Victory Capital Holdings Inc

NASDAQ:VCTR

Earnings Call Transcript 2020-Q3

[Operator]

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

I would now like to hand the conference over to your speaker today, Matt Dennis. Thank you, sir. You may begin.

[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 found in our earnings press release and in the slide presentation accompanying this call, both of which can be accessed on the Investor Relations portions of our 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 Third Quarter 2020 Earnings Call. I'm joined today by Michael Policarpo, our President, Chief Financial and Administrative Officer; as well as Matt Dennis, our Chief of Staff and Director of Investor Relations.

Today, we announced plans to acquire THB Asset Management, which we are very excited about. I'll start off by providing the business overview for the quarter and then an overview of the transaction and 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. Victory Capital generated record financial results for the quarter and 9-month periods. Adjusted net income with tax benefit was a record $1 per diluted share. That's up 12% from the second quarter of 2020 and up 10% from the third quarter of last year. Adjusted EBITDA margin improved to a record high of 51% for the quarter. Our ability to achieve industry-leading operating margins while continuing to invest in our business shows the strength and efficiency of our business model. Total AUM grew to $132.7 billion for the quarter. That's up 3% from $129.1 billion at June 30 and up 7% from the end of the first quarter. We had long-term gross sales of $5.1 billion during the quarter and long-term net outflows of $2.9 billion. We continue to see some disruption in our net flows as a result of the sale of USAA's brokerage business as we have seen throughout the year. However, the level of disruption slowed as the third quarter progressed, and this trend of slowing is continuing into the fourth quarter. We are encouraged by the sales activity on the intermediary and institutional sides of our business as well, where we have a strong won but not yet funded book and a very healthy sales pipeline.

We are also winning platform placements and specifically for our USAA funds. Examples of recent intermediary platform placements include the addition of 15 USAA mutual funds and 3 ETFs under the Northwestern Mutual platform. Principal is now offering all the USAA funds on its defined contribution recordkeeping platform. Additionally, Empower Retirement recently added all USAA funds with the R6 share class as well as institutional share classes for the USAA intermediate term bond, USAA income, USAA international and USAA sustainable world funds to its recordkeeping platform. Key to our distribution success going forward will be continuing to execute within and to build out our retail and institutional channels. Continuing to evolve the direct channel is also important, which I will discuss in more detail in the next slide. Lastly, we are starting to see our won but not yet funded book begin to fund this month and anticipate a good portion of it to continue to fund through the end of the year and the first quarter of next year. We don't report intra-quarter flows, but I thought it was important to make this note.

From a capital management perspective, we repaid an additional $44 million in debt during the quarter, lowering our leverage ratio to 2x at quarter end. Subsequent to quarter end, we reduced debt by an additional $20 million to $817 million. Additionally, we announced a 17% increase in our regular quarterly cash dividend as well as a new $15 million share repurchase program. We remain committed to our strategy of creating flexibility through reduction of debt so we can pursue inorganic opportunities while also returning capital to shareholders through dividends and share buybacks. Our acquisition pipeline remains exceptionally strong, and we continue to look for larger-scale transactions that enhance our business. I want to be clear that the acquisition of THB and the investment in Alderwood do not impede our ability to execute on a larger acquisition, neither constrains our capital or limits our ability from an operational perspective to execute.

Turning to Slide 6. I'd like to provide a brief update on our direct channel and external distribution opportunities for the USAA mutual funds, ETFs and 529 College Savings Plan. We continue to invest in the direct channel to enhance the user experience and expand their reach among the broader USAA membership and the military community. Within weeks, we'll be rolling out a new state-of-the-art digital experience. This is going to advance our direct channel marketing and sales opportunities while delivering a richer digital experience for investors. It will also provide us with the opportunity to more effectively promote the sale of our products to individual investors who do not carry USAA members through this channel. We continue to benefit from our referral agreement with USAA and our ability to deliver a diversified set of competitive products to USAA members. Since we launched the direct business in July 2019, we have approximately 100,000 new account registrations. These accounts range in size and product, however, one common demographic is that half of them were opened by investors under 40 years old. They tend to be smaller accounts. However, their value is enhanced to us by being attached to an automatic investment plan.

Keep in mind, the size of the account doesn't necessarily equate to the quality of the account as there is an opportunity to interact directly with the investors of this channel and expand the relationship through the direct interaction. Moreover, the foundation of the channel is to build long-lasting relationships and provide guidance through an investors' financial journey. In regards to the USAA 529 College Savings Plan, it remains net flow positive since the acquisition and for the year-to-date period and AUM reached a record high in the third quarter. In August, we launched our first multichannel paid media campaign in a number of regions in the U.S., each with a strong military presence. The campaign was designed to increase brand awareness and drive engagement among the USAA membership and military community in general. To date, the campaign has already generated close to 6 million digital and social impressions, which is helping to increase our brand recognition within the military community. We expect these types of efforts to grow in both frequency and scale over time, which will support the growth of the direct channel.

In addition to our marketing and digital efforts, we are focused on continuing to expand the investment capabilities that we offer direct to members as well as through financial advisers. Recently, we added new share classes to several USAA mutual funds to provide additional choice for financial advisers and their end clients. During the quarter, we began offering taxable and tax-exempt fixed income separately managed accounts, SMAs, direct to members. These custom solutions, which leverage the expertise of the USAA investment fixed income franchise, are particularly appealing to high net worth investors who are seeking a more institutional and personalized approach for management of their assets. We expect to extend this capability to our intermediary platform partners in early 2021.

