Pzena Investment Management Q4 2008 Earnings Call Transcript

| About: Pzena Investment (PZN)

Pzena Investment Management, Inc. (NYSE:PZN)

Q4 2008 Earnings Call

February 11, 2009 10:00 AM ET

Executives

Wayne A. Palladino - Chief Financial Officer and Treasurer

Richard S. Pzena - Chairman, Chief Executive Officer, and Co-Chief Investment Officer

Analysts

Marc Irizarry - Goldman Sachs

Hugh Miller - Sidoti & Co. LLC

Roger Smith - Fox-Pitt Kelton

Tim Shea - JPMorgan

Robert Lee - Keefe, Bruyette & Woods

William Katz - Buckingham Research

Operator

Good afternoon. My name is Jessica and I will be your conference operator today. At this time, I would like to welcome everyone to the Pzena Fourth Quarter and Full Year 2008 Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (Operator Instructions) Thank you. Mr. Palladino, you may begin your conference.

Wayne A. Palladino

All right, Jessica, thank you very much. I am Wayne Palladino, Chief Financial Officer of Pzena Investment Management. And I am pleased to welcome you to our fourth quarter and full year 2008 earnings conference call. As always, I am joined by Rich Pzena, Chief Executive Officer and Co-Chief Investment Officer of the firm.

Our fourth quarter and full year 2008 earnings press release contains the financial tables for the periods we are going to discuss. If you don't have a copy, it can be obtained on our website at www.pzena.com in the Investor Relations section. Replays of this call will be available for the next week at our website or by telephone at the number given in the press release.

From time to time, information or statements provided by us, including those within this conference call, may contain certain forward-looking statements related to future events, future financial performance, strategies, expectations, competitive environment and regulations. Forward-looking statements are based on information available at the time these statements are made and/or management's good faith belief as of that time with respect to future events and are subject to risks and uncertainties that could cause actual performance or results to differ materially from those expressed in our or suggested by the forward-looking statements. Such risks and uncertainties include, but are not limited to loss of revenue due to contract terminations and redemptions, our ownership structure, catastrophic or unpredictable events, unavailability of third party retail distribution channels, damage to our reputation or interpretation thereof and positioning relative to market fluctuations in the market and the competitive conditions in the mutual fund, asset management and broader financial services sectors.

For a discussion concerning some of these and other risks, uncertainties and other important factors that could affect future results, please see forward-looking statements and, where applicable, risk factors in the company's annual report on Form 10-K and Forms 10-Q as filed with the Securities and Exchange Commission on March 31, 2008 and November 13, 2008 respectively.

In addition, please be advised that because of the prohibitions on selective disclosure, the company, as a matter of policy, does not disclose material that is not public information on our conference calls. If one of your questions requires the disclosure of material non-public information, the company will not be able to respond to it.

I would like to begin by highlighting some of our financial results. We reported revenues for the fourth quarter and full year 2008 of $18 million and $101.4 million respectively, operating income of $64.4 million for the full year 2008 and net loss attributable to the publicly held shares for full year 2008 of $3.7 million and loss per share of $0.60.

On a pro forma basis, 2008 net income was $2.8 million or $0.45 per diluted share.

I'll review our financial results in greater detail in a few minutes. First, I would like to turn the call over to Rich Pzena who will discuss our view of the investing environment and how we are positioned relative to it.

Richard S. Pzena

Thanks Wayne. The fourth quarter of 2008 was one of the most difficult quarters, if not the single most difficult quarter, in the careers of most of today's investment managers and their clients.

Besides a slide of 22% in the S&P 500 and an economic contraction of 3.8%, the sense of uncertainty and insecurity is greater than we have experienced in a very long time.

In the face of that uncertainty, our full year client flows turned negative with most of the outflows concentrated in the second half of the year. As liquidity dried up for many institutional investors, they turned 0to the equity markets as a source of funding their short-term needs.

Over recent years, many institutions had dramatically increased their allocations to illiquid investments which turned out to be even less liquid than expected.

In private equity, regular distributions essentially ceased as the market to sell holdings dried up. And in a sort of double-whammy, scheduled funding obligations continued. Further, many hedge funds put gates on their clients, preventing them from accessing their funds as expected. Even the fixed income and money market funds experienced unexpected illiquidity.

During this time, the equity markets remained relatively liquid. Several of our clients have referred to their long only mangers like us as an ATM machine as they were forced to sell equities at a point that they thought inadvisable, but had no option.

Although it is difficult to truly know, most clients that withdrew funds indicated that the reason was either a desire for a reduction in exposure to equity markets or a need for liquidity.

The good news is that the trends seem to be moderating. The fourth quarter was better than the third. And so far, the first quarter of 2009 has been better than the fourth. Let's hope these trends continue.

So how are we responding to these challenges? There are two ways to address the question. What are doing from an investment perspective and what are we doing from a business perspective? I'll tackle over the investment question first. But as you will hear, the answers bear some similarity to each other.

