Virtus Investment Partners, Inc. Q2 FY2020 Earnings Call

Good morning. My name is Kevin, and I'll be your conference operator today. I would like to welcome everyone to the Virtus Investment Partners quarterly conference call. The slide presentation for this call is available in the Investor Relations section of the Virtus website at www.virtus.com. This call is also being recorded and will be available for replay on the Virtus website. I will now turn the conference over to your host, Sean Rourke.

Thank you, Kevin, and good morning, everyone. On behalf of Virtus Investment Partners, I would like to welcome you to the discussion of our operating and financial results for the second quarter of 2020. Our speakers today are George Aylward, President and CEO of Virtus; and Mike Angerthal, Chief Financial Officer. Following their prepared remarks, we'll have a Q&A period. Before we begin, I direct your attention to the important disclosures on Page 2 of the slide presentation that accompanies the webcast. Certain matters discussed on this call may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and, as such, are subject to known and unknown risks and uncertainties, including, but not limited to, those factors set forth in today's news release and discussed in our SEC filings. These risks and uncertainties may cause actual results to differ materially from those discussed in the statements. In addition to results presented on a GAAP basis, we use certain non-GAAP measures to evaluate our financial results. Our non-GAAP financial measures are not substitutes for GAAP financial measures and should be read in conjunction with the GAAP results. Reconciliations of these non-GAAP financial measures to the applicable GAAP measures are included in today's news release and financial supplement, which are available on the website. Now I'd like to turn the call over to George. George?

Thank you, Sean. Good morning, everyone. Thank you for joining us on our second quarter earnings conference call. We are pleased with the second quarter results, which included strong positive net flows, our highest level of sales, continued excellent investment performance, disciplined expense management and further reduction in debt and continued return of capital. We're especially pleased with the strong organic growth, which exceeded 11% on an annualized basis, and the composition of the growth being broad-based with contributions across product categories and investment strategies. The favorable trends that we've experienced in sales and flows reflect the distinctive and differentiated nature of our investment strategies as well as the quality of our retail and institutional distribution. I would also highlight our announcement earlier this month that we've entered into an agreement for a strategic partnership with Allianz Global Investors, which would add approximately $24 billion in assets under management and what we would expect to be a highly accretive transaction that would enhance our fund offerings, distribution capabilities and growth opportunities. So turning now to a review of the results. Long-term assets under management at June 30 recovered to near peak levels, increasing sequentially by nearly $18 billion or 20% to $107.1 billion as a result of both market appreciation and positive net flows. Total assets, which include liquidity strategies, ended the period at $108.5 billion. Sales momentum continued with a sequential increase of 30% to $9.1 billion, our highest level since becoming public, with significant increases in open-end funds, retail separate accounts and institutional. For the quarter, we had $2.5 billion of positive net flows with strong momentum across products and asset classes. This continued the favorable trend we've seen this year, other than the disruption earlier in the year during the worst of the market dislocation. Open-end net flows were positive $0.4 billion, primarily due to strong positive net flows in domestic equity. Retail separate accounts had positive net flows of $0.8 billion, led by the intermediary-sold channel, which has now generated 18 consecutive quarters of positive flows. Institutional net flows were positive $1.5 billion with contributions from existing mandates and new accounts, reflecting the attractiveness of our investment strategies and continued traction from our investments in institutional distribution. In terms of what we're seeing in July for the month-to-date, the trends of the second quarter have continued: solid sales and positive net flows in open-end funds, retail separate accounts and institutional. Our financial results for the quarter reflected the impact of last quarter's equity market declines as lower beginning-of-period assets led to a sequential decline in average assets, which had an unfavorable effect on investment management fees for the quarter. Largely offsetting the revenue decline was a significant decrease in expenses due to lower seasonal employment expenses as well as lower travel and entertainment. Operating income, as adjusted, of $40.5 million and the related margin of 34.3% increased from $40.1 million and 31.5%, respectively, in the first quarter. Earnings per share, as adjusted, declined 2% from the first quarter to $3.24, largely due to lower revenues, mostly offset by significantly lower other operating expenses and the impact of the seasonal employment expenses in the first quarter. Turning now to capital. We continued our balanced, prudent approach to capital management. During the quarter, we repurchased approximately 75,000 shares or about 1% of shares outstanding and continued the consistent pay down of our term loan, ending the quarter with net debt to bank EBITDA of 0.3x. Over the past year, we've reduced our debt by 25%. With that, let me turn the call over to Mike to provide more detail on the results. Mike?

