Victory Capital Holdings, Inc. Q2 FY2023 Earnings Call

Good morning, and welcome to the Victory Capital Second Quarter 2023 Earnings Conference Call. All callers are in a listen-only mode. Following the company’s prepared remarks there will be a question-and-answer session. I will now turn the call over to Mr. Matthew Dennis, Chief of Staff and Director of Investor Relations. Please go ahead, Mr. Dennis.

Thank you. Before I turn the call over to David Brown, I would like to remind you that during today's conference call, we may make a number of forward-looking statements. Please note that Victory Capital's actual results may differ materially from these statements. Please refer to our SEC filings for a list of some of the risk factors that may cause actual results to differ materially from those expressed on today's call. Victory Capital assumes no duty and does not undertake any obligation to update any forward-looking statements. Our press release that was issued after the market closed yesterday discloses both GAAP and non-GAAP financial results. We believe the non-GAAP measures enhance the understanding of our business and our performance. Reconciliations between these non-GAAP measures and the most comparable GAAP measures are included in tables that can be found in our earnings press release and in the slide presentation accompanying this call, both of which are available on the Investor Relations portion of our website at ir.vcm.com. It is now my pleasure to turn the call over to David Brown, Chairman and CEO. David?

Thanks, Matt. Good morning, and welcome to Victory Capital's second quarter 2023 earnings conference call. I'm joined today by Michael Policarpo, our President, Chief Financial and Administrative Officer, as well as Matt Dennis, our Chief of Staff and Director of Investor Relations. I'll start today by providing an overview of the second quarter. After that, I will turn the call over to Mike to review the financial results in detail. Following our prepared remarks, Mike, Matt and I will be available to take your questions. The quarterly business overview begins on Slide 5. We generated another quarter of strong revenue, earnings, and margins to close out the first half of the year. Long-term net flows improved for the second consecutive quarter with outflows of $1 billion compared with the $1.2 billion of outflows recorded in the first quarter. This excludes the 3 basis points passive mandate redemption in April, which is previously disclosed in our April AUM release. Average AUM was essentially flat quarter-over-quarter, and our average fee realization rose to 52.1 basis points, which contributed to higher revenue compared with the first quarter of the year. Our margins remained exceptional coming in at 50.9% this quarter, which highlights the differentiated nature of our operating platform and its highly variable expense structure. This is the 12th quarter in a row that we achieved margins above our long-term guidance of 49%. And this is the eighth quarter over that period where our margin surpassed 50%. Our long-term margin guidance remains unchanged at 49%. And keep in mind, this does factor in ongoing strategic investments that will help us grow our business in the future. Adjusted net income or tax benefit rose to $1.11 per diluted share in the quarter, up from $1.08 in the previous quarter. Substantial capital return to shareholders continued through the first half of 2023. We repurchased a record 1.5 million of our shares this quarter versus 1.4 million in the first quarter. We allocated $47 million to share repurchases and paid out $21 million in cash dividends for a total capital return of $68 million for the quarter. On a year-to-date basis, we've repurchased 2.9 million shares for $92 million and paid cash dividends of $43 million for a total return of capital in the first half of $135 million. We continue to invest in our business in a number of different areas. We launched our new brokerage platform in April and rebranded the direct channel at the same time. Additionally, we continue to allocate resources to data and technology and are embarking on a few new marketing and distribution initiatives as well. Turning to Slide 7. Investment performance remains excellent and consistent. At quarter end, 42 of our mutual funds and ETFs had four or five star overall ratings from Morningstar. These four and five star products account for nearly two-thirds of our AUM in mutual funds and ETFs. Additionally, approximately three-quarters of our total AUM outperformed benchmarks for the three, five, and 10-year measurement periods ended June 30. A number of our products rose into the top quartile according to Morningstar's