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Executives

Alan F. Magleby - Director of Investor Relations & Communications

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

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

Analysts

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

William R. Katz - Citigroup Inc, Research Division

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

Roger A. Freeman - Barclays Capital, Research Division

Cynthia Mayer - BofA Merrill Lynch, Research Division

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

Craig Siegenthaler - Crédit Suisse AG, Research Division

Matthew Kelley - Morgan Stanley, Research Division

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

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

Douglas Sipkin - Susquehanna Financial Group, LLLP, Research Division

Legg Mason (LM) Q1 2013 Earnings Call July 27, 2012 8:00 AM ET

Operator

Greetings, and welcome to the Legg Mason First Quarter Fiscal Year 2013 Earnings Call. [Operator Instructions] As a reminder, this teleconference is being recorded. It is now my pleasure to introduce your host, Alan Magleby, Head of Investor Relations and Corporate Communications. 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 first fiscal quarter 2013 ended June 30, 2012. 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, 2012, 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 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. And I would like to thank everyone for joining the Legg Mason earnings call.

Legg Mason made significant progress, positioning the firm for long-term growth, even amid valuation retrenchment across global investment markets, which led to a drop in our quarterly revenues. In particular, we believe these kinds of conditions played at the strength of our diversified asset base and to the depth and breadth of our managers' specialized expertise.

In a recent note to clients, Chuck Royce noted that as Europe meets its challenges, and as the U.S. begins to get its own fiscal house in order, which is not likely to happen until after the elections, we should move out of the range-bound equity market to the upside.

Isaac Suede is in China meeting with clients and financial leaders, and has restated his belief that they will engineer to a soft landing. He points out that they have already cut rates twice, changed the reserve requirements 3 times, and while the Shanghai index is still lagging, he reminds us, changes are never instantaneous in China, and these equity markets should do much better and could be the harbinger for a wider September improvement.

And in a Barron's profile, ClearBridge's Hersh Cowen continued to emphasize the unprecedented risk premium that high-quality, dividend-paying stocks have relative to bonds and sees growing opportunities in these stocks.

Meanwhile, in fixed income credit markets, where both institutional and retail investors continued to add flows, Western's Steve Walsh took a more cautious tone at the Morningstar Investment Conference recently. He stated that it is nearly impossible to come to a conclusive opinion on how Europe will play out. With the market price for negative outcomes, Western has concluded that staying modestly long spread risks and staying attuned to the changing landscape seems to be the right approach.

Overall, at the corporate level, we continue to manage the business, aware of the current environment, including keeping a close eye on expenses, while investing in areas that will position us for long-term revenue and diversified earnings growth with a near-term focus on organic growth.

Let's start with the highlights to the quarter on Slide 3. On a GAAP basis, we announced a net loss of $9.5 million, which reflects charges related to our very successful debt restructuring and fund launches. Adjusted income was nearly $89 million.

In May, we announced a new capital plan, which is part of our broader efforts to enhance financial flexibility and position Legg Mason for sustained growth. In doing so, we reduced our outstanding debt by $350 million and refinanced debt that was due in 2015 with longer-term maturities. This resulted in a largely noncash charge of $0.32 per share. The quarter includes $800 million raised for ClearBridge's third MLP fund and $200 million in a new Western REIT. Our financial results reflect $0.11 per share in costs related to launching these new products.

Our long-term flow story continues to improve, particularly in the critical area of fixed income. And in the quarter, we bought back the remaining $155 million of the original $1 billion board authorization, and we expect to continue the program under our new authorization throughout the year. We ended the quarter with $800 million in cash.

Slide 4 shows our assets by asset class. In the quarter, equity assets were affected by market depreciation of approximately $9 billion versus fixed income market appreciation of approximately $5 billion. Average AUM of $635 billion was in line with our prior quarter. Market valuation declines and outflows reduced equity as a percent of total AUM to 24% though [indiscernible] data.

Finally, our liquidity number includes the disposition of $4.6 billion in assets to Morgan Stanley Smith Barney. There was about $2 billion remaining from these sweep assets at quarter end, and those were transferred this month.

Slide 5 shows our net flows. Legg Mason continues to make progress on long-term flows with improvement in each of the last 3 quarters. This was the best quarter for long-term outflows in nearly 5 years. Key contributors to this improvement were Western and Brandywine in fixed income and ClearBridge in equity. Both Legg Mason and our affiliates continue to focus on building our momentum in fixed income and equity. Liquidity flows were positive, x the disposition of assets to Morgan Stanley.

Slide 6 shows assets by affiliate in order of their contribution to the quarter's earnings. First is Western at $445 billion, in line with last quarter. And in terms of flows, they improved to modestly positive, x $1.6 billion out in the sovereign mandate we have been referencing for some time.

We'll talk about Western in more detail in the next slide. But it does continue to see interest in specialized mandates globally. And those specialized mandates continue to reflect higher fees and mandates that terminated in the quarter. Growth in both specialized mandates and retail fund flows will, over time, have a positive impact on the revenues as well. As investment performance continues to be strong, we see particular opportunity for them as we relaunched the Western U.S. funds to leverage their institutional brand to promote those funds in the retail, institutional and retirement segments.

