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Alan F. Magleby - Director of Investor Relations & Communications

Joseph A. Sullivan - Chief Executive Officer, President and Director

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


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

Christopher Harris - Wells Fargo Securities, LLC, Research Division

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

William R. Katz - Citigroup Inc, Research Division

Macrae Sykes - Gabelli & Company, Inc.

Matthew Kelley - Morgan Stanley, Research Division

Roger A. Freeman - Barclays Capital, Research Division

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

Michael Carrier - BofA Merrill Lynch, Research Division

Douglas Sipkin - Susquehanna Financial Group, LLLP, Research Division

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

Legg Mason (LM) Q4 2013 Earnings Call April 30, 2013 8:00 AM ET


Welcome to the Legg Mason Fiscal Fourth Quarter and Full Year 2013 Earnings Call. [Operator Instructions] Please note that this teleconference is being recorded.

It is now my pleasure to introduce your host, Alan Magleby, Head of Investor Relations and Corporate Communications. Thank you, Mr. Magleby, and you may begin.

Alan F. Magleby

Thank you, and good morning. On behalf of Legg Mason, I would like to welcome you to our conference call to discuss operating results for the fiscal 2013 fourth quarter and the fiscal year ended March 31, 2013.

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 in the company's quarterly reports on Form 10-Q.

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

Now I'd like to turn this call over to Mr. Joe Sullivan. Joe?

Joseph A. Sullivan

Thank you, Alan, and as always, we appreciate your interest in Legg Mason. On a personal note, I'd also want to thank everyone who has expressed support since our Board of Directors named me CEO, and I am honored, humbled and excited to lead such a wonderful company.

I am very energized by the opportunity before us, and I want you to know that in working with the board, our affiliate leadership and our executive team, we have a clearer framework for how to build Legg Mason as we look confidently toward its future. That confidence is clearly tied to initiatives that we believe will enhance our competitive positioning.

That said, we know that our results are also dependent, to some extent, on market and economic conditions. In that regard, we do believe that the U.S. and other global economies are making steady progress, albeit slowly and unevenly. Such a macroeconomic backdrop has historically proven to be beneficial for investors and in turn, for firms like ours.

Now let me outline how we intend to capitalize on the opportunity to take Legg Mason forward.

Legg Mason's competitive advantage is the combination of both our independent investment affiliates and the ability to leverage their expertise through our global distribution platform. We do this broadly and effectively across channels and geographies, and we see meaningful opportunity to grow our retail market share from here.

Many of the very best investment managers in this industry place a high value on a business model that affords them maximum investment and operational independence and autonomy. Ours is just such a business model, and we believe that it promotes innovation and an entrepreneurial mindset that, over time, can lead to superior long-term investment performance.

Our centralized product and distribution platforms with 500 employees globally give us the ability to leverage the ideas and products of our investment managers on a global basis. This combination, well-coordinated and well-executed, sets Legg Mason apart and is a key factor in positioning our organization.

Now while our commitment to this model is clear, we recognize that it can always be improved. To that end, we are working with our investment affiliate partners to improve and optimize both our portfolio of investment products and capabilities and how they are distributed.

On the investment side, this means working alongside our affiliates to add or to upgrade existing investment capabilities. We can accomplish this in multiple ways, as we recently demonstrated with the Fauchier transaction.

Where appropriate, we will continue to diversify and optimize our portfolio of managers and investment capabilities.

As for distribution, we already enjoy a compelling global footprint that generated approximately $57 billion in growth sales last year, a figure that we expect will continue to grow. We are working with our affiliates in evaluating ways to improve how we currently partner and to invest and expand where we have distribution gaps.

Taken together, these enhancements in both product and distribution suggest a continued improvement of our model. We fully believe that as we execute on this plan of constant improvement, Legg Mason will be better positioned to stabilize and grow our assets under management and, consequently, improve our top line, drive profitability and deliver long-term results for shareholders.

So let's look at the results for the quarter beginning on Slide 3. We reported fourth quarter net income of $29 million or $0.23 per share. Adjusted income was $67 million or $0.52 per share. We closed the Fauchier Partners transaction and appointed a new executive leadership team.

We repurchased 3.7 million shares of Legg Mason stock for $109 million, while maintaining a cash position of over $900 million. Over 80% of strategy assets under management exceeds performance benchmarks over all time periods.

And long-term outflows decreased 80% from the prior quarter. This represents the lowest level of long-term outflows since September 2007. Now to be sure, less negative is still negative. However, the improvement in net flows is meaningful and encouraging.

Slide 4 shows our AUM by affiliate in order of their fiscal year contribution to earnings. And rather than go through each affiliate in granular detail, I would like to talk at a high level across the key asset classes. So let's start with fixed income, focusing on Western and Brandywine.

Western's AUM was down slightly quarter-over-quarter, driven largely by negative FX. Long-term outflows improved dramatically despite $3 billion in exchange rate-related redemptions from retail Japanese investors. Won but not yet funded mandates at Western ended the quarter at nearly $4 billion, with finals presentations also up significantly from the previous quarter. The largest mandates won in the quarter came in specialized mandate categories, including bank loans, global sovereigns and emerging markets.

