Pzena Investment Management, Inc. - Quarter Report: 2008 March (Form 10-Q)

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

x		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
		For the quarterly period ended March 31, 2008
OR
o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
		For the transition period from:                 to

 

Commission File Number 001-33761

 

PZENA INVESTMENT MANAGEMENT, INC.

(Exact name of registrant as specified in its charter)

 

 

 

(212) 355-1600

(Registrant’s telephone number including area code)

 

Not Applicable

(Former name, former address, and former fiscal year if changed since last report)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x     No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o     No x

 

As of  May 14, 2008 there were 6,123,494 outstanding shares of the registrant’s Class A common stock, par value $0.01 per share.

 

As of  May 14, 2008 there were 57,950,910 outstanding shares of the registrant’s Class B common stock, par value $0.000001 per share.

 

 

PZENA INVESTMENT MANAGEMENT, INC.

FORM 10-Q

TABLE OF CONTENTS

 

			Page
PART I — FINANCIAL INFORMATION			3
Item 1.	Consolidated Statements of Financial Condition of Pzena Investment Management, Inc. as of March 31, 2008 (unaudited) and December 31, 2007		3
	Consolidated Statements of Operations (unaudited) of Pzena Investment Management, Inc. for the Three Months Ended March 31, 2008 and March 31, 2007		4
	Consolidated Statements of Cash Flows (unaudited) of Pzena Investment Management, Inc. for the Three Months Ended March 31, 2008 and March 31, 2007		5
	Consolidated Statements of Changes in Equity (unaudited) of Pzena Investment Management, Inc. for the Three Months Ended March 31, 2008 and March 31, 2007		6
	Notes to Consolidated Financial Statements (unaudited)		7
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		27
Item 3.	Quantitative and Qualitative Disclosures About Market Risk		40
Item 4T.	Controls and Procedures		40
PART II — OTHER INFORMATION			41
Item 1.	Legal Proceedings		41
Item 1A.	Risk Factors		41
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		41
Item 3.	Defaults Upon Senior Securities		41
Item 4.	Submission of Matters to a Vote of Security Holders		41
Item 5.	Other Information		41
Item 6.	Exhibits		42

 

 

EXPLANATORY NOTE

 

On October 30, 2007, Pzena Investment Management, Inc. (the “Company”) consummated an initial public offering of 6,100,000 shares of its Class A common stock in which it received net proceeds of approximately $98.9 million that it used to purchase 6,100,000 membership units of Pzena Investment Management, LLC, representing 9.5% of the then outstanding membership units of Pzena Investment Management, LLC. Concurrently with the consummation of this initial public offering, (i) the operating agreement of Pzena Investment Management, LLC (the “Operating Agreement”) was amended and restated such that, among other things, Pzena Investment Management, Inc. became the sole managing member of Pzena Investment Management, LLC and (ii) related reorganization transactions were consummated. Accordingly, as of and subsequent to October 30, 2007, (i) Pzena Investment Management, Inc. will consolidate the financial results of Pzena Investment Management, LLC with its own and reflect the remaining membership interest in Pzena Investment Management, LLC as a non-controlling interest in its consolidated financial statements, and (ii) Pzena Investment Management, Inc.’s income will be generated by its economic interest in Pzena Investment Management, LLC’s net income. As of March 31, 2008, the holders of Class A common stock (through the Company) and the holders of Class B units of the operating company held approximately 9.6% and 90.4%, respectively, of the economic interests in the operations of the business.  Therefore, this Quarterly Report on Form 10-Q presents the following financial statements:

 

1)              the consolidated statement of operations, the consolidated statement of cash flows and the consolidated statement of changes in equity, of Pzena Investment Management, LLC for the three months ended March 31, 2007; and

 

2)              the consolidated financial statements of Pzena Investment Management, Inc. as of and for the three months ended March 31, 2008 and the consolidated statement of financial condition of Pzena Investment Management, Inc. as of December 31, 2007.

 

“We,” “us,” “our,” and the “Company” refer to: (i) Pzena Investment Management, Inc. and its subsidiaries, including Pzena Investment Management, LLC and all of its subsidiaries, following the consummation of the above-referenced initial public offering, amendment and restatement of the Operating Agreement and related reorganization transactions on October 30, 2007, and (ii) to Pzena Investment Management, LLC and all of its subsidiaries prior to the consummation of these transactions. The “operating company” refers to Pzena Investment Management, LLC.

 

1

 

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

 

This Quarterly Report on Form 10-Q contains forward-looking statements. Forward-looking statements provide our current expectations, or forecasts, of future events. Forward-looking statements include statements about our expectations, beliefs, plans, objectives, intentions, assumptions and other statements that are not historical facts. Words or phrases such as “anticipate,” “believe,” “continue,” “ongoing,” “estimate,” “expect,” “intend,” “may,” “plan,” “potential,” “predict,” “project” or similar words or phrases, or the negatives of those words or phrases, may identify forward-looking statements, but the absence of these words does not necessarily mean that a statement is not forward-looking.

 

Forward-looking statements are subject to known and unknown risks and uncertainties and are based on potentially inaccurate assumptions that could cause actual results to differ materially from those expected or implied by the forward-looking statements. Our actual results could differ materially from those anticipated in forward-looking statements for many reasons, including the factors described in Item 1A, “Risk Factors” in Part I of our Annual Report on Form 10-K for our fiscal year ended December 31, 2007. Accordingly, you should not unduly rely on these forward-looking statements, which speak only as of the date of this Quarterly Report on Form 10-Q. We undertake no obligation to publicly revise any forward-looking statements to reflect circumstances or events after the date of this Quarterly Report on Form 10-Q, or to reflect the occurrence of unanticipated events. You should, however, review the factors and risks we describe in the reports we will file from time to time with the SEC after the date of this Quarterly Report on Form 10-Q.

