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Virtus Investment Partners Inc. (NASDAQ:VRTS)

Q2 2014 Earnings Conference Call

July 28, 2014 4:30 PM ET

Executives

Joe Fazzino – IR

George Aylward – President and CEO

Mike Angerthal – EVP and CFO

Analysts

Michael Kim – Sandler O’Neill

Tom Whitehead – Morgan Stanley

Mike Carrier – Bank of America Merrill Lynch

Steven Schwartz – Raymond James

Marc Irizarry – Goldman Sachs

Operator

Good afternoon, my name is Estaban, and I will be your conference operator today. I would like to welcome everyone to the Virtus Investment Partners Quarterly Conference Call. The slide presentation for this call is available in the investor relations section of the Virtus website, www.virtus.com. This call is also being recorded and will be available for replay on the Virtus website. At this time all participants are in a listen-only mode. After the speaker’s remarks, there will be question-and-answer session. (Operator Instructions).

I will turn the conference over to your host, Joe Fazzino.

Joe Fazzino

Thank you, Estaban, and good afternoon everyone. On behalf of Virtus Investment Partners, I would like to welcome you to the discussion of our operating and financial results for the second quarter of 2014.

Before we begin, I direct your attention to the important disclosures on Page 2 of the slide presentation that accompanies this webcast.

Certain matters discussed on this call 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 these statements. These statements may be identified by such words as expect, anticipate, believe, outlook, may and similar terms.

For a discussion of these risks and uncertainties, please see the Risk Factors and Management Discussion and Analysis sections of our periodic reports that are filed with the SEC, as well as our other recent filings, which are available in the Investor Relations section of our website, www.virtus.com.

In addition to results presented on a GAAP basis, Virtus uses certain non-GAAP measures to evaluate its financial results. Our non-GAAP financial measures are not substitutes for GAAP measures and should be read in conjunction with GAAP results. Reconciliations of these non-GAAP financial measures to the applicable GAAP measures are included in our earnings press release, which is available on our website.

For this call, we have a presentation including an appendix that is accessible with the webcast through the Investor Relations section of virtus.com.

Today, we will begin with remarks from President and Chief Executive Officer, George Aylward, who will review our operating results and accomplishments for the quarter. Mike Angerthal, Executive Vice President and Chief Financial Officer, will then discuss our financial results in further detail and will also review the balance sheet and capital items. We will conclude by opening the call to your questions.

Now I would like to turn the call over to George Aylward.

George Aylward

Thank you, Joe, and good afternoon everyone. We appreciate having you on the call with us today. I’m pleased to talk our financial and operating results and some of our accomplishments in the quarter. The second quarter was a strong one, and before a review at the results and give some context, let me take a moment to highlight some of the significant accomplishments.

We generated our highest levels of operating income as adjusted, assets under management and revenue. We also expanded our product offerings with a new closed in fund and the liquid alternative funds and we announced our first quarterly dividend.

We recognized that with multiple operating initiatives underway to grow and enhance the business, the activity in the quarter may impact the comparability for ongoing profitability, so Mike and I will highlight some identified items to help you better understand the results.

So, turning to the results, let me start on slide 5. Total assets increased 17% over the prior year quarter to $61.4 billion as a result of strong net flows from our open-end and closed-end funds, as well as a positive market during the quarter.

The $1 billion in total positive net flows this quarter represented an annualized organic growth rate of 7%. Long-term open-end mutual fund sales were $3.1 billion which represents a 34% annualized sales rate and open end net flows were $0.8 billion which represents an 8% organic growth rate.

Our diverse and strong performing mutual funds allowed us to achieve our 21st consecutive quarter of positive long-term open end fund that flows. Our fund sales and organic growth rates were both at the higher end of the industry averages in the second quarter.

Sales inflows were well balanced across product types managers and investment styles. It’s an important element of our strategy to have a diversity of products across asset classes. And in the quarter, each of our four top selling funds was in a different asset class, fixed income, international equity, domestic equity and alternatives. And we have positive fund net flows in each of those asset classes.

We achieved double-digit organic growth in both international equity led by emerging markets fund and in alternatives led by our long-short offering.

Fixed income net flows increased in the quarter as our strong performing differentiated multi-sector offerings managed by Newfleet continue to resonate with investors.

We are pleased with the trends in mutual fund flows in July. While the month is not yet over, July is tracking to be our strongest month for open-end mutual fund net flows so far this year.

The introduction of new products is a key element of our strategy and our business model facilitates active product introductions. In the quarter, we introduced the Duff & Phelps Select Energy MLP close-end fund or DSE. The introduction of the fund demonstrates both our ability to leverage existing capabilities of our managers and new products and the effectiveness of our distribution.

Duff has a successful track record managing MLPs and its other funds, and we are pleased to introduce the first of their dedicated MLP products.

The launch rate is $463 million prior to the potential exercise of the underwriter’s overall allotment option or the addition of leverage which can be as much as 33% of total fund assets including leverage. The fund is expected to add financial leverage in the third quarter.

