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Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Good morning, and welcome to Franklin Resources Earnings Conference Call for the Quarter and Fiscal Year Ended September 30, 2018.
Please note that the financial results to be presented in this commentary are preliminary. Statements made in this conference call regarding Franklin Resources, Inc., which are not historical facts, are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements involve a number of known and unknown risks, uncertainties, and other important factors that could cause actual results to differ materially from any future results expressed or implied by such forward-looking statements.
These and other risks, uncertainties, and other important factors are described in more detail in Franklin's recent filings with the Securities and Exchange Commission, including in the risk factors and MD&A sections of Franklin's most recent Form 10-K and 10-Q filings.
Good morning. My name is Donna and I will be your conference operator today. At this time, all participants are in a listen-only mode. As a reminder, this conference is being recorded.
At this time, I'd like to turn the call over to Franklin Resources' Chairman and CEO, Mr. Greg Johnson. Mr. Johnson, you may begin.
Well, good morning and thank you for joining today's call to discuss fourth quarter and fiscal year results. This year marked a period of significant investment for the company as we reevaluated several facets of our business, continued to invest in ongoing strategic initiatives, and expanded our capabilities.
These investments contributed to lower operating income this year, but we firmly believe we now have the appropriate organizational structures in place to meet evolving client needs. We also returned more than $3.5 billion to investors through dividends and buybacks, in addition to that used for strategic acquisitions to enhance and expand our investment capabilities.
Our heavy mix of value-style funds weighed on flows, but we are optimistic about our flagship products' performance moving forward, as we've seen very strong performance in our key global macro and global equity funds into the quarter-end and into October.
With me today is our CFO, Ken Lewis, and we also have some special guests here to discuss this morning's exciting acquisition announcement. I'd like to extend a warm welcome to Benefit Street Partners' Chief Executive Officer, Tom Gahan; and President, Rich Byrne. Tom is dialing in from BSP's offices in New York, where he's been meeting with his team, and Rich is here with us in person in San Mateo.
Tom has been with BSP since the beginning and previously served as Chief Executive Officer of Deutsche Bank Securities, and Head of Corporate and Investment Banking in the Americas. Rich also previously served at Deutsche Bank Securities in the capacity of Chief Executive Officer for a number of years. We're excited to welcome these talented people to our firm and we hope you find their participation on today's call helpful.
I'd like to now hand it over to Tom for some opening remarks.
Thanks, Greg. Rich and I are happy to join the call this morning to discuss the partnership we're building with Franklin Templeton. We both believe that Franklin will be the perfect long-term partner. I can tell you that on behalf of the entire BSP team, we're super excited to join this world-class global organization and combine our alternative credit products and investment capabilities with Franklin's tremendous investment platform.
We believe this combination will serve to augment our investment capabilities, while accelerating our growth prospects. All five of our core strategies have significant and secular growth opportunities. We believe that the Franklin umbrella will improve our information flows, also expanding our origination capabilities. In particular, we look forward to working with Franklin's global distribution platform to offer new products with extremely attractive risk-adjusted returns to their clients.
In short, this is a win-win for our team, the combined platform, and most importantly, our investors. In addition, Franklin's long history of successfully acquiring platforms, while maintaining the strengths and independence of the investment processes, give us confidence that this will be a mutually beneficial endeavor. Our investment team and process will be unchanged and the team has strong, mutually aligned incentives to continue delivering best-in-class returns to our investor base. Our conservative investment style will mesh well with Franklin's focus on long-term value creation for investors.
In conclusion, we feel fortunate to be navigating the markets and future opportunities with Greg, Jenny, and the entire Franklin team as our partner. Thank you.
Thanks, Tom. So with that, we'd like to open it up for your questions.
Thank you. The floor is now open for questions. Our first question is coming from Glenn Schorr of Evercore ISI. Please go ahead.
Hi. How are you? So I like Benefit Street and I like the space. Never mind there's big concerns about too much growth in private credit. I think there's a big ramp if you do it right. So, a little more question on what – I get what Benefit Street brings to Franklin. Could we talk a little bit more about what Franklin brings to Benefit Street? Does it expand distribution and which parts of it?
And this might be a stretch, but I know I've given you heat over the years of how you have this great retail fixed income platform, but never really grew a big institutional platform. Could Benefit Street be a launching pad towards a bigger institutional public fixed income as well?
I'll take that. This is Greg. And I think the immediate opportunity for us looking at our worldwide distribution network, the relationships we have with sovereign wealth funds around the globe, I would say that Benefit Street has been very successful growing with a relatively small distribution group and relied some on third-party distribution, where we think this asset class in this environment with floating rate, first lien, more defensive characteristics is very attractive to institutions that are concerned about rates, but need fixed income exposure.
So, we clearly see this as a growth opportunity, where immediately we can plug and play this with our institutional network and then explore the retail channel, whether it's a high net worth channel or looking at the type of interval funds or closed end funds that could be attractive in the retail space. So, we think there is immediate demand and opportunity for our distribution channels. And I'll turn it to Rich if he has any additional comments.
Sure, Greg. I think the way we think of it at Benefit Street is Franklin brings a lot of things. Tom mentioned some of them in his remarks, but it's pedigree, global reach, distribution, balance sheet, and information flow. So if you think about it, we have a number of alternative strategies. We think they generate some really attractive risk-adjusted returns, to the extent we can aid in our sourcing or information flow through the analyst at Franklin and all the other things that it brings, that's great for our ability to deliver returns to our investors.
But as far as delivering our products to a broader set of investors, our footprint on institutions, we've raised $26 billion over the 10 years that we've been around. But our footprint just isn't big enough and this deal comes at just the right time for us. And I would add, as you said, on the retail side, the only products that we have that really touch the retail market at all are two permanent capital vehicles. We have a publicly filing, but not listed BDC and mortgage REIT. And to the extent we can tap into the massive retail distribution here at Franklin, those are big growth areas as well.
