Virtus Investment Partners, Inc. Q3 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 of this call is available in the Investor Relations section of the Virtus website, www.virtus.com. This call is also being recorded and will be available for replay on the Virtus website. Operator provided standard instructions for participants. I would now like to 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 third 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 this 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 these 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 results 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 our website. Now I would like to turn the call over to George. George?

Thanks, Sean. Good morning, everyone, and thank you for joining us on our third quarter earnings conference call. We are pleased with the consistently strong operating performance that continued to be demonstrated in the quarter, which included positive net flows and strong sales, our highest level of assets under management, revenues and earnings per share, continued excellent investment performance, disciplined expense management and an increased dividend and continued debt reduction. We're especially pleased with the positive net flows we generated in total and across product categories. Annualized organic growth exceeded 4% in the quarter and was nearly 3% over the trailing 12 months, which included the significant market disruption in the first quarter. Favorable trends in flows and sales reflect the differentiated nature of our investment strategies, consistent strong investment performance, and the breadth and effectiveness of our retail and institutional distribution. Turning to a review of the results. Our long-term assets under management at September 30 reached their highest level, increasing sequentially by nearly $8 billion or 7% to $115 billion as a result of both market appreciation and positive net flows. Total assets, which include liquidity strategies, ended the period at $116.5 billion. Sales momentum continued with $7.6 billion of inflows, representing our second best quarter of sales. While sales were down sequentially from the second quarter, that was largely due to meaningful flows last quarter into an existing institutional subadvisory mandate. Year-to-date sales were up 54% with significant increases in open-end funds, retail separate accounts and institutional. For the quarter, we had $1.2 billion of positive net flows with strong momentum in both retail separate accounts and open-end funds, continuing the trend we have seen over the past year. Retail separate accounts have delivered consistently positive net flows, reaching $1.1 billion in the third quarter, led by the intermediary-sold channel. Open-end net flows were positive $0.4 billion primarily due to the strength in domestic equity and investment-grade fixed income. Institutional net outflows were $0.3 billion, down from $1.5 billion of net inflows last quarter. Over the past four quarters, institutional has generated over $1 billion of positive net flows representing organic growth rate exceeding 3%, with contributions from existing mandates and new accounts, reflecting the attractiveness of our investment strategies and the continued traction in institutional distribution. In terms of what we're seeing in October for flows, while it's still very early, the trends we have seen throughout the year for both products and asset classes have continued. Our financial results for the quarter reflected the continued market rebound in addition to the impact of the current operating environment on travel expenses. Operating income, as adjusted, of $54.1 million and the related margin of 39.3% increased from $40.5 million and 34.3%, respectively, in the second quarter. Earnings per share, as adjusted, reached their highest level, increasing 39% sequentially to $4.49 due to higher revenues and lower other operating expenses. Turning now to capital. We continued our balanced and prudent approach to capital management, and we maintain a capital position that provides flexibility for future growth opportunities. During the quarter, we raised the quarterly common dividend by 22%; repurchased approximately 54,000 shares or 0.7% of shares outstanding; and continued the consistent pay-down of debt, ending the quarter with net debt to bank EBITDA of 0.1x. Over the past year, we have reduced our debt by 26%. 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 September 30, long-term assets were $115 billion, up 7% from $107.1 billion at June 30. The sequential increase reflected $7.1 billion of market appreciation and $1.2 billion of positive net flows. All asset classes contributed to AUM growth during the quarter, led by domestic and international equity, which increased 9% and 12%, respectively. Assets continued to be diversified by product type, with open-end funds, institutional and retail separate accounts representing approximately 38%, 32% and 21% of long-term AUM, respectively. In terms of asset classes, equity assets represented 70% of long-term AUM, with 77% of that in domestic equity and 23% in international. Fixed income assets declined as a percentage of total to 26% primarily due to the rise in equity markets during the period. We continue to generate strong relative investment performance across our strategies. As of September 30, approximately 80% of rated fund assets had 4- or 5-star Morningstar ratings and 98% were in 3-, 4- or 5-star funds. We currently have eight funds with AUM of $1 billion or more that are rated 4- or 5-stars, representing a diverse set of strategies from four different managers. In addition to this very strong fund performance, 96% of institutional assets and 100% of retail separate account assets were beating their benchmarks on a three-year basis as of September 30, and 66% of institutional assets and 84% of retail separate account assets were outperforming their benchmarks on a five-year basis. Also, 86% of institutional assets were exceeding the median performance of their peer groups on the same five-year basis. Turning to Slide 8, Asset Flows. Net inflows of $1.2 billion in the third quarter represented a 4.3% annualized organic growth