The markets decline in the fourth quarter dramatically expanded the opportunity of available investments. In fact, equity markets themselves became far more attractive than at any point since 1980. We calculate the expected return on the S&P 500 to be approximately 15% today, and that assumes that long-term return on equity for American companies averages only 12.7% in the future, below the long-term average and significantly below the recent history. But in 1980, the 10-year treasury was 12%; today it is about 3%. So the spread is as wide as we have seen for many decades.

To restore the spread to its 20-year average, the S&P 500 would have to rise by 50%. And to restore this spread to the generally accepted 600 basis point equity risk premium, the S&P 500 would have to rise by over 35%.

Similarly, the spread between cheap stocks and the rest of the market is unusually wide. In fact, with the exception of the Internet bubble, when cheap stocks were relatively cheap, though not absolutely cheap, the spread is as large as it has been in decades. So not only is the stock market cheap, but value stocks are compelling. If you can choose the companies that make it through this crisis, expected returns are close to 20%.

The trick of course is to choose the survivors. And for us, 2008 was a year in which some of the companies that we deemed to be survivors turned out not to be. Clearly, we made some big mistakes in taking such a large exposure in an environment that turned out to be far worse than we had expected.

So what did we learn from the past year and how is our investment portfolio positioned going forward?

The biggest lessons that we learned are that sentiment can have an impact not only on the share price of the company, but also on the business itself and government action can actually be triggered by sentiment issues as well. So where we thought we were exposed to only volatility and share price, we turned out to be exposed to failure risk as well. Some of these well publicized failures like Fannie Mae, Freddie Mac and Wachovia were surprises to us and we believe could have been avoided by a different policy response. Nevertheless, the policy response was what it was and in hindsight, we had too much exposure to these risks.

Accordingly, we have been much more aware of the risks that sentiment can have on a business and on government actions. As such, we ceased adding to our financial holdings, thereby effectively reducing our exposure to financial services companies as their share prices declined. In particular, we have limited exposure to the highest risk institutions where government action can be unpredictable. From a high of roughly 40% financials, our exposure in most of our strategies has fallen to approximately 25%.

Nevertheless, we believe that the current exposures reflect appropriately the risks inherent in the positions, risks that we misjudged a year ago. Most of our portfolio actions in the past 90 days have been to exploit the general decline in valuation for solid non-financial companies with little or no viability risks. Many of these companies have fallen sharply from their highs due to significant near-term earnings uncertainty. Yet many of the companies have little or no risk of failure due to low or no debt outstanding and cost structures which are highly variable.

Take Boeing as an example. While it is difficult to predict how many airplanes will be sold in the next few years, the company is a great, low debt franchise with a stable defense business and a variable (ph) cost structure. Though at two-thirds off its high, we see an opportunity to wait and get paid. There are many such opportunities.

So the primary portfolio initiatives over the past few months have been to increase our exposure to great franchises with significant earnings uncertainty but little viability risks.

Formally, we have modified our screening strategy to incorporate a major recession in the near term and the lack of availability of debt financing with the incumbent requirement to fund operations using dilutive equity offerings.

But our basic premise that good businesses at deeply depressed prices as a valid investment strategy remains in tact. We have made no significant changes to our investment philosophy or our investment process. We have simply expanded our definition of risk to include uncertainties that we hadn't contemplated in the past.

We believe that once the economy begins to stabilize, the bargains that are out there will become obvious to the market and we should reap the rewards for our clients. In fact, there is an argument that a recession does more to focus the investing public on valuation that any other single event. We think this recession is not an exception. The momentum strategies that did so well in the period leading up to this recession have soured far more severely than value strategies. And while value strategies have not outperformed the market yet, they have ceased underperforming.

With respect to our business strategy, it's no different than our investment strategy. We have positioned Pzena Investment Management to be a survivor by dramatically reducing our cost structure, reducing our financial leverage and increasing the use of equity incentives to retain our staff.

Our investment team is totally intact. We have 20 research professionals and they are busier than ever identifying opportunities that appear extremely attractive. Although we had to lay off approximately 10% of our workforce in the quarter, almost all of the reductions came from our back office and operational teams, reflecting the reduced asset base that we manage.

Not that there haven't been sacrifices. Consistent with the pay practices for the leadership at other financial services firms, our entire Executive Committee elected to take no cash bonus this year and cash bonuses were slashed for our highly compensated staff across the board. In some cases, these bonuses have been replaced with options to acquire equity in our operating company. Although these options may be dilutive, we granted approximately 3.5% of the outstanding shares, they have clearly aligned a recovery in our investment performance with compensation.

The most gratifying aspect of our bonus reduction policy is that it has been accomplished with the willing participation of most, if not all, of our professionals. Rather than be forced to reduce investment staff, our team opted to accept lower cash compensation.

We used some of the reduced cash compensation to dramatically lower our debt burden during the year. Our total debt at year end was $38 million, down from $60 million at the beginning of 2008. And subsequent to the end of the fourth quarter, we paid down another $8 million. Today, our long-term debt is approximately equal to the sum of our cash balance and our accounts receivable and there are no financial covenants associated with the debt. These receivables are as close to cash as one might imagine since our bad debt experience has been negligible. So the financial risk of the firm has been dramatically reduced, if not eliminated, and we continue to be cash flow positive.

