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Edited Transcript of LM earnings conference call or presentation 26-Jul-17 9:00pm GMT

Thomson Reuters StreetEvents

Q1 2018 Legg Mason Inc Earnings Call

BALTIMORE Aug 12, 2017 (Thomson StreetEvents) -- Edited Transcript of Legg Mason Inc earnings conference call or presentation Wednesday, July 26, 2017 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, Director of Communications and Director of IR

* Joseph A. Sullivan

Legg Mason, Inc. - Chairman, CEO & President

* Peter Hamilton Nachtwey

Legg Mason, Inc. - CFO & Senior Executive VP

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Conference Call Participants

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* Christopher Meo Harris

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

* Craig William Siegenthaler

Crédit Suisse AG, Research Division - Global Research Product Head for the Asset Management Industry

* Daniel Thomas Fannon

Jefferies LLC, Research Division - Senior Equity Research Analyst

* Glenn Paul Schorr

Evercore ISI, Research Division - Senior MD, Senior Research Analyst and Fundamental Research Analyst

* Kenneth S. Lee

RBC Capital Markets, LLC, Research Division - Analyst

* 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

* 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 First Fiscal Quarter 2018 Earnings Call. My name is Nicole, and I'll be your operator for today's teleconference. (Operator Instructions) Please note that this teleconference 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, Director of Communications and Director of IR [2]

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Thank you. On behalf of Legg Mason, I would like to welcome you to our conference call to discuss operating results for the fiscal 2018 first quarter ended June 30, 2017.

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, 2017, and in the company's subsequent filings with the Securities and Exchange Commission.

During the call today, we may also discuss non-GAAP financial information. Reconciliations of the non-GAAP financial information to the comparable GAAP financial information can be found in the press release that 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. Pete Nachtwey, Legg Mason's CFO, who will discuss our financial results. In addition, following the 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, CEO & President [3]

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Thank you, Alan, and welcome to all of you. As always, we appreciate you taking time to listen in this afternoon and for your interest in Legg Mason.

I am pleased to report strong core results for our first fiscal quarter of 2018 and what feels like good momentum as we continue to execute on and see the benefits of our strategy of expanding client choice. As you've seen over the past 4 years, we have dramatically expanded investment capabilities adding multi-asset class investing with QS, non-U. S. equity with Martin Currie, infrastructure with RARE, alternatives with EnTrustPermal and private equity commercial real estate with Clarion Partners. We've significantly increased the number of next generation strategies, up 20%, with over 140 products and more than $30 billion in assets under management. And finally, we've meaningfully expanded our vehicle creation capabilities both internally and with our investment in Precidian. This has repositioned Legg Mason as a far more compelling platform for growth.

To be clear, changing industry dynamics continue. Investor demand for passive over active strategies is increasing. Pricing pressures are a challenge, and distribution platform consolidation continues. That said, we increasingly believe that Legg Mason is becoming a platform of choice for our clients, driven by the ongoing diversification of the company and the strength of Legg Mason Global Distribution. And while we are very pleased with the quarter both financially and strategically, we know that success won't be linear. We will experience wins and offsets along the way. But in general, we feel quite good about our overall positioning.

Growth in newer strategies at Martin Currie Australia, RARE and Western Asset, combined with continued momentum in more traditional equity and fixed income products, a new record in retail SMA AUM of $69 billion and continued progress in innovative vehicle development has also reinforced our strategy and continues to position us for opportunity.

Specifically for the quarter on Page 2, we reported operating revenues of $794 million and net income of $0.52 per share. Despite a few large outflows including nearly $2.5 billion at QS and RARE that we previously highlighted, we recorded net quarterly long-term inflows of $500 million, including $1 billion in equity inflows and $300 million of fixed income inflows, which more than offset alternatives outflows driven by the RARE redemption.

Aside from that large outflow, Clarion had a very solid quarter while EnTrustPermal made continued progress in diversifying its book of business. And finally, as you know, ours is a business that generates significant amounts of cash. We retained a vast majority of that cash, given our tax shield, which results in a very low cash tax rate. This allows us to thoughtfully deploy capital between investing in the business and returning capital to shareholders through dividends and share repurchase. Pete will go through the details in a minute, but we did reduce our share count by another 2.7 million shares in the quarter.

So with that introduction, let's review our results by investment strategy. Against the backdrop in which active equity mutual funds in the U.S. recorded outflows for the 12th consecutive quarter, equities across our affiliates platform were net positive with inflows of $1 billion, led by ClearBridge and Martin Currie, which more than offset equity outflows at Brandywine, QS and Royce. ClearBridge AUM is at a high of $127 billion with net inflows of nearly $2 billion for the quarter illustrating the importance of differentiated active strategies across multiple vehicle options. Martin Currie saw $1.4 billion of inflows driven in large part by continued demand for their Australian income and real asset strategies in Japan.

Fixed income inflows of $300 billion for the quarter were predominantly led by Western's core and macro op strategies. Western showed strength on our global distribution platform across the globe with 4 of 5 regions outside the U.S. and 6 of 8 channels in the U.S. experiencing positive net sales.

As I mentioned, net outflows in alternatives of $800 million were driven primarily by the RARE outflow I mentioned. RARE's remaining book does not have further significant concentration risk in our view. Performance remains quite good. Positive net flows into the RARE retail UCITS fund continue and interest in infrastructure investing, particularly as a newer source of income continues to grow.

EnTrustPermal's quarterly outflows improved significantly. June was a positive month for them, led by growing interest in their direct lending and co-investment vehicles. One such fund is our first co-investment strategy made available to retail investors on a major distribution platform giving them a strong entry point as interest in alternative products and uncorrelated alpha continues to grow.

Clarion had several institutional wins in the quarter and we continue working with them to build flows on our distribution platform particularly through private banks. Bringing these types of alternative strategies to the individual investor always takes time, but the interest in them is strong. Clarion is in advanced discussions with several non-U. S. investors interested in commercial real estate, and there is now a feeder structure in place for investors outside the U.S. into their core open-end fund.

