Virtus Investment Partners, Inc. Q1 FY2023 Earnings Call

Good morning, my name is Michelle, and I will 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 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 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 2023. Our speakers today are George Aylward, President and CEO, and Mike Angerthal, Chief Financial Officer. Following the prepared remarks, we'll have a Q&A period. Before we begin, please note the disclosures on page two 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. They 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'd like to turn the call over to George. George?

Thank you, Sean and good morning everyone. I'll start today with an overview of the results we reported earlier before turning it over to Mike to provide more detail. Key highlights of the first quarter included a meaningful improvement in our open-end fund flows from lower redemptions and a strong increase in sales of equity strategies, positive net flows in retail, separate accounts and ETFs, solid investment performance across product types, a sequential improvement in our operating margin excluding seasonal items, and we continue to have a well-positioned balance sheet with modest net leverage at quarter-end. After the quarter on April 1st, we closed on our acquisition of AlphaSimplex which expands and diversifies our alternative non-correlated investment offerings and further advances our strategy to offer clients a broad array of capabilities that can appeal across market cycles and through changes in investor preferences. Turning now to review the results. Total assets under management increased 4% to $155 billion due to market appreciation, partially offset by net outflows. Sales declined sequentially to $6.2 billion due to lower institutional sales in the prior quarter, which included a meaningful client funding and a CLO issuance. Retail fund sales were unchanged at $3 billion, with a meaningful increase in equity sales offset by lower fixed-income and alternatives. Retail separate account sales increased 12% led by SMID equities. Total net flows were $1.9 billion, a significant improvement from the prior quarter due to lower redemptions in all products, but particularly in mutual funds, where net flows improved by $2 billion. By product, retail separate accounts delivered positive net flows due to private client, but also included improved intermediary sponsored net flows. Fund net outflows of $1.8 billion improved from $3.8 billion, with improvements in nearly all strategies and marking the best net flow performance since the fourth quarter of 2021. Emerging markets, SMID and large-cap equity funds each generated positive net flows. Institutional had modest net outflows of $0.2 billion, down from the positive net flows in the prior quarter, while this business is inherently lumpy on a short-term basis; over the past four quarters, Institutional has generated organic growth in a challenging environment. In terms of what we've seen in April, our institutional pipeline is as strong as we've seen it with expected fundings that see no redemptions over the next several quarters. Our first quarter financial results reflected the impact of our normal seasonally higher employment expenses, absent which we achieved sequential improvements in both operating income and margin, as we continue to closely manage expenses while generating higher revenues. Excluding the seasonal employment expenses, the operating margin was 33.2%, up 140 basis points from the fourth quarter due to lower variable incentive compensation and lower other operating expenses. Earnings per share as adjusted of $4.20 included $1.11 of seasonal employment expenses; excluding those items, EPS as adjusted increased 3% over the prior quarter. Turning now to capital, we ended the quarter with a modest net-debt position as the first quarter represents our highest quarter of cash utilization, given the timing of annual incentives and the revenue participation payment. We did not repurchase shares in the open market in the first quarter given other cash priorities, but we continue to view share buybacks as an important element of our capital management strategy. After quarter-end, we completed the acquisition of AlphaSimplex for $130 million using balance sheet resources, including our revolving credit facility. Our balanced and prudent approach to capital management has positioned us to continue to invest in growth initiatives such as the addition of AlphaSimplex and other recent additions of affiliated managers, while returning capital to shareholders and maintaining appropriate levels of working capital and leverage. With that, I will 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 31st, assets under management were $154.8 billion, up 4% from $149.4 billion at December 31st. The sequential change reflected $7.8 billion of market appreciation and $1.9 billion of net outflows. Ending assets under management were 2% higher than average assets under management of $152.4 billion, which increased 3% due to market performance. AlphaSimplex AUM at March 31st was $7.8 billion, a decline from February 28th due to market performance, which was in line with expectations for their type of strategies. That was partially offset by positive net flows, both for the month and for the quarter. Our assets under management are well-diversified by asset class and product type. At March 31st, equity was 57%, fixed income and multi-asset strategies combined were 37% and alternatives were 7% of AUM. By product type, institutional represented 34% of total AUM, with US retail funds and retail separate accounts at 32% and 24% respectively. Giving effect to the AlphaSimplex transaction, our pro forma total assets under management are $162.6 billion, with institutional assets increasing to 36% of AUM and alternative strategies increasing to 11%, which is a meaningful change from the 3% prior to the addition of AlphaSimplex and Westchester Capital. We continue to have compelling long-term relative investment performance across products and strategies. At March 31st, approximately 43% of rated fund assets had four or five stars and 87% were in three, four, or five-star funds. We had seven funds with AUM of $1 billion or more and 30 funds in total that were rated four or five