Thank you, George. Good morning, everyone. Starting with our results on Slide 7, assets under management. At June 30, long-term assets were $107.1 billion, up 20% from $89.5 billion at March 31. The sequential increase reflected $15.2 billion of market appreciation and $2.5 billion of positive net flows. Nearly all asset classes contributed to AUM growth during the quarter, led by domestic equity, which increased 33%. Assets continue to be diversified by product type with open-end funds, institutional and retail separate accounts representing approximately 37%, 32% and 21% of long-term AUM, respectively. In terms of asset classes, equity assets represented 69% of long-term AUM with 78% of that in domestic equity and 22% in international. Fixed-income assets declined as a percentage of total to 27%, primarily due to the sharp rise in equity markets during the period. We continue to generate strong relative investment performance across our strategies. As of June 30, approximately 84% of rated fund assets had 4 or 5 stars, and 98% were in 3, 4 or 5-star funds. We currently have 9 funds with AUM of $1 billion or more that are rated 4 or 5 stars, representing a diverse set of strategies from 5 different managers. In addition to this very strong fund performance, 94% of institutional assets were beating their benchmarks on a 5-year basis as of June 30, and 82% of assets were exceeding the median performance of their peer groups on the same 5-year basis. Turning to Slide 8, asset flows. Positive net flows of $2.5 billion in the second quarter represented a strong 11% annualized organic growth rate. For the trailing 4 quarters, net flows were positive $0.5 billion. In the second quarter, net flow contributions were diverse by product with positive net flows in open-end funds, retail separate accounts and institutional, as well as being positive across multiple asset classes, and this marked the sixth consecutive quarter for positive equity net flows in aggregate. Net flows for open-end funds were positive $0.4 billion for the quarter, a marked improvement from net outflows in the prior quarter. Looking at open-end fund flows by asset class. Domestic equity net flows are positive $1.2 billion, up from breakeven last quarter. Flows are positive across all domestic equity strategies with particular strength in mid-cap, where net flows increased by over 100% sequentially to $0.6 billion. Fixed-income fund net outflows were $0.3 billion, a significant improvement from $1.4 billion of net outflows in the first quarter. The second quarter net outflows were primarily in more credit-sensitive strategies, while investment-grade fixed income had positive net flows. International equity funds had net outflows of $0.6 billion as modest positive net flows in developed market strategies were more than offset by net outflows in emerging markets, which included a $0.3 billion modeled reallocation. Total sales for the quarter were very strong, up 30% sequentially and 77% year-over-year to $9.1 billion, marking the second consecutive quarter that our sales have reached their highest level since becoming public. And on a year-to-date basis, sales have increased 52% over the prior year period. Sales growth in the quarter was driven by open-end funds, retail separate accounts and institutional. Fund sales of $4.4 billion increased $0.5 billion or 13% sequentially, with increases in both equity and fixed income. Equity fund sales increased 18%, driven by a 45% increase in domestic equity, partially offset by a 24% decline in international. Fixed income sales were up 6% with increases in investment-grade strategies. Retail separate account sales of $1.5 billion were up 40% sequentially, with strong sales growth across asset classes and investment strategies, including a 107% increase in domestic large-cap strategies. Institutional sales of $3.1 billion increased by $1.6 billion from the first quarter due to flows into both existing and new mandates across multiple affiliates. This included meaningful flows into an existing subadvisory mandate. Turning to Slide 9. Investment management fees, as adjusted, of $104.6 million decreased $7.7 million or 7% sequentially. The decline in investment management fees for the quarter despite strong AUM growth reflected the impact of lower beginning AUM on average assets, which declined sequentially by 7%. I would note that end-of-quarter AUM was sharply higher than the average for the quarter. The average fee rate on long-term assets for the quarter was 46.8 basis points, unchanged sequentially and up 0.5 basis points from the prior year period. With respect to open-end funds, the fee rate increased to 58.4 basis points from 57.8 basis points in the first quarter, reflecting the significant market-driven increase in equity assets and the ongoing positive fee rate differential between sales and redemptions. This quarter, the blended fee rate on fund sales was 58 basis points, while the rate on redemptions was 54 basis points. Slide 10 shows the 5-quarter trend in employment expenses. Total employment expenses, as adjusted, of $59 million decreased 12% sequentially. The decrease largely reflects the $7.7 million of seasonal employment expenses in the first quarter as well as lower profit-based incentive compensation, partially offset by an increase in variable sales compensation due to higher commissionable sales. As a percentage of revenues, employment expenses were 49.9%, which reflected the impact of the higher retail sales as well as lower average AUM. For the third quarter, we anticipate that employment expenses as a percentage of revenues will track towards the high end or above the 46% to 48% range we have previously discussed, assuming current market levels and a continuation of strong sales trends. Turning to Slide 11. Other operating expenses, as adjusted, were $17.4 million, down from $18.9 million in the prior quarter and included the annual equity grant to the Board of Directors of $0.8 million. Excluding the Board grant, other operating expenses, as adjusted, were $16.6 million or 14.1% of revenues. The sequential decline in other operating expenses was primarily due to lower travel and entertainment activities in the current environment. Looking forward, we continue to expect that other operating expenses in the short term may remain below or at the low end of the previously stated $18 million to $20 million quarterly range, given limited visibility into a return to a more normalized operating environment. Slide 12 illustrates the trend in earnings. Operating income, as adjusted, of $40.5 million increased $0.4 million or 1% sequentially due to the lower employment and other operating expenses, mostly offset by lower revenues. The operating margin, as adjusted, of 34.3% compared to 31.5% in the prior quarter. Interest and dividend income of $1.1 million declined from $3.4 million. The decline reflected lower yields on cash and reduced distributions on our seed and CLO investments. We believe this is an appropriate level for the third quarter. The effective tax rate, as adjusted, for the quarter was 27%, down from 29% in the prior quarter. We believe 27% is reasonable, all else being equal. Net income, as adjusted, of $3.24 per diluted share decreased $0.08 or 2% sequentially, primarily due to lower revenues and lower interest and dividend income, mostly offset by the decline in employment and other operating expenses. Regarding GAAP results. Second quarter net income per share of $1.43 compared with a net loss of $0.58 per share in the first quarter and included the following items: $0.87 of CLO refinancing expenses, $0.48 of increased liability to reflect the fair value of the minority interest and $0.22 of realized and unrealized losses on investments. Slide 13 shows the trend of our capital position and related liquidity metrics. Working capital at June 30 of $156 million was essentially flat sequentially as debt repayments and return of capital to shareholders was offset by operating earnings. Gross debt outstanding at June 30 was $241 million as we repaid $17.5 million during the quarter. Over the past year, we have reduced gross debt by $75 million or 24%. The net debt to bank EBITDA ratio of 0.3x at June 30 was down from 0.5x at March 31 and 0.7x a year ago due to EBITDA growth, lower debt and a higher cash balance. Gross debt-to-EBITDA was 1.1x at quarter end, down from 1.5x in the prior year. Regarding return of capital to shareholders, we repurchased 74,897 shares of common stock for $7.5 million, representing 1% of beginning-of-quarter total outstanding shares, and net settled 21,473 shares for $2 million. With that, let me turn the call back over to George. George?

