Good morning and welcome to Victory Capital's Second Quarter 2018 Earnings Conference Call. [Operator Instructions] Please note that today's event is being recorded. I would now like to turn the conference over to Lisa Seballos for Victory Capital. Please go ahead.

Good morning. Before I turn the call over to David Brown, I would like to note that today's discussion may contain forward-looking statements and as such, includes certain risks and uncertainties. Please refer to our press release and our SEC filings for more information on the specific risks that could cause our actual results to differ materially from the projections described in today's discussion. 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 report certain financial measures that do not conform to Generally Accepted Accounting Principles. We believe these non-GAAP measures enhance the understanding of our performance. Reconciliations between these GAAP and non-GAAP measures are included in the table found in our earnings release and the slide presentation accompanying this call, which can be accessed on our Investor Relations portion of our website located at ir.vcm.com. Now I would like to turn the call over to David Brown, Chairman and CEO.

Good morning and welcome to Victory Capital's Second Quarter 2018 Earnings Call. I'm joined today by Terry Sullivan, our Chief Financial Officer; and Mike Policarpo, our Chief Operating Officer. I'm going to spend a few minutes discussing highlights of our second quarter results as well as some components of our long-term strategy. Then I will turn it over to Terry, who will review our financial results for the quarter in more detail. Following our prepared remarks, Terry, Mike and I will be available to take questions. We'll start on Slide 5. I'm pleased to report that Victory Capital delivered strong financial results for the second quarter of 2018. Relative investment performance across our investment franchises and our Solutions Platform remained strong, with 83% of our AUM outperforming its respective benchmarks over the trailing 1-year period and 80% over the trailing 5-year. Looking at performance based on the number of strategies, 74% of our strategies outperformed benchmarks over the trailing 1-year and 71% over the trailing 5-year. Additionally, as of June 30, 2018, 69% of AUM in our mutual funds and ETFs earned 4- or 5-star overall ratings from Morningstar, and 64% earned 4 or 5 stars over 5 years. In our focused asset classes, 82% of AUM outperformed its respective benchmarks over the trailing 1-year period and 80% over the trailing 5-year. Among strategies in our focused asset classes, 63% outperformed their respective benchmarks over the trailing 1-year and 61% over the trailing 5-year. 20 of the 30 funds and ETFs in our focused asset classes earned 4- or 5-star overall ratings from Morningstar as of June 30, 2018. We are very pleased with these investment results. Assets under management increased to $62.3 billion during the quarter, which is the result of an improving flow picture and positive market action.…

Thanks, Dave. The financial results review for the second quarter 2018 begins on Page 16. AUM ended the period at $62.3 billion. This is an increase of 2.3% in a quarter in which we experienced positive market action and improved flows relative to the first quarter. Revenue decreased slightly to $104.4 million and is up 3% from the second quarter over last year. Our ANI with tax benefit EPS was $0.41 and EBITDA margin was 39%. Both measures reflect increases quarter-over-quarter, and in the case of year-over-year, significant growth as we continue to execute on our strategy. Overall, very solid financial results, especially within an industry facing headwinds. On the capital management front, we maintained our focus on reducing debt while introducing another lever to our capital policy. During the second quarter and in subsequent activity in July-August, we reduced our Term Loan B debt outstanding to $280 million, a 13% decrease from March 31 and 22% decrease from our $360 million level at the time of our IPO. The pre-payments over the course of the second quarter and July and early August have resulted in $2.2 million in annualized interest expense savings. Additionally, our board authorized a $15 million share repurchase program that we began executing in May. We believe the repurchase program is aligned with driving shareholder value and reflects our confidence in our long-term business strategy. Most importantly -- and I want to stress this -- it does not at all alter or limit our ability to focus on M&A or re-invest in our business for growth. Our strong cash flow profile enables us to strike the right balance across our capital management priorities: M&A, deleveraging and buybacks, in that order. Slide 17 provides more perspective on our AUM progression. Our AUM grew 9% from the second…

[Operator Instructions] Our first question comes from the line of Michael Carrier of Bank of America-Merrill Lynch. Again, Michael Carrier, your line is now open.

