Live Oak Bancshares Inc

NYSE:LOB

Earnings Call Transcript 2021-Q4

[Greg Seward, Executive Vice President and General Counsel]

Thank you, and good morning, everyone. Welcome to Live Oak's Fourth Quarter 2021 Earnings Conference Call. We are webcasting live over the Internet, and this call is being recorded. To access the call over the Internet and review the presentation materials and commentary that we will reference on the call, please visit our website at investor.liveoakbank.com and go to today's call on our event calendar for supporting materials. Our fourth quarter earnings release is also available on our website.

Before we get started, I would like to caution you that we may make forward-looking statements during today's call that are subject to risks and uncertainties. Factors that may cause actual results to differ materially from our expectations are detailed in the materials accompanying this call and in our SEC filings.

We do not undertake to update the forward-looking statements to reflect the impact of circumstances or events that may arise after the date of today's call. Information about any non-GAAP financial measures referenced including a reconciliation of those measures to GAAP measures can also be found in our SEC filings and in the presentation materials and commentary.

I will now turn the call over to Chip Mahan, our Chairman and Chief Executive Officer.

[Chip Mahan, Chairman and Chief Executive Officer]

Thanks, Greg, and good morning to all who have joined to review our performance for 2021. I am speaking to you by recording is cell coverage in my current location is a bit spotty. I will kick things off with a few brief overarching comments on the state of our business with a peak into the future and then turn things over to BJ and Huntley to describe our best quarter and best year since inception. We're going to talk a lot about growth today, both in the past and in the future.

That said, we never strayed from our guiding principles of soundness, profitability and growth in that order. We're beginning to see a few things. Our government-guaranteed lending platform is scalable. We have grown from lending money to veterinarians, one industry, one vertical and now it's 35. We've accomplished this, credit quality for these small businesses with very little or no capital is unprecedented.

Total nonaccrual loans in this bank today are $23 million or 67 bps on a total unguaranteed portfolio at year-end of $3.5 billion. $15 million of our nonaccruals are continuing to pay as agreed. This is remarkable in this segment. It has taken us 14 years to prove it.

And more recently, over the last few years, we've expanded beyond our theory of verticality. Our general lending group has grown from eight highly skilled Wells Fargo lenders to twenty-two, adding similar quality individuals from other banks.

So, where does that leave us on the loan side of the balance sheet in terms of the future SBA opportunity? In the last 24 months, 1,800 banks have made an SBA loan. My guess is that there are at least 4,000 SBA lenders trained with primarily two skills. One, is it a good loan? Does my bank want to lend money to a small business operator that has no capital? The SBA prefers that their banks prove that the borrower cannot find credit elsewhere. Secondly, does the loan meet the highly technical and stringent requirements of the SBA's 500-page standard operating procedure book?

My guess is that 100% of the 4,000 lenders in this country have heard of Live Oak Bank. My secondary guess is that their view of us, in all likelihood, is favorable. Given that we're going to launch a new business unit to determine who are the best and the brightest of this lot. And yes, we will be searching for the appropriate support staff of underwriters, closers and services. This group will also support growth in our conventional specialty lending group that has grown nicely following our customers' upmarket.

You got to spend money to make money. We've proven we can do that over the last 14 years and more recently with our general lending expansion. And we're going to do a lot more of it. But is it worth it? Here's how we look at it. Assume a lender can produce $30 million of loans a year. In five years, that lender's portfolio has grown to $150 million, expected payoffs begin in six years, let's assume the portfolio levels out of the 150, times a 4% net interest margin yields pretax pre-provision earnings of $6 million. This is a highly liquid, highly profitable book of business supported by a staff of only five Live Oakers.

Now on to Phase 2. What about deposits? Here's the way we're thinking about the future of the liability side of the balance sheet. Huntley and Renato will tell you where we are on completing the cycle of the total Finxact conversion. That is door number one and essential to create the product factory that we have discussed before. Door number two is to build out a bespoke bank for each of our deposit-heavy verticals. Door number three is our developer portal, which will make banking as a service, the easiest to use in the industry today.

So yes, creating noninterest-bearing deposits at scale is just around the corner. But what does it mean? Here's what I think. Take First Republic Bank, Jim Herbert has created an organic growth machine by creating unmatched service to the right customer. Those customers grow on their own and then refer like-kind friends, which enhances that growth. Only a small percentage of FRC's growth comes from strangers. As Jim says, “Spend more money on service, not advertising.” All of that for his bank translates into the NPS score of 73. Our overall lending NPS score is 67. Our overall deposit score is 42, the combined is 47.

So, what's going on here? Our loan repeat customers are 20%. But why? We're an SBA lender. The agency's proclaimed lender of last resort. Our borrowers want to graduate. We're building more that they can graduate to. FRC surrounds you with service from day one. Most interaction is on the deposit side: wires, overdrafts, notary work, et cetera, et cetera.

Imagine opportunities to excel where Renato fully digitizes our customers' experience by tying together bank stuff like loans, access to the payment system, plus elegantly interfacing with practice management software, plus budgeting and forecasting, plus tax prep, plus payroll, et cetera, et cetera. So many touch points, so much stickiness.

