Virtus Investment Partners Inc (VRTS) 2017 Q4 法說會逐字稿

Good morning. My name is Andrew, and I'll be your conference operator today. I would like to welcome everyone to the Virtus Investment Partners quarterly conference call. The slide presentation for this call is available in the Investor Relations section of the Virtus website, www.virtus.com. This call is also being recorded and will be available for replay on the Virtus website. (Operator Instructions)

I will now turn the conference to your host, Jeanne Hess. Please go ahead.

Thank you, and good morning, everyone. On behalf of Virtus Investment Partners, I would like to welcome you to the discussion of our operating and financial results for the fourth quarter of 2017.

Before we begin, I direct your attention to the important disclosures on Page 2 of the slide presentation that accompanies this webcast. 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 earnings release and discussed in our annual report on Form 10-K and quarterly report on Form 10-Q and other 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, Virtus uses certain non-GAAP measures to evaluate its financial results. Our non-GAAP financial measures are not substitutes for GAAP financial results and should be read in conjunction with GAAP results. Reconciliations of these non-GAAP financial measures to the applicable GAAP measures are included in our earnings press release, which is available on our website.

Now I'd like to turn the call over to our President and CEO, George Aylward. George?

Thank you, Jeanne, and good morning, everyone. I'll start today by discussing the results for the quarter, including assets, flows, earnings, before turning it over to Mike for more detail on the financial results. Before taking your question, I will make some comments on our agreement with Sustainable Growth Advisers, or SGA, that was announced earlier this morning.

Now let me begin with assets under management and flows. Long-term AUM increased 1.9% sequentially to $88.8 billion, as strong market appreciation more than offset net outflows. Total assets, which include liquidity strategies, ended the period at $91 billion. Total sales were $4.1 billion compared with $4.6 billion in the third quarter, which included a CLO issuance of $0.5 billion. Total net flows were negative $0.8 billion in the quarter compared with a positive $0.2 billion sequentially as net inflows in retail separate accounts and ETFs were more than offset by net outflows in institutional and open-end funds.

Retail separate accounts net flows continued to be positive in the quarter, due primarily to the quality-oriented equity strategies offered by Kayne Anderson Rudnick. We have had positive flows in retail separate accounts for the past 8 quarters and continue to believe that the growth outlook in this category remains strong. ETFs also continue to generate positive flows in the quarter, reflecting higher sales.

Institutional net flows were negative $0.4 billion as increased sales were offset by higher redemptions. Institutional flows were generally lumpy, and there were no notable outflows or inflows in any single strategy in the quarter.

Mutual fund net flows were negative $0.6 billion compared to flat in the third quarter, due primarily to outflows in bank loan strategies, consistent with the industry trend for that asset class.

Mutual funds have generated positive net flows in the quarter, including Kayne Small-Cap Growth, Small-Cap Core and International Small-Cap Funds; the Emerging Market Opportunities Fund managed by Vontobel; and the Multi-Sector Short-Term Bond Fund from Newfleet.

Our relative investment performance continued to be solid as of December 31, with 81% of rated fund AUM having 4 and 5 stars and approximately 90% of the institutional assets beating their benchmarks on a 3- and 5-year basis.

In terms of January flows, mutual fund net flows were positive across asset classes, and retail growth sales, which include retail separate accounts, were the strongest we've seen in almost 5 years. As for other product categories, the one thing of note is that, as we previously announced, we issued a new $400 million CLO managed by Seix in January.

Moving on to the financial results. Revenue as adjusted increased 5% in the quarter due to higher average assets and higher fee rates that more than offset a 2% increase in operating expenses, which included $0.9 million of transaction costs for the SGA agreement. The higher revenues as adjusted as well as the realization of all expected synergies from the RidgeWorth transaction resulted in an 11% sequential quarter increase in operating income as adjusted.

Operating margin as adjusted increased to 35.7% from 33.8% in the prior quarter and 28.4% in the prior year quarter.

