Earnings Call Transcript - HLNE Q2 2021

Operator, Operator

Good morning, ladies and gentlemen. Thank you for standing by, and welcome to the Hamilton Lane Incorporated Second Quarter Fiscal Year 2021 Earnings Conference Call. Please be advised that today's conference is being recorded. I would now like to turn the conference over to your speaker today, John Oh, Vice President, Investor Relations. Please go ahead.

John Oh, Vice President, Investor Relations

Thank you, Julie. Good morning, and welcome to the Hamilton Lane Q2 Fiscal 2021 Earnings Call. Today, I will be joined virtually by Mario Giannini, CEO; Erik Hirsch, Vice Chairman; and Atul Varma, CFO. Before we discuss the quarter's results, we want to remind you that we will be making forward-looking statements based on our current expectations for the business. These statements are subject to risks and uncertainties that may cause the actual results to differ materially. For a discussion of these risks, please review the risk factors included in Hamilton Lane's fiscal 2020 10-K and subsequent reports we file with the SEC. We will also be referring to non-GAAP measures that we view as important in assessing the performance of our business. Reconciliation of those non-GAAP measures to GAAP can be found in the earnings presentation materials made available on the public Investor Relations section of the Hamilton Lane website. Our detailed financial results will be made available when our 10-Q is filed. Please note that nothing on this call represents an offer to sell or a solicitation to purchase interest in any of Hamilton Lane's products. Beginning on Slide 3. Year-to-date, our management and advisory fee revenue grew by nearly 12%, while our fee-related earnings grew by over 14% versus the prior year period. This translated into year-to-date GAAP EPS of $0.79 based on $25.1 million of GAAP net income and non-GAAP EPS of $0.91 based on $48.8 million of adjusted net income. We have also declared a dividend of $0.3125 per share this quarter, which keeps us on track with a 13.6% increase over last fiscal year, equating to the targeted $1.25 per share for fiscal year 2021. With that, I'll now turn the call over to Mario.