stars. On a five-year basis, 74% of our rated fund AUM was outperforming the median performance of their peer groups. In addition to strong fund performance as of March 31st, 88% of retail separate account assets and 64% of institutional assets were outperforming their benchmarks over five years. I would also note that our managers performed well during the volatile first quarter with 55%, 89%, and 60% of mutual fund retail separate accounts and institutional AUM respectively, beating benchmarks for the period. Turning to Slide 8, asset flows. Total sales were $6.2 billion, down from $7.3 billion last quarter. The decline was due to higher institutional sales in the prior quarter, which included a large funding and a growth equity mandate and a $300 million CLO issuance, partially offset by higher retail separate account sales. By product, fund sales of $3 billion were essentially flat as higher sales of equity strategies, which were up 44%, were offset by lower fixed income and alternative sales. Retail separate account sales of $1.4 billion increased 12%, largely driven by SMID-cap equity strategies. Institutional sales were $1.9 million, down from $3 billion in the fourth quarter, that included the large funding and CLO issuance. Institutional sales continued to be well-diversified across affiliates, strategies, and geographies and in the first quarter, our 10 largest institutional net inflows represented four different affiliate managers and several non-US clients. Total net outflows were $1.9 billion, with the improvement from $3.4 billion of net outflows in the prior quarter, largely due to open-end funds. Reviewing by product for open-end funds, the improvement we saw early in the quarter reversed in March though net outflows of $1.8 billion improved significantly from $3.8 billion in the fourth quarter. Almost all strategies had an improvement in net flows and there were positive net flows in SMID-cap, emerging markets and large-cap equities. In retail separate accounts, positive net flows of $0.1 billion, compared with net outflows of $0.4 billion in the fourth quarter and were due to continued positive net flows in private client. Institutional had modest net outflows of $0.2 billion. Turning to Slide 9, investment management fees as adjusted of $157.6 million increased $1.5 million or 1%, reflecting the 3% sequential increase in average assets under management and a modestly higher average fee rate, partially offset by two fewer days in the quarter. The average fee rate of 42 basis points increased by 0.3 basis points from 41.7 in the prior quarter. The fee rate increased for both open-end funds and retail separate accounts and on an overall basis, the fee rate has been very stable remaining in the 41 to 42 basis point range over the past five quarters. Performance fees in the quarter of $0.2 million, compared with $0.5 million in the fourth quarter. Looking forward and taking into account AlphaSimplex, we believe a modestly higher range of 42 to 44 basis points is reasonable for modeling purposes. Slide 10 shows the five-quarter trend in employment expenses. Total employment expenses as adjusted of $98.6 million increased 12% sequentially, reflecting $11.4 million of seasonal items related to the timing of annual incentives, including incremental payroll taxes, benefits and accelerated stock-based compensation expense. Excluding the seasonal items, employment expenses declined by 1% sequentially due to lower variable incentive compensation. Employment expenses were 55.8% of revenue as adjusted, but excluding the seasonal items, they were 49.3%, representing an 80 basis point sequential improvement primarily due to lower variable incentives. Looking ahead, we anticipate employment expenses as a percentage of revenues in a range of 49% to 51%, though as always it will be highly variable based on market performance, in particular, as well as profits and sales. Turning to Slide 11, other operating expenses as adjusted were $29.8 million, down $1 million or 3% from the fourth quarter. The sequential decrease was largely due to lower professional fees and seasonally lower travel and related activity and also reflected close management of all discretionary expenditures while we continue to selectively invest in key areas to support growth of the business. Looking ahead, we anticipate other operating expenses as adjusted will be in a quarterly range of $31 million to $34 million. 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 $47.4 million declined $8.7 million or 16% sequentially due to the seasonal employment items. Excluding those items, operating income increased 5%. The operating margin as adjusted of 26.8% compared with 31.8% in the fourth quarter. Excluding the seasonal items, the operating margin improved by 140 basis points to 33.2%. Net income as adjusted of $4.20 per diluted share, which included $1.11 of seasonal expenses, compared with $5.17 in the fourth quarter. Regarding GAAP results, net income per share of $5.21 increased from $4.77 per share in the fourth quarter and included $0.93 benefit from fair-value adjustments to affiliate non-controlling interests and $0.64 of net realized and unrealized gains on investments. Slide 13 shows the trend of our capital liquidity and select balance sheet items. Working capital was $184 million at March 31st, essentially unchanged from December 31st and we ended the quarter with net debt of $47 million, representing net leverage of 0.2 times EBITDA. The first quarter is seasonally our highest quarter of cash utilization and included the payment of annual incentives, seasonal employment expenses and the revenue participation payment of $27 million. In addition, during the first quarter we net settled 70,716 shares for $12.2 million to satisfy employee tax obligations. The AlphaSimplex acquisition in April was funded with a combination of cash on hand and $50 million of debt from our $175 million revolving credit facility, which we have had available to provide short-term financial flexibility and we expect to repay as we generate cash this year. Giving effect to the acquisition, we continue to have a strong balance sheet with more than adequate levels of working capital and modest leverage, providing meaningful financial flexibility. With that, let me turn the call back over to George.