Now from investment strategies, let's move to diversification by product and vehicle, which contributed to very strong net sales across our affiliates on our distribution platform this quarter. As I mentioned, we strategically expanded client choice in recent years by building out an internal vehicle team and making an investment in Precidian. This represents another plank in our platform of choice for our distribution partners as investor demand across investment vehicles ebbs and flows.

SMA flows on our platform continued to accelerate while we simultaneously built out our ETF and CIT vehicle suite. Just this month, we launched a small cap smart beta ETF that tracks a proprietary multifactor index developed by Royce. We have launched 3 fully transparent active ETFs, with some of ClearBridge's flagship managers in strategies where doing so doesn't compromise our managers' intellectual property or elevate the risk of traders front running our clients. They include an all-cap growth ETF managed by 3 of ClearBridge's most well-known managers and 2 ETFs that leverage ClearBridge's 30-year track record in ESG investing. We expect there to be more opportunities to launch fully transparent active ETFs for more of our managers in the coming quarters.

This is a good place to remind you about the unfunded wins in our smart beta ETFs that we discussed during our inter-quarter call. You may recall that we were advised of 2 large allocations totaling $450 million into LVHD, our low volatility high dividend ETF strategy, managed by QS and expected to fund by next fall. Remember, $200 million of those allocations are both a strategy and vehicle transfer. So in this case, choice is helping our asset retention.

Total net new assets for Legg Mason between the 2 ETF allocations will be approximately $250 million in the September quarter. And as that strategy continues to gain scale, the opportunity increases for larger distributors to make even more meaningful allocations.

Next, we discussed that the industry needs a solution to bring actively managed strategies to market in a semitransparent ETF vehicle that protects the confidential nature of a manager's IP and avoids the front running issue. That capability exists within Precidian Investments and with significant industry support for this technology, we are hopeful that the SEC will approve the application for their ActiveShares vehicle. We were certainly pleased during the quarter to have Nationwide join us, Blackrock, Capital Research, J.P. Morgan as well as Bats and the NYSE in supporting this important investor solution. There's no doubt that the breadth of choice across strategies and vehicles is both a competitive advantage and a longer-term tailwind for our business, as Legg Mason's distribution partners continue to focus on fewer and deeper relationships.

So let's close by talking about our progress and success in client access, most notably through our Global Distribution platform. As we've frequently stated, we see that platform as a key strategic asset and have continued to invest in it over the years. It enables us to bring greater innovation and choice to investors and we've seen a strong return on that investment over the past 5 years, with annual gross sales rising at a 10% compounded annual growth rate to $82 billion for our last fiscal year, and net sales of just over $34 billion over that 5-year period. Assets on the platform now stand at a record $312 billion.

Gross sales for the quarter were just over $20 billion, with quarterly net sales just under $6 billion. The 14th quarter of positive net sales on the platform in the last 15 quarters. Strong net sales certainly reflect elevated gross sales as well as significantly lower redemption rates, which reflect, to a degree, the acceleration to different vehicles with greater persistency rates such as SMAs and CITs. Legg Mason's current redemption rate of approximately 18% implies a 5-year persistency of client assets, which compares favorably to U.S. mutual fund benchmarks currently in the 22% range.

We're pleased that our retail gross and net sales were well diversified across our affiliates, as 4 of 5 international regions, 7 of 8 U.S. channels and 7 of 9 of our investment affiliates were net positive in the quarter.

Our retail platform in Europe has its best flow quarter in 2 years, and Legg Mason Japan in particular saw its dramatic success continue with the Martin Currie Australia real asset and high dividend Australian equity strategies. To be clear, we do expect capacity constraints will cost a bit of slowing of Japanese sales into those strategies.

This past quarter was the fourth in the past 5 of net inflows in our traditional U.S. business and reflected the highest level of net sales since the 2014 fixed income money in motion trade, which we believe to be quite an achievement.

And finally, we have integrated QS's asset allocation capabilities into Financial Guard's platform, augmenting the value add of that portal for distribution partners, who seek better ways to offer goals-based financial advice to clients of all sizes. While it is very early, we are excited about the potential to establish deeper relationships with our distribution partners and I look forward to updating you further with respect to Financial Guard on future calls.

And now let me turn the call over to Pete.

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

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Thanks, Joe. I'll start off on Slide 5. As Joe noted, for the quarter, we generated earnings of $51 million or $0.52 per diluted share. However, these results included charges and credits that combine to negatively impact our results by $0.14 per share. Despite those impacts, we had a strong quarter in our core financial results. So let me walk you through some of the items that we think will help you better understand our core performance.

First, as referenced in our 10-K, we incurred noncash intangible impairment charges related to RARE that totaled $34 million. We also incurred acquisition and transition-related costs of $3 million at EnTrustPermal and $2 million in corporate severance costs related to staff reductions in fiscal Q4 of 2017. These charges were partially offset by contingent consideration credits totaling $17 million and net tax credits of approximately $1 million. The combination of these items collectively explains the $0.14 I noted earlier.

Now I will turn to some other highlights. Average AUM increased to $740 billion, with the increase largely driven by the reclassification of model SMA assets to AUM from AUA, which brings us in line with industry practice. Our operating revenues increased $71 million from fiscal Q4, primarily due to a $57 million increase in pass-through performance fees at Clarion. In addition, increased average long-term AUM and 1 additional day in the quarter contributed to the improvement. We estimate next quarter's nonpass-through performance fees to be approximately $5 million to $10 million. Additionally, pass-through performance fees at Clarion are estimated to add an incremental $5 million in fiscal Q2.