So we believe that Pzena Investment Management would qualify as one of the businesses that we would invest in: A good business that doesn't have viability issues, but a near-term earnings outlook that remains uncertain.

At this point, I would like to turn the call back over to Wayne Palladino who will review in more depth the financial results of the fourth quarter and the year.

Wayne A. Palladino

All right, thank you Rich. Certain financial results I am going to discuss are presented on a pro forma basis as we believe these adjustments and the non-GAAP measurements derived from them provide information to better analyze the company's results between periods and over time. You can see details of these pro forma adjustments in our press release.

Let's start off by discussing assets under management or AUM, our fee rates and revenues.

Our assets under management during the fourth quarter of 2008 declined by $4.8 billion or 31% from $15.5 billion at September 30, 2008 to $10.7 billion at December 31, 2008.

Over 80% of this or $3.9 billion of the decline was investment performance-related with net outflows of $0.9 billion accounting for the remainder of the decline.

The full year numbers show similar trends. Our assets declined $12.9 billion or 54.7% from $23.6 billion at December 31, 2007. Again, nearly 80% or $10 billion of this decline was due to our negative investment performances with $2.9 billion of net outflows.

At December 31, 2008, the company's $10.7 billion in AUM consisted of $6.4 billion in separately managed accounts and $4.3 billion in sub-advised accounts. Assets in separately managed accounts decreased $3 billion or 31.9% to $6.4 billion at December 31, 2008 from $9.4 billion at September 30, 2008, due primarily to $2.4 billion in market depreciation and $0.6 billion in net outflows. Sub-advised assets declined $1.8 billion or 29.5% during the fourth quarter from $6.1 billion at the end of the third quarter of 2008, due again primarily to $1.5 billion in market depreciation and $0.3 billion in net outflows.

Our fourth quarter 2008 revenues were $18 million, down by 48.3% from $34.8 million in the fourth quarter of 2007 and down by 28.3% from the third quarter of 2008, which were $25.1 million. The reduction in revenues were due to declines in average assets under management offset to an extent by an increase in our weighted average fees.

For the year, 2008 revenues were $101.4 million, down 31.1% from $147.1 million in 2007. The reduction in annual revenues was also due to declines in average assets under management.

Average assets under management were $12 billion for the fourth quarter of 2008, down 54.5% from $26.4 billion for the fourth quarter of 2007 and down 31.8% from $17.6 billion for the third quarter of 2008. For the year, average assets under management were $18.1 billion, down 36% from $28.3 billion in 2007.

Our weighted average fee rate increased to 59.8 basis points in the fourth quarter of 2008, up from an average of 53 basis points in the fourth quarter of 2007 and 56.9 basis points in the third quarter of 2008. This was mainly due to an increase in the weighted average fees generated by our separately managed accounts and, on an annual basis, the result of the continued shift in asset mix towards separately managed accounts which comprise 60% of our fourth quarter 2007 weighted average AUM... I'm sorry, 2008 weighted average AUM, up from 56.9% in the fourth quarter of 2007 and down slightly from 61.4% in the third quarter of 2008.

Weighted average fees for separately managed accounts increased to an average of 75.2 basis points for the fourth quarter of 2008 from an average of 64.9 basis points for the fourth quarter of 2007 and from 67.1 basis points for the third quarter of 2008.

This change was mainly due to a higher mix of assets in our international and global strategies, which generally carry a higher fee than our domestic strategies, lower average account size due to the decline in the market and some impact from clients that pay in advance.

Weighted average fees for sub-advised accounts decreased slightly to an average of 37 basis points for the fourth quarter of 2008 from an average of 37.2 basis points for the fourth quarter of 2007 and from an average of 40.6 basis points for the third quarter of 2008. For the year, weighted average fee rates increased to 56.2 basis points from 52.1 basis points in 2007.

Now let's turn our attention to the remainder of the P&L.

I would like to draw your attention to the compensation expense for the quarter, which was essentially zero. As Rich discussed, we realigned our year-end compensation packages to reflect the adverse economic environment we find ourselves in.

Consequently, we dramatically reduced the cash bonus payments for senior professionals within the firm. While we offset some of the reduced cash compensation with option grants, the net effect was that we had accrued enough compensation expense through the first three quarters of the year that no additional expense was required for the fourth quarter. Thus, comparisons of fourth quarter operating expenses with prior periods are not relevant.

For the full year 2008, our compensation expense was reduced by $8.3 million or 24.4% to $25.7 million versus pro forma 2007 compensation expense of $33.9 million.

This painful expense reduction comes from three items: The reduction in cash bonuses, which is the largest piece; the reduction in staff that we announced last quarter and from lower variable compensation expense that is tied directly to assets under management. Based on current asset levels, we would expect 2009 compensation expense to be slightly lower than full year 2008 levels.