 

Forward-looking statements include, but are not limited to, statements about:

 

·    our anticipated future results of operations and operating cash flows;

 

·    our business strategies and investment policies;

 

·    our financing plans and the availability of short-term borrowing;

 

·    our competitive position and the effects of competition on our business;

 

·    potential growth opportunities available to us;

 

·    the recruitment and retention of our employees;

 

·    our expected levels of compensation for our employees;

 

·    our potential operating performance, achievements, efficiency and cost reduction efforts;

 

·    our expected tax rate;

 

·    changes in interest rates;

 

·    our expectation with respect to the economy, capital markets, the market for asset management services and other industry trends;

 

·    the benefits to our business resulting from the effects of the reorganization we consummated on October 30, 2007; and

 

·    the impact of future legislation and regulation, and changes in existing legislation and regulation, on our business.

 

The reports that we file with the SEC, accessible on the SEC’s website at www.sec.gov, identify additional factors that can affect forward-looking statements.

 

2

 

PART I. FINANCIAL INFORMATION          

 

Item 1.  Financial Statements.

 

PZENA INVESTMENT MANAGEMENT, INC.

 

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

(in thousands, except share and per-share amounts)

 

		As of
		March 31,			December 31,
		2008			2007
		(unaudited)
ASSETS
Cash and Cash Equivalents		$	36,000		$	27,184
Due from Broker		77			268
Advisory Fees Receivable		21,625			26,061
Investments in Marketable Securities, at Fair Value		36,545			27,465
Receivable from Related Parties		418			351
Other Receivables		175			1,040
Prepaid Expenses and Other Assets		635			881
Deferred Tax Assets		67,632			68,233
Property and Equipment, Net of Accumulated Depreciation of $1,527 and $1,412, respectively		3,098			3,163
TOTAL ASSETS		$	166,205		$	154,646
LIABILITIES AND EQUITY
Liabilities:
Accounts Payable and Accrued Expenses		$	10,003		$	8,542
Securities Sold Short, at Fair Value		3,518			1,028
Due to Broker		126			4,101
Dividends Payable		7,058			7,045
Long Term Debt		60,000			60,000
Liability to Selling Shareholders		58,391			58,391
Other Liabilities		1,772			1,105
TOTAL LIABILITIES		140,868			140,212
Commitments and Contingencies		—			—
Non-Controlling Interests		20,208			16,355
Equity:
Preferred Stock (Par Value $0.01; 200,000,000 Shares Authorized; None Outstanding)		—			—
Class A Common Stock (Par Value $0.01; 750,000,000 Shares Authorized; 6,123,494 and 6,111,118 Shares Issued and Outstanding in 2008 and 2007, respectively)		61			61
Class B Common Stock (Par Value $0.000001; 750,000,000 Shares Authorized; 57,950,910 and 57,937,910 Shares Issued and Outstanding in 2008 and 2007, respectively)		—			—
Additional Paid-In Capital		4,907			(2,043		)
Accumulated Other Comprehensive Income		(46		)	—
Retained Earnings		207			61
TOTAL EQUITY		5,129			(1,921		)
TOTAL LIABILITIES AND EQUITY		$	166,205		$	154,646

 

See accompanying notes to consolidated financial statements

 

3

 

PZENA INVESTMENT MANAGEMENT, INC.

(Prior to October 30, 2007 - Pzena Investment Management, LLC)

 

UNAUDITED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except share and per-share amounts)

 

		For the Three Months Ended March 31,
		2008			2007
REVENUE		$	30,012		$	35,298
EXPENSES
Compensation and Benefits Expense		8,951			103,824
General and Administrative Expenses		3,043			2,089
TOTAL OPERATING EXPENSES		11,994			105,913
Operating Income/(Loss)		18,018			(70,615		)
OTHER INCOME/(EXPENSE)
Interest Income		197			286
Interest Expense		(963		)	—
Dividend Income, Net		281			129
Realized and Unrealized Loss, Net on Marketable Securities and Securities Sold Short		(3,580		)	(170		)
Equity in Loss of Affiliates		—			(42		)
Other		(14		)	32
Total Other Income/(Expense)		(4,079		)	235
Income/(Loss) Before Income Taxes and Non-Controlling Interests		13,939			(70,380		)
Provision for Income Taxes		1,542			1,129
Non-Controlling Interests		11,577			(9		)
Income/(Loss) Before Interest on Mandatorily Redeemable Units		820			(71,500		)
Interest on Mandatorily Redeemable Units		—			16,575
Net Income/(Loss)		$	820		$	(88,075	)
Net Income for Basic Earnings per Share		$	820
Basic Earnings per Share		$	0.13
Basic Weighted Average Shares Outstanding		6,119,686
Net Income for Diluted Earnings per Share		$	8,597
Diluted Earnings per Share		$	0.13
Diluted Weighted Average Shares Outstanding		64,070,596

 

See accompanying notes to consolidated financial statements

 

4

 

PZENA INVESTMENT MANAGEMENT, INC.