In keeping with our initiative to integrate material ESG considerations alongside long-standing disciplined investment processes, we recently revised the strategy for the USAA World Growth Fund to focus on sustainable and responsible investing and ESG considerations. In conjunction with this change, the fund's name has been changed to the USAA Sustainable World Fund. Looking ahead, we'll soon be introducing 2 new thematic ETFs designed specifically to appeal to the military community. We will also be adding a new no load member share class, specifically designed for the direct channel for 11 of our existing Victory Funds in conjunction with the launch of our new digital experience. This means that members will be able to invest directly in funds and in-demand asset classes not previously available through the USAA mutual funds platform. The combination of excellent service from our contact center representatives, a new modern digital experience, supported by innovative and focused marketing campaigns and specialized products is the form of success and growth in this channel.

On Slide 8, I'll review our investment results for the quarter. As of September 30, more than 2/3 of company-wide AUM in mutual funds and ETFs was ranked 4 or 5 stars overall by Morningstar. 15 funds were ranked in the top quartile by Morningstar for the trailing 1-year period, including 11 funds in the top quintile. Performance of the fixed income funds managed by our USAA Investments franchise continued to improve. The percentage of AUM in those products outperforming its respective benchmarks over the trailing 3-year period was 89% as of September 30. 10 out of 14 of those funds are ranked 4 or 5 stars overall by Morningstar as of September 30. This excellent investment performance will help us in our placement and distribution efforts as we continue to make progress to set the foundation for distribution success with this franchise.

Looking at the investment performance of our VictoryShares ETFs, 5 were ranked in the top quartile by Morningstar, including 2 ranked in the top decile for the trailing 1-year period. We're particularly excited about our 2 active fixed income ETFs, UITB and USTB, which achieved their 3-year track records in October and at month end, ranked in the 19th and 10th percentile, respectively, by Morningstar. Finally, we launched our first thematic ETF, QQQN, in September and are seeing significant interest from financial advisers and end investors. As of November 1, we've attracted approximately $80 million in AUM into the strategy with strong investment performance results as well. QQQN offers exposure to the 50 stocks that are next in line for the inclusion in the NASDAQ-100 Index and seeks to provide investment results that track the performance of the NASDAQ Q-50 Index, which has a 10-year track record.

Turning to Slide 10, I'll review the planned acquisition of THB Asset Management, which will become our tenth investment franchise. THB is a great fit for us on many levels and highlights our ability to strike financially attractive, creative deal structures with talented investment organizations. The framework of the transaction is no different than many of the transactions we have executed in the past in which we buy 100% of the existing company and bring the investment team on to our platform where they benefit from our operational, marketing and distribution capabilities. THB has a 38-year history with an impressive investment performance track record, currently manages approximately $435 million in the micro-cap, small-cap and mid-cap asset classes, including U.S., global and international strategies. These are capacity-constrained asset classes that we like and know well. These are also asset classes in which active management is an important part of a well-diversified portfolio. From a business perspective, THB has significant room for AUM growth across its product set, which we think we can significantly accelerate with our distribution capabilities.

All THB's strategies have ESG considerations fully integrated into their investment processes. In fact, THB was an early adopter and has been managing socially responsible investment portfolios for decades. In addition to serving clients in the U.S., THB has a footprint in Australia and Europe and provides us with expanded distribution opportunity in regions in which we have limited presence today. This will benefit all our franchises as we look to leverage THB's distribution footprint to sell more of our investment strategies outside the U.S. The transaction is expected to close in early 2021 and be immediately accretive to earnings. Nominal consideration will be paid for the asset. We will not need to use any of our capital. Consistent with our business model, THB's investment team will become employees and shareholders of Victory Capital and already are significant investors in their own products. Additionally, the newly created franchise will be subject to our standard compensation agreement based on revenue sharing, and as I mentioned before, will leverage our operational marketing and distribution platforms. THB's entrepreneurial, client-first culture aligns well with ours, and we are very pleased to welcome them to our team.

On Slide 11, we'll highlight THB's stellar investment performance track record. As you can see, all 4 of the THB's primary strategies have outperformed their respective benchmark for nearly every time period shown and since inception. Keep in mind, this data is net of fees. Additionally, THB's strategies rank among the top tier of their strategy peer groups according to eVestment. As of September 30, the micro-cap, small-cap and mid-cap and the international opportunity strategies were all ranked in the top quartile for the 1-year period according to eVestment and 2 of the 4 strategies were ranked in top decile. 3 of the 4 strategies were also ranked in the top quartile over the 3-year period, and 3 of the 4 were top quintile performers for the 5-year period. This is a testament to the strength and consistency of their processes and long tenure managing strategies in these specialized asset classes.

Turning to Slide 12, I'd like to touch briefly on our strategic investment in Alderwood Partners. In September, we announced that we had acquired a 15% interest in Alderwood. Alderwood is a London-based investment advisory firm focused on taking stakes in specialist boutique asset management businesses. It was founded earlier this year by Jonathan Little, who with previous firms has an established history of success acquiring stakes in specialist asset managers around the world. Alderwood is planning to raise a single private equity style fund to deploy its strategy. I will be a member of the Board at the general partner level, and we intend to also participate as an investor in the fund. In addition to providing attractive return opportunity, this invest in a proven M&A capability provides us with a number of compelling strategic opportunities. It broadens our international scope for future growth via acquisitions, particularly in the U.K. and on the European continent. Additionally, it expands our opportunities for complementary distribution alliances, including selling Victory managed products into new regions and distributing products managed offshore in the U.S. via our established distribution networks. Finally, it provides us with access to strategic partnerships, leveraging organizational and regulatory platforms in non-U.S. jurisdictions.

Now I'll turn it over to Mike to review our financial results for the quarter.

