Welcome to the Franklin Resources Earnings Conference Call for the quarter ended December 31, 2022. Hello. My name is JP, and I will be your call operator today. As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Selene Oh, Head of Investor Relations for Franklin Resources. You may begin.

Good morning, and thank you for joining us today to discuss our quarterly results. Statements made on this conference call regarding Franklin Resources, Inc., which are not historical facts, are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements involve a number of known and unknown risks, uncertainties, and other important factors that could cause actual results to differ materially from any future results expressed or implied by such forward-looking statements. These and other risks, uncertainties, and other important factors are described in more detail in Franklin's recent filings with the Securities and Exchange Commission, including in the Risk Factors and the MD&A sections of Franklin's most recent Form 10-K and 10-Q filings. Now I'd like to turn the call over to Jenny Johnson, our President and Chief Executive Officer.

Thank you, Selene. Hello, everyone, and thank you for joining us today to discuss Franklin Templeton's results for the first fiscal quarter of 2023. I'm joined by Matt Nicholls, our CFO and COO; and Adam Spector, our Head of Global Distribution. We're pleased to answer any questions you have. But first, I'd like to call out a few highlights from the quarter. Despite the challenging market backdrop in our first fiscal quarter, we saw a number of positive developments to further diversify our business. This quarter, we continued to see net inflows into key growth areas such as our three largest alternative managers: Benefit Street Partners, Clarion Partners, and Lexington Partners, as well as multi-asset strategies, ETF, and our custom indexing solution platform, Canvas. We were also pleased to see additional positive indicators impacting our business, including an increase in our institutional won but unfunded pipeline and improving overall investment performance across our strategies. I'll cover all of this in more detail momentarily. While the industry landscape remained under pressure, we have continued to benefit from our diversified mix of asset classes, geographies, client types, and investment vehicles. Turning now to flows. We generated total net inflows of $6.6 billion this quarter, inclusive of $17.5 billion of net inflows from cash management. Long-term net outflows were $10.9 billion and included reinvested distributions of $12.1 billion. This quarter, we saw net inflows into key growth areas of client demand. Starting with alternatives, as mentioned earlier, our three largest alternative managers, Benefit Street Partners, Clarion Partners, and Lexington Partners, each had net inflows for the quarter totaling $2.4 billion. Multi-asset net flows increased almost fivefold from the prior quarter to $2.4 billion, driven by interest in the multi-asset category, our flagship Franklin Income Fund, with its flexible approach to changing market conditions. The $70 billion U.S. fund is now rated four stars overall by Morningstar and continues to have strong performance. Our broader multi-asset solutions strategies were also in net inflows. Fixed income net outflows of $13.3 billion were primarily due to certain U.S. taxable and global opportunistic strategies. Client interest, however, continued, and we benefited from having a broad range of fixed income strategies with non-correlated investment philosophies, including net inflows into certain core bond, U.S. income, and tax-efficient strategies. We are pleased to note that Western's performance reverted back to its leadership position during the quarter. At quarter-end, 89% of the firm's strategies outperformed the benchmark on an AUM basis for the quarter, and Western's two primary core bond funds were ranked in the top decile on a quarter-to-date basis versus their respective peer groups. Equity net inflows were $300 million and included $9 billion in reinvested distributions. This quarter, the risk-off environment continued to impact investor sentiment on certain growth strategies, which were offset by positive net flows into strategies such as large cap and all-cap value, large-cap core, and emerging markets. Cash management generated the highest net inflows in over a decade, with $17.5 billion of inflows driven by institutional demand for low-risk assets at a higher risk-free rate, diversified across client types. As a leading SMA provider, particularly in model delivery, we ended the quarter