trailing three-year rankings. These include the Victory Income Investors Tax-Exempt Intermediate Term Bond Fund, Victory RS Global Fund, Victory RS Partners Fund, and the Victory RS Investors Fund as well as the Victory Munder MidCap Fund and our emerging markets value momentum ETF. In total, approximately 43% of our mutual funds to ETF AUM is ranked in the top quartile as of June 30th. Focusing specifically on the 16 fixed income products managed by our Victory Income Investors franchise that are rated by Morningstar, 14 of those 16 products representing 95% of that AUM ended the quarter with four or five-star overall ratings. Given this investment performance, the trillions of dollars presently invested in money market funds, and the distribution we have built out for this franchise over the last few years, we believe we are nicely positioned to capture inflows into these products as the Fed's tightening cycle subsides, and investors begin to migrate their holdings into longer-duration fixed income strategies. Turning to Slide 8. We continue to generate robust excess free cash flow in the second quarter. Once again, we remain opportunistic with our share repurchase activity this quarter, given where our shares were trading during the period. While we intend to remain flexible with our capital allocation, it is important to state that we are not deviating from our proven approach of making our company better through acquisitions. Over the long run, we believe that the best use of our excess free cash flow is to invest in both organic growth initiatives and strategic acquisitions to create shareholder value. On the organic side, in addition to what I mentioned a few slides back, we are also investing in new product development. One recent example is our VictoryShares Free Cash Flow ETF, ticker VFLO, that we launched in June. On the inorganic side, we are spending quite a bit of time conducting diligence on multiple inorganic opportunities. Although timing and getting to a transaction close cannot be guaranteed, we are generally optimistic with what we are seeing and how things are going. That being said, we remain patient, disciplined, and selective as we evaluate opportunities aimed at enhancing shareholder value over the long term. Before I turn the call over to Mike, I want to take a moment to highlight a significant company milestone. On Monday, we celebrated our 10th anniversary of being an independent company. In 2013, when we executed on our management buyout, employees contributed about a third of the required equity, and the balance of the equity was funded by Crestview Partners. Our other private equity investor, Reverence Capital Partners, began their investment in the fourth quarter of 2014. Crestview and Reverence have been long-term investors and neither firm sold any shares leading up to or during our initial public offering in February of 2018. For the calendar year 2018, we ended the year with $53 billion of AUM, generated revenue of $413 million, and adjusted EBITDA of $160 million with an adjusted EBITDA margin of 38.7% and adjusted net income with tax benefit per diluted share of $1.64. Since then, we have more than tripled our AUM and increased our run rate revenue and earnings by more than twofold. But most importantly, we made our company better and more durable by significantly diversifying our business across investment products, asset classes, broadening distribution, and adding size and scale with substantially increased efficiency and has allowed us to expand our margins by well over 1,000 basis points during our time of being a public company. It wasn't until November of 2021 that our private equity holders executed on their first sale of VCTR shares in a secondary offering. Since then, they've either sold or distributed more than 23 million shares, taking their combined ownership stake down from approximately 67% at the time of the IPO to approximately 32% today. The relationship with our private equity holders has been a textbook case of a genuine win-win over the past decade. We are very proud of our track record on executing on our differentiated strategy and the ability to produce an attractive return for the shareholders who understood our strategy and believed in our vision from the very beginning. While they remain shareholders today, given the nature of their business model, we anticipate monetization of their investments will continue moving forward. Although we anticipated the decision to monetize and the exact timing of that monetization are at the sole discretion of their respective organizations. With that, I will turn the call over to Mike to go through the quarter's financial results in greater detail. Mike?

