Clayton G. Deutsch - Chief Executive Officer, President and Director Jeanne Hess David J.

Kaye - Chief Financial Officer and Executive Vice President

Jennifer H. Demba - SunTrust Robinson Humphrey, Inc., Research Division Christopher McGratty - Keefe, Bruyette, & Woods, Inc., Research Division Alexander Twerdahl - Sandler O'Neill + Partners, L.P., Research Division Christopher W.

Marinac - FIG Partners, LLC, Research Division Casey Haire - Jefferies LLC, Research Division Thomas Alonso - Macquarie Research

Thank you. Good morning.

This is Clay Deutsch, Chief Executive Officer and President of Boston Private Financial Holdings. Welcome to our third quarter 2013 earnings conference call.

Joining me this morning are David Kaye, our Chief Financial Officer; and Jeanne Hess, our Vice President for Investor Relations. Mark Thompson, Chief Executive Officer of Boston Private Bank and a regular on these calls, is unable to make it this morning.

At this time, I'll ask Jeanne to read the Safe Harbor provisions before we make additional remarks.

Good morning. This call contains forward-looking statements regarding strategic objectives and expectations for future results of operations and financial prospects.

They are based upon the current belief and expectations of Boston Private's management and are subject to certain risks and uncertainty. Actual results may differ from those set forth in the forward-looking statements.

I refer you also to the forward-looking statements contained in our earnings release, which identify the number of factors that could cause material differences between actual and anticipated results or other expectations expressed. Additional factors that could cause Boston Private's results to differ materially from those described in the forward-looking statements can be found in the company's filings submitted to the SEC.

All subsequent written and oral forward-looking statements attributable to Boston Private or any person acting on our behalf are expressly qualified by these cautionary statements. Boston Private does not undertake any obligation to update any forward-looking statements to reflect circumstances or events that occur after the forward-looking statements are made.

Thank you for joining our call this morning. In the third quarter, our company generated net income of $18.3 million or $0.22 per share.

Our reported return on common equity for the quarter was 12.3%, aided by expense discipline and a $6 million provision credit. As we look across our core businesses for revenue growth, we believe that the growth of our Wealth Management businesses is strong.

Total Wealth Management fees increased 9% year-over-year. Assets under management rose 4% quarter-to-quarter and 13% year-over-year and now total $22.7 billion.

AUM net flows were positive for the quarter and positive across all 3 of our Wealth Management channels. Total Private Banking revenue declined quarter-to-quarter as a result of continued yield compression and a 42% decline in residential mortgage gain on sale.

Our private bank realized 2% quarter-to-quarter loan growth and 8% quarter-to-quarter deposit growth. We have built liquidity and we look forward to putting excess liquidity to work through our client-centered lending activity across our 3 major private banking markets.

Our expense discipline is serving us well as evidenced by the 8% decline in operating expenses on a linked-quarter basis and an 11% decline year-over-year. Finally, our credit quality continues to improve and our charge-offs remain negligible.

Reserves relative to actual loss experienced remains strong. Our $6 million provision credit reflects our continued portfolio de-risking, coupled with very disciplined loan growth.

Looking forward, we remain fixated on driving core business development and generating a more acceptable revenue growth profile. At this point, I'd like to turn it over to Dave for more detail on our financial performance, and then I'll return for some concluding comments.

Dave?

Thanks, Clay. Good morning, everyone.

My comments will begin with slide -- on Slide 3 of the earnings presentation, and that could be found in the Investor Relations section of our website, which is bostonprivate.com. On Slide 3, we show our linked quarter consolidated P&L highlights.

Net interest income declined 4% in the quarter and core fees decreased 1%. About 75% of our NII decline was driven by the loss of $1.2 million in net interest income related to the Pacific Northwest offices.

The remainder was due to NIM compression. Other income declined in the quarter as Q2 was elevated due to the gain on sale of the Pacific Northwest Private Banking offices.

Total expenses are down 8% in the quarter to $52 million, and that reflects a normalized level of expenses for our company. It also fully captures the $10 million in cost savings that we announced in the third quarter of 2012 and we committed to fully capture by the third quarter of 2013.

If you exclude the gain on the Pacific Northwest office sale, pretax income increased 36% on a linked-quarter basis, and pretax pre-provision income actually increased 17%. Slide 4 shows our spread in fee-based revenues, and it's really a core revenue profile for the quarter as we exclude the gain on sale of the Pacific Northwest offices in the second quarter.

Core fees were down 1% in the quarter as growth in the wealth advisory fees were offset by declines in the investment management and trust fees and also declines in the gain on sale of residential mortgages. However, overall core fees are still up 8% on a year-over-year basis.

