Legg Mason, Inc. F2Q10 (Qtr End 09/30/09) Earnings Call Transcript

Oct.22.09 | About: Legg Mason (LM)

Legg Mason, Inc. (NYSE:LM)

F2Q10 (Qtr End 09/30/09) Earnings Call Transcript

October 22, 2009 8:30 am ET

Executives

Alan Magleby – Director, IR and Communications

Mark Fetting – Chairman and CEO

C.J. Daley – EVP, CFO and Treasurer

Analysts

Dan Fannon – Jefferies

Roger Freeman – Barclays Capital

William Katz – Buckingham Research

Cynthia Mayer – Bank of America

Michael Carrier – Deutsche Bank

Robert Lee – KBW

Marc Irizarry – Goldman Sachs

Matt Snowling – FBR Capital

Craig Siegenthaler – Credit Suisse

Max Geiss [ph] – Gabelli & Company

Douglas Sipkin – Pali

Jeff Hopson – Stifel

Operator

Good day, ladies and gentlemen, and welcome to your Legg Mason Quarterly Earnings Call. (Operator instructions). And as a reminder, this is being recorded.

I would now like to turn the program over to Mr. Alan Magleby, Director of Investor Relations and Communications. Please go ahead.

Alan Magleby

Thank you. On behalf of Legg Mason, I would like to welcome you to our conference call to discuss operating results for the fiscal 2010 second quarter ended September 30, 2009.

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, 2009 and in the company's quarterly reports on Form 10-Q.

This morning's call will include remarks from the following speakers. Mr. Mark Fetting, Legg Mason's Chairman and CEO, and Mr. C.J. Daley, our CFO, who will discuss Legg Mason's financial results. In addition, following a review of the company's quarter, we will then open the call to Q&A.

Now, I would like to turn this call over to Mr. Mark Fetting.

Mark Fetting

Thank you, Alan and good morning to all and thank you for joining us today. We are pleased with our results for this quarter and are determined to forge on with our turnaround mission at Legg Mason.

In the first half of our fiscal year, Legg Mason continued to generate strong cash income, improved investment performance and profitability. Some of the highlights of this quarter include, revenues quarter-over-quarter up 8% to almost $660 million due to higher assets under management and a greater percentage of equity assets and performance fees.

Operating income as adjusted with $102 million up 14% based on higher revenues. Our operating margin as adjusted this quarter was 21%. We net distribution and servicing costs and mark-to-market deferred comp and seed impacts to determine this number. As many analysts and investors are focused on operating margins, we will add this metric to our disclosures going forward.

Net income was $46 million or $0.30 a share. That number is down quarter-over-quarter, primarily reflecting the transaction cost of $22 million related to the equity unit exchange, offset by lower interest expenses and a higher share count after that transaction closed. Importantly, our net income is considerably better than the last we posted a year ago. Cash income on an adjusted basis was $90 million or $0.59 a share.

We have been working hard on our strategic priorities and I will give you an update on our progress a bit later. With the cash we have been generating we are in a good position to further reduce debt and to reinvest in our business as we work through 2010. For the second half of the year, we will be focused on pursuing further efficiencies, improving investment performance, and net flows.

If you go to Slide 3 of the deck, you’ll see our business model and it’s important that we restate this to our key stakeholders. We believe our multi-manager business model is delivering positive results. We are one, engaging with our investment affiliates on key matters; two, achieving distribution and shared service leverage to gain share and drive profits worldwide; and three, managing our capital and our business portfolio for long-term shareholder value.

We have been pleased with the improved investment performance of our affiliates so far this year and are focused on supporting continued improvement and other enhancements in their franchise. We have identified areas where we need to expand our investment capabilities across affiliates and are working to fill those gaps. One example where this has worked out well is at Western, which took advantage of the credit crisis to hire senior, respected credit talent and enhance its team.

Our Americas and international distribution organizations are focused on bringing innovative solutions to the marketplace and expanding our presence. As you can see, we have been working hard on all of our strategic priorities.

If you go to Slide 4, assets under management have risen to $703 billion, driven by market appreciation and significantly reduced outflows. All of our principal affiliates have hired assets under management quarter-over-quarter, in most cases driven by market performance. We have seen continued inflows in Royce, modest inflows at Legg Mason Capital Management, while others are seeing marked improvement in outflows, many trending break-even.

Equity assets as a percentage of total AUM continue to move up and at 9/30, equity assets were 24% of the total or $166 billion. That’s up from 22% in the June quarter and 20% in the March quarter. Equity outflows were the lowest since December of ’06. Fixed income was 55% of our assets and liquidity, 21%.

If you go to the next slide on flows, you’ll see that on a quarter-over-quarter basis, total outflows have continued to improve substantially and have been reduced sequentially by 73% to $8 billion. Now, recall our trend here is a steady improvement in rate of outflows going from a negative 9% to minus 6% to 5% to now just over 1% and clearly our goal is to swing that positive.

In fixed income, we have seen sequential improvements every quarter since December of ’08 while our equity flows are almost break-even. Liquidity business saw inflows of $4.1 billion, reflecting strength in our institutional business outside the U.S.