The $463 million-raised for total close-end fund assets to $7.5 billion at June 30, an increase of 17% from the prior year. Close-end fund assets which are generally considered the most stable assets now represent 13% of our long-term assets under management and 16% of run-rate investment management piece at June 30. This is the third new close-end fund we have introduced in the past three years and we are confident that there are opportunities to introduce other strategies in the close-end fund structure.

Also in the quarter, we officially launched our liquid alternative open-end mutual funds that we’ve discussed on prior calls. Since the launch in April, our sales and marketing teams have been actively involved for preparing materials and creating, and introducing the new Virtus alternatives branding as the funds have begun to build their track records.

Our primary area of focus at this stage is working with our distribution partners to gain access and educate financial advisors on how to appropriately employ these products in their client’s portfolios.

In terms of access, the funds are now available at many of the independent broker dealers, while the major wire-houses are still in the process of reviewing the new funds which we expect will be completed in the third and fourth quarters. We look forward to the funds being more widely available for investors.

Turning to slide 6, operating income, as adjusted increased 22% to $38.8 million which was our highest level of quarterly earnings. The related adjusted margin increased to 47% from 44% the prior year quarter. The increase in operating income as adjusted is a result of higher invested management piece from AUM growth and the leverage-ability of the business partially offset by cost associated with several other discreet business activities.

Moving on to the GAAP numbers, second quarter earnings per share were $2.10 which includes $0.67 of one-time structuring fees and sales based compensation related to the close-end fund launch. There are several other items impacting the current quarter’s operating expenses that we believe are important to recognize in order to understand our ongoing profitability.

These items had $0.16 per share impact and include costs related to new product introductions, the annuals grants to directors, the final transition expenses of our internalization of Newfleet and several other discreet business activities.

Before handing it over to Mike, I would like to talk about our capital strategy. In May we declared our first quarterly cash dividend of $0.45 per share. The declaration of our first dividend is a significant step in our overall capital strategy.

When we became the popular (ph) company five years ago, we had a minimal amount of capital. We have worked hard as a company to grow our capital position to protect and grow the business. We were supported by shareholders when we raised equity in 2013 for the purpose of right-sizing our seed capital program to take advantage of the numerous growth opportunities afforded us by our business model and strategy.

And throughout the past five years, we have also maintained the continuous program of returning capital to shareholders, previously only through stock repurchases. As a dividend declaration illustrates, we continue to believe that a meaningful portion of cash flow generated by the business should be earmarked for return to shareholders.

We ended the quarter with a very strong balance sheet with $423 million of cash and investments which included $224 million in capital allocated to seed new products. At the same time, we continued to generate strong and growing cash flows.

So, in terms of our capital strategy, as we continue to generate additional capital, we believe it is appropriate to provide maximum operating flexibility by maintaining a balance between allocating capital to three components, supporting the ongoing operations of the business, investing in the growth of the business and providing a meaningful return to shareholders.

With that, let me turn the call over to Mike to provide more detail on the financial results. And then we’ll open up the call to questions. Mike?

Mike Angerthal

Thank you, George. Good afternoon everyone. Today I’m going to review our quarterly results starting with assets under management, sales and flows. Then I’ll review our key income statement line items and discuss our balance sheet and capital position.

Starting on Slide 8, assets under management. We ended the quarter with our highest level of total assets of $61.4 billion, which represented an increase of 17% from the prior year and 6% from the prior quarter.

The $8.7 billion year-over-year increase is primarily attributable to $7 billion of market appreciation and $2.4 billion of cumulative positive net flows. On a sequential basis, the increase in assets reflects market appreciation of $2.5 billion and net inflows of $1 billion, which included $463 million from the June IPO of the Duff & Phelps Select Energy MLP Fund.

The new funds assets exclude the impact of leverage which is expected to be added during the third quarter. The expected level of leverage would be in the range of $200 million to $225 million, it’s important to note that we are an investment management fees on the total managed assets of the fund including the levered assets.

As a reminder, in our AUM tables, we report the impact of leverage on assets through other rather than inflows, so you’ll see that in the third quarter.

As noted in the data at the bottom of the chart, alternative assets ended the quarter at 11% of total assets, which is an increase of 400 basis points from the prior year. Money market funds continue to comprise a smaller percentage of our business and now represent a modest 2% of total assets.

Turning to slide 9, asset flows. Total flows were positive $1 billion primarily as a result of strong net flows into long-term open-end mutual funds and the successful close-end fund launch.

Total sales for the quarter were $4 billion, $3.1 billion of which were open-end mutual funds. Sales of open-end mutual funds decreased 14% from the first quarter reflective of industry trends but our open-end mutual fund sales rate for the quarter was 34% which continues to be above industry averages.

Open-end mutual fund net flows were $0.8 billion in the second quarter which equates to an annualized organic growth rate of 8.1%, which is also above industry averages.

To provide additional transparency into the mutual fund flows, here are some general highlights by asset class. Specifically, international equity fund net flows are positive $0.3 billion, a significant change from the prior quarter net outflows of $0.5 billion. Positive flows are primarily driven by lower redemptions and emerging market opportunities.

