Start Time: 10:00
End Time: 11:10
OM Asset Management (NYSE:OMAM)
Q4 2015 Earnings Conference Call
February 04, 2016, 10:00 AM ET
Peter L. Bain - President and CEO
Stephen H. Belgrad - EVP and CFO
Brett Perryman - Head of IR
Craig Siegenthaler - Credit Suisse
Michael Carrier - Bank of America Merrill Lynch
Michael Kim - Sandler O'Neill Partners
Ann Dai - Keefe, Bruyette & Woods
Bill Katz - Citi
Michael Cyprys - Morgan Stanley
Ladies and gentlemen, thank you for standing by. Welcome to the OMAM Earnings Conference Call and Webcast for the Fourth Quarter and Full-Year 2015. During the call, all participants will be in a listen-only mode. After the presentation, we will conduct a question-and-answer session. [Operator Instructions]. Please note that this call is being recorded today, February 4 at 10 am Eastern Time.
I would now like to turn the meeting over to Brett Perryman, Head of Investor Relations. Please go ahead, Brett.
Good morning, and welcome to OMAM's conference call to discuss our results for the fourth quarter and full year 2015. Before we get started, I would like to note that certain comments made on this call may constitute forward-looking statements for the purposes of the Safe Harbor provision under the Private Securities Litigation Reform Act of 1995. Forward-looking statements are identified by words such as expect, anticipate, may, intend, believe, estimate, project, and other similar expressions.
Such statements involve a number of risks, uncertainties and other factors that could cause actual results to differ materially from these forward-looking statements. These factors include, but are not limited to, the factors described in OMAM's filings made with the Securities and Exchange Commission, including our Form S-1 as filed with the SEC on June 8, 2015, as amended, under the heading "Risk Factors."
Any forward-looking statements that we make on this call are based on assumptions as of today and we undertake no obligation to update these statements as a result of new information or future events. We urge you not to place undue reliance on any forward-looking statements.
During this call, we may discuss non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today's earnings press release, which is available in the Investor Relations section of our Web site, where you will also find the slides that we will use as part of our discussion this morning.
Today's call will be led by Peter Bain, our President and Chief Executive Officer; and Steve Belgrad, our Chief Financial Officer.
I will now turn the call over to Peter.
Peter L. Bain
Thank you, Brett. Good morning, everyone. Thank you for take the time with us this morning to talk about the business. We do know you are very busy. There’s a lot going on, so we appreciate it. What I’d like to do is walk you through some key drivers and observations both about the fourth quarter of 2015 as well as the full year. And then ask Steve to walk you through a little more financial detail. And then we’ll look forward, as always, to Q&A with you to have a real conversation about the business.
For the year 2015, we delivered ENI per share of $1.24 to our shareholders. That’s a little less than $0.02 down from the $1.26 that we delivered in 2014, and the fourth quarter really tells the story. In the fourth quarter, we delivered $0.30 a share and that compares to the fourth quarter prior period of $0.39. The difference in those two fourth quarters really is entirely performance fees. And so what you can see when you look at the year-over-year results is that the core earnings engine of the franchise delivered growth in 2015 even with the substantial volatility and market declines of the entire second half of the year.
On the flow front, the fourth quarter again was a challenge with about 3.2 billion of net AUM outflow in the fourth quarter aggregating 5.1 billion on the AUM front for the year. For the year, however, we did continue to generate and it reflects the positive asset mix we’ve been exhibiting over the last few quarters. We generated 18.9 million of net organic revenue growth over the year 2015, which is about 2.6% of the beginning of the year run rate management fees. That includes and reflects a $6.6 million net revenue outflow in the fourth quarter, the first quarter in the last seven where we’ve had a net revenue outflow and we’ll spend some time on this because I think it’s important to walk you through the way it played out.
At a high level, the favorable mix shift continued in the fourth quarter even with the net revenue outflow, as the weighted average fee on our inflows exceeded the weighted average fee on our outflows. But what you’ll see when we get there is we had a one quarter jump in the outflow fee basis, and that’s reflective of two principle one-time components.
One, in the fourth quarter we had a substantial sovereign wealth withdrawal and we also had higher than usual alternative hard asset disposals. And I’ll remind, this group as you know the reason that we report hard asset disposals as a distinct category is because they’re in fact a good event for the client. It means that our alternative managers Heitman in real estate and Campbell Global in timber have harvested an investment realized the value for clients and distributed those proceeds.
And on the sovereign wealth withdrawal, you can see in the detail later that in essence the sovereign wealth relationships we had in the Middle East emptied out essentially over the course of the year. And those assets were at a higher fee than the other assets that departed in that quarter, and we’ll see that in detail later.
The last piece in the outflow puzzle was continuing outflows in our U.S. equity sub-advisory category. Our AUM ended the year at 212.4 billion, which is up 1.8% quarter-over-quarter and down 3.8% for the entire year. Looking forward, our long-term investment performance remains strong and at December 31, 60%, 83% and 92% respectively of our revenues were being generated by client relationships, outperforming benchmarks on one, three and five-year basis.
And then the last piece for the highlights would be our view on capital deployment and capital management. We continue meeting with potential acquisition candidates and that program carries on. That pipeline continues to progress. But reflecting our view of where the stock is trading and the way the overall industry has essentially rerated down in the quarter, we thought it was appropriate to ask our Board to authorize us to be able to participate in a stock buyback program. And because of our UK domicile that authorization will require shareholder approval, which we’ll seek but we have included that in this quarter’s actions by us.
Moving into the deck, if you take a look at Slide 4, this is just a reminder of the overall business model and how it supports a four-prong growth strategy and we’ll walk through each of these components starting first with the core affiliate performance, where the business stands, how the investment performance was generated. And then moving through the role that our growth initiatives with the affiliates together with global distribution have played in adding value to the franchise.
