Waddell & Reed Financial (WDR) Henry John Herrmann on Q1 2016 Results - Earnings Call Transcript

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Waddell & Reed Financial, Inc. (NYSE:WDR) Q1 2016 Earnings Call April 26, 2016 10:00 AM ET

Executives

Henry John Herrmann - Chairman & Chief Executive Officer

Nicole McIntosh-Russell - Vice President-Investor Relations

Philip James Sanders - Chief Investment Officer & Senior Vice President

Thomas W. Butch - Chief Marketing Officer & Executive Vice President

Brent K. Bloss - Chief Financial Officer, Treasurer & Senior VP

Analysts

Michael S. Kim - Sandler O'Neill & Partners LP

Chris C. Shutler - William Blair & Co. LLC

Glenn Schorr - Evercore ISI

Daniel Thomas Fannon - Jefferies LLC

William Raymond Katz - Citigroup Global Markets, Inc. (Broker)

Adam Q. Beatty - Bank of America Merrill Lynch

Robert Lee - Keefe, Bruyette & Woods, Inc.

Patrick Davitt - Autonomous Research US LP

Eric Berg - RBC Capital Markets LLC

Macrae Sykes - Gabelli & Co.

Operator

Good morning, everyone, and welcome to the Waddell & Reed First Quarter Earnings Conference Call. All participants will be in a listen-only mode. After today's presentation, there will be an opportunity to ask questions. Please also note that today's event is being recorded.

At this time, I'd like to turn the conference call over to Mr. Hank Herrmann, Chairman, Chief Executive Officer. Sir, please go ahead.

Henry John Herrmann - Chairman & Chief Executive Officer

Thank you. Good morning. With me today are Tom Butch, our Chief Marketing Officer; Brent Bloss, our Chief Financial Officer; Phil Sanders, our Chief Investment Officer; and Nicole Russell, our VP of Investor Relations.

Nicole, would you read the forward-looking statements, please?

Nicole McIntosh-Russell - Vice President-Investor Relations

During this call, some of our comments and responses will include forward-looking statements. While we believe these statements to be reasonable based on information that is currently available to us, actual results could materially differ from those expressed or implied due to a number of factors, including, but not limited to, those we referenced in our public filing with the SEC. We assume no duty to update any forward-looking statements.

Materials that are relevant to today's call, including a copy of today's earnings press release as well as supplemental schedule, have been posted on our website at waddell.com under the Corporate tab.

Henry John Herrmann - Chairman & Chief Executive Officer

Thank you, Nicole, and good morning, again. Weak firm performance and tightened market volatility continued to pressure flows. Asset Strategy was the largest with $4.6 billion of outflows during the quarter, pressured by significant redemptions from a large third-party distributor.

We also experienced an increase in outflows from some of our other franchise funds. Improving performance is critical and, as such, priority number one. I believe in on our investment process and I'm confident that we have the right people and the right resources to get us back to delivering competitive investment returns.

Philip James Sanders - Chief Investment Officer & Senior Vice President

Good morning. This is Phil. The unusual market volatility during the quarter created an environment that few active managers navigated successfully. Persistently slow global growth, unusually accommodative global central banks, negative interest rates and the uncertainty regarding the upcoming U.S. elections remain at the forefront of investor concerns.

These ongoing economic, political and policy risks have resulted in a market where perceived safety, stability and yield remain in high demand. In our view, this has resulted in an environment where significant valuation and correlation anomalies are evident across specific sectors and the market in general. We believe these will normalize over time, thereby creating a more favorable backdrop for active management.

While the current environment has been challenging for active managers, it is also true that we have not executed particularly well across a meaningful portion of our product line. Recent fund performance has been disappointing by out firms' historical standards, especially in several franchise products that have been important sales drivers.

The reasons for these performance shortfalls vary by product and cannot be attributed to one or two specific factors. Nevertheless, it is our job to effectively manage through all types of environments and we clearly need to do a better job in that regard.

Our firm has a long and successful track record of strong investment performance. As Hank said, we believe we have the right team and resources in place, along with an investment process that has stood the test of time. Consequently, we are confident that when we look back, the recent performance challenges were proved to be an aberration.

I'll now turn it over to Tom. Tom?

Thomas W. Butch - Chief Marketing Officer & Executive Vice President

Thank you, Phil. I would like to start my prepared remarks with comments about Asset Strategy. The Strategy shrunk to $16 billion at quarter end and today it totals roughly $13 billion. As mentioned on our last call, a large institutional account gave us notification that they would be reallocating away from the fund and did so in mid-April with a $2 billion withdrawal.

Asset Strategy outflows were exacerbated during the quarter by an unexpected and unusual decision by a broker-dealer to suspend sales of the fund and suggest liquidation of advisory positions in it. This meant the fund was no longer available for new sales at that broker-dealer effective February 8.

Asset Strategy AUM at that firm, at that time, was approximately $2 billion, $660 million of which was in advisory account. At the end of the first quarter, approximately $175 million remained in advisory accounts, and that amount is projected to be liquidated by May 10.

In total, approximately $865 million in Asset Strategy assets remain at this firm as of today. We're working diligently to preserve the position of this fund on all third-party platforms, and have met with every broker-dealer in seeking to secure its position.

