Artisan Partners Asset Management Inc. Q1 FY2022 Earnings Call

Hello, and thank you for standing by. My name is Rocco, and I will be your conference operator today. At this time, all participants are in a listen-only mode. After the prepared remarks, management will conduct a question-and-answer session, and conference participants will be given instructions at that time. As a reminder, this conference call is being recorded. At this time, I would like to turn the call over to Makela Taphorn, Director, Investor Relations for Artisan Partners Asset Management. Please go ahead.

Thank you. Welcome to the Artisan Partners Asset Management Business update and earnings call. Today's call will include remarks from Eric Colson, CEO, and C.J. Daley, CFO. Our latest results and investor presentation are available on the Investor Relations section of our website. And following these remarks, we will open up the line for questions. Before we begin, I'd like to remind you that comments made on today's call, including responses to questions, may deal with forward-looking statements. These are subject to risks and uncertainties and 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 reference non-GAAP financial measures. You can find reconciliations of those measures to the most comparable GAAP measures in our earnings release. With that, I'll now turn the call over to Eric Colson.

Thank you, Makela, and thank you everyone for joining the call or reading the transcript. We appreciate you taking the time. Artisan Partners is a high value-added investment firm designed for investment talent to thrive in a thoughtful growth environment. We know who we are and constantly remind ourselves and others. We have remained disciplined in our philosophy and business model, while also expanding our investment platform and capabilities. Today, we offer investment talent the same entrepreneurial opportunity and investment autonomy that we have offered since 1995, but we have significantly expanded investment degrees of freedom, operational support, and multi-channel global distribution. The consistency and repeatability of who we are and what we do have steadily grown our business value over time, our ability to generate alpha for clients, our ability to generate successful careers for people, and our ability to generate long-term returns for shareholders. We recently launched the Artisan Global Unconstrained and Artisan Emerging Markets debt opportunities strategies. These launches and all of the work behind them exemplify how we execute and build business value. On Slide 2, you can see the team we have built with Mike Cirami, Mike O'Brien, and Sarah Orvin. Since they joined last September, we have built a diverse team of 11 investment professionals. We located the team inside their own four walls in Boston where they wanted to be. We have built customized research management tools, stood up new order management and trade execution technology, and established local market access in over 100 developed, emerging, and frontier countries at initial launch. We ceded the team's first two strategies and we recruited and hired a proven distribution leader with deep experience building an EM debt business. Today, after a little more than six months at Artisan Partners, the team is running money and open for business. Emerging Markets Debt brings together a number of attractive investment and business characteristics, a large and growing investment opportunity set to differentiate from the index and peers; a large addressable market of sophisticated investors and allocators to build a long-duration client base with attractive fees and a limited supply of investment talent with the experience resources and degrees of freedom possessed by the Artisan EMsights Capital Group. On Slide 3, is our repeatable process for franchise development. This is how we drive business value. We take the time to find and recruit the right investment leadership, unique investment leaders who are passionate about what they do, want to own the outcome, and are willing to take risk and bet on themselves. Around that leadership, we bring together additional talent and resources including proven distribution leadership. We provide infrastructure and customized technology. We provide autonomy and space to execute a process and develop a culture. And we are patient, focusing on establishing a strong foundation and a compelling investment track record. We have successfully executed this process across time and asset classes and through market cycles. While each franchise takes its own path, we have a stated set of franchise characteristics we seek to achieve and we have a disciplined process for achieving and maintaining those characteristics through time. This is what our management team does. We maintain an investment-first culture. We bring to bear the entire resources of our firm to support our investment teams. We minimize investment team distractions. We maintain economic and risk alignment. We insulate our firm from short-term pressures and noise. We focus on building long-term business value. Today, we see opportunity all around us. Industry consolidation is focused on scale, solutions, and distribution, not on creating great homes for investment talent. Creative investors are increasingly risk-managed, diluted, and disintermediated from end clients. At Artisan Partners, we are staying true to who we are, emphasizing creative talent, autonomous investing, broad opportunity sets, and a patient long-term mindset. The milestones we've passed with the EMsights Capital Group are milestones we've passed many times before. We know we have a lot more to do; we also know the potential outcome if we execute as we have in the past, business value that compounds and diversifies and ultimately yields economic value. On Slide 4, you can see the AUM outcome of recent launches. Underlying the AUM outcome is tremendous business value creation, investment leadership surrounded by additional talent and resource, well-established investment process, and emerging investment team cultures, compelling early investment track records, and foundational business development on which to build broader investment platforms. It takes time, but if we remain patient and focused on the things we can control, we expect successful outcomes will follow. On Slide 5, we have expanded the view across time and across the firm. On the top part of the page, we have summarized investments we have made in our business over the last 10 years. By following the repeatable process I described earlier, we have doubled investment teams from five to 10 and doubled investment strategies from 12 to 24. Expanding investment degrees of freedom, we have added multiple new asset classes and significantly increased the markets and instruments available to our investment teams. And we have built out our distribution capabilities across geographies and channels, nearly tripling relationships greater than $200 million and increasing our number of non-US investors and client relationships more than sixfold. Our disciplined approach, repeatable process, and proven success strengthen our brand and reputation and increase our probability of successful outcomes going forward. Similar to the power of compounding revenue growth, successful franchise development has a compounding effect on future business value. For example, in 2013, when Bryan Krug joined Artisan to launch our credit team, we were unproven in fixed income. What we have built with Bryan was an important data point when Mike Cirami, Sarah Orvin, and Mike O'Brien decided to join Artisan last year. They saw a firm that could support fixed income, build new operations to support emerging market debt, and be a successful home for a differentiated fixed income team. We lean into franchise development by identifying the right talent for us and stacking resources to put the odds in our favor. Our approach differs from firms that refer to investments as manufacturing or engineering products for mass distribution. They play the odds and time horizon differently. In the long run, we believe that we produce sustainable growth outcomes with lower risk for all stakeholders. On these calls and in other forums, I spend most of my time on investments and how we are driving business value, as opposed to reading off recent numbers. We focus on what we can control and seek to build business value over the long term. So quarterly or even annually, economic outcomes are not terribly relevant to what we are trying to do in managing the business. But over longer periods, we do expect economic outcomes to reflect the growth of our business value. Over the last 10 years, since approximately the time we launched the credit team and began focusing in earnest on degrees of freedom, we have more than doubled our AUM from $74 billion to $160 billion, more than doubled our annual revenue from $506 million to $1.2 billion; maintained an adjusted operating margin in the 40% range and inclusive of our upcoming dividend distributed $30.31 per share to our shareholders, more than our IPO price of $30 per share in 2013. Looking forward, we will continue to focus on building business value, investing in our existing franchises, recruiting new talent and launching new franchises, launching new strategies with broad opportunity sets and large addressable markets, expanding our operating platform in fixed income, private investing in Greater China, and further investing in digital marketing, accessing the wealth channel and other global distribution capabilities. We are confident we can grow business value as we have in the past. And eventually, we expect economic value to reflect business value creation. I will now turn it over to C.J. to discuss our more recent results.

