Victory Capital Holdings Inc (VCTR) 2019 Q1 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Victory Capital First Quarter 2019 Earnings Call. (Operator Instructions) And as a reminder, today's conference call is being recorded.

I'd now like to turn the conference over to Matthew Dennis, Director of Investor Relations. Please go ahead.

Thank you, Candice. Good morning. Before I'd turn the call over to David Brown, I would like to note that today's discussion contains forward-looking statements and, as such, includes risk and uncertainties. Please refer to our press release and our SEC filings for more information on specific risk factors that could cause actual results to differ materially from those projected in our forward-looking statements. While a recording of this call will be made available by us on our website, any forward-looking statements that we make on this call are based on assumptions as of today, and we undertake no obligation to update these forward-looking statements to reflect new information or future events that occur or circumstances that exist after the date on which they were made.

In addition to U.S. GAAP reporting, we also report certain financial measures that do not conform to generally accepted accounting principles. We believe these non-GAAP measures enhance the understanding of our business and our performance. Reconciliations between these non-GAAP measures and the most comparable related GAAP measures are included in tables that can be found in our earnings press release and the slide presentation accompanying this call. Both can be accessed on the Investor Relations portion of our website at ir.vcm.com.

Now I'll turn the call over to David Brown, Chairman and CEO.

Thank you, Matt. Good morning and welcome to Victory Capital's First Quarter 2019 Earnings Call. I'm joined today by Michael Policarpo, our President, Chief Financial Officer and Chief Administrative Officer; as well as Matt Dennis, our Director of Investor Relations. I'm going to spend a few minutes discussing our business results. I'll also provide an update on our planned acquisition of USAA Asset Management Company. Then I'll turn it over to Mike, who will review our financial results for the quarter in more detail. Following our prepared remarks, Mike, Matt and I will be available to take questions.

We'll start on Slide 5. Victory Capital achieved strong financial results during the first quarter of 2019. Total AUM increased during the quarter and year-to-date through April 30, 2019. The first quarter was also marked by healthy margins, earnings and cash flows. Total AUM grew to $61 billion as of April 30, 2019. Year-to-date net flows were slightly negative at $300 million through the end of April, but have turned positive in early May following the funding of a few larger mandates in the RS mid-cap growth strategy and our solutions platform.

We believe our business performance year-to-date illustrates the sound positioning of our integrated multi-boutique business model in a rapidly evolving industry and the effectiveness of our distribution platform. While we have seen some realization of our won but not yet funded book, it remained strong as does our sales pipeline. We have favorable expectations that the momentum we are currently seeing from a gross to net flow perspective will continue through the remainder of 2019.

But the planned acquisition of USAA Asset Management Company remains on track and is targeted to close effective July 1, 2019. The more we learn about the USAA business and the member platform, the more excited we are about this tremendous opportunity, which will truly transform our company in so many ways. It will meaningly diversify our AUM and investment capabilities, while further enhancing our economies of scale. It will also significantly expand our distribution platform to include a direct channel to serve USAA members. Additionally, USAA Asset Management Company has begun to establish a solid footprint in the retail intermediary in RIA channels, which has strong potential to accelerate with the support and effort of Victory Capital's well-established distribution and marketing platform. All these factors will put us in an even greater position to be successful as we move forward.

I have 2 very important updates on the acquisition to share today. First, the shareholder approval process is complete for the USAA mutual funds and ETFs. This is a very critical milestone in bringing the acquisition to close. Second, we've increased our cost synergy estimates from $100 million to $110 million. We now expect $60 million of synergies to be in place at close, up from the original estimate of $42 million. $95 million of synergies are expected within 6 months of close, up from $83 million. The full $110 million is expected to be in place within 12 to 15 months of close. This schedule is accelerated from previously communicated time frames. Additionally, our guidance on onetime cost of $50 million associated with the realization of the synergies remains unchanged. As we continue to progress with the integration, we're finding even more opportunities to gain efficiencies as a combined platform. I hope to be able to share even better news on this front as we move towards close.

Let's turn to Slide 6, which illustrates the current diversification of our business from multiple perspectives, including by business and distribution channel, by product type and by asset class. Approximately 56% of our AUM is from institutional clients and 44% from retail clients as of the end of the quarter. As I previously mentioned, we expect our acquisition of USAA Asset Management Company to significantly enhance the diversification characteristics of our business through expansion of our investment capabilities, product set and distribution system.