Western also successfully closed the CLO product that we had referenced last quarter, raising approximately $500 million. And Western's 5-year performance numbers have significantly improved, with 92% of their fixed income strategy assets beating benchmark as of March 31, which is likely helping to drive positive momentum.

Brandywine continues to see very strong interest in global and absolute return fixed income strategies. Brandywine finished Q4 with their best quarter of net inflows in over 5 years. Brandywine's won but not yet funded mandates stand at $800 million through the first half of April.

And Brandywine's investment performance remains strong. All of their U.S. fixed income mutual funds remain top quartile, and 75% of those, top decile in Lipper rankings since inception. And Brandywine had one of its best performance fee quarters ever helped by some accounts that had annual locks at the end of March.

Now on to equities, where we experienced significant quarter-over-quarter improvement in outflows, driven by a strong quarter of inflows at ClearBridge and a reduced level of outflows at both Royce and Batterymarch.

ClearBridge had strong positive net flows in what was their best net flow quarter since the closing of the Citi transaction in 2005. This was driven primarily by a large sub-advisory win, solid retail sales in the U.S., as well as a new product launched in Japan. Unfunded wins as of March 31 stood at $800 million.

ClearBridge has done a great job of positioning the firm's capabilities around 3 key themes. The first is income strategies, where they see significant potential globally and some immediate opportunities in Japan. Second is concentrated high conviction, where they've had a number of wins in retail models. And the third is managed volatility strategies such as ClearBridge appreciation, which have had appeal for cautious investors who have been hesitant about returning to the market.

Royce and Batterymarch still experienced outflows in the quarter, but at a reduced rate from Q3. Royce is still working through some relative performance challenges, and while redemption rates at Royce have stabilized, their focus now is on improving sales. At Batterymarch, short-term performance has improved, and we are actively working with them to position their managed volatility products as part of what will be an overall push on solutions-based strategies in our distribution platform.

Now let's finish with alternatives. Assets under management at Permal reached $22 billion at quarter end, driven by the closing of the Fauchier Partners transaction. Industry growth in the fund-to-fund space continues to rotate to the institutional from high net worth channels and, as Permal has expanded their global institutional platform through the Fauchier deal, they are now even better positioned to build on their momentum in the U.S. institutional market.

The key to long-term success in the fund-to-fund business will be scale and the ability to offer clients multiple customized alternative strategies, and Permal is positioned well on both fronts. To that end, we believe that Permal has a unique advantage in their leading buy-side managed account platform, which offers clients greater transparency, more competitive fees and enhanced liquidity.

Permal's managed account platform is well developed and now makes up 1/3 of Permal's assets under management, presenting a wonderful opportunity to expand that capability to new Fauchier clients. Permal's institutional assets under management are now 55% of its total compared to 38% a year ago, evidencing Permal's evolution over the past few years to a business with significantly greater client diversification and balance.

We will look for additional opportunities to add new alternative capabilities to Permal going forward.

Slide 5 shows investment performance. Over 80% of our long-term AUM beat benchmark over all time periods. Performance of fund AUM versus the Lipper category average is a bit more mixed, reflecting a few challenges around some of our equity managers.

Slide 6 shows a sampling of awards won by investment affiliates throughout the year. We're quite proud that so many of our managers have been recognized for their investment success.

Slide 7 highlights our centralized global retail distribution. Now I'd like to step back and talk for a minute about distribution and how we believe that world-class distribution is a key driver of shareholder value.

Now first, as an overriding philosophy, our approach to distribution, be it institutional or retail, is straightforward. We honor the preferences of our clients with respect to how they want to be served. Along those lines, on the institutional side, it is clear that clients expect direct access to our investment managers, and we fully support that approach. On the other hand, our third-party distribution clients and their client-facing advisors prefer a more centralized approach through which Legg Mason, in partnership with our affiliates, provides solutions to investment challenges across asset classes and among our many managers.

The solutions business is becoming an increasingly important approach to how the industry works with distribution platforms, and here, we believe that Legg Mason has a unique opportunity. Our portfolio of top managers fits beautifully into the solutions concept in that we can customize investment solution strategies from among our many managers to deliver the predictive outcomes that are increasingly desired in the marketplace.

We intend to invest more resources in our solutions capability, and I intend to lead the way in making sure our clients know that we are not only in that business but that our capability is compelling and our intention is to expand it significantly.

At most of our major affiliates, we have made the conscious decision to brand retail products, leading with the affiliate name and combined with an endorsement by Legg Mason as the parent company. We can leverage the affiliates' reputation and brand at the product level and streamline how financial advisors can find and access those products on our distribution partners' platforms.

We have also recently initiated global marketing and investor education campaigns around specific investor needs and our solutions for them. We began in the quarter with a focus on global income, and you will see more campaigns driven by investor needs as we move forward.

Now let me touch upon our Global Distribution results. Global retail distribution achieved its best fiscal year in net flows since 2007, and in the U.S., net flows for the year improved by $7.5 billion. For fiscal 2013, gross sales in Global Distribution were up nearly $8 billion to approximately $57 billion. And their net flows for the year were positive $2.2 billion as compared to an outflow of $2.3 billion in the prior fiscal year.

Outflows during the fourth quarter in Global Distribution were $700 million, driven by Japan, where we saw outflows in non-yen denominated fixed income products most likely related to investors locking in profits in existing investments. Going forward, we continue to see good opportunities in Japan, particularly in U.S. equity products, as well as new flows into emerging market debt.