Slide 6 speaks to our assets by affiliates. And as we’ve done in the past, they are in order of their contribution to earnings. All of our primary managers saw quarter-over-quarter increases in AUM. Western Assets were up 5% to $505 billion. The firm has seen strong performance rebound this year.

At the end of the quarter, all nine Western Asset’s funds outperformed their benchmarks for the three-month period, eight of nine outperformed for the year-to-date and one-year period. It will take time for this out-performance to further impact the three and five-year numbers, though improvement is happening here also and we believe that if this trend continues, this should have a positive effect on flows.

While they still see outflows in more traditional asset classes like Core and Core Plus, it is encouraging to see both domestically and outside of the U.S., there is an offset in other product areas, investment-grade credits worldwide, global TIPs and emerging markets in particular.

Another new area of interest for Western is local currency products. They seated an Asian local currency product three years ago in Singapore and just received an important mandate. There is also interest and in fact, considerable momentum in our Brazilian and Australian currency products in Japan.

Let’s get to Permal where assets are up 6% to $18.2 billion. In the past quarter, Permal has seen more than $1 billion in firm-wide gross sales during the quarter while redemption levels are now back to more normalized pre-Lehman levels. Permal is seen as one of the stronger funded hedge fund firms to come out of last year’s market turmoil and as a result, they’ve seen a robust pipeline across all regions and in particular, in the institutional space.

ClearBridge Advisors, our largest equity affiliate, had an 11% increase in AUM to $52 billion. Performance continues to head in the right direction and ClearBridge is trending closer to positive cash flows. The team won a $300 million mandate from an insurance company, which funded in October and is in eight finals as we speak. Hersh Cohen, along with other teammates, presented at the Schwab conference in September and their presentation got very high marks from advisors in the audience, with the majority of those surveys expressing new interest in the products.

Assets at Royce were up 23% to almost $29 billion. The team continues to see inflows in the second quarter amid continued strong performance across the complex. Legg Mason Capital Management assets were up 23% to almost $17 billion with modest positive flows. The funds continue to generate strong year-to-date performance as recognized by Barron’s a few weeks ago.

Since their exclusivity with Smith Barney expired in February, Capital Management’s products are now available on approximately 350 platforms, greatly enhancing their distribution opportunity. Team has been out visiting clients, consultants and intermediaries and we are hopeful this will be a new avenue of growth for all of us.

Brandywine assets are up 11%, generated strong performance in the fixed income products over the past year, sees opportunities for products across – outside the U.S. We are also getting good traction with Brandywine in our Americas distribution efforts. We won a mandate from a large wealth manager for their diversified – with their diversified large cap value product, which will fund in the fourth quarter. We are actively pursuing other opportunities from products as well.

Finally, Batterymarch is up 15% to $20 billion. This was driven by market appreciation and a reduction in outflows. Batterymarch is starting to see mandates that will run earlier in the year fund and one mandate funded in the quarter and several others are expected to follow next year.

Now, Americas’ distribution is the focus of slide or page 7. Our team has revamped their sales strategy and has been implementing this new approach over the past several quarters. As you can see, our net sales from this unit has improved significantly since the March quarter.

Though this chart shows quarterly improvement, flows in our long-term products sold in the channel have improved since the same period a year ago in seven out of the past nine months. We continue to make progress in diversifying our sales base in the national broker-dealer channel. And on a fiscal year-to-date basis, we have seen non-Smith Barney gross sales grow 34% year-over-year. In addition, we are continuing to grow our RIA and wealth management channel, a newer focus for us, and sequential sales there are up 14%.

From an international standpoint, in the next slide, you can see the same trends. And in fact, our net long-term sales in our funds area from this unit has been positive for both the June and September quarters. Net flows have improved versus the same period in ’08 in all nine months of the year. We saw net flows at approximately of $1.1 billion in the organization, primarily in fixed income strategies, though we also saw in the flows and the products managed by Capital Management, Royce, and Congruix, our Asian equity affiliate.

Inflows from the international regions are coming from products we or our affiliates have launched since this year. New products alone have delivered $1.6 billion in AUM year-to-date.

Now, let’s shift to performance. As you can see, it’s been strong investment performance this year whereby 81% of our long-term U.S. fund assets are beating their one-year Lipper category average. This is up from 43% in March. Strong performance for this year obviously takes time to roll into three and five-year numbers but each has improved since the beginning of the year with 65% beating the three year and 62% beating the five year.

Interestingly, our 10-year numbers, which have always been strong, are now identical to our one-year number with 81% beating the category. This reflects continued improvement at Western, Capital Management, ClearBridge, and continued strong numbers from Royce.

You take a look at our asset mix and just business highlights, you can see the mix is improving with equity assets up 24% of AUM and we are focusing on expanding that. We saw positive net flows in our liquidity business due to strong performance in our funds and strength in our offshore institutional business. Royce continued to have positive inflows and Capital Management was modestly positive for the quarter. We are – we have seen improving outflows at our other affiliates significantly down each quarter. And we continue to focus on product innovation, which as I noted earlier, is contributing to inflows.

Some of the quarter’s new fund launches and other product initiatives are highlighted in the quarter release and in particular, you can see a global credit product that we are launching in the closed end space with Western that we think should be very well received and we got a terrific underwriting group there.

