MS Q3 2017 Earnings Call
Operator: Good morning. My name is Denise, and I’ll be your conference operator today. At this time, I’d like to welcome everyone to the Eaton Vance Corp. Third Fiscal Quarter Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. [Operator Instructions] Thank you. Daniel Cataldo, Treasurer, you may begin your conference.
Daniel Cataldo: Good morning, and welcome to the Eaton Vance Corp fiscal 2017 third quarter earnings call and webcast. With me this morning are Tom Faust, Chairman and CEO; and Laurie Hylton, our CFO. We’ll first comment on the quarter, and then take your questions. The full earnings release and charts we will refer to during the call are available on our website, eatonvance.com, under the heading Press Releases. Today’s presentation contains forward-looking statements about our business and financial results. The actual results may differ materially from those projected due to risks and uncertainties in our business, including, but not limited to, those discussed in our SEC filings. These filings, including our 2016 annual report and Form 10-K, are available on our website or upon request at no charge I’ll now turn the call over to Tom.
Tom Faust: Thanks, Dan. Good morning, everyone, and thank you for joining us. July 31 marked the end of our third quarter and first nine months of fiscal 2017. The strong internal growth we experienced in the first two quarters of the fiscal year continued through the third quarter, putting the company on pace to realize record net flows for the fiscal year and by a wide margin. This comes amid a challenging environment in which many peer companies have struggled to grow at all. For the quarter, we were reporting $0.62 of adjusted earnings per diluted share, up 11% from the third quarter of last year and flat versus the preceding quarter. As Laurie will discuss in a few minutes, this quarter’s adjusted earnings include $0.03 a share of cost in connection with employee terminations, special fund expense reimbursements and one-time legal and investigative costs not present in the preceding quarter and not expected to recur. We closed the third fiscal quarter with a record $405.6 billion of consolidated assets under management, up 5% from the prior quarter-end and up 21% from a year ago. Net flows in the third quarter were $9.1 billion, equal to a 9% annualized internal growth rate in managed assets. Backing out lower fee exposure management mandates, our quarterly net flows were $8.1 billion, which equates to 11% annualized internal growth. Through the first nine months of the fiscal year, net flows of $29.9 billion equates to 12% annualized internal growth in managed assets, which already exceeds our best-ever full year net flow results. Looking at our flows from the perspective of net income, net impact to management fee revenue, results remain very solid. We realized annualized internal growth in management fee revenues of 6% for the fiscal third quarter and the first nine months of the fiscal year. Continuing the trend of recent reporting periods, this quarter’s positive flow results were broadly distributed. In fact, this was the second quarter in a row where we had positive net flows across each of our reporting categories. Equity, fixed income, floating-rate income, alternative, portfolio implementation and exposure management, investment categories and funds, institutional separate accounts, high net worth separate accounts and retail managed accounts all had positive flows for the quarter. Equity category net inflows of $1.5 billion were driven by Parametric defensive equity and option overlay strategies, Eaton Vance management large-cap growth and Atlanta Capital SMID-Cap core strategies. In fixed income, municipal and corporate bond ladder strategies led the way in generating $1.3 billion of net inflows in the quarter, with the actively managed munis and emerging market debt mandates also contributing. After strong net inflows in 2016, high-yield has been a drag on our flow results thus far in 2017, consistent with the overall industry trends. This quarter, the decision by a large financial intermediary to reduce high-yield allocations in their tactical allocation models resulted in roughly $500 million of redemptions from our high-yield bond funds. Although retail demand for floating-rate bank-owned funds has slowed in recent months, we still generated $1.5 billion in net floating-rate flows in the quarter, which equates to 16% annualized organic growth. Growth in floating-rate assets was well balanced between retail and institutional clients. The quarter’s floating-rate flows include a $210 million raised in the July initial public offering of the Eaton Vance Floating-Rate 2022 Target Term Trust. Upon the exercise of the greenshoe and the addition of leverage, we expect the fund to realize a total size of approximately $340 million. We view the target term trust structure as particularly well suited for the bank-owned asset class and hope to bring additional offerings to market over the coming quarters. In the alternative category, net flows continue to be dominated by our global macro absolute return funds offered in the U.S. and internationally, which accounted for over $635 million of the $690 million total category net inflows for the quarter. Our global macro strategies continue to grain traction on the basis of strong one-year, three-year, five-year and 10-year investment performance with demonstrated low volatility and low correlation to U.S. and international equity and fixed income market returns. Portfolio implementation net inflows of $3.1 billion were driven primarily by Parametric Custom Core equity separate accounts offered to retail on high net worth investors, which generated over $2.9 billion in net inflows for the quarter and $9.4 billion for the fiscal year-to-date. Custom Core remains one of our fastest-growing businesses with retail on high net worth Custom Core separate account assets increasing nearly 50% over the past nine months to $48.6 billion. Like indexed ETFs and indexed mutual funds, Custom Core provides investors with low-cost access to broad equity market exposures with high correlation to a specified equity index. Unlike shareholders of ETFs and mutual funds, investors in Parametric Custom Core accounts hold underlying securities positions directly, which enables portfolios to be tailored to reflect client-specified Responsible Investing criteria, factor tilt and portfolio exclusions and also providing more favorable tax treatment. Different from an ETF or mutual fund, losses harvest on an individual securities held in a Custom Core portfolio can be used to offset client gains on other investments, reducing the client’s net realized capital gains. Custom Core portfolios are also frequently constructed from a client’s existing holdings, which can help lower transition costs and taxes, a benefit not available in mutual fund and ETF investing. As we have mentioned in prior calls, we frequently market Parametric Custom Core strategies in conjunction with Eaton Vance municipal and corporate bond ladders and refer to the combined offering as custom beta. As can be seen on Page 17 of the cost slides, our total managed assets in custom beta strategies offered as retail on high net worth separate accounts is now $64.5 billion, up 48% from the beginning of