Next is Royce at $36 billion, down primarily due to market depreciation and, to a lesser degree, an increase in outflows consistent with industry trends and small-cap equities. Royce is actively engaged with their clients and distribution partners amidst these sector headwinds. Most recent market trends are emphasizing mega caps overall and defensive stocks in small caps. And this creates pressure on their short-term performance. However, as they have done throughout their history over similar cycles, they are increasing their vigilance to make sure they are positioned well for long-term opportunities.

Next is ClearBridge at $56 billion, down slightly for the quarter. Under Terrence Murphy, the firm is making real progress with a sharpened strategic focus on 3 core competitive advantages: equity income, concentrated alpha and low volatility. ClearBridge had approximately $3 billion in new wins in the quarter, of which $1.9 billion was funded, ending the quarter with $1.1 billion in unfunded wins. The wins this quarter came in dividend products, aggressive growth and large-cap value, as recent relative performance was strong. And they raised their third MLP closed-end fund, bringing total MLP assets to approximately $4 billion.

Next is Permal at $17.2 billion, with the decline in AUM, driven by outflows in the high net worth sector, partially offset by institutional wins, market depreciation and the effect of adverse foreign exchange. Permal continues to enjoy a valuable leadership position in the fund of hedge fund space and should continue to benefit from overall projected growth for alternative strategies.

The lumpiness of the institutional segment, now accounting for 45% of AUM, was evident this quarter. U.S. institutional continued to see inflow, while non-U.S. is more mixed. Won-but-not-funded stands at approximately $300 million, with strong July performance boding well, with a robust pipeline of other opportunities over the fiscal year.

This quarter also included a $150 million outflow, which is the previously disclosed wind down of a sub-advisory account. The performance had been outstanding, but the sponsor is closing the account for unrelated reasons. We expect the wind down to be complete by the end of the calendar year and involving a remaining $150 million. Traditional broker-dealer high net worth continues to be in outflows at the same pace, while the independent high net worth initiatives saw some adverse lumpiness this quarter, but future pipeline remains encouraging. Permal's private equity team, strategic expansion in China and innovative use of customized solutions are added engines for growth, where we work closely together.

Next is Brandywine at $39 billion, driven by net inflows for the quarter. Brandywine is emerging as a formidable manager, whose top-down strategies and fixed income are complementary to our overall mix. Positive flows came from both the institutional channel, including a new relationship with the global consultant as well as from continued momentum in retail funds, importantly both U.S. and cross border. Brandywine had $700 million in unfunded wins, including several with expected upside over the year. That would be over the next 12 months. And performance across their funds remains in the top quartile.

Finally, Batterymarch at $15.6 billion is down from last quarter. Macro events in these volatile markets continue to challenge quantitative managers, impacting short-term performance results in certain strategies. In the quarter, we worked with them to launch certain volatility management products that aim to provide investors with income and downside protection.

Slide 7 is an update on Western Asset. The chart on the upper-left side shows AUM by mandate. Assets in specialized mandates are up 45%, as Western continued to see interest in strategies like emerging market, U.S. and global corporate, high yield, Australia Core and Brazil total return.

In the quarter, there were a couple of specific instances, in which existing institutional clients took money out of lower-yielding strategy and moved it in a higher-fee, specialized mandates. Their pipeline includes nearly $2 billion that are one and not funded, up nearly 25% from the year-ago period. Institutional interest in Core and Core Plus has picked up, joining the retail channel's continued good momentum.

The chart on the upper-right side shows 98% of composite assets beating their benchmark over the 3-year period. That outstanding performance should help both their institutional and retail growth. And finally, the lower half of the slide shows the improvement over the last year in long-term flow trend. We've adopted the Western institutional brand across all of its U.S. retail products. And after-fund mergers expect to offer a streamlined fund lineup in the fall with the full range of share classes. Overall, Western is very well positioned across all aspects of the fixed income markets, particularly as it leverages on-the-ground global capabilities in investing and sales and client service.

Slide 8 shows investment performance, both versus the benchmark and versus peers. We are pleased that overall performance has held up well, even amid volatile equity markets. For the critical 3-year period, 80% of assets beat benchmarks, but performance against peers at certain equity managers is down compared to last quarter. In particular, fixed income performance was strong, with both Western and Brandywine showing impressive performance.

Slide 9 shows an overview of our global distribution platform. This platform has $217 billion in long-term assets and serves retail and individual clients in the Americas, Europe, Asia and Australia across a number of our affiliates. Increasingly, I see this as a compelling competitive advantage and a key component of our growth strategy going forward. Today, we have a broad suite of products across equity, fixed income and alternatives. Strong performance and an emphasis on new products will be critical to our growth.

Globally, our distribution platform has been in net inflows for 7 of the past 10 quarters. And while our international team has been a key driver of that momentum in the past, this quarter, the U.S. team had their highest level of net inflows since March of '07. Our international [indiscernible] had positive net flows for the past 14 quarters.

