Ladies and gentlemen, thank you for standing by, and welcome to the Victory Capital Management Second Quarter 2020 Results Conference Call. [Operator instructions] I would now like to hand the conference over to your speaker today, Matthew Dennis. Thank you. Please go ahead, sir.

Good morning. Before I turn the call over to David Brown, I would like to note that today's discussion contains forward-looking statements and, as such, include certain risks and uncertainties. Please refer to our press release and our SEC filings for more information on specific risk factors that could cause actual results to differ materially from those projected in the forward-looking statements. While a recording of this call will be made available by us on our website, any forward-looking statements that we make on this call are based on assumptions as of today and we undertake no obligation to update these forward-looking statements to reflect new information or future events that occur or circumstances that exist after the date on which they were made. In addition to U.S. GAAP reporting, we also report certain financial measures that do not conform to generally accepted accounting principles. We believe these non-GAAP measures enhance the understanding of our business and our performance. Reconciliations between these non-GAAP measures and the most comparable GAAP measures are included in tables that can be found in our earnings press release and in the slide presentation accompanying this call, both of which can be accessed on our Investor Relations website at ir.vcm.com. It's now my pleasure to turn the call over to David Brown, Chairman and CEO.

Thanks, Matt. Good morning, and welcome to Victory Capital's Second Quarter 2020 Earnings Call. I'm joined today by Michael Policarpo, our President, Chief Financial Administrative Officer; as well as Matt Dennis, our Chief of Staff and Director of Investor Relations. I'm going to start with a business overview of the quarter. Then I will turn it over to Mike, who will review our financial results in greater detail. Following our prepared remarks, Mike, Matt and I will be available to take questions. The business overview begins on Slide 5. I'm pleased to report that Victory Capital produced record financial results across a number of different areas for the second quarter and first half of 2020. Despite the market volatility and complexities related to COVID-19, we generated record revenue, profit margins and net earnings for the first half of the year. This is a testament not only to our business model, which is designed to deliver robust profitability in all market conditions, but also to our ability to successfully execute on our long-term growth strategy. AUM grew to $129.1 billion for the quarter, up from $123.8 billion at March 31. At quarter end, AUM was up more than 100% relative to the end of the second quarter of 2019. Turning to flows. We experienced significant outflows directly tied to the disruption caused by the closing of the Schwab acquisition of USAA's brokerage business at the end of May. One part of that was brokerage clients who chose to transfer their accounts to brokerage competitors other than Schwab, and at the same time, liquidated some or all of their USAA mutual fund holdings. This impact on flows was onetime in nature and can be compared with traditional asset management acquisition consent process in which movement of accounts causes some leakage of assets.…

Thanks, Dave, and good morning, everyone. The financial results review begins on Slide 13. Overall, we are very pleased with our strong financial performance in the quarter and first half. Revenue for the quarter was $181.9 million, in line with the 11% lower average AUM compared with the first quarter. Revenues were up nearly double versus the same quarter last year. GAAP earnings were $0.61 per diluted share, which was down from the first quarter, reflecting an additional $12.5 million of acquisition-related expenses recorded in the second quarter. You may recall, we make adjustments to reflect the current fair value of future contingency payments on our balance sheet for the USAA acquisition each quarter. For the second quarter, this resulted in a $10.8 million quarter-over-quarter increase in GAAP operating expense, which accounted for most of the variance. The markup in fair value for that contingent liability reflected the market's rebound in the second quarter, combined with the lower discount rate used in the net present value calculation and one more quarter of actual results. Adjusted net income with tax benefit was $0.89 per diluted share in the quarter. This was down $0.03 from the first quarter and up 134% from the same quarter last year when we reported ANI with tax benefit of $0.38 per diluted share. GAAP operating margin was 36.2% and reflects the higher noncash balance sheet adjustment I just mentioned. Adjusted EBITDA margin expanded to 47.5%, which was 270 basis points wider than in the first quarter. This record high-margin level is particularly noteworthy considering the investments we continue to make to support future growth and is a testament to our unique business model. With continued debt reduction, our leverage ratio improved to 2.2x at the end of June. In addition, we returned approximately $10.6 million to…

[Operator instructions] Your first question is from Ken Worthington with JPMorgan.