the fiscal year. In both equity and fixed income custom beta offerings, we believe we are the market leader in terms of managed assets and more importantly, product features and service levels. These are scaled businesses not subject to capacity constraints that we continue to believe were in the early stages of their growth directory – trajectory. In a highly differentiated way, they position Eaton Vance to benefit significantly from the growing demand for passive investment strategies across core asset classes. Our final reporting category, exposure management, had net inflows of $1.1 billion in the third quarter. As a reminder, this is a Parametric business offering primarily futures-based overlay strategies to institutional clients, so they can add, remove or hedge market exposures within their portfolios in a transparent, efficient and highly customized manner without disrupting their underlying holdings. At an average fee rate of 5 basis points, this is our lowest fee business but also one of our strongest growth areas. Since entering this business through the acquisition of the former Clifton Group in December 2012, assets in exposure management have increased from $32 billion to today’s $82.8 billion, growing in a rate of 23% annually. Relationships with significant institutional clients established through exposure management assignments have also, on numerous occasions, resulted in new business wins for other Parametric strategies, a side benefit of this distinctive and high-value offering. Turning to investment performance. We continue to see strong results across a broad range of our strategies. At July 31, we offered 69 mutual funds with at least one class of shares currently rated four or five stars by MorningStar, including 26 five-star-rated funds. 76% of our mutual fund assets are in funds outperforming their MorningStar peer group median over three years and 72% over five years and 10 years. Income and alternative strategies are a source of particular performance strength for Eaton Vance with five-star-rated funds and floating-rate, ultrashort and short duration, high-yield, emerging market debt, global macro, government income and multiple national and state municipal bond categories. Our performance in numerous income categories compares favorably not only to other actively managed funds but also to the leading index ETFs in the same category. Across floating-rate bank loans, high-yield bonds, core bonds, emerging market local income, municipal income and short-term government income, our funds are outperforming the leading ETF competition net of fees over multiple time periods often by a significant margin. That’s a story that we are increasingly starting to tell. Investors who experience better returns from equity index ETFs over actively managed funds often assume that the same ETF return advantage applies in fixed income as well. That simply hasn’t been the case, certainly not with respect to many of our funds. Before I call – turn the call over to Laurie, I’d like to comment on two Eaton Vance initiatives of strategic importance; the recent acquisition of Calvert Investments and the rollout of NextShares’ exchange-traded managed funds. As you likely know, we acquired the business assets of Calvert Investments on December 30, 2016. Calvert is a recognized leader in Responsible Investing with $11.9 billion of assets under management at the close of the transaction, which includes $2 billion sub-advised by our affiliate, Atlantic Capital, and, therefore, previously included in our consolidated managed assets. The Calvert funds are one of the largest and most diversified families who responsibly invest in mutual funds, encompassing actively and passively managed equity, fixed income and asset allocation strategies managed in accordance with the Calvert principles for responsible investment. We bought Calvert to serve the growing market for Responsible Investing, one of the leading trends in asset management. By combining our management and distribution resources with Calvert’s expertise and leading reputation in Responsible Investing, we seek to make Calvert a meaningfully larger and more impactful company. Seven months into our ownership of Calvert, I’m pleased to report that the assimilation of Calvert into the Eaton Vance organization is now largely complete, and that Calvert is beginning to contribute to the company’s internal growth. In the third quarter, net flows into Calvert funds and accounts turned positive, with gross spread across a range of responsibly managed Calvert fixed income and equity funds. Earlier this month, we’ve learned of a major win for Calvert in the responsible management fixed income mandates, which we view as a significant opportunity beyond this assignment. For the balance of this year, our focus for Calvert is to finalize development of a strategic growth plan and to begin implementation. Across retail and institutional, active and passive, equity income and multi-asset, we see enormous potential for Calvert to grow from current levels. Now turning to NextShares. As a reminder, this is an SEC-approved new fund structure combining proprietary active management with the conveniences and potential performance and tax advantages of exchange-traded products. Our NextShares Solutions subsidiary holds patents and other intellectual property rights relating to NextShares and is seeking to commercialize NextShares by entering into licensing and service agreements with fund companies. Since gaining SEC approval at the end of 2014, we focused on two primary objectives; signing up fund sponsors to offer NextShares and gaining distribution access to broker-dealers. With last week’s announcement by Brandes Investment Partners, there are now 16 fund companies that have entered into preliminary NextShares license agreement, albeit one of which have now received SEC exemptive relief to offer NextShares. Eight NextShares funds, three from Eaton Vance, three from Waddell & Reed and two Gabelli Funds, are now live in the market, with funds from two other sponsors, Hartford and Pioneer, currently in registration. On the distribution side, our main focus is the pending launch of NextShares at UBS through their network of 7,100 U.S. financial advisers, which is slated for November. We are pleased with UBS’s broad support of this initiative and are excited for this opportunity to bring NextShares to a large audience of financial advisers and clients. Today, the path for – to financial success for our NextShares initiative is reasonably clear; launch a range of compelling investment strategies as NextShares; drive fund sales for those strategies to successful levels at UBS; and then leverage success at UBS to gain broader distribution access and the introduction of additional compelling NextShares strategies from a growing list of fund sponsors. By this time next year, we should have a good indication that this is achievable. As our NextShares initiative plays out, Eaton Vance remains exceptionally well-positioned for continued growth, with positive momentum across a broad range of investment businesses and new opportunities arising through Calvert and our expanding distribution platform. I see no reason why we can’t continue to build on recent successes. That concludes my prepared remarks, and I will now turn the call over to Laurie.