General and administrative expenses were $3 million in the fourth quarter of 2008, a decrease of $2.5 million or 45.5% from $5.5 million in the fourth quarter of 2007 and a decrease of $1.4 million or 31.8% from pro forma 2007 fourth quarter. This is a result of decreased professional fees, data system costs arising from ongoing efforts to reduce overall operating expenditures. For the full year 2008, general and administrative expenses were $11.4 million versus $13 million for 2007 and $12 million on a pro forma basis for 2007. This decline of $0.6 million or 5% from pro forma 2007 levels, which was driven by reductions in data systems as well as general containment measures... cost containment measures.

For the year, operating expenses were $37 million compared with $142.7 million for 2007. Excluding the first quarter 2007 charges related to mandatory redemption provisions of our operating company units, pro forma 2007 operating expenses were $45.9 million. This represents a reduction in operating expenses of $8.9 million or 19.4% from pro forma 2007 levels. While we have already taken big chunks of expense out of our system, we continue to look for ways to further reduce operating expenses. Barring major changes in our assets under management, we expect 2009 operating expenses to be slightly below the 2008 levels.

Given the lack of compensation expense in the fourth quarter, operating income comparisons to fourth quarter 2008 is just not relevant.

For the year, 2008 operating income was $64.4 million compared with $4.4 million for 2007. On a pro forma basis, operating income was $101.2 million for the year ended December 31, 2007.

For the year, 2008 operating margins were 63.5% compared with 3% for 2007. 2007 pro forma operating margins were 68.8%.

Other income expense was an expense of $5.8 million for the quarter of 2008, which consisted primarily of $7.3 million in charges related to negative performance of the company's investments in its own products. These charges were partially offset by the benefit of $2.9 million associated with a waiver by our selling shareholders of all payments due to them for 2008 and 2009 tax years under the tax receivable agreement.

This represents 85% of the expected tax benefit in 2008 and 2009 generated from amortization of the step up in basis the company received when it acquired units in our operating company from the selling shareholders of the IPO that would not otherwise have been due to the selling shareholders... that would have been due to the selling shareholders.

Other income expense declined $3.3 million for the fourth quarter of 2008 compared with the fourth quarter of 2007, primarily as a result of the negative performance of company investments, partially offset by the income associated with the tax receivable agreement waiver I just mentioned. Excluding amounts associated with the tax receivable agreement, the annual declines in pro forma fourth quarter other income expense was generated by negative performance of our investments.

For the full year 2008, other income expense was income of $35.7 million compared with an expense of $2.1 million for 2007. On a pro forma basis, other income expense was an expense of $20.5 million for 2008 and an expense of $4.3 million for 2007. The annual decline in pro forma other income expense was generated primarily by the negative performance of our investments.

On January 23, 2009, we prepaid $8 million of our existing bank debt, lowering the outstanding principal to $14 million. We expect the absolute dollar amount of our interest expense to come down accordingly.

The provision for income taxes was $0.7 million in the fourth quarter of 2008 compared with $1.7 million for the fourth quarter of 2007. On a pro forma basis, the pro forma income tax... provision for income taxes was $2 million for the fourth quarter of 2007. The annual declines in provision were generated primarily by a reduction in taxable income at the operating company.

We have provided supplemental income statement data on the last page of the press releases to assist you in deriving our effective tax rate.

Excluding amounts associated with the tax receivable waiver I discussed earlier, our effective tax rates for the fourth quarter and full year 2008 were 45.2% and 45.8% respectively. Our effective tax rates for the fourth quarter and full year 2007 were 47.5% and 47.8% respectively. As you can see, this number varies slightly from period to period but is usually around 46%.

As a result of the foregoing, we reported $0.56 of net income per basic share and $0.13 of net income per diluted share for the fourth quarter 2008.

For the year, net loss per share was $0.60. On a pro forma basis, we reported $0.09 and $0.45 respectively of net income per diluted share for the quarter and year ended December 31, 2008.

With respect to the balance sheet, cash stands at approximately $27.4 million at December 31, 2008, a number that includes $300,000 of cash held by our consolidated investment partnerships. I would also like to note that at December 31, 2008, our debt was about equal to our cash plus accounts receivable and our debt contained no financial covenants.

And now, we would be happy to take any questions.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from Marc Irizarry with Goldman Sachs.

Marc Irizarry - Goldman Sachs

Great, it's Marc Irizarry at Goldman Sachs. Rich, maybe you can expand a little bit on what's happening in terms of institutional rebalancing, where you fit in and what's happening on the consultant side in terms of the way they are viewing some of what seemed to be modest changes in the way you are screening your investments.

Richard Pzena

Sure. I don't think there is a whole lot of difference out there in the way that either consultants or our clients are perceiving us. Obviously, when you have a period of underperformance, everybody is interested in understanding what did you learn from that period of underperformance to make sure that you are incorporating that learning into your process, but not changing the basic fundamental philosophy and investment process that you engage in. And I think for the most part, they are convinced. We still remain on the recommended list of most of the major institutional consulting firms. In fact, we've just been selected by one of the major ones to sub-advise some of their own funds that they have a fiduciary responsibility for. So it remains good.

From the client perspective, obviously, it's very mixed. There are those that were unhappy with our investment performance and terminated us. There are those that rebalanced normally as we got out of black. And there are those that added money, or we even got new account relationships. So we continue to have all of those things happening.