rate. For the trailing four quarters, net flows were positive $2.8 billion or a 2.7% organic growth rate. In the third quarter, net flow contributions were diverse, by product with net inflows in retail separate accounts, open-end funds and exchange-traded funds as well as by asset class with positive net flows in equity, fixed income and alternatives. Notably, this marked the seventh consecutive quarter for net inflows in equity, while fixed income net flows also turned positive. And while institutional net flows were negative, this included $1.6 billion outflow from a single client. For the year-to-date and trailing 12-month periods, institutional net flows were positive. Looking at open-end funds, net flows were positive $0.4 billion consistent with the second quarter. By asset class, domestic equity open-end fund net flows were positive $0.6 billion in the quarter, with positive flows of $1.8 billion on a year-to-date basis for a 14% annualized organic growth rate. Flows are positive in large, mid and SMID cap, with SMID particularly strong this quarter with a 28% sequential increase in net flows. Fixed income open-end fund net outflows were $0.1 billion, a significant improvement from prior quarters as outflows in more credit-sensitive strategies continue to abate. International equity funds had net outflows of $0.1 billion as positive net flows in developed market strategies were offset by net outflows in emerging markets. Total sales for the quarter continued to be strong at $7.6 billion, though down from record second quarter levels that included $1.8 billion of flows into an existing institutional mandate. On a year-to-date basis, sales were up 54%, led by growth in institutional, retail separate accounts and open-end funds. For the quarter by product, retail separate account sales of $1.7 billion were up 16% sequentially, led by particularly strong growth of SMID and international strategies. Fund sales of $3.8 billion decreased $0.6 billion or 14% sequentially primarily due to lower sales of small-cap and fixed income strategies. Notable areas of growth were SMID, up 38%; and international developed markets, up 32%. Institutional sales of $2.1 billion represented the second highest quarterly level and included flows into both existing and new mandates across multiple affiliates. The sequential decline from $3.1 billion reflected the large inflow into an existing account in the prior quarter. Turning to Slide 9. Investment management fees, as adjusted, of $122.4 million increased $17.8 million or 17% sequentially. The increase reflected 15% growth in average assets due to market appreciation and positive net flows as well as $2 million in performance-related fees, up from $0.6 million in the prior quarter. The average fee rate on long-term assets for the quarter was 47 basis points, up 0.2 basis points sequentially. With respect to open-end funds, the fee rate increased to 59.5 basis points from 58.4 in the second 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 60 basis points, while the rate on redemptions was 57 basis points. Slide 10 shows the five-quarter trend in employment expenses. Total employment expenses, as adjusted, of $66.1 million increased 12% sequentially, largely reflecting higher profit-based incentive compensation. As a percentage of revenues, employment expenses were 48%. We believe that this is a reasonable level for the fourth quarter, all else being equal. Turning to Slide 11. Other operating expenses, as adjusted, were $16.3 million, down sequentially from $17.4 million, largely due to the impact of the $0.8 million annual equity grant to the Board of Directors in the prior quarter. The third quarter level of other operating expenses continued to reflect the operating environment, as travel and related expenses remained muted. Looking ahead to the fourth quarter, we anticipate that other operating expenses, as adjusted, will approximate recent levels. Slide 12 illustrates the trend in earnings. Operating income, as adjusted, of $54.1 million increased $13.6 million or 34% sequentially due to the increase in revenues partially offset by the higher employment expenses. The operating margin as adjusted of 39.3% increased by 500 basis points from 34.3% in the prior quarter. Noncontrolling interest, as adjusted, increased by $0.4 million to $2.4 million due to growth in earnings at a majority-owned affiliate. The effective tax rate, as adjusted, for the quarter was 27%, unchanged from the prior quarter. We believe 27% is reasonable going forward, all else being equal. Net income, as adjusted, of $4.49 per diluted share increased by $1.25 or 39% sequentially, primarily due to higher revenues and lower other operating expenses. I would point out that our weighted average diluted share count increased by 102,000 shares or 1% from the prior quarter, reflecting the impact of a higher share price and performance adjustments in long-term equity awards in the calculation of dilutive shares. Regarding GAAP results. Third quarter net income per share of $3.71 compared with $1.43 per share in the second quarter and included the following items: a $1.09 reduction, reflecting the increase in the fair value of the minority interest liability; and $0.75 of realized and unrealized gains on investments. Slide 13 shows the trend of our capital position and related liquidity metrics. Working capital was $159 million at September 30, up 2% sequentially as operating earnings more than offset debt repayments and return of capital. Gross debt outstanding at September 30 was $223 million, as we repaid $17.5 million during the quarter. Over the past year, we have reduced gross debt by $78 million or 26%. The net debt to bank EBITDA ratio of 0.1x at September 30 was down from 0.3x at June 30 and 0.5x a year ago due to EBITDA growth, lower debt and a higher cash balance. Gross debt to EBITDA was 1.0x at quarter end, down from 1.5x in the prior year. Regarding return of capital to shareholders, we repurchased 53,867 shares of common stock for $7.5 million, resulting in a 0.7% reduction in common shares outstanding, and we announced a 22% increase in our quarterly common dividend to $0.82 per share. With that, let me turn the call back over to George. George?