Slide 8 provides a snapshot of our scorecard, which we believe provides strong evidence that our unique culture and platform are working for investment franchises and in turn for our clients. We were honored to be ranked ninth in Barron's Best Fund Families of 2018 for the 1-year period ended December 31, 2018. This is our best-ever ranking by Barron's and marks the second consecutive year that Victory Capital has earned a place among the Top 10 Best Fund Families. It is the fifth consecutive year that we have been ranked among the Top 25 Best Fund Families by Barron's.

Slide 9 illustrates our short- and long-term outperformance relative to benchmarks. I'd like to point out our strong 3- and 5-year performance results as these are the time periods used most often by current and potential clients when making investment decisions. Also, we continue to deliver excellent long-term investment results, as illustrated by the percentage of our AUM and strategies outperforming their respective benchmarks over 10 years.

Looking at our full suite of mutual funds and ETFs on Slide 10, 67% of AUM in those products was ranked 4 or 5 stars by Morningstar on an overall basis for the period ended March 31, 2019. 59% of AUM was ranked 4 or 5 star over 3 years, 67% over 5 years and 78% over 10 years.

Slide 12 provides a snapshot of the growth and diversification of Victory Capital's AUM after the close of the USAA Asset Management Company acquisition. USAA Asset Management Company's AUM as of March 31, 2019, was $80 billion. This includes $70 billion in AUM invested through the direct member channel, the 529 College Savings Plan and the intermediary platform. It also includes an additional $10 billion in AUM that's invested in the USAA mutual funds through the managed money product that is offered to members through the USAA brokerage platform.

Note that we're using a full $80 billion as the AUM base because we will receive full economics on this amount. However, we will continue to report these assets separately to ensure that we can properly track and monitor each of these buckets. Based on the AUM for both entities as of March 31, 2019, Victory Capital's pro forma AUM at the close of the transaction is expected to be approximately $138.1 billion.

The acquisition will significantly diversify our asset mix. When the transaction is complete, active domestic equities will make up less than 40% of our pro forma AUM, and active domestic and global non-U. S. equities combined will be just under 50%. Importantly, our solutions platform will make up 19% of our pro forma AUM. Fixed income and money markets will increase to 33%, which should have a positive impact in reducing the volatility of our AUM.

The fixed income platform continues to deliver very strong investment performance. 100% of USAA's 12 taxable and tax-exempt fixed-income funds earned 4- or 5-star overall rankings from Morningstar as of March 31, 2019. Additionally, we like the money market business because it will enable our shareholders, specifically in the USAA direct member channel, to derisk their portfolios without leaving our platform. It will also help us to stay fully connected to those members, and we believe it will serve us well from a net flow perspective. We'll also add a 529 College Savings Plan as well as new product capabilities in target date and target risk portfolios, which should further increase our penetration with retirement plan advisers and participants.

Our VictoryShares ETF platform will also expand with the addition of 6 USAA ETFs, including 2 active fixed income ETFs. This type of diversification is important to our business because it gives us the opportunity to significantly expand relationship with our clients by offering them a full suite of value-added options based on their risk tolerance and time frames.

Slide 13 outlines the progress that we have made in integrating USAA Asset Management Company onto our platform. As discussed earlier, the shareholder approval process for mutual funds and ETFs is complete. Additionally, 50 key USAA investment professionals have been retained and will join Victory Capital at close. Staffing of the call center for the direct member channel is nearly complete, with 50 employees coming over from USAA. Additionally, our outsourcing partners have retained 120 USAA employees, who will be dedicated to member services and back-office functions. The employees of our outsourcing partners will be co-located with us in our San Antonio headquarters.

The strong retention of USAA investment professionals and service associates is important because it is one of the ways in which we will ensure that we deliver continuity and a high level of service to members. Our distribution team is currently undergoing training on the USAA investment products and will be fully prepared at close to begin presenting the strategies to a large base of clients that we currently serve. The USAA strategies represent a significant growth opportunity for us in the intermediary and institutional channels, and we intend to leverage our experienced team of sales professionals to expand on the footprint that USAA has already established. Plans to integrate USAA Asset Management Company into our back-office infrastructure are well underway, and all the service provider conversions have been structured to ensure minimal disruptions.

We are also close to finalizing our location and facility design for our new corporate headquarters in San Antonio, and we'll be able to share those details post close. We are very confident in our ability to seamlessly integrate USAA Asset Management business onto our platform given what we have learned since we announced the transaction and all the work that has been done over the past several months. We're excited to welcome USAA investments as our 10th investment franchise.