Thanks, Dave, and good morning, everyone. The financial results review begins on Slide 11. Assets under management increased nearly 2% from $158.6 billion at the end of March to $161.6 billion by the end of June. While the point-to-point variance was higher, our average AUM was slightly lower than in the first quarter due to intra-quarter market volatility. The higher ending point of AUM in June gives us a nice jump-off point to start the third quarter from a revenue perspective. Revenue of $204.2 million was up in the second quarter compared with the $201.3 million of revenue in the first quarter. The higher revenue on the lower average AUM was a result of a higher quarter-over-quarter fee rate realization and one additional day in the period. GAAP operating income was $87.5 million in the quarter, and our adjusted EBITDA was $104 million, both up from the previous quarter. Second quarter net income was $56.7 million or $0.83 per diluted share on a GAAP basis, resulting in GAAP EPS increasing by 17% from the prior quarter. And adjusted net income or tax benefit rose quarter-over-quarter to $75.9 million or $1.11 per diluted share. The quarterly cash dividend of $0.32 per share will be payable on September 25 to shareholders of record on September 11. On Slide 12, you can see a steady increase in total AUM over the trailing 12-month period, reaching $161.6 billion at the end of the second quarter. Our AUM remains well diversified from a distribution channel and client perspective. We are also well diversified from a vehicle perspective with ETFs and separately managed accounts, including model delivery, representing more than a third of our total AUM. Turning to Slide 13. Long-term gross flows were $5.6 billion in the quarter. Industry-wide softness in gross sales has persisted with investors remaining hesitant to enter the market given heightened volatility and uncertainty, and holding cash has become an attractive risk-adjusted option for many investors. Five franchises, including Integrity, New Energy Capital, RS Global, Sycamore, and WestEnd each had positive net flows for the second quarter. In fact, WestEnd has been net flow positive since the acquisition closed at the end of 2021 for the full calendar year 2022 and to date in 2023. This is a result of not only their excellent investment performance but also enhanced distribution reach and winning new platform placements since the acquisition. Moreover, strong industry tailwinds, such as an increasing adoption of model portfolios by financial advisers and the shift to fee-based revenue models in the industry have reinforced our original thesis regarding the attractive growth profile of WestEnd. We also achieved positive net flows in our active ETF products during the quarter, which we believe is a very attractive vehicle wrapper with excellent growth prospects going forward. Slide 14 illustrates our revenue by quarter. Our fee rate increased 0.4 basis points in the second quarter, which is the highest fee rate realization we have recorded in the past four quarters. In general, fees have remained steady, and asset class, client, and vehicle mix are the primary drivers of quarterly fee rate variations. On Slide 15, we break out our expenses for the quarter. Total expenses declined by $9.9 million or 7% to $129.6 million from the first quarter, driven by lower operating expenses. GAAP operating expenses were down $10.1 million or 8% in the quarter. This reflected lower compensation expense and lower non-cash expenses, including depreciation and amortization, as well as expenses associated with the change in value of consideration payable for acquisitions. Cash compensation expense was in line with expectations, and as you can see from the graphic on this slide, as a percentage of revenue, cash compensation remains in a very narrow range. Moving on to our non-GAAP results on Slide 16. Adjusted net income rose to $66.4 million in the second quarter. The tax benefit in the quarter held steady at $9.5 million, resulting in ANI with tax benefit increasing to $75.9 million or $1.11 per diluted share. Our adjusted EBITDA margin expanded to 50.9% in the quarter. We are maintaining our long-term margin guidance of 49%, which is inclusive of continued investments in numerous areas to support our future growth. Finally, turning to Slide 17. While we did not pay down any debt in the first half of this year, our net leverage ratio improved to 2.3 times at the end of June due to our growth in earnings during the quarter and slightly higher cash position. The average interest rate paid on our debt increased just 19 basis points to 5.43% in the quarter. This was the smallest quarter-over-quarter interest rate increase in the past five quarters and takes into account the $450 million hedge portion of our debt, which is fixed at 3.15%. Our $100 million revolver remains undrawn, and GAAP operating cash flow from operations was $77.4 million in the second quarter. That concludes our prepared remarks. I will now turn it back over to the operator for questions.

And your first question comes from the line of Etienne Ricard from BMO Capital Markets. Your line is open.

Thank you and good morning. To circle back on the launch of brokerage capabilities in your direct channel, how do you think about the opportunity to cross-sell your strategies? And what improvement are you expecting as it relates to the number of products held for customer?

