Artisan Partners Asset Management Inc

NYSE:APAM

Earnings Call Transcript 2022-Q3

[Operator]

Hello, and thank you for standing by. My name is Rocco, and I will be your conference operator today. At this time all participants are in a listen-only mode. [Operator Instructions]. As a reminder, this conference call is being recorded.

At this time, I will turn the call over to Artisan Partners Asset Management.

[Makela Taphorn, IR]

Thank you. Welcome to the Artisan Partners Asset Management Business Update and Earnings Call. Today's call will include remarks from Eric Colson, CEO; and C.J. Daley, CFO. Following these remarks, we'll open the line for questions.

Our latest results and investor presentation are available on the Investor Relations section of our website.

Before we begin, I would like to remind you that comments made on today's call, including responses to questions, may include forward-looking statements. These are subject to risks, uncertainties and are presented in the earnings release and detailed in our filings with the SEC. We are not required to update or revise any of these statements following the call.

In addition, some of our remarks will include references to non-GAAP financial measures. You can find reconciliations to those measures to the most comparable GAAP measures in the earnings release.

I will now turn it over to Eric Colson.

[Eric Colson, CEO]

Thank you, everyone, for joining the call or reading the transcript. Slide 1 summarizes our business philosophy and approach.

Artisan Partners is a high value-added investment firm, designed for talent to thrive in a thoughtful growth environment. Thoughtful growth is core to who we are. Thoughtful growth is important for attracting new talent and retaining and stimulating existing talent. Investment degrees of freedom increase the probability that we can generate alpha and differentiated outcomes versus peers and indexes. In that way, Artisan's thoughtful growth directly benefits existing clients and existing strategies.

Through thoughtful growth, we also grow and evolve our strategy lineup to align with evolving asset allocations. This allows us to reach new clients and increase our partnership with existing clients. Thoughtful growth is important to our stockholders. Through growth, we extend the duration of existing talent and expand the number of investment decision makers. We diversify our business and sources of alpha. We offset natural attrition that occurs over time as we compound capital for long periods. And by increasing our capabilities and offerings, we increase the number of embedded options for growth.

Thoughtful growth is careful, incremental and disciplined. Growth that is consistent with who we are as a high value-added, talent-driven firm. Our commitment to thoughtful growth explains why we are not investing in passive investment strategies, a highly concentrated scale business or why we don't invest in a large sales force to transact directly with retail and wealth clients. We do not have an edge in those areas.

Our edge is as a home for investment talent and as a manager of high value-added differentiated investment strategies. We invest behind that edge. We spend time and money on investment capabilities that enhance our high value-added strategies, differentiate them from passive and exposure products and evolve in the direction of alternative investment allocations.

If we deliver, as we have in the past, there will be plenty of long-term demand for what we do and plenty of opportunity for top and bottom line growth. On last year's third quarter earnings call, I laid out long-term investments we are making in three areas to broaden into alternative-oriented strategies, differentiated credit, private investing and China.

Over the last 12 months, we have continued to incrementally invest in each of these areas. This is most apparent in differentiated credit. Over the last 12 months, we have successfully launched the Artisan Floating Rate strategy, which invests in floating rate leverage loans, the Artisan Emerging Markets Debt opportunity strategy, a blended currency emerging markets debt strategy, the Artisan's Emerging Markets Local opportunity strategy, a local currency emerging market debt strategy, and the Artisan Global Unconstrained strategy, a global macro portfolio.

As shown on Slide 2, we now offer clients six differentiated credit strategies. Consistent with who we are, we have focused on high value-added asset classes characterized by attractive absolute return potential, large investment opportunity sets allowing for alpha and differentiation, long-term demand from sophisticated asset allocators and attractive economics consistent with the value we can deliver.

2022 may appear to have been an inauspicious time to launch 4 fixed income-oriented strategies, but we have never attempted to time the market with new teams or new strategies. Our approach is thoughtful, methodical and long term. We start with the right talent, which is extremely rare, difficult to identify, and takes time to recruit. We identify long-term asset allocation trends that fit with our talent and high value-added approach. We get the people, resources and alignment in place. We launch when we are ready, not when we think a market is going to rip or client demand is going to soar.

