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Executives

Rich Pzena - Chairman, Co-CIO and CEO

Greg Martin - CFO

Analysts

Alex Blostein - Goldman Sachs

Larry Hedden - KBW

Roger Smith - Macquarie

Pzena Investment Management Inc. (PZN) Q1 2011 Earnings Call April 27, 2011 10:00 AM ET

Operator

Good morning. My name is Natalia, and I will be your conference operator today. At this time I’d like to welcome everyone to the Pzena First Quarter 2011 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers remarks there will be a question-and-answer session. (Operator Instructions) Thank you.

I’d now like to turn the call over to Mr. Greg Martin. Sir, you may begin.

Greg Martin

Thank you very much Natalia. Good morning. I’m Greg Martin, Chief Financial Officer of Pzena Investment Management. I’d like to take this opportunity to welcome you all and thank you for joining us on our first quarter 2011 earnings conference call.

With me on the call is our Chief Executive Officer and Co-Chief Investment Officer, Rich Pzena.

Our earnings press release contains the financial tables for the period to be discussed. If you don’t have a copy it can be obtained in the Investor Relations section on our website at www.pzena.com. Replay of this call will be available for the next week on our website.

Before we begin I’d like to reference the standard legal disclaimer. Statements made in the presentation today may contain forward looking information about management’s plans, projections, expectations, strategic objectives, business prospects, anticipated financial results and other similar matters. A variety of factors many of which are beyond the company’s control affect the operations, performance, business strategy and result of the company and can cause actual results and experiences to differ materially from the expectations or objective expressed in these statements.

These factors include but are not limited to the factors described in the company’s reports filed with the SEC which are available on our website and on the SECs website www.sec.gov. Investors are cautioned not to place undue reliance on forward-looking statements which speaks only as of the date on which these statements are made. The company does not undertake to update such statements to reflect the impact of circumstances or events that arise after the date these statements were made. Investors should however, consult any further disclosure that company may make in records filed with the SEC. In addition, please be advised that because of the prohibitions on selected disclosure the company as a matter of policy does not disclose material that is not public information on that conference calls. If one of your questions require the disclosure of material non-public information, you will not be able to respond to it. Thank you.

Before I turn the call over to Rich, I’d like to first mention some financial highlights. We reported non-GAAP diluted EPS of $0.10 per share and 6.2 million in non-GAAP diluted net income. Revenues were 21.8 million for the quarter and our operating income was 11.5 million. Our cash balance was 22.1 million at quarter end and we declared our $0.03 per share of quarterly dividend last night. I’ll shed some light on our financial results in a few minutes but first I will turn the call over to Rich who discuss our view of the investing environment and we are positioned relative to it.

Rich Pzena

Thanks Greg. Global equity market advanced in the quarter with the MHCI all country world index up 4.4% in U.S. dollar terms. Markets recovered during the latter part of March after being whacked by the disaster in Japan and turmoil in the Middle East and North Africa which pushed oil passed the $100 per barrel. The U.S. market registered solid gains during the quarter with the S&P 500 index up 5.9% and the Russell 2000 index at small cap stock up 7.9%. The MCHI Europe index posted a 6.6% advanced during the quarter helped in large part by the euro which moved up almost 6% against the dollar during the quarter. The MCHI emerging market index was up 2.1% over the same period with energy producers for example Russia posting double-digits gains. Japan however, fell 4.9% reflecting the impacts of the earthquake, tsunami and nuclear disaster.

Despite headwinds of high oil prices Japan’s potential impact on the global supply chain and sovereign debt problems to name a few, investors confidence and the sustainability of the economic recovery is likely a major underlying factor in the continued advance in equities.

Earnings on the whole beat expectations in the fourth quarter and many analysts are predicting double-digit EPS growth in 2011 and 2012. Investor focus also appears to be shifting from an obsession with macro forces to the actual performance of individual companies. Co-relation or how much stock prices move together is one barometer to gauge whether macro high co-relation or company specific low co-relation forces are driving the market. Co-relations peak most recently in September 2010 at the hike of macro concerns and it declined substantially since then giving us reason to believe we are returning to stock sectors market.