You take a look at our strategic priorities and the progress on them and I’ve shared with you, we and the Board have identified five key priorities that should drive shareholder value going forward. We’ve made progress against each of these this quarter and will continue to focus on executing against the goals.

Relative to balance sheet, the equity unit exchange we announced earlier in the summer closed in August with over 91% of equity units tendered. Our debt to capital ratio is now down at the 25% range and we continue to look at ways to reduce our debt levels.

Second, as previously announced, we’ve identified a number of cost savings in the corporate area that we’ve taken as of June 30. Even with the markets improved and revenues growing, we will continue to be vigilant on costs at both the corporate and affiliate level.

Our third priority is engaging with our affiliates and there we’ve been working together and delivering improved performance. We continue to engage with them on support initiatives and on ways we can invest with them to enhance their franchise.

Our fourth priority is to grow the distribution and product innovation and to do so in an effective and efficient matter to drive shareholder value. These efforts are showing through in our net sales numbers. And finally, we are looking at investments and bolt-on M&A opportunities and actively reviewing a targeted pipeline.

I’ll turn it now to C.J. and then come back for a quick close before we open it up for Q&A.

C.J. Daley

Thanks, Mark. As Mark has indicated, we are continuing to see improved trends in assets under management, client flows, and revenues, all resulting in improved earnings on an adjusted cash income basis and a slightly lower earnings on – in the quarter on a GAAP basis, primarily as a result of charges incurred related to the equity conversion in August and lower non-operating income.

Our summary financial results for the quarter are on Slide 12 of the investor deck. Our GAAP earnings per share was $0.30 per share or $46 million and it includes the $22 million of pretax transaction costs related to the equity unit conversions, partially offset by $15 million of lower interest expense.

Cash income as adjusted was $0.59 per share or $90 million and also reflects the transaction costs and lower interest expense. During the quarter, as you know, we completed the exchange of 91% of our $1.15 billion in equity units that we issued in May of 2008.

While the transaction charges of $22 million reduced our earnings, the exchange was affected to further improve our financial strength and flexibility, which is demonstrated by the resulting $15 million reduction in quarterly interest expense. As a result of accelerating the equity conversion, which is accretive to earnings beginning in the December quarter, our interest expense at current run rate levels declined 34% to approximately $114 million annually.

Our interest coverage ratio on a pro forma basis, which removes all interest expense related to the tendered units which will occur over the next three quarters, would increase to 8.7 times from our actual coverage ratio of 4.9 times at September 30th. The conversion was another important step to improve our financial position and earnings results.

Our operating margin as adjusted was 21%, up from 20% last quarter and was negatively impacted by approximately 100 basis points of duplicate rent related to our corporate headquarters relocation and annual promotional and governance costs unique to the quarter. Our adjusted margin excludes the effect of mark-to-market on investment gains and losses related to compensation expense and is based on revenues less third party distribution expenses.

Revenues for the quarter were $659.9 million and were up 8% from revenues of $613.1 million in the prior quarter. This reflects a 6% increase in average AUM and as well as an increase in the percentage of higher yielding equity assets and higher performance fees at Permal and Western, modestly offset by some additional fee waivers in our liquidity business.

Our equity assets, as Mark mentioned, represented 24% of our total assets under management and are an important driver to increasing our margin levels. Equity assets, as we’ve said before, generally have higher average fees and our equity managers typically have higher margin.

Although operating income for the September quarter was up, which reflects income from core operations, net income was down as a result of the charges associated with the exchange offer, as well as lower fund support credits compared to the prior quarter. During the quarter, all but $5 million of outstanding fund support expired.

Our effective tax rate was 37% this quarter, in line with our expectations. But as you will see in the tax provision slide later in the deck, the federal portion of this tax is shielded by both our future tax deductions from purchased goodwill and net operating loss carry-forwards.

Moving on to Slide 13, you’ll see the line items of our operating expense, which increased 5% in the quarter. The increase was primarily attributable to increased compensation on higher revenues at our investment management affiliates and higher occupancy costs due to the relocation of our corporate headquarters. In addition, certain annual promotional and governance expenses were incurred during this quarter.

Distribution and servicing expenses were lower than you may have expected this quarter. This is driven by two primary factors. First, last quarter included $4 million of costs related to the launch of a closed-end fund and secondly, as a result of an increase in revenues from higher equity assets, generally, which have a much lower payout to third party distributors. Occupancy expenses were up $3.1 million from last quarter due to the relocation of our company headquarters in December and includes approximately $1.5 million in duplicate rent.

Finally, on expenses, we continue to actively pursue subletting the last of our excess space in several locations. When complete, you should expect to see non-cash charges of approximately $30 million in total over the next couple of quarters. The non-cash charges are determined based on the amount of space we sublet, the timing of the sublease, and the sublease rates we were able to achieve.

We continue to be proactive in strengthening our balance sheet and while these one-off charges are noise when they occur, we believe they are prudent economic moves for the company and our shareholders.

Slide 14, we highlight our comp and benefits expense, expressed as percentage of net revenues, which are operating revenues less distribution and servicing costs. Our compensation ratio of 53.8% has trended higher than we’ve previously seen due to higher revenue and cost disciplines within our revenue share affiliates.

