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Section 1: 10-Q (10-Q)

Document
Table of Contents

 
UNITED STATES
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 September 30, 2017
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)
Delaware
 
20-8999751
(State or Other Jurisdiction of
 
(I.R.S. Employer
Incorporation or Organization)
 
Identification No.)
320 Park Avenue
New York, New York 10022
(Address of Principal Executive Offices) (Zip Code)
Registrant’s telephone number, including area code: (212) 355-1600

Not Applicable
(Former Address of Principal Executive Offices) (Zip Code)

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 has submitted electronically and posted on its corporate web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). 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 the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and "emerging growth company" in Rule 12b-2 of the Exchange Act.
Large accelerated filer o
Accelerated filer x
Non-accelerated filer o
 
 
(Do not check if a smaller reporting company)
Smaller reporting company o
Emerging growth company o
 
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. Yes o No o
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 November 2, 2017, there were 17,302,029 outstanding shares of the registrant’s Class A common stock, par value $0.01 per share.
As of November 2, 2017, there were 51,237,519 outstanding shares of the registrant’s Class B common stock, par value $0.000001 per share.
 


Table of Contents

PZENA INVESTMENT MANAGEMENT, INC.
FORM 10-Q
TABLE OF CONTENTS

 
 
 
Page
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

i

Table of Contents

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 our views, plans, estimates, and expectations. Potentially inaccurate assumptions 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, 2016.  Accordingly, you should not unduly rely on these forward-looking statements, which speak only as of the date they are made.  We undertake no obligation to publicly revise any forward-looking statements included in this Quarterly Report to reflect circumstances or events after the date of this Quarterly Report, 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 Securities and Exchange Commission ("SEC"), after the date of this Quarterly Report on Form 10-Q.

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

our ability to respond to global economic, market, business and geopolitical conditions;
our anticipated future results of operations and operating cash flows;
our successful formulation and execution of business strategies and investment policies;
our financing plans and the availability of short- or long-term borrowing, or equity financing;
our competitive position and the effects of competition on our business;
our ability to identify and capture potential growth opportunities available to us;
the effective recruitment and retention of our key executives and 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 expectations with respect to the economy, capital markets, the market for asset management services, and other industry trends; 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.

 

ii

Table of Contents

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
 
September 30, 2017
 
December 31, 2016
 
(unaudited)
 
 
ASSETS
 
 
 
Cash and Cash Equivalents ($3,399 and $3,258)1
$
47,910

 
$
43,522

Restricted Cash
4,590

 
3,636

Due from Broker ($128 and $0)1
128

 
842

Advisory Fees Receivable
31,906

 
26,326

Investments in Marketable Securities, at Fair Value ($5,456 and $3,174)1
20,254

 
14,323

Equity Method Investments
7,955

 
7,987

Receivable from Related Parties
1,470

 
1,008

Other Receivables ($17 and $9)1
116

 
302

Prepaid Expenses and Other Assets
709

 
769

Deferred Tax Asset
70,417

 
73,441

Property and Equipment, Net of Accumulated Depreciation of $2,796 and $2,260, respectively
6,424

 
6,965

TOTAL ASSETS
$
191,879

 
$
179,121

LIABILITIES AND EQUITY
 

 
 

Liabilities:
 

 
 

Accounts Payable and Accrued Expenses ($12 and $18)1
$
24,822

 
$
24,648

Due to Broker ($570 and $3)1
571

 
17

Securities Sold Short, at Fair Value
3,586

 
2,622

Liability to Selling and Converting Shareholders
65,485

 
65,485

Deferred Compensation Liability
3,145

 
4,157

Other Liabilities
704

 
858

TOTAL LIABILITIES
98,313

 
97,787

Commitments and Contingencies (see Note 12)


 


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; 17,285,307 and 17,340,090 Shares Issued and Outstanding in 2017 and 2016, respectively)
172

