Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

Legg Mason (NYSE:LM)

Q3 2013 Earnings Call

February 01, 2013 8:00 am ET

Executives

Alan F. Magleby - Director of Investor Relations & Communications

Joseph A. Sullivan - Interim Chief Executive Officer and Head of Global Distribution

Peter H. Nachtwey - Chief Financial Officer, Principal Accounting Officer and Senior Executive Vice President

Analysts

Roger A. Freeman - Barclays Capital, Research Division

Daniel Thomas Fannon - Jefferies & Company, Inc., Research Division

William R. Katz - Citigroup Inc, Research Division

Michael S. Kim - Sandler O'Neill + Partners, L.P., Research Division

Robert Lee - Keefe, Bruyette, & Woods, Inc., Research Division

Macrae Sykes - Gabelli & Company, Inc.

Matthew Kelley - Morgan Stanley, Research Division

Michael Carrier - BofA Merrill Lynch, Research Division

Glenn Schorr - Nomura Securities Co. Ltd., Research Division

J. Jeffrey Hopson - Stifel, Nicolaus & Co., Inc., Research Division

Douglas Sipkin - Susquehanna Financial Group, LLLP, Research Division

Eric N. Berg - RBC Capital Markets, LLC, Research Division

Marc S. Irizarry - Goldman Sachs Group Inc., Research Division

Operator

Welcome to the Legg Mason Third Quarter Fiscal Year 2013 Earnings Call. [Operator Instructions] Please note that this conference is being recorded. It is now my pleasure to introduce your host, Alan Magleby, Head of Investor Relations and Corporate Communications. Mr. Magleby, you may begin.

Alan F. Magleby

Thank you. On behalf of Legg Mason, I would like to welcome you to our conference call to discuss operating results for the fiscal 2013 third quarter ended December 31, 2012. This presentation may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are not statements of facts or guarantees of future performance and are subject to risks, uncertainties and other factors that may cause actual results to differ materially from those discussed in the statements.

For a discussion of these risks and uncertainties, please see risk factors and management's discussion and analysis of financial condition and results of operations in the company's annual report on Form 10-K for the fiscal year ended March 31, 2012, and the company's quarterly reports on Form 10-Q and the company's current report on Form 8-K filed January 22, 2013.

This morning's call will include remarks from the following speakers: Mr. Joseph Sullivan, Legg Mason's Interim CEO; and Mr. Pete Nachtwey, Legg Mason's CFO, who will discuss our financial results. In addition, following the review of the company's quarter, we will then open the call to Q&A.

Now I would like to turn this call over to Mr. Joseph Sullivan. Joe?

Joseph A. Sullivan

Thank you, Alan, and good morning, everyone. As always, I appreciate your continued interest in Legg Mason and in taking time this morning to participate in our fiscal 2013 third quarter earnings call.

As you may remember from our last earnings call, I stated that despite my status as interim CEO, I was committed to demonstrating continued progress on and in fact accelerating Legg Mason's turnaround. To that end, I'm pleased with the efforts of our entire corporate organization and our affiliate colleagues. I want to reiterate that our leadership team is very engaged with the Board of Directors on our strategic direction, and our goal quite simply is to return to growth and continue to position the company for long-term shareholder value.

Certainly, challenges remain, but I am optimistic about our prospects. And in my remarks today, I'll identify areas where I believe we are making progress, as well as those where more work needs to be done. And I'll reference some data points throughout my remarks for emphasis.

But before we move on to our third quarter results, let me take a moment to update you on a topic that I know is on the minds of many: the CEO search currently underway. The search committee of the Board is nearing the completion of a very comprehensive and thorough process that has included a large number of high-quality candidates. While we're not quite there yet, I think it reasonable to expect an announcement and introduction of our new permanent CEO in the not-too-distant future. And with that, let's go on to our results for the quarter on Page 3.

For the quarter, we announced a net loss of $454 million or $3.45 per diluted share due to noncash impairment charges. These noncash charges were related to fund contracts acquired in the 2005 Permal and Citigroup transactions and reflect revised assumptions of the value of those contracts in the current market environment. Adjusted income for the quarter was nearly $92 million or $0.70 per share.

Also during the quarter, we announced the acquisition of Fauchier Partners, which will be combined with Permal to expand their global institutional fund of hedge fund platform. We are quite excited about this transaction, which should close in the March quarter. It represents an important step in growing our alternative capabilities through Permal and is a great example of our leadership team working closely with our affiliates and our board to build value for shareholders. This Permal-Fauchier Partners combination will be very attractive to clients worldwide who look for size and scale in their managers.

Also, we recently announced the strategic integration of the business operations of Legg Mason Capital Management into ClearBridge Investments. This initiative will benefit both LMCM and our clients by enabling the Baltimore-based team to focus exclusively on investing, while ClearBridge will benefit from the addition of some seasoned distribution and client service professionals. This combination will be neutral to modestly accretive in the short term after some normal transition-related expenses and timing considerations. However, longer term, we expect to realize additional operating synergies.

With respect to our share buyback, we continue to repurchase shares, albeit at a lower level than previous quarters. The slower pace of buyback was the result of a blackout period for a portion of the quarter related to the December announcements of Fauchier Partners and other matters. We expect, subject to market conditions, our repurchases in the fiscal fourth quarter to make up for those that we were not able to complete during the December quarter. And while we've been consistent in returning capital to our shareholders, we've also been able to maintain a strong cash position.

On the product side, we worked closely with a major distribution partner during the quarter and successfully launched a new, non-listed, closed-end fund focused on middle-market debt, one of the first such funds of its kind. And finally, we continued to roll out our strategy to emphasize our affiliate brands in retail products. Our fund boards approved the change of both ClearBridge and Permal U.S. retail funds to reflect and lead with the name of the affiliate, a change that was implemented on January 2. This strategy underscores our belief that Legg Mason should leverage the strong reputation its affiliates have in their respective asset classes endorsed by the strength of Legg Mason as parent.