Over the past year, we conducted a U.S. retail branding review to determine how best to use the respective brand recognition of our key managers, backed by the financial strength of Legg Mason and to show the diversity of our offerings. We are starting with the Western rebranding in the fall, and we'll make similar refinements at other affiliates targeted to be launched in the first half of calendar '13.

Slide 10 shows some of the areas in which we've gained momentum in our distribution platform. It bears repeating that I think we are extremely well positioned across our product set to grow our AUM to this strategic asset. As you can see, the products that are driving sales come from a number of our affiliates across all of our geographies. This includes closed-end funds and institutional-like mandates at insurance clients and distribution partners which will vary from quarter.

In the lower left corner, we show gross sales versus persistency rates, which speaks to the expected longevity of client assets within our platform. We have seen our gross sales trend higher in recent quarters, while at the same time maintaining strong levels of asset retention versus peers.

The right side of the chart shows an area of key strength for Legg Mason, closed-end Funds, in which we are now a top 5 player based on total AUM. In the bottom right chart, you can see we are tapping into the expertise of a number of our affiliates. In fact, over the last 4 years, we have averaged 20% of all closed-end fund market issuances, advancing our leadership ranking. In particular, the closed-end fund structure has been a good one for the MLP market, which has had strong yield equity investors seeking new sources of income. These are high-fee, long-term assets.

And with that, I will now turn it over to Pete.

Peter H. Nachtwey

Thanks, Mark. As Mark noted, we made significant progress on a number of funds in positioning the firm for long-term growth. Specifically, we had a number of positive events during our first fiscal quarter of 2013. The upfront cost of which significantly reduced our GAAP earnings per share, but the outcomes of which will contribute to future earnings momentum and growth.

The first of these was the successful launch of our new capital plan, where we paid off our $1.25 billion in senior convertible notes, raised $650 million in the debt capital markets and secured a bank term loan for $500 million, along with revolver capacity for another $500 million. We also significantly diversified our debt investor base, while reducing our outstanding debt by $350 million and laddering out our debt maturities.

Also, as part of the new capital plan, the board authorized an additional $1 billion share buyback to be deployed over the next several years. The P&L cost of the debt extinguishment in the current quarter was $69 million or $0.32 per diluted share, which is principally noncash.

We also raised $800 million in a ClearBridge closed-end fund and $200 million in a Western REIT IPO that together resulted in a $23 million or $0.11 per diluted share in fund launch cost this quarter. All of these transactions will be additive to GAAP earnings on a go-forward basis. During the quarter, and related to our capital plan, we repurchased 6.2 million shares of stock at a cost of $155 million. This was the final piece remaining from the prior $1 billion share buyback authorization.

In terms of other share activity in the quarter, in addition to the $155 million in repurchases, we issued approximately 1.3 million shares of stock in May, related to our annual long-term incentive awards. Since both the share repurchase and the stock awards occurred approximately mid-quarter, only about half of those shares are reflected in this quarter's weighted average share count. Absent any additional share repurchases, our ending in average diluted share count for the September 30 quarter would be 135.5 million shares.

Finally, a number of other factors impacted our results. These included lower revenues despite average AUM being flat on the prior period. This reflected a mix shift, with a 4% decline in higher-fee equity AUM, offset by an increase in average AUM for both fixed income and, in particular, liquidity. And as anticipated, performance fees came in below the March quarter but above December's.

Now, let's turn to Slide 11 to review the financial highlights for the quarter. As Mark noted earlier, the fiscal first quarter net loss was $9.5 million or $0.07 diluted share, reflecting the impact of the debt extinguishment and the fund launch cost, which together totaled $0.43 per share. Operating revenues were down 3% compared to the prior quarter, due to lower advisory fees, reflecting a decline in average equity AUM and a $6 million drop in performance fees earned this quarter. This quarter's performance fees were largely driven by Western, LM Global Equities and Brandywine. While impossible to predict with any precision, we anticipate next quarter's performance fees to be in line with this quarter's level.

Operating expenses declined 4%, reflecting lower mark-to-market gains on deferred comp and seed investments, which are offset in other nonoperating income and expenses. These were partly offset by higher fund launch cost of $23 million this quarter, compared to $9 million in the prior quarter. Adjusted income, which excludes the debt extinguishment cost, was $89 million for the quarter or $0.64 per diluted share, with a drop from last quarter's $124 million level driven by 3 things: First, the higher fund launch cost; secondly, a mark-to-market loss on corporate seed investments of $6 million compared with gains in fiscal Q4 of $10 million; and lastly, $16 million in onetime gains recorded last quarter.

Moving onto Slide 12. The only other item to highlight here is our effective income tax rate which was 28% on a GAAP basis. But excluding the impact of our consolidated investment vehicles, the rate would've been 35% in line with our targeted effective tax rate. The tax outlook for next quarter is for a lower effective rate, as we expect to benefit from another U.K. tax rate reduction of 2%, which will occur in fiscal Q2 as it has, the last 2 years. This will result in an approximate $18 million tax credit in the second fiscal quarter, and we then expect the effective rate to return to the 34% to 36% level over the last 2 quarters of fiscal 2013.

