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PZN > SEC Filings for PZN > Form 10-Q on 6-Aug-2013All Recent SEC Filings

Show all filings for PZENA INVESTMENT MANAGEMENT, INC. | Request a Trial to NEW EDGAR Online Pro

Form 10-Q for PZENA INVESTMENT MANAGEMENT, INC.


6-Aug-2013

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

Overview

We are a public-equity investment management firm that utilizes a classic value investment approach across all of our investment strategies. We currently manage assets in a variety of value-oriented investment strategies across a wide range of market capitalizations in both U.S. and non-U.S. capital markets. At June 30, 2013, our assets under management, or AUM, was $20.3 billion. We manage separate accounts on behalf of institutions and high net worth individuals, and act as sub-investment adviser for a variety of SEC-registered mutual funds and non-U.S. funds.

We function as the sole managing member of our operating company, Pzena Investment Management, LLC (the "operating company"). As a result, we:
(i) consolidate the financial results of our operating company with our own, and reflect the membership interest in it that we do not own as a non-controlling interest in our consolidated financial statements; and (ii) recognize income generated from our economic interest in our operating company's net income. As of June 30, 2013, the holders of Class A common stock (through the Company) and the holders of Class B units of our operating company held approximately 18.9% and 81.1%, respectively, of the economic interests in the operations of our business.

Non-GAAP Net Income

Our results for the three and six months ended June 30, 2013 and 2012 included recurring adjustments related to the Company's tax receivable agreement and the associated liability to its selling and converting shareholders. We believe that these accounting adjustments add a measure of non-operational complexity which partially obscures the underlying performance of our business. In evaluating our financial condition and results of operations, we also review certain non-GAAP measures of earnings, which exclude these items. Excluding these adjustments, non-GAAP diluted net income and non-GAAP diluted earnings per share were $6.3 million and $0.09, respectively, for the three months ended June 30, 2013 and $4.5 million and $0.07, respectively, for three months ended June 30, 2012. Excluding these adjustments, non-GAAP diluted net income and non-GAAP diluted earnings per share were $12.0 million and $0.18, respectively, for the six months ended June 30, 2013 and $10.1 million and $0.15, respectively, for six months ended June 30, 2012. GAAP and non-GAAP net income for diluted earnings per share generally assumes all operating company membership units are converted into Company stock at the beginning of the reporting period, and the resulting change to our net income associated with our increased interest in the operating company is taxed at our effective tax rate, exclusive of other adjustments, and the adjustments related to our tax receivable agreement and the associated liability to selling and converting shareholders. Our effective tax rate, exclusive of these adjustments, was approximately 41.6% for each of the three and six months ended June 30, 2013 and 42.8% for each of the three and six months ended June 30, 2012. See "Operating Results - Income Tax Expense" below.

We use these non-GAAP measures to assess the strength of the underlying operations of the business. We believe that these adjustments, and the non-GAAP measures derived from them, provide information to better analyze our operations between periods, and over time. We also use non-GAAP net income as one factor in determining the amount of dividends we pay. See "Dividend Policy" below. Investors should consider these non-GAAP measures in addition to, and not as a substitute for, financial measures prepared in accordance with GAAP.


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A reconciliation of the non-GAAP measures to the most comparable GAAP measures is included below:

                                          For the Three Months Ended June 30,              For the Six Months Ended June 30,
                                             2013                     2012                   2013                     2012
                                                            (In thousands, except share and per share data)
GAAP Net Income                      $           1,266         $             614     $           2,435         $           1,621
Net Effect of Tax Receivable
Agreement                                          (41 )                     131                  (227 )                      35
Non-GAAP Net Income                  $           1,225         $             745     $           2,208         $           1,656
GAAP Net Income Attributable to
Non-Controlling Interest of Pzena
Investment Management, LLC           $           8,715         $           6,508     $          16,829         $          14,717
Less: Assumed Corporate Income Taxes             3,623                     2,789                 6,996                     6,306
Assumed After-Tax Income of Pzena
Investment Management, LLC                       5,092                     3,719                 9,833                     8,411
Non-GAAP Net Income of Pzena
Investment Management, Inc.                      1,225                       745                 2,208                     1,656
Non-GAAP Diluted Net Income          $           6,317         $           4,464     $          12,041         $          10,067
Non-GAAP Diluted Earnings Per Share
Attributable to
Pzena Investment Management, Inc.
Common Stockholders:
Non-GAAP Net Income for Diluted
Earnings per Share                   $           6,317         $           4,464     $          12,041         $          10,067
Non-GAAP Diluted Earnings Per Share  $            0.09         $            0.07     $            0.18         $            0.15
Non-GAAP Diluted Weighted-Average
Shares Outstanding                          66,562,823                65,426,774            66,550,266                65,395,327