[Michael Policarpo, executive]

Thanks, Dave, and good morning, everyone. The financial results review begins on Slide 14.

We produced record results for the third quarter and 9-month period, thanks to focused execution in our integrated operating platform. Our ability to consistently generate strong financial performance throughout this year's market swings is a testament to the efficiency and flexibility of our differentiated business model. Revenues for the third quarter increased 4% from the June quarter, reaching $188.7 million. For the 9 months, revenues were $575 million, up 46% from the $394 million reported for the same period in 2019.

GAAP operating margin expanded to 43% in the third quarter, which was substantially wider than the second quarter of this year and the same quarter last year. This resulted in adjusted EBITDA margin widening to a record high 51%. Adjusted net income with tax benefit grew $8.4 million or 13% from the second quarter to $73.4 million. This was $6.1 million or 9% higher than in the last year's third quarter despite 9% lower year-over-year average AUM. GAAP earnings were $0.76 per diluted share in the quarter. This was up 25% from the second quarter of this year and more than twice the GAAP EPS generated in last year's third quarter. Adjusted net income with tax benefit reached a quarterly record of $1 per diluted share.

For the 9 months, GAAP EPS and adjusted EPS also set new highs. GAAP earnings per diluted share increased 185% to $2.14 for the 2020 9-month period compared with $0.75 in 2019. And adjusted net income with tax benefit rose $87 million to $207 million or $2.81 per diluted share, up 72% from $120 million or $1.64 per diluted share in the comparable period last year. We continue to reduce debt at an accelerated pace, improving our leverage ratio to 2x at the end of September. In addition, we returned approximately $13.9 million to shareholders in the form of cash dividends and share repurchases during the quarter. As Dave highlighted, the Board authorized another $15 million share repurchase plan, and we increased our cash dividend for the second consecutive quarter. With this latest 17% increase, our quarterly dividend rate is now $0.07 per share, which is up 40% since the beginning of this year.

Turning to Slide 15. Total AUM rose 3% during the quarter. $132.7 billion of AUM at the end of the quarter reflects positive market action that was partially offset by net outflows. AUM is up 7% since the end of March. Long-term asset flows are covered on Slide 16. Gross flows were in line with the second quarter, and we experienced our second consecutive quarter of modestly improving redemptions. While still a challenge, flows were better in the third quarter compared with either the first or second quarter of the year. As Dave mentioned earlier, we are beginning to see our won but not yet funded book begin to be realized, which should have a positive impact on our flows for the quarter. Several investment franchises were net flow positive in the third quarter and year-to-date periods. INCORE, Trivalent and Sophus all generated positive net long-term flows, and the RS Global strategy was also net flow positive for the 3- and 9-month periods ending in September.

Turning to Slide 17. Quarter-over-quarter revenues increased by 4%, which is slightly ahead of the 3% increase in average AUM. The average fee rate in the quarter declined just slightly by 0.3 basis points to 56.4% from 56.7% basis points in the second quarter. Gross management fees increased 1.1 basis points as a result of the positive asset mix shift from the recovering equity markets. We lost 0.8 basis point from the fulcrum fees taking effect this quarter on certain USAA mutual funds. Looking forward, we are encouraged by the sharply improving investment performance in most of the USAA funds with fulcrum fees. Particularly, the larger USAA fixed income products have seen strong investment performance against their respective benchmarks since the credit markets were dislocated in March of this year. That short period of disruption will have less of an impact on the fulcrum fee realization in future look-back periods, which will grow until we reach a 36-month rolling interval.

Moving to Slide 18. Continuous improvement in expense management remains a priority. Total expenses once again declined in the quarter, marking our fourth consecutive quarter of lower expenses. You can see from the chart, as we move further past the closing of the USAA acquisition, we have less accounting noise as the volatility in our expenses have normalized. Personnel expense declined 3% quarter-over-quarter. This was primarily driven by a reduction in noncash deferred compensation expense related to asset value adjustments in our deferred compensation plan investments. Cash compensation was flat in Q3 compared with Q2. Other operating expenses declined by 5% or $2.8 million from the second quarter, reflecting lower distribution and asset-based expenses. This was driven by lower platform expenses, which declined $3.8 million and was partially offset by higher sub administration, sub advisory and middle-office expenses.

Nonoperating expense levels reflected significantly lower interest expense related to our deleveraging and lower cost of debt. The increase in Q3 related to lower unrealized gains recognized on deferred compensation plan investments. Acquisition-related expenses were $3.5 million lower in the quarter. The decrease was primarily attributable to the adjustment of the contingent acquisition liability that we run through our P&L each quarter. Quarter-over-quarter, this was lower in the third quarter at $2 million compared with $5.3 million in the second quarter. That liability on our balance sheet was adjusted from $119 million at the end of June to $121 million at the end of September. Our first annual cash payment will be paid this quarter, reducing that liability. As previously disclosed, we anticipate making the maximum annual payment of $37.5 million, which is based on a revenue retention calculation from the acquisition.

Slide 19 highlights our non-GAAP metrics for the quarter. Adjusted net income with tax benefit reached a record high of $1 per diluted share for the third quarter. This was up 12% from $0.89 in the second quarter and up 10% from $0.91 per diluted share in last year's same quarter. The operating margin expansion we have generated this year is a testament to our focused execution. A sizable portion of the margin improvement we have seen is expected to be sustained in the future and is not attributable to a onetime COVID-related reduction of expenses. That being said, not all of the margin improvement will stay as it will be impacted by the timing and amounts of noncapitalized investments that we are making in technology, data and distribution to better our platform. Adjusted net income with tax benefit totaled $73.4 million in the third quarter, which was comprised of adjusted net income of $66.7 million and a scheduled cash tax benefit of $6.7 million. This was up 13% from $65.1 million in the second quarter and 9% ahead of the third quarter of last year. Adjusted EBITDA was up 11% or more than $9 million, reaching $95.6 million compared with $86.3 million in the prior quarter. This resulted in adjusted EBITDA margins expanding 320 basis points to a record 50.7% in the third quarter, eclipsing the previous record of 47.5% established in the second quarter of this year.

