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Edited Transcript of LM earnings conference call or presentation 30-Oct-19 9:00pm GMT

Q2 2020 Legg Mason Inc Earnings Call

BALTIMORE Nov 5, 2019 (Thomson StreetEvents) -- Edited Transcript of Legg Mason Inc earnings conference call or presentation Wednesday, October 30, 2019 at 9:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Alan F. Magleby

Legg Mason, Inc. - MD & Head of IR

* Joseph A. Sullivan

Legg Mason, Inc. - Chairman, President & CEO

* Peter Hamilton Nachtwey

Legg Mason, Inc. - CFO & Senior EVP

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Conference Call Participants

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* Brian Bertram Bedell

Deutsche Bank AG, Research Division - Director in Equity Research

* Christopher Meo Harris

Wells Fargo Securities, LLC, Research Division - Director and Senior Equity Research Analyst

* Craig William Siegenthaler

Crédit Suisse AG, Research Division - MD

* Daniel Thomas Fannon

Jefferies LLC, Research Division - Senior Equity Research Analyst

* Kenneth S. Lee

RBC Capital Markets, Research Division - VP of Equity Research

* Macrae Sykes

G. Research, LLC - Research Analyst

* Michael J. Cyprys

Morgan Stanley, Research Division - Executive Director and Senior Research Analyst

* Michael Roger Carrier

BofA Merrill Lynch, Research Division - Director

* Patrick Davitt

Autonomous Research LLP - Partner, United States Asset Managers

* Robert Andrew Lee

Keefe, Bruyette, & Woods, Inc., Research Division - MD & Analyst

* William R. Katz

Citigroup Inc, Research Division - MD

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Presentation

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Operator [1]

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Welcome to the Legg Mason Second Fiscal Quarter 2020 Earnings Call. My name is Ash, and I will be your operator for today's conference call. (Operator Instructions) Please note that this conference call is being recorded. It is now my pleasure to introduce your host, Alan Magleby, Head of Investor Relations. Thank you. Mr. Magleby, you may begin.

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Alan F. Magleby, Legg Mason, Inc. - MD & Head of IR [2]

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Thank you, Ash. On behalf of Legg Mason, I would like to welcome you to our conference call to discuss operating results for the fiscal 2020 second quarter ended September 30, 2019.

This presentation may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are not statements of facts or guarantees of future performance and are subject to risks, uncertainties and other factors that may cause actual results to differ materially from those discussed in the statements.

For a discussion of these risks and uncertainties, please see Risk factors and Management's Discussion and Analysis of financial condition and results of operations in the company's annual report on Form 10-K for the fiscal year ended March 31, 2019, and in the company's subsequent filings with the Securities and Exchange Commission.

During today's call, we may discuss non-GAAP financial information. Reconciliations of non-GAAP financial information to the comparable GAAP financial information can be found in the press release and in the presentation we issued this afternoon, which is available in the Investor Relations section of our website.

The company undertakes no obligation to update the information contained in this presentation to reflect subsequently occurring events or circumstances.

Today's call will include remarks from Mr. Joe Sullivan, Legg Mason's Chairman and CEO; and Mr. Peter Nachtwey, Legg Mason's CFO, who will discuss our financial results. In addition, following a review of the company's quarter, we will then open the call to Q&A.

Now I would like to turn this call over to Mr. Joe Sullivan. Joe?

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Joseph A. Sullivan, Legg Mason, Inc. - Chairman, President & CEO [3]

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Thanks, Al. Good evening, welcome and thank you for joining us as we review Legg Mason's results for our second fiscal quarter of 2020. As usual, our CFO, Peter Nachtwey is joining me.

I plan to cover 3 topics deceiving: First, I want to share my perspective with a high-level look at the quarter. Next, I want to discuss how we think about creating value for clients and shareholders. And then finally, I'd like to provide you with a sense of our mindset going forward.

So let's start with the quarter. Legg Mason delivered strong results in a volatile quarter for the markets. Long-term flows were essentially flat at out $200 million in the quarter or what equates to roughly 0.1% on an annualized basis. And while we're never happy with outflows of any magnitude, these results seem to compare favorably within the context of the industry. Our AUM, revenues, margin and earnings per share were all up nicely quarter-over-quarter.

Overall, the mix of our business helped us as inflows into alternatives largely offset outflows in equities and modest outflows in fixed income. Our affiliates saw inflows in the retail channel offset some outflows and rebalancing on the institutional side.

And finally, notwithstanding some pockets of underperformance, our affiliates continued to deliver strong overall investment performance for our clients. So again, all in all, I'd say it was a very good quarter.

Now let me share how we plan to continue creating value for our clients and shareholders with some specific examples of each.

We believe that we create value in 3 ways through, first, the thoughtful diversification of our business, which leads to 2 critical outcomes: expanding choice for clients while delivering a greater resiliency of results for shareholders. Second, the efficient execution of our strategic restructuring, which positions us to deliver greater margins for shareholders and have greater investment capital if and as we see opportunity. And then third, by capitalizing on our investments, which further position us for future growth.

So let's drill down a little bit on the intentional diversification of our business across investment strategies, vehicles and client access, which is fundamental to our strategy and where we saw further progress this quarter.

Starting with investment strategy diversification. In equities, the broader availability of Martin Currie's emerging markets strategy in U.S. contributed inflows in the quarter, and these inflows do not include a large U.S. institutional win of approximately $500 million in that strategy that funded this month. In addition, as part of our ongoing collaboration with global banking partners, we launched 3 new fixed income products in Asia, Europe and Latin America, solving for the strong demand for income and which have raised approximately $1.6 billion this past year.

And on October 16, we announced the launch of our first commercial real estate-focused fund designed for individual investors. The Clarion Partners Real Estate Income Fund for CP REIF will bring Clarion's nearly 4 decades of expertise in private real estate to the broader U.S. retail market through Legg Mason for the first time.