On Slide 6, the only item to highlight here is our effective GAAP tax rate, which was 31%, slightly lower than our projection for the quarter. As we think about fiscal year 2018, we project our GAAP tax rate to be at the low end of a 30% to 35% range, as you can see in the appendix on Slide 21. Our actual cash tax rate was 8%, which continues to run at a substantially lower level than our historical GAAP rate. Our cash tax rate should stay below 10% through the early part of the next decade, after which, we will continue to benefit from goodwill amortization from our most recent acquisitions well into the future.

On Slide 7, you can see that a variety of factors led to a significant increase on our long-term AUM. This included the reclass of SMA model assets of $16 billion, which I mentioned earlier. In addition, market and other along with long-term inflows and positive FX combined to increase AUM by $10 billion. Liquidity outflows were $12 billion and Clarion had approximately $1 billion of realizations that we started disclosing separately in our May AUM release. And lastly, you will note that our final AUM is down slightly from our earlier reported preliminary number, which is due to some reclasses and true-ups as we close the books on the quarter.

Turning to Slide 8. Fixed income inflows were $300 million, with positive flows at Western. Equity inflows totaled $1 billion driven by ClearBridge and Martin Currie. Alternative outflows slowed to $800 million despite the $1.5 billion institutional redemption at RARE that we disclosed in May and with Clarion turning positive for the quarter.

The consolidated operating revenue yield on Slide 9 was basically unchanged. This was despite modest drops in alternatives and equity, due to rounding impacts across all asset classes in a consolidated number.

Operating expenses on Slide 10 increased by $74 million, $57 million of which relates to the increase in Clarion performance fee pass-throughs. And I'll discuss the other drivers of the increased comp expense on the next slide.

In addition, as I referenced earlier, we had a $34 million noncash intangible impairment charge, partially offset by a $17 million earn out credit. Occupancy expenses decreased largely due to higher real estate charges in the prior quarter and communications and tech expenses declined, reflecting lower consulting fees and data center costs. Other expenses declined from last quarter due to lower advertising and T&E expenses.

Turning to Slide 11. Comp and benefits increased by $67 million, with $57 million of that increase resulting from the pass-throughs at Clarion. The $14 million increase in core, salary, incentives and benefits was largely due to seasonal factors primarily related to accelerated deferred comp on retirement eligible employees as well as increased compensation on higher revenues and the comp impact of lower non-comp expenses at revenue share affiliates. Next quarter, we expect the comp ratio to drop down to a range of 54% to 55%, reflecting a drop off in seasonal compensation factors.

Slide 12 shows our operating margin as adjusted, which increased from last quarter, reflecting the impact of higher average long-term AUM and 1 additional day in the quarter.

Slide 13 is a roll forward from fiscal Q4's net income of $0.76 to this quarter's net income of $0.52 per share. As you may recall, FQ4 results included tax credits and gains on sale of nonstrategic managers and other items that net, increased earnings per share by $0.11. In the current quarter, higher operating earnings increased earnings per share by $0.05, primarily due to increased revenues and lower noncomp expenses partially offset by higher seasonal compensation. The impacts of the decrease in mark-to-market on our seed and corporate investments does not offset in comp as well as higher taxes were partially mitigated by the impact of our share buybacks and together, combined to decrease earnings per share by $0.04 quarter-over-quarter. Finally, the combination of items I mentioned in my opening remarks decreased our current quarter's earnings per share by $0.14.

Slide 14 highlights our disciplined and balanced approach to capital deployment. In the upper left, you can see we have steadily reduced our share count by 42% since March 2010. And in the upper right, you can see that we've highlighted our dividend progression over that same period. We have now increased our annual dividend for 8 straight years from $0.12 per share in 2010 to the current level of $1.12 per share, and this current dividend rate represents an eightfold increase since March 2010.

On the bottom of the chart, you can see our total annual return of capital since 2011 as well as for the first quarter of fiscal '18. You will note that this quarter reflects 102 million of share retirements through a combination of open market purchases as well as shares from our net share settlement program related to annual vesting of deferred compensation. As Joe mentioned on last quarter's call, our target of capital return for fiscal 2018 is approximately $450 million. However, with our dividend increase, this means our share repurchases will moderate from our usual $90 million a quarter, or $360 million annually, to $85 million per quarter. Albeit, we still plan buybacks of 90 million in fiscal Q2 under programs that are already in place. Thus in the second half of our fiscal year, we are planning for buybacks at a $75 million per quarter pace, meaning, in total for the year, we will deploy $340 million for our buyback program and $110 million in dividends to shareholders.

So thanks as always for your interest in Legg Mason, and now let me turn it back over to Joe.

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

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Before we go to questions, let me remind you why we believe that our strategy of expanding client choice should continue to drive growth for Legg Mason and benefit our shareholders.

We worked in a world in which clients expect us to anticipate their needs, provide guidance and solutions that help them achieve their financial goals and do so in an easily accessible, intuitive and cost-effective way. Providing greater client choice makes us increasingly relevant for those clients, particularly in a competitive environment where distribution partners are looking to create deeper relationships with fewer select partners who offer more options. This is a distinct competitive advantage for Legg Mason and is essential to being a key strategic partner and provider to them.

Executing on this strategy has been a journey and will continue to be as the markets and industry evolve. We have made great progress, and while we expect ups and downs along the way, we like our positioning and expect to take additional market share over time. This strategy also benefits our shareholders in naturally diversifying Legg Mason by asset class, vehicle, client type and geography thereby bringing more balance to our business and positioning us to deliver more for our shareholders over the long run.

And with that, I am happy to take your questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) And our first question comes from Dan Fannon from Jefferies.

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Daniel Thomas Fannon, Jefferies LLC, Research Division - Senior Equity Research Analyst [2]

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I guess, first question is for you, Pete. Just looking in the next quarter and beyond, are we looking at kind of a cleaner quarter in terms of charges? And then thinking about some of the line items x comp, which you already gave guidance for, are these reasonable run rates for things like communication, occupancy and other?