Thanks, Mike. Before we take your questions, I would like to comment on the partnership with Allianz Global Investors. We are very excited about this relationship, which is a unique and mutually beneficial partnership. For us, the partnership would increase our assets by approximately 22%, add complementary and attractive investment offerings, enhance our distribution capabilities and be highly accretive to earnings without requiring any payments at close. Allianz will gain access to our strong, focused retail distribution and administrative capabilities to support growth, and the partnership would allow them to focus more closely on their U.S. distribution efforts in institutional and other markets that are more closely aligned with their priorities. Upon completion, which is subject to certain approvals and that we expect to occur near the end of the year, we would add Allianz's approximately $24 billion of assets, based on June 30 AUM, by assuming responsibilities as the investment adviser, distributor and/or administrator of their $16 billion of open-end funds, $5 billion of closed-end funds and $3 billion of retail separate accounts. Allianz would continue to manage the majority of the assets, approximately $16 billion, as a select sub-adviser. While their value equity team, which manages approximately $8 billion, would join us as a new affiliate, similar to our other boutique managers. In addition to adding significant scale, the partnership would further diversify our investment strategies, adding multi-asset, thematic equity and alternative strategies that are differentiated from our current offerings and provide the potential for greater opportunity for clients through changing market cycles. Investment performance on these assets has been outstanding. Of the open-end fund AUM, 88% is in the 10 largest rated funds, 7 of which are rated 4 or 5 stars by Morningstar. On a pro forma basis, we would have a total of 41 4 and 5-star funds, representing over 82% of our fund AUM. We will also enhance our growth opportunities by expanding our offerings of funds in retail separate accounts through our broad national distribution in wirehouses and independent brokers, making us a more meaningful distribution partner and leveraging Allianz's investment capabilities to evaluate new products for U.S. retail investors. Regarding the financial impact, the agreement is structured with an alignment of economic interest over time that will not require any payment at close. Based on June 30 assets under management, we would expect the relationship would be immediately accretive to earnings per share, as adjusted, and well in excess of 20%. We will be providing additional financial details and updates as we get closer to the closing of the partnership. So with that, we'll now take your questions. Kevin, would you open up the line, please?

