Artisan Partners Asset Management Inc. Q3 FY2020 Earnings Call

Hello, and thank you for standing by. My name is Andrew. I will be your conference operator today. As a reminder, this conference call is being recorded. At this time, I would like to turn the conference over to Makela Taphorn, Director, Investor Relations for Artisan Partners Asset Management.

Thank you. Welcome to the Artisan Partners Asset Management Business Update and Earnings Call. Today's call will include remarks from Eric Colson, Chairman and CEO, and C.J. Daley, CFO. Our latest results and investor presentation are available on the Investor Relations section of our website. Following these remarks, we will open the line for questions. Before we begin, I'd like to remind you that comments made on today's call, including responses to your questions, may deal with forward-looking statements, which are subject to risks and uncertainties. These are presented in the earnings release and detailed in our filings with the SEC. We are not required to update or revise any of these statements following the call. In addition, some of our remarks made today will include references to non-GAAP financial measures. You can find reconciliations of those measures to the most comparable GAAP measures in the earnings release. I will now turn the call over to Eric Colson.

Thank you, Makela, and thank you, everyone, for joining the call or reading the transcript. Today, Artisan Partners is managing more assets for more clients across more autonomous investment teams and strategies than ever before. We are compounding wealth for clients. We are creating new growth opportunities for internal and external talent, and we are generating results for shareholders. In the third quarter, we earned more revenue than ever before in our history, and we recently declared our highest quarterly dividend ever at $0.83 per share. These outcomes result from investments we have made in the firm over long periods of time, identifying, recruiting and retaining great investment talent; investing in new people and reinvesting in our existing franchises; launching high value-added investment strategies that fit with long-term asset allocation trends; building our flexible and resilient operating platform; and developing our high-quality leverage distribution model and team. In today's highly uncertain and rapidly changing environment, we are operating well. We are getting the day-to-day job done. And at the same time, we are making forward progress with business initiatives that we expect to yield further long-term sustainable growth. Turning to Slide 2. As previously announced in the third quarter, two experienced portfolio managers, Beini Zhou and Anand Vasagiri, rejoined Artisan International Value team and launched the Artisan International Small Cap Value strategy. Earlier in their careers, Beini and Anand worked as analysts under David Samra, the founder and leader of our International Value franchise. Beini and Anand are well versed in the team's value investing philosophy and process. The new strategy is a natural extension for David and the International Value franchise, providing the group an opportunity to exploit an inefficient part of the market and further develop the franchise's expertise and business. Also, Tiffany Hsiao and Yuanyuan Ji joined the Artisan Global Equity team. We are currently working with Tiffany and Yuanyuan to build and resource their team and design and launch a strategy to invest in post-venture firms in Greater China. We expect this strategy will include both public and private investments, providing investors with differentiated access to the Chinese growth story. The strategy should also fit with long-term demand from sophisticated clients who are increasing allocations to China to capture growth and catch up with China's status as the world's second largest economy. On Slide 3, you can see where the recent additions fit into the longer-term development of the International Value and Global Equity franchises, two of our longest-tenured groups. Our autonomous investment team model is extremely flexible. We try to develop a common set of franchise traits across all the investment teams, but the path and the form that traits take are unique for each team. David Samra and Dan O'Keefe founded the International Value team in 2002. On the strength of the performance of the flagship International Value strategy, they launched the Global Value strategy in 2007. They developed their franchise and business to the point that in 2018, it made sense to evolve into two separate teams, creating an opportunity and space for further growth. Earlier this year, Dan's Global Value franchise launched the Select Equity Strategy. Now, David has taken another step with Beini and Anand and the International Small Cap Value strategy. For 25 years, Mark Yockey has been developing the Global Equity franchise. Today, within Mark's investment ecosystem, we have the flagship first-generation international growth strategy, the second-generation global equity strategy, the third-generation International small-mid growth strategy managed by Rezo Kanovich, and the next-generation strategy we are working on with Tiffany and Yuanyuan. This team approach allows us to provide the space, autonomy and ownership necessary to attract great talent. At the same time, we are injecting new experience, expertise and ideas into established