First, with the Schwab -- with Schwab having closed our deal with USAA, are you observing any change in behavior or how the USAA clients are sort of reacting to the marketing in your offering? And I apologize, you give an inch and they take a mile. But with the information you gave us on account registration, to help us put that in context. You said 79,000 accounts. Did all 79,000 accounts get funded? You sort of mentioned it via registration. And then how many closed during that time period? If only 5,000 closed, 79,000 looks great. If 200,000 closed, 79,000, doesn't look as great. So if you can give us that context, that would be helpful, too.

Ken, it's Dave. So let me take the question in different pieces. I think the first part of your question was around, are we seeing different behavior from our clients given the Schwab acquisition close? The answer is, as I said in my prepared remarks, during the time of switching over to Schwab, we saw a lot of noise, meaning there were some brokerage clients that had our funds that either didn't go over to Schwab or made changes at those times. We think that, that is more of a onetime phenomenon. As far as the 79,500 that have opened accounts, yes, they've all funded. We used the term registrations, but they've all funded. And the way we look at the opportunity set, there's 12.5 million USAA members that do not have an account with us. So the opportunity set for us is unbelievable. As we've said for the last 12 months, we've really not done a large marketing effort just yet. We have a very methodical path of how we want to get set up. We've centered around client service. We've centered around getting our technology right and then eventually getting to the point where we go out and start marketing, and we're not even at that point yet and we've already experienced these 79,500 accounts. Looking at the closed accounts, with the noise around the transaction, wouldn't be the way we look at it. What we've seen is really great opportunity, and we really are excited about what the future holds.

Okay. Great. And then just maybe switching gears a little bit. Prior to the USAA acquisition, one of your focuses was really on small- and mid-cap investing. How do you think about boosting mid-sales here and returning net flows to the positive?

So Ken, it's Dave again. We look at our small-cap lineup, we have excellent investment performance. A lot of those products are distributed through our retirement intermediary channel, some through the subadviser channel. We think that we'll be able to grow those products with the performance we have. Really no different. We were in, I think, a time frame where we have some of our products that are closed due to capacity. Some are bringing on good investment performance. As we said, we saw some delays in our won but not yet funded and our pipelines, which now are building back up and are now starting to fund. So when I look forward on both those asset classes, I think we're going to be in really good shape from an organic growth perspective.

Your next question is from Alex Blostein with Goldman Sachs.

So just building on some of the USAA opportunities. Can you talk a little bit about the size of the USAA 529 Plan? So where does it stand today in terms of AUM? Does it currently consist of only USAA kind of legacy product? Or are you starting to introduce some of the Victory products in there as well? And kind of how do you anticipate that process to work?

So the USAA 529 Plan, I believe, is close to $4 billion. And the product makeup underneath there is made up primarily of our products. And if you remember, we made some changes underneath when we did the acquisition. At the time, we switched out some subadvisers to other subadvisers. And then we also switched in some of our franchises. So we're really happy with the lineup underneath. And we think that, that's an area that we can grow. We are net flow positive on the USAA 529 Plan since we've purchased the business. We also had a net account positive on that plan as well. And as I said in my prepared remarks, we are the exclusive provider for the USAA 529 Plan.

Got it. That's helpful. And then just quickly on the modeling. You pointed out the June fee rate, it was 57.7 basis points. Is that a decent jumping off point as we're thinking about the third quarter? Or are there still any sort of ins and outs related to USAA transaction or anything else notable we need to keep in mind as we think about third quarter fee rate?

Alex, it's Mike. Yes, the 57.7 basis points in June is the way we think about it going forward. That takes out some of the noise in Q2 with respect to some of the liquidations on the money market funds.