And maybe, Tom, you could expand on. I think the institutional opportunity for us, we think this is the final piece is having the full platform of credit available and we're seeing more demand in the institutional space, where you have mandates, where you can be tactical in moving between different categories.
Yeah. No, I think that's right. I mean, we're definitely seeing increased demand for the products that we manage and we're seeing increased demand for effectively commingled structures that take combinations of what we do. Markets are always constantly changing and opportunities are constantly changing, and having that type of flexibility is becoming more and more important to our investor base.
Okay. And one final thing, anything you could tell us about performance on – it's going to sound ridiculous, but how you know these guys are good and what record are you looking at that you can show us over time?
Well, I think we, obviously, did a lot of due diligence and looked at the records. And also, more importantly, we looked at the structures and downside protection, and I think that our first reaction like anybody is, hey, we're late in the credit cycle, and that was our first reaction and even my initial discussions. And the more we got to know the business that we think this is really in a great position to benefit from any dislocation. And we haven't talked about, but it's not just private debt, it's distressed, it's long/short credit, it's high yield, it's other sectors that we think can do very well.
And I think the important part of their business model is that the funds are more like private equity type funds, where you have – you call on capital, there's dry powder there, you get market dislocations, you can have fresh powder put into the market. That's very different than the daily valuation, which has to sell as redemptions come in.
So I think we looked at the defensive nature of how the assets are positioned and captive, and that was very attractive. And also the lower leverage on the products versus the industry averages and the fact that this is one of the groups that has been doing it for a while since the global financial crisis and you have a lot of new entrants kind of coming in now and they've done it, done very well through the entire cycle with less leverage than others.
All right. Thanks for all of that. I appreciate it.
Thank you. Our next question is coming from Robert Lee of KBW. Please go ahead.
Great. Thanks for taking my questions, and maybe like drill into the Benefit Street a little bit more. If I'm reading it correctly, financially, you're only buying the management fee stream and not buying the incentive fee stream. And any color you have kind of around – I'm assuming they're going to work as a kind of stand-alone entity, even though you own 100%. Kind of any color you may have around kind of their current profitability and margins?
Yeah. I mean, I'll take the first part and then maybe turn it to Ken on detail. I think the carry is the same carry percentages that existed before. So a percentage of the carry goes to the team, a percentage goes to Franklin, and none of that's changed. And I think that – and the majority of the carry goes to the team, 60%, and 40% to Franklin. So, yes, performance fees are still very important in the equation of the value and accretion for this deal. And I'll have Ken talk about the numbers.
Sure. Thanks, Greg. So when we looked at this deal – and I know in the commentary we talked about that being neutral next year. I think the first thing to point out is when we're talking about accretion, we're talking about GAAP accretion. And so, while it's neutral, next year under GAAP basis we do see it accreting over time in the 5% to 10% range going forward, and that's on a GAAP basis. If you were to back out noncash items, it would be a lot more accretive, which I know some of our peers do.
Is it possible to get some sense to that? I mean, in terms of as we model it and kind of think about that cash generation. Means...
Yeah.
...is it tax benefits or what we'll see next quarter.
Yeah, we don't think this will close, first of all, until like the second quarter. And then in FY 2019 we're saying it's neutral, but it should start to be accretive in the second year.
And is all the $26 billion of assets fee generating? And kind of any color on what is the size of the kind of uncalled capital that's not earning fees yet as kind of the dry powder?
Well, we can have – yeah, we disclosed run rate revenues, so that's one thing I'll point you to. And I think maybe Rich will talk about the dry powder.
Yeah. The capital that we have under management, $26 billion, is we have – as we mentioned, most of that – actually over 85% is long life capital, meaning that it's either in a drawdown structure or in our permanent capital vehicles, et cetera. We lever our funds – our two most recent funds, our flagship private debt fund, our distressed fund. We have actually some other funds as well. I have not finished drawing down all their capital yet, so we still have a fair amount of powder and – in that runway.
That's $2 billion in dry, $2 billion to $3 billion.
Great. And then if I could – I appreciate your patience – maybe back to the core business. Ken, end of the year, kind of looking ahead, what are your latest thoughts about kind of what we should be thinking for expense growth next year? I mean, previously you wanted to hold it down to, I believe, less than 3% or – that's still a good number? Where does that stand?
That's right, Rob. So, we finished our budget process in August/September, and that process was consistent with the guidance that I provided last quarter that we were budgeting expenses to go up 2% to 3%. But no sooner than was the ink dry on that that we started to look towards ways to get that expense growth down. And then, with the recent market activity, we're accelerating that. So, we do think that – while the budgets, we're projecting to grow 2% to 3%, we do think that there are opportunities to reduce expenses more. And so, even get it down to half that perhaps or even more than that.
But just a word of caution there, some of these things – these levers that we have, and we do think there are several of them, they're a little bit – take a little longer to pull, and they take a little longer for the benefits to be seen through the P&L. Having said all that, because of the cyclical nature of the expenses, we do think next quarter we should have flat expenses.
Great. Thanks for taking my questions.
Thanks.
Thank you. Our next question is coming from Michael Carrier of Bank of America Merrill Lynch. Please proceed with your question.
Thanks, guys. Maybe first one just another question on the Benefit Street Partners. Just when I think about the $26 billion in maybe like the management fees, is that mostly on commitments or NAV? And then any margin color. And maybe for the team, like Tom, just wanted to get your sense, it seems like there's more – there's, obviously, structural growth, but there's a lot of like competition coming into that market. So, just how are you guys looking at deploying capital, given where we are in this cycle and how the structure is of some of these products kind of protect downside?