Laurie Hylton: Thank you, Tom, and good morning. Today, we reported adjusted earnings per diluted share of $0.62 for the third quarter of fiscal 2017, up 11% from $0.56 of adjusted earnings per diluted share in the third quarter of fiscal 2016 and unchanged from $0.62 of adjusted earnings per diluted share reported in the second quarter of fiscal 2017. On a GAAP basis, we earned $0.58 per diluted share in the third quarter of fiscal 2017, $0.55 in the third quarter of fiscal 2016 and $0.62 in the second quarter of fiscal 2017. As you can see in Attachment 2 to our press release, adjustments from reported GAAP earnings in the third quarter of fiscal 2017 includes $3.5 million of closed-end fund structuring fees paid in connection with the initial public offering of Eaton Vance Floating-Rate 2022 Target Term Trust in July and $5.4 million recognized on the extinguishment of debt associated with retiring the remaining $250 million aggregate principal amount of our 6.5% senior notes due in October 2017. The adjustment from reported GAAP earnings for the third quarter of fiscal 2016 reflects $2.3 million of closed-end fund structuring fees paid in connection with the initial public offering of Eaton Vance High Income 2021 Target Term Trust in May 2016. Adjusted earnings per diluted share equaled GAAP earnings per diluted share for the second quarter of fiscal 2017. As I’ll describe in more detail, costs in connection with employee terminations, special fund expense reimbursements and one-time legal and investigative costs, reduced adjusted earnings by $0.03 per diluted share in the third quarter of fiscal 2017 and $0.01 per diluted share in the third quarter 2016. Such costs were negligible in this year’s second quarter. As you can see in Attachment 2 to our press release, adjusted operating income, which excludes the closed-end fund structuring fees paid in the third quarters of fiscal 2017 and fiscal 2016, increased by 14% year-over-year and 6% sequentially. Our adjusted operating margin was 31.6% in the third quarter of fiscal 2017, slightly down from the 32% reported in the third quarter of fiscal 2016 and substantially unchanged from the 31.5% reported in the second quarter of fiscal 2017. As Tom mentioned, managed assets growth was strong in the third quarter of fiscal 2016. Ending consolidated managed assets at July 31, 2017, reached a record $405.6 billion, an increase of 5% from the prior quarter-end, driven by solid net flows and positive market returns. Ending consolidated managed assets increased 31% from July 31, 2016, reflecting strong net flows, favorable markets and the impact of the Calvert acquisition at the end of calendar 2016. Average managed assets in the third quarter of fiscal 2017 increased 22% versus the third quarter of fiscal 2016, driving a 15% increase in revenue. Revenue growth trailed growth in average managed assets year-over-year, primarily due to a decline in our average management fee rate from 35.6 basis points in the third quarter of fiscal 2016 to 34.2 basis points in the third quarter of fiscal 2017. This decline in our average management fee rate is primarily attributable to the ongoing shift in our business mix as lower fee exposure management, portfolio implementation and bond ladder businesses have become a larger percentage of our assets under management. Average managed assets in the third quarter of fiscal 2017 increased 5% versus the second quarter of fiscal 2017, generating a 5% growth in revenue. Sequentially, our average management fee rate was relatively stable, declining from 34.7 basis points in the second quarter of fiscal 2017 to 34.2 basis points in the third quarter of fiscal 2017. Although strong flows into our lower fee strategies continue, net inflows into higher fee strategies helped mitigate the overall fee rate decline. Performance fees, which are excluded from the calculation of our average fee rates, contributed $0.5 million and $2.7 million in the third quarters of fiscal 2017 and fiscal 2016, respectively, and were negligible in the second quarter of fiscal 2017. As Tom noted, we realized 6% annualized internal growth in management fees on 9% annualized internal growth in managed assets in the third quarter of fiscal 2017. This represents a significant improvement over the third quarter of fiscal 2016 when we realized 3% annualized internal growth in management fees on 9% annualized internal growth in managed assets. The spread between management fee and AUM growth rates in this year’s third quarter also compares favorably to the preceding quarter when we generated 7% annualized internal growth in management fees on 14% annualized internal growth in managed assets. We’re pleased to see asset growth translating into demonstrable revenue growth and are optimistic about our ability to continue to build on this momentum in the last quarter of our fiscal year. Third quarter consolidated revenues were the highest in company history. Turning to expenses. Compensation expense in the third quarter of fiscal 2017 increased by 17% from the third quarter of fiscal 2016, reflecting increases in sales-based incentive accruals driven by strong product sales; higher operating income-based bonus accruals driven by increased profitability; incremental compensation expenses associated with the Calvert acquisition; higher salaries and benefits associated with other increases in headcount; and higher stock-based compensation and other compensation costs associated with employee termination. Sequentially, compensation expense increased by approximately 5% from the second quarter of fiscal 2017, reflecting the impact of three more payroll days in the third quarter as well as many of the same drivers identified in our year-over-year comparison. As mentioned in the release, severance and other costs associated with employee terminations totaled $3 million in the third quarter versus $1.9 million in last year’s third quarter and $200,000 in the second quarter of this fiscal year. Backing out employee termination costs, our third quarter compensation costs were up 3% over the preceding quarter. Based on what we see today, we do not expect to incur meaningful amounts of employee termination costs in the fourth quarter, so that should be a boost to next quarter’s sequential earnings comparison. Non-compensation distribution related costs, including distribution and service fee expenses and the amortization of deferred sales commissions, increased 16% and 10% versus the third quarter of fiscal 2016 and the second quarter of fiscal 2017, respectively, reflecting increases in closed-end fund