Victory Capital Holdings Inc

NASDAQ:VCTR

Earnings Call Transcript 2020-Q2

[Operator]

Ladies and gentlemen, thank you for standing by, and welcome to the Victory Capital Management Second Quarter 2020 Results Conference Call. [Operator Instructions]

I would now like to hand the conference over to your speaker today, Matthew Dennis. Thank you. Please go ahead, sir.

[Matthew Dennis, executive]

Good morning. Before I turn the call over to David Brown, I would like to note that today's discussion contains forward-looking statements and, as such, include certain risks and uncertainties. Please refer to our press release and our SEC filings for more information on specific risk factors that could cause actual results to differ materially from those projected in the forward-looking statements. While a recording of this call will be made available by us on our website, any forward-looking statements that we make on this call are based on assumptions as of today and we undertake no obligation to update these forward-looking statements to reflect new information or future events that occur or circumstances that exist after the date on which they were made.

In addition to U.S. GAAP reporting, we also report certain financial measures that do not conform to generally accepted accounting principles. We believe these non-GAAP measures enhance the understanding of our business and our performance. Reconciliations between these non-GAAP measures and the most comparable GAAP measures are included in tables that can be found in our earnings press release and in the slide presentation accompanying this call, both of which can be accessed on our Investor Relations website at ir.vcm.com.

It's now my pleasure to turn the call over to David Brown, Chairman and CEO.

[David Brown, executive]

Thanks, Matt. Good morning, and welcome to Victory Capital's Second Quarter 2020 Earnings Call. I'm joined today by Michael Policarpo, our President, Chief Financial Administrative Officer; as well as Matt Dennis, our Chief of Staff and Director of Investor Relations.

I'm going to start with a business overview of the quarter. Then I will turn it over to Mike, who will review our financial results in greater detail. Following our prepared remarks, Mike, Matt and I will be available to take questions.

The business overview begins on Slide 5. I'm pleased to report that Victory Capital produced record financial results across a number of different areas for the second quarter and first half of 2020. Despite the market volatility and complexities related to COVID-19, we generated record revenue, profit margins and net earnings for the first half of the year. This is a testament not only to our business model, which is designed to deliver robust profitability in all market conditions, but also to our ability to successfully execute on our long-term growth strategy. AUM grew to $129.1 billion for the quarter, up from $123.8 billion at March 31. At quarter end, AUM was up more than 100% relative to the end of the second quarter of 2019.

Turning to flows. We experienced significant outflows directly tied to the disruption caused by the closing of the Schwab acquisition of USAA's brokerage business at the end of May. One part of that was brokerage clients who chose to transfer their accounts to brokerage competitors other than Schwab, and at the same time, liquidated some or all of their USAA mutual fund holdings. This impact on flows was onetime in nature and can be compared with traditional asset management acquisition consent process in which movement of accounts causes some leakage of assets. While the level of movement was slightly higher than we expected, we have continued to see improvement since the closing date.

In addition, and as expected and disclosed previously, we experienced $8 billion in short-term net outflows from our money market funds as they transitioned to Schwab's platform. These assets were subject to a revenue-sharing arrangement and were therefore, not profitable for us.

Moreover, in conjunction with the sale of the brokerage and UMP businesses, USAA also moved its trust service business to a firm with in-house trust capabilities, which resulted in approximately $500 million in long-term net outflows for us. We've also experienced delays in gaining shelf space for the USAA fixed income products managed by our USAA investments franchise. These delays were tied to the impact of COVID-19 and the disruption in the credit markets. We are seeing activity pick back up and believe this was just a temporary slowdown. Additionally, we saw a temporary pause in search and finals activities in our institutional channel as decision-makers delayed certain allocation processes due to COVID-19.

We are starting to see activity return to normal levels in our intermediary and institutional channels. Our sales pipelines remain strong and are growing quickly and our won but not yet funded book is building and has nice momentum. Additionally, we are close to achieving an important milestone within our growth efforts in the direct channel via the launch of the new digital platform, which we expect to occur this calendar year and will have a positive impact on flows over the long term. I will discuss this in detail later on in the presentation.