Turning to Slide 5, which is our net interest margin. Our reported NIM decreased 15 basis points in the quarter, down to 2.99%.

The decline was really driven by 3 items, each with about a 5 basis point impact. First, we had higher cash balances; second, some yield compression; and third, a lower recapture of nonaccrual interest and fewer prepay fees.

On Slide 6, we show the provision credit of $6 million in the quarter was really driven by 2 factors: first, we had a declining balance of problem loans and that contributed $3.6 million of provision credit; and second, we recorded $2.4 million in net recoveries. As we continue to work down our problem loans and recover past charge-offs, we could potentially see additional credits in the coming quarters.

Slide 7 shows the past 5 quarters of our Tier 1 common ratio. On a linked-quarter basis, it increased by roughly 20 basis points to 10.1%.

On a year-over-year basis, the ratio is up approximately 40 basis points. We're very comfortable with our current capital levels, and we remain focused on efficient capital management going forward.

Now moving on to Slide 8 which shows our private bank performance highlights. In the third quarter, total revenue at the private bank decreased 19%.

Again, due predominantly to the $10.6 million gain on sale from the Pacific Northwest offices that we booked in the second quarter. When you normalize for that sale, revenue declined 3% on a linked-quarter basis.

This decrease reflects 2 factors: first, the net interest income decline of 4%, which, again, most of that was due to the absence of Pacific Northwest interest income; and also, the core fee decline was due to a 42% decline in the gain on sale of residential mortgages. Expenses for the bank were down 10% on a linked-quarter basis due to savings in marketing and other.

The bank accounted for about 80% of the linked quarter decline in our total consolidated operating expenses. On Slide 9, we show the past 5 quarters of loan balances by type.

Total loans increased 2% on a linked-quarter basis due to growth in residential mortgages, commercial loans and construction loans. At the individual market level, total loans were up 3% in New England, up 2% in Southern California and down 1% in the San Francisco Bay Area.

On a year-to-date basis, total loans increased 2%. Turning to Slide 10, we show our total deposits, which increased 8% to $4.9 billion in the third quarter.

We saw a linked-quarter growth of 20% in Demand Deposits and an 8% growth in the Money Market Accounts. The growth was driven by strong business development across all 3 of our markets.

We're pleased to note that the deposit increase was achieved without increasing core deposit costs. Now I'll turn it back over to Clay.

Thanks, Dave. Turning to Slide 11, Investment Management.

Our Investment Management fees decreased 3% on a linked-quarter basis, reflecting lower AUM balances in the second quarter versus the first quarter. Remember that our investment managers record revenue on a 1-quarter lag basis.

As a result, the Investment Management segment fees and revenue shown here for Q3 reflect AUM balances as of June 30, 2013. Expenses increased 1% to $8.4 million in the quarter.

The EBITDA margin for our investment managers was 27% in the quarter while pretax margin was 20%. The segment overall reported net inflows of $17 million for the quarter.

Segment AUM increased 6% and now totals $9.7 billion. As you know, our investment managers show the greatest level of volatility among our Wealth Management businesses, and it is helpful to evaluate year-over-year performance.

On a year-over-year basis, AUM is up 13%, which we believe is in line with a broad spectrum of strong asset managers. Slide 12, linked-quarter wealth advisory performance highlights.

Our wealth advisors had another strong quarter, with revenue growth of 4% to $10.7 million. Operating expenses increased 7% to $7.3 million due largely to a formulaic true-up of the bonus pool at one of our firms.

The segment's third quarter EBITDA decreased to 34%, but that still remains well above our target of 30%. Segment AUM increased 3% on a linked-quarter basis to $8.8 billion.

Wealth advisory net inflows were $16 million in the quarter. More information on AUM net flows can be found on Slide 13.

In the third quarter, net inflows were $52 million across the company. While we were happy to see the reversal of the second quarter net outflow, we need to see much greater levels of inflows across our segments.

Developing consistently positive flows across all of our Wealth Management channels remains a top priority in the company. Finally, before taking your questions, I would like to offer some perspectives on the interplay between the current economic environment and attainment of our long-term return on equity targets.

As you all know, our long-term target is a return on stated equity of 12%. Our target for 2013, a year in which we foresaw a challenging spread in revenue environment, was adjusted to 11% in our second quarter 2012 earnings call.

Attainment of an 11% return on equity target beyond 2013, obviously, will require greater revenue growth. This year, we are retaining our non-spread fee revenue growth goals, our expense targets and our quality targets and our capital goals.

