Virtus Investment Partners Inc (VRTS) 2018 Q3 法說會逐字稿

Good morning. My name is Joelle, 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, Joe Fazzino.

Thank you, Joelle, 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 third quarter of 2018.

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, quarterly reports 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 the 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 would like to turn the call over to our President and CEO, George Aylward. George ...

Thanks, Joe, and good morning, everyone. I'll start today with an overview of the quarter, before turning it over to Mike to provide detail on the financial results. As we begin, I'd remind you that our third quarter results include the addition of Sustainable Growth Advisers or SGA, which closed on July 1.

Looking at the quarter, we believe the results reflect the strength and diversity of our business. In particular, I would note that the results demonstrated continued positive net flows; a favorable shift in our asset mix; meaningful growth in revenues, earnings and margin; continued strong investment performance; and further diversification of our business by product, strategy and geography.

So turning to the assets and flows for the quarter. Despite what continues to be a challenging environment for active asset managers, we again generated positive organic growth with a favorable mix in flows and assets under management. Long-term AUM increased 16% sequentially to $103.9 billion with the addition of assets from SGA, strong market performance and positive net flows. Total assets, which include the liquidity strategies, ended the period at $105.6 billion. Total sales of $6.3 billion were meaningfully higher than the $4.6 billion in the prior year and just shy of the very high level of $6.6 billion in the prior quarter, as increased sales in retail had separate accounts and institutional were more than offset by a decrease in open-end funds.

Total net flows remained positive at $0.5 billion, representing a 2.2% annualized organic growth rate on long-term AUM, primarily as a result of positive net flows in retail separate accounts and open-end funds. Retail separate account net flows were positive $0.4 billion with increased sales in the intermediary sold managed accounts and continued positive net flows in the private client business. The positive net flows in open-end funds resulted from continued good strong sales in domestic equity, including Kayne's small- and mid-cap offerings, as well as Zevenbergen's concentrated large-cap growth products.

In terms of fixed income, the Seix Floating Rate High Income Fund contributed positive net flows in the quarter.

Institutional had modest net outflows of $0.1 billion, as stronger sales were offset by higher redemptions. The $1.5 billion of sales in the quarter included a significant contribution from SGA as well as new mandates that funded a 2:1 weather affiliates.

Redemptions were evenly split between outflows on existing and closed accounts and across various strategies at our affiliates.

In terms of what we're seeing in October, which has turned out to be an extremely volatile and challenging month, we have had outflows in our mutual funds, particularly in the first half of the month.

Regarding other products, institutional in terms of what we're aware of, looking to be flat on a net flow basis. And in structured products, we currently have a CLO in the warehouse space.

Moving to the financial results. Operating income, as adjusted, increased by 28% to $48.2 million, and the related margin increased to 38%. The contribution from SGA as well as higher revenues from organic growth, market appreciation and performance-related fees contributed to the increase.

Revenues, as adjusted, increased 16% sequentially, primarily due to higher investment management fees from higher-average assets and fee rate.

The increase in the average assets was primarily due to SGA but also benefited from market appreciation and positive flows.

The fee rate increase was due to performance fees and an increased open-end fund fee rate that reflected a favorable shift in mix of our assets.

Operating expenses, as adjusted, increased 10% sequentially, reflecting higher employment expenses, as adjusted, due to the addition of SGA and higher profit-based variable compensation, partially offset by a 5% decrease in other operating expenses, as adjusted.

Turning to capital in the balance sheet. As we've demonstrated, our approach to capital management includes balancing our investing in the business, return to capital of shareholders and maintaining an appropriate level of leverage.

As we indicated on our last call, with our current level of cash flow, we believe, we can address all 3. Our priority is based on the facts and circumstances at any given time. This quarter, our main capital usage was closing on our investment in SGA, but in addition, we used $5 million for share repurchases, announced 22% increase in our common stock dividend and made $11.6 million of debt repayments.

With the benefits of our enhanced scale, higher margin and increased earnings, we believe we can continue to return capital of shareholders, invest in growth and maintain appropriate leverage.

With that, let me turn it over to Mike. Mike?

Thank you, George. And hello, everyone. Before I review the results in detail, let me provide some of the key highlights. In particular, we had meaningful AUM growth as a result of SGA, market appreciation and continued positive flows. Revenue was also higher, reflecting the growth of the business at a more favorable AUM mix.