(Prior to October 30, 2007 - Pzena Investment Management, LLC)

 

UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

 

		For the Three Months Ended March 31,
		2008			2007
OPERATING ACTIVITIES
Net Income/(Loss)		$	820		$	(88,075	)
Adjustments to Reconcile Net Income/(Loss) to Cash Provided by Operating Activities:
Depreciation		115			74
Non-Cash Compensation		344			81,884
Director Share Grant		140			—
Realized and Unrealized Loss, Net on Marketable Securities and Securities Sold Short		3,580			170
Non-Controlling Interests		11,577			(9		)
Equity in Loss of Affiliates		—			42
Deferred Income Taxes		547			(231		)
Changes in Operating Assets and Liabilities:
Advisory Fees Receivable		4,436			(1,689		)
Due from Broker		191			765
Restricted Cash		—			(22		)
Prepaid Expenses and Other Assets		1,111			493
Due to Broker		(3,975		)	(2,691		)
Accrued Expenses, Accounts Payable and Other Liabilities		1,508			5,022
Purchases of Marketable Securities and Securities Sold Short		(16,836		)	(6,986		)
Proceeds from Sale of Marketable Securities and Securities Sold Short		6,667			7,453
Net Cash Provided by/(Used in) Operating Activities		10,225			(3,800		)
INVESTING ACTIVITIES
Receivable from Related Parties		(67		)	76
Purchases of Property and Equipment		(50		)	(32		)
Net Cash Provided by/(Used in) Investing Activities		(117		)	44
FINANCING ACTIVITIES
Contributions from Non-Controlling Interests		6,833			1,462
Distributions to Non-Controlling Interests		(1,080		)	(2,067		)
Dividends		(672		)	—
Distributions to Members		(6,373		)	—
Net Cash Used in Financing Activities		(1,292		)	(605		)
NET CHANGE IN CASH		$	8,816		$	(4,361	)
CASH AND CASH EQUIVALENTS - Beginning of Period		$	27,184		$	30,920
Net Change in Cash		8,816			(4,361		)
CASH AND CASH EQUIVALENTS - End of Period		$	36,000		$	26,559
Supplementary Cash Flow Information:
Interest Paid:
On Mandatorily Redeemable Units		$	—		$	18,995
Other		$	982		$	—
Income Taxes Paid		$	—		$	—

 

See accompanying notes to consolidated financial statements

 

5

PZENA INVESTMENT MANAGEMENT, INC.

(Prior to October 30, 2007 - Pzena Investment Management, LLC)

 

UNAUDITED CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY

(in thousands, except share and per-share amounts)

 

		Capital Units		Shares of Class A Common Stock		Shares of Class B Common Stock		Members’ Capital			Class A Common Stock			Class B Common Stock			Additional Paid-In Capital			Accumulated Other Comprehensive Income			Retained Earnings			Excess of Liabilities Over Assets			Total
Balance at December 31, 2007		—		6,111,118		57,937,910		$	—		$	61		$	—		$	(2,043	)	$	—		$	61		$	—		$	(1,921	)
Issuance of Class A Common Stock		—		12,376		—		—			—			—			11			—			—			—			11
Issuance of Class B Common Stock		—		—		13,000		—			—			—			—			—			—			—			—
Net Income		—		—		—		—			—			—			—			—			820			—			820
Amortization of Deferred Compensation		—		—		—		—			—			—			16			—			—			—			16
Accumulated Other Comprehensive Income		—		—		—		—			—			—			—			(46		)	—			—			(46		)
Equity Effect of Operating Company Net Deficit on Non-Controlling Interests		—		—		—		—			—			—			6,923			—			—			—			6,923
Class A Cash Dividends Declared ($0.11 per share)		—		—		—		—			—			—			—			—			(674		)	—			(674		)
Balance at March 31, 2008		—		6,123,494		57,950,910		$	—		$	61		$	—		$	4,907		$	(46	)	$	207		$	—		$	5,129
Balance at December 31, 2006		—		—		—		$	—		$	—		$	—		$	—		$	—		$	—		$	(729,966	)	$	(729,966	)
Net Loss Before Interest on Mandatorily Redeemable Units		—		—		—		—			—			—			—			—			—			(71,500		)	(71,500		)
Interest on Mandatorily Redeemable Units		—		—		—		—			—			—			—			—			—			(16,575		)	(16,575		)
Amortization of Deferred Compensation		—		—		—		—			—			—			—			—			—			1,901			1,901
Reclassification of Liabilities to Capital Units		12,755,744		—		—		875,096			—			—			—			—			(816,140		)	816,140			875,096
Balance at March 31, 2007		12,755,744		—		—		$	875,096		$	—		$	—		$	—		$	—		$	(816,140	)	$	—		$	58,956

 

See accompanying notes to consolidated financial statements

 

6

 

PZENA INVESTMENT MANAGEMENT, INC

(Prior to October 30, 2007, Pzena Investment Management, LLC)

 

UNAUDITED NOTES TO THE FINANCIAL STATEMENTS

 

Note 1—Organization

 

Pzena Investment Management, Inc. (the “Company”) functions as the holding company through which the business of its operating company, Pzena Investment Management, LLC, is conducted.  The Company was incorporated in the State of Delaware on May 8, 2007.  On May 10, 2007, the Company issued 100 shares of its common stock for $100 to Richard S. Pzena, the sole director of the Company as of that date.  On October 30, 2007, the Company consummated an initial public offering of 6,100,000 shares of its Class A common stock, par value $0.01 per share, for net proceeds of approximately $98.9 million, after payment of underwriting discounts and offering expenses.  These net proceeds were used to purchase 6,100,000 membership units of Pzena Investment Management, LLC, representing 9.5% of its then outstanding membership units, from its two outside investors and one former employee. Concurrently with the consummation of the Company’s initial public offering, the Operating Agreement of Pzena Investment Management, LLC (the “Operating Agreement”) was amended and restated such that, among other things, the Company became the sole managing member of Pzena Investment Management, LLC.  The acquisition of the operating company’s membership interests by Pzena Investment Management, Inc. has been treated as a reorganization of entities under common control pursuant to the guidance set forth in Financial Accounting Standards Board Technical Bulletin No. 85-5, Issues Relating to Accounting for Business Combinations (“FTB 85-5”).  Accordingly, the net assets assumed by the Company through the offering have been reported at Pzena Investment Management, LLC’s historical cost basis.  As a result of these transactions, as of and subsequent to October 30, 2007, (i) the Company has consolidated the financial results of Pzena Investment Management, LLC with its own and reflected the membership interest in it that it does not own as a non-controlling interest in its consolidated financial statements, and (ii) the Company’s income will be generated by its economic interest in Pzena Investment Management, LLC’s net income.  Reported results for the periods prior to October 30, 2007 reflect solely the operations of Pzena Investment Management, LLC.