Slide 13 is a roll forward from fiscal Q4's earnings per share of $0.54 to this quarter's EPS loss of $0.07. The fiscal Q4 items on the first red bar totaling $0.11, include onetime gains, closed-end fund launch costs, mark-to-market on seed, transition-related cost and tax adjustments. The key items for this quarter, which are on the next 3 bars, include $0.32 related to the debt extinguishment, $0.11 related to the fund launch costs and $0.03 impact from the negative mark-to-market on seed investments. And then the final contributor is the $0.04 decline in other net revenue and operating expenses, which was largely driven by the decline in operating revenues.

Turning to Slide 14. You can see that the advisory fee yield decreased this quarter from 35 basis points to 34 bps, driven by asset mix, specifically lower average equity AUM on the quarter, combined with higher average fixed income and liquidity AUM.

On Slide 15, operating expense for the quarter decreased primarily due to lower comp expense, which I'll discuss in the next slide. Other factors impacting operating expenses were higher distribution and servicing costs, reflecting the fund launches this quarter and totaling $21 million compared to $8 million of closed-end loss last quarter. Excluding these 2 items, distribution in servicing expenses were down 2%, reflecting the lower revenues. Communications and tech expenses decreased, reflecting lower affiliated-related technology costs. And finally, other expenses decreased due to lower fund-related costs and trading losses, offsetting compensation, which were partially offset by the impact of last quarter's FSA assessment refund.

Turning to Slide 16. Total comp and benefits were down from last quarter, reflecting lower deferred comp and seed investment-related expenses, offsetting nonoperating income and due to lower revenues. As you can see, the comp and benefit to net revenue ratio was 58%, however, 3% of this amount relates to fund launch costs. And as additional context, this quarter's ratio also reflects lower net revenues, which had a further 1% impact on a comp and benefit ratio due to the denominator impact.

Turning to Slide 17. The operating margin, as adjusted, declined from last quarter, reflecting the impact of the 2 fund launches this quarter. These combined for a 4% reduction in the adjusted operating margin for the quarter.

I'll wrap up on Slide 18, which covers one of the key highlights in our fiscal first quarter, which was the announcement of our capital plan and included several key events. We repurchased $1.25 billion in convertible senior notes, using $250 million from our bank line, the proceeds of a $600 million 7-year bond offering and $350 million in cash. This reduced our gross debt by $350 million.

In addition, late in June, we refinanced our $500 million credit facility with a 5-year amortizing term loan, and amended and extended our $500 million revolver that is now completely undrawn. As part of the transaction, we announced that we would buy back the remaining $155 million from the original board buyback authorization and we accomplished that, buying back 6.2 million shares. We also announced a new $1 billion authorization that we are currently deploying -- plan to deploy at a rate of up to 65% of cash generated from operations prospectively. As always, subject to market conditions.

The benefits from the debt restructuring aspect of the new capital plan include delevering of balance sheet, laddering out our debt maturities, as illustrated on the chart at the bottom right and diversifying our sources of capital from both the banks and bond investors. Additionally, we will reduce our GAAP interest expense by $36 million annually. As Mark mentioned earlier, these transactions greatly enhanced our financial flexibility, going forward. And finally, we end the quarter with approximately $800 million in cash after delevering the balance sheet and buying back 155 million of our shares.

So thanks again for your time and attention. And now, Mark, back to you.

Mark Raymond Fetting

Thanks, Pete. Slide 19 shows the diversity and scale of our business across asset classes, client domicile and revenues.

As we've shown in previous quarters, from a gross revenue standpoint, Legg Mason does have a significant balance between equity, fixed income and alternatives. We want to continue to deepen and strengthen that balance across geographies, asset classes and channels. We will invest in our affiliate franchises and continue to look at selected bolt-on and lift-out acquisitions.

Slide 20 updates the metrics we've been watching closely as we managed the business. As the chart on the upper left-hand side shows, we continue to make progress on our long-term flows. On the lower left-hand side, we recapped our successful streamlining effort that we finalized last quarter, with annualized cost savings of $143 million.

On the upper right-hand side, we show how we allocated capital in the current quarter and past 2 fiscal quarters. In the current quarter, we reduced debt by $350 million, completed the remaining $155 million of our original $1 billion share repurchase and paid out our quarterly dividend. With the completion of our debt transaction in the quarter, we have enhanced our financial flexibility and positioned ourselves to continue to invest in our franchise. And finally, we show that the 3-year composite performance number remains strong, which should contribute to our improving flow story and to our organic growth.

On a go-forward basis, as shown in Slide 21, we plan to allocate capital to further diversify and grow earnings, as follows: One, organic growth. This is our top priority: Institutional and retail across the firm; accelerating where we have strong product and performance; developing, and where necessary, seeding new products including additional closed-end fund launches. Two, filling product gaps. We will work with our affiliates on product development, as well as on selected bolt-on and lift-out opportunities. Three, we will continue to return capital to shareholders with both share repurchase and dividend.