Thank you, Eric. Following Eric's comments on our long-term results, I'll provide some commentary on our financial results for the first quarter of 2022. Our earnings release includes both GAAP and adjusted financial results. My comments will focus primarily on adjusted results. After advancing most of 2021, global markets fell considerably in the first quarter of 2022 due to broad uncertainty regarding the war in Ukraine, inflation, rising interest rates, and the continued cloud of the pandemic. Given the lower markets, our AUM and revenues declined as well. AUM at the end of March 2022 was $159.6 billion, down $15.2 billion or 9% compared to the prior quarter. AUM declined 2% compared to the first quarter of 2021. Despite negative markets, net client cash flows for the quarter were positive at $700 million, representing a 2% annualized organic growth rate. We launched two new strategies during the quarter: The value income strategy managed by the U.S. Value team and the Global Unconstrained strategy, the first strategy launched by the EMsights Capital Group. The second strategy managed by the team, Emerging Markets debt opportunities, was launched on April 7th. 15 of our strategies had net client cash inflows during the quarter. The international value strategy was the largest contributor to net client cash inflows with inflows from a diverse set of clients. AUM by generation is on slide 8. All generations declined in AUM, as a result of the market declines. Generation one experienced net inflows and drove the firm's overall net flows for the quarter. Percentage mix of AUM by generation fee rates and other metrics remains largely unchanged from the prior quarter. Quarterly results are on the next slide. Revenues in the first quarter declined $33 million, 11% sequentially in line with the 8% decline in average AUM, along with two fewer days in the quarter. Year-over-year quarterly revenues declined 3%, principally due to the absence of performance fees in the current quarter compared to the 2021 quarter. Adjusted operating expenses in the first quarter declined $1.7 million, compared to the fourth quarter of 2021. The decline in operating expenses reflects lower variable operating expenses, primarily incentive compensation, partially offset by higher first quarter seasonal expenses, annual merit increases, and higher long-term incentive compensation expenses. Adjusted operating expenses increased $6.6 million year-over-year, reflecting the addition of the EMsights investment team, annual merit increases, and an increased number of full-time employees consistent with our talent-driven business model. We also continue to invest in our talent through annual grants of franchise capital and restricted stock awards to align our key talent with clients and shareholders and in technology and data through the expansion of the breadth of our operating and distribution capabilities within active management to support new teams and strategy launches. Adjusted operating income for the March 2022 quarter was $106 million, which is an adjusted operating margin of 37.7%. The decline in our operating margin from the December 2021 quarter was principally due to lower revenues as a result of market declines and higher seasonal expenses. Adjusted net income per share was $0.98 for the March 2022 quarter. Our balance sheet remains healthy, as modest borrowings are supported by strong cash generation. And as we have throughout our history, we remain committed to distributing the majority of the cash we generate every year. This quarter our Board of Directors declared a quarterly dividend of $0.76 per share. Including this dividend, we have declared dividends of $4.58 over the last 12 months, resulting in a 12% dividend yield using the share price at the end of March. In closing, our financial model, and in particular the variability of approximately 60% of our expenses, continues to serve us well and provides predictability and sustainability to weather ever-changing global market conditions. That concludes my remarks. And I will now turn the call back to our operator for Q&A.