From the firms perspective this has created an environment that I’d characterize as stable. Our AUM stands at 16.3 billion at the end of the quarter, up 4.5% from 15.6 billion at December 31st. Operating margins were 52.8% this quarter versus 53.2% in the prior quarter and cash flow continues to be solid with operating activities generating $12.3 million during the quarter.

I’m very pleased to report that we were selected by the Vanguard Group to be one of four sub-advisors to their actively managed emerging markets fund. This expands our relationship with Vanguard as we currently sub-advised an Irish domicile U.S. large cap equity fund for them. We are also in advanced stages with another firm for a meaningful mandate for emerging markets valued strategy.

For an institutional new business standpoint, we haven’t seen a dramatic uptick in new mandates available for our strategy, but we haven’t seen a dramatic fall off either. Clients continue to be interested in pursuing alternatives despite the fact that most returns in this area with the exception of the very best alternative firms have been less than compelling. We will continue to stick to our [meetings] and will continue to execute our strategy and stay patient until conditions change. Investors have rewarded us in the past for this and we expect they will reward us again in the near future.

We are very encouraged by the current investment outlook. Companies have rapidly restored operating margins and returns on equity across the globe accomplished through swift and decisive action by management to adjust to their costs structures to a lower level of current and expected activity.

Our own five year projections of corporate performance also reflect the conservative stance which co-relates well below past cycles and operating margins inline with long-term averages. Corporate cash flows also continue to be strong illustrated by the 7.3% current free cash flow yield of our global value portfolio. This has resulted in declining debt levels and corporate balance sheets across our global investment index.

Valuations no higher than two year's ago are still reasonable and most regions the expected returns on equity are attracted spreads are in the normal range and the price to normalize earnings ratios of our portfolio are generally at the low end of historical ranges. With high quality opportunities at moderate valuations based on conservative assumptions, we find ourselves in a very good part of the value cycle with what we believe to be the underpinnings for solid long-term performance.

I’ll now turn the call over to Greg Martin our CFO to review financial results for the quarter.

Greg Martin

Thank you, Rich. I’ll start off by discussing our AUM, fee rates and revenues. Our average AUM was 16.2 billion during the quarter up 9% from last quarter and 13% from first quarter of last year. We ended the quarter at AUM of 16.3 billion up 4% from the end of last quarter which ended at 15.6 billion and up 6% from the first quarter of last year which ended at 15.4 billion. The $0.7 billion growth from last quarter was primarily result of 0.9 billion in market appreciation. 0.9 billion change from first quarter last year it was result of 1.8 billion in market appreciation offset by 0.9 billion in net outflows.

Our AUM consisted of 13.0 billion in institutional accounts and 3.3 billion in retail accounts at March 31, 2011. Assets in institutional accounts grew 4% during the quarter primarily due to market appreciation offset by small net outflows. Retail assets were up 6% from last quarter as a result of market appreciation.

Revenues were 21.8 million for the first quarter of 2011 up 6% from last quarter and 14% from last year first quarter. The increase from last quarter was primarily driven by increase average AUM, slightly offset by a decrease in the weighted average fee rate. The increase from first quarter last year was primarily driven by increase in both average AUM and weighted average fee rate.

Our weighted average fee rate was 53.9 basis points for the first quarter of 2011, 55.5 basis point last quarter and 53.2 basis points for the first quarter last year. The decrease from last quarter was largely a result of an increase in the average size of the company’s institutional accounts. The company feared these schedules typically throughout lower rates as account size increases. The increase from first quarter last year was primarily due to a shift in asset mix towards our institutional accounts.

Institutional accounts comprised about 80% of average assets for the first quarter of 2011 compared to about 76% for the first quarter of 2010. In addition, the expiration of the temporary voluntary partial fee waiver on the John Hancock Classic Value Fund, which ended in May 2010, contributed to an increase in the weighted average fee rate compared to that at the first quarter 2010.

The weighted average fee rate for institutional accounts was 57.8 basis point in the first quarter of 2011 down from 59.6 basis point last quarter and 59.4 basis points from the first quarter of last year. These decreases were both primarily due to an increase in the average size for institutional accounts as well as a shift for certain of our clients to a performance based fee. These performance based fees pay incentive fees according to our performance relative to certain agreed upon benchmarks which results in a lower base fee, but allows us to earn higher fees if the relevant investment strategy outperforms the agreed upon benchmark. This decrease was offset to an extent by shift in asset mix amongst our institutional products and an increase in performance fees recognized.