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

Question-and-Answer Session

Operator

[Operator Instructions] Our first question is from the line of Dan Fannon of Jefferies & Company.

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

Just in terms of flows, if you look at this quarter, we've -- the improvement of fixed income is noticeable. We've been down this kind of path before. And I just want to get your sense -- you gave some comments around backlog. I guess, how do you feel about the consistency of kind of improving flow trends beyond kind of what we've seen in the last 3 months? I mean, the backlog appears to be going, as I said -- do you think that this kind of the building of momentum that we should continue to see kind of improving flow trends beyond into the next kind of several quarters?

Mark Raymond Fetting

Yes, Dan. We continue to be encouraged by the steady, and I think impressive progress, particularly in fixed income. Western, across the board. We gave the won-but-not-funded pipeline, but we also note that their finals kind of inventory, if you will, is up impressively. Brandywine continues across the board, and while the won-but-not-funded piece is a bit lower than prior quarter, there's a couple of elements there that should have, as I mentioned, some upside over a 12-month period. Ditto at ClearBridge. We've really made some good progress there, both this quarter just completed and what we're looking at in terms of pipeline there. And then Permal, as I pointed out, there is some lumpiness there, because they're now more engaged in the institutional business. But over the next several quarters, they've got a lot of attractive opportunities there and are poised subject to bringing it over the goal line to make some real progress.

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

Okay, that's helpful. And then my follow-up, and just in terms of the rebranding at Western. And I guess, first off, is there potentially other rebrandings that you might think about with other affiliates? And then are there any cost savings that might occur as a result of kind of the fund consolidation that's going to go on?

Mark Raymond Fetting

I would say the primary thrust here is to play to our strengths, across best product, best performance, candidly, best brand, in terms of recognition in the marketplace. And so we're starting with Western, but we will do some others, and it will also have a continued supporting endorsement of Legg Mason to draw out the strength of financial backing, the diversity, the lineup et cetera. The cost savings is really not significant. And candidly, some of them might just go to the benefit of the fund shareholders in terms of our governance. The primary thing here is growth.

Operator

Our next question is from the line of Bill Katz with Citigroup.

William R. Katz - Citigroup Inc, Research Division

Just, Mark, in terms of your 3 core priorities, and sort of maybe a follow-on to the second question as before, should we anticipate you willing to sacrifice the margin for growth?

Mark Raymond Fetting

Well, the way I'd like to do is kind of prudent balance. This is the kind of time where you want to make some trade-offs. We're going to be focused as we have on expenses, both at the parent level and certainly the affiliate level. But at the same time, we see some real opportunities, and even with some market headwinds. And as you see, our investors see some light at the end of the tunnel here, and hopefully, our clients do over time, as well. So we don't want to give up on those opportunities. And they can range from global retail to expansion in China with Permal as an example, and so we're going to continue to, I think, balance that prudently, Bill.

William R. Katz - Citigroup Inc, Research Division

Okay. Just in terms of -- I ask the same question each quarter, I apologize. But just in terms of the up to 65%, given sort of where the stock is trading versus the growth you see, how should we thinking about that for free cash flow perspective? Should we be moving around with 65%, or is that just really too aggressive on our part?

Mark Raymond Fetting

Well, I'll give a highlight and then Pete will follow. But we want to be clear, because as you recall, the last quarter, we were not able to be as clear, because while we intended to get done what we did do, we couldn't speak about it. So we've done to the $155 million, we did the debt refinancing and we've given our goal with the board support of up to $65 million. We will be in the market deploying that, subject to business and market conditions. Pete can give you a little more color, if you want.

Peter H. Nachtwey

Yes, Bill. I think the current priorities for cash are going to be to make sure we have enough to protect and grow the business and make the investments that Mark just spoke about. On the other hand, we're absolutely committed to deploying that additional $1 billion at 65% of prospective cash flow starting with fiscal '13. But as always, subject to market conditions.

Operator

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

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

I got disconnected, so I apologize if you've already answered this discussion. But just wanted to come back to the outlook for margins. I understand there were some noise this quarter, but it does seem like margins remain under pressure, understanding that the market environment has certainly been a headwind. So just any color on how you see kind of the profitability playing out as you look ahead.

Mark Raymond Fetting

Yes, Michael, good question. This quarter, we had these closed-end fund launches, where effectively permanent capital vehicles, both the closed-end fund and Western's REIT. And that had a 4% negative impact on the operating margin. But it's effectively CapEx on our business. So you add that back and then take into account, we probably had the 1% denominator effect from the drop in revenue. So get right in that kind of 21% zone. The current levels of AUM in revenues, that's where we see a kind of normalized type of margin. On the other hand, our focus is going to be on growing revenues. We've got a very leverageable structure at this stage below of our cost, so we think we'll grow it from there by growing revenues.

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

Okay. And then second, in terms of the global sovereign mandate, I think you mentioned related outflows were $1.6 billion this quarter, which is down from prior levels. So is this a good run rate going forward? And then can you just give us an update on how much is left in terms of that mandate?