Fourth quarter earnings per share as adjusted increased 13% to $2.60 from $2.30 in the prior quarter on higher operating income as adjusted.

Turning to the balance sheet. During the quarter, we seeded a new fixed income UCIT as part of our strategy to expand our product offerings for offshore investors. In addition, we facilitated a reset transaction on one of our existing CLOs, thereby extending its reinvestment period and maturity date.

Now I'll turn it over to Mike to provide a more detailed view with financial results and the balance sheet. Mike?

Thank you, George. Good morning, everyone. Starting on Slide 7, assets under management. We ended the quarter with long-term assets of $88.8 billion, which reflects increases of 1.9% and 96% from the prior quarter and prior year quarter, respectively. The sequential increase reflects market appreciation of $2.7 billion, partially offset by net outflows of $0.8 billion and other activity of negative $0.3 billion, which primarily includes dividend distributions. The change from the prior year reflects the assets from the RidgeWorth acquisition, market appreciation of $9 billion and net outflows of $0.2 billion.

Our long-term AUM continues to be well diversified by product type, with $43.1 billion in open-end funds, $20.8 billion in institutional, $13.9 billion of retail separate accounts, $6.7 billion in closed-end funds, $3.3 billion of structured products and $1 billion in ETFs.

At December 31, our assets remained balanced between fixed income and equity, with equity increasing slightly in the quarter to 52% of total assets.

Turning to Slide 8, asset flows. Total sales were $4.1 billion, a sequential quarter decrease of $0.5 billion or 10%, primarily due to the launch of a CLO in the prior quarter. Total sales increased from the prior year quarter by 56% or $1.5 billion on higher sales in institutional, retail separate accounts and open-end funds. Net outflows for the quarter were $0.8 billion as the combined net inflows from retail separate accounts and ETFs of $0.3 billion were more than offset by net outflows in open-end funds and institutional. I would note that for the year, retail separate accounts and ETFs generated $1.6 billion of positive flows, an increase of 69% from 2016.

With respect to mutual funds, net outflows for the quarter were $0.6 billion as positive flows in equities were more than offset by negative flows in fixed income. The flows by asset class were as follows: International Equity Fund had net inflows of $0.2 billion in the quarter, an increase from $0.1 billion in the prior quarter. The increase was due to higher net inflows in the Emerging Markets Opportunities Fund and the International Small-Cap Fund. Domestic equity funds had net outflows of $0.1 billion as net inflows in small-cap strategies were more than offset by net outflows in mid- and large-cap strategies. Fixed income funds had net outflows of $0.5 billion compared to flat flows in the third quarter as inflows in the multi-sector strategies were offset by outflows in bank loan strategies, consistent with market trends in this investment category.

Turning to Slide 9. Investment management fees as adjusted of $102.1 million increased by $3.7 million from the prior quarter. The sequential quarter increase of 4% was due to higher average assets under management and a higher net fee rate. The average fee rate on long-term assets for the quarter was 45.4 basis points compared with 44.8 basis points for the third quarter. The increase in the blended fee rate reflects lower mutual fund expense reimbursements, partially offset by lower incentive fees on structured products.

The fourth quarter open-end fund fee rate increased to 50 basis points from 48 in the prior quarter due to the impact of lower fund expense reimbursements as a result of the consolidation of service providers and an increase in average assets and higher fee equity products due to market appreciation. Incentive fees on structured products decreased to $0.1 million from $0.8 million in the prior quarter.

I would also note that the ETF fee rate decreased sequentially to 16 basis points from 27 basis points due to higher expense reimbursements on newly launched funds. For modeling purposes, we believe the 50 basis points for the open-end fund fee rate and 23 basis points for the ETF fee rate are reasonable assumptions, all else being equal.

Slide 10 shows the 5-quarter trend in employment expenses. Total employment expenses as adjusted of $52.6 million increased 1% from the prior quarter. The increase was due to higher profit-based incentive compensation. As a percentage of revenues as adjusted, employment expenses were 48% compared with 50% in the third quarter.