Operating margins increased, as a result of the higher revenues and the benefits of scale and the leveragability of our model. And earnings per share grew significantly from both the prior quarter and the prior year. Importantly, the increase in EPS was primarily the result of organic growth, complemented by the earnings contribution from SGA.

So let me move to Slide 7, assets under management. At September 30, long-term assets were $103.9 billion, which reflects a sequential quarter increase of 15.7% and an increase of 19.3% from the prior year quarter. The sequential increase included $11.3 billion of assets from SGA, as of July 1, as well as market appreciation of $2.5 billion and positive net flows of $0.5 billion. The SGA beginning assets are reflected in the other row in our AUM roll forwards with $10.5 billion in institutional and $0.8 billion in retail separate accounts.

The change from the prior year, also, primarily reflects the addition of SGA assets, market appreciation of $6.3 billion and positive net flows of $0.3 billion. As a result of adding SGA's assets, which are primarily institutional, our product mix has become more diversified with institutional comprising 30% of long-term AUM at September 30, compared with 22% at June 30. SGA also provides us with more exposure to non-U. S. clients.

AUM diversity improved by asset class, product type and channel. And we expanded our financial supplement disclosure to include additional asset-class detail.

Two points that I would like to highlight. Our domestic equity assets are more diversified by market cap with neither a large nor small caps exceeding 20% of total AUM and are further diversified among core, growth and value strategies.

In addition, emerging market equities are a less significant portion and now comprise approximately 7% of long-term AUM. As of September 30, 32 retail mutual funds, representing 83% of Morningstar-rated fund AUM, had 4 or 5 stars. And a total of 53 funds, representing 98% of rated retail fund AUM, had 3, 4 or 5 stars. Each of the company's 5 largest mutual funds is a 5- or 4-star fund. In addition, 75% of institutional assets were beating their benchmarks on a 5-year basis, as of the end of the third quarter.

Turning to Slide 8, asset flows. Total sales were $6.3 billion, a decrease of 6% sequentially, as higher retail separate accounts and institutional sales were offset by lower open-end fund sales. We generated $0.5 billion of positive net flows in the quarter, reflecting positive net flows in open-end funds and retail separate accounts, partially offset by modest net outflows in ETFs and institutional.

With respect to open-end mutual funds, net flows for the quarter were $0.3 billion, representing an annualized organic growth rate of 3.1%. This organic growth rate resulted from strong total sales and included a 34% annualized sales rate for open-end funds.

Looking at mutual fund flows by asset class. Domestic equity funds, primarily small- and mid-cap strategies at Kayne continued to generate a strong inflows with $0.8 billion compared to $1.5 billion in the prior quarter. Kayne's mid-cap core and growth strategies sales were up compared to the prior quarter, and while the small-cap strategies sales remain strong, they were down from the elevated levels of the second quarter.

International equity funds, which include both developed and emerging markets, had modest net outflows of $0.1 billion in the quarter, consistent with the prior quarter. Positive net flows of $0.3 billion in the international small-cap fund

were offset by $0.4 billion of net outflows in the emerging and developed markets' large-cap funds.

Fixed income funds had net outflows of $0.3 billion compared with $0.2 billion in the prior quarter, as $0.2 billion of positive flows and bank loan strategies were offset by modest net outflows in investment grade and short-term bond strategies.

Regarding flows and other products. Retail separate account net flows were positive $0.4 billion in the quarter, representing an annualized organic growth rate of 9.7% as Kayne continued to generate positive net flows in both intermediary-sponsored and private-client accounts. Institutional flows, which can vary greatly, reflected $1.5 billion of inflows, including new accounts at Newfleet, Kayne, and SGA, offset by outflows of $1.6 million across various strategies. The outflows were evenly split between closed accounts, including a client reallocation to quantitative and passive strategies and existing accounts, primarily sub-advisory fund relationships that have recurring sales and redemptions. It's also worth noting that on a year-to-date basis, total net flows are positive $1.1 billion, reflecting an annualized organic growth rate of 1.6%, consistent with the same year-to-date period in 2017.