at $105 billion in SMA AUM. Canvas has achieved net inflows every quarter since the platform launched in September 2019, and AUM increased over 25% in the quarter. ETFs had $1 billion in net inflows and reached $13.3 billion in AUM. We launched the ClearBridge Sustainable Infrastructure ETF during the quarter and added specialized sales resources to strengthen our ETF efforts. We were also pleased to see our institutional pipeline of won but not funded mandates increased by $8.8 billion to $23.8 billion and included a $7.5 billion fixed income institutional mandate. Turning now to performance. Our investment teams have remained true to their distinct disciplines and time-tested approaches, relentlessly searching for those long-term investment opportunities that market dislocations often present. We saw an uptick in relative investment performance in nearly all standard time periods. This quarter, the majority of our strategy composite AUM and mutual funds AUM outperformed their benchmarks and peers, respectively, on a one-, three-, five-, and ten-year basis. In addition, 51% of mutual fund AUM was in funds rated four or five stars by Morningstar. As I've said time and again, the next decade is not likely to look like the last, and we continue to invest strategically in areas that are shaping the future of our industry. Alternative investing is one of those areas. During the quarter, we closed the acquisition of Alcentra, a leading European alternative credit manager. This acquisition increased our alternative credit AUM to $78.5 billion. And as for secondary private equity, as of November 30, Lexington had raised $12.8 billion for its latest fund and continues its fundraising efforts. Alternative assets now account for $257 billion, or 19% of our total AUM and a higher percentage of adjusted revenue. We are now one of the largest managers of alternative assets and are realizing our aspiration to be one of the few diversified firms globally that offers the major categories of alternative assets. One of the lessons that 2022 taught many investors is that diversifying beyond traditional asset classes to solve for their long-term goals is probably a good idea. We think this will drive increased adoption of alternative assets in the wealth channel where we've made progress. We continue to focus on product development and suitability, sales and marketing, and client education and the distribution of alternatives and wealth management. For example, Benefit Street Partners announced the launch of Franklin BSP Private Credit Fund, investing in U.S. middle market private credit seeking to generate strong current income and superior risk-adjusted returns across market cycles. In November, the Franklin Templeton Academy announced the launch of its alternative education program as part of our ongoing effort to build knowledge and proficiency around the alternative investment landscape. The program offers a comprehensive curriculum on various types of alternatives, including courses on private equity, real estate, private credit, infrastructure, and hedge strategies. Touching briefly on our financial results, which reflect two months of Alcentra given its closing on November 1. Ending AUM was $1.39 trillion, an increase of 7% from the prior quarter, primarily due to market appreciation and the addition of Alcentra. Average AUM decreased by 1.5% to $1.35 trillion. Adjusted revenues were $1.44 billion, a decrease of 6% from the prior quarter. The decrease was driven by lower adjusted performance fees and lower average AUM. However, the effective fee rate, which excludes performance fees, was 39 basis points, a slight uptick compared to 38.8 basis points last quarter. Adjusted operating income was $395.1 million, a decline of 20% from the prior quarter or 12% excluding annual deferred compensation acceleration for retirement-eligible employees of $37 million. We continue to benefit from a strong balance sheet with total cash and investments of $6.6 billion at quarter-end after reflecting the purchase of Alcentra and the payment of fiscal year-end cash bonuses. Let me wrap up by saying that over our 75-year history, our North Star has always been the clients we serve. We are committed to continuing to seek opportunities to expand our capabilities to provide investors with financial investments that are important in reaching their goals. Finally, I would like to thank our global employees without whom our progress would not be possible. Their work is greatly appreciated, and I thank them for their many contributions to our organization. Now let's turn it over to your questions. Operator?