At this time, only three firms have more than $1 billion in Asset Strategy, including our own broker-dealer whose holdings represent approximately one-quarter of the fund's asset.

Beyond Asset Strategy, as Hank and Phil noted, performance inflows were challenged in a number of our large product. We're optimistic about the potential in a number of funds, including some of the recently launched funds, such as those featuring Apollo as a sub-advisor for the alternative credit sleeve.

In limited distribution, these funds have accumulated assets of roughly $375 million since their October launch. The funds turned six months old on April 1 and we are hopeful for broadened distribution opportunities for them in the near future.

Our international core equity fund delivered solid net flows in the quarter, and a handful of funds saw positive flows as well, though at lesser volume. The high income fund flows improved each sequential month during the quarter, with higher sales volume and lower redemptions approaching break-even in March. We continue to assess new product opportunities through a multi-disciplinary internal committee and our pipeline in that regard remains fertile.

Last week we filed a registration statement with the Securities and Exchange Commission to register three exchange-traded managed funds, or ETMFs. We continue to believe ETMFs are unique and progressive investment product option that in time will be adopted broadly in the marketplace.

Turning our focus now to our Advisors channel. You may have noticed in our press release this morning that our disclosure has evolved to include additional broker-dealer measurements. We do believe that having proprietary distribution will continue to be valuable, and may be even more important as the external distribution environment continues to evolve.

We have reviewed the final version of the DOL rule and noted that the final rule, in addition to removing some of the proposals' most challenging operational requirements, also specifically recognized the legitimacy of proprietary products within a best-interest construct. We have an internal team that has been working on the DOL rule since it was first announced, and we continue to follow developments closely and prepare for its arrival diligently.

The implementation of Project E, detailed last quarter, remains on schedule, with our share class conversion on proprietary products slated for early summer, and new technologies and advisory products for later this year. This effort will ensure the competitive viability of Waddell & Reed Inc. and give us greater strategic flexibility in managing it. Response from our field to the Project E initiative has been enthusiastic.

Our challenge is to achieve the right balance between strategic investments in our business, while managing costs and preserving margin.

Brent will walk you through a financial impact of our cost reductions and updates to Project E estimate. Brent?

Brent K. Bloss - Chief Financial Officer, Treasurer & Senior VP

Thanks, Tom. In February, we announced the cost reduction initiative which was aimed at reducing fixed costs by approximately 10% off of 2015's run rate. We have completed this process and have identified the costs necessary to meet our savings goal of $40 million. We expect that approximately two-thirds of our target number will be realized in 2016 and for savings to hit their full run rate in 2017.

Once fully implemented, these reductions will result in a 10% drop in U&D indirect cost, an 8% drop in compensation cost, and a 9% drop in G&A cost compared to 2015 total. During the second quarter, we expect to record a severance charge of approximately $16 million to $17 million.

I would now like to update you separately on the cost of investments to Project E and the share class conversion. We have begun our work on building the new platform and expensed $1.2 million during the first quarter. We believe our original estimate of one-time costs of $8 million remains a good estimate.

With regard to the share class conversion, we expect to convert load-waived A shares in our advisory products to Class I shares in mid to late June. Our estimates for the financial impact of this share class conversion remain unchanged as the asset level in our advisory accounts was consistent between periods. You will see a schedule with a detailed breakdown of Project E's impact on our P&L on our website.

Hank will now take you through the first quarter highlight.

Henry John Herrmann - Chairman & Chief Executive Officer

Thanks, Brent. First quarter net income of $37 million and earnings per share of $0.45 declined roughly 40% compared to the fourth quarter of 2015 and 45% compared to the same quarter last year. Included in net income during the quarter was investment losses of $10 million, compared to gains of $7.6 million last quarter and gains of $4 million in last year's first quarter. The operating margin declined to 22.1% as fixed costs could not be adjusted rapidly enough to offset the steep decline in assets.

Assets under management fell below the $100 billion mark for the first time since 2012, as outflows persisted amidst a combination of weak fund performance and lower demand for actively managed funds. April is showing early signs of performance improvement across most of our fund complexes.

Finally, we took advantage of our depressed stock price and purchased a total of 1.1 million shares during the first quarter and an additional 259,000 shares in April. Including share repurchase and dividends, we returned nearly $70 million to our shareholders so far this year.

We are focused on reestablishing the growth we've enjoyed for more than a decade. We believe that offering a wide span of products best positions us to capture opportunities.

I look forward to speaking with you again in the coming quarters. Operator, at this time I would like to open the call for questions.

Question-and-Answer Session

Operator

Ladies and gentlemen, at this time, we'll begin the question-and-answer session. Our first question today comes from Michael Kim from Sandler O'Neill. Please go ahead with your question.

Michael S. Kim - Sandler O'Neill & Partners LP

Hey, guys. Good morning. First, Hank, I think last quarter you sort of mentioned that you expected outflows to slow this year versus last year. Just wondering if you still believe that to be the case now that we've gotten a little further into the year.

