Earnings Call Transcript - VRTS Q4 2022

Operator, Operator

Good morning. My name is Michelle, and I will be your conference operator today. I would like to welcome everyone to 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 Virtus website. At this time all participants are in listen-only mode. After the speakers' remarks, there will be a question-and-answer period, and instructions will follow at that time. I will now turn the conference over to your host, Sean Rourke.

Sean Rourke, Host

Thanks, Michelle. 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 fourth quarter of 2022. 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. As such, they 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 have 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. George?

George Aylward, President and CEO

Thank you, Sean. Good morning, everyone. I will start with an overview of the results we reported earlier today before turning it over to Mike to provide more detail. The fourth quarter remained challenging, consistent with the trends throughout the year. In addition to a volatile market and heightened uncertainty, open-end fund flows industry-wide were particularly negative, most notably in December, as investor sentiment-driven activity resulted in some of the most elevated fund net outflows of an already historically difficult year. While we had net outflows in the quarter due to higher redemptions, we did have a meaningful increase in sales across products and asset classes, positive institutional net flows, and a higher average fee rate which has been resilient despite industry trends. We also continued to see solid investment performance, and maintained significant balance sheet flexibility with a net cash position at December 31. We have built our organization to navigate challenging environments like these and are positioned for market stabilization recovery with increasingly well-diversified products and capabilities that can attract assets across market cycles and changing investor preferences. We continue to focus on the execution of our strategy and building out capabilities to position us for future growth as the environment improves. Turning now to review the results: total assets under management increased 3% to $149 billion, primarily due to market appreciation, partially offset by net outflows. Sales increased 27% to $7.3 billion with increases across all product types and most asset classes. Institutional sales doubled to $3 billion, benefiting from a large inflow into an existing mandate, contributions from non-U.S. clients, and the issuance of a new CLO. Retail sales also increased, with open-end funds up 5% due to higher sales of equity, fixed income, and alternative strategies, and retail separate accounts rose 4% due to investment-grade fixed income. Net outflows were $3.4 billion, essentially unchanged from the prior quarter and again, primarily due to elevated redemptions. Net outflows were primarily in mutual funds, consistent with industry trends, but also included net outflows in the intermediary-distributed retail separate accounts, while institutional and private client generated positive net flows. By product, institutional net flows were positive $0.8 billion, reflecting the meaningful increase in a domestic large-cap growth equity mandate, and $300 million from the issuance of the CLO. Institutional net flows have been positive in eight of the last nine quarters, and considering the challenging environment we are pleased with this consistent level of activity. However, net outflows of $3.8 billion were elevated, in line with market trends and were particularly negative in the month of December. Retail separate account net flows were again negative due to higher redemptions, reflecting retail investor sentiment. In terms of what we saw in January, mutual fund net flows were still negative, but improved meaningfully from the fourth quarter and represented the best month of flows since September of 2021, including improvements in both sales and redemption rates. In particular, we saw positive net flows in our international global products, as well as certain of our small-cap and fixed income products. The institutional pipeline remains strong with known wins, exceeding known redemptions over the next two quarters. Our fourth quarter financial results once again reflected the impact of market declines over the course of the year. Operating income as adjusted was $56 million, down from $65 million sequentially, and the related margin of 31.8% declined from 35% due to lower revenues and relatively stable operating expenses. Earnings per share as adjusted decreased 10% to $5.17, reflecting the impact of decline in average assets under management. Turning now to capital: given our solid cash flow generation and balance sheet, we continue to return capital to shareholders, while maintaining appropriate levels of working capital and leverage. During the quarter, we repurchased 10 million of our common shares, totaling 90 million for the full year, and we've reduced shares outstanding by 4.3% in 2022. We ended the quarter in a net cash position of $77 million and continue to have significant flexibility in managing our capital needs, with total cash on hand at year-end of $338 million, a $175 million undrawn revolver, and $128 million in investments, providing ongoing flexibility to invest in the business and continue to return capital to shareholders. Before I turn the call over to Mike, I would like to provide a brief update on our agreement to add AlphaSimplex, a leading provider of liquid alternative investment solutions as an affiliated manager. As we've discussed previously, AlphaSimplex will enhance and diversify our investment offerings, provide additional product and distribution growth opportunities, and expand our presence in the alternatives category. The transaction, which we expect to close near the end of the first quarter, will be funded with existing balance sheet resources that include our undrawn credit facility. We expect it to be immediately accretive to earnings consistent with the 10% level we previously provided. Given the timing of the close, the first quarter outlook Mike will provide for various metrics will not include the impact of the transaction. We will update you on the modeling for AlphaSimplex and its impact on our outlook on the next call. With that, I'll turn the call over to Mike. Mike?