Nicole, please move on. It seems like there's a problem with Michael Carrier's phone line.

Our next question comes from the line of Ken Worthington of JPMorgan.

It looks like we're seeing a transition from Sycamore to other fund families like RS and Trivalent. So how is that transition going in your mind, and where do you think the sales force is in this transition?

I think you're correct. There is a transition going on from Sycamore to other franchises. The other franchises that are really, where we're seeing a lot of traction are RS, Trivalent, Sophus, and then our VictoryShares and Solutions Platform. As I went through in the prepared remarks, we're making great traction with a lot of the Retail and Retirement platforms as well as institutionally.

Okay, and then I know you had discussed a little bit about the deal environment, but maybe talk about some of the challenges that you've been facing in terms of executing a deal. I think in the past, you guys discussed the desire to try a transaction, try to execute a transaction every year or so, and I think it's been about 2 years now. So what are the challenges you're facing, and maybe is it more realistic for us to expect you to pursue a transaction maybe every 2 to 3 years, or is sort of a 1-year outlook sort of still realistic as we look to the future?

So a couple of parts to that. I'd say the first part is we look at the environment and the competition as really, as being the same as it has been. We actually welcome the competition. It shows our strength and really the uniqueness of what our plan--or what our platform offers. And I would also say around the timing, although we could never tell you exactly how -- what the frequency that we would do transactions with -- I would tell you that we are really working to get to conclusion on a number of the opportunities we have. Historically, this team -- and what I mean by "this team" is this is the management team that has executed all of the transactions in the past -- has been very active and we've been very successful. There really is no reason to believe that the pace and what we've accomplished in the past is not a good indication of what is to come in the near future. So I would say from a frequency perspective, no change from what we've always discussed. From a pricing perspective, as we discussed previously, I think the pricing is wide, and it really depends on the profile of the business. We're not seeing really a lot of change in the pricing when we talk to potential acquisition targets.

Our next question comes from the line of Michael Carrier with Bank of America-Merrill Lynch.

David, maybe the first one, just on the flow picture. So you guys came in around breakeven, which relative to the industry, it was a win when we look at some of the trends in the quarter. Just wanted to get some color. You gave a lot of, I would say, distribution color, what you guys have been working on. But it seems like you're still seeing something like the rebalancing. So just wanted to get some sense of maybe what level are you still seeing on the rebalancing side? And then if I looked over the last 12 months, how much, like, say, distribution traction are you seeing, particular, I would say, on the newer products or things that are in the Solutions area, some of the growth areas? Because it sounds like there is traction. You gave some of the numbers for the quarter. But just wanted to see maybe the momentum that you're seeing.

Yes, I guess to start on really the rebalancing, it definitely slowed this quarter, as we said in our prepared remarks. It's hard to predict. Many of the rebalancing activity is in the best-performing products as clients look to reallocate. It is sporadic and it's very unique to each client. So it's hard to predict, but we did see it slow. I wouldn't attempt to predict what will happen going forward. But it did slow this quarter. As far as the traction, we're really excited about what we're seeing from a progress on the distribution side, specifically on the Solutions side. We've grown that platform, the ETF platform, every single quarter that we've been in the business. We have increased market share by 55% this year. And we really believe that we're really just in the beginning of the industry allocating, clients allocating a lot more in assets, and we think we're going to have a -- play a big part in it. And then we're also seeing on the distribution side, it to be pretty balanced. We've made great progress on the institutional side in the subadviser channel and then also in the retirement channel. And it's really multi-franchise. So when we think of Trivalent, Sophus, VictoryShares, RS, we're really seeing great progress there. And we really, as we look out, we think we have really good prospects around growing those franchises.

And then, Terry, maybe just a quick one on expenses. It seems like you came in a bit better this quarter. When you look at maybe some of the synergies and efficiencies that you realized from past deals versus some of the investment initiatives, how should we be thinking about sort of the expense base? And was there anything more unusual, say, this quarter?