As a reminder, in the first quarter of each year, we incur higher levels of payroll taxes and other benefits that amounted to $3.4 million in the first quarter of 2017. Of this amount, $3 million was attributable to incremental payroll taxes and retirement-eligible employees' stock-based compensation. We expect these costs to increase by approximately 35% in the first quarter, in line with higher staffing that resulted from the RidgeWorth transaction.

The remaining $0.4 million of the first quarter 2017 seasonal items was related to benefit costs, primarily the timing of the (401)k match, which we expect to increase to approximately $2 million due to the higher staffing levels as well as planned modifications.

The trend in other operating expenses as adjusted reflects the timing of product, distribution and operational activities. Other operating expenses as adjusted were $16.7 million, an increase of $0.6 million or 4% sequentially. The current quarter includes $0.9 million of transaction costs associated with the SGA agreement. Excluding those costs, other operating expenses as adjusted were $15.8 million.

Slide 12 illustrates the trend of financial results. In terms of the non-GAAP results, operating income as adjusted was $39.1 million, an increase of $3.9 million or 11% compared to the prior quarter. Operating margin as adjusted was 35.7%, an increase of 190 basis points from the prior quarter and 730 basis points from the prior year. The fourth quarter margin reflects the impact of the $25 million in synergies related to the RidgeWorth transaction.

Earnings per share as adjusted were $2.60 in the quarter, an increase of $0.30 or 13% sequentially. Weighted average shares outstanding as adjusted declined 1% sequentially as the higher common stock price in the quarter resulted in the preferred shares hypothetically converting to 55,000 fewer common shares than in the third quarter.

The fourth quarter effective tax rate as adjusted increased sequentially by 70 basis points to 39%, reflecting changes in the 2017 state tax apportionment factors. Notably, the fourth quarter rate was not impacted by the Tax Cuts and Jobs Act.

In terms of our effective rate going forward, our preliminary analysis of the impact of the new federal tax rates indicates an effective rate as adjusted of approximately 28% compared with the 39%. The decrease reflects the decline in the federal rate, partially offset by certain federal tax limitations on deductions and the impact of the lower federal rate on state tax deductions.

Regarding GAAP results. Fourth quarter net income per share was $0.46 compared to $2.21 per share in the third quarter. Fourth quarter GAAP earnings included the following items: a noncash tax charge of $13.1 million or $1.76 per share, reflecting the impact of the new tax legislation that resulted in the remeasurement of our deferred tax assets at the new lower corporate tax rates; acquisition and integration costs of $3.3 million or $0.28 per share, which decreased from $4.9 million or $0.36 per share in the third quarter; and a 12% decrease in weighted average diluted shares outstanding, due primarily to this quarter's calculation of the if-converted method. As we mentioned previously, each quarter, under GAAP, we calculate whether it's more dilutive to deduct the preferred dividend from net income or treat the preferred shares as if converted into common shares. For the fourth quarter, deducting the dividend was more dilutive, given lower income that included the impact of the tax charge. In the third quarter, it was more dilutive to treat the shares as converted, given the higher level of net income.

Slide 13 shows the trend of our capital position and related liquidity metrics. At December 31, seed capital investments were $118.4 million and within the targeted range of $100 million to $150 million, which will fluctuate based on our specific product and distribution needs. In the quarter, we recycled certain existing seed investments to launch the multi-sector income UCIT managed by Newfleet.

CLO investments were $108.3 million, an increase of $19.6 million from September 30 due to the company's investment in the reset transaction of a 2013 vintage CLO managed by Seix. The benefits of the reset transaction include the extension of the maturity date and reinvestment period for the $425 million CLO as well as lower CLO liability costs.

In the quarter, our seed capital and CLO investments generated $2.9 million of dividend and interest income, which represents the yield on those investments, compared with $4.1 million in the prior quarter. It's important to note that while this is not included in our non-GAAP measure, net income as adjusted, it provides a significant economic benefit to the company.