Our first question comes from Jeremy Campbell, Barclays.

So George, the Allianz partnership is really interesting and innovative. Wondering if you can give us some high-level background on how the deal came about. And maybe if you view this as a little bit more of a one-off unique situation, or if there's potential further demand from other asset managers looking to partner on retail distribution?

Sure. The way I would characterize it without going into specific details is this is a partnership, not a transaction. This is about growth and alignment of interests. This is a going-forward arrangement. So this is not a deal where a party is looking to do a transaction and get a check. This is about two companies working together to create growth and profitability and partner on that going forward. So I think in that way, it is a very aligned structure. I think one that fits the relative nature of what each of us are trying to achieve. So we think it is a very good way of approaching it. It is a little unusual, but I think it's reflective of what we're each looking for in terms of growth in the future. I would also say it expresses their confidence in themselves and their managers and their ability to generate good performance and their confidence that we can help grow those assets. Clearly, the structure of the deal is much more aligned for them to have the opportunity to continue to participate in that. So I think that's something that actually gives us more confidence. It's a good structure. It's a good alignment of interest. I think it's good for everyone involved: Allianz, Virtus, our shareholders, their shareholders and, importantly, all the fund shareholders that are involved here. Is this a one-off or will there be others like this? This is unusual. So every circumstance is a little different. I would not expect every deal going forward to be structured like this because each one has a different need or a different fit in terms of what they're looking to achieve. In some instances, there are transactions that require an upfront capital structure as opposed to a capital-light or back-end capital type of structure. But if you do hear of any other opportunities or other people interested in doing this, you have my contact information, and I encourage you to give that information to them. I'm available.

Great. And then, Mike, maybe this one is for you. Thanks for the little peek behind the curtain on the deal accretion expectations here. Can you just give us a little bit of color on the expected incremental margin that funnels into that ballpark you forecast? I imagine that excluding the value team, there really isn't much in the way of incremental expenses to the distribution side on the partnership piece of the equation.

Yes. The major inputs into the level that we refer to as being well in excess of 20% are obviously the fee rate on the $24 billion of assets under management. So you have an average fee rate in the range of 35 to 40 basis points. For incremental margins, we've talked historically of 50% to 60% incremental margins, and that varies depending on the nature of the assets under management. In this structure, as George alluded to, we can largely leverage the existing infrastructure that we have in place from both an administrative and distribution standpoint. So we'd be in that range of incremental margin. As we get closer to the close, we'll update you on some of those specifics.

Our next question comes from Mike Carrier with Bank of America.