structuring fees and higher marketing and promotion costs. The year-over-year increase also reflects an increase in distribution-related costs associated with the addition of the Calvert funds acquired at the end of calendar 2016. Backing out closed-end fund structuring fees, which we do in calculating adjusted operating income and adjusted earnings per diluted share, our non-compensation distribution-related costs in the third quarter were up 15% year-over-year and up 4% over the prior quarter. Fund-related expenses increased by 57% and 18% versus the third quarter of fiscal 2016 and the second quarter of fiscal 2017, respectively, primarily reflecting increases in fund expenses borne by the company on funds for which we earn an all-in fee and $1.9 million in one-time reimbursements made to the funds by the company during the third quarter of fiscal 2017. The year-over-year increase also reflects increases in sub-advisory fees paid in fund subsidies associated with the addition of the Calvert funds. I would note that the $1.9 million in fund reimbursements made this quarter were one-time in nature and should not recur, another potential boost to fourth quarter earnings comparison. Other operating expenses were up 7% versus the third quarter of fiscal 2016, and up 2% from the second quarter of fiscal 2017. The year-over-year increase primarily reflects increases in travel, communications, professional services, other corporate expenses and information technology spending. Other operating expenses this quarter included approximately $600,000 of one-time legal and consulting costs in conjunction with the investigation of the fraudulent activities of a former Eaton Vance management trader. We continue to spend $2 million per quarter in connection with our NextShares initiative. Net gains and other investment income on seed capital investments contributed $0.01 to earnings per diluted share in the third quarter of fiscal 2017 and fiscal 2016 and contributed $0.02 to earnings per diluted share in the second quarter of fiscal 2017. When quantifying the impact of our seed capital investments on earnings each quarter, we take into consideration our pro rata share of the gains, losses and other investment income earned on investments and sponsored funds, whether accounted for as consolidated funds, separate accounts or equity method investments as well as the gains and losses recognized on derivatives used to hedge these investments. We then report the per share impact, net of income taxes and net income attributable to non-controlling interest. We continue to hedge the market exposures of our seed capital portfolio to the extent practicable to minimize the earnings volatility associated with our seed portfolio. Net gains and other investment income in the second quarter of fiscal 2017 included a non-recurring $1.9 million gain recognized upon the release from escrow of payments received in connection with the company’s sale of its equity interest in Lloyd George Management in fiscal 2011. Our effective tax rate for the third quarter of fiscal 2017 was 36.9%. Excluding the effect of consolidated CLO entity earnings and losses allocated to other beneficial interest holders in the quarters where applicable, our effective tax rate was 36.9% for the third quarter of fiscal 2017, 38.5% for the third quarter of fiscal 2016, and 37.5% for the second quarter of fiscal 2017. With among the highest tax rates of corporate taxpayers worldwide, Eaton Vance would be a major beneficiary if efforts in Washington to lower the U.S. corporate tax rate proved to be successful. In April, we issued $300 million in aggregate principal amount of 3.5% 10-year senior notes due in 2017 and issued a redemption notice for our $250 million of 6.5% senior notes due this October. On May 6, we used $256.8 million of the net proceeds received from the April debt offering to retire the 6.5% senior notes and paid $6.8 million in accrued interest fees and expenses associated with the redemption, of which $4.4 million was recognized as the loss on extinguishment of debt in the current quarter. The issuance of the 3.5% senior notes and the redemption of the 6.5% senior notes will result in an annual reduction in interest expense of approximately $5.8 million. In other capital management activities, we repurchased 443,000 shares of non-voting common stock for approximately $21.3 million in the third quarter of fiscal 2017. We anticipate continuing to pursue repurchases in the fourth quarter. We finished our third quarter – third fiscal quarter holding $634.8 million of cash, cash equivalents and short-term debt securities and approximately $356.1 million in seed capital investments. We also have a $300 million credit facility, which is currently undrawn. It’s worth mentioning that different from what our balance sheet may suggest, we have not significantly increased our seed capital portfolio during fiscal 2017. The increase in investments shown on our balance sheet is largely offset by a corresponding increase in redeemable non-controlling interest, reflecting the impact of new consolidation guidance adopted during the first quarter of fiscal 2017 that necessitates the consolidation of a greater number of funds in our seed capital portfolio at lower levels of ownership. As a final note, I would observe that Eaton Vance continues to operate at high levels of profitability and to maintain significant financial flexibility, even as we support strong business growth. Looking forward to the fourth quarter of the fiscal year, based on what we see today, we expect earnings comparison to benefit from both higher average assets under management, driving growth in revenue and the absence of certain one-time expenses as described that weighed upon third quarter results. These remain good times for Eaton Vance. This concludes our prepared comments. At this point, we’d like to take any questions you may have.
Operator: [Operator Instructions] Your first question comes from Chris Shutler with William Blair. Your line is open.
Chris Shutler: Yes. Good morning. In Parametric’s custom beta or Custom Core areas, I think the average fee rate is about 15 basis points. Maybe just confirm that. And then, can you talk about the competition in that space? And what are the kind of the hindrances in your view from this area taking off becoming as popular or even more popular than ETFs, at least with high net worth investors?
Tom Faust: I think your average fee estimate is low. Maybe we can – maybe Dan has that number. I think it’s more in the 20 basis point range. Is that…
Daniel Cataldo: Yes.