Mark Raymond Fetting

Yes, that's a good run rate, kind of certainly consistent with the current month. We've never really given the amount out of respect for the client that we work with there, but I think you can use that run rate through the rest of the fiscal year.

Peter H. Nachtwey

And then to emphasize it's effectively just slightly over 1 basis point fee rate gross, so very little impact on the bottom line.

Operator

Our next question is coming from the line of Roger Freeman of Barclays Capital.

Roger A. Freeman - Barclays Capital, Research Division

Can you just go through a little bit more specifics around what exactly the rebranding entails? For example, what are you doing with Western when you start that up? Are there going to be costs associated with that as well?

Peter H. Nachtwey

No. There'll be some minor costs, but candidly they're built into kind of our core plan. But the key here is that Western has for -- really, for a -- more than a decade, had Western institutional funds, and then we've had Legg Mason funds managed by Western. In some cases, very similar mandates. And what we did was just play to our strength and put together the best lineup. We also feel there's a real advantage to leveraging Western's institutional franchise in that retail and quasi-retail market. So specifically, what's very exciting about this is one of our flagship -- or 2 of our flagship funds, the Western Core and Core Plus fund, at the conclusion of this, and into the fall with a real focused support of our distribution team, we'll now have all of the share classes of -- the intermediaries like, whereas previously, they've only had a few. So we're very excited about this. We think the costs are candidly very good investments, and the big o here is to improve flow.

Peter H. Nachtwey

Yes. And then, Roger, actually on a go-forward basis, we've also got some minor cost savings by just merging these funds and share classes. So the investment at that end will more than pay for itself. But this is much more about having LN8:42 PM GD and Western be able to partner on growing that aspect of the business.

Roger A. Freeman - Barclays Capital, Research Division

Okay. That's helpful. And then, I guess, just following on around Western, and one, an update on the retail launch of some of those funds. You mentioned it, but where -- I think that was starting up this quarter. So what kind of -- what do you have in terms of distributor signed up on that? And then just also on the new mandates in the specialized mandates, can you give us on average what kind of capture rate that's coming on at? So we can think about that against, say, that sovereign mandate that's coming out and what the net differential is?

Mark Raymond Fetting

Yes. In terms of -- just to be clear on the Western fund relaunch, if you will, we are actually working with distributors that we've had long relationships with. So it's really kind of not signing up any new distributors. It's taking a revamped , bolstered product line under the Western brand and really pushing hard with full-share classes. Those 2 funds, by the way, in terms of the lead vehicles really have terrific records on a 1-, 3- and 5-year basis. And we're very, very proud of that. Relative to the kind of fee impact to the specialized, as we've said, it's clear to us, across the new business that we're getting on the specialized mandates, that the fees are at incremental levels attractively. Kind of 2, sometimes 3x, a core mandate. So this has been very attractive. And over time, as we've said, the more they do in specialized, the more they do in retail, the more we'll get some fee expansion, certainly significantly greater than what we're losing in something like the global sovereign, which is a true anomaly, so that's kind of a one-off.

Operator

Our next question is from the line of Cynthia Meyer of Bank of America Merrill Lynch.

Cynthia Mayer - BofA Merrill Lynch, Research Division

I guess, just to clarify maybe a little bit on the comp, it sounds like -- you said it was a 55% adjusted comp-to-revenues ratio? And is that a ratio you would expect to hit?

Mark Raymond Fetting

Yes, Cynthia, good question. So when you look at -- the headline number was 58%, but that includes the 3% impact for the closed-end fund launches and then roughly an additional 1% again for this denominator effect of lower revenue. So we kind of see this AUM level and level of revenues, comp ratio in the 54% to 55% range, because as has Mark said we're going to keep making the prudent investments we need to make to grow the business long term.

Cynthia Mayer - BofA Merrill Lynch, Research Division

Okay. And I think last quarter, you mentioned that a key Permal fund might cross high-water marks in the late summer. So I'm just hoping you can update us.

Peter H. Nachtwey

Yes, I mean, obviously, the market, even though we had a nice little rally the last 2 weeks in June, overall, was still down in that second calendar quarter, so we're probably pushed out another quarter or so on that one fund.

Operator

Our next question is from Glenn Schorr of Nomura Securities.

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

Just following up on one of the previous questions on capture rate versus outflows. Maybe instead of just in Western, a bit broader, because you have a lot of puts and takes going on. So maybe, the average fee capture on the new business being won across the group versus what's going out on most across the equity?

Mark Raymond Fetting

Yes, so you could see, this quarter challenged us, because the fee rate dropped because of the mix. And the mix is really a function of the more equities and alternatives we do, the more it's likely that fee rate's going to grow. The more fixed income versus equity and alternatives that we do, the more it's going to decline a bit. So, I think, on a go-forward basis, you should -- as markets improve, and our flows improve in both equity, alternatives and fixed, we should expect that fee rate to grow, and that would be kind of additive to margin improvement. Clearly, things like the closed-end fund and the REIT, these are all retail, full-fee businesses with good long-term assets. So they're helpful, as well.

