Virtus Investment Partners, Inc. Q3 FY2024 Earnings Call

Good morning. My name is Dede, 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, 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 speaker's 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, Dede, 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 third quarter of 2024. Our speakers today are George Aylward, President and CEO; and Mike Angerthal, Chief Financial Officer. Following their 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 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.

Thank you, Sean, and good morning, everyone. So I'll start today with an overview of the results we reported this morning and then turn it over to Mike to give a little more detail. We had strong operating and financial performance in the third quarter, which included higher sequential sales in all products, continued positive net flows in retail separate accounts, ETFs, and global funds, attractive long-term as well as recent investment performance across strategies, and operating margin at the highest level in two years, increased return of capital, including our seventh consecutive annual dividend increase, investments in the business, including for a CLO issuance and in the equity of an affiliate, and repayment of debt, ending the quarter with modest net leverage and significant financial flexibility. While we had overall net outflows in the quarter, we were pleased with sales growth and momentum as well as the improvement in net flows, which were reflective of a more favorable market environment for our strategies. As I noted, recent investment performance was strong across products with 62% of assets outperforming peers in the third quarter. Quality coming back in favor particularly benefited our equity managers, with 82% of our equity assets outperforming peers in the quarter. We continue to be active in introducing new products and offerings. We recently introduced or filed to launch several new products, including an actively managed ETF from Kayne Anderson Rudnick focused on high-quality mid-cap equities and an actively managed private credit CLO ETF from Sykes. These followed the second quarter introduction of AlphaSimplex managed futures ETF. Turning now to a review of the results. Total assets under management increased 6% to $183.7 billion, due to market performance and positive net flows in retail separate accounts, ETFs, and global funds. The strong contribution from market performance was favorably impacted by our meaningful exposure to small, SMID, and mid-caps, which represented 61% of equity AUM. Sales increased 7% with growth in each product category and momentum building throughout the quarter, with September having our highest level of sales since January. Net outflows of $1.7 billion improved from $2.6 billion in the prior quarter, with sequential improvements in both open-end funds and institutional, and again, with September being the best month of flows of the quarter. For institutional, net outflows of $1.1 billion improved sequentially from $1.7 billion. The net outflows were largely driven by redemptions of lower fee mandates, with the average fee rate on redemptions meaningfully lower than the rate on inflows. Institutional flows also included the issuance of a new $0.3 billion Seix CLO. Seix, which launched its leveraged loan strategy nearly 20 years ago, now manages 10 CLOs with approximately $3.4 billion in assets that generate an attractive return and meaningful cash flow. Retail separate accounts generated positive net flows of $0.4 billion and have delivered a 5% organic growth rate over the past year with consistent positive net flows in the intermediary sold channel and in private client, which is our wealth management business at Kayne Anderson Rudnick. The business had $8.7 billion of AUM at September 30 and has generated over five years of positive net flows, more than doubling its assets under management over the period. Kayne's wealth management business is ranked seventh on the Forbes Top RIA Firms List for 2024 and for Barron's Top 100 Independent Advisors, they had rankings of third for 2024 and have been in the top 10 for 12 consecutive years. Open-end fund net outflows of $1 billion improved from $1.3 billion in the second quarter, primarily due to fixed income strategies, which generated positive net flows. In terms of what we're seeing so far in October, retail separate accounts, global funds, and ETFs continue to be positive in net flows, and US retail funds is tracking similarly to the third quarter. For Institutional, while known redemptions for the fourth quarter currently exceed known wins, the revenue impact would be essentially neutral given the redemptions would be from lower fee mandates. In terms of our financial results, the third quarter reflected modestly higher average AUM levels and our ongoing management of expenses. The operating margin was 34.4%, up sequentially from 32.5% due to higher investment management fees and lower employment and other operating expenses. The operating margin reached its highest level in two years, benefiting from higher revenues and the leverageability of our business, as well as a disciplined management of discretionary expenses. We have maintained other operating expenses in a consistent range despite inflationary pressure, reflecting various initiatives, including the streamlining of investment systems and data usage that have delivered run-rate cost savings. Earnings per share as adjusted of $6.92 increased 6% from the second quarter to the highest level since the first quarter of 2022. Turning now to capital, our business generates a significant amount of quarterly cash flow that supports our consistent return of capital to shareholders and investment in the growth of the business. In the third quarter, we increased our share buyback to $15 million, raised our quarterly dividend for the seventh consecutive year and made a discretionary payment on our term loan, ending the quarter with a very modest net debt position of 0.1 times EBITDA. Our solid balance sheet and cash flow generation provides flexibility to continue to balance all elements of our capital management strategy. We have consistently applied a balanced approach to capital management. Over the past five years, we have repurchased 1.4 million shares for approximately $265 million, reducing the share count by 12% on a net basis and have consistently raised the quarterly dividend by double digits each year. We also invested meaningfully in the growth of the business, aiding four new managers and seeding new products and strategies that have supported our AUM growth over the period and that positions us for continued growth over time. With that, I'll turn the call over to Mike.