We are also seeing growing market demand for packaged third-party model solutions as financial advisers seek new ways to simplify their practices, lower costs and help manage overall risk in client portfolios. It is in these models that we are leveraging the portfolio construction expertise of QS Investors to bring to market several multi-asset portfolios. These models are often comprised of active and passive investments utilizing Legg Mason funds, Legg Mason ETFs as well as third-party ETFs within an SMA vehicle. And we expect to see continued interest in outsourcing asset allocation and portfolio construction to model providers across our retail channels.

Next, our vehicle diversification continues to enable us to play both offense and defense in this very competitive and dynamic market. As we've previously shared, only about 50 percent-or-so of our gross U.S. sales are in mutual fund vehicles. And yet this quarter, we bucked broader industry trends generating positive net sales in U.S. mutual funds. At the same time, we also saw positive net sales in our SMA, ETF and collective investment trust or CIT vehicles.

Now I want to stop and focus for a moment on CITs. Our current AUM in CITs stands at $6.4 billion, up from $3.4 billion in September of 2018. This growth in AUM was driven largely by both net new sales of approximately $850 million and $2 billion of transfers from other vehicles. So this story exemplifies the power of how vehicle choice enables us to play both offense and defense. Offering our investment strategies across multiple vehicles both enhances client acquisition and promotes client retention.

And lastly, we saw broader channel diversification this quarter with new drivers of gross and net sales in 3 channels with strong results where we continue to make good progress: the wealth management, independent and retirement channels in the U.S. Of particular note is the record performance of our U.S. wealth management team both in gross and net sales as well as a record start to the fiscal year by our retirement team. Further, internationally, our Australia team posted its 13th consecutive quarter of net positive sales, reflecting the thoughtful allocation of resources within distribution, which has enabled us to increase our business and market share in these growth channels and in this region.

Now I'd like to update you on the second way we're creating value through our strategic restructuring. I am pleased to say that we are making very good progress on these efforts. We continue to project total savings of $100 million or more. We are realizing those savings a bit of ahead of schedule. And we have narrowed the range of our restructuring costs to between $125 million and $135 million. Again, good, solid progress against this commitment.

And now, let me turn to the third way that we're creating value, capitalizing on our investments.

While some investments, be they investments in relationships or products or technologies, will yield more immediate results, others will represent longer-term growth opportunities for us.

So let's let look at some of examples of more immediate opportunities. In June, we announced a strategic alliance with Actinver, Mexico's largest private bank in terms of number of clients, which marked our first retail distribution effort in that country. Actinver quickly introduced 3 local funds using models provided by ClearBridge, Martin Currie and Western and we have been pleased to see nearly $100 million flow into these funds since June.

And looking ahead, we remain extremely excited by the industry's interest in ActiveShares, the SEC approved semitransparent active ETF structure. We believe this structure is an evolution in ETFs and the potential revolution in active management. 12 firms have licensed the technology through Precidian, 30 more are in various stages of contract execution and the first product launch is likely to happen sometime early next year.

And finally, we also announced that we are partnering with Cathay Financial Holdings and Quantifeed, a digital wealth manager in which we own a minority investment, to introduce theme-based investment solutions to investors in Taiwan. And we have also facilitated a relationship between Quantifeed and one of our larger Japanese clients.

So let me close now with some thoughts about how we think about where we are going. This industry continues to change and be challenged on a variety of fronts. The allure to investors of passive strategies; relentless pressure on pricing; ongoing increases in the necessary investments in technology, distribution and marketing, this change is as relentless as it is certain. Winning in the future requires a mindset of finding opportunity in change rather than being overwhelmed by it. Winning requires being agile, trying new approaches and being willing to take risk. Winning means recognizing the shifting landscape and not simply identifying what clients want today, but anticipating what they will expect tomorrow. Winning is about being prepared to serve clients as they want to be served and not as we're currently prepared to serve them. This is the mindset that we try and employ every day. This is why we are creating new investment strategies for investors like CP REIF to deliver greater risk-adjusted returns in a low rate and likely lower return world. This is why we have invested in new vehicle technologies like Precidian's ActiveShares, which could potentially revolutionize active investing. And this is why we are establishing new and deeper partnerships with clients around the world, including partners such as our recent agreement with Actinver in Mexico, and investing in different technologies and portals such as Quantifeed and Embark: to give clients access to our investment strategies in the manner in which they choose to receive them.

Change is threatening, but only if you don't change. Change also represents a great opportunity, but only if you don't embrace change quickly. We are committed to continuing to turn change upside down to find the opportunity that change affords.

And with that, I'll turn it over to Pete.

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Peter Hamilton Nachtwey, Legg Mason, Inc. - CFO & Senior EVP [4]

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Thanks, Joe. Good evening, everyone. I'll start off with the highlights on Slide 2. Legg Mason reported GAAP net income of $67 million and adjusted net income of $86 million or $0.95 per share. We also made meaningful progress on our strategic restructuring efforts where we continue to project at least $100 million of annualized savings.

Moving on to AUM. At quarter end, we stood at $782 billion. And as Joe noted, overall flows for the quarter were basically flat with $2.4 billion of alternative inflows being offset by equity and fixed income outflows.

Gross sales were strong across global description platform at $22.4 billion while net sales remained positive at $2.6 billion despite a challenging macro backdrop.

And looking forward, investment performance remains strong with 79% and 82% of strategy AUM beating benchmark for the 3- and 5-year periods while for the Lipper category averages 66% and 71% of AUM beat peers for the same periods.

Now let's look at our affiliates on Slide 3. Five of our 9 affiliates generated positive long-term flows for the quarter including all 3 alternative managers and 2 of our equity managers. Unfunded wins and committed uncalled capital were down from their prior quarter, primarily reflecting a significant funding at EnTrust Global. And we remain encouraged by our overall pipeline of opportunities, which remains very robust.