Good morning. I want to start by saying that we are in the early stages of our brokerage platform, which we launched at the end of April this year. We are making significant progress. There is a great opportunity for us to cross-sell our investment strategies to both existing and new clients. However, I believe the real opportunity lies in getting closer to our clients. This means offering them more product choices and aiding them in their financial future, allowing us to become a bigger part of their financial lives through an expanded product selection. This will involve more of our own products, as well as products from other firms available on our brokerage platform. Ultimately, our goal is to better assist our clients and attract new ones.

Okay. Understood. Switching gears a little bit on New Energy Capital. Could you please remind us of the potential for scale in that business as well as how investor interest is holding up in this macro backdrop? And lastly, the timeline for future fundraising.

So New Energy was our first entrance into really private markets. And the business is smaller relative to our overall business. Think of it as a $1 billion or sub-$1 billion platform. The opportunity there is to go out and to launch new funds. We were net flow positive for this quarter with them. And it's really just the beginning of New Energy, and that's also the beginning for us in the private market part of the industry.

And your next question comes from the line of Craig Siegenthaler from Bank of America. Your line is open.

Hey, good morning, Dave, Michael, hope you're both doing well.

Good morning.

Good morning.

Fixed income continues to be a challenge for Victory in terms of net flows despite fairly strong performance. As we look ahead to the second half of the year and into 2024, are you anticipating a significant increase in industry fixed income flows after the Fed pauses? Additionally, how do you believe your bond business is set up for this transition?

So, as mentioned in the script, we believe that in the second half of this year and into next year, investors will likely shift from money market funds or very short-term fixed income investments to longer duration options. From our viewpoint, which we detailed in the script, we offer a range of products with strong performance, established track records, and high ratings from Morningstar. Over the years, we've also broadened our distribution. Thus, we feel well positioned. Some of the challenges we've faced in the first half of the year have come from certain non-core fixed income products, such as floating rate and high yield, where we've noticed investors moving into money market investments. Once these investors become comfortable enough to leave those money market products, we believe we are well positioned, and we are optimistic about this potential shift. We see this as a significant factor that could drive our organic growth opportunities moving forward.

Great. For my follow-up, I want to circle back on M&A, just given the rebounding markets here. I wanted to see what that's changed. Has there been any change in valuation multiples over the last six months? The financing side looked a little more challenged last year, is that starting to ease a little bit, too?

I think sellers have come down in their expectations. So I would say that there's probably a lot more conversations happening that potentially can get to a conclusion. We have seen some activity from Victory's perspective, we're really encouraged. We're working hard and part of our growth over the last decade has been through acquisitions. And I would anticipate that going forward and I'd also anticipate, and I've said this before, that coming out of some of these challenging periods, you see a lot of M&A activity in this industry, and I don't think it's going to be any different this time. And if you assume we're coming out of a challenging period through this year and into next year, I think the M&A activity is going to happen, and I think there's going to be a lot of it, and we're going to participate in it.

And your next question comes from the line of Mike Brown from KBW. Your line is open.

Great. Hi, good morning, guys.

Good morning.

Hi, Mike.

So I guess a really nice margin result this quarter. As you called out, this is the 12th consecutive quarter above your 49% guidance, looks like the lower comp was certainly helpful this quarter. Any thoughts on perhaps changing that guidance? Or any quick comments on how to think about maybe the coming quarters here?

I’ll begin and then Mike will follow. We’ve always approached margin guidance from a long-term viewpoint, considering the fluctuations in our investments, market conditions, and revenue realization. It’s challenging to evaluate it on a quarter-by-quarter basis, but we have consistently exceeded our guidance. We’re confident in our guidance of 49%. Over the long term, we have a uniquely strong operating platform. This is the second highest operating margin we’ve achieved as a public company, the first being in Q4 of 2020. The fact that we have reached our second highest margin in this environment speaks volumes about our platform.

Yes. I would add. I think the ability for us to continue to make the investments, and we highlighted a few areas where we are reinvesting for long-term, data, product, distribution, continuing to invest in those areas really pointed for the future. And as Dave mentioned, those investments will ebb and flow. So while this quarter, we had a 50.9% margin we think that the beauty of the model is it's highly consistent. And if you go back and look, we've been operating at 49% margins for the last 12 quarters, and that includes those investments.