Revenue

We generate revenue primarily from management fees and performance fees, which we collectively refer to as our advisory fees, by managing assets on behalf of institutional accounts and for retail clients, which are generally open-end mutual funds catering primarily to retail investors. Our advisory fee income is recognized over the period in which investment management services are provided. Following the preferred method identified in the Revenue Recognition Topic of the Financial Accounting Standards Board Accounting Standards Codification ("FASB ASC"), income from performance fees is recorded at the conclusion of the contractual performance period, when all contingencies are resolved.

Our advisory fees are primarily driven by the level of our AUM. Our AUM increases or decreases with the net inflows or outflows of funds into our various investment strategies and with the investment performance thereof. In order to increase our AUM and expand our business, we must develop and market investment strategies that suit the investment needs of our target clients, and provide attractive returns over the long term. The value and composition of our AUM, and our ability to continue to attract clients, will depend on a variety of factors including, among other things:

• our ability to educate our target clients about our classic value investment strategies and provide them with exceptional client service;

• the relative investment performance of our investment strategies, as compared to competing products and market indices;

• competitive conditions in the investment management and broader financial services sectors;

• general economic conditions;

• investor sentiment and confidence; and

• our decision to close strategies when we deem it to be in the best interests of our clients.


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For our institutional accounts, we are paid fees according to a schedule, which varies by investment strategy. The substantial majority of these accounts pay us management fees pursuant to a schedule in which the rate we earn on the AUM declines as the amount of AUM increases.

Pursuant to our sub-investment advisory agreements with our retail clients, we are generally paid a management fee according to a schedule in which the rate we earn on the AUM declines as the amount of AUM increases. Certain of these funds pay us fixed-rate management fees. Due to the substantially larger account size of certain of these accounts, the average advisory fees we earn on them, as a percentage of AUM, are lower than the advisory fees we earn on our institutional accounts.

Certain of our clients pay us fees according to the performance of their accounts relative to certain agreed-upon benchmarks, which results in a lower base fee, but allows us to earn higher fees if the relevant investment strategy outperforms the agreed-upon benchmark.

The majority of advisory fees we earn on institutional accounts is based on the value of our AUM at a specific date on a quarterly basis, either in arrears or advance. Advisory fees on certain of our institutional accounts, and with respect to all of our retail accounts, are calculated based on the average of the monthly or daily market value. Advisory fees are also generally adjusted for any cash flows into or out of a portfolio, where the cash flow represents greater than 10% of the value of the portfolio. While a specific group of accounts may use the same fee rate, the method used to calculate the fee according to the fee rate schedule may differ as described above.

Our advisory fees may fluctuate based on a number of factors, including the following:

• changes in AUM due to appreciation or depreciation of our investment portfolios, and the levels of the contribution and withdrawal of assets by new and existing clients;

• distribution of AUM among our investment strategies, which have differing fee schedules;

• distribution of AUM between institutional accounts and retail accounts, for which we generally earn lower overall advisory fees; and

• the level of our performance with respect to accounts on which we are paid performance fees.

Expenses

Our expenses consist primarily of Compensation and Benefits Expense, as well as General and Administrative Expense. Our largest expense is Compensation and Benefits, which includes the salaries, bonuses, equity-based compensation, and related benefits and payroll costs attributable to our employee members and employees. Compensation and benefits packages are benchmarked against relevant industry and geographic peer groups in order to attract and retain qualified personnel. General and Administrative Expense includes office rent and other expenses, professional and outside services fees, depreciation, and the costs associated with operating and maintaining our research, trading, and portfolio accounting systems. Our occupancy-related costs and professional services expenses, in particular, generally increase or decrease in relative proportion to the overall size and scale of our business operations.

