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Executives

Alan F. Magleby - Director of Investor Relations and Communications

Joseph A. Sullivan - President, Chief Executive Officer, Member of Board of Directors, and Member of Finance Committee

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

Analysts

Christopher Harris - Wells Fargo Securities, LLC, Research Division

Matthew Kelley - Morgan Stanley, Research Division

William R. Katz - Citigroup Inc, Research Division

Macrae Sykes - Gabelli & Company, Inc.

Daniel Thomas Fannon - Jefferies LLC, Research Division

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

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

Craig Siegenthaler - Crédit Suisse AG, Research Division

Glenn Schorr - ISI Group Inc., Research Division

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

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

Douglas Sipkin - Susquehanna Financial Group, LLLP, Research Division

Legg Mason (LM) Q2 2014 Earnings Call October 25, 2013 8:00 AM ET

Operator

Welcome to the Legg Mason's Second Fiscal Quarter 2014 Earnings Call. [Operator Instructions] Please note this teleconference is being recorded. It is now my pleasure to introduce your host, Alan Magleby, Head of Investor Relations and Communications. Thank you, Mr. Magleby, you may begin.

Alan F. Magleby

Thank you. On behalf of Legg Mason, I would like to welcome you to our conference call to discuss operating results for the fiscal 2014 second quarter ended September 30, 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, 2013, and in the company's quarterly reports on Form 10-Q.

This morning's call will include remarks from 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 our view 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. Joe Sullivan. Joe?

Joseph A. Sullivan

Thank you, Alan, and good morning, everyone. As always, I appreciate your interest in Legg Mason, and I welcome you to our second fiscal quarter 2014 earnings call. A year ago, last month, September 2012, marked the beginning of an important leadership transition for Legg Mason. And I am proud to say that over this past year, we have made significant progress. Most importantly, the impact of our efforts is starting to be reflected in our financial performance. Certainly, we have more work to do. We're pleased with our progress but not satisfied. At the core of our efforts we'll be strengthening our enterprise, enhancing our industry leadership position, and at a high level, building a better Legg Mason for the future.

I'd like to thank the many of you who attended our investor luncheon in September. As you will recall, Pete Nachtwey walked you through some of the critical financial elements of our business model, including a discussion of our comp ratio, our margin and our tax shield, among other metrics. I think that there were 3 very powerful takeaways from that luncheon. First, we are a company that generates a significant amount of cash. Due to our tax shield, we keep a significant amount of that cash, and while we will continue to invest in the growth of our business, we are able to return a significant amount of that cash that we keep to shareholders through dividends and our share repurchase plan.

Secondly, we also discussed steps to further improve the efficiency of the company, actions that resulted in incremental charges of $9.5 million this quarter. Staying focused on maintaining a highly productive and efficient corporate structure is a daily commitment for us.

The third clear takeaway is our focus on returning Legg Mason to sustainable long-term growth. And I believe that our flow data and operating performance shows that we're making good progress on that front as well. So I hope as a result of that luncheon, investors now have a better understanding and appreciation of our business model and most importantly, our perspective on the earnings power and potential operating leverage of Legg Mason. I will speak to that growth a bit later on our call, but for now, let's walk through our financial and operating results for the second quarter.

Slide 3 shows highlights from the quarter just ended. The quarter shows continued financial progress over the year-ago period with higher earnings per share, driven by higher revenues. To complement this growth, we continued our quarterly share repurchase program, buying 2.7 million shares for $90 million. And we were able to do this while increasing our cash position over the prior quarter by $45 million to $712 million. We continue to review, and as appropriate, take action with respect to small subscale and our non-core affiliates in businesses in a measured and thoughtful manner. We completed the previously announced divestiture of Private Capital Management and announced an orderly wind down of our emerging market equities affiliate, Esemplia. In Canada, we modified our client service model, transitioning responsibility for institutional client coverage back to our affiliates. And we are pleased that Moody's affirmed our rating of Baa1 and moved Legg Mason's outlook to stable from negative. Finally, overall investment performance remains strong with 80% of strategy AUM exceeding performance benchmarks for all periods.

Now let's get into some detail. Slide 4 is our standard presentation of AUM by affiliate. As we've reported, we experienced long-term net outflows for the quarter, and while I'll never feel good about reporting net outflows, I will say that our net flows results within the context of the market environment and considering strategic initiatives that we've undertaken, are about as we expected.

Now let me provide some commentary by asset class starting with fixed income. Western Asset had modest long-term net inflows for the quarter. In fact, this was the first quarter of long-term net inflow for Western since September 2007, reflecting continued strength in investment performance across the board. During the quarter, Western earned wins in specialized institutional mandates within the MBS, ABS, high-yield and bank loan sectors. Western's continued strategic focus on the insurance sector has also paid off with AUM increasing each of the past 3 years within that client channel. These inflows offset muni outflows in the retail channel and some modest outflow in Core and tip strategies, as well as the ongoing low fee global sovereign mandate outflow. Won, but not yet funded mandates at Western, stand at $3 billion, up slightly from last quarter. Western's RFP pipeline, while down in the aggregate, includes a significant uptick in finals presentations. And in fact, the company has already exceeded through 9 months the total number of finals presentations for any of the entire last 4 years. On the product front, Western has seen great command for a new unconstrained alternative light product run by Ken Leech and team which has seen inflows of nearly $500 million in just a few months.