Our first question comes from Glenn Schorr from Evercore.

I guess a question on the fixed income side. We saw outflows in the fourth quarter, but the outlook for '23 should be a lot better for the industry. Just curious on that thought overall and how you think Western in particular is positioned in the year ahead?

Thank you, Glenn. First, as we mentioned this quarter, the core bond portfolio at Western experienced net flows. We continue to witness strong gross sales for Western products, with 89% of strategies outperforming. Specifically, Core Plus and Core ranked second and eighth in their peer group for the quarter, showcasing impressive recent performance. The pipeline has over $10 billion for Western, which includes the $7.5 billion mandate we've discussed. They are receiving excellent support overall. What excites us is that many institutional players have been somewhat slow to move, which is why we've seen significant strength in our institutional money funds, with continued flows through January. Institutions appear to be waiting to determine when rates will peak, but as they start to re-enter the market, we have three outstanding brands in Franklin, Brandywine, and Western. To highlight this, Brandywine Global's performance compared to Western Core Plus and Franklin Core Plus shows only a 0.12 and 0.17 correlation in excess returns. Regardless of the perspective on fixed income, we have strong brands in that area. Adam, would you like to add anything?

Yes. I would just add, Jenny, that the performance turnaround is really across the board. If you look at where our Global Bond Fund is, that's now top decile as well. So really good performance everywhere. On top of that, I would say that one of the things that differentiates us is the breadth of fixed income we offer. We see a number of DB plans now more fully funded. We're able to offer them liability-based fixed income. You can look at what we do in high yield and global bonds and munis. It's really a breadth of capability in fixed income, and we're seeing demand grow in all of those sectors.

Jenny, maybe I'll keep it at the high level because look, the margin compression is impossible to manage when the market drops as much as it did. Again, as you think rolling forward, we got the benefit of the market lift in the fourth quarter and early this year. Just curious on how you're thinking about what you do actively and proactively in '23 and where you think we can get to a 'normal' backdrop if there's such a thing?

Sorry. So are you asking in the sense of what M&A, in the sense of expense?

I apologize. I'm really talking about the adjusted margin and expenses, just expenses up, revenues down. It’s hard to do in the short term when the markets drop. But how you're approaching that margin? Or is that an outcome? In other words, do you manage towards it? Or is it an outcome of the environment?

So I don't think we manage for margin, and I'll let Matt jump in on this. But you're absolutely right. This is one of those businesses where you get a disproportionate benefit to the markets going on the upside because your margins can expand, and then you're slammed on the downside because you can't possibly adjust your expenses quickly enough. I think the good news is the work we've been doing. Part of it is just when you do the amount of M&A we do, you're naturally kind of reinventing how you work and figuring out where you can take out costs. We've been able to absorb a lot of the expenses that we've had in the M&A. But Matt, do you want to talk about kind of expectations on margins going forward based on where the market is?

Yes. I mean, I'll just say a few things on that, and I'm happy to provide the guide. Maybe that would be another question that will come up. But generally speaking, 35% to 40% of our adjusted expense base, as we've communicated in the past, is variable in nature with the market and performance. We're always very much looking at the other 60% to 65% of our expense base to see if we can be more efficient and effective, particularly in a difficult environment. Some of the transactions we've done on the M&A side have prompted further reviews of those sorts of activities. We're very active around that. In the down market, as you alluded to, Glenn, that we've experienced, it takes some time to carefully consider adjustments to keep up with revenue declines while making sure that we remain competitive in terms of compensation and investing in the business, and we've done both of those things: competitive in comp, and we continue to invest in the business in a significant way, in our opinion. But we've also taken, or are in the process of taking, significant action across the business to make sure that we're being disciplined and continue to be disciplined with our expenses. We've paused non-essential hiring. We've just completed a voluntary buyout process, excluding our investment staff. We've got an execution plan in place to introduce additional operational efficiencies across the firm. In the last three years, in addition to savings from our merger transaction, we've already outsourced operational activity that's created efficiencies for our funds, first and foremost, but have also lowered future CapEx expenditures for our firm, while simplifying our company operations. This has enabled us to continue to invest heavily in the business where we need to in the areas of growth that we've talked a lot about, but at the same time, it has also enabled us to keep our expenses in check, including the margin.

Your next question comes from the line of Ken Worthington from JPMorgan.

So Jenny, you mentioned fixed income performance has really improved. Is one quarter of great performance enough given the more positive backdrop for fixed income and credit? And what is the risk that there's a lot of money movement in the industry in fixed income for 2023 and Franklin misses it due to weaker performance from last year?

Well, again, I mean you have the Core Bond, which was the net flows of I think of $1.5 billion this quarter. And Core Plus is one of our top-selling funds. So even though it's still in net outflows, it's dramatically improved in outflows. Templeton Global Bond, I mean, it’s amazing when you look at that, as Adam mentioned, it is beating its benchmark and peers in all four time periods. So it's a pretty massive turnaround. I think it's outperforming its benchmark by 1,200 basis points for the year, which you carry that back. Performance is always going to predict the future. If you look at that, 87 of 134 fixed income composites: across the firm in the one-, three-, five-, and ten-year periods, is only underperforming in one period. So we actually think we're incredibly well positioned. As I mentioned earlier, the diversification of the excess returns between Brandywine, Franklin, and Western gives people a chance to hedge themselves within our own enterprise or if they have a view, can express it with one of our managers. As we've said, Western has been a little bit more viewing that I think rates will probably decline, maybe towards the end of the year, while the Franklin side probably would say more like in 2024. The key is that we think we have great opportunities wherever you want to be in fixed income, and we believe that people now that you can get actual returns in fixed income, you're going to see more allocations there.

