TWST: In the recovering economy, what do you think are going to be the primary headwinds for the asset managers in 2011?

Mr. Kim: As always, I think the biggest risk for the asset managers is really a prolonged equity market downturn since obviously, assets under management and therefore earnings are highly leveraged to the broader markets. Also, I think a derivative of a sustained market pullback would likely be a retrenchment in risk appetites more broadly, so investors might move assets back into, let's say, lower-fee fixed income or money market funds, or even take money out of the system altogether, which would restrict a source a growth for the industry. Then finally, I think potential regulatory change could impact certain, what I call "industry hot spots," whether that's money market funds, 12B-1 fees, or more broadly, the relationship between the asset managers and their distribution partners. Having said that, our view is that any regulatory changes would likely be more evolutionary as opposed to revolutionary, and would probably be phased in over a relatively long period of time. So I think those are the risks or headwinds that I would highlight for the group.

TWST: How far up the risk curve do you think retail investors and institutional investors are going to move in 2011, and how will that impact your group?

Mr. Kim: I think we have seen clear evidence that retail investors have already started to re-risk just based on industry mutual fund data. So net flows into equity funds have turned meaningfully positive after equity funds suffered pretty sustained outflows for the last eight months of 2010, and then at the same time, demand for fixed income products has weakened as interest rates have started to move higher. So I think that's potentially a trend that will continue through the course of this year. Then, turning to the institutional side of business, I would say that the shift probably hasn't been as pronounced thus far, which is not surprising, just given that pension plans are typically more deliberate in terms of allocation decisions. But I do see the re-risking trend continuing to play out, and that's likely going to drive a step up in flows, margins and earnings growth for the asset managers more broadly.

TWST: When we last spoke, in June, you expected that over time U.S. non-retail investors would begin to shift money away from savings accounts in favor of capital market solutions. What are your latest observations on that trend, and which of the asset managers you cover have gained from traction there?

Mr. Kim: I would say anecdotally, we have seen further evidence of that trend, although this is a long-term process that's likely going to play out over time. I would expect overseas investors to continue to gravitate toward capital market solutions based on demographic trends that are similar to what we're going through here in the U.S. You've got an emerging middle class in many geographies outside of the U.S., and you've got generally low mutual fund penetration rates across many markets in different parts of the world. So I think the best-positioned asset managers are going to be the firms with long-established on-the-ground operations in these local markets. So I would highlight Franklin Resources (BEN) and Invesco (IVZ). I think those are the clear leaders. And then I would also mention T. Rowe Price (TROW). They have been increasingly gaining traction with non-U.S. investors, and that has really been focus for the firm more recently.

TWST: In our last interview we discussed institutional investors becoming more proactive and replacing underperforming managers. Has that borne out to any material extent and if so, have any of your asset managers been hurt by it?

Mr. Kim: Broadly speaking, we've seen institutional investors basically sitting on their hands for the better part of two years, but more recently, we have started to see signs that pension plans and endowments and foundations are getting a bit more proactive in terms of making changes to their portfolios. I think there is more to come on that front, particularly in the first half of this year, assuming the markets remain cooperative and institutions get more comfortable repositioning their investments. And then in terms of specific companies, I think firms that have suffered some pretty sizeable institutional redemptions include AllianceBernstein (AB), Artio Global (ART) as well as Legg Mason (LM). Just looking forward, flows follow performance as always. So I think sales and redemption trends are going to be determined by how quickly these firms can turn around their relative returns.

TWST: In your KKR report, you wrote that demand for alternative strategies for the group in general is rising. Would you elaborate on that and tell us what the implications may be for your group?

Mr. Kim: The fact is that pension plans remain broadly underfunded, even after the run-up that we've seen in the equity markets in the last couple of years. So that suggests to us that in order to close the gaps between asset levels and projected liabilities, these funds are going to have to increase allocations to higher-return strategies like hedge funds, private equity and real estate. So firms with well-positioned alternative platforms are likely going to be the ones that see a pickup in demand for these products. So aside from pure-play asset managers like a KKR (KKR), managers best positioned to benefit likely include AMG (AMG), Invesco and then Legg Mason as well.

TWST: What is your take on valuations for the group?