Your next question is from Kenneth Lee with RBC Capital Markets.

Wondering if you could just provide a little bit more color around the solutions business net flows. Maybe you could just comment on seeing some net inflows and net outflows.

It's Dave, Ken. We -- the solutions business really saw a good number of outflows during the quarter due to a lot of the noise that we've seen with the Schwab transaction. When we think of that business going forward and we think of what clients are looking for, we think it's pretty well positioned to provide the intellectual capabilities that portfolios are needing right now. So what I mean by that is some of the ETFs that we're launching, some of the ETFs that we had, some of the separate accounts that we're doing for certain institutional clients and then also on the retail and retirement side.

Great. And then just one follow-up, if I may. You mentioned in terms of the distribution expenses, some removal of platform expenses in the quarter. Wonder if you could quantify the impact or give us a good sense of what the run rate could be going forward?

Sure. Thanks, Ken. It's Mike. Yes, as we talked about in the slides, operating expenses overall were down 9% quarter-over-quarter. And a lot of that was driven by the expenses that are tied to average net assets. So our distribution fees and other expenses that are variable, which includes our distribution platform fees as well as our subadministration, middle-office and back-office expenses. With respect to the distribution fees, they were down actually 24% quarter-over-quarter. And some of that relates to the removal of the money market assets that we paid a distribution expense on. As well as we saw some additional efficiencies in our overall distribution network.

Your next question is from Randy Binner with B. Riley.

I had a couple. One, I guess, on the EBITDA margin, obviously, it was very good this quarter. And I think it is above the -- where we thought it was guided to or targeted. And the comments on -- with the previous analysts were that your fees, AUM are going to stay at a pretty similar level. So can you -- are we looking at potentially even higher EBITDA margin as we look forward in the model?

Randy, it's Mike. Yes, I think our guidance has been 46%, post all the synergies, and that's really where we are. If you look at our year-to-date margins, that's still the guidance that we would continue to guide towards. We've talked about, you may see some plus or minus quarter-over-quarter just based on efficiencies as well as reinvestment that we're making in the business. So I think if you look at it, we still would guide to the 46% going forward.

Okay. Great. And then just on the comments around potentially doing another acquisition. I guess -- I feel like maybe some of the questions have touched on it a little bit, but maybe not as directly as I'd like. What can you share with us about opportunities that you're seeing in the market?

Randy, it's Dave. It's plentiful. I think we have become an acquirer of choice so we're having lots of conversations. I think we were pretty clear in our prepared remarks about preparing our balance sheet for acquisitions. And historically, we have done an acquisition every year or so. And I think that cadence, as we've guided, is probably the right way to look at it over a longer period of time. And we have USAA integrated. We have our debt paydown happening pretty aggressively, and we continue to generate pretty strong cash flow. We have achieved all of the synergies from an expense perspective on the USAA acquisition. So when we look at it, right now, we think our platform is ready for another acquisition. And we're evaluating many of them now. And as we do, our primary hurdle is, does it make our company better. And that's where we start. And as we review the acquisitions, we're looking to make our company better. And that's how I would guide you on that.

Was -- would making Victory better be another kind of huge scale play like USAA? Those are my words, but I think that's what it was. Or would it be more acquiring, kind of stickier, more value-added products?

We really start from the portfolio. We start from the product set, and does it fit in the client's portfolio, is it a product that clients are going to want when you look 3 years out, 5 years out, so we start there. And I think that would lead you to deals that could be smaller, and that deals could look from a size-wise to USAA. We've really not blocked any size off. What I would say is we are absolutely looking at transactions in asset classes that we don't sit in today, which we think have some tailwinds. We think our organization is ready on those. And so I would say is we trace it back from the portfolio and from where we think the client's going to want to go in the future and really don't look at it from a size perspective. But I think that leads you really to doing something smaller or something larger.

Your next question is from Chris Shutler with William Blair.