Could you comment on the broader investor sentiment? Looking at your flow trends and those of your peers, it appears that gross sales have remained quite soft, which is an important aspect of the net flow trends we've observed. What factors do you believe would encourage investors to engage more meaningfully? Are there any signs of improvement you have noticed in this area?

I agree that gross flows from an industry perspective have been weak. Many investors are currently sitting in money market investments, with around $7 trillion, which represents about a quarter of the industry, allocated to money markets. There is uncertainty regarding the future direction of the Fed and interest rates. For many investors, earning 5% in a money market with essentially no risk is an attractive risk-adjusted return. Once we have more clarity on the Fed and the economy, I believe a significant portion of that money will start to move, which is something we are looking forward to. We are observing some movement now, with an increase in our own activity, although it hasn't yet been fully funded in the institutional channel. Our WestEnd platform has also shown a promising uptick. I am confident that once clarity is achieved, we will witness a substantial flow of funds into various types of investments. Until that time, many advisers and investors will likely remain comfortable earning a 5% yield in money markets. Looking back two years, the yields on money markets were much lower, making the current return a favorable risk-adjusted opportunity when viewed in historical context.

Okay. Great. Thanks, David. Congrats on the anniversary. It's a big milestone.

Thank you.

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

Hi, good morning, Dave and Mike. This is Michael Cho for Ken Worthington. I wanted to follow up on the margin and organic investment discussion. You mentioned several different organic initiatives, and I’m curious about the long-term margin target of 49%. What level of annual organic investment is assumed in that long-term target?

We have established a long-term margin guidance of 49%, considering that we will be investing in our business to promote growth. Currently, we are making significant investments, as Mike mentioned, in areas such as data and technology. We've launched a new brokerage platform and rebranded our direct business. Additionally, we have introduced various products and are undertaking many other initiatives that involve investing in our business, which we will continue to do. We believe achieving a balance between investing for organic growth and maintaining our 49% long-term guidance is crucial. Our operating model differs from others in the industry, as a significant portion of our expenses are variable, giving us the flexibility to scale our operations up or down during challenging market conditions while preserving our margins. Thus, we feel confident that we are effectively managing both our investments and our margin target.

Your next question comes from Alex Bolstein from Goldman Sachs. Your line is open.

Hi, guys. Luke here, on for Alex. Thanks for taking the question. Can you just provide a quick update on capital allocation strategy? Obviously, buybacks continue to be very healthy and are encouraging. But how are you balancing that with debt paydown and inorganic activity? And on the inorganic side, are there any specific areas of focus you guys are thinking about as you do your due diligence? Thanks.

Good morning. Our capital management strategy has remained consistent and unchanged. We aim to maintain balance sheet flexibility to implement our unique strategy, which includes the inorganic opportunities you've mentioned. The strong financial performance we've achieved and the diversification of our business have been supported by the organic investments we've made, while inorganic investments have allowed us to stay flexible. Regarding the buybacks we've executed in the first half of the year, we are balancing that with other capital management elements. Our decisions have been opportunistic and based on facts and circumstances. In recent quarters, we've focused on returning value to shareholders, which we believe is the right shift in our allocation strategy. We have a favorable debt structure, with approximately $450 million of our debt hedged, helping us reduce interest costs and guiding our future decisions. We also see value in share buybacks as a way to reinforce our stock's worth. Looking ahead, our priority for using excess cash will continue to be on inorganic growth, and we want to ensure we have the necessary capacity and resources to achieve that.