Turning to Slide 9. Investment management fees, as adjusted, of $123.4 million increased $18.8 million or 18% sequentially due to higher average assets under management, a higher average fee rate and $3.6 million of performance-related fees. Average long-term assets under management increased 15%, as a result of the addition of SGA, positive flows and market appreciation during the quarter. The average fee rate on long-term assets for the quarter was 47.4 basis points, an increase from 46.7 basis points in the prior quarter. Excluding the $3.6 million in a performance-related fees, the long-term average fee rate was 46 basis points, reflecting the addition of SGA institutional assets, partially offset by a higher open-end fund fee rate.

With respect to open-end funds, the fee rate increased to 54.3 basis points from 51.8 in the second quarter. The increase is a continuation of the trend we've seen over the past several quarters, which is the result of a positive fee rate differential between sales and redemptions.

This quarter, the blended fee rate on mutual fund sales was strong, at approximately 66 basis points, while the rate date -- the rate on redemptions was approximately 54 basis points. The structured product fee rate of 60 basis points included $2.3 million of a performance-related fee on a 2007 vintage CLO that had been previously called.

Excluding the impact of the performance-related fee, the structured product fee rate was 35.4 basis points, consistent with the prior quarter. The institutional fee rate of 31.9 basis points increased modestly from the prior quarter and included a $1.3 million performance-related fee that represented the first year of performance measurement for that account. Excluding the performance-related fee, which will be measured on a quarterly basis going forward, the institutional fee rate was 30.1 basis points, which is a reasonable rate for modeling in the fourth quarter.

We do not have performance-related fees every quarter, but have them periodically, and we are seeing more requests from institutional clients for these types of fee structures.

Slide 10 shows the 5-quarter trend in employment expenses. Total employment expenses, as adjusted, of $61.7 million, increased 15% sequentially from the second quarter. The increase in employment expenses reflects the incremental expenses of SGA and higher profit-based variable compensation. As a percentage of revenues, as adjusted, employment expenses were 48.0%, a decline of 50 basis points, sequentially.

The trend in other operating expenses, as adjusted, reflects the timing of product, distribution and operational activities. Other operating expenses, as adjusted, were $17.4 million, a decrease of $0.8 million or 5% from the prior quarter, which included our annual equity grants to the Board of Directors of $0.8 million. Excluding the director grants, expenses were flat, as the addition of SGA's expenses was offset by lower sales and marketing expenses that declined $0.6 million sequentially.

As we look ahead to the fourth quarter, with our expectations of higher sales and marketing activities, other operating expenses could move to the higher end of our range of $16.5 million to $18.5 million.

Slide 12 illustrates the true trend of earnings. Operating income, as adjusted, of $48.2 million, increased $10.6 million or 28% sequentially and $13 million or 37% from the prior year quarter. Operating margin, as adjusted, was 38% compared with 34% in both the second quarter and the prior year quarter.

Net income, as adjusted, of $3.64 per diluted share increased $0.67 or 23% from $2.97 per share in the prior quarter. The majority, approximately 70% of the $0.67 per share sequential increase, is attributable to higher revenues and profitability from organic asset growth, with the remainder related to the contribution from SGA.

The effective tax rate, as adjusted, for the quarter was 26.7%, a decline from 28% in the prior quarter. The decrease in the effective tax rate is the result of the impact of the majority ownership structure of the SGA investment on the calculation of tax expense. We believe this quarter's rate is good for modeling, going forward.

It's important to note that there are 2 items of economic value that are not included in net income, as adjusted. Interest and dividends earned on CLO and seed investments were $3.4 million or $0.30 on an after-tax per-share basis in the quarter, compared with $4.6 million or $0.39 per share in the prior quarter. And, intangible tax asset amortization, as a result of acquisitions, including the SGA transaction, will provide a cash tax benefit over the next 15 years of approximately $10.5 million per year at current tax rates.

Regarding GAAP results, third quarter net income per share was $3.19 compared with $2.75 in the second quarter. Third quarter net of tax GAAP earnings included the following items: $0.35 per share related to a one-time tax benefit; $0.37 per share of acquisition and integration costs, primarily related to costs associated with the closing of the SGA transaction; and $0.49 per share of unrealized losses on investments.