franchises, which creates new options for growth and should ultimately extend franchise duration. When we talk about growth, we always say thoughtful growth. That means growth that is consistent with who we are as a high value-added, talent-driven investment firm. Slide 4 shows some of the areas where we've been thoughtfully growing. It all starts with investments. We continue to add great new investment talent and to reinvest in existing talent. We continue to add degrees of investment freedom within existing strategies and with new strategies. We continue to develop all three generations of strategies, and we are exploring the next generation. The first-generation strategies continue to represent about half of our business, and we expect these strategies to remain an important part of asset allocations for many years to come. Our second-generation global strategies continue to experience strong demand, in particular from non-U.S. institutional investors. Year-to-date, the second-generation strategies have raised $1.6 billion in net client cash flows. Our third-generation strategies continue to see extremely strong business development, particularly in the U.S. wealth channel, which we expect to be a source of long-term secular growth. Year-to-date, the third-generation strategies have raised $5.7 billion in net inflows, an annualized organic growth rate of 63%. As part of our thoughtful growth mentality, we are trying to bring together great investment talent, investment resources and degrees of freedom and long-term demand. Within that framework, what might the next generation of Artisan strategies look like? We see public and private securities coming together, multiple degrees of investment freedom in the same strategy and more ways for clients to access our investment ideas and expertise, such as through co-investments. As we match great investors with additional degrees of freedom, they will have the ability to further differentiate themselves, and clients will have the ability to access multiple expressions of our investment ideas and expertise. Our thoughtful approach to growth extends beyond investment. We have always maintained a lean distribution model that complements our investment-first approach. By keeping our fixed sales costs low, we are not under pressure to generate or manufacture products to feed a distribution machine. Our distribution team is high-quality and flexible. They minimize the time our portfolio managers spend on distribution, and they serve multiple client types across our target geographies around the world. We maintain this approach by focusing on points of leverage. Recently, we have spent more time cultivating and developing strategic relationships with clients and allocators who invest across multiple investment teams and strategies. These clients and gatekeepers know who we are and trust us as a firm. We are working to build on that trust and deepen those relationships. Our firm-wide year-to-date net inflows of $5 billion include multiple investments from strategic client relationships. Our investment and distribution operations are enabled by our flexible operating platform. We have methodically developed our people, technology, mobility and resiliency over long periods of time. We were well prepared for work at home, and we have operated extremely well throughout this extended period. We will continue to invest in this critical part of our business. Our long-term investment outcomes are shown on Slide 5. Since inception, 12 of our 18 strategies have outperformed their indexes by more than 300 basis points per year after fees. We have generated long-term alpha and outperformed peers in first-, second- and third-generation strategies. We have diversified and broadened our sources of alpha across investment teams, asset classes and generations. Our greatest asset and our greatest source of future growth is the long-term performance shown on this page and the people behind it. Turning to my final slide. I want to emphasize our focus on thoughtful growth by placing our firm within the larger industry context. On this slide, we've laid out a simplified model of a horizontally and vertically integrated asset management company, a group that packages together investments, solutions and advice to deliver a holistic outcome for end clients, often retail clients. These asset managers are intensely focused on scale, packaging and pricing. Much of the recent industry consolidation is driven by this pursuit of breadth and scale. There's nothing wrong with this, but it's very different from what we do, and we want to make sure that our clients and other gatekeepers, our people and our shareholders understand the difference. Artisan Partners is an investment firm focused on high value-added investing. The red box shows our part of the investment universe. We focus on talent, investment resources and culture and degrees of freedom. We compete on the quality of our people and our net-of-fee performance and the trustworthiness of our brand. These are the things that we are most focused on. These are the areas where we have a competitive advantage. As long as we continue to get investments right, there will be multiple ways for us to reach end clients and for us to continue to generate long-term sustainable outcomes for all of our constituents. I will now turn it over to C.J. to discuss our third quarter and year-to-date results.