And that core affiliate piece starts on Slide 5. There you can see on the top left the annual AUM progression starting at January 1 of 2015 with just under 221 billion of AUM and how over the course of the year the net flow and then the market decline brought us to the 212.4 billion AUM that we had at year-end 2015. The bottom left shows that fourth quarter where we regained through the market recovery some AUM, the 208 billion that you saw at 9/30 ending the year at 212 billion.
And on the right side, a breakdown of the AUM and diversification in the franchise both by affiliates as well as asset class. And again our diversification across asset classes as between U.S. equity, alternatives, real estate, timber, global equity, emerging markets and international continues to be very strong.
Slide 6 gives us a little bit more of a look into the flow data we were talking about earlier. Here on the left side of the page, you can see that AUM flow number, the 3.2 billion in the fourth quarter and how that translated on the right side of the page into the 6.6 million of net revenue outflow in that quarter.
What I’ll point to you here to try and give you a little more specifics on the asset mix that we discussed earlier, if you go to the bottom of the right-hand graph to the line items and you see the basis points inflow line item. And if you carry that across to the four quarters of 2015, you can see that the basis points on our inflows remained fairly steady in the mid-40s to a little bit more than mid-40s basis points.
But when you go down one line to the basis points on our outflows, there you can see that anomaly in the fourth quarter caused by the sovereign wealth withdrawal and the hard asset disposal where the basis points on outflows went from the very low 30s in the first three quarters of the year to 37 basis points in that fourth quarter. And it’s really that jump to the 37 basis points on those one-time outflows that triggered the flip into negative organic revenue flow.
And that, if you go to Slide 7, gives us a look at that in even more detail. Because if you look on the left side, you can see in the AUM net flow that the global and non-U.S. equity category flipped from 1.3 billion net positive in the third quarter to 600 million net outflow in the fourth. And likewise when you parallel that into the fee basis of those asset classes and go to the right-hand graph, which is the revenue impact, you can see that in the third quarter our global and non-U.S. equity asset class generated 5.6 million of net revenue inflow and the flip in the fourth quarter was to a 1.1 million net revenue outflow on that global non-U.S. equity asset class. If you look at that net delta quarter-over-quarter, it equates to a $6.7 million net revenue delta in that asset class, which is in fact therefore the impact on the overall franchise because it’s a 6.6 million number for the company.
Page 8 gives us a better feel for the core affiliate investment performance delivered and we remain in strong shape there. In addition to the revenue-weighted performance that we talked about earlier where 60%, 83% and 92% of revenues are coming from assets beating benchmark, we also track our number of at-scale strategies, which are strategies that have more than 1 million under management in them. And then what percentage of those strategies are beating benchmarks. And there on one, three and five-year it’s 72%, 83% and 88% beating benchmark. And on the AUM basis, on the right, that kind of industry standard one, on one, three and five-year basis we’re in good shape at 72%, 73% and 91% of our AUM beating their benchmarks.
When you shift to Slide 9 and start thinking through the strategy in place about providing value from the center to the affiliates and to the overall franchise, this is a page that we thought on an annual basis can help you get a feel for the overall initiatives that are very long-term in nature and therefore we do this so far annually rather than quarterly. And the three graphs on this page give you a feel for the contribution from the center and our strategy to the growth of the business.
The far left one is an analysis with respect to the strategies that we have seeded using our balance sheet seed capital pool, what sales were generated in 2015 into those seeded products and that’s $3.8 billion of sales for the year. And then that middle graph is the growth capital tracking of what assets were raised into strategies that were a result of our investing growth capital, creating lift-outs or funding on a co-investment basis the affiliates efforts. That’s another 1.4 billion of sales.
And then on the right side of this graph you can see the global distribution initiative. And as we carry on into 2015, global distribution raised another $1.4 billion for the benefit of our affiliates. When you take those three pieces and then put them into the framework of the overall franchise, that’s what we try and give you a feel for on Page 10.
What we’re showing here over the years is of the overall gross sales franchise-wide, what percentage of those are coming from efforts as a result of the strategy that we put in place at the center. And here in 2015 in a genuinely challenging year, you can see that our strategic initiative actually contributed a quarter of the entire gross sales of the system. So I think we’re very comfortable with the initiatives we put in place, the strategies that we built on, on the foundation of our profit sharing model with real minority equity of the affiliates and the way those strategic initiatives coupled with the operating model to continue to generate meaningful inflow and value for the system overall.
And then the last page I’ll spend time on with you this morning before handing it off to Steve is Slide 11, which is again designed to give you a sense of the diversification that we’re going to continue to try and build into the business model. And here what we’re taking a look at is the top five selling strategies in the system. And in 2015, the top five selling strategies came from four different affiliates. And so we’re very pleased again with the ongoing diversification of the model we’re building.
And then if you slice those data in another way, those top five selling products only represent 40% of the sales in the system last year. And I think if you look at the industry generally and look at any particular managers, top five selling strategies in a year, they’re going to represent a reasonably substantially higher percentage of gross sales for the systems than that.
So I think from our perspective, the core engine in a very challenging year delivered growth and delivered meaningful returns. The alpha generation of our affiliates continued to be strong and the contributions from the center of the strategy continued to be material.
With that, I’ll turn it over to Steve so that he can walk through in a little more detail with you some financial results, and then we’ll look forward to Q&A.
Stephen H. Belgrad
Great. Thanks, Peter, and good morning. The fourth quarter of 2015 was a challenging one for the industry and OMAM faced many of the same headwinds as our peers in terms of flows and markets. While the headline ENI results for the quarter show a decline from the fourth quarter of last year, this was primarily a result of lower performance fees, which by their nature can be volatile from year-to-year.
Looking beyond this element of revenue, the core profitability of the business remains solid. In the fourth quarter, we saw a number of positive financial trends in the business including continued increases in fee rates, the benefits of a variable cost structure and performance in line with the key metrics we guided to on previous calls.
The first month of 2016 has brought its own challenges and I’ll give more detail regarding our expectations for 2016 shortly. But we’re clearly benefitted by our profit sharing operating model. In periods of declining markets and margin, the OMAM shareholder impact is cushioned by lower formulaic bonuses and distributions at the affiliates. These are key elements of our economic model.