Slide 4 shows Assets Under Management by affiliate in order of their year-to-date earnings contribution. Despite continuing strong investment performance and notwithstanding some very significant market challenges for active managers, it was a disappointing quarter from a flow perspective, an area in which we need to improve.

First, Western at nearly $462 billion. In addition to the global sovereign mandate that we've referenced for some time, outflows were primarily driven by a state pension fund that reallocated its fixed-income portfolio and the successful completion of the PPIP fund. Won but not yet funded mandates at quarter end were $600 million. Importantly, reflecting the continued migration of Western's business to specialized mandates and structured products, Western also raised a $500 million bank loan CLO that priced on January 23, and Western expects additional opportunities to launch similar funds in the current market environment, much like its recent follow-on activity in the REIT space. And as referenced above, we raised nearly $200 million in the quarter with a major distribution partner in a non-listed, closed-end fund that invests in middle-market debt, one of the first of its kind. Middle-market debt funds are a new fund category and we believe that we can expand our presence in this sector with new and similar offerings.

Next, Royce at approximately $35 billion, where strong market performance and improved investment performance was offset by a pickup in outflows for the quarter. A key priority for Royce in this environment is to increase sales by expanding into new channels with Legg Mason's retail distribution team while leveraging their long-established wealth management and DCIO channel presence. This month, Royce had a $100 million takeover win in the wealth management channel, which we see as a good sign that investors are beginning to come back into the active equity space generally and small caps in particular. The out-performance of yield-oriented small cap stocks in recent quarters, really driven by the Fed's quantitative easing initiative, seems to have run its course, which if it continues, should benefit the high-quality companies that have lagged in performance and many of which have been a meaningful part of Royce's portfolios for some time.

Following Royce is ClearBridge investments at $57 billion. Outflows increased in the quarter as a large, multibillion-dollar, sub-advisory client reallocated nearly $600 million from long equities into alternatives. Like many active equities managers, ClearBridge also experienced an increase in retail outflows after the election, which may have been tied to uncertainty around the potential for new federal tax policies. Won but not yet funded mandates at quarter end were $1.2 billion.

ClearBridge continues to see interest in their strong MLP capability as well as their small cap growth, mid-cap core and income products. Momentum is clearly building at ClearBridge as the firm continues to diversify with wins in new retail channels and a growing pipeline of institutional finals presentations.

And as I mentioned, we finalized plans during the quarter to integrate the business operations of Legg Mason Capital Management with ClearBridge, with the Baltimore-based team led by Sam Peters reporting into the ClearBridge investment team in New York. This initiative should have no impact on any existing ClearBridge portfolios or investment teams, while the Baltimore-based team will benefit from a focus on investment performance and benefit from a larger operational platform. ClearBridge, led by CEO Terrence Murphy, has proven it can integrate investment teams whose investment philosophies and processes are similar to its own without disruption.

Next, Permal at $16 billion is down from last quarter. While the business continues to make strong progress in institutional channels, this quarter's net outflows were driven by the continued weakness from global high net worth channels and the maturation of a large structured product. Total unfunded wins for Permal for the quarter stand at approximately $550 million. During the quarter, Permal raised approximately $100 million in a new product for which the initial lockup is 2 years.

And as I mentioned in my opening, Legg Mason and Permal announced the acquisition of Fauchier Partners in December, and I'll give details on that in a later slide. Very importantly, nearly 80% of performance-fee eligible AUM are now at their high-water marks. And this year, Permal is set to make significant inroads into the Chinese market. It has opened an office in Shanghai, appointed a Chinese national as country head and is now just waiting for its business license.

Brandywine, now at $43 billion, had net inflows for the quarter, and the company's AUM was up 30% in calendar year 2012. Total unfunded wins for the quarter were $334 million, a quarter-over-quarter drop-off in won but not funded mandates that is consistent with its experience in prior December quarters. Legg Mason's January AUM will also include a $500 million cash flow into Brandywine from an existing client. All of Brandywine's U.S. mutual funds are in the top quartile since inception, with most being in the top decile.

And finally, Batterymarch at $12.5 billion. Batterymarch experienced a handful of expected but meaningful institutional redemptions during the quarter. This was due in part to the continued pressure on long-only active equity managers, but was also the result of choppy investment performance, reflecting an investment bias in global cyclical growth in some strategies that has proved to be early. However, recent improvements in those stocks suggest that the cyclical bias is now beginning to be reflected more positively in the investment results of Batterymarch.

Batterymarch continues to work with their clients invested in their flagship emerging markets product set to educate them on this investment thesis and the impact on their performance. And Batterymarch is developing new managed volatility products, a category that is seeing good client interest in the variable annuity space, and our distribution teams continue to work with them to source new client opportunities.

Moving to Slide 5, we highlight investment performance. The left side of the slide shows the performance of our strategy AUM versus the benchmark, which is a broad representation of our Assets Under Management. As you can see, more than 80% of our strategy AUM beats the benchmark over all time periods. The right side of the slide shows the percentage of fund assets beating their Lipper category average, which also demonstrates our affiliate's strong investment performance.

Now Slide 6 presents an update on our global distribution platform, with total long-term AUM of $222 billion sourced from retail and quasi-institutional clients in the Americas, Europe, Asia and Australia. Retail assets remain very attractive from both a margin and a persistency standpoint and today, we enjoy a broad suite of products across equity, fixed income and alternatives and among all of our affiliates.

Fiscal year-to-date, we have launched 15 new products, with total assets of just under $1.4 billion as of year end in the key focus areas of alternatives, solutions and income. Additionally, we continue our work on improving the productivity and expanding the market share of our sales teams. New product development, sales productivity improvements and market share gains will be important drivers of our growth in the retail space going forward.

So let's look at our results for the quarter. Our international division had its 16th consecutive quarter of positive net flows. Globally, including both U.S. and international, we experienced outflows in the aggregate for this quarter. However, we have achieved inflows in global distribution in 8 of the last 12 quarters.