Our net interest income development has been disappointing, with net interest income declining throughout 2013. And our rate of balance sheet growth has been below our targets through most of this year to date.

In this third quarter just ended, we have more recently driven healthy deposit growth and we have built liquidity. We have carefully managed loan growth in our residential mortgage and commercial lending business lines.

Aggregate loan balances are about $150 million behind our target, largely reflecting pay-downs of criticized assets and reduced borrowings by nonstrategic clients. Throughout this year, we have been purposely lagging loan growth to allow deposit liquidity to build, and we are now within our liquidity preferences.

Maintaining recent levels of positive deposit growth will allow us an opportunity to grow loans closer to our stated target of mid-single digits per annum. Looking forward, we do anticipate an environment with more delayed tapering and a prolonged period of accommodation.

Continuation of this yield environment will challenge us in sustaining our 11% threshold beyond interim expense management steps and reduced reserved levels linked to continued asset quality improvement. We will continue to pursue a broad range of growth initiatives to push revenue development into more positive territory and closer to the growth needed to deliver a sustainable return-on-equity profile within our 11% to 12% strike zone.

With that, I'd like to now invite your questions.

Just expanding on the comments you made at the end of your monologue. In terms of revenue growth initiatives, can you just talk about -- since your loan growth has been a little bit disappointing year-to-date, can you talk about what you may be doing differently going forward than maybe you were before?

And if we could talk about, specifically in California, what you feel like is going well, what is not going so well.

Yes, Jen. Let me start by saying, I think our lenders have been doing a great job.

So I would describe loan growth as tightly managed to build liquidity. I would not call it disappointing.

It has been below our target of 5% to 6%. That's been by design and direction from on high.

We have wanted to build liquidity through the year. And frankly, our deposit growth through the first 2 quarters was slow, largely reflecting us getting things going on the West Coast.

As I look at the loan portfolio, I'm proud of our residential mortgage lenders. Our new money purchase mortgage business is quite strong.

So in an industry environment where refi is going the way you all know that it's gone, we continue to build pretty high-quality residential mortgage portfolio. And on the commercial lending side, we like the caliber of the business, the caliber of the underlying client flow that we see in all 3 markets.

Commercial lending, of course, though, has been net against continued effort to reduce problem assets and also to reduce borrowings by nonstrategic clients. So lending has been, as you see it, by design.

With the uptick in liquidity in the third quarter, which we believe is not a temporary blip, we're excited about getting closer to our long-term baseline which we have declared as kind of upper single-digit deposit growth, mid single-digit loan growth. And that profile would help us quite a bit obviously with net interest income development.

Clay, on the ROE, just correct me if I'm wrong, your goal longer term was 12%, but wasn't that something you had talked about achieving in 2014?

Yes, we had said 11% this year and 12% in '14. And Chris, I just think -- I think '12 is going to be hard in this revenue environment.

Obviously, we're going to -- we're doing a good job on the ROE target this year. We're getting there in a way that I think investors will value however they value it.

I'm proud of the expense discipline. I'm very proud of the quality improvement.

But reserves are not a perpetuity even though our lending and credit people are among the stars of our company. What they've done on the de-risking is phenomenal, and we still have more to go there.

Ultimately though, the needle's got to move on revenue. I think all of us are somewhat dependent on what you think the net interest income environment is going to look like in the coming year.

Personally, I think the second coming of a more normal rate environment is going to be delayed. I think it's going to be delayed.

And if this environment persists, we'll continue to work hard to be around 11%. 12% remains our long-term target.

Okay. I mean, you guys have been pretty vocal and pretty clear about getting to the ROE and you've gutted the expenses twice and the credit is completely been turned off -- turned around.

I guess, if your initiatives aren't successful that you've lined up, I guess, can you talk about longer-term strategy? The environment is what it is and everyone has to operate in it, but you guys have -- do have a valuable franchise, and I'd be interested in your kind of comments here.

Yes, Chris, the franchise value or franchise power to me lies in 2 broad areas. We have terrific Wealth Management businesses and we have a spectrum of Wealth Management businesses.

So I think we're distinctive, yet nicely diversified. And we need to continue to build out that Wealth Management revenue stream.

I'm encouraged by what we see in the revenue development on the fee side of the house. And everything we continued to do there will just help our overall company profile.

I think the second element of franchise power is we -- we're in 3 very good private banking markets. The franchise in New England has been strong and continues to be strong, and the up case for us is continuing the improvement rate that we see in Southern California and in the Bay Area.

I'm very proud of our teams in both those California markets and we see signs of good things in terms of client acquisition, deposit development, lending build. We're starting to get Wealth Management build in those West Coast markets.