Tom Faust: Okay.
Daniel Cataldo: Chris, if you look at the Custom Core equity business that we package in the custom beta product set, the Custom Core equity fee rates are roughly 20 to 21 basis points.
Chris Shutler: Okay. Great.
Tom Faust: I think that – maybe I’ll take the rest of the question. This is a business that we’re seeing strong growth, and I mentioned we’re up roughly 50% in assets in revenues just in the last nine months. So clearly, we’re seeing significant growth there. And that’s looking at – I’m isolating that what we sell to high net worth and retail investors from – we have a, I’ll call, legacy business that’s related but not serving the same kind of clients. It doesn’t have those same kind of growth dynamics, but it’s – I think it’s around like $50 billion at the end of the quarter in retail and high net worth, growing about 50% for the first nine months. We see a lot of potential for growth there, as you suggest. It doesn’t work for everyone. For one, it’s a minimum investment at Eaton Vance or Parametric of $250,000, so it’s not a mass-market product. It’s for higher net worth investors. There are several competitors. The most significant is a company called Aperio, A-P-E-R-I-O, based in San Francisco, that is largely focused on this opportunity. I think we’re roughly, I’m going to say, three times the size they are in this business, two times to three times the size. But they’re a significant competitor for us. For larger mandates, we will run up against them. There are some other competitors, not of particular size. That’s the – Aperio is the major competitor today in a direct sense. Indirectly, obviously, we’re competing against other providers of separately managed accounts. And more particularly, we’re also competing against other providers of index-based solutions, most notably, the big ETF and index fund providers. This is a very different business than managing an ETF or index mutual fund. These portfolios are highly customized. Every account is a separate account, so it’s individual holdings, separate onboarding process. Parametric in total runs something north of 40,000 accounts. So there’s a factory aspect of this business that I think makes it challenging for others to get in. Scale matters, customization matters, product features matter and service matters, and we think we’ve done a good job across all channels of really representing Parametric and Eaton Vance as the market leader in this category with the broadest product suite, with the most robust systems and with the highest levels of service. You asked a question about the open-ended nature of the opportunity, which we would certainly agree with. There is a very large market for index-based strategies in the trillions of dollars. We are the largest player in this but tiny compared to that opportunity at our current size of – in the range of $50 billion. So we think there’s a lot of legs for this business to grow, and we’re certainly committed to that as a core element of our growth strategy going forward. Parametric had an annual – had their annual, what I call, strategy summit last week in Seattle, and Laurie and I were out there for that. And clearly, this is a key focus of theirs in looking to build out their business over the coming years and certainly, will continue to be an important driver of the overall growth of Eaton Vance.
Chris Shutler: All right. Great, thanks, Tom. And then, how for along do you think you are in terms of just awareness of this capability amongst both retail and institutional? I don’t know if you can break out the AUM and custom data between those two.
Tom Faust: Yes. So it’s not retail versus – most institutional market you think of as being non-taxable. This is primarily serving a taxable customer base. There are plenty of exceptions to that. But the most significant part of the assets, I think in our slides, we break it out between the tax managed and the non. But the – for most customers, the tax advantages of holding securities directly is the primary appeal that’s changing at the margin, but we see it continuing to be primarily a retail and high net worth-driven as opposed to traditional institutional business. At a very large size, customers can do this themselves, but for customers in a range of $250,000 to maybe $10 million to $50 million, having a third-party specialist like Parametric take on this activity is, I think, a significant benefit. And we’re investing quite significantly to grow this to add product features and to scale up the technology to allow us to meet the growing demand and to serve a growing base of clients. Big opportunities.
Daniel Cataldo: And Chris, just in terms of the breakdown of the custom beta assets, think of it, and these are what’s reflected in Slide 17 in our charts is $64.5 billion in total AUM. $15.9 billion of that would be in the laddered products, both muni and corporate. And the balance would be Custom Core equity strategies managed by Parametric.
Chris Shutler: All right. Thanks a lot.
Operator: Your next question comes from Robert Lee with KBW. Your line is open.
Robert Lee: All right. Thanks. Good morning, everyone.
Laurie Hylton: Good morning.
Robert Lee: A couple of questions, maybe first starting with the separate account, the SMA business, managed account business. So obviously, the portfolio implementation is the big driver of that. But if I do my numbers correctly, it looks like you had pretty good flows outside of portfolio outside of those businesses. So can you maybe give us a little bit of an update of your retail SMA business and what’s happening there outside of the – outside of this?
Tom Faust: Yes. I think the piece – the other piece that’s not in the portfolio implementation category is our muni and corporate bond ladders, which are – we put in this custom beta suite. So the primary drivers of retail managed account growth is Parametric Custom Core and Eaton Vance muni and corporate ladders. Parametric Custom Core shows up under implementation. The ladders show up under fixed income flows.
Robert Lee: All right. Great. And I mean, equity flows in the quarter were very strong, certainly bucking industry trend. I mean, can you maybe just update us a little bit on some of the drivers there whether they may be some a lot of – perhaps a large private fund closing or anything of that nature that may have helped it in the quarter?
Tom Faust: The biggest factor or the biggest driver of the growth is a Parametric business that most commonly described as defensive equity. Sometimes, we call it volatility risk premium, but these are equity strategies with built-in option overlays. And they’re having strong success selling this primarily to institutional clients where it’s frequently positioned as a lower-cost, more transparent and frequently better performing alternative to hedge funds. And that’s a significant part of the growth of our overall equity business. Maybe, Dan, I don’t know if you have any numbers there to share.
