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Legg Mason (NYSE:LM)

Q3 2012 Earnings Call

January 27, 2012 8:30 am ET

Executives

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

Mark Raymond Fetting - Chairman, Chief Executive Officer, President and Member of Finance Committee

Alan F. Magleby - Director of Investor Relations & Communications

Analysts

Matthew Kelley - Morgan Stanley, Research Division

Michael Carrier - Deutsche Bank AG, Research Division

Cynthia Mayer - BofA Merrill Lynch, Research Division

Glenn Schorr - Nomura Securities Co. Ltd., Research Division

Macrae Sykes - Gabelli & Company, Inc.

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

Steven M. Truong - Barclays Capital, Research Division

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

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

J. Jeffrey Hopson - Stifel, Nicolaus & Co., Inc., Research Division

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

Operator

Greetings, and welcome to the Legg Mason Third Quarter Fiscal Year 2012 Earnings Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Alan Magleby, Head of Investor Relations and Corporate Communications. Thank you, Mr. Magleby, 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 third fiscal quarter 2012 ended December 31, 2011.

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, 2011, and in the company's quarterly reports on Form 10-Q.

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

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

Mark Raymond Fetting

Thank you, Alan. Good morning, and welcome to our call for the December 31 quarter. Our results for the quarter reflected the effect of 2011's second half market turmoil, which impacted our asset and revenue levels. Even so, our core business fundamentals held up well, particularly when you add back the considerable transition costs this quarter, which largely concludes our streamlining initiative.

Our flow picture improved for the period as performance across our key affiliates remains strong and our distribution teams work closely with them to build momentum. By the end of the period, we had completed the 18 months streamlining that we announced in May 2010, on time and on budget. We are now realizing our targeted $140 million in annual cost savings. We could not have done this without the tireless efforts of our employees, and we thank them for the successful execution of this ambitious initiative.

In addition, we enter the new calendar year with a balance sheet that remains strong and flexible with year-over-year cash levels almost flat, even after the return of $0.5 billion to shareholders over the past 12 months. This financial strength not only allows us to deploy capital opportunistically, but it also allows us to confidently invest in growing the business in new products and segments. Earlier this month, we held an investment forum for clients, FAs and media in New York with senior investment professionals from Western, Permal, ClearBridge and Royce.

We had over 1,000 participants accessing the webcast or dialing in on the phone with more attending in person. One of the central questions of the discussion was what will it take to get investors back into the markets, particularly the equity markets. Our panelists agree that most advisers and retail investors will need to see a sustained rise in equity prices for some period of time. In this regard, we are encouraged by January's good start.

In the meantime, our managers continue to see value in the market whether that be yields on high-quality equities that are the most attractive relative to bonds since the mid-'50s or non-treasury sectors of the bond markets, such as munis, credit and high yield.

So now let's shift to our results on Slide 3. For the quarter, Legg Mason reported net income of $28 million and adjusted income of nearly $77 million. Results were impacted by higher transition-related charges, lower average AUM, which drove lower revenues, as well as lower performance fees.

Importantly, we completed our restructuring on time and on budget. We had $26 million in cost savings this quarter, and we achieved our goal of $35 million in the current quarter or $140 million on an annualized basis. We ended the quarter in a position of strength with $1.2 billion of cash on our balance sheet, which we expect to use to both invest in growth and as appropriate, return to shareholders.

On Slide 4, we see our Assets Under Management by asset class. We ended the quarter with $627 billion, up sequentially driven by market appreciation and reduced outflows both overall and for long-term assets. By asset class, we had 25% of our assets in equity, 56% in fixed income and 19% in liquidity.

Slide 5 shows our net flows for the quarter. The long-term outflows improved from the prior quarter while liquidity flows were positive, reflecting an overall trend away from risk. Equity outflows were down slightly consistent with industry experience. Liquidity inflows were nearly $11 billion, again reflecting the derisking that occurred in the quarter.

Fixed income outflows decreased from the prior quarter and resulted from continued withdrawals in the low fee, global sovereign mandate, risk rebalancing among institutional clients and a continued move by some clients to passive mandates. Of the $7.1 billion in fixed income outflows, the sovereign mandate accounted for $3.8 billion.

Though the quarter's outflows were modestly better than last quarter, they were significantly improved from the December quarters in each of the prior 3 years. And we saw positive fixed income, income flows in the month of December despite the continued outflows from the global sovereign mandate. Overall, while 1 month is not a trend, based on the facts today, we are encouraged by the momentum we see both at key affiliates and in the markets.

Slide 6 shows our assets by affiliates. Let's start with Western with $442 billion, up from the previous quarter driven by market appreciation and liquidity inflows. Fixed income outflows were driven primarily by the global sovereign mandate we've referenced for some time and other factors cited previously. These were partially offset by continued money into specialized mandates. We will go into more detail about Western in the next slide.

Next is Royce at nearly $36 billion, up from the prior quarter due to market appreciation. Royce had outflows in the quarter and for the calendar year. Importantly, Royce's 3- and 5-year performance numbers remain strong. We are very pleased to partner with Royce in our offshore usage range, which we raised $600 million in the calendar year.

Next is Permal at nearly $18 billion. Gains in the U.S. institutional segment and new geographic regions in Asia and the Middle East were offset by continued high networth outflows as the eurozone and general market volatility remained in the headlines. Permal is continuing to grow the institutional business. In the U.S., they had additional inflows of $150 million in the quarter and continued advances in the U.K. They closed a $250 million opportunistic fund in the quarter and expected to roll out additional products that are similarly focused in the calendar year.