Mario Giannini, CEO

Thanks, John, and good morning. We had another strong quarter of growth and are proud of our team that has shown tremendous effort in meeting and exceeding the needs of our clients, all while juggling their own daily lives. While we continue to operate virtually across many of our global locations, we are starting to see some return to normal in several of our offices outside the U.S. as it is important to have in-person meetings with clients and prospects. Across the firm, productivity and output remain strong, employee engagement is high, and we continue to rely on our strong technology backbone to keep us connected and to service our clients. This has all resulted in continued growth and support from both new and existing clients. I'll shift gears now and turn to an update on our new headquarters build and highlight a new office we've opened in Asia. A quick reminder regarding our new headquarters. We signed a 17-year lease to occupy approximately 130,000 square feet in a newly constructed building located in suburban Philadelphia. The square footage nearly doubles our current footprint. And while we envision growing into the space over time, in the near term, the additional footprint allows us to provide a safe and socially distant work environment for our employees. If we find ourselves with extra space, we wish to sublet it. Construction continues to progress well, and we anticipate relocating to the new space in the first half of 2021. In Asia, we've opened a new office in Singapore. This further expands our Asian presence and puts us closer to investors and investment opportunities in that region. I'd also like to speak about a few recognitions the firm recently received. I highlight that not only because it speaks to the first-class organization we've built but also to demonstrate what is truly important to us and our culture. I'm proud to say that for the 9th consecutive year, Hamilton Lane has been selected as a Best Place to Work in Pennsylvania by the Central Penn Business Journal. It's a statewide program dedicated to recognizing Pennsylvania's best employers. In addition, the firm was recently designated by the Private Equity Women Investor Network as the International Limited Partner of the Year for 2020. This award is given annually to an outstanding institutional limited partner who has demonstrated a commitment to encouraging and supporting female investors in the private equity industry. It's a tremendous honor to be selected for this award and reflects the deep commitment that Hamilton Lane has to creating a diverse work environment. Recent months have caused us, like many firms, to again reexamine our principles and to ask whether we can do more. I answer that question with a yes. We are extremely proud of the caliber of the organization we have built, with women and minorities representing 50% of our workforce globally and 46% of our senior leadership team. While these figures alone position us as a leader in our industry, we are focused on further improving and enhancing our efforts to build a truly diverse and inclusive organization. There has not been a time in recent memory when organizations cared more about who they are partnering with, and we are working hard to ensure we continue to be an organization that brings pride to our clients, partners, and shareholders. Finally, before I move to cover some of the quarter's results in detail, let me now take a minute to talk about the current state of the private markets. Margins similar to the public markets, valuations, fundraising, and deal activity across all sectors have rebounded, in some cases, to levels higher than what we saw pre-pandemic. The readout has not been uniform across industries; we see strong growth in sectors such as technology, while others, like energy, are struggling. Investors reacted, and at no point did we witness the panic reaction we saw during the global financial crisis. By and large, investors have maintained, and more often increased, their allocations and have continued investing across all parts of the private markets. There has been a small shift favoring growth-oriented investments in some areas of the credit markets, but we haven't seen any significant changes in how investors are approaching the private markets. Let me now turn to some results for the quarter. Beginning on Slide 4. Here, we highlight our total asset footprint, which we define as the sum of our AUM, assets under management, and AUA, assets under advisement. Our total asset footprint for the quarter stood at approximately USD 547 billion and represents a 14% increase year-over-year, continuing our long-term growth trend. Consistent with prior quarters, AUM growth year-over-year, approximately USD 7 billion or nearly 11%, came from both our specialized funds and customized separate accounts and continues to be diversified across client type, size of client, and geographic region. Our focus remains on simply growing and winning across both lines of business, and we are pleased with our continued success. As for our AUA, similar to what we've seen with our AUM growth year-over-year, which came in at over USD 58 billion or approximately 14%, this also came from various client types and geographic regions. As we've mentioned on prior earnings calls, AUA can fluctuate quarter-to-quarter for various reasons, but the revenue associated with AUA does not necessarily move in lock-step with those changes. While this quarter saw an increase in AUA dollars relative to the previous quarter, we will continue to emphasize that no direct correlation exists between the scale of AUA dollars and revenue generation. Let me now turn it over to Erik.