Comparing fourth quarter of '15 to fourth quarter of '14, economic net income was down 22% quarter-over-quarter at 36.5 million or $0.30 per share driven by a $23 million decline in performance fees from an excellent 2014 to a weaker 2015 given volatile markets. Core profit was stable, excluding performance fees.
While market declines and outflows resulted in a 3% decline in average assets from the year-ago quarter, excluding equity accounted affiliates, our continued shift in asset mix towards higher fee products enabled us to grow management fee revenue by 3% during this period. Combined, operating expenses in variable comp fell by 2.5% year-over-year driven by lower G&A and variable compensation.
However, this was not enough to offset the 9.5% overall revenue decline caused by the decline in performance fees. As a result, the ENI operating margin declined from 40.8% in Q4 '14 to 36.2% in Q4 '15. Excluding the impact of performance fees in both periods, the core margins were steady at 35%.
In line with earnings, our adjusted EBITDA fell 22% at 51.5 million for the fourth quarter of '15 compared to Q4 '14. But in spite of the lower fourth quarter 2015 performance fees, the business was able to keep full year 2015 earnings essentially even, down 1.1% to 149.7 million and full year EBITDA was up 1% to 212.7 million.
All annual data discussed in this presentation excludes the impact of our extraordinary performance fee in the second quarter of 2015, which added 11.4 million net of taxes to our income.
Slide 13 gives a better perspective of our financial trends over the last five quarters, as average assets peaked in the second quarter and then declined primarily due to market movements. For each period, we showed the core earnings power of the business by breaking out the impact of performance fees.
While average assets, including equity accounted affiliates, declined 2% during the period from Q4 '14 to Q4 '15, the increase in fee rates from 32.9 basis points to 34.7 basis points offset this trend, as revenue excluding performance fees rose 3% during this period. Overall, comparing Q4 '14 to Q4 '15 before performance fees, we see that margin and pre-tax ENI have both been consistent period-over-period.
Slide 14 lays out the same metrics over the period from 2011 to 2015 and gives a longer-term perspective of the meaningful growth generated by the franchise. We’ve again isolated the impact of performance fees. The 2011 to 2015 CAGR is noted above the relevant metrics and we’ve also indicated the change between 2014 and 2015 on a full year basis. During the five-year period, ENI revenue increased 11% annually on average while pre-tax ENI had a 13% CAGR and margin increased from 32% to 37%.
Comparing full year '14 to full year '15, revenue was up 4% including performance fees and 8% excluding them leading to unchanged pre-tax ENI overall and up 6% excluding performance fees. Margin was down about 2% to 37% on a total basis and down 35 basis points to 36% excluding performance fees.
2015 results include approximately $10 million of public company-related expenses compared to only 2.4 million for the one quarter we were public in 2014, more than accounting for the change in non-performance fee margin.
Slide 15 provides the ENI P&L for the three and twelve months ended December 31, 2015 and 2014. The numbered circles to the left highlight profit drivers, which we’ll cover in more detail in subsequent slides. In this analysis, you can clearly see the impact of the fourth quarter 2014 performance fees relative to 2015.
While management fees and other income from our equity accounted affiliates were both up for the three months and twelve months period, a decline in performance fees of 78% and 60% respectively had a significant impact on bottom line results. I’ll discuss the drivers of the performance fee decline in more detail on Page 17.
Our 26% tax rate benefitted by our UK domicile and intercompany interest was lower than the 27% we were expecting. In a low growth or flat earnings environment, like 2015, the fixed dollar amount of our tax benefit acts as a cushion on earnings volatility through a reduced effective tax rate. Depending on actual results in 2016, I’d expect the tax rate to be in the 25% to 26% range this year.
Slide 16 provides insight into the drivers of management fee growth. 2015 saw a continuation of the positive trend of higher fee assets driving an advantageous mix shift and overall higher fee rates. On a combined basis, our average fee rate increased one basis point to 34.3 basis points in 2015 from 33.3 basis points in 2014.
In the left box, you can see average assets for 2014 and 2015 again split out by our four key asset classes. The box on the right provides the gross management fee revenue generated by these asset classes. On an overall basis, average assets were up 5% year-over-year and gross management fees including equity accounted affiliates were up 8% year-over-year.
As you’ll recall, our different asset classes have very different fee rates. Global non-U.S. equities and alternatives have average management fee rates of 42 to 44 basis points while U.S. equities and fixed income have average management fee rates of 21 to 25 basis points. In 2015, the average fee rate on U.S. equity increased by one basis point as outflows occurred in the lowest fee mandate and alternatives increased by 2 basis points as flows went into higher fee real estate and other alternative assets.
During this period, the combined share of higher fee global non-U.S. and alternatives went up by 3% to 56% of our average assets while the mix of U.S. equity decreased approximately 3% to 37%. This shift was primarily driven by flows. Alternatives and global non-U.S. were the key driver of management fee growth as an average AUM increased to 12% and 9% respectively year-over-year drove management fee increases of 16% and 9% directly in these categories. Management fees and U.S. equities also increased.
The average asset in gross fees in these bar charts represent all assets managed by our affiliates including the equity accounted affiliates Heitman and ICM. To tie back to ENI revenue, you need to subtract the average assets and management fees associated with the equity-accounted affiliates, which we’ve done below each bar.
Slide 17 provides additional detail around performance fees on both an annual and quarterly basis. The number at the top of each bar represents gross performance fees earned by our consolidated affiliates. The number in dark green, net performance fee, represents the performance fee contribution to pre-tax ENI after the affiliate share is taken out through variable compensation and distribution.
Overall, four of our five consolidated affiliates generated performance fees in 2015. The magnitude of these fees vary by firm and by product and was very diversified. While OMAM is not typically a performance fee driven business, since 2012 normal performance fees have never represented more than 5.5% of our annual fee revenue. These fees were clearly an important element in the change in fourth quarter and full year revenue and profit in 2015.