 

Pzena Investment Management, LLC is an investment adviser which is registered under the Investment Advisers Act of 1940 and is headquartered in New York, New York.  As of March 31, 2008, the Company managed assets in a variety of value-oriented investment strategies across a wide range of market capitalizations in both U.S. and international capital markets.

 

The Company, though its investment in its operating company, has consolidated the results of operations and financial condition of the following private investment partnerships as of March 31, 2008:

 

Entity		Type of Entity (Date of Formation)		Ownership at March 31, 2008
Pzena Large Cap Value Fund		Massachusetts Trust (11/1/2002)		99.6%
Pzena Large Cap Value Fund II		Massachusetts Trust (8/1/2006)		99.9%
Pzena International Value Service		Delaware Limited Liability Company (12/22/2003)		2.2%
Pzena Global Value Service		Delaware Limited Liability Company (12/22/2003)		0.0%
Pzena Emerging Markets Value Service		Delaware Limited Liability Company (12/28/2006)		21.0%
Pzena Mega Cap Value Fund		Massachusetts Trust (2/23/2007)		99.9%
Pzena Value Partners		Limited Partnership (1/22/2008)		16.8%
Pzena Emerging Markets Country Value Service		Delaware Limited Liability Company (12/28/2007)		99.9%
Pzena Emerging Markets Focused Value Service		Delaware Limited Liability Company (12/28/2007)		99.9%

 

7

 

PZENA INVESTMENT MANAGEMENT, INC

(Prior to October 30, 2007, Pzena Investment Management, LLC)

 

UNAUDITED NOTES TO THE FINANCIAL STATEMENTS (CONTINUED)

 

Pursuant to its Operating Agreement, the operating company will continue until December 31, 2026, unless a terminating event, as defined in the Operating Agreement, occurs prior to this date. Operating company members are not liable for repayment, satisfaction or discharge of any debts, liabilities or obligations of the operating company, except to the extent of their capital accounts.

 

Note 2—Significant Accounting Policies

 

Basis of Presentation:

 

The consolidated financial statements are prepared in conformity with U.S. generally accepted accounting principles and related Securities and Exchange Commission rules and regulations.  The Company’s policy is to consolidate all majority-owned subsidiaries in which it has a controlling financial interest and variable interest entities where the Company is deemed to be the primary beneficiary.  The Company also consolidates non-variable-interest entities in which it acts as the general partner or managing member.  All significant inter-company transactions and balances have been eliminated.

 

In addition to the results of its operating company, the consolidated financial statements of the Company include the results of operations and financial condition of the Pzena Large Cap Value Fund, the Pzena Large Cap Value Fund II, the Pzena Emerging Markets Value Service, the Pzena Emerging Markets Country Value Service, the Pzena Emerging Markets Focused Value Service, Pzena Value Partners and the Pzena Mega Cap Value Fund as of, and from, the dates of their formation.  Pursuant to the guidance of Emerging Issues Task Force Issue 04-5, Determining Whether a General Partner, or the General Partners as a Group, Controls a Limited Partnership or Similar Entity When the Limited Partners Have Certain Rights (“EITF 04-5”), the results of operations and financial condition of the Pzena International Value Service and the Pzena Global Value Service were consolidated January 1, 2006, while the Pzena Emerging Markets Value Service was consolidated since December 31, 2007.  Pzena Value Partners was similarly consolidated as of and from the date of its formation.  The Pzena Investment Management Select Fund was consolidated through January 23, 2007, the date of its liquidation.  All of these entities represent private investment partnerships over which the Company exercises or exercised control.  Non-controlling interests recorded on the consolidated financial statements of the Company includes the non-controlling interests of the outside investors in each of these entities as well as that of the operating company.

 

These consolidated investment partnerships are investment companies under the American Institute of Certified Public Accountants Audit and Accounting Guide for Investment Companies (the “AICPA Guide”).  The Company has retained the specialized accounting for these partnerships pursuant to Emerging Issues Task Force Issue No. 85-12, Retention of Specialized Accounting for Investments in Consolidation (“EITF 85-12”).  Thus, the Company reports the investment partnerships’ investments in marketable securities and securities sold short at fair value, with net realized and unrealized gains and losses reported in earnings in the consolidated statements of operations.

 

Non-controlling interests in the operations of the Company’s consolidated subsidiaries are comprised of the following:

 

8

 

PZENA INVESTMENT MANAGEMENT, INC

(Prior to October 30, 2007, Pzena Investment Management, LLC)

 

UNAUDITED NOTES TO THE FINANCIAL STATEMENTS (CONTINUED)

 

		For the Three Months Ended March 31,
		2008			2007
		(in thousands)
Non-Controlling Interest of Pzena Investment Management, LLC		$	13,477		$	—
Non-Controlling Interest in Consolidated Subsidiaries		(1,900		)	(9		)
Non-Controlling Interests		$	11,577		$	(9	)

 

As discussed further in Note 15, the Company has not recorded a non-controlling interest associated with the acquisition of its operating company, as the post offering net equity of the operating company was less than zero.  Pursuant to the guidance in Emerging Issues Task Force Issue No. 95-7, Implementation Issues Related to the Treatment of Minority Interest in Certain Real Estate Trusts (“EITF 95-7”), an operating company non-controlling interest will not be recorded until the initial deficit that existed at acquisition is extinguished.