Importantly, we enjoyed meaningful sales improvements in other global regions outside of the U.S., with inflows in Europe, Asia and Latin America partially offsetting the Japanese outflow.

We firmly believe that Global Distribution is a strategic competitive advantage that is attractive to both our existing affiliate and with potential acquisition candidates. Our intent is to take what we believe to be a very powerful distribution capability and make it stronger still.

And with that, I'll turn it over to Pete.

Peter Hamilton Nachtwey

Thanks, Joe. Turning to Slide 8, I'll start with the financial highlights for the quarter. As Joe noted, we generated earnings of $29 million or $0.23 per diluted share. This quarter, our GAAP EPS was negatively impacted by both the real estate related charges of $53 million or $0.27 per diluted share and by the restructuring of our senior leadership team that resulted in a cost of $8.5 million or $0.04 per diluted share. Adjusted income was $67 million for the quarter or $0.52 per share and was affected by the same 2 expense items.

Average AUM increased by about 1% from the prior quarter, driven by both increased equity and liquidity assets. Also, a shift in the mix to more equity AUM contributed to a higher advisory fee rate in the quarter.

The driver of the 1% decrease in operating revenues over the prior quarter was a $13 million decrease in performance fees. Here, you should recall that last quarter's performance fees included the $32 million PPIP fee at Western. This quarter's performance fees at $33 million were our highest level of non-calendar year performance fees since June of 2007 and included significant fees of Brandywine from several accounts with an annual lock in the quarter, as well as an increase in fees at Permal. Approximately 50% of this quarter's performance fees were for accounts with annual locks. Western Asset, PCM and Legg Mason Global Equities also contributed performance fees this quarter.

While impossible to predict with precision, we project that next quarter's performance fees could be in the $10 million to $20 million range, with the decline largely resulting from Brandywine's higher fiscal fourth quarter fees from accounts with annual locks.

Operating expenses included the $53 million real estate related losses and the executive restructuring charge mentioned previously. I'll provide a little more color on operating expenses later.

On the balance sheet front, this quarter, we repurchased an additional 3.7 million shares for $109 million. Going forward, we anticipate share repurchases of $80 million to $90 million per quarter, as always, subject to markets, which is consistent with our plan to use up to 65% of our operating cash flow for buybacks.

Moving on to Slide 9. The only other item to highlight here is our effective income tax rate which was 37% on a GAAP basis, reflecting certain nondeductible expenses and year-end true-ups. Going forward, we're still forecasting our effective GAAP tax rate to be in the 34% to 36% range, although we also anticipate a possibly reduced rate in the September quarter related to another U.K. corporate tax rate reduction. Also, as you will see on a later slide, the actual cash taxes we currently play are at a substantially lower rate.

Turning to Slide 10, our assets under management were up 2% from the prior quarter, thanks to market appreciation of over $12 billion, which was net of a $5 billion decline due to foreign currency movements. As Joe noted earlier, ending AUM also reflects the fact we had a significant decline in our long-term outflows this quarter.

In the quarter, equity as a percentage of total AUM increased to 24% from 22% in the prior quarter, while fixed income assets as a percentage of total AUM declined to 55% from 57% last quarter. In large part, these moves were due to higher equity markets and slightly negative fixed income markets.

As we look forward to April, I wanted to highlight that we expect to have a liquidity redemption in the $10 billion to $12 billion range relating to a sovereign client, with the ultimate amount dependent on their quarterly cash needs.

Long-term flows on Slide 11 improved dramatically from the prior quarter due to the shift in market sentiment to active U.S. equities and a reduction in institutional redemptions. In fact, at $3 billion, this was our lowest level of long-term outflows since September of 2007.

Fixed income outflows declined to $400 million from $6.8 billion in the prior quarter. This quarter's results included $1.3 billion in ongoing redemptions related to the low fee global sovereign mandate, as well as yen exchange rate driven redemptions at Western of $3 billion.

Equity outflows declined to $2.6 billion from $8.3 billion last quarter. Included in this number were Global Equities redemptions of over $1 billion in the month of January, which I referenced on last quarter's call. There was marked improvement in outflows across our key affiliates, led by ClearBridge Investments who had their best quarter of flows and, in fact, had inflows for the first time since the Citi transaction in December of 2005.

Slide 12 shows the advisory fee trend, with this quarter's rate increasing 1 basis point to 34 bps, reflecting the change in AUM mix. Our average AUM increased by over 1%, with equities helping to drive this improvement. Average equity AUM was up $5 billion, while average fixed income AUM was down $3 billion.

Operating expenses on Slide 13 decreased to $625 million from $1.3 billion largely due to last quarter reflecting the intangibles impairment charge.

Occupancy expenses increased due to the $53 million in real estate related charges. As a result of the actions we have just taken in our office space, we are expecting a $10 million decline in annual occupancy costs in future years.

And finally, other expenses increased slightly due to reserves for legal costs at one of our affiliates, as well as higher fund related costs. Looking ahead to the next quarter, we expect approximately $3 million in technology and severance charges resulting from the combination of operations of Legg Mason Capital Management and ClearBridge.

Turning to Slide 14, salary and benefits decreased $14 million, in large part due to the impact of the PPIP performance fees in fiscal Q3. There were also lower Permal restructuring costs relative to last quarter.