As we mentioned on prior calls, flows in previous quarters were impacted by distribution partners moving to an underweight for emerging market equities. We believe that a sentiment changes in this asset class we are well positioned to gather assets with our strong performing emerging market opportunities front.

Fixed income net flows were positive $0.3 billion primarily related to our multi-sector short-term bond fund. The fund is rated five stars and has topped SIL (ph) relative performance on a 1, 3, 5, 10 and 15-year basis.

Domestic equity net flows were a positive $0.1 billion as defensive equity strategies continue to be attracted to investors who seek to maintain or increase their equity exposure while managing downside risk.

Alternative strategy net flows are positive $0.1 billion primarily attributable to our existing long-short offering as our new alternative funds are not yet widely available. As a reminder, we include additional disclosure about mutual fund flows by asset class in the supplemental appendix in our earnings deck.

Separately managed account net flows were $0.2 billion compared with outflows of $0.6 billion in the prior quarter, which as we mentioned on last quarter’s call was attributable to the redemption of a low-fee optional relay account.

Institutional net outflows were $31 million in the quarter as positive net inflows in our fixed income strategies from Newfleet were offset by the redemption of the single low-fee mandate.

Turning to investment management fees on slide 10. Investment management fees increased to $74.5 million up 16% from the first quarter of last year and 4% on a sequential quarter basis. The components of the change in investment management fees are average assets and fee rates.

Average long-term assets under management of $57.7 billion increased 12% from the prior year and 4% from the sequential quarter due to market appreciation and positive net flows.

The average fee rate was 50.7 basis points, an increase of 2 basis points from the prior year and a modest decrease of 0.2 basis points sequentially. The increase in the fee rate from the prior year primarily reflects an increase in assets into our higher fee mutual funds.

Over the past four quarters, over 92% of our net fund flows have been into higher fee equity and alternative strategies. And an extra day in the quarter added $0.7 million of investment management fees on a sequential quarter basis.

The closed-end fund fee rate for the quarter was 63.6 basis points and was not affected by the DSE launch, has it only impacted our fees for one day in the quarter. We anticipate that the closed-end fund fee rate will increase to approximately 67 basis points for the third quarter, reflecting the full quarter impact of the DSE raise and leverage which we expect will be added by the middle of August.

Turning to employment expenses, this quarter included certain items that will not recur in the third quarter. First, we had $0.4 million of Newfleet transition costs, which represents $0.02 per share. The second quarter marked the three-year anniversary of the internalization of Newfleet and the final quarter of transition costs. This $0.02 per share is a component of the $0.16 per share of costs impacting the quarter that George referred to in his overview.

In addition, we incurred $0.5 million of closed-end fund sales based compensation related to the closed-end fund launch. This expense represents $0.03 per share of the $0.67 per share closed-end fund launch costs. The remaining $0.64 per share cost is included in distribution and administration expenses on the income statement.

The key metric to consider for modeling is the ratio of employment expenses to revenues as adjusted. Given the timing of multiple expense items this quarter, I’ll provide some context on how these items are expected to impact the ratio.

Excluding the impact of Newfleet transition costs and closed-end fund sales based compensation the employment ratio would have been 41.6% rather than 42.6%. Furthermore, after incorporating the impact of our ending long-term assets under management including the DSE launch, we expect the third quarter ratio to decline by approximately 150 basis points to around 40% of revenues as adjusted with all things being equal.

Turning to other operating expenses, let me describe the key items impacting this line item this quarter as several are not expected to impact ongoing profitability. Earlier George referenced $0.16 of items in his overview of the results and I previously described $0.02 of that $0.16 on the prior slide, employment expenses.

The remainder $2.1 million of pre-tax items or $0.14 per share are reflected in the dotted box for the second quarter. These identified items are as follows. $0.7 million or $0.05 of costs associated with the introduction of both the liquid alternative funds as well as the closed-end fund, and these costs included organizational and branding expenses associated with the roll-out of these new products.

$0.5 million or $0.03 of the costs associated with the annual grants to our board of directors, as this item only occurs in the second quarter of each year, $0.9 million or $0.06 of costs due to the several discreet business activities simultaneously underway during the quarter.

Excluding the total $2.1 million of these items, the ratio of other operating expenses to revenues as adjusted would have been 13.2% rather than 15.8%. This result is more in line with our historical trend and consistent with our expectations for the third quarter, again with all things being equal.

Another specific cost that I would like to highlight is the $0.5 million or $0.03 per share of system transition costs. We did not include that in the $0.16 of items due to this initiative being ongoing.

As we mentioned last quarter, we and our affiliates collectively made the decision to move to a third party service provider for middle and back-office support. Since it’s the first time we’ve recorded expenses related to this project, I’ll provide transparency on how the system’s transition cost will be reflected in our non-GAAP results.

The costs that we will include in our non-GAAP adjustment are those that are either transitional or duplicative to existing costs. These costs are expected to occur over the next two years and the quarterly expenses will vary based on the progress of the project. We expect $0.5 million to be at the high-end of the quarterly range.