Slide 20 is a snapshot of our capital management activity in the quarter. We returned a total of $13.9 million to shareholders in the form of share repurchases and dividends. During the quarter, we repurchased 529,000 shares at an average cost of $17.72 per share. The $15 million share repurchase authorization that commenced in early June has been exhausted, and the Board authorized a new share repurchase program of the same $15 million size that will commence when our trading window reopens next week and be effective through the end of 2022. At the same time, we paid down an additional $44 million in debt during the quarter and held $56 million in cash at quarter end. Some of that cash build is earmarked for the payments to USAA. In the past few weeks, subsequent to quarter end, we paid down an additional $20 million of debt. Our rapid deleveraging, the lower interest rate environment and our first quarter debt repricing have significantly lowered our total cost of debt.

In the top right of this slide, we have included a chart to illustrate this sharp decline. As you can see, our total cost of debt, which includes amortization of debt financing, has been reduced by more than half since the third quarter of 2019. Last year, our interest rate was 5.6% in the third quarter, and that has been reduced to 3.1% in this year's same quarter. Moreover, we have mitigated interest rate risk by instituting a hedge that essentially fixed the interest rate under 3.5% or more than half of our outstanding debt through its duration. For perspective, our interest expense has declined almost 60% from $15.3 million in last year's third quarter to $6.2 million in this year's comparable quarter. And something to note is the annualized savings on our debt is generating more free cash flow for us than the cost of accelerating our share repurchases and both of this year's cash dividend increases.

With total debt reduction approaching $300 million since we originated our term loan and the realization of the anticipated earnings power, our net debt to annualized adjusted EBITDA ratio has improved to 2x and is trending down quite rapidly from our actions. Our $100 million committed revolver remains undrawn, and we continue to generate substantial cash flow. GAAP net cash flow from operating activities in the 9 months of this year totaled $183 million, which does not include more than $20 million we booked as cash tax benefit during the first 3 quarters of the year.

Slide 21 lists several of the objectives we laid out in 2018 at the time of our IPO. We announced another accretive acquisition with THB Asset Management becoming our tenth franchise. THB also hits on our desire to broaden our distribution and is a proof point that our platform represents a genuine value proposition for high-performing investment managers seeking to accelerate growth. As you can see from the table at the bottom, we have generated substantial profitable growth through the first 3 quarters of the year. This strong performance can be attributed to our integrated model combined with crisp execution by our team throughout the organization.

Over the past 2 years, for the 9-month period, we have achieved an 81% increase in revenues, expanded margins by 860 basis points, more than tripled our GAAP earnings per diluted share and more than doubled adjusted net income with tax benefit. At the same time that we are achieving notable profit margins and earnings growth, we are reinvesting significantly in the business to obtain the best technology and people to maintain our competitive edge. We believe it's a mistake for a management team to be overly focused on the short term. And while we are focused on executing every day, we also know that lasting value creation happens over longer time periods and feel the bottom chart is our report card for our evolution as a public company, which we are quite proud of.

We have a couple of additional slides at the end of the deck for your reference. The first one contains a chart illustrating our anticipated cash tax deductions scheduled over the next 15 years. That is followed by our capital allocation strategy, which is essentially unchanged. Our priority remains using excess cash flow to reduce debt and enhance the flexibility of our balance sheet. However, as we evolve as a company, and our financial condition continues to strengthen, it is gratifying to be able to return even more capital to shareholders while continuing full speed ahead with executing on our strategy for long-term growth.

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 Chris Shutler with William Blair.

[Christopher Shutler, analyst]

Dave, do you expect more like THB-like deals over time? It would seem like that -- I mean the structure makes sense, would seem like a nice opportunity given your distribution capabilities, marrying those with smaller firms that have strong investment performance. I know you're trying to balance larger deals with smaller deals because they both take a lot of time, but does it make sense to kind of bifurcate the investment function and focus on both at the same time?

[David Brown, executive]

Let me start off by saying the THB acquisition fits perfectly into our model. If we can find deals where we don't use our capital, we can bring on tremendous investment talent in asset classes where we know them well, where we can distribute them, where we think we're experts in them and put them into our network and accelerate their growth, we would do them all day long. That being said, we definitely are looking for larger acquisitions. We're spending a lot of time around doing due diligence on the larger opportunities. We have a deep enough team where we can do both. And I would expect as time moves forward because of the platform we've built that we'll be doing both of these kinds of transactions. The sequencing will depend on what the opportunity set is. But if you looked at a THB and you looked at the asset classes, you looked at the ESG considerations they use in their investment processes and you, quite honestly, look at the performance and the rankings, those are tremendous opportunities for us to bring on organic growth.

THB is all about growing. It is accretive day 1. But it's really all about organic growth. And the capacity for the products as they sit today is somewhere between $15 billion to $20 billion. And we think we can plug them into our distribution system quite quickly. And so these are really tremendous opportunities. And years ago, we would not have been able to bring a team on like this. But with the platform we've built, we can do it, and we can also pursue the larger acquisitions.

