Virtus Investment Partners, Inc. Q1 FY2022 Earnings Call

Good morning. My name is Cherry, 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, www.virtus.com. This call is being recorded and will be available for replay on the Virtus website. At this time, all participants are in a listen-only mode. After the speakers’ presentation remarks, there will be a question-and-answer period and instructions will follow at that time. I will now turn the conference to your host, Sean Rourke.

Thank you, and good morning, everyone. On behalf of Virtus Investment Partners, I’d like to welcome you to the discussion of our operating and financial results for the First Quarter of 2022. Our speakers today are George Aylward, President and CEO; and Mike Angerthal, Chief Financial Officer. Following the prepared remarks, we will have a Q&A period. Before we begin, please note the disclosures on Page 2 of the slide presentation. 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 results and should be read in conjunction with the GAAP results. Reconciliations of these non-GAAP financial measures and the applicable GAAP measures are included in today’s news release and financial supplement, which are available on our website. Now, I’d like to turn the call over to George. George?

Thank you, Sean. Good morning, everyone. I’ll start with an overview of the results we reported earlier today and then Mike will provide more detail. Our first quarter financial and operating performance in the context of the challenging market environment was strong. We did have net outflows in open-end funds; however, the quarter also included strong sales in all product categories, including meaningful growth in funds and institutional. We continued to see positive net flows in retail separate accounts and institutional, higher operating income, and earnings per share as adjusted compared with the prior year period, along with increased capital return to shareholders. This is also the first full quarter to include contributions from each of our three recent strategic transactions, AllianzGI, Westchester Capital, and Stone Harbor, which collectively added complementary and differentiated investment strategies, significantly increased scale, and enhanced our distribution capabilities while being financially accretive. I would also note that of our top 20 funds with positive net flows in the quarter, nine were managed by either AGI, Westchester, or Stone Harbor. As for our most recent transaction, Stone Harbor, the integration is proceeding as expected and going well. We are making particularly good progress integrating Stone Harbor’s global distribution, which will augment our existing resources and enhance non-U.S. distribution opportunities for all our affiliates, including in areas where we previously had limited presence. We are also making progress integrating Stone Harbor’s end-to-end operating platform, which will also be available to our other affiliates. Turning now to review the results. Total assets under management after reaching their highest level last quarter declined 2% to $183.3 billion due to market performance and net outflows, mostly offset by the addition of $14.7 billion of AUM from Stone Harbor on January 1. Sales momentum continued despite the significant market volatility, with $9.4 billion of inflows, up sequentially from $8.7 billion. The momentum in this type of market reflects the effectiveness of our distribution capabilities and attractive range of investment strategies that appeal to investors in varying market environments as their preferences shift. The quarter open-end fund sales grew meaningfully with increases in most strategies, while institutional sales reached their second-highest quarterly level. For net flows by product, we had net outflows in open-end funds while institutional and retail separate accounts continued to generate positive net flows. Fund net outflows were higher sequentially, impacted by higher redemptions driven by investor behavior in a volatile market, particularly in the more growth-oriented equity strategies. However, there were notable areas of strength, including strong positive flows in bank loans, alternatives, and SMID cap equity. Fund net outflows were more pronounced in January, with some subsequent improvement thereafter. Institutional net flows were positive for the sixth consecutive quarter, benefiting from continued traction at multiple affiliates and from both existing mandates and new accounts, including a significant addition to a Stone Harbor mandate. Non-U.S. mandates contributed meaningfully to institutional flows, reflecting our investments in distribution and resources over the past several years. Retail separate accounts generated positive net flows for the 16th consecutive quarter, with a 6% organic growth rate. In terms of what we’re seeing in April, open-end fund flow trends remain consistent with the first quarter, as does the market volatility. Areas of strength in open-end fund sales inflows continue to include bank loans as well as alternatives. Regarding institutional, our current pipeline of potential business is the strongest we have seen. Though, it is early in the quarter and markets remain challenged. Our first quarter financial results reflected the impact from the more challenging markets that began in January, as well as our normal seasonally higher employment expenses. The sequential decline in operating income and margin was primarily the result of those items. Year-over-year, operating income as adjusted increased 16%, reflecting revenue growth from higher average assets, including the benefit of the three transactions. Earnings per share as adjusted increased 16% over the first quarter of 2021 to $7.87. The sequential decline in EPS reflected the market-driven revenue decline and the seasonal employment expenses. Turning now to capital. We increased the level of stock buybacks from $25 million in the prior quarter to $30 million and net settled an additional $13 million for a total of $43 million repurchased or net settled during the period. Including our dividend, which we raised in the second half of last year, we returned $57 million to shareholders in the first quarter, which is more than double the $26 million we returned in the first quarter of last year. This increased return of capital is reflective of our balanced approach to capital management that provides flexibility to prioritize different elements as circumstances warrant. Our balance sheet remains strong. We ended the quarter with a modest net debt position of $48 million, as the first quarter represents our highest quarter of cash utilization given the timing of annual incentives, and the quarter also included transaction and revenue participation payments. With that, I’ll turn the call over to Mike. Mike?