Turning to the remainder of the P&L, our compensation expense was 8.4 million for the quarter up 12% from last quarter and 14% from the first quarter of last year. Both increases in compensation were driven primarily by increases in our discretionary bonus accruals and non-cash compensation.

G&A expenses were 1.9 million for the first quarter down 10% from last quarter, primarily as a result of the timing of professional fees incurred. G&A expenses remain consistent with the first quarter of 2010.

Operating margins were 52.8% this quarter, 53.2% last quarter and 51.0% in the first quarter of last year. Our non-GAAP income statement adjust for certain valuation allowance and tax receivable agreement items. I will add some color to these adjustments in a bit, but for now I’ll focus my remaining remarks on the non-GAAP information.

Net of outside interest other income of 0.2 million both this quarter and last quarter both consisted primarily of net realized and unrealized gains from investments and interest in dividend income. Net of outside interest first quarter 2010 other income of 0.4 million was comprised of the same items, in addition to some offsetting interest expense. Other income has decreased from the first quarter of 2010 as a result of offsetting less firm assets invested in our own products.

The effective rate for our earning cooperative business taxes was 6.6% this quarter, 5.8% last quarter and 6.0% for the first quarter of last year. The fluctuation in these effective tax rates are driven by driven by certain expenses that are primarily non-deductible for UBT purposes. As mentioned in the past this rate varies from period-to-period but generally be between 5 and 7% on an non-going basis.

The allocation to the non-public members of our operating company was approximately 85.5% of the operating company’s net income this quarter and last quarter and approximately 86.6% in the first quarter of last year. The variance in these percentage is a result of changes in the ownership interest of the public entity in the operating company. Given the exchange that occurred at the end of the first quarter 2011, the allocation to the non-public member to our operating company will be approximately 84.6% of the operating company’s net income beginning in the second quarter.

The effective rate for our corporate income taxes exclusive of UBT was 42.8% this quarter and 42.6% last quarter and the first quarter of last year. This is inline with our expectations of our corporate effective tax rate being between 42 and 43%. We anticipate this to be the approximate rate going forward. As a result of the foregoing we reported basic and diluted non-GAAP EPS of $0.10.

Before we turn it over to question, I’d like to briefly walk through the valuation allowance and tax receivable adjustments. These adjustments arrive as a result of revised estimates of future taxable income and our ability to utilize our deferred tax asset. The net effect to these adjustments is a difference between our non-GAAP and GAAP results. We recognized a 0.9 million decrease in our valuation allowance and 0.1 million increase in our liability to our selling and converting shareholders for the quarter.

On a quarterly basis we would expect to record adjustments to the valuation allowance and our liability to our selling and converting shareholders as e extent our projections out in future quarters. The ultimate amount of these adjustments will depend on our estimates of the future taxable income of the operating company and the level of our economic interest in it.

Inclusive of the effect of the valuation allowance and tax receivable agreement amount I just discussed, we reported GAAP basic EPS of $0.18 and diluted EPS of $0.11 for the quarter. Thanks for joining us, we would now be happy to take any questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question is from the line of Alex Blostein [Goldman Sachs].

Alex Blostein - Goldman Sachs

Hey, guys, good morning. First question on the institutional business, I was hoping you guys could give a little bit more color on the outflows. The gross outflows seem like they have picked up a little bit. And then, Rich, just a broader question on the product lineup. It feels like the three-year numbers are getting better, and some of that is just I guess a function of the environment, a little RFP activity in the space. But do you feel like you potentially might need to think about different strategies that you guys might want to pursue with a tilt towards alternatives at all?

Rich Pzena

Okay. The first question growth outflows, yes, the quarter had institutional growth outflows that were a little bit higher than they have been in prior quarters, but there is nothing in there that you would view as anything other than noise. And hopefully as we report future quarters you will be able to see that. But it's been as we look at it, we are fairly stable at our normal level of growth outflows. They are going to fluctuate a little bit quarter-by-quarter but over the average of the year. It feels like it's stabilized, some of this would do to rebalancing out our products that happens when they outperform. In fact that tends to step up when you outperform given the nature of our clients. There is also some randomness to that as well. But we don’t see any issue on the growth outflow side.