Henry John Herrmann - Chairman & Chief Executive Officer

I do. Maybe Tom wants to order (13:47) specific or not, to put some color on that. But I think the really steep runoff in Asset Strategy fund is such a place that it should modify.

Thomas W. Butch - Chief Marketing Officer & Executive Vice President

Mike, this is Tom. I would agree with that. As I mentioned in my opening remarks, a quarter of the remaining asset base in Asset Strategy is at the Waddell & Reed broker-dealer, and therefore is far stickier than any external broker-dealer asset in the fund.

And again, I think in addition to that, there was somewhat of an artificial acceleration based on what I described relative to the actions of one of our broker-dealers, and those numbers also suggest that that will run its course as well.

That said, obviously we need to reignite growth sales momentum at a rate greater than it is today, and as performance turns and as certain of our newer products mature and gain space at the broker-dealers, we're confident and hopeful that that takes place.

Henry John Herrmann - Chairman & Chief Executive Officer

Mike, this is Hank back again to follow up some more. I think you're aware that our Mid Cap Growth fund and our High Income fund were also important contributors to the outflows. As you probably know, the stress in the high-yield market has turned around to now excitement, I suppose, maybe that's going too far. But, anyway, our situation has improved quite a bit. And so, that's another thought about moderating.

And then finally, on this subject, our Mid Cap Growth product has also been troubled with meaningful outflows, again performance-related and certainly beginning in the first quarter and carrying on until the present. The relative performance of that product has improved very substantially and I think that should also contribute to a slowing in outflows and hopefully an improvement in inflows.

So I think between the three comments, we provide the color we've got available.

Michael S. Kim - Sandler O'Neill & Partners LP

Got it. That's helpful. And then, just so I'm clear, Brent, you walked through some expected expense declines across some various line items. Just so I'm understanding that correctly, those percent declines represent sort of full-year 2016 versus 2015 levels, is that right?

Brent K. Bloss - Chief Financial Officer, Treasurer & Senior VP

Yeah. Those are annualized drops off of 2015 numbers. Now, as I said, we would expect to realize around two thirds of those during 2016. So you take 65% to 70% of those percentages, and that should get you to what our expectations are for drops in those expense lines.

Michael S. Kim - Sandler O'Neill & Partners LP

Got it. Okay. Understood. And then finally maybe, just to come back to Hank, any sort of updated thoughts on buybacks just in light of the stocks' more recent decline versus preserving capital for the dividend?

Henry John Herrmann - Chairman & Chief Executive Officer

You know what? I intend to work on both. Obviously, the sharp decline here provides another opportunity to be adding to positions. I don't want to tell you I'm about to go to the trading room, but I expect that we'll continue to accumulate more shares.

Michael S. Kim - Sandler O'Neill & Partners LP

Okay. Fair enough. Thanks for taking my questions.

Henry John Herrmann - Chairman & Chief Executive Officer

Okay.

Operator

Our next question comes from Chris Shutler from William Blair. Please go ahead with your question.

Chris C. Shutler - William Blair & Co. LLC

Hey, guys. Good morning. Could you maybe give us a sense of how large the investment team is as we sit here today relative to last quarter or a year ago?

Henry John Herrmann - Chairman & Chief Executive Officer

I'll have Phil answer that one.

Philip James Sanders - Chief Investment Officer & Senior Vice President

Currently we have, I don't have the exact number, but probably 80-plus investment professionals. That's a combination of portfolio managers, analysts, economists, currency experts, traders and so forth. On a year-over-year basis, it's probably not that different. I would just say that we've lost – we had 3 departures as part of the cost reduction efforts that Brent highlighted; only 3 from the investment division out of 80-plus. We had one co-portfolio manager in a product, and then two analysts. And I guess the total number of investment professionals, yeah, was like 88 last year and probably low 80s this year or something like that. We can get those exact numbers for you.

Chris C. Shutler - William Blair & Co. LLC

Okay. No, that's helpful. Thank you. And then maybe for Tom on the institutional pipeline, just maybe walk us through where you're seeing interest, and any large redemptions or wins that you've been notified of, I guess, besides the ones that you mentioned earlier?

And I also wanted to clarify on the large broker-dealer and the Asset Strategy issue. I think you called out the amount of Asset Strategy AUM that's still remaining with that one large broker-dealer. Could you just repeat that?

Thomas W. Butch - Chief Marketing Officer & Executive Vice President

Yeah. The number I said was $865 million.

Chris C. Shutler - William Blair & Co. LLC

Okay.

Thomas W. Butch - Chief Marketing Officer & Executive Vice President

That's a reasonably current number. On the institutional side, to answer your questions in reverse, reminding everyone on the call that there was, in addition to the Asset Strategy redemption last quarter, also announced a redemption of another position on the order of $800 million, which (20:01) high strategy for which we had served as sub-advisor. Both of those were terminated in April. So, both were made known last quarter, both were terminated in April.

Relative to the pipeline, the interest remains principally in the Large Cap Growth and large cap core strategies. We added a number of opportunities in the first quarter in both of those strategies, but we don't have any wins or any losses of consequence to announce...

Chris C. Shutler - William Blair & Co. LLC

Okay.

Thomas W. Butch - Chief Marketing Officer & Executive Vice President

...other than the two that I mentioned having happened in April.