To be clear, what we've experienced during the first 2 quarters of this year from a flow perspective is attributed to a number of the aforementioned factors, many of which are onetime in nature, and we believe this is merely a speed bump in our ability to generate organic growth over the longer term. Overall, our outlook on flows for the remainder of the year and especially into 2021, is trending positive as we work our way through some of the onetime items.

Looking at our financial results for the quarter, adjusted net income or tax benefit was $0.89 per diluted share, and EBITDA was $86.3 million. Adjusted EBITDA margin improved to a record high of 47.5% for the quarter, further demonstrating the power and efficiency of our business model. Our investment franchises generated outstanding investment performance during the second quarter, with 68% of total AUM outperforming benchmarks for the 3-year period ended June 30, 2020. For the 5-year period, 69% of our total AUM outperformed their respective benchmarks.

We continued our disciplined capital allocation strategy. We ended the quarter with $881 million of debt. That's down 20% from $1.1 billion in July of 2019. Subsequent to quarter end, we reduced outstanding debt by additional $20 million to bring the balance down to $860 million currently. We have also significantly reduced the cost of our debt through repricing and implementing an interest rate hedge. The 20% cash dividend increase announced today by our Board reflects strong current and projected cash flows for our business. During the quarter, most of our free cash flow was used to reduce debt in preparation for potential acquisition opportunities that we are currently evaluating. To be clear, our capital allocation strategy has always been to reduce debt as our top priority, so that we have the flexibility to do acquisitions in the future. Our stock buyback and dividend programs are secondary to this objectives.

I also want to acknowledge our talented professionals for their hard work and dedication on behalf of our clients during the past several months, despite doing a substantial disruption in their personal lives. We've continued to deliver exceptional service to our clients during these unprecedented times. We've also learned a great deal as an organization about the importance of being nimble and adaptable, which will benefit our business and our clients in the future.

Turning to Slide 6. I want to discuss the substantial progress that has been made since we closed the acquisition of USAA's Asset Management business just over 1 year ago. As a refresher, on July 1 of last year, we reopened a direct channel, so USAA members could once again invest directly. We knew that paramount to our success in the direct channel, was creating a foundation for replicating the same high level of service that USAA members are accustomed to receiving. As quickly as during our first quarter of ownership, service scores were above our goal based on member surveys completed and remain at that level today. That was and is quite an achievement and will provide the foundation for our success in this channel.

In parallel with our integration efforts to bring the USAA business successfully on to our platform, we've been dedicating financial and professional resources to enhance our digital platform for members. In April, we launched our new Genesys call system technology, which improved handle times and enhanced efficiency. Additionally, the new system is fully integrated with our CRM technology, so it better supports our marketing initiatives to gain wallet share with our existing members and attract new members to our platform.

Later this year, we'll be rolling out a new state-of-the-art digital platform. This is going to significantly advance our direct channel marketing opportunities while delivering a richer digital experience for members who prefer to transact or be supported online. The combination of the excellent service from our contact center representatives and a new modern digital platform, supported by innovative and focused marketing campaigns, is the formula for success and growth in this channel. We will also benefit from our ability to leverage the USAA brand to deliver a strong and diversified set of products to members.

On Slide 7, I'd like to talk more specifically about the growth opportunity we see in the direct channel and provide some examples of our progress to date. Since we closed the acquisition and reopened the channel, we've opened approximately 79,500 new mutual fund in 529 Plan accounts. That equates to a high single-digit annual growth rate, with only minimal marketing support to date. Account openings in the first half of 2020 were up close to 30% relative to the second half of last year. Additionally, approximately 28% of new mutual fund registrations are electing an automatic investment plan, which represents recurring monthly investments into our products. Again, we achieved these results with only limited marketing support and expect our progress will accelerate as we complete our integration and build efforts and execute against our growth plan for this channel.

The USAA 529 College Savings Plan is a good example that represents a growth opportunity for us. As a reminder, we are the exclusive provider of the USAA 529 Plan. 529 Plan AUM is net flow positive year-to-date and since the close of the acquisition. Net new 529 Plan accounts are also up for those same time periods. More than 50% of 529 Plan accounts are set up as automatic investment plans. Additionally, we're seeing a strong trend towards opening accounts online versus by phone and expect to see those numbers improve even further when we launch our new digital experience.