Mike Angerthal, Chief Financial Officer

Thank you, George. Good morning, everyone. Starting with our results on Slide 7, Assets Under Management. At December 31, assets under management were $149.4 billion, up 3% from $145 billion at September 30. The sequential change reflected $8.8 billion of market appreciation and $3.4 billion of net outflows. Average assets under management in the quarter were $148.6 billion, down 5% due to market performance and net outflows. Our assets under management remained well diversified by product type and asset class. Institutional represented 34% of total AUM at December 31, with U.S. retail funds and retail separate accounts at 32% and 24%, respectively. By asset class, equity was 55%, fixed income and multi-asset strategies were combined 38%, and alternatives were 7% of AUM. We continue to generate strong relative investment performance across strategies. At December 31, approximately 57% of rated fund assets had four or five stars, and 90% were in three, four, or five-star funds. We had nine funds with AUM of $1 billion or more that were rated four or five stars, representing a diverse set of strategies from five different managers. On a five-year basis, 75% of our rated fund AUM was outperforming the median performance of their peer groups. In addition to strong fund performance, as of December 31, 87% of retail separate account assets and 61% of institutional assets were outperforming their benchmarks over five years. Also, 57% of institutional assets were exceeding the median performance of the peer groups on the same five-year basis. Turning to Slide 8, Asset Flows. Total sales increased by 27% to $7.3 billion, reflecting growth in each product, particularly institutional. By product, institutional sales were $3 billion, up from $1.5 billion in the third quarter, due to a significant additional funding into a domestic large-cap growth equity mandate, in addition to the $300 million CLO issuance. Fund sales of $3 billion increased 5% with particularly strong growth in alternatives, domestic small cap, and global equity. Retail separate account sales of $1.2 billion increased 4% largely driven by investment-grade fixed income. Total net outflows were $3.4 billion, primarily due to open-end funds. Reviewing by product, institutional generated positive net flows of $0.8 billion, with meaningful contributions from non-U.S. clients. Strengthened non-U.S. came from multiple affiliates, and included both new mandates and fundings to existing accounts. For open-end funds, net outflows were $3.8 billion, up from $2.8 billion in the third quarter due to elevated redemptions and consistent with negative retail trends. In retail separate accounts, net outflows of $0.4 billion, compared with $0.2 billion in the third quarter, with investment-grade generating positive net flows. In our private client business, net flows remained positive as they have for 16 consecutive quarters. Turning to Slide 9, investment management fees as adjusted of $156.1 million, declined by $7.9 million or 5%, reflecting the 5% sequential decline in average assets under management. The average fee rate of 41.7 basis points compared with 41.5 basis points in the prior quarter. The fee rate increased modestly on a sequential basis for each product category. And on an overall basis, the fee rate has remained in the 41 to 42 basis points range over the course of 2022. Performance fees in the quarter were $0.5 million, up from $0.3 million in the prior quarter, favorably impacting the fee rate by 0.1 basis points in both periods. Looking forward into the first quarter, we believe the range of 41 to 43 basis points remains reasonable. Slide 10 shows the five-quarter trend in employment expenses. Total employment expenses as adjusted of $88.3 million decreased sequentially from $88.7 million. Lower profit and sales-based compensation was partially offset by market valuation adjustments and investment-related compensation utilized in deferred plans. These valuation adjustments are hedged and fully offset by a corresponding amount included in other income. As a percentage of revenues, employment expenses were 50.1%, up from 47.8% in the third quarter, primarily due to lower revenue. For the first quarter, the fourth quarter ratio would be a reasonable level to expect, though it will be subject to variability based on market performance and profits. For modeling purposes, the first quarter will also include seasonal employment expenses which are incremental to this outlook. Turning to Slide 11, other operating expenses as adjusted were $30.8 million and compared with $31.1 million in the prior quarter, which included approximately $1 million of costs associated with the AlphaSimplex transaction. Excluding these transaction costs from the prior period, other operating expenses as adjusted increased by $0.7 million or 2.3%, largely due to higher sales and marketing activity, which continues to normalize, as well as efficiency and distribution initiatives. For the first quarter of 2023, we anticipate other operating expenses as adjusted will be at a similar level as the past three quarters. We continue to closely manage all discretionary expenditures and initiatives. While our expenses have been impacted by inflationary pressure, increasing costs of contracts with key vendors, service providers and suppliers, as well as by the ongoing resumption of sales activity toward more normalized levels, our focus on discretionary spending has generally offset those increases, allowing us to maintain other operating expenses at a relatively stable level over the past several quarters. In addition, our expense management efforts have supported our ability to continue to invest in select strategic initiatives that we expect will benefit future operating leverage and expand our growth capabilities. Slide 12 illustrates the trend in earnings. Operating income as adjusted of $56.1 million, declined $8.8 million or 14% sequentially due to lower revenues. The operating margin as adjusted of 31.8% compared with 35% in the third quarter. Net income as adjusted of $5.17 per diluted share declined 10% from the prior quarter. Regarding GAAP results, net income per share of $4.77 increased from $4.25 per share in the third quarter and included $1.53 benefit from the fair value adjustments to affiliate non-controlling interests and $0.78 of net realized and unrealized gains on investments, partially offset by $1.03 of CLO issuance expense, $0.50 of negative fair value adjustments to contingent consideration and $0.41 of discrete tax adjustments. Slide 13 shows the trend of our capital liquidity and select balance sheet items. Working capital was $181 million at December 31, down from $195 million at September 30, as investments and our new CLO and return of capital to shareholders exceeded cash earnings. Contingent consideration, which includes estimated revenue participation at earn-out payments, was $128 million at December 31, down sequentially from $134 million. This amount will vary over time, based on changes in the underlying related revenue streams. During the fourth quarter, we repurchased 53,320 shares of common stock for $10 million, and over the past year, we have reduced shares outstanding by 4.3%. At December 31, gross debt to EBITDA was 0.8 times and net cash of $77 million increased from $47 million at September 30. First quarter 2023 cash obligations include payment of annual incentives, seasonal employment expenses, a revenue participation payment, and as mentioned, we expect to close AlphaSimplex near the end of the quarter.