Brandywine Global has also had modest fixed income inflows which were offset by equity outflows during the quarter. Brandywine's won, but not yet funded, mandates closed the quarter at $1.1 billion. Brandywine continues to see a growing interest in global and absolute return fixed income strategies from both new and existing clients. And this theme, moving to alternative sources of alpha, is one that we are hearing from a number of our managers. Also included in Brandywine's pipeline, is a large cap value sub-advisory mandate, as they've seen continued improvement in the investment performance of their equities products.

In equities, strong momentum at ClearBridge Investments was offset by some continued slow weakness at other affiliates. ClearBridge had broad-based inflows of $1.9 billion, marking the third straight quarter of net inflows for the firm. A little less than half of the net inflows resulted from sales through our Global Distribution teams internationally, highlighting the increasing diversification of the ClearBridge business in recent years. Specifically, ClearBridge partnered with our retail team at Legg Mason Japan to create products and mandates around their compelling capabilities and income, generating $2 billion in inflows fiscal year to date. Won, but not yet funded, mandates for ClearBridge at quarter end stood at $2.7 billion.

Now, I would like to take a moment to recognize and congratulate Richie Freeman and Alvin Bowman from ClearBridge. ClearBridge has kicked off a celebration of the 30th anniversary of the aggressive growth fund, which Richie has managed since inception. If you haven't already, I urge you to read Barnes recent writeup on Ricci and the Aggressive Growth Fund.

Outflows at Royce continued as ongoing redemptions domestically more than offset inflows on the international side of the business. The challenges at Royce from a flow perspective are real, and I don't want to minimize them. That said, these challenges are more of a subscription issue than a redemption issue. Redemptions at Royce are certainly elevated, but it is new sales which have dropped more significantly. Therefore, improving performance is especially important for Royce to enable the firm to begin increasing subscriptions once again. To improve their results, Royce has recently added additional sales resources to help address the decline in subscriptions. It is also important to note, however, that while Royce has suffered from investment underperformance, that performance is still quite positive on an absolute basis, which, together with favorable markets, has caused the firm's AUM to actually increase by more than $2 billion, both quarter-over-quarter and year-over-year.

Batterymarch did experience outflows during the quarter, including the large redemption in a global equity mandate that we had previously signaled. However, I am encouraged as Batterymarch and our Global Distribution teams continue to work on smart beta mandate opportunities, as institutions continue to seek mandates that customize market exposure across the risk spectrum. RFP activity at Batterymarch is greater this year than the last 3 years combined, reflecting this shift in client demand. We now need to convert that RFP activity into business.

In alternatives, we saw some continued, albeit reduced outflows, in the Fauchier business, while Permal's legacy business was flat. We believe that the AUM associated with the Fauchier transaction is stabilizing around the lower end of our targeted range that we had projected at the time of the deal, and we are quite pleased that Fauchier's investment performance and the performance fees that should result have been better-than-expected.

Permal's institutional business is now 54% of their total AUM, up from 36% in the same period a year ago. And the firm had positive institutional net flows from their legacy business in the U.S. and internationally. Permal continues to market its ability to create custom mandates through its managed account platform, which now has $7.6 billion in AUM across 82 different vehicles. Permal's unfunded wins at quarter end were $550 million. The company launched an activist fund during the quarter, importantly leveraging some of the investment capability that the firm acquired in the Fauchier transaction. And client interest in the that strategy appears high. Going forward, Permal's growth opportunities should continue to come from customized solutions across our growing institutional base globally and new products that we expect to roll out in the U.S. retail market in the coming quarter.

Slide 5 shows investment performance. As I alluded to earlier, we have 80% or more of strategy AUM beating benchmarks over all time periods. Fund performance versus peers, however, is a bit more mixed, reflecting short-term underperformance in Royce and some fixed income products.

Slide 6 focuses on Global Distribution. I want to reiterate an important theme that we often emphasize in our discussion of our retail distribution platform, specifically, the diversification and balance of our distribution business across the U.S. retail, quasi-institutional and international retail channels. This diversification allows us to balance cyclical softness in certain regions and channels with strength in others. And we've seen this time and again. Specifically for the quarter, we achieved gross sales of $15.5 billion across the platform, which is up 13% from the same period a year ago. Year-to-date gross sales were $32.6 billion, a 20% increase over the year ago period. However, net outflows in our retail business during the quarter picked up, driven by outflow in munis and at Royce, as well as the large equity outflow at Batterymarch, all of which more than offset strong inflows into ClearBridge Investments. Net retail flows at Western improved in various taxable strategies and Japanese outflows diminished.

The top half of the chart highlights the gross and net sales activity for our Global Distribution team for the quarter and year-to-date. While the sales picture is strong, the outflows story reflects the headwinds we've just discussed in munis and at Royce in Batterymarch. The bottom half of the slide reflects the tactical pivoting our sales teams have accomplished that reflects both increasing client demand for the type of equity products that we have, and a strong investment performance of those products. You will notice that we've seen a significant increase in various ClearBridge equity strategies, while continuing to have sales success in various fixed income products at both Western and Brandywine. We do see further growth opportunities in a number of ClearBridge strategies, and we anticipate a greater interest in more absolute return and unconstrained strategies in the fixed income arena.

And with that, let me turn it over to Pete to discuss the financials.