 

The Company acts as the investment manager for four trusts and one offshore investment company, each of which are considered variable-interest entities.  All of these entities are vehicles through which the Company offers its Global Value and/or International Value strategies.  The Company is not considered the primary beneficiary of any of these entities.  Correspondingly, their results of operations and financial condition are not consolidated by the Company.  The total net assets of these variable-interest entities were approximately $809.6 million and $902.8 million at March 31, 2008 and December 31, 2007, respectively.  The Company is not exposed to losses as a result of its involvement with these entities because it has no direct investment in them.

 

Investments in private investment partnerships in which the Company has a minority interest and exercises significant influence are accounted for using the equity method.  Such investments, if any, are reflected on the consolidated statements of financial condition as investments in affiliates and are recorded at the amount of capital reported by the respective private investment partnerships.  Such capital accounts reflect the contributions paid to, distributions received from, and the equity earnings of, the private investment partnerships.  The earnings of these private investment partnerships are included in equity in earnings/(loss) of affiliates in the consolidated statements of operations.

 

Prior to March 31, 2007, the operating company’s membership units were categorized as either Compensatory Units or Capital Units.  Because both types of units had features of both debt and equity, the operating company accounted for them pursuant to Statement of Financial Accounting Standards No. 123(R), Share-Based Payment (“FAS 123(R)”), and Statement of Financial Accounting Standards No. 150, Accounting for Certain Financial Instruments With Characteristics of Both Liabilities and Equity (“FAS 150”), as described further below.

 

Compensatory Units consisted of units that were granted to employees and members for services rendered.  Through March 31, 2007, the distributions associated with these units, and the subsequent incremental increase or decrease in their redemption value, were accounted for as part of compensation and benefits expense on the consolidated statements of operations, as further discussed below.

 

Capital Units included units issued to founders and those purchased by certain employees. Through March 31, 2007, the distributions associated with these units, and the subsequent incremental increase or decrease in their redemption value, were accounted for as part of interest in mandatorily redeemable units on the consolidated statements of operations.

 

9

 

PZENA INVESTMENT MANAGEMENT, INC

(Prior to October 30, 2007, Pzena Investment Management, LLC)

 

UNAUDITED NOTES TO THE FINANCIAL STATEMENTS (CONTINUED)

 

Effective March 31, 2007, the operating company amended its Operating Agreement to remove all mandatory redemption provisions.  As all of its membership units thereafter had only equity characteristics, neither distributions, nor subsequent incremental changes to their value, were charged against income from the effective date of the amendment.

 

Management’s Use of Estimates:

 

The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses for the period.  Actual results could differ from those estimates.

 

Fair Values of Financial Instruments:

 

The carrying amount of all financial instruments in the consolidated statements of financial condition, including marketable securities, approximates their fair values.

 

Revenue Recognition:

 

Revenue, comprised of advisory fee income, is recognized over the period in which investment management services are provided.  Advisory fee income includes management fees that are calculated based on percentages of assets under management, generally billed quarterly, either in arrears or advance, depending on their contractual terms.  Advisory fee income also includes incentive fees that may be earned by the Company depending on the investment return of the assets under management. Incentive fee arrangements generally entitle the Company to participate, on a fixed-percentage basis, in any returns generated in excess of an agreed-upon benchmark.  The Company’s participation percentage in such return differentials is then multiplied by assets under management to determine the incentive fees earned.  Returns are calculated on an annualized basis over the contract’s measurement period, which may extend up to three years.  Incentive fees are generally payable annually.  Pursuant to the preferred accounting method under Emerging Issues Task Force Issue D-96, Accounting for Management Fees Based on a Formula (“EITF D-96”), such incentive fee income is recorded at the conclusion of the contractual performance period when all contingencies are resolved.  The Company recognized no such incentive fees for the three months ended March 31, 2008 and 2007.

 

Unit-based Compensation:

 

Until March 31, 2007, compensation and benefits expense included the distributions made on Compensatory Units outstanding, as well as the incremental increases or decreases in the redemption values of these units subsequent to their grant date over their vesting period.  Distributions were generally paid on the operating company’s income before non-cash compensation charges.  Redemption values were determined based on fair value.

 

The Operating Agreement was amended as of March 31, 2007 to eliminate the obligation to redeem units under any circumstance.  Since all Compensatory Units thereafter had only equity characteristics, neither distributions, nor subsequent incremental changes to these units’ value, were charged against income subsequent to March 31, 2007.  In addition, as of March 31, 2007, the operating company accelerated the vesting of all Compensatory Units then subject to vesting.  The operating company recorded a $65.0 million one-time charge in compensation and benefits expense which was associated with this acceleration as of March 31, 2007.

 

10

 

PZENA INVESTMENT MANAGEMENT, INC

(Prior to October 30, 2007, Pzena Investment Management, LLC)

 

UNAUDITED NOTES TO THE FINANCIAL STATEMENTS (CONTINUED)

 

Interest on Mandatorily Redeemable Units:

 

Until the amendment of its Operating Agreement on March 31, 2007, the operating company recorded a net liability for its Capital Units equal to the accumulated redemption value as of the balance sheet date of all such outstanding units.  This liability also included any undistributed earnings attributable to such units. As such, interest on mandatorily redeemable units included distributions made on Capital Units outstanding, as well as the incremental increases or decreases in the redemption values of these units.  Distributions are generally paid on the operating company’s income before non-cash compensation charges. Redemption values were determined based on fair value.

 

Prior to March 31, 2007, Capital Units were required to be redeemed on the death of a member. Effective March 31, 2007, the Operating Agreement was amended to eliminate the obligation to redeem units under any circumstance.  Since all Capital Units thereafter had only equity characteristics, neither distributions, nor subsequent incremental changes to these units’ value, were charged against income subsequent to the effective date of the amendment.  The $16.6 million charge recorded in 2007 represents the distributions and incremental changes to these units’ fair value through March 31, 2007.