Chris C. Shutler - William Blair & Co. LLC

Yeah. Okay. So about $3 billion in total?

Thomas W. Butch - Chief Marketing Officer & Executive Vice President

Yeah. $2.8 billion. Right.

Chris C. Shutler - William Blair & Co. LLC

$2.8 billion. Yeah. Okay. Thank you.

Operator

Our next question comes from Glenn Schorr from Evercore ISI. Please go ahead with your question.

Glenn Schorr - Evercore ISI

Hi. Thanks very much. Just want to make sure I understood your comments on the investment and other income in the release. So you entered in some total return swaps to hedge out the economic risk or the market risk, but didn't get that all in place this quarter hence the mark-to-market. But, going forward, does that mean we should not see any big positive or negative swings as you've tried to hedge out most of that mark-to-market?

Brent K. Bloss - Chief Financial Officer, Treasurer & Senior VP

Yeah. Glenn, this is Brent. That's correct. About 75% of the investments that we have that are equity method or trading, which are low securities that the gains or losses would go through the income statement, are hedged currently. And so, back to your question, 75% of that would be hedged, and we shouldn't see much volatility going forward through the income statement.

Glenn Schorr - Evercore ISI

Okay. Curious where your debt-to-EBITDA is now, and if you have any specific constraints on where you'd let that go, if that's the right measure to be looking at.

Brent K. Bloss - Chief Financial Officer, Treasurer & Senior VP

Yeah. I don't have that in front of me, Glenn, but I can tell you that we're well under our marks there and it's not a concern at this time.

Glenn Schorr - Evercore ISI

Okay.

Henry John Herrmann - Chairman & Chief Executive Officer

We'll get back to you with the precise answer.

Glenn Schorr - Evercore ISI

No problem. Thanks, Hank. Last one's also from the release. You made two comments I'm curious if you can expand on. One was intensify the efforts to broaden the product line. I don't know if that's about things like Apollo, LaSalle and Pictet which we know about or there's new stuff. And also there was a comment in there about consolidating several sponsored funds, and if you could just give a little color on how big, how many?

Henry John Herrmann - Chairman & Chief Executive Officer

That letter points – I think might have been some mistake in our articulation. I don't remember that being in or anyway. We're checking.

Thomas W. Butch - Chief Marketing Officer & Executive Vice President

In the meantime, I can just mention, Glenn, that the intent of that comment was to suggest that the work we've been doing over the past many quarters to broaden the product line with products such as those you mentioned is still very much in place, and we have a lot of work going on to find those opportunities which best suit our investment management capabilities and match them with market needs. And so it was really just an indication that our effort to continue to diversify the product line remains very much intact.

Glenn Schorr - Evercore ISI

Okay. Thank you.

Brent K. Bloss - Chief Financial Officer, Treasurer & Senior VP

And Glenn, on your question on consolidated funds, we did seed some of our IGI investments at the beginning of the quarter, which pushed us over 50% in our SICAV, which under accounting rules require that we consolidate the funds onto our balance sheet. As a result of that – I mean, at the time, most of it – and it remains today, most of it's our seed money in there. So the growth up on the balance sheet is around $11 million for non-controlling interest related to the consolidation of that SICAV.

Glenn Schorr - Evercore ISI

Okay. I got it. Thank you very much.

Operator

Our next question comes from Dan Fannon from Jefferies. Please go ahead with your question.

Daniel Thomas Fannon - Jefferies LLC

Thanks. Good morning. I guess, Tom, I would like to just flush out a little bit more on the DOL and kind of think about – maybe you have Project E that was started prior to DOL. You now have the final rules. And maybe talk about what, from a spend perspective, might be resulting in higher expenses just from trying to delineate between the two, both from DOL and what you guys are already doing in Project E?

Thomas W. Butch - Chief Marketing Officer & Executive Vice President

I'll pass that off to Brent related to the projected expenses of DOL. But I would prior to that just make a couple comments. I think echoing what I said in my opening comments and those are that, from the perspective of our broker-dealer, the final rule softens the technology burden and again, most important for us, recognized important role of proprietary products and acknowledge their applicability within a best-interest construct.

I think also important from our perspective was the fact that it provided for the presentation of the best-interest contract, which we will utilize, at account opening and as part of that account opening process, rather than at the initiation of client contact. So, all-in-all, sort of as pretext that Brent will talk about relative to the numbers, certain of the technology burdens that were the most onerous in the draft proposal seem to have abated somewhat in the final draft and final proposal.

Brent K. Bloss - Chief Financial Officer, Treasurer & Senior VP

Right. So, as it relates to costs, as we've stated, we're still going through the proposal and we believe at this time that most of the cost will be related to consulting, legal, some of the operational aspects, websites, as well as processing in the field, which right now we have the Project E initiative going on where we can implement that as part of Project E, so hopefully straight through processing with anything we have to do around documentation.

So, at this point, it's just a guess, but we're thinking it's probably a seven-figure number that we'll have to refine as we go along here, as we dig in and understand the cost. But, right now, those are the components we think we'll need to figure out in the coming weeks.