Erik Hirsch, Vice Chairman

Thank you, Mario, and good morning. Moving on to Slide 5, we highlight our fee-earning AUM. As a reminder, fee-earning AUM is the combination of our customized separate accounts and our specialized funds with basis point-driven management fees. We will continue to emphasize that this is the most significant driver of our business as it makes up over 80% of our management and advisory fees. Relative to the prior year period, total fee-earning AUM grew by $3.2 billion or nearly 9%, stemming from positive fund flows from across both our specialized funds and our customized separate accounts. Taken separately, nearly $1.7 billion of net fee-earning AUM came from our customized separate accounts. Over the same time period, $1.5 billion came from our specialized funds. Growth in these two segments continues to be driven by four key components: one, re-ups from our existing clients; two, winning and adding new clients; three, growing our existing fund platforms; and four, raising new specialized funds. What you also see here is that our fee rates continue to remain steady. Moving to Slide 6. Fee-earning AUM from our customized separate accounts stood at $24.6 billion, growing approximately 7% over the past 12 months. We continue to see the growth come from across the type, size, and geographic location of our clients. Also, over the last 12 months, more than 80% of the gross inflows into customized separate accounts came from existing clients. You've heard us say in the past that re-ups from our existing client base remain a key component of the growth we've achieved in this segment of fee-earning AUM. In addition to re-ups, we continue to expand our client base by winning and adding brand-new relationships, which, in turn, provide a growing base for future re-up opportunities. Moving to our specialized fund, growth here continues to be strong. We are executing well across our existing product suite and are tactically introducing new product lines. Overall, demand remains robust and, like the rest of our business, comes from a diversified set of investors around the globe. Over the past 12 months, we've achieved positive inflows of nearly $1.5 billion, resulting in an approximately 11% increase in fee-earning AUM. Turning to fund-specific updates. I'll start with our current secondary fund, which continues to be the primary driver of growth in specialized fund fee-earning AUM. During this recent quarter, we closed on approximately $250 million of LP commitments, bringing the total dollars raised for this product to approximately $2.5 billion. In prior calls, we indicated we had until October 2020 to finish raising this fund. However, given strong demand and a robust pipeline of investment opportunities, our current investors have graciously allowed us to extend the fundraising deadline to January 2021. Lastly, similar to prior closes with this product, this closing generated retro fees of $2.9 million in the quarter. Next, our annual credit fund focused series continues to attract capital. To date, the current series has raised over $290 million of commitments, and we have until the end of January 2021 to complete raising capital. For the benefit of those less familiar with the series, it is a relatively unique structure where we continually raise and deploy dollars simultaneously. Therefore, it's less about targeting a set amount of dollars to raise, as you typically see across funds with a multi-year deployment period and more about ensuring we size the product in line with the current opportunity set. This inevitably will lead to some size variability from series to series. We typically see commitments to this product being more calendar back-end weighted and would expect that to continue for this raise. Next up is our direct equity fund. For those less familiar with this fund and its strategy, here we invest directly into companies alongside leading fund managers. We have successfully raised four prior funds in this vertical, with our last fund having raised approximately $1.7 billion. I am pleased to announce that on October 9, we held the first close for our fifth fund at nearly $320 million. The fund has not yet been turned on as we are still finishing up investing our current fund and thus, no fees for this period. Based on pipeline and pacing, we would anticipate that this new fund goes live starting in January 2021. For this new fund, we've made an alteration to the fee model, reflecting some changing investor preferences. Our prior four funds had a traditional 1% management fee on committed capital, which then switched to 1% on net invested capital after the investment period. Carried interest was charged at a 10% rate over an 8% hurdle following a European waterfall method. For this new fund, we are providing investors with a choice: either the traditional 1% management fee on committed capital with a 10% carry, just as we have in the past, or opting for a 1% management fee on net invested capital, which will come with a carry rate of 12.5%. The hurdle rate remains at 8%, as does the European waterfall methodology. We are seeing some investors more focused on early IRR management and thus prefer invested capital models and are willing to pay more for performance on the back end. Part of being a good partner to your clients is listening, understanding preferences, and being responsive. For this first close, 33% of the capital opted for the traditional model and 67% opted for the invested capital and higher carry option. We are encouraged by the results from this first close completed post-pandemic, and we look forward to providing you with updates as we continue to raise this fund. Finally, we continue to see strength in our white label initiatives where we partner with distribution houses and provide products into those channels. Outside of the United States, we continue to see positive net inflows into our semi-liquid Evergreen product and are encouraged by the success we have achieved to date. Before I end here, I want to discuss our latest technology investment. On September 2, Honcho, a SaaS-oriented company focused on compliance-related solutions, announced the closing of its Series A financing round, where Hamilton Lane invested balance sheet capital alongside a blue-chip investor group that included FINTOP Capital and Peter Thiel. Our investment in Honcho was another example of us partnering with leading technology franchises to come together to solve a problem. Not all of these solutions are commercial opportunities for Hamilton Lane. In this case, it would be odd if we announced that Hamilton Lane is now selling compliance software. There are, however, problems we think need addressing because in doing so, it makes our firm and our industry better and stronger, and we believe that leads to more growth. So here with Honcho, as with other similar situations, Hamilton Lane was proud to be a strategic partner and investor. With that, I'll turn it over to Atul to discuss the financials.