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Peter Hamilton Nachtwey, Legg Mason, Inc. - CFO & Senior Executive VP [3]

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Actually, very good question, Dan. A couple of things for next quarter, but your initial premise is right, they definitely should be cleaner quarters as we're going forward. Really, 2 things for next quarter to think about. We've probably about $2 million to $3 million in severance, just as we continue to really ratchet down on costs and headcount, but we see that number being about $2 million or $3 million next quarter. And then communications technology will probably be up. It was a little bit lower this quarter than normal. And then we've got a few projects going on that's probably going to go up about $3 million to $4 million next quarter. And the rest of them, I think, are pretty good run rates.

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Daniel Thomas Fannon, Jefferies LLC, Research Division - Senior Equity Research Analyst [4]

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Great. And then I guess, just a follow-up, Joe, on just some of your comments around flows and the backlog. I guess, historically, you've kind of given us a little bit of update on some of the known stuff that you happen to know at this point in the quarter for July that maybe either coming in and out, if there's any update at there, that would be helpful. And then also, just within the alternative book, if you could just give a little more color maybe at the legacy Permal versus some of the EnTrust where you're seeing maybe still some redemptions or challenges versus some of the opportunity.

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

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Sure. So let's talk a little bit about July 1st. At this point in time, and again, I always preface this, you all know there's 3 days left to go or so and we could get a month-end surprise either one way or the other. But looking at net flows for the month at this point in time, we would expect them to be in the $1 billion plus or minus range, something like that. And there's really -- we see continuing strength in the retail side. So that's encouraging. And I would say that, that is largely equity, both equities and fixed positive with some outs in alternatives, and I will come back to that in a minute. Beyond this month, just to be aware, we do see an outflow -- or actually, 2 outflows on the fixed side. We always call them out when they're low fee because in fact, these are very low fee outflows with about $2.5 billion going out between now and the end of the quarter. And again, very low fee on that. The good news is we also have some visibility into some fundings that will come in that, quite frankly, will more than offset the revenue impact of those lower fee outflows. As it relates to your question around Alts. For the month, we are seeing Clarion positive. We are seeing RARE positive. We are seeing EnTrust out. And I would say that that's really, Dan, a continuation of pressure on the commingled hedge fund business. And this really speaks to why we -- a big part of why we're excited about and very happy with the acquisition of EnTrust and the combination with Permal because the business activity, the growth activity and the new activity that's going on with respect to commingle -- or co-investment products, direct lending products, tend to be higher-margin products, but also longer lock-up products. So that's -- those are things that are appealing to people now. They have more significant alpha opportunities for clients. There's a lot of interest in them, but there remains pressure and where we're seeing the pressure at EnTrust is in really the legacy commingled hedge fund business.

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Operator [6]

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And our next question comes from Craig Siegenthaler with Crédit Suisse.

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Craig William Siegenthaler, Crédit Suisse AG, Research Division - Global Research Product Head for the Asset Management Industry [7]

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I want to start on QS. The affiliate's still outflowing and I noticed their pipeline of unfunded wins still looks a little light at only $200 million. Can you update us on this affiliate? And I just want your thought that solutions-driven product set will be in higher demand today, given that's what really all investors are demanding these days.

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Joseph A. Sullivan, Legg Mason, Inc. - Chairman, CEO & President [8]

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Yes, good question. I think it's an interesting observation, Craig, because we had -- we started the quarter with a meaningful outflow at QS, which was really more a reallocation from active to passive with a large client. On the other side of that though, the activity level at QS is higher than we've ever seen. You're exactly right, that what they are doing in terms of multi-asset class and allocation strategies is in increasing demand and we are seeing that, we are experiencing it. Interestingly, a validation of what they do, QS was just named 1 of 3, and 1 of only 2 outside, managers -- or managers that was given an external model allocation positioning within one of our large distribution partners. So I think it validates their ability to deliver -- to create, manage and deliver third-party models. So they are -- their activity level is frankly through the roof. There's just a lot going on. In many cases, they're being placed into models that ultimately, we believe, will generate flows but are not necessarily take overs. So we feel good about QS. We're actually -- we actually think about the need to continue to invest in QS. And then don't forget that QS is really the intellectual property behind our smart beta ETFs. And we are seeing a meaningful uptake in our -- particularly our low vol, high div strategy there. So we feel pretty good about it. And we see that flow picture improving nicely for them, particularly around ETFs in July.

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Craig William Siegenthaler, Crédit Suisse AG, Research Division - Global Research Product Head for the Asset Management Industry [9]

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Got it. And then just as my follow-up. I know a lot of us discount the liquidity business because it only generates 13 basis points of management fees. But if you look at the AUM there, it used to be around $150 billion 3 years ago. Now it's roughly cut in half. Can you just remind us what caused the 50% decline in liquidity AUM? And also, how does your outlook change just given the rising short-term rates here?

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Joseph A. Sullivan, Legg Mason, Inc. - Chairman, CEO & President [10]

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So a couple of things. You remember, we had a significant out with respect to money market reform. So we had a lot of flows, a lot of our prime fund business did transfer out to government funds, and in some cases, outside of us to banks as well. And we've seen that move in recent -- over this quarter. We've seen more move-in to the banking sector because -- just frankly because the rates have been a little bit higher than in the government space, what we can offer in the government space. I wouldn't say there's been a strategic move or anything like that. We are still -- it's still a good business for us. It can be really lumpy. We have a large corporate in the institutional -- or large corporate and sovereign wealth clients that quite frankly actively manage their cash through our money market funds, and so we'll see it balloon up, we'll see it balloon down. As I said, we saw a meaningful change with money market reform. But I think since then, and you should expect continued volatility in that business because that's the way the clients that we have utilize it. They utilize it for whatever their current cash needs are and when they have excess cash, they put it into it.

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Operator [11]

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And our next question comes from Chris Harris with Wells Fargo.