Thank you, Mike. Before we take your questions, I'd like to provide an update on the strategic partnership with Allianz Global Investors. During the third quarter, we received the necessary fund board approvals, and the fund's shareholder approval and consent process has commenced. We currently expect to close early in the first quarter of 2021. We're very excited about this partnership, which will add significant scale, further diversify our investment strategies with complementary and attractive offerings, and provide incremental growth opportunities. At September 30, Allianz's assets related to the partnership had increased to $25.7 billion and consisted of $16.8 billion of open-end funds, $5 billion of closed-end funds, $3.4 billion of separate accounts and $0.5 billion of institutional, with a blended fee rate of approximately 37 basis points. Investment performance on the assets continues to be very strong. On a combined basis for Virtus and Allianz, 80% of Morningstar-rated AUM would be in 4- or 5-star funds and 97% would be in 3-, 4- and 5-star. Overall, we would have 39 4- or 5-star rated funds on a pro forma basis. As we indicated in July, the partnership is also financially compelling and will be immediately accretive. We have increased our estimated accretion to be at least 30% to earnings per share, as adjusted, based on the annualized third quarter results. We will provide more detail prior to the close. We'll now take your questions. Kevin, can you open up the line, please?

Operator provided standard instructions for the question-and-answer session. Our first question comes from Jeremy Campbell with Barclays.

Before I ask my question here, I just want to clarify, George, on that Slide 15 you just ran through. The fee rates that you're showing there are net to Virtus, correct?

Yes. Yes, they're on a comparable basis to what we show for our other fees, so they are net.

Perfect. Perfect. And I know, George, we've spoken M&A at length in the past here, and really happy to see that Allianz accretion guide higher. But with Allianz being capital-light and Virtus is now basically delevered, and it seems like the asset manager M&A activity is heating up here, so just wondering if we can get your view on kind of the recent deal flow in the sector and maybe what the pipeline would look like for asset managers that have characteristics you would find attractive, with a good fit to Virtus.