I will tell you, though, that the marketplace today institutionally is pretty frozen. I think you are looking at investment committees or pension departments that are sort of shell-shocked by what's going on. And they are dealing with issues that they never imagined that they would be dealing with. And asset allocation today isn't the number one concern on their minds. So we don't see a lot of activity. At least we haven't seen a lot of activity other than emergency reactions in the last, call it, four or five or six months. Whether that will change in 2009, I don't know; maybe. But so far, no sign of it.

Marc Irizarry - Goldman Sachs

And then just in terms of some of the termination notices, did those actually hit in this quarter's flows, or how should we think about what the pipeline of inflows and outflows look on the institutional side?

Richard Pzena

Our typical notice period for our terminations are less than 24 hours. So you just get it faxed, and you're done. Remember, we don't have custody of any of the client assets. So administratively, there is no issue; we just get a letter that says please stops trading in our account, and that's it. And it's pretty rare that there is significant notice. So terminations, obviously, were the largest in the third quarter. They fell quite sharply from the third to the fourth quarter and were almost non-existent so far this year. But we are five weeks into the year, so it's hard to tell. I guess I would tell you if you were going to base your analysis on the very recent activity, you would feel good. But it's really erratic, so I don't even want to go there.

Marc Irizarry - Goldman Sachs

And then just in terms of the operating margin, Wayne, maybe you can expand a little bit on comp and benefits relative to how willing you are to sort of give out more equity at the operating company level. How should we think about that for 2009 and maybe you can just help quantify a little bit in terms of a slight decline in comp, just a little more color there?

Wayne Palladino

Yes, I think when you look at the 2009 comp line, Marc, what I would be doing is I think the combination of cash and additional equity compensation is going to be probably just slightly lower than what you saw for full year 2008. And I would look, you see the pro forma results there actually as well... there is about $25.7 million for 2008. So it will be a touch less than that.

Richard Pzena

And the mix, by the way, I'll just add to that, is currently forecast or budgeted to be pretty similar between cash and non-cash compensation. So during... so much of it depends on where our flows are for the rest of the year. But if you just spread (ph) that we have our assets under management at the end of the year are the same as they are today, and everything else being equal, we would probably issue a similar amount of equity next year and have a similar cash versus non-cash mix. Does that help?

Marc Irizarry - Goldman Sachs

That's helpful. Thanks.

Richard Pzena

Great.

Operator: Your next question comes from Hugh Miller with Sidoti.

Hugh Miller - Sidoti & Co. LLC

Good morning. I was wondering if you could give a little bit of additional color on the cost reductions you guys had alluded to that you are still looking into and potentially could see as we head into 2009.

Richard Pzena

Hugh, the cost... for us, the costs are mostly compensation expense. I mean when you look at our cost structure, it's... three-quarters of the cost is compensation expenses. So we did some layoffs, as you know, in the fourth quarter, which were painful and we are hoping not to have to repeat any more of those. It obviously... it depends on where assets wind up going. But again, I'll answer the question the same way. If assets stay where they are today, we don't really have any issue on needing to do another round of layoffs.

We think that it's really important to maintain the investment team in tact. This is really what our franchise is. So we think there is probably a little room to lower comp a little bit. We have the full year effect of some of those layoffs that we had taken only in the fourth quarter that will be on the negative side. But it's nothing dramatic on the positive side from a comp perspective. So that's why we are forecasting only slightly down.

As far as other expenses go, the ability to cut costs there are... we have... we are looking at everything is the way I would put it. But there are some significant costs that are sort of structural with regard to being a publicly traded company, with regard to maintaining compliance and legal and operational infrastructure, but you don't have that much flexibility unless the size of the business changes.

Hugh Miller - Sidoti & Co. LLC

Okay. And looking at the balance sheet, the investment in marketable securities line, down substantially on a linked-quarter basis. Obviously, some of that had to do with the negative investment performance for the securities that you are investing there. But can you give some insight into what may have caused the decline outside of that particular area?

Richard Pzena

Yes, I mean there is two big... there is probably three big areas. One is just the decline in the value of the investments. That's probably the single biggest one, unfortunately.

The second biggest one is we had a deferred comp plan that in 2007 and prior years, employees had allocated amongst the various products in the firm. And during the year... during the fourth quarter, every year, the employees have the option to reallocate where those shares, where those investments go. And I think with almost no exception, everyone reallocated the company stock. And so we liquidated the investments that were held on our balance sheet on behalf of our employees and it went into common stock.

And the third area was we discontinued the incubation of some of the products that we deemed to be not really marketable anytime in the near future. And so we have got... we have it down now to a... so today, the marketable securities are effectively 100% the incubation of additional product, which we think is the right size and we have to consolidate some of our actual investment partnerships. So the net exposure of ours net of minority interest is around $5 million, and that's where we think it will be for the year.

Hugh Miller - Sidoti & Co. LLC

Okay, great color there. And I guess just looking at the flows for January, anticipating that there was some modest inflows. I was just wondering maybe if you could give any insight there as to what you were seeing in the month of January. You alluded to some of it in your commentary prior, but any other insight would be great.