Atul Varma, CFO

Thank you, Erik, and good morning, everyone. Slide 8 of the presentation shows the financial highlights for the first half of fiscal 2021. We continue to see solid growth in our business, with management and advisory fees up nearly 12% versus the prior year period. Our specialized funds revenue increased $10 million or 19% compared to the prior year period, driven by almost $1.4 billion in fee-earning AUM added from our latest secondary fund between periods. We recognized $6.1 million of retro fees from the secondary fund in the current year period, compared to $2.8 million from our latest co-investment fund in the prior year period. As many of you are likely aware, investors that come into later closes of the fund for many of our products pay retroactive fees dating back to the fund's first close. Therefore, you typically see a spike in management fee related to that fund for the quarter in which subsequent closings occur. Revenue from our customized separate accounts increased approximately $2.9 million compared to the prior year period due to re-ups from existing clients and the addition of several new clients. Revenue from our advisory and reporting offerings increased approximately $2.3 million compared to the prior year period. The final component of our revenue is incentive fees. Incentive fees for the year-to-date period were $20.5 million. This fiscal quarter saw strong realization activity from the second co-investment fund that materially contributed to the quarterly carry total. That is a 2008 vintage fund that has performed well, with a 2.5x multiple on realized deals contributing over $80 million in realized carry since 2018 and over $20 million in unrealized carry remaining. We remain a very diversified carry story with over 60 vehicles in a carry position that are backed by our portfolio of underlying companies. Moving to Slide 9, we provide some additional detail on our unrealized carry balance. We saw a strong rebound in the markets this quarter, in line with market performance, with the balance up by 7% from the prior year even as we recognized $40 million of incentive fees during that period. Just to remind everyone, we don't control these positions and thus don't control the timing of the exits. Turning to Slide 10, which profiles our earnings. Our fee-related earnings were up 14% versus the prior year period as a result of the revenue growth we discussed earlier. In regard to our expenses, total expenses increased by $12 million compared with the prior year period. General and administrative expenses decreased by $5.6 million due primarily to decreases in travel expenses, consulting and professional fees and commissions. Total compensation and benefits increased by $17.6 million due to strong operating performance and an increase in headcount. $5.1 million of this increase, however, is attributable to incentive fee-related compensation. For the compensation growth in our fee-related earnings, our goal has been to maintain a steady to slightly increasing fee-related earnings margin, which we are on pace for this year. Let me take a moment here to remind everyone about the rent expense associated with the headquarters move that Mario spoke about earlier in the call. While the building is likely to be fully completed sometime next year, as we mentioned in a prior call, we will begin expensing the rent starting in the third fiscal quarter. We expect the impact on our G&A expenses will be a run rate increase of $4 million to $5 million annually stemming from the new lease. Moving to our balance sheet on Slide 11. Our largest asset on the balance sheet is investments alongside our clients in our customized separate accounts and specialized funds. Similar to our unrealized carry balance, this quarter saw an increase in value relative to the previous quarter, primarily due to increased valuation changes. In regard to our liabilities, we continue to be modestly leveraged. And with that, we thank you for joining the call and are happy to take any questions.

Operator, Operator

Your first question comes from Ken Worthington with JP Morgan.

Kenneth Worthington, Analyst

If we look at net sales, commitments less distributions, September was a slower quarter. Commitments looked like they were in the range of historical levels, but distributions looked elevated. So what is the outlook for distributions? And maybe could you walk through how you're thinking about the different drivers, realizations versus step-downs and others in the fund and separate account businesses? And if distributions are going to remain at this level, can you talk about the opportunity to drive better contributions and maybe like an outlook or a pipeline, particularly in separate accounts on the contribution side?

Erik Hirsch, Vice Chairman

Ken, thanks. It's Erik. I'll take that. As we said in prior calls, some of this is really just type-related, particularly around the separate account side. So on the separate account side, as you know, we're in a tranching mode. We had seen some tranches that expired, and we don't always have exact matches for the new tranche to come online. But the driver on the distributions in this time period is that we have had, and secondary would be an example. Some of those funds that are now at that kind of 12-year time period are rolling off to be non-fee earning. So it's a combination: one, aging of the asset; two, what's happening with actual distributions; and three, the timing mismatches between re-ups and tranches expiring. We continue to point to growth continues to look strong from our end, and we think some of this just becomes timing noise.