Once we launch, we are patient, maximizing the investment team's time spent investing, establishing a track record. We invest in dedicated distribution aligned with the investment team. Our long-term time horizon reduces the importance of short-term market and demand dynamics and places a premium on getting the foundation right.

Slide three shows the outcome of our approach since Bryan Krug joined Artisan in 2013 and established our Denver-based credit team. The team's high income strategy has consistently outperformed the high-yield index and peers. For the trailing 5-year period, Lipper ranks the Artisan High Income Fund as the number 4 fund out of 338 high-yield funds. Bryan and his team have a differentiated philosophy and approach relative to rating agencies and other managers. The team focuses more on earnings and cash flow and less on the hard assets on borrowers' balance sheets.

In addition, unlike many high-yield managers, the Artisan Credit team invest opportunistically and at times significantly in floating rate levered loans. The significant use of loans nearly doubles their opportunity set from approximately $1.5 trillion of face value debt to approximately $3 trillion. The Artisan Credit opportunity strategy, which now has a 5-year track record, provides the investment team additional degrees of freedom, greater concentration, more distressed and less liquid credits, shorting and private investments. The team has used that flexibility to generate average annual returns of more than 8% since inception in July of 2017 after fees. That's more than 6 percentage points per year greater than the high-yield index.

As an additional reference point, since 2017, we calculate the middle markets private lending has generated an average annual return of approximately 8% before fees with less liquidity. In order to provide clients access to the investment team's credit picking skills with minimal duration risk, we launched the Artisan Floating Rate strategy at the end of last year. We also further developed the team's leadership, promoting Seth Yaeger to Co-Portfolio Manager of the floating rate strategy.

Since establishing the Artisan Credit team 8 years ago, we have consistently grown the team's business over time, raising almost $7 billion in cumulative net flows. Early growth was almost entirely from the wealth channel. As the team became more established at Artisan and extended its track record, we have diversified the business with institutional allocators and separate accounts, which remains a focus.

The weighted average fee across the team's AUM is 64 basis points, reflecting the team's value production for clients and demand for scarce alpha. Looking forward, we believe the Artisan Credit team has the leadership, breadth and depth of talent, resources and ambition to become a multidimensional credit franchise, managing an array of high value-added strategies, vehicles and investments. Future strategies may offer amplified participation in a particular theme or a subset of investments, such as a dedicated distressed or dislocation strategy or co-investment opportunities.

The team also has the capability to expand further into private investing and to manage structured vehicles, which would expand their client base into insurance and bank balance sheets. We are pleased with how the Artisan Credit franchise has developed so far, but we believe we are still in the early stages of building out a premier credit platform.

Slide four summarizes the three strategies managed by our second fixed income team, the EMsights Capital Group. Early performance has been strong. Since inception, on May 1, emerging market debt opportunities has outperformed its index by 735 basis points after fees. Since inception on April 1, Artisan Global Unconstrained has generated a 2.51% return after fees, a positive absolute return during a period in which most global markets have declined significantly.

In addition to strong absolute and index relative performance, both strategies have performed well relative to peers. We expect to see demand for the EMsights Capital Group across all of our distribution channels, both in and outside the United States. The FT reports that $70 billion has flowed out of EM bond funds this year, the most ever on record. That creates opportunity for us. Money looking for a home with a proven manager in an asset class we believe has long-term staying power. We are excited by this opportunity and are in the late-stage discussions with early institutional capital.

We are still very early with the EMsights Capital Group, but we believe this team has enormous potential to generate differentiated returns and build a high-quality, sizable business. Our build-out of differentiated credit capabilities is similar to the development of our global strategies and distribution between 2005 and 2013, and our high degree of freedom strategies beginning in 2014 and continuing to today.

The strategies we launched during our globalization phase account for approximately $42 billion of our current AUM, and run rate revenues of approximately $234 million. The strategies we have launched since 2014 account for approximately $23 billion in AUM and run rate revenues of approximately $185 million. These are successful growth outcomes as a result of the methodical execution of our thoughtful growth approach.

We believe we will see similar long-term outcomes with the differentiated credit businesses we are building today. Once we invest behind new talent and strategies, we are disciplined in seeing these investments through with operational and distribution alignment. As shown on Slide five, since 2012, we have grown from 5 to 10 investment teams, from 12 to 25 investment strategies. And from only public equity to now include long/short equity, high-yield credit, long-short credit, public private hybrid, emerging markets debt, and global macro.