In Q3, we'll be launching our first multichannel media campaign in a number of regions in the U.S., each with a strong military presence. The campaign is designed to increase brand awareness and drive engagement among the USAA membership and the military community in general. We expect these kinds of efforts to grow in both frequency and scale over time, which will support the growth of the channel.

In addition to our marketing and digital efforts, we are focused on ensuring that we are continuing to expand the investment expertise that we offer to members as well as through financial advisers. At the end of Q2, we added new share classes to several USAA mutual funds to provide additional choice for advisers and their end-clients. We will also be introducing a new no-load member share class for 11 of our existing Victory funds later on this year. This means that members will be able to invest directly in funds and asset classes not previously available through the USAA mutual funds platform. Additionally, we intend to launch 3 new VictoryShares thematic ETFs this year, 2 of which are being developed specifically for the military community.

Finally, we are partnering with Schwab to serve USAA members. Schwab is a long-time client and trusted business partner and shares our commitment to provide exceptional service. We're excited to be working alongside them to serve members and deliver focused programs for the military community.

Turning to Slide 8. I'd like to provide some additional detail around our referral agreement with USAA. We continue to partner with USAA to market our products to approximately 12.5 million USAA members who do not have an account with us today. I'm pleased to report that the referral process that we have in place is working. As I mentioned previously, we've gained 79,500 USAA mutual fund and 529 Plan account registration since last July. A core part of the referral process is demand generation efforts that USAA is doing with a broader membership on our behalf. This includes paid media and e-mail campaigns run by USAA, among other tactics. Once a member accesses a Victory Capital page on usaa.com, there is a clear and easy online path to opening a mutual fund or 529 Plan account with us. Keep in mind as well that we have an exclusive license to use the USAA brand, which creates strong connectivity for members. The member chooses to call USAA's toll-free number. The automated voice response system asked them a series of questions determined if it is appropriate to direct them to the Victory Capital contact center, which is staffed by experienced member service representatives, many of whom are previous USAA employees. So they understand the military community and the importance of providing outstanding service to members.

On Slide 10, I will review our investment results for the quarter. As of June 30, 64% of company-wide AUM in mutual funds and ETFs was ranked 4 or 5 stars overall by Morningstar. 13 funds were ranked in the top quintile by Morningstar for the trailing 1-year period including 3 funds, Victory Trivalent International Small-Cap Class I, USAA NASDAQ-100 Index Class R6 and USAA Small Cap Stock institutional, which were ranked in the top decile. Performance of the fixed income funds managed by our USAA Investments franchise, improved significantly quarter-over-quarter. The percentage of AUM in those products outperforming its respective benchmarks over the trailing year -- 3-year period was 82% as of June 30. Nine out of 14 of those funds were ranked 4 or 5 Stars overall by Morningstar as of June 30. This excellent investment performance will help us in our placement and distribution efforts.

Looking at performance of our Victory shares ETFs, 5 were ranked in the top quartile by Morningstar, including 3 ranked in the top 3 percentile for the trailing 1-year period. Two ETFs, VictoryShares Dividend Accelerator ETF, and VictoryShares Multi-Factor Minimum Volatility ETF achieved their 3-year track records during the second quarter and earned overall rankings of 4 and 5 Stars, respectively, from Morningstar as of June 30.

On Slide 11, I'd like to recap the benefits of our next-generation business model. We are a growth company in the industry where most are struggling to maintain the status quo. Our model, which combines autonomous investment qualities with the benefits of a fully integrated, centralized operating and distribution platform, is genuinely unique. Our ability to effectively navigate the current environment highlights the resiliency and effectiveness of our model. Our structure avoids the disadvantages facing multi-boutiques, such as lacks of control from partial ownership, complexity, operating redundancies or lack of real scale. We share none of these challenges. Let me be clear, we do not view ourselves as a multi-boutique. Victory Capital is a single registered investment adviser and our independently-branded investment franchises and solutions platform are not separate entities, but part of our company and our platform. This provides effective controls while also allowing each franchise to remain completely autonomous in their investment process in their quest to generate alpha. Additionally, our revenue-sharing model with our franchises mitigates complexity and creates alignment, and we have no significant operating redundancies.