I guess it sounds like, Dave, you're feeling more optimistic on flows going forward, but it looks to me like there's been roughly another $1 billion of mutual fund outflows in July, give or take. So just help me reconcile those 2 thoughts. And do you see a path to positive flows in the back half?

So I think that there -- let me start off by saying that there is definitely noise in our flow numbers, which we view a lot of that noise to be onetime in nature, centered around really the transaction of Schwab purchasing the USAA brokerage business. Coupled with that, there has been, as I said in my prepared remarks, a little bit of a slowdown on gaining shelf space for some of our products due to COVID-19. Some of the institutional allocators slowed down. We're seeing those two things pick back up. I'm very encouraged by what I've seen on the direct channel. I'll remind you that we go back and we've been talking about this for a year, there's 12.5 million members that don't have an account with us. And we have not aggressively marketed that at all yet. I'm very encouraged by the investment performance of a number of our products. So we're looking forward. And I think as we work our way through noise, I think you'll see some of the investments we've made in some of the products that are doing well from a performance perspective, really lead the way in growing.

Dave, just a follow-up on that. If USAA mutual fund clients are -- in the case where they would move their assets to like a Schwab brokerage account and liquidate their USAA funds as part of that, would that -- would you know that they're going to Schwab? I know that's not necessarily the issue you've been seeing, but would you have any way to know that?

We have transparency into whether they hold our mutual fund or not. What they do after they liquidate, we don't know. We have our direct accounts, which we have our direct relationships with. And then we have accounts as with the rest of our business, where we are a provider on a platform, and that's how I had categorized the accounts that sit within Schwab.

Okay. And then lastly, you talked about the fee rate kind of being consistent with June going forward, that it's a good jumping off point. But I did want to just go back to the fact that the USAA fulcrum fees start to take effect. So should we view that as basically up to wash?

Chris, it's Mike. So I think as we've said on the fulcrum fee, we've waived it for the first 12 months. So it's not in the Q2 numbers. It will begin in Q3. And as we've said, it's uncertain, but not all of the USAA funds, and it's also an accumulating calculation. So it'll start with, if you will, starting at the 13th month and then roll up to a rolling 36-month calculation. At this point, we don't have an estimate. The performance, obviously, is fluid and builds ongoing as part of the calculation. But that will be, in our Q3 numbers, will be the first instance of the fulcrum fee impact.

Okay. So at this point, you don't have a view whether that's a positive or a negative to the fee rate?

Correct.

Your next question is from Jeremy Campbell with Barclays.

Dave, I know you've mentioned here you built cash and mentioned the M&A opportunities are plentiful. I'm just wondering if you could provide some color on whether the year-to-date COVID experience with the big sell-off and subsequent rally back has perhaps brought some newer potential sellers to the table? Or are these mostly asset managers that were looking to sell in 2019, but maybe just got delayed due to the COVID sell-off?

I would say both. I think there is some delayed sellers, and I absolutely think that has brought new participants in potentially selling asset management businesses. So as I said, there is a lot of opportunity out there to do a lot of different things. And I think for us, it's a transaction that fits into our longer-term strategy. And our challenge is not really the volume of opportunity. The challenge is finding the correct one.

Got it. And then just maybe as a follow-up there. Obviously, we also recently had a deal in the market where Allianz effectively is partnering with Virtus for retail distribution. And Victory has a very robust retail sales platform as well. So just wondering if something like that in a more capital-light, partnership-type deal structure would look attractive to you in addition to your more typical M&A kind of buyout deal structure?

It would. We thought that transaction was creative and we think that for the right partner and the right opportunity, we would be open to that. I think there's going to be more structured transactions that look like a partnership as opposed to a traditional acquisition going forward, given the dynamics of distribution. And that really is centered around, if you have established distribution today, I think there's an opportunity to be successful in distributing your product, if you do all of the right things. If you don't have established distribution today, COVID-19 as well as the evolving industry really makes it challenging to kind of start from scratch on distribution. So I think there's going to be lots of opportunity, and we would be a participant in that if we found the right opportunity.

