Revenues are highly dependent on both the value and composition of AUM. The following is a summary of the firm's AUM for each of the years ended December 31, 2008, 2007, and 2006:

                                         Assets Under Management by Product
                                                 As of December 31,
          (in millions)                 2008              2007            2006
          Mutual funds               $     3,114       $     2,910       $ 2,518
          Separate accounts                1,175               998           875
          Private investment funds           221               495           315

          Total AUM                  $     4,510       $     4,403       $ 3,708




  (in millions)                                           2008        2007        2006
  AUM at beginning of year                              $  4,403     $ 3,708     $ 1,531
  Net cash inflows
  mutual funds                                             1,328         362       1,333
  separate accounts                                          812          70         441
  private investment funds                                  (162 )       170         164

                                                           1,978         602       1,938
  Net market appreciation / (depreciation) and income     (1,871 )        93         239

  Increase during the year                                   107         695       2,177

  AUM at end of year                                    $  4,510     $ 4,403     $ 3,708

Consolidated Results of Operations
The following is a discussion of the consolidated results of operations of the Company and a detailed discussion of the Company's revenues and expenses.

                           2008         2007        % Change        2007         2006         % Change
Net income (in
thousands)                $ 3,276      $ 9,932            -67 %    $ 9,932      $ 8,065              23 %

Net income per share
Basic                     $  1.36      $  4.61            -70 %    $  4.61      $  4.51               2 %
Diluted                   $  1.36      $  4.39            -69 %    $  4.39      $  3.63              21 %

Weighted average
shares outstanding (in
thousands)
Basic                       2,400        2,156                       2,156        1,787
Diluted                     2,408        2,264                       2,264        2,220

Year Ended December 31, 2008 compared with Year Ended December 31, 2007 The Company posted net income of $3.3 million ($1.36 per diluted share) for the year ended December 31, 2008, compared with net income of $9.9 million ($4.39 per diluted share) for the year ended December 31, 2007. Net income decreased despite a 2% increase in AUM due to a negative return on the Company's corporate investment portfolio and a loss from Beacon Hill of approximately $1.4 million as it starts up its operation.
Operating expenses increased by 22% in 2008 primarily driven by the following:
• Employee compensation expense increased by 31%, or $6.1 million, primarily due to an increase in overall staff from 42 to 57, long-term equity awards, and an acceleration of vesting of certain restricted stock awards.

• Sales and marketing expenses increased by 26%, or $165 thousand, primarily due to an increase in travel and other marketing expenses related to new business growth during 2008. Despite only a 2% increase in AUM in 2008 compared to 2007, the Company generated over $1.9 billion in net new client assets during 2008.

• Despite continued growth in mutual fund assets under management during 2008, mutual fund administration expense decreased by 6%, or $142 thousand due to a re-negotiation of certain vendor contracts resulting in both expense reductions and a shifting of certain expense obligations directly to the Diamond Hill Funds.

Year Ended December 31, 2007 compared with Year Ended December 31, 2006 The Company posted net income of $9.9 million ($4.39 per diluted share) for the year ended December 31, 2007, compared with net income of $8.1 million ($3.63 per diluted share) for the year ended December 31, 2006. The increase in profitability was directly attributable to an increase in investment advisory and mutual fund administration fees which correlated to an increase in AUM of $695 million during 2007. The increase in profitability was achieved despite a 98% decrease in performance incentive fees due to investment performance in client portfolios not exceeding the hurdle rate.
Operating expenses increased by 23% in 2007 primarily driven by the following:
• Employee compensation expense increased by 10%, or $1.9 million, primarily due to an increase in overall staff from 31 to 42.

• Consistent with continued growth in mutual fund assets under management, mutual fund administration expense increased by 44%, or $735 thousand.

• Consistent with higher investment advisory incentive fees, third party distribution expenses increased by 94%, or $731 thousand. A large portion of this increase was related to an increase in assets of the Company's private investment funds.