Sorry, that's not just the public markets; that's the private markets also. So Benefits Street Partners, Alcentra. They've got some very strong performance and interesting funds and both in demand.

Yes, I was just going to say we've seen clients build multi-fixed income fleets with different Franklin components and oftentimes adding additional assets because they see how uncorrelated the various strategies are with each other.

Your next question comes from the line of Alex Blostein from Goldman Sachs.

I was hoping we can dig into your alternatives franchise for a couple of minutes. If we look at the AUM, excluding Alcentra this quarter, AUM seems to be kind of flat, actually down a little bit sequentially. So I'm just curious what's offsetting sort of the good fundraising momentum that you mentioned. Now I know the convention of AUM is not the same as fee-paying AUM. So maybe just help us unpack what fee-paying AUM has done over the last couple of quarters, what it is now? And what are the drivers of fee-paying AUM in alts over the next several quarters?

Matt, do you want to take the fee-paying AUM?

The core of the question and then Jenny and Adam, you should answer more, is that the outflows and the softness that we've experienced in alternatives, Alex, is driven by the liquid alts area of the firm. It's not our primary kind of private market specialist investment managers. BSP, Clarion, and Lexington have all experienced positive flows and organic growth. I think what you're referring to is the overall number when you exclude Alcentra where that is. It's slightly negative. That's driven by outflows and softness in both performance and flows on the liquid alts side.

K2 and Western macro opportunities would be the two areas that you're seeing. Everything else has actually grown. Lexington, Benefit Street Partners, and Clarion have all experienced growth.

Yes. And can you help us just break down fee-paying AUM, kind of what's liquid versus what's illiquid? And as you sort of think about the pipeline of opportunities on the more private side of things, it would be helpful just to get a little more granularity. So for instance, like the Lexington $12.5 billion or $12.8 billion fundraise, is that already all in the fee-paying AUM number? And is it a management fee? Or is that going to turn on once the fund is closing? So just a little more granularity, that would be helpful.

Yes. The Lexington fund, go ahead, Jenny.

Go ahead, Matt.

The Lexington fund that's being raised so far, that's all fee-paying. So it's the future raise that they're continuing to work on that isn't yet included. But the number that we put into the executive commentary is included.

When you inquire about liquid versus illiquid or tied up assets, I assume you mean assets that are tied up. Most of BSP, Clarion, and Lexington Partners consist of long-term tied up assets. K2, on the other hand, has their liquid alternatives, which provide more flexibility, as reflected in their redemption numbers and macro opportunities.

Got it. Maybe just for a quick follow-up. I was hoping you guys could hit on the institutional pipeline. Very nice to see an improvement sequentially. Can you talk to the fee rate on the overall institutional pipeline? And the timing of conversions as you expect it today?

Yes. I would say that the timing is going to be typical of what we've seen in the past. I think it's usually about half of that pipeline or so converts in the quarter. I wouldn't see a real change in that. In terms of the fee rate, we tend to have scaled fee schedules. So when you have larger mandates, those priced a little cheaper than smaller mandates. We have a big chunky one in there right now. But in general, I don't see that the fees we've been charging on institutional asset management changing all that much quarter-over-quarter.

Your next question comes from the line of Bill Katz from Credit Suisse.

I was wondering if you could just talk a little bit about where you see the exit base fee rate at the end of the year versus what you sort of reported. And then as you think about your commentary about sort of money continue to go into institutional cash management and some of these larger fixed income mandates. How does that sort of play off against what's happening on the alternative side?

Bill. So on the fee rate, we expect it to remain around 39 basis points, and it may be slightly higher than that for the year as a whole, but that's where we expect it to be, as we've discussed in the past. As you know this well, the upward pressure on the fee rate is if we are more successful in expanding our alternative asset business, and if equities continue to come back, that pushes up. If we get continued flow into money market funds and broader fixed income on the institutional side, in particular, that could push the fee rate down. But as we've modeled that and looked at the mix of our business, we think that 39 basis points is a very reasonable guide for the effective fee rate.

Okay. As a follow-up, I was wondering if you could talk a little about expenses and provide an update on the run rate numbers. There are a couple of variables to consider this quarter. Can you explain the $37 million in deferred compensation? Does that get recognized as expenses? Additionally, your guidance last quarter was higher for some of the non-comp expenses compared to what you reported. Can you discuss any timing issues or how we should view the rest of the year?