Thanks, Eric. Good morning, everyone. I'll start with our financial model principles, which are on Page 7. A focus on long-term growth requires discipline and impatience. The stability of our recurring management fee revenue, coupled with the variable nature of our expenses, resulted in increased profitability and operating margins in the September quarter. We remain thoughtful about where we focus our time and resources, making targeted investments in talent, distribution and operations to support sustainable financial outcomes for our shareholders. We concentrate on compounding client assets by generating excess returns over benchmarks rather than focusing on net client cash flows. In 2020, we have been able to achieve both excess performance and net inflows, and the results which follow reflect the success of executing our models. AUM at September 30 was $134.3 billion, up 11% compared to last quarter and up 19% compared to the September 2019 quarter. The increase in AUM over the quarter reflected a continued recovery in global equity markets and strong excess returns generated by our investment levels. In addition, net client cash inflows were $2.1 billion in the quarter, representing a 7% annualized organic growth rate. In the current quarter, we continued to see elevated levels of gross client activity driven by both institutional and wealth clients. Flows were driven primarily by large institutional non-U.S. mandates and our second-generation strategies and continued strong flows in our third-generation strategies. The AUM by generation slide, which we have provided in prior quarters is on Slide 9. AUM across all generations benefited from strong market performance and excess returns during the quarter and year-to-date. On a weighted average asset basis, our strategies outperformed their respective benchmarks by over 275 basis points in the third quarter. Both second- and third-generation strategies had net positive flows in the quarter. Third-generation strategies now account for 16% of total AUM, up from 14% last quarter as a result of both some strong investment performance and organic growth. Average AUM grew 20% in the third quarter compared to the June quarter and 16% compared to the third quarter of 2019. Year-to-date average AUM grew 8% compared to the same period in 2019, despite the significant downturn in global equity markets in the first quarter of 2020. Our complete GAAP and adjusted results are presented in our earnings release. My comments on our financial results will focus on adjusted results. Revenues in the third quarter of 2020 grew 15% and operating expenses increased 7% compared to the second quarter of 2020. Recurring management fees, which exclude performance fees, increased in line with the increase in average AUM for the quarter. Expenses increased in the current quarter, primarily as a result of variable incentive compensation adjusting to higher levels of revenues. Other expenses continue to be lower, primarily as a result of reduced travel in the current environment. Our operating margin in the quarter increased to 41.8% compared to 37.8% last quarter and 37.2% in the third quarter of 2019. Adjusted net income per adjusted share of $0.90 grew 27% compared to the previous quarter and 29% in the September 2019 quarter. Year-to-date, revenues were up 8% on higher average AUM and an increase in performance fees. Operating income grew 20% and our year-to-date operating margin was 38.3%, an improvement over 34.6% in 2019. Adjusted net income per adjusted share was $2.27, up 18% compared to the same year-to-date period in 2019. Key balance sheet metrics are on Slide 13. Our balance sheet remains healthy. We maintain approximately $100 million of excess cash to fund operations, seed new products and make continued investments. In addition, we maintain an undrawn line of credit of $100 million. Our Board of Directors has declared a cash dividend of $0.83 per share with respect to the third quarter of 2020. The $0.83 per share is consistent with our policy to distribute approximately 80% of the cash generated each quarter, and it represents an annualized yield of approximately 7.5% before consideration of the special annual dividend. As in prior years, in January, following the end of our fiscal year, our Board will consider the distribution of a portion of the retained cash generated in 2020 in the form of a special annual dividend. Each year when determining the amount of the special annual dividend, the Board will consider the amount of cash needed for general corporate purposes, investments in growth and strategic initiatives as well as the current market environment. Looking forward to next quarter's results, our U.S. mutual funds make their required annual income and capital gains distributions in the fourth quarter. The majority of these distributions are reinvested, but some clients choose not to reinvest. We estimate that the total cash outflows in the fourth quarter resulting from distributions that are not reinvested will be approximately $450 million. We intend to break this amount out separately in our AUM roll forward next quarter. That concludes my comments, and we look forward to your questions.