Now that markets have turned and business has improved, talent retention has become a focus for Legg Mason as well as the entire asset management industry. Our revenue sharing model inherently addresses this dynamic because the portion of each incremental dollar of revenue retained by the affiliate that is not used for operating costs is included in their bonus pools.

What we have seen this quarter is that affiliate non-compensation operating costs have remained steady or declined, leaving more available for incentive compensation. With the current revenue mix and affiliate focus on non-comp costs, we expect the comp ratio in the next quarter to hover around the current level. In addition, part of the increase of our compensation costs were for higher commission payments made on higher mutual fund sales and the anticipated increases in incentive compensation on higher profitability.

Slide 15 is our balance sheet. And as we stated last quarter, one of our strategic priorities is to strengthen the balance sheet. In August, we took a significant step to so through the tender offer for the holders to exchange their equity units for common stock plus cash, a transaction that’s accretive to earnings beginning in December quarter, despite higher shares outstanding.

The offer was very successful and you know we had 91% of the holders tendering their shares. As a result, we have reduced our debt by over $1 billion and increased stockholders’ equity by a similar amount and it now stands at $5.7 billion. Our debt-to-capital ratio improved to 25% from 39% and we still have $1.1 billion in excess cash. As you can see on our income statement, our interest expense is down $15 million from the June quarter and that savings will continue in future quarters.

If you look at Slide 16, you can see that our tax rate, which is 37% is – half of that is non-cash. This is one of the areas that we want to highlight and an area that we think investors and analysts should focus on and it’s basically the benefit that we received from the two tax items that aren’t reflected in our GAAP results, but which – but do affect our ability to generate cash.

When you translate our effective tax rate into dollars on the right side of the schedule, you see that we have $4.7 billion of future income that is shielded from U.S. federal taxes and will provide significant future cash flow benefits to the company.

So in closing, it’s important to note that we now have had two consecutive quarters of profitability. We continue to strengthen the balance sheet, we have improved our debt ratios, maintained a strong cash position, and increased our equity capital. Cash generation, which I’m defining as EBITDA less cash paid for taxes, interest, and dividends, is meaningful and has risen three-fold over the past two quarters as a result of reduced interest expense, lower cash taxes, and reduced dividend payments and is now in excess of $100 million per quarter.

With that, I look forward to answering your questions and will turn it back over to Mark for some closing comments.

Mark Fetting

Thanks, C.J. In closing, Legg Mason has generated another strong quarter of cash income with assets up 7% and revenue up 8% sequentially. Legg Mason continued to operate its business efficiently and further strengthened its balance sheet.

With the cash we’ve been generating, we believe we are in a good position during the second half of the year to reduce debt, to support new product launches, and otherwise reinvest in our businesses, and consider targeted acquisition opportunities. We are working on improving our operating margin. We are hard at work on improving performance and turning our overall assets under management flows to positive.

We are encouraged by the decline in the long-term outflows and the activity we are seeing in our pipeline and sales channel and certainly the positive liquidity flows we had this quarter.

Next week, the Board is expected to approve a new compensation plan for senior management with clear accountability for improved metrics on investment performance, net flows, and operating margin compared to our competitors.

In summary, we forge on with our turnaround mission at Legg Mason and will drive improved results for our clients and our shareholders and we thank you very much for your interest and we'll now take your questions.

Question-and-Answer Session

Operator

Thank you. (Operator instructions). Our first question comes from Dan Fannon of Jefferies.

Dan Fannon – Jefferies

Hi, good morning. Could you guys talk a bit about your pipeline in a little bit more detail and then kind of give us a sense, Mark, as you guys look at your outlook, when you actually think flows can turn positive and what is a reasonable time period for that to occur?

Mark Fetting

Yes. Well, there is probably two parts of the question that we should think about. First would be the institutional business and second would be our retail/quasi retail business. So on the institutional business in terms of the pipeline, what we’ve seen and you and others have noticed in your work is the – clearly, a shift is occurring out there with institutional mandates and currently there has been a lot of activity in interest in fixed income and particularly investment-grade fixed income. On the equity side, it’s been a softer environment, as planned sponsors are still de-risking and working more into kind of the whole LDI and related direction.

Importantly, what we see however is increased interest as we mentioned, let’s say with ClearBridge, as we’ve seen with Capital Management and our equity affiliates are starting to get activity and the trends are positive. And the key will be our ability to close that business.

On the fixed income side, we have definitely seen a fall-off in total activity and I would say that the softest area would be in the Core and Core Plus side, but where we are in the pipeline and we are with these other product areas ranging from global TIPs to global credit to emerging market, our win rate is as high as it’s ever been. So we are encouraged and we see as the pickup occurs that with our improved performance that the story gets stronger and we’ll be able to turn even in the Core, Core Plus area in the fixed income side.

Now, let’s go to the retail side. The retail side, you can clearly see activity picking up and we have gained share in an aggregate in our mutual funds business when you combine equity, fixed income, and muni and the kind of pieces of that are on the equity side, a definite improving trend; on the muni side, a very strong performance; and then in the fixed income side, we were gaining for a while, we lost the momentum relative to the kind of short-term performance but now that that’s come back we are hoping we can swing that as well.

I covered a lot of territory there, Dan. I hope it’s helpful.