So the up case for our company and for the revenue line, to me, lies in those 2 broad areas, Chris, Wealth Management fee build and really harnessing the franchise strength of 3, not 1, private banking markets.

All right. Dave, one question on the margin.

You built liquidity in the quarter like you talked about, and can you talk about near-term expectations for NIM? Will the liquidity be deployed and should you see sustainability around a 3% NIM or are we going to bleed into the 2.90s?

Yes, Chris, we could see some bleed of NIM depending on the new loans that are coming on. I think when you look at our residential portfolio on the loan side, the new residential loans are coming on at about what our current book is at.

On the commercial side, I think we still see loans coming in lower than the yield for our overall book, and so that could be a drag because I don't see opportunities much on the liability side to bring costs down further. I think we're happy with having stabilized the costs.

And we just need to grow our deposits, our core deposits more. But we could see a little bit more pressure in the near term on the margin.

Can you just talk a little bit about based on your loan portfolio and your deposit complexion what the ideal interest rate scenario would be for you guys? What has to happen to rates for us to see the margin really kind of take off?

Yes, I mean, let me give a general answer and then Dave can elaborate. Our best scenario, I think, would be the Fed's dream scenario, which would be a relatively stable or relatively pegged short rate with some steepness in slope to the yield curve.

So -- whether you call it "normalization," but a return to a more normal short to long spread would be good for any spread-based intermediary in the industry and would certainly benefit us.

I think Clay said it all. If we can get the -- a little steepening in the curve, over the long term, we do benefit from steadily rising rates.

So we'll -- that'll help us.

Okay, and then just looking at Slide 13, on the inflows of AUM. And is there anything to be read into the fourth quarter of last year having very strong flows?

Is there any sort of seasonality or anything like that, that would indicate that maybe 4Q '13 will be just as strong?

Well, it wasn't seasonal, Alex. Q4 was blipped up by 2 team acquisitions at Anchor Capital that brought us a pretty nice onetime bump in onboarded AUM.

Okay. And then maybe talking a little bit more to that point.

Can you talk about maybe what you're seeing for M&A? Is Boston Private ready to look at further acquisitions, specifically in the Wealth Management standpoint, to increase AUM and drive fee revenues higher?

Well, I'll just say what I've said publicly, we are interested in exploring acquisitions that would accelerate our Wealth Management development. And we've been pretty actively looking at extensions to our wealth advisory businesses, our investment management businesses, and we'll continue that search.

What I've said public -- I've taken a vow to do nothing stupid. We like bolt-ons and lift-outs and things of that ilk rather than kind of big bang M&A.

But we will continue to look for the same kinds of opportunities that we just mentioned earlier. What Anchor did in the fourth quarter was a nice addition to the company.

It's Chris Marinac. Clay, I wanted to follow up on your comment and Dave's too about sort of looking at the margin going forward under a higher rate environment.

I guess, just should we lean on your prior disclosures or even the upcoming 10-Q about the sort of rate sensitivity? Or is there another way of sort of thinking about it?

Just in terms of trying to quantify even just in the big picture kind of the step-up of earnings under that better rate environment.

Yes, Chris, I mean, the -- we have a variety of assumptions in disclosing interest rate sensitivity. Obviously, if rates were rise in parallel, we show sensitivity related to a 200 uptick.

I mean, if -- again, that's not reflective if the curve was to steepen a little bit. We'd get a little bit better improvement there.

And so we'll -- in the short term, we do feel some pressure if the short-term rates rise just because it takes our -- the asset side a little bit longer to reprice. But over the long term, we definitely benefit from rising rates.

The steepening beats the shift, Chris.

I understand. I understand.

And I guess back to expenses. I mean, so the normalized rate you have now, what does that imply in terms of sort of core growth next year?

Is that sort of at the rate of inflation, near 2%, 2.5%, or would it be a little different just given your progress here?

No, I think that's fair. We'll see some type of inflation -- cost inflation pressure of about 2%.

Okay. And then last question just has to do with sort of EBITDA margins and kind of how you see that in the Wealth Management space in the future.

Do you see room for that to change further either up or down?

Yes, Chris. Our target's 30%, 30% EBITDA margin.

We do believe that there is upside operating leverage in our Wealth Management firms, and we think in the upstroke quarters that our wealth advisors and our investment managers have demonstrated that.

It's actually Casey. Apologies for the confusion.

I was wondering about possibly capital deployment. Obviously, de-risking continues to go quite well.

Clay, I know you've mentioned in the past that you'd like to earn the right to live on bottom quintile capital ratios. I'm just curious when we might see some capital deployed.