Daniel Thomas Fannon - Jefferies LLC

And to be clear, that would be additive to the percentage declines that you highlighted earlier with regards to your expense reduction initiatives?

Brent K. Bloss - Chief Financial Officer, Treasurer & Senior VP

We have baked in right now, I believe, about $0.5 million related to that effort into our Project E analysis. We would be updating off of that number.

Daniel Thomas Fannon - Jefferies LLC

Got it. And then I guess, just generally on the Advisor business, redemption rates remain very low. I guess, just curious about your ability to attract advisors. I saw head count was down modestly. But how do you think that's going to trend going forward, or do you expect to grow that? And as this transition occurs with DOL and other things, do you anticipate redemption rates changing at all?

Thomas W. Butch - Chief Marketing Officer & Executive Vice President

Well, the redemption rate has been remarkably steady over time. And we don't foresee a reason to believe that that will change materially. Relative to the attraction of advisors, it's kind of sluggish industry-wide, but that said, I think our pipeline is actually better than where we were at this time last year. I think the value proposition continues to resonate with experienced advisors.

And on the classic side, we're probably offering to fewer candidates and really emphasizing quality and proactive sourcing of potential financial advisors on that side. So we've seen – other than the industry being kind of sluggish as the DOL was gestating, we've seen no material effect on our recruiting, and in fact, think we're in a better spot than we were this time last year.

Daniel Thomas Fannon - Jefferies LLC

Great. Thank you.

Operator

Our next question comes from Bill Katz from Citi. Please go ahead with your question.

William Raymond Katz - Citigroup Global Markets, Inc. (Broker)

Okay. Thanks so much for taking the questions. I just want to stay with DOL for a moment. Within the Advisor channel, can you give me an update of how much of your sales are coming from variable annuity? And if you could break that down between proprietary and non-proprietary.

And then, on that same line, you mentioned 25% of the Asset Strategy fund is still from that particular channel. I'm sort of curious, as you contemplate some of the deeper insights of the base, if you will, how do you get strategic comfort that that is not elevated litigation risk associated with the underlying performance trend and some of the impartiality dynamics of the new law? Thanks.

Thomas W. Butch - Chief Marketing Officer & Executive Vice President

Well, relative to the VA piece, I think your question was what – they're not a huge part of sales, on the order of 10%-ish in the first quarter, about $115 million. Most of those sales are in products which have, as their sub-accounts, our product.

Relative to your second question, these are all things that we will have to work on as we determine our response to the best-interest contract. Obviously, we will live within the spirit of that and its specific intent. We believe our advisors have historically embraced a best-interest ethic. But relative to specific questions about specific funds, probably premature to answer those.

William Raymond Katz - Citigroup Global Markets, Inc. (Broker)

Okay. And then, just stepping back for a moment, appreciate your performance has gotten a little bit better most recently. But if you look at your gross sale dynamic, those have been trending lower. What strategies – I know you mentioned you have a couple of newer products sort of incubating, if you will. Is there a step-up of marketing spend, is it just time, what do you think helps drive the possibility of boosting the gross sales for the franchise?

Thomas W. Butch - Chief Marketing Officer & Executive Vice President

I think there's a couple of things, Bill. First of all, as I mentioned and reiterated in one of the prior questions, we've had a pretty aggressive product development effort over the last few years. The process of getting those funds up on platforms, as you likely know, takes time. We're getting to a place where we believe that a lot of those products either have matured in terms of time, or in terms of assets or both to get broader placement.

I'm talking about things like the Apollo products, the LaSalle, Global Real Estate products, which we believe have generated initial interest, but are not in as broad distribution as what we required for them to be really meaningful in terms of sales.

Relative to things that have some salience right now, we've had multiple quarters in a row of good sales performance in the International Core Equity fund. Energy has shown some signs of growth. And again, as mentioned previously, a number of our franchise products are starting to show some degree of turnaround in their performance. And that will be very important.

Obviously, the funds that have the weight of assets and have the weight of marketplace salience and are the best-known are going to be important. So I think it's a mix of the funds which historically have performed coming back and a number of the newer strategies gaining footing in the marketplace.

Relative to spend, our effort always has been investing in the wholesaling process and engaging the firms in that way rather than a very broad-based advertising spend.

William Raymond Katz - Citigroup Global Markets, Inc. (Broker)

And just one last one. Thanks for your patience taking all my questions this morning. Just coming back to Asset Strategy fund, so two questions there as well. First one is, could you give us just general background of why the intermediary has suggested liquidating the fund? And then, can you give us an update of what the private holdings are within the fund, given the current level of $13 billion of assets, I think the number you gave us just in your prepared comments?

Thomas W. Butch - Chief Marketing Officer & Executive Vice President

I can take the first piece. The factors cited are none that will surprise you, I don't think, performance and portfolio management turnover being of primacy. And your comment about the privates and their place in the portfolio also is something that came into that conversation.

William Raymond Katz - Citigroup Global Markets, Inc. (Broker)

And where do the privates stand today?