The top right side of the slide shows quarterly net flows. Gross sales remained steady, driven by gains in some key channels, but were offset by a pick up in outflows from Royce funds and the loss of the large sub-advisory mandate. As you can see at the bottom left of the slide, the funds driving our gross sales cut across a number of asset classes and several of our affiliates. The bottom right corner shows sales persistency, which has remained above the industry average in 3 of the past 4 quarters, but ticked down this quarter in part as a result of the sub-advisory mandate loss. Our sales teams remain focused on increasing asset persistency, which can meaningfully impact our profitability.

Slide 7 provides more detail around our recently announced Fauchier Partners transaction. The transaction, which is anticipated to close in the March quarter, is expected to be accretive to earnings in the first year. It is a great example of the kind of transaction that we can pursue to add growth within our affiliates and our asset portfolio more broadly. The transaction significantly expands Permal's institutional business across clients and geographies. The combined global investment team will be largely based in New York and London with an additional presence now in Paris and Singapore.

As many of you know, Permal has had significant success in recent years transitioning and diversifying their book of business to include the U.S. institutional market. Fauchier Partners is complementary in that it has extensive pension and insurance clients in Europe and Asia Pacific. Fauchier Partners' well-respected product set of hedged equity and event-driven strategies is also very complementary with Permal, which is known largely for fixed income, credit and macro investing. Additionally, the combined firm will have a multi-year distribution agreement with BNP Paribas Investment Partners, opening that channel to Permal products.

AUM at December 31 was $5.8 billion. We are very pleased with the reception that the transaction has received from clients, but we do expect some scheduled outflows that were fully factored into the deal. We continue to see alternatives as being an important driver of growth for Legg Mason. We believe that Permal now has an even more robust platform and product set to offer clients around the world, and we plan to continue working with Permal on additional opportunities.

Slide 8 outlines the restructuring agreements that we completed with Permal during the quarter. There are 3 key elements to this restructuring: a management equity plan, a revised revenue share agreement and new multi-year employment contracts with key Permal employees. While Permal is the first affiliate with whom we've structured an equity plan, we expect this to be a good framework for creating stronger alignment with our other affiliates. The objective of this type of plan is to create financial incentives for affiliate management teams to invest in long-term growth initiatives and to create a tool for recruiting and retaining talent. And finally but very importantly, we believe it will be an important part of succession planning, as both the current management team and the next generation of affiliate leaders will have longer-term financial incentives to create and preserve value.

So let's walk through the elements of the profits interest management equity plan. Equity plan recipients have the opportunity to participate in 15% of the incremental growth of enterprise value from the date of implementation. We expect the annual charge from these equity awards to be less than $1 million per year as Permal and Legg Mason share equally in the plan's annual expense. As I just mentioned, the payments will be structured over an extended time horizon, incenting employees to take steps that create future, long-term enterprise value.

There is broad-based employee and management participation in the plan, with the flexibility to include future hires and the awards vest over 5 years. The amended revenue share agreement includes co-investment in Permal's expansion into China and in the U.S. retail business. Our shareholders will benefit from a progressively higher revenue share on incremental growth above certain hurdles. And finally, we have executed multi-year employment contracts with key Permal professionals.

And with that, let me turn it over to Pete to walk through the numbers for the quarter. Pete?

Peter H. Nachtwey

Thanks, Joe. Turning to Slide 9. I'll start with the financial highlights for the quarter.

As Joe noted, we generated a GAAP loss of $454 million or $3.45 per diluted share. This quarter, our GAAP EPS was negatively impacted by both the noncash impairment charges of $734 million, as well as $9 million or $0.07 per share of net tax adjustments related to foreign tax credits and reserves partially offset by favorable reserve true-ups due to completion of tax audits related to prior years. Taken together, these items reduced earnings per share by $3.93.

Adjusted income was $92 million for the quarter or $0.70 per share. There were a series of items I will touch on more fully in a moment that includes the $9 million or $0.07 per share net tax adjustments, which collectively reduced adjusted income by $12 million or $0.09 per share. Average AUM increased about 1.5% from the prior quarter driven by increased liquidity assets.

A shift in the mix to less equity and more liquidity AUM contributed to a lower advisory fee rate in the quarter. The driver of the 5% increase in operating revenues over the prior quarter was a $36 million increase in performance fees. This quarter's performance fees included the $32 million PPIP fee that I called out last quarter, as well as additional performance fees at Western, Brandywine, Permal and Legg Mason Global Equities. While impossible to predict with precision, we project that next quarter's performance fees will be modestly higher than this quarters fees once you exclude the impact of this quarter's one-time PPIP fee.

Operating expenses included the $734 million in impairment charges. This quarter's expenses also included 2 items related to Permal. As disclosed in the 8-K we released in December, there were $6 million in costs related to the restructuring and, of this amount, $2 million will recur in future quarters. There was another $1 million in legal fees recorded this quarter related to the Fauchier transaction. This quarter's expenses also included about $2.5 million in costs associated with the launch of Western's middle market debt closed-end fund. I'll provide a little more color on operating expenses later.

On the balance sheet front, this quarter, we repurchased an additional 2.8 million shares for $71 million. We also accelerated our fiscal Q3 dividend payment into December for tax purposes.

Moving on to Slide 10. The only other item to highlight here is our effective income tax rate, which was 28% on a GAAP basis, reflecting the impairment charge and net tax adjustments that I mentioned earlier. It is important to note for this quarter this is a tax benefit rate reflecting the fact that we had a GAAP loss for the quarter. Going forward, we still envision our effective tax rate to be in the 34% to 36% range.

Turning to Slide 11. Our Assets Under Management were in line with the prior quarter thanks to market appreciation of over $6 billion despite FX reducing our AUM by nearly $5 billion. As Joe noted earlier, we had outflows at our equity affiliates which, combined with the uptick in liquidity assets, caused equity as a percentage of total AUM to drop slightly to 22%.

Long-term flows on Slide 12 deteriorated from the prior quarter due in part to some affiliate-specific equity outflows described earlier, as well as the industry-wide increase in U.S. active equity flows. Fixed income outflows increased to $6.8 billion this quarter with 3 quarters of the outflows driven by a combination of 3 items at Western, the $2.4 billion large pension client, $1.1 billion from the PPIP program and $1.6 billion in ongoing redemptions related to the low-fee global sovereign mandate.