Once the transition is complete, the platform will be scalable to accommodate both our in AUM and any new affiliates. And the costs of these activities will become variable rather than fixed.

Slide 13, illustrates the quarterly trend in operating income as adjusted and the associated margin. In the second quarter, operating income as adjusted was $38.8 million, an increase of $7.1 million or 22% on a comparative basis to the prior year. The substantial increase primarily reflects revenue growth from the cumulative impact of $2.4 billion of positive net flows and $7 billion from market appreciation over the past four quarters, along with the benefit of a leverage-able business and our variable expense structure.

The sequential increase of $2.2 million or 6% and operating income as adjusted, primarily reflects higher revenues as adjusted of $3.1 million partially offset by higher other operating expenses. Lower payroll taxes in the quarter were offset by higher variable incentive compensation.

The operating margin as adjusted for the second quarter was 47%, an increase of 250 basis points from the second quarter of 2013, and an increase of 90 basis points on a sequential quarter basis.

Concerning GAAP results, net income attributable to common stockholders was $19.5 million or $2.10 per diluted common share and included $0.67 per share of closed-end fund launch costs. Excluding the impact of the closed-end fund launch, earnings per share would have been $2.77, an increase of $0.86 per share or 45% over the prior year.

The average number of fully diluted shares outstanding was $9.3 million in the second quarter of 2014, a 16% increase from the second quarter of 2013 as a result of our equity offering last September.

On a sequential basis, earnings per share excluding closed-end fund launch costs were up $0.43 or 18% per share. The change is primarily attributable to an operating income increase of $0.04 per share despite the $0.16 of items identified earlier.

Higher investment gains and income of $0.34 per share including an $0.18 per share increase in realized gains on investments as we recorded with a very strong cash in investments of working capital position.

At June 30, 2014, our cash investments were $423 million or $46 on a per share basis, an increase of $4 per share from $42 per share in the sequential quarter.

We ended the quarter with working capital of $186 million, a decrease of $85 million or 31% from the first quarter. The decrease is attributable to net seed capital activity on the percent compared to the first quarter, reflecting the net activity of the seed program, primarily the seeding of three liquid alternative funds.

In terms of return of capital to shareholders, during the quarter we announced the initiation of a quarterly cash dividend of $0.45 per share, for shareholders of record on the close of business on July 31, 2014. Given our strong operating results, working capital and seed capital levels, we believed it was the appropriate time to introduce a dividend.

In addition to the dividend decoration, we repurchased 13.9 million of shares in the quarter, which consists of 12.5 million through our ongoing share repurchase program and 1.4 million of net settlements of vesting restricted stock units to cover employee tax obligations.

We remain focused on balancing investments in the business with a meaningful return of capital to shareholders. On a year-to-date basis, we have effectively returned $25.5 million of capital or $2.74 per share to shareholders. This represents 57% of our net income excluding the impact of closed-end fund launch costs and unrealized gains and losses on our seed portfolio.

With that, let me turn the call back over to George.

George Aylward

Thank you, Mike. That concludes our prepared remarks. So now let’s take some questions. Estaban, can you open up the lines please?

Question-and-Answer Session

Operator

Certainly. (Operator Instructions). Our first question comes from Michael Kim with Sandler O’Neill.

Michael Kim – Sandler O’Neill

Hi, guys, good afternoon. First, just given your sales approach that you’ve talked about in the past where you’re trying to understand what the essays and the ultimate end clients are looking for, just wondering what sort of feedback your wholesalers are getting in terms of demand and allocation trends and risk appetites, broadly speaking?

George Aylward

Yes, it’s a great question. One of the challenges is you don’t have a uniform experience. So I think you’re generally seeing sort of what we’re seeing, the convergence of some ways of two trends.

One is, of individuals who are sort of seeing a five and half year bull-run market and sort of saying I need to participate more in that upside and then you have others that are saying wow, that’s a long time. I need to more of a risk managed approach.

And we see that particularly in the domestic – in the downside domestic equity type products, where you have some people that are not interested in it because they think that they should be on the bandwagon of the up-market and you see of other people getting into it because they know that a bull-run cannot go forever.

And we’re also seeing, there is a divergence in terms of financial advisors, some of whom are looking to sort of outsource some of their decision making to ore total packaged solutions which as you know we offer. And others that are very focused on building portfolios themselves and really accessing some of the building blocks.

But we do see that there increasingly is a trend that a financial advisor here he cannot do it all themselves and they can’t make all of those asset allocation decisions. So I think that’s why you’re seeing somewhat of an increase in some of the products that actually take that from them in terms of being more of a packaged type of asset allocation product.

And that will fit with a lot of the stuff that we’re doing particularly on the liquid alt side. So I think that’s one of the major things we’re seeing right now.

Michael Kim – Sandler O’Neill

Okay. And then second, as you mentioned, EM Ops Fund had a nice rebound inflows in the second quarter, so just wondering if some of that bounce-back may have related to any changes and allocations on any of the platforms?