Your next question is from Sumeet Mody with Piper Sandler.

Just one for me on the comp ratio kind of bump-up in the quarter. Just wanted to see how we should think about that accrual for 2020, considering the first and second quarters?

Sumeet, it's Mike. Yes, so if you look at the cash compensation ratio, it's held at about 23% for the first and second quarter. What we've talked about in the prepared remarks and what we've talked about in Q1 is there is some noise related to our mark-to-market for our deferred compensation plan with all of the volatility in the marketplace. So that was a $7.3 million expense to compensation in Q2 that's driving that a little bit higher when you look at the overall compensation ratio. The offset to that is sitting in other income. So that is a mark-to-market of assets that sit in a plan and an offset to expense. So there really is no P&L or cash impact associated with that. And that's how we look at it. So from a cash compensation on an ongoing perspective, 23% is the ballpark, plus or minus, based on what's happening from a growth perspective in the business.

Your next question is from Robert Lee with KBW.

I guess the first one is on the earn-outs. Can you just remind us, in addition to the first earn-out year, the -- I believe there's another two, if memory serves me. Can you just remind us on kind of the earn-outs, the potential future earn-outs and the timing?

Sure, Rob. It's Mike. So the way the earn-out is structured, it's a maximum of $150 million that can be paid out. And the way we structured it is a one fourth of it, so $37.5 million each year. So you'll look at it in what we've said in our remarks is the first earn-out will be paid in the second half of this year, the full $37.5 million is what we expect. And then there will be three more beyond that as well.

Okay, great. And then also on the USAA brand, I know -- I believe that was, I think, a 3-year agreement that you could use the brand and then kind of have to re-evaluate. So I know it's only year-end, but you just update us on if that is -- if I am correct that you kind of have to beat some type of licensing agreement with USAA in a year or so to maintain the brand? And any sense as you look out what that could entail?

It's Dave. It is a three-year agreement. We're one year into the three years, and I think we're very early on in the licensing agreement. I think we've done a phenomenal job representing USAA and serving their members, which has been our collective goal, USAA and Victory, is to give great client service to their members. And I think we've done that. So I think we've done an excellent job doing that. And we have two more years under this licensing agreement, as you said.

Okay. And just maybe last one on the earn-outs. When you make the $37 million payment, does that generate or create additional tax benefits, does that kind of -- I assume most of that ends up being goodwill in some form? I assume it creates some tax deductible goodwill?

Yes. Bob, it's Mike. It does. So I think we included a slide this quarter that shows the tax amortization that we expect to achieve over the next 15 years, and there is a little bit of a ramp-up over the next four years. And that really is, as we make those payments, those go into the tax amortization calculation.

Our next question is from Besi Amisia [ph] with Bank of America.

This is Gayatri [ph] filling in on behalf of Mike Carrier. The question that I had in mind was regarding the flows that you mentioned earlier. You said that you were having a more positive outlook for the rest of the year. And I was just curious if you could provide more color on some of the areas where you're seeing strength towards some of the areas where you could potentially see some weakness as we go into the rest of the year?

It's Dave. Some areas where we're seeing strength are won but not yet funded book is strong as it's been this year. A lot of that is in the subadviser and institutional part of our business. We've also seen a pickup in our retirement side as well. As I said in my prepared remarks, the second half of the year, we'll be launching our digital platform, which will be positive from a gross flow perspective for the direct platform. Our investment performance has come back exceptionally strong on our USAA fixed income franchise, and we are starting to see that franchise gain really important shelf space that we were unable to gain during the second quarter and first quarter a lot because of the COVID-19 impact. We're also launching some new products. We talked about three new ETFS, two of them will be geared towards the military community. And then on the other side of that, some of the noise are a onetime impact of the close of the acquisition of the USAA brokerage business by Schwab will absolutely slow down and is slowing down. And when you put all that together in our outlook, as I said, especially as you move into 2021, is quite positive on that front.

Your next question is from Michael Cyprys with Morgan Stanley.