Benefits and payroll taxes are $3 million lower, with the decline primarily resulting from last quarter's $3.8 million acceleration of deferred comp expenses that otherwise would have hit in fiscal Q4, partially offset by seasonal FICA restarts and other employee benefit related costs. Management transition costs and severance include costs related to the senior management restructuring and Legg Mason Capital Management's staffing reductions, as well as the executive retention awards.

Slide 15 highlights the operating margin as adjusted, which decreased to 9.7% from last quarter's 19.8%, largely due to the real estate and senior management restructuring charges, which combined to reduce the operating margin as adjusted by 11 percentage points. Last quarter's operating margin was reduced by approximately 1% due to a combination of accelerated deferred comp, the Permal restructuring and closed-end fund costs, which were partially offset by the one-time PPIP performance fee for Western.

Slide 16 is a roll-forward from fiscal Q3's GAAP earnings per share loss of $3.45 to this quarter's profit of $0.23 per share. Fiscal Q3's loss resulted from $3.86 per share in impairment charges. And you may recall, fiscal Q3 also included a number of one-off items which totaled $0.08. Fiscal Q4 included $0.05 in core earnings improvement, largely driven by higher performance fees and increased advisory fees.

Fiscal Q4 items which are listed in the footnote at the bottom of the slide were largely driven by the combination of real estate write-offs and executive restructuring costs of $0.31 per share. As you can see, x the real estate write-offs and severance, it was a solid quarter, enhanced by the increase in performance fees from annual lock accounts.

On Slide 17, the key, once again, is our cash taxes, which are still coming in at 7%. This low cash tax rate allows for both additional investments in the business and additional return of capital to shareholders. Specifically, the low rate 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 realize a positive cash savings of $1.5 billion.

I'll wrap up on Slide 18, which highlights how we've both returned capital to shareholders and maintained our cash position, thanks to strong cash generation. In the upper left, you can see that we have reduced our share count by 38 million shares or 23% over the last 3 years, and we still have $730 million of board authorized repurchases remaining to deploy.

In the upper right, we've highlighted our annualized quarterly dividends over the same 3-year time frame. With the most recent $0.02 increase in our quarterly dividend, we will now be paying out at a rate of $0.52 per year, meaning that we will have more than quadrupled our dividend payout over the past 3 years.

In the bottom left, you can see that we maintained our ending cash balance at over $900 million. This cash level is down from the same period a year ago, as over the past 12 months, we have de-levered the balance sheet by $350 million as part of our new capital plan and have repurchased $425 million in stock, acquired Fauchier for $63 million and paid dividends of $44 million. Taken together, nearly $900 million in cash spent on capital items during the fiscal year, yet still leaving us with over $900 million cash on hand at year end.

Looking ahead to next quarter, we are expecting our cash balance to decline to approximately $600 million. The June cash balance is usually our lowest for the year due to bonus payments in mid-May. Also in the June quarter, we expect to continue our share repurchase program, and we are making an annual amortization payment on our bank term loan of $50 million. But as we look ahead over fiscal 2014, we would expect the cash balance to rebuild towards current levels.

So thanks again for your time and attention. And now I'll turn it back to Joe.

Joseph A. Sullivan

Thank you, Pete. Before we go to Q&A, let me reflect on our 4 key operating priorities for creating shareholder value, how we performed against them in 2013 and how we intend to execute on them in the coming year.

First is ensuring that our affiliate investment managers have a lineup of relevant products in high investor demand categories. In 2013, we and our affiliates made progress on this priority through product innovation, and together, we launched more than 20 new products that raised more than $3 billion in assets under management. Where there was an opportunity to do so, we built on the strong investment capabilities of our existing managers, like the MLP franchise that we enjoy with ClearBridge Investments. Likewise, Western extended its investment expertise in credit and MBS through the creation of a mortgage REIT and the structuring of a CLO. We acquired Fauchier Partners, which expanded both Permal's investment landscape and institutional distribution, a transaction that we expect to be a model for strengthening the various capabilities of other affiliates in the coming years.

It is important to note that we've had a number of interesting conversations in recent months about similar types of opportunities, and we are accelerating our efforts to capitalize on those opportunities. And we will continue to rationalize subscale, underperforming or nonstrategic affiliates and products as we have done in the past.

Our second key operating priority is compelling investment performance, which is obviously critical to our success. Our investment affiliates and we, along with them, are very committed to constantly reviewing investment performance in both good and difficult times, understanding, of course, that from time to time, some strategies will be periodically challenged and lag their benchmarks. In fiscal 2013, I am proud of the fact that our overall strategy performance improved year-over-year versus benchmark and over multiple time periods, and a number of specific products won acknowledgment from industry sources.

At the corporate level, we continued to pursue ways to help our affiliates attract and retain key talent, with an eye on sustaining and improving investment performance. To that end, we created an equity plan for Permal's key leadership, and we are in discussions with other key affiliates about similar equity plans. Done well, affiliate level equity plans, like the Permal plan, can help strengthen our affiliates for long-term success and help create greater alignment with Legg Mason and our shareholders.

Our third operating priority is delivering world-class distribution. And as I outlined previously, we believe it to be a key growth driver for our business. Quite simply, our focus from here is on expanding market share, improving our sales productivity and increasing persistency in asset retention and doing so in collaboration with our affiliate partners.