We incur additional expenses associated with being a public company for, among other things, director and officer insurance, director fees, SEC reporting and compliance (including Sarbanes-Oxley and Dodd-Frank compliance), professional fees, transfer agent fees, and other similar expenses. These additional expenses have and will continue to reduce our net income.

Our expenses may fluctuate due to a number of factors, including the following:

• variations in the level of total compensation expense due to, among other things, bonuses, awards of equity to our employees and employee members of our operating company, changes in our employee count and mix, and competitive factors; and

• general and administrative expenses, such as rent, professional service fees and data-related costs, incurred, as necessary, to run our business.

Other Income/(Expense)


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Other Income/(Expense) is derived primarily from investment income or loss arising from our consolidated subsidiaries, income or loss generated by our investments in third-party mutual funds, and interest income generated on our cash balances. Other Income/(Expense) is also affected by changes in our estimates of the liability due to our selling and converting shareholders associated with payments owed to them under the tax receivable agreement which was executed in connection with our reorganization and initial public offering on October 30, 2007. As discussed further below under "Tax Receivable Agreement," this liability represents 85% of the amount of cash savings, if any, in U.S. federal, state, and local income tax that we realize as a result of the amortization of the increases in tax basis generated from our acquisitions of our operating company's units from our selling and converting shareholders. We expect the interest and investment components of Other Income/(Expense), in the aggregate, to fluctuate based on market conditions and the performance of our consolidated investment partnerships and other investments.
Non-Controlling Interests

Our operating company has historically consolidated the results of operations of the private investment partnerships over which we exercise a controlling influence. We are the sole managing member of our operating company and control its business and affairs and, therefore, consolidate its financial results with ours. In light of our employees' and outside investors' interest in our operating company, we have reflected their membership interests as a non-controlling interest in our consolidated financial statements. As a result, our income is generated by our economic interest in our operating company's net income. As of June 30, 2013, the holders of Class A common stock (through the Company) and the holders of Class B units of the operating company held approximately 18.9% and 81.1%, respectively, of the economic interests in the operations of the business.

Operating Results

Assets Under Management and Flows

As of June 30, 2013, our approximately $20.3 billion of AUM was invested in a variety of value-oriented investment strategies, representing distinct capitalization segments of U.S. and non-U.S. equity markets. The performance of our largest investment strategies as of June 30, 2013 is further described below. We follow the same investment process for each of these strategies. Our investment strategies are distinguished by the market capitalization ranges from which we select securities for their portfolios, which we refer to as each strategy's investment universe, as well as the regions in which we invest and the degree to which we concentrate on a limited number of holdings. While our investment process includes ongoing review of companies in the investment universes described below, our actual investments may include companies outside of the relevant market capitalization range at the time of our investment. In addition, the number of holdings typically found in the portfolios of each of our investment strategies may vary, as described below.

The following table indicates the annualized returns, gross and net (which represents annualized returns prior to, and after, payment of advisory fees, respectively), of our six largest investment strategies from their inception to June 30, 2013, and in the five-year, three-year, and one-year periods ended June 30, 2013, as well as the performance of the market index which is most commonly used by our clients to compare the performance of the relevant investment strategy over those time periods.