 

Compensatory Units Subject to Mandatory Redemption:

 

Until the amendment of its Operating Agreement on March 31, 2007, the operating company recorded a net liability for its Compensatory Units equal to the accumulated redemption value as of the balance sheet date of all such outstanding units.  This liability also included any undistributed earnings attributable to such units.

 

Prior to March 31, 2007, vested Compensatory Units were required to be redeemed on the death of a member. Effective March 31, 2007, the operating company amended its Operating Agreement to remove all mandatory redemption provisions.  As of that date, the liability associated with these units was reclassified as equity.  Further, as of March 31, 2007, the operating company accelerated the vesting of all Compensatory Units then subject to vesting.

 

Earnings per Share:

 

Prior to October 30, 2007, reported results of operations are solely those of Pzena Investment Management, LLC.  As the operating company is a private limited liability corporation, no historical earnings per share calculations have been reported prior to this date.  Subsequent to October 30, 2007, earnings per share reflect the per share allocation of the Company’s economic interest in its operating company.

 

Basic earnings per share is computed by dividing the Company’s net income by the weighted-average number of shares outstanding during the reporting period.  Diluted net income per share adjusts this calculation to reflect the impact of all outstanding operating company membership units as well as outstanding options and phantom operating units to the extent that they would have a dilutive effect on net income per share for the reporting period.  Net income for diluted earnings per share assumes all operating company membership units are converted into Company stock at the beginning of the reporting period and the resulting change to Company net income associated with its increased interest in the operating company is taxed at the Company’s effective tax rate.  For the three months ended March 31, 2008, approximately 954,310 options to purchase operating company units freely convertible into Company common stock and 89,826 phantom operating units were excluded from the calculation of diluted net income per share, as their inclusion would have had an antidilutive effect for the period.

 

11

 

PZENA INVESTMENT MANAGEMENT, INC

(Prior to October 30, 2007, Pzena Investment Management, LLC)

 

UNAUDITED NOTES TO THE FINANCIAL STATEMENTS (CONTINUED)

 

The Company’s  basic and diluted earnings per share, generated from its economic interest in the operating company, were determined as follows (in thousands, except for share and per-share amounts):

 

Net Income for Basic Earnings per Share		$	820
Basic Weighted Average Shares Outstanding		6,119,686
Basic Earnings per Share		$	0.13
Net Income for Diluted Earnings per Share		$	8,597
Basic Weighted Average Shares Outstanding		6,119,686
Dilutive Effect of Operating Company Units		57,950,910
Diluted Weighted Average Shares Outstanding		64,070,596
Diluted Earnings per Share		$	0.13

 

Cash and Cash Equivalents:

 

The Company considers all highly-liquid debt instruments with an original maturity of three months or less at the time of purchase to be cash equivalents.

 

Interest on cash and cash equivalents is recorded as interest income on the consolidated statements of operations.

 

Due to/from Broker:

 

Due to/from broker consists primarily of cash balances and amounts receivable/payable for unsettled securities transactions held/initiated at the clearing brokers of the Company’s consolidated investment partnerships.

 

Investments in Securities:

 

Investments in marketable securities and securities sold short represent primarily the securities held by the Company’s consolidated investment partnerships.  All such securities are recorded at fair value, with net realized and unrealized gains and losses reported in earnings in the consolidated statements of operations.

 

The Company adopted the provisions of Statement of Financial Accounting Standard No. 157, Fair Value Measurements (“FAS 157”), on January 1, 2008.  FAS 157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.  FAS 157 also establishes a framework for measuring fair value and a valuation hierarchy based upon the transparency of inputs used in the valuation of an asset or liability.  Classification within the hierarchy is based upon the lowest level of input that is significant to the fair value measurement. The valuation hierarchy contains three levels: (i) valuation inputs are unadjusted quoted market prices for identical assets or liabilities in active markets (Level 1); (ii) valuation inputs are quoted prices for identical assets or liabilities in markets that are not active, quoted market prices for similar assets and liabilities in active markets and other observable inputs directly or indirectly related to the asset or liability being measured (Level 2) and; (iii) valuation inputs are unobservable and significant to the fair value measurement (Level 3).

 

The Company’s fair value measurements relate to its interest rate swap as well as its investments in marketable securities and securities sold short, which are primarily exchange-traded securities with quoted prices in active markets. The fair value measurements of the securities have been classified as Level 1. The fair value measurement of the interest rate swap has been determined primarily based upon the market prices for interest rate swaps with similar provisions and forward interest rate curves, and has been classified as Level 2.

 

12

 

PZENA INVESTMENT MANAGEMENT, INC

(Prior to October 30, 2007, Pzena Investment Management, LLC)

 

UNAUDITED NOTES TO THE FINANCIAL STATEMENTS (CONTINUED)

 

The following table presents these instruments’ fair value at March 31, 2008 (in thousands):

 

		Level 1			Level 2			Level 3
Marketable Securities		$	36,545		$	—		$	—
Securities Sold Short		(3,518		)	—			—
Interest Rate Swap		—			(477		)	—
Total Fair Value		$	33,027		$	(477	)	$	—

 

Securities Valuation:

 

Investments in marketable equity securities and securities sold short which are traded on a national securities exchange are carried at fair value based on the last reported sales price on the valuation date.  If no reported sales occurred on the valuation date, investments in securities are valued at the bid price and securities sold short are valued at the ask price. Securities transactions are recorded on the trade date.

 

The net realized gain or loss on sales of securities and securities sold short is determined on a specific identification basis and is included in realized and unrealized gain/(loss), net on marketable securities and securities sold short in the consolidated statements of operations.

 

Concentrations of Credit Risk:

 

Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of cash and cash equivalents, amounts due from brokers and advisory fees receivable.  The Company maintains its cash, temporary cash and restricted cash investments in bank deposits and other accounts whose balances, at times, exceed federally insured limits.