 
173

Class B Common Stock (Par Value $0.000001; 750,000,000 Shares Authorized; 51,131,080 and 50,461,598 Shares Issued and Outstanding in 2017 and 2016, respectively)

 

Additional Paid-In Capital
7,056

 
5,996

Retained Earnings
25,778

 
22,349

Accumulated Other Comprehensive Loss
1

 
(25
)
Total Pzena Investment Management, Inc.'s Equity
33,007

 
28,493

Non-Controlling Interests
60,559

 
52,841

TOTAL EQUITY
93,566

 
81,334

TOTAL LIABILITIES AND EQUITY
$
191,879

 
$
179,121


1
Asset and liability amounts in parentheses represent the aggregated balances at September 30, 2017 and December 31, 2016 attributable to Pzena International Value Service (a series of Pzena Investment Management International, LLC) and Pzena Investment Management Special Situations, LLC, which were variable interest entities as of September 30, 2017 and December 31, 2016, respectively.









See accompanying notes to unaudited consolidated financial statements.

1

Table of Contents

PZENA INVESTMENT MANAGEMENT, INC.
UNAUDITED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except share and per-share amounts)

 
For the Three Months Ended September 30,
 
For the Nine Months Ended September 30,
 
2017
 
2016
 
2017
 
2016
REVENUE
$
36,229

 
$
26,990

 
$
102,386

 
$
79,263

EXPENSES
 
 
 
 
 
 
 
Compensation and Benefits Expense
14,763

 
11,767

 
44,681

 
35,964

General and Administrative Expense
3,062

 
3,271

 
9,585

 
9,790

Total Operating Expenses
17,825

 
15,038

 
54,266

 
45,754

Operating Income
18,404

 
11,952

 
48,120

 
33,509

OTHER INCOME
 
 
 
 
 

 
 

Interest Income
76

 
12

 
106

 
69

Dividend Income
117

 
84

 
318

 
258

Net Realized and Unrealized Gains from Investments
626

 
880

 
1,719

 
493

Equity in Earnings of Affiliates
428

 
653

 
1,083

 
638

Change in Liability to Selling and Converting Shareholders

 
(1,200
)
 

 
(1,378
)
Other Income
59

 
11

 
178

 
(15
)
Total Other Income
1,306

 
440

 
3,404

 
65

Income Before Income Taxes
19,710

 
12,392

 
51,524

 
33,574

Income Tax Expense
2,493

 
471

 
6,460

 
2,938

Net Income
17,217

 
11,921

 
45,064

 
30,636

Less: Net Income Attributable to Non-Controlling Interests
14,228

 
9,756

 
37,110

 
25,443

Net Income Attributable to Pzena Investment Management, Inc.
$
2,989

 
$
2,165

 
$
7,954

 
$
5,193

 
 
 
 
 
 
 
 
Net Income for Basic Earnings per Share
$
2,989

 
$
2,165

 
$
7,954

 
$
5,193

Basic Earnings per Share
$
0.17

 
$
0.13

 
$
0.46

 
$
0.33

Basic Weighted Average Shares Outstanding1
17,285,307

 
16,390,298

 
17,319,948

 
15,807,340

 
 
 
 
 
 
 
 
Net Income for Diluted Earnings per Share
$
11,862

 
$
8,192

 
$
31,077

 
$
21,167

Diluted Earnings per Share
$
0.17

 
$
0.12

 
$
0.44

 
$
0.31

Diluted Weighted Average Shares Outstanding1
70,763,213

 
68,656,042

 
70,845,892

 
68,609,667

 
 
 
 
 
 
 
 
Cash Dividends per Share of Class A Common Stock
$
0.03

 
$
0.03

 
$
0.34

 
$
0.38

1 
The Company issues restricted shares of Class A common stock and restricted Class B units that have non-forfeitable dividend rights. Under the "two-class method," these shares and units are considered participating securities and are required to be included in the computation of basic and diluted earnings per share. 


See accompanying notes to unaudited consolidated financial statements.