Thank you, Mike. We will now take your questions. Michelle, would you open up the line please?

Thank you. Our first question comes from the line of Sumeet Mody with Piper Sandler. Your line is open. Please go ahead.

Thanks. Good morning, everyone. I wanted to start with AlphaSimplex, which has approximately $7.8 billion in assets under management, down about 30% since the announcement in the third quarter of 2022 when it was around $11 billion. Can you discuss the flow and market dynamics that contributed to this decline over the past few quarters, especially considering that Virtus' alternative assets under management also decreased by about 8% during that time? Additionally, do you have any updates on the 10% accretion estimate that was mentioned at the announcement?

Sure. On the first part, the change in the AlphaSimplex assets, reflected in the February numbers and then the March ones, and that decline is in line with what you would expect with those strategies. If you sort of look at the most comparable index for their strategies, the ESG trend index is in line with that. Those strategies are very different from some of our others. They moved in line. As Mike noted in his comments, the AlphaSimplex for both the month of March and the quarter had positive flows. So it's really market impact, and again with the unique nature of those strategies and how they perform in market cycles. Since our original disclosure last year, there's been a lot of volatility in the market, particularly near the end of the year, those indices faced challenges. They moved in line with the strategies they manage, but from the client perspective, again in the first quarter, they had positive flows. On the second point, Mike, go ahead.

Yeah, thinking about accretion, we did reflect that in some of the modeling updates that we gave for each of the key metrics. You noted that the fee rate ticked up modestly because the fee rate of AlphaSimplex products is modestly higher than the blended fee rate. So we gave their impact on each of the line items, and there have been changes both in the assets of AlphaSimplex, as well as the existing Virtus business. Generally in line with how we were thinking about it, and the updated metrics will bring you to the revised figures.

Got it. Thank you. I guess my follow-up here is regarding that. So on the other expense line, $31 million to $34 million seems to be what you guys cited and I know you guys have mentioned in the press release, lower seasonal travel cost in the first quarter. Can you maybe just talk about where you are with the full kind of travel and entertainment expense ramp back from pandemic levels? And then what are the sort of changes due to AlphaSimplex being the driver between that $31 million run rate you've been at and the new guide of $31 million, $34 million?

Yeah, I think as you noted, T&E has two dynamics going on, one in this first quarter. Generally, there was less travel given the weather impact on certain parts of the country. In terms of just where we are post-COVID remote era, we have not fully returned to full levels of T&E. There have been changes regarding how that works, particularly on the retail side. That has contributed to the volatility in the last few quarters that we have seen in that area, including T&E and professional expenses that can shift the numbers a bit.

And then you're right, we've been in a very tight range over the past four or five quarters and were down 3% sequentially on other operating expenses. The new revised level does incorporate bringing AlphaSimplex on, so you saw us come in a little bit lower than the prior quarter, but we now reflected the new range to account for the AlphaSimplex business expenses that will start fully in the second quarter.