Thank you. We will now begin the question-and-answer session. Today's first question comes from Dan Fannon at Jefferies & Company. Please go ahead.

Thank you. Good morning. Regarding the EMsights opportunity, is there anything fundamentally different about this strategy that could lead to faster scaling? Also, how does this compare to other strategies you have launched and expanded? What channels do you anticipate will initially contribute to AUM, and considering the current global unrest, is there a high demand for this type of strategy? Please elaborate on that.

Yes, hi Dan, it's Eric. I'm not sure how much I can discuss the speed of scaling. As we've mentioned, we've developed these franchises with a focus on quality, ensuring they have longevity rather than rushing to market for the sake of it. I feel that approaching timing has not been our strong suit, but we've excelled at identifying the right talent and creating resources around our team, as highlighted in our discussion. The potential is substantial. If you examine fixed income in emerging markets, it constitutes about 30% of the total global fixed income, which is around $30 trillion. Since 2004, it has expanded from roughly $3 trillion to $24 trillion in the local market, representing 80% of the emerging market opportunity. There's considerable inefficiency within this sector, and active management seems to perform significantly better than passive management. We believe passive alternatives are relatively ineffective and costly, presenting a strong opportunity for active management within a growing landscape of securities, including sovereign, corporate, and loans. The emerging market debt space parallels what we have observed in the high-yield market. In high yield, there are about 160 strategies from roughly 120 firms, with the top five managing between $40 billion and over $100 billion in total. In contrast, the emerging market debt segment has close to 100 strategies, a bit fewer than high yield and with fewer firms, yet the top five manage between $40 billion and $75 billion. This indicates significant growth potential. We believe this opportunity is often overlooked in conventional asset allocation. I concur with your point regarding the current uncertainty potentially providing good opportunities in the long term. When we assess our team’s capabilities, the potential for active management, and the overall market, this aligns with our approach to entering an asset class. Additionally, considering the fees and the operational challenges we discussed, this strategy is not the easiest to introduce, especially in a startup atmosphere. There are limited opportunities for teams to establish this approach. Therefore, I see the scalability for us as quite promising. While we're not aiming to be in the top five, it signifies a path toward scale, and we will ensure that we proceed with the highest quality to maintain that longevity.

Thank you. That's helpful. And then just as a follow-up, C.J., just thinking about the 1Q expense levels and as you look through the rest of the year, had some funds that started the team's been on the new team that we just chatted about has been on for some time. But how should we think about the progression of some of the fixed costs if there was any one-time things in this quarter associated with those fund launches or kind of normalization of other expenses would be helpful.

Hi, Dan. So I think we're on target with the guidance we gave you last quarter. And we brought on the new team in September of last year. So there was a fair amount of run-rate expense built in last quarter. So quarter-over-quarter I think we're at a pretty good run rate. They will be moving into some permanent space in Boston eventually. So you'll see occupancy tick up just a slight bit, but the rest of the expenses really should be fully baked in.

And then ladies and gentlemen, our next question today comes from Bill Katz at Citigroup. Please go ahead.

Thank you for the update and for taking the questions this morning. I'd like to follow up on the last discussion. Can you clarify your current status regarding overall headcount growth? Last quarter, you mentioned an approximate 10% increase in headcount. How far along are you in that process, and what increase in expenses might be expected as a result?