 

The concentration of credit risk with respect to advisory fees receivable is generally limited due to the short payment terms extended to clients by the Company.  On a periodic basis, the Company evaluates its advisory fees receivable and establishes an allowance for doubtful accounts, if necessary, based on a history of past write-offs and collections and current credit conditions.  For the three months  ended March 31, 2008 and 2007, approximately 16% and 22%, respectively, of the Company’s advisory fees were generated from an advisory agreement with one client.  At March 31, 2008 and December 31, 2007, no allowance for doubtful accounts has been deemed necessary.

 

Financial Instruments:

 

The operating company has entered into an interest rate swap agreement to manage its exposure to changes in interest rates associated with its three-year, $60.0 million term loan facility.  This instrument was not entered into for trading purposes.  The counterparty to this agreement is a major financial institution.    Pursuant to Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Certain Hedging Activities (“FAS 133”), the Company records this cash flow hedge at fair value as a component of other liabilities on the consolidated statement of financial position.  The Company’s pro rata share of the changes in the fair value of this agreement are recorded as a component of accumulated other comprehensive income.  At March 31, 2008, the approximate fair value of this swap agreement was negative $0.5 million.

 

Property and Equipment:

 

Property and equipment is carried at cost, less accumulated depreciation and amortization. Depreciation is provided on a straight-line basis over the estimated useful lives of the respective assets, which range from three to seven years.  Leasehold improvements are amortized on a straight-line basis over the shorter of the useful life of the improvements or the remaining lease term.

 

13

 

PZENA INVESTMENT MANAGEMENT, INC

(Prior to October 30, 2007, Pzena Investment Management, LLC)

 

UNAUDITED NOTES TO THE FINANCIAL STATEMENTS (CONTINUED)

 

Business Segments:

 

The Company views its operations as comprising one operating segment.

 

Income Taxes:

 

The Company is a “C” corporation under the Internal Revenue Code, and thus liable for federal, state and local taxes on the income derived from its economic interest in its operating company.  The operating company is a limited liability company that has elected to be treated as a partnership for tax purposes.  It has not made provision for federal or state income taxes because it is the personal responsibility of each of the operating company’s members (including the Company) to separately report their proportionate share of the operating company’s taxable income or loss.  Similarly, the income of the Company’s consolidated investment partnerships is not subject to income taxes, as it is allocated to each partnership’s individual partners.  The operating company has made a provision for New York City Unincorporated Business Tax, or New York City UBT.

 

The Company and its consolidated subsidiaries account for all state, local and federal taxation pursuant to the asset and liability method, which requires deferred income tax assets and liabilities to be recorded for temporary differences between the financial statement and tax bases of assets and liabilities that will result in taxable or deductible amounts in the future, based on enacted tax laws and rates applicable to the periods in which the temporary differences are expected to affect taxable income. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized. At March 31, 2008 and December 31, 2007, no such valuation allowances were deemed necessary.  The income tax provision, or credit, is the tax payable or refundable for the period, plus or minus the change during the period in deferred tax assets and liabilities.

 

Foreign Currency:

 

Investment securities and other assets and liabilities denominated in foreign currencies are translated into U.S. dollar amounts at the date of valuation.  Purchases and sales of investment securities and income and expense items denominated in foreign currencies are translated into U.S. dollar amounts on the respective dates of such transactions.

 

The Company does not isolate that portion of the results of its operations resulting from changes in foreign exchange rates on investments from the fluctuations arising from changes in market prices of securities held.  Such fluctuations are included in the net realized and unrealized gain/(loss), net on marketable securities and securities sold short.

 

Reported net realized foreign exchange gains or losses arise from sales of foreign currencies, currency gains or losses realized between the trade and settlement dates on securities transactions, and the difference between the amounts of dividends, interest, and foreign withholding taxes recorded on the Company’s books and the U.S. dollar equivalent of the amounts actually received or paid.  Net unrealized foreign exchange gains and losses arise from changes in the fair values of assets and liabilities resulting from changes in exchange rates.

 

New Accounting Pronouncements:

 

In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (“FAS 159”).  FAS 159 permits an entity to elect to measure certain financial instruments and certain other items at fair value with changes in fair value recognized in earnings.  FAS 159 is effective for fiscal years beginning after November 15, 2007.  Since the Company chose not to elect this fair value option, the impact of the adoption of this statement was not material.

 

14

 

PZENA INVESTMENT MANAGEMENT, INC

(Prior to October 30, 2007, Pzena Investment Management, LLC)

 

UNAUDITED NOTES TO THE FINANCIAL STATEMENTS (CONTINUED)

 

In December 2007, the FASB issued Statement of Financial Accounting Standards No. 141 (revised 2007), Business Combinations (“FAS 141R”) which replaces Statement of Financial Accounting Standards No. 141, Business Combinations. FAS 141R establishes the principles and requirements for how an acquirer: (i) recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree; (ii) recognizes and measures the goodwill acquired in the business combination or a gain from a bargain purchase; and (iii) discloses the business combination.  FAS 141R applies to all transactions in which an entity obtains control of one or more businesses, including transactions that occur without the transfer of any type of consideration. FAS 141R is effective on a prospective basis for all business combinations on or after December 15, 2008, with the exception of the accounting for valuation allowances on deferred taxes and acquired tax contingencies.  Early adoption is not allowed.  The Company is in the process of assessing the impact of this standard on its consolidated financial statements.

 

In December 2007, the FASB issued Statement of Financial Accounting Standards No. 160, Noncontrolling Interests in Consolidated Financial Statements—an amendment of ARB No. 51 (“FAS 160”). FAS 160 amends ARB No. 51 and establishes accounting and reporting standards that require noncontrolling interests (previously referred to as minority interest) to be reported as a component of equity, changes in a parent’s ownership interest while the parent retains its controlling interest be accounted for as equity transactions, and upon a loss of control, retained ownership interest will be remeasured at fair value, with any gain or loss recognized in earnings. FAS 160 is effective for the Company on January 1, 2009, except for the presentation and disclosure requirements, which will be applied retrospectively.  Early adoption is not allowed.  The Company is in the process of assessing the impact of this standard on its consolidated financial statements.