2

Table of Contents

PZENA INVESTMENT MANAGEMENT, INC.
UNAUDITED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(in thousands)



 
For the Three Months Ended September 30,
 
For the Nine Months Ended September 30,
 
2017
 
2016
 
2017
 
2016
NET INCOME
$
17,217

 
$
11,921

 
$
45,064

 
$
30,636

OTHER COMPREHENSIVE GAIN/ (LOSS)
 
 
 
 
 
 
 
Foreign Currency Translation Adjustment
48

 
(16
)
 
104

 
(57
)
Total Other Comprehensive Gain/ (Loss)
48

 
(16
)
 
104

 
(57
)
Comprehensive Income
17,265

 
11,905

 
45,168

 
30,579

Less: Comprehensive Income Attributable to Non-Controlling Interests
14,264

 
9,744

 
37,188

 
25,400

Total Comprehensive Income Attributable to Pzena Investment Management, Inc.
$
3,001

 
$
2,161

 
$
7,980

 
$
5,179

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 































See accompanying notes to unaudited consolidated financial statements.

3

Table of Contents

PZENA INVESTMENT MANAGEMENT, INC.
UNAUDITED CONSOLIDATED STATEMENT OF CHANGES IN EQUITY
(in thousands, except share and per-share amounts)  
 
Shares of
Class A
Common Stock
 
Shares of
Class B
Common Stock
 
Class A
Common Stock
 
Additional
Paid-In Capital
 
Accumulated Other Comprehensive Loss
 
Retained
Earnings
 
   Non-Controlling
Interests
 
Total Equity
Balance at December 31, 2016
17,340,090

 
50,461,598

 
$
173

 
$
5,996

 
$
(25
)
 
$
22,349

 
$
52,841

 
$
81,334

Adjustment for the Cumulative Effect of Applying ASU 2016-09

 

 

 

 

 
1,377

 

 
1,377

Adjusted Balance at January 1, 2017
17,340,090

 
50,461,598

 
173

 
5,996

 
(25
)
 
23,726

 
52,841

 
82,711

Amortization of Non-Cash Compensation
24,934

 
22,410

 

 
801

 

 

 
2,340

 
3,141

Issuance of Shares under Equity Incentive Plan

 
620,543

 

 
1,118

 

 

 
3,295

 
4,413

Sale of Shares under Equity Incentive Plan

 
29,426

 

 
47

 

 

 
140

 
187

Directors' Share Grants

 

 

 
96

 

 

 
286

 
382

Net Income

 

 

 

 

 
7,954

 
37,110

 
45,064

Foreign Currency Translation Adjustments

 

 

 

 
26

 

 
78

 
104

Repurchase and Retirement of Class A Common Stock
(79,717
)
 

 
(1
)
 
(707
)
 

 

 

 
(708
)
Repurchase and Retirement of Class B Units

 
(2,897
)
 

 
(10
)
 

 

 
(29
)
 
(39
)
Class A Cash Dividends Declared and Paid ($0.34 per share)

 

 

 

 

 
(5,902
)
 

 
(5,902
)
Contributions from Non-Controlling Interests

 

 

 

 

 

 
4,054

 
4,054

Distributions to Non-Controlling Interests

 

 

 

 

 

 
(39,841
)
 
(39,841
)
Other

 

 

 
(285
)
 

 

 
285

 

Balance at September 30, 2017
17,285,307

 
51,131,080

 
$
172

 
$
7,056

 
$
1

 
$
25,778

 
$
60,559

 
$
93,566

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Shares of
Class A
Common Stock
 
Shares of
Class B
Common Stock
 
Class A
Common Stock
 
Additional
Paid-In Capital
 
Accumulated Other Comprehensive Loss
 
Retained
Earnings
 
   Non-Controlling
Interests
 
Total Equity
Balance at December 31, 2015
15,218,355

 
52,089,472

 
$
152

 
$
5,819

 
$
(2
)
 