Maybe I'll have Rich address that. And, Tom, you can jump in at the end if you have anything to add.
Sure. Thanks, Greg. We have a number of products. The one that people seem to ask about the most is around private debt. There undoubtedly has been more competition there, spreads have tightened, there's been some new players, but a couple of remarks. One is, everything we've read, it's probably the most unallocated asset class within alternatives, certainly relative to PE or real estate, et cetera. So, every projection we've seen shows that market considerably growing, almost doubling over the next five years. And despite tighter spreads and somewhat weaker documents, we still think for the most part across the continuum that we run – remember, we're sort of a credit ecosystem always looking around relative value. It really is the best risk-adjusted returns for the most part that we see across the credit spectrum.
And the only other thing I would add, and maybe if Tom wants to chime in here, is size matters. So, there may be more competitors in the market. Some stats we looked at recently is less than 20% of all the new funds formed are over $1 billion. Size really matters. Size matters because of the size of the teams. I mean, this is a very labor intensive business, private debt. You just have research analyst doing a lot of work for you. You have liquid markets to sell to. Oftentimes, we're the only lender. So, size matters as far as size of teams, monitoring, and all that, but it also manages commitment.
So across our platform, almost half of our AUM, about $12 billion, is in private debt, means that we can commit up to, and in some cases even above, $300 million per deal. Remember, the average size of deal we're doing on a middle market loan is a $30 million, $40 million, $50 million company. $50 million EBITDA companies don't need $25 million. They need commitments of multiple hundred millions. And believe it or not, there really aren't that many providers out there, the banks aren't in that business for the most part, that can do that.
And so, I think what you'll see over time is consolidation. And for us, hopefully, under the Franklin umbrella, just make us that much better at doing our job, and that's just private debt. Of course, we have a lot of other strategies which benefit from the same bank disintermediation, and a lot of the same fundamental factors that does private debt.
Tom, do you want to add anything? Are you...
Yeah, I can add just quickly. I think one on more of a sort of technical question I think you began with, on our private equity style funds, fees are charged undrawn as opposed committed capital. We think that actually places us in sort of a much better position with our investors. That's how they work. But I think just echoing Rich's comments that scale matters, and we have 50 people that are originating, we can write checks of multiple hundreds of millions of dollars.
When we're talking to financial sponsors, owners of companies, management teams, and we can say, look, we can underwrite your entire cap structure, we can underwrite acquisitions, et cetera. That direct transfer mechanism is becoming more and more important. And we think that the combination with Franklin is going to sort of further elevate us and continue to separate us from the smaller players who just can't do that.
All right. Thanks. And just a quick follow-up maybe for Ken. Just on capital, so you guys were active on the buyback. You did this transaction. Going forward just wanted to get a sense. I know you guys have a ton of cash and you generate a lot, but just from a priority standpoint, does this change anything in terms of the pace of buybacks that you guys have been kind of run rating?
Sure. And I think we did see the buybacks slowdown this quarter. I think that's – the trend, all things being equal, would have continued. Of course, that could be offset with the market right now. And so, as you know, we're pretty opportunistic. But we think that this acquisition and our buyback practices are consistent with our historical practices. If you look back what we've done with the year, after tax reform we've had almost 200% payout of earnings this year. And this is consistent, this acquisition.
So, I would just say the answer from our perspective is this acquisition doesn't affect our capital management program and I wouldn't relate it. There's a little slowdown quarter-to-quarter. It wasn't because of this deal...
Correct, right.
...on cash. There's plenty of cash for buybacks.
Got it. Thanks a lot.
Thank you. Our next question is coming from Bill Katz of Citi. Please go ahead.
Okay. Thank you very much for taking the question and congratulations on the transaction to both parties. Just sort of on that, I just wonder if you could just maybe peel back one more level here on the economics of it. It sounds like there's some money upfront, some money down the road. Just trying to tie back to your GAAP neutral, and then some improvement on the other side of that. Maybe talk a little bit about how much is paid upfront and what some of the milestones might be in terms of earn-outs and when that might be, what kind of margin are we talking about, and then can you quantify the intangible amortization.
Sure. I think the margin in this business are extremely attractive. And over the next few years, that will be largely offset by retention programs. Just a little bit about the deal itself, we have the $683 million initial considerations. As we mentioned earlier, the key employees will still accrue the majority of performance fees, and they will also participate in retention programs. We stagger the vesting over the next six years, with the more senior individuals having the longer vesting periods. And the partners will invest, as we mentioned, 20% of the after-tax proceeds.
So if you consider the commitment to invest in the future funds and the deferred programs, approximately half of the total consideration is backend loaded and we think that's aligned – and including the carry. And so we think that all the interests are aligned there.
And I would just add. I think, for us, that was a key point in the structure of this deal that based on the ownership structure allowed us to put much more of the consideration to employees and vesting over time. And I think like any deal you do, where it's one thing buying the company, it's another thing to be sure the key people are going to stick around. I think in this case, we would say that there's a higher probability of people staying, because the incentives are better for them than the prior structure, and nothing's been altered. It's just been more attractive with vesting over four to six years.
And senior management will enter into a non-compete and non-solicit agreements too over a six-year period.
Okay. And then my follow-up – thank you for that. My follow-up question this sort of stands on the core business as well. So when I look at the gross sales dynamics, they continue to weaken both quarter-to-quarter and year-on-year. However, could you give maybe a little bit more color around any kind of intra-quarter trends that you may have seen in terms of, given the performance has improved as the quarter sort of unfold a little bit? And then any sort of color, what you're sort of seeing just given the turmoil that's continued into October?
Yeah. I mean, I would start by, for us, we've always felt that with a large base of value assets, you need some market setback and sell-off and volatility to get the value back in favor, and rising rates certainly, as we've said before, historically in that kind of market value tends to outperform growth. So, if you look at September/October, it's probably the strongest overall performance we have had relative to our peer groups in the industry.