Slide 13 shows the trend of our capital position and related liquidity metrics. Working capital at September 30, 2018 of $128.2 million, increased $33.9 million or 36% sequentially, reflecting operating earnings, investments in the business, changes in debt outstanding and return of capital to shareholders. For investments in the business, during the quarter, we closed on the $129.5 million SGA transaction that was financed with $105 million of borrowings at existing balance sheet resources. This increased gross debt to $363.1 million on the July 1, closing date. Gross debt outstanding, at September 30, was $351.5 million, as we repaid $11.6 million of debt, representing a $1.6 million scheduled payment and an additional $10 million payment that will be applied to our annual cash flow sweep obligation, which is due in the first quarter of 2019.

As we mentioned on the second quarter call, our working capital includes an estimate of the required debt repayment over the next 12 months. At September 30, our estimate of the excess cash flow sweep obligation was $17 million, down from $33 million at June 30, which have the effect of increasing working capital by $16 million, sequentially.

The net leverage ratio was 0.9x net debt-to-EBITDA at September 30, an increase from 0.7x at June 30, primarily reflecting the incremental borrowing related to the SGA transaction. Bank EBITDA for the third quarter was $57 million.

Regarding return of capital to shareholders, share repurchases in the quarter totaled $5 million or approximately 38,200 shares of common stock, which represented 0.5% of total outstanding common shares, as adjusted.

In addition, we announced a $0.10 increase to the common dividend to $0.55 per share. The increase reflects the higher cash flow generation of the business and represents the first increase since we implemented a dividend in 2014.

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

Thanks, Mike. Looking ahead, we remain confident that the advantages and leveragability of our multi-boutique model; our diversification across affiliates, asset classes, channels and products; and our strong investment performance position us well for further growth.

So with that, we'll take your questions. Joelle, can you open up the line, please?

(Operator Instructions) Our first question comes from Ari Ghosh with Credit Suisse.

On the institutional channel, you mentioned the flows were flattish in early October, I believe. So just curious what the dynamics look like over here. The pipeline has been growing quite nicely, but also are you seeing a pickup in redemption notices? Given the market backdrop, just curious how that's playing out there. And then, also if you could give us some color on Kayne's overall performance, I believe the longer term is quite strong, but curious what the one year and the nearer term looks like for the overall AUM.

On the first one, the institutional. So what we're, sort of, referring to is what is it that we're, sort of, aware of here, as we're, what, 3.5 weeks into October. And as I indicated, that's generally looking flattish. And the way I would, sort of, articulate that is, I think a lot of people are just not doing a lot right now, so I wouldn't -- because, again, the month has really been a challenging month. So there's not a lot of activity, but we do have sales in the pipeline and we do think there is some other things that could, eventually, go out in the trending sort of net. We're still happy with, as we pointed in the call, having multiple affiliates having sales in a given quarter is a positive momentum for us because we, sort of, separately had a little bit of some of the smaller legacy business that's just going to run out on a normal basis. So for us, the primary driver is getting the diversity of sales and the growth of the sales, where they are. And as we, sort of, alluded to as we were talking about the flows in this quarter for institutional, which were -- again, were generally flattish, modestly negative, that did include, what we referred to as, a client reallocation to pass the strategies. And that did impact a couple of our equity strategies. We don't see that necessarily, for that situation to be continuing, but who knows what the institutional investors will do, depending on how the rest of the year pans out. And I'm sorry, what was the other part of your question?

And then, just on the overall Kayne Anderson performance. Because a lot of that - a lot of your flows in -- on the institutional side, estimate is driven by Kayne as well. So just curious what the overall leg of -- the nearer term one year looks like for them, across the board? With some of your peers, you've seen -- you keep on deterioration, given what markets are doing. So I was wondering if -- what their overall performance look like in the nearer term.

Yes. We -- I mean, with Kayne and with their focus on the asset classes, in the small caps and the mid caps, a lot of activity you see, related to them, will be influenced by how is the market feeling about those market caps. Kayne -- and I think why Kayne is attractive as a manager is a very disciplined approach to quality investing, right? So that's the way to think of them. So even the periods where they have outperformance or underperformance, the people that are attracted to them are people who like companies with very low debts that have defensible competitive advantages. So actually, from what we've seen over the years, I think 2002, was when we entered into our relationship with Kayne, their approach to investing is actually more attractive, the more volatile and the weaker the equity market is, because, generally, their companies have lower debt and have much more defensible and competitive advantage. So those are the companies they seek to invest in. And so -- but they will be subject to -- as we saw in the second quarter, where there was a high level of demand in the smaller caps and it'll be interesting to see how the rest of the year shakes out. We've seen an uptick in mid cap, which we think is a smart play. For this point in the cycle, it's just the question will be, what is the -- will next 2 months in the quarter look like.