Yes, thank you, Bill. There was some fluctuation in the numbers across different components from one quarter to the next. I will discuss our expectations for the second quarter of '23 regarding various components, followed by an overview of our projections for the entire year, which should aid your modeling efforts. I previously mentioned the effective fee rate at 39 basis points, which we expect to maintain next quarter. These figures take into account our ongoing investments in the franchise and a full quarter of Alcentra, compared to two months last quarter. For compensation and benefits, assuming $50 million in performance fees per quarter, we anticipate the total to decrease to between $700 million and $710 million, which includes salary increases and adjustments to our 401(k) and health plans. We foresee IS&T costs to be between $115 million and $120 million, remaining relatively stable. Occupancy expenses are expected to be around $60 million, also flat, as we continue to normalize our return-to-office efforts globally. We project general and administrative expenses to be in the high $140 million range, approximately $147 million to $148 million, reflecting our expectations for placement fees and normalizing travel and entertainment expenses, estimated at $15 million to $20 million per quarter. We anticipate our tax rate to be between 25% and 27%. Regarding our annual guidance, which includes continual significant investments in our organic growth strategies, we acknowledge it's still early in the year and we face some market uncertainty. However, keeping everything else constant and despite improved market conditions in the last quarter that caught many by surprise, we will adhere to last quarter's annual guidance of adjusted operating expenses between $3.95 billion and $4 billion, likely leaning toward the higher end due to recent market trends. This guidance excludes performance fee compensation and factors in a full year of Lexington, as last year we had only six months, along with 11 months of Alcentra since our closing in November. By fiscal year-end on September 30, we expect our total expenses to be lower than last year, accounting for the additions of Lexington and Alcentra, with a decrease in the low single digits, around 2% to 3%.

Your next question comes from the line of Brennan Hawken from UBS.

Thinking about what drove the variance, Matthew, to the fee rate last quarter. What do you think caused that to work out to be different than you had expected and a little bit lower? And how should we think about potentially those factors playing into the outlook for the fee rate to be stable at 39?

We decided to hold off on a closing that our partners at Lexington Partners were expecting to occur until this current quarter. This resulted in a difference of approximately 0.4 basis points. Additionally, the product mix contributed a difference of around 0.3 basis points compared to our expectations for the higher end of the 39s. I anticipated it could have reached as high as 39.7 or 39.8, but it could also have been as low as 39, so I guided in the middle. Ultimately, we ended up a bit low due to these factors. The increase in the effective fee rate from 38.8 to 39 was primarily because we increased our alternatives by adding Alcentra, which contributed about 0.3 basis points. We also added significant money market assets, which, while not the lowest fees, are lower than alternative assets, accounting for about 0.1 or 0.05 of the difference. We feel confident with the 39 basis points because when we project our alternative asset business and consider reasonable market assumptions around equity and the significant opportunities in fixed income, they tend to offset each other, leading us to around 39 basis points. We believe that's a reasonable estimate.

I appreciate that forward-looking comments on fee rates are challenging. Thank you for that additional context; it’s very helpful. When we consider your discussions about the bond outlook and the increased interest, it provides valuable insight. One concern I often hear from investors is the deterioration in Western's performance track record from last year. Can you share whether this interest relates to some of those larger strategies that have faced tougher performance times, or is it directed towards other products? Or is the interest continuing despite the performance setback due to a focus on different time frames? Any further clarification would be appreciated.

Yes. I mean I think the message that we're giving is there's a lot of interest in Western. I mean their Core Bond and Core Bond Plus are some of our biggest grossing sales funds, and Core Bond netted $1.5 billion this quarter. So Brennan, I think we feel really good about Western and the flows there.

Yes, I would say that also Core Plus is still our biggest selling fund, right? They had some performance challenges, but clients stuck with them. They've been doing this for a long time. And again, 89% of their AUM outperformed for the quarter.

Sorry, I was on mute. The other thing I was going to add to that is again, maybe it's an obvious statement. But on the institutional side, in particular, investors expect to have a consistent process and a view from a portfolio management perspective, and Western has stuck to what they said they're going to do. And this is the outcome from that. We have a very broad range, as Jenny mentioned, of other views internally. So we have a lot of fixed income opportunities, whether one works well or not; there's others that will offset that. So a lot of opportunities across the franchise, both public and private markets.