George Aylward

It did not relate, I’m not aware of any specific changes in the current under-weights that most of the distributors have. I think the activity you’re seeing is basically financial advisors and individual clients making decisions on their own in terms of what they want their allocation. So we have not yet seen what benefited from change in the direction of the allocations from an underweight to an equal weight. So we have not seen that yet.

Again, we do strongly believe that the sentiment in terms of allocations to emerging markets will change. And just as it went from over-weight to equal weight to underweight, the reversal would be true as well.

Michael Kim – Sandler O’Neill

Okay. And then finally, just a bit off-topic but just given the price of a stock these days in the volatility of EPS, given your outsized seed capital portfolio and the limited share count, any thoughts on a potential stock split?

George Aylward

We’ve had questions about stock split, I mean I think we focus primarily on the fundamentals of generating high levels of profit. I think we’re pleased with our ability to demonstrate continued cumulative growth over an extended period of time.

And if we were to conclude that there was a way to add more value to shareholders by splitting the stock we would. Again, that question has come up for a lot of companies. I don’t – I’d like to think that I mean, the size of our focus have one factor but in terms of the volatility and EPS, the reason we do try to take a lot of time on these calls to try to go through the results is to make sure people can really see just the underlying trend which has just been incredibly consistent in terms of its direction and as well as its growth.

But if I were, if we were to conclude that there would be some way to provide additional shareholder value by doing that, we would. I think as you look at historical examples of that you don’t necessarily see a lot of benefits to shareholders from that. But absolutely always keep an open mind to think like that.

Michael Kim – Sandler O’Neill

Okay, fair enough. Thanks for taking my questions.

George Aylward

Thank you.

Operator

Our next question comes from Tom Whitehead with Morgan Stanley.

Tom Whitehead – Morgan Stanley

Hi guys, thanks for taking my question. Just wanted to start on the closed-end fund launch. So obviously, it’s a smart structure to launch something in the income or yield-oriented space, but it’s been a pretty slow year for closed-end fund launches. I think it’s just that third, yours was just the third this year. So I was hoping to get your view on that market from here and your take on investors’ appetites for more products like the one you launched in June?

George Aylward

Yes, no, great question. And it has actually been a very, challenged environment for closed-end funds. But to underscore what you said earlier, we and many people think a closed-end fund structure is a very effective structure given the closed nature of the assets to execute very interesting strategies to the benefit of the investors. And as I indicated we’ve now – we have total of nine, we’ve launched three in the last three years.

The window had been pretty much dry for a period of time. But we did have an opportunity this year and with the strategy we thought it was compelling which was taking the long-standing capabilities that Duff & Phelps has in the general space.

And then some specific work that they’ve done on MLPs and other funds and do a dedicated fund and make that available. I think that’s a category as you know as well as I do that has impacted a lot by sort of sentiment by the large number of people invest in closed-end funds. And in particular, how existing closed-end funds are trading in terms of the value to any of the – whether it be a premium or a discount.

And that absolutely does have an impact in terms of the ability to bring a new one to market. I would arguably, actually shouldn’t make an impact on whether any individual offering is a good choice for investors or not. But it is the real world.

But we do think that that is an attractive vehicle. And I think as some of the other asset classes that have historically been put out closed-end funds, traded a bit of ratio in terms of discount or actually premium to NAV that they’ll be more opportunity.

Currently, yield has always been the big attractiveness for closed-end fund investors which we fully understand. Philosophically I think we and others believe that the structure actually lends itself to non-yield products, i.e. more access type products that over a long period of time, if you’re executing any strategy that doesn’t have to worry about redemptions, you can generate some incredible total return.

So, we actually would look forward to that being another avenue for closed end funds and not just only focused in on the yield side of the equation but being focused in on really long-term nature. And we think some alternative strategies fit really well into that space. And some of the stuff that we’ve been focused on would fit there and we look forward to the opportunity for the closed-end markets to sort of be attracted to an access as opposed to a traditional type of yield closed-end fund.

Tom Whitehead – Morgan Stanley

That’s great, thanks. That’s great color. And then just the second one I had was on capital return, just to flush that out a little bit obviously. You’ve become a little more balanced in the capital return, balancing growth versus sort of a total return package to shareholders.

I think you said 57% of net income year-to-date. So maybe just if it’s possible, could you maybe help us sort of quantify or figure out the magnitude of your capital return strategy going forward maybe in the context of net income or sort of cash flow as some of your peers do? Thanks.

George Aylward

Yes, no, it’s a good question. I smiled because as you said we’ve become more balanced in our approach to capital. Well, to be clear, we originally had none. So it wasn’t balanced because all of our capital was to protect the business. And then as we were modestly successful we had some capital to grow the business.

And then we had an opportunity to right-size the seed capital program which is what I refer to as the growth in the business. And we now, we feel very good now that where we are in terms of $424 million – $423 million of cash and investments. We have a very strong balance sheet.