Laurie Hylton: Over $900 million.
Daniel Cataldo: Yes, a couple of other contributors in the quarter, as has been in past quarters, the Atlanta Capital SMID-Cap Fund contributed positively. And we did have a successful closing of a private fund in the quarter as well.
Robert Lee: Great. And maybe, if I could, one last question on Hexavest, a really two-parter. Yes, I noticed that clearly, not all their flows are included in your flows, but it looks like they turned positive in the quarter. Can you maybe update us on their business trends and – which looked like they’ve improved? And then also, if memory serves me, you should be coming up towards a point where you may have the option to buy in a larger stake in Hexavest. Are we approaching that? And kind of what are your thoughts around that?
Tom Faust: Yes. So the – I’d comment on both of those. The business has turned up. The full numbers that show up on some of our slides and in the exhibits to the release indicate that, I think, they had $0.5 billion or so of net inflows in the quarter, which is an upturn from generally negative flows recently. And that’s fairly broad-based. It’s primarily driven by global equity mandates, some in the U.S., some in markets around the world. We see pretty good momentum there. They’ve had an upgrade in ratings from several consultants, and this is a product that based primarily on the very strong performance they had on a relative basis in the market downturn in late 2015, early 2016. We’re able to position this as a defensively oriented equity strategy that can be thought of as a nice complement to other sort of higher-octane global equity strategies that investors have. So we’re having some success positioning that way. Your memory serves you right about the option we have. Just to some of the particulars, the fifth anniversary of the closing of our acquisition of a 49% interest in Hexavest was in early August. At the end of this month, there will be – let’s say, we’ll have – for the – we’ll have an option to acquire up to a 75% interest in Hexavest based on a fixed multiple of earnings for the 12-month period ending on August 31. And so some time, there’s a period – so sometimes, between now and end of the year, roughly, let’s call it, November, December, that option period will kick in. We’ve certainly had preliminary discussions with Hexavest. We like this business very much. And I think it’s fair to say that if we can get comfortable with the terms of both the transaction and the terms of the ongoing business relationship going forward, that we’d like to own a majority of this company. But we’re not there yet, and there’s some negotiations that has to happen between now and doing it. But positively disposed and on the right terms, we’d certainly be eager to do this.
Unidentified Analyst: Great. Thanks for taking my question.
Operator: [Operator Instructions] Your next question comes from Bill Katz with Citigroup. Your line is open.
Bill Katz: Thank you very much, I appreciate taking the question. So Laurie, maybe for yourself. Just as we look ahead, the $3 million of severance this quarter, is there a way to sort of think about what kind of incremental savings there might be longer term? And then on the fee rate disclosure, which we certainly appreciate, how should we think about just the averaging impact? It seems like you had a very strong July in terms of both overall asset growth as well as flow and what that might mean for fee rates within the bigger picture of a bit of a downward trend. That’s my first question.
Laurie Hylton: Okay. So just in terms of the compensation, I think if you’re trying to sort of forecast that what the rest of the year might look like, we’ve disclosed that we had roughly $3 million worth of severance associated with employee terminations. I think pulling that out, the third quarter run rate is a pretty good run rate. Now I’ll caveat that with our normal disclosures around the fact that roughly 40% of our compensation is variable. So to the extent that there’s a distinct change in either sales patterns or there’s a distinct change in our profitability for the fourth quarter, that could change. But barring any unforeseen anomalies, I would anticipate that our third quarter run rate, excluding that $3 million charge, is a pretty good number work with for the fourth quarter. In terms of the fee rates, I don’t – I think that there’s obviously continued pressure associated, particularly in the fixed income category associated with the growth in the separate accounts associated with our ladders business. So you will continue to see that. Third quarter flows were strong. There were certainly strong flows in July, but I don’t think that necessarily, the timing of our flows impacted the effective fee rate. I think it’s more a function of what’s actually happening within the category in the mix. Most of our categories, we would not anticipate seeing any significant changes as we’re moving into the fourth quarter. The two categories where we have seen changes this quarter and we would conceivably see some additional changes going forward just because of the pressures of the mix on the business would be in the equity category just as we see the shift in where the flows are coming in and then in fixed income because of the pressure on the ladders.
Bill Katz: Okay, that’s very helpful. And just a follow-up, Tom, you spoke very constructively on where you are with Calvert. It seems logical based on what we’re seeing as well. I guess, two-part question. First part is, how do we think about the incremental fee rate? And then secondly, you highlight the fixed income win, but maybe more broadly, how do we think about sort of sizing that income opportunity?