Permal's cumulative unfunded wins were over $300 million. Legg Mason recently received approval from the SEC to offer a non-exchange listed closed-end fund that is a fund of hedge funds and is sub-advised by Permal. We expect to begin offering this fund to accredited investors in the near future.

Next is ClearBridge at $51 billion driven by higher equity markets. Looking forward to 2012,the key focus will be on income-oriented products in which ClearBridge has good performance. The Legg Mason, ClearBridge Equity Income Builder performed well for the calendar year. A U.K. version of the fund launched in the quarter attracted $30 million in client money by year end, and that has risen nearly $45 million through the first half of January.

Next is Batterymarch at nearly $18 billion, up sequentially driven by market appreciation. Showing improvement, the firm's performance for the quarter and year ending December 31, 2011, was strong across products. 86% of the firm's composites beat their benchmarks for the quarter and 68% of composites beat their benchmarks for the year.

Projected funding in fiscal Q4 includes an additional $200 million from an existing client into Batterymarch's U.S. Small Cap fund and approximately $50 million into the fund's global emerging market strategy. Longer term, Batterymarch has also garnered interest in several products under development, including managed volatility and inflation-sensitive strategies.

Brandywine ended the quarter at $33 billion driven by market appreciation and modest inflows. Brandywine has approximately $300 million in its one, but not funded pipeline. Its global bond fund has just established a 5-year track record with strong performance across the period. This fund has crossed the $1 billion mark, and we've seen inflows of approximately $100 million a month over the past several months. We have worked with Brandywine to add the fund to various platforms, and their specialists are out on the road with our wholesalers on a regular basis.

Legg Mason Capital Management ended the quarter at over $8 billion. During the quarter, the firm announced that Sam Peters will be taking over as Chief Investment Officer and as sole Manager of the Value Trust in April 2012.

Page 7 shows an update on Western asset. The upper left slide shows the total assets by mandate. The percentage of assets in specialized and broad market portfolios remains similar to last year -- last quarter, while taxable liquidity rose by a couple of percentage points. Western continues to see the most interest in its fixed-income business from specialized mandates, which typically are for smaller dollar amounts, but are generally higher fee assignments.

All of the final presentations held in the quarter were for specialized mandates. The vast majority of the mandates won, but not yet funded in the quarter, were also for specialized mandates. The upper right corner of the slide shows the percentage of composite assets beating the benchmarks. It shows continued strength in the 3-year numbers. Our performance for the December '11 quarter remained strong in key strategies. Performance for the 1-year period modestly underperformed the benchmark as an even stronger December '10 quarter rolled off.

Finally, the chart on the bottom shows long-term net flows. As you can see, outflows were improved slightly versus the previous quarter. However, they significantly improved versus the December quarters in '08, '09 and '10. Western's business continues to improve even with the softness in the institutional demand for active Core and Core Plus mandates.

Areas of client interest include global credit, emerging market debt, high yield and multi-sector strategy. Another emerging area is active ETFs. Earlier this month, WisdomTree, an ETF sponsor, announced a new partnership with Western to create credit products. Legg Mason has an application in front of the SEC for actively managed products and has filed a proposed short duration bond fund as an initial product.

Slide 8 shows our composite performance versus the benchmark covering 90% of our total assets. Three and 10-year numbers remained strong, while there was a drop in percent of assets beating benchmarks in the 1 year. This reflects the Q4 '10, '11 differences that I cited previously.

Slide 9 shows long-term fund performance against the category average, which shows performance against peers. Here, we show marked improvement in the 1-year numbers and consistent performance in 3-, 5- and 10-year numbers, each with over 70% majority.

Slide 10 shows the breakdown of our global distribution platform. Total assets of $213 billion are serviced across North America, Asia, Europe, Australia and Japan. And we continue to expand our presence in markets, channels and advisers globally. The reorganization of our sales team in the United States that we announced last summer became effective last quarter, and we are very pleased with the initial receptivity to our expanded advisor coverage.

Outside the U.S., our business in Japan, while down a bit given currency moves in the quarter, is still quite strong. It is complemented by beachhead investments in Europe and Asia. We are seeing encouraging receptivity to our efforts, particularly in Europe.

While not covering every category, the product lineup that we are now marketing globally is the strongest it has been in years. We have multiple products with strong performance in key segments across equities, fixed-income alternatives to offer our clients.

Slide 11 shows the trends in our U.S. distribution long-term flows. Net outflows in the quarter declined to $3.5 billion as opposed to $4.3 billion in the previous quarter. Over the past few months, redemption rates have modestly improved and compared favorably to the industry. Municipal and taxable fixed income mutual fund flows returned to positive in the quarter. And we believe we are in the strongest position we have been in with regard to our product set for some time.

On the fixed-income side, this includes our Brandywine managed global bond fund and in contrast to what we've noted on the institutional side of the business, we see meaningful opportunity in the retail market for Western and Core and Core Plus mandates and growing interest in emerging market debt and high yield. Western's Core and Core Plus offerings were recently added to a large retirement plan. It is expected to fund in March with an initial $450 million.