Sure. Yes, so M&A or inorganic actions, more broadly, as we've always said, for us, we're very thoughtful that our long-term growth strategy to create shareholder value is not predicated on M&A. But that being said, given our business model and significant experience and success with M&A, that is a tool in our toolbox. And it gives us the flexibility to look at it from the perspective of something to accelerate or expand or diversify future growth, and we can be thoughtful about that. So as we look at the environment, and again, for some of the factors that you cite, we're currently — we have organic growth, we have good investment performance, we have a low-leveraged balance sheet. That gives us a lot of flexibility in terms of the kind of things we think about. We're not being required to do any kind of an M&A. So as I look at that environment, which we've always been very active in and we're very selective, we continue to think that given our business model, as we look to build out our portfolio of differentiated strategies, there's going to continue to be opportunities. We think we have a very compelling value proposition as it relates to that. And we look at the whole continuum. So those things which are very strategic in terms of adding product capabilities are fundamental to our business model of being seen as a provider of very select, specialized, best-in-class boutique managers. But that being said, things that can unlock some of the scale and leveraging of our business model are also very attractive, and things that would expand our client base, diversifying from where it is. So we actually feel very well positioned for the reasons that I've just discussed. That doesn't mean that we feel any necessity to do M&A for the sake of doing M&A, but we feel very optimistic about our relative attractiveness and the opportunity set that's out there.

Great. And then just maybe to follow up on the organic side. Obviously it's been pretty impressive here, especially once we lap some of that bank loan headwind. And you're kind of looking at a really good string of inflows, especially in equities, active equities, and that's an area where the industry has seen a lot of structural outflows. I guess, when we take a step back, what do you attribute the strength to for Virtus from an inflow perspective in face of all of these sector headwinds?

Yes. It's a great question. It starts with our fundamental offering of a collection of very differentiated boutique managers that have distinctive strategies and approaches to investing. We've never tried to generically offer all things to all people. So when you talk about equity, our equity managers, Kayne and SGA are two examples, are very different, and their compelling nature of how they invest has made them attractive. So it starts with having good managers and good investment performance. In this competitive active versus passive and fee-conscious world, having truly differentiated managers that can distinguish themselves on a risk-adjusted basis is really important. But then you need to have effective distribution. We've generally said we have to have both of those things working in tandem. Because of the diversity of our products, our view is that we'll generally always have something that should be attractive to investors at a given point in time. During times when one asset class is out of favor, we will participate. Even during the period where we had outflows in loans, beneath that there was strength in other products. There will be a time where loans will be our best-selling strategy. I just don't know when it will be. That's the point of what we do with our portfolio of differentiated managers and offerings: to have that holistic full set of building blocks that, because they're differentiated, and because our distribution and marketing resources are consultative and thoughtful in how they position them, we can succeed across cycles. Lastly, we don't make money from raising assets alone; we make money from retaining assets. A lot of the work we do is about making sure we sell products correctly so they have a longer life, which ultimately creates more accretion and profitability to the bottom line.

Our next question comes from Sumeet Mody with Piper Sandler.

Just one more on the Allianz partnership. It's nice to see the added detail around AUM levels and net performance. Just wondering how the flow profile has looked over the last quarter and through October, particularly the SMAs and the subadvised block being advised by Allianz, how that's been doing. And we noticed a couple of the retail funds have liquidated last month, so any color there would be helpful, too.

Well, on the first part, in terms of the flows for their funds, obviously they're not our funds, so we're not going to give a lot of clarity in terms of the activities that are going on there, nor do we think the activity in their fund flows will necessarily be indicative of what it should look like in our portfolio model, but they've generally done well in terms of their funds. On the second piece, some of the other actions that they had previously taken in terms of their fund offering lineup are not related to the funds that we will be taking on as part of our strategic partnership.

No. I think you covered it. We've provided some detail by asset and product type in the slide. The AUM in total grew about 7% from the June 30 level. As George alluded to, the investment performance across that product lineup is very strong and it complements our offerings very nicely.

Yes. I want to highlight that point because some people may not be focusing on it as much. They are really good products. If you look at the performance numbers, we've always been proud of our investment performance profile on the fund side and the Morningstar side. Allianz's performance is equally strong and complementary to what we have. From the asset growth numbers, you can derive that those funds, even amid the change of control activity, are doing quite well.