Peter Hamilton Nachtwey

Thanks, Joe. Turning to Slide 7. I'll start with the financial highlights for the quarter. We generated earnings of $86 million or $0.70 per share. I also want to highlight that this quarter, our GAAP earnings benefited from a U.K. tax rate reduction of $19 million or $0.16 per share. In addition, as Joe previously discussed at our September investor luncheon, we are continuing our work on several business efficiency initiatives. As we refined our plans on these, we currently expect a total of approximately $23 million in severance and other costs, of which, we incurred $9.5 million this quarter, and we expect annual run rate savings of $11 million to kick in during our fiscal Q4. Also in this quarter, we incurred a $1.8 million loss on the sale of PCM. Adjusted income was $104 million for the quarter or $0.85 per share, which was also impacted by the severance and other costs. Average AUM in total was slightly lower than the prior quarter with average fixed income down 3%, but average equity AUM up 2%, reflecting broad market trends. Operating revenues were in line with the prior quarter, despite lower performance fees and the lower average AUM. This quarter's total performance fees of $17 million, were primarily from Permal, Brandywine and Western. While impossible to predict with any precision, we estimate that next quarter's performance fees could be in the $35 million to $45 million range, due in large part to calendar year end lags at Permal, which includes the impact from our acquisition earlier this year of Fauchier. Operating expenses included the $9.5 million in severance and other costs related to our efficiency initiatives, and I will provide a little more color on overall expenses later.

On the balance sheet front, this quarter, we repurchased an additional 2.7 million shares for $90 million. Going forward, we continue to anticipate share repurchases of $80 million to $90 million per quarter. As always, subject to markets and/or growth opportunities, which is consistent with our plan to use up to 65% of our operating cash flow for buy backs.

Moving on to Slide 8. The only item to highlight here is our GAAP effective income tax rate of 18%, reflecting the U.K. corporate tax rate reduction, in which also includes the impact of consolidated investment vehicles. Going forward, we are forecasting our effective GAAP tax rate for the fiscal 2014 to be around 30%, including the impact of the U.K. rate reduction this quarter.

And as you will see on a later slide, the actual cash taxes we currently pay continue to be at a substantially lower level than our GAAP rate.

Turning to Slide 9. Our assets under management were up 2% from the prior quarter due to market increases of over $14 billion, of which nearly $2.5 billion was due to currency movements. In the quarter, equity as a percentage of total AUM, remained unchanged from last quarter at 26%, while fixed income assets remained at 54%. In large part, the overall increase in AUM was due to positive equity and fixed income markets during the quarter. There is also $1.3 billion in AUM dispositions related to the PCM sale.

Long-term flows on Slide 10 declined from the prior quarters positive flows, as modest fixed income inflows were more than offset by equity outflows. Fixed income inflows this quarter were $300 million, compared to inflows of $900 million in the prior quarter. This quarter's results included just under $1 billion in ongoing redemptions related to the low fee global sovereign mandate, as well as a $500 million increase in retail muni redemptions.

Equity outflows increased to $4 billion from $700 million last quarter. Recall that last quarter benefited from the $1 billion ClearBridge closed-end fund launch. This quarter's outflows included the large global equity redemption of Batterymarch, which we called out in July, and approximately $700 million related to the Esemplia wind down. On the liquidity front, inflows were $2.3 billion.

Slide 11 shows the advisory fee trend, with this quarter's rate unchanged from last quarter. Average long-term AUM decreased 2%. And within that move, average equity assets were up $3 billion, while average fixed income assets were down nearly $11 billion, due to market concerns around the Fed's Tapering Plans early in the quarter.

Operating expenses on Slide 12 decreased to $563 million from $587 million last quarter.

I'll discuss comp and benefits on the next slide, but as to the other components, distribution and servicing expenses decreased $15 million from the prior quarter, primarily due to the closed-end fund launch in fiscal Q1. This was partially offset by increases related to several relatively small accrual adjustments to distribution partner compensation.

Occupancy expenses decreased due to a credit related to the reserves for last fiscal year's space consolidation. The credit resulted from our ability to sublet some of the space sooner than originally anticipated. The other expense decrease was largely driven by lower T&E expenses and professional fees, along with the currency impact on non-U.S. dollar expenses during the quarter, all of which more than offset this quarter's annual director fees.

Turning to Slide 13. Compensation and benefits, overall, decreased by $2 million. The primary driver was lower benefits and payroll taxes due to tax payments last quarter arising from fiscal year end bonuses paid in mid-May. The severance relates to the previously disclosed corporate efficiency initiatives. And as a reminder, last quarter's closed-end fund launch caused increased the compensation ratio by 3%.

Slide 14 highlights the operating margin as adjusted, which increased to 22.3% from last quarter's 17.9%. Several items impacted our margin this quarter. The severance and other costs related to our efficiency initiatives and business integration costs had a negative effect, but were partly offset by the occupancy lease credit. The combination of these reduced our margin by approximately 1.5 percentage points this quarter. Last quarter's operating margin included the closed-end fund costs, which reduced the operating margin as adjusted by 4 percentage points.

Slide 15 is a roll forward from fiscal Q1's earnings per share of $0.38 to this quarter's $0.70 per share. Fiscal Q1 included the closed-end fund cost that totaled $0.14. While this quarter included a $0.05 related to various corporate items, including the previously discussed efficiency initiatives, loss on the sale of PCM and positive occupancy credits. Fiscal Q2 also included the U.K. tax benefit of $0.16.

In addition, the mark-to-market on corporate investments, that are not offsetting compensation, was $0.05 higher than last quarter, as a result of higher equity and fixed income markets. Finally, changes in net revenues and expenses, along with share repurchases for the second quarter increased earnings per share by $0.02.

On Slide 16, you can see that our effective GAAP tax rate for the quarter was 18%. And the forecast for the full year is for a 30% GAAP tax rate, as I mentioned earlier. But the key, once again, is our cash taxes which continue to run at 4%. We expect the cash tax rate to bounce back to approximately 6% to 8% in fiscal 2015 and for the foreseeable future. This low cash tax rate allows for both additional investments in the business and additional return to capital to shareholders.