Slide 14 highlights some of the distinct strengths and benefits of the USAA direct member-based channel. As we said in the past, USAA has built an extremely loyal member base that really can't be compared to that of any other financial services organization. For the quarter ended March 31, 2019, USAA Asset Management Company achieved relatively flat flows. This is inclusive of $200 million of inflows into money market funds. This stability of flows is especially impressive given that many companies going through an acquisition consent process experience some client disruption between the time that the transaction is announced and the close. We believe this is another illustration of the strong loyalty shown by the members within the direct channel and highlights how well-received the transaction is by the USAA members who are mutual fund and ETF shareholders.

USAA's mutual fund business has attained an 82% retention rate over the last 5 years. In the direct mutual fund channel, the average member has been invested with the company for 11 years. USAA's direct member channel represents a tremendous opportunity to further expand relationships with more than 1.5 million USAA members, who own at least one investment product today and to establish new relationships with the remaining 12 million members, who do not yet own an investment product.

Among members who are already mutual fund investors, 24% have elected an automatic investment plan, which represents a meaningful opportunity for those members to achieve steady and consistent account growth over time. We also think there is a good opportunity to grow the number of automatic investment plans as we move forward.

USAA's 529 College Savings Plan has attained an impressive AUM retention rate of 86% over 5 years. The average 529 Plan client has been invested with USAA for 7 years. Not surprising, automatic investment plans represent 60% of gross sales for the 529 Plan.

We intend to build on the foundation that USAA has put in place and grow the direct member business by focusing on 3 key objectives. First, we'll work to retain existing assets by enhancing the level of investment services that USAA members receive today. Second, we'll work to increase share of wallet among members who currently own investment product.

One example of how we'll achieve this is by encouraging members who have automatic investment plans to escalate their contributions as they mature and their incomes grow. We expect to do this by leveraging the expertise of our contact center representatives, most of whom are coming over from USAA as well as online portfolio planning tools that will be available via the USAA web and mobile portals.

Finally, we intend to acquire new investors from among the 12 million USAA members, who do not currently have an investment account, by investing in educational campaigns and marketing strategies designed to increase awareness of the USAA mutual funds and ETF products. We will do this in coordination with USAA, which should increase the likelihood of success.

The strong link back to the USAA organization is very important. USAA makes it a priority to ensure that its members have a positive experience, including with services delivered by its partner firms. USAA is working with us to ensure that members can seamlessly access investment services alongside USAA's other products and services. We're extremely honored to work with USAA and intend to continue USAA's long-standing tradition of putting members' needs first.

I will now turn it over to Mike to review our pro forma guidance for the transaction as well as our first quarter results

Thanks, Dave. Before I begin, I'd like to say how pleased I am to be back in the CFO role for Victory. It's been a very smooth transition and we've had the opportunity to enhance our staffing by filling new roles in investor relations, analytical support and corporate strategy.

I'll start my remarks this morning by reviewing the annualized pro forma guidance that we expect from the USAA transaction, which is shown on Page 15. The acquisition USAA Asset Management Company will transform our financial profile and deliver the size, scale and diversification that we believe is critical to succeed in today's investment management environment. Based on combined AUM for both firms as of March 31, 2019, including the USAA managed money component, we expect to have pro forma AUM of $138 billion across more than 120 investment strategies when the transaction closes. We expect to generate more than $850 million in annual revenue and nearly $400 million in adjusted EBITDA with adjusted EBITDA margins of approximately 46%. Please keep in mind, these figures are based on March 31, 2019, AUM levels.

As we discussed earlier, we are ahead of our cost synergy estimates and have accelerated our expected time line for achieving them. This is a result of our continued work to integrate the USAA Asset Management business onto our platform. Our guidance on onetime cost of $50 million associated with the realization of the synergies remains unchanged. Additionally, we expect EPS accretion to be more than 100% in 2020, which would represent our first full year of ownership. This is an increase from our original guidance. Assuming a July 1, 2019, close date, the impact on 2019 EPS accretion is expected to be greater than 40%. We have fully committed debt financing for the acquisition. Our pro forma net debt-to-EBITDA ratio at close of the transaction is expected to be approximately 2.9x. Additionally, strong first quarter cash flow from operations has enabled us to continue to accumulate cash to support the acquisition.

The financial results review for the quarter begin on Slide 17. Victory Capital achieved strong financial results in the first quarter of 2019 as markets recovered from the unprecedented volatility that we experienced in the fourth quarter of 2018. The execution of our financial plan in Q1 2019 highlights the resiliency of our integrated multi-boutique business model in changing market conditions.

Total AUM increased to $61 billion as of April 30, 2019. Year-to-date net flows were slightly negative at $300 million through the end of April, but have turned positive in early May following the funding of a few new business mandates, as Dave mentioned earlier.