Thank you, George. It's a pleasure to join you all this morning. Beginning with our results, on Slide 7, our total assets under management experienced a 6% increase to $183.7 billion by September 30, primarily driven by $12.6 billion from favorable market performance. Average assets under management rose slightly to $176 billion, with ending assets 4.4% higher than the quarterly average. Year-over-year, our AUM saw a 13% increase, fueled by market performance and steady organic growth in retail separate accounts, global funds, and ETFs. Over the past year, retail separate account AUM has risen by 31%, with a 5% organic growth, showing consistent positive net flows in both intermediary sold channels and our wealth management business. Global Funds AUM increased by 29% year-over-year, supported by 7% organic growth, and ETF AUM surged by 88%, with 65% organic growth. We continue to deliver strong long-term relative investment performance across our products and strategies. As of September 30, 58% of rated retail fund assets were rated four or five stars, with 90% being in three, four, or five-star funds. Additionally, 63% of fund AUM outperformed their peers' median over a five-year span, and 84% of retail separate account assets surpassed benchmarks during the same period. Our ETFs also performed well, with 95% of assets outperforming the median of their peer groups over three years, and five of our 14 rated ETFs received four or five-star ratings. Across all products, 57% of AUM as of September 30 were exceeding their benchmarks over the five-year timeframe. Moving to Slide 8, total sales grew by 7% to $6.6 billion, with increases noted in every product category. Compared to the same quarter last year, sales jumped 14%. Institutional sales reached $1.2 billion, up 3% sequentially, which included the issuance of a new $0.3 billion CLO. Retail separate account sales rose by 4% to $2.3 billion, driven by higher sales in the intermediary sold channel. The strong investment performance from our retail separate account strategies has led to consistent demand for the product. Open-end fund sales saw a sequential increase of 12% to $3.1 billion, buoyed by fixed income and alternative strategies. Total net outflows improved to $1.7 billion from $2.6 billion last quarter, with positive net flows in retail separate accounts, ETFs, and global funds. Looking at the products, institutional net outflows decreased to $1.1 billion from $1.7 billion sequentially, affected by the CLO issuance. These net outflows were mainly from a couple of larger low-fee accounts, averaging around 8 basis points in fee rate. Institutional flows may vary depending on the timing of client decisions. Retail separate accounts maintained positive net flows in both intermediary sold and wealth management channels, totaling $0.4 billion for the quarter. For open-end funds, net outflows stood at $1 billion, an improvement from $1.3 billion the previous quarter, primarily due to fixed income strategies performing well. Within open-end funds, fixed income, SMID-cap, and global equity strategies recorded positive net flows. Additionally, across all products, fixed income net flows were positive for the quarter. Transitioning to Slide 9, adjusted investment management fees totaled $185.5 million, an increase of $1.8 million or 1%, reflecting a moderate rise in average assets under management and a relatively stable fee rate. The average fee rate was 41.9 basis points compared to 42.2 basis points in the previous quarter. Excluding performance fees, the average fee for the third quarter was 41.8 basis points, nearly unchanged from last quarter. Our average fee rate, excluding performance fees, has remained stable within a narrow range over the past few years, a testament to our solid investment performance and the unique nature of our products, such as high conviction, high-quality strategies, small caps, emerging