Revenue

(in Thousands)              2008          2007         % Change         2007          2006         % Change
Investment advisory       $ 40,486      $ 35,165             15%      $ 35,165      $ 20,247             74%
Performance incentive          379           174            118%           174         7,947            -98%
Mutual fund
administration, net          6,154         5,969              3%         5,969         3,710             61%

Total                       47,019        41,308             14%        41,308        31,904             29%

Revenue for the Year Ended December 31, 2008 compared with Year Ended December 31, 2007
As a percent of total 2008 revenues, investment advisory fees account for 86%, performance incentive fees account for less than 1%, and mutual fund administration fees make up the remaining 13%. This compares to 85%, less than 1%, and 14%, respectively, for 2007.
Investment Advisory Fees. Investment advisory fees are generally calculated as a percentage of average net AUM at various levels depending on the investment product. The Company's average advisory fee rate for the year ended December 31, 2008 was 0.81% compared to 0.83% for the year ended December 31, 2007. Effective June 30, 2008, the Diamond Hill Long-Short Fund, which has a 0.90% advisory fee, was closed to new investors. As a result, there was a decrease in the cash flows into that Fund during the second half of 2008. In addition, there were cash outflows from the Long-Short Fund during the second half of the year resulting in a decrease in assets for that Fund of 26%. These factors contributed to the slight decrease in the average advisory fee rate for 2008 compared to 2007. The overall increase in investment advisory fees year over year was primarily due to an increase in AUM throughout 2008. Despite the modest increase in AUM from $4.4 billion at December 31, 2007 to $4.5 billion at December 31, 2008, average AUM for the entire year was approximately $4.9 billion, which was the primary driver of the increase in investment advisory fees in 2008 compared to 2007. Performance Incentive Fees. Performance incentive fees are generally equal to 20% of the performance increase in client accounts after a 5% annual hurdle is achieved. The fees are dependent on both AUM and absolute investment performance in client accounts and can be very volatile from period to period. Incentive fee AUM totaled $378 million at December 31, 2008 compared to $581 million at the end of 2007. Incentive fee revenue for both 2008 and 2007 was relatively immaterial due to the absolute performance of the Company's incentive fee products. While the Company's incentive fee products have performed well in 2008 relative to the broader stock market indexes they still have declined substantially on an absolute basis. Given that most of the incentive fee assets have a high water mark and an annual absolute return hurdle, it is unlikely the Company will earn any meaningful incentive fees until significant positive client returns are generated or new client money is invested in the products.

Mutual Fund Administration Fees. Mutual fund administration fees are calculated as a percentage of average net assets under administration in the Diamond Hill Funds. The Company earns 0.30% on Class A and Class C shares and 0.18% on Class I shares. As assets in the Funds have grown, the Company has realized certain economies of scale; and as a result, the Company has lowered its administration fees each of the last four years to pass on those economies of scale to fund shareholders. Despite these fee reductions, fund administration revenues increased by $185 thousand over 2007 due to the increase in assets under administration.
Revenue for the Year Ended December 31, 2007 compared with Year Ended December 31, 2006
As a percent of total 2007 revenues, investment advisory fees account for 85%, performance incentive fees account for less than 1%, and mutual fund administration fees make up the remaining 14%. This compares to 63%, 25%, and 12%, respectively, for 2006.
Investment Advisory Fees. Investment advisory fees are generally calculated as a percentage of average net AUM at various levels depending on the investment product. The Company's average advisory fee rate for the year ended December 31, 2007 was 0.83% compared to 0.76% for the year ended December 31, 2006. This increase was mainly due to the increase in assets under management in the long-short products, which have a higher advisory fee. The overall increase in investment advisory fees year over year was primarily due to an increase in AUM of $695 million in 2007.
Performance Incentive Fees. Performance incentive fees are equal to 20% of the performance increase in client accounts after a 5% annual hurdle is achieved. The fees are dependent on both AUM and absolute investment performance in client accounts and can be very volatile from period to period. Incentive fee AUM totaled $581 million at December 31, 2007 compared to $374 million at the end of 2006. Despite the 55% increase in incentive fee AUM, absolute investment performance in client accounts during 2007 generally did not exceed the required 5% annual hurdle and therefore performance incentive fees were down 98% compared to 2006.
Mutual Fund Administration Fees. Mutual fund administration fees are calculated as a percentage of average net assets under administration in the Diamond Hill Funds. In 2007, the Company earned 0.32% on Class A and Class C shares and 0.18% on Class I shares. As assets in the Funds grew the Company realized certain economies of scale; and as a result, the Company has lowered its administration fees by approximately 10% in each of 2007, 2006, and 2005 to pass on those economies of scale to fund shareholders. Despite lowering fees by 11% during 2007, fund administration revenues increased by $2.3 million over 2006 due to the increase in assets under administration.