Richard Pzena

Yes, I mean we had some positive... we had flows in during so far this year that are mostly tied to that one consulting firm that I mentioned that had selected us to manage assets on their behalf. So that's... it's lumpy and it was reasonably sizable. So at the same time outflows so far have been pretty small this year. I don't know that there is any more color I can give. We continue to be involved in discussions of the nature of taking those kinds of accounts and they are ongoing. But we had a lot of funding so far this year.

Hugh Miller - Sidoti & Co. LLC

Okay. Thank you.

Operator

Your next question comes from Roger Smith with FPK.

Roger Smith - Fox-Pitt Kelton

Well, thanks very much. I just want to talk a little bit about the changing in the definition of risk I guess within the model. And I guess you touched a little bit... it's really on, and I guess you can correct me if I'm wrong, more on the risk if these companies go out of business. And it sounds like that's changed the allocation to financials a lot. What specifically are you really doing with that risk and are you worried at all that that might hurt the performance of the portfolio? Should we really get out of this recession faster and these valuations come back?

Richard Pzena

Yes, Roger, obviously, that is the dilemma that we wrestle with, which is what's the appropriate level of investment and in companies that are... that clearly have huge upside to the extent that the financial crisis has resolved and the economic crisis moderates versus the risk that you have that's not the case. And we had big exposures to institutions where we thought that that risk reward trade off was favorable, but the idea that there would be either government intervention or failure as a very, very remote possibility caused us to take positions that were 4% and 5% of the portfolio in some of these high profile financial institutions.

Today, if you say, or I'll cite the one that's the most controversial in our portfolio, Citigroup, if you say that if everything becomes wonderful from this point on and they don't need to issue any more dilutive equity and they are not nationalized, you have, with think, upside that's enormous, be ten-fold or more in share price. On the other hand, you weigh that against the risk that something happens that either causes you to loose all your equity or causes you to be substantially diluted, and it's very difficult to assess what the probability of those outcomes are.

So we've deemed it prudent to only hold 1% to 2% positions in those kind of stocks and in aggregate to hold less than 10% of the portfolio on those kinds of stocks compared to probably double that exposure a year ago. So we are foregoing some upside. On the other hand, I doubt... if you took this to the extreme and there aren't very many people that would say I'm going to put all my money into Citibank because it has such big upside compared to the downside.

So these are not easy questions to say where do you want to put that exposure. But this is the debate that we have had and this is where we decided we overexposed and blew it. And because the nature of some of the companies that we hold in our portfolio have such upside, we still think we are preserving a lot of it even thought it's not quite the size that we had anticipated when we had a much bigger exposure.

Roger Smith - Fox-Pitt Kelton

Great, thanks a lot. And then I guess with the debt, I think you guys indicated that it's down to $14 million now, and I think you have enough cash and I guess cash and receivables to pay that off. Is the anticipation, though, to kind of keep this debt at this level right now going forward, or are you guys thinking about looking to potentially eliminate that debt?

Richard Pzena

Well we would like to eliminate... eventually, we would like to eliminate the debt. We have... the $14 million in bank debt, let me just clarify that, and we have $16 million of subordinated debt on top of that as of today. Both of those debt issues contain restrictions on our ability to pay dividends. So we either have to pay the debt off so that we can pay dividends, or we have to wait for a better credit environment where we can renegotiate (ph) the terms of those loans and allow dividend payment. So at this point, I've got to say the plan is to pay it off.

Roger Smith - Fox-Pitt Kelton

Okay. Great. And then just the last question I want to talk about is on the options expense here and making sure that I understand more from an accounting point of view how things flow through. You said you guys issued 3.5% of the equity in options. How much of that... like what should we think about from a share count point of view and how will that kind of flow through in the next couple of quarters? And then how much... if I look at the income statement now, it looks like most of the compensation is cash compensation and then next year will have some piece that's an equity grant competition. So just how does that break out?

Wayne Palladino

Yes, let me maybe start with that, Roger, and then Rich can chime in if he has some additional detail. The number of... and this was mainly option expense or option grants that you saw at the very end of 2008. The amount was about 3.5% of the outstanding, the fully diluted outstanding share base. So it's about 2.2 million options and the expense associated with that was fully taken in the fourth quarter results, and that about $4 million.

What you would expect to see in terms of the impact on share count going forward would just be the typical calculation of basic and fully diluted shares, whether they're in the money or out of the money. So there is nothing more complicated than that in terms of how to assess it. And then I think with regard to the future, based on Rich's comment before, all things being equal right now, we would expect to see probably similar levels in 2009.

Roger Smith - Fox-Pitt Kelton

Okay. No, that makes sense. But the stock that the employees shifted I guess from investments that you guys had in that marketable securities, does that change the share count that we should be thinking about?

Richard Pzena

It does, but it's a much smaller magnitude. I don't have...

Wayne Palladino

Yes, we'll get you the exact number, Roger. But it wasn't a huge number.

Roger Smith - Fox-Pitt Kelton

That's fine. Great. Thanks very much.

Wayne Palladino

Okay.