Got it. That's helpful. And then, just on capital, you continue to buy back a modest amount, each quarter. But what will it take to get a little more aggressive, here? I guess, with the deal, kind of, closed behind you now, how are you thinking about buybacks, just given the current value from the stock and the fee -- the free cash flow that you highlighted, like, could you get a little more aggressive? Are you looking to be a little more opportunistic, given what the markets are doing in the overall, sort of, valuation spread of Virtus versus the traditional peers?

Yes. Sure. Great question. And the way I would, sort of, articulate it if you look at it historically, we've had periods where the primary focus of our capital has been repurchases, some it's been investing in acquisitions and in some, it's been launching products. And as I, sort of, indicated in the prepared remarks, a lot of it depends upon facts and circumstances in the quarter, right? So closing on a transaction is fact and circumstance in the quarter, which would cause us to be, obviously, utilizing cash to complete what we think is a great acquisitions to diversify our asset base, give us more non-U. S. exposure and give us assets to a great high conviction growth equity capability. But every quarter is different. And so we do consider all the factors, including how our stock is trading, relative to what we think is reasonable in the peers. And the whole point of us having flexibility in our capital structure is so we can take advantage of opportunities, and in one quarter, it might be a transaction, and in one quarter, it might be, as we've done in the past, very aggressive stock repurchases. So we're pleased at the strength of our balance sheet in terms of what we have available, for seed in cash flow, allows us to prioritize things differently. So I would really look at it as it's something we toggle back and forth between depending upon different things. And our stock price -- the average stock price of our last quarter is different than it has been in the first 3 weeks of this month. So that's something we're very cognizant on.

Our next question comes from Michael Cyprys with Morgan Stanley.

Just wanted to talk a little bit about the seed book and the investment portfolio that you have on the balance sheet. If you could just update us on where those stand. I think, you had some amounts on that in the presentation. If you could just talk a little bit about the composition of where those stand today, what the expectation is for that going forward, either in terms of redeploying, returning to shareholders, and how much would you say is truly accessed at this point?

Yes. I'll start on that. Michael, it's Mike Angerthal. I'll answer in a couple of ways. And I think we've talked about our seed capital range between $100 million and $150 million. And we've been consistent over the last, probably, 1.5 years or so between $100 million and $110 million. As you know, the way we think about those are we're deploying product in there to facilitate organic growth, and I think you're seeing that in products that George alluded to, at Kayne Anderson, like international small cap and others that have been instrumental to the organic growth. So that's not a part of the balance sheet, that really is contributing meaningfully to the return levels that we talked about. That's really the CLO portfolio, which again is like $103 million or $104 million for the quarter. And that's really the impetus that drove the $3.6 million of interest and dividend income that we referred to that, as you know, we do not include in our non-GAAP measure. So that's something that is included in the EBITDA, which we highlighted that was $57 million for the quarter. So it's an important component of generating that cash flow that enables us to execute on some of our capital priorities that George alluded to. So I don't think about those elements as, generally, part of what we would be using to be opportunistic to do other capital activities. When we look at capital overall, we look at the strength of the -- of that $57 million in the quarter, we're generating strong cash flows, enabling on us to execute honest -- meaningful return of capital to shareholders. We paid down a little debt this quarter just to ensure we have continued operating flexibility. And we have a balance sheet that has working capital at the spend level that's, generally, in line with our range and enables us to withstand shocks in the market that we're dealing with now. So I wouldn't look necessarily at our balance sheet assets to be redeployed. I would look to the cash flow that we're generating. And those assets are instrumental for the seed, for product launches and for the CLO, where we're generally supporting our fixed income managers for important product launches on the structured products side.

Great. And just on the CLOs, it's -- it is becoming a larger portion of your AUM base, still small on the grand scheme of things, but up quite significantly over the past couple of years. So maybe just curious, your thoughts on the overall CLO industry, which has also seen a lot of growth but there's also a little bit growing concerns in some pockets around credit quality and user covenant like provisions and some challenges, of some funding of CLO equity in the marketplace, in the past couple of weeks. So just curious what you're seeing today in the marketplace on CLOs, thoughts on the relative source to CLO equity versus that, what's on the books in terms of the balance sheet, in terms of how you're using it. And any color around the composition of that CLO that's on the balance sheet in terms of vertical slices versus just the equity.