Expenses

(in Thousands)              2008          2007        % Change         2007          2006         % Change
Compensation and
related costs             $ 26,120      $ 20,007            31%      $ 20,007      $ 18,148             10%
General and
administrative               2,643         2,659            -1%         2,659         1,137            134%
Sales and marketing            796           632            26%           632           384             65%
Third party
distribution                 1,452         1,512            -4%         1,512           781             94%
Mutual fund
administration               2,279         2,420            -6%         2,420         1,686             44%

Total                       33,290        27,230            22%        27,230        22,136             23%

Expenses for the Year Ended December 31, 2008 compared with Year Ended December 31, 2007
Compensation and Related Costs. Employee compensation and benefits increased by $6.1 million, or 31%, in 2008, primarily due to a 36% increase in the number of staff, long-term equity awards, and the accelerated vesting of certain restricted stock awards.
Incentive compensation for 2008 totaled $13,000,000 an increase of $550,000 or 4% from 2007. Under the Company's 2006 performance based compensation plan the compensation committee of the board of directors establishes annual operating profit margin (OPM) targets to be used to determine the incentive pool and officer awards. For 2008 the OPM target was approximately 35% based on actual revenue of approximately $47 million. Under the plan the operating results of Beacon Hill are excluded from this determination. After consideration of a number of factors management recommended, and the compensation committee approved, a reduction of the OPM for the year to 32.3% which increased the incentive pool by approximately $1.3 million and reduced the incentive awards made to officers by 10.4%. Management felt that certain unusual expenses, particularly the impact of accelerated vesting for non-officer restricted stock awards from 2009 to 2008, resulted in a pool that was inadequate. The accelerated vesting increased compensation expense by approximately $1 million and was done in part to generate a $6.7 million tax deduction which reduced the company's tax liability for 2008 and also contributed towards generating sufficient negative tax earnings and profits for 2008 such that the character of the special cash dividend paid in the fourth quarter was 100% return of capital. General and Administrative. General and administrative expenses decreased by $16 thousand, or 1%. During 2007, the Company experienced a $452 thousand loss due to a trading error causing an increase in the general and administrative expenses during that period. Excluding the trading error, general and administrative expenses increased by $436 thousand, or 19%, period over period to support the continued growth of the Company.
Sales and Marketing. Sales and marketing expenses increased by $164 thousand, or 26%, during 2008. This increase is commensurate with the increase in investment advisory revenue and was primarily due to increased expense related to marketing materials and additional travel related expense incurred related to new business attained during the year.
Third Party Distribution. Third party distribution expense represents payments made to third party intermediaries directly related to sales made by those parties of the Company's investment products. 94% and 99% of this expense in 2008 and 2007, respectively, is related to client investments in the Company's private investment funds. The remainder represents payments related to sales in the Company's mutual fund products. The period over period increase or decrease directly corresponds to the increase or decrease in investment advisory fees earned by the Company.
Mutual Fund Administration. Mutual fund administration expenses decreased by $141 thousand during 2008. A large portion of mutual fund administration expense is calculated based on a percent of assets under administration in the Diamond Hill Funds. Despite the increase in mutual fund AUM in 2008 compared to 2007, the decrease is attributable to a re-negotiation of certain vendor contracts resulting in both expense reductions and a shifting of certain expense obligations directly to the Diamond Hill Funds. Absent this contract re-negotiation, mutual fund administration expenses generally correlate with an increase or decrease in mutual fund assets under administration. Expenses for the Year Ended December 31, 2007 compared with Year Ended December 31, 2006
Compensation and Related Costs. Employee compensation and benefits increased by $1.9 million, or 10%, in 2007, primarily due to a 31% increase in the number of staff.
General and Administrative. The increase in general and administrative expenses of $1.5 million, or 134%, resulted from general increases associated with the overall growth of the Company and an increase in expenditures for investment research and portfolio accounting systems. Additionally, during the third quarter of 2007 the Company incurred a $452 thousand loss related to a trading error in a client account.