[Christopher Shutler, analyst]

Okay. And then 2 quick follow-ups on the financial side. So first, on EBITDA margin, can you give us a sense if AUM were to essentially remain flat from 9/30, like would you expect that margin to be down how many basis points, I guess, versus the Q3 level? And then on the fulcrum fees, can you help us understand with the improved performance in Q3, does that help the fee rate looking out to Q4? I just want to make sure I understand the mechanics of how that works?

[Michael Policarpo, executive]

Thanks, Chris. I think with respect to the margins, obviously, we're pleased with the margins, record results, talks about our ability to execute. As we said in the script, the sizable amount of the margin expansion that we experienced will be sustained, and it's not attributable to any sort of a COVID reduction in expense. Anything we're doing and seeing in reduction in expense related to COVID, we're reinvesting that today in other ways to access distribution. With that said, I do think going forward, we are going to continue to reinvest in the business. So I don't think the levels that you see -- they will ebb and flow quarter-by-quarter, as we've said in the past. We're continuing to evaluate kind of the longer-term margins of the business as we digest the investments that we're making in technology, in data, in the direct channel. And don't have, at this time, updated guidance for it. But I would say, again, we continue to believe we've got a superior business model that can drive strong investment performance and strong financial results.

With respect to the fulcrum fees, which I think was the second question that you asked, yes, the impact of the fulcrum fees, as we said, was 0.8 basis points negative for the quarter. And a reminder how those work. So we waived the impact of fulcrum fees for 1 year post the USAA transaction. That begun, if you will, with the start of Q3, and we are building up to a 36-month interval. So as we see investment performance improve, and we mentioned that 89% of the USAA fixed income products are outperforming their benchmarks over a trailing 3-year period as of 9/30, as we see that to continue, we will see impact of that going forward to the positive. We talked about the impact potentially was 1 to 2 basis points on the firm, positive or negative. And we would say, with the performance that we've seen, we would expect that to continue to see improvement as we go out. And the impact as we build for the full 36 months will be reduced by that short-term period of underperformance that we saw in Q1 on the USAA fixed income products.

[Christopher Shutler, analyst]

So fair to think that if Q3 was down 0.8 basis points that -- in terms of impact that Q4 is up, but less than -- so you recoup some of that negative 0.8 basically in Q4, but probably not all of it?

[Michael Policarpo, executive]

Yes, that's fair. Yes, I mean, it will -- I mean it depends. We're midway through Q4 at this point in time. So it will depend on what the performance looks like. But yes, the impact of it going out will become less and less as we build the track record to the 3-year, 36 months kind of full impact that's rolling once we get to it.

[Operator]

Your next question is from Cullen Johnson with B. Riley Securities.

[Cullen Johnson, analyst]

On the THB deal, could you just talk a little bit more about how the revenue sharing arrangement is structured?

[Michael Policarpo, executive]

Yes. So it is part of really our standard revenue share that we've talked about with all of our investment professionals. And really, that's -- we don't give guidance with respect to what that looks like, but it is -- really, as Dave mentioned in prepared remarks and in his comments, this one fits really well into our platform. They'll become VCTR shareholders. They'll be integrating onto the platform. They'll leverage our operating platform and efficiency and really be focused solely on managing money and plugged into our distribution. And their compensation scheme is standard with respect to what we offer to all of our investment franchises.

[David Brown, executive]

And maybe I would add one thing, it's Dave. There is no special structure to the revenue sharing agreement that we have to them because we're acquiring the business. It is, as Mike said, and I'll just reiterate, just a standard revenue share agreement that we have with all our other franchises.

[Cullen Johnson, analyst]

Okay. And then kind of looking at capital management. Just as debt pay down -- or I guess, as the cost of debt and your financing cost kind of comes down and rates are relatively low, does that, in any way, make debt pay down, maybe a little bit less attractive relative to other forms of use of that capital, like a buyback or something?

[David Brown, executive]

It's Dave. What we're doing is we're striking a balance. And I think the balance that we have today, where we're increasing our dividend, we've done that over the last few quarters. We have a buyback program I think that represents our opinion of what the value of the stock is, along with paying down the debt pretty aggressively. Our strategy is to continue to pay down the debt aggressively. That's not changing. Because for us, the best use of capital is to have the flexibility on our balance sheet to go and do acquisitions that are accretive and that are value added for our firm. So even though the cost has come down and even though the balance in we're at -- as we said in this script, we are at 2x, we still are going to continue to pay down aggressively. But we are looking at other ways of returning capital to shareholders, and we're doing that through the dividend and increasing the dividend and through our buybacks.

[Operator]

Your next question is from Alex Blostein with Goldman Sachs.

[Alexander Blostein, analyst]

I was hoping to talk a little bit about the flow dynamics in the quarter and maybe get an update on any sort of Schwab-related attrition that's still kind of ongoing through the platform because I know that's obviously been something that's been weighing on that flows for a little bit of time. So maybe an update where we stand there and the path to maybe turning flow positive over the next couple of quarters?

[David Brown, executive]

So let me start with the path to being positive. I think we started off in the script talking about there still is some drag on our flow profile from the sale of the USAA brokerage business to Schwab. That is slowing. We anticipate over time that, that will slow and come to a stop, if you will. That should help at least from a leaking perspective. When you think of the front door, you think of our won but not yet funded business. We stated that this month, we're starting to see and have seen some of that won but not yet funded book fund. We have a really healthy pipeline sales pipeline in the institutional and intermediary channel. The direct channel, we'll be launching our new digital experience here in the next few weeks. So when you think about what we've done historically in our legacy channels, if you will, we feel great because we have great product, we have excellent investment performance. THB will help that, the build-out of the direct channel.