On a three year record we have one more quarter where there will be a substantive improvement in our three year record as we drop second quarter of 2008 which was a particularly fourth quarter and actually it was June that was particularly four month 2008. And after that is completed we should have a pretty compare and looking three year record. Our five year record though remember still has (inaudible) and there are some who look at the five year record as well. But our very long-term record and our three year record was then the booking is really good.

The issue of alternative is an interesting one, and we debated internally all the time. Clearly when you listen to what people say they want and the way they are acting it would say to you, you should be offering alternative product because that’s what is in demand right now. On the other hand every time we look at it, it's real hard for us to think that that’s the most sensible strategy for either off score for our clients. We know what we are good at and we think that we are acting in the best long-term interest of the firm and our shareholders by doing what we are best at. There maybe a time when in the future but we would consider alternatives, but given the risk return that’s available by being long only today is the hard crust to logically say that this is wise to be shifting to alternatives and we would rather (inaudible) in what we think is the right thing to do. So, you may call it stubborn but we are stubbornly speaking to our meeting.

Alex Blostein - Goldman Sachs

Fair enough. And then the second question was on the Vanguard sub advisory mandate with the emerging markets product you guys mentioned. Was that already I guess in the run rate this quarter or should we start to see an improvement in flow in the retail channel again starting next quarter? And then when you think about the fee rate relative to the overall fee rate in the retail channel, how does that compare?

Rich Pzena

The Vanguard fund is still not operating at, so it's in registration that’s a new fund that’s in registration with the SEC. So, there is no flows associated with it. And there won’t be any flows in the second quarter associated with it either, unless we get lucky and it's sort of ready by the end of the second quarter. But I’d say you would be looking in the third quarter before you see anything. But fee rate is significantly higher than the fee rate we have in the retail channel, simply because it's emerging markets rather than primarily U.S. and it reflects our emerging markets fee schedule. So, unless money starts to come in it should have a positive impact on our retail weighted average fee rate.

Operator

Your next question is from the line of Larry Hedden [KBW].

Larry Hedden - KBW

Hi, good morning. I wasn't able to determine from your commentary, but did you guys realize some performance fees in 1Q? And if so can you quantify any of those?

Rich Pzena

Of course, very, very similar to the first quarter.

Larry Hedden - KBW

Okay. And then I believe on the last quarter's conference call, I think you indicated that AUM subject to performance fee was roughly 10% of AUM. First, is that correct? And if so, has that percentage changed at all?

Rich Pzena

I know 10% is about the right number and it really hasn’t changed, we have one account that switched to a performance fee but it wasn’t big enough that it would dramatically impact that percentage.

Larry Hedden - KBW

Fair enough. And then in your commentary you also mentioned that you had expected or were in negotiation with another mandate for the emerging market strategy. Is that another mandate like on the sub advise side or would that be institutional?

Rich Pzena

Yes, it would in our institutional, on the institutional side.

Larry Hedden - KBW

Great. And then just one housekeeping item. Could you give us a sense of the rough breakout of the U.S. strategies in terms of say large-cap what would be equivalent to the value service and small-cap?

Rich Pzena

In terms of assets under management?

Larry Hedden - KBW

Yes.

Rich Pzena

The large cap is just around $7 billion, the small cap is around $1.3 billion, with that 400 million in mid cap and about $2 billion in value.

Larry Hedden - KBW

Great. And then just one last question. How much of the comp in the first quarter roughly was more seasonal in nature?

Rich Pzena

A little but insignificant.

Larry Hedden - KBW

Fair enough. Thank you. Thanks for answering all my questions.

Operator

(Operator Instructions) Your next question is from the line of Roger Smith [Macquarie].

Roger Smith - Macquarie

Thanks. Can we just stay right on that compensation line for a minute, because it does look like it's higher. And if you made some comments in the prepared remarks I can go back to those. But it seems like that's up a little bit and then the headcount is down a little bit. So I'm just trying to understand is compensation just mildly moving up here or is there really something else going on?