Sales and Marketing. Sales and marketing expenses increased by $248 thousand, or 65% during 2007. This increase was commensurate with the increase in investment advisory revenue and was primarily due to increased expense related to marketing materials and additional travel related expense incurred related to new business attained during the year.
Third Party Distribution. Third party distribution expense represents payments made to third party intermediaries directly related to sales made by those parties of the Company's investment products. Substantially all of this expense in 2007 and 2006 was related to new client investments in the Company's private investment funds. The year over year increases directly correspond to the increase in investment advisory fees earned by the Company.
Mutual Fund Administration. Mutual fund administration expenses increased by $734 thousand during 2007. A large portion of mutual fund administration expense is calculated based on a percent of assets under administration in the Diamond Hill Funds. The year over year increases are consistent with the continued growth in assets under administration.
Beacon Hill Fund Services
During 2008, Beacon Hill generated a pre-tax loss of $1.4 million on $117 thousand in revenue as it substantially completed its infrastructure. It is currently staffed with seven experienced professionals and expects to receive a limited purpose broker/dealer license in the first quarter of 2009. Beacon Hill has been actively marketing its services and has commitments from several clients to commence services at various starting dates throughout 2009. These commitments are annually recurring engagements; however, there is no guarantee that the associated revenue will be realized. The Company hopes Beacon Hill will achieve a run rate breakeven by the end of 2009. Liquidity and Capital Resources
The Company's entire investment portfolio is in readily marketable securities, which provide for cash liquidity, if needed. Investments in mutual funds are valued at their quoted current net asset value. Investments in private investment funds and equity securities are valued independently based on readily available market quotations. Inflation is expected to have no material impact on the Company's performance.
As of December 31, 2008, the Company had working capital of approximately $24.1 million compared to $37.5 million at December 31, 2007. Working capital includes cash, securities owned and accounts receivable, net of all liabilities. The Company has no debt and its available working capital is expected to be sufficient to cover current expenses. The Company does not expect any material capital expenditures during 2009.
Operating activities during 2008 provided cash flows of $17.4 million, up $7.4 million from 2007, including a decrease in net income of $6.6 million, non-cash stock-based compensation expense of $4.3 million, a change in unrealized gain/loss of $2.9 million and increase in accrued liabilities of $9.7 million. Net cash provided in investing activities totaled $13 million, compared to net cash used in investing activities of $15 million in 2007. Capital spending for property and equipment decreased to $363 thousand in 2008, a decline of $59 thousand from 2007. Net cash used by financing activities was $26.6 million in 2008, compared to net cash provided by financing activities of $7.5 million in 2007. Substantially all of this increase in cash used by financing activities related to the $24.4 million dividend payment made in 2008. Operating activities during 2007 provided cash flows of $10 million, down $8.1 million from 2006, including increased net income of $1.9 million and non-cash stock-based compensation expense of $1.4 million. Net cash used in investing activities totaled $15 million, up just over $4 million from 2006. The Company's investments in mutual funds and equity securities made from its larger available cash balances were $15.3 million in 2007, up $4.1 million from 2006. Decreased capital spending for property and equipment was $304 thousand in 2007, a decline of $151 thousand from 2006. Net cash provided by financing activities was $7.5 million in 2007, up $6.7 million from 2006. Substantially all of this increase was due to common stock issued during 2007 relating to the exercise of options and warrants.