Net debt at December 31 was $127.2 million that resulted in a net debt to bank EBITDA ratio of 0.7x, a decrease from 0.9x at September 30, reflecting cash generated by the business. As a reminder, bank EBITDA is calculated in accordance with our credit agreement and is generally defined as operating income as adjusted plus stock-based compensation, dividend and interest income on investments and fully phased-in synergies.

With that, let me turn the call back over to George. George?

Thanks, Mike. The last item I want to discuss before taking your questions is our announcement this morning of our agreement to purchase the majority interest in SGA, a boutique manager with $11.6 billion in assets under management as of December 31. SGA manages distinctive high-conviction U.S. and global growth equity portfolios primarily for institutional clients. The addition of SGA into our family of affiliated managers would further diversify our offerings for our strategies, product lines and clients. They would add distinctive growth equity capability to our current offerings and significantly expand our institutional and international client base. Their assets are primarily in U.S. and global large-cap growth equity strategies, with $7.1 billion and $4.5 billion in AUM, respectively. They manage their strategies with a research-focused approach that invest in differentiated global businesses that they believe offer predictable and sustainable growth. Their distinctive, high-conviction approach to growth equity investing and attractive investment performance has generated strong demand for their strategies, particularly global equity in the institutional market.

They've grown significantly since their founding in 2003. Their AUM has nearly doubled over the past 3 years. And in 2017, they generated approximately $2.4 billion in positive net flows. This clearly illustrates how well positioned they are in a environment that has generally favored passive investing.

Essentially, all their assets are managed by institutional clients in separate accounts with sub-advisory mandates. SGA would increase our institutional AUM from 23% of total assets at December 31 to approximately 31% on a pro forma basis. They would also add a meaningful international presence to our business. They currently manage about $4 billion or so for institutional clients in Australia, Canada, Europe, Japan and Middle East.

We are optimistic about the growth outlook for SGA. They have strong relationships with consultants and a solid pipeline, which should present opportunities for further growth in the institutional channel. In addition, as we do with our other affiliates, we will look to make their strategies available to other product structures and in other channels. We believe there are opportunities to expand their presence in the retail markets, leveraging our U.S. retail distribution resources. We will also selectively make their strategies available through other product structures, including retail separate accounts, mutual funds, ETFs or UCITS.

We will acquire 70% interest in the company consisting of the minority position held by a private equity investor and a portion of the equity held by SGA's partners. The purchase price at closing would be $129.5 million, pending any purchase price adjustments tied to client consents. All of the partners, including the 3 cofounders, have entered into long-term employment agreements. They will also retain equity in the firm, which aligns interests with shareholders, and invest a significant portion of the transaction proceeds into their strategies, which aligns interests with their clients. Like our other affiliated managers, SGA will continue to operate as an individual boutique retaining autonomy over its investment process, maintaining its independent structure, culture, brand and control over day-to-day activities.

We expect to finance this transaction using balance sheet resources and debt from our existing credit capacity of $100 million or new financing, depending upon market conditions. Our expectation is that our net leverage will remain below 2x debt to EBITDA.

The transaction is financially attractive and it is expected to deliver an IRR of approximately 20% and be immediately accretive to non-GAAP earnings. We expect EPS as adjusted accretion of approximately 6% on a pro forma run rate basis of fourth quarter 2017 earnings, excluding transaction costs. In addition, purchased intangibles will reduce tax obligations. As would be expected with the acquisition of a smaller focused boutique firm, there is no significant duplication of costs. We expect the transaction to close by the middle of 2018.

The addition of SGA as our newest boutique affiliate illustrates an important component of our growth strategy and a key element of our value proposition. We have often said and will continue to say that our long-term growth is not dependent on an M&A strategy. However, a key element of our multi-boutique model is that it provides us with opportunities to selectively partner with distinctive boutiques and support their growth by offering their strategies in the different product structures and providing access to our distribution resources.