Finally, our ability to preserve the unique investment culture of each franchise while achieving significant synergies to our centralized platform makes our model very conducive to the current M&A environment.

Now I'll turn it over to Mike for his financial review. Mike?

[Michael Policarpo, executive]

Thanks, Dave, and good morning, everyone. The financial results review begins on Slide 13. Overall, we are very pleased with our strong financial performance in the quarter and first half. Revenue for the quarter was $181.9 million, in line with the 11% lower average AUM compared with the first quarter. Revenues were up nearly double versus the same quarter last year. GAAP earnings were $0.61 per diluted share, which was down from the first quarter, reflecting an additional $12.5 million of acquisition-related expenses recorded in the second quarter. You may recall, we make adjustments to reflect the current fair value of future contingency payments on our balance sheet for the USAA acquisition each quarter. For the second quarter, this resulted in a $10.8 million quarter-over-quarter increase in GAAP operating expense, which accounted for most of the variance. The markup in fair value for that contingent liability reflected the market's rebound in the second quarter, combined with the lower discount rate used in the net present value calculation and one more quarter of actual results.

Adjusted net income with tax benefit was $0.89 per diluted share in the quarter. This was down $0.03 from the first quarter and up 134% from the same quarter last year when we reported ANI with tax benefit of $0.38 per diluted share. GAAP operating margin was 36.2% and reflects the higher noncash balance sheet adjustment I just mentioned. Adjusted EBITDA margin expanded to 47.5%, which was 270 basis points wider than in the first quarter. This record high-margin level is particularly noteworthy considering the investments we continue to make to support future growth and is a testament to our unique business model.

With continued debt reduction, our leverage ratio improved to 2.2x at the end of June. In addition, we returned approximately $10.6 million to shareholders in the form of cash dividends and share repurchases. We exhausted our prior share repurchase program during the quarter, and the Board authorized a new program that commenced in early June. And as Dave highlighted, we also increased the quarterly cash dividend by 20% to $0.06 per share, beginning with our next dividend, which is being paid in September.

Turning to Slide 14. Total AUM rose 4% during the quarter. The $129.1 billion of AUM at the end of June reflects positive market actions during the quarter, which was offset by flows directly and indirectly related to the closing of the sale of USAA's brokerage business. The outflows were primarily short-term money market assets that were not profitable. While the outflows impacted AUM and revenue, there was very little earnings impact due to the offsetting reduction in related distribution fees. Money market assets declined by $8 million in the quarter to $3.6 billion at June 30. Money markets now represent less than 3% of our consolidated AUM. This is down from $12.1 billion or nearly 10% of AUM at the end of the first quarter. Long-term assets rose more than 12% from the end of March. This is inclusive of the nearly $500 million of long-term trust assets that we were previously managing, which were outsourced by USAA to a third party.

On Slide 15, we go into long-term asset flow in a bit more detail. Consistent with the first quarter of the year, our credit-sensitive fixed-income products experienced more outflows compared with our other asset classes. We experienced redemptions in association with the USAA brokerage transaction, as Dave mentioned earlier, which closed on May 26. Timing-wise, close to half of the net long-term outflows during the quarter occurred in May, coinciding with the transaction. As we ended the quarter, consolidated net long-term flows improved in June compared with May. Several investment franchises and strategies were net flow positive in the quarter and 6-month period.

For the first half of 2020, INCORE, Trivalent, Sophus and the RS Global team all generated positive net long-term flows.

Revenues are covered on Slide 16. Quarter-over-quarter revenues decreased by the same percentage as average AUM despite a slightly lower average fee rate realization. Year-over-year, revenues essentially doubled from the same quarter in 2019. There are several offsetting factors that impacted our average fee rate realization during the quarter. Yield support on certain money markets lowered our average fee rate by approximately 1 basis point. Partially offsetting this was a beneficial mix shift due to equity market recovery and the money market liquidations associated with the USAA brokerage transaction. In addition, we have less money market assets requiring yield support during the final 5 weeks of the quarter. In June, our average fee rate realization increased to 57.7 basis points which is a cleaner view of where we ended the quarter.