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

Okay. And then one other, on Western's performance, obviously, very strong, and you mentioned about the won-but-not-funded platform. But I'm curious as the tenure just keeps creeping lower, I think, it's down another 25, 30 basis points just in July. Is there any sticking point where it just kind of starts freezing up institutional flow? I'm just curious what you've seen lately and how clients are thinking about just the ever declining yields?

Mark Raymond Fetting

No. I think both institutional and retail clients are certainly, if anything, since the last time we spoke, kind of more oriented towards fixed income and a focus on yield. Even at lower yields on a relative basis, there seems to be an attraction. Obviously, that frustrates our equity guys. But one of the interesting things that's happened this quarter is institutional demand for Core, Core Plus picked up. But the retail side has been plowing into that, whether that's the kind of investment-grade category, the mortgage category, et cetera. But to see that on the institutional side is encouraging. Obviously, Western has very strong numbers there. That's a business, over time, that -- particularly as their 5-year number improve -- gets parallel along the 1 and 3 should be good for us.

Peter H. Nachtwey

Yes. The other thing is, Glenn, that we see going on there is people are still allocating -- big clients are still allocating more to fixed income. And the way they're focusing in terms of getting yield or things that played our strength but the Western and Brandywine in terms of credit global and longer duration types of vehicles.

Operator

Our next question is coming from Craig Siegenthaler of Crédit Suisse Group.

Craig Siegenthaler - Crédit Suisse AG, Research Division

Just with the roughly $1 of annualized cash EPS benefit from the tax yield, I'm wondering if you can help us think about how this $34 million-ish proportion should roughly trend over the next 2 years? And also when do you expect us to kind of roll off towards 0?

Peter H. Nachtwey

Well, in terms of the tax yield, we've got the slide on the Appendix, we can go over it this quarter. But we've got something in the magnitude of $400 million of NOL. And then a significant amount of goodwill and intangibles beyond that, that we'll be able to amortize for tax. So we don't really start seeing any decline in that until out and about fiscal 2017 and probably fiscal '20 before you really see a significant drop off.

Craig Siegenthaler - Crédit Suisse AG, Research Division

Got it, got it. And then just real quick on the closed-end fund market, volumes in this market are down significantly since pre-crisis levels, but Legg Mason is really proving that they're one of the new leaders in this market. Can you talk about your outlook for this business and also, where potential sources of inflows and closed-end fund ratings may come from?

Mark Raymond Fetting

Yes. We continue, as you know, to be very encouraged and proud of what we've accomplished there. And we want to continue to make sure there's investment integrity to each and every one of the offerings, and obviously, good demand. The key for us has been to work closely with our distribution partners in coming up with what are real innovative solutions. So going forward, we're very excited about some potential products in the alternative space with Permal, in the fixed income space with some specialized capabilities of Western. And of course we'll continue to take advantage of kind of niche opportunities under that umbrella of MLP that ClearBridge has. We are actively working on some things that should happen over the next quarter or 2.

Peter H. Nachtwey

And Craig, the other thing is we can grow these vehicles, the closed-end funds, a little bit less so. But we can add leverage to them, and we get a fee on the gross assets, including a leverage. And then particularly the WAM REIT is able to do secondary. So they launched that with the idea that, that can grow significantly not only through their asset management skills but also through doing secondaries. Most of these platforms start out relatively small in the $100 million to $200 million but grow relatively quickly to $1.5 billion to $2 billion. So even within the vehicles themselves, we can get some growth in addition to launching new ones.

Operator

Our next question is from the line of Matt Kelly with Morgan Stanley.

Matthew Kelley - Morgan Stanley, Research Division

So I was just curious to get more of kind of a high-level question from the equity side. What's -- from some of your affiliates in equities, what's the sense as to what could drive equity mutual fund inflows going forward? What conditions do we need in a market. Is it about the relative level of the market? Or is it all about macro headlines and uncertainty?

Mark Raymond Fetting

Well, this is both the joy and challenge of having a diversified mix, where you have the bond guys, the equity guys. The equity guys would say that what it's going to take is probably some deterioration in returns to the fixed income side and also kind of evidence of movement in the equity markets, specifically, in terms of the movement on the equity markets. Chuck pointed out that he sees people increasingly aware that you just have to come to a resolution in the U.S. on the fiscal cliff issues that you have to -- and in fact, kind of this week, you can see some progress on that. Europe's got to kind of work through it. One of our managers talks about kind of an end result of a structure of -- similar to kind of the United States of Europe, as a governing structure that puts in more kind of, if you will, fetters-less discipline into things. Those kinds of things sometime after the election and the market always is forward-thinking and perhaps kind of seeing it in advance, could be very encouraging, because the fundamentals particularly in U.S. market in terms of what companies are doing with lower, deleveraged housing seems to be troughing for sure and a little bit of uptick, lower energy costs, productivity, those things are clearly evident. And if we can get rid of this kind of political crisis in confidence, I think, you got something that really starts to move.