Yes, Bill. We're on target. We've had pretty robust recruiting in the last year into this year. So we're both on target in terms of headcount and the expense guidance I gave on those fixed compensation costs.

Thank you for that. I’d like to refine my question. Eric, you mentioned a strong environment for other teams. Can you discuss whether the recent market activity and volatility have impacted us in any way? Additionally, where do you see the most potential for growth? Are we mainly focusing on expanding the credit side of the platform, or is there a broader strategy at play? Thank you.

Yes. We've seen quite a bit of activity in the alternative space. In our view, many of these hedge fund platforms have become quite sizable. I think we can look back over the last few years. And the bulk of the assets have gone to hedge fund platforms. So there's some scalable teams that reside in those franchises and that range is the gamut from credit to other liquid alt strategies that may fit the Artisan model. And we also see the M&A activity has been quite active. And as we've seen in our past, that type of activity has yielded a favorable outcome for our model of teams becoming available or interested in finding an entrepreneurial home. So the catalysts are still out there and the market uncertainty is growing. And our history of launching teams and sticking with those teams, as we've said in the past, the teams we have today are the same teams we've had since inception and seeing through those teams to build a great brand, and we continue to have a very active dialogue in the marketplace more in the alternative space. Many of the areas that we've listed out some of the themes around Asia and China specifically around credit and continue to think about the public-private hybrid product mix those are all areas of interest for us, Bill.

Thank you, Eric. Thank you, C.J.

And ladies and gentlemen, our next question today comes from Alex Blostein with Goldman Sachs. Please go ahead.

Hey, good afternoon. Thanks, Eric and C.J. as well. Just building on that lineup question from Bill to the last point you guys made. So, I guess question is around newer teams and, it sounds like the conversations are picking up. And Eric, as you sounded, mostly on the – more so on the alt side. But given the capabilities you guys have built out internally to sort of support these teams should we be thinking about resources that are already largely in place and therefore sort of incremental margins on bringing in new teams should yield better results than what we've seen over the last, let's say a couple of launches just given the fact you've been adding more capabilities and more infrastructure to support those teams?

Yeah. Certainly, we have made a sizable investment in Emerging Markets debt. We also made a sizable investment back when we first launched credit with Bryan Krug in 2014. And as we stated on the call, we think that there is a lot of leverage built in the on-boarding of new teams and new asset classes that as you expand, your capabilities in credit, you have really sunk that cost into the business, and the incremental cost of a new team in credit will be much lower given the two teams we have today. I will add that, while the activity is quite active in the alt space, we have a lot of existing team growth and franchise growth, which we've highlighted over past calls. So while activity is high on looking at new talent, our core focus right now is delivering on what we brought in and seeing that through. So my expectations are fairly low on new teams. Looking at the next few quarters, these quarters will be really looking and broadening our network. The focus of the business on these next quarters and year is to deliver on what we brought in at the highest quality. So, I don't want to have people walk away from this call that that activity is going to yield a short-term outcome. The broad networking is an opportunity to broaden out the business over the medium term. It typically takes a year to two of courtship in bringing in teams. So my mindset is on the current teams right now, but the activity remains high on networking.

Got it. Great, that's helpful. My second question is around some of the capital return dynamics. And Eric, you mentioned on this call and on prior calls as well that there is still a quite substantial disconnect between the value of the business and the economic value I guess that you guys are sort of seeing. So, with that in mind any updated thoughts around pivoting to capital return strategy and introducing a more sizable buyback?

I'll take that one, Alex. Our model does not really lend us to sell very well to buybacks. Since the IPO, as Eric mentioned, and we've mentioned before, we paid out close to 100% of the cash we've generated with a pretty healthy dividend yield. So we really have limited cash available for buybacks. We do invest in the business through seed capital and launching new products, which over time generates economic value, but we continue to prefer the predictability of the dividend policy and see no reason to change that at this point.

And ladies and gentlemen, our next question today comes from Robert Lee, KBW. Please go ahead.

Great. Thanks. Good morning, good afternoon, Eric, C.J. and Makela. And I apologize. Eric, you may have covered some of this in your prepared remarks, but looking in the current environment, obviously, you did talk about it being attractive for active strategies such as the EMSights. But can you talk a little bit more about some of the more traditional strategies? If you think back to two years and we had the initial flow of COVID, markets are down a lot and you saw kind of a surge of demand in the immediate quarters subsequent to that sharp sell-off. So, do you see weakness we've had year-to-date starting to create similar types of opportunities for you? Are you starting to see a lot of your long-term or maybe not so long-term clients start to rethink and something to take more time to look at allocating towards your strategies or liquid, call it, equities active equities in general?