Moving to Slide 17. Total expenses continued to decline in the second quarter. Personnel expenses went up slightly, increasing 3% from the first quarter. This was solely due to noncash deferred compensation expense increasing by $7.3 million in the second quarter due to changes in our deferred compensation liability from market action recovery. This more than offset the impact from lower average AUM in the quarter and a $3.4 million decrease in payroll taxes and employee benefits due to our normal first half calendar seasonality. Other cash operating expenses were down 17% from the first quarter. This was driven by a 24% decline in distribution and other asset-based expenses related to lower platform distribution expenses. The removal of the money market assets that were previously on the USAA brokerage platform contributed to this decline.

We also experienced reductions in broker-dealer distribution fees and subadministration and middle office expenses. These reductions were in line with the change in average AUM during the quarter and T&E expense was down 90% quarter-over-quarter. Nonoperating expenses declined 60% and benefited from a $7.3 million improvement in other income. The higher other income in the quarter resulted primarily from the market recovery and the associated increase in the value of investments in the deferred compensation plan. Interest expenses and other financing costs declined by 15% from the first quarter due to the lower average debt balance and lower interest rates.

Over the past 3 quarters, interest expense and other financing costs have been slashed by more than 40% from $16.9 million in the third quarter of 2019 to $9.7 million in the most recent quarter. This improves our interest coverage ratio to approximately 9x based on the current adjusted EBITDA run rate. Acquisition-related expenses increased $12.5 million from the prior quarter. As I touched on in my opening remarks, at the end of June, the carrying value of the contingent acquisition payment liability was marked up by $5.3 million. This essentially reversed the $5.5 million markdown at the end of the first quarter resulting in the negative acquisition-related expense for that quarter. The net impact was a noncash $10.8 million swing between quarters, which drove that increase.

Slide 18 highlights our non-GAAP metrics for the quarter. Adjusted net income with tax benefits came in at $0.89 per diluted share. This was off just 3% from the first quarter and up 134% from $0.38 per diluted share in last year's same quarter. Adjusted net income with tax benefit totaled $65.1 million in the quarter, which was comprised of adjusted net income of $58.3 million and a cash tax benefit of $6.7 million. The 5% decline from the first quarter was less than double-digit percentage decline in revenue. This was partially due to the -- removing the unprofitable money market assets during the quarter. ANI with tax benefit was up 135% from $27.7 million in last year's second quarter. Adjusted EBITDA was up just 6% from the first quarter at $86.3 million and increased by 136% from $36.6 million in the second quarter of 2019. This resulted in adjusted EBITDA margin expanding by 270 basis points to 47.5% in the second quarter, which set a new record high for any quarter in our history.

What strikes me as I look at this chart, is how we have been able to increase margins and sustain healthy earnings despite lower revenue. Compared to the third quarter of last year, which was our first quarter of ownership following the USAA acquisition, average AUM was down by 12% in the second quarter of this year and revenue was down 15%. However, ANI with tax benefit per share only declined 2% on approximately the same number of weighted average shares. This not only demonstrates another proof point for the efficiency and resiliency of our uniquely integrated model, but also highlights our ability to effectively manage the core elements of our business.

Turning to Slide 19. Before we leave the non-GAAP discussion, this chart shows our projected tax amortization schedule over the next 15 years. You can see the fixed cash tax benefit we anticipate receiving in future years in the dark blue bars. This schedule assumes we pay 100% of the contingent acquisition payments for the USAA acquisition, which is what creates the slight ramp through 2024. Now that we are beyond the first anniversary of the acquisition, we're able to confirm that we have retained more than 100% of the revenue acquired and therefore, expect to pay the maximum first year earn-out payment of $37.5 million. That payment will occur in the second half of this year.

For tax purposes, we expect to amortize a total of $1.8 billion over the next 15 years. Assuming tax rates remain at 25%, this will result in future cash tax savings for us totaling $441 million. When we discount that cash back to today using a conservative 10% discount rate, this is worth more than $200 million or approximately $3 per share of cash. All we need to do to guarantee the substantial boost to cash flow is maintain profitability.