Again, we think given our up-model and strategy, we have on a relative basis more opportunities to invest in growth in the business than any similar sized company. But we have those two buckets filled. And we’ve always done return on capital and we just started dividend and what I was indicating in the earlier remarks is, so we have those pieces but we’re still generating a lot of cash flow and growing the business.

And we do think that as we look to allocate that future growth in capital that they will have to feed all three of those components. You can continue to have enough to protect the business which we sort of look at as percentage of operating annual expenses on an ongoing basis.

Our seed capital program which again was about $223 million, I think in our previous call, Mike had given indication that that could be up slightly $250 million. That will obviously grow as the business grows.

And you sort of can see the level what we’ve done in terms of return of capital to stock repurchases plus dividends. But that’s now the piece that’s new and that’s growing. So Mike gave you a stat on that but it isn’t that has some variability. So Mike, I don’t know if you want to give a little bit of color around the metric that we use but the fact that there can variability related to that.

Mike Angerthal

Yes. And Tom, you touched on the metric and the 57%, just to be clear it’s net income excluding unrealized mark-to-market. That sort of gets to the point that there will be variability in net income that’s on a non-cash basis. So, when we think about the metric of our return on capital it will generally be net income exclusive of unrealized mark-to-markets.

And then if there is any significant type of transaction, such as the impact on the income statement in the period on the closed-end fund launch this period, where we had $10 million expense flow through the income statement, that clearly impacts our income statement and cash flow. So we’ll adjust that and look at that metric which is the first sort of baseline that we do.

And as George alluded to, there are several factors that go into the consideration of the level that will be returned. And I think historically we’ve been in a range of the high 30s to this 57%. And that’s on a year-to-date basis, it could also fluctuate any given quarter. So, there are – a number of considerations that we’ll look at when we consider a level of return on capital.

Tom Whitehead – Morgan Stanley

Okay, great, thanks a lot for taking my questions, guys.

George Aylward

Yes.

Mike Angerthal

Thank you.

Operator

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

Mike Carrier – Bank of America Merrill Lynch

Thanks. Just a question on the flow side, flows across the funds have been strong. Just some color on the non-fund channels, so maybe the separate accounts institutional, just what’s maybe driving the outflows, whether its products performance, and then just what you guys are working on to try to turn that around?

George Aylward

Yes, that’s a great question. And because again, what you see in terms of the SMEs and the institutional is not the same as the retail, the open-end funds, which we acknowledge has been obviously an incredibly strong performer for us. The two are very different. So I would describe each of them very differently.

The institutional business, I would just – well, first of all in terms of flows, just to be clear. What we pointed out in this quarter was really again one low fee account that’s been around for a while that has matured in one way and redeemed. Then on the SME side, we had pointed out last quarter an over-size incredibly low fee, a basis point account that went away last quarter.

So, the way we describe institutional is, our institutional strategies don’t mirror all of our open-end fund strategies so we only do institutional for our own affiliates and for none of our sub-advise types of relationships.

So, some of our open end funds which are supported by partners who are non-affiliates we don’t do institutionally. So you don’t have the same breadth of product capabilities on the institutional or SME side as we do on the open-end side.

And the institutional what we sort of said about that before is, if several of our managers were very good and had very high caliber institutional strategies. And over the last year or two we have been investing in additional resources to help grow and expand those. But I think what you’re sort of seeing now is an older legacy book of institutional business where you do see some lumpy fall-outs. But we hope that that will be balanced by some investments we’ve made in the last one to two years for resources that we’ll hopefully show a different trend there.

And on the SME side, which again is retail oriented product, it’s really focused in on our small mid-cap offerings out at Kayne Anderson Rudnick and that includes both broker-dealer type of wrapped product as well as private client. Again, if that’s a good business again based on the size and the scale, you’re really just sort of seeing a lot of choppiness in that. But that’s going to be more reflective of how their equity strategies are doing.

So, but again those were all areas that we see as growth engines, potential growth engines for us and we made a lot of investments on both the SME side as well as the institutional side.

Mike Carrier – Bank of America Merrill Lynch

Okay, that’s helpful. And then just on the non-ops side, so I just wanted to maybe understand just from an outlook and I understand it’s going to be somewhat volatile just given what it is.

But when we think about the mark-to-market versus the realized gains and when I think about the seed portfolio, is there something that we should be thinking about in terms of, I don’t know if there’s a duration of the assets that have been in certain funds and then when we would expect to see some of those realized gains versus obviously the mark-to-market or is it going to be when those opportunities come up and you take the gains?

George Aylward

Yes, well let me, and Mike will give you additional color. But I mean, we’ll start just by acknowledging I mean, with cash and investments $423 million of which $224 million is heat capital. Given the size of our P&L, the good news is that we believe has a very robust level for a company our size. But we acknowledge that we’ll create some volatility.

And again, it’s going to be in the two lines, it’s going to be either in the unrealized or in those periods where we take money out, you’re going to see the realized. And you’ve really seen bulk of it this quarter.