Operator

Our next question comes from Roger Freeman from Barclays Capital.

Roger Freeman – Barclays Capital

Hi, good morning. Yes, can I maybe just follow up on your comments there? I mean, specifically the institutional, the commentary about institutions moving into fixed income, I’m just wondering, is that – I mean, is that what you are seeing here now – I mean, because the BlackRock call the other day had a pretty different story, which was – they are saying, “Institutions are now risk – increasing their risk tolerance and moving into equities.” I’m just trying to figure out why there is a different trend.

Mark Fetting

Yes, I guess our – all I can speak to is our experience. And our experience is that while that’s a – there is a trend that’s starting, we haven't seen that as demonstrably as the way you just characterized it. I think there is still – I think it’s going to be slow to come back as we’ve seen in the equity side and as we’ve seen particularly in the institutional market after severe market conditions like we’ve been through.

Operator

Our next question comes from William Katz of Buckingham Research.

William Katz – Buckingham Research

Hi, thank you. Good morning, everyone. Just want to go back to C.J., maybe Mark, your perspective too. You mentioned that the adjusted comps stripping out the deferred comp and the other noise relative to net revenue was sort of running north of 53%, close to 54%. Your prior guidance had been sort of 50% to 52%. Is this sort of a new run rate level and I guess I’m a little puzzled because you’ve always said that your equity affiliates are more profitable. So is this – can you help me sort of counter-balance those trends?

Mark Fetting

Yes. As C.J. indicated Bill, I think the industry, based on the recovery that’s underway and just the year-over-year delight that we all feel, is moving from an environment of real focus on cost reduction to an appropriate renewed focus on talent retention and making sure you’ve got – and there maybe some catch-up to that as you prepare for the end of the year.

In that regard, you can see that we’ve modestly gone up to 53.8% versus our kind of historic band. And I think the kind of projection that C.J. has about this of kind hovering asset level is a reasonable one. At the same time, what you don't want to miss is part of that is because the – for those that are on a revenue share, it means that they are holding their non-comp costs down to provide for that because as you know, when those that are revenue share, the net number to us remains the same.

So on the revenue share side, that’s what happening and on those affiliates and our corporate costs we have – we think picked it up in recognition of the work the people have done, but still overall a clear commitment to raising the operating margin.

Operator

Our next question comes from Cynthia Mayer from Bank of America.

Cynthia Mayer – Bank of America

Hi, good morning.

Mark Fetting

Good morning.

Cynthia Mayer – Bank of America

Just circling back I guess to the question of institutional flows, you mentioned a falloff in total activity and some other managers have also said that on the institutional side they think the replacement process has been delayed as pensions and others are focused more on questions of things like allocation. So I'm thinking – I'm wondering if you think that as well and if so, do you think that there – do you see any danger in terms of replacements and redemptions if replacements pick up from here?

Mark Fetting

No, I do think there is a longstanding pattern of – that you always have to be sensitive to that with experiences of disappointing performance. When the recovery happens, some clients take the money off the table even with the improving performance and we’ve certainly seen a bit of that both in the fixed income and longer history in the equity side. But let me be clear to all since there is obvious interest and as there should be, net-net this is a very bullish opportunity for the asset management business and the institutional.

It’s just going to take some time for them to work through the cycles. I’ve been through this now for 30 years and it’s very clear, this is an inflection point. Planned sponsors and their consultants pause, reflect. The consultants themselves, business activities have been severely eroded on a year-over-year basis just because of fewer hiring, fewer mandates, et cetera.

But what happens from this is a real pickup and a sense of what’s the right allocation going forward and we think we are very well poised on that across the asset allocation choice, whether it’s fixed income with Western and Brandywine, equity with our series of affiliates, and then alternatives with Permal and hedge – funded hedge fund business and Permal in particular has seen very interest – a keen interest on that as they come back into that asset class.

Operator

Our next question comes from Michael Carrier from Deutsche Bank.

Michael Carrier – Deutsche Bank

Thanks, guys. Just a couple of number questions actually. First, just going back to the comp, we are seeing the trend this quarter just given the improvement in both the industry and just the markets, but some catch-up in terms of approval for the first and second quarters. So I guess, when you look at the comp level, any indication in terms of how much was a catch-up versus just running at a higher level because the environment is better and you need to retain talent?

And then just on the non-operating line items, the other bucket – I think there was that noise, there was a deferred comp of $24 million, which is a positive and then the negative in terms of the equity unit charge $22 million, but that would net out to like a positive too. So just wondering if there were more like seed investment gains or some other items in that line.

C.J. Daley

Okay, let me hit the comp first. The vast majority, over 90% of the increase in the comp rate this quarter really revolves our revenue share affiliate model and as Mark explained, it really is just geography in their P&Ls. To the extent that they contain non-comp costs, more of that is going to go into compensation. However, our take and our margin remains the same that we get from the affiliates. So it really is just some geography. The – on – you can see on – in our operating margin now, as you can see the amount of gains and losses in other income and expense that we’ve added back to our operating income to get to our adjusted margin. So this quarter it was about $24 million.

Operator

Our next question comes from William Katz of Buckingham Research.