Slide 20 is a snapshot of our capital management activity in the quarter. We returned a total of $10.6 million to shareholders in the form of share repurchases and dividends. During the quarter, we repurchased 457,000 shares at an average cost of $15.73. Our prior $15 million share authorization was exhausted during the second quarter and as previously announced, the Board authorized a new share repurchase program of the same $15 million size that commenced in early June. At the same time, we paid down an additional $33 million in debt and ended the quarter with $55 million in cash on the balance sheet. That cash balance does not reflect approximately $16.5 million in open market debt purchases made at a discount to par in the second quarter that had not yet settled by June 30. By repurchasing our debt at a discount in the market to get a bigger bang for the buck versus paying it down a par. However, doing this creates a lag between the open-market transaction when the trade gets settled and when the debt is formally retired. With a total of $240 million in debt reduction since we originated the loan in July of last year, our net debt to trailing 12-month adjusted EBITDA ratio declined to 2.2x at the end of the quarter. Our $100 million revolver remains undrawn, and we continue to generate substantial cash flow with GAAP net cash flow from operating activities in the first 6 months of this year, totaling more than $120 million, which does not include the more than $13 million of non-GAAP cash tax benefits realized in the period.

Turning to Slide 21 quickly before we go to questions. I'll leave you with one final comment. I'm sure these charts look familiar to most of you. They represent our beneficial value-creation cycle on the left and our capital allocation strategy on the right. Both remain unaffected by either the market's volatility or disruption associated with the global COVID pandemic. Most of our free cash flow is still being allocated to rapidly reducing debt to enhance balance sheet flexibility in preparation for acquisition opportunities. The chart on the right represents allocations in the second quarter, excluding the $18.1 million increase in cash on hand from the end of March. As I mentioned, most of that increase is due to settlement timing of debt repurchases. We remain confident that our best use of capital and for creating shareholder value is leveraging our integrated business model and growing through organic means and acquisitions.

This concludes our prepared remarks. I will now turn it back over to the operator for questions.

[Operator]

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

[Kenneth Worthington, analyst]

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

[David Brown, executive]

Ken, it's Dave. So let me take the question in different pieces. I think the first part of your question was around, are we seeing different behavior from our clients given the Schwab acquisition close? The answer is, as I said in my prepared remarks, during the time of switching over to Schwab, we saw a lot of noise, meaning there were some brokerage clients that had our funds that either didn't go over to Schwab or made changes at those times. We think that, that is more of a onetime phenomenon.

As far as the 79,500 that have opened accounts, yes, they've all funded. We used the term registrations, but they've all funded. And the way we look at the opportunity set, there's 12.5 million USAA members that do not have an account with us. So the opportunity set for us is unbelievable. As we've said for the last 12 months, we've really not done a large marketing effort just yet. We have a very methodical path of how we want to get set up. We've centered around client service. We've centered around getting our technology right and then eventually getting to the point where we go out and start marketing, and we're not even at that point yet and we've already experienced these 79,500 accounts.

Looking at the closed accounts, with the noise around the transaction, wouldn't be the way we look at it. What we've seen is really great opportunity, and we really are excited about what the future holds.

[Kenneth Worthington, analyst]

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

[David Brown, executive]

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

[Operator]

Your next question is from Alex Blostein with Goldman Sachs.

[Alexander Blostein, analyst]

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

[David Brown, executive]

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

[Alexander Blostein, analyst]

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

[Michael Policarpo, executive]

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

[Operator]

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

[Kenneth Lee, analyst]

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

[David Brown, executive]

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

[Kenneth Lee, analyst]

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

[Michael Policarpo, executive]

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

[Operator]

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

[Randolph Binner, analyst]

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

[Michael Policarpo, executive]

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

[Randolph Binner, analyst]

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

[David Brown, executive]

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

[Randolph Binner, analyst]

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

[David Brown, executive]

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

[Operator]

Your next question is from Chris Shutler with William Blair.

[Christopher Shutler, analyst]

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

[David Brown, executive]

So I think that there -- let me start off by saying that there is definitely noise in our flow numbers, which we view a lot of that noise to be onetime in nature, centered around really the transaction of Schwab purchasing the USAA brokerage business. Coupled with that, there has been, as I said in my prepared remarks, a little bit of a slowdown on gaining shelf space for some of our products due to COVID-19. Some of the institutional allocators slowed down. We're seeing those 2 things pick back up. I'm very encouraged by what I've seen on the direct channel. I'll remind you that we go back and we've been talking about this for a year, there's 12.5 million members that don't have an account with us. And we have not aggressively marketed that at all yet. I'm very encouraged by the investment performance of a number of our products. So we're looking forward. And I think as we work our way through noise, I think you'll see some of the investments we've made in some of the products that are doing well from a performance perspective, really lead the way in growing.