And even to me, the immediate where I think we could turn flows fairly quickly, it's still our top selling funds would be around the global macro, global bond, where in this kind of environment where you have the uncertainty, you have rising rates, and in the last probably five weeks we picked up close to 600 basis points against our competitive universe here, and have a positive return the last 12 months.
So I think that's the one to me that from a flow standpoint that I think could turn fairly quickly. I think the others, we have better relative numbers with Templeton, with Mutual, as you'd expect, in this kind of market, but I still think it would take a little bit more time to see that translate to sales. I think the immediate opportunity is still what has been our big driver. And if you look at the last time we had the global financial crisis and coming out of it in the last decade in equities, that's where the global bonds did so well. So, I think that that story will be attractive.
And that said, we did see a slight pickup in U.S. retail sales even last quarter.
Okay. Thank you.
Thanks.
Thank you. Our next question is coming from Craig Siegenthaler of Credit Suisse. Please go ahead.
Thanks. Good morning, Greg, Ken. How did Benefit Street's private credit funds perform in 2008 and 2009 in terms of realized losses?
I'll let Rich take it.
Easy question to answer. We're exactly 10 years old, so we really started at the – I think it was a couple of weeks, right around the Lehman demise. So at Benefit Street, we don't have the crisis in our sphere.
And I think maybe it's important just to point out, and maybe Tom or Rich, I think our first reaction was the same kind of question, well, CLOs were a disaster during the global financial crisis, but again when you really look at and understand the difference, these are not mortgage-related CLOs. They're not CDOs. And actually this asset class performed – it was one of the top performing fixed income classes during the global financial crisis.
So, Tom, you want to add anything on that?
Sure. Yeah. I mean, so from inception we've had virtually zero losses. Obviously, it's been a pretty favorable credit environment, but there are plenty of losses out there amongst our competitors. With respect to sort of what's going on in the broadly syndicated loan marketplace, CLOs, et cetera. If you look back to the actual returns of CLOs through the GFC, the returns are amazingly strong. Since then, the structures, CLO 2.0, have gotten stronger. We are very conservative in the way that we underwrite credit. And we believe that the CLO structures are going to be able to weather any foreseeable downturn in the marketplace and still be able to protect investors in those structures.
Okay. Thank you.
I'll also add...
Just a quick follow-up here.
Wait. We just had one – Rich has one quick comment.
Yeah. Maybe embedded in the question is where we are in the cycle now. Clearly, the market's exhibiting a lot of late cycle behavior. If you look at our portfolios across our platform, you'll see a very different construct. Right now, in our private debt strategies, we're, give or take, 90% senior secured top of the capital structure. Loan-to-values are across our platform around 50%. In fact, in our most current fund, our flagship, we're investing now – excuse me, it's under 50%. So, we've got a lot of dry powder. We think the portfolio is very defensive.
As Tom mentioned, we've had a de minimis amount of losses since inception. And the point I made earlier about the – that most of our capital is long life capital gives us the ability to make disciplined investment decisions during market downturns and not be subject to flows. So, this is a fixed income business. Credits generally have limited upside and lots of downside. We're managing for that downturn and, frankly, are looking forward to it.
Thanks, guys, very comprehensive. Just one quick follow-up. What is the appetite for another special dividend around year end, just given that tax repatriation is no longer a hurdle?
Yeah, I think that's just one of the quivers and the arrows that we have to look at. And it's a board decision, as is the regular dividend. And I don't think, as Greg pointed out, nothing's really changed in our capital management policies or practices.
So, yeah, it would be under consideration and we'd get feedback on it as we usually do.
Thanks, guys.
Thank you. Our next question is coming from Ken Worthington of JPMorgan. Please go ahead.
Hi. Good morning and thanks for taking my questions. So maybe first, what kind of balance sheet or liquidity risk does Franklin take here with this acquisition? Maybe to what extent does Franklin buy a balance sheet with Benefit Street with CLO tranches or other balance sheet investments in the Benefit Street funds? And then what sort of liquidity provisions do the products have here? And how confident is Franklin that it won't have to step up to provide customer liquidity, should trading in the underlying investments dry up when customers look to redeem?
You sound like one of our board members. I think these are exactly the right questions to ask when looking at these types of investments, and we've done extensive due diligence around any potential liability or balance sheet issues. And really, again, the key here is the structure, where it's private equity-like fixed. You have terms of seven years with the private debt funds. There is no liquidity issue. They're in there for seven years, so you don't have a meet a daily redemption type of step-up that you could have in a 1940 Act Fund or any other vehicles that have daily liquidity. These are very much, whether it's the REIT or BDC permanent capital.
And so, we really looked at that carefully. We looked at the liabilities, If there were any that related to these instruments in the GFC. And really felt strongly that that hasn't been an issue certainly even with the CLO side going through the GFC, where the management companies have had any liability or any kind of issuance. And also the structure around – whether it's a partnership with funds – again, we don't have the balance sheet issues of having to put it on our balance sheet.
Okay. And there's no investments in the Benefit Street funds at all (00:34:05)?
Yes, there will be, but – yes, but for us, that's something we modeled out and looked at. It's a small percentage for the type of funds that we would normally do, and I think our view was that it wouldn't exceed. If we hit all of our growth targets and assets grew and doubled in size, our maximum at any one time would be somewhere around $230 million, $240 million of capital. And we think that's a pretty good use of the $240 million if that's where, better than sitting in 2% treasuries.
Okay, great. Thank you. And then, can you give us a little background on the seller here? So, I guess, my assumption in Provident (sic) [Providence] is a seller here along with management. Maybe, what's the history and why are they selling, if the outlook for the business is so good, as you've represented, why do they see now as the right time to be transferring a lot of the economics from them as the owners to you, as the new owner?