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

I think you mentioned, on the institutional side, some wins with new clients despite the one lumpy redemption. So just wanted to get some color on the traction that you have been seeing in that channel, including the number of new clients or more mandates by current clients. And then just curious on the one redemption in the quarter, if that was performance-related or something else had driven that.

Mike?

Yes. Michael, on the redemption, I'll hit that one first. It was a $0.6 billion redemption from a single client. It was a product that we have been managing at one of our affiliates since 2012, so over eight years, and the client internalized those portfolio management activities. So nothing to do with performance; it was a single internalization. With respect to new mandates, they're really balanced. We had flows both in new mandates as well as in existing accounts. The new mandates were across four of our affiliates. We had contributions from SGA and Kayne, which we've been talking about, and we also had new mandates from Duff and Seix. So a real balanced contribution, and we think that supports the traction we've been talking about. Although sales levels were down period-over-period, it is important to note that institutional sales were our second highest level on record. If you strip out that one significant mandate last quarter into an existing account, we've been consistent in seeing traction on the institutional side. So we're generally pleased with that.

Yes. And on the closed-end fund market question asked earlier, we think it's a great product structure. Closed-end funds can be a compelling element of a retail investor's portfolio. We continue to look at areas where we can use either existing strategies or combinations of existing and newer strategies into that market. We're pleased to see activity in that space because our strategies and managers are well positioned for those types of opportunities.

Our next question comes from Michael Cyprys with Morgan Stanley.

I just wanted to follow up on the international distribution UCITS products. It looks like you have about $4 billion of international-domiciled AUM. How are you approaching distribution internationally? Who are you partnering with? What sort of channels are you looking at? How are you approaching that differently versus distribution in the U.S.? And at what point would it make sense to maybe further accelerate that through inorganic means on the international side?

We see growing our non-U.S. client base as a high long-term strategic priority. That can be achieved organically by investing in the business and also through inorganic opportunities. In terms of our current distribution in the non-U.S. market, some of it is affiliate-centric, where individual affiliated managers have successfully obtained mandates from non-U.S. clients. Some affiliates have a bigger book than others. We have some non-U.S. resources to support those that need it. On the UCITS side, distribution is a combination of both non-U.S. clients as well as non-U.S. residents in the U.S. market. We distribute some UCITS both outside the U.S. and in channels here in the U.S. to non-residents. We look at all those elements to grow, and our model is flexible in how we support growth on the retail side, both U.S. and non-U.S. On the institutional side, it's a mix of individual affiliate activities and Virtus-supported activities for our affiliates. Many of our managers have opportunity outside the U.S. where they are not as well known as they are in the U.S. retail market, and we see a great opportunity for them globally.

Great. And then just a follow-up on the SGA business and the transaction you guys did a couple years ago. Can you talk about how that's performing relative to your expectations at the time of the announcement? What metrics are you looking at to assess that as well?

My original impression was that SGA was a phenomenal firm and a great team, and they have met and exceeded those expectations. They've done a great job in terms of quality and discipline in managing clients' assets and their thoughtfulness about how they approach their business. In partnering with us, there are more ways we can support them in certain markets. They have met or exceeded our expectations.

Great. And then maybe a quick one. On the Allianz Global Investors transaction, you mentioned it will provide incremental growth opportunities for Virtus. Can you elaborate on that and what are the top areas you're most excited about in terms of additions to growth?

If you look at their product lineup, they expand in multi-asset and include offerings in ESG and other areas that are not currently in our product portfolio. Those are growth opportunities because they complete our set of building blocks for a well-diversified portfolio. As part of the transaction, we'll establish a new boutique affiliate, which we think will create opportunities, particularly in retail separate accounts and on the institutional side. We're happy with the investment performance, the transaction, and we look forward to closing.

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

Okay. I want to thank everyone for joining us today. We certainly encourage you to call if you have any further questions. Stay safe.

That concludes today's call. Thank you for participating. You may now disconnect.