Yes. I think I'd start there, a couple of points on that, it's Mike Angerthal. Our CLO exposure -- our balance sheet exposure has been reduced this year, and we were beneficiary of the changes in the risk retention rules. So we are pleased with that. As -- looking to that product on asset under management basis, as George alluded to, our Seix affiliate has a product in the warehouse currently. They are a seasoned issuer going back probably over a decade with -- or 15 years led by George Goudelias and his team. They have a product in the warehouse phase and they have -- also have third-party equity that is generally been a long-term sponsor to them in launching products. And we'll take positions alongside to support and sponsor launches of products, but we have a high degree of confidence in that team. They manage a -- an industry-leading bank loan product as well, so they're very in tune with the market, and we have great degree of confidence in their ability to navigate through these kind of choppy markets. And certainly, the CLO market will go through ebbs and flows, but there are significant participants in there, we have a great degree of confidence in them. Newfleet also has done CLOs in the past, but right now, they're -- they refinanced a transaction this year, but there's nothing currently in the warehouse on the Newfleet side.

Yes. Just on CLOs, just in particular -- because, again, I think you, sort of, alluded to, there's been a little bit of a coverage about trying to make some kind of an analogous connection to cov-lite CLOs and high-risk non-paper]mortgages that were used to create CDOs and CBOs that imploded during the financial crisis. And I don't think it's probably fair to make the analogy because there's a lot of differences in terms of structural differences that have been put in place on those products and the credit quality. So I'm always surprised that the only thing they focus in on is cov-lite, as opposed to the caliber and the quality of the underwriting that's being done in many of those companies like ourselves, which are strong company even if we're below investment grade and in the structural enhancements that are in those products. And we've had CLOs from the pre-financial crisis that made it through the financial crisis. And Seix being a new addition to our family, is a very experienced seasoned issuer. So I'm -- I think people make an over analogy to the mortgage-backed security issues that occurred in the financial crisis.

And just a quick follow-up on that point. The balance sheet position of the CLOs, is that all equity? And to what extent is there any, sort of, use or balance sheet risk around the warehousing phase and the construction of the CLOs?

Of the -- the $103 million is generally first loss equity. We exited some of the debt tranches where we held vertical slices earlier in the year. As per the warehouse phase, we have a capital investment in that, we do expect to securitize. And based on the market conditions, our expectation would be in over the next 3 to 6 month or so. But our exposure there is like $7.5 million. So we made that investment earlier this year.

Our next question comes from Alex Blostein with Goldman Sachs.

First question, just a follow-up to an earlier discussion around flows, so far in October. So you guys highlighted the deal, but in channel was up since you've obviously seen some challenges, I think. Public data would show something in the $500 million, about those range, and a lot of it is coming from Kayne. So maybe comment a little bit on where the strength and flows we've seen from Kayne over the last couple of years, what type of the strategies or what type of accounts, I guess, would that go into? And how should we think about the stickiness of the money that went into that product over the last few years, given sort of the near-term turbulence in the markets?

Well, a couple of things. So for October, so -- what we, sort of, alluded to is that -- so for October, which has just been really an awful month, that we do have negative flows. It was probably the first half, particularly the first half of the year -- first half of the month. And I'd, sort of, give attribution in a couple of categories. One is just the general nature of a volatile and scary month that has caused investors to hesitate, so I think we're seeing some impact on that -- on the sale side. I think you -- we specifically -- and again, also in the first half of the month, had some idiosyncratic reallocations. And then, also you deal with asset classes and how in favor or out of favor they are. And if you saw a little bit of activity in small cap, some of that could be attributable to how did somebody feel about small caps, in terms of where we are in the mortgage cycle and in advance of midterm elections. With the way -- there -- if you're asking specifically about Kayne, and I spoke a little bit about -- earlier about why you would invest with Kayne. And it, again, is because you want to have investments in companies of higher -- generally higher quality and generally that have less debt and less exposure. So you'll be attracted to those in certain markets and not in others. In terms of where the assets are placed, there is both the retail separate accounts as well as mutual funds. And while some of those are in the same firms, generally, sometimes see different behavior in terms of people in separate -- retail separate accounts versus funds. Funds, generally, are more volatile, more in and out than you generally see in separately managed accounts. And then, I think as you know, we also did for 2 of those strategies have some communications regarding soft closes on some of those products, which does always create a little bit of clunkiness as you get around that period of time. But, well, what I would really say and I've seen you and others refer to it, it's hard for me to really read too much into 3.5 weeks into October, which has ended up as it's historically is the most volatile month. So that would really be the characterization, if that helps.