And Western's pipeline is building significantly as we speak.

Your next question comes from the line of Craig Siegenthaler from Bank of America.

So my question is on retail alts. Many pure alt firms have been building out their retail distribution efforts pretty aggressively since 2020. But Franklin has always had a very strong retail effort going back kind of more than 20 years. So I wanted to hear you articulate how you're using your global retail distribution really as an advantage for your alternative affiliates like Clarion, Lexington, Benefit Street? And also how the affiliates are leveraging their local sales teams versus Franklin at the center?

I'll begin, and then Adam can add his thoughts. Retail alternatives are quite complex. First, you need the right products in the appropriate vehicles, which is challenging in illiquid asset classes. Next, you must educate and persuade the gatekeepers at distributors, as well as train your entire sales team to understand these products. This requires a different sales approach compared to traditional mutual funds. Additionally, financial advisers need to be informed about why specific products and their characteristics are beneficial for portfolios. Unlike institutions, financial advisers must also consider each end client's liquidity needs, which complicates the process. However, the positive aspect for us is that we have excellent product offerings from all our managers. For instance, BSP has various products with their BDCs and interval funds, Clarion offers its CPREIF and Opportunity Zone, and K2 has numerous options in the liquid alternative space. Moreover, Lexington is now launching on iCapital, which is crucial for the RIA channel in managing paperwork and capital calls, a significant pain point for advisers. Internally, we've recognized that a wholesaler alone cannot complete the sale. Therefore, we've established a joint venture between our alternatives teams and our distribution team, hiring specialists to support traditional distribution in retail or wealth channels to facilitate the final sale. We've been actively hiring in this area, and we're optimistic about the progress we're making. Adam, would you like to add anything?

Well, yes, you took most of it, Jenny. But what I would say is that on top of that, this is a great example of where we're able to use our unique structure in terms of brand. Our alternative firms have great brands in the institutional are less known in the wealth channel. So we're still really putting the brands forward, the BSP, the Lexington to Clarion in the institutional channel. But when we go to market in the wealth channels, we're going to market at alternatives by Franklin Templeton. That is really playing off of the brand name that resonates so well in those channels. This is another place where we're using our general specialist model so that our salespeople, who have long-standing relationships and significant AUM in the wealth channel, can go in as the lead, but they're introducing our alternative specialists, which we build out to over 35 people now, and those people are just focused on the wealth channel. We've invested really heavily in education because we think that the first way to get growth in the channel is product development, having the right product in the right wrappers. Soon after that, it's building education so advisers understand how to use these products. After that, it's sales, and that's where we have the alternative specialists working with our field force in concert with each other.

And I'll just add one other thing from a finance perspective for what it's worth; this is not a short-term project or something like that. This is a very long-term, very strategic decision that we've made to invest in this separate group basically that's between two other major areas of the firm, that requires its own separate marketing, sales, product strategy, education, as Jenny mentioned. This is a very expensive endeavor that we've thought through very carefully, and we've justified it by the fact that we have acquired leading businesses in the alternative asset markets that we think long term are highly interesting and applicable to the broader markets. But just as a reminder, we acquired these businesses because they had their own institutional growth, and what we're talking about here on top of that is additional growth in the long term that we think we can capitalize upon.

And as a mark of progress, we are currently in market with Clarion, with BSP, with Lexington, and our Venture Capital group—all of them in the wealth channel are actively raising assets.

I have a follow-up, and it's more of a CFO-type question for Matt. But I wanted to get a little more color on your alt-net flow definition in the $2.4 billion that you highlighted in the quarter. Is the inflow the initial sale? Or is it when the fees actually turn on with the product? And then also, do you include realizations in the outflow? Or are they included in the market appreciation, other line of the AUM roll forward?

No, the realizations are included in other markets. They're not particularly material for us, which is why we do it that way. As we continue to expand our alternative asset business, we'll continue to review that. I don't actually know off the top of my head on the $2.4 billion of positive net inflow. What is fee-paying? It's probably 80% of it, but we'll come back to you on that specifically. But I'm pretty sure it's like 80%, something like that.

Your next question comes from the line of Dan Fannon from Jefferies.

I wanted to have another question on fixed income and understanding or acknowledging your comments on Western and those funds still being on the gross sales side quite strong. But if I look at gross sales since you've owned Legg Mason, this was the second lowest quarter for gross sales. So maybe talk about where you're seeing the traction in gross sales outside of maybe the Core and Core Plus.