Our model allows us to partner with the right firm for particular capability by having a flexible approach to partnering, thereby not limiting our opportunity set. We have successfully leveraged our multi-boutique model over the years to expand our affiliated managers with the establishment of Newfleet in 2011, adding Rampart in 2012, Virtus ETF Solutions in 2015 and Seix, Ceredex and Silvant through the RidgeWorth acquisition in 2017.

We believe our value proposition is attractive to boutique managers because they can focus on providing their investment strategies to their clients while benefiting from the scale, distribution and other resources of a larger organization.

We're excited about this opportunity. SGA is a quality investment management firm offering a distinctive approach to growth investing, which is additive to our current investment offerings and provides an important part of an investor's well-diversified portfolio.

With that, let us open up to questions. Andrew, can you open up the lines, please?

(Operator Instructions) Our first question comes from the line of Ari Ghosh with Crédit Suisse.

So real quick on the SGA deal. Could you, first, maybe talk a little bit about the fee rate and how that compares to your existing institutional blend? Maybe then touch on what performance has looked like recently. And then of the $2.4 billion of inflows that you called out for 2017, is that sort of in line with what the company is doing, has been doing in prior years? And looking forward, what -- if you could size up their pipeline, that would be pretty helpful as well.

Sure. I'll see what I can do to sort of answer some of those questions. So in the first part, you're asking about their institutional business, and we're very pleased to be expanding our assets in that channel as we look to diversify a little bit away more from retail. So I think, Mike, their institutional fee profile...

Is generally consistent with the blended institutional rate that we reported around 31 basis points. I think it's fair to use that in your assumptions on their AUM, Ari.

And then in terms of just the reference I made on some of their flows, as I sort of indicated, they were started in 2003, they're at $11.6 billion. In the last 3 years, they more than doubled, and last year, about the $2-plus billion number that I gave you. I think that sort of gives you an indication of sort of what that net flow profile has looked like over those years. And I missed the second part of the beginning of the first question, Ari. You broke up a little bit.

Yes, sorry about that. I know there were a lot of questions embedded. But if you can just touch on maybe what the pipeline looks like, either the magnitude of it or your competitive prior. Just want to get a sense of the pipeline that we're looking at over the next 12 months from SGA.

Sure, sure. And as I assume you can understand, we're not going to give any kind of insight into their pipeline at the time we're announcing a transaction that we haven't yet completed. But again, we feel very good about the opportunity set that they've had and the types of relationships they have and that we continue to see that they'll have those opportunities going forward. And down the line, we'll start talking more a little bit about specifics on pipeline.

Great. It was worth a shot. And then just a quick follow-up. Following the deal, how should we think about capital deployment for 2018 and '19? Does this transaction change either the magnitude or timing of the plans that you had over the next 12 months? Or should we still continue to sort of expect quarterly buybacks, keeping the share count where it is right now around these levels and then maybe even paying down some of your debt every year?

Yes -- no. And it's a great question. And again, Mike and I have both repeatedly said we really -- it's important to us to maintain flexibility because we really do look at a primary goal of organic growth in the business, and as you know, we've set aside portions of our capital structure that we utilize and recycle for the organic development of new products and investments now increasingly in CLOs. We've been very aggressive at the appropriate times on stock repurchases when we believe it's the highest and the best use of shareholders' capital. And the same is true on the M&A side, where we -- while we spent a lot of time looking at lots of things over the years, we've actually been very selective. And then we happen to have now done the big RidgeWorth transaction and SGA, it really was as a result of us really being very comfortable that these were very good opportunities at that time. So I think we'll continue to maintain the flexibility. As we said very clearly, we're going to be using the debt and the balance sheet side to finance this transaction, keeping our leverage at a 2x kind of a number. But we're going to continue to generate significant cash flow and, obviously, post the transaction with SGA. That's a cash flow positive type of a business. So we'll continue to evaluate at any point in time the different uses of the capital for things we've done in the past. Mike, do you want to add anything to that?