Slide 13 shows the advisory fee trend. With this quarter's rate dropping 1 basis point to 33 bps reflecting the change in AUM mix, our average AUM increased, but this increase was entirely driven by lower fee liquidity AUM while long-term average AUM was flat. Average equity AUM was down about $4 billion, while fixed income was up about the same amount.

Operating expenses on Slide 14 increased to $1.3 billion, largely due to the impairment charge this quarter. In addition, distribution and servicing expenses were down nearly $2 million. This despite the fact that nearly $2 million in costs related to Western's middle market closed-end fund launch hit this quarter. This reflects the lower AUM in certain of our products.

Communications and technology expenses increased as last quarter benefited from a catch-up adjustment for renegotiated vendor contracts. Occupancy expenses were up nearly $4 million as last quarter's expenses included a $3 million lease reserve reduction related to office space held for sublease. And finally, other expenses increased $2 million from fiscal Q2 due to legal fees related to the Fauchier transaction and Permal restructuring, as well as higher T&E.

Looking ahead to the next quarter, we expect to report charges for space reductions related to Legg Mason Capital Management's integration with ClearBridge and the tightening up of our space requirements at corporate. As a result, we will be reporting lease write-offs of approximately $45 million to $55 million in fiscal Q4. And then starting in fiscal year '14, we anticipate occupancy savings of approximately $10 million per annum. In addition, next quarter we will incur about $4 million in costs for severance and technology write-offs related to Legg Mason Capital Management and ClearBridge operations integration.

Turning to Slide 15. Total comp and benefits increased $6 million despite lower mark-to-market on deferred comp and seed investments and lower management transition costs. The increase largely reflects higher affiliate compensation related to PPIP, the Permal restructuring costs and the acceleration of some deferred compensation from our fiscal Q4 into calendar 2012.

So moving up the table, management transition costs are for the executive retention awards as well as the executive search firm costs. Then as you can see, the comp and benefit to net revenue ratio, excluding the mark-to-market on deferred comp and the management transition costs, was 57%. Several factors combined to increase the comp and benefit ratio by 2% for the quarter. These included the Permal restructuring expenses, approximately $4 million in accelerated vesting of deferred comp and the closed-end fund launch costs.

Slide 16 highlights the operating margin as adjusted, which decreased to 19.8% from last quarter's 21.2%, largely due to Permal restructuring, the accelerated deferred comp and the closed-end fund cost. The current quarter also benefited from the one-time PPIP performance fee.

Slide 17 is a roll-forward from fiscal Q2's earnings per share of $0.60 to this quarter's loss of $3.45 per share. As you may recall, fiscal Q2 included a $0.13 benefit related to the U.K. tax rate adjustment. Fiscal Q3 included the $3.86 per share related to the noncash impairment charge and a net $0.07 related to the tax items I noted earlier. There were also $0.08 per share in costs associated with the Permal restructuring, the Fauchier Partners acquisition, accelerated deferred comp charges, management transition costs and closed-end fund launch costs. Offsetting these expense items, net earnings per share was $0.06 higher due to the PPIP-related performance fees. And finally, other changes in net revenues and expense produced a positive $0.03 for the quarter.

On Slide 18, the key, once again, is our cash taxes, which are now coming in at 7%. This low cash tax rate allows for both additional investment in the business and additional return of capital to shareholders. This is an area we will continue to highlight for investors. Specifically, this lower level of cash taxes results from our NOL carryforward and our ability to amortize our goodwill and indefinite-lived intangibles for tax purposes. When you translate our effective tax rate into dollars, on the right side of the schedule, you see that over time we will realize a positive cash savings of $1.5 billion.

I'll wrap up on Slide 19, which highlights our cash position as well as capital utilization over the prior 2 fiscal years and through the first 3 quarters of our fiscal 2013. In the upper left-hand corner, you'll note that we ended the quarter with a cash balance of $900 million in line with last quarter. This quarter, we repurchased $71 million of stock and accelerated our regular dividend payment from January to December, which resulted in dividend payments of $29 million this quarter. With regard to repurchases, we were blacked out from buying back shares for a period in December but, subject to market factors, we expect to make up for that shortfall with additional share repurchases in fiscal Q4.

In the upper right, we summarized our cash utilization for share repurchases and dividends in fiscal 2011 of $472 million and fiscal '12 of $444 million. And in fiscal 2013, to date we've used $371 million for share repurchases and dividends along with $358 million for prepaying, delevering and terming out our debt, for a total cash utilization of $729 million while still maintaining over $900 million in cash. Overall, we have returned significant capital to shareholders, and we'll continue to do so going forward while also providing funding next quarter for an accretive acquisition in the alternative space, one of our key focus areas.

So thank you for your time and attention, and now I'll turn it back to Joe.

Joseph A. Sullivan

Thanks, Pete. Before we go to questions, I'd like to quickly recap what we've done this quarter and put it in the context of our strategic progress over the last 2 years. I'll also touch on a few of our goals going forward.

In terms of the last 3 months, we announced a significant acquisition, our first in 7 years and one that was both opportunistic and disciplined. As I previously described, we've collaborated with Permal in establishing a management equity plan, in restructuring our revenue share agreement and in signing multi-year employment contracts with key Permal employees. We completed our work to bring 2 of our managers together in a way that allows LMCM to focus on delivering investment performance to its clients while leveraging the larger ClearBridge infrastructure. And we continue to pursue better operating efficiencies within the organization, a focus we have made part of our corporate DNA.

Better operating efficiency and balance sheet improvement has been a priority over the past 2 years, and progress in these 2 areas has positioned us to invest in our franchise. As a reminder, in fiscal 2011 and 2012, we completed a corporate streamlining effort that generated annualized cost savings of over $140 million, and we have worked diligently to keep those costs from creeping back in.