Turning to Slide 4. You can see the asset class mix of our unfunded wins and committed uncalled capital remains diverse with 47% coming from fixed income, 33% from alternatives and 20% from equities. Furthermore, the underlying mix of the unfunded wins and uncalled capital within each asset class remains well diversified across products and strategies.

Slide 5 highlights our global distribution platform. Notably, gross sales were basically level on a sequential basis despite what is typically a slower quarter seasonally and we are very pleased to be up 29% from the same quarter last year.

Our overall redemption rate ticked up, reflecting a significant transfer of assets from a mutual fund to a CIT. However, net sales remained solidly positive, and while they declined on a sequential basis to $2.6 million of inflows in fiscal Q2, this still represented an improvement of $4 billion versus the net redemptions in the same quarter last year.

And looking at the full first half of fiscal 2020, LMGD saw a record growth sales while net sales at $6.6 billion were the third best start ever for the first half of a fiscal year.

Moving to Slide 6. Since I already highlighted our bottom line earnings, I'll move on to operating revenues, which increased by $38 million or 5% quarter-over-quarter. This was driven by an increase in performance fees as well as higher average AUM and 1 additional day in the quarter. These were partially offset by a modest decline in the operating revenue yield.

This quarter, we realized $13 million of non-pass-through performance fees, which was $9 million above our forecast as a result of fees related to a certain Clarion postdeal AUM client. And as a reminder, we are now just about 18 months away from Legg Mason participating in a majority of Clarion's performance fee-earning AUM.

For next quarter, we estimate non-pass-through performance fees of $5 million to $10 million and pass-through performance fees at approximately $5 million.

Our adjusted operating margin was 25% for the second fiscal quarter versus 21.6% in the prior quarter. This reflects lower seasonal compensation, higher revenues and the impact of realized cost savings.

Finally, our GAAP tax rate came in at 27%, which includes the impact of certain discrete tax items while our cash tax rate was only 7% for the quarter.

And for your adjusted earnings models, we expect next quarter's tax rate to remain in the range of 27% to 28%.

On Slide 7, you can see that AUM increased due to market appreciation, which was partially offset by liquidity outflows, negative FX and slight long-term outflows and realizations. Our operating revenue yield of 36 basis points was down slightly but within our forecasted range, reflecting reduced alternative and equity revenue yields and higher average fixed income assets. But importantly, the drop was primarily driven by changes in asset mix and rounding as opposed to any changes in pricing.

Specifically, the alternative revenue yield reflects a lower fee rate associated with the funding of a significant institutional mandate. Also affiliate mix plays a part here with Clarion contributing an increasing share of our overall alternative AUM at the somewhat lower fee rates applicable to core real estate private equity. The equity fee rate decline continues to reflect lower fee institutional fundings and the ongoing shift to lower-fee vehicles as well as affiliate mix.

Operating expenses on Slide 8 decreased by $3 million on a sequential basis, primarily due to a $13 million decrease in restructuring charges. Excluding those charges, expenses were up $10 million due to higher compensation on higher net revenues, partially offset by seasonal compensation factors during the prior quarter, savings from our strategic restructuring and lower mark-to-market impacts on seed and deferred compensation benefits.

Turning to Slide 9. Our comp ratio for the quarter was 55%, down from the prior quarter and in line with our forecast. Salary, incentives and benefits decreased as expected due to seasonal compensation factors in the prior quarter and the savings from our strategic restructuring. These were partially offset by higher compensation on increased net revenues.

Next quarter, we expect our comp ratio to decrease to a range of 53% to 55% reflecting additional savings from our strategic restructuring.

As shown on Slide 10, our adjusted operating margin increased primarily due to seasonal comp, higher net revenues and strategic restructuring saves.

Slide 11 is a roll forward from fiscal Q1's adjusted EPS of $0.75 to this quarter's $0.95. The EPS improvement reflects $0.07 from higher net revenues, $0.05 of lower seasonal comp and $0.04 in additional restructuring savings. We also had another $0.04 positive impact reflecting lower conference and T&E expenses in the quarter, which were partially offset by the impact from higher shares outstanding and taxes.

On Slide 12, we've updated the schedule depicting savings and associated costs related to our strategic restructuring program. As a reminder, we have arranged the columns to mirror the time periods in your models while the line items provide the details that you need for each period.

As you can see on the far right, in the fiscal 2021 column, our savings target remains $100 million or more while our cost to achieve these savings are in the range of $125 million to $135 million.

Fiscal Q2, we reported $15 million of savings with cumulative savings realized now at $29 million. We expect to realize an additional $19 million of savings in fiscal Q3 followed by another $22 million in fiscal Q4. This will bring our cumulative savings to approximately $70 million by the end of fiscal '20.

We've now achieved run rate savings of 58% and project to capture over 90% of run rate saves by the end of this fiscal year. But please note these are still projections, so actual line item results may differ especially due to rounding.

In terms of cost to achieve these savings, we had $16 million this quarter and we're expecting an additional $21 million in fiscal Q3. For the full fiscal year, we're anticipating costs of $80 million to $85 million with additional costs of approximately $35 million to $40 million in fiscal '21.

With that, let me turn it back over to Joe for his closing comments.

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Joseph A. Sullivan, Legg Mason, Inc. - Chairman, President & CEO [5]

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Thanks, Pete. In closing, we have been executing on the strategy that we put forth for some time now, yet remaining agile enough to evolve and pivot as the industry change requires.