And remember, a recent McKinsey study reminds us the loan-to-deposit ratio of small businesses with revenues under $5 million is 20%. That's right. Deposits are 5x what they borrow. Our industry has done a terrible job of taking care of these businesses. We have the capital and the earnings power to finish our mission and build this new platform to enhance the performance of small business America. BJ and Huntley will provide details on our financial performance for last year and how we're going to get there.

BJ, over to you first.

[William Losch, Chief Financial Officer]

Excellent. Thanks Chip. Good morning, everybody. As Chip said, we finished 2021 on quite a high note, building on the significant momentum we've seen really over the last two years in production, profitability growth and talent acquisition. Our quest to be America's small business bank continues and 2021 was a year that saw significant milestones towards that goal. 2022 will be more of the same.

The unique power of our core lending model dedicated to small business creates significant revenue that allows us to both deliver meaningful current earnings and growth while also aggressively investing for the future.

As you can see, starting on Slide 5, 2021 earnings per share were $3.71. We generated 75% growth year-over-year in adjusted PPNR, driven by 37% revenue growth and 19% expense growth. The revenue growth was driven by outstanding loan production of $3.9 billion, up 46% from the prior year. Even with selling about 35% of our guaranteed loan volume, we still generated 32% loan growth on the balance sheet.

This outstanding core business performance, coupled primarily with the benefit of a $44 million gain on one of our ventures investments, resulted in 23% growth in tangible book value per share; excellent value creation.

We delivered key accomplishments across the three dimensions of our business, verticality, scalability and optionality. First, in our core lending model focused on small businesses, founded and built on the theory of verticality and knowing your customers and their businesses deeply, we saw high-quality, profitable, balanced and sustainable loan growth across our small business, specialty finance and energy and infrastructure groups.

Second, we continue to scale our capabilities, talent, product and technology-wise, which will enable further growth, deepen customer relationships, increase retention and provide both a high-touch and a high-tech experience for our customers all on a next-generation technology platform.

Thirdly, we're uniquely positioned to thrive in the future banking landscape. We've proven capabilities a focus on innovation and strategic investments in financial technology that we use for both improvement in customer experience and as a source of growth capital.

Turning to Slide 7. Let's take a look at some highlights from the fourth quarter. Reported EPS was $0.66 in the quarter on 11% growth in pretax income and 8% growth in adjusted PPNR. You may have noted that both net income and EPS for the quarter were impacted by a much higher-than-normal effective tax rate of 37% versus a full year effective tax rate of 21%.

This was roughly a $0.06 impact to EPS in Q4. Investment tax credits associated with renewable energy investments that were anticipated to close in 2021 and reflected in our tax rates reported in the first three quarters were delayed by supply chain issues related to the pandemic.

Therefore, the Q4 effective tax rate was adjusted for this full year impact. These credits are expected to close in the first half of 2022. A few quick highlights on the fourth quarter. Strong pretax earnings and PPNR growth continue to be driven by outstanding loan production and balance sheet growth. We experienced our third consecutive $1 billion loan origination quarter, resulting in 7% loan growth, excluding PPP.

Credit quality continues to be very healthy with virtually no net charge-offs in the quarter and a reduction in nonaccruals. We continue to attract talent, particularly in our lending and technology groups. We introduced our operating account called Title and made loan servicing enhancements that continue to improve our customer experience, all moving us towards our goal of building the community bank of the future.

And Live Oak Ventures made one investment during the quarter. The Fintech space remains very active overall, and we see a lot of exciting innovation occurring across the Fintech landscape, both Huntley and Neil will give you a lot more color on these last two topics in a moment.

Turning to Slide 8, you’ll see more detail on our adjusted earnings highlights. Adjusted PPNR growth of 8% linked quarter was made up of both revenue and expense growth of 8%. The net interest margin expanded nicely again up 8 basis points linked quarter to 3.83%. And due to the strong positive operating leverage in the business, we again saw a decline in the adjusted efficiency ratio, which has declined 700 basis points since 4Q 2020.

Diving a bit deeper into the revenue drivers on Slide 9, you see the total revenue growth of 8% linked quarter and 40% year-over-year was driven by the strong loan growth and resulting net interest income, which was up 7% linked quarter and 50% year-over-year. On the fee income side, we continue to see healthy sale premiums on our guaranteed loan sales with the average net gain in the fourth quarter of 110%.

Turning to expenses on Slide 10. As we discussed on the Q3 call, we anticipated having a strong hiring quarter, and we did. We added 39 net new Live Oakers, which was the driver of our expense growth in the quarter. And over the course of 2021, we on-boarded 164 net new people, growing our employee base by 26%. Importantly, over 80% of those new hires were revenue generating lender or lender support personnel.

Turning to the balance sheet and returns on Slide 11. Both linked quarter and year-over-year loan growth and deposit growth were excellent. Loan growth excluding PPP was up 7% and 32% linked quarter and prior year quarter respectively. That strong loan growth was driven by our third consecutive quarter of greater than $1 billion in originations across our lending platform, well balanced among SBA and conventional products as you can see on Slide 12.