The first question comes from Mike Carrier of Bank of America.

Eric, more of a strategy question, but you hired new teams and more recently, you added talent to 4 G, which has gone very well. When you think about having more strategies, is there a limit, like in the third generation, particularly from a distribution standpoint? And do you and the team spend less time? Or is there a constant focus on talent as you start thinking about building out that next generation?

Yes, certainly. We've always said there's an operational limit to how we onboard talent. We've always done it in a fairly thoughtful way to make sure that the operations can support the new strategy without taking away from existing resources, supporting our current mature teams. We've thought about the vehicles and the channels and the geographies that we go into, ensuring we have the right support and depth to move into newer strategies and teams. If we're going to start a new strategy or a new team and set it up properly from day one, we have moved slower than probably most firms on finding talent and bringing them into the organization. To me, that's the real limitation, and it's a good practice to ensure that we fundamentally set up strategies for success from day one, rather than launching multiple strategies and hoping a few work within a distribution platform. So that does govern the amount of teams we're looking at, but we see quite a few opportunities in the marketplace. So we're always on the lookout for talent and continue to see a good array of opportunities. But the properly onboarded team does limit what we can do.

Okay. That makes sense. And then, C.J., just on how to think about the model and margins? You guys had shown margin from your time. But as you continue to bring in healthy flows and some of these strategies scale up, does anything shift in terms of compensation? Like whether payouts or structures that you see more coming to the bottom line? Just more curious on how it works or if there's tipping points in terms of asset levels that are driving that?

Yes, Mike, as we onboard teams, each team is unique, but they will all operate under the same economic model. The only variation may be in the start-up costs, which typically fall within a narrow range. Historically, these costs have not significantly impacted our results, and we fund them through current earnings, so there is no strain on the balance sheet. Additionally, the time it takes for teams to reach full scale means they will rely on the 25% revenue share, complemented by a firm supplement that we usually guarantee for the first three years. Therefore, I don't believe there is anything significant you need to know regarding the teams we are adding or the model we have used in the past.

The next question comes from Chris Shutler of William Blair.

On the new International Small Cap Value and Greater China post-venture strategies, I realize it's very early days, but any thoughts on how large those could ultimately be? And where you'd be comfortable? And how we should think about fee rates in those?

Yes. Both those strategies, like most things we do, in the early phase are capacity-constrained strategies. Capacity-constrained strategies typically yield a higher fee rate. In the case of the post-venture Greater China fund, this is a new fund that has more degrees of freedom that will move slower than most to ensure that we're set up properly in the region and that we're equipped to support the team. So I would expect both of those strategies to move and grow at a slower pace than we've seen more recently with some of our strategies that have come to market.

Okay. Got it. And then, Eric, you talked about working to deepen relationships with gatekeepers. If there's anything that you're doing differently today compared to a year or two ago or that you're emphasizing more today? Just any more color there?

I think the environment's obviously quite different. We're all working from home for the most part, so seeing clients, gatekeepers, prospects and operating is quite different. Fortunately, over the last five years, we have invested in a new CRM. We've strengthened our website backbone and have implemented software tools for tracking and connecting with clients, consultants and prospects, which is yielding a great investment now. We're starting to utilize those capabilities more than I ever thought possible, and I believe we are doing quite a few things differently because of the environment. Given our trusted brand, coupled with the content and connectivity, we are performing well in this environment.

Okay. Makes sense. And lastly, one for C.J., just on the occupancy expense being up a little bit in the quarter. Is this kind of a new level jumping-off point? And maybe just what caused the increase?

No. Chris, we had a charge in the quarter. We were subleasing some space in New York. The firm that was subleasing it ran into difficulty due to the current pandemic, and so we took a write-off for that space.

The next question comes from Kenneth Lee of RBC Capital Markets.