Got it. Yes, that's helpful. And then second question, I was hoping you guys could expand on your earlier comments around changes you're seeing in the institutional appetite for performance fee structures. So maybe talk a little bit about which type of products -- what's the typical arrangement between just a, kind of, base fee versus performance fee. And just broader thoughts on whether or not you expect it to adapt more of those structures, and how that could impact your fee rates in the institutional business.

Yes. And you're right, it's a hybrid type of structure that we're seeing. And we saw at one of our affiliates, Duff & Phelps, one of their clients implemented this type of fee structure where you have a base fee and there's a percentage on a relative analysis of performance versus benchmark. And then, we've seen in the RFP process these type of similar structures, where they will generally have a base fee component and a measurement against a relative benchmark. We actually saw that on one of the mandates that we discussed, that got funded at one of our affiliates this quarter. So we're it more and more from institutional clients to, generally, align interests with the portfolio manager and during the outcome from the clients. So it's something we're monitoring. It's still less than 3% of our total revenue for this period and something -- if it becomes -- continue to become more meaningful, we'll provide more transparency around it. And I think one important thing to note on the $1.3 million that we recognized this quarter, was for a full 1-year period, so I wouldn't expect it to be at that type of level going forward. But it obviously will vary based on performance relative to the benchmark and other factors. But it is something we're seeing a bit more of.

Yes, then the structure makes a lot of sense. What's the typical delta between -- I guess, in terms of you guys seeing, in terms of the cut up reset base fee versus bill all-in the fee prior to the change? I'm just trying to get a flavor for the magnitude of base fee change, ex performance fees.

It's hard. It will vary depending on the asset class. And again, we only have a couple of them. So in some period, the net outcome will be higher, in some periods it will be lower than what the base fee was. So it's hard to characterize that specifically.

Okay. Understood, and then last, just a cleanup question. So Mike, you guys just talked about -- of the interest and dividend, $0.30 this quarter not being captured in your adjusted earnings. And then you also got a tax shield. Back-of-the-envelope, looks like that's almost 20% of your, kind of, reported adjusted earnings number. Any thoughts about shifting the reporting metric to incorporate these items similar to, I guess, a lot of the peers in the space for you guys? And then, with respect to the $0.30 specifically, I think you mentioned it's down sequentially. What was the reason for the decline in this $0.30 and, kind of, interest dividend income, a decent run rate here?

Yes. It's a a good question, and I'll address both parts. I mean, the contribution for the balance sheet investments has increased significantly. And we had an earlier question on that, specifically in the contribution and the makeup of the change materially when we did the RidgeWorth transaction because of the more meaningful CLO business. So we haven't updated our metric, since the transaction. It's something we're spending a lot of time internally looking at. So certainly, from the balance sheet investments, investors look at the cash flow generation of companies like ours and we are spiking out the cash component of that. So it is consistent with what we think investors should be looking at and do look at in evaluating how to value firms like ours. So we are looking carefully at that. Any time we change our performance metrics, we want to be measured and have it in context of what's going on. So we do that very thoughtfully, but it is something under evaluation, especially as it relates to the interest in dividend and income.

On the tax side, that's a little bit more difficult. If there's variance, as you know, in practice, where some bring their cash tax rate or estimate their cash tax rate, we try and point investors to the balance sheet and look at the deferred tax assets on there. And then we highlight the benefit we'll have on the tax shield, so to speak, which provides, as we said, $10.5 million over 15 years. And we've seen investors look at that on a net present value basis to try and ascribe value to that. And you're absolutely right, we're seeing that at a level that's somewhat meaningful, very meaningful when you're looking at stock prices, and we talk about that on an NPV basis. So we'll continue to provide transparency on that. We'll evaluate it in context of the metrics. I'm not as far advanced on that one in the metric as I am on the first item.