The investments we make in our business take time to pay off. Because of our build, not buy approach, all of our investments run through our income statement, reducing short-term profitability. The P&L impact of current investments has been amplified by the market drawdown, pushing our adjusted operating margin from 45% a year ago to 33% for the prior period. We are extremely mindful of the margin decline. 2022 has been a historically bad year in markets. Rarely have both equity and fixed income valuation declined to such an extent at the same time.

Through the third quarter, the 60-40 portfolio was down 21%, the second worst performance since 1900. We feel the impact of these declines as do our clients and employees. We have built our business and financial model with these periods specifically in mind, to be a source of stability for talent, clients and stockholders, to allow us to capitalize on the investment and business opportunities that present themselves in periods of heightened volatility, uncertainty and fear. More than half our expenses automatically adjust down with AUM, including the vast majority of investment team compensation. This creates transparency, predictability and stability for our people.

We also have experience. We have been through these periods before, our investment teams, our management team, our Board of Directors. We have a well-communicated long-term mindset and confidence in who we are and the investments we are making.

Before turning it over to C.J., I want to spend a minute on Slide six, which is a slide we used last quarter as well. I think the perspective and history on Slide six warrants repeating. Sharp market sell-offs occur more frequently than many people think. And Artisan Partners has a history have taken advantage of these periods for the benefit of clients and ultimately stockholders.

Since our founding in 1995, there have been 12 calendar quarters in which the indexes, to which our strategies are compared, have declined by more than 10%. In 8 of 11 12-month periods, following a 10% drawdown, our firm-wide asset-weighted performance has exceeded benchmark performance. Across the 11 periods, Alpha averages 297 basis points. The three periods in which we underperformed were particularly sharp recoveries with clients and our firm benefiting from absolute returns of 31%, 23% and 59%. Our underperformance across these three periods averaged approximately 380 basis points.

If you extend the time horizon and look at the following 3-year periods, we have outperformed 8 of 10 times, with performance averaging 308 basis points. If you reduce the drawdown triggered to 5%, there have been 23 such quarters since our founding, including all three quarters of 2022. We have outperformed in 13 of 20 subsequent 12-month periods and in 16 of 19 subsequent 3-year periods with outperformance averaging 391 basis points.

Our investment teams have been able to take advantage of selloffs in the past, and we believe they will have the ability to do so again. We are well positioned as a firm to take advantage of opportunities that present themselves in times like these, whether it be talent seeking a better home or clients seeking a more stable partner. Our business is resilient and working. We are confident in our ability to execute through this period, come out stronger and continue to thoughtfully grow the firm over the long term.

I will now turn it to C.J. to discuss recent financial results.

[Charles Daley, CFO]

Thanks, Eric. Our third quarter and year-to-date financial results reflect the sharp decline in local markets and the impact of the investments in growth Eric highlighted. The combination of the decline in global markets and these investments in future growth are weighing on our revenue levels and operating margin. However, as Eric referenced, our financial model was built to absorb fluctuations in global markets.

While our operating margin decreases during market drawdowns, the impact is lessened by the variable nature of our compensation plans. For example, total adjusted operating expenses have decreased $11.6 million on a year-to-date basis, despite investments in new investment teams and strategies, and investments made in people and technology to build operational capacity. Our single largest expense, incentive compensation paid to our investment and distribution teams decreased as a result of our variable expense model and was cut by 17% or $47 million in the 9 months of this year compared to 2021.

While year-to-date market declines have been sharp, our financial model allows us to continue to focus on the long term rather than react to short-term market swings. We are confident that the investments we're making for future growth during this disruptive period will be rewarded.

Consistent with previous market cycles, we intend to be thoughtful and cautious with cost additions in the current environment, but we'll continue to execute on our growth initiatives and be opportunistic despite the impact on short-term results.

Our historical financial results are on Slide eight. These results give us confidence that our approach to long-term growth has historically served us well, with revenue and adjusted operating income, compounding at annual growth rates of 7% and 6%, respectively, over the last 10 years. Even with the recent pullback, our financial model has allowed us to generate operating margins in excess of 30% throughout market cycles.