Yes. I'll address the types of inorganic growth opportunities we are considering. Firstly, any initiative we pursue must enhance the company. Our previous efforts have significantly improved our financial position, but our primary focus has always been on making the company stronger. We evaluate potential transactions based on this criterion. We're particularly interested in transformational deals that are substantial in size and scale, creating multiple avenues for value through products and new distribution channels, similar to our past initiatives. Another area of interest is acquiring products that align with the future goals of our investors, such as WestEnd, New Energy, and THB, which offer exceptional products that resonate with our clients' needs. We're considering a variety of opportunities, ranging from small to large in scale. As Mike mentioned, we have various methods available for acquisitions, which may include leveraging debt. We generate cash, explore structuring options, and have implemented different strategies. We believe that we now possess the balance sheet strength and resources necessary to effectively pursue M&A activities.

I appreciate the color there. And maybe a nice segue into a follow-up. So WestEnd has obviously been like a very successful acquisition for you guys. Can you help frame for us how significant of a driver it has been and you expect it to be maybe for the quantum of flows? And is there anything specific that you can speak to that's driven the recent pickup in activity here? Thank you.

I'll address the second part of that question. The recent increase is primarily due to the overall market environment. WestEnd has demonstrated excellent investment performance, and importantly, they provide valuable solutions to advisers and clients. This hasn't changed; it's largely a reflection of general market sentiment. The team responsible for servicing and selling the product has been doing an outstanding job. Since we completed the acquisition at the start of 2022, we have seen consistent organic growth. From early 2022 to now, our product has grown organically during every measured timeframe, with growth throughout all of 2022 and into 2023. Our expectations for WestEnd moving forward are high, as we believe they will be a significant contributor to our organic growth. As investor sentiment improves, we anticipate their organic growth will increase as well. It's worth recalling that when we made the acquisition, WestEnd was a double-digit annual organic growth company, and I see no reason why we can't achieve similar growth in a stable market environment.

And your next question comes from the line of Matthew Howlett from B. Riley Securities. Your line is open.

Good morning and thanks for taking my question. Most of my questions have been answered, but Dave, I want to ask you on the 12 platforms, how often do you feel a need to get involved from a management strategy? Remind us again, sort of how often in the past you step in on the day-to-day and so forth?

Our model focuses on independent autonomous investment franchises. Investment professionals are engaged daily in researching and managing portfolios as they see fit on a top-tier platform. They are responsible for building and positioning these portfolios. This approach is central to our business strategy, which we believe leads to strong investment performance. Our investment performance has been impressive and consistent, thanks to our 12 investment franchises, where teams create their own portfolios and communicate them without interference from non-investment professionals. This commitment to independence has been a hallmark of our company over the past decade.

There’s no need to intervene and guide someone who may not be performing at the same level as others; you can just let them continue as they have in the past, and that’s how you manage the company.

Yes. It's all about providing them all of the necessary tools that they need to build portfolios and to manage client assets. And so our focus is on providing them all of the tools to do that. They take those tools. They build the portfolios. And then our job as well is to go out and make sure that we secure them clients and that we service those clients. And we let them focus as much of their time as possible on the portfolio and making the decisions around the portfolio.

Makes a lot of sense. And that leads into my next question. You run the gamut in terms of what you're looking at in terms of M&A. How do you narrow it down? Does it come down to sort of the best value out there, the needs of the company or a geography we'd like to be in? I mean you're going to presumably see a lot of potential deals out there. I mean what can you tell us in terms of how you prioritize all that's out there?

Yes. I believe we have a strong track record with our mergers and acquisitions over the past ten years. Our prioritization is not based on asset class, size, scale, or even financial benefits; it's focused on finding the best fit for the company. In my view, this industry will continue to see consolidation in the foreseeable future, presenting many opportunities. Determining the best fit for your organization is one of the challenges facing leadership teams. Part of this process involves quantitative analysis, including investment performance and analytics, while another part relies on our experience with acquisitions.

And there are no further questions at this time. Mr. Dave Brown. I turn the call back over to you for some final closing remarks.

Thank you, and we appreciate everybody's interest in Victory Capital. We look forward to keeping you posted on our progress as we execute on our strategy through the second half of the year. Thanks for attending, and have a great day.

This concludes today's conference call. Thank you for your participation. You may now disconnect.