Thank you, George. Good morning, everyone. Starting with our results on Slide 7, assets under management. At March 31, assets under management were $183.3 billion, down 2% from $187.2 billion at December 31. The sequential change reflected $6.5 billion of market decline and $2 billion of net outflows, which were largely offset by the addition of the assets from Stone Harbor. Assets continue to be diversified by product type, with U.S. retail funds representing 36% of assets, institutional 31%, and retail separate accounts 22%. The recent strategic transactions have furthered our diversification by asset class. Equity assets represented 56% of AUM, down from 63% in the prior year period. Fixed income and alternative assets grew to 25% and 6%, respectively, up from 21% and 3% a year ago. We continued to generate strong relative investment performance across strategies. At March 31, approximately 62% of rated fund assets had four or five stars, and 90% were in three, four, or five-star funds. We had 12 funds with AUM of $1 billion or more that were rated four or five stars, the same level as a year ago, representing a diverse set of strategies from five different managers. In addition to strong fund performance, as of March 31, 81% of retail separate account assets and 58% of institutional assets were beating their benchmarks on a three-year basis. Also, 82% of retail separate account assets and 64% of institutional assets were outperforming their benchmarks over five years. Additionally, 80% of institutional assets were exceeding the median performance of their peer groups on the same five-year basis. Turning to Slide 8, asset flows. Total sales were $9.4 billion, up 8% sequentially from $8.7 billion. By product, fund sales of $5 billion increased 14% due to higher sales across most strategies. Bank loan fund sales were particularly strong, up 160%, and alternatives were up by 44%. Institutional sales increased 16% to $2.4 billion, benefiting from both new mandates as well as inflows into existing ones. Retail separate account sales were $2 billion, down from $2.2 billion in the fourth quarter. Overall net outflows were $2 billion, as positive flows in institutional and retail separate accounts were more than offset by net outflows in open-end funds. Institutional net flows of $0.8 billion were positive for the sixth consecutive quarter, again benefiting from mandates at multiple affiliates and across asset classes, including a positive emerging markets debt contribution. In retail separate accounts, net inflows were $0.6 billion driven by domestic SMID cap core with an annualized organic growth rate of 6%. For open-end funds, net outflows were $3.4 billion, with net outflows in equity, particularly growth equity, consistent with industry trends, as well as in convertibles while bank loans and alternative funds generated positive net inflows. Turning to Slide 9. Investment management fees as adjusted of $196.3 million declined $7.1 million or 4% sequentially, reflecting a lower average fee rate and two fewer days, partially offset by higher average AUM due to the addition of Stone Harbor’s institutional assets. The average fee rate for the quarter was 41.9 basis points, down 1.8 basis points sequentially. The lower fee rate largely reflected a higher proportion of institutional assets due to the Stone Harbor AUM, as well as lower equity assets due to market performance. Average assets increased $5.5 billion to $190.1 billion due to the addition of the Stone Harbor assets in January. However, excluding these assets, average AUM decreased by approximately $8 billion due to market depreciation and net outflows. Performance fees in the quarter of $0.6 million were relatively unchanged from the prior quarter level of $0.7 million. Looking ahead for all products, we continue to believe the range of 41 to 43 basis points is reasonable, with the second quarter at the low end of the range. Slide 10 shows the five-quarter trend in employment expenses. Total employment expenses as adjusted of $101.6 million increased 10% sequentially, primarily reflecting $9.7 million of seasonal items related to the timing of annual incentives, which included incremental payroll taxes, benefits, and