And on Slide 13, you can see that the strong originations with 54% of that volume fully funded in the quarter more than offset prepayments and continued PPP runoff, resulting in that 7% net loan growth before loan sales. Our efficient deposit platform continues to provide fuel for our loan growth with both strong retention and new balance growth, as you can see on Slide 14. The introduction of our new business checking account will positively impact our funding mix overtime as well.

This strong loan and deposit growth has been achieved with well-disciplined pricing. Average core loan yields have remained stable. Deposit costs declined nicely over the course of 2021, leading to that strong net interest margin expansion of 50 basis points to 3.83% and almost 70 basis points on a reported basis to just over 4%.

Turning to credit on Slide 16. Our long-standing practice of frequent contact with existing customers and prudent underwriting remains a top priority. You see that our non-accruals declined past dues remain very low and we had virtually zero net charge-offs in the fourth quarter.

On Slide 17, you see in the upper right, our capital ratios remain very strong. Note the green 22% bubble we call out on the graph, which is the capital plus reserve coverage of the unguaranteed portion of our loan portfolio, which is almost 2 times higher than most other banks. This plus the $2.9 billion of highly liquid guaranteed loans on our books, give us of comfort and balance sheet flexibility.

Wrapping up on Slide 18 with a look at our performance versus industry peers, as Chip said earlier, soundness, profitability and growth in that order is what we strive for, and we’re hitting on all cylinders.

With that, I’ll turn it over to Huntley and Neil to give you a little bit more color. Huntley?

[Huntley Garriott, President]

Thanks, BJ. As Chip and BJ mentioned our 2021 performance, it really was a phenomenal year, and we think it sets us up incredibly well the future. Core revenue growth of 37%, expense growth of 20% drove 75% increase in PPNR. It’s pretty amazing operating leverage. Let me spend a few minutes talking about the strength of our lending franchise and then about our technology platform and how we think all that fits together.

So, if you look at our lending franchise on Page 21, small business lending continues to be the major driver of growth and profitability for us and that success has allowed us, as BJ mentioned, to invest heavily into developing our next-generation technology platform. From our roots as an SBA 7(a) lender across just a handful of industry verticals, we’ve diversified into over 35 verticals that you can see on the left-hand side across three distinct business segments: small business, specialty finance and energy and infrastructure.

On the right-hand side of the page, you can see that over half of our origination volume in 2021 still comes from that traditional SBA customers. But increasingly, we’re serving a broader mix of customers with a broader suite of lending products. As we’ve grown as a company, we’ve also grown with our customers, increasingly following them up market and into covering the institutional capital providers that serve them.

In our specialty finance division, we serve businesses primarily in the $2 million to $10 million EBITDA range, and we continue to see significant capital flows and great financing opportunities there, whether it be from founder-owned companies, small institutional sponsors, search funds or self-funded acquisitions. Our work with DSOs, the consolidators in the dental space is a perfect example of how we’ve grown in the industry, and we plan to expand that model into other sectors like veterinarians and medical.

Specialty finance accounted for almost 30% of our loan origination in 2021, and we expect it to be an important driver of our balance sheet going forward. One of the most significant tailwinds in our lending across small business and specialty finance has been the amount of business acquisitions that we’re seeing in the market.

These transactions account for a little under half of our overall volume, and we believe the macro trends will continue as baby boomers look to continue this trend of transitioning ownership. Our third lending division is the renewable energy and the infrastructure space, where we’re really proud not only of the impact we’re having on carbon reduction, but also our position in the industry, and we’re really excited about the future growth potential.

Investment capital continues to flow into the renewable space with private equity and venture capital in renewable energy and clean tech hitting another record in 2021. The legislative environment remains accommodative, both at the federal and the state level, and we see the potential for meaningful increase in investments if the BBB Bill passes.

We also have a dedicated team serving rural markets and helping to support the infrastructure and businesses there. Our sweet spot in this space remains the USDA lending, but we’re increasingly spending time across a broader range of customers and technologies with a broader suite of lending products.

At just 15% of our total origination, we believe there’s meaningful opportunity for us to grow in this business. Our overall growth prospects across all of our lending platforms come down to three elements. One, as Chip mentioned, finding the top talent to join us. Two, is providing them with the best platform and that’s culture, benefit, technology, support. And then three is continuing to enter into new verticals and markets where we see opportunity.

Despite our lending success, we recognize that we still have areas to improve. Our focus has and always will be on credit quality, which remains really solid, but we’re also laser-focused on improving our customer experience, which primarily means getting faster. Lending volume this past year was significantly greater than we anticipated.

You all may recall at the start of last year, we expected a little over $3 billion in origination volume when we ended the year just shy of $4 billion. That’s definitely a high-class problem, but we got behind in our support infrastructure, and we had to lean hard into hiring folks to catch up.

We now have that infrastructure in place and our growth will be more proportionate as we go forward. In 2022, we’ll continue to focus on tracking talent, but we’ll also focus on reengineering our lending technology and our processes as we roll out a new on-boarding experience for loan customers and improve our document and data management capabilities.

We’ll be leveraging the latest generation of nCino for that loan origination work, and we’re also working to unify our customer experience across all our products and channels, which will ultimately set the stage, as Chip mentioned, to convert our loan customers to the Finxact Core.