Tom, do you want to take that one?
Sure. Yeah, listen, Providence has been a great partner and they're with us from day one. Our business has become larger and more complicated. We have capital needs and distribution needs that really couldn't be fulfilled by our existing partner. I mean, they're a sector-based private equity fund, really successful at what they do. And we determine jointly that it was probably the best time to start thinking about bringing in a partner for us for the long-term that could really help us on sort of that pedigree, that global recognition, access to distribution, capital to seed, new products, new teams, et cetera. And this was just a natural time to sort of do that, given our growth and sort of how much our business is so different from what they do.
Okay, great. Thank you very much.
Thank you. Our next question is coming from Brian Bedell of Deutsche Bank. Please go ahead.
Great. Thanks. Good morning, folks.
Good morning.
Maybe to tie in a lot of the comments on Benefit Street and after a couple of questions on it. Financially, Ken, I think you mentioned you thought over the long-term this could be 5% to 10% accretive. I guess, just if that's GAAP or non-GAAP?
And then you guys have sort of given us some good detail here on the structure in terms of the $683 million, that amount being half of the total consideration. But I think you also mentioned, carry as a component of that. So, just trying to get a sense of what – if carry is a significant part of that versus actual cash laid out by Franklin. I think you also mentioned the assets doubling over time in a four to six-year timeframe. So just wanted to, first of all, try to get a sense of that on the financial side if that tie into the 5% to 10% accretion.
Seems there's a lot there. Let's see where to begin on that. So, first of all, it was kind of a long-term endeavor here. What I was saying was that the team will – they're participating in majority of the carry, and that is – will align their interests, the different components, as I mentioned, over six years. And that is why we're saying it's neutral in the beginning, but over time – could you repeat some of the questions...
Yeah, yeah, yeah, sure, yeah, no worries.
...or just repeat the questions?
Yeah, no worries. You're answering part of it. So as we go to the four- to six-year timeframe that you sort of talked about, and you also mentioned sort of a goal of assets doubling in time, it sounds like some of the incentive is going to be the retained carry by the teams, and then some of the contingent consideration will be cash laid out like a typical earn-out structure. And is that coming into that 5% to 10% accretion? And, I guess, that 5% to 10%, do you see that as sort of – not in 2020, but more like four to five years out?
I think, yeah, my time horizon was about four or five years, and it included all of that in my numbers and it was GAAP, as I mentioned. So, if you backed out the noncash components, the accretion would be a lot higher than that.
Great. And then, sorry, did you give the amortization...
Sorry. No, we said that's – we'll give more details on those on the next quarter call in around.
Got it. Yeah, that makes sense. And then on the growth side...
Yeah. So next quarter when it closes, we'll give some more guidance on individual line items.
Okay, that's great. And then, I guess, more broadly, just the cross-sell that this can – I guess, your sort of idea of to what extent you can sell this into your institutional channels, particularly on the insurance side, which clearly has increasing need for liquid credit. And I think you also mentioned retail product structures as well, although, obviously, I would think they would have to be more liquid. But do you have plans on launching it with retail products?
Yeah. I think those are absolutely all attractive prospects and we have a team that calls on the general account insurance business. This would be a natural quick fit. It's not that complicated of a story for, I think, a generalist institutional team to go out and at least talk about and see if – like, whether it's sovereign wealth fund where you have relationships around the globe. This is a natural category.
And even – my interest – it was interesting on why, I felt like this category was one we had to look at. I was just sitting on two endowment boards and the consultant came in and said, we're going to educate the board on private credit. I said, hmm, this is interesting. This is a category, and again, because it just fits so neatly into this rising rate and having more quality around it and the attractive yields you get by eliminating the bank, I think it is very attractive that way.
And the retail side, whether it's the high net worth side with fiduciary is an easy first introduction. But we've already seen interest from our traditional retail channel around whether you have an interval structure or a closed-end structure. I mean, those are all things we will explore right away, and we think that we can do that fairly quickly.
That's great color. Thanks. Just one on expenses, the base that you're growing from, Ken, for the 2% to 3% growth for next year, is that expense base $2.16 billion? Do I have that right? (00:42:06) excluding the sales and distribution expense.
Yeah, I'm giving you the number excluding the sales and distribution and marketing line.
That's $2.16 billion for fiscal 2018, unless there's other one timers in there?
I'm not – I think that's about right, but I think you should just verify that with Investor Relations later.
Okay. Yeah, will do. Thank you so much.
Thank you. Our next question is coming from Patrick Davitt of Autonomous Research. Please go ahead.
Thanks, guys. Could you maybe just step back and give us an idea of the process for the BSP discussions, evolution, who went to who, was this investment banking driven? And should we take this to indicate that there's a healthy pipeline of similar deals out there as you've kind of gone through these processes?
Clarify that, how did we – oh, the BSP. I thought you said the BDC. Okay.
No, no. BSP, sorry. How did the process play out? Yeah.
Yeah. This was not an auction or a book or somebody going out and saying, we want to sell to the highest bidder. This was a – came from relationship of one of our board members with Tom and introduced us and just thought this would be a very interesting fit, because he's heard in our meetings how we want to continue to build our alternatives business. And he personally knew Tom and his team and knew Rich and David, and just felt like this was the right cultural fit. These guys have a long history of working together. Our people knew many of their senior people going back to Merrill Lynch days in high yield and things.
So, I think that got us off to a good start in the discussions and our first reaction, like many, where we were late in the credit cycle know and the more we understood the business and the opportunities to benefit from any downturn with distressed and long/short and just the conservative nature of how they're running their business, we got very comfortable and very excited about it and that's really how. And we did a lot of due diligence, because it's a new area for us and for all the questions that were raised on this call around capital, any future liabilities, all those things we wanted to be very careful about. So, I think that's really how it came, but it was not a bidding process at all.