Mr. Kim: I think valuations are still pretty broadly attractive. At this point, the group is currently trading at roughly 15 times this year's earnings and then about 13 times as we look out to 2012. And so that's meaningfully below the long-term average p/e of around 17 times for the group. So assuming the markets remain favorable, I would expect to see an upward revaluation for the sector, not just back to historical levels, but even higher than that as investors are increasingly focused on growth. In this type of environment, we think the asset managers can generate some of the highest growth rates out there, in many cases in the range of 20% to 25%. So just given that dynamic, I would expect valuations to continue to trend higher.

TWST: You pointed out AllianceBernstein as being one of the firms that has suffered as a result of institutional investors being more proactive. Is that the only one right now?

Mr. Kim: I think, like you said, Alliance continues to struggle with some pretty steep redemptions almost across the board, although I would say that outflows did moderate in January, which is similar to what we saw across the industry. But having said that, ongoing redemptions likely continue to pressure AUM, and therefore earnings growth, as we look out over the next couple of years. Also, I would mention that longer-term investment performance track records are still quite weak across most of the equity franchise, so you've got lead indicators that are generally unfavorable. Then finally, from a valuation standpoint, although Alliance is currently trading at a modest discount to peers, we still think the relative p/e doesn't fully capture the firm's subpar growth prospects, as well as stock's MLP structure, which works as a pretty meaningful headwind for institutional ownership and therefore, liquidity. So bottom line, even though the stock has underperformed more recently, we still see a further downside from here.

TWST: Last time we spoke, you had a "buy" rating on Waddell & Reed, and you've since then downgraded it to a "hold." Why is that?

Mr. Kim: We still like Waddell's (WDR) AUM mix. So most of their assets are in equity mutual funds. Having said that, I think the firm's flow leadership has narrowed and will likely continue to do so, just as a result of ongoing flow concentration. Most of their flows are still centered in their flagship asset strategy fund. So they remain highly dependent on that particular product. And then more broadly, I don't think you're going to see flows into the asset strategy fund pour in at the same pace that we saw in, let's say, 2009 and the early part of last year, because of the fact that this is more of a defensive strategy. So assuming retail investors continue to reallocate in favor of more aggressive products, that suggests to us that Waddell's market share gains have likely peaked. And then finally, I think the stock has just gotten a bit ahead of itself from a valuation standpoint. Waddell is currently the second most expensive asset manager stock out there, trailing only T. Rowe Price, which has historically commanded a premium multiple. So again, as we look forward, I think further multiple expansion for Waddell & Reed is probably pretty limited from here.

TWST: What is your overall advice to investors in the asset management sector?

Mr. Kim: We're still bullish on the sector overall. I think you're going to see earnings growth continue to accelerate as both retail and institutional investors increasingly re-risk their portfolios. That will in turn drive higher AUM and margins, and then I think as a result, you are likely going to see an upward revaluation for these stocks as the group comes back into favor with investors. And these are high-beta stocks. To the extent that the broader markets remain cooperatives, we would expect the asset managers to continue to outperform. And then more specifically, we think investors will do well by owning either differentiated asset managers with scale, diversification or positioning advantages. So firms like an AMG, Franklin, Invesco and KKR, or by playing deep value stories or turnaround stories, like a Legg Mason.

TWST: While there are a few interesting opportunities within your group, which of the asset managers do you think has the most compelling story right now?

Mr. Kim: Our top pick in the space is AMG. Aside from being, I think, among the best positioned asset managers out there to capitalize on some of the broader industry trends that we've been talking about - so re-risking more broadly, higher growth prospects outside of the U.S. and alternative strategies. Aside from that, we think AMG will generate best-in-class earnings growth, based on a couple of key differentiating factors that I would add in. First, AMG is a bit different from a traditional asset manager in that they employ a manager of managers acquisition-led business strategy. So one of the levers of growth that they can pull is acquisitions. We expect management to remain active on the deal front this year, and that will likely drive incremental earnings growth.

Second, a number of the firm's affiliates offer products with performance fee structures, whether it's hedge funds, private equity funds or long-only institutional separate accounts. So we've come through a period of somewhat muted contributions, but as the markets have recovered, many more of these products are now in a position to generate pretty sizeable performance fees this year and beyond. So again, I think this is a differentiating factor for AMG versus almost every other asset manager. So you think about the existing affiliate base being very well positioned. You've got deal flow continuing to add to the growth story, and then you've got performance fees increasingly coming on board. So it just seems like the stars are aligning for the company these days.

TWST: Thank you. (MES)

Note: Opinions and recommendations are as of 03/01/11.

Michael Kim

Managing Director

Sandler O'Neill + Partners, L.P.

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