Turning to our technology platform. This past year was truly a remarkable one for us as it relates to the build-out of our capabilities. After years of hard work, we successfully completed our deposit conversion onto our next-gen core and launched our small business checking account just 10 weeks after the deposit conversion.

It’s a pretty remarkable feat and something that I think will be virtually impossible on a legacy core. And this foundation has set the stage for our entire technology road map where we will add features, design products and integrate offerings at a pace that’s far superior to what we could do on legacy platforms.

Importantly, as we head into this year, we’re focused on enhancing loan origination processes, adding more features to small business, checking and launching a score-based small balance lending product. BJ talked about the investments we’ve made primarily in hiring and that will continue. It will continue to be predominantly tied to revenue, including additional talent and lending areas, building out some new deposit verticals and technology talent.

On the technology side, we’ve kept our team lean by design, leveraging our ecosystem partners like Finxact and Apiture as much as possible. With our core live now, we’ve reached the stage where we can further build out our own team focusing not only on enhancing our customer experience, but importantly, on delivering technology designed to drive revenue.

For example, building out API-as-a-Service capabilities along the lines of what Plaid and Stripe have done, but specifically for small business banking. We’re expanding to seven Sprint teams across lending, deposits, infrastructure and data that will roughly double the size of our development team and dramatically accelerate the pace of our innovation.

Two of these squads will be 100% focused on improving our existing efficiency and velocity of our core business and the rest designed to build out the net new opportunities. As you all have heard by now, we launched our small business checking account product title that complements our business savings and CDs.

One of the key features of this digital on-boarding for small businesses has a loan driven our business savings and CD balances to over $1.3 billion in just over a year. And in the last month of our launch, we put on about 100 small business checking accounts without any marketing.

Page 23 lays out the features that we believe small businesses are looking for as it relates to banking. What we’ve witnessed in the market is the creation of some really innovative products around some of these, primarily coming out of the Fintech space like merchant POS, invoicing, expense management, et cetera. And all of these products have a really important role and they’re helping small businesses, but very few of them are able to integrate and centralize these products together to make life easy for the small business owner.

Our product today out of the gate is basic by design and serves the needs of our smallest businesses. But our road map is clear, and with the ability to build or buy each of these point solutions will quickly and methodically enhance the functionality to better serve a broad range of small businesses. Upcoming releases will include QuickBooks integration, merchant capabilities and working capital product. Perhaps the most important piece of this roadmap is our small balance working capital product, which sits at the top of almost all of our small business customers wish list when we ask them what they need?

The industry overall has struggled to make quick credit decisions for small businesses and efficiently fund these loans. When we roll out this product in the middle of the year, you’ll see the tangible benefits of our new platform: Seamless customer experience, limited data entry and integrated product offering and lightning-fast delivery. We think all of these products and services come together to deliver what we call the community bank of the future. And what do we mean by that? We think community banks have and will continue to play a vital role, especially supporting small businesses by combining local knowledge and personalized service.

Where many community banks have struggled is in delivering a world-class digital experience. We think increasingly communities are defined not by geography but by shared interest, like veterinarians. On the next-generation technology stack, we’ll create bespoke banks for each of these industry verticals as well as new verticals. And it’s called these community banks, each one dedicated to serve a specific constituency with specific products and integrations. And like LEGO blocks, we will add and remove these products to create a tailored experience for these customers.

The banking features and insights required to run a dental practice are very different than those required to run a restaurant. And our ability to customize that is at the core of why we built this new technology stack. Our deep domain expertise in these areas, coupled with this flexible technology, will allow us to deliver these bespoke community banks quickly and cost effectively.

A key element of delivering this community bank is our ability to embed our bank and partners that serve these small businesses. In many industries, small businesses rely heavily on practice management software for appointments, billing, inventory. With an API-enabled banking solution, we’ll integrate banking products directly into the software and partners that our customers use, improving their experience, leveraging rich data sets to inform credit decisions and provide targeted insights to customers as well as driving low-cost customer acquisition.

If each industry vertical is its own community bank, then each partnership with a practice management software or application could be considered a branch in this digital community bank. This embedded banking opportunity, as we call it, is a critical component to our strategy to become America’s small business bank, and we’re really excited to see it come to life. The strength of our core lending business continues to provide us the opportunity to invest in what we believe is the future of the industry and our company.

This final slide we think of as the flywheel is central to the success of Live Oak. At its core, it’s all about the people: attracting, retaining, developing and engaging them. That’s mission one. Then all we ask is that they take care of their customers. To do that, we build the proper technology infrastructure, we deliver products and services and we have deep domain expertise to serve our customers, all designed to truly help them. The customer then gets the best of both worlds, the high tech and the high touch.

With that, I’ll turn it over to Neil to talk about the investing side of the business, which continues to be a meaningful driver of our strategy.

[Neil Underwood, President]

Thank you, Huntley. So, moving on to Slide 31. I really like this slide because it talks to the evolution of Fintech investing in Live Oak Bank. After nCino’s success, we formed Live Oak Ventures, and the goal is to directly invest in best-in-class apps for our customers and employees. You’ve seen some of those in the slides previously.