Maybe just one more on the partnership, and maybe partnering that with just your capital position. You guys have been active on paying down debt. You're in a comfortable position on your net debt level. With this partnership, I know you mentioned no upfront payment, but how will that impact your debt level or your net debt position over the next 3 to 5 years in terms of payments? And then given that, when you think about capital priority, are you still in a pretty good position that you have flexibility to look at other opportunities if they arise?

Sure. The way this will be structured is as a participation in the net revenues earned; it will always be a subset of what we receive. So theoretically, there will not be any mismatch that reduces our available capital because there will always be a net cash contribution as long as there are assets and as long as we continue to sell those. In terms of the impact on our capital structure, we view it as incredibly favorable because it does not create any locked-in obligation or an obligation mismatch between receipt of cash and payment. On the second part of your question, we've been very thoughtful around our capital. We were pleased that as we went through the dislocations in the first quarter that because we have been cautious with our capital and not over-levered, we were able to navigate through that period and maintain our dividend, our stock repurchases and our consistent pay down of debt. We also were able to opportunistically reduce more debt and have working capital be flat quarter-over-quarter. As Mike indicated, our working capital is essentially unchanged. We view that as a testament to the thoughtful approach we take to the balance sheet. We do have a good balance sheet that got us through this environment, and we do see opportunities going forward to continue to look for ways to grow the business. Our primary focus, including with the Allianz relationship, will be how we create sustainable growth and long-term value. Having that flexibility in our capital is a positive.

Great. Okay. That makes sense. And then just on the flow stream, I understand you have good performance, some products on demand and industry trends. You've had some rebalancing and reallocation that it looks like you guys have benefitted from, but it still seems like a pretty significant pickup. Anything lumpy there? And one of the areas that seems to be more active industry-wide is the closed-end fund side. Over the next 12 months, do you see opportunities in that area as well?

On the flows, we're happy with our ability to continue to generate on a relative basis good flows. In the second quarter, the 11% organic growth rate is strong, but even more important is that other than the period of dislocation in mid-March to early April, we've consistently been in positive flows. A lot of it is driven by having great managers across the board—from SGA to Kayne to Duff—who have done a great job. You can't do any of this unless you have good, differentiated and predictable performance and capabilities. That's the foundation. We've been effective on distribution as well. The retail environment has become more challenging because relationship-based wholesaling is constrained in a work-from-home world. That's why established relationships are important; they enable Zoom calls and other contact. We've been able to leverage technology and strong, trusting relationships built over years with an experienced sales force to navigate the environment effectively. As a result, we've had two record quarters in a row for sales and strong net flows. Going forward, things will continue to evolve and likely become a hybrid model. This period has been a learning experience, particularly in the retail channel. On the intermediary and wholesaler side, everyone has learned how to be more effective and share information in ways that should benefit clients over time.

Our next question comes from Michael Cyprys of Morgan Stanley.

Congratulations on the AGI transaction. It looks like the price flexes based on revenue, AUM or maybe just revenue. I was hoping you could unpack how to think about what portion—Is there a sort of floor minimum amount that would be paid? How should we think about the breakpoints and the degree of flexibility where that contingent payment flexes? If revenues are down 10% in terms of what's being acquired here, does that contingent payment flex pro rata so there's a lower payment made on a subsequent basis? Are there any catch-ups on prior payments? How should we be thinking about how that works?

Sure. We'll provide more details and updates on specifics as we go through the year prior to close. Think of this as a participatory structure. For dollars coming in, a percentage of those dollars will be the amounts that you would consider to be consideration of some type. It will always be a total alignment. If no dollars come in, no dollars go out. There is no minimum or floor. This is a true alignment of interests, participation in the net revenue-type earnings. There won't be mismatches, and there won't be watermarks or catch-up payments. It is participation in the profits we jointly generate through growth of the assets, through their managing those assets and us distributing them. It's a good alignment of interest. We'll provide more details on timing of payments; they will occur infrequently, once a year after the anniversary of the closing. We'll give more specifics as we get closer to the closing.

Technical difficulty.

I'm sorry, you broke up there.

Kevin, is the line open for Michael?

Hello. Can you guys hear me? Sorry about that.

Mike, we lost you there. You might have to repeat the entire question.