During this fiscal year, we improved our balance sheet by deleveraging, refinancing, laddering maturities and diversifying our fixed income investor base. This significantly improved our financial flexibility and strength. These balance sheet initiatives, along with the expense savings I just mentioned, have been a key driver of our ability to return capital to shareholders. Since fiscal 2011, we have returned $1.65 billion to investors in the form of stock repurchases, dividends and debt repayment, and we have maintained over $900 million in cash on our balance sheet.

With that financial foundation in place, our work continues with a primary focus on growth. We intend to build on and through our affiliate model, which provides us with strong brand recognition, portfolio diversification by asset class and delivers strong investment results. We will also continue to evaluate strategic acquisitions that ensure that we have a broad product and investment strategies mix that positions us well for growth across geographies, asset classes and distribution channels.

As always, we will be strategic in looking for opportunities to be more efficient and effective across all business functions no matter how small or incremental. And most importantly, we are focused on turning our long-term flows positive. This will be a function of continuing our strong investment performance, ongoing product innovation and improving on our sales metrics, all of which are underway.

So in closing, I would like to reiterate that we are engaged with the Board and our affiliate leadership on this strategy. As we do so, we believe we'll be better positioned to deliver on efficient revenue growth, expanded margins and improved earnings leverage across our organization.

And with that, let me open it up to your questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Roger Freeman from Barclays.

Roger A. Freeman - Barclays Capital, Research Division

Just I guess the 2 funds that you got retail approval for, can you expand on the strategy? How many of the distribution partners you're going to be selling it through and sort of what the initial go-to-market strategy is?

Joseph A. Sullivan

Roger, I think you were referring to our middle market debt fund, is that correct?

Roger A. Freeman - Barclays Capital, Research Division

No, I think as -- I'm going through my notes, I think it was -- there were 2 funds that you had gotten authorization. It wasn't the middle market debt.

Joseph A. Sullivan

Okay. So one of the structured products that we, and again I'm trying to answer -- I think I'm answering your question, but one of the products -- we had a few different products during last quarter and this quarter. We did have -- Western successfully priced a $500 million bank loan CDO in the Street, that's one. That was a January initiative. Royce had a $100 million takeover win in the wealth management channel. Permal has also structured a new fund, kind of a -- I kind of put it in the category of flexible or go-any-way fund. It has a 2-year lockup. That was in the amount of $100 million. I think those were the 3 that we referenced.

Roger A. Freeman - Barclays Capital, Research Division

Okay. Okay. Great. That's helpful.

Joseph A. Sullivan

And then we did also -- Brandywine did receive an inflow in January, not part of our unfunded wins but an unscheduled inflow from an existing sovereign wealth client of an additional $500 million. That's a January number as well.

Roger A. Freeman - Barclays Capital, Research Division

Okay. All right. And just, I guess, the second question is with the restructured agreement with Permal, you kind of implied that it could be a template going forward. Is there opportunity to rework agreements with other affiliates? Or are you referring to any sort of future affiliate like deals that you might do?

Joseph A. Sullivan

Well, I think that we look at the opportunity to add an equity component for our affiliates as really strategic. As I pointed out, it's good for recruiting, it's good for retention of key employees and it really helps for the management teams and the employees who participate in the upside. So these were in growth units. It helps them to think longer term and give them a stake in building and investing for the long term. So as I mentioned, we absolutely look at it as a framework to work with each of our affiliates to try to introduce it and in the case of potential acquisitions, add a similar type of program. But we do think it makes us stronger, and it makes -- it's obviously of interest to all of our affiliates.

Operator

Our next question comes from Dan Fannon from Jefferies.

Daniel Thomas Fannon - Jefferies & Company, Inc., Research Division

I guess, you got a lot of comments on flows and individual managers. Any comments on January? We've heard from a lot of your competitors about trends getting better. I guess, if you could just give some comments, maybe how broadly that's occurring or where you're seeing the most rate of change.

Joseph A. Sullivan

Sure, Dan. We've had, I think, a good January in some respects, and we've had some dings in a couple of other respects. We've had -- on the downside, we've had a couple of global equity institutional mandates that would -- that are going to be coming out in January in the neighborhood of $1 billion, maybe a little bit more than that. We had seen a slowdown in December, and we've seen that continue with some redemptions in our Japanese fixed income business. So that's been a little bit softer. That's really been the result of the yen trade. And maybe counterintuitively, as the yen is weakened, actually investors there are slowing their subscriptions but they're also taking profits. So we've seen some slowdown in that business. On the more positive side, we had a very strong month in the U.S., in our U.S. retail. And in fact, and I think this reflects both the market clearly but also our initiatives in U.S. retail distribution, we had what we believe to be either the best or very close to the best non-deal flow month, net flow month in the U.S. in over 5 years. So a mixed -- a little bit of a mixed month, but I think some good signs as well.

Operator

Our next question comes from Bill Katz from Citi.

William R. Katz - Citigroup Inc, Research Division

Maybe this question's parsing your words a little too closely, but you mentioned that your buyback was a little bit below planned due to the transaction and other matters. Could you tell us what some of those other matters might have been beyond like a typical earnings blackout period?

Peter H. Nachtwey

Yes, Bill, this is Pete. So basically, it was the dual announcements of both the Fauchier transaction and then our impairment charge. So while we were in the final rounds on both of those, we had the blackout for a bit.

William R. Katz - Citigroup Inc, Research Division

Okay. So no other matters really?

Peter H. Nachtwey

No.

William R. Katz - Citigroup Inc, Research Division

Okay. Second question is the bigger picture. If rates were to begin to rise, do you have a sense of what the duration is on WAM Co.'s assets? I'm just sort of wondering about net asset value dynamics in a rising rate backdrop.

Peter H. Nachtwey

Well, as you know, 2 impacts in terms of rising rates for us, one would be an ability to take the waivers off on our money market funds. And then the flip side is, in terms of the longer duration fixed income product, it's one of the things they've been looking at very hard, managing with their clients and a key reason we've been getting into more specialized mandates. So it's a combination of managing the duration down, also getting into some inflation-protective products and then also looking a little more globally for yield that might be less impacted by a rise in U.S. rates is kind of where Western's been focused, as is Brandywine.