And I think the point is, we've said before, we're open to any deal that looks like it has quality people, a quality record, and it's an area that can grow. And I think that's – we looked at this business and just feel like there can be some bumps like all credit areas have, but the middle market corporate business is one that – it's hard for the banks to get back into and it's a big market and we think very attractive in this environment.
Great. Thanks. That's helpful. And then just a quick one, I may have missed this earlier, but did you give the weighted average tenure of AUM? I imagine it's in the kind of five to seven-year range.
It is, but that's really the private debt side. I think there is permanent as well. So maybe, Rich...
Yeah. Each of our strategies is different. For private debt, our funds are long lock-up funds, generally seven years. On the BDC and the mortgage REIT, those are permanent capital vehicles. They're publicly filed, they're not traded at the moment, but we plan on listing those and think of those as any permanent capital vehicle.
Thank you.
Thanks.
Thank you. Our next question is coming from Brennan Hawken of UBS. Please go ahead.
Hi. Good morning. Thanks for taking the question. Just a quick one; I don't think you touched on this, but when you spoke to your assumptions – this is on the BSP transaction. When you spoke to your assumptions about year two accretion, could you let us know what credit trends are embedded within those assumptions?
Yeah. The assumptions are that there would be future fund launches that are consistent with past fund launches and growing slightly. So, maybe like 1% or 2% or 3% growth in those fund launches, and that was the major assumption driving revenue.
Okay. And I'll...
We looked at downside scenarios, but we didn't really for – to say, what does the credit world look like next year, and I think the assumptions for those numbers are more where we are today, more or less.
Right.
Okay, got it. Thank you. And then, given the fact that there's leverage used in these funds, can you give us an idea about what kind of loss tolerance there is before the earnings stream to Franklin would be impaired from some of these?
And then given your response to Ken's question, I assume that means that Franklin is not going to be providing the leverage to these existing funds. But you made a reference to maybe launching a few products that might be a bit more aligned with the core business. And in those scenarios, would that be a situation where Franklin might be the provider of that leverage or are you guys staying away from that altogether?
We don't envision providing leverage to the products.
Yeah. I'd say that we have no plans in providing the leverage. And I'll have maybe Rich address the leverage.
Yeah. Our funds are relatively light leverage certainly as compared to many of the peers in our spaces, different funds little different. On a private debt side and our BDC, we've run leverage of well under 1 times; will vary throughout the cycle, but anywhere from 0.5 to 0.8. More recently, in our earlier vintages, it was actually substantially even lower than that. Our bilateral providers in private debt and in some of our other products are the banks you'd expect them to be, Wells, JPMorgan, Goldman Sachs, et cetera. In our commercial real estate business, we take advantage of warehouses and CLO financing as they take out to our warehouses. And again, those are bank lenders that we take advantage of across our platform. We enjoy a lot of relationships across the street. Hopefully, that will even get better with our – post acquisition. But, no, we don't envision doing anything on a lending basis with Franklin.
Okay. Thanks.
Thank you. Our next question is coming from Dan Fannon of Jefferies. Please go ahead.
Thanks. I guess, Ken, given your accretion assumptions, are you thinking about going to a non-GAAP reporting on a go-forward basis? And then also if you could just give us some context of what performance fees have looked like over the previous couple of years for this business?
Well, regarding the non-GAAP disclosures, that will be part of our analysis when we get closer to closing on it. We analyze that every year, frankly, and it just hasn't been material enough to make a compelling argument. This may change that, but we'll have to wait and see on that. In terms of performance fees, historically, it wasn't a significant part of our valuation or projections going forward. We don't include a significant part of performance fees when we were talking about the accretion calculation. So, I think that's probably the essence of your question there.
Performance fees, you need to put in context, this is not a private equity-type structure and they're more probable and less as far as upside. And maybe, Tom, you could touch on that just a little bit on where that expectation is around the performance fee.
Yeah. Sure, Greg. Well, obviously, it's a function of the marketplace and the opportunities. I'd say that our – when you think about performance fees for private debt vehicles, the debt product is very different than, say, the private equity product, whereby private equity you can earn multiples of your investment, while debt you're lending money and the goal is to get your money back plus a reasonable return. And so, we think about debt multiples or fund multiples or multiples of money being anywhere from about 1.4 to a 1.7, potential outliers out at 2 times if you're in a more sort of interesting credit environment than we're in today. And in terms of historicals, we generated sort of market-leading returns in our debt vehicles and we hope to be able to continue to do that.
Great. And then, just as a follow-up, in the core business, Ken, just thinking about the fee rate decline this quarter, I assume mostly because of mix. But, I guess, as you think about next year and kind of the outlook for the next 12 months, how should we think about the fee rate?
Yeah. I think one of the factors was that the daily average assets under management, which a lot of the funds are calculated on, was lower than the straight monthly due to the volatility. And I think that was kind of a factor going that reduced it. Going forward, we're not seeing a significant – we're not projecting a significant decrease in effective fee rate over 2018.
Okay. Thank you.
Thank you. Our next question is coming from Alex Blostein of Goldman Sachs. Please go ahead.
Hi. Thanks, guys, for taking the question. So the first one, I guess, on the deal, as you look out and you guys articulated this earlier some of the potential revenue synergies with Franklin's distribution, as you kind of compare and contrast to some of the other deals you guys have made, whether it's K2 or some of the others, what's sort of different about this one from a distribution perspective? And, I guess, what worked well versus what didn't work well in your prior experience that you could try to do something differently with this one?