Our fourth priority is continuing to drive operating efficiency. Focusing on a highly competitive cost structure will help drive margin expansion and earnings over the long-term, enable us to be more nimble in our decision making and provide more capital to invest in our business and return to shareholders.

This past quarter, we launched an initiative in conjunction with a third-party consultant to identify ways in which we can improve effectiveness of our corporate operations. We're excited about this initiative, and we will have updates on our progress in the coming quarters.

While we believe that we have achieved the vast majority of operating efficiencies available to us, some additional refinement is likely and we believe achievable. We expect that there may be some incremental one-time charges related to this initiative, but I see this as an important and necessary step toward our commitment to ongoing better operating efficiency. We will quantify for you what charges and related savings, if any, related to this initiative as we get further into the process.

And as many of you have seen, we have reorganized our executive leadership team, with certain members of our team having ownership for a number of these key objectives.

So today, we look to build on the work done over the past 3 years: cost-reduction, strengthening the balance sheet and rightsizing the organization. We would characterize those efforts as defensive activities and very different from where we believe we stand today. Although more work still needs to be done from here, I can confidently say that the 4 priorities I just outlined have us squarely on offense, and it is now time for us to put some points on the board.

Creating shareholder value starts with executing on these priorities because we believe that collectively, they will position us for sustainable organic growth. This effort will be complemented by an equal commitment to returning capital to shareholders through both buybacks and dividends.

So I hope you can hear my excitement about and my confidence in our future. And with that, I will open it up to questions.

Question-and-Answer Session


[Operator Instructions] And our first question is from Dan Fannon from Jefferies.

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

I guess, to follow up on your comments, Joe, about the equity plans and kind of the negotiations or discussions that are going on with the various affiliates. Are those ongoing, and we could potentially see announcements going forward or potential changes in the current agreements as these unfold in the coming months?

Joseph A. Sullivan

Dan, thank you. Good question. A couple of key things. First of all, we do believe that creating affiliate level equity for the key leadership is an important strategic evolution of our model. It creates alignment. It creates good behavior. It helps with succession planning. And we are at various stages from just cursory conversations to a deeper level of discussions with basically all of our affiliates. The Permal deal is a nice blueprint for affiliate equity, but each affiliate is different, and any equity plan will reflect those differences. As it relates to restructuring of existing rev shares, I think we've said in the past that we don't expect anything further with respect to that.

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

Okay, that's helpful. Then I guess, specifically on Permal. If you can maybe give us an update on performance. I understand the industry inflows were a bit challenged, but just trying -- it continues to kind of fall down. If we just kind of look at your stack rankings of contributing managers to profitability, kind of, where does the performance sit, and kind of give us a sense of kind of maybe for the performance fee outlook for some of their bigger funds.

Joseph A. Sullivan

Sure, so I'll take the first part of that and then maybe hand it over to Pete. Not surprisingly, flows in the high net worth channel do remain challenged, and they remain in outflow. As I pointed out in my comments, Permal really has done a great job over the last few years of transitioning from, frankly, when we acquired them virtually an entirely or a 100% high net worth business to now, about 55% or so of their AUMs being institutional in nature. In the quarter, while high net worth was in outflow, private equity in the U.S. institutional side did have modest inflow. We do -- we did have with Fauchier a little bit of outflow since the acquisition, but again, that was priced into it and expected. And I don't know that we mentioned it, but their pipeline going forward for the quarter in unfunded wins was at about $400 million. Pete, I'll let you talk about the performance fees.

Peter Hamilton Nachtwey

Sure, Joe. Just quickly, Dan, about 85% of their assets that are eligible for performance fees are at high watermark at this stage. And the majority of Permal's -- I think actually, all of the legacy Permal funds earn those fees quarterly, but the new Fauchier assets effectively have annual locks at December 31.


And our next question is from Chris Harris from Wells Fargo Securities.

Christopher Harris - Wells Fargo Securities, LLC, Research Division

So Joe, you talked about kind of enhancing your capabilities with some of your affiliates. And I'm just curious, are there some initiatives beyond the distribution channel you guys are looking at? And then related to that, how should we think about how some of these initiatives might affect the growth rate of your expenses?

Joseph A. Sullivan

Chris, I think, clearly, if you go back to kind of my 4 key objectives, when we work with the affiliates, we really work with them on 3 levels. One is distribution, as you referenced, and we think we can continue to improve that. Secondly, is really in the product capability. And as we've mentioned a few times with Permal, we -- the Fauchier deal with Permal expanded both their distribution and their investment capabilities, and that's the kind of thing that we would look to for all of our affiliates. So are there opportunities to do bolt-ins or acquisitions that we can fold into existing affiliates to strengthen their product capability and their investment talent? And then just performance, and really, that's predominantly at the affiliate level, but that's where we work with them and we support them and help them in constantly reviewing their investment performance because, as we know, investment performance is table stakes, and you've got to have compelling investment performance on relevant products for your distribution to be able to kick in. So we really focus with all 3 -- on all 3 of those key objectives with our affiliates: products, performance and distribution. And as it relates to how that could impact our costs and our margins, we've got to be prudent about that. We will invest where it makes sense and where it's appropriate, as we did with Fauchier. We will invest in growth, and we've got to balance that against returning capital to shareholders.