And on the equity side there's growing interest in ClearBridge's income solutions and Royce's diverse offerings. Slide 12 shows trends in our international distribution platform. Our international division posted its 12th straight quarter of positive flows although at a reduced level. Net flows were down driven primarily by reduced inflows into Brazilian and Australian bond funds, given currency and interest rate movements in the quarter. Also included in these numbers is an international client that moved out of the fund and into an institutional account through Western.

Year-to-date, even with challenges in Europe given events surrounding the euro, the region had modestly positive flows driven by clients in Brandywine's Global bond fund, Western's high-yield fund and ClearBridge's aggressive growth fund. During the period, the U.K. business successfully launched a U.S. equity income fund mirroring the $4 billion strategy in the U.S.

As the team looks to the year end and the year ahead, they believe they have a window of opportunity to capture market share from competitors, particularly on the fixed income side. And now to Pete.

Peter H. Nachtwey

Thanks, Mark. As you could tell from Mark's comments, we had a challenging quarter, primarily due to market-driven impacts on our long-term AUM, as well as our final round of large transition-related costs. So while we saw improvement in our ending equity market valuations from the prior quarter, our average AUM was still down quarter-over-quarter. Also volatility and investor-risk aversion continue to adversely impact our high-yielding asset flows.

While the decline in average AUM and lower performance fees resulted in lower sequential revenues, we continue to deliver strong investment performance to our clients and the flow picture did improve somewhat over the September quarter. We completed our streamlining as of December 31. And on the balance sheet front, we ended the period with over $1.2 billion in cash, $850 million of which is available to invest in the business or return to shareholders.

Our fiscal third quarter saw a ramp-up in transition-related cost of $42 million as we completed all of our significant streamlining activities. Consequently, next quarter's results will be cleaner on this front as we will have minimal transition-related cost while seeing our first quarter of the full $35 million in cost savings. For the period, a number of other factors impacted our results. Though ending AUM of $627 billion was higher than the prior quarter end, average assets were lower by $21 billion despite improving long-term asset outflows and liquidity inflows.

The lower average AUM put pressure on revenues, margins and earnings during the quarter. Also our performance fees came in below recent levels and significantly below the prior year quarter. Finally, the unrealized losses on our balance sheet investments of $1.8 million were significantly improved from last quarter's unrealized losses of $19.7 million. This quarter's relatively small loss was primarily driven by our alternative and emerging market seed investments.

As a reminder, the fact that GAAP requires us to mark these investments to market each quarter creates volatility in our short-term results, but it is important to note these losses are unrealized, and our strong balance sheet and liquidity give us the ability to hold these investments until our strategic objectives have been achieved.

Now let's turn to Page 13 to review the financial highlights for the quarter. The fiscal third quarter 2012 net income of $28 million yielded $0.20 in earnings per diluted share, including the impact of transition-related cost, which reduced our net income by $0.21 per diluted share. Operating revenues were down 6% compared to the prior quarter due to a $21 billion or 3% decrease in average AUM, a slightly lower advisory fee yield reflecting a drop in average equity AUM and a decline in performance fees.

The $6.1 million in performance fees earned this quarter were largely driven by our fixed income managers: Western Asset and Brandywine. The decline from the prior quarter reflected lower fees from Permal and Western. In Permal's case, their fees are based on absolute performance and on that basis, they're below their high-water marks, particularly in their fixed-income mandate, which drives a significant portion of their fees.

On a relative performance basis, although this mandate had negative performance, it did beat the hedge fund index their institutional clients measure them against. We anticipate the next couple of quarters' performance fees to be roughly in line with those generated in the December quarter.

Operating expenses were up 1% reflecting a $42 million transition-related cost this quarter, which was up $27 million from the prior quarter. In addition, the mark-to-market on deferred comp and seed investments, which are offset in other nonoperating income and expenses was a $2 million positive in fiscal Q3 compared with a $14 million negative in the prior quarter.

Excluding these 2 items, operating expenses were down 7% reflecting lower compensation of affiliates operating under our revenue share arrangements. The adjusted income, which excludes certain noncash and other items, was $77 million for the quarter or $0.55 per diluted share, which also includes the transition-related expenses.

Moving on to Slide 14, the only other item to highlight here is our effective income tax rate, which was 26% on a GAAP basis compared with a net negative rate in the prior quarter as a result of the benefit from the U.K. tax reduction.

For the fiscal fourth quarter, we expect our rate to be in the low to mid-30% range on a GAAP basis. But I'd also like to highlight, as has been the case in prior periods, our cash taxes will be much lower as our net operating loss carryforwards and foreign credits, along with our ability to amortize a significant amount of our intangible assets for tax purposes will generate $1.6 billion in future cash tax benefits. This will reduce the actual cash taxes we will pay both this year and prospectively and will allow us to utilize this extra cash for the benefit of shareholders.

Flipping to Slide 15. You can see that the advisory fee yield declined this quarter from 35 basis points to 34 basis points, driven by lower average equity AUM and a simultaneous increase in average liquidity AUM during the quarter.

On Slide 16, operating expenses for the quarter increased due to the transition-related costs compared with $15 million of transition-related costs in the prior quarter. In addition, the impact of mark-to-market adjustments on deferred comp and seed investments resulted in an increase of $2 million in compensation expense compared with a $14 million reduction last quarter. Distribution and servicing costs were lower due to the lower average AUM and revenues. Communications and technology increased as a result of transition-related costs, as well as higher consulting expenses incurred by revenue-sharing affiliates.