William Katz – Buckingham Research

Okay. Just a follow-up question. I – some of your competitors have – associated with the PPIP have (inaudible) it’s been in the papers that they sort of started the funding process into this new quarter and yet, we haven't Legg Mason’s name in there. So I’m sort of curious if you can maybe give us an update on your positioning in that initiative or conversely does this new credit closed end fund by Wamco, is that sort of a – has been part of that or is it sort of a different angle at this point?

C.J. Daley

Bill, on the PPIP, as you know, we were one of the nine managers selected and I think as you’ve pointed out, some have closed to the – at the minimum amount and others like ourselves are still at it. We are still very much at that, we’ve got a number of key institutional clients in; we are still working through it. The market environment, as has been observed, had for – relative to, particularly for institutional clients’ kind of expectations, the markets moved away from us a little bit and anybody in this space right now just in terms of expected returns in an absolute level.

However, on a relative – relative to other investment opportunities, the advantage is still quite significant. We are still active on that and we’ll obviously report when appropriate. On the closed end side, we did as part of the PPIP have a retail product and that retail product plus others – the current market conditions were not as promising. So we immediately moved on to this closed end global credit, which we have a lot of good and strong expectation on. So we think net-net, the flow opportunity might be comparable, but it’s just going to come in a different area.

Operator

Our next question comes from Craig Siegenthaler from Credit Suisse.

Mark Fetting

Craig?

Operator

Sir, your line is open.

Operator

Our next question comes from Robert Lee from KBW.

Robert Lee – KBW

Thanks. Good morning, guys.

Mark Fetting

Good morning.

C.J. Daley

Good morning.

Robert Lee – KBW

Actually, a couple of questions. I mean, first, maybe just going back to one that was just asked on the other income. If we just net essentially the $22 million or odd expenses to the exchange offer and seed, gains on deferred comp and seed investments let’s assume they kind of net each other, there is still about $18 million, $19 million of other income. So is that a one-time thing, were there other gains driving that? Is that something that we should expect – kind of what is that?

C.J. Daley

Well, the majority of it is gains on seed that’s not offsetting comp. We have some corporate seed investments book of that, and so those gains and losses run through other income and expense.

Operator

Our next question comes from Marc Irizarry from Goldman Sachs.

Marc Irizarry – Goldman Sachs

Great, thanks. Just following up on that C.J. Was there anything extraordinary in the – running through the interest expense line item?

C.J. Daley

Interest expense really reflects the reduction in the charge for the interest expense on the equity units. The $22 million charge includes a portion of interest expense for the quarter that we would have paid. And so you see the full effect in the interest expense line of the inducement, the $15 million reduction.

Operator

Our next question comes from Matt Snowling from FBR Capital.

Matt Snowling – FBR Capital

Yes, thanks. Good morning.

Mark Fetting

Good morning.

Matt Snowling – FBR Capital

Mark, Royce looks like it’s been the source of some of the strongest flows, at least in the equities, but if I got this correct, September you reported outflows out of Royce. So I'm wondering if there is any reason for that shift and are there any real capacity issues that we should be worrying about?

Mark Fetting

No, there is really not. I will say that in that number was one institutional client that shifted allocation that would be kind of what I call a one-off and if you took that away, their kind of general retail flow story was pretty consistent.

Operator

Our next question comes from Craig Siegenthaler from Credit Suisse.

Craig Siegenthaler – Credit Suisse

Thanks. Can you guys hear me?

C.J. Daley

Yes, we can.

Craig Siegenthaler – Credit Suisse

All right, great. On the duplicate rent issue or expense on the two Baltimore properties, I’m wondering how much was that and when should we start taking that out of earnings?

C.J. Daley

The duplicate rent was about $1.5 million this quarter and in the December quarter, you should – assuming that depending on how successful we are in subletting some of that space, you’ll see that lead into the December quarter in terms of reduced occupancy expense.

Operator

Our next question comes from Roger Freeman from Barclays Capital.

Roger Freeman – Barclays Capital

Hi, just a couple of follow-ups. Actually, just on that rental expense, can you tell us, just curious, where rental rates are coming out on what you are subleasing versus what you are paying?

C.J. Daley

On the sublease? I mean –

Roger Freeman – Barclays Capital

Yes.

C.J. Daley

It’s all over the place, but as you can imagine, the markets have really turned against it, especially on the commercial side, which is like the real estate side. So we have taken appropriate charges in prior quarters to reflect where we think we can sublet the space.

Mark Fetting

Yes and look, this is something that is not the ideal situation, but we’ve aggressively moved on it knowing there is a lag in any kind of space planning that goes on. And as is probably typical in the business, more often than not when the big buildings go up, it’s a sign of the top of the market and that is the investment market.

In this case, what we’ve done, and I’m very proud of the team, is on this, is like in New York, we basically made some money in the sublease relative to what the tenant was doing. In Baltimore, we clearly had to make some concessions, but they are certainly not material relative to our overall numbers, but it’s a sign of current condition. So we are going to continue to be aggressive about this, but very conscious of not giving the shop away if it doesn't make sense.

Roger Freeman – Barclays Capital

Relative to where you are coming out in some of the latest transactions, what you reserve for, I mean is it – where you are getting is sort of in line is where you thought the market was going to go?