markets, liquid alternatives, and various fixed-income strategies, including bank loans. Looking forward, we consider the third-quarter average fee rate reasonable for modeling. As always, the fee rate will fluctuate based on market conditions and asset composition. Slide 10 monitors the five-quarter trend in employment expenses. Adjusted total employment expenses totaled $102.5 million, a 1% decrease sequentially due to lower fixed costs. They represented 50% of revenues, down 100 basis points. Looking forward, we believe the range of 49% to 51% for employment expenses as a percentage of revenues is reasonable. However, it may vary based on market performance and sales. Moving on to Slide 11, other adjusted operating expenses were $29.8 million, down $1.5 million or 5%, due to ongoing cost management and last quarter’s annual grant to the Board of Directors. As a percentage of revenues, other operating expenses dropped 90 basis points sequentially and 80 basis points compared to the prior year. These expenses reached the lowest level since Q1 of 2023, despite onboarding costs for a new affiliated manager. As George highlighted, we have been disciplined with discretionary spending and have streamlined our cost structure, including consolidating portfolio management support systems. For modeling purposes, the level of other operating expenses for the third quarter appears reasonable. Slide 12 presents the earnings trend. Adjusted operating income was $70.5 million, up $4.5 million or 7% sequentially, primarily due to higher average assets under management and lower operating expenses. The adjusted operating margin rose to 34.4%, up from 32.5% in the second quarter, marking the highest level since the third quarter of 2022. Year-to-date, the operating margin has increased by 60 basis points compared to the previous year. Regarding non-operating items, interest and dividend income decreased by $1.8 million, mainly due to the prior quarter's elevated interest income from a CLO issued last year. An average of the past two quarters of interest and dividend income would be a good reference for modeling. Non-controlling interests were down $0.4 million sequentially, primarily because our ownership of affiliates increased during the quarter. Net income as adjusted was $6.92 per diluted share, up from $6.53 in the second quarter. Year-to-date, diluted earnings per share rose by 19% over the previous year. In terms of GAAP, net income per share was $5.71, an increase from $2.43 per share in the second quarter, accounting for $0.64 of expense related to an increase in minority interests' fair value and $0.10 in acquisition and integration costs, slightly offset by $0.41 in fair value adjustments to contingent consideration. Slide 13 displays our capital, liquidity, and select balance sheet trends. Working capital was $108.5 million on September 30, down from $143 million as cash generated did not fully counterbalance investments in affiliated managers, returned capital to shareholders, CLO sponsorship, and debt repayment. Cash and equivalents grew sequentially to $195.5 million from $183 million as of June 30. In the third quarter, we repurchased 72,850 shares of common stock for $14.9 million and made a payment of $10.7 million on our term loans. As of September 30, our gross debt-to-EBITDA was 0.8 times, with net debt at $46 million or 0.1 times EBITDA. We generated $84 million in EBITDA for the third quarter, an increase of 2% sequentially due to higher average AUM and reduced operating expenses, and up 3% year-over-year. Other capital expenditures this quarter totaled $24.4 million for sponsoring the new CLO and $28.6 million for increasing equity in a majority-owned affiliate. We maintain sufficient working capital levels and modest leverage, providing us the financial flexibility to invest in our business, return capital, and manage our debt. Now, I'll hand the call back to George.