Occupancy also increased due to $28 million in transition-related costs associated with the closure of various op and tech facilities, partially offset by lease reserves adjustment of approximately $5 million.

And finally, the increase in other expenses also includes some transition-related costs, as well as higher operating costs largely at certain revenue-sharing affiliates, which are offset in comp and benefits.

GAAP basis comp and benefits highlighted on Slide 17 were down 3% from last quarter, reflecting lower revenues and in the case of comp, lower transition-related cost, which were partially offset by higher deferred comp and seed investment-related expenses. Excluding the deferred comp and seed investment offset and transition-related costs, comp and benefit to net revenue ratio was 52%. This was down slightly from the prior quarter, principally due to increases in other expenses at the affiliates that are offsetting compensation. Normalized comp to net revenue ratio should approximate 53% in near term now that our streamlining is complete.

Turning to Slide 18, the operating margin as adjusted came in slightly better than last quarter's results despite the 6% decrease in revenues as expenses ex transition-related cost and mark-to-market on deferred comp and seed came in 7% lower.

Turning to Slide 19, we were very pleased to have completed our streamlining on time and on budget. As I highlighted on last quarter's call, December 31 was the final milestone in our streamlining initiatives as we completed closing certain of our tech and op centers and had our final scheduled staff reductions. Over a 20-month period ending on January 1, 2012, we reduced headcount by over 500 employees or about 33% of our March 2010 corporate level staffing.

With the $42 million in transition-related expenses this quarter, that brings our total transition-related cost to $126 million, and we expect the final $3 million in transition-related cost next quarter. Also next quarter, we will achieve our $35 million savings, which represents an annual run rate of approximately $140 million.

Speaking of our fiscal fourth quarter, while we normally do not provide guidance, we recognize that this year is a bit unusual with our turnaround so I would like to provide you with an update on our outlook. For the market recovery in the December quarter, we are continuing to project earnings per share of $0.42 to $0.52 per share, reflecting moderate market appreciation for the remainder of the quarter. Our current thinking is that we will likely to come in at the mid to lower end of that range due to a drop in previously reported performance fees.

Now turning to Slide 20. Despite continued market volatility, which led to our lower revenues, the ability of the Legg Mason operating model to generate substantial cash remain intact during the quarter. As you can see from our cash balances, we have over $1.2 billion of total cash as of December 31, 2011, $850 million of which is in excess of our operating needs. We also have seed investments of close to $400 million. And over the past 12 months, we've repurchased $470 million of stock and paid out $42 million in dividends while maintaining cash levels substantially the same as December 2010.

As I indicated on the fiscal Q2 earnings call, we do not anticipate deploying the final $150 million of our -- excuse me, $155 million of our current share repurchase authorization until fiscal 2013.

Our ending share count is now around 140 million shares, reflecting cumulative repurchases of 28.2 million shares or 17% of the shares outstanding since the board authorization in May 2010. To complement our repurchases, the board declared a quarterly cash dividend of $0.08 per share, unchanged from the prior quarter.

Thank you for your time and attention this morning, and now I'll turn it back to Mark.

Mark Raymond Fetting

Thank you, Pete. Slide 21 shows our 3 strategic drivers for value creation: first, outstanding independent investment managers; second, a continued disciplined on a corporate center that delivers strategic value, particularly in global distribution; and third, a balanced portfolio across asset classes, geographies and channels.

Slide 22 is a slide we introduced last quarter, which highlights our progress on various initiatives and performance metrics that we believe are positioning us for earnings leverage into an eventual recovery. One of the most important metrics in our opinion is the ability to generate cash even with volatile markets impacting asset and revenue levels. The chart at the top left highlights that our operating income as adjusted remains solid despite the lower average AUM this quarter. This is a strength of the affiliate model, and we remain confident that if current trends hold, including ongoing volatility, that this chart will likely hold up well.

As Pete just covered and consistent with rating agency considerations, we do not anticipate repurchasing shares until the new fiscal year commences on April 1. But we are continually evaluating capital allocation. As you can see from the chart, the vast majority of the capital deployed in fiscal year-to-date is in the form of share repurchases and to a lesser extent, dividends.

We also continue to look at seed investments in areas where we believe there is investor demand as we consider these investments to be important drivers of future organic growth. To this end, a listing of our top new products is shown in the Appendix.

Additionally, as you stay on Page 22 on the lower left, over the last 4 quarters, we've generated annualized cost savings of more than $100 million. And as Pete stated, we are realizing the full $140 million annual run rate savings this quarter.

Finally, we focused on performance and client service and out-performance in the critical 3-year time period remains strong. We were pleased that flow trends improved this quarter and are certainly working hard to build on our momentum over the longer term.

So our ongoing cash generation, completed expense reductions, solid investment performance and customer service and a balance sheet capable of returning significant capital to shareholders gives us optimism that we're in a good position to grow our earnings over time and create long-term value for shareholders. We're excited to be executing on these goals.

And with that, we'll open the line for questions, and I thank you.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question's coming from Daniel Fannon of Jefferies & Company.

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

I guess, Pete, the first question is on the guidance. Just wanted to get a handle on some of the moving parts. I understand you said performance fees are going to be lower. But with regard to the market assumptions, I -- since you last reported markets are up rather substantially and then thinking about this quarter, are you assuming further market appreciation from here or from year end?