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Christopher Meo Harris, Wells Fargo Securities, LLC, Research Division - Director and Senior Equity Research Analyst [12]

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Question on your operating margin. When I look at the progression of the adjusted margin on Slide 12, you guys have clearly had a nice bump up from the lows as you've realized the synergies. Those charges have kind of come off the P&L. But when we look at it here, we're just now getting back to levels where you guys were a couple of summers ago. And I would think that these deals would be ultimately margin-accretive. So I know there's probably a lot of moving parts to it but can you guys comment a little bit on why your margin isn't a bit higher? Why it's not eclipsing the levels that we saw back in June and Sep of '15?

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Peter Hamilton Nachtwey, Legg Mason, Inc. - CFO & Senior Executive VP [13]

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Yes, sure, Chris. And I think, maybe, prospectively, as you think about our margin, first of all, we've got a very scalable model. It's one of the things we've talked about a lot. There's only a few things that are directly tied to it -- tied to revenue in terms of expenses or commission-based sales and then to a certain extent, our retro affiliates on comp. But we think we've got a very scalable model. I think, if you look at it at any -- over any given period of time now, there can be lumpy stuff going in and out. In particular, I'm guessing, if we go back and look at exactly what September 15 was, we may have had a higher amount of performance fees or some other impact that would have been driving that a bit higher. But I think as we go forward, we're assuming normal markets where we've got pretty bullish outlook in terms of where the margin can go.

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Operator [14]

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And our next question comes from Mac Sykes from Gabelli.

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Macrae Sykes, G. Research, LLC - Research Analyst [15]

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I have a 2-part question about the SMA business and your success there. Maybe if you could just outline some of the broader aspects of why it's successful for Legg? Whether it's scale, efficiency of delivery, performance, combination of both. And then could you just break out if you can how much of the sales are new versus replacement for current LM vehicles and strategies.

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

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Well, a couple of things. Let's think about it first as it relates to SMAs. I think, you asked why are we successful there and you said is it scale, is it efficiency, is it products and the answer is yes. And I think it's also experience. We've been in this business for, I don't know, 10 or 15 years, maybe even a little bit longer. And so it's something that we do well and we've -- we are known for it in the industry. Now remember that you really have 2 kinds of components to it now. You have SMA deliver -- SMA implementation where we do the implementation. You also have SMA model, model delivery. And in those 2 spaces combined, we are #2 in the industry. As it relates to SMA model delivery, we are -- it is the faster growing part of the business, and we are actually #1 in that space. And so I think that goes back to our history and to our experience. And that's why I think I've mentioned that we were, I think, roughly $69 billion in AUM on that platform currently. And if you think about that, that's just compared to a total retail AUM in the neighborhood of $310 billion or thereabouts. So a not insignificant part of our AUM is tied to that. We do see a greater persistency and we've talked about that. I think you see roughly, something closer to a 5-year persistency, maybe even a little bit more with respect to SMA. So it's a really good business for us there. I'm trying to think what else you asked. I mean, obviously, we've got -- look, in this environment, having the choice of vehicles, whether it's DOL or whether it's SMAs or ETFs in a DOL world because they're more efficient, tax efficient because they're cheaper, frankly, because they're customized, in that kind of environment, these kinds of strategies or these kinds of vehicles are very, very attractive. And I think that because we're known for it, because we have experience in it, because we have products in equities. People have asked, why are you flowing in equities? Well, ClearBridge has got one of the larger categories in the equity space, large-cap value. That's a very high-performing fund. We can deliver it in the SMA vehicle and we have great experience in doing so. And so that's really where it's coming. We can't tell you with any certainty how much is replacing existing funds because we don't necessarily always know when it's leaving a mutual fund and when it's coming back into the SMA. We don't necessarily always know that. But we do know that, and I'll just share with you that in a quarter once again, roughly 50% of our sales in the U.S. were into the SMA vehicle or at least -- I should say not in vehicles other than mutual funds and the vast majority of that, in the SMA.

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Operator [17]

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And our next question comes from Kenneth Lee from RBC Capital Markets.

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Kenneth S. Lee, RBC Capital Markets, LLC, Research Division - Analyst [18]

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Just had a follow-up question on EnTrustPermal. Is there any way that you could disclose the specific flows within, like, direct lending and the coinvesting versus the legacy Permal?

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

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Yes. I would say that the flows, we're not seeing a tremendous amount of flows yet. We're seeing a significant amount of fundraising activity. We are in the fundraising period for their new co-investment fund. Now we did have -- in the previous co-investment fund, we did have about $900 million in the quarter move from committed but uncalled capital into investing. So we felt good about that. But this is the lag. What happens is the managers have to be able to -- they don't call the capital until they find investments that make sense. We have a small amount deployed in their Blue Ocean direct lending strategy, but there's still a significant amount there that is in the uncalled capital. So we're seeing fundraising continue with both Blue Ocean or direct lending strategy. We've just embarked on the fundraising period in their strategic opportunities fund, co-investment fund. We did deploy about $900 million in their previous co-investment fund. So we feel pretty good about it. As I said earlier, the traditional commingled hedge fund business remains under pressure and that's industrywide.

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Kenneth S. Lee, RBC Capital Markets, LLC, Research Division - Analyst [20]

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Got you. And I just have one more question. In terms of the global distribution, looks as if it's building positive momentum in terms of net sales. What are your thoughts, like, on the next steps? Any thoughts on potential international expansion or anything else in the near term?