Okay. Glad you guys can hear me now. So just on the accretion, you guys had said well in excess of 20%, but I imagine that does not reflect the contingent payment that would be made. How much would that accretion come down if you were to sort of deduct for that contingent payment? Would that be more like in the high single digits or low teens area? Over what timeframe would that contingent payment be made? I was thinking about 8 years, but I heard maybe 5 for others. How should we be thinking about that?

Yes. In terms of the well in excess of 20% accretion, using June 30 assets and thinking about how it will fit into our net income and reported earnings per share, we don't technically need a lot of additional resources because we're leveraging much of our existing infrastructure. The flex in that number of how much in excess of 20% it will be relates to the opportunities for us to invest in maximizing growth. There is no contingent payment in the sense of a fixed obligation; they will participate in a percentage of earnings that are generated over a period of time. We'll provide more information that will help you triangulate the free cash flow implications, but it will be an attractive number and it will not be well in excess of 20%.

Just thinking through the contingent payments, those would show up as a financing activity. It's really a liquidity activity rather than what we've been referring to in terms of the EPS accretion of well in excess of 20%. That will show up in liquidity measures. From an accounting perspective, you'll see a present value of any of these payments recorded as a liability on the balance sheet at the time of close. There are many inputs that go into that, and we'll provide details as we get closer to close.

If you're thinking about free cash flow accretion, it will be free cash flow accretive. If your question is whether free cash flow accretion is going to be in the 20%-plus level, the answer is no. When we give more information, you'll be able to triangulate on that; it will be an attractive number but not well in excess of 20%.

Our next question comes from Sumeet Mody with Piper Sandler.

I noticed that the fee rate on separate accounts remained elevated in the quarter after that nice increase in the first. Mike, what's driving that, and should we think about that rate remaining elevated for the rest of the year?

We talked about some of the inputs that have impacted the fee rate, including equity markets and flows. On separate accounts, we've seen strength predominantly in domestic equity, so I view this quarter as a good fee rate for modeling purposes, all else being equal with the equity market levels where they're at.

The next question is a follow-up from Michael Cyprys with Morgan Stanley.

Just wanted to dig in a little more on the institutional strength we saw in the quarter. How much of the sales were coming from existing clients in those strategies versus existing clients that you're cross-selling other products to versus new clients entirely? Any color on how that has been evolving and on cross-sell approaches would be helpful.

What was nice about the institutional flows is that it was broad: multiple affiliates, multiple strategies and included both new mandates and meaningful inputs into existing mandates. Our institutional business has gone from a limited number of affiliates to multiple affiliates, and the nature of the business has become more consistent over time. Over the last several quarters, it's been a cumulative build of more consistency and breadth. The second quarter illustrates that progress. It's still a lumpy business, but we're pleased with the traction and the pipeline feels like it's reaching a more mature place.

In the prepared remarks, we indicated there were meaningful flows into an existing subadvisory mandate. SGA has broad relationships and contributed through an important relationship with one of our distribution partners in the quarter. We also had new mandates at Duff and Kayne, including a new mandate into a strategy where the client had prior positive experience and funded a different strategy. So we're seeing traction that is broad-based across new mandates and existing accounts. The business can be lumpy, but we're pleased with the recent traction and with early July trends as well.

Great. Any additional color on the retail SMA intermediary-sold strength that's continuing into July? How many platforms is that coming from, and how diversified across strategies?

We have had 17 consecutive quarters of positive flows on the retail separate accounts, and it's broad-based. We've had success through several of our affiliates: Kayne, SGA and Seix on the fixed-income side. Predominantly, growth over time has been in domestic equity offerings. Our SMID offerings have been very strong. It's occurring across a number of major distribution platforms, indicative of strong investment performance across those offerings. It is at multiple distribution partners and has been consistent over time.

This concludes the question-and-answer session. I would like to turn the conference back over to Mr. Aylward.

Great. I want to thank everyone today. I hope everyone is staying safe and healthy, and I look forward to talking to you in the future. In the meantime, if you have any questions, please reach out. Thank you very much.

That concludes today's call. Thank you for participating. You may all now disconnect, and have a wonderful day.