[Christopher Shutler, analyst]

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

[David Brown, executive]

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

[Christopher Shutler, analyst]

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

[Michael Policarpo, executive]

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

[Christopher Shutler, analyst]

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

[Michael Policarpo, executive]

Correct.

[Operator]

Your next question is from Jeremy Campbell with Barclays.

[Jeremy Campbell, analyst]

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

[David Brown, executive]

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

[Jeremy Campbell, analyst]

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

[David Brown, executive]

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

[Operator]

Your next question is from Sumeet Mody with Piper Sandler.

[Sumeet Mody, analyst]

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

[Michael Policarpo, executive]

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

[Operator]

Your next question is from Robert Lee with ABW (sic) [ KBW ].

[Robert Lee, analyst]

I guess the first one is on the earn-outs. Can you just remind us, in addition to the first earn-out year, the -- I believe there's another 2, if memory serves me. Can you just remind us on kind of the earn-outs, the potential future earn-outs and the timing?

[Michael Policarpo, executive]

Sure, Rob. It's Mike. So the way the earn-out is structured, it's a maximum of $150 million that can be paid out. And the way we structured it is a 1/4 of it, so $37.5 million each year. So you'll look at it in what we've said in our remarks is the first earn-out will be paid in the second half of this year, the full $37.5 million is what we expect. And then there will be 3 more beyond that as well.

[Robert Lee, analyst]

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

[David Brown, executive]

It's Dave. It is a 3-year agreement. We're one year into the 3 years, and I think we're very early on in the licensing agreement. I think we've done a phenomenal job representing USAA and serving their members, which has been our collective goal, USAA and Victory, is to give great client service to their members. And I think we've done that. So I think we've done an excellent job doing that. And we have 2 more years under this licensing agreement, as you said.

[Robert Lee, analyst]

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

[Michael Policarpo, executive]

Yes. Bob, it's Mike. It does. So I think we included a slide this quarter that shows the tax amortization that we expect to achieve over the next 15 years, and there is a little bit of a ramp-up over the next 4 years. And that really is, as we make those payments, those go into the tax amortization calculation.

[Operator]

Our next question is from Gayathri Ramkrishnan with Bank of America.

[Gayathri Ramkrishnan, analyst]

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

[David Brown, executive]

It's Dave. Some areas where we're seeing strength are won but not yet funded book is strong as it's been this year. A lot of that is in the subadviser and institutional part of our business. We've also seen a pickup in our retirement side as well. As I said in my prepared remarks, the second half of the year, we'll be launching our digital platform, which will be positive from a gross flow perspective for the direct platform. Our investment performance has come back exceptionally strong on our USAA fixed income franchise, and we are starting to see that franchise gain really important shelf space that we were unable to gain during the second quarter and first quarter a lot because of the COVID-19 impact. We're also launching some new products. We talked about 3 new ETFS, 2 of them will be geared towards the military community. And then on the other side of that, some of the noise are a onetime impact of the close of the acquisition of the USAA brokerage business by Schwab will absolutely slow down and is slowing down. And when you put all that together in our outlook, as I said, especially as you move into 2021, is quite positive on that front.

[Operator]

Your next question is from Michael Cyprys with Morgan Stanley.

[Michael Cyprys, analyst]

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

[Michael Policarpo, executive]

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

[Michael Cyprys, analyst]

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

[Michael Policarpo, executive]

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

[Michael Cyprys, analyst]

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

[Michael Policarpo, executive]

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

[Michael Cyprys, analyst]

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

[David Brown, executive]

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

[Michael Cyprys, analyst]

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

[David Brown, executive]

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

[Operator]

Your final question is a follow-up question from Robert Lee with ABW (sic) [ KBW ].

[Robert Lee, analyst]

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

[David Brown, executive]

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

[Operator]

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

[David Brown, executive]

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

[Operator]

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