Revenue decreased 9% to $87.5 million quarter-over-quarter as a result of lower average net assets, 2 fewer days in the quarter and the prospective adoption of ASU 2014-09. The new accounting standard requires that we account for certain fund waivers and reimbursements as a constant revenue and no longer as operating expenses. The impact of this prospective adoption of ASU 2014-09 resulted in a decline of $4.1 million in revenue compared with Q4 2018. Note that prior periods were not adjusted. Adjusting for this change in accounting, revenue realization held constant at 62 basis points relative to the prior quarter.

Adjusted EPS was $0.35, down 8% from Q4 2018. And adjusted EBITDA margin was 38.4%, an increase of 50 basis points from the prior quarter, even with some increased operating expense seasonality. On the capital management front, we continue to return capital to shareholders with our ongoing share repurchase program and accumulated cash as part of our acquisition financing strategy. We repurchased approximately 123,000 shares during the quarter at an average price of $10.93 per share. Our cash balance is $66.3 million, up from $51.5 million at year-end. And our Term Loan B debt outstanding is $280 million. Our net debt-to-EBITDA ratio stood at 1.5x as of the end of the quarter.

Slide 18 provides a snapshot of our AUM over time. Our AUM increased to $61 billion as of April 30 2019, after finishing the first quarter at $58.1 billion. This was up from $52.8 billion at the end of the year. We continue to operate a well-diversified platform relative to our AUM size and are quite pleased with the scale and growth potential, which will continue to evolve following the completion of the USAA Asset Management acquisition.

Slide 19 provides perspective on our organic flow performance over the last several quarters and through April 2019. Year-to-date through the end of April, net flows were slightly negative at $300 million, but have turned positive in early May due to the net new flow activity we discussed earlier. We saw slight net outflows through April 30, as some expected fundings were pushed into May and beyond and we continued to experience outflows in one of our mid-cap strategies.

Additionally, our VictoryShares ETF platform experienced net outflows of $58 million during the first quarter following 19 consecutive quarters of positive net flows. We believe the market disruption in the fourth quarter slowed some of the growth momentum that we've experienced with our solutions and ETF strategies. We are now seeing a more positive trend as we are progressing through the second quarter. Several of the franchises that we believe represent the growers of the future are experiencing positive momentum, including Trivalent Investments, RS Growth and Sophus Capital.

Gross flows for the month of April were $2.2 billion. Year-to-date gross flows were $5.2 billion, as new business obtained during the first 4 months of the year continue to amplify our strong won but not yet funded pipeline. We believe this validates the strength of our distribution platform and the competitiveness of our investment strategies. Our outlook is favorable for continued momentum in gross to net flows through the remainder of 2019.

Slide 20 provides a snapshot of quarterly revenues. First quarter 2019 revenues decreased 9% from the fourth quarter of 2018. There are 3 significant drivers of this decline. First, approximately half of the decline is related to our adoption of ASU 2014-09. As I stated earlier, the impact of the prospective adoption of the new accounting standard resulted in a decline of $4.1 million in reported revenue in the first quarter. Note, prior periods have not been adjusted. Adjusting for this change in accounting, revenue realization held constant at 62 basis points relative to the prior quarter. Second, average net assets declined by 3% quarter-over-quarter. Finally, as the majority of our revenue was day weighted and Q1 had 2 less days than Q4, this had a negative impact representing the balance of the quarterly decline.

Turning to Slide 21. Expenses decreased 25% year-over-year due primarily to operational efficiencies driven by integrated multi-boutique business model and the adoption of ASU 2014-09. As a result of the new accounting method, we will no longer expense fund expense reimbursements that are now being included as a reduction to revenue. Additionally, lower AUM levels reduced distributions and asset-based variable costs, and our debt refinancing and deleveraging efforts significantly lowered net interest expense.

Consolidated expenses decreased 12% for Q1 2019 compared with Q4 2018, driven by decreases in operating expenses and nonoperating expenses. This was partially offset by a 2% increase in personnel expenses, resulting from seasonally higher payroll tax and benefits cost at the beginning of each calendar year.

Operating expenses decreased $5.4 million or 15% quarter-over-quarter, driven by the variable nature of our integrated model and the adoption of ASU 2014-09. Nonoperating expenses decreased by $4.3 million relative to the fourth quarter. This decrease was related to 2 noncash items.