Operator

Your next question comes from Ken Worthington with JPMorgan.

Tim Shea - JPMorgan

Hi, this is Tim Shea filling in for Ken. The first question that we have is going back to the account terminations. Would it be possible to get any color on the percentage of net flows that came from account terminations versus other flows in 3Q versus 4Q?

Richard Pzena

You mean separating out inflows versus outflows, is that what you are asking?

Tim Shea - JPMorgan

Separating out the net flows that came from account terminations versus other types of flows like reallocations or cash withdrawals for liquidity purposes?

Richard Pzena

Yes, we are wrestling right now with what the appropriate level of disclosure is for us on flows. And so I'm going to unfortunately have to bag off (ph) on that question. And we can give you some flavor for it. I don't have the data in front of me, but I think a lot of investment managers are struggling with how much should you disclose from a flow perspective. And we've been disclosing just net flows on the basis that the gross flows are so erratic and not indicative of trends. But it would be more misleading to disclose that than it would be helpful. But we are rethinking that.

So hopefully, we can answer that question for you in the future rather than today. I apologize for the way I'm answering this.

Tim Shea - JPMorgan

Or is it possible to get any color as to the number of account terminations just in a relative sense that you saw in maybe 2Q, 3Q, 4Q last year?

Richard Pzena

I can probably give you some basic flavor that on separately managed accounts, outflows in 2Q were pretty negligible. In the third quarter, they were the worst that we had ever seen in our history. And we had very little inflow. So you can sort of figure that out. And in the fourth quarter, they were less than half of what they were in the third quarter. And so far, this year, they are almost non-existent. Does that help?

Tim Shea - JPMorgan

Yes, that helps. Moving on to growth versus value performance, because if we look at the Russell 1000 growth versus the Russell 1000 value, what we see is that pretty much from mid-2006 through mid-2008, we saw growth out performance and we saw then value started outperforming really in the second half of 2008. But so far in 2009, if we are looking at the Russell 1000 growth versus value, we see it's about 1000 basis points of growth out performance again. So going back to your comments earlier about value now outperforming growth, we are just wondering how are you looking at that and what indices are you looking at in order to come to that determination.

Richard Pzena

Well, we're not looking at growth versus value. So I want to clarify if I said growth versus value. I was more looking... we've looked at momentum versus value only because growth... momentum indicators over long periods of time dramatically outperform the market and value over time dramatically outperforms the market. And the Russell 1000 growth and the Russell 1000 value don't do anything because they don't... they are just like the market over the long term. So we only think of value as being deep value, not the Russell 1000 value. And deep value would be how did the cheapest decile or the cheapest quintile of low P/E or low price to book or something like that do and momentum is buying the stocks with the strongest price momentum. And there has been a major shift, as you indicated, in mid-2008 away from momentum and towards value. But what doesn't get captured in the extremes of either those value indices or the momentum indices is kind of the boring tocks. And the boring stocks are what's done the best. So this is the environment for being boring. But being boring over the long term has... you can't find any compelling academic evidence to suggest that that's a good investment strategy.

So all I was trying to refer to there were that over that entire period from July through very recently, value indices have not underperformed any further. Obviously, the last month, you're right, it's the difference for last month. But I don't know what to make of that information other than that there is still fear in the marketplace.

Tim Shea - JPMorgan

Okay. I think that that's it for us. Thanks.

Richard Pzena

You're welcome.

Operator

Your next question comes from Robert Lee with KBW.

Robert Lee - Keefe, Bruyette & Woods

Thanks. Good morning everyone.

Richard Pzena

Good morning.

Robert Lee - Keefe, Bruyette & Woods

Hey, Rich, I have a question for you, maybe one you wouldn't be able to... won't be able to answer, but I'll ask it anyway. If you look at where you are now, given what the firm has been through in the past year with the stock price and assets under management, is there anything to make you, I mean... don't know... rethink or think about whether remaining a kind of independent company down the path is still the right answer? And I mean this in the context of is there a... do you think there is much to be gained by attaching yourself to a larger organization with more distribution, removing the, what I am sure, are the headaches in dealing with being a public company?

Richard Pzena

Maybe this won't sound very great coming from my perspective, but there aren't that many headaches of dealing with a public company. I probably shouldn't speak on behalf of my whole staff because they all deal with all the headaches more than I do. But we are constantly thinking about a strategic direction for us. And I am not sure that I can come up with a lot of really great reasons why being part of another organization would do anything for us. We could take some costs out for sure, the costs of being public. The painful part is more the costs than the headaches. And at some point, you have to say, is it worth it? But we have a nice niche in the institutional value world where I don't think our issues are distribution. When you have performance problems like we've had over the past 18 months, having more distribution doesn't really help you.

So from my perspective, being independent and having that ability to focus on really the only thing that matters in this business in the long run, which is your investment performance is the best strategic option. We fortunately have a business model, in the good times had very enormous profit margins. And even in a year like this where we wind up with a 60% or so profit margin, operating margin, you say you've got a lot of flexibility to try and make it through.