And our next question is from Michael Kim from Sandler O'Neill.

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

First, I apologize if I heard this wrong, but, Joe, I think you mentioned you don't have any plans to restructure any of the revenue sharing arrangements. So just wondering how we should be thinking about the economic impact related to any potential equity grants to the affiliate management teams.

Joseph A. Sullivan

Well, Michael, I'll confirm that as -- for what we see right now, we don't see any of our affiliates where we would be looking to restructure or rework their existing revenue share. Pete, do you want to pick up part 2 there?

Peter Hamilton Nachtwey

Yes, sure, Michael. So as we've discussed during the -- in the context of the Permal deal, the economic impact in terms of the P&L is totally driven off more or less the option value that's attributable to the -- what they would participate in, in terms of growth and value of the firm. And in the Permal case, there's kind of a model for the rest of the affiliates. The total expense over the vesting period, that's about 5 years, is $10 million. So of that $10 million, that gets spread over a 5-year vesting period, so $2 million of expense per year, and half of that is picked up by Permal. So the actual impact to our P&L is only $1 million a year.

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

Got it. Yes, that's great. And then second question, you mentioned maybe a bit of a -- more of a focus on M&A opportunities. So just curious in terms of what you're seeing as it relates to kind of supply, competition, pricing trends, particularly as it relates to maybe some of the types of properties that may be in higher demand, so high-quality international equities, alternatives, franchises, like that.

Joseph A. Sullivan

Sure. Well, clearly, and we've stated it for quite a while, we're very interested in adding a non-U.S. equity capability. It is a gap in our product lineup. It's something that's essential that we need to bring in to our interim business. Away from that though, Michael, we are seeing a number of smaller potential opportunities of companies similar to Fauchier, where they may be subscale, they may be a good quality company, but given sort of operating and revenue -- or operating and regulatory pressures and costs associated with those, these companies are looking to join up with a larger partner. And you've seen that not just with us. You've seen some of our competitors add, particularly in the funded hedge fund space, over the last 3 or 4 months. So we're not the only ones seeing it, others are as well. But there are a number of good opportunities, smaller opportunities, that I think are complementary adds to our existing affiliate lineups and products. So between additional bolt-ins and complementary adds in terms of talent and capability, and then candidly a non-U.S. equity capability that would likely be larger. And look, anything of that nature, a non-U.S. equity is in very high demand, and then obviously anything of a quality -- with good quality would be also even in greater demand. So you have to balance pricing with that -- availability and pricing and all of that kind of stuff. But the good news is, since the Fauchier transaction, it demonstrated to the marketplace that we're back in the game of M&A. And I can tell you, Jeff Nattans is probably busier than he's been in a number of years, dealing with bankers and opportunities that are out there. So we're excited about it.


Our next question is from Bill Katz from Citi.

William R. Katz - Citigroup Inc, Research Division

I just want to spend a little more time on the margin discussion. What I heard is, so the spend on the solutions business and spend on the global brand, how do you reconcile that versus the 20-some odd percent core margin? Could we be looking at a few more quarters of spend exceeding growth rates of revenues x market impact, or could margins go up at the same time that you're spending?

Joseph A. Sullivan

I think, Bill, look, that's the balance that we have to draw here, right? And one of the reasons that we're going through, and I think Pete alluded to it and as did I, is our sort of bottoms-up review is we're looking at our existing spend right now, and we're looking at the effectiveness of that spend and are there opportunities to reallocate that spend in some way, shape or form. We're not looking at just driving our margins down and our costs up, but we do have to spend and invest in our business to continue to look to grow. So there are initiatives, but we've got to do it within the context of a reasonable spend. We think we can find some opportunities to free up some spend by being more effective and more efficient in both our corporate and distribution -- current corporate and distribution spend.

William R. Katz - Citigroup Inc, Research Division

Okay. And then you mentioned, as part of the optimization opportunity, I was just looking through your slide that has all the affiliates on there, and they all seem to be of scale. Is it products within those affiliates that there might be opportunity for some incremental efficiencies, or are there still part of the affiliates here that are just proving to be non-core?

Joseph A. Sullivan

Bill, we -- and I think it -- I know this is an important question to you because you bring it up frequently. We've got a huge stake in the success of each of our affiliates. And we'll do what we've done in the past, which is, we constantly evaluate all of our affiliates. We evaluate their businesses, we evaluate their products, we evaluate their performance. We do all of that on an ongoing basis. That's why we're here. And we do 3 things. We consider supporting them if it's needed and, quite frankly, over the last 30 years, all of our affiliates have needed that support at one time or another. We will consider divesting if we determine and if we conclude that the affiliate is not strategic. And then we'll consider consolidating it -- or consolidating an affiliate if it's subscale or underperforming. We do that with affiliates, we do that with products. And we have examples of that. Our history on that is clear in my mind. We've had the Bartlett and Barret divestitures. We've had Legg Mason Capital Management and Global Currents, where we merged. And we've also rationalized products over the years. So this is a constant evaluative process. Now you'll appreciate, and I think everybody will, that we don't discuss publicly what the various options are that we consider periodically, but we'll certainly let you know and we'll let you know immediately when we have something final to announce.