Yes, I would say a couple of things about expenses and how that translates to what we think are positive impacts on our margins. I think, first and foremost, we have reached a normalized level of expenses, and that is consistent with our overall integrated multi-boutique model. I want to punctuate that point. The real driver of our margins has to do with the integrated model, where not only can we help franchises grow organically, but they can plug into a centralized infrastructure and support system which can drive economies of scale for us. So we think that's a really important element and is really the driver. It's the model that we're talking about here. We also have, over the course of the years that we've executed our M&A strategy, an important part of our M&A strategy has been integration and optimizing the people, process and technology associated with our platform. So if you look at some of the decision we made at variabilizing our cost base, outsourcing some relationships, that all leads to investments that we have made that are now resulting in margins that we're quite comfortable with. I think the last point I would make is that the platform -- and again, the nature of the model is such that there's upside. Our incremental margins are in excess of where we are today. And so we think that positions the business very well.

Our next question comes from the line of Jeremy Campbell of Barclays.

Just appreciate the color on M&A. Just kind of wondering, kind of in this market right now where we're at, where sentiment around asset managers is kind of weak and you really have a divergence in kind of company by company, I guess how does that play into the whole conversational aspect of your M&A pipeline? Are you seeing any sort of differentiation in your conversations about willingness to sell, kind of with what's going on with the macro [indiscernible] right now?

I would say that what we offer and what we've talked about for a while is we really are value-added to these businesses that are potentially looking to sell. We bring best-of-class operations and technology and administration. And then we really bring an opportunity to distribute the product while keeping their investment autonomy, their brand. And many of the conversations that we're talking about, we're talking about how best to grow the target's business, how best to -- when they look out 5, 10 years -- how best to position themselves. So many of the discussions are really around the future of these businesses and less around the mindset of, "I really want to sell." It's more around, "How can we grow our business? How can we ensure our business stays competitive?" That is the nature of a lot of our conversations. And again, as I said before, our conversations have been pretty consistent and steady, and our pipeline is very full when it comes to acquisition targets.

And then just one other thing on flows. It's not unexpected that your non-focused is still a little bit of a drag. But kind of, as we kind of look forward from here, I guess what kind of timeline do you think until we can see that be maybe a bit less of a drag, and so that we can get more of a pull-through of your kind of focused strategies on the overall flow number?

We've grown. As we've showed on the slide, we've grown from 38% of our business back in 2013 to it now being 79% of our business, the focused asset classes. We think as that has grown, that will overtake any drag that we're seeing on the non-focused. I'm not sure we have a time frame, but I can tell you that the momentum, as you saw this quarter, and as we look out and look at our investment performance and we look at actually open capacity, so just in 2 franchises, Sophus and Trivalent, there's approximately $25 billion of open capacity. So you have open capacity there, you've got great investment performance, you have an area where active is still winning against passive. There's not as much of a headwind there. So we're pretty excited about that and how the business is shaping up. From a transition or timing perspective, I think it will continue to evolve. I'm not sure we have a date or can give you exact, but we think the trend is going in the right way.

Our next question comes from the line of Michael Cyprys of Morgan Stanley.

You mentioned Fidelity's price actions earlier on the passive side. Just curious how you see that filtering through, playing out on the pricing of active management as that gap widens. Just curious, your perspective there. And also, if you could talk to your latest viewpoints on the trajectory for your own fee rate. And also related to that, what if any appetite are you hearing from clients for performance-based pricing?

So I'll start off on the Fidelity comment. First, we've been in a highly competitive fee environment for years. So the announcement, although it was headline-grabbing, I would say that we, our business in active management has been in a highly competitive environment from a fee perspective. I'd like to point out for our business specifically, we have about 60% of our mutual fund AUM is priced median or lower. And we review pricing at least every quarter. We've already reduced a number of our mutual funds in pricing. We've created share classes. So we feel that from our business perspective, it's nothing new. And we have not seen and we're not really seeing any significant pricing pressure today, or are we anticipating from this announcement any significant pricing pressure in the short term. Now if we're wrong on that and there is, we actually think our business model is extremely well positioned from an industry perspective. We have close to 80% of our assets are in these focused asset classes. These are non-commoditized asset classes where active is still winning. They are less susceptible to pricing pressure. And then also, and Terry mentioned this earlier, our business model is integrated, it's scaled. In the areas where we are, there's variable expenses, which we place a high focus on. It is really designed to absorb higher expenses and lower fees, should we see an acceleration of that. Specifically, on performance fees and the appetite for clients, we've had many discussions with clients in the institutional channel and also on the Retail and Retirement side. And I would say the appetite, at least from our interactions, is not that high. Many of our clients don't want performance-based fees; some do. As you know, it is not impactful to our business. We don't have a lot of performance-based relationships.