Finally, we continue to manage controllable expenses with our integrated multi-boutique model to effectively drive strong, industry-leading margins and counterbalance the pressures of market volatility. It's important to note that this prudent expense management has not impaired our ability to invest in our platform. We continue to make great strides in enhancing our technology, marketing and distribution capabilities to support future growth. We believe the ability to effectively manage expenses while still investing in our platform is a distinct advantage of our integrated operating model.

Our non-GAAP earnings, EPS and margin metrics are shown on Slide 22. EPS decreased 13% year-over-year and 8% quarter-over-quarter, driven by lower quarterly revenues and EBITDA, resulting from the market downturn experienced in Q4 2018. ANI with tax benefit for Q1 2019 was $25.3 million compared to $27 million in the last quarter of 2018. Adjusted EBITDA was $33.6 million, down 8% from Q4 2018. It should be noted that our adjusted EBITDA margins continue to approach 40%, a level that positions us among the leaders in the industry and provides another proof point on the scaling power of our integrated model.

Finally, turning to Slide 23, we continue to deliver against our balanced and strategically aligned capital management plan in the first quarter. We believe our approach optimizes shareholder value creation, taking into consideration all factors. We have fully committed debt financing with our relationship bank partners for the USAA Asset Management acquisition. Our net debt balance stands at $222 million, yielding a net debt-to-EBITDA ratio of 1.5x. We increased our cash by $15 million to $66.3 million during the quarter in anticipation of funding the USAA Asset Management transaction.

We continue to execute on our share repurchase program. We repurchased approximately 123,000 shares during the quarter, bringing the total shares repurchased to approximately 979,000 at an average share price of $9.59 per share since the initiation of the program in May 2018. We believe the share buyback program demonstrates our thoughtful and proactive approach to capital management and reflects our confidence in our long-term business strategy. With the pending close of our USAA Asset Management acquisition, we're very comfortable with the flexibility we have in our capital structure for driving long-term shareholder value.

Our projected debt-to-EBITDA run rate after the close is now expected to be 2.9x. Post close, we will be generating substantial free cash flow, and our primary use of this cash will be to delever the balance sheet to give us full flexibility as we continue to pursue shareholder accretive acquisitions. We continuously monitor our capital structure and regularly consider all tools at our disposal for returning capital to shareholders, including share repurchases and potentially initiating a cash dividend at some point in the future, should it make sense. Finally, we intend to file our Form 10-Q later today, which will provide additional details on our financial and operating performance during the quarter. This concludes our prepared remarks.

I would now like to turn the call back to the operator for the Q&A portion of the call.

(Operator Instructions) And our first question comes from Sumeet Mody from Sandler O'Neill.

Saw the commentary on the reversal of flows thus far in the second quarter, $755 million of inflows in April, sounds like over $350 million in May. Just want to get a better feel for where those flows are coming from, maybe by distribution channel, asset class, any color there would be helpful.

Sure. The flows are coming from a number of different distribution channels, the sub-adviser channel, the institutional channel and then pockets of the retail channel. It's really multi-franchise. A few of the franchises that we're seeing flows in RS Growth. We're seeing flows in solutions and in our ETF business.

And our next question comes from Randy Binner from B. Riley FBR.

This is actually Ryan Aceto on for Randy. Turning to USAA. The $60 million cost synergies you guys are now expecting to see, could you help us size up where you're expecting that to come through? Is that going to be personnel or G&A-based?

Yes. The $60 million in really the entire $110 million will be across a few broad buckets: back office; middle office, as we implore an outsourcing model; we'll have some across sub-advisers that we're taking in-house and changing; and then there is also just the power of the integrated model that will get some scale across corporate and administrative functions.

Perfect. And then as far as the strictly G&A line, what's a good run rate do you think we should be looking at going forward after the USAA acquisition rolls in?

Yes. So I think we put on page -- Slide 15, we kind of put where we expected the overall margins to be post kind of the synergy realization in the 45% or 46%. I think that's how we're looking at it. From a margin perspective, we think it's the power of our model allows us to operate the business with that capacity. And if you think about it, 2/3 of the expenses that we have in the business today are variable, including compensation, sales commissions as well as kind of our back office, middle office and distribution. So I think that's how we are looking at it from the standpoint of where those buckets fall.

And our next question comes from Chris Shutler from William Blair.

With USAA, you talked about there's an opportunity related to deepening wallet share among members who are already using an investment product. There's also an opportunity to go after the 12 million members that do not use a product. You provided a little detail there, but can you dig in a little more to each of those areas and how you plan to go to market going forward?