It’s important to note that Live Oak Ventures continues to flourish as we see directing investing as a core strategy of the bank. A great example of that, by the way, is our latest investment in an early-stage company by the name of Able.ai. And these guys are great. There’s 10, 10x Stanford engineers implementing real AI around document ingestion and classification across the entire lending continuum. This solution will arm our lending team with yet another weapon to speed up the lending process.

Moving to the right. You guys know about Canapi Fund I, we launched it three years ago, $650 million, have been super active, I mean, actually to the point where we’re now coming to a close as we’ve invested the lion’s share of the capital in the companies you see here. And the thesis is working. We’re winning the lead against the blue chips in New York and Silicon Valley. We’re getting greater allocation, better economics. And we’re sitting on boards and really, we’re right in the middle of all the information flow, which is super important.

We’re excited to announce the launch of Canapi Fund II. We are targeting $750 million. We are receiving very positive feedback and responses from our current bank LPs. We expect the first close actually in March. And like Fund 1, the bank will share in the 2 and 20 economics.

Moving on to the next slide. Nothing really new to see here, just a few minor adjustments to the positive. The important thing is we’ll continue to track this and the Live Oak Ventures portfolio broken down by the original cash investment carry value and applied value. And the next slide, again, is just to emphasize that Live Oak Ventures will continue to remain very active in direct investing with dedicated resources at the bank and that will be comprised of obviously follow-ons to support the existing portfolio companies and then net new investments categorized as follows: one, that help the bank, like bank infrastructure, Able is actually a great example of this.

Second category, those that help our SMB customers. So, Huntley briefly mentioned investing or practice management software to support embedded banking. That’s going to be really important. We think there will be investment opportunities there as well. And then lastly, across the spectrum incubation where we will continue to create net new companies, pre-product, pre-revenue. And we’ll continue to update you on these as the time as they roll out.

So, BJ, back to you.

[William Losch, Chief Financial Officer]

All right. Thanks, Neil, Huntley, and I think we can open it up for questions.

[Operator]

[Operator Instructions] Our first question comes from Jennifer Demba with Truist Securities.

[Jennifer Demba, Truist Securities]

Thank you. Good morning. So, with the hires you’ve made over the last several months and the ones you intend to make in 2022, what kind of loan origination outlook does the company have over the next few quarters?

[William Losch, Chief Financial Officer]

Hey Jennifer, it’s BJ. I’ll start and Huntley can certainly jump in. But we finished the year quite strong, and we’re very pleased with that, and we’re very optimistic about the outlook as well. The pipelines that we see are still quite strong. The new lenders that we hired last year had a partial positive impact, and they’re going to have even more of an impact on a full year in 2022, and we’ll be continuing to add incremental net new lenders in 2022 as well.

So, of 3.9 was a good year. We certainly see origination volume over 4 for 2022 and with the incremental new hires that we have, plus the momentum that we see in the business, we continue to think that, that could even move higher that could also certainly helps. That’s still moving through the process in D.C., of course. We don’t assume that we’re going to get continued enhancements there, but that would be gravy on top of what we currently see as very positive outlook. Huntley?

[Huntley Garriott, President]

Well said.

[Jennifer Demba, Truist Securities]

Thanks, BJ. What kind of hiring plans you have budgeted for this year versus what was the 164 new hires last year?

[Huntley Garriott, President]

Yes. I think you should expect probably a similar pace of that. And I think it is, like we said, the majority of that will be revenue producing on the lending side. We talked about the technology side, so probably a quarter of that will be in the technology side and then a bit scattered around that. But pretty similar, I think, net numbers.

[Jennifer Demba, Truist Securities]

Okay. And just one more question for you, BJ. With higher Fed funds likely over the next several quarters, what do you think that does to the net interest margin outlook for Live Oak’s, given your deposit mix now and how it may be changing over the next couple of years?

[William Losch, Chief Financial Officer]

Sure. Yes. So, Jennifer, we put a few characteristics on our margin page, just too kind of outline some of the dynamics that we’ll see. But if we start Q4 2021 with a 402 [ph] margin reported in 383 on an adjusted basis. We see over the course of 2022 that those should converge more towards the adjusted NIM number by the end of the year. So, we still see very, very healthy net interest margins. But as rates start to increase, particularly in the back half of the year, we would see that conversion happening accordingly.

[Jennifer Demba, Truist Securities]

Okay. Thanks so much.

[William Losch, Chief Financial Officer]

Sure.

[Operator]

Our next question comes from Steven Alexopoulos from JPMorgan.

[Steven Alexopoulos, JPMorgan]

Good morning, everyone.

[Neil Underwood, President]

Hey, Steve.

[Huntley Garriott, President]

Hey, Steve.

[Steven Alexopoulos, JPMorgan]

I wanted to first follow-up on Chip’s comments that you need to spend money to make money. So, expenses were up almost 20% in 2021. What’s the outlook for 2022?

[William Losch, Chief Financial Officer]

Yes, I’ll start and Huntley can certainly jump in. First, I think it’s really important to say that we fully expect to grow revenues much faster than expenses. And as I said at the beginning, we are very fortunate here to have the core business lending model as a significant revenue growth engine that allows us to invest in new lenders, new technology that’s going to propel us into the future.