Are you speaking specifically just fixed income or equities as well?

Just fixed income, this was the second lowest gross sales number since you've owned Legg Mason. So we've already talked about Western. So I assume there's something else that may be having some slowdown.

Well, what I would say is that if you take a look at where the yield curve is right now and look at the shape of it and look how much you can make on the short end, it's a record quarter for us in cash management. So a lot of that really is just, I think, a temporary phenomenon where fixed income investors are able to park money on the short end, get a pretty attractive yield, and wait for the right entry point.

We are seeing positive momentum in municipal bonds. We have some investments in the SMA channel, and our muni ladders are performing very well for us. In terms of diversification, 11 of our top 20 net inflows are coming from outside our largest 20 funds, indicating a broad level of diversification. Our U.S. Income and various multi-asset strategies also include fixed income components and are attracting flows as well.

Okay. And then just thinking about performance fees, I know obviously very hard to predict, but it seems like you are seeing redemptions in your liquid strategy. So maybe get a sense of kind of where performance sits broadly within the alternative universe and how we should, I guess, maybe performance-fee eligible AUM today versus a year ago, high watermarks, other numbers or things you can put around to give a sense of this year's outlook for performance fees versus last year or other time periods?

Yes, performance fees are challenging to forecast. However, thanks to the robust performance of our related funds, we are seeing strong results. Approximately 90% of our alternative asset funds are outperforming or are in a favorable performance area, which positions us well for performance fees. We anticipate generating performance fees consistently, which is why we have adjusted our guidance to $50 million per quarter, an increase from the previous range of $10 million to $25 million. This new figure reflects our confidence in achieving it reliably. That said, there can be episodic fluctuations in performance fees related to timing and redemption activities. For instance, in the last quarter, we experienced a redemption that resulted in an additional $55 million in performance fees from Clarion. Our guidance will remain at $50 million, but we believe that based on our performance, asset mix, and investment horizon, there's potential for us to exceed this amount as we expand our alternative asset business. Overall, our future performance looks promising on both an absolute and relative scale, which contributes to our higher guidance of $50 million per quarter.

Your next question comes from the line of Patrick Davitt from Autonomous Research.

I just have one kind of broader philosophical question. You're obviously getting really good traction with your ETF suite, and news flow suggests that you've been more active converting mutual funds to ETFs than some others. Obviously, bond ETFs appear to be getting a lot more traction over the last year or so. So could you speak to your willingness to get more aggressive with ETF conversions for some of your more larger strategies? And what is the debate kind of for and against going down that road?

We take great pride in our ETF franchise, and our team is highly experienced, having originally come from BGI. We have launched a diverse suite, and by the end of the quarter, we reported approximately $13.3 billion in ETF assets under management. Of that, 44% was active, 30% passive, and 26% Smart Beta, making us one of the pioneering multi-factor Smart Beta managers. During this quarter, we achieved $1 billion in net sales from our $13.3 billion in AUM, marking us as one of the fastest-growing in the sector. Out of that, $200 million stemmed from converting mutual funds, while the remaining $800 million was generated from actual sales in markets such as the U.S., Europe, Canada, and Australia. We focus on strategies, and we consistently find that distributors prefer ETFs and mutual funds to be distinct to avoid suitability conflicts. It's crucial to differentiate between the two. In the case of the funds we converted, we believed they were well-positioned but lacked traction in the mutual fund channel. Many advisers only sell ETFs, meaning we must have an ETF to gain their support. We're continually assessing our offerings to determine if conversions make sense. However, conversions can be complex since existing fund holders may not wish to switch to an ETF, and we must navigate that process carefully. Whenever we identify a well-performing mutual fund that isn't gaining traction, we will evaluate the possibility of converting it into an ETF.

And the only add I would have to that is we have to look at who holds the mutual fund. To the extent, for instance, that it has a large retirement or 401(k) holding, that can sometimes make the conversion a little more complicated. As Jenny said, our ETF strategy, I think, is pretty differentiated with the 44% in active. It's also global. That's the other thing I would add. When we look at that $1 billion flow, about half of that came from outside of the U.S. We’re also willing to put differentiated asset classes like our infrastructure income into an ETF; I think that's a little different. Even when we're in passive, which is the minority of our ETFs, they're in niches where we think we can be highly cost competitive and differentiated like single-country ETF.