Joseph A. Sullivan

Bill, the other thing, too, is that if you get to a point where the fixed income markets soften and the equity markets outperform, then you'll likely see some additional rebalancing, but back in on the institutional side, back into fixed income as fixed income becomes more attractive if, in fact, it falls off. So there's a lot of dynamics that go back and forth there.

Operator

Our next question comes from Michael Kim from Sandler O'Neill.

Michael S. Kim - Sandler O'Neill + Partners, L.P., Research Division

First, Joe, I know you guys have continued to move forward in terms of following the plan you laid out last quarter for kind of the strategic direction of the firm, but just wondering what are the major kind of decisions that need to be made once the CEO position is decided upon. Does the Board sort of, at that point, circle back to thinking through the affiliate model? And what some of the other options are on the table? Any color there would be helpful.

Joseph A. Sullivan

Sure. I think, Michael, candidly, there has been no discussion on our affiliate model. We're very much committed to the affiliate model. We believe that it is a strategic advantage for us. So we're committed to that model. The strategic work that we've done with the Board has really been largely around strengthening and filling out our asset class portfolio. We benefit from the standpoint that we have strong fixed income in Western and Brandywine. We've got some strong equity capabilities in Royce and ClearBridge, Batterymarch and others, Royce certainly. But -- and obviously with Permal, and we've been investing there through -- with the Fauchier acquisition. So we've got alternatives, we've got fixed, we've got equity. But we do have gaps. We do have gaps in alternatives, where there are other types of alternatives beyond fund-of-hedge funds. We have significant gaps in our global equity capability, our non-U.S. equity, whether it be global equity, international or emerging markets. So we've really focused on that, and then we've really focused on strengthening our distribution and how we do that in the U.S., international, institutionally, the whole package. We've got a good framework. We've got a good foundation in both products and distribution, but how do we take it up a notch and fill it out and build it out further?

Operator

Our next question comes from Robert Lee from KBW.

Robert Lee - Keefe, Bruyette, & Woods, Inc., Research Division

I just want to maybe make sure I understand some of the moving pieces in comps and benefits and actually, more specifically, expectations going forward. So if we look at kind of some of the, call it, one-time or nonrecurring items, I mean, should we be thinking that the comp ratio kind of is going to revert back to this 55% range going forward? Or is there anything else that we should be thinking about, and how that's going to move with the revenue over the next couple of quarters?

Peter H. Nachtwey

Good question, Robert, and we do expect in the near term it probably trends back to 55%. But you got to keep in mind the way our rev share model works that virtually all of our affiliates are getting a higher share of revenue than what our comp ratio is today. And to the extent their revenue grows, which is a happy event for both them and for the shareholders, every incremental dollar comes in at a slightly higher comp ratio. But as of right now, we expect to be right in that zone, and that's where we would've been last quarter without the special items, as you noted.

Robert Lee - Keefe, Bruyette, & Woods, Inc., Research Division

Okay. And maybe just looking at Western a little bit. Could we maybe get some update on, I guess, one of the -- clearly, performance doesn't seem to be the issue, but maybe one of the flow challenges is kind of still the big core bond business, so to speak, which maybe that's still subject to kind of getting reallocated away. Can you maybe update us on, within Western, kind of the current size of that block and kind of what you're seeing in demand for core bonds? Is that product still an outflow and you're pretty much offsetting it with inflows in other places, as well?

Joseph A. Sullivan

Sure, Rob. Thank you. Maybe just to take a step back and think just for a moment, Western really continues to progress through a transition that, frankly -- and challenging transition that has taken, frankly, much longer than any of us would've imagined. Obviously, Western went through a very difficult period from an investment performance perspective during the crisis. They've done really a great job of improving their risk management and at the same time delivering terrific results. What we have seen though is that during that time, clients have really migrated from an emphasis on core products. And this is not entirely different to what's gone on in the retail space, but institutional clients have really migrated from a focus or a dependence or emphasis on core products to 2 paths really: one is to an increasing commitment to the passive space, and obviously we're not in that space; but also a commitment and a focus on allocating their fixed income portfolio to more specialized mandates. And candidly, those specialized mandates are among a much larger group of potential managers and in smaller amounts. And so they've done, I think, a very good job. Their performance has been terrific. They've done a good job at migrating and the percentage of their specialized mandates as a percent of their total AUM continues to increase. So it's a transition for them. They had the performance issues, then they've had to transition their business model to account for it. The other thing that I'm particularly encouraged about with respect to Western is they're very opportunistic. So they saw an opportunity just this month in the CLO market and tapped it for $500 million with a Wall Street firm. They -- the REIT, another example of being opportunistic. And so it's taken longer than we would've wanted, but they're doing the right things. Clearly, the new searches that are out there include less -- fewer RFPs for core products. It's, again, this migration and transition that Western continues to go through, but they're making progress.

Operator

Our next question comes from Mac Sykes from Gabelli & Company.

Macrae Sykes - Gabelli & Company, Inc.

Just back to alternatives for a second. Maybe you could give us a little color on what you're leveraging now on the existing product platform, and where do you want to be in a few years in terms of shifting the AUM mix? And then secondarily, how should we think about that in terms of your efforts from organic growth versus acquisition growth?

Joseph A. Sullivan

Well, Mac, currently, we're working with Permal on a number of initiatives to kind of bring the fund-of-hedge fund capability to the U.S. retail space. That's a huge initiative for Permal. It takes a lot a work. It's not easy to create these things in 40-at-type [ph] funds, but we're working very closely with them to do that. You asked a little bit of a different question around mix and that really goes back to the earlier question on the strategic work that we've done with the Board. It's -- we really have taken a look out -- taken a look forward to say what kind of mix do we think we need to have? And it's clear that we are currently overweighted in fixed income. And the way we want to correct that is not by reducing our fixed income but by increasing particularly our exposure in non-U.S. equities and in alternatives. And with respect to alternatives, it could be further expansion in the fund-of-hedge funds space, but I think we're most interested in other alternative areas, be it infrastructure, natural resources, private equity, et cetera, et cetera. I'm not going to give you specific percentages right now because that's part of the strategic work that's still underway. But it's clear, both in terms of our organic work and our focus with retail distribution as well as the inorganic and looking to do additional transactions, we want to change that asset mix of business -- our portfolio.