And there are benefits to being public in the long run that are the reasons we did it at the beginning, which are one, mostly concern the ability to compensate people with equity, as you witnessed from the stock option program this year. Plus to the extent we ever found opportunities to expand our business in the future for groups that wanted to join us that were smaller than us, having that equity base is a real plus.

So we are not thinking about discontinuing being a public company. We are constantly thinking about what our options are, though. And I just don't think combining with a bigger one right now is the sensible one.

Robert Lee - Keefe, Bruyette & Woods

Okay, great. I appreciate the response.

Richard Pzena

Sure.

Operator

Your next question comes from William Katz with Buckingham Research.

William Katz - Buckingham Research

Okay, thank you. Good morning. Just a couple of questions. I was wondering, Rich, if you can sort of talk a little bit about the relationship with Hancock, what they are sort to saying there. It doesn't seem to be much of an improvement in the flows there. Maybe you can sort of give an update on sort of the sensitivity on redemptions on that side and is there any strategic pressure given the performance of the funds in there. That's my first question.

Richard Pzena

No, the relationship with Hancock remains very strong, but issues on flows have nothing really to do with the relationship. We spend a lot of time with Hancock. We devote a lot of effort to meeting with their clients, and they truly appreciate it. So obviously, they are not happy that there are outflows and they are not happy with the investment performance. But we are not... I think the relationship is quite solid. So I don't know, I guess that was your question. I don't know what else I can add on that.

William Katz - Buckingham Research

Okay, that's helpful. Second one is, as you look at the array of your products that you have remaining, the AUM levels in most of them outside of the large cap value fund are relatively teeny in scope. Are there any strategic issues here from a client perspective of giving you meaningful mandates that might otherwise make them a very large client within a particular fund?

Richard Pzena

Sure, those are always issues. Given that there is not a lot of mandates that we are in competition for right now, it's not an issue right now. But we are almost experiencing the opposite. We are experiencing people asking us to do things, especially for them where we have no other assets under management, where they would be the sole client simply because they like our process and they like our discipline, so. But you are right, there are some of... there always will be that issue. But it's still hard to call them puny in that from the sense of our small cap is of the scale and size that would not create any issue for anybody. Our value strategy is of that scope and size, our global, our large cap value. And some of the other ones that have smaller assets under management where there is a lot of overlap in the research process. We haven't really... that issue hasn't been raised.

William Katz - Buckingham Research

I'm sorry to interrupt you, Rich. The reason I was asking that is there seems to be a fairly accelerated concentration of distribution of distribution or doubt (ph) happening here. And it seems like one of the common refrains coming out of most management teams is that scale becomes more important. I was just sort of wondering if there was any tiny kind of issue just given the array of under $2 billion type portfolios here.

Richard Pzena

Yes, I don't think scale becomes an issue at all in the institutional client world. Maybe it's more of an issue in the mutual fund or retail world where there is a lot of costs to distribution. But our business is almost no cost distribution model.

William Katz - Buckingham Research

And just two last questions. One on... as you think about the discussion on margin, is that sort of a function of AUM growth at this point. Is there any type of potential upward pressure on compensation as we look out into maybe second half of '09, even '010 to the extent that AUM would actually start to rise? Would there be any kind of thought of a make hole, if you will, on compensation giving most probably a pretty lean year in '07 and '08 respectively, above and beyond the mix shift?

Richard Pzena

Yes, in '07, clearly not. In '07, I don't think anybody here would view come as a lean year. In '08, you are right; it was a real (inaudible) year. And the question is what is the right... what is fair comp for our employees? And we believe that with the combination of cash and options that we've paid people we are not far off from market comp. We believe market comp is a lot lower, and we don't have actual survey data yet to document that. But we haven't had anybody departing. And so for us, we've always paid people based on what we've... we want to be... we aim to be at the... in the top core quartile of the market in pay, in cash comp and then supplement that with equity. And that would be the process that we would continue to want to follow. So if we miss the mark here on fair comps and it becomes obviously in the second half or in 2010 that we would have to raise it, we'll raise it. But I don't think that it will be raised simply because the AUM goes up.

Wayne Palladino - Chief Financial Officer and Treasurer

All right. And also consider, Bill, that a portion of this year's comp was in equity/options, which, if and when AUM rises, and presumably the value of a firm rises, that also gives people an opportunity to participate in that.

William Katz - Buckingham Research

Right. Okay. And just last one, Wayne, while I have you, what's the strike place that was used to grant these options?

Wayne Palladino - Chief Financial Officer and Treasurer

$4.22.

William Katz - Buckingham Research

I'm sorry?

Wayne Palladino - Chief Financial Officer and Treasurer

$4.22 to 12/31.

William Katz - Buckingham Research

Okay. Thank you for taking all my questions.

Richard Pzena

Sure.

Operator

And there are no further questions at this time. Do you have any closing remarks?

Wayne Palladino - Chief Financial Officer and Treasurer

No, we would just like to thank everyone for joining us on the call and we look forward to seeing them again at the end of next quarter.

Operator

This concludes today's conference call. You may now disconnect.

Wayne Palladino - Chief Financial Officer and Treasurer

Thank you.

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