. equity market-making. And that should get us to point from a probabilistic point of view where we won’t have quarters quite as extreme as we have really in the last two. And I think that, that is what we are focused on, that’s a business planning, investment, management execution problem. And the reason why I don’t think there is risk management issues, we do review revenues relative to risk metrics, relative to all the things on a regular basis. And in addition, I don’t think it’s necessarily an issue with respect to our models and capabilities because on a pre-price improvement basis, our models are performing as we would expect. So we will have difficult environments from time-to-time. They are exacerbated by the fact that price improvement is significantly higher than it was a year, year-and-a-half ago and that just makes the volatility more pronounced. But if I understand your question and I think the best way to tackle it besides making more money is diversifying revenues and growing our agency execution business, so that we can have businesses that have a high mean but are volatile, but our shareholders don’t have to wear so much volatility.

Ken Worthington

Got it. Okay. And then I am sorry I think a couple other people have circled this and sorry, I apologize if it’s redundant. But 2017 anticipates some pretty decent cost cutting, how was the restructuring meant to drive down costs, likely to impact the revenue generation capabilities?

Daniel Coleman

We don’t anticipate it impacting. I mean we have a little bit of a tailwind with real estate in 2017. We have been working on consolidating or building new technologies and I think we will get some of the benefits of that in 2017. So I don’t think that we should expect any headwind due to our cost reduction efforts.

Ken Worthington

Okay, great. Thank you very much.

Daniel Coleman

Thank you.

Operator

And we will take our final question from Chris Harris with Wells Fargo.

Chris Harris

Thanks guys. Maybe we can start a little bit on some clarifying items, as it relates to the expense outlook. The $700 million you guys laid out for non-transaction based expenses, what expenses exactly are excluded from that number. I know obviously transaction expenses are, but is there any other expenses on your income statement that are excluded, I think collateralized financing costs might be, but I didn’t know, if there is anything in addition to that?

Daniel Coleman

From our point of view, we have run the business on a net revenue basis I think IFRS would account for that way. And so it would include the variable cost of transactions plus the cost of financing of our positions does not include the – we are not talking about the corporate bond, it’s just the costs of collateralized financing of our positions?

Chris Harris

Got it, okay. And then the 10% to 15% reduction, you guys are targeting for ‘17, is that from 2016 or is that from the 2015 level?

Daniel Coleman

I think that’s more from the 2015 level. I think what we – the best way to think about it and I said it in the talk today, it’s more like a 7% to 8% decrease from the $700 million to what we expect in 2017.

Chris Harris

Okay, alright. That makes some sense. Then just to think about these costs more holistically. I am just wondering, I know you do have some costs that are rolling out of that business in ‘16 related to real estate and so on. But why does it take such a long time to get the other costs out, we are looking at over a year, is it mostly due to the fact that a lot of this is related to systems and tech, it just takes a lot to get through all of that or is there something else related to these expense initiatives?

Daniel Coleman

Let’s put in perspective. Our real estate costs went up $9 million in 2015 and arguably another $21 million incremental in 2016ish round there. And yet, we are taking our costs down in 2016 by 5% from 2015. So I think, we are taking quite a bit of costs out in lots of different ways, it’s just its offset by the real estate and then we will benefit in 2017. So I think those – that’s optically that may help explain it. Other costs are incremental from building out new systems, new processes that takes a long, long time. But I think we have done a lot on the cost front since this merger and we will continue to focus on it. And I think you will see it come to fruition next year.

Chris Harris

Okay, great. And then maybe a quick question on the performance in the quarter. I think one of the things you guys had mentioned was problematic was that the environment got a little bit more competitive. And I didn’t know if you had any color as to why that might have been the case in the fourth quarter and then whether or not that may or may not persist in 2016?

Daniel Coleman

Let me be clear. I think third quarter is quite competitive. It was just quite an extraordinary environment that it didn’t really show through in our numbers. I think Q3 and Q4 were more competitive than previous quarters. It’s hard to predict why it’s happening from an environmental point of view. One thing going back to previous question, when we look at building our business in the future, we have to acknowledge that the difficulties and complexities of this environment and we have to look at also at diversifying wave from environment that arguably is becoming more volatile because of price improvement is such a big portion of a contra revenue effect or such a big impact on our business. So the environment in Q3 and Q4 were tough for them, previously I don’t see it letting up at this point. I think this is an important business to us. It’s important, we have an important client base here, but at the same time I expect this business to be a lower percentage of our revenues this year compared to last year and in ‘17 versus ‘16.

Chris Harris

Okay, thank you.

Daniel Coleman

Thank you.

Operator

And that will conclude our question and answer session. Ladies and gentlemen that does conclude today’s conference. Thank you for your participation.

Daniel Coleman

Thank you.

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