Operator

Our next question comes from Matt Kelley from Morgan Stanley.

Matthew Kelley - Morgan Stanley, Research Division

So just a little bit more on Permal for you guys. Just wanted to get your sense for the changes in AUM over the past year, 1.5 years there. Just given your focus on fixed income and macro, is this a kind of a -- I don't want to call it style box, but the asset classes that you're in, or is it performance? Just curious to get your sense for why the assets have been shrinking and how you think you could move forward or accelerate to the positive with the Fauchier deal?

Joseph A. Sullivan

Sure. So I think that the real issue there has been less about the products we're in, and that's not entirely true. I mean, there has been -- it's been muted. The performance in some of their products has been relatively competitive, in fact, relatively good. But on an absolute basis, not quite Earth-shattering on an absolute basis. However, the real issue with AUM has been a continued outflow in the high net worth business, and they have been in transition over the last few years to more of an institutional business. They've clearly seen improvement there last quarter, for example. The outflow that they had was virtually all high net worth. They were actually in net inflow in the institutional side in the U.S. Fauchier -- and that's really what Fauchier was all about, is a strategic transaction that extends both their product line, so the product line is very complementary; gets them into long/short, for example; but that's not really been a product area for them. It extends, it adds people, it adds European and Asian institutional distribution. So it's really complementary in terms of clients, geographies and products.

Operator

Our next question comes from Mike Carrier from Bank of America Merrill Lynch.

Michael Carrier - BofA Merrill Lynch, Research Division

Maybe one more just on Permal and then Fauchier. I guess 2 things, one is on the expectations on the acquisition. You mentioned some outflows. I think when you announced it, it was 6 2 and now it's 5 8. So just based on -- obviously, anything can happen. But based on what your expectations are, when that closes, do you have kind of an estimate of where you think those AUM -- where the AUM will be? And then just on Permal, you gave some guidance just on the profit interest in terms of that million. In terms of that revised revenue share, like how should we think about that in terms of the near term? Any type of hit to the comp ratio? But then obviously long term, if it's successful, we should expect that benefit to start to kick in. But just any guidance around that?

Joseph A. Sullivan

Okay. Mike, thank you for that. Let me answer part 1, and then I'll kind of turn it over to part 2 for Pete. Again, I want to make it clear. Fauchier for us was a strategic acquisition. Obviously, it was not an asset grab. We brought assets, but we brought great people, great products, complementary clients and geographic reach. It's all about -- that deal was all about making Permal better over the long term. Now part of the reason a company like Fauchier was available and frankly, what we've seen with other similar managers and other competitors in our space who have made similar acquisitions, the fund-of-hedge funds space has been under pressure and many of the smaller managers even more so. And so as we entered into discussions, Fauchier was having some outflow, and we knew that and we tracked that and we projected that and we worked through that in terms of the transaction; in structuring the deal, we factored that in completely, an anticipated or scheduled level of outflow at Fauchier. So we factored that into the deal. I don't think it's a great -- I don't think it's appropriate right now, given we haven't even really closed, for me to talk specifically about flows, what I expect them to be. But there will be some outflow, and we've known that from day 1 in our conversations. Pete, do you want to talk a little more specifics?

Peter H. Nachtwey

Yes, thanks, Joe, and good questions, Mike. Just to close the loop on the Fauchier side of it, so as we've said, that's going to be modestly accretive in the near term. And then we expect it to grow in the longer term. As Permal realizes some synergies, we'll actually grow our rev share off just the Fauchier piece. So it starts out accretive and should get to be more so down the road. And as you're looking at the impact of our revised revenue share agreement with them in terms of comp ratio, more or less, what we've simply done is kind of document facts on the ground. We had a very high rev share there back at the peak, and we've had to help them a bit in the past. So this is kind of documenting the level of where we are already. But it does allow us, again in the future, to step the rev share back up as their AUM grows and improves.

Operator

Our next question comes from Glenn Schorr from Nomura.

Glenn Schorr - Nomura Securities Co. Ltd., Research Division

So I appreciate the details you gave us on the big tax benefit and the big cash balances. I guess my question is, given your aspirations on increasing the non-U.S. equity component, the alternative component over time, I'm curious on -- the use of cash continues to be focused on buybacks. Given your debt to EBITDA, I would think you want to either delever or save for the acquisition front. So curious on your thoughts on that, and if the rating agencies are okay with the ongoing buyback program.

Peter H. Nachtwey

Yes, no, good questions, Glenn. Thank you. So first of all, the agencies are fine, and we stay in constant dialogue with them. And when we structured this new buyback, the new tranche of $1 billion, had a very firm agreement with them that 65% of operating cash flow was a comfortable number, allowing us to meet our other commitments and still make some investments in the business. And then as it relates to the trade-off between buyback and either debt refinancing or doing deals, number one, we felt, coming out of the crisis, it was still appropriate to maintain a little extra capital and particularly while we could lock in rates lower for longer, which is what we did with this bond deal and our current bank deal. And then as we look at the trade-off on the cash we have on the balance sheet, do we invest in the business or do we buy back stock? It really comes down to a kind of ROI for our investors. If it's a better deal to continue to buy back stock than the deals we have in front of us, we'll continue to do those. And there's nothing really blocking us today from doing the kind of size deals -- not thinking about transformational deals, as we've said in the past at this point. I think we have plenty of capacity with the cash on the balance sheet, an undrawn revolver of $500 million and an ability to put a little more leverage on if we're buying incremental EBITDA. So we're constantly balancing all of those things as we think about capital allocation.

Operator

Our next question comes from Jeff Hopson from Stifel.