Kenneth Worthington, Analyst

Okay. Is there any outlook? If we look at over the next couple of quarters, are there enough tranches expiring to suggest that we'll likely remain in this $1 billion-plus distribution range? Or will that moderate and you're just unclear on that?

Erik Hirsch, Vice Chairman

It's a little unclear, partly because the liquidity is obviously not under our control. You can look at the aging of the assets, but what we're seeing in terms of what we would expect from a pure liquidity standpoint is a bit outside of our control.

Kenneth Worthington, Analyst

Okay. The new fee structure in the co-invest fund, do you think that allows you to make that fund bigger and attract more investors or was this something you needed to do to just sort of reach your pre-existing targets?

Erik Hirsch, Vice Chairman

I think it's too early to tell. The reason for the change was, as we said, to be responsive to what investors want. We're finding that people like choice. We provided a good creative solution depending on whether clients are more focused on upfront or back-ended fees. We anticipate having a strong first close, particularly since this was all conducted post-pandemic, and we have a long runway ahead from a timing perspective for fundraising.

Operator, Operator

And your next question comes from the line of Michael Cyprys with Morgan Stanley.

Michael Cyprys, Analyst

If we look at the fee-related revenues, they are up around 12% year-on-year just for the quarter versus a year ago, while the fee-related expenses are up around 8% or so the earnings. It looks like you guys have about 400 basis points positive operating leverage. I'm curious how you would characterize that sort of spread. Are you perhaps getting a lift from the travel side? Can you provide some color on where you see that gap normalizing between the revenue growth versus the expense growth?

Erik Hirsch, Vice Chairman

Yes, Mike, it's Erik. All the points you mentioned about G&A expenses have been true. It's hard to forecast out. While we are seeing a degree of return to normal in some parts outside the U.S., we aren't witnessing big events to take part of our G&A. It's too early to determine if those numbers will return to what they were or remain lower. The rent situation we covered, so we expect G&A to increase as that rent starts to come online. However, the variability in G&A attributed to COVID is still too early to clarify what 'new normal' looks like.

Michael Cyprys, Analyst

Okay. I understand. You guys recently raised an impact fund, I think maybe last quarter or the prior quarter. On the comingled specialized fund side, what sort of new funds or strategies could make sense to bring to market as you look out over the next couple of years?

Erik Hirsch, Vice Chairman

Yes, certainly. We view ourselves as a relatively young and small player in the comingled product side with aspirations to grow significantly. Currently, much of our growth is from enhancing existing platforms. We have a lot of untapped potential in the product market, and while we will be cautious about telegraphing our next moves, there are many opportunities for new funds, including impact investing.

Operator, Operator

And your next question comes from the line of Alexander Blostein with Goldman Sachs.

Alexander Blostein, Analyst

I wanted to follow-up on the pricing structure change that you discussed earlier. Why now? Are you seeing explicit pressure from LPs to make these types of changes? Do you see this as a Hamilton Lane dynamic or more of an industry phenomenon? Also, do you think we could see a similar structure spillover into other vehicles outside of the co-invest fund?

Mario Giannini, CEO

Alex, it's Mario. I wouldn't call it pressure. It's more a question of aligning with what investors are looking for. We have clients with different goals in the market. People prefer choices, especially regarding J-curve sensitivity. So we adapted to what the market wants. This reflects the maturity of the asset class rather than an immediate pressure to change.

Alexander Blostein, Analyst

Got it. Thanks. And a quick modeling follow-up. Looks like the incentive comp rate in the quarter came in a bit better than expected. How are you guys thinking about compensation in relation to carry as we may see a pickup in utilization?

Atul Varma, CFO

Alex, it's Atul. The carry came in strong this quarter, driving the compensation up. We see business performance influencing compensation quarter-to-quarter. As we continue hiring and filling growth gaps, expect some variability. However, at year-end, margins should appear stable and trending upwards over time.