In addition, we have paid investors cash dividends of $31.47 per share since going public, representing an average 8% annual dividend yield.

An overview of financial results begins on Slide 9. Global equity markets declined approximately 7% for the quarter, and 26% for the year-to-date period. As a result, our AUM declined to $120.6 billion at the end of the September quarter, down 8% compared to last quarter, and down 31% compared to the September quarter in 2021. Clients continue to reallocate away from risk during the quarter, resulting in net client outflows of $1.1 billion for the quarter and $4.6 billion for the year-to-date period. The outflows were primarily from our global equity and non-U.S. growth strategies.

Average AUM was $132.9 billion for the quarter down 8% sequentially and 25% compared to the September quarter 2021. Year-to-date, average AUM has declined 14% compared to the first 9 months of 2021.

Slide 10 shows our AUM by generation. Across all generations, AUM was impacted by declining global markets during the quarter and year-to-date periods. There were no material changes in the weighted average management fee or AUM mix by generation or vehicle.

Financial results are presented on Slides 11 and 12. Our complete GAAP and adjusted results are presented in our earnings release.

Quarterly revenues declined 7% compared to the previous quarter and 26% compared to the third quarter of 2021 on lower average AUM. Year-to-date revenues were down 16% from 2021 on lower average AUM and lower performance fees. Performance fee revenues have been negligible in 2022 compared to $11.2 million in the 2021 year-to-date period.

Adjusted operating expenses for the quarter decreased 5% sequentially due to the decline in incentive compensation expense as a result of lower revenues as well as a decrease in general and administrative expenses. Year-to-date, adjusted operating expenses decreased 2% compared to the 9-month period ended September 2021. The $47 million decrease in incentive compensation expense, resulting from our variable cost structure, was partially offset by increases in travel as well as base compensation, technology and office space expenses to support future growth.

Adjusted operating income declined 11% for the quarter compared to the second quarter and declined 33% for the year compared to 2021. Likewise, adjusted net income per adjusted share declined 11% for the quarter compared to the second quarter and declined 34% for the year compared to 2021.

Turning to Slide 13. Our balance sheet remains strong and continues to support our capital management practices and our variable cash dividend payout model. As previously announced, during the quarter, we closed on the refinancing of $90 million of maturing senior notes pursuant to an agreement executed in December 2021. The new notes bear interest at a fixed rate of 3.1% and will mature in August 2032. The lower rate will reduce annual interest expense by $2.4 million.

Our unused $100 million revolving credit facility was also extended for an additional 5-year period. Our leverage ratio remained at 0.4 times for the trailing 12 months and is 0.5 times on a quarterly run rate basis.

During the quarter, we invested an additional $30 million of seed capital into new investment products and currently we have $118 million of seed capital invested in products that are building towards scale. Investing in new strategies is an important component of our future growth. Accordingly, we currently plan to retain a portion of the special dividend to fund future seed investments.

Moving to Slide 14. Even with the investments in future growth, we continue to return capital to shareholders on a consistent and predictable basis through quarterly dividend payments. In accordance with our capital management policy, our Board of Directors declared a quarterly dividend of $0.56 per share with respect to the September 2022 quarter, which represents approximately 80% of the cash generated. Including this declaration, we have declared dividends of $3.67 per share during 2022.

In the fourth quarter, we expect the Artisan funds to complete their annual income and capital gain distributions. Based on current estimates and assumptions, we expect fourth quarter distributions to result in approximately $300 million of net client cash outflows from investors who choose not to reinvest their distribution. That's down from $2.3 billion of client cash outflows related to fund distributions in 2021.

That concludes my prepared remarks, and I will turn the call back to the operator.

[Operator]

[Operator Instructions] Today's first question comes from Alex Blostein with Goldman Sachs. Please go ahead.

[Alex Blostein, Goldman Sachs]

Hi, good morning. Good afternoon and thanks for taking my question. Eric, I was hoping we could start with some of the cross currents you're seeing from institutional asset allocations, given all the macro volatility. Obviously, we've seen a significant pullback in both equity and fixed income values. And you talked about, I guess, some of the secular dynamics and how you're positioning the product. But as you look out into 2023, what are some of the key kind of shifts in asset allocations that you expect to see from institutions and how that might impact your asset base?