Tom Faust: Yes. So fee rates on Calvert business, I would say, are broadly representative of our overall business. Their fixed income is similar to Eaton Vance’s historical fixed income. Their equity is similar to Eaton Vance’s equity fee rates. They do have a – some index products that, as you would expect, operate at lower average fee rates, not surprisingly, given this environment. Some of their growth has been in those kinds of mandates. On the equity side, their biggest growers currently are sort of opposite ends of the fee rates. Spectrum 1 is a 5-star-rated emerging market equity fund, which is actively managed and full fee; and the other is a U.S. core responsible index fund, which is priced like an equity index fund. So it kind of is all over the map but broadly representative of the kinds of fund business, fund assets that we have and fee rates that we have typically in our fund business. They don’t have a lot of business today outside of mutual funds, so the fee rates there are pretty transparent, and the flows are also pretty transparent. The opportunity that I highlighted this recent win, which is not yet funded but which was awarded earlier this month, is for an institutional separate account. It will be at a lower average, a lower fee rate than they get on their fund business like most institutional separate accounts. For us, the interesting thing is Calvert really didn’t have an institutional business prior to becoming part of Eaton Vance. And they have an excellent fixed income capability that involves a range of high-performing strategies across various asset classes but quite distinctively, with included responsible investment criteria baked into the investment decision-making and baked into what we deliver to clients. And that’s a fairly rare thing in the marketplace these days. There are a number of players that would purport to offer responsibly managed equity mandates. There are very few that offer responsibly managed income mandates, particularly that have the capability to survive a rigorous vetting by institutional consultants and institutional clients. So we see a big opportunity to leverage Calvert’s brand, their strong investment performance record, particularly on the fixed income side, and push that into the institutional market. There are, as you would imagine, a lot of companies in the U.S. and internationally that are very dedicated to running their business in a responsible way of offering responsible investment solutions to their employees as part of their retirement plans, also dedicated to the responsible management of corporate cash and near-cash assets. We think all of those are ultimately potential candidates for the Calvert message that you, too, can – you can manage your fixed income assets responsibly, not just your equity assets. So a very interesting time, a lot of focus on Responsible Investing. We feel like we’ve sort of gotten beyond this initial step of bringing Calvert into Eaton Vance and now in a position of starting to realize some growth opportunities, and we see some very significant ones. And we’re delighted to get this first win, and we’re hopeful that it will make it easier to win other institutional mandates for Calvert, particularly on the fixed income side.
Operator: Your next question comes from Glenn Schorr with Evercore ISI. Your line is open.
Glenn Schorr: Hi, thanks very much. A question on margins. Because I’m watching like the markets are up, and you’re getting great growth across a bunch of your different products. Some of them are super leverageable like bond ladders, exposure management, portfolio implementation. I’m curious why margins don’t expand more. And maybe if you could talk about that in the context of is there a purposeful spend while the markets are good? And clearly, it’s producing growth. Maybe you could talk about it in terms of the profitability bogey that you use for the profitability-based comp. Just curious why we wouldn’t see bigger margin expansion.
Laurie Hylton: Yes. A couple of things that I would say on that. One, obviously, we have a little bit of a quality problem going here, and that we’ve got significant growth in the business in terms of our inflows. And we’ve got a sales team that is going to be compensated on that. So to the extent that we’ve got strong periods of organic growth, we’re going to see increases in comp are going to tick up associated with that. I think that in terms of our overall margins, we obviously had some sort of one-time pressures this quarter that muted the results. We’ve talked about that. We’ve also talked about what margins might look like if you pull some of those numbers out. So I think there would have been some incremental growth this quarter if we haven’t had some of those one-time events. I also would acknowledge that we are now in an environment where there is going to be some increased spending associated with both trying to ensure that we’ve got technology platforms that are scalable, particularly given these sort of factory businesses that Tom has referenced in terms of our ladders and our Custom Core as well as regulatory pressures that will require us to do some incremental spend to ensure that we’re keeping up to date in those areas. So I think that we’re not unlike other advisers or other traditional asset managers out there facing these challenges. I do think that we’ve got some opportunities for margin expansion if we’re able to control our discretionary spend and make some of these growth-related investments very tactically. But I think it’s just the nature of the game right now that they’re going to be – there’s going to be pressure on margin in a period of strong growth and some technology investment.
Glenn Schorr: Got you. And I guess, the one follow-up I had is on your comments. I heard you loud and clear on UBS coming online in November. When they launch, what should we expect? How are they rolling that out? Are you behind the scenes educating them on the product? Like with eight funds up and running, should we expect it to be a gradual process over the next year? I’m just curious on your thoughts.
Tom Faust: Yes. There is a – there’s a training process that is ongoing at UBS now. They do all training modules and are in the process of making that available to advisers and branch managers. That’s ultimately a UBS initiative at Eaton Vance, and NextShares Solutions were – clearly contributed to that. We do expect additional product, both Eaton Vance-sponsored and non-Eaton Vance NextShares funds to be available and in the marketplace by the time of that anticipated November launch of NextShares within UBS. It will actually be a staged launch. There won’t be a full menu of products available from day one. Also, it won’t be available across all UBS platforms from day one. So I think what you should anticipate is a staged introduction where our focus is just from a business standpoint, is trying to make available, I think, the word I used was compelling investment strategies as NextShares and to drive adviser interest in NextShares by putting very strong investment structures, very strong investment capabilities inside this unique vehicle of NextShares. And so we’re thrilled with how this is going, the support we’re getting across UBS. They feel like this is something that they can offer to their clients that today is highly differentiated. And that they’re very committed to this, but it’s not going to be – I’m not going to raise $1 billion on – in the middle of November. This is setting the stage for a broad-based success built around a few key product strategies, some of which will be launched by November, and then some of which will be coming out over the following months.
Glenn Schorr: Okay. Thanks so much, Tom.
Operator: Your next question comes from Michael Carrier from Bank of America Merrill Lynch. Your line is open.
Michael Carrier: Hi, thanks a lot. Laurie, maybe just one on costs, and thanks for breaking out the one-time items, and probably less focused in the fourth quarter and more as we head into the next year. Just given your comments on some of the tech rig spend, is there maybe like a base of expense growth that we should be expecting and maybe nonperformance-related because, obviously, that will ebb and flow? And then just on the compensation related to sales, if the fee rate on the sales product is much different across the products that you guys sell, is that taken into consideration, meaning there’s no real comp pressure if something on like the portfolio implementation versus equities? So I just wanted to get a sense on how that works just given that we haven’t seen a ton of operating leverage.