George Aylward, President and CEO

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

Operator, Operator

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

Sumeet Mody, Analyst

Thanks. Good morning, guys. So nice to hear retail flow starting off well for the year. Sorry if I missed this. Can you guys talk about what you're seeing on the institutional and SMA channels as well in January so far?

George Aylward, President and CEO

Sure. For mutual funds, we commented on the month of January, and after a really challenging 2022, particularly December was when we closed out January. In terms of the even sales rate or redemption rate, as well as overall dollars, as I noted, it was the best month since September of 2021. That was really good to see. We particularly saw some categories like international and global actually as a category in the fund set be positive, as well as some select areas of strength within small caps, but not all of them, and also some fixed income. Although I am more optimistic for fixed income later on in the year. The institutional pipeline remains strong. That's been an area of focus for us where we put our attention and resources, and several of our initiatives are related to maximizing that. So we're really happy to see the consistency of what's in a lumpy business. Though it's still generating strong levels over the nine quarters, we've noted eight have been positive, and the pipeline is good. The non-U.S. concentration continues to get a bit better. So that has become significant contributors. That's across affiliates and strategies, so that's great to see. On the retail separate account side, given the nature of that business, particularly the intermediary retail channel, where some of the strategies are done model-only or through other provisions, we don't have as much real-time access to some of that information. But generally, because that business is concentrated in our equity strategy, particularly growth and smaller cap, mid-cap kind of strategies, it's going to go with a broader market. So I think what you saw in the fourth quarter for that was really just reflective of the sentiment on those equity strategies. While we do have a smaller piece that's in fixed income, that's where you kind of saw a little bit of an uptick in the January comment.

Sumeet Mody, Analyst

Great, thanks, really helpful. And then on the AlphaSimplex transaction, what was the AUM to end the year for that? And can you maybe talk about some of the demand you're seeing on the institutional side specifically for them, and how that's been going to start the year as well?

Mike Angerthal, Chief Financial Officer

Yeah, so for AlphaSimplex, until we close, we're not going to make comments on their business or their business results. Obviously, they're part of another company, so we're not going to comment on that. But we're continuing to do a lot of work related to the preparation of the integration. We're very excited about having them as an addition to the family of boutiques. They have a great team over there. We’ve spent a lot of time internally here thinking about ways to leverage their capabilities and expertise. Again, they're in the alternative space. In the periods in the beginning of last year, where traditional strategies were underperforming, they were outperforming. There will be – we will have a strong correlation to some of our more correlated strategies. But we're really excited about the opportunity for us to sort of apply what they can do across a whole host of things. And they remain, in our view, best-in-class in terms of what they do.

Sumeet Mody, Analyst

Got it, great. And then the last one for me on the ETF side of the business. I know the AUM has been pretty stable over the last few years. Can you just maybe update us on the growth strategy, more long-term? Are you focusing on growing that kind of organically or more M&A opportunities over the next year or two as they present themselves?

George Aylward, President and CEO

Yeah, I mean, we always focus on ensuring that we have an organic growth strategy for products and in the ETF space. We've seen more product introductions, including some active fixed income ETFs. That continues to be an area where we've had some existing strategies, and we actually launched one in the quarter, the Stone Harbor ETF. That continues to be an area of product introduction. One of the things we actually worked on throughout the latter part of last year was optimizing ways to more fully incorporate them into our overall retail distribution. They have been part of it, but the data on ETFs is a little more challenging than the data on open-end funds. We feel that, in addition to building out our products, we’ve made some refinements in leveraging our existing retail resources to be even more effective in bringing those to market. I think that's an area where investors will increasingly be looking at ETFs, particularly with some active strategies as opposed to the passive strategies, which we will continue to do.