The 22.7 million fourth quarter decline in fees from 29 million to 6.3 million more than accounted for our $17.5 million decline in revenue and 10 million decline in profit in this period. Likewise, for the full year, the 20.6 million difference in performance fees was a 3% hit to our revenue growth and over a 5% hit to our profit growth. The significant difference in fees between these two years says as much about the strong fees and unusual timing in 2014 as it does about 2015.
While it’s fairly typical for performance fees to be concentrated in the fourth quarter, this trend was particularly notable in 2014. In 2013 and '15, 40% and 46% of performance fees respectively were in the fourth quarter while in 2014, 85% were in Q4 exaggerating the quarterly variance in 2015.
As you can see in the chart on the lower left, which provides performance fees from 2011 through 2015, 2014 was an exceptional year, up 90% from the prior year while 2015 was more similar to 2013. Clearly, it’s too early to predict performance fees for 2016 given where we are in the year, but we’ll certainly keep you updated on significant developments as the year progresses.
Slide 18 provides perspective regarding ENI operating expenses for the three months and years ended December 31, '15 and 2014 and breaks up several of our key expense items. Our operating expenses tend to have a seasonal component with the fourth quarter typically the highest quarter due to payroll taxes associated and accrued with year-end bonuses.
On a full year basis, our ratio of operating expenses to management fees, the operating expense ratio was 38.5% in 2015 in line with our expectations and guidance of approximately 38%. Total ENI operating expenses grew by 2% between Q4 '14 and Q4 '15 while the core level of expenses before sales-based compensation and public company costs notated by the subtotal line grew at a slightly higher rate of approximately 3%.
Looking at the subtotal line, you can see that the ratio of core operating expenses to management fees stayed constant at 37% in the comparative quarters of 2014 and 2015. Likewise, on an annual basis, while core operating expenses grew 8% year-over-year, the ratio of core expense to management fees stayed constant at 34%. The ratio of total operating expense to management fees declined slightly from 41.6% to 41% from Q4 '14 to Q4 '15 primarily as a result of a decline in public company operating expenses to 1.6 million from 2.2 million in the quarter we went public.
Sales-based compensation, which had been growing faster than management fees, has leveled off as a result of lower gross sales and AUM. We would expect the growth of sales-based compensation to generally track the growth of revenue associated with our gross sales. I’ll give further perspective on our 2016 expense expectations at the end of this presentation.
The next key driver of profitability is variable compensation shown in more detail on Slide 19. The table at the bottom of this slide divides total variable compensation into its two components, cash variable comp and equity amortization. As you can see, cash variable comp decreased 14% quarter-over-quarter and 1% year-over-year.
We’ve also calculated the ratio of total variable compensation to earnings before variable compensation, which we refer to as the variable compensation ratio. This ratio moved from 37.9% in Q4 '14 to 41% in Q4 '15. The latter represents a more normal variable compensation ratio with the prior year quarter depressed due to the large performance fees that occurred in Q4 '14.
For full year 2015, the variable compensation ratio of 41.6% was in line with expectations and guidance, which was in the range of 41% to 42%. For 2016, assuming stabilization and growth of the equity markets from here, I’d expect the variable compensation ratio to be in the range of 42% to 43%.
Affiliate key employee distributions for the three months and years ended December 31, '15 and 2014 are shown on Slide 20. Distributions represents a share of affiliate process owned by the affiliate’s key employees. Between Q4 '14 and Q4 '15, distributions fell 4% from 11.4 million to 10.9 million while earnings after variable comp were down 20% quarter-over-quarter.
The higher reduction in earnings relative to distribution resulted in an increase in the distribution ratio or affiliate key employee distributions as a percent of earnings after variable comp from 15.1% to 18%. Both of these ratios are anomalies. Once again the large performance fee in Q4 2014 skews the distribution ratio lower than normal in that period, and the mix of affiliate profits and performance fees relative to employee ownership in Q4 '15 caused this ratio to be higher than normal.
On a full year basis, distributions actually fell 3% in part due to the repurchase of equity from an affiliate in the fourth quarter of 2014, while earnings after variable comp was flat. The 2015 distribution ratio of 15.9% was slightly lower than 2014 and in line with our full year expectation of 16%. We would expect the same range to carry over into full year 2016.
Turning now to the balance sheet and capital on Slide 21. We said previously that we believe our balance sheet provides multiple opportunities to increase shareholder value. One of these opportunities is through the implementation of a share repurchase program. Given our low level of financial leverage of 0.4 times debt to EBITDA combined with a sector-wide fall in asset manager share valuation, we believe that it may be beneficial to shareholders and accretive to EPS to repurchase our shares. At the same time, we’re conscious of the already low levels of flows and liquidity in our shares.
For now, our Board has authorized a $150 million repurchase program, which represents about 10% of our outstanding shares at current price levels and between 25% and 30% of our flows. Due to our UK domicile and New York Stock Exchange listing, we’ll need to get a shareholder vote to confirm the repurchase program. We intend to seek this vote no later than our annual meeting on April 29 and possibly before.
In addition to the repurchase program, we continue to have the financial flexibility to execute on our acquisition growth strategy. As Peter mentioned, we remain in the market for new affiliates that meet our investment criteria. With only 90 million drawn on our $350 million credit facility, significant ongoing cash generation and a 25% dividend payout, access to financing is not a meaningful constraint to executing both acquisition and a share repurchase program. On March 31, we’ll pay our quarterly dividend of $0.08 per share to shareholders of record on March 18. This dividend rate reflects our standard 25% payout ratio.
Looking ahead to 2016, I wanted to get some perspective on the market’s impact on AUM as of the end of January and on the variability of our cost structure. Clearly, January was a difficult start to what was already positioned as a challenging year for the asset management industry. Like many of our peers, as a result of the market volatility in the second half of 2015, OMAM’s 2015 year-end AUM of 212.4 billion was 3.8% below 2015 average AUM of 221 billion, positioning us for flat to low gross management fees.