Philip James Sanders - Chief Investment Officer & Senior Vice President

Yeah. Bill, this is Phil. Obviously, we're limited as to what we can – a lot of information we can talk about in terms of positioning of the illiquids with respect to confidentiality obligations, but can say that finished the year calendar 2015 a little over 11%. And we did sell some of the illiquids in the fourth quarter of 2015, had additional sales in the first quarter of 2016, and stand with a position now slightly below the level that we exited at the end of the year. So, despite outflows, the liquidity position – the illiquid position has dropped slightly over the course of the quarter.

William Raymond Katz - Citigroup Global Markets, Inc. (Broker)

Okay. Does that hold – I'm sorry, the last one. Does that hold true then with the known outflows coming up for the $2.8 million to $2-some billion that's coming out on the sub-advisor side? Does that ratio go up because of that?

Nicole McIntosh-Russell - Vice President-Investor Relations

Bill, this is Nicole. Just to be clear, the $2.8 billion of outflows, only $2 billion of that is Asset Strategy. The other $800 million is a different account.

William Raymond Katz - Citigroup Global Markets, Inc. (Broker)

Right, all right. So – okay, I'll follow up offline. Thanks, guys.

Nicole McIntosh-Russell - Vice President-Investor Relations

Yeah.

Operator

Our next question comes from Michael Carrier from Bank of America Merrill Lynch. Please go ahead with your question.

Adam Q. Beatty - Bank of America Merrill Lynch

Thank you and good morning. This is Adam Beatty in for Mike. First, just a quick follow-up on performance in the quarter. I was wondering if there was anything among the major products about the way that they were positioned that prove to be, especially or notably, at odds with the market action in the quarter. Thanks.

Philip James Sanders - Chief Investment Officer & Senior Vice President

Well, this is Phil. As is typically the case, there's really a lot of different reasons for performance issues. It's always a combination of sector positioning and security selection and so forth.

I think, in general, a couple observations perhaps across the complex, probably a little overexposed healthcare which underperformed a little, underperformed to the consumer staples, and kind of the so-called stable stocks which in our view are pretty highly valued across the marketplace. So, just in a general sense, some of the funds are probably underrepresented there.

So it's really different things for different products, but I think there was a reversal of a lot of the momentum factors and growth factors and so forth. But not – there's never one thing you can point to. We did see improved performance out of Mid Cap Growth that was touched on by Hank. That product actually had a very solid first quarter. And that's kind of what we said.

But it's just really a combination of a lot of different things and it varies product-by-product.

Adam Q. Beatty - Bank of America Merrill Lynch

Yeah. Thanks, Phil. Appreciate the detail. And then on ETMFs, just wanted to get your overall perspective on, as kind of an arm's length third-party with the process of registering and launching, and anything you've observed so far about the trading of the ETMFs that are out there in terms of your expectations and maybe any possible concern? Thanks.

Thomas W. Butch - Chief Marketing Officer & Executive Vice President

The early days have revealed no structural concerns. From a business perspective, I think, separately, the consideration of these products I think slowed as the broker-dealer community was awaiting final DOL ruling. And we're hopeful that, as that is digested in the broker-dealer firms, that the product will find its way into much broader distribution than exists today. We're obviously in close touch with our partners at NextShares and are optimistic that that will take place.

Adam Q. Beatty - Bank of America Merrill Lynch

Thanks. Do you expect to maintain kind of a run rate pace of product launches, or get those first few out and wait and see a little bit?

Thomas W. Butch - Chief Marketing Officer & Executive Vice President

Our focus right now is getting those first few out. And assessing both the response to your first question that they're working as we think they will and then obviously we have to assess where the marketplace is relative to adoption. So the focus right now is on the first set of them.

Adam Q. Beatty - Bank of America Merrill Lynch

Great. That's helpful. Thank you for taking our questions.

Operator

Our next question comes from Robert Lee from KBW. Please go ahead with your question.

Robert Lee - Keefe, Bruyette & Woods, Inc.

Thanks. Good morning. I guess, a couple of questions around the Advisor channel, or I guess the retail broker-dealer channel now. Can you update us on fee-based accounts? I mean, obviously you have the disclosure there about proportion of AUA. But I guess, number one, just trying to get more updated numbers on kind of, from a new sales mix, how much of your new sales are going into fee-based accounts.

And then also that $17.4 billion, if memory serves me, that's not entirely Waddell-managed funds product, there may be some other third-party products in there. If that's the case, do you see that as maybe one aspect of the DOL rule that makes further changing going forward? And then how should we think of that from kind of at least a U&D perspective in terms of does that enhance the U&D margin to some degree as more assets flow to fee-based accounts? I'm just trying to get a feel for shifts there and how that may flow through distribution revenues.

Thomas W. Butch - Chief Marketing Officer & Executive Vice President

Okay. Let me – I think there are a handful of things in there, Rob, let me take a swat at it and others might want to as well. Roughly two-thirds of new sales go into advisory products, and that number has been consistent for a number of quarters.

And in terms of your question relative to the mix, yes, there are certainly other products in those fee-based accounts, remembering of course that we have two discrete channels, classic and choice. How that mix changes over time, prop versus non-prop, is something that will evolve as it evolves. If it's instructive at all to look at our past experience, the migration is not steep at the front-end. And as a greater choice evolves in our channel, we would believe it to be measured.