accelerated stock-based compensation expense as a result of equity grants made to retirement-eligible employees. Excluding the seasonal items, employment expenses were essentially flat sequentially. As a percentage of revenues, employment expenses were 45.8%, but excluding the seasonal items, they were 41.4%. The sequential increase, excluding the seasonal items, reflected market-driven revenue declines. Looking forward, we believe a reasonable range for employment expenses as adjusted would be 42% to 44% of revenues, subject to variability based on markets and sales. For the second quarter, absent a notable improvement in the markets, we would be at or above the high end of the range. Turning to Slide 11, other operating expenses as adjusted were $29.3 million, up 28% on a sequential basis from $22.9 million. The sequential increase of $6.5 million reflected the addition of operating costs for Stone Harbor and $1.3 million of business initiative discrete expenses. The incremental expenses from Stone Harbor include valuable enhancements to our global distribution resources and a comprehensive investment in risk operating and technology platform that will eliminate previously planned multiyear initiatives and enhancements, each of which can be leveraged across our affiliates. Looking forward, we would expect other operating expenses in a range of $27 million to $31 million per quarter, reflecting a more normalized level of travel and entertainment activities. For modeling purposes, keep in mind that our annual Board of Directors equity grants occur in the second quarter. Slide 12 illustrates the trend in earnings. Operating income as adjusted of $90.1 million declined $26.7 million or 23% sequentially due to lower revenues and higher employment and other operating expenses. Compared with the prior year quarter, operating income as adjusted increased 16% due to growth in the business, including accretive strategic transactions. The operating margin as adjusted of 40.6% compared with 50.2% in the fourth quarter. Excluding seasonal employment items, the operating margin was 45%, down sequentially due to lower revenue. Net income as adjusted was $7.87 per diluted share, which included $0.91 of net seasonal expenses, compared with $10.36 in the fourth quarter and $6.78 in the first quarter of last year. Regarding GAAP results, net income per share was $4.22, decreasing from $6.29 per share in the fourth quarter, including the following items: $1.97 of realized and unrealized losses on investments; $0.61 of acquisition and integration costs; and $0.57 reduction reflecting the increase in the fair value of the minority interest liability. Slide 13 shows the trend of our capital liquidity and select balance sheet items. Working capital was $196 million at March 31, down sequentially from $220 million, as cash generated by the business was more than offset by $56 million in return of capital to shareholders, as well as the closing payment for Stone Harbor. Cash and equivalents declined sequentially to $225 million from $379 million at December 31. Cash utilization in the quarter included the payment of annual incentives and the AllianzGI revenue participation, as well as the return of capital and Stone Harbor closing payments. As a reminder, the first quarter typically represents the low point of our cash during the year. At March 31, gross debt to EBITDA was 0.6 times, the same level as December 31 and down from 0.8 times at March 31, 2021. Net debt at March 31 was $48 million or 0.1 times EBITDA. We generated $101 million of EBITDA in the first quarter, down sequentially due to seasonal employment items and lower AUM, but up 16% from the prior year level. During the first quarter, we repurchased 125,452 shares of common stock for $30 million, above the prior quarter level of $25 million, and net settled an additional 61,859 shares for $13.4 million to satisfy employee tax obligations. Over the past year, total outstanding shares have been reduced by 2.3%. Looking ahead, with respect to capital management, as they were in the first quarter, share repurchases will continue to be a priority given the stock's recent trading levels. With that, let me turn the call back over to George.