And I'd remind you on the direct channel, once we're able to launch our digital experience, that will allow us to more effectively and efficiently market and go after not just existing members, but other people that aren't even USAA members. That will give us a wider opportunity. And then we've also added products. I spoke in the script about SMAs, I spoke about new member share classes, and we have more to come from a product expansion perspective. And then when you put all of that together, as we look forward, we think that we will flip into organic growth. We've had quarters where we've had organic growth. We've had quarters the last few where we haven't. We think we've gone through a little bit of a drag because of the messiness of the sale to Schwab, but those are onetime things from our perspective. What I would say, the 100,000 new registrations that we've had since July, that isn't a onetime event. The noise around the Schwab transaction is a onetime event. The 100,000 registrations, new account registrations, we have opened up, that's consistent. That's a huge green shoot for us. And there's a lot of great data in there.

And I think as we've called out in the script, half of those new registrations are people under 40 years old. And that is a great dynamic for us because it allows us to build relationships, long-term relationships, to guide those new registrations through a financial journey through their life. And we're acting as a group that can help them through that journey. So we're really excited about what the future brings on the organic side. And we're starting -- as we said in the script, we're starting to see the light in some of the other areas where we think we can make an impact.

[Alexander Blostein, analyst]

That's very helpful. And I guess maybe just a clarification. On the institutional pipeline that you talked about, any sense for what strategies and what sort of associate fee rates are with that pipeline given intuitional to be obviously lower than the retail channel?

[David Brown, executive]

Yes. So there are standard fees. There's not any excessive discounting. And fees are dependent through channel and their sub channels on the institutional side and also by product. As far as the franchises, it's Sycamore, it's RS Growth, it's RS Global, it's Trivalent, it's Sophus, it's our solutions platform and our ETFs. And I think you'll see you'll see a wide range of our franchises really participate in the won but not yet funded fundings as well as in our pipeline. And I would also add, the USAA fixed income franchise, we have been building out distribution. It takes time. We articulated just a few examples. We think that, that, over time, especially with the tailwinds in that asset class, we can be very beneficial our net flow profile, and we really have not seen that yet. And that's -- so that's a great opportunity for us as well. And as Mike pointed out, the performance for that franchise, ex the March, April time frame, has been excellent. And they have a long-term track record. They have scale. And they really have not been commercially marketed until they joined our organization. And that's just an area where it just takes time in its building blocks, and we're building those blocks.

[Alexander Blostein, analyst]

Got you. And just a follow-up on capital management and sorry to nitpick, I guess, a little bit. But as you -- hear your comments on aggressively paying down debt so that all makes sense. But given the increased cash flow generation in the business, should we be thinking about sort of the same percentage of EBITDA going towards debt pay down? Or generally kind of thinking the same dollar amounts going towards debt pay down, and therefore, that actually frees up a little bit more capacity for you guys to do other things?

[David Brown, executive]

So we don't evaluate it exactly that way. What I would say is we are absolutely thinking about with the cost of the debt and the excess cash flow should and how much should we pay down in debt? And what other ways can we reward shareholders through dividends and buybacks and other things we can do? We just think we're in a great position from a capital perspective. You know about the deferred tax asset that we have, which reduces our tax drag and our conversion from EBITDA to free cash flow. And I think being at 2x and articulating today the reduction in not just the expense of interest, but actually, the cost, just allows us, I think, every quarter to reevaluate it. And we're looking at rewarding shareholders in a couple of different ways, and one of them is definitely going to be through dividends and buybacks and the other way is going to be paying down debt. So we have the flexibility in the balance sheet to do accretive deals like we did with USAA and others.

[Operator]

Your next question is from Jeremy Campbell with Barclays.

[Jeremy Campbell, analyst]

And Dave, maybe sticking with the M&A point you just ended there on. I remember going back early summer, you guys were a bit excited about potential M&A activity in the space for the back half, and it seems like it's heating up a little bit. Most of the reports seem to be around these scale type deals that aren't really your bread and butter here. But just kind of wondering if you can provide some high-level color on what you're seeing around M&A discussions in the industry versus what maybe we see kind of reflected in the press. Are there kind of disproportionate scale deal conversations versus deals with characteristics that Victory would normally look at? Is everything robust? How would you characterize it?

[David Brown, executive]

Well, I would start off saying there has been a lot of discussion and activity in the M&A market for asset management as we all know from all the things that have happened over the last couple of months. For us, we've been active for 7.5 years. So even though the industry now is waking up for consolidation, we've been doing and evaluating for 7-plus years. So we've been pretty consistent. We've done a number of transactions consistently over years and they varied in size and scope, but they've all had one common theme, which is to make our company better. We have looked at very large deals and are looking at very large deals, and we're looking at smaller things. A good example is THB. I do think that things that have been in the press have skewed everything up to these large consolidation. For us, we absolutely are interested in larger transactions, but it has to make our company better and it can't be just financial engineering.

We appreciate that our platform allows us to gain a lot of synergies. We look at that as a component of a transaction, but not the only reason we would ever do a transaction. The transaction has to be strategic for us through distribution, through product expansion or other things. And then if the synergies occur, great. But we are as active in the M&A side as we've ever been, but we are as selective as we've ever been. And we feel like we're extremely experienced. We have a very experienced team here, and we are selective, and we know what we're looking for. And the big caution, I think, for us and for the industry is to just do a deal to do a deal, and that isn't what we're trying to do. But just to leave you with, it's really all over from a size and -- perspective. And I would also say that there are lots of people willing to speak now that maybe in the past were not willing to speak.