Sure. Chris, let me start with deepening wallet share. As I stated kind of in the prepared remarks, I think there is a tremendous opportunity to better serve the members through education, through product expansion, through updating some of their retirement plans, some of their savings plans and really working directly with those already existing members who have investment products. We'll employ a number of different strategies there via online and then also through our call center.

On the 12 million members that don't today have an investment product, we'll approach them in a way, introducing the ability to help them with, again, their retirement plan, their college savings plans. We'll do that again through online and also through our call center. And we'll really do that with the help of USAA to really expand that 1 -- or grow that 1.5 million number. We think that the real opportunity on that bucket is really just an awareness and an education. USAA has done a great job to get to 1.5 million members, but there's still a lot of opportunity with the remaining 12 million members.

Okay. There's 2 other ones, quick ones. Maybe on the $10 million of incremental cost synergies, what areas are those coming in? And then maybe talk about the deal pipeline.

Hey, Chris. Yes, so the incremental $10 million is really coming across all of the different buckets that we mentioned previously. So as we've done our work from announced to today, we found incremental opportunities. And again, I think when we went out back in November, we probably had a little bit of conservatism in the numbers that we had out there. But again, as we've dug in and done the work, it's really coming across all the different areas as we dug in with our integration team and USAA.

Yes. In regards to the deal pipeline, first, I would say that we still feel like the industry is just starting to begin to consolidate. And we think that's going to accelerate our platform. Again, as we have discussions and conversations with lots of different potential partners, we think it's extremely differentiated. We think it's in demand.

So our pipeline, and I kind of repeated this really every quarter, it just continues to be super strong. I think that the pace and the cadence that we have done deals in the past will continue, if not accelerate. And we couldn't be more excited about the opportunity, just given our track record and what we see coming with the industry. And last thing I would say is we feel that we are as well positioned, if not better positioned, than any firm in the industry to take advantage of the consolidating industry.

And our next question comes from Robert Lee from KBW.

I have a couple of questions. Just kind of maybe bigger picture a little bit with the USAA, well, 2 questions here. Number one, in some other kind of large acquisitions, mergers, it was often seen as an opportunity to adjust pricing on different products, maybe to make them more saleable or attractive and -- maybe could you talk about that. I don't believe it's part of your plan, but is that something you're doing or we should be thinking about?

And secondly, as you look to accelerate USAA product sales through your own distribution in the intermediary channels, can you highlight which products you think you can get the best traction with quicker? Is it -- I'm going to assume it's maybe the fixed income products, but are there specific strategies you think could really kind of hit the ground running?

Let me start off with the pricing question. We evaluate our own pricing every quarter, and we've done that for years. When we diligence USAA, we looked at their pricing. We think it's competitive. We will continue to evaluate their pricing just as we do our legacy business. Today, there are just a few areas that we will consider lowering pricing, but nothing that is materially significant. Where you will see, potentially down the road, where the mutual fund shareholders of USAA will see some pricing relief is really some of the scale and size that will accrue to the current shareholders.

And then on really growing within the intermediary channel, really our existing channel, the USAA products, we think there is a tremendous opportunity to take the fixed income product set tax exempt out to really our distribution partners that have not had or have been introduced to the USAA fixed income products. We've got there tremendous opportunity. We also think on some of the ETFs and the solutions that we think we can make traction there. And I'll remind you on the fixed income side for USAA, all of the Morningstar -- all of the products are either 4- or 5-star rated on Morningstar and the performance is excellent. So we think that when we introduce those products that we will have a lot of traction and success with that.

Great. Then maybe 2 quick follow-ups, if I could. Sticking with the USAA -- well, both of them are USAA related. They have a bunch of their equity products I think, in particular, that are sub-advised by other parties. I mean is there -- how do you think of an opportunity for migrating some of those strategies to your internal managers, assuming it's appropriate? And then the second follow-up question or fourth follow-up question is, your EPS accretion, I'm assuming that's adjusted EPS, and is that including tax benefits? I just want to reconfirm that.

So let me start off with the sub-adviser migration and then Mike will answer the EPS question. First, we will work with their mutual fund board to evaluate the sub-advisers and where it makes sense for our investment franchises to participate in managing those mutual funds. We've been working with them quite a bit and we think there's a significant opportunity. We will announce that at close. But we think there is a real opportunity for our franchises to participate in a way that's the best thing for the end mutual fund shareholder. And we also think that over the long run, that some of the performance will get better and improve with the participation of our franchises. But I would look at close to see how we'll allocate assets to our franchises.

And with respect to the accretion numbers that we provided, they are reflective of the tax benefit. So really, they're updated for kind of current financial profile as well as current leverage profile, and they are adjusted for tax benefits related to the USAA transaction.