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

Macrae Sykes - Gabelli & Company, Inc.

You mentioned Japan in your comments. And just given the extraordinary events that we've seen in the first quarter, I was wondering if you could talk about changes you were seeing over there in the retail environment, and then whether you expect these trends to persist.

Joseph A. Sullivan

Sure. First of all, let me back up a little bit for you, Mac. This was really the first quarter in the last 4 years that our international business was in outflow, which is quite an extraordinary record, and it was largely driven by retail fixed income outflow. Our sales activity was actually pretty much flat. It was down modestly about $300 million quarter-over-quarter. But again, the outflow and the slowdown in sales was driven by the fixed income side. Japan, I would say -- and I guess this is like virtually all geographies and all investors, but can be very thematic in their investing. It's been -- Japan has been a huge success for us over the past several years, and currently, has somewhere in the neighborhood of $28 billion in retail AUM. The recent outflows there really reflect 2 things. One, profit-taking in existing positions that are current -- currency related. And the second thing is Japanese tax year end profit-taking, which is customary. I can't tell you for sure which of those weighs heavier in this past quarter, but we think both are impacting it. As far as the go-forward with respect to particularly in Japan, we do see significant opportunities on a go-forward basis there, certainly in U.S. equity income, and we've seen our teams there pivot over the last quarter -- 2 quarters, and we've experienced some pretty nice pickup, particularly at ClearBridge, with some of our equity income products. We also think that there could be a reversal, although we're not sure of the fixed income flows, but we do see some opportunities in emerging market debt there.


Our next question is from Matt Kelley from Morgan Stanley.

Matthew Kelley - Morgan Stanley, Research Division

Joe, I was hoping you could -- I've read a lot recently about changes in kind of some of the retail distribution channels and what products they're offering and whatnot. And I was hoping you could give perspective on any changes you're seeing there and any product additions that you're getting that might be selling better as well. So when you think about what products are being distributed, is there actually a positive mix shift for what you're actually selling versus what you haven't been selling has been kind of delisted?

Joseph A. Sullivan

You were cutting in and out a little bit, but I think I'll answer -- I'll answer what I think you asked and then you can correct me or ask me to elaborate. I would say there's 2 things. We've been focused on a product basis, and this does relate to specifically to what clients, I think, globally are really focused on. But in the product area, the products that we've been creating really are around 3 buckets: one is income, one is alternative and the other's really managed volatility and more productive outcomes. Those are themes that we are hearing over and over and over again from our investors globally. I mentioned earlier, our marketing teams recently completed what was really a pretty compelling global income survey. And we've learned a lot from that, specifically that investors, not surprisingly, view income as a particularly important need. Secondly, that they're not getting enough of it, no surprise there. But very importantly, that they're willing to consider different types of income-generating investments than maybe their advisors and, frankly, managers have expected. So they're willing to go beyond the borders, they're willing to go into global fixed income, they're willing to go into different equity strategies more than before. So we're seeing a significant emphasis continued on income alternatives where they can get a little bit more alpha and then really manage volatility. I'll stop there.


Our next question is from Roger Freeman from Barclays.

Roger A. Freeman - Barclays Capital, Research Division

I wondered if you could just run through -- or maybe just aggregate some of the flow commentary -- outlook commentary. I think you said $10 billion to $20 billion, if I heard, of sovereign mandate coming out in the June quarter. And I guess if you net that against anything that you -- that has funded already quarter-to-date or that you expect to, can you comment maybe on what those fixed income flows might look like? And also there's that legacy outflow that had been coming out at, like, $600 million a month. Can you update us on that?

Peter Hamilton Nachtwey

Sure, Roger. Actually, just to clarify, the $10 billion to $12 billion out is in liquidity funds, so it's a sovereign wealth client that just had some typically annual needs in this quarter. And we don't know exactly the number, but it's in the $10 billion to $12 billion range. And then the other, the global sovereign mandate is roughly running a little under $500 million a month. And right now, we anticipate that probably lasting for another year, at which point it's anticipated to level out.


Our next question is from Robert Lee from KBW.

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

First thing is just on Japan. I mean, I know you mentioned that with ClearBridge, you see that as a market where there's some opportunity. And then, although I noticed in this quarter, you did have some outflows there. Could you maybe, number one, update us on kind of your presence in that market, maybe size it a bit? And given that, is it being impacted by some near-term flows? Is that kind of a one-off, or do you think that's going to last a while?

Joseph A. Sullivan

Well, again, we've seen the -- really with the currency-related moves in Japan, we've seen some challenges in terms of our fixed income product there. The product is -- it's not that the product isn't performing, it actually is performing, and investors there are taking profits. And whether that's related to their year end -- the Japanese tax year end, we're not sure. But it's really profit-taking really, it's not performance issues. The good news is, as I mentioned earlier, our Japan team has pivoted and is moving what candidly is actually higher margin product in U.S. equities, so particularly with ClearBridge. We see tremendous opportunity there. And broadly, if you look at it in Japan, we've got, I think I mentioned, $28 billion or so in retail assets, but we've got $43 billion in total assets, including some global sovereign mandates managed directly and serviced directly by our affiliates. So we've got a pretty significant presence particularly in Japan. We also have a presence in Hong Kong, we have a presence in Singapore, we have a presence in Taiwan. All of which are growing, but Japan has really been the home run for us in Asia.