Sumeet Mody, Analyst

Great, thanks, George.

George Aylward, President and CEO

Okay, thank you.

Operator, Operator

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.

Michael Cyprys, Analyst

Hey, good morning. Thanks for taking the question. Maybe just on fixed income, just curious to hear your perspective on the prospects for potentially a strong year of flows into fixed income, just given the higher interest rate backdrop. Which strategies do you think are well positioned to capture that?

George Aylward, President and CEO

Yeah, I mean, my general view is that particularly going into this year, there could be a good opportunity for credit strategies or fixed income strategies. I'm not going to make any predictions, because every time I turn on the TV, I see slightly conflicting thoughts around where the markets are going. However, I do think there is an opportunity for those strategies. I also think that there are broad opportunities, as not all investors will approach this in the same way. I believe there will be opportunities in our shorter duration products, particularly one of our flagship products, the Multisector Short Term Bond Fund, and low duration is a related product. I think those are opportunities there. I also think that emerging market debt has been an area where people have not been gathering money; that's cyclical. Depending on your global views, there could be good opportunities there as well. Overall, I think across the continuum of fixed income products, as people reevaluate their portfolios and what they should look like going forward, there will increasingly be opportunities, particularly for those fixed income products that have targeted approaches.

Michael Cyprys, Analyst

Great. And just on the international distribution, also if you could update us on the build-out there, how that's progressing, and how much that contributed in terms of AUM and flows? And maybe talk about some of the initiatives from the sales and distribution teams' standpoint?

George Aylward, President and CEO

Yeah. We continue to be very happy about that. Mike can give a bit of color around the relative contribution. But we have continued to increase that business, with non-U.S. clients contributing from roughly zero to 5%, 10% to about 15% as we stand here now. There has been a clear attribution for the quarter reflecting that contribution. Non-U.S. continues to be a great opportunity for many of our managers, as previously, they hadn't participated to a significant degree. We've had large mandates outside the U.S. from multiple affiliates and large mandates from various affiliates in the same quarter. So that's been an area of focus and one of the attributes of the Stone Harbor transaction, which added high-caliber, non-U.S. institutional distribution resources that have done a tremendous job of marketing our managers where we might otherwise not have had resources. Some initiatives we have behind that are really to support and maximize that, considering the different regulatory environments in those areas. We've been focused on streamlining ways to expand our reach. Mike, could you provide the attribution on the contribution?

Mike Angerthal, Chief Financial Officer

Yeah, I think you highlighted it. Just to put a finer point on it, we've had, where in the past we've had maybe one or two affiliates contributing selectively. Internationally, we've had four or five affiliates deliver both new mandates and additional fundings through existing mandates. And George alluded to the pipeline, that trend continues where we see it across affiliates and across geography. It's gratifying to see that investment bring consistency, especially in this market environment.

Michael Cyprys, Analyst

Right, and maybe just the last one for me. Coming back to your point earlier, George, regarding building out capabilities to position the firm for growth. As you look at the firm today, how well positioned is it relative to the opportunity set? Where would you like to see more extension in either footprint or product set? Any organic or inorganic opportunities? How are you thinking about that? And could you provide an update on those conversations and how they are progressing today versus a year ago?

George Aylward, President and CEO

Sure, on the organic side. We always think about the product offering set. We feel very well represented in traditional active management. Our inorganic focus has led us to explore non-correlated or less correlated alternative strategies. We believe there are opportunities there. We see opportunities in taking advantage of the individual strengths we have among our affiliates with more multi-asset and more model-based collective types of products. Our affiliates provide the building blocks of a well-diversified portfolio, and while we offer comprehensive solutions, I see great opportunities in recent resources that we added, which will accelerate our goals. I mentioned AlphaSimplex, and I believe there’s a broader application of their capabilities we can utilize across our product set. Most of our managers are active fundamental managers, and they bring quantitative capabilities. There’s great opportunity there. Regarding the market side, the non-U.S. area is a high priority, as it's a fertile ground for us. We haven't had significant resources in that respect for the past 10 to 15 years. That would also include leveraging global funds. Recently, most of our product introductions have focused on ETFs and not on the open side. All of these comments align with what I’ve mentioned regarding our increasingly diversified set of offerings as the market environment becomes more favorable. We feel good about that. While our growth strategy is not dependent on M&A, we remain active in discussions and continue to ensure that we're selectively engaging in intuitive transactions.

Michael Cyprys, Analyst

Great, thank you.

George Aylward, President and CEO

Thank you.

Operator, Operator

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

George Aylward, President and CEO

Great. I just want to thank everyone for joining us today. We encourage you to call us if you have any further questions. Enjoy the rest of your day. Thank you.

Operator, Operator

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