Laurie Hylton: I can – I’ll start with the first question regarding what our technology spend is anticipated to look like for next year. And I’ll tell you that we’re in the process of looking at that right now. We’re obviously – we’re in our budgeting and planning process. We’ve got a pretty robust process that we go through that’s cross-functional, looking at all of our initiatives and how they intertwine, particularly amongst our core company at Eaton Vance as well as our city areas. So I don’t have specific guidance to give you on that outside. I don’t think there’s anything that is going to seismically change the way that we’ve made investments spend. Some of these projects are projects that are already underway and won’t necessarily impact the financials incrementally. I just would caution everybody that obviously, there are a number of things that are going into effect in 2018, not the least of which is some of the method initiatives and other things that we have to deal with. So there will be some incremental spend there. In terms of the sales incentive, you’re absolutely correct. There is a very different sales compensation paid on lower fee business and on higher fee business based on – particularly when you start doing a breakout between mutual fund sales and some of our very rapidly growing separate account, retail managed account franchises. So that definitely has taken into consideration, and we wouldn’t see necessarily a disproportionate impact in comp related to those businesses that isn’t necessarily coming to on the revenue side.
Tom Faust: And my comment, just on the sales-based compensation. The way things work here, and I suspect other places, is we set sales compensation for different – for an array of different strategies at the beginning of the year. And with limited exceptions, we don’t change those much during the year. And so what happens in a year like this when sales for a lot of our products are way, way, way over what we budgeted, we’re paying a lot of salespeople for bringing the assets in. We normally think of a new asset that’s brought in as not really contributing to the bottom line for the first six to 12 months, depending on what it cost to bring it in. We’ve had a lot of that this year. We’re paying a lot of salespeople this year. But we don’t want to turn off the spigot and disincentivize our good salespeople by stopping paying them on new business. So it’s just the nature of the business that when you see this surge in sales like we’ve experienced this year, we’re already three quarters into the year, we’re already at net – record net flows. You see this expense bump that we don’t think sales are going to necessarily stay at these elevated levels on an ongoing basis. As they normalize, we like to see sales expense normalize, and we should see more of the revenues that we’re generating from these new sales fall to the bottom line. That’s kind of the way our business works.
Operator: Your next question comes from Patrick Davitt with Autonomous Research. Your line is open.
Patrick Davitt: Hi, good morning and thank you. So it sounds like you’re attributing most of the fee compression and the individual kind of higher fee buckets to mix. One of the key themes we heard in July from those reporters was either the beginnings or process of a more comprehensive fee review and even some hints that those cuts are being made. Is any of that feeding into the compression we’re seeing? And/ or do you feel like that there’s increasing pressure to do a similar type fee review? And if not, why do you think you’re less exposed to that trend than the others?
Tom Faust: Well, we – investment management is a competitive business. And there are fee cuts in many kinds of businesses. It’s probably stronger on the passive side than it is on the active side and at least on the commodity end of the passive business. But it also applies to a range of active strategies. We are not immune to that. We – clearly, for us, the primary driver of declining fee rates is mix, but that’s not the whole story. There are places where we used to manage money for x, and now we manage money for 90% of x. And in some cases, it’s less than that. So we’re going to be competitive in the marketplace. What we prefer to do is to have fees that are not the lowest in the industry. But based on performance and service, we justify that fee differential, but there are times and places where we compete on a fee basis just as much as anybody else in our business.
Operator: Your last question comes from Ken Worthington with JPMorgan. Your line is open.
Ken Worthington: Hi, thanks for squeezing me in. Maybe just a little flyer here on the portfolio implementation, exposure management. Obviously, very successful asset gathers for you and businesses for you. A number of these strategies have used futures and options. So we’re curious to see does, and if so, how does a low-volatility environment impact both these businesses, either from an attractiveness of offering or pricing of the products?
Tom Faust: Yes. So portfolio implementation, unless I’m missing something, there’s no element of derivatives in that. That’s – those are directly owned securities. The exposure management business is heavily derivatives-based. It’s primarily futures. We’re using futures to provide a low-cost efficient way to add exposure or to take exposure away. We have the ability if futures are trading rich relative to cash instruments to use cash instruments instead. Generally, the underlying client here is not using these for leverage purposes, though they certainly have that capability. We don’t – so we don’t really – whether a low-volume environment, I don’t think, meaningfully impacts the exposure management business. Where we do have some exposure to this is we highlighted that the defensive equity strategies and other, what we call, managed options or volatility risk premiums, these are offerings that Parametric has. In reporting, those fall into our equity bucket. And we do certainly because these are option strategies that when volatility is low, that the premiums that can be earned by selling options are lower. And I would say that the business continues to work well, perform well. Primarily, what we’re doing in these businesses is to, on a risk – in a risk-managed way, position clients to capture the, what we call, volatility risk premium. That is the – what someone described as the fees that are earned by writers of insurance or providers of leverage. You can think of buying a – selling a put option and selling insurance. You can think of as selling a call option as providing a source of leverage, and there is compensation for that. So under – much of the underlying thesis that we offer and selling these products is capturing that substantially uncorrelated source of alpha that you can add on to an underlying equity or fixed income portfolio. Despite the low volatility, we may be able to grow that business. And frankly, I don’t see a significant threat to that business if we continue in a low volatility environment for a while.
Operator: And there are no further questions queued up at this time. I’ll turn the call back over to Daniel Cataldo.
Daniel Cataldo: Thank you, and thank you all for joining us this morning. We hope you enjoy the rest of the summer, and look forward to reporting back to you upon the close of our fiscal 2017 in November. Thanks.
Operator: This concludes today’s conference call. You may now disconnect.