Yes. And, Ari, just to point out from a specific standpoint, as you know, the existing term loan has an excess cash flow sweep feature in it, which we'll calculate based on 2018 calendar year, and there'll be a required paydown based on that calculation in Q1 '19. So certainly, thinking through the priorities, that's a contractual covenant that we'll follow. And that -- after that, I think as George outlined, we'll evaluate capital going forward.

And our next question comes from the line of Michael Carrier with Bank of America.

This is actually Sameer Murukutla on for Michael Carrier. A quick question on the tax rate. I know you gave us the 28%. It seems a little high versus your peers. So can you just give us any more detail on why it's ending up at 28% versus the lower 20s?

I haven't seen the peers. But certainly, when we look at it, the 39%, and we're certainly pleased to be a beneficiary of the Tax Cuts and Jobs Act. The -- there are certain federal deductions that will have limitations under the new rules, so that will certainly be something that goes into our rate. So the -- you have -- the 35% and the 21% plus the state tax will have some limitations on the deductions, and then the state tax deductions are further limited by the reduction in the federal rate. So I think 28% is a good estimate, and to the extent that changes, we'll true it up.

Okay. I guess just as a follow-up, it's a question on your margin outlook going forward. You did 35.7% in the quarter, and now you announced the SGA deal. Looking forward, where do you think this margin could maybe top out at?

One of the bigger drivers of any fluctuation in our margin will really be how are the markets doing and what are our asset levels. So January, obviously, having equity markets that were strong. But as a reminder, only half of our assets are in equities, 52% and 48% is in fixed income. So we're pleased where the margin came in. We highlighted 1 or 2 small items, specifically the transaction costs related to that. And as you sort of think about SGA, it's an equity shop large-cap growth, so it's not a highly cost expensive way to manage money. So we're not going to give any specifics in terms of the margin, but again, that would be a transaction that you should think would be accretive to our margins as opposed to dilutive to our margin.

Yes. We've also talked about incremental margins or cash ratios in the 50% to 55% range. And I think that there's always a caveat of where the AUM growth or revenue growth comes from. But I think that's a -- it's a good assumption going forward.

(Operator Instructions) And we have a question from the line of Michael Cyprys.

Just wanted to circle back on the SGA transaction. Just on the operational -- organizational structure, just if you could elaborate a bit on how this sort of affiliate is going to fit within your overall organization relative to the other affiliates that you have. It seems you centralize a little bit more operations, in some cases. It didn't quite get the sense that you're going to pull as much to the center with this one relative to others. Maybe I'm misinterpreting that a little bit. Also, the 70% stake, why 70%? How are you thinking about that? I think you -- some of the other affiliates, you have a little bit of a larger stake there. And the other is revenue shares, how is this one going to work as well?

Yes, a couple of things, just to be very clear. In -- for all of our affiliates, they operate in their -- as their own firms, their own identity, their own locations, their own culture, total control over their investment process and running their day-to-day business. And it is correct to say that we do have the ability to offer different types of infrastructure or systems or data that can be shared on a multi-affiliate basis when it allows for economies of scale and all that. But each of -- to be real clear, each of our affiliates, they do operate as very distinct separate and individual businesses. SGA is a large-cap growth equity manager, approximately 25 people who are managing the $12 billion, they'll continue to do exactly what they do now. And our job is to do what we can to support them or to make things easier for them and to help them in their opportunities in terms of managing their business and executing their business plan. So that's sort of the way I would describe both SGA and our multi-boutiques. I'm sorry, 70%. I forgot the second part of your question. 70%. You're correct in saying that our structures include 100%. We also include some that are less than 100%. And that was sort of the point I was making when I talked about the flexibility of our business model because for us, what's really important is finding the right partner for the right strategy. So whether it's an ETF business or whether it's a very distinctive, differentiated, high-conviction growth equity manager, we're not going to limit our opportunity set to any kind of a cookie-cutter structure. So what -- the only thing that's consistent amongst our affiliates is that they stay who they are, they're independent, they manage money and they take care of their clients. But whether it's 70% or whether it's 100%, each of -- that structure will really depend on each individual opportunity.