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

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Thanks, Ken. We're -- I've mentioned it before, we're just very proud of our global distribution platform. It's clearly a strategic asset. We're -- I wouldn't want to say we're hitting on all cylinders, but we're certainly -- we've got great momentum in that area. But at the same time, I want to be clear that I think we've got pretty good runway. And so in some of -- as we talk about flows, and as we think about the business, we think about classic active and we think about next-generation active. And for the past quarter, we were winning in both classic active and next-generation active. So with respect to equities, for example, significant flows into large-cap value at ClearBridge, again, that's taking advantage of our SMA vehicle capability. It's taking advantage of a very large category strategy, large-cap value, with very good performance. All of those factors and then you combine with it industry consolidation and things like that, all those things are a confluence to helping our flows in that category. We also saw Martin Currie during the quarter, which we consider more of a next-generation active strategy with their Australian high dividend and real asset strategies continuing their strength in Japan. Now to be clear, I mentioned it in my note -- in my comments, that we expect that to really taper off in here a bit with -- because the strategy has reached capacity. But I think that we look at -- as I was mentioning earlier, the large-cap value or we look in the fixed income space where we were winning in core strategies. Again, those would be classic active but we're also winning in next-generation strategies such as macro ops. In the larger strategies, I would say both in fixed income Core and Core Plus, and in the equity strategies where we have good performance in our large categories like large-cap value at ClearBridge. We see a lot of runway. We see a lot of opportunity to continue to take share. So I kind of said this over and over again, but in that classic active space, it's all about having the right strategies, having good performance, having the right vehicles, having the right pricing and then having a good strong distribution team to take advantage of it. And I think -- did I say large-cap value? I meant large-cap growth. Sorry.

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Operator [22]

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Our next question comes from Michael Cyprys from Morgan Stanley.

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Michael J. Cyprys, Morgan Stanley, Research Division - Executive Director and Senior Research Analyst [23]

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Just wanted to circle back on the SMAs as you've been growing that out on the SMA model delivery front. How much would you say is in fixed income out of the total? I know that's been a challenging area for some in the industry. I'm just curious how you're able to kind of thread the needle and make that work within the SMA and model delivery format?

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Joseph A. Sullivan, Legg Mason, Inc. - Chairman, CEO & President [24]

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Actually, what's -- here's an interesting growth opportunity for us, Michael. So the split in our portfolio is there's about 75-25 equity to fixed. And it's really 2 of our affiliates. It's only -- now it's 2 of our larger affiliates but it's ClearBridge and it's Western. And they've got a long history in that space, both of them. So we've got that down. One of the opportunities we have and we're currently working on is bringing some of our other affiliates such as Martin Currie onboard to that platform and we're really excited about that because we like to bring our GMS product onto that platform. Martin Currie's got a terrific emerging-market capability. It's a capability that builds in ESG, so it's unique in that regard, it's high-performing. And we think that we can -- it will be an attractive add to the SMA platform. It's our goal ultimately to get all of our affiliates onto that platform. It just takes some time to do so. But short answer to your question is currently, it's 75-25, equity, fixed income.

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Michael J. Cyprys, Morgan Stanley, Research Division - Executive Director and Senior Research Analyst [25]

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Great. Circling back on the distribution comments from earlier. Just curious more strategically how you're thinking about expanding distribution globally, perhaps maybe through some sort of strategic arrangements. What sort of ideas could be on the agenda there?

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Joseph A. Sullivan, Legg Mason, Inc. - Chairman, CEO & President [26]

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So I think about that in 3 categories. One is, strategically, I see us doing things with our clients more as we've talked about. And this is a global phenomenon. It works with our distribution partners in the U.S., works with our institutional clients all over the world, and certainly, with our -- the large global partners that we have, the big banks and the big insurance companies that are global in nature. I think we have an opportunity to partner more deeply with them because all large, whether it's retail-oriented, platforms, or retail-oriented global banks or institutional clients, all -- this phenomenon of fewer but larger and more diversified broader partners is in play and we're benefiting from that. We're not the only ones but we're one. So I think finding ways to partner closer with our clients is going to be an opportunity for sort of strategic growth globally. I think secondly, we've made the investment in Financial Guard and that's -- it's early, it's nascent stage. But we really feel good about the potential to utilize technology over the long term to access, to support our distribution partners in a more effective way and to access more -- and to access more of the market than we can in a traditional way. And then thirdly, we just -- every year, just through our kind of planning and budgeting process, we're continuing to add incrementally where we see opportunities to -- and in particular, with our new affiliates. So we've got new capabilities and new affiliates that give us reason to expand our distribution team, and that's not only, by the way, in sales but it's also in marketing and product development. So we're being sober about how we invest in global distribution and we want to be thoughtful about that, but we do that incrementally every year. So we add and grow that business every single year.

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Operator [27]

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And our next question comes from Patrick Davitt from Autonomous.

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Patrick Davitt, [28]

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You mentioned the strategies that have been popular in Japan closing. Could you give us a little more on the scaling of how much that could slow growth in the global distribution?

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

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Well, look, I think, it's hard to say exactly. I mean, we've got other strategies that are working in Japan and we've got other strategies that are working throughout. So there's always offsets. We've just -- it's been a nice piece of business for us. It's been a good part of Martin Currie's growth over the last year or so. But there are other products and other strategies that we can offer, whether it be through Martin Currie or other of our affiliates. So I can't really, I don't really want to project what I think the flows are going to be there. But they will slow, they will decrease in terms of new sales into that strategy. It's just a capacity issue there. And so we expect to see flows or sales into that strategy slow. That's why we're diversified. We look for other strategies that can then replace it.

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Patrick Davitt, [30]

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Okay. And then my quick follow-up is on the Precidian nontransparent ETF product. Do you think we need all or more of the SEC commissioners in place for that to move forward? Or do you think progress is happening despite it's still in D.C.?