[Jeremy Campbell, analyst]

Got it. And then I think you had noted earlier -- obviously, THB is a little on the smaller side, but I know you had noted there's an Australian footprint, and you guys would look to maybe kind of tap into distribution there. Obviously, now that THB is part of a much larger organization to Victory, I mean, is there any opportunity to try and tap into the superannuation program down in Australia? Or are there other opportunities outside that?

[David Brown, executive]

Well, THB has a footprint, a distribution footprint in Australia as well as in Europe. So part of the opportunity for us is to, first of all, help THB expand their footprint in Australia and Europe with our resources and what we can bring to the table. But part of that also is to take some of our franchises that do fit for an Australian investor, be it one of the larger funds or a European investor and take some of our franchises and introduce our franchises through those distribution channels and potentially sell, if you will, our products over there. We would not have that opportunity without the THB acquisition.

[Operator]

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

[Gayathri Ramkrishnan, analyst]

This is Gayathri filling in for Mike Carrier. I was wondering how does the fee outlook really change, especially in the context of the new affiliate and also with other potential M&As you're thinking about in the future?

[Michael Policarpo, executive]

Great. So from a fee perspective, I think we look at it as our fees are really what's seen in the marketplace. So I think it will be dependent on the type of business that we win or the type of business that we acquire. So THB being a good example. They have capacity-constrained products, micro-cap, small-cap, mid-cap, U.S., global and international, which really speaks to probably higher fees just from where that business is usually priced because of the capacity constraints as well as the distribution that we win the business in. So really, it will be -- the fee mix going forward will be a byproduct of the products as well as the distribution channels. But we say this a lot, I think it's really important, for us, the way we think about it is we're margin focused. So we can win business on our platform at market fee rates and still deliver strong margins. Example is our solutions business, those products are 20 or 30 basis points but because of the infrastructure and the operating platform that we have, the margin on those tend to be at or above really where our firm margins are at. So I think it is a byproduct of what we win and the acquisitions that we look at as well as the fee rates that are competitive from a marketplace perspective.

[David Brown, executive]

Yes. I would add -- it's Dave. I would just add one other point that if you go back and look at previous quarters and look at -- the fee rates have actually come down, our average fee rates have come down, but our margins have expanded. And I think that's just really a testament to our model. And so we care about fees. Investors care very much about fees. I think investors -- what's top of mind for investors is really value and not necessarily exactly the fees. Investors will pay a fair fee for an excellent investment manager. What they will not do is pay a fair or a high fee for bad investment results. So while we think we have great investment franchises and we can charge fair fees, I think the most important thing is our model allows us to have flexible structures on fees and to be flexible. And I think the margin expansion over a time where actually our average fee rate has come down as a firm, I think it says everything you need to know about the model and the way it operates.

[Operator]

Your next question is from Robert Lee with KBW.

[Robert Lee, analyst]

I mean maybe the first one and just going back to the pipeline. Is it possible to kind of size what that was coming into the quarter? I mean we -- I understand that's [ growing ], but maybe you have some sense of the proportion, it would be helpful. And then the second question would be with USAA. In addition to contingent payments, if I remember correctly, your -- you have the right to use the USAA name, I think, maybe for another 1.5 years or so. If you could just refresh us on that. And since I assume you have to reenter negotiations on that sooner than later, kind of how we should be thinking of that maybe from a cost perspective or how we should layer that into a forecast?

[David Brown, executive]

So let me start off with the pipeline and the size. I would -- we don't report intra-quarter flows. We don't report the size of the pipeline or the size of our won but not yet funded book. I would just say that it's sizable and leave it at that. On the USAA name, we're building a business. We're building a business that goes direct to investors. The USAA brand has been important and will be important, but I think the most important thing is we are building a business that really directly interacts today with the majority of our clients, our USAA members. In the future, there might be more clients that actually aren't USAA members. Maybe they're military, but they haven't signed up with USAA. But it's really about the business that we're building and the capabilities. We're building a commercial business that ultimately will be a marketplace for investors to invest with us in a way where they can get really good product, really good service and a really good digital experience.

We do have the brand, I think, from 3 years. It's publicly disclosed 3 years from the close. I'm not going to predict anything around that. USAA has been great partners to us. We have been great partners to them. And I think that has always been the opportunity, and I fully expect going forward that we're going to have a great relationship like we have with them today.

[Robert Lee, analyst]

Great. And maybe as a follow-up on the M&A. Can you give us maybe, I don't know if it's rank order, what you would view as strategic priorities in any M&A? And what I mean by that is are there certain kind of investment areas or distribution resources that you're -- I understand you have to be opportunistic to what is out there, but do you have the like kind of rank order, the top priorities? That would be helpful.

[David Brown, executive]

Yes. I think it's really simple. Our #1 priority is to make our company better. And any acquisition we do that makes -- any acquisition that brings us the opportunity to make our company better, we're interested in. And that is around a product set, that is around distribution reach. We are not looking to do a transaction to be at a certain size. We feel that we are at scale today for the things that we do, and I think you can see that in our margin. And remember, our margin is really net of reinvesting in our business. So from a forced ranking, we don't look at it that way. We look at it where if it makes our company better and makes our platform better, we're very interested. And that comes in a lot of different sizes and shapes and forms.

[Robert Lee, analyst]

Okay. All right. And then I'm sorry, I did have one last one. Maybe going back to the expenses and expense growth. Understanding you're not giving specific guidance, but is there a way that we should think of this going forward that, I don't know, inflation plus 200 basis points? Just trying to get some framework for -- I mean, I assume you have like some sense of projects you have on the drawing board. So some sense of kind of the scale and the spending increase, I'll call it, or rate of increase going forward.