Just one around the potential for cash needs. You mentioned in the prepared remarks keeping aside roughly about $100 million for potential needs. Wondering if you could just call out any special uses of cash, any initiatives or investments that we should be aware of within that fourth-quarter time frame, especially as the Board considers the special dividend?

Yes. Thanks, Ken. Our policy on our dividend has remained the same. To date, we have distributed all the cash we've earned in a year through the special. There have been a few years where the market environment caused us to hold back a little bit. So as of now, it’s the same policy. We will wait to see how the year turns out from an earnings standpoint. We'll also consider other uses and the market environment. Therefore, when we get to January, we will have a recommendation and the Board will weigh in to decide the level of the special.

I have a follow-up question regarding Slide 6. I appreciate the information provided. At a high level, in the context of potential industry consolidation, do you anticipate any additional challenges for the company in maintaining distribution relationships? Some larger competitors mention experiencing benefits of scale in this area. I'm curious how you view this situation evolving.

Yes. Certainly, I think that was part of the comments on strategic relationships and how we interact with distribution partners. We've seen a slight uptick in our strategic partners that we're working with. As we continue to deliver more strategies across more asset classes than we've ever done and perform well, we're seeing a greater breadth and deeper relationships with some of these partners. Moving forward, there's always going to be a need for good investment strategies and opportunities embedded in whatever ecosystem is out in the marketplace. We feel that the high value-added investment structure we offer will always fit within a segment, and we don’t have to build-out and be all things to all people.

Next question comes from William Katz of Citigroup.

So Eric, you made two comments I found intriguing. One was the Gen 4 opportunity. The other was some of these more strategic relationships that sound like more of a multi-asset opportunity. Could you, on the latter, maybe size what kind of assets you have and the tenor of those assets? And then on Gen 4, could you expand a little bit more about the multiple investing opportunities? I just didn't quite see the linkage to that, but it did sound interesting to me.

Yes. I guess on the size and tenor of strategic relationships, it really runs the gamut. We've seen an uptick with some of our large institutional corporate clients. This past quarter, we've seen more larger broker-dealers and regional broker-dealers. The most interesting, though, comes from the regional RIA and financial advisers. We're starting to see a bit of an uptick there. It may not have the scale and size of a larger broker-dealer, but that wealth channel is growing with the number of products they're using. So it's both the size of dollars and the number of products that's piquing our interest and leading to my comments about strategic relationships. Regarding Gen 4 or using multiple degrees of freedom, originally, we broadened out by geography or by types of securities. Now you're starting to see teams wanting to use private securities. They want to hedge in those strategies, using multiple asset classes and different securities. In the future, you could see teams wanting to use public and private investments and hedging as well. These degrees of freedom will come into play, differing from the one-dimensional change we saw moving from generation two to three.

Okay. And just a quick follow-up for me. You mentioned earlier that Gen 1, which is about half of your assets, continues to interest investors. Is there a tipping point where that platform gets back into positive flow? Or are there more structural headwinds we should consider at this point?

That's a tough one to forecast, and we've been battling the active/passive trend. There has been quite a bit of movement towards passive in that segment. I feel confident that a market-cap style structure will continue. It's been prevalent in many of our clients for a long time, and we don't see that changing. The strategies we're offering are producing competitive performance that is yielding good flows, but forecasting more passive pressure in the future is challenging.

The next question comes from Ryan Bailey of Goldman Sachs.

I actually wanted to come back to the first question regarding having investment professionals and PMs in existing teams. Is this a strategic change in preference for you, preferring more investment professionals in existing teams for bigger benefits or is it just another tool in your toolkit?

Ryan, this is Eric. There's no change in how we think about bringing talent into the organization. We highlighted that we have quite a bit of flexibility in how we bring in talent, which may vary inside of an existing team or onboarding a new team. Thus, I think it's just another tool that we're emphasizing, showcasing the flexibility of our model for talent integration.

And Ryan, with respect to expenses, both additions to our firm occurred during the third quarter. So there will be a little bit more expense, but nothing material that I would guide you to model into your existing expectations.