Great. And just as a follow-up, can you talk to what you view as the compelling strategic rationale for this transaction? It doesn't seem like it's a cost synergy play here. And if you can just give a little bit of history recap in terms of how long you've been in discussion with them and any sort of color around that.

Yes, and great point. This is not about synergies. No. This is a product capability, right? So as we look through the myriad of different types of transactions that we've looked at -- and I'll use actual illustrations, right? So the RidgeWorth transaction was really a twofer. It was 3 great affiliates to add to the family and the capabilities as well as an opportunity to unlock great synergies in terms of duplications of costs and effectively almost double the size of the company. So that brought with it many, many elements. This is a product addition capability as with Rampart where we brought in the differentiated portable yield/optional related strategy; and then ETF Solutions, which is really more about the product expansion and how do we effectively accelerate our ability to enter into the ETF business. And as you may remember, when we made our investment, it was $70 million, and they're now $1.1 billion, which we're very happy with that. So each of those will be looked at through the filter of either adding a great capability, expanding our product opportunity set or if we can couple that with synergies. And synergies are great, they're gravy, but really, what's core in the transaction is getting really good managers that can grow. So we look through the whole continuum of those, and again, as I've said, we sort of have done one of each and we'll continue to look for those things that fit going forward.

Got it. Okay. So it's about the product capability here that you're picking up, that you have a portable international portfolio and that's a key thing.

Absolutely.

If I can just sneak in another follow-up question, if that's okay?

Yes.

Just on alignment of interests, just curious how you're thinking about aligning interests with this affiliate and how that may differ, if at all, from some of the other affiliates and just probably your thinking on that.

Yes, I don't think it differs materially. I mean, the alignment of interests by maintaining the minority interest, they have a significant alignment of interests with us to grow that business and to grow it in terms of its overall profitability, which is sort of how we're generally judged and evaluated and valued. So I think that's a great alignment of interests. And that's not inconsistent with our other affiliates where, really, the models we have, which are all profit-based, I can't remember before if you said you thought they were revenue or not, but our models are really more profit contribution based. So for every dollar of profit that is contributed by the affiliates to the shareholders of Virtus, a percentage of that is really utilized to provide for incentive compensation for the affiliates. And we've always thought that, that was a great clear line of sight from the affiliates into our shareholders. And then generally, as we've said, we do use Virtus equity in certain components to further align those structures. So for us, alignment from those affiliates and those investment professionals to Virtus shareholders is very important, and we feel pretty good about the structure we have.

And our next question comes from the line of Surinder Thind with Jefferies.

Just following up earlier on the question about just the use of capital and how you're thinking about it. I just wanted to clarify 1 or 2 things. First is, did I hear correctly that the leverage ratio was going to -- after the SGA acquisition, will approach 2x net debt to EBITDA? And if so, that that's about the maximum level that you're comfortable with at this point? Was that correct?

No. Just to clarify, I think we were alluding to gross debt to EBITDA post the transaction. And I don't think we gave specific level of what we'd be comfortable with, just that will be the level that would be on a pro forma basis, assuming utilization of the credit facility that's got $100 million of capacity on it would result in that type of leverage.

Understood. Can you provide some color around where you -- what levels you would be comfortable with? Or is it much more situational in a sense that, obviously, as the leverage ratio goes up, your ability -- you talked about being flexible in your approach to the ways that you want to be able to grow the firm or maintaining flexibility. So as your leverage ratio goes up, the ability to grow inorganically obviously decreases. And so at what point does debt paydown become a priority over other means of -- whether it's share repurchases and stuff?