I don't know how much upside there is right now in terms of growth of advisory as a percentage because it has remained stable for several quarters. I think, though, as we enhance these products both through technology, through planning tools and through the span of products available, that is what I think would change what has been a fairly static percentage.

It's hard to sort of project a number relative to prop versus non-prop, but there will be some migration toward non-prop we would imagine and it's baked into our financials over the first couple years of these new advisory programs. Experience with other advisors who have adopted a broader platform here has been on the order of 25%-ish, 30%-ish.

Brent K. Bloss - Chief Financial Officer, Treasurer & Senior VP

Rob, this is Brent. I think you asked the question how much of the AUA and advisory accounts is prop, and it looks to be about $15.4 billion of that $17.4 billion.

Robert Lee - Keefe, Bruyette & Woods, Inc.

And I guess, if I think of – assuming the current fee rate on average is about 100 basis points on the kind of fee-based accounts, how should we be thinking of that? I think your direct margin has generally been about 70%. Is there any reason that we should think when we're trying to think about distribution margin over time that, as more and more goes to fee-based accounts, if that relationship's going to change meaningfully or is there kind of different kind of revenue split with advisors on those kinds of accounts?

Brent K. Bloss - Chief Financial Officer, Treasurer & Senior VP

No, it's fairly consistent across the board. So I wouldn't see that percentage changing much, Rob, as we move forward. Even with the non-proprietary products, as Tom was mentioning, the move to those, we still receive the wrap fee, which is on average instead of 100 basis points, I think it's around 125 basis points. So we receive that fee regardless of whether it's a proprietary or non-proprietary product.

Robert Lee - Keefe, Bruyette & Woods, Inc.

Okay. Great. Those are my questions. Thank you.

Operator

Our next question...

Brent K. Bloss - Chief Financial Officer, Treasurer & Senior VP

And then just to follow up real quick on Glenn Schorr's question on the debt-to-EBITDA, it's at 0.45. Our covenant is at 3. So we have lots of coverage.

Operator

Our next question comes from Patrick Davitt from Autonomous. Please go ahead with your question.

Patrick Davitt - Autonomous Research US LP

Hi. Good morning, guys. On the two broker-dealers that you mentioned you're working with keeping on their platform, where do you think we are in that process and to what extent is the DOL playing into that decision process given where the performance is?

Thomas W. Butch - Chief Marketing Officer & Executive Vice President

I think we only – I think what we said was we are working with all of – if you're talking about Asset Strategy, then we're working with all of our broker-dealer partners. Was that your question?

Patrick Davitt - Autonomous Research US LP

Yeah. I guess, you mentioned that there were only two left, though, on top of your own?

Thomas W. Butch - Chief Marketing Officer & Executive Vice President

No, I...

Patrick Davitt - Autonomous Research US LP

I guess, I missed.

Thomas W. Butch - Chief Marketing Officer & Executive Vice President

Oh, I'm sorry.

Patrick Davitt - Autonomous Research US LP

Yeah.

Thomas W. Butch - Chief Marketing Officer & Executive Vice President

Nicole reminds me that there are just two left that have more than $1 billion in the fund.

Patrick Davitt - Autonomous Research US LP

Right. That's what I'm getting at. Yeah, yeah. Okay.

Thomas W. Butch - Chief Marketing Officer & Executive Vice President

And I guess what I would say is we have – we, the collective we, meaning our national accounts team and, in most if not all the cases, representatives from the portfolio management team have spent time at every broker-dealer that has any position of materiality talking about the fund.

Only one other broker-dealer has taken an action to limit the sales of the fund, and that was only to limit to new clients, that is, no new clients could come into the fund, but the existing clients continue to have the opportunity to buy the fund.

And at this moment in time, where we are in the fund's history and performance, the new client piece is I think less relevant than the existing client base. And that particular broker-dealer has about $600 million in the fund. I would say that only that and the one that was mentioned previously have taken any such action, and we are in constant contact with all the others.

Patrick Davitt - Autonomous Research US LP

Okay. That's all I had. Thanks.

Operator

Our next question comes from Eric Berg from RBC Capital Markets.

Eric Berg - RBC Capital Markets LLC

Thanks very much and good morning. Just one question. Tom, as you adopt the best-interest contract exemption, understanding that that allows distributors to continue to earn or generate commissions, earn commissions, but doesn't relieve them of the responsibility to do what's best for the customer, do you think that it is likely that looking at this DOL alone in isolation, that that will lead to a reduction in the share of proprietary sales, if only to create a greater appearance of impartiality and balance, or not necessarily?

Thomas W. Butch - Chief Marketing Officer & Executive Vice President

Eric, I think it's hard to predict that as a causal factor. I think, as I said before, there'll be multi-factor analysis by advisors of what is best-interest, and we will support that effort. I think the migration – I think the confluence of timing between the DOL and the Project E is more responsive to your question. I think – with the modifications that we are making through Project E to our advisory products, I think that will be more likely a source of the broadening of the asset base beyond our proprietary than in isolation will be the DOL.

Eric Berg - RBC Capital Markets LLC

I understand. Thanks very much.

Operator

Our next question comes from Mac Sykes from Gabelli. Please go ahead with your question.