And our next question comes from Kenneth Lee from RBC Capital Markets.

Just a follow-up on the M&A opportunities. How do you think about -- what particular new investment capabilities or strategies would you be looking for in the potential opportunity? Or are there other potential areas such as geographic reach or distribution that you can be thinking about?

How we look at M&A might be a little bit different than others. We don't necessarily focus on a specific asset class or a product. Where we start is with a concept of any acquisition we would do needs to make our company better. It cannot be a financial-only transaction. It has to be strategically beneficial to us. From a product perspective, we are looking at products that really fit in the client portfolios, products that are going to matter to clients where we can win. We talk about products for tomorrow less likely to be disintermediated by passes. So from a product perspective, it's really those are the characteristics and you can fit that -- those characteristics in a number of different asset classes.

From a geography standpoint, we are interested in opportunities outside of the U.S. and have directed some of our efforts around evaluating those opportunities. And I would also say that there are so many opportunities out there given where the industry is. And as I said earlier that our platform, as we speak to more people, really is in demand. I think we're going to have our choice of the top opportunities when we think about adhering to what we're really looking for.

Great. And just one follow-up on the solutions business. How would you characterize the current environment in terms of competitive environment for smart beta ETFs as well as client demand for smart beta ETFs?

It is getting more competitive than it was a few years ago. That being said, with the right product, with the right track record and with the right distribution system and servicing, I think firms like ours can still be successful. But it is definitely gotten a little more competitive. I don't see the beta exposure ETFs, if you will, as the competitors. The competitors are firms that's like ours, and it is still early but getting more competitive.

And our next question comes from Ken Worthington from JPMorgan.

We're seeing some larger distribution platforms cutting manager and product lists in 2018. Are you still seeing distribution cut down their list or has this stabilized? And then clearly, USAA represents expanded distribution for you. But maybe talk about maybe where else Victory sees opportunity to expand either new distribution or increased penetration with existing relationships?

Ken, as far as the reducing the number of partners by the larger platforms, we have not experienced that to any real material level. We have been pretty stable with our partners. Our strategy is to have a good number of strategic partners and go deep with those partners from our product set. That is really where we see the opportunity to grow our existing distribution is to really get deeper with some of our larger partners. And we are pretty well covered from a distribution standpoint on the retail and retirement side as well as in the institutional side. We think it's just getting deeper with our partners.

The USAA acquisition is really a new distribution channel. We think of it as the third distribution channel. It's direct. We think that's going to be material from expanding our distribution. It is also an opportunity to think about other direct channels outside of USAA. We will evaluate that as we progress through the USAA close. And as that business starts to come onto our platform, we'll think about other opportunities where we can work with direct buyers of our product in a direct model.

Okay. Great. And then just a little one on stock-based comp was much slower in 1Q than we've seen, I think, at any quarter since you've been public. Was this revenue recognition rule changes? Or was there something else driving the decline? And I guess if it's not revenue recognition, is this the new rate -- run rate?

Yes. Ken, no, there were some forfeitures of stock in Q1 that we reduced stock compensation that had been taken. The run rate really is closer to what you saw in Q4 going forward.

And our next question comes from Mike Carrier from Bank of America.

First question, just on the improved flow backdrop, I know you give the same color, and then the confidence in '19, just any changes in your distribution team or initiatives that's driving this or is it increased demand from the clients? And if the latter, since performance has been positive, anything else that you're seeing that's driving it? I mean, is it on the sales side or is it on lower redemptions?

I think it isn't anything new. We've talked about our distribution platform quite a bit. It is really the realization of some investments and some hard work by our distribution professionals. There are long lead times between working with a client and then actually working through a contact and eventually funding, and that's what we have seen. Our investment performance is strong. And I think where we have turned a corner as an organization from a flow perspective. Both Mike and I, prepared remarks, I think we made that clear. And we expect the momentum to continue going forward.

Okay. And then just second question. Mike, just on the capital management, you mentioned post the deal, the focus on delevering from the 2.9x and positioning for more capacity ahead, which makes sense. Just so we can gauge like buyback activity versus delevering in future deals, like where do you want to manage that leverage ratio over time? Whether maybe it's now when you're closing a deal so it's going to be on the higher end versus if there is not a lot of activity and you're paying down debt, like how low could that go?