Thank you, Mike. So we will now take your questions. Dede, would you open up the lines, please?

And our first question comes from Crispin Love of Piper Sandler. Your line is open.

Thank you and good morning everyone. Hope you’re well. First, can you just give a little bit more detail on what you're seeing in the fourth quarter as it pertains to flows? I know, it's early, but you did mention that you had the highest level of sales in September for the third quarter, which I do assume was partly driven by some of the market moves we saw. Kind of first, one, how does that compare to October? And then just how are the trends running relative to the third quarter for sales and net flows? And are there any significant flows that you expect in the last two months of the year that are worth calling out?

In the final months of the year, there's typically a lot of volatility due to tax implications and an election cycle, making it difficult to predict what November and December will bring. We could see significant fluctuations, both up and down, for various reasons. So, I'll set that aside for now. Regarding October compared to September, we are still observing positive inflows in our retail separates, ETFs, and global funds, which is encouraging. Our ETF segment, having launched products over the years to establish strong track records, is starting to receive flows now that some of these products have reached a three-year performance milestone. We're very pleased with this trend. On the funds side, it has been an interesting year, with large-cap momentum leading the markets early on. In the third quarter, we noticed a shift back towards quality managers, who have generally been overweight in equities, and many of our managers performed exceptionally well. The main concern lies with investors' risk appetite and their current perspectives. We are satisfied with our fixed income results, and as we have indicated, we are seeing positive inflows across all fixed income products. We expect this trend to continue in October, pending any changes in the market. Overall, we feel good about our positioning, but there are still many factors at year-end that could have either positive or negative effects.

Thanks, George. I definitely appreciate that, there could be a lot of volatility in the kind of the coming weeks and coming months for the election. But second question for me, just on adjusted other OpEx came in below your prior $32 million guide. Just curious, if you can dig a little bit deeper there. Mike, based on your comments, it seems like the run rates for the fourth quarter should be about that $30 million level. Do you think that $30 million level makes sense for the next several quarters as we move into 2025? And also, is there any more room for cost streamlining in that line? Thank you.

Yeah. I mean, a quick response and then Mike will go through in detail. So as we've tried to communicate on that line, that line has had a lot of cost increases and inflationary pressure over the last few years. And as you've seen, our number has been actually very stable, and to your point now, actually tipping down a little bit. So really, what you've been seeing is a net of two things. It's the increase in costs from many of the service providers that is common in our industry. But then simultaneously, the plans and the actions we've had in place to try to do some optimizing and rationalizations of costs. So you're seeing the net of those in terms of the flatness of that line. Mike?

Yeah. And Crispin, I appreciate the commentary. We certainly think the level this quarter is appropriate for modeling purposes looking ahead. As George alluded to, we do have inflationary considerations as we look further out. But certainly, for the short run, some of the actions that we've been talking about over quarters now around streamlining of investment support systems and data feeds and providers have really taken hold in the results. So reducing the number of data feeds, consolidating systems is having a positive impact. So we think this is appropriate for modeling. We'll update that outlook further on if we see anything different going further out.

Thank you, both. Appreciate you taking my questions.

Thank you. Our next question comes from Michael Cyprys of Morgan Stanley. Your line is open.

Hi, this is Annalei Davis on for Mike Cyprys. My question is on how you guys are thinking about inorganic growth. Just wondering any color you guys can share on M&A conversations you've been having? And then what are you guys evaluating when you're considering an opportunity? Thanks.

Sure. So on the first part on the organic growth, we continue to see the best organic growth opportunities currently where we've been seeing them, which is in the retail separate accounts, ETFs, and the global funds. We think those are particularly strong opportunities for us in all of those categories; that broader product category is growing. Open-end funds in the industry are having their challenges, particularly on the active side. So that, I would put in a different area. We continue to see a lot of opportunity on the institutional side. It's very lumpy and it's very impacted by institutional investors making different repositioning decisions quarter-to-quarter. So we expect that to continue to be lumpy, but we do believe based upon the breadth of the pipeline, which is really just sort of indicative of where we're having conversations and where we're making presentations, we do feel good about that and what that opportunity set is for us, particularly outside the US, which we continue to see as a higher value opportunity for us for organic growth. On the M&A, as we've said before, for us, it's critical that we do not require M&A for growth and that we have an organic growth strategy. But for our M&A strategy, we continue to look at ways to add additional capabilities that are not currently within the family of managers that we have. The recent ones have been focused in on the more less correlated parts of the markets in terms of the AlphaSimplex and the Westchester transaction. We continue to see that as the area of interest since we're well represented across the traditional asset classes. And private markets, in particular, like everyone we continue to see that as a great opportunity set that is an area where we are spending time. And we ultimately believe that expanding our offerings to include those types of offerings, possibly even in combination with public securities is an opportunity that we're focused on.