Yeah. We've come off of really the 2020 pandemic where when a crisis like that occurs and we've obviously seen it again with Russia and Ukraine, correlations go closer to one and everybody is behaving the same. And I think what you're saying, Rob, is after that initial March 2020, you saw the active management thrive there. And more in that period, you saw growth drive as many of the technology health care coming off of the pandemic landed itself for work at home or many people operating differently. The Russia-Ukraine crisis obviously caused another period where everything started behaving in a similar fashion. And now as that starts settling down and we clearly aren't anywhere near coming out of that conflict, we're still heavily in it. But you've seen a rotation occur there and some of the value managers have done better with, obviously, energy, industrial, utility, pushing that forward. You see our traditional strategies, in some cases, thriving there. And you see it most acutely with the international value team, a first-generation strategy. And many people do look at these generations and say our generation one in attrition and it's just all about generation three. I think we've built an enormous amount of diversification and we're continuing to build that now with a new franchise. But the power of some of our traditional franchises are shining through some of these periods. And you saw that with the growth franchise in 2020, and now you're starting to see it with international value in some of our other value franchises in 2021. And it does bring back, I think, the power of traditional asset management, but it's a great asset to have and it will continue to be. And as things normalize and provide the time period for both styles to shine, you see the three and five-year numbers, which are very strong across the mix of Artisan strategies.

Great. Thanks for that answer. Also, maybe, my follow-up question. If I look on page five of your handout, you provide some color on how the distribution relationships have developed over the past decade. I was wondering if we can maybe take a little bit of a different slice to that. I'm just curious, if you look at your distribution footprint today, I mean, and if you think of the various distribution channels, whether it's DC, RIA, additional institutional, wirehouses, I mean, is it hard to kind of maybe in some way kind of rank order, like, where you're seeing kind of the most momentum or strength or where do you feel like there's the most opportunity for greater penetration and where you're currently maybe underexposed?

Yes. On a go-forward basis, the intermediary channel. And a subset of the institutional and those are converging. Let's take the endowment foundation family office, coupled with the financial adviser RIA, that group of clients have been more active for us. The traditional institutional has been a very strong client base and has been sticky, as well as the non-US institutional. But on a future basis, using more digital resources and broadening out our distribution efforts within our dedicated franchises to focus on the financial adviser RIA family office endowment foundation, if you put that grouping together, we see a push in that space.

Ladies and gentlemen, our next question today comes from John Dunn in Evercore ISI. Please go ahead.

I was wondering, can you maybe talk about how much the market moved so far this year may have changed the fund closing kind of picture.

Yes, certainly. We consider various factors when managing capacity, including overall total capacity related to portfolio liquidity. We assess the amount of money flowing in and the speed of those flows. Additionally, we examine the asset mix, especially if it is coming from a concentrated asset base. All these factors signal the need to manage capacity. The recent market pullback has provided some opportunities. Markets can fluctuate, so we remain cautious. We have been managing capacity even as markets surged by 20% or 30%, and as they decline, we find more availability. This allows us to implement soft closings and communicate with our clients. We ensure we provide opportunities for existing clients to manage capacity. In our soft closing, we have certainly done this with international value and will continue to work with existing clients to rebalance and manage capacity across other strategies. While this offers us additional flexibility, we are also mindful of the risk if markets move against us, as it can impact the integrity of our strategy and client perceptions, making recovery difficult. In summary, we have some room to take on a bit more.

Got you. And then just where we are in 2022 probably put a pause on how fast the China Post-Venture effort can go. Could you maybe talk about how you think about that playing out more over the medium-term once we maybe get to a better place than we are now?

Yes, I think you can say that for privates too, that there's been a little bit of pause in the private markets as well. And it's the whole point of why we don't manufacture engineered products and try to manage for the short run, because it's very easy to then get disheartened by that and unwind it. And we really look at the medium to long-term there that it's the second-largest economy. We think that most funds are underweighted to China in the long run. The opportunity and the breadth of securities in China. We remain quite wide with the ability for active management. And as we see some of the volatility dampen and in the next mid-term time period, clearly the short term is still challenged, that China remains a very attractive opportunity for us.

And ladies and gentlemen, this concludes today's question-and-answer session and today's conference call. We thank you all for attending today's presentation. You may now disconnect your lines and have a wonderful day.