Is it in 2014? Or what's the catalyst?

Yes, Emlen, I -- everything you've said, I'll stand by. And we've said previously we want to manage our capital very efficiently and -- or I'm sorry, is this Casey or...

Yes, it is. I apologize for the confusion.

Casey, I want to manage our capital very efficiently. I think our de-risking will earn us the right to do that.

I stand by all those statements. We haven't really declared it as a bottom quintile, bottom quartile.

And I want to stay clearly on the good side of capital adequacy and on the good side of the regulators, but we do want to manage our capital very efficiently. Our preferred return of capital strategy is an escalating dividend.

We have refrained from declaring a target payout ratio, but we do have a capital plan that we're very comfortable with and we think can provide for that. So our preferred vehicle is an escalating dividend.

Beyond that, we have a broad range of tools. We do have share repurchase ability.

We constantly look at a full range of things, including special dividends and the like, but our preferred vehicle will be thoughtful management of an escalating dividend.

Okay. And then, on the -- in terms of de-risking and sounds like credit provisions could be here for the next little bit, I'm just curious -- I assume this is coming from Northern California.

Can you just confirm that geography? And then, I know it's tough, but just best guess in terms of what inning we're in, in terms of de-risking?

Yes, Casey, I'll take that. It has been Northern California to a large extent that's where we benefited from the improved credit quality.

They were the source of the $2.5 million in net recoveries or the large bulk of it. What -- in terms of what inning we're in, I've described this before, we have in this quarter about $12.5 million net of reserves that are associated with our problem loans, the special mention, the classified, the impaired loans.

Those -- so we have $12.5 million. Last quarter, it was $16 million.

A year ago, it was probably closer to $30 million. That has been a source of provision credit for us, I mean, as to how much further that can go down.

I mean, it probably will never get to 0. We'll always have something there, but it's been steadily marching its way down.

So I think we're through a large bulk of that now and expect that in a year from now, that we'll have another -- peel back the size that we had in this previous year, but we're not done.

Got you. Okay, and then just last one.

The deposit growth, apologies if I missed this, but where is it -- what geography is it coming from? Is it spread out or is it California?

Just some color there.

It's encouraging, Casey, that's it's been nicely spread across all 3 markets. A big part of it is our deposit leadership and deposit services model kicking in to a greater extent in the West Coast markets, which are more recently modified to our private banking model.

But it's been nice deposit build in all 3 markets, and that has us encouraged. I especially like that it was accomplished without rate promotions or any kind of up pay.

And we'd love to keep that going.

Clay, I just want to make sure I understand your comments on the loan growth earlier in the call. You noted that it's a somewhat challenging environment but that you guys have kind of kept your lenders under tight rein.

I mean, does that mean that your -- you see opportunity to increase loan growth is just a matter of maybe loosening up on those reins a little bit or are you seeing a pickup in demand?

Tom, just one clarification on that. Part of the reason our loan growth has been less has been because we've worked down our problem loans.

So that reduction in our problem loans, as Clay said, and the reduction in sort of nonstrategic client borrowings has weighed on that. You're really seeing a net number as that starts to -- that reduction starts to dissipate.

The same production will obviously produce a greater net growth. Yes, Clay, expand on that.

Yes. I'll just maybe elaborate a little bit.

There's no question that from a top-down balance sheet management perspective, I've made a very special request of our lending leaders to be measured about loan growth this year. We have outstanding residential mortgage people and we have outstanding commercial lenders.

And they absolutely are capable of generating more high-quality loan demand than what we've booked this year. So while -- the macro, and you read the -- you read the Fed Beige Books and everything that just came out this Wednesday, nationwide, loan demand, I think they used the word tepid.

We're pretty nichey and we're pretty focused. And I've seen enough this year in our pipeline and in our client development to know that our lenders are capable of more.

And we've asked them kind of with a serve the company mentality to ride the brakes a little bit because we felt it was very important to build liquidity and not get too far out over our skis in terms of loan intensity and loan as a percent of assets. We're back down within our liquidity comfort zone void by the deposit build that we were just talking about.

And I think if we can get back toward our more normal long-term balance sheet objectives of kind of that 7-ish, 7%, 8% deposit growth, 5%, 6% loan growth, which we do think on the lending side is well within our reach given the strength of our lenders, that would be a good thing. That would be a good thing.

Okay, fair enough. And then just real quick, a quick modeling question for you, Dave.

What's a good tax rate?

32%.

I was going to say 0, but it seems unpatriotic.

Well, I'll simply say, thank you, all. And as always, we appreciate your interest in our company, and we look forward being back next quarter.