Just wanted to follow-up on the new slide that you're having here on the cash tax benefits. Just curious how you're thinking about the potential impact of tax rates to go up, say, from 21% statutory to 28%, maybe at the high end of what's kind of been discussed. How would that impact the calculations on the cash tax benefits? How are you thinking about that?

Sure, Mike. It's Mike. Yes. So we would look at it. We've assumed a 25% tax rate in that calculation. So if the rates do go up to something higher than 25% from a corporate kind of federal and state perspective, how we look at it to something higher. The tax amortization that we'll be able to recognize will be higher than that. So there will be a higher impact to the overall cash savings.

And what's the underlying federal that you're assuming in your 25%? Is that a 21% plus a 4% for state?

Yes, 21%. We have 21% plus 4%.

Got it. So if the federal goes from 21% to 28%, and that 700 basis points pickup and you'd kind of add that on to the 25%, so you'd be at 31%, is what you'd be using here instead of the 25%? Is that the right way to think about that?

That's the way we're thinking about it, yes.

Got it. Okay. And then just maybe a follow-up on the fixed income side, the industry saw a lot of inflows in the second quarter in fixed income, big improvement, over $100 billion across the industry. Yet when we look at your gross sales, they were down a bit sequentially on the gross sales. I understand on the redemption side, which you've talked about some of the pressures with the brokerage, but just on the gross sales. Any color you can provide there around why that was down meaningfully in the quarter and what your expectations are here into the second half?

Mike, it's Dave. Really, that's around when we think about the future for fixed income, at least for us, it's around gaining shelf space. So as we were in the second quarter, our ability to really introduce the USAA Investments franchise onto new platforms was slowed down. And as we look forward, we're gaining shelf space, we'll gain shelf space. As well as the significant pickup in investment performance, we think we'll participate kind of in the tailwind but the second quarter, we did not participate as much as we wanted to as we watched the industry grow, we were unable to do that. But I think when we look forward, gaining shelf space, coupled with really good investment performance and a really long-term track record of success, we feel really good about the opportunity there.

Any incremental color you could provide around some of the actions that you're taking and initiatives that you have in place in order to help further accelerate the gains from the shelf space side?

Really, it's been the same playbook we've used over the last decade. What has occurred is the inability to really get the meetings and have the shelf space providers put new funds on to the platform. I think as the shelf space analysts are more comfortable with the environment we're in, they're starting to put new products on the shelf. So there's really no new tactics. It was really working our way through the current situation with COVID-19 and really just continuing to do the things we've done in the past.

Your final question is a follow-up question from Robert Lee with ABW.

Great. Just quickly going back to the M&A and acquisitions. Could you just remind us, I mean, how you think about -- if there is even any capacity constraints, but how do you think about capacity for transactions in terms of kind of where -- understanding that you like to pay -- you will pay down debt rapidly, but kind of how you think about where you would kind of want to top out and say it's debt to EBITDA? And kind of how you're thinking about your capacity size-wise for transactions going forward?

It's Dave. So the way we look at it is we feel like we have a number of different tools to do acquisitions. Clearly, we have debt, we have cash that we're accumulating, that you would accumulate between announce and close. There's a structuring element to it where you can have an earn-out structure, you could utilize revenue share. And when we put all of those pieces together, we think we have all the tools to really have the full flexibility to do the acquisitions that with our -- in scope right now for us. We have not given a top end on a debt-to-EBITDA or leverage ratio. I think every transaction is different. But I think where we're at today, we don't really see our balance sheet or financing as a constraint to execute on anything that we're considering today.

I would now like to turn the call back over to David Brown for any final comments.

Thank you for joining us this morning. We look forward to keeping you updated on our progress. Next week, we are attending the UBS Financial Services Conference. And on September 15, we'll be at the Barclays Global Financial Services Conference. We hope to see you there virtually. I hope you all have a good day, and stay well.

This concludes today's conference call. Thank you for participating. You may now disconnect.