I think the other thing I'd add, and I think we put this into our prepared remarks. It's not insignificant that we've reorganized this group in ETFs to be more focused with their own sales effort embedded within the team. It's similar, frankly, to what Jenny has reorganized around our multi-asset solutions area. These are the areas where we are heavily investing with resources and focus as opposed to them being part of a very large group that's attempting to do lots of different things. We're seeing some green shoots from that reorganization work and focus across the franchise. I point out both multi-asset solutions and ETFs in that regard.

Your next question comes from the line of Mike Brown from KBW.

So I wanted to ask on real estate. So with Clarion's just over $80 billion or $80 billion or so, there's clearly some challenges facing the industry. Can you just provide us with an update on what you're seeing from this asset class and how you think investor sentiment could progress from here? And then if possible, could you just touch on how much that contributes to performance fees and other revenue?

Yes, I'll address the first part of your question. Matt, please provide insight on the performance fees. Clarion has mainly operated as an institutional manager, and it is only recently that we've introduced them to the wealth and retail sector. The CPREIF fund is small but growing rapidly, and there have been very few redemption requests. On the institutional side, Clarion's real estate portfolios have concentrated on industrial, multifamily, life sciences, and self-storage, which make up 85% of their portfolios and have performed remarkably well. Their performance has only declined by about 1.5%. Regarding the redemption queue, it has shifted from positive to negative requests. They have the option to fulfill these requests and typically aim to meet about 10% of them, which equates to around 5% to 6% of NAV annually. This situation differs significantly from challenges faced in the wealth channel. Currently, their clients are mainly institutional, and the redemption queues primarily arise from other areas of those clients' portfolios that have underperformed, requiring a rebalance due to an overexposure to real estate. Matt, would you like to discuss performance fees?

Yes, thank you, Jenny. I need to clarify something important regarding the 10% of the queue being paid out. This does not translate into 5% to 6% of NAV per quarter; it's actually 5% to 6% of NAV per year. I want to make that very clear. Additionally, as Jenny pointed out, there is no forced liquidation in this industry, as it would not be the most beneficial for the portfolios or investors. As for performance fees, Clarion is significantly above the threshold, and we would be surprised if we didn't see ongoing performance fees being paid on a substantial portion of Clarion funds over the next year or more.

Your next question comes from the line of Michael Cyprys from Morgan Stanley.

Matt, a question for you. I wanted to come back to expenses. So I hear you on a net basis that it's about 2% to 3% lower. I was hoping you might be able to elaborate on how you're able to achieve that. What would you say are the top 3 to 5 areas that are most meaningful in driving that decline? And do you view this as a one-year efficiency drive? Or would you envision limited to declining expenses as you look out beyond this year?

We consider these expenses as structural and expect them to persist beyond this year. There will always be some variable expenses that should decrease with market conditions, and we are committed to managing that carefully. This situation is a blend of both factors. After our significant merger which included substantial cost reductions and efficiency improvements, we must scrutinize all operations thoroughly. We've significantly increased our assets under management and diversified our business, resulting in a more complex operation. However, we believe there are synergies that can be leveraged through our operational expertise across the franchise. We are fortunate to have established centers of excellence in Hyderabad and Poznan and plan to maximize our presence in these locations. Our strategy involves being selective about hiring and replacements during turnover, implementing voluntary buyouts, and streamlining the organization while analyzing control layers. We have successfully executed our transaction plans that have allowed us to eliminate more costs than expected, contributing to margin expansion opportunities while keeping expenses stable. Additionally, we have completed significant outsourcing in fund administration and transfer agency functions, and we are now focusing on revamping our investment technology operations, a major initiative that will take several years. All our investment managers support this effort, and we believe that having a unified system and vendor across the firm is advantageous while still allowing for specialization within teams. Initiatives like these significantly enhance our efficiency, effectiveness, and collaboration throughout the company.

This concludes today's Q&A session. I would now like to hand the call back over to Jenny Johnson, Franklin's President and CEO, for final comments.

Okay. Well, I just want to thank everybody for participating in today's call. I would once again like to thank our employees for their hard work and dedication, and we look forward to speaking to all of you again next quarter. Thank you.

This concludes today's conference call. You may now disconnect.