Thank you, Mike. So we’ll now take everyone’s questions. Cherry, would you open up the lines, please?

Your first question comes in the line of Sumeet Mody from Piper Sandler. Your line is now open.

Hey, thanks. Good morning guys. Just wanted to start on the SMA and institutional businesses; it’s good to see another quarter of inflows for both. Just wondering if you could help us frame how to think about client demand for those products today, maybe contrast that with what you’re seeing in the retail segment. And then what dynamics we should be thinking about from the outside that allow for such consistent inflows? Is it mostly performance-based as a major driver there or any particular market environment you think that demand could reverse out?

Sure. It’s a great question, because there is different behavior within those three categories of open-end funds, retail separate accounts, and institutional, even for the same strategies. It’s not unusual for us to actually have a strategy that could be net negative on the open-end side but actually be positive on either institutional or retail separate. So they can have different behavioral patterns, the more extreme being the institutional versus the open-end fund. A lot of times, the drivers of a lot of the institutional activity depend on asset allocation and long-term portfolio construction. The institutional side often shows an appetite to invest in strategies that are out of favor as an entry point, whereas on the retail side, you sometimes see people behave as if those strategies are an exit point. Regarding the institutional inflows, we’ve invested resources, hired personnel, and tried to introduce many of our affiliates to institutional clients, particularly in non-U.S. markets over the last few years. The recent transaction with Stone Harbor expanded our resources and significantly enhanced our institutional reach, particularly in non-U.S. markets where many of our affiliates have had limited opportunities in the past. In the outlook for April, the pipeline of potential institutional business is robust; it continues to show strength and diversity. Retail separate accounts behave similarly to retail open-end funds, but generally, they are used as parts of long-term portfolios with less trading activity.

Great, thanks. That was really helpful, George. Just turning to the capital allocation strategy. I mean, I know you guys are always talking about that kind of primary balanced strategy going forward. But given the drawdown we’ve seen over the course of the first quarter and into April, all the cash flow generation capabilities that have improved despite the market environment and kind of the balance sheet capital today, is this elevated level of buybacks a decent assumption for the appetite going forward, as you trade at such a deep discount to the peer group? How should we think about the quarterly capacity you guys are comfortable buying back in environments like this?

Yes. I mean, as I commented, we have a balanced approach. The good news is we have a strong balance sheet right now, and we still have good cash flow and a high margin. So we have the flexibility to do multiple things. Even in a challenging quarter, we increased our stock buybacks, indicating our commitment to that as a strategy. We feel very comfortable with our strong balance sheet, good cash flow, and our views around what to do with that cash, particularly given where our stock is trading, will definitely factor in.

Thanks so much. One more from me here on just the structure of the distribution effort. Can you just remind us how much is centralized? How much do you have kind of on the specialist sales side? And as you continue to scale the franchise, does full centralization of that sales make any sense for you guys? Or is that not how you think about the long-term strategy around the structure of the distribution effort?

Well, I break it into two pieces. On the retail side, particularly the intermediary distributor retail, that is effectively a shared or centralized service. Virtus operates in the retail space as one point of access to a diverse collection of managers specializing in different asset classes. Our sales force and national accounts on the ETF side and retirement side operate through a coordinated team that collaborates with each of our individual affiliates. However, the institutional side is different; it’s affiliate-driven, where a lot of those clients prefer to have direct contact with individual affiliates. In areas where we can contribute the most, it’s usually where an affiliate may not have direct capabilities. A perfect example is non-U.S. distribution, where we can provide sales professionals to sell multiple strategies. So the retail side remains highly coordinated and centralized while the institutional side adopts a more hybrid approach.