Peter H. Nachtwey

The market appreciation we started with -- in fact, where we were at the end of last week and then just modest appreciation in the equity markets for the rest of the quarter. And on performance fees, we're currently envisioning those staying about where they were at December for the next couple of quarters. Is that helpful?

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

Okay. And there's no other -- I mean it just seems like that number should still be, it should be higher, I guess is what I'm coming back to. Is there other moving parts in there?

Peter H. Nachtwey

No. And -- if you mean on the performance fee side?

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

No, just the overall earnings number in terms of the range. At the low end is what you have said.

Peter H. Nachtwey

Correct, and that's just due again to the big drop in the markets leading up to December.

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

Okay. And then I guess, with regards to discussions you guys are having with the rating agencies and also at the board level in the context of your cash, very cognizant what you guys have done year-to-date. But looking ahead, I guess what is the kind of sticking points that the rating agencies here are kind of focused on and kind of how should we think about the fiscal year for 2013 with regards to the kind of capital deployment?

Mark Raymond Fetting

Yes, Dan, this is Mark. I think it should be clear that Legg Mason is committed to deploying capital to both grow the business and reward shareholders through buybacks and dividends when it makes sense. Our track record over the last year plus certainly speaks for itself. As Pete said, our current plan is to repurchase the additional 155 beginning in fiscal '13. That's consistent with dialogue we've had with the rating agencies when we established our initial authorization. Having said that, we will continue to review both our capital structure and our capital allocation priorities with the board on a regular basis, also review that with the rating agencies. And we would expect that to include continued buybacks as a portion of our operating cash flow going forward. So we'll kind of keep you posted as we go along, but that's the basic status.

Operator

Our next question is coming from Michael Kim of Sandler O'Neill.

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

First, focusing on Western, understanding there's going to be some lumpiness every quarter, but do you feel like you may have reached sort of an inflection point where the wins across the more specialized strategies are increasingly offsetting kind of the redemptions for the global sovereign and the Core and Core Plus mandates?

Mark Raymond Fetting

Yes, Michael. Certainly, we feel very good about kind of the continued recovery at Western. And as we've previously updated everyone, the performance improvement echoed by consultant support continues to show good results. So if you take a theme going forward and say, and I think a number of consultants have pointed out, that fixed-income globally will continue to have substantial demand, although moderated from the prior years, Western's ability to win in that is improving. And some highlights in terms of just updates that we've given in the past, they have a won, but not yet funded amount of about $1.3 billion, which is the same as the prior quarter. They continue to get gains from existing clients. That is actually up 74%, and their losses from those clients is reducing meaningfully. So kind of the net ability to grow the book off of existing clients is improving. The areas where they're getting the momentum, both from existing clients and new clients is a pretty good range of this specialized category. It's ranging from muni to high yield to emerging market to limited duration to portable alpha. These are all areas where they had positive net flows for the quarter. So we feel good about the momentum there. And obviously, if you kind of back into the month of December, that was a important milestone. As always, we're going to say a month is not a trend make, but we're encouraged across-the-board there.

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

Okay, that's helpful. And then maybe a question for Peter. Now that the streamlining process is complete, what's the outlook for margins? How much operating leverage is left in the model now that most of the expenses have been pushed down to the affiliates, if you will? So is it really just -- are margins really just a function of kind of the mix skewing towards higher fee products at this point?

Peter H. Nachtwey

Yes, Michael, that's kind of spot on. I mean we're confident at getting another 200 basis points of margin improvement here in the fourth quarter just from the reductions that we made at December 31. And then longer term, it's really a combination of what the markets will do from a mix and a flow standpoint. Last kind of normalized quarter you can look at, if you went back to June and adjusted for transition costs and savings at that point in time, I think you can get a good idea of the operating leverage that we have in the model as we go forward. We can hold corporate cost pretty tightly as we increase the volume.

Operator

Our next question is coming from Glenn Schorr of Nomura Securities.

Glenn Schorr - Nomura Securities Co. Ltd., Research Division

Just curious to get your thoughts on how your institutional clients, especially at Western, are going to think about these lower rates for longer environments. So if we have the flat rate in curve for the next 3 years, what happens to Core and Core Plus fixed-income mandates? Do you see an increasing trend toward passive things like that?

Mark Raymond Fetting

Yes, Glenn. Clearly, with the Feds announcement, a trend that has already been in place with institutional clients about adjusting for a lower rate environment will probably be strengthened. Western is well along the path of pivoting to make sure that their specialized solutions across the global client base are being deployed successfully. And so in that regard, I kind of reemphasize this broad area ranging from high yield to emerging markets to other kind of alpha-oriented strategies and really underscore one of the big themes that all of the consultants are talking about in this environment is kind of a global solution to this. And Western is really, we believe, one of the best, if not the best positioned to deliver that in terms of where their investment teams are located, their servicing teams and the client base that they serve in the markets that they invest in. So we think that's a good opportunity for us. I'll also say that the Core, Core Plus business, which Western is proud to have a leading position in, remains an important asset base. And they continue to win some business in that category. It's just at a lower rate as you would expect.

Glenn Schorr - Nomura Securities Co. Ltd., Research Division

And just curious on -- I know this is art not science, but how much of it reaches for yield a little bit into a lot of these specialized solutions versus just going the passive route? I know it's a real conundrum for the end clients.