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Joseph A. Sullivan, Legg Mason, Inc. - Chairman, CEO & President [31]

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So we continue to have good dialogue with the commission and with the staff even very recently. I feel pretty good about our opportunity there but I mean, I don't have any more insight than you do. But the dialogue has been, I think, constructive. I think it's, as more and more industry participants sign up for it and kind of put their hand up behind it, as I mentioned, Nationwide, this past quarter, joined us in terms of the licensing agreement; J.P. Morgan before that. Precidian's got something on the order of 20 or 25 different managers that are at various stages of looking at or negotiating licensing agreements. So it's clearly got the endorsement and support of the industry. I -- I don't know if it's going to happen. I can't predict what the commission's going to do. But I'm hopeful, and I'm encouraged by the fact that we've been able to have some ongoing dialogue with them. So we'll see. But clearly, we believe it to be an industry solution and a lot of people agree with us. So -- and it's something the industry needs, right? I mean, we need the ability to have a semitransparent active ETF methodology in the marketplace. There's a lot of active strategies that would come to market, but for the fact that we have this issue of transparency in the risk of the investor IP and front running. So we need a solution, we've got a solution. The industry believes we have one, and hopefully, we can convince the commission that it's time to move.

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Operator [32]

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And our next question comes from Bill Katz from Citigroup.

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William R Katz, Citigroup Inc, Research Division - MD [33]

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I just want to circle back to the discussion on fee rates. The first part of the question is, I think you reclassed about $12 million from distribution up into the management fee. But it looks like you only need it for this particular core. I'm just trying to understand the nuance of that. If you do adjust for that adjustment, if you will, it looks like the fee rate dropped about 0.5 basis point or so, maybe slightly higher, and it sounds like if over [50%] of your sales are going other into other than mutual fund product, could you talk -- mention how you to sort of think the fee rate plays out from here versus volumes? Please help us understand what the pricing difference is between mutual funds and SMAs so we could project forward?

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Peter Hamilton Nachtwey, Legg Mason, Inc. - CFO & Senior Executive VP [34]

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Yes, Bill. So first of all, your conjecture's correct in terms of the revenues from the things that were previously classified as AUA have always been in revenues. So the denominator change here did have an impact and was -- the rounding actually kind of kept us flat overall in our field though at 39 basis points. And we spent a bunch of time thinking about what the right way to handle this in terms of going back and restating all prior periods. We just didn't think that made a lot of sense, so we're just doing it on a go-forward basis. In terms of pricing, the SMAs are priced lower because of there's a bunch of expenses that we don't have to incur anymore that we normally bake into our mutual fund fee. So basically, the margin off of SMA fees -- and again, it's going to be -- it's hard to give you specific numbers because it's going to depend on which affiliate it is, whether it's equity or fixed income and what the strategies. But in general, our affiliates, and we look at those things as about the same from a profit margin perspective. So whatever drop in the fee buys is really offset by expenses. We don't have to cover at the manager level.

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William R Katz, Citigroup Inc, Research Division - MD [35]

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Okay. And then Joe, I think -- as my follow-up, I think you've mentioned, maybe sort of embedded in your comments before. But it sounds like you've got on to a couple of different new platforms for both Clarion and EnTrust. I'm just wondering if you could seize the opportunity that you foresee for that -- for the both of those buckets, if you will. And then I presume that, that is separate and above and beyond Blue Ocean or the strategic opportunity or maybe that's not correct?

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

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It's no different than those two. I think the special opportunities is on one of the retail platforms. I think that fundraising period, it ends later, sometime in the fall. They've had good interest in it but I can't really size at it at this point yet. And then same with Blue Ocean. I know we've had some success in kind of making introductions and actually getting some commitments on Blue Ocean through their global distribution platform. But those are really the 2 that they're working on right now. And I think we've gotten -- I think we've got on the order of $200 million, maybe a little bit plus in Blue Ocean, and I don't know what we've got yet -- it's just too early to size the strategic opportunities. I think it's too early for that.

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Operator [37]

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And our next question comes from Michael Carrier from BMO Merrill Lynch.

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

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Joe, maybe -- first one, I know sometimes you got a lot of information on it. But just the move that Shanda did during the quarter on the share sales, if you have any information on from, like, a strategic standpoint, it doesn't seem like any shift there. But just to get your take on that board seats, like anything that potentially changes versus what was originally announced, maybe things that have been progressing as you expected?

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

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Sure. So let me kind of preface it this way. I mean, obviously, we were very disappointed to learn of their sale. And I -- as you know, I mean, as with any investor at any time, I can't really speak to what their internal investment strategy is or their philosophy is. They did, just in terms of their thinking and their -- I was pleased to see that in the 13D that they filed, they were pretty clear about how they view the company. Just for those of you who maybe haven't read the 13D, I did make a copy of it, and their comment was Shanda continues to be very supportive of Legg Mason's strategy of expanding client choice across investment strategies, product vehicles and client access as well as its investment managers and the leadership of the management team, of Board of Directors. I was glad to see that, obviously. So all that said, we’re happy to have them continue as directors and we look forward to their contributions as directors. They -- at this point in time, and it's sort of a timing question, but they will retain 2 directors on the board and that's more of a timing issue than anything else. All things being equal and if there's no change in their ownership percentage, that would fall to 1 at a year from now. But what I can tell you about -- what I can tell you additionally is the following: they -- first of all, they completed their commitment to make a donation to our Legg Mason Foundation, which was important. They continued to invest with our affiliates including after their share sale. They have been helpful, and we've talked about their commitment to help us in China, and they have been helpful with that China initiative although to be clear, that remains still very early stage and we're hopeful that they will -- that we're going to be able to benefit from their technology expertise. So on all those other pieces, we feel good about how they followed through on that. So that's really all I can tell you that. I wish I could tell you more, but I don't -- really, there's nothing really for me to tell you.

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

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No, that's helpful. And then just a follow-up, in terms of some of the vehicles, I mean, you guys mentioned on SMAs and you guys are the leader there. But when you think about where you are based on the demand that you're seeing and maybe the build out of the different vehicles, so SMAs across the affiliates, whether it's somebody at the [BTS], looking internationally, whether it's CCAs, UCITS, OIC, SOIC, just where do you kind of feel Legg Mason is versus maybe that potential opportunity given the demand that you're seeing shipped around in terms of different vehicles?