Like everyone in our industry and particularly other active managers, we continue to be impacted by a wide array of factors, but executing on our plan still enables us to adapt to and thrive in a changing landscape. We are diversifying our business, which makes us a more attractive partner for our clients, and despite the changes and challenges of our industry, provides a certain degree of resiliency to our results for our shareholders. We are delivering on our restructuring plans while controlling costs and thoughtfully managing the balance sheet.

And we are finding opportunity in change as we continue to work to bring our existing investments to fruition while pursuing new investments to further develop opportunities that will pay off over the longer term.

And with that, Ash, we'll open up it up for questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question is from Robert Lee from KBW.

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Robert Andrew Lee, Keefe, Bruyette, & Woods, Inc., Research Division - MD & Analyst [2]

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First, thanks for the updated -- or the new GAAP to non-GAAP reconciliation in the appendix, it's very helpful. So thanks for doing that. I guess maybe first question I'd have is now that you've -- on capital management, I'll start there. As you've moved past paying down the debt, obviously, you've got to fund the cost saves as we kind of start getting towards the latter part of this year, could you maybe update us on current thinking what the priority will be? Was it going back to share repurchase next -- should we expect that next year?

And then maybe a second part of that is related now that Mr. Peltz has been -- and his representatives have been on the Board at least a few months, is there anything you could update us on his -- on what his priorities are or what his thinking may be since he's joined?

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Joseph A. Sullivan, Legg Mason, Inc. - Chairman, President & CEO [3]

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Sure. Thanks, Rob. First of all, on capital management, I would say there's not really any update. We've been fairly consistent about how we think about our excess cash. We think of it as discretionary cash that we have following our use for CapEx, for tax obligations, for dividends and debt service and for other requirements like seed capital. We look at those things first and then we think about how we utilize that excess cash. Currently, our focus is on, having paid off the $250 million of senior notes back in July, we now look at it and we recognize that we have some expenses related to this restructuring, so that's going to take priority. But we also need to go, on a go-forward, spend some more time with our Board to think through once we get through that how we're going to prioritize capital allocation. So haven't finalized that yet. We're going to use our excess cash right now to support and facilitate this corporate restructuring. But as soon as we have some greater visibility on what we'll do with that discretionary or excess cash after that, we'll let you know.

As it relates to Nelson and Ed and Trian, it's really the same story. We never really speak for them. I think from what they have said publicly, they see what we see, which is the opportunity, and frankly, the need for us as a company to operate more efficiently, and obviously, we're already on that path with our strategic restructuring. So we will continue with kind of a relentless focus on cost management. And then, in addition to operating more efficiently, we need to continue to find ways to operate more effectively with our clients to drive growth. And beyond that, that's what we're focused on with them and with our entire Board right now.

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Operator [4]

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Our next question is from Bill Katz from Citi.

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William R. Katz, Citigroup Inc, Research Division - MD [5]

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So I appreciate that you have sort of accelerated the percentage of savings, it looks like from 80%-plus to now over 90%. But when I look at the absolute dollars, I apologize if I misinterpreted the data, it looks like it's about similar from last quarter's guidance. So how does that math foot? And does that imply maybe some deeper underlying investment spend as an offset?

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Peter Hamilton Nachtwey, Legg Mason, Inc. - CFO & Senior EVP [6]

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Yes. Actually, I think, Bill, probably the one thing to focus on is what's the run rate at the end of the quarter, at the end of the period. Like for example, at 9/30, we've got a number of people that are going to be leaving or generate additional savings in the next quarter. That's in our run rate at the end of fiscal Q2, but it's not in our actual fiscal Q2 savings. And so we have the same thing impacting the out quarters here. Maybe Al can walk you through the math if needed after the call. But effectively, it's the delta between kind of run rate versus what's actually in the quarter.

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Joseph A. Sullivan, Legg Mason, Inc. - Chairman, President & CEO [7]

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It's timing.

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William R. Katz, Citigroup Inc, Research Division - MD [8]

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Okay. So it's exit level versus what you did during the quarter?

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Peter Hamilton Nachtwey, Legg Mason, Inc. - CFO & Senior EVP [9]

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Correct. Yes. You got it.

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William R. Katz, Citigroup Inc, Research Division - MD [10]

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Okay. That's very helpful. And then, Joe, maybe a big picture and maybe this ties in with your choice and discussion on pricing. You've had some changes in the U.S., one of the major distributors at UBS, in terms of what they're thinking about doing on the SMA footprint. You've been a pretty big generator of SMA growth just generally speaking. How do you sort of see that segment of the business sort of evolving from here? And then where do you think you are in terms of the decompression on the business with maybe some focus on the equity side of the house.

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Joseph A. Sullivan, Legg Mason, Inc. - Chairman, President & CEO [11]

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Sure. So you raised the announcement last week from UBS and obviously they're a good partner of ours and we are working closely with them to try to further understand the details of how this program, new program, is going to work for clients, for asset managers. And so there's still some work to be done on that. But as we think about it based on what we understand at this point, we think about this development in a couple of ways. First, it really reinforces how critical it is and how critical it remains really for us to deliver -- and all managers, to deliver very differentiated investment strategies. It's really increasingly clear that undifferentiated investment strategies will be subject to intense pricing pressure, and frankly, a risk of outflow to passive.

Secondly, but when we kind of turn the challenge or the change upside down a little bit and when we look at the opportunity, we have -- as you know, we have a leadership position in retail SMAs, which does, I think, position us to turn this into an opportunity by taking market share. It's really our breadth of strategies and the infrastructure to support them that has created a certain degree of scale that really allows us to favorably compete and grow in the space.

So we're going to look at it as an opportunity. Now admittedly, we may see, and we will likely see, over time pressure on those rates and we're seeing that across the patch in every aspect of our business. Every firm is seeing impact on pricing. But we've been able to hold it off a little bit by bringing more differentiated strategies like CP REIF, that development -- that's a strategy that's highly differentiated and where we are able to kind of maintain or hold pricing a little bit better than, frankly, in more general market or core-type strategies.