Mark Raymond Fetting

Yes, I have said in prior calls that the passive theme continues, but it's more kind of a minority of the story, a couple of clients. This most recent quarter is an example. It was one client moved to passive to mandates about just under $1 billion of assets, whereas in prior quarters, it had been a couple of clients. So it's there. It will continue, but there still is, and I would argue in an environment where kind of achieving returns to offset the liabilities they have that they're investing against requires an opportunity for active management to deliver. And then going beyond just fixed income, this is a heck of an opportunity for our equity managers and Permal in the alternative space, and they're taking advantage of it.

Glenn Schorr - Nomura Securities Co. Ltd., Research Division

Last quickie, you mentioned some of the Permal's fixed-income funds were below their high-water mark. Can you give a little sizing on that's just so we know what we're looking at going forward?

Mark Raymond Fetting

Well, I'll start, and then Pete might want to follow up. But basically, let's just keep in mind that in that space, they get paid on absolute returns. And in the calendar year '11, their biggest capability area is fixed-income strategy and kind of any risk on fixed-income portfolio obviously delivered negative returns in the -- particularly in the latter half of '11. So while they came in negative, they still -- were above their benchmark by a couple of hundred to 300 basis points depending on the client base that you're using. We think that kind of earns back over a couple of quarters and that's the high level. Pete, anything?

Peter H. Nachtwey

Glenn, just thinking about how we can be helpful here without releasing competitive stuff, but with the level they're at today, historically, they've taken about 2 quarters to recover the high-water mark. So that's kind of what we're looking at.

Operator

Our next question's coming from Roger Freeman of Barclays Capital.

Steven M. Truong - Barclays Capital, Research Division

It's Steven Truong here for Roger. Can you comment on the M&A landscape, sort of the pace of conversations and sort of what you may be looking at? And how that currently stacks up against your capital priorities?

Mark Raymond Fetting

Yes. Well, we continue to have been focused on completing our streamlining and also continue to focus on seeking positive areas where we could fill product gaps, so we're not interested in big transformational situations. And in the near term, we're focused on kind of organic growth completing the streamlining. We do anticipate in the outyears of, let's say, '13 and '14 of filling some of those gaps, and we think there's some interesting opportunities down the road for that. We are not pursuing any of the larger transactions being contemplated now that others may be pursuing.

Steven M. Truong - Barclays Capital, Research Division

And my follow-up, if I may, Pete, can you give some color on the tax rate? You talked about a little bit in your prepared comments, but it seems like it was lower this quarter. And what should we be modeling in going forward, and how should we think about it?

Peter H. Nachtwey

Sure, Steven. And I always like to preface this with thinking about the cash side. So there's a GAAP rate. From a cash standpoint it's much lower because of our tax attributes, our NOL carryforwards and the ability to amortize our goodwill and intangibles. But in terms of the GAAP rate, this quarter was heavily impacted by the onetime charges we had in transition costs, which were basically U.S. based. So they had the significant reduction in the U.S. tax rate. On a go forward, we're continuing to guide towards something that's in the 33% to 35% range.

Operator

Our next question's coming from Jeff Hopson of Stifel, Nicolaus.

J. Jeffrey Hopson - Stifel, Nicolaus & Co., Inc., Research Division

So Permal, in terms of profitability, is falling below Royce. And my question is, is that more due to the performance fee issue or is that related, I guess, to the transition of institutional mandates versus the high net worth?

Mark Raymond Fetting

First off, it's awfully close, so while we do rank as you know, Jeff, kind of in order both Permal, Royce and ClearBridge are meaningful contributors to our profitability as you would expect behind Western. The delta is certainly driven by the performance fee piece. And here again, we think that will be restored in a couple of quarters assuming a continued relative performance continues to be strong and the absolute returns go positive.

J. Jeffrey Hopson - Stifel, Nicolaus & Co., Inc., Research Division

Okay. And then in terms of follow-up. On the expense side, Pete, as we look into March and June, besides comp and if we strip out transition costs from December, in terms of other and communication costs in some of those line items, where will we see the additional benefit from the cost reduction, I guess?

Peter H. Nachtwey

Yes, the majority of it's going to continue to come through the comp line. We reduced over 100 positions again at December. And then the other place you'll see it is in occupancy just as we've kind of written off the space that we're not going to be using going forward.

J. Jeffrey Hopson - Stifel, Nicolaus & Co., Inc., Research Division

Okay, but you gave us a 53% number. Why wouldn't that fall, I guess?

Peter H. Nachtwey

Sorry, Jeff. They had -- the big chunk of our comp, keep in mind, comes from our affiliates, which are focused on a revenue share arrangement. So whatever they don't spend, in terms of their own occupancy, tech, et cetera, goes into comp. So there's a pretty big structural piece of the comp ratio. But we do anticipate on a go-forward basis holding a corporate cost, and to a certain extent, distribution that aren't tied to sales. A big chunk of our distribution, the internal cost are commission based, but there's also a big chunk that's just salary and bonus based. So we're focused on holding headcount down in both the corporate and distribution on the administrative side.

Operator

Our next question's coming from Cynthia Mayer of Bank of America Merrill Lynch.

Cynthia Mayer - BofA Merrill Lynch, Research Division

Just a follow-up on Permal, can you give us a breakdown maybe of their assets at this point in terms of how much is still eurozone high net worth versus U.K. and Asia and institutional? And also how's the outlook in terms of the nervousness in eurozone, high net worth? And where do you think those flows will go?