Great. Thanks. And then maybe just another one on capital allocation. How much do you guys anticipate allocating? And how do you see the seed book today? And then just wondering if there's any more opportunity to introduce additional new products? Thanks.

On the last piece on the new products, we absolutely continue to see opportunities, and we have a lot of things that are currently under development. Much of the activity recently over the last year or two has been really focused on the ETFs and the global funds, as well as certain strategies available in CITs for markets that prefer that type of a vehicle for that. So we have a very active agenda of items and things that we'll be putting in for filings in those areas. And again, correlated to where we see the growth, right? So most of our product development activity is on the retail separates, it's on the ETFs, it's on the global funds. So we'll continue to do that where we're kind of well represented in the open-end funds, we have a pretty broad representation.

Thank you very much. Good morning everybody. Appreciate you taking the questions. I was wondering, if you could expand a little bit on the affiliate step-up in the quarter. When did it happen? How should we think about the residual impact maybe to NCI? And I don't know, if you want to talk about which affiliate it is, but how do you think about the pipeline for other opportunities to sort of deepen your ownership of your existing footprint? And maybe what multiple we should be thinking about you're paying on that incremental equity? Thank you.

I'll just do a brief intro to that, and Mike can go through it. So most of our affiliates are actually wholly-owned, we do only have one that's majority owned and we have a minority interest in another. So Mike will go through that, so I would really look at that as the descriptions that Mike is going to give related to the predetermined structural changes that we made in that transaction really only relate to one.

Good morning, Bill. The affiliates that George mentioned were established in 2018. As part of the original transaction, we have increased our majority ownership for the past two years, and this will be the third year of a four-year plan. We will finalize these staged equity purchases next year around the same time in the third quarter. This quarter, our ownership increased to approximately 80%, which affected the change in the non-controlling interest as you pointed out. This change occurred midway through the quarter. Therefore, all else being equal, you can expect the non-controlling interest balance to decrease slightly next quarter, reflecting our ownership impact on that result.

Thank you for your insights. I remember our earlier conversation. I apologize for any confusion with my question. To revisit the M&A topic, there have been numerous transactions recently, both large and small, driven by the competition for retail democratization and access to fast-growing sectors like private markets. Does this influence the urgency, financial discipline, or overall strategy regarding incremental growth? While it's encouraging to see some improvement in flows, there are still challenges, and it appears to be a modestly negative situation overall. How can you effectively tap into some of these rapidly expanding economic areas?

Yeah. So I think for traditional managers, again, right now, currently, the experience and the opportunity set on traditional managers is different than the alternatives in the private markets, which have gone through a cycle of really strong attractiveness. For those of us who have been around for a really long time, it used to be the opposite in terms of the privates having more of the volatility in the traditionals. So I do think there continues to be the opportunity for the convergence of those two. And I think that's why there are a lot of firms that are having conversations or looking to do transactions in terms of trying to bring the publics and the privates closer together in terms of offerings to clients. So allowing, using the democratization of private markets, or alternatives into the retail space. So I think there are a lot of conversations that are going around in that space. I think we do it as well and as much as anyone else is currently doing that. I think really, there is a diversified set of offerings that every client is needing. So I think those of us like us who offer multiple strategies are continuing to look to sort of build out those various sets of offerings.

Can I squeeze one more in?

Yeah, sure.

Thank you for the opportunity to ask another question. Regarding the institutional pipeline, you mentioned that the known outflows are slightly better than the known inflows. Can you discuss what the main issues have been that are affecting the flow outlook for institutional investments? It doesn't appear to be related to performance. Is it a matter of product variety or reallocations? What are some common challenges or obstacles that might be preventing that business from returning to positive growth? Thank you.