So positive operating leverage should definitely continue. With that, though, on the expense side, what I would say is, we saw a 26% growth in headcount over the course of 2021. If you annualize that for a salary and benefits impact, that’s probably a good proxy for salary and benefit increases from 2021 to 2022, plus a little bit more for partial year incremental hires that Huntley talked about.

We’ll have those investment tax credits that flow through the expense line, but that have a benefit on the tax line that will come through, as I talked about in the first half of 2022. And then pretty much all the other line items generally speaking, should grow with inflation. So that gives you, I think, hopefully, Steve, a pretty good amount of color on how to think about the expense growth for next year.

[Steven Alexopoulos, JPMorgan]

Okay, BJ. So said another way, it sounds like it's a similar outlook for 2022 than what we saw in 2021? Is that...

[Chip Mahan, Chairman and Chief Executive Officer]

Steve, can you hear me? This is Chip. Sorry, guys. Can you hear me loud and clear, Huntley?

[Huntley Garriott, President]

Yes, sir.

[Chip Mahan, Chairman and Chief Executive Officer]

Yes. So, I'll end up screwing up BJ's comments, probably. So, here's an example, right? The M&A in this business is the gift that keeps on giving, right? So, the old Compass Bank became BBVA, was purchased by PNC. We did a bit of a lift out down there. And now I think we have 12, 14 folks lenders, closures, underwriters. And as all that continues across the country, just who knows. I mean we now have a group that is totally dedicated to recruiting. And if we can replicate that and soon to be 100 cities in the United States over the next three to five years of the best and the brightest SBA lenders, as I alluded to in my opening comments, we're going to do that.

We're going to find the best and brightest. And how you budget that? I mean as articulate as BJ was, if we did another lift out of 15 or 20 new folks, I mean you're going to put expenses in front of revenues for a re-bid.

[Steven Alexopoulos, JPMorgan]

Okay. So, you'll clearly remain opportunistic. But from a core basis Chip, we don't know what's going to happen on the hiring side. It sounds like a fairly similar setup, but it could be a little higher if more revenue opportunities present themselves. Okay.

[William Losch, Chief Financial Officer]

I think that's fair, Steve.

[Steven Alexopoulos, JPMorgan]

I think I got it. Okay. BJ, I want to understand your commentary around the margin. So, if the forward curve plays out so we see for hikes, in terms of the core net margin or ex-PPP fees, it sounds like you're expecting the core margin to lift. Is that correct?

[William Losch, Chief Financial Officer]

Yes. I think, again, we start the core margin at 3.83%, right, and the reported NIM at 4.02% and so I say converging down to the 3.83%. Yes, I think we see the adjusted margin as being fairly stable. We've just under 50% of our portfolio is variable. We do think that the first handful of moves will – a lot of the deposit lag will occur. So again, by the end of the year, maybe it's converging, but we still see the adjusted NIM staying pretty stable throughout the course of the year.

[Steven Alexopoulos, JPMorgan]

Okay. That's helpful. And then finally, I appreciate the optimism that originations can stay above $4 billion in 2022. Should we think about – if that plays out, should we think loan sales stay pretty consistent around this $200 million per quarter range? And what's the outlook for gain on sale margin for 2022? Thanks.

[William Losch, Chief Financial Officer]

Yes. So, we generally target about 35% of eligible SBA volume that's generated in any given year to be sold and that's exactly what we did in 2021. So, it might fluctuate every quarter based on the opportunities that we see. But generally, we think 35% of SBA and about 100% of the U.S. DA volume.

So, we'll keep that as a consistent framework. But as production is growing, that also means that eligible sales are growing as well. And so, we do think that gain on sale, dollar amounts will be growing through 2022 at a pretty healthy clip.

[Huntley Garriott, President]

Yes. And the other thing I'd add to that is we've had a fair amount of construction projects that we've entered into over the last couple of years. The USDA projects largely and then some across our SBA. As those projects finish, they then become eligible for sale. So just the amount of production we've had in the last couple of years, you'll see a bit higher eligibility coming from prior production until that I think will flow through.

[William Losch, Chief Financial Officer]

Yes, and that's a great point. And in terms of premiums, to Huntley's point, SBA will be average net premium is around maybe 109% or 110%. The USDA is usually in the 115% range or so. So again, I think we see pretty healthy premiums going into next year, maybe a bit of a modest decline, but higher eligibility for sale, maybe a little bit more mix towards USDA, which has generally higher premiums, and therefore, the dollar amount of gain on sale seeing a pretty continuous increase.

[Steven Alexopoulos, JPMorgan]

Perfect, thanks for the color.

[William Losch, Chief Financial Officer]

Sure, thanks Steve.

[Operator]

Our next question comes from Michael Perito with KBW.

[Michael Perito, KBW]

Hey good morning. Thanks for taking my questions. I wanted to just spend another second on the topic we just – you guys were just discussing. So, I mean, just to summarize, make sure I kind of capturing it accurately. I mean it sounds like the originations you guys are – the pipeline suggests that you guys are comfortable – are hopeful that you can do another $4 billion plus a year, but I guess, just is it fair to assume that the trends in the back half of this year with the conventional lending group being a larger percentage of that, that will continue, I imagine, and make up for maybe some loss just general volume, obviously, I know you guys expect to gain market share, but just general volume if the SBA 7(a) approved fundings come down a bit from a very elevated 2021? Is that generally a fair way to summarize the set up?