And as a reminder, the low cash rate results from our NOL carryforward and our ability to amortize goodwill and indefinite-lived intangibles for tax purposes, but which are not amortized for GAAP. When you translate our cash tax rate into estimated dollars saved, which are on the right side of the schedule, you see that over time, we continue to expect to realize a positive cash savings of $1.4 billion.

I'll wrap up on Slide 17, which highlights how we've both returned capital to shareholders and how we have maintained our cash position, thanks to strong cash generation. In the upper left, you can see that we have reduced our share count by 40 million shares or 25% over the last 4 years, and we still have $550 million of Board authorized repurchases remaining. In the upper right, we've highlighted our annualized quarterly dividends. And as you can see, we have steadily increased our dividend payout to $0.52 per share over the last 3.5 years.

In the bottom left, you can see that our ending cash balance was approximately $700 million. As we look ahead, over the rest of fiscal 2014, we would expect the cash balance to rebuild towards last year's ending level, even while investing in the business, buying back a significant amount of stock, increasing our dividend and paying down our bank term loan. Finally, as noted in the last bullet on the bottom right, our seed investments now stand at $363 million, which is up from $331 million last quarter.

So thanks again for your time and your interest in Legg Mason. And now, I'll turn it back to Joe.

Joseph A. Sullivan

Thanks, Pete. Now I'd like to call your attention to Slide 18, while I review our 4 key operating priorities, which, if successfully executed, will drive consistent long-term organic growth. Again, I'm pleased to say that we're making solid progress on all 4 priorities.

First, we are focused on products that are currently in high investor demand categories, while innovating products around anticipated future investor demand. As I touched upon earlier, each of our affiliates has a number of initiatives that they are pursuing directly with institutions and our retail product teams. The common theme across all of them is an increasing client need and our ability to create customized solutions, increasingly around unconstrained risk mitigation or other nontraditional mandates. Legg Mason Global Asset Allocation, our solutions affiliate, which works with and across all of our managers, sees a number of promising opportunities to partner with our distribution platform, to source institutional mandates currently coming primarily from insurance companies. Specifically, 1 insurance dynamic multi-strategy mandate managed by LMGAA has now grown to $1.2 billion as of October 1. And on the global retail side, in addition, to the multi-asset class solutions I just mentioned, we are launching new products focused primarily on themes around alternatives and income.

Year-to-date, our product teams have launched 12 products through global distribution, and we are expanding our suite of alternative products across the liquidity spectrum with Permal, Western and Brandywine Global. So as we've said, we must have products in high demand categories and we're continuing to develop and add them to our lineup. Next, these high demand products must perform well. You heard me say, that compelling investment performance is table stakes in this business. Nothing has changed in this regard, and I don't expect that it ever will. Therefore, we remain committed to relentlessly pursuing those compelling investment results for our investor clients.

Third, we are very excited about evolving our distribution platform to achieve world-class status. As I've said many times, we see our Global Distribution platform as a key strategic asset of Legg Mason and a real differentiator for the company in the marketplace. I have challenged our global teams to raise their game and become the industry leader in this critical operating priority. We have a number of active initiatives that we are pursuing today to achieve greater penetration and market share by employing rigorous segmentation strategies to identify the most promising opportunities that we see across all of our geographies. As one example, we have recently added a number of SMA strategies from ClearBridge and Western, with 2 wirehouse distribution partners in the U.S. And we are implementing an aggressive campaign targeting advisors most likely to use these strategies to raise assets. In both cases, we believe we are well positioned to take market share, given the impressive investment performance of these products. Also in the U.S., we have initiated a highly targeted approach across a specific segment of high opportunity RIA clients, which is one of our fastest growing distribution segments.

In Japan, where we currently enjoy a significant market share in U.S. equity fund sales, we see continued opportunity to build upon that success, driven largely by ClearBridge's high dividend equity, small and mid-cap equity, and MLP products. In Europe, gross flows from new clients were 14% of the total European flows, as we continue to expand our relationships across the continent. Much of the upcoming activity in Europe will be focused around a broad-based U.S. equity campaign, covering 4 of our affiliates, as well as an upcoming roadshow for Western's global credit absolute return capability.

In Asia x-Japan, we see ongoing opportunities in the retail and private banking segments in Hong Kong, China and Taiwan. Our near-term product focus in Asia includes leveraging the U.S. equity campaigns underway in other regions, as well as other targeted fixed income opportunities. We do see the income theme as continuing to be very sustainable globally, even as the retail investors' comfort level with risk and equities slowly returns. As I've said before, we have a good distribution team today, but we expect to have a great distribution team tomorrow. And finally, we must be constantly vigilant in running Legg Mason with the highest degree of efficiency and effectiveness, and we remain committed to doing so. I hope you've seen that we continue to follow through on that commitment. Again, executing on these 4 key priorities, in conjunction with a compelling best of both worlds model, and a strong and diversified foundation from which to build, will position us to win for our clients and our shareholders.

Slide 19 looks at all of the cumulative actions that we have taken over the past year to position the firm for the future and to build a better Legg Mason. These are largely a number of smaller steps that, taken together, will continue to have a tangible positive impact on our earnings going forward.