If I could just ask a follow-up question just on the non-focused asset classes. You called out the flows and the AUM for those asset classes. Just curious if you could talk to the profitability levels and revenue levels and contribution from the non-focused asset classes, and in what situation or scenario could it make sense to consider some sort of strategic alternatives there as it relates to the non-focused asset classes?

Yes, I would say that there's really no material divergence in what we see from a profitability standpoint in our focused versus non-focused asset classes. And I think that when we think holistically about that part of the business, we still have plenty of optimism for growth in those parts. So I wouldn't say that we're contemplating anything strategic around non-focused asset classes.

I would add just one other thing. As you know, our franchises are integrated into our business. So unlike other multi-boutiques, our franchises are very integrated. And I'd also stress that although we have -- although these non-focused asset classes are not seeing -- I'd say there's headwinds -- we still very much like the way they're approaching the asset class, how they're approaching portfolio construction and stock selection. And we think, in a different environment -- and at some point, the environment might change -- these are going to be winners as well. So these are not outcasts if you will. These are franchises which we think are highly competitive. They're just in an area of the market where there are headwinds.

Our next question comes from the line of Alex Blostein of Goldman Sachs.

So maybe just back to the M&A discussion one more time. Could you guys maybe give a little bit more color around the pipeline and spend a minute, maybe, on the top-off strategies you guys are pursuing? Anything in terms of kind of composition of the pipeline, either by size of potential targets or, again, kind of the strategies that they're pursuing?

So let me start on the types of products first. We're very focused on, really, products of the future. And what we mean by that is these are products that will fit into clients' portfolios. These are products that are going to matter when they think about allocating to active management. They're solutions-based. And it's an area, from a product perspective, where we think we can win from an active-passive comparison and really from a competitive comparison. And typically when you have those attributes, those products turn into higher-fee, higher-margin, kind of less potential for disintermediation by the passive winds, if you will. So from a product perspective, that's what we're looking for. I guess from a pipeline and size, we are looking at -- really, we've used this $10 billion to $75 billion range. We're looking at opportunities within that range, and there are some that are smaller and there are some that are larger. It's really a wide range, but the common theme of all of the opportunities we're looking at is these are really organizations where we think the product set is for the future, where we think there's a cultural match, where we think that we can bring these businesses onto our platform and add a lot of value to their business and really make their businesses better on our platform.

Understood. And you had a little bit on that in some of the earlier responses. But has there been much in terms of a change in competitor landscape when it accounts for some of these properties? Obviously, the reason we are all ask is that the industry's facing significant challenges and everybody's trying to figure out a way to kind of outgrow them. So as you think about other asset managers' potential looking to do deals, how has that changed recently versus the last couple of years? And again, is that starting to impact some of the deal discussions?

So I think you're right. I think there are more people pursing acquisition strategies than in the past to try to account for some of the slower growth. But many of those firms have never done acquisitions in the past. We're very experienced. And also, I think we have a very unique lane from an acquisition standpoint. We have a very unique platform that has very distinct and specific strengths. And I think it's very unique. So when we're having discussions, although there might be more people pursuing the property, we think that there are very few that have the same strengths and unique positives that we have. So, therefore, I would say from a competition standpoint, it really has been the same because we have, I think, very few competitors with what we're offering.

Maybe I could just sneak in one more. So the ETF strategy's definitely gaining some momentum for you guys. Can you spend a minute on pricing? And is that becoming at all of an issue, given the fact that smart beta's a category that continues to face incremental pricing headwinds? And are you guys thinking about anything on the partnership front where you could partner more directly with either some of the retail brokers or some of the digital distribution platforms to accelerate that growth?