Peter H. Nachtwey

And Matt, the other thing we're talking about our equity PMs and watching what some of our peers are doing, the other issue is where do you invest? So Europe's in recession, U.K., definitely in recession. Asia and China growth are slowing down. And in the U.S., you've got stocks yielding higher than the -- way higher than the 10-year treasury. So a lot of things are starting to swing back towards U.S. equities at this point.

Mark Raymond Fetting

But it's going to take some time, and we're prepared to work through it.

Operator

Our next question is from the line of Jeff Hopson with Stifel, Nicholas.

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

I may have missed it, but Permal, what were the flows in the quarter? And I think you commented on performance, how is the relative performance there? And then I'm sorry, but just on the numbers between -- for the closed-end fund cost , how much in comp and how much in distribution expense?

Mark Raymond Fetting

All right. So on Permal, Permal did have kind of modest outflows for the quarter. And it really was a netting effect of continued inflow on U.S. institutional, continued outflow in the kind of what we call traditional high net worth, but some lumpiness that we will periodically see, what we call their kind of independent high net worth channel, places where they've made a lot of progress. There just seemed to be a pause, but we see basically that pipeline's still quite strong. On the non-U.S. institutional, things were a little mixed. It was more of a risk-off kind of attitude there. Overall, going forward, we continue to see a lot of good opportunities for Permal. And particularly, over these next several quarters kind of we'll be clear if we can close those things and take them over the goal line, we'll have some good results. And performance, you asked about the performance. The relative performance of Permal continues to be good to very good, and in fact, July was a very good plus month for them, which is encouraging as they kind of face-off on this pipeline of new business opportunities.

Peter H. Nachtwey

And Jeff, on your closed-end fund launch cost, roughly $21 million in D&S, and you have $2 million to $3 million in comp.

Operator

Our next question is coming from the line of Eric Berg of RBC Capital Markets.

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

I'm still struggling a little bit with the response to the question. I'm hoping I can -- you can build on your answer to the question about the rebranding, the question from Roger. Is it that you are just stepping up your advertising of the retail funds of Western or you're attaching the Western brand to the Western funds? In which case, the question would be what had been the brand? If you could just go over this and build on earlier response. I would be ...

Mark Raymond Fetting

Sure. Thanks, Eric. Here, again, Western has been throughout its now 40-year history, a highly regarded institutional manager and over roughly the last 10 to 15 years has been kind of extending its presence into the retail market. We made a joint decision with Western that now is the time to really leverage all of the fixed income retail offerings that they do under the Western brand, with still kind of an association of -- as a Legg Mason company. And it is that the extension strategy, leveraging their long-established brand as the lead with continued support from Legg Mason that we're going to be following, and we will follow that same strategy with other managers. We've been doing this with Royce quite successfully for some time. Royce is a highly respected brand in the small-cap market and has its own constituency. But then with an association with Legg Mason in markets that are -- have been new to them over the roughly 10-year period that we've been working together has been very beneficial. So this is really continuing a path that has been proven successful for us with some of our other managers, and we'll continue to do it with others.

Operator

We only have time for one more question. That question is coming from the line of Doug Sipkin with Susquehanna.

Douglas Sipkin - Susquehanna Financial Group, LLLP, Research Division

I just wanted to maybe drill down a little bit on the equity business, talking about maybe opportunities for long-term growth. At least from my perspective, it would seem like the best thing you guys probably do especially in a tough market for equity is try to seek out a stronger equity manager to really help regain some momentum. I mean, while I get the market is choppy, I mean, it still looks like you guys seem pretty -- fees and levels of equity outflows of the game which is weighing on the revenue yield. So I know you guys have a plan for stock buyback through several years. But I just want to get your sense of what the dialogues are or maybe you guys could do something to grow on the equity side?

Mark Raymond Fetting

You're correct to point out, we've got continued work to do on the equity front at $150 billion in aggregate, we're clearly a formidable player in the equity markets. We're principally focused on the U.S. equity market. So we would like to expand our capabilities in non-U.S. or international equity. And let me kind of briefly hit each of the key managers there. ClearBridge is doing a terrific job, and we're working with ClearBridge to kind of continue to bolster their lineup. In Royce, you have a long-standing leader in small and micro-cap investing. And while that sector has got some clear headwinds, and they, performance-wise, as I mentioned has some short-term pressure. They're really quite active and respected as a voice that's kind of how to properly allocate into the sector. And we see that over time will be a continued good business for us. On the international equity front, working with our teams and potentially in bolt-ons, that would be an area, and medium-term, injecting a standalone manager could be a possibility as they stay in the medium longer-term. We do have specialty teams doing emerging market equities, both at Batterymarch and in our global equities team. And in fact, we've got a wonderful momentum going with their Australian equity team, making available the capability to Japanese investors, that's actually developed some good momentum. So that's the overview. I agree with your general direction.

Operator

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

Mark Raymond Fetting

I want to thank everybody. We are proud of the progress we've made, but keenly aware that we're not delivering on all fronts, flows, margin improvement, et cetera among the things that we see. Working closely with our affiliates, we are determined to continue to deliver on and deliver a full set of success to our clients, to our colleagues and to our shareholders. So we thank you, all, very much.

Operator

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

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