Then came January. On the left side of the page, we have provided a rough perspective of the January market impact on our AUM based solely on the major benchmarks in our asset categories. Based on these indices, we would expect total assets including equity accounted affiliates to be down about 4.5% for the month with market movement, excluding any alpha generation or flows.
In light of the recent market volatility, we’ve received a number of inquiries around the variability of our cost structure. In this environment, I really appreciate the benefits of our profit share model. Not only do our affiliates have aligned incentives to actively manage discretionary expenses but our operating structure automatically adjust variable comp and distribution that changes in profitability.
In the lower right box, we’ve provided a theoretical example of the impact of an immediate 10% change in equity markets on 2016 base projections. Given there are approximately 75% equity mix, a 10% equity decline would reduce management fee, performance fee and other revenue by about 8%. In this scenario, the self-adjustment mechanism of direct asset-based expenses, variable comp and distributions would lower cost by about 6% resulting in a net profit decline of approximately 12%, assuming other factors are unchanged.
Of course, additional actions to lower expenses further but we’re hesitant to harm the median-term growth of the business by slowing or eliminating multiyear strategic investment initiatives. Aggressive action would certainly be considered if the markets deteriorated more significantly or the economy slows substantially. But for now, we believe the right course of action is to reduce discretionary costs where we can while absorbing modest short-term margin compression, which will be recovered in future years.
With this in mind, I’d expect our operating expenses to be in the range of 40% to 42% of management fees in 2016 before gaining scale in a more normal operating environment. Our objective, as always, is to create value for shareholders by positioning the franchise for continued growth.
Now I’d like to turn the call back to the operator and Pete and I are happy to answer any questions you may have.
[Operator Instructions]. Your first question comes from the line of Craig Siegenthaler from Credit Suisse. Your line is now open.
Thanks, guys. Good morning.
Peter L. Bain
Stephen H. Belgrad
So I want to circle back on the buyback. So your liquidity, as you mentioned, is a lot lower than some other asset manager stock, so I just want to hear you perspective on how you really plan to manage liquidity while also reducing the float at the same time?
Peter L. Bain
Yes. Look, it’s exactly the right issue to hone in on, Craig, and it’s something that we’ve had probably the most important analysis and debate on internally. I think you’re right. There’s lots of conversation in a market like this about buybacks and I think what you’ve seen is a number of other public firms talk about their buyback activity. All of those other firms are fully distributed businesses. And so we’re uniquely positioned. We recognize that we’re only about 35% publicly distributed. We have been cognizant of that float question. I think there’s no doubt in our views that increasing the float as a business proposition is a very wise thing to do. So what we’ve got to balance against that is our view as to capital deployment and our view as to the way the industry has traded down and rerated down. And at a certain point, we just look at a stock price and say, there’s so much potential accretion that we can create for our shareholders by engaging in that activity that we’re going to do it and we’ll balance that against the float. And I think given where the industry is traded and given where our stock is, we certainly wanted to be in a position to be able to act on it. And really that’s really all we’ve done is to get the Board to authorize us to do it. We’ll get the shareholders because of our UK domicile to approve it. And it just gives us the flexibility to do it. The other reality is we are so again deleveraged as a firm that we have the cash capacity to do that as well as undertake M&A. So, it’s one of those very interesting time periods for us as a firm. We are pretty unique. We’re going into a challenging market with great liquidity, great cash resources and yet we’ve got this public float issue that we want to be very careful and sensitive too. And then that’s how we’re going to look at the buyback and that’s how we’re going to evaluate whether to go into the market.
And then Peter, just as my follow up, does this in any way give a signal in terms of the M&A environment today? Obviously, risky asset prices are down, maybe smart sellers aren’t as well to sell today as they were six, nine months ago. And also, can you refocus the buyback away from the float towards potential old mutual PLC distributions in the future?
Peter L. Bain
Yes. You got two in there, Craig, and I got to separate them because they’re different. Let me do the M&A one first. I want to be really, really clear on this one. The buyback is an entirely different strategic question from M&A and we have the liquidity and cash to do both. So, one has effectively no impact on the other and they’re just both good capital deployment, value creation alternatives. And then in the M&A segment specifically, it really is a function of which segment you’re looking at. I mean you’re quite right. If you’re talking about traditional long-only managers and they’re very good businesses and they’re generating outflow, but their AUM base is simply down because of macro market levels, they’re the ones who might want to say, let’s take a pause because we have a strong belief that in six to nine months we’re going to be in a different position, and that makes sense. But there’s a whole world or alternative managers out there with very interesting non-core related strategies who are delivering value, who are interested in exploring strategic opportunities and aren’t really negatively impacted in the same way that traditional long-only equity managers are. And I think we’ve discussed in the past when we’ve identified asset classes that would be strategic for us in M&A, there are a number of them that are alternative classes. And those are the ones where we’re focusing our conversations currently and those are the right places for us to be. On the last piece, which was the PLC question, to enable us as a regulatory and governance matter to engage in a bilateral repurchase of equity from PLC, that likewise under the legal regime would require shareholder approval and that’s something that we would certainly consider. We’re in discussions with PLC and our Board about that. And certainly it’s something that we would be very sensitive to our public shareholders about and more than likely would want to have some conversations with them about it as well. But that certainly is an avenue that you want to have a conversation with PLC about.
Stephen H. Belgrad
And just to clarify, the shareholder vote on a PLC directed buyback would have to be for shareholders, excluding PLC.
Peter L. Bain
We’d have to secure approval of a majority of non-PLC shareholders for that component of it, that’s right.
Got it. Thanks, guys.
Peter L. Bain
Your next question comes from the line of Michael Carrier from Bank of America Merrill Lynch. Your line is now open.
All right. Thanks, guys.
Peter L. Bain
Hi. Pete, just on the organic growth outlook, it looks like from a performance standpoint the affiliates are holding up well despite the volatility. You still have the product areas that are in demand. So, any sense – I know there is some lumpy items this quarter but when you think about the outlook where the investor demand is coming in, what you have to offer? How you kind of see that outlook? I know the volatility makes it a little bit tougher.