Selected Quarterly Information
Unaudited quarterly results of operations for the years ended December 31, 2008
and 2007 is summarized below:

                                                       At or For the Quarter Ended
                                         2008                                                2007
(in thousands)       12/31        09/30        06/30        03/31        12/31        09/30        06/30        03/31
Assets Under
Management (in
millions)           $  4,510     $  5,548     $  5,486     $  4,665     $  4,403     $  4,380     $  4,479     $ 4,169
Total revenue         10,372       13,348       12,396       10,903       10,883       10,701       10,369       9,355
Total operating
expenses               8,447        9,126        8,340        7,378        6,847        7,168        6,947       6,268

Operating income       1,925        4,222        4,056        3,525        4,036        3,533        3,422       3,087


Investment Return     (4,180 )     (2,319 )     (1,331 )       (375 )        175          534          230         (30 )

Net income (loss)   $ (1,713 )   $  1,224     $  1,779     $  1,986     $  2,876     $  2,648     $  2,414     $ 1,994


Diluted EPS         $  (0.70 )   $   0.50     $   0.73     $   0.82     $   1.23     $   1.14     $   1.05     $  0.91


Diluted shares
outstanding            2,455        2,444        2,447        2,426        2,335        2,322        2,302       2,196

The net loss in the fourth quarter of 2008 is due to significant deterioration of overall market in the fourth quarter of 2008, which caused an 18.7% decrease in AUM in the fourth quarter of 2008 compared to third quarter 2008. This decrease in AUM had a direct correlation with the decrease in revenue during the fourth quarter of 2008 compared to third quarter 2008 as revenue is generated based upon AUM. In addition, the corporate investment portfolio had a net loss of $4.1 million in fourth quarter 2008, which further contributed to the decrease in net income for the quarter ended December 31, 2008. Contractual Obligations
The following table presents a summary of the Company's future obligations under the terms of an operating lease and other contractual purchase obligations at December 31, 2008. Other purchase obligations include contractual amounts that will be due for the purchase of services to be used in the Company's operations such as mutual fund sub-administration and portfolio accounting software. These obligations may be cancelable at earlier times than those indicated under certain conditions that may involve termination fees. Because these obligations are of a normal recurring nature, the Company expects that it will fund them from future cash flows from operations. The information presented does not include operating expenses or capital expenditures that will be committed in the normal course of operations in 2009 and future years:

                                                                   Payments Due by Period
                                  Total            2009          2010-2011       2012-2013          Later
Operating lease obligations    $ 1,159,000      $   259,000      $  516,000      $  384,000      $         -
Purchase obligations             2,486,000        2,326,000         160,000               -                -

Total                          $ 3,645,000      $ 2,585,000      $  676,000      $  384,000      $         -

Off-Balance Sheet Arrangements
The Company has no off-balance sheet arrangements. It does not have any obligation under a guarantee contract, or a retained or contingent interest in assets or similar arrangement that serves as credit, liquidity or market risk support for such assets, or any other obligation, including a contingent obligation, under a contract that would be accounted for as a derivative instrument or arising out of a variable interest.

Critical Accounting Policies and Estimates Provisions for Income Tax Taxes. The Company accounts for income taxes in accordance with SFAS No. 109, "Accounting for Income Taxes." The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity's financial statements or tax returns. Judgment is required in assessing the future tax consequences of events that have been recognized in the Company's financial statements or tax returns.
Revenue Recognition on Incentive-Based Advisory Contracts. The Company has certain investment advisory contracts in which a portion of the fees are based on investment performance achieved in the respective client portfolio in excess of 5%. EITF Abstract Topic No. D-96, "Accounting for Management Fees Based on a Formula," identifies two methods by which incentive revenue may be recorded. Under "Method 1," incentive fees are recorded at the end of the contract year. Under "Method 2," incentive fees are recorded periodically and calculated as the amount that would be due under the formula at any point in time as if the contract was terminated at that date. Management has chosen the more . . .