So let me close by touching upon some of the things that you may see from us over the near term. Let's start with management equity plans. We are continuing to work on creating equity participation plans that reflect, to a degree, the unique nature of each of our affiliates. I am pleased with the progress we are making and I'm hoping to announce new equity plans at some of our affiliates in the near future. In addition, we will continue to pursue investing in our affiliate manager franchises, helping them to expand and grow their business. We have a lot of opportunity and interaction on this front right now, reflecting both the attractiveness of our affiliates and Legg Mason as a home for teams and small boutiques looking for a strong partner.

In addition, I announced a while back that we have a search underway for a head of business development. I am pleased to say that we have had a strong lineup of potential candidates interview for this position, and that the search process is proceeding well. And finally, we will continue to look to leverage the pipes that we've built in our global distribution platform to deliver investment solutions to retail clients around the world. And now, we're happy to take your questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Chris Harris from Wells Fargo Securities.

Christopher Harris - Wells Fargo Securities, LLC, Research Division

Curious with the recent pullback we've had in interest rates so far, last few months and the Fed potentially on hold for a longer. I'm wondering, has the tone of the conversation with Western's clients changed at all? And you think that might be setting up the December quarter for may be a little bit better flows?

Joseph A. Sullivan

Chris, I think that most of the institutional clients that Western deals with have -- are a bit more forward-looking. So I don't think they kind of short-term ups and downs that we see in terms of the market affect as much their long-term thinking. And I think there's a general sense, and I think Western and all of us agree with this, that rates will ultimately begin to move up, not necessarily sharply, but there will be a gradual increase in rates. And with respect to that, many of the conversations that Western is having with their clients are around really moving towards more unconstrained and absolute return strategies that sort of mitigate duration risk and things like that. We're actually seeing some of that come through in the wins that Western is already getting. But again, importantly, both Western and Brandywine are seeing more and more clients interested in and talking about and considering these sort of alternative fixed income strategies, which they can offer. And I think that has continued. That hasn't really changed with these ups and downs in the market.

Operator

Our next question comes from Matt Kelley from Morgan Stanley.

Matthew Kelley - Morgan Stanley, Research Division

I wanted to come back to what you guys said about the alternatives capability. You talked a lot about the liquid capabilities. I've been curious in getting your thoughts, given you're a large institutional client franchise about your liquids and anything you're thinking about potentially being accretive or bolt-on there.

Joseph A. Sullivan

Matt, I guess, you asked a couple of different questions, I think, but as it relates to sort of acquisitions or bolt-ins, we are working, as we've said, with virtually all of our affiliates to look at adding capabilities, investment capabilities, to their franchise. That's something new that we've really begun to do more in the last year or so. And we're doing that with Western, we're doing that with ClearBridge, we're doing that with Royce. And it's really not necessarily directed towards liquid or illiquid investment capabilities. It's just whatever seems to be a good fit for their lineup and their strategy. As it relates to sort of increasing, again, this all goes back to this theme of different liquid alternatives particularly on the retail side, and sort of alternative strategies, be it in equities or particularly in fixed income, both institutionally and retail. So I think what we're seeing evolve is just this migration away from sort of traditional strategies. And we think, we're well positioned for that to more, again, unconstrained, uncorrelated strategies. But on the retail side, in particular, liquid strategies.

Operator

Our next question comes from William Katz from Citi.

William R. Katz - Citigroup Inc, Research Division

If you look at your fee rate, so I listened to you talk a little bit about the sort of change in average assets, and then the incremental buying that's coming in versus may be what you're losing, and I know there's a lot of moving parts with things you're winding down, et cetera. But as I think about your pipeline from here, and you saw put the marketing side, is the fee rate likely to move higher given the new business? Or trend flat? What's sort of the outlook there?

Joseph A. Sullivan

Well, I'll let Pete get into, maybe a little detail on this, Bill. But what I do see is that our fee rate is all about markets and mix, right? And so as we see, and as you've seen sort of in our global distribution platform, the pivoting towards more equity and towards other increasingly towards ClearBridge, you will see our fee rate naturally kind of elevate as a result of that. As well as if the markets are healthy, that will also kind of tend to lift our fee rates. Pete?

Peter Hamilton Nachtwey

Yes, the only thing I'd add to that is, clearly, equity is going to be a much higher rate along with alternatives. So as we see those markets improving, absolutely we see the fee rate moving up with those markets. The other thing that we keep talking about, appears Mr. Bernanke is going to keep pushing it out a bit, but when fee waivers come off on our money market funds that will also drive up the rate down the road, Bill.

William R. Katz - Citigroup Inc, Research Division

Okay, that's helpful. And just a follow-up question. Just on the alternative platforms, if you look around some of the sort of pure-play alternative managers, they've been putting up some very impressive organic growth trends with some pretty good lead indicators and it’s the update from Permal seems a little underwhelming at the end of the day. How much of that just relates to further attrition coming off the high net worth area, perhaps in Europe? Or how much of it just has to do with maybe been holding pattern waiting to see how that Fauchier transaction plays out?

Peter Hamilton Nachtwey

So, Bill, I think it'll be fair to say that Permal has continued to see the high net worth business in Europe, in particular, their legacy, their kind of traditional business has been soft. At the same time, they've done, I think a terrific job of repositioning their firm and repositioning their business on the institutional side. So their legacy, even the Legacy Permal Institutional Business is, I think, doing well. We've got some, I think I said $550 million of unfunded wins there. I think, as we see the AUM stabilizing at Fauchier, I feel pretty good about that. What is new, I think, related to Permal is that we do -- we are introducing, particularly in our U.S. distribution channel, some new strategies around Permal that we haven't had before. Now, I am not projecting that those are going to ramp up huge next quarter, but I think we've added them to our lineup. It is what clients are looking for. And we're excited about it. So I would disagree that it’s an underwhelming outlook. I think it's actually a good outlook.