Macrae Sykes - Gabelli & Co.

Good morning. Thank you for taking my questions. Two. First, is the relationship issues with IAS at that major broker-dealer that you highlighted, is that just about IAS, or has the relationship been somewhat impaired by the situation in a broader case?

Thomas W. Butch - Chief Marketing Officer & Executive Vice President

Thank you for asking that question. I should have clarified that sooner. It is quite specifically related to Asset Strategy. And senior representatives of that firm went to great lengths to ensure us that the broad relationship with Ivy and Waddell & Reed is one that is very much intact and one for which they have great respect. And every action that we have seen subsequent to this move with Asset Strategy reflects the veracity of those comments that they made.

Macrae Sykes - Gabelli & Co.

And this one's for Hank. In terms of Waddell & Reed's culture, I mean as CEO in directing the management team, I mean how do you in this kind of situation of turning around think about getting the best performance out of your employees, whether it's investment management, client relations, advisors? I mean, have you changed any incentives around compensation longer-term or some other perhaps not intangibles or just communications with the employees? I'm just curious in terms of how you're motivating people to get the best out of them. Thank you.

Henry John Herrmann - Chairman & Chief Executive Officer

Wow. A lot of different questions wrapped in one, I guess. But the number one characteristic of this organization is that we're money managers and that converts into analysts and portfolio managers being extremely important to the success of the organization. We always had an attitude that people in those parts of the company get paid on the basis of their relative performance and this contribution to the organization as a whole. I don't anticipate any change in that.

And we monitor individual performance very carefully at the analyst and the portfolio manager level in terms of how they execute their responsibilities relative to the peers that they're measured against. And I think that's always been a very important part of their motivation and a very important part of our culture, and it will continue to be that way looking forward.

Obviously, we've had a tough period for relative performance. There is no man for all seasons and we've had an extremely unusual season, so to speak, here over the last year-and-a-half or so in terms of a whole bunch of things I know you're totally familiar with. But the volatility associated with preferences within the investment base in terms of taste for cyclicals, growth, defensive, aggressive, domestic, foreign, has been the sort of thing that in several different occasions has shown very sharp changes in direction, and occasionally it's been very difficult not to be wrong-footed. And I think that's played a big role in how we've been doing. And I expect that, and it was mentioned earlier, that anomalies that have been created are going to lead to opportunities. They are leading to opportunities, and I believe we'll exploit them.

I know it's a little bit long-winded, but it's a very good question. I just wanted to communicate that our longstanding commitment to the investment process and the investment people is going to continue. I'll just remind you that, early on, I've spent many, many years as an analyst and portfolio manager, and I really, really understand the importance of having an organization that's geared toward supporting their needs and allowing them to be successful.

So thanks for the question and hopefully it's helpful.

Macrae Sykes - Gabelli & Co.

Thank you.

Operator

Our next question is a follow-up from Dan Fannon from Jefferies. Please go ahead with your question.

Daniel Thomas Fannon - Jefferies LLC

Yeah. Hey, Brent. Just a couple of numbers' questions. Can you break out the severance number in the first quarter that was in the comp line? And if I also just run rate G&A for the decline in 1Q versus – and then kind of annualize that, that's well above the kind of 10% or 9% number you talked about. So can you just give us a little bit of guidance on how the G&A line might kind of progress throughout the year?

Brent K. Bloss - Chief Financial Officer, Treasurer & Senior VP

Yeah. To answer your first question first, there was about $1.7 million of severance in the first quarter. And then, in terms of the G&A, you're right, the drop that I gave you off the 2015 rates was about 9%. That just has to do with the cost reductions of the percentage of the $40 million that'll hit that line. But there's also other factors in that line. The dealer service cost is a variable component of that line, which with the IY&R (54:21) shares, when the asset base declines, which I think Nicole puts out on the website or it's in the Q, the assets for IY&R (54:36), as those drop, there's a pass-through that goes through the G&A line. So, as of right now, that's a reduction forecasted to be about $6 million to $7 million in the G&A line. So, that's probably why you're seeing a larger variance in the quarter.

Daniel Thomas Fannon - Jefferies LLC

And that $6 million to $7 million was – is that the quarter – I guess what time is that, this 1Q?

Brent K. Bloss - Chief Financial Officer, Treasurer & Senior VP

That's an annualized number.

Daniel Thomas Fannon - Jefferies LLC

Okay. Great. Thank you.

Brent K. Bloss - Chief Financial Officer, Treasurer & Senior VP

Let me give you a little bit of more color on the G&A line for the quarter. Some of the savings came from lower legal costs and advertising costs. So we started backing off some of those expenses in the first quarter. So there were a couple of million dollars related to legal and advertising that were impacting the first quarter.

Operator

And ladies and gentlemen, at this time it's showing no additional questions. I'd like to turn the conference call back over to management for any closing remarks.

Henry John Herrmann - Chairman & Chief Executive Officer

Well, thank you all for listening in. We look forward to talking to you next time around. Thanks for your time. Have a good day.

Operator

Ladies and gentlemen, that does conclude today's conference call. We do thank you for attending. You may now disconnect your lines.

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