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                                                       Period Ended June 30, 20131
Investment Strategy (Inception
Date)                                  Since Inception        5 Years       3 Years       1 Year
Large Cap Focused Value (October
2000)
Annualized Gross Returns                       6.2 %              8.6 %        18.0 %        32.7 %
Annualized Net Returns                         5.7 %              8.1 %        17.5 %        32.1 %
Russell 1000® Value Index                      5.4 %              6.7 %        18.5 %        25.3 %
Global Focused Value (January 2004)
Annualized Gross Returns                       4.2 %              3.5 %        13.8 %        31.0 %
Annualized Net Returns                         3.4 %              2.8 %        13.1 %        30.2 %
MSCI(SM) World Index-Net/U.S.$2                5.6 %              2.7 %        13.7 %        18.6 %
Large Cap Expanded Value (July
2012)
Annualized Gross Returns                      33.6 %                -             -          33.6 %
Annualized Net Returns                        33.4 %                -             -          33.4 %
Russell 1000® Value Index                     25.3 %                -             -          25.3 %
International (ex-U.S) Expanded
Value (November 2008)
Annualized Gross Returns                      14.5 %                -          12.3 %        28.3 %
Annualized Net Returns                        14.2 %                -          12.0 %        27.9 %
MSCI® EAFE Index-Net/U.S.$2                    9.5 %                -          10.1 %        18.6 %
Focused Value (January 1996)
Annualized Gross Returns                      10.8 %              9.7 %        19.3 %        33.1 %
Annualized Net Returns                         9.9 %              9.0 %        18.6 %        32.4 %
Russell 1000® Value Index                      8.4 %              6.7 %        18.5 %        25.3 %
Small Cap Focused Value (January
1996)
Annualized Gross Returns                      14.1 %             15.5 %        19.0 %        28.4 %
Annualized Net Returns                        12.8 %             14.3 %        17.8 %        27.2 %
Russell 2000® Value Index                      9.9 %              8.6 %        17.3 %        24.8 %

1 The historical returns of these investment strategies are not necessarily indicative of their future performance, or the future performance of any of our other current or future investment strategies.

2 Net of applicable withholding taxes and presented in U.S. $.

Large Cap Focused Value. We screen a universe of the 500 largest U.S. listed companies, based on market capitalization, to build a portfolio generally consisting of 30 to 40 stocks. We launched this strategy in October 2000. At June 30, 2013, the Large Cap Focused Value strategy generated a one-year gross return of 32.7%, outperforming its benchmark. The main drivers of this outperformance were our exposure to the financial services and technology sectors, an underweight position in the utilities sector, and the portfolio's housing-related holdings, partially offset by certain holdings in the consumer discretionary and energy sectors.

Global Focused Value. We screen a universe of the 1,500 largest non U.S. listed companies, based on market capitalization, and the 500 largest U.S. listed companies, based on market capitalization, to build a portfolio generally consisting of 40 to 60 stocks. We launched this strategy in January 2004. At June 30, 2013, the Global Focused Value strategy generated a one-year gross return of 31.0%, outperforming its benchmark. The portfolio's top contributors to relative performance were the financial services, industrials, information technology, and materials sectors. This outperformance was partially offset by certain stocks in the energy sector.

Large Cap Expanded Value. We screen a universe of the 500 largest U.S. listed companies, based on market capitalization, to build a portfolio generally consisting of 50 to 80 stocks. We launched this strategy in July 2012. At June 30,


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2013, the Large Cap Expanded Value strategy generated a one-year gross return of 33.6%, outperforming its benchmark. This outperformance was driven primarily by the financial services sector, our underweight exposure to the utilities sector and the portfolio's housing-related holdings, partially offset by certain holdings in the consumer discretionary and energy sectors.

International (ex-U.S.) Expanded Value. We screen a universe of the 1,500 largest non-U.S. listed companies, based on market capitalization, to build a portfolio generally consisting of 60 to 80 stocks. We launched this strategy in November 2008. At June 30, 2013, the International (ex-U.S.) Expanded Value strategy generated a one-year gross return of 28.3%, outperforming its benchmark. The largest contributors to this outperformance was our stock selection in the industrials, materials, consumer discretionary and financial services sectors, partially offset by our overweight investment exposure to the energy sector.

Focused Value. We screen a universe of the 1,000 largest U.S. listed companies, based on market capitalization, to build a portfolio generally consisting of 30 to 40 stocks. We launched this strategy in January 1996. At June 30, 2013, the Focused Value strategy generated a one-year gross return of 33.1%, outperforming its benchmark. The main contributors to this outperformance were our exposure to the financial services sector, the portfolio's housing-related holdings, and underweight investment exposure to the utilities sector, partially offset by certain holdings in the consumer discretionary sector.

Small Cap Focused Value. We screen a universe of U.S. listed companies ranked from the 1,001st to 3,000th largest, based on market capitalization, to build a portfolio generally consisting of 40 to 50 stocks. We launched this strategy in January 1996. At June 30, 2013, the Small Cap Focused Value strategy generated a one-year gross return of 28.4%, outperforming its benchmark. A broad number of holdings across a diverse range of industries contributed to this outperformance, specifically certain stocks in the financial services, healthcare, and materials and processing sectors. This outperformance was partially offset by certain stocks in the consumer discretionary sector.