 

In March 2008, the FASB issued Statement of Financial Accounting Standards No. 161, Disclosures about Derivative Instruments and Hedging Activities (“FAS 161”). FAS 161 is intended to improve financial reporting about derivative instruments and hedging activities by requiring enhanced disclosures to enable investors to better understand their effects on an entity’s financial position, financial performance, and cash flows.  It is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008.  The Company is in the process of assessing the impact of this standard on its consolidated financial statements.

 

Note 3—Property and Equipment

 

Property and equipment, net, is comprised of the following:

 

15

 

PZENA INVESTMENT MANAGEMENT, INC

(Prior to October 30, 2007, Pzena Investment Management, LLC)

 

UNAUDITED NOTES TO THE FINANCIAL STATEMENTS (CONTINUED)

 

		As of
		March 31,			December 31,
		2008			2007
		(in thousands)
Computer Hardware		$	836		$	796
Computer Software		156			152
Furniture and Fixtures		1,162			1,156
Office Equipment		243			243
Leasehold Improvements		2,228			2,228
Total		4,625			4,575
Less: Accumulated Depreciation and Amortization		(1,527		)	(1,412		)
Total		$	3,098		$	3,163

 

Depreciation and amortization expense, included in general and administrative expenses, totaled $0.1 million and $0.1 million for the three months ended March 31, 2008 and 2007, respectively.

 

Note 4—Related Party Transactions

 

For the three months ended March 31, 2008 and 2007, the Company earned $1.8 million and $1.5 million, respectively, in investment advisory fees from unconsolidated entities for which it acts as the investment manager.

 

At March 31, 2008 and December 31, 2007, the Company had advanced $0.1 million and $0.1 million, respectively, to an international investment company for organization and start-up costs, which are included in receivable from related parties on the consolidated statements of financial condition.  The Company is the sponsor and investment manager of this entity.

 

At March 31, 2008 and December 31, 2007, receivable from related parties included $0.1 million and $0.1 million, respectively, of loans to employees.  These loans are in the form of forgivable promissory notes which are amortized through compensation expense pursuant to their terms.

 

Employees of the Company who are considered accredited investors have the ability to open separately-managed accounts, or invest in certain of the Company’s consolidated investment partnerships, without being assessed advisory fees.  Investments by employees in separately-managed accounts are permitted only at the discretion of the Executive Committee of the Company, but are generally not subject to the same minimum investment levels that are required of outside investors.  Some of the investment advisory fees that are waived on separately managed accounts for employees are for strategies that typically have account fee minimums, which vary by strategy, but typically average approximately $50,000 per account per year.

 

Note 5—Investments in Affiliates

 

The Company held an investment in, and acted as manager of, an unconsolidated investment partnership which was accounted for under the equity method.  Summary financial information related to this entity is as follows:

 

16

 

PZENA INVESTMENT MANAGEMENT, INC

(Prior to October 30, 2007, Pzena Investment Management, LLC)

 

UNAUDITED NOTES TO THE FINANCIAL STATEMENTS (CONTINUED)

 

		PAI Hedged Value Fund, LLC
		For the Three Months Ended March 31,
		2008			2007
		(in thousands)
Net Investment Income		$	—		$	5
Net Realized and Unrealized Loss		—			(145		)
Net Loss		$	—		$	(140	)
Company’s Equity in Loss		$	—		$	(42	)
Ownership Percentage		0		%	29		%

 

 In the fourth quarter of 2007, the decision was made to dissolve the PAI Hedged Value Fund, LLC. This entity was consolidated beginning October 1, 2007, the effective date of the withdrawal of the external joint venture partner, until it was fully liquidated on December 28, 2007.

 

Note 6—Commitments and Contingencies

 

In the normal course of business, the Company enters into agreements that include indemnities in favor of third parties, such as engagement letters with advisors and consultants.  In certain cases, the Company may have recourse against third parties with respect to these indemnities.  The Company maintains insurance policies that may provide coverage against certain claims under these indemnities. FASB issued Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others (“FIN 45”), providing accounting and disclosure requirements for certain guarantees.  The Company has had no claims or payments pursuant to these agreements, and it believes the likelihood of a claim being made is remote.  Utilizing the methodology in FIN 45, the Company’s estimate of the value of such guarantees is de minimis, and, therefore, an accrual has not been made in the consolidated financial statements.

 

In the normal course of business, the Company may be subject to various legal and administrative proceedings. On November 21, 2007 and January 16, 2008, respectively, substantively identical putative class action lawsuits were commenced in the United States District Court for the Southern District of New York against the Company and Richard S. Pzena, our chief executive officer, seeking remedies under Section 11 of the Securities Act of 1933, as amended. The Court consolidated the lawsuits and appointed co-lead plaintiffs, who filed a consolidated amended complaint.  The consolidated amended complaint names as defendants the Company, Richard S. Pzena, and two of the underwriters of our initial public offering, Goldman Sachs & Co., Inc. and UBS Securities LLC.  Plaintiffs seek to represent a class of all persons who purchased or otherwise acquired Class A common stock issued pursuant or traceable to the Company’s initial public offering.  The consolidated amended complaint alleges that the registration statement and prospectus relating to the initial public offering of the Company’s Class A common stock contained material misstatements and omissions and wrongfully failed to disclose net redemptions in the John Hancock Classic Value Fund for which the Company acts as sub-investment advisor.  The consolidated amended complaint seeks damages in an unspecified amount including rescission or rescissory damages.  The Company believes that the allegations and claims are without merit and intends to contest these claims vigorously.

 

17