C.J. Daley

Well, yes, but to the extent we subleased as I said in my remarks, you would expect to see charges of approximately $30 million if we are successful in all of the space we are trying to sublet and that really is just reflective of the lower rate that we can get on a discounted cash flow basis over the remaining term.

Operator

Our next question comes from Max Geiss [ph] from Gabelli & Company.

Max Geiss – Gabelli & Company

Hi guys, thanks for the time here. Just quickly, we’ve seen an uptick in the announced M&A recently in a couple of deals. Just any sense that the prices paid would change your thinking about capital allocation in the short run?

Mark Fetting

Well, I think what you are referring to is the current deals coming in very – as I've said, along last couple of quarters, this is time to buying up, time to be selling asset management and those deals. I do think each of those situations has some special circumstances to them in the more recent transactions.

Relative to our capital allocation, I think our priorities remain consistent that first order of business would be to further reduce our debt as appropriate in kind of working with our bank syndicate on that. Second would be to take advantage of opportunities that we see and we do see this environment is advantageous. So we would like to take advantage of that and then the other matters, as we sequentially work through it.

Operator

Our next question comes from Douglas Sipkin from Pali.

Douglas Sipkin – Pali

Yes, thank you and good morning to all. Just sort of an accounting question, I’m trying to sort of fine-tune the model. Just want to understand, the share count I guess this quarter didn’t fully reflect the exchange, correct? I guess eventually it’s going to grow to like 162 next quarter?

C.J. Daley

Yes, that’s correct. We – diluted shares are on weighted average basis. So the exchange closed on August 15th. So you saw about half of it lead into the quarter.

Douglas Sipkin – Pali

I guess and – but it looks like though you were able to recognize the full $15 million in interest and so I’m just – or was some of that the extra put in that charge, I guess maybe –

C.J. Daley

Yes. Yes, the half quarter of interest that was in interest expense in prior quarters, was – is characterized in the $22 million.

Douglas Sipkin – Pali

Okay. But when we think about your interest expense, the $28.5 million or so is sort of the right number going forward?

C.J. Daley

That’s correct.

Douglas Sipkin – Pali

Okay. And then just on the real estate, I think you had mentioned you are going to have a non-cash real estate expense. How should we be thinking about that running through the model, over what period of time?

C.J. Daley

Well, if we are – it – I can’t give you exact timing. We’d hope to try to get it all done in the December quarter. But if that doesn't happen, we – it’d probably be over December and the March quarter.

Operator

Our next question comes from Robert Lee from KBW.

Robert Lee – KBW

Thanks again. I learned my lesson, I'm going to ask all my questions upfront. First one is, would it be possible to break out what the deferred compensation balance is in investments so we can -- that would probably help us I think model the volatility on that line. Second thing, maybe you could update us – I think you may have done this last quarter, but with the Smith Barney, Morgan Stanley JV and kind of the liquidity pull you managed for them, kind of any updated status related to your expectations around that?

And third thing is kind of a broader – a strategic question, one of the things some of your competitors talk about, you see it in the trade rags too, is the growing number of asset managers kind of trying to do a fiduciary management, obviously BlackRock talks about a lot, but there is others. Can you talk a little bit about how you feel your position or – to go after that kind of business or that’s kind of a segment of the marketplace that you have interest in, particularly given kind of your – the way you are structured with the different operating subsidiaries?

Mark Fetting

Yes, let me hit the last two and then C.J. will come back specifically on the deferred comp question. And those are great questions, Robert. The Morgan Stanley, Smith Barney situation on liquidity is that we were – we are in active discussions with them. As you would probably have noted that in the sale with Invesco and then essentially their retail business, it did not include the liquidity business. And so there is really no change to that story other than we are continuing to work with the leadership team at Morgan Stanley, Smith Barney and actually feel good about the discussions relative to – there is definite optionality there.

Relative to going after the fiduciary world, that’s a very perceptive question because there is quite a lot. As you go through these inflection points in the institutional space, there is a desire to look more broadly at asset allocation across the board and we think we are very well poised for that. As an example, Western is mounting a client kind of outreach effort across their whole series of capabilities and in so doing, talking about how they can be responsive to these issues, albeit with a fixed income side. And so too is Permal on an alternative basis.

So we believe the client would be well served by continuing to go after the best managers in that space and we work closely with their consultants to pursue it. It is an issue that we are going to watch over time. We think we are poised actually well to continue to take advantage of it.

C.J., you want to hit the – ?

C.J. Daley

Yes. So if you think about it, we have a little over $200 million of seed investments that we do not offset in comp and those are seed investments that the firm has made for products and so the mark-to-market there will flow through net income and not the offset income. That – I hope that’s helpful.

Operator

Our next question comes from Cynthia Mayer of Bank of America.

Cynthia Mayer – Bank of America

Hi. I'm just wondering if you can give the amount of the fee waivers and maybe what your outlook is there and also wondering if you can give a little more color on what drove the increase in money market assets given outflows in the rest of the industry.

C.J. Daley

Yes, Cynthia, fee waivers really weren’t that big of a deal in the quarter. We have a $150 billion plus liquidity book. It represents less than 10% of our net revenues. And in terms of your model, in the quarter, it really only represented $2 million of profitability. And even at current interest rates, we would only expect going forward there would be another $1 million or so of reduced profitability. So our view is that you won't see a material change next quarter.