Yes. Bottom line is on that, those are 2 items of true economic value that truly create value, either create cash or shield cash outflows for us. And the reason Mike highlights it and we always highlight it is to do what you're doing, which is try to figure how to think about it, because again, those are earning streams that people should be ascribing some form of valuation to.

And then, on your second point, Alex, we had a decline of a little over $1 million quarter-over-quarter on the interest and dividend income, and that's generally due to lower distributions from the CLO investments. And again, as I alluded to, that's the majority of the contribution there. And CLO investments on the equity traunch, as you probably know, don't have coupons -- set coupon rates or yield associated with them, so they could vary period to period. What we've talked about and what we've seen is generally over an annual period, a yield in range of like 6.5% on the balance sheet. So when we think about it, we look at it more over an annual period, and that has been, sort of, the general context of the level we've seen.

Our next question comes from Jeremy Campbell with Barclays.

Most have been asked and answered, but just one, kind of, cleanup question here. I think from some of your peers, I think like the rough relationship between incentive revenue is like 50% of that gets, kind of, given back through the comp line. Is that really, kind of, the applicable ratio to Virtus? So I think, you guys called out like, I think, $3.5 million of incentive-based revenue. Does that mean $1.5 million to $2 million was the contributor to the increase in comp?

Yes. I mean, we typically don't share affiliate level information on what ratio is. I think the better way to look at is on the employment expense line. We highlighted and came in at the low end of the range for this quarter, at 48%. And as you know, there are incentive compensation elements to those fees and it does impact the employment ratio. And, George?

Yes. Again, it's just we don't give detail into the breakdown of all of that. There's so many things that come together in the creation of a sharing in an affiliate comp plan and that -- to give that one piece doesn't really give a lot.

Yes. I'm just trying to -- like is it referred to whopping off that extra piece of -- on the fee rate side for the modeling go forward, for what you guys talked about earlier, I just want to make sure that we're also thinking about the expense line the right way, too.

Yes. And you may want to do just the incremental margin you've talked about at 50%. It's just, all else being equal, a good way to think about it.

Our next question comes from Michael Carrier with Bank of America Merrill Lynch.

Just one for me. Just given what we've seen over the past few quarters in terms of the flow strength and then, what you mentioned in October and obviously the shifting dynamics, kind of, in the market. Just wanted to get your guided sense when you think of the product line up in the distribution and the sales teams, if we're in an environment where maybe some of the small caps or soft closes, maybe it's little bit more interest on the value side. When you think about the products that you guys have, what are the ones that would potentially start to stand out in a, kind of, in a shifting backdrop over the next 12, 24 months?

Yes. I mean, it's a great question, but the big unknown is really, where is the market going? Where do investor preferences go, right? And, generally, a lot of our strategies are more overweight to slightly more defensive or higher quality types of approaches. I definitely think there's a scenario where there is a movement from growth to value. Again, we have value capabilities, so that could be something that could be -- become more interesting for people. The market is volatile. I would think people would want to be more in quality-oriented types of strategies rather than high-octane strategies. We generally don't have a lot of our assets and those types of capabilities. And then, the real question is really, what's happening with interest rates and where do people -- how do they want to access fixed income. And in terms of looking at yield, and right now we, sort of, pointed out that the Seix high income fund is in positive flow, so that right now is attractive. But are people going to be taking a different look at things like investment grade? So the bottom line is the reason that we try to have a variety and a diversity of different managers and capabilities is hopefully that when one is out of favor, the other one in favor, right? So if growth is out of favor and value is in favor, we can play that. And if spread fixed income is out of favor and high-quality sleep at night, investment grade is back in favor, we can play that as well. So we do, sort of, think through that. So in terms of our product suite that we can, sort of, have attractive offerings in different market cycles. I mean, the whole point for us is try to avoid that piece-and-fabric concept, which -- sometimes, it means that things blend out a little bit, but it's good to have the flexibility. So it'll be interesting to see. I think the market will probably decide after the midterm elections and then, later in the year what it wants to be in 2019.

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

Great. Thank you. And I just want to thank everyone for joining us today. And as we always do, I would encourage you to give a call if you have any other further questions. Thanks, and have a great weekend.

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