Permal is making progress internationally. And globally, on the institutional side with the manager account platform. So we feel pretty good about where they're going and what the prospects are.

Operator

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

Macrae Sykes - Gabelli & Company, Inc.

My question is for Pete. I think it's fair to say that the market returns is here beaten most expectations. We see a number of positive results from asset managers. So my question is it pertains to Legg and also the industry. Do you think accounting accruals may be behind and we're likely to see some catch-ups in the December quarter?

Peter Hamilton Nachtwey

Mac, I'm not sure, I totally understand your question is accounting accruals as it relates to what?

Macrae Sykes - Gabelli & Company, Inc.

So as you think about the full year comp from a lot of the asset managers, I know you're on a different fiscal year and also have a different makeup in terms of your revenue share. But do you think that expectations around returns and accruals for the year maybe behind given where the markets have moved today?

Joseph A. Sullivan

Got it. Helpful. We're effectively are accruing -- we are on a real-time basis. So we look at the comp every -- quite frankly on monthly close basis. And whatever -- we have comp at 2 levels. One is revenue share affiliates. So once they know what the revenue share is and what their other expenses are, they're accruing the rest of that in compensation. And then at the parent level, we have bonus targets that are based on performance in large part and those get accrued as we're going along during the year for those folks who are on kind of performance based comp. And for the folks who are really just here that are in support roles and we don't have a similar kind of performance base, those are accrued straight line over time.

Operator

Our next question comes from Dan Fannon from Jefferies.

Daniel Thomas Fannon - Jefferies LLC, Research Division

Just in terms of performance fees, I appreciate the outlook for next quarter, but was wondering just a bit longer term. You think about some of the products you're seeing demand at Western and in other affiliates. Are you -- in the new products that you're launching than with performance fee attributes and then maybe give a sense of kind of the performance fee eligibile AUM today versus maybe previous periods?

Joseph A. Sullivan

Sure, Dan. Bottom line is, the businesses that we have that are in the performance fee business, Western, Permal, Brandywine, primarily, we have a few others. But absolutely, in the alternative space, it's more and more focused on performance fees. And even in a number of the traditional business, particularly with our large institutional clients where we'll make a trade-off maybe for a lower base fee, but that's going to come with a much higher opportunity set on the performance fee side. And so when you look at what's eligible, roughly 60% plus at Permal are eligible at this stage. And then some of the other affiliates, Brandywine's more in the mid-teens and Western is around 5% or 6%.

Operator

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

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

First question. One of the points of differentiation you've talked about is sort of this ongoing partnership with your affiliates post acquisition. But it does seem now that some of the other manager, managers models, maybe are starting to get more focused on leveraging shared support services, particularly on the distribution front. Just to be curious to get your sense on how that might impact your competitive positioning, particularly as it relates to M&A opportunities?

Joseph A. Sullivan

Well, Michael. I think as we've talked about, our global distribution platform is just a huge competitive strength of ours, asset of ours, and I think differentiator. And I think clearly, other of our competitors, I can't speak to their strategy obviously. But to build out what we've got is -- it takes an enormous amount of time and it takes, quite frankly, an enormous amount of expense. We've made that investment over the last 5 or 6 years. And so we're positioned. And as it relates to M&A, last year, I think we've talked about the fact that we have $57 billion in gross sales in this channel, we're running at 20% ahead of that right now. I mentioned that we introduced the U.S. equity product in Japan, and in less than 9 months, have generated about $2 billion in sales. I think that shows not the potential of what somebody might want to or hope to build and create. It shows the reality of what we have. Now again, I've talked about it. We have a good business. We can be even better. So when it comes to M&A, and we're kind of competing with the somebody who's actually hoping to get in the Retail business or has a nascent retail business. We've got the retail business. We've got the pipes laid, we've made the investment. And now, it's about leveraging that. We'll continue to invest in distribution, but the significant investment of both time and money has been made. And I think that gives us a very clear advantage because we're delivering results and potential companies that have interest in us can absolutely see those results. So it's not on the come, it's on the now.

Operator

Our next question comes from Robert Lee from KBW.

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

I was just curious, I mean in looking at Royce a little bit. And I know you have in one of the slides where they do you use your global distribution platform. But I guess, my sense have been, they really have the use of predominately for their non-U.S. part of their business. Is that the case? And is it possible to -- why wouldn't they be more integrated within the U.S. distribution platform, if kind of distribution seems to be one of their issue right now in the U.S.?

Joseph A. Sullivan

Rob, there's a couple of things. Royce, when we acquired Royce several years ago, they came to us with a strength, kind of a legacy strength and a historical strength in the wealth management and the DCIO channels. And so, they have long done a great job and had significant market share in those channels. We support that. And we also have people who are covering in global distribution or in U.S. distribution those channels. And so we support that and we work with Royce to expand that presence there. What we do really work with Royce very actively in terms of distribution, as you mentioned, was on international side, but back to the U.S., we work with them very actively in the wire house channel, in the independent channel. And so it's -- I wouldn't say, I don't think it's accurate to say that we don't really support them or help them. I think they would tell you that we help them a great deal in terms of expanding their reach and their coverage away from their traditional strength, which is in the RIA and wealth management channels.

Operator

Our next question comes from Craig Siegenthaler from Crédit Suisse.