We look at a lot of factors as we sort of think about that, and we'll refer back to some of the comments we made at around the time of the RidgeWorth transaction. So as we sort of think about leverage, we've always run the business very conservatively and for most of our existence did not utilize leverage. In part, it was because of our size and sort of the risk profile of the equity exposure that we had. And as we've grown and developed and expanded and diversified the business, we've gotten a little bit more comfortable with certain levels of leverage. And now, obviously, with the SGA addition of another manager, different strategy, diversified into retail, that will influence. So we sort of think about how diverse our business is, how large the business is and how we can sort of manage the leverage, and then we sort of couple that with what I was addressing earlier, which is -- our job is very simple. What is the best way to create value for shareholders, so we do like to make sure that we have that flexibility. So keeping within very comfortable range of leverage while at the same time, evaluating, considering opportunities to create value. And as you're aware, we do maintain on our balance sheet significant other resources in terms of our seed capital as well as now in terms of other investments primarily in the CLO. So we do -- we have a balance sheet that we sort of evaluate for different types of opportunities. So Mike?

Yes, and I'll just reiterate the point on the debt paydowns, the facility requirement of the excess cash flow sweep. So certainly, that will be a priority to service the debt and those paydowns.

Sure. I mean, the question was more around, obviously, more than just what the requirements are. And then I guess in terms of -- the other thing I'd like to touch base on is just kind of how you guys are thinking about expenses. We've kind of touched on this a little bit in the past, and we've talked about generally industry spend being a little bit higher than maybe in years prior. And then as we've kind of gone through this earnings season, one of the themes that's been emerging is that most that have reported thus far, their expense outlook has perhaps been higher than what the analyst community was thinking about going into the earnings call. How should we think about where you guys are in terms of -- the theme has basically been that now is still the time to invest, right? Things are changing, and so we're going to continue to invest and elevate investment. How should we think about where your guys' model, given that everybody operates so autonomously? And is there a risk where -- that you guys begin to fall behind given that everybody gets autonomous versus trying to cut -- force everybody to say no, we need to really think about a more centralized approach to some of the things that we're doing?

Yes. So let me clarify a whole bunch of things. Each of our affiliates has autonomy of managing their clients' assets and running their business. We do provide the benefits of scale for the whole variety of different cost elements, right? So whether it's trading systems that are multi-affiliate, whether it's outsourced middle and back office. So don't confuse the language I'm using about how they operate autonomously in terms of managing money and servicing clients that they're not benefiting tremendously from the scale of the combined business, and many of the services and contracts and costs of managing money, we're able to do within multi-affiliate structure. So there are no -- so if you're thinking that there's somehow duplication of costs of cost affiliate, that really is not a correct way to sort of think about us.

Yes. It wasn't so much that it was -- it's more around where maybe just some of the incremental spend is occurring in terms of enhancing capabilities. The back office part, I guess I'm comfortable with in the sense that obviously, that is one of the big advantages of boutique becoming part of the Virtus model is a lot of these -- the core technical things that you need to do to run your systems or your operations, you guys do take care of all of that. My question was more about where a lot of the -- some of the incremental investment tends to be is in -- obviously, there's a technology component, but there's also just trying to enhance the capabilities, whether it's -- or the decision-making processes, whether it's trying to go through new sources of data or those kinds of things.

Sure. No, okay, so now I understand. So what I'll add to that is if you're talking about industry ride and what's going on with cost structures, I think all of us will sort of say costs are going up, not down, and whether it's distribution costs, whether, to your point, it's enhancements to investment processes with either data or AI types of capabilities, those are all things that will cost more money, not less. So again, I think in those areas -- by having retail as a good example, by having a shared retail cost, so where a lot of us have to invest in retail, having to share it amongst the multi-boutiques is very helpful. Adding a new affiliate doesn't mean we have to add anything on the retail distribution side. We have the workforce, we have the capabilities, we have the relationships in place. But for those other things that you sort of were referring to, again, as appropriate, if we can utilize a single-source service provider to help multiple affiliates, we would look to do that. But really, for -- particularly, the area of affiliates focused on their investment process, we're there to sort of support them and make it easier for them to do that, that's really what we sort of rely on them for.

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

Great. And I want to thank everyone for joining us today, and we certainly encourage you to call us if you have any other further questions. Thank you very much.

That concludes today's conference. Thank you for participating, and you may now disconnect. Everyone, have a wonderful day.