[Eric Colson, CEO]

Alex, yes, there is a lot of cross currents that we see in the marketplace. It's continuing through year-end. We still see the risk-off mindset, which you saw in this quarter's flow. That mindset seems to be carrying forward. There's a lot of discussion around yields and credit going forward. Obviously, with yields moving up and people matching that to their assumed rate of return, we think there'll be some asset allocation movement in the first half of next year. But right now, it's still fairly hard to predict if that will get to a risk-on standpoint. And given the mix of strategies that we have and our minds -- emphasis on equity and high value-added strategies and more risk appetite strategies, we need to see a little bit more of that to come back to get into a really offensive position.

But the credit cycle seems very interesting given the development made with the EMsights Capital Group and really the establishment and the second generation of strategies occurring in the credit strategy -- the Credit team we have in Denver.

[Alex Blostein, Goldman Sachs]

Yes. All makes sense. And then my second question is for C.J. I was hoping you could comment on the special dividend dynamic as you head into the end of the year. So maybe how much capital do you guys expect to retain this year as you built out some of these strategies? And then, do you think this is going to be just a 2022 dynamic or because you guys are expanding the product line up and might do more in privates down the road, which will require maybe a little bit more capital from a GP commit, we might ultimately end up with a lower total payout from -- on the dividend side versus what we've seen in prior years?

[Charles Daley, CFO]

Yes, Alex. Good question. So we've actually have held back cash in prior years. We held back 5% of the total cash generated last year, which reduced the special by about 25% had we paid out the full. We're expecting about the same this year. So in total, about a 95% payout. Obviously, we reserve the right to make the final decision as we get to the end of the year. But that would result in us holding back about $10 million, $12 million and then paying out 75% of the amount that we've held back for the special, which is right where we were last year.

[Alex Blostein, Goldman Sachs]

Great. Thanks so much.

[Operator]

[Operator Instructions] Our next question today comes from Kenneth Lee of RBC Capital Markets. Please go ahead.

[Kenneth Lee, RBC Capital Markets]

Hey, good afternoon. And thanks for taking the question. Just one on Slide three in terms of the Credit team in terms of net flows. Looking forward, just wondering if you can give your thoughts about the proportion of demand from institutional investors versus intermediaries. And maybe, could you also talk about some of the key factors for gaining traction with institutional investors, knowing that perhaps track record might be one of them, but if there's any other factors that those investors are looking for? Thanks.

[Eric Colson, CEO]

No. Certainly, the -- as we mentioned in the remarks that the Credit team really established a strong foothold in the wealth channel or our intermediary channel, and we built up a very diverse client base. But as you've heard in the past that we -- basing each team off their revenue share, and we look a lot at the right clients on the right terms and build a broad client base, and we like to extend the duration of that client base as much as possible.

So our emphasis more recently has been on the institutional client base for the Credit team, and we have been establishing a broader base there. And really, it's nailing down those terms and fees, and extending the duration is our focus right now. So those were the key traits we're looking at to round out the asset base for the high income strategy. And then obviously, the newer strategies are in the earlier stages and we don't have the same focus and restriction on those asset bases for those strategies.

[Kenneth Lee, RBC Capital Markets]

Got you. Very helpful. And just one follow-up, if I may. You touched upon this in terms of future investments. I wonder if you could just further expand upon thoughts about how you think the pace of future investments could trend just given the current macro and market backdrop. Thanks.

[Eric Colson, CEO]

I'll take an answer on that for the investment teams and strategies that we're looking at. We've obviously added quite a few strategies over the last 12 months. It's been our most active period really in the history of the firm. And as you've seen in our history, our mindset is to find the high-quality teams and then see those through their first couple of years and build a strong team, a strong foundation and a strong asset base.

Our expectation going into next year is to focus on seeing a lot of those strategies build that foundation and build that asset base across the board. So my expectation around strategies and teams will be much lighter than you saw last year.

[Kenneth Lee, RBC Capital Markets]

Got you. Very helpful. Thanks again.

[Operator]

And ladies and gentlemen, this concludes today's question-and-answer session and today's conference call. We thank you all for attending today's presentation. You may now disconnect your lines, and have a wonderful day.