Well, I think this is a fairly simple story compared to – like, K2 is a little bit more complicated and liquid alts of fund of funds and do a retail channel. And we've been very successful in fundraising that area, but there's been, I'd say, some headwinds institutionally that we knew about on the standard fund of funds business, so, we've been kind of evolving that. But when I look at the amount we've raised in Europe and the U.S. in the K2 side and continue to be one of our areas of positive inflows and growth, I mean, I think that's done okay.
I think this is just an easier story as far as getting out there and telling exactly what this team does in an asset class that may be relatively new, but one that people can understand pretty quickly what benefits it has and getting an adjustable rate with X return above where the market is. And I think institutions, the benefit of the lockup is important too, the liquidity factor of getting that extra yield by having it held over a seven-year period or so. I think that's something institutions understand and can easily do.
I think it's a little longer in the retail channel, but I just think this is more mainstream, I would say, than a more complex fund of funds type product of a K2. But again, I think as far as we look at the billions we've raised in retail with K2 and continued to do that, especially in this kind of market, where the other factor were the fund of funds in a lower vol product in a straight up rising market, it doesn't look that attractive. It starts to look attractive again in the kind of market we're seeing right now. And that was the same in Europe. We saw a real pickup in interest when we had some volatility a few quarters ago and now we're seeing more interest again.
And our team also sees an opportunity to expand on the RIA relationship base through the BDC and the REIT products. So it was another – they were excited about that.
Got you. That's a helpful angle. So second question, Ken, for you just around expenses, so I just want to make sure I understand the message. So 2% to 3% probably a little lower, so it sounds like you guys are aiming to do closer to maybe 1% to 2%. Tell me if that's not right here, but that's what it sounded like.
I guess, taking a step back, if we are in a little bit more of a choppier market backdrop, let's just say zero beta, could expenses go down or do you guys think you still have a fair bit of investing you guys need to do to sort of drop expenses this kind of 1% to 2% range?
I think there's opportunities for expenses to go down, with the caveat that there's not a lot of what you might reference as low-hanging fruit. So, the opportunities are there, but it's longer to identify and longer to execute. But we do think there are opportunities to reduce expenses, and just sort of some examples. And looking at the strategic investments that we made not just in the last year, but the last five years, and just assessing them are they successful, should we be doing something different, there's the easy stuff like tamping down G&A expense. We have a large component of comp is variable. And then just looking at our investment management distribution capabilities that maybe aren't operating at scale, can we be more efficient, increasing automation, increasing our global sourcing in low-cost jurisdiction. That's just to name a few, but there are clearly opportunities that we think can reduce expenses.
Got it, great. Thanks so much.
Thank you. Our next question is coming from Mike Cyprys of Morgan Stanley. Please go ahead.
Hey. Good morning. Thanks for taking the question. Just hoping you talk a little bit about the private equity JV in Asia, if you could talk about your new partner out there, how you're thinking about building out the business, what sort of goals/objectives do you have, how are you thinking about the opportunity set there, and why start with fund of funds, which has fees on fees?
Well, I think it's somebody who we admire who has built a very strong business with Asia Alts and we've a local, Melissa Ma, who we've gotten to know and respect and somebody who has a very strong following. And I think if she wanted to partner with us to build a broader based PE fund of funds, she brought the kind of people in that have that expertise and relationships and has the ability to go out and fundraise without a lot of help from us to get started. I think that was all attractive. And willing to put her own capital into it along with management, and doing really a JV that way.
And I think it helps us get to know different segments of the institutional marketplace, where they've historically been strong and introduced relationships, as well as helping us with our nascent private equity effort in how we build out that business, having that expertise of somebody who's really dealt with all of the best ones over time in certain regions. So I think those were a lot of the reasons along with it's another alternative capability. And I think it's just having the opportunity with the management team that we knew and not a real drag on our existing distribution system, where we think it can be up and profitable pretty quickly.
Great. Thanks. And just as a follow-up question, if you could just talk a little bit about your solutions business. I know that's been a strategic priority of yours. If you could just update us on how that's progressing, where we stand in terms of AUM, what's new in terms of hiring, new products, goals you have for that business looking out the next couple of years. Thanks.
Yeah. I think we're extremely excited about it and we've made some great hires and two high profiled people that along with Ed and have built a lot of new products within there. And I think, more importantly, immediately we've seen the benefits with some of our – the variable annuity changes, where they may be looking for a lower-vol equity-type product, we now can save some assets and move them into as some of these ones wind down and that's what they're looking for. And we've been able to do that in certain cases.
It also allows us – we've combined many of our different groups with risk premia and quantitative into systemic kind of quant. We've been able to build our factor-based ETFs, which are doing extremely well on a relative basis. And our U.S. multifactor one is up to 400-plus million dollars, and that's really a benefit of having that capability within the solutions group. So it really has pulled a lot of pieces together.
And I think the other part is just the ability to offer various types of sleeves that could be attractive in many of the different models that are out there. And as the market evolves from a product-driven place to more of a outcome-oriented solutions basis having specific solutions that can fit, whether it's a technology platform, those are just getting more and more important as these technology platforms get in between the end investor and the advisor. And we've got to figure out ways to get on that shelf space and solutions really helps there.
So, I think we look at it as we're fully staffed now, we've built the products, and we're going out to market with them. And I think the immediate benefit is really some of the ETF help, but also just having different customized options available for some of the insurance relationships that we've seen a direct benefit.
Great. Thank you very much.
Thanks.
Thank you. Our next question is coming from Sean Peche of Ranmore. Please go ahead.
Good morning and thanks for taking my question. Mr. Johnson, during the last call, you said Franklin was quite possibly the best buy out there, and I happen to agree with you. And with the share price some 10% lower, can I ask why the board hasn't been accelerating the rate of buybacks, as price has fallen and/or indeed even considering taking on debt to repurchase this potential portion of the company at the current value, which looks to be around five times normalized earnings, excluding cash and investments, especially given the change in value growth cycle, which looks to be under way?