So I'll start off on pricing. We have not seen pricing pressure with our ETFs. They're priced from 30 to 45 basis points. You can see that they're growing. Our ETF business is very differentiated. Think of it as an active intuition in a rules-based way. We've got a track record. Many of our ETFs have 3-plus-year track records, and we're high-touch client service as well with our ETF buyers. So we have not seen the pricing pressure. We have partnered with NASDAQ. We have a partnership with NASDAQ. And as in -- as I said in our prepared remarks, we have great distribution penetration on the retail side with some of the largest partners. We're exploring lots of partnerships, but we really feel like we're very well positioned, and we feel like that part of the ETF market is really getting ready to grow quite significantly, and we think we're very well positioned with products that have size and products that have track records that are Morningstar rated and very well positioned on some of the larger platforms.

Our next question comes from the line of Robert Lee of KBW.

Sorry to just kind of keep on the M&A theme, but a few questions. First, maybe could you talk a little bit about how maybe some things maybe have evolved or changed since your IPO? And what I mean specifically is could you refresh our memory on what your target leverage ratio would be? I mean if I think of the 3.6 it was a year ago, that's pretty far above where a lot of kind of public peers kind of target. And then I guess maybe as part of that, understanding some of the unique strengths of your model and looking for the consolidation benefits, some of your competitors -- and this isn't new -- but some of your competitors obviously have a different model. Also looking at similar properties with good growth prospects, presumably some that are not currently in outflow. And they're also more willing to keep equity in the hands of those people they partner up with. So can you maybe talk a little bit about whether your model kind of is actually -- you end up kind of targeting a somewhat different product set than some of your peers who have an affiliate model with kind of an equity component to it. Or do you think that advantages you or disadvantages you in some cases, considering that you're all looking at kind of the growth-ier businesses out there?

So let me start with what's changed since the IPO. When we went public in February, I think that has only enhanced our ability to attract partners to our platform. It's been viewed very positively in all the discussions we've had. As Terry has mentioned, the leverage ratio has come down. I believe we're at 1.7x today. We have not given guidance on target leverage ratios, but we have significantly reduced our leverage quite aggressively. As far as our operating platform and our M&A strategy, we are differentiated, as you've pointed out. We have an integrated approach. But as I stated in our prepared remarks, we are flexible, and we are flexible to other structures, and some of those other structures could look different than what we've done in the past, which could be more similar to what maybe some of our competitors are doing. But the big difference and the uniqueness of our platform is we have a centralized distribution and marketing system that has size and scale that typically is utilizing relationships that can help grow these potential acquisition targets. And then we also have a centralized operating platform, which includes technology and administration, which typically is better or as good as the entity we're acquiring, so they view that as an upgrade. But I would say that our opportunity to potentially garner synergies on our platform when we do these transactions is very differentiated because of the centralized model. I think it allows us actually more flexibility in the types of businesses we're able to pursue and actually look at it in a way where our scope of potential opportunities is actually as wide, if not wider than maybe some of our competitors because of that aspect. As I mentioned earlier about our products that we're pursuing, these are products, as I've talked about, that are really products of the future. They're value-added; they're differentiated. And I'm not sure that there's really a narrow scope on that. I think that that's a pretty wide range of potential products.

Let's maybe one follow-up. I mean you -- many of your peers, all different business models, have been dedicating or dedicated a pretty significant amount of capital over the past several years to seed capital, bringing on new strategies and -- I mean you guys have plenty of, obviously, plenty of products to work with. But you haven't had to use capital for that. I mean do you see that changing in kind of, maybe over the short and intermediate term just as the competitive pressures to build in the industry and kind of always have to innovate to some degree, I guess, depending -- particularly in things like multi-asset class and what-not. So do you see that at all becoming a greater capital need over the next several years?

We've had great success growing smaller products. I think our ETF example that we've given is a great example of taking smaller products and growing them, and we have a great track record of doing that in a number of other asset classes. I've always said that the best gauge of whether a product is marketable and salable is to get a client to buy it. And so we don't think for our business that there's going to be a need for a large pool of seed capital, and I think that's really a testament to our distribution system and our relationships that we have.