[Huntley Garriott, President]

Yes, Michael, I think that’s right. I think we continue to see a lot of opportunity on the SBA side. And even if the market is down a bit, where we play in primarily business acquisitions and expansions, we continue to see real momentum in that space. So, we think a little bit were less, maybe less volatile to the total SBA market and think we’ll continue to drive that. But I think the mix should be probably about consistent across the product set as we look into this year.

[Michael Perito, KBW]

Okay. And when you guys say that the – you guys have hope to kind of see continued growth in the gain on sale for next year, is that – I guess, can you compartmentalize that a bit more for me? Is that year-on-year or is that based off the run rate you guys had at the back half of the year, which seemed a little higher than what was normal or any more color you can provide there?

[William Losch, Chief Financial Officer]

Yes. I think Steve or excuse me, Mike, if you look at Q3 to Q4, we sold about the same amount of guaranteed loans, but we had maybe $1.5 million more in gain, and that’s simply related to the mix of what we sold. I think we sold about 60% in the quarter that was variable versus 40% fixed or fixed adjusting and the SBA versus USDA is going to make a difference.

But overall, I think growing – if you take Q4 and then just look forward, we do think that there is incremental growth quarter-over-quarter in 2022 from an aggregate gain on sale perspective because of what Huntley and I just talked about, continuing to grow the SBA-eligible sales, number one; and number two, more volume of USDA product that will be coming on eligible for sale at higher premiums.

[Michael Perito, KBW]

And on that last point, so I mean if we look back kind of pre-pandemic, I mean, you guys – I think the margins were in the 8% range. But I guess to put some numbers around it, I mean, you guys are saying that too specific, I mean, it could very well remain north of that 9% you guys have been doing just because you’re selling more USDA loans than you might have been two years, two-plus years ago relative to the mix of loans sold?

[William Losch, Chief Financial Officer]

Yes. That’s fair to say.

[Michael Perito, KBW]

Okay. Thanks for that. And then on the embedded finance initiative and the Banking-as-a-Service stuff that Huntley was mentioning in his prepared remarks. So just wondering if you guys could break down a little bit more what that could look like. I think historically, you guys have said that you want the Live Oak brand incorporated. You’re not so much into kind of the sponsorship model when the name is just on the back of a debit card or something like that.

But obviously, there are some funding opportunities out there and those types of relationships. And it seems like from a tech stack standpoint, there really have not been holding you guys back from exploring some of these opportunities. So, I’m just curious if you can maybe break out a little bit more with some – generally with some of those opportunities look like I’m sure you can’t be too specific, but my guess is somewhere in the works, if you’re planning on launching this year? So, I just would love a little more color if you can provide it.

[Huntley Garriott, President]

Sure. I’m happy to, and I can start and if we want to get technical Renato here, too. From a go-to-market strategy, as we look at this, we’re really focused still on the small business customer and helping them and our ability to integrate into the practice management software, the networks, the associations, the buying groups, the wholesalers, all of these different application service providers that deepen the relationship with the small business and where we can embed our banking product, that is really our primary mission and where we are going to market.

We do believe, as you think about Banking-as-a-Service and providing banking product, whether it’s through a Fintech or otherwise, we do think we have a cost advantage, a flexibility advantage and just an overall a technology advantage, and so we’re looking at that and maybe a couple of little things pop up here and there that we want to do. But that isn’t our primary focus. As we think about it right now, it's really focused on what software and what applications touch the small business and how can we deepen those relationships with integration.

[Michael Perito, KBW]

So is your expectation that anything you do in this arena, would it be something more tilted towards trying to generate lower cost funding at this point? I mean whatever it looks like, I guess we'll have better color when you announce something, but is it fair to assume that that's where the focus is?

[Huntley Garriott, President]

Yes. I think there's three primary places. We think that this need for small balance credit is a real opportunity and with better data and credit decisions. We think that, that is – will be a driver, and that's a great product that we want to offer that typically comes with the operating account. And so, then those non-interest-bearing deposits, especially now that rates are starting to rise, the value proposition in there continues to increase. And then third, it puts us squarely in the middle of payment flows, and we think there's a big opportunity around that, too. So that's how we're thinking about it, Mike. Definitely, the checking balance is an important driver, but there's really, I think, three main categories that we're pushing on.

[Michael Perito, KBW]

Helpful. And then maybe a question for Neil kind of on that last point that Huntley brought up. For the Fund II within Canapi, any broader thoughts of where you think the focus of that fund could shift? I mean there's a lot going on in the payment, stable coin, block-chain-based, real-time payments, B2B payments world. I imagine you guys are looking at that at stuff. I don't know that a lot of formally has been announced for Live Oak. But just curious if you can maybe provide any thoughts about where you think that fund could trend, and if those are areas of focus that there could be overlap?

[William Losch, Chief Financial Officer]

Yes, I think there are Canapi, we haven't announced yet just had a large investment in a company that helps banks be a custodian of crypto. So, holding on to Bitcoin trading, Bitcoin and so there's – obviously, you've seen a lot of activity on that side. We tend to stay away from tokens and maybe NFTs. we tend to really like anything around KYC, KYB fraud prevention and obviously, the infrastructure and the custodian side of all that is crypto. Crypto means many things to many different people.