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Operator [12]

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Our next question is from Mac Sykes from Gabelli.

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Macrae Sykes, G. Research, LLC - Research Analyst [13]

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I actually have 2 questions and I'll just ask them together. First, how should we think about the magnitude of AUM and total funds expected to launch in the first wave of the Precidian vehicle?

And then my second question is about what is the capacity with the new Clarion product?

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Joseph A. Sullivan, Legg Mason, Inc. - Chairman, President & CEO [14]

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I think as it relates to the Precidian, it's hard to say what the magnitude of launches are. We know we've been working with all of our licensees and partnering with them to prepare them to be able to launch. We need to get through some operational and kind of work streams to get that up to speed. But we do expect our first launch will be in probably early part of 2020, we that will likely be with American Century and we will likely to have a Legg Mason launch that follows that fairly quickly. But how quickly other firms -- from what we hear, people are pretty excited about it and anxious to come to market with these. But we'll just have to wait and see. It's hard to predict how quickly that happens.

As far as capacity, Pete, do you have...

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Peter Hamilton Nachtwey, Legg Mason, Inc. - CFO & Senior EVP [15]

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Yes. Joe, because I've actually been working with the Clarion guys on this a good bit and as well some of our distribution partners. Effectively, what -- a number of the large retail distribution partners in the high net worth area are talking about a need, they perceive to get clients about a 5% allocation in real estate from less than 1% today. So the opportunity set is massive and there's very few competitors out there. Some good competitors, Blackstone has done a great job, Starwood, Brookfield. Now if you look at the trajectory, I think the last numbers I saw, Blackstone was raising something north of $100 million a month in their similar product. Now obviously, they have got a bit of head start on us, but in terms of opportunity here, it's a very large one. But it's going to take some time to get on platforms and get it up and running.

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Joseph A. Sullivan, Legg Mason, Inc. - Chairman, President & CEO [16]

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So Mac, just to follow on a little bit with Precidian because, obviously, I highlighted earlier we're pretty excited about that. And as I mentioned, we have executed agreements with 12 licensees and that represents something over 25%-or-so of the U.S. equity mutual fund assets in the marketplace and there's 30-plus contracts that are outstanding and that are in various stages of execution. I alluded to or mentioned that we expect our first ActiveShares ETF launch to be sometime in early 2020.

But just to give you a kind of a sense for what's going on, there's really what I would call 3 categories of work that are underway to bring ActiveShares to launch. And the first are really just various filings that are really applicable to any new ETF coming to market, whether it's a passive or whether it's active or semitransparent, filings such as a 19b-4. That's the first kind of piece of work that's underway with respect to this.

The second category of work is really work that's related specifically to ActiveShares such as Reg M or [reg show] type filings. And the good news, on those work streams, those ActiveShares-specific filings is that the approvals once attained can be then leveraged by other licensees in their filings going forward. So that's a highly efficient opportunity there.

And then, finally, as I alluded to, there are a variety of legal and operational work streams that are being completed in preparation for going live next year.

And as I said, Precidian is really actively working with all licensees and helping them to come to market. For those of you who are so interested, you can find details around some of those operational work streams and legal work streams can be found on ActiveShares.com. But there's really a lot of momentum building around ActiveShares and we're excited about that. In just the last month, Precidian has participated in 7 different industry conferences and then cohosted a very successful licensee event with the Cboe that was attended by more than 100 of our licensees -- or 100 of our attendees, excuse me. So a lot of activity, a lot of momentum and a lot of enthusiasm around ActiveShares and we'll keep you posted as things move forward.

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Operator [17]

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Our next question is from Kenneth Lee from RBC Capital Markets.

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Kenneth S. Lee, RBC Capital Markets, Research Division - VP of Equity Research [18]

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Just to follow up on that in terms of the Precidian and the filing template as well as the work streams that are going on right now. Is the thinking that there's a lot of initial work that needs to be done since it's a relatively new product, but then presumably once the first few initial products launch, we could see perhaps an elevated tempo of product introductions simply because they can sort of leverage off the existing filings that have been done previously?

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Joseph A. Sullivan, Legg Mason, Inc. - Chairman, President & CEO [19]

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I think that's exactly right. There's, as I said, a fair amount of plumbing that kind of needs to be put in place, operational-type plumbing that needs to be put in place. So I think that's exactly right. I think they'll get into the market, and as people get comfortable with how they trade, that will encourage people to come to market with more as well. And then the SEC has recently made the exemptive relief process easier as well. So all those things speak exactly, Ken, to what you're saying, which is as we get through the first few launches, things should be able to move much quicker.

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Kenneth S. Lee, RBC Capital Markets, Research Division - VP of Equity Research [20]

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Great. And just a quick follow-up. Could you provide any color around some of the outflows being seen within QS Investors? I mean it sounds that there's a lot of potential growth opportunity there. Just wondering whether there's any kind of particular outflows that you want to call out there.

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Joseph A. Sullivan, Legg Mason, Inc. - Chairman, President & CEO [21]

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Actually the outflows that QS has realized really over the last several years have been more related to the legacy active business, the Quant business, the active U.S. equity Quant business, that they brought when we acquired them and that we merged then to Batterymarch. That's been the business that's been under the most pressure. They did lose a little bit through a recent merger and acquisition in the industry. I don't need to go into detail on that, but that was one where that mandate was brought in-house. But where they are actually most active is, as I mentioned, in creating models and solution-based types of products where they're actually doing quite well and getting great positioning on various platforms. So really the outflows are related to more legacy business. Again, Quant equity business that's just been under pressure, frankly.

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Operator [22]

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Our next question is from Craig Siegenthaler with Crédit Suisse.