Mark Raymond Fetting

So Permal's overall asset base is now over 40% institutional. And that is, as we've said in the past, from really a standing start of 0 when we first brought Permal into the family approximately 5 years ago, so that's been a very steady and successful progression. I think they were highlighted in one of the recent rankings in one of the industry journals as one of the top winners of new business in that space. I think they ranked second overall. Relative to the eurozone traditional high net worth business, Cynthia, Isaac Souede talks about kind of the new retail and the kind of legacy retail. The legacy retail, which was their traditional high net worth business through intermediaries remains on the sidelines. And that has been disappointing. They were starting to come back in pre the volatility of second half of '11, and they've actually stepped back again. The new retail, which they have really done quite a good job of, of working with kind of new distribution partners in Asia and parts of Europe is picking up some slack there. And that, plus the institutional, is what is really driving their growth going forward, there is obvious expectation that the traditional retail high net worth would come back. But you got to get less volatility, and I don't think anyone is prepared to say that's going to happen in near time. So that's the update.

Cynthia Mayer - BofA Merrill Lynch, Research Division

Okay, I guess, of that 60% that's retail, is most of that, what he would call traditional old retail?

Mark Raymond Fetting

No, no, no. It's starting to move, and going forward, maybe we can provide some color on that. We haven't really drilled down. But I would say the momentum of that 60%, there are parts of that, that are really kind of new relationship. So it's going to be less than 60% that's tied to the legacy piece.

Cynthia Mayer - BofA Merrill Lynch, Research Division

And how much of it overall is in Europe?

Mark Raymond Fetting

I'm going to say if you're not counting the Middle East and you're really looking at traditional Europe, it's certainly going to be less than 50% and probably somewhere -- I'd rather not -- we can get some color on that -- maybe at the next presentation, we can get some color on that.

Cynthia Mayer - BofA Merrill Lynch, Research Division

So in the release, you mentioned that you want to invest in organic growth. And you mentioned how you might want to fill in some things in '13 and '14. Other than that, were you referring -- can you be a little more specific -- were you referring to -- are there other ways where you can take your cash and improve organic growth?

Mark Raymond Fetting

Well, certainly working with each of the affiliates on initiatives, whether that's seed capital or potential lift-outs to kind of support specialized skill expansion would be some areas. Let's just take some of the new products that we've been working on. We have that listing in the Appendix and that's, I think, a very strong lineup of products that have been launched over the last couple of years covering both equity and fixed income across both Asia, U.S. and even Europe markets. If you look more specifically, we talked about the going effective with the new Permal product. We continue to work very well with key dealers in the closed-end space for both Brandywine and Western. And this equity income builder strategy that ClearBridge has, we are putting some real firepower behind in terms of getting it out into the retail and kind of what we call, instividual systems.

Cynthia Mayer - BofA Merrill Lynch, Research Division

Got it, okay. It sounds like you referring to seeding new products there, so...

Mark Raymond Fetting

Right.

Operator

Our next question's coming from Matthew Kelley of Morgan Stanley.

Matthew Kelley - Morgan Stanley, Research Division

Just wanted to touch base with you a little bit more on Western product demand. I know you mentioned global credit, emerging market's debt, high-yield debt and multi-sector. Just curious to get your thoughts on how big you are in those strategies and if there are any product extensions, platform extensions, et cetera, that you think can make you bigger?

Mark Raymond Fetting

Yes, well, certainly areas like global credit, multi-strat, et cetera, we're certainly one of the larger players in that space globally and command a very good market position. In emerging market and high yield, we do have a broader competitive set and would rank among the larger of the top 10 or 15, but that areas -- those areas are more diversified in terms of market position.

Matthew Kelley - Morgan Stanley, Research Division

Okay, great. A follow-up from me would be on ETFs. Your thought on -- ultimately, the ETF industry's positioning in your -- in Western's Core wheelhouse, if you will. So how big do you think it can get when and how -- when do you think you'll add additional products to get a bigger share there or to get a share there?

Mark Raymond Fetting

Yes, as you can see, we're pursuing active ETF initiatives with Western. One of our equity managers served as a sub-advisor for one as well, and we'll continue to do that. We don't see it appealing to us to kind of participate in the kind of commodity side of the business. And while a significant share of assets is going to, let's say, passive ETF as has been pointed out in some studies. I will say that to the extent we move away from a highly correlated kind of directional market and into a more -- market where active strategies prevail, I suspect some of that rapid share rise levels off as it has in the past kind of over the 30 years I've been in this business. Just watching what went on in the institutional side there were kind of periods of, advance, periods of leveling off and those would be good opportunities for us on the active site. So we're going to pursue active ETF, but we're also going to stay focused on delivering strong returns as an overall active manager.

Operator

Our next question's coming from Michael Carrier of Deutsche Bank.

Michael Carrier - Deutsche Bank AG, Research Division

First is on performance fees. When we look at this quarter, you guys mentioned some of the Permal products on the absolute level. Anything else in there in terms of weighing on that? And then probably more importantly, just when you're looking out like any other products that are kind of getting near to return levels, where we could see that start to pick up?

Mark Raymond Fetting

Well overall, Western has been a contributor of performance fees. And as you would imagine, the out-performance that both the category delivered and they delivered in '10 was strong. And in '11 market where I think, 90% of Core Plus managers didn't beat the benchmark and most of those fees are paid against benchmark, there was a bit of a decline. But still, we're getting some fees there. It's periodic, but other managers that contribute would be Brandywine, which is currently the case. Royce periodically around several of their closed-end funds that have performance fee strategies and then a couple of our other equity managers, although they have not been in the zone recently.