Got it. Thanks. And then last one here before I hop back in the queue, just on capital allocation. I know you guys didn't pay down any debt or repurchase shares in the open market in the first quarter and ended the quarter with over $200 million in cash. I assume that $80 million payment for AlphaSimplex comes out of second-quarter cash, but why not repurchase more stock in the quarter? How do we think about the balance between the items for Q2 given all the moving parts?

Sure. Stock repurchases, which we've consistently done for many years, is a very important part of our capital management strategy. In the first quarter, there were a lot of moving parts; it is our highest cash utilization quarter, with several competing demands. We also anticipated closing on the transaction. In this interest rate environment, it was a challenging decision. With the various priorities and the market environment, we did not execute open share repurchases, but we had net settlements of $12 million which also impacted what could have been in terms of shares. Despite that, stock buybacks remain an important part of our strategy; however, we must balance many factors.

Thanks for taking the questions.

Thank you.

And one moment for our next question. And our next question comes from the line of Michael Cyprys with Morgan Stanley. Your line is open. Please go ahead.

Thank you, good morning. Maybe continuing with the conversation on AlphaSimplex now the deal is closed. Can you speak to some of the ways that you can leverage their capabilities and expertise to accelerate growth?

Sure. We're very excited about having them become part of the family, and as we said when we announced the transaction, we currently have great diversity of traditional, long-only equity managers. Expanding some of our capabilities to include those that are less correlated to markets on the equity and fixed income side is very attractive to us. They currently have compelling offerings, primarily for their institutional clients, but also including a fund that they are the current manager of. Our opportunity set from our perspective is the broader range of channels and clients that could utilize their strategies in a well-diversified portfolio. The conversations we've been having internally focus on how to make those capabilities available to a broader array of potential investors. This would include offering their strategies through other types of vehicles that could be more attractive. There's also untapped opportunity in what they can offer. Looking at their history, we believe there's a significant opportunity to expand what they currently have into markets where we have additional strength and focus, and bringing their innovative technology and methods to deepen opportunities for those offerings. Additionally, we're looking to extend their reach beyond the U.S. market.

Maybe speaking of the institutional pipeline, could you elaborate a little bit more on the types of strategies that you're seeing in there? You mentioned it's quite robust. Could you elaborate or help quantify the size of the pipeline today, and how much of the fundings you're seeing or expect to come through here in the second quarter?

Yeah, as Mike noted in his comments, what's interesting about the first quarter is that if you look at the ten largest inflows, it really spanned multiple managers and multiple capabilities across different geographical areas. When looking at a pipeline, right, you always have the victories and the challenges, which affect how those wins shape up. This is the strongest we've seen it, and it spans equity, fixed income, and different strategies. The challenge is always the timing, because you can't control the timing of those flows, and that's why there can be some lumpiness within each quarter. Mike, any additional insights?

I think you covered it nicely. We've seen particular interest in global strategies, whether they're global equity, global real estate, or emerging markets. We've seen strong interest in those strategies across managers. It is diverse, and while timing is difficult to project, we're pleased with the traction we've observed.

Great. Thank you. And just last one for me on M&A. Now with the AlphaSimplex deal closed, congratulations on that. The question becomes, how much time and thinking are you spending on incremental M&A from here? What sort of properties are you seeing in the marketplace that could make sense? Could you also talk about how private valuations have evolved?

As you know, we always emphasize that our long-term growth strategies are not solely predicated on M&A. However, we can partner with specialized firms to help expand our offerings and distribution channels. Our main focus remains on organically leveraging the capabilities we already have from our great managers. We've identified significant growth in the non-U.S. institutional market. Many of our product developments have been in ETFs and UCITS, so you will continue to see us pursue those avenues. We remain active in considering M&A opportunities in the market and evaluate them based on the strategic rationale and how well they fit with our existing portfolio. Things like product additions similar to AlphaSimplex and Westchester, which emphasize moving from traditional strategies into non-correlated strategies, remain areas of interest. Additionally, we continue to investigate opportunities internationally. In terms of valuations, there hasn’t been much activity in terms of deals closing in our space recently, but a disconnect does exist between public and private markets.

Great. Thank you.

Thank you. I just want to thank everyone again for joining us and for following us, and we certainly encourage you to give us a call if you have any other questions. Thank you.

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