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Craig William Siegenthaler, Crédit Suisse AG, Research Division - MD [23]

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I have a CFO question for Pete, here, first. So with debt now, I think, $2 billion following the $250 million repayment this quarter, what is the updated excess cash level to use in the net debt calc because I don't think you put out a balance sheet yet for fiscal 2Q.

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Peter Hamilton Nachtwey, Legg Mason, Inc. - CFO & Senior EVP [24]

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Yes. Well, typically we talk about kind of a minimum cash level of $250 million, which is regulatory capital and then, call it, roughly a month of kind of working capital expenses, but we've also got CapEx, dividend, all those kind of things that we need to play in there. So whatever you see as putting out, going to take $250 million off of that and that's what we got to "play with." But then keep in mind, we've got to fund CapEx, taxes, interest, dividends, et cetera, so does that get you where you need?

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Craig William Siegenthaler, Crédit Suisse AG, Research Division - MD [25]

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And Pete, where does this put -- and one more step though. Where does this put the net debt-to-EBITDA ratio now? And any thoughts on how this could trend just given the elevated cash charges over the next year?

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Peter Hamilton Nachtwey, Legg Mason, Inc. - CFO & Senior EVP [26]

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I think we see this getting down to like below 2x by the end of the calendar year on adjusted EBITDA. And again, each of the agencies calculates a little bit differently. We ought to be getting below that bright line, which I know is something that people have been watching. And then depending on -- I don't think you see us building a ton of cash going forward, but to the extent that we've got excess cash on the balance sheet, we'll definitely get credit for that in calculating the leverage ratio.

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Operator [27]

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Our next question is from Daniel Fannon from Jefferies.

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Daniel Thomas Fannon, Jefferies LLC, Research Division - Senior Equity Research Analyst [28]

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My question's on fixed income. Looking at your guys performance as well as kind of the category as a whole, I guess, it would seem that Western has -- should or could be doing potentially even better than it is. And so was curious if there is any capacity constraints there or if there is something from a distribution perspective that you guys are focused on to potentially accelerate kind of the sales environment?

And then also if you could update us on Brandywine, which is seeing some outflows and kind of what's going on there?

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Joseph A. Sullivan, Legg Mason, Inc. - Chairman, President & CEO [29]

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Sure. Let's talk about Western for a minute. I think about it in a couple of ways. First of all, when I think of Western, kind of 3 words come to mind: first is demand, second is performance and third is share. Right now, as you know, the demand for fixed income is strong broadly and globally. Western -- so that's a good thing. Western has terrific investment performance, especially in the largest broad market strategies. And in fact, Western is taking taxable market share, particularly in certain of our retail channels.

On the institutional side, they continue to report a pretty high level of institutional activity and then we've seen a nice pickup in their fundings last quarter as well as their unfunded wins.

So we feel pretty good about how they're positioned. We did see some redemptions on the institutional side during the quarter, some related to some M&A activity with certain clients, some related to reallocation out of fixed income actually into equities and that was actually a transfer into ClearBridge. So that was not great news for Western, but good news for ClearBridge. Their long-term assets, as you might imagine, at Western are really the highest level since the financial crisis. So they've continued to deliver great performance. I think they believe there's opportunity for them to continue to grow on both the retail and institutional side, and so we feel pretty good about them.

I think as it relates to Brandywine, Brandywine has had some shorter-term performance challenges, which I think has slowed down subscriptions a little bit for them, but their long-term investment performance is still quite -- really quite strong. And so we've seen this before a little bit with them where their performance can be more volatile and -- but the long-term performance is strong and that bodes well.

By the way, you asked me about capacity as it relates to Western. I don't think generally they have significant capacity constraints with respect -- with the exception maybe of 1 strategy, which would be their macro opp strategy, which is their unconstrained strategy, which has done quite well and managed by Ken. They do have some capacity constraints there, but they're plenty -- they're quite a ways away at this point in time from being concerned about that.

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Operator [30]

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Our next question is from Brian Bedell from Deutsche Bank.

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Brian Bertram Bedell, Deutsche Bank AG, Research Division - Director in Equity Research [31]

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Maybe just to go back to the Precidian side. Obviously, that launch getting pushed back a little bit here. Is the holdup on the operational plumbing, is that more from the market infrastructure for the ETF vehicles, so this would the market makers, authorized participant, the accounting agent? Or is it more from internal side in terms of getting the legal documents lined up and the plans internally at the managers that are planning to launch the ETFs?

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Joseph A. Sullivan, Legg Mason, Inc. - Chairman, President & CEO [32]

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Yes. Look, I wouldn't characterize it, Brian, as being pushed back. I think it's just part of the process and some of these things take time. There do remain sort of discrete approvals and filings that need to be made with the regulators and we don't control the timing on those. There is some plumbing that needs to get done, but it's not material. We don't think of it as being pushed back, we just think of it as part of the process. So we feel good about how things are moving forward.

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Brian Bertram Bedell, Deutsche Bank AG, Research Division - Director in Equity Research [33]

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Okay. And the timing of your options to buy the majority stake, when does that expire?

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Joseph A. Sullivan, Legg Mason, Inc. - Chairman, President & CEO [34]

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Yes. So we need to notify them that we are going to be exercising that increase by mid-January and then there's a 9-month due diligence period that follows before we actually formally exercise it -- or have to formally exercise it.

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Brian Bertram Bedell, Deutsche Bank AG, Research Division - Director in Equity Research [35]

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Okay. Great. And then maybe just a few, if you could comment on flows in October. The $500 million win is from Martin Currie. Maybe just any other update on flows to date?