Craig Siegenthaler - Crédit Suisse AG, Research Division

Just had a follow-up on the management equity incentive plan. And I heard your comments are towards the end of the prepared remarks. But is this something we should expect all affiliates to have one day in the future or is it more or likely that maybe just kind of 1 or 2 because it's not one-size-fits-all here?

Joseph A. Sullivan

Well, Craig, you're right, it's not one-size-fits-all. And quite frankly, it's why these things take some time. Each one of our affiliates is unique and distinct, and so we've got to work through kind of issues that are specific to each and every affiliate. I think it is our hope that we would -- it's my intention and my hope that we would be able to execute management equity plans with each of our affiliates because we think that this is ultimately a good thing for them and a good thing for our shareholders. If you recall, in addition to kind of changing the nature and increasing alignment with our affiliates, we also get the benefit, when we complete these, of longer-term employment contracts. And we also, as part of it, have the potential for increased margin expansion. So from a Legg Mason shareholder perspective, these are good things and we want that. We -- on the other hand, our affiliates get an opportunity to participate in the growth and the value of their franchise. So we think this is a really good thing, virtually everyone of our affiliates -- not even virtually, everyone of our affiliates has an interest in it. And now, we just need to work through it with each and everyone. And it just takes time.

Operator

Our next question comes from Glenn Schorr from ISI Group.

Glenn Schorr - ISI Group Inc., Research Division

So you've obviously been managing your cost well. But I guess the question is, now that we all have a better appreciation for concentration risk and key man risk. It's tough to deal with always. But in a lower growth environment and given your mix, is it really tough with the affiliate model? I guess I'm curious on how you manage that whole conundrum of managing cost, but revenues aren't growing much, and then the revenue share agreements in general?

Joseph A. Sullivan

Matt, thanks for your question. You're right, that we have been keeping a very tight fist on cost. And there's 2 buckets of cost, so keep in mind. One is at the affiliate level, one is at the parent level. So affiliates really have the chance to control their own destiny in terms of spending. So the less they spend on facilities, travel, market research, et cetera, they are able to significantly impact their bonus pool that way. But I think, both we, at the parent level and at the affiliates, are very focused on growth from here, I think our, by and large, our affiliate bonus pools are robust. They're maybe not all the way back to precrisis levels, but they're pretty well back. And in some cases, they are back there. So we're reasonably saying, as Joe mentioned, the management equity plans for us are one of the keys really to add another leg to the stool on how we rewarded the key talent at our affiliates in a way that benefits the shareholders from a long-term standpoint. But I don't have a lot of concerns in the near-term about compensation in the environment we're in right now with the markets.

Operator

Our next question comes from Marc Irizarry from Goldman Sachs.

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

I guess this is for both Joe and Pete. Just following on to the idea of going and looking at some of the equity participation plans and thinking about growing the franchise. How does using capital for seed investments in the individual affiliates, maybe you could just talk about how using the seeding program, how that might play into maybe discussions around growth at the affiliates. Does that come into play in terms of when you're negotiating equity participation and maybe you can just give us an update, Pete, on the seed portfolio?

Peter Hamilton Nachtwey

Sure. I'm happy to do that and, Joe, may you want to add some additional thoughts just in terms of strategic, but maybe I'll talk a bit about process. So we have a capital committee at the Legg Mason level that consists of me and our treasurer, but then a host of other people, including our head of risk management, including the people in distribution, including our Chief Investment Officer for a business we call Global Asset Allocation. So we kind of cover the map with the right skill sets around the table to review quarterly requests by our affiliates. Very often, they come in within quarters, and we'll call special meetings. But we're in a very robust discussions with both the affiliates and distributions around what are the hot products out there and more importantly, what are -- what we kind of call, second, third frontier products. The things we're looking at, that we need to get seed in the ground today, they're going to foster growth in 2 to 3 years. Joe?

Joseph A. Sullivan

Yes, I think one of the other things that I don't think, Pete, you mentioned, was we do a pretty good job of recycling that seed capital. So we manage it very actively. We watch it. And if and as the strategy doesn't seem to be something that is either working from an investment standpoint or relevant from a client standpoint, we turn that over pretty quickly and look to recycle that very actively. I think seed, as it relates to kind of strategically, Marc, it's one of the -- what I think of is sort of the real values that we bring to potential candidate to our existing lineup of affiliates and the potential new affiliates. So we talk about the fact that they can affect that transaction for an affiliate and we've done that in the past. And we could in the future in terms of acquiring them and that being something that is important. We talked about the global distribution platform we have us being a hugely distinguishing factor. And then the third piece is this willingness to continue to invest our capital into an affiliate, existing affiliate or perspective affiliate, through either 1 of 2 ways. One is, as we did with Permal, the Fauchier transaction where we participated and kind of JV-ed on an acquisition. But the other one is in seed capital. And a willingness that we have to invest our capital to help develop products for them to grow.

Peter Hamilton Nachtwey

I might add something, Marc. In terms of the focus of where we are deploying that capital is the places where we think we can get third-party AUM and third-party revenue, fee revenue, the fastest. So that's really one of the top criteria, what's the IRR on it and how fast we can go through our third-party AUM.

Operator

Our next question comes from Eric Berg from RBC Capital.

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

There seems to be a pattern emerging in outflows in the tax rate area, in the municipal area. Obviously, we've had the bankruptcy of Detroit and growing concerns about the city of Chicago with the multiple downgrade there. But if I do have it right, that this is not true, this is true not only on Legg Mason but industry-wide, what's your sense of what's driving this?