Peter L. Bain
The volatility does make it tougher. In the conversations that we’re having with our affiliates as well as our global distribution folks who are out in the markets outside the U.S., here’s I think what we’re hearing and experiencing. The volatility does not seem to be resulting in institutional investors making decisions to exit the equity markets and go to cash, but what is being looked at and therefore may create a tiny bit of pause, which I think is benign is whether there’s going to be a rotation among equity classes. And if that is what happens, I think we’re in reasonable shape because we are in a well diversified set of equity classes across the spectrum and we have deliverable alpha in those classes. So in fact the institutional world goes into a rotational phase, because of the volatility, I think we feel okay about that.
Okay, that’s good. And then Steve you gave a lot of the guidance on some of the ratios in the expenses. I guess just on the operating expenses, when you think about this environment and the update for January, that’s just helpful, but when you think about the areas that you can pull back if you do get into a more challenging environment, do you have much flexibility there? I know the model isn’t as sensitive as maybe the more traditional model but just in terms of what you do have some variable cost levers?
Stephen H. Belgrad
Look, Mike, we’ve already begun to – it’s been clear towards the end of the year and in the beginning of this year that it was going to be a more challenging environment. And as we’ve managed the center and had discussions with affiliates, we’ve been focused on things anywhere from my normal cost of living increases, the base salaries. We’ve been very, very tight on that at the center in terms of trying to pull back from things like that that are in a way discretionary that you do when you know the environment’s going to be tough. And looking at things like G&A expenses that are discretionary. I think the good news about the model is that the affiliates have the same incentive to be managing their businesses and looking at their operating costs. And there are a lot of things that we were looking at from an expense point of view in the budget when we went through that process that you can look at and try to figure out, look, can you delay it for six months or a year and there are other things like our strategic initiative that we – they’re sort of multiyear investments that you can’t just say, well, the team has started but let’s not pay them for six months or something. So we’re continuing to invest for the long term while looking at where there are discretionary ways to defer things like cost of living or defer things that we may be able to spend money six months out or next year once the environment is more clear.
Okay. Thanks a lot.
Peter L. Bain
Your next question comes from the line of Michael Kim with Sandler O'Neill. Your line is open.
Hi, guys. Good morning. First, just a follow up on the share repurchase authorization. I know you mentioned the vote potentially at the end of April but assuming you get the approval, just curious how we should be thinking about buybacks in terms of your approach and timelines, if you will.
Peter L. Bain
That’s work that we and the Board are engaged in, in real time and this answer may sound simplistic but I think it’s true. There’s not a lot of rocket science. We look very hard at where the stock is priced. And we’ve got an IRR analysis of the deployment of capital. And we would take a hard look at that time where the stock is trading, what options we have to deploy capital to create value for shareholders and where the buyback sorts itself out in terms of that IRR relative return. And if we conclude that it’s a compelling IRR for our shareholders, we’ll take a look at the average daily volume, we’ll take a look at how much we can buy back, we’ll take a look at where PLC is on the issue and then we’ll execute it accordingly. It’s very straightforward stuff. That’s the interesting thing about buyback. You’re not evaluating the culture of an acquisition candidate, you’re not engaging in a lot of subjective analysis. It’s very much a function of where’s the stock trading and what alternative deployment returns can you generate with your capital and that’s exactly how we’ll look at it.
Okay, that’s helpful. And then in terms of deals, I guess there’s been some questions around PLC. So just wondering how much input they have, if any, as it relates to potential transactions because I understand they want to maximize the value of their ownership stake but they might also have their own capital or accounting issues, if you will, to focus on. And then, does that dynamic change assuming they go below a certain ownership position?
Peter L. Bain
Yes, all right, a couple of things there. One, the capital issue related to PLC was simply a function of their having to work through the new Solvency II regulatory regime in the UK and that was just work that needed to be completed. That work is completed. And based on our discussions with them and our M&A program, we do not see any capital constraint associated with Solvency II or capital ratios that would impact what we proposed to do on the M&A front. And on the financing front, we’re still financing and so therefore there’s no cash issue. So we don’t have a concern there. PLC understands our strategy, is engaged in conversation with us about it and supports it. There’s a shareholders’ agreement that was a part of the registration statement and without getting too technical, the framework we operate in is to the extent there’s an acquisition transaction the purchase price of which is in excess of 100 million. Then PLC will need to approve it and we’re obviously in governance framework with them that is designed to get that managed correctly and appropriately. So I think that’s really the framework that we’re in on that front and it’s pretty benign.
Got it, okay. And then just one last --
Peter L. Bain
You had one more thing, Mike, I apologize, let me finish that, which is as a regulatory and accounting matter, when PLC ownership goes below 50%, then the impact of the intangibles that are generated by an asset management acquisition on PLC’s Solvency II ratios is meaningfully reduced. That’s the one trigger. So there is a relevance to how much they own and it is relatively more benign for them in terms of the accounting and regulatory capital impact on their Solvency II ratio if they own less than 50% of us.
Got it, okay. And then just one last quick one. I know you highlighted this earlier but just to be clear, as we look at sort of the AUM from clients in the Middle East being down from I think 1.7 billion at the end of the third quarter to like 300 million at the end of the fourth quarter, is that sort of a good indication in terms of both the size of the related redemptions in the fourth quarter as well as kind of the level of assets at risk going forward?
Peter L. Bain
That’s exactly what it is, Michael, yes. And in fact what I would point out for the group is I’d go back even further. If you look at where we started 2014 in the Middle East, it was 4.1 billion. So we have now in 2015 endured a 4.1 billion number that went to 300 million. So I think our view is for better or worse, that downside has gone.
Got it, okay. Thanks for taking my questions.
Peter L. Bain
Your next question comes from the line of Robert Lee with KBW. Your line is now open.
Hi. Good morning. This is Ann Dai standing in for Rob.
Peter L. Bain
You did not sound like Rob.