Rich Pzena

No, it's just compensation mildly moving up. The headcount is really temporarily down reflecting the fact that we have to book that we had a little turnover and it should be rebounded by the next time we reported. So, there is no change in headcount.

Roger Smith - Macquarie

Okay. And that headcount, that's not investment professionals really then, that's other folks in the firm?

Rich Pzena

That’s correct. It's mostly on the administrative side.

Roger Smith - Macquarie

Okay. And then if we can stay or move over to the assets under management. Inside the products, whether it be institutional retail and I guess more focused on institutional, is there anything happening in the sales side that we should be aware of? Meaning are all of these sales coming from existing clients or are there new clients that are coming into the firm at this point in time?

Rich Pzena

Yes, it's actually skewed towards new clients with a pretty heavy focus coming from outside the United States particularly Australia where we had some significant wins and continue to have significant wins that we think will fund in the coming quarters.

Roger Smith - Macquarie

Okay. And then really I guess if we stay on the distribution efforts. I mean you just mentioned Australia is a big thing. We have heard from some of the other competitors that boutique managers are really in vogue right now, particularly from money outside the U.S. Can you talk about, I guess, what distribution efforts you're making and are you seeing that same type of trend and can we expect an uptick in the gross sales levels going forward?

Rich Pzena

Well, I hope that’s right. I guess I’d say. I don’t really know the answer to whether a boutique so in vogue or not. I think at some you wonder whether you are still a boutique anymore, I don’t know what assets under management that you have our boutique into regular, but I think there has been general disenchantment with the biggest firms. So, I think that’s true. And as far as our distribution strategy goes, we are adding sales people, we had one join us already, we have won a second who has accepted and we are waiting for them to join. And we have another offer outstanding and then we are looking for one more beyond that. So, we are making a pretty big investment over the course of the next 12 months. Now you have to realize that it doesn’t turn interest sales immediately. We don’t even let the sales people go out for six months after we hire them. So, we are talking about this being a 2012 phenomena and we are hopeful that our sales efforts will pay out further.

Roger Smith - Macquarie

Okay. But should we then expect compensation to increase mildly during this 2011 then ahead of the sales from the adding of these people?

Rich Pzena

Yes, but mildly is a good way of putting it.

Roger Smith - Macquarie

Okay. And is there any sort of geographic focus that they'll be concentrating on?

Rich Pzena

Yes, we are actually looking specifically for Europe, specifically for the U.S. At this point not specifically for Asia we are happy with the way things are going in Australia. And you can see the Australia sales person that we have, we hired in January of 2010. And we opened the office in July of 2010, as about a year later that these things they are further.

Roger Smith - Macquarie

Okay. Got you. And then my last question I guess is on the Vanguard mandate. Was there anything specific that happened during that RFP process or during the win process that you can tell us that would have caused them to pick you?

Rich Pzena

I’d say that Vanguard has been trying to work with us for a very, very long time. We had discussions with them about virtually all of our strategies over the course of 10 year's probably. And generally the fees are a big problems because the fees that they have typically paid there sub advisors has not met our fee schedule and we have routinely stucked to our fee schedule. And I think they came to the realization that for the extent that they wanted to have high quality sub advisors, they have to be willing to pay market prices for the services and I think they exhibited a willingness to do that.

Roger Smith - Macquarie

Okay, great. And then do you have any kind of indication or expectations of how that fund grows over time?

Rich Pzena

I mean I only know how to answer that. The only thing I can tell you is that Vanguard manages about 60 or $70 billion in taxes emerging markets. Big for them, this is their first foray into active in emerging markets. So, it's hard to predict it could be big. I think they think it's going to be big. We are hopeful.

Roger Smith - Macquarie

Right. I just guess what I was try to understand is like when they come out with this fund is there sort of a big splash at the beginning like we would expect a decent amount of assets to come in right away and then sort of become more of a normal level or is it just sort of normal rate.

Rich Pzena

Because we are sub advisors we never really know how these things work. So, I’m sure they are planning to promote it. And the pace that it evolves we can’t even venture I guess.

Roger Smith - Macquarie

Right. No, no, that's fair. I appreciate the time.

Operator

There are no further questions.

Greg Martin

Okay. Well thank you everyone for joining us in today’s call.

Operator

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

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