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Joseph A. Sullivan, Legg Mason, Inc. - Chairman, President & CEO [36]

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Brian, you've gotten 3 questions in here, nicely going. Nicely done, Brian. You're going to take over Bill Katz's reign here. Bill, I said that with a smile, Bill, by the way. So for October -- but, Ash, cut Brian off now. As always, though, I caveat this as much as I can because we still have more than a week to go to finalize our numbers. So it's likely that some month-end subscriptions or redemptions, which are scheduled will come in and can take our numbers up or down from here. But at the moment, it's looking like we're going to have pretty good month with inflows at this point in all 3 asset classes. So we feel pretty good about it.

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Operator [37]

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Our next question is from Mike Carrier from Bank of America Merrill Lynch.

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Michael Roger Carrier, BofA Merrill Lynch, Research Division - Director [38]

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Just given the strength that you're seeing in alternatives, could you just give us any color on the drivers? Are there any like larger fundraisings that are underway that are contributing to the strength?

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Joseph A. Sullivan, Legg Mason, Inc. - Chairman, President & CEO [39]

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So I think Pete referenced the fact that EnTrust had a nice significant win that funded in the quarter and we continue to see them having success and really having evolved their business away from the kind of traditional fund of hedge fund business. And the redemptions in that business are decreasing and being reduced simply because the amount of assets -- in part because the amount of assets are much fewer than they used to be. But they're seeing EnTrust's significant interest in their Blue Ocean Strategy, their direct lending maritime business. They're continuing to see very strong interest in their co-investment strategy. So they've really pivoted and evolved that business and they continue to see good interest there.

Clarion has been a rock. I think they've been, I should have it in front of me, but I think it's 12 straight quarters or something of -- 12 or 13 straight quarters of inflows for us. I think they've been an inflow every quarter since we acquired them but 1. They continue to see great interest in their Lion Property Fund and Lion Investment Trust. And so Clarion's just been a consistent grower for us. Rare after some choppiness in the first few years, we are starting to see interest in liquid infrastructure with rare pickup and we've had some success with -- particularly in Europe with our fund there in Europe. But we're also going to be launching an income fund here in the U.S. shortly. I don't think we have quite yet, but I think it's shortly. So we just kind of feel good across all 3 of those companies within our alternatives class.

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Michael Roger Carrier, BofA Merrill Lynch, Research Division - Director [40]

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Okay. That's helpful. And then just a follow-up. You mentioned vehicles of choice including the model portfolios, I mean how do you think about like fee rates with more growth in those areas?

And then in SMAs, we know your scale and model portfolio is a little bit less visible, so how do you think about maybe the incremental margins as well in that part of the business?

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Joseph A. Sullivan, Legg Mason, Inc. - Chairman, President & CEO [41]

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So I think as it relates to fee rates, I mean I just I think we should just kind of concede that fee rates are going to be under pressure whether you're talking about SMAs, you're talking about mutual funds, whatever. Every aspect of our business, there are pressures related to fee rates. I think what we've described before though is that as it relates to SMAs, for example, the persistency of those assets for us historically has been longer. So ultimately, the margin even though the fee rates are lower on the retail SMA than the mutual fund with the persistency extending out a bit, the profitability of those and the margin of those are actually as attractive as our mutual fund business. But again, I think we just need to take as given that we're going to be under pressure, whether it be retail or institutional, almost in every aspect of our business. Now that said, it goes back to what I said earlier about the more you can create differentiated strategies, you can push back on pricing pressure. But when those strategies are not differentiated, then you're going to be under even greater pressure.

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Peter Hamilton Nachtwey, Legg Mason, Inc. - CFO & Senior EVP [42]

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Yes. And Mike, I might explain on kind of the margin operating leverage point because this is one of the reasons that we've been putting out the parent margin on an annual basis so you can see that in this. Particularly now with the streamlining at corporate, we're capturing -- any revenue that comes up to the parent, we're capturing 85% to 95% of that in the operating margin. So it's not that we're willing to take business at any price, but those dollars that are coming up the parent are pretty profitable.

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Operator [43]

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Our next question is from Chris Harris from Wells Fargo.

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Christopher Meo Harris, Wells Fargo Securities, LLC, Research Division - Director and Senior Equity Research Analyst [44]

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A couple on your performance fees. Pete, I think you said, but I missed it, what percent of Clarion's performance fees will you be receiving, I believe in the beginning of fiscal '22?

And then once you do start receiving those, how is that going to impact other line items on your income statement like your comp ratio and noncontrolling interest?

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Peter Hamilton Nachtwey, Legg Mason, Inc. - CFO & Senior EVP [45]

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Yes. Good questions, Chris. And actually, you didn't miss it because I didn't give you a percentage. So it's one of those that's still changing mix of -- again, if you go back to the deal that we constructed with Clarion, is they kept the performance fees on pre-closing AUM and then after 5 years, which is coming up, as you pointed out, in the summer of 2021, we'll start participating in the performance fees and all the co-mingled funds and a new AUM that's come into the separate accounts. But if that -- we know to be the majority, but exactly how much, it's tough to predict because that's just a constantly changing mix of AUM.

And in terms of how it impacts the P&L when we get out there, the split with the team will be 50-50, which is pretty much standard in the market. So 50% of the performance fees will go to the team and comp, 50% will go to bottom line of which we get 82%.

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Joseph A. Sullivan, Legg Mason, Inc. - Chairman, President & CEO [46]

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And we didn't pay anything for those.

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Peter Hamilton Nachtwey, Legg Mason, Inc. - CFO & Senior EVP [47]

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Which -- exactly. None of that was priced in or put into the EBITDA that we priced the deal under.

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Operator [48]

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Our next question is from Patrick Davitt with Autonomous Research.

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Patrick Davitt, Autonomous Research LLP - Partner, United States Asset Managers [49]

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I have a question on the CIT discussion. Obviously, we've seen this -- a bigger impact to this at other firms, but I think the first time you've called it out so pointedly. So I guess could you speak to the overall economics of the shift like this to you, assuming there is a lower management fee, but is there an offset on the expense side, which is something we've have heard from those who have a little bit more scale than you do? And then within that theme, could you update us on the total kind of DC AUM pool as we think about the amount of AUM that could transfer?