I mean, the wealth master’s money that we put in September and then took out in April, was a great use of shareholders’ capital in terms of what it did to help us launch the fund and create third party assets but also have a good-good standalone return on that money. And that has now been recycled. So, you’re always going to see some of that. But Mike, can you maybe give just a little bit more color on how they can sort of think about modeling?

Mike Angerthal

Yes, I think from a modeling perspective, Michael what we’ve done is we’ve continued to provide detailed disclosure on where each of our seed capital investments that’s in the appendix of the earnings deck.

And as George indicated, we will recycle the capital and we think of the realize-ability of those gains, differently than unrealized activity. But again, the intent of our seed capital program is to position the product to gather third party assets under management.

And that could be as soon as in the wealth masters’ product less than one year where we were able to withdraw the entire amount of seed capital as recognized the gain or with other products there – the capital could remain in the product for a longer period of time. And we’re just tracking on an unrealized basis until either the product accumulates the scale of third party assets under management or it’s recycled.

So, we’ll continue to provide transparency on that and be clear on the intent of how we deploy our seed capital and how we think about it on an ongoing basis.

Mike Carrier – Bank of America Merrill Lynch

Okay, thanks a lot.

George Aylward

Thank you.

Operator

Our next question comes from Steven Schwartz with Raymond James.

Steven Schwartz – Raymond James

Hi guys, how you’re doing?

George Aylward

Hi, good afternoon. How are you?

Mike Angerthal

Hi.

Steven Schwartz – Raymond James

Joe, it’s been a pleasure.

George Aylward

Thank you.

Steven Schwartz – Raymond James

Okay, so just back on this and looking at the Appendix and the scheduled marketable securities, so basically what I’m looking here is at the, you’ve got 28.8, 27.6, 196.3, 252.7, make life easy, assume markets appreciate 2%, I would apply that to the 257 or the 252.7, Mike?

Mike Angerthal

Yes, that sounds like the right math.

Steven Schwartz – Raymond James

Okay. And then, whatever I would take off, it actually looked like a very, very low amount for minority interest like 5%?

Mike Angerthal

Yes, as we deployed the majority of the seed capital investment this quarter, the majority of the results from our seed capital are basically the firms or the companies. So the asset, so the minority level is low as we gather more third party assets but still retain a majority interest in those products. That number will grow until the point we deconsolidate and then you wouldn’t see that roll impact it at all. And we’ll continue to provide that transparency to aide in modeling for you.

Steven Schwartz – Raymond James

Okay, appreciate that. And then just going back on some stuff, I just want to make sure that the amounts that you went over on slide 11, slide 12, that was all taken out as an adjustment, that’s correct? And the only other thing that would be missing would be the $0.64 for the closed-end fund?

Mike Angerthal

There was $0.67 related to the closed-end fund which was that of our operating income as adjusted. And we were clear to try and highlight which elements are the non-GAAP elements on those two pages versus items that we wanted to call out because of the discreet nature of those items, some of them were falling off, some of them are not repeating.

So, when we look at operating income as adjusted, of that $0.16 that number excludes the only non-GAAP items are the Newfleet transition costs, those costs again are ending this period. And then the board grants which they happen in the second quarter of each year, so we have historically been adjusting for those.

Steven Schwartz – Raymond James

Right.

Mike Angerthal

So that’s what you see on page 13 in the operating income as adjusted. The other $0.11 is included in that. And we broke it out on pages 11 and 12 to really aide in your ability to model those two rows, the employment expense and the other operating expenses.

Because there are certain items this period that again we thought were discreet in nature. We wanted to point out where we think those ratios look as we’re looking ahead to the third quarter. So, that’s where we came with the 13%, 13.2% of revenues as adjusted on other operating expenses. And the employment expense that we’re looking at to 40% of employment expenses into the third quarter.

So, we really wanted to provide that clarity because this quarter more than other quarters, we had multiple business activities going on that we thought were important for us to identify for you.

Steven Schwartz – Raymond James

Okay, was there any share-based compensation associated with Newfleet this quarter?

Mike Angerthal

Yes, there was and we again break that out on the…

Steven Schwartz – Raymond James

Was that included in the Newfleet transition expenses?

Mike Angerthal

Yes.

George Aylward

Yes.

Steven Schwartz – Raymond James

Okay. And then finally, George, you talked about July, the open-end fund net flows being strong. It looks like it’s going to come in the strongest of the year. I don’t expect you to give us the number but can you talk about maybe the drivers, what areas?

George Aylward

The thing I like best about, actually the flow is not only just in July but the second quarter is really the diversity, right. Because you’re going to have periods where you have outside participation and we benefited from that. I mean, we had blow-out quarters from EM back in the period when we were just about to close it.

And in some ways I think that’s unhealthy because it sort of overshadows for us. I think it overshadowed just the underlying strength of the diversity. So I have to say, as I’ve looked through it in the second quarter and continue in July, what I like about it is the spread that it’s nice and spread amongst some of the – all the asset classes. But it’s nice I’m seeing some of the newer funds starting to have a little bit more activity than they’ve had before.