Yes. So I think what we've always said is that our use of our balance sheet in kind of capital management is going to be driven to support the overall business strategy, which will include inorganic growth opportunities. And we have used the balance sheet effectively such as here where the leverage will go up. But I think for us, we really haven't come out and set a range, but I would expect that we want to maintain flexibility with the balance sheet and the capital structure to be able to do shareholder-accretive deals. We think our business model and our integrated multi-boutique allows us the opportunity to integrate, extract cost synergies. And then going forward, the margin sustainability is pretty strong, so we should be able to continue to generate a significant amount of free cash flow to use to deleverage.

So I think when we IPO-ed a year ago, we were about 2x, and we delevered down to 1.5x as of the end of the quarter. We'll be a much bigger organization going forward. We will be much more well-balanced and durable, as Dave said, with the asset mix becoming more balanced between equities and fixed income and solutions. The model itself really is very low from a capital expenditure perspective where we don't have to make multiple investments across our platform to sustain it since it is integrated. So I think we would want to maintain flexibility going forward. So not trying to be evasive on answering the question, but I think the ranges that we've operated in, we're comfortable with. And we'll use the cash to delever very quickly post the USAA deal.

And our next question comes from Michael Cyprys from Morgan Stanley.

I just wanted to dig in a little bit on the expense outlook post integration. What would be the right underlying expense growth that we should be thinking about, say, if markets are flat? And then if markets rise, how to think about any sort of incremental expense growth from there post integration?

Yes. So as we've said, 2/3 of our expenses plus are variable, that will grow with AUM revenue and size of the overall business. So I think as the business grows, you can think about 2/3 of the expense base growing in some capacity with that business growth. And then the remaining costs that are fixed, we feel like growth of a couple of percent is probably fair. Thinking about the low level of fixed costs that we have in the business and our ability to reinvest, we think that's probably a fair way to look at it going forward post the USAA transaction.

And I would add, Michael, I would add one thing to that. We've come out with the mid-40s margins kind of on a go-forward basis inclusive of USAA. We think those margins are sustainable, and sustainable from a perspective that we're going to continue to reinvest in our platform, in distribution technology and other areas. So even with the reinvestment, the mid-40s margin is a good number to model off of. Going up from there is probably not, at least significantly, not likely given the environment we are in. And I think that's how you should think about expense growth.

Great. And then just a follow-up on capital management. You mentioned the idea of potentially initiating a cash dividend at some point in the future if it makes sense. Just curious on what scenario would that make sense. If you could just talk about how you'd approach that and what factors would you consider around initiating a dividend and also the magnitude of such a dividend?

First, we evaluate every quarter with our Board, our capital management policy inclusive of a dividend. It makes a lot of sense post the USAA transaction close, given that we'll be a transformed company with a totally different financial profile to look at our capital management. And we will look at a dividend pretty closely. That being said, the most important thing on our capital management is flexibility to execute our strategy. And really, the environment we're in today, we feel like having a flexible balance sheet with the appropriate leverage levels to execute on acquisitions. So if we were to put a dividend in place, it would have to fit within those constraints on our balance sheet and our cash flow.

And we now have time for one question. And our final question comes from the line of Robert Lee from KBW.

I just have a follow-up question on the flows. So I mean, clearly, April into May, seeing this sharp improvement. But I'm just kind of curious about kind of the pattern leading up to April. It wasn't like April 1, all of a sudden, the spigot turned on. Was this kind of something that started to build over the course of Q1? So -- and you kind of hit the tipping point as you got towards April. How should we -- just kind of curious about the progression of it.

I think it was realization of our won but not yet funded book that had experienced some delays from what we were anticipating. We don't control when clients decide to fund. I think the fourth quarter disruption really did impact us in the first quarter in a lot of our strategies and the asset classes we manage. And I also think the realization of our investment performance, there has been a little bit of a comeback of active, at least from the things the people that we have spoken to. And I think you put all that together and April, and then now through May and kind of what we see over the horizon, we feel pretty good about the flow picture.

And that concludes our question-and-answer session for today. I would like to turn the conference back over to David Brown for closing remarks.

Thank you. We appreciate your interest in Victory Capital and hope to see many of you in person over the next several weeks. Next week, we'll be meeting with investors in Los Angeles and attending the B. Riley Institutional Investor Conference. On May 30, we'll be in New York at the KBW Asset Management Conference. On June 6, we'll be in Chicago at William Blair's Annual Growth Stock Conference. And the following week on June 10 -- June 12, we'll be back in New York attending the Morgan Stanley Financials Conference.

Thank you, again, for taking the time to participate in our call. This is really an exciting year for Victory Capital, and we look forward to keeping you updated on our progress. As always, if you have any additional questions, please don't hesitate to contact Matt. Thank you.

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program, and you may all disconnect. Everyone, have a great day.