Operator, Operator

And your next question comes from the line of Robert Lee with KBW.

Robert Lee, Analyst

Most of my questions were asked, but just maybe a quick one. What were the rental fees in the quarter? I think I heard $2.9 million, but I don't know if it refers to just the secondary fund or other mutual fees.

Erik Hirsch, Vice Chairman

Yes. The $2.9 million, Rob, was from the secondary fund, which drove the retro fees.

Robert Lee, Analyst

Okay, great. Regarding the direct equities fund, the first close took place, and fundraising is expected to be 18 months from then. My understanding is that the current expectation is it won't turn live until you finish investing the current fund, likely in the first calendar quarter. Is that correct?

Erik Hirsch, Vice Chairman

That's correct, Rob. We held the first close on over $300 million. The fund goes live once we finish investing the previous fund. Based on pipeline opportunities, we expect the new fund to go live in January 2021, assuming the pipeline holds.

Robert Lee, Analyst

Got it. What are your general thoughts on potential increases in realization activity? Based on earnings from other firms, it seems they are more optimistic regarding selling assets and IPOs.

Mario Giannini, CEO

Rob, it's Mario. We're likely to see increased realization activity as many expect potential tax increases in the U.S. Tax considerations could motivate deals to get done before year-end. However, this is uncertain based on election results. Overall, markets are strong, and exit activity has generally increased across geographies and sectors.

Operator, Operator

Our next question comes from the line of Chris Shutler with William Blair.

Christopher Shutler, Analyst

How much of Hamilton Lane's fee-paying AUM would you classify today as direct investing or co-investments? Do you expect that percentage to grow over time? Does that have any impact on comp expense trends over time?

Erik Hirsch, Vice Chairman

It's Erik. We haven't broken out the portion, but in total AUM, it's relatively small. You saw what our last co-investment fund was at sub-$2 billion. While it includes separate accounts, it remains a smaller portion relative to total AUM. However, investment in this area is fast-growing as many investors seek access to direct equity opportunities, which will bring in more carry components, thus leading to increased incentive compensation.

Operator, Operator

And do you plan to disclose a committed, not yet fee-paying AUM number in the future?

Erik Hirsch, Vice Chairman

We currently do not plan on providing that. While some firms disclose those numbers as growth already built in, it isn't novel in our industry. We don't want to overly focus on that as it's a common aspect of many contracts, and it's not our mindset to emphasize that.

Christopher Shutler, Analyst

Got it. And just to clarify geographically, how much of your assets today are U.S. versus non-U.S. clients? Any updates on flows or trends?

Erik Hirsch, Vice Chairman

We maintain a relatively steady 60-40 business, with 60% North America and 40% non-U.S. clientele. This ratio has remained stable since we went public, showing growth in the U.S. and Europe.

Operator, Operator

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

Michael Cyprys, Analyst

I just wanted to circle back on your credit fund strategy. Can you talk about your approach to investing that capital and how you build a diversified portfolio there?

Erik Hirsch, Vice Chairman

Sure. For our credit fund, we adopt an opportunistic approach. We raised it as an opportunistic vehicle enabling us to be tactical depending on market conditions. Currently, we're focusing on performing credit due to healthy markets, but the structure allows us to pivot toward nonperforming credits in case of market dislocation.

Michael Cyprys, Analyst

Great. Lastly, can you talk about the decision to open an office in Singapore? What was the thought process behind that move?

Mario Giannini, CEO

In Singapore, it recognizes the growing presence of the region. We opened offices where we have clients and investments. Singapore, especially in venture capital, has become a hub. The private market environment is robust, making this location strategic. In terms of staffing, we can start small, focusing on both investment and client-oriented personnel. We evaluate additional offices based on client and investment activity.

Operator, Operator

There are no further questions at this time. I will turn the call back over to the presenters for closing remarks.

Erik Hirsch, Vice Chairman

Thank you very much. I want to thank everyone for taking the time to join us, and I hope everyone stays well. Take care.

Operator, Operator

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