Yeah. No, all good I think points, and there are volume considerations and you can't just go out and buy. And I know that your next question will be, why don't you do a tender or something with that. I think those are all things we talk about and consider, and I guess I was wrong last quarter if the stock's down 10%. But we...
No, just early.
But we are looking at all of that and I think the management – we and our board feel strongly that a one of the strongest balance sheets is going to be a weapon for us for creating value over the long term and having options in – as we enter a more uncertain period with a strong balance sheet is where we want to be. And capital is something that I think we – again, as I've said, I think the high rating is attractive to institutional investors, and not having debt on the balance sheet as an investment company we think is very important. And I'll let Ken if he wants to add anything.
Just add I think – I'm sure you're aware that the board did increase the share repurchase last February, so...
Yes. Look, I must commend you in how patient you've been, because many of your peers, who've been less patient, don't have the ability to take advantage of the low prices that are currently out there in the asset management space. But one doesn't want you to miss the opportunity. And perhaps as evidence of the growth value cycle having turned, I'd point out that Franklin Resources has substantially outperformed Amazon this month. But is the market right to be fearful of a substantial acquisition or should we expect more smaller bolt-on type acquisitions of the type announced today?
Yeah. I mean, as I've said before, I think large acquisitions are very difficult. There's a lot of risk in them, and just the brand and who you are as a firm. But I think, again, if the right situation came up, where you think you can take out a lot of costs and create value, we're going to certainly look at that and be open to that. But I think as we've stated before, I think today we're over $40 billion in alternatives. We'd like to be bigger in that. So, yes, if we think things – if there's attractive other businesses to fit into that category, that's one we want to continue to grow.
And part of the attractiveness of BSP is having the kind of people that are plugged into the Street and relationships and see different things come up that could be interesting for us. And I think that that – Rich and Tom are builders and entered a lot of different areas just starting at private credit, and that's the kind of talent, again, that I think when you have in the organization, you're going to get a lot of new looks at some new businesses and we're going to continue to do that.
Perhaps just one last question. Has Franklin been approached by I know a number of large banks and financial services companies, Goldmans and the likes, are looking at increasing their exposure in investment management? Has Franklin been approached in that regard?
Well, we wouldn't say – I mean, I think there's always conversations, I think but we don't really talk about whether we've been approached or not formally or informally.
All right. Thank you.
Thanks.
Thank you. Our next question is coming from Robert Lee of KBW. Please proceed with your follow-up.
Thanks for taking my follow-up and, I guess, I just had a question here. I guess, at the beginning of the call, Greg, you mentioned that you kind of felt you had kind of a lot of the structures built that you need at this point, and I know you talked about the solutions business. But can you maybe dive a little deeper into that, where you're referring primarily to kind of building out the CIT capability or are there some other businesses that we should be thinking about that now you feel you're in a better position to go out and accelerate marketing?
Well, I think it just allows you to leverage – when I look at our business and say, you've got all these lines and you've got all this expertise in so many different places, and having a group now that really interacts and has the kind of people at a level of experience that the rest of the CIOs respect and work with, it helps us in a lot of areas. It helps us just in how we communicate our views on where the markets are and tactical allocation views, where clients want to hear that. And part of our – I think the difficulty we've had in delivering that as a firm has been that we were somewhat siloed and are, and think that's important with investment teams to have independence.
But we also have to have the ability to leverage and be tactical across these different groups to add alpha over time, I think that's what they're doing. And I think the customization that's out there, whether it's commingled trust like you mentioned, whether it's separately managed accounts, these are all businesses now that we have more flexibility in addressing customized demands from clients and interest and whether it's retirement income sleeve or an inflation protected fixed income piece. We can do all that much more efficiently now and having that I think. And even just the disparate pieces we had with quantitative and risk premia groups and AlphaParity now all under one group, it's much better organized and, I think, simpler for the clients to kind of understand.
So we just think that's going to be more and more important as we move from this product-driven brokerage world to more of a solutions outcome and technology-driven world, where they're going to be looking for specific tools to build the portfolio, and that's really what solutions allows you to do.
Great. Thanks for taking my follow-up.
Thanks.
Thank you. Our next question is coming from Brian Bedell of Deutsche Bank. Please proceed with your follow-up.
Great. Thanks for taking the follow-up. Real quick, just can I always ask you this, the cash balances of $6.8 billion, looks like that is net of everything, but what portion of that do you view as excess excluding the working capital needs, which I think are still significant in overseas?
We like to call it opportunistic capital.
Or an ammo.
Ammo, yes, even better.
And our current estimate is that that number is between $3 billion and $4 billion.
Okay. And then, another one I usually ask you, but since you mentioned the cost save (01:09:35) ability to potentially reduce costs, the outsourcing of some of the fund administration, you – obviously, we saw the Oppenheimer/Invesco deal and a large part of that $475 million of cost saves they're getting is from outsourcing what has been internally done in Oppenheimer. Any consideration on your end for doing that, or is that part of what you're thinking about for the potential to reduce costs, or is that still a decision that's sort of in the distant future?
No, it would absolutely be something that we would look at, as part of that exercise. So, that's a part of the laundry list that I went over. Having said that, I think it's important to keep in mind for us the low cost base that we have, because of our presence in low-cost jurisdictions. So, we're an outsource provider. It needs to be global and it needs to be at a pretty cheap price for it to be compelling for us, because we have our low expense base and cost base.
Okay, got it. Thank you.
Thank you. At this time, I would like to turn the floor back over to management for closing comments.
Well, thank you for attending our call today and thank you, Rich, for coming out here and Tom participating, and we are certainly excited about the future with Benefit Street Partners. Thank you.
Ladies and gentlemen, thank you for your participation. This concludes today's conference. You may disconnect your lines at this time and have a wonderful day.