So, we love block-chain, we love infrastructure. There are some things that we're staying away from. But all of it makes banks be better on behalf of the customers. And relative to the actual overall strategy for Fund II, look there's 250 billion lines of cobalt code that drive financial services right now. I think we're 20% through the total retooling, moving it to API first cloud native. And so, we're going to continue to invest in companies that help evolve those strategies. And the API stuff is really important because it supports the embedded banking strategy.

So, as we embed our bank into practice management software providers, you asked a great question. I mean, it's going to have we think, pretty significant effects on the cost of funding over the next – over the many years to come, none of that we could have done without a brand-new core with Finxact because they just can't scale and the API sets are not rich enough in some of the 30-, 40-year-old code out there. So some more of the same in Canapi II. We'll probably do bigger investments, larger, just given the fund size is going to be bigger, but with all of our bank LPs in mind.

[Michael Perito, KBW]

Got it. And then sorry, I may just sneak 1 more in, and I apologize if I missed this, I was going to jump in between self this morning. But just I heard the commentary about why the tax rate was so high, but was there anything about what you guys expect it to be next year?

[William Losch, Chief Financial Officer]

Yes. I think, Mike, a good assumption is in the 20% to 21%, 22% range. If we do more investment tax credit business, which we expect to do, it certainly could go lower. But I think having that range is your current assumption is probably a good one.

[Michael Perito, KBW]

Got it. Great. Thank you, guys, for taking all my questions.

[William Losch, Chief Financial Officer]

Sure. Thanks Mike.

[Operator]

Our next question comes from Chris Donat with Piper Sandler.

[Chris Donat, Piper Sandler]

Good morning, everyone. Thanks for taking my question. Neil, I wanted to start with you, and I'll ask the question, and I suspect you're not going to answer it the way I want to, but we'll understand. With those Live Oak Ventures remaining active, can you quantify how much capital is expected to be committed there? I know you said opportunistic, so I imagine it will depend on a lot of things, but any range or ballpark based on historical activity would be helpful?

[Neil Underwood, President]

Yes. I think that probably not right now. I think we're talking with the Board about interesting ways to downstream capital, also investing at the bank. I think – the thing to think about though, and I think the thing that makes this really interesting, is that many of these companies, Able is a great example, are really early stage. So, we don't need to invest a really large sum of money to own a meaningful piece just given the stage and the maturity and that allows us to be really efficient with our capital and still get significant upside, assuming these companies go with the right trajectory. So, I maybe look at it through that lens instead. At some point, we may be prepared to talk about some ranges, but that's kind of how I respond.

[Chris Donat, Piper Sandler]

Okay. That's helpful. Once you said opportunistic, it seems like there's a lot that will depend to understand that. And then I wanted to just go back to one issue on gain to sales, BJ, is there anything we should be watching with the potential mix of originations on the SBA side with rising rates in terms of the percentage of fixed versus variable? Or is that not something that should really change that much in a rising rate environment?

[William Losch, Chief Financial Officer]

Yes, that's a good question, Chris. I think [indiscernible] Davidson and in our Treasury Group and our secondary group do an excellent job really kind of trying to study the market and seeing how we can maximize what we're doing from a sale perspective, and they look at the mix of variable fixed, fixed adjusting SBA, USDA, et cetera. To see what makes the most sense. I do think that, generally speaking, we're looking at trying to sell product that maybe has a higher propensity to prepay. We're also looking at maybe selling some more fixed or fixed adjusted at certain points of time to manage our balance sheet and our interest rate risk.

So, a lot of things go into the Rubik's cube of how we look at, what we should sell and what we should retain on balance sheet for the carry income, but back to my earlier comments, I think looking at all of that sitting here today, we do still continue to see pretty healthy opportunity to increase gain on sale each quarter going into next year.

[Chris Donat, Piper Sandler]

Okay. And then just wanted one clarification on expenses. Just looking at away from compensation, but you have had increases in professional services and data processing. I thought, I heard the comment that basically all other expense lines other than comp should be kind of with inflation, is that effect – that covers professional services and data processing, right?

[William Losch, Chief Financial Officer]

It does. I think, yes, to put a little bit of a finer point on it, Chris, you're right. Data processing probably continues to go up. Maybe it's a little bit more than inflation because of the technology investments that we're making. Loan expenses as it relates to originations will maybe go up more with production, but professional fees should likely come down, some of the other line items come down. So, in general, I was trying to say it all the rest of it grows with inflation. The biggest driver, of course, is going to be our salary and benefits line as we continue to add talent.

[Chris Donat, Piper Sandler]

Okay, that’s helpful BJ. Thanks. Appreciated.

[William Losch, Chief Financial Officer]

Thanks, Chris.

[Operator]

And I'm not showing any further questions at this time. I'd like to turn the call back over to our host for any closing remarks.

[Greg Seward, Executive Vice President and General Counsel]

Great. Well, we really appreciate everybody's time and their interest. We are here for any follow-up that you would like and hope you have a great rest of the day.

[Operator]

Ladies and gentlemen, this does conclude today's presentation. You may now disconnect, and have a wonderful day.