Got it. Thanks so much, George. Thanks for taking my questions.

No, thank you.

Great. Thank you. Good morning.

Good morning.

Just on the SMA part of the business, can you just remind us which some of the largest strategies and affiliates that you currently have available on the SMA platform? And then could you also maybe talk about some of the initiatives that you have in place around getting more strategies or affiliates onto the SMA platform and some of the initiatives for getting those onto broader distribution and intermediary platforms?

Sure. On retail separate accounts, Kayne Anderson Rudnick is the largest. We also have strategies available in fixed income and value space. We spend considerable time trying to introduce one of the uses of our seed capital, which you see in our balance sheet, to incubate track records ultimately made available for our retail offerings. Many of the strategies that we’re gathering assets for today, and last year are ones we probably seeded three or four years ago. A couple of the Kayne strategies in particular, have been successful as a result of building the track record over time. We continue to see the retail separate account opportunity as attractive, and we’ll keep looking to expand to as many viable strategies in that area as possible.

Great. And then can you just remind us, I believe you guys mostly have a revenue share model? Can you just remind us how that sort of flexes and operates in a down market like what we’re seeing year-to-date and month-to-date?

Sure. We actually have a profit-based model. Our alignment of interest is designed to incentivize everyone to generate operating income. Our affiliates share in the profit that they bring to the bottom line, which is linked to the profit of Virtus shareholders. We think that’s a good model in terms of operational management through difficult times. Our affiliates’ incentives are all profit-based.

Great. And maybe just last one around capital management, I heard you mention the buyback in terms of that being a priority. I didn’t hear anything on debt pay down. Is that off the table for now? How are you thinking about that? Maybe bringing that back from the forefront at some point. And then also on M&A, something you guys have spoken about in the past and clearly have executed well against over the years. Just curious where that is on your priority stack today. Maybe you could kind of give us a little flavor or color for what you’re seeing in the marketplace today and how the current market volatility is possibly accelerating or delaying any sort of potential things you may be considering.

Sure. On the capital side, again, we feel very comfortable because our balance sheet is strong and our cash flow is robust, giving us the flexibility to do multiple things. We prioritize various options based on the cycle. When deciding between buying back stock or paying down debt, we will be influenced by how we perceive our stock is trading concerning its fair valuation. Given the current market environment, we may not rush to pay down debt since our stock prices currently look more attractive. On M&A, the environment continues to be highly active. While we prefer that our growth strategy does not solely rely on M&A, we're still exploring multiple opportunities. The number of potential opportunities has increased due to ongoing market volatility. Market fluctuations may delay certain decisions or expedite others before we enter a prolonged downturn. Overall, we remain actively engaged in evaluating opportunities.

And if I could just speak of one additional one in there just around the types of things that you’re interested in potentially on the M&A front, I think in the past you had suggested areas focusing on product types with uncorrelated returns and international distribution. Are those still at the top of your list? Any others that you would flag in terms of what you’re prioritizing and looking at?

Sure. You hit it right. Generally across traditional long-only strategies, we have strong coverage with our affiliates. The areas we focus on include specialized asset classes like emerging market debt, particularly alternatives and less correlated strategies. Westchester is a good example of the type of acquisition we pursue, as those strategies tend to be attractive during market volatility. We continue to seek out opportunities that have lower correlation to traditional long equity or fixed income products. Expanding our distribution footprint, particularly focusing on institutional non-U.S. markets is also a priority. We are always looking for strategic rationale for acquisitions and conduct ourselves with discipline in this area.

Great. Thanks for taking my questions.

There are no questions at this time. This concludes our Q&A session. I would like to turn the conference back over to Mr. Aylward.

Great. As always, I want to thank everyone for joining us today, and we certainly encourage you to reach out if you have any further questions. Enjoy the rest of your day.

That concludes today’s call. Thank you all for your participation. You may now disconnect.