[Michael Policarpo, executive]

Sure. Yes. It's Mike. So I think, as I said, we're evaluating the kind of long-term guidance with respect to margins. If you look at -- our year-to-date margins are 47.5%. We think there's opportunity going forward to continue to see some expansion. As for the investments that we're making, we're -- they will ebb and flow a bit based on timing, Rob. So we're not trying to give a lot more guidance around that. It will depend on things like the product sets. Dave talked a lot about we're introducing new products. We're introducing new technology. Data and analytics are a huge part of kind of the opportunity set for us going forward with respect to distribution. So I would just say, I think 47.5% year-to-date is where we are from an actual perspective, and we think there's opportunity beyond that.

[Operator]

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

[Kenneth Lee, analyst]

Wondering if you could just further expand upon the growth opportunities outside the U.S. that could be available through the Alderwood. And specifically, how could this help potential acquisition prospects?

[David Brown, executive]

Sure. It's Dave. So the Alderwood opportunity for us, first, is we're making an investment in a firm, and we're taking a small stake in a general partnership. We'll also be committing some capital to the fund, the LP, over a number of years, and that will be dependent on a number of things, but it won't be a large amount of capital. The opportunity for us, number one, is -- outside of we think it's going to be a great financial return, is potentially to increase our pipeline through that channel in opportunities we wouldn't normally see, and that's outside of the U.S. So that's the first thing is really giving us the ability, giving us a channel, if you will, to look at transactions that are outside the U.S. The second piece is there could be an opportunity for us to leverage distribution partnerships through the connecting through Alderwood and potentially the firms that Alderwood would acquire or invest in. There could be some cross-border distribution opportunities. Both the cross-border distribution opportunities and the M&A channel are really exciting to us. And then lastly, the opportunity to have non-U.S. regulatory considerations done. So if there's firms there that are in different countries, and we can utilize some of their regulatory approvals and do business over there, that would be helpful as well for us.

[Kenneth Lee, analyst]

Great. Very helpful. And just one follow-up, if I may. You've talked about further expanding the fixed income distribution and more specifically, some of the -- you highlighted some of the fixed income ETFs. Just wondering, over the near term, I wonder if you could just further expand upon any potential next steps that we should expect as you continue to further expand the distribution efforts for the fixed income products.

[David Brown, executive]

So we -- as we said in the script, we just gave a few examples of distribution that we're building on the intermediary side. There's more of those that we haven't disclosed. We're also working on an SMA structure, and that would be in the product expansion that we'll introduce to our partners, intermediary partners early part of '21. And if you look at the flows in the fixed income SMA space, they're plentiful, and we think we have a really good offering there and a great investment team. So we think that, that will be beneficial. But it's all about building distribution. It's what we do. It's what our distribution team does. And it's about building distribution block by block, and we're building the blocks right now to set up the distribution for a really high-quality, great performing fixed income franchise.

[Operator]

Your next question is from Ken Worthington with JPMorgan.

[Kenneth Worthington, analyst]

Actually, that cleaned up the last of my questions asked and answered.

[Operator]

Your next question is from Michael Cyprys with Morgan Stanley.

[Michael Cyprys, analyst]

Maybe just one question for you guys. Just curious as you're bringing on more investment teams and franchises and plugging it into your distribution, can you just talk about how your distribution team would approach prioritizing what could be a number of different small-cap or mid-cap strategies?

[David Brown, executive]

Sure, Michael, it's Dave. So that is our model. We have multiple franchises in the same asset class. We have a long history of being able to sell and service multiple clients with buying multiple franchises in the same asset class. And really, what happened is, is our sales and client service professionals learn the investment process. And then when they're interacting with their clients, they're providing solutions to their clients, and the clients are really selecting the appropriate franchise that fits them. So we're not really going out and pushing a specific franchise to a client. We're always going and trying to solve issues for clients. And having a lot of franchises or multiple franchises in the same asset class just gives us more options or more ways to solve some of the challenges that our clients face.

[Operator]

Your next question is from Sumeet Mody with Piper Sandler.

[Sumeet Mody, analyst]

Most of my questions have been asked as well. I just -- maybe one here on new client growth. For the USAA channel, if my math is right, it looks like you guys added about 35,000 new accounts in the second half of '19, about 45,000 in the first half of this year and another 21,000 here in the third. With the new digital platform coming onboard, combined with kind of that August multimedia campaign and the opportunities set still in front of you, how are you guys thinking about that magnitude of growth here? And maybe how do you think that translates to AUM growth?

[David Brown, executive]

And so I don't know if your numbers are exactly correct. But I would just say, going forward, the digital platform we're going to roll out, the new digital experience, I would think would help with new accounts and I think would help with everything that we're trying to do. I'm not going to venture to predict what will happen with the asset growth and what happens with how we're interacting with new clients. What I would say, and as I said earlier, is signing up 100,000 new registrations is real. It's not a onetime event. It's been very consistent. We're getting great feedback. And some of the challenges we've seen in that channel as well as the channel where we're interacting with Schwab, a lot of that are onetime. The new account registrations are consistent, and that is -- as I used the term, it's a green shoot. And I think if you look into it, you can see what's happening and that we're signing up new clients.

[Operator]

There are no further questions at this time. I'll now turn it back over to Mr. Brown for closing remarks.

[David Brown, executive]

Sure. Well, thank you for joining us this morning. We really appreciate your interest. Next week, we will be attending the Bank of America Financials Conference. And in December, we'll be attending the Goldman Sachs and BMO conferences. We hope to see you there virtually and looking forward to updating you on our progress. Thank you.

[Operator]

Ladies and gentlemen, this does conclude today's conference call. Thank you for participating. You may now disconnect.