That's a good question. Part of it has been the adjustment in client positioning. We've seen outflows that are not typically due to account or mandate terminations, but rather due to re-balancing or reduction in allocations. For certain equity strategies, if they exceed the target allocation due to strong market or manager performance, rebalancing occurs. It's somewhat frustrating because the outflows we are experiencing aren't mainly due to terminated mandates, but are tied to reallocations. Like many managers, we need to address the requirements of institutional clients as they manage their overall asset allocation and determine where we fit in. Some of the outflows have been influenced by changes in equity allocations. We hope that our fixed income and other non-correlated offerings will help compensate for this, although it is a longer-term process. Many institutional clients seem to be focusing more on rebalancing their allocations than on adding new investments. However, our pipeline remains strong; we are engaged in discussions and processes across various managers, strategies, and regions, but the market is quite competitive, making success challenging.

Okay, thank you for taking all my questions this morning.

Yeah, no problem.

Thank you. Our next question comes from Ben Budish of Barclays. Your line is open.

Hi, good morning. Thanks for taking the question. Maybe first, I just wanted to ask on the ETF side, maybe a two-parter. I guess, what are your thoughts on the product pipeline for 2025? And then, I think not too long ago, you kind of commented that your ETFs were not available to all of your intermediaries. So just curious if the distribution is now kind of fully baked in. It just seems like there's a lot of momentum there. Curious how much could be either continued from an expansion of distribution and then thoughts on the new product side?

We are really excited about our new products. We've mentioned a few recent offerings and our filings that included three of our managers. Actively managed ETFs are increasingly becoming a significant part of the business for many financial advisors. Previously, most growth came from the passive space where a lot of assets were raised, but we're seeing growing interest in the actively managed sector, especially in fixed income, where we launched several funds last year. Some of these have now gained sufficient track records, leading to inflows, such as with our Seix leveraged loan ETF, which we are pleased to see receiving the flows it deserves. We have introduced an ETF for AlphaSimplex and are launching one for Seix in the CLO and private credit space. Additionally, Kayne, which excels in the mid-cap sector, is also introducing an ETF. This aligns with the trend where more financial advisors prefer using ETFs in their portfolios. We plan to expand in this area and look for opportunities to create more solution-oriented products by combining our individual ETFs into managed model portfolios. Availability of ETFs can be influenced by their size, as some may lack access at certain levels. However, as these funds grow and accumulate assets, their availability will improve. We're optimistic about this growth, as our assets recently approached $2.8 billion. We see continued opportunity in this area, especially as interest in open-end funds wanes compared to ETFs.

Got it, very helpful. I have a separate question regarding capital allocation. You recently announced a significant dividend increase, and I'm curious about your thoughts on what this will look like over the next several years. It seems that the payout rate has increased from a teens level to a low 30s level compared to five or six years ago. As time goes on, at what point do you anticipate being more constrained by your overall EPS growth? How are you approaching the balance between payout ratio and providing investors with steady dividend increases, especially since the payout ratio has risen in recent years?

Yeah. No. And absolutely, both of those need to be balanced. I think we do believe, and we've said philosophically, we do think that having investors have an expectation that we do value continued expectations of growth in the dividend is part of how we do want to approach that. So we think that is something that from a strategy perspective, we think is an important part of that. The absolute level of that increase, again, will also be evaluated against other alternatives, right? We have generally done our increases probably in the double-digit range, or above that, but it will always be balanced as we do with our level of stock buybacks or other activities that we're doing. But we have had seven years of annual dividend increases, and we do think that that is an underlying element of our strategy. Mike, anything you'd add to that?

No, I think you covered it.

Great. Well, thank you for taking my questions.

Absolutely. Thank you.

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

Great. Thank you so much. And I want to thank everyone today for joining us. And as always, if you have any other questions, please feel free to reach out, and have a great day. Thank you.

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