Our next question comes from the line of Andrew Disdier of Sandler O'Neill.

So just as a follow-up on the M&A, you've described your strategy as a majority, if not kind of 100% stake, in target firms. So to Rob's question, given the step-up in competition in what's presumably more selection for sellers as far as potential deal terms go, I guess how flexible are you and willing to be with the targets, whether it be deal terms, pricing, whatever it might be in order to execute a transaction? Or should it look similar or sound similar to what we've heard in the past?

I would start off saying that we are flexible. The transactions we've done in the past have been all very different and unique. Each transaction is unique to itself. I don't think there's one type of transaction, so all the transactions are unique. We've been flexible in what we've done historically, and we will be flexible going forward. A key component of our M&A strategy is our platform and how the potential target plugs into our platform is really where a lot of the flexibility occurs. In the past, we've done 100% deals where we've bought 100% of the company because it made sense for that transaction. As we look forward, we'll have a flexible mindset with some key components that we -- from a platform perspective that we won't move. And part of it is integrating into our platform, but there are lots of different ways to do that. I would just end and say that our platform is a positive and is not viewed as a negative from the people we're talking to, and our structure that we approach them with is a positive, and we actually believe that it widens our universe of opportunities as opposed to shrink them.

Understood. And then, Terry, appreciate the commentary on a normalized level of expenses for the quarter. So noticed that there were some PM adjustments and tweaks during the quarter, reduced a couple of affiliates. Just wanted to ensure -- or franchises, rather -- but just wanted to ensure that the reduction in PMs is kind of fully captured in that top line, or are we going to see that step down a touch, just given some of the timing during the quarter?

No, I would say what you're looking at is reflective of normalized levels.

Our next question comes from the line of Kenneth Lee of RBC Capital Markets.

Just one on the separate accounts. Were there any particular drivers for the outflows in the quarter? Thanks.

No, nothing in particular. I think the outflows you saw there are consistent with some of the themes that we talked about earlier, predominantly client rebalancing.

And just one follow-up question. Wonder if you could give any updates on efforts to expand presence with Registered Investment Advisers?

We wouldn't point to any specific strategies beyond some of the things that we talked about earlier. The retail channel for us, which is where we would put the RIA channel, is robust. We have taken a building block approach to that channel as well as our other intermediaries in the sense that we have had good traction with a number of our franchises, and we're building on that momentum with some of the other flow leaders that we've discussed. So we have a fairly consistent approach across the wire houses and the RIAs.

And our next question comes from the line of Chris Shutler of William Blair

One more on the M&A front. So of the more serious conversations you're having, can you give us some sense how much is proprietary versus more formal processes? And then are the sellers more weighted to larger FIs, or are you seeing more independent firms?

I would say the conversations, the opportunities really come from a number of different avenues, so proprietary and from processes. I take both. And then on your second part of your question, can you actually repeat it, because you went in and out?

So just the weighting to larger financial institutions relative to independent firms?

I think it's mixed as well. I think we're seeing both. I don't think there's one heavily skewed to one group or another.

Okay, and then, Terry, just a couple of cleanups. The G&A expense, $7.1 million in the quarter. Just want to confirm that's a good run rate going forward. And then the incentive comp as a percentage of pre-bonus EBITDA, if you could give us a sense of what that was in the quarter.

Yes, the G&A is normalized, so I think that's a good way to think about it. And on the incentive comp, as we've discussed before, it's a function of pre-incentive EBITDA, so thereby a function of revenue and, effectively, earnings. We have the flexibility to be in the 30% to 35% band, and the target or I guess the guidance we give right now, it's in 30% to 31% range.

30% to 31% for the year?

Correct.

Thank you, and I'm showing no further questions at this time. I'd like to hand the call back to David Brown for any closing remarks.

Thank you. Thanks for taking the time today to participate in our earnings call. If you have any additional questions, please don't hesitate to contact us. And thank you for your interest in Victory Capital.

Ladies and gentlemen, thank you for participating in today's conference. That does conclude today's program. You may all disconnect. Everyone have a great day.