Mark Fetting

And then going back to your question in terms of our inflows versus others, I think first off, it’s a testament to the partnership lead by Western, but certainly supported by Legg Mason. Through this tough period with lots of issues in our liquidity, we I think strengthened relationships and a number of relationships came back once we got rid of exposures that concerned them.

In particular, in the international client base, there is just a number of those relationships chose to reinvest with us although they had choices elsewhere. If you look at our yields, our yields are solidly in the top quartile, but by no means peak – we are not chasing yields here. So I really think it’s a product of A, just the strength of the underlying investment case that we present, a strengthened risk reduction activity and strong relationship skills.

Operator

Our next question comes from Jeff Hopson from Stifel.

Jeff Hopson – Stifel

Okay, thanks a lot. You may have given this, but Permal, did you kind of talk a little bit about the difference in flows between the retail business that had fallen off and then maybe institutional, which maybe is improving? And then the discussion about the comp ratio in the geography there, does that – what are I guess the implications for operating leverage then as we move forward?

C.J. Daley

Yes, let me hit both of those if I can, Jeff. The first one on Permal, what we've seen and this being a real leader in a space that’s gone through very difficult both fundamentals and then of course issues tied to Madoff, et cetera, which we had no exposure to; and in light of that, a – what we would call the kind of retail high net worth business, particularly in Europe, really exited quickly. Any structured product that was put together tended to kind of exit quickly.

Higher net worth clients and institutional clients had more thoughtful response. So let’s – Permal’s response to all of this is let’s on a go-forward basis focus on quality clients, not quantity clients and that’s really where they are and they are very encouraged in the U.S. in the progress they’ve been making with institutional finals.

On the comp ratio, this is really going to be the judgment call and all of us is asset managers, public or private have to navigate right now because if you come out of a cycle like this, a lot of people tightened the belt and took appropriately significant comp reduction. How do you kind of take that back while still rebuilding your overall operating margin? And I would say at the margin as we’ve always pointed out, our operating margin tend to when we’ve done best in the kind of low-to-mid 30s, the peer group of integrated firms are always going to be a bit higher because of the inherent difference in our model, but we have always been able to keep that gap narrow enough that with – if offset by really strong performance, which delivers good organic growth, which makes it a very good return for our shareholders and that’s the mission we are on.

So the 20% or 21% operating margin that we see today we are committed to growing, we may not grow at as much as others on a pure integrated model who are also combating the same comp issue, but we are not going to let it get in the way of continuing to grow it and that kind of low-30 goal over the next couple of years is really very much on our mind and it’s tied to, as I concluded the call, with our commitment of accountability with our Board and ultimately you, shareholders.

Operator

We do have time for one more question and our last question comes from Roger Freeman from Barclays Capital.

Roger Freeman – Barclays Capital

I'm sorry, yes, I had a couple and let me just throw them all in here. The realization rate was up just marginally sequentially, but you kind of pointed to obviously the strong sort of equity performance was up a couple of percentage points as a percent of total mix. So I guess I would have thought maybe the realization rate would go up a little bit more. Is there anything else to kind of think about in terms of sort your mix there? That’s number one.

And then, I guess I’ll just ask one other one. You kind of point out the NOL benefit and I guess, is that accretive to you through cash flow? What is your – is there a plan to distribute that as a dividend? The shareholders kind of think about that as real value or should we just think about that adds to the cash balance in your capital base to deploy in some way down the road?

Mark Fetting

Let me hit the NOL issue and then C.J. can hit the realization. I think what we are trying to point out, as several have observed, that if you consider the embedded deferred tax benefit that’s been in the business based on our model and also the NOL piece, that we have a considerable tax yield for basically almost 20 years in terms of the time we’ve got to utilize it. And that is certainly going to improve our cash margin to our – on our earnings.

It won’t automatically lead to any change in our capital deployment because the near-term opportunity is clear, let’s reduce some debt, let’s invest in the businesses where we see opportunities and let’s, as one question came earlier, take advantage of an environment where good, targeted acquisitions make sense that can deliver accretive earnings to us, let’s consider that. Beyond that, if things go well enough, of course there will be opportunities to think about, but that’s not the near-term, I think, priority.

C.J., you want to hit that – ?

C.J. Daley

Yes. I mean, it’s really just a combination of the mix. I mean, liquidity assets were up as well, equity assets were up. So it really is a mix issue, but as equity continues to rise, we’ll see it – we’ll see that continue to rise. But some of that is just the fact that liquidity and fixed income are offsetting what you would expect to see on a full basis point from the equity asset rise.

Mark Fetting

I think we probably should wrap up at this stage, operator. And I’ll make some concluding comments.

Look, as you can see and I hope you can hear, we are very pleased with the progress we are making. At the same time, we are very determined to press on because there is more progress to be secured for our shareholders and our clients. And we commit to that, we appreciate your interest. I want to thank our colleagues across our firm, both with our affiliates and our corporate colleagues that we have come together through this period and this mission of turnaround at Legg Mason is absolutely our focus and we look forward to continuing to deliver improved results for our clients and our shareholders and we thank you all for the call today.

Operator

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

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