Got it. And maybe if I could just follow-up on what you mentioned regarding the differences in flow sources for Gen 3, being more wealth-focused. Is there a reason why you haven't seen as much interest from the institutional side, even though performance has been quite good in Gen 3 strategies?

Yes. We do see good interest from the institutions and consultants. I think when you break down the institutional client base of corporates, endowments, foundations, etc., they are still continuing down that trend of private equity into private debt and real estate. Given the opportunities available in that space, we've seen the institutional marketplace focusing more on alternatives. You're starting to observe the commercialization of those strategies returning to wealth or retail markets, and you might see tips to incorporate them into target date funds. However, the real difference is that institutional clients remain focused on the alternative space.

Next question comes from Dan Fannon of Jefferies.

I wanted to ask about capacity given the move in markets and your AUM from both flows and beta. Are there certain strategies that are close to your watch list for managing capacity?

Yes. There are a few strategies that we've been keeping an eye on, and we've seen really strong interest in the growth team. Thus, the global opportunities strategy is something we're monitoring, as well as the U.S. small-cap growth strategy. We're very mindful of ensuring we find the right clients on the right terms for these strategies. Additionally, we’ve been addressing flows of dollars going in and out to balance our positions as we look at replacing dollars that have gone out.

Okay. And then, C.J., just a follow-up on expenses, given the environment. Obviously, certain discretionary expenditures are lower. As you think about next year, are there any technology, office or other expenses we should think about that might be beyond the normal flow? As a follow-up, with performance fees, should we expect to see more AUM coming in through SMAs that could be bigger contributors going forward?

Yes. So I'll start with expenses. Obviously, the pandemic and the work-from-home situation, along with restricted travel, has positively impacted our expense trajectory. However, whether those expenses will return to normal is uncertain at this moment. With regard to technology, we are running pretty flat compared to last year, perhaps a slight increase. I anticipate that in 2021, you might see mid-single-digit growth in technology expenditures, primarily due to higher market data costs and contract renewals. Other than that, there really isn't anything noteworthy to mention. Regarding performance fees, you've indeed witnessed an uptick this year, attributable to our performance. There is about $3 billion of separate account AUM subject to performance fees as well as our two hedge fund, private fund vehicles. Fourth quarter presents significant opportunities for performance fees, and given the strong performance this year, we expect good opportunities for next year as well. However, everything hinges on performance.

The next question comes from Robert Lee of KBW.

I apologize if this has come up already, but Eric and C.J., with the new teams and structures surrounding private funds and liquid assets, do you feel you have implemented the necessary infrastructure to handle those types of fund structures and reporting requirements? Or is it kind of incremental costs, and are they small? I'm just curious, is this going to be more of a discrete fund structure or more akin to a perpetual fund that's constantly raising capital?

Rob, it's Eric. I'll let C.J. comment afterwards. The strategies we're implementing and the vehicles we're considering are in place. We have private funds and have invested in distribution. Essentially, it's about setting up the team properly and ensuring it is done wisely. We already have several private vehicles in place, and we believe our operational infrastructure is adequate. Therefore, we do not anticipate any increase in costs related to these vehicles.

Yes. I don't have anything further to add. Our operations are ready, and we've been preparing for this over a number of years.

I appreciate it. Just curious whether the fund structure is more like an interval fund or whether it will just be a discrete raised capital investment type structure?

No. We won’t be launching a new vehicle.

Okay. My last question. Again, I apologize if this was asked earlier. Given your recent successes, particularly in some of the second-generation strategies or even third-generation, should we anticipate any capacity issues looking forward, particularly if current trends persist into the first part of next year? Are we expected to manage and possibly limit institutional or individual investors as you've done in the past to maintain the mix?

Yes. We certainly will, in the future, manage capacity as we've done in the past to ensure a long-duration client base and a robust fee mix. We indeed intend to continue that practice moving forward, hence that will play a role in the years to come.

This concludes our question-and-answer session and today's conference. Thank you for attending today's presentation. You may now disconnect.