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

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I think, if you -- I feel really good, Michael, to be perfectly honest with you. When we think about, for example, the U.S., we talk about, obviously, the '40 Act fund, the SMAs. We talk about collective investment trust. We talk about VITs. We've got capabilities, very solid and long-standing capabilities on all of these. We've also -- we operated, I think, it's in 14 different fund raisers globally. So we're able to get to market very, very quickly in strategies or as quickly as it's possible. So I feel like we are -- we're certainly not behind the curve in this as it relates to ETFs. We've got a significant pipeline of the ETFs, both in terms of active ETFs that we want to get into the market as well as semitransparent, if and when Precidian gets approved. So we feel good about that. Let me give you an example of our agility as it relates to vehicle creation. So we had -- as part of the RARE outflow that we experienced with a large distributor, as part of that, we actually had a significant amount, over a couple of $100 million, within that strategy of institutional money that wanted to stay in the strategy. But we had -- but there was not a vehicle for them to be able to do it. And within a very short period of time, we're able to pull together all the teams both in the U.S. and internationally to get a vehicle created in a cross-border vehicle to make sure that we could make that transfer from the previous vehicle that it had been in to a cross-border vehicle UCITS structure. And we were able to do that in a very short period of time to make sure that we could protect and defend those assets. And we did. So it's just simply a matter that we've got -- as I've said, a pipeline, that sequence of transparent ETFs that we want to get into the market. We've done even some additional smart beta ETFs. We've put one into the market just this month with Royce. And -- so we've got a very robust vehicle pipeline. We still got product development, new strategies that we're developing but now, what's really ramping is the development of new vehicles for existing strategies.

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Operator [42]

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We only have time for one more question. Question is from Glenn Schorr from Evercore.

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Glenn Paul Schorr, Evercore ISI, Research Division - Senior MD, Senior Research Analyst and Fundamental Research Analyst [43]

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So it's really just a quick 2-part. So I totally get the expanding the whole product choice distribution, client-type geography, and that's -- actually, I grew up in that happening at the retail side. I'm curious how much of that is happening on the institutional side of the business? Are the consultants really on board? Do they care about -- does the end client want that it's showing up in RFPs or are we talking primarily in the retail side?

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Joseph A. Sullivan, Legg Mason, Inc. - Chairman, CEO & President [44]

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Well, I think as it relates to vehicles, you're talking more about -- I think, more about the retail side of the business, but you know not necessarily entirely. I think the institutional business just remains very lumpy, and I think our consultant rankings and relationships across the board are very strong. We've talked about the fact that Western's rankings and ratings at the consultants have improved dramatically. I think you're seeing that a little bit, Glenn, in the opportunities that we see. We've talked about this over a few -- the last few calls that what we feel good about is both in fixed income and equities, in particular, and alternatives, but fixed income and equities, we see our level of opportunities increasing and it's pretty much across the patch. Now at any given quarter, some are going to be up and some are going to be down, but Western, for example, there are opportunities that are up this quarter. Martin Currie's opportunities are up this quarter. They move up and down. But overall, the level of opportunities that all of our affiliates in total are seeing are increasing, and so we feel good about that. We still have to win them, their competitive situation, so we still have to win them. But overall, our opportunities set is increasing and we feel good about that.

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Glenn Paul Schorr, Evercore ISI, Research Division - Senior MD, Senior Research Analyst and Fundamental Research Analyst [45]

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And I feel that and I see that in the products you're growing and I see the opportunities you talked to us. The question I have on that is there any trade off of the diversity of choice and stability versus overall growth? Meaning, an earlier question pointed out, that margins haven't expanded as much you'd think with the growth that you've seen, flows are plus or minus any given quarter, but we haven't seen any material positive organic growth. Should we just focus on earnings and -- or should we eventually get to a point where margins do expand, flows do expand?

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

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Well, look, we -- I would say that's what we expect on both. Look, on the flow side, I feel pretty good about the fact that we've been holding our own in here in an environment where the industry, particularly the active space is under tremendous pressure. We've held our own pretty well. We've had some headwinds. We know that over the last few years, Royce has been a headwind. That is generally speaking slowing, but it's been a headwind. We know that we had some headwinds in our traditional -- or not traditional, but in our alternatives business, which we are going to have irrespective with Permal because they were largely concentrated in the commingled hedge fund space. So that space has been under pressure. So we've had some kind of high-level industry headwinds and some specific headwinds that we've been battling. But in the meantime, I think, largely our business, we've held in pretty well during a period of significant flow into the passive space. But we do believe we feel good about where -- what our flow trajectory looks like. We're always going to have ins and outs, we're always going to have ups and downs, but we also believe that we've got an opportunity in here to increase margins. We're not going to be what some of the integrated firms are, we know that. But we do believe that we'll see margins increase.

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

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I think the things about -- and it was a good question earlier on the margin trend over the last couple of years. But you have to keep in mind, we've also sold some things along the way. Some of them had material impact on our margin like Legg Mason LMIC. And then the other thing, this is not pure normalized number, it's -- so there's some things in this number that are transition-related costs, et cetera, and those are going to affect the layer behind us at this stage. So again, we feel good about it being scalable with normal markets and the fuller trends that we have, we feel pretty bullish in terms of where it can go from here.

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Operator [48]

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That concludes our question-and-answer session. And I would now like to turn the floor back over to Mr. Sullivan for closing comments.

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Joseph A. Sullivan, Legg Mason, Inc. - Chairman, CEO & President [49]

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Thank you, Nicole. I just like to thank all of you for joining us this evening for a recap of our first quarter earnings. And as always, I'd like to acknowledge and thank my colleagues and our affiliates at Legg Mason for all you've done to deliver and expand choice for our clients, deliver for them and our shareholders. And I look forward to updating you all on our progress again next quarter. Have a good evening.

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Operator [50]

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