Our earnings and cash flows are heavily dependent upon prevailing financial market conditions. Significant increases or decreases in the various securities markets, particularly the equities markets, can have a material impact on our results of operations, financial condition, and cash flows.

The change in AUM in our institutional accounts and our retail accounts for the three, six and twelve months ended June 30, 2013 and 2012 is described below. Inflows are composed solely of the investment of new or additional assets by new or existing clients. Outflows consist solely of redemptions of assets by existing clients.


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Assets Under Management
($ billions)
                                 For the Three Months Ended June 30,          For the Six Months Ended June 30,          For the Twelve Months Ended June 30,
                                     2013                   2012                 2013                   2012                  2013                    2012

Institutional Accounts
 Assets
   Beginning of Period        $          12.2         $          12.2     $          11.2         $          11.3     $           10.9         $           12.9
     Inflows                              0.1                     0.3                 0.5                     0.4                  0.8                      1.4
     Outflows                            (0.4 )                  (0.7 )              (0.9 )                  (1.6 )               (2.2 )                   (2.5 )
     Net Flows                           (0.3 )                  (0.4 )              (0.4 )                  (1.2 )               (1.4 )                   (1.1 )
     Market
Appreciation/(Depreciation)               0.7                    (0.9 )               1.8                     0.8                  3.1                     (0.9 )
   End of Period              $          12.6         $          10.9     $          12.6         $          10.9     $           12.6         $           10.9

Retail Accounts
 Assets
   Beginning of Period
Assets                        $           7.3         $           2.5     $           5.9         $           2.2     $            2.2         $            3.0
     Inflows                              0.3                     0.1                 1.1                     0.3                  4.8                      0.7
     Outflows                            (0.4 )                  (0.2 )              (0.6 )                  (0.4 )               (1.1 )                   (1.3 )
     Net Flows                           (0.1 )                  (0.1 )               0.5                    (0.1 )                3.7                     (0.6 )
     Market
Appreciation/(Depreciation)               0.5                    (0.2 )               1.3                     0.1                  1.8                     (0.2 )
   End of Period              $           7.7         $           2.2     $           7.7         $           2.2     $            7.7         $            2.2

Total
 Assets
   Beginning of Period        $          19.5         $          14.7     $          17.1         $          13.5     $           13.1         $           15.9
     Inflows                              0.4                     0.4                 1.6                     0.7                  5.6                      2.1
     Outflows                            (0.8 )                  (0.9 )              (1.5 )                  (2.0 )               (3.3 )                   (3.8 )
     Net Flows                           (0.4 )                  (0.5 )               0.1                    (1.3 )                2.3                     (1.7 )
     Market
Appreciation/(Depreciation)               1.2                    (1.1 )               3.1                     0.9                  4.9                     (1.1 )
   End of Period              $          20.3         $          13.1     $          20.3         $          13.1     $           20.3         $           13.1


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The following table describes the allocation of our AUM among our investment strategies, as of June 30, 2013 and 2012:

                                AUM at June 30,
Investment Strategy              2013         2012
                                 (in billions)
U.S. Value Strategies1      $    13.5        $  7.2
Global Value Strategies1          4.6           3.9
Non-U.S. Value Strategies         2.2           2.0
Total                       $    20.3        $ 13.1

1 During 2013, approximately $0.1 billion of previously reported assets under management in U.S. Value Strategies has been reclassified to Global Value Strategies. Historical information has been reclassified for all periods presented.

Three Months Ended June 30, 2013 versus June 30, 2012

At June 30, 2013, we managed $12.6 billion in institutional accounts and $7.7 billion in retail accounts, for a total of $20.3 billion in assets. For the three months ended June 30, 2013, we experienced market appreciation of $1.2 billion and total gross inflows of $0.4 billion, which were partially offset by total gross outflows of $0.8 billion. Assets in institutional accounts increased by $0.4 billion, or 3.3%, from $12.2 billion at March 31, 2013 due to $0.7 billion in market appreciation and $0.1 billion in gross inflows, partially offset by $0.4 billion in gross outflows. Assets in retail accounts increased by . . .

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