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Joseph A. Sullivan, Legg Mason, Inc. - Chairman, President & CEO [50]

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Look, I think, first of all, typically, fee rates are lower on CITs and expenses are lower as well. I wouldn't say they're significantly lower on the expense side, but they're somewhat lower. We view that -- again, that's playing defense. Look, if we don't have these vehicles, we run the risk of losing the assets altogether. And so we're going to -- where appropriate and where clients are pressing and where it's appropriate for them, we're going to look to move them into the vehicles that they need or that they want. And obviously persistency in many of these situations is increased, particularly in the retirement channel. Our retirement channel is one that is growing. I don't -- we haven't really looked at how much of that business, our current business, in the DCIO space is likely to move. But it's not something that we see as being imminent, but we think it's just, over time, it's something that we can at least offer to defend assets that may not be under pressure from a performance standpoint, but maybe just from a vehicle perspective. And so we're not necessarily encouraging it, but we're there and prepared to deal with it if and as it comes.

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Operator [51]

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Our next question is from Michael Cyprys from Morgan Stanley.

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Michael J. Cyprys, Morgan Stanley, Research Division - Executive Director and Senior Research Analyst [52]

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Just first question for Pete, just maybe on the comp ratio guide of 53% to 55% next quarter. I guess just how much of that is driven by lower performance fees that you guys are guiding to? And how should we be thinking about that comp ratio guiding into next year. And related to that, the operating margin, 25% in the quarter, is that -- how sustainable is that from here as we look out?

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Peter Hamilton Nachtwey, Legg Mason, Inc. - CFO & Senior EVP [53]

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Yes. Well, I think the 53% to 55%, being in that range, some of that's going to be impacted by the performance fees but some of it's also impacted by our strategic restructuring costs. On the margin front, we're really pleased to see the uptick and some of it was seasonal factors and some of it was help from the market, but a good bit of it was coming from the strategic restructuring.

Next quarter, we're probably going to be about the same zip code from a margin standpoint because we don't have that much more of the savings coming online in the quarter and we've got a little bit of what we call BAU or business-as-usual costs that will uptick next quarter. But after that, we see the remaining of those -- remainder of those savings should be positively impacting the margin.

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Michael J. Cyprys, Morgan Stanley, Research Division - Executive Director and Senior Research Analyst [54]

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Great. And just on the strategic repositioning of the costs base. I was just hoping you can update us on some of the actions you guys are taking to cut costs specifically such as automating certain tasks, how you guys are thinking about that, outsourcing certain services, extracting greater savings from vendors. If you could just give us a sense in terms of some of the actions you guys are taking, will take and how and where specifically you guys are thinking about really cutting costs?

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Peter Hamilton Nachtwey, Legg Mason, Inc. - CFO & Senior EVP [55]

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I was just going to say pretty much everything you said, Michael, is -- that's in the list. I mean we're still continuing our partnership with IBM on the -- give them a little commercial on outsourced procurement. We just had a call today with -- that frankly, gave me goosebumps, after a 40-plus-year career, not many things give me goosebumps, but we're going to be going live with our common financial platform over the weekend with a number of our affiliates for the first time, and it's been a multiyear project. So there's just been a lot of stuff, and pretty much everybody around the organization is looking at ways to come in and do their job faster, better, smarter and whether we can do that through just stop doing things, automating them, artificial intelligence and robots, outsourcing, we're looking at all that stuff. And it's having impact. I mean we're not immune to the pricing pressures. We think we can hold serve pretty well there, better maybe than others, but we're not immune to it. On the other hand, there is a lot of opportunity, if you're taking advantage of it, to control costs.

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Joseph A. Sullivan, Legg Mason, Inc. - Chairman, President & CEO [56]

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Michael, we've looked at things. It's been tough because we've focused on looking at things that are kind of nice-to-haves that we've enjoyed over the years, they're not necessarily need-to-haves. So we've had to make some tough choices on that as well.

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Operator [57]

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We only have time for one more question, and that question is from Bill Katz from Citi.

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William R. Katz, Citigroup Inc, Research Division - MD [58]

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Joe. I'm almost scared to ask, but I will anyway. So a little bit of a narrow question, but I'm still curious. In your charges this quarter, there was about $3.5 million other professional fee item not associated with the implementation cost. I'm still curious, could you talk about what is behind that charge?

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Peter Hamilton Nachtwey, Legg Mason, Inc. - CFO & Senior EVP [59]

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Yes. Just a number of things from Board structure and legal structure things that are not part of what we're putting out there in terms of $100 million of saves. But they're costs that we've incurred, but they're behind us and we don't see them recurring.

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William R. Katz, Citigroup Inc, Research Division - MD [60]

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Okay. But it doesn't affect go-forward strategy, I guess the underlying question.

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Peter Hamilton Nachtwey, Legg Mason, Inc. - CFO & Senior EVP [61]

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No. No. Not at all.

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Operator [62]

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Thank you. That concludes our question-and-answer session, and I would now like to turn the call over to Mr. Sullivan.

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Joseph A. Sullivan, Legg Mason, Inc. - Chairman, President & CEO [63]

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Thank you, Ash. And thanks to all of you for joining us this evening. We're pleased with our progress this quarter on a number of fronts, but not satisfied, as we know so much more is available to us as we capitalize on the opportunity that change brings. I also want to thank my affiliate and Legg Mason colleagues, as always, for their continued focus every day on our clients.

And with that, we look forward to updating you on our progress again next quarter, and I wish you a very good evening. Thank you.

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Operator [64]

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This concludes today's conference call. Thank you for your participation. You may now disconnect your lines at this time.