Yes, I don’t look like Rob either. So, good morning all. I just wanted to zoom in quickly on the sales that you’re generating through your strategic initiatives. I’m just wondering if you could give us – you’ve lifted them down but if you could give us an update on where each of them stand in terms of the stage. So are there relatively done? Do you feel like there’s more work to do on some of them? And then looking forward, where do you feel like there are some gaps that you could maybe invest in and drive some additional sales?
Peter L. Bain
Okay, that’s fair. On the products that are included in the seed capital graph, I would say that those products are now in the market because the track record is seasoned and due to saleable and therefore it’s not as if those products are, if you will, finished at all. In fact, they are simply active products in the market that can continue to grow and we would hope they would continue to grow. So that’s a good positioning for that. In the growth initiatives in the middle, some are still in our view seasoning their records and therefore we think there is more potential for acceleration of sales in that segment as they mature, because some of those are relatively newer initiatives. And then on the global distribution side, I think our challenge there is to make sure we continue to bring good product that is in the demand for the kind of sophisticated non-U.S. investors and sub-advisory platforms that global distribution calls on to position them well. Interestingly, there’s a statistic that I think is useful in evaluating the global distribution framework, which is – and to get a feel for the size of relationships that group are working with. You see a big difference in the AUM brought in 2014 versus 2015 but from my perspective, interestingly, in 2015 the AUM came in, in nine new relationships; 1.4 billion in 2015 came in, in eight new relationships. And what can happen in that market is you can bring in a new relationship that will have a substantial initial funding in that market. You can also bring in an important relationship that will have a relatively modest initial funding that can grow. And so in terms of activity and performance of global distribution, we’re very comfortable that 2015 was a productive year and continue to make progress, and frankly it also highlights what 2013 and 2014 were in terms of real successes. So that’s how I look at those three components.
I appreciate the color and thank you.
Peter L. Bain
Your next question comes from Bill Katz with Citi. Your line is now open.
Good afternoon, everyone. Thanks for taking my questions. Just, Pete, you mentioned that you could see some potential rotation. I’m sort of curious what asset classes do you think would be vulnerable, what subcategories do you think will be vulnerable versus what might grow? And how might that impact your revenue capture trends?
Peter L. Bain
I think that if I think through the rotation and this was really based on the conversations I’ve been having with our distribution people as well as the affiliates, I think that there are clients looking very hard at global equity and trying to make some sense out of, is now the time given the uncertainty in the overall world framework and frankly what is the potential decoupling of major regions, do you want to see some rotation out of global and into more specific equity classes. So that’s one I would keep an eye on. The other one, which is sort of a flipside of that, interestingly enough, is I’ve talked to a number of people who are engaged in conversations with institutional investors who are really looking at emerging markets for an entry point. And I think that that’s kind of a bifurcated framework where some – the issue they’re wrestling through and doing analysis on is, is it still the proverbial falling knife or is it now in fact the entry point because it’s been oversold. So I’d say of all the asset classes to think about in terms of general rotational trends, I think that global is one you keep an eye on, on the potential rotation out and the emerging markets is a potential rotation in for what that’s worth.
That’s helpful. And so as a framework – your presentation is by the way best in class and really very helpful. When you talk about your pipeline and obviously you’ve explained away some of the sovereign wealth exposure here that’s sort of dumb down your organic growth rate. When I look at your pipeline from here, how does it look qualitatively or quantitatively versus maybe a year ago or six months ago, just want to try and get a sense of how the volatility may have hurt or helped the overall lead indicator for growth?
Peter L. Bain
Yes, it’s a good question because my answer is different depending upon is it a year ago or six months ago and that’s what interesting, Bill. This is a dynamic market. Sometimes you’re in a long, long-term trend; other times you’re in transition period. I think this is a market that’s in transition. I would tell you that the pipeline today relative to a year ago is probably a little more conservatively positioned. There’s a little more caution and concern, because I think January of '15 we had a really good looking pipeline and you had a very strong first six months. But I think if you asked us what the pipeline looks like today relatively to four or five months ago, I would tell you I think we feel good about the pipeline today, because I think we have some clarity at least in our view of where we think we can provide real value to clients in the market and are in real conversations with them about that. So that’s how I kind of parse that out.
Okay. And then just a last one, it’s sort of a two-part question, so intrigued [ph] with your IRR calculation, which makes a lot of sense. How do you think about the IRR, is it the same IRR between a deal and buyback because I’m wondering if you’re willing to share what your cost to capital is? And then separately, can you give us an update on what kind of alternative managers you’re looking at these days?
Stephen H. Belgrad
Yes. On the IRR, theoretically at least, the way we’ve thought about it is we’re repurchasing our own shares. And so we look at it at the entry point that we’re buying in. The dividends over, say, a five-year period and then what theoretically the exit would be at various P multiples, growth rates of earnings, that sort of thing and look at what kind of IRR we have. I mean in general, one might think of our pure rock bottom sort of cost to capital at probably about 8% to 9%. If we’re looking at M&A transactions, realistically it clearly has to be about 15%. We would sort of stay in the 15% to 20% what we’re looking at in M&A transactions and that’s sort of the hurdle that we think about when we’re looking at stock buybacks as well. Likewise from an EPS accretion, we’re again looking at, okay, for a $100 million of acquisitions what would be the accretion to EPS be. And then likewise at a certain level of stock buyback, what kind of accretion would you get for the same amount of proceeds buying at different prices. And you can pretty easily come to a breakeven of okay above a certain level, M&A is probably – provides better accretion and below a certain level, buyback is more accretion. And so that’s sort of the way we think about it. That’s not to say it’s sort of an ironclad rule but those are sort of the theoretical ways that we’re coming about trying to think about, okay, in the market on a buyback basis and at what prices might you slow down or pull back a little bit.