So, again I think generally overall as we spoke in the second quarter, all the asset classes were doing well for us. I think that continues to be true in July. So, to me that’s great. Because it hasn’t been that great to say, it hasn’t been the greatest second quarter or July for the industry as a whole.

I mean, there has, been a lot of challenges. So I think particularly on the fixed income side, and again I’m biased. But I really think what we have with Newfleet and their multi-sector approach, which I would call the original unconstrained strategy, it’s really a very compelling strategy regardless of what you think is going on with rate.

So, we think we’re having some good experiences in areas that others might not see. But the diversity is what I speak to, but again, as I always say, we will generally be reflective of what goes on in the industry. But generally what we’ve outperformed they have been above average in some of those experiences.

Steven Schwartz – Raymond James

Okay, and then in your commentary, you mentioned a new unconstrained fund, you just reminded me of that. Is that – that’s an open-end fund, I take it. Is there going to be any seed capital going into that?

George Aylward

It is an open end fund. And again, it will be leveraging the incredible talent that then Newfleet came out in the multi-sector strategy for their existing funds. But they will have a lot more – a greater ability to expand in terms of whether they like or don’t like a sector including the ability to go short, which doesn’t come into play in the existing funds that they have and making a few more calls previously.

So, it’s yet another way to access the incredible strength that Newfleet has in knowing what sectors to be in and out of, but having them take basically more bets in terms of putting it down. It is an open-end fund, so we just did the filing. It will require seed capital commensurate with 14-sector fixed income fund.

So, you’ve generally seen that – people, you have to see those above $20 million in order to execute the strategy appropriately.

Steven Schwartz – Raymond James

One more. Was the over-alignment done on the new closed-end fund?

George Aylward

It is not closed. I mean, it’s 45-day period that has not ended yet. So, that won’t be until June 27, so we’ll get probably 9th or 10th it is when they will be done.

Steven Schwartz – Raymond James

Okay, all right. Thank you.

George Aylward

Thank you.

Mike Angerthal

Thanks, Steve.

Operator

Our last question comes from Marc Irizarry with Goldman Sachs.

Marc Irizarry – Goldman Sachs

Great, thanks. Just on the alternatives uptake, I guess in the wire-houses, can you maybe talk about the demand as it stands today and how you maybe see the – your new alternatives offerings playing out in the wire-houses? And then just related to that, did the closed-end fund launch, does that encumber in any way maybe the, your distribution ability during the period so that maybe, that was a little bit more of a highlight from the distribution than some of the other products? Thanks.

George Aylward

Sure, on the second one first. So, for the closed-end fund, while we’re doing the closed end fund, it is an IPO and it’s pretty much, almost a full 30 days. And our sales force is very focused in on that. So, does it create distraction from some of our open end fund sales? Absolutely, because our wholesalers are very focused in on that.

I think the good news is you’ve seen we didn’t have a negative, really that much of a negative impact in our quarterly sales. And I think that’s sort of a testament just to strengthen the ongoing relationships that we have with FAs, that even if they’re out on the road very focused on the Duff & Phelps Select Energy MLP Fund that we continue to have flows related to our other products. But absolutely, it was a big percentage of their time for that 30-day period.

Going over to the alternatives, one thing I didn’t mention, the good thing, one of the many good things since the launch of those funds is right out of the gates. We’re very pleased with how they’re performing. It’s as we look at those funds and again, you have to look at those funds relative to other types of non-correlated, non-traditional types of products.

We’ve just been very pleased with the performance from Cliff Water who does obviously the manager selection as well as the portfolio construction they’ve just done really well. So couldn’t be happier with how the funds have performed right out of the gate, albeit it’s a very, very short period of time.

In terms of the general appetite we continue to see just an incredible demand for these types of products and strategies, and there have been two or three funds that have been playing in this space so they’ve gotten a lot of flows. We believe it will be healthy for financial advisors to have less concentration in some of those products.

And we think ours will fit very well in their line-ups. Obviously our funds are working their way through the wire-houses who are very thoughtful in terms of doing their research and their approvals. So we’ve gotten through on the – just very recently on some of the smaller independents and RAIs. And the wire-houses we’re expecting to start seeing access in the third and the fourth quarter.

So, we’re very much looking forward to having the ability to actually distribute those funds in what is perennial in one of our strongest areas for flows. Effectively you have really not seen any flows, meaningful flows yet for these funds. But once they’re turned on would be the first opportunity we will have to truly generate some flows.

Marc Irizarry – Goldman Sachs

Okay, great, thank you.

George Aylward

Thank you.

Operator

This concludes our question-and-answer session. I’d like to turn the conference back over to Mr. Aylward for any closing remarks.

George Aylward

Okay. I just want to thank everyone. I mean, I know this was an unusual time for us. And we wanted to be respectful of people’s time and we had a lot of information that we were trying to provide clarity on. So, we appreciate your time. And as always, if you have any additional questions or follow-up, please feel free to reach out to us. So, thanks everyone. Have a great day.

Operator

That concludes today’s teleconference. Thank you for your participating. You may now disconnect.

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