Joseph A. Sullivan

Well, I think you just articulated, and I think there's a lot of uncertainty in the marketplace around certainly Detroit, Chicago, Puerto Rico. There's just been a lot of uncertainty in the marketplace in munis. And so we've certainly -- we've been a market leader in that space. We've had a significant market share in that space. So we have experienced a redemption rate, that I would say is a bit elevated vis-à-vis the industry. But I think again it's not anything that's particularly related to us. We've had a little bit of underperformance, investment performance, so that maybe contributing a little bit. But we are a market leader in that. So we would expect, when there are headwinds in that space, to have a little bit of elevated redemptions. And we're seeing that.

Operator

Our next question comes from Douglas Sipkin from Susquehanna.

Douglas Sipkin - Susquehanna Financial Group, LLLP, Research Division

Just wanted to drill down a little bit on the equity products suite, and I guess 2 questions. One, of the -- I believe Royce is now like 38 6, is any of that institutional or is it all retail?

Joseph A. Sullivan

I would say it's essentially all retail. There might be a couple of small plans in there. And to the extent that you -- the wealth management channel, in some respects, operates kind of quasi-institutional. They tend to have larger positions, and so they can move and kind of -- they look at the business and they think of themselves and they operate a little bit more institutional-like than the classic retail wholesaling business. But on balance, I think they would say that, that business is almost entirely retail.

Douglas Sipkin - Susquehanna Financial Group, LLLP, Research Division

Great. And then just to follow-up. I know that -- I believe at the lunch, you guys talk about sort of leveraging your existing affiliates to sort of make some inroads with the international clients and international products versus maybe doing something on the acquisition front. I guess it wasn't really clear where you guys stood. Any update around potentially doing something inorganically or developing more capability through existing affiliates to capitalize on potentially maybe even more flows now moving outside the U.S.?

Joseph A. Sullivan

Sure. Let me just kind of update you where we are on that. First of all, this issue of sort of adding global equity investment capability continues to be really my #1 priority in terms of what I do every day. I literally think about it every single day. And I think what you're referring to, Doug, is when we talked about that at the investor lunch, what I said is our goal is not to do a deal, our goal is to add this capability. And that remains the goal. And we can accomplish that, in my mind, essentially in 3 ways. We can do in a transaction and I am meeting with, talking to both bankers and actual potential candidate firms, certainly not everyday, but regularly, and evaluating those opportunities if and as they come. And initiating those opportunities as we think appropriate. The other alternative or one of the other alternatives is to do extensions out of existing capabilities. So it is true that we do have -- it's not accurate to represent that we don't have any non-U.S. equity capability. We do have non-U.S. equity capability. We have it at Royce, we have it at Capital Management, we have it at Brandywine, we have it across various of our affiliates. Now it tends to be small. It's a little bit, in many cases, newer products, not always, but in many cases, newer products. Batterymarch, we do a fair amount of emerging market products. But -- so we could decide to really invest and do product extensions and go after that capability within existing affiliates. And the third way we could do that is frankly to create an affiliate. And we actually are working with a search firm right now to identify potential teams around whom we could actually create an affiliate. Now that obviously takes a longer period of time. But it might not -- I would think it would be a very attractive option to somebody embedded within a large organization or potentially a small -- again, it could be a lift out or it could be an acquisition to come and create a global equity affiliate on behalf of Legg Mason and tap into this global distribution platform we have. So it's a huge priority. I'm working on it in one way, shape or form literally every day, and I'm confident that we will ultimately get there.

Operator

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

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

Just kind of a quick follow-up question, maybe for Pete. Just in terms of expenses. Any outlook on how we should be thinking about some of the non-comp line items going forward just after taking into consideration some of the noise that may have skewed the second quarter numbers? And then stepping back, it seems like you held the line on cost this quarter, so does that suggest we could see some additional follow through in terms of further margin expansion from here?

Peter Hamilton Nachtwey

Well, as Joe has, I think, mentioned often, efficiency is just job 1 for us, we're going to continue to focus very tightly on controlling cost and finding ways to do things faster, better, smarter. But it will be a long-term effort that we're going to continue to focus on. So the things you've seen, a lot of things that we've done and that we've disclosed publicly are impacting the comp line at parent. But if you kind of do the walk in terms of this quarter versus last quarter, DNS expense was still a little bit elevated, it was up quite a bit last quarter because of the closed-end fund launch. This quarter, it was still up a bit because of the greenshoe came in on the closed-end fund launch. We had cost around that during the quarter. And we also had some accrual true-ups with couple of our distribution partners. And then moving down, communications technology had a bit of a spike because of just annual market data services that we pay for it and expense in the quarter and then some printing costs. So again, we had envisioned that probably drops back a bit as we look forward. And then in the other line, which went down, I think, significantly from quarter-over-quarter, but embedded in there was also some annual director fees that are again, a onetime annually type of charge. So that last line will bounce around a bit. It's got T&E in there, it's got FX, et cetera. But in general, it did kind of fell back into a range that should be a reasonable run rate. So hopefully, -- but, and just a reminder, we've got $11 million in annual saves because of our business initiatives. Again, a lot of that's going to sit in the comp and benefit line.

Operator

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

Joseph A. Sullivan

Thank you, operator. And I want to thank all of you for listening this morning. We do truly appreciate your continued interest in Legg Mason. I just like to close by reiterating what I said earlier, which is, we've come a long way over this past year of transition. And I think we've made quite a bit of progress. We are all very pleased with that progress, but we're not satisfied. I want to thank my colleagues globally here at Legg Mason and with our affiliates for their continued commitment and dedication to building a better Legg Mason. We're getting there. And with that, thank you again for listening, and I wish you all a good day.

Operator

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

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