Peter L. Bain
And on the M&A question, Bill, on the alternative asset classes, I think what we’ve said in the past and this continues to hold true, which is good, is in the alternative space we find alternative credit interesting. And that is a pretty interesting class. It can encompass a number of core skills in terms of distress debt or high yield debt or actually direct lending origination in various markets; middle market, mezzanine, various places in the capital stack. So that alternative credit space continues to be interesting to us; likewise, broadly defined category of private equity. It’s an interesting earning stream. The investor horizon in terms of duration tends to be non-core related and differentiated and more stable and extended. But there are different components to those businesses also, obviously. They tend to have a higher component of performance-based compensation either in the form of a carry or a preferred return or a performance fee. And also they tend to have components involving co-investment capital. So as distinct from owning a participation in the earnings stream thrown off by a long-only manager who is receiving management fees on the basis of AUM, you need to take a look at the economic model of an alternative manager and really understand what the earning streams are of that business model, where they can come from and what capital risks are associated with it. And you need to make sure that you are very, very comfortable with the actual risk you’re taking as an owner, and critically importantly you need to be very smart about how you allocate those cash flows as between ownership and management, because I think there are aspects of those businesses that will militate toward wanting management to retain the vast majority of certain performance and carried interest and equity-based earning streams, because I think the clients and the institutional consultants in the community believe that that’s where those components of fees should go. So it’s a different asset class but we continue to look at it and those are the components that we think are interesting.
Okay. Thanks for the color.
Peter L. Bain
Your next question comes from the line of Michael Cyprys with Morgan Stanley. Your line is now open.
Hi. Good morning.
Peter L. Bain
Good morning, Michael.
Thanks for all the detail in the presentation of disclosure, it’s very helpful.
Peter L. Bain
Just starting off on the impact of lower market values and you had that slide at the end of the presentation on the impact to expenses, it certainly seems pretty formulaic in terms of how it flows those the variable comp given your business model. And just on the expenses, recognize you don’t want to harm the medium-term growth prospects of the business and the opportunities. So, I guess just at what point do you reconsider. What will need to happen there? And then second, what other action could you take even before that just in terms of opportunities either for greater outsourcing at the center or even at the affiliate level, and what sort of streamlining could take place at the affiliate level in terms of back office operations and outsourcing?
Peter L. Bain
I will give you my business answer, Michael, because I think actually that’s your question is philosophically how do we look at this. And I’ll start by reminding everyone that that bottom right graph on Page 22, the headline is hypothetical, right. Let’s remember this is hypothetical and hypothetical here is pretty extreme. It’s essentially saying a full 10% drop in the market immediately and then no appreciation for the rest of the year. So, that’s a pretty extreme situation, all right. And in that framework, you’re talking about a franchise that would only experience a 12% decline in ENI. So I think we start there and say, if that’s the environment that actually occurs we got some room to watch what’s happening with the business and we will. Now philosophically in looking at expenses, we basically trifurcate, if you will, the world of expense in our mind. One is, expense related to investments we’re making in the business that we believe are long-term strategic and will create compound value for the franchise. The second is expenses that are incurred in conjunction with revenue-generating activity. And then the third is operating expense, which is not related to revenue generation but is in our view important to the business. You don’t just stop managing risk because expenses are tight and risk doesn’t necessarily generate revenue, right. And so we’re going to work very hard to be very thoughtful and not pennywise pound foolish in working on the expense base. We’re inclined certainly in the existing environment and probably even in the hypothetical one to continue to make the investments, the strategic growth initiatives in the business that we think are going to create compound value. We’re likely to continue to take on expense that’s generating revenue but we will look at the nature of the revenue and its certainty and the potential impact on the business of pulling back on that. And then with respect to non-revenue related expense, you have to have a hard look at what business function is that expense supporting. And if it’s related to managing risk and managing compliance, that’s important to this business. And so underlying all of this is I think an important assumption, which is we don’t waste money when the market’s good in the first place. And so when we think about cutting expenses, it’s not like there’s a bunch of money that we’ve been wasting that we just stop wasting. Every expense that we incur, we already incurred because it’s serving a business function. We recognize of course if you have a genuinely precipitous environment, you have to take a hard look and I have a view on this as well, which is after sort of 20 years in doing this at different places including Legg in 2008 and 2009, you don’t do something like, well, we need to cut expenses 10% across the board. That’s actually not possible to do. The way you work through genuinely extreme circumstances is you look at your activities and what you have to do is make a very tough decision about which activities you are simply going to stop engaging in. And that’s the way we’ll approach that if the market ever really got to that point and we do not believe it’s there now.
Great, that’s very helpful. And then just a follow up given the challenging environment here and the skew toward equities within your portfolio. I guess just how are you thinking about evolving the affiliate mix from here, and does the market move that we’ve seen change at all your thinking around sort of what next to add or even accelerating that.
Peter L. Bain
Yes, I don’t know that it accelerates it but it certainly doesn’t change it. We’ve always talked about the strength of the franchise being in the equity markets and how well diversified among the equity markets we are. That’s still true. And therefore we talked about wanting to execute acquisition transactions that will strategically diversify our skill set, alternative credit, private equity, non-core related return to product. That continues to be true. So I think we’re an equity long manager. The equity markets have been challenged. We were already looking to diversify beyond and that continues to be true. I don’t know that it accelerates it.
So not much interest in fixed income outside of alternative credit.
Peter L. Bain
It depends on how you characterize alternative credit. I mean there’s a case to be made that the smartest income business you can engage in is the intelligent origination of direct lending credit in this market, right. And by the way, what kind of fixed income can you actually get somebody to pay you for.
Peter L. Bain
Okay. Thanks, Michael.
This concludes our question-and-answer session. I’d like to turn the conference call back over to Peter Bain.
Peter L. Bain
Thanks very much. You guys, we kept you a little longer than our customary call but I think we covered a lot, I hope it was helpful. We certainly appreciate you taking the time. And it is interesting times. Our job is to manage assets for clients’ benefit and generate alpha in the markets, whatever is happening, and that is what we’re doing now and it’s what we’re going to continue to do. And I look forward to – I hope seeing a number of you in the next few weeks as we catch up with everyone. Thanks very much.
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