Michael Carrier - Deutsche Bank AG, Research Division

Okay, that's helpful. And then just looking at flows, on the equity side, the whole industry is weak. There's a few products that might be working, whether it's passive equity income. And then on the fixed income side, I think your 3-year performance looks really good, 1-year, 5-year, a bit weaker. And then you had the structural issues in terms of low rates, passive movement versus that credit. So you guys give some color in terms of demand in the past, in terms of RFP activity in some of those products versus where you're seeing outflows. And you kind of have touched on that throughout, but I just wanted to see if you had any update? I think last quarter or the quarter before, I think it was up like 75% or something. It was -- I just didn't know if you guys gave any update related to the pipeline or the flows.

Mark Raymond Fetting

Well, if you take a look at our equity business overall, over $150 billion given the multi-manager approach that we have, you really got to kind of talk almost firm-by-firm. And Royce, an important part of my commentary around where we see things today in terms of momentum, in the quarter ending 12/30, small cap was in outflows, and as therefore, so too was Royce. You can see in your mutual fund data through sources that small cap is meaningfully less in outflows January to date, so too is Royce. So that's kind of a favorable development that could continue. Just basic returns give some support to that. The Russell 2000 is up 7% year-to-date versus the S&P in 5% and the Dow at 4%. Batterymarch improvement in performance in calendar year '11 is important because the longer-term challenges are now being kind of offset with improved performance in key strategies like emerging markets. And we referenced a couple of funded -- not yet funded wins in their both emerging market and small caps space. ClearBridge, I'm kind of hitting it several times because I think it's a very important opportunity is their income-oriented strategies, equity income builder, dividend strat, alongside their aggressive growth and even they're fundamental value has shown some performance. So I think to the extent that equity investor comes back, we have a range of options that can take advantage of that, and that's what where we're going to be focused on.

Operator

Our next question's coming from Robert Lee of KBW [Operator Instructions]

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

First question is I'm just curious about the net operating loss carryforwards. My, I guess, impression would be that you're not quite at a point where you're using those yet. And if so, kind of do you have a sense of what earnings level, I guess, on a tax basis or adjusted basis you need to get to before you really start being able to tap into that benefit?

Peter H. Nachtwey

Actually, we are starting to see some of the benefit from that. We don't envision starting to fully use both the NOLs in what we refer to as our tax shield, which is the amortization of goodwill and long lived intangibles for tax that we don't amortize for GAAP. That will happen in future years. But we start envisioning kind of needing a full portion, if you will, of NOLs and that tax yield starting next fiscal year. We will be earning enough on a tax basis to -- that, that will start winding down. And as we've disclosed in the past, that's about a $1.6 billion cash benefit over the next 5 to 10 years.

Operator

Our next question's coming from Alex Blostein of Goldman Sachs.

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

Marc Irizarry, Goldman Sachs. Mark, can you talk about the momentum that you're seeing in December on fixed income? You said you're encouraged by the momentum. If you sort of peel back the parts of the gross sales versus the net redemptions or the outflows and fixed income, have you seen, would you characterize what you're seeing now as a bigger pickup in gross sales or sort of having in the redemptions?

Mark Raymond Fetting

Actually, Mark, I'm seeing both. I'm seeing kind of a pickup in the gross and a continued reduction in the redemptions. And the areas where redemptions have been most prevalent, let's say, the kind of broad market mandates, that is consistently declining. And so the net number while still negative is each and every quarter and almost each and every month becoming less and less. And that's part of this inflection point that we certainly saw in December. And here again, we're not predicting a trend yet, but we're encouraged. And certainly, January to date has been encouraging. So that's the update there.

Operator

We only have time for one more question coming from Mac Sykes of Gabelli & Company.

Macrae Sykes - Gabelli & Company, Inc.

Just given the restructuring at the U.S. distribution, are there different expectations going forward in terms of net flows there versus the entire complex?

Mark Raymond Fetting

Yes, the key theme there is under the really wonderful leadership of Joe Sullivan is the sense that we have a broader array of product. We don't -- we still have some gaps, but beyond those gaps that probably aren't going to be filled organically. We have a broader array of product across our sales force, both in the U.S. and internationally, and hence, they're out there. So the idea that we would have strong fixed income product with Western and Brandywine, a series of now alternative products through Permal. And then the equity space, the strategies that I talked about, whether that's Royce, ClearBridge, Batterymarch, et cetera, this is very encouraging now that we got to get investors back into the markets, and we've got to fight for share across a competitive set. But we're encouraged on that.

Operator

Thank you. And that concludes our question-and-answer session. I'd like to hand the floor back over to Mr. Mark Fetting for any closing remarks.

Mark Raymond Fetting

Yes, well, I want to thank everyone. I want to thank my colleagues. This is the quarter where we really have completed the streamlining in earning that full $140 million, and that enables us to pivot to growth. And in doing that, we may be, I think, properly conservative as we look through these volatile markets about where we see things. But let's be clear, where we see things right now, we're encouraged. We see that across our fixed income business, across our equity business, across our alternatives business and to the extent markets improve beyond the conservative assumptions that we've talked about, things could be even better. If not, we're prepared for that as well. So I want to thank everyone and look forward to continuing to give updates as our progress continues.

Operator

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

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