J. Jeffrey Hopson - Stifel, Nicolaus & Co., Inc., Research Division

Just on Legg Mason Capital, can you give us a sense of what the assets are left there? And as it moves over, any sense on what that could do to the short term flows? I'm assuming that the $1 billion outflow in January is from Legg Mason Capital. But any sense there? And then Joe, you mentioned sales metrics as a part of the improvement going forward. Can you get more specific on what you're talking about there as to how that will help on the flow side?

Joseph A. Sullivan

Sure. So just to be clear, the $1 billion outflow in January was not related to Legg Mason Capital Management. It was a Global Equities outflow, from one of our Global Equities managers. As it relates to sort of the anticipation with respect to Capital Management, we'll just have to wait and see. I mean, this really will not impact the investment team or the investment process in any way at Capital Management. All it simply does is, and frankly, it allows them to focus exclusively on the investment process, on their clients, on client service and their investment process. So we're not necessarily projecting a significant outflow there, but we'll just have to wait and see. We're not changing the fund names. We're not changing any of that. We'll just have to wait and see. As it relates to the retail side of the business, we're very focused on -- we've got a good, strong foundation. We've got approaching 100 people who work with clients throughout the U.S. on the retail side. We need to improve our productivity there. We've got good productivity, but our product set would suggest that we can grow productivity even more. And we can grow our market share more. Again, we have product sets that are across asset classes, and we can grow more there. So between growing productivity, growing our market share and continuing improvement on our persistency, we feel pretty good about where we are in the U.S. retail space.

Operator

Our next question comes from Douglas Sipkin from Susquehanna.

Douglas Sipkin - Susquehanna Financial Group, LLLP, Research Division

I was hoping to maybe get a little better educated on the tax shield. Admittedly, I'm not an expert on it, but I'm trying to understand it. So it just -- I mean, I guess, my question is, does anything impact it at all? I was just thinking from the standpoint of, clearly, your earnings have not been what you thought, as evidenced by some of the impairments recently. And secondly, you've taken some impairments, which I imagine may ultimately -- could have an impact on goodwill, which also is a portion of this tax shield. So is there a scenario where the tax shield gets implicated? Or is it really kryptonite and nothing can break it?

Peter H. Nachtwey

Great analogy, but I'd probably say it's a little more like titanium. But either way, it's pretty rock solid and the only thing that would cause it to go down would be if we felt we would have an inability to use some of the smaller items that are embedded in there, like foreign tax credits, et cetera. There is a shot clock on those. But keep in mind, we're earning at a pretty good pace, over $500 million in EBITDA and running at a reasonably healthy pretax income number. So again, we wouldn't put these numbers in the deck if we didn't believe that we're going to be able to use them.

Operator

Our next question comes from Eric Berg from RBC Capital Markets.

Eric N. Berg - RBC Capital Markets, LLC, Research Division

My questions really focus on the restructuring of Permal. And my first one is, why did it happen there? Was there any relationship to the acquisition? Why did it happen there? Why wasn't it at any of your other managers? And then relatedly, obviously, there will be interest by the other affiliates. Have you begun the process of restructuring their deals as well?

Joseph A. Sullivan

Mark (sic) [Eric], first of all, one of the things that's important to remember is that Permal has been and remains by far, frankly, our most significant rev share affiliate. So the fact of the matter is, and Pete alluded to this earlier, that the former rev share that was in place, frankly, was too high. It was set in 2005, during the high-water times, and it was just too high of a rev share for them to operate. They've seen their costs increase since the crisis as a result of kind of the Madoff effect of what they need to do from an infrastructure standpoint to sustain and grow their business, and the rev share that we had in place formerly was just too high. So we have been supporting them for the last few years and effectively had a lower rev share as a result of what. What we've simply done is formalize that arrangement, but we've also done so in a way that does provide us potential increase -- additional increase or return to higher levels of rev share if and when the business returns and as it grows. So we have not begun these kind of restructuring negotiations with other affiliates because, frankly, we don't see the need for it. What we are open to and what I referred to is, on the management equity plan, we do think that is strategically the right thing to do for the business and we're open to having conversations and have had some preliminary conversations with other of our affiliates around that.

Operator

We only have time for one more question. Our last question is from Marc Irizarry from Goldman Sachs.

Marc S. Irizarry - Goldman Sachs Group Inc., Research Division

So just related to the last part, about the equity interest. So when you think about the strategic imperative of the revenue share model and profit-sharing and sort of your growth plan, if you will, should we just be thinking about the comp ratio as higher over time? And how willing are you, sort of, to put the cart in front of the horse in terms of getting some of those interests setup sooner rather than later?

Peter H. Nachtwey

Yes, Marc. So in terms of the impact on the comp ratio, first of all, these equity deals, because they're really structured as growth units and therefore option value that in part the affiliate is paying for, there's a relatively small GAAP charge for these things. And then as we look forward down the road, as Sully indicated, we do think they're great aligners of interest between the shareholder and our affiliates. And again, there could be minor upticks in comp ratio as some of the affiliates continue to do better, if they have a higher share of the revenue than our comp ratio. But at the same time, we think we'll be levering corporate and distribution where we've got a lot of fixed -- fixed or quasi-fixed comp related costs because we're at the right scale to be able to support a much higher level of assets at this stage.

Operator

That concludes our question-and-answer session, and I'd like to turn the floor back over to Mr. Sullivan for closing comments.

Joseph A. Sullivan

Thank you. First, I'd like to thank you all once again for joining us this morning, and I hope that you hear that we remain committed to making progress on our turnaround and have good reasons to remain optimistic that returning to growth and improving upon our financial performance is within our reach and doing so will result in improving shareholder value. And finally, I want to thank my colleagues at Legg Mason and the affiliates, once again, for staying focused on this mission during our transition and in so doing, making progress on our turnaround.

And with that, I'll close, and I wish you all a good day. Thank you.

Operator

This concludes today's teleconference. Thank you for your participation. You may now disconnect your lines at this time.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: Legg Mason Management Discusses Q3 2013 Results - Earnings Call Transcript
This Transcript
All Transcripts