Our next question is from Michael Carrier from Merrill Lynch.

Michael Carrier - BofA Merrill Lynch, Research Division

Just on the flows, the industry flows were obviously much stronger this quarter. You guys benefited. And you had some wins that you noted not only during your comments today, but also on the last call. So I'm just trying to gauge. You mentioned some good wins or -- that are in the pipeline that haven't been funded yet at Western, at Brandywine and I think at ClearBridge. I'm just wondering, x those wins, when you look at sort of the, I don't know, I don't want to call it core, but the normal ins and outs, like what's the sentiment or what's the mood relative to the past couple of months? Like, is it still kind of the same trend?

Joseph A. Sullivan

Michael, I'll tell you, I don't -- I want to be careful and not get over our skis here. I think the mood, as you asked, and the sentiment is better, and it feels better. Yes, we had some good wins, and we certainly improved quarter-over-quarter. What's happening at ClearBridge is very powerful, as we mentioned, $1.7 billion in positive net flows for the quarter, their best quarter since we acquired them in 2005. The people at ClearBridge are feeling very confident, and they should be. Batterymarch saw their outflows reduce significantly, as did Royce. On the fixed income side, Western clearly improved quarter-over-quarter; Brandywine, again, its best quarter of positive net -- positive flows since December of '07. So there are some good feelings out there. Now we're still battling it, we're -- as I mentioned in my remarks, we're not in inflow yet, so it's still out. But the rate has reduced substantially, and we feel good about it. When you talk to the folks at Western, their outstanding RFPs stand at $35 billion, that's up 18% quarter-over-quarter. That's a good number, and that feels pretty good. Now they're RFPs, they're not wins, and their job will be to convert them to wins, but that's a nice trend. Their unfunded wins, we mentioned, were $3.9 billion. That's up from $600 million in the third quarter and up from -- up by about $700 million year-over-year. And just as a note, of those $3.9 billion in unfunded wins, $1.5 billion have funded in the first quarter. So we do feel better. We're not declaring victory by any stretch, and it's one quarter. So we want to not get too far over our skis, but you asked about the confidence level and the mood, and I think people feel good that we're -- we've made good progress and that we can hopefully put some wins on -- continue to put some wins on the board.


Our next question is from Douglas Sipkin from Susquehanna.

Douglas Sipkin - Susquehanna Financial Group, LLLP, Research Division

Just quick question, can you sort of articulate the difference between sort of the strategy benchmark and the traditional stuff? Because I'm just trying to reconcile, I know there's a little bit of a difference between the two, so it'd help to maybe get some light on to sort of how the strategy benchmarks.

Joseph A. Sullivan

So just to be clear, when we talk about performance versus benchmark, that's heavily weighted by fixed income. And you look at our numbers there, and we're significantly outperforming in the 1- and 3-year areas. When we look at performance versus Lipper averages, that's more heavily weighted by our retail equity funds, where we're underperforming for the 1- and 3-year area, and candidly, that's weighted a little bit more by Royce. So I think that's where you get the difference.


The next question is from Marc Irizarry from Goldman Sachs.

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

Just on some of the changes and initiatives as you look forward now to improve operating efficiency. Can you talk a little bit about how that will play out for your Global Distribution versus the U.S. distribution?

Joseph A. Sullivan

Marc, I think we have opportunities in terms of -- and I think I'm going to answer this, but in terms of investing in both. We see tremendous opportunity in both the U.S. and international. Obviously, as everybody knows, the international side will be growing at a faster rate. But that said, fully 50% of global AUMs still reside here in the U.S., and we see opportunity to gain market share in the U.S. So it will be a balanced investment, both in the U.S. and international. Did that answer your question?

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

Some of the initiatives that you talked about that are in process, I mean, is there also some low-hanging fruit on the global side or areas or regions where you look at and say, maybe it's -- maybe there's some efficiencies there, or some maybe less productive resources at work that maybe should be brought -- either brought back to the U.S. or repositioned globally?

Peter Hamilton Nachtwey

Marc, the initiative -- this is Pete. The initiatives that Joe was referring to include one that's kind of a full bottoms-up across the entire organization, not just distribution, but also corporate. And it's something we've never really done. We've done a couple rounds of cost-cutting, but they've mostly been top-down. This is really going brick-by-brick, person-by-person, process-by-process around corporate and Global Distribution. And the goal isn't just to find things that we can cut costs on, but also to streamline the organization to create capacity for growth, as a number of other folks have asked that question of how do we pay for growth, this is going to be a key way to do it.


That concludes our question-and-answer session. And I would now like to turn the floor back over to Mr. Sullivan for closing remarks.

Joseph A. Sullivan

Thank you. And I'd like to thank all of you for your time this morning and interest in Legg Mason. I'd also like to thank our board and my colleagues, both at our affiliates and here in Legg Mason, for their support and for their contributions to a strong quarter and a good year.

I've talked a lot about opportunities this morning, and we recognize and are very excited about the opportunity before us, and we intend to capitalize on it. Interestingly, I noticed that today's daily quote on Bloomberg seems particularly appropriate. Confucius said, "The gods cannot help those who don't seize opportunities." I can assure you we intend to seize this opportunity.

So thank you all for your time. And have a good day.


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

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