$
12,453

 
$
67,040

 
$
85,462

Adjustment for the Cumulative Effect of Applying ASU 2015-02

 

 

 

 

 

 
(10,835
)
 
(10,835
)
Adjusted Balance at January 1, 2016
15,218,355

 
52,089,472

 
152

 
5,819

 
(2
)
 
12,453

 
56,205

 
74,627

Unit Conversion
1,369,811

 
(1,369,811
)
 
14

 
1,243

 

 

 
(1,071
)
 
186

Amortization of Non-Cash Compensation
24,934

 
22,723

 

 
518

 

 

 
1,551

 
2,069

Sale of Shares under Equity Incentive Plan

 
81,871

 

 
91

 

 

 
286

 
377

Directors' Shares

 

 

 
87

 

 

 
289

 
376

Net Income

 

 

 

 

 
5,193

 
25,443

 
30,636

Foreign Currency Translation Adjustments

 

 

 

 
(14
)
 

 
(43
)
 
(57
)
Option Exercise

 
24,027

 

 
12

 

 

 
39

 
51

Repurchase and Retirement of Class A Common Stock
(258,279
)
 

 
(2
)
 
(2,005
)
 

 

 

 
(2,007
)
Repurchase and Retirement of Class B Units

 
(8,574
)
 

 
(16
)
 

 

 
(50
)
 
(66
)
Class A Cash Dividends Declared and Paid ($0.38 per share)

 

 

 

 

 
(5,794
)
 

 
(5,794
)
Contributions from Non-Controlling Interests

 

 

 

 

 

 
584

 
584

Distributions to Non-Controlling Interests

 

 

 

 

 

 
(39,695
)
 
(39,695
)
Effect of Deconsolidation

 

 

 

 

 

 
(80
)
 
(80
)
Other

 

 

 
(281
)
 

 

 
281

 

Balance at September 30, 2016
16,354,821

 
50,839,708

 
$
164

 
$
5,468

 
$
(16
)
 
$
11,852

 
$
43,739

 
$
61,207

See accompanying notes to unaudited consolidated financial statements.

4

Table of Contents


PZENA INVESTMENT MANAGEMENT, INC.
UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
 
For the Three Months Ended September 30,
 
For the Nine Months Ended September 30,
 
2017
 
2016
 
2017
 
2016
OPERATING ACTIVITIES
 
 
 
 
 
 
 
Net Income
$
17,217

 
$
11,921

 
$
45,064

 
$
30,636

Adjustments to Reconcile Net Income to Cash
 
 
 
 
 
 
 
Provided by Operating Activities:
 
 
 
 
 
 
 
Depreciation
256

 
263

 
757

 
802

Loss on Disposal of Fixed Assets

 

 
6

 

Non-Cash Compensation
2,937

 
1,765

 
7,868

 
4,947

Directors' Share Grants
100

 
99

 
382

 
376

Net Realized and Unrealized (Gains)/ Losses from Investments
(626
)
 
(880
)
 
(1,719
)
 
(493
)
Equity in (Earnings)/ Losses of Affiliates
(428
)
 
(653
)
 
(1,083
)
 
(638
)
Foreign Currency Translation Adjustments
48

 
(16
)
 
104

 
(57
)
Change in Liability to Selling and Converting Shareholders

 
1,200

 

 
1,378

Deferred Income Taxes
1,744

 
(282
)
 
4,400

 
1,215

Changes in Operating Assets and Liabilities:


 


 


 


Advisory Fees Receivable
(2,182
)
 
(4,067
)
 
(5,580
)
 
(3,336
)
Due from Broker
692

 
294

 
749

 
(41
)
Restricted Cash
(292
)
 
(41
)
 
(954
)
 
45

Prepaid Expenses and Other Assets
164

 
219

 
246

 
(3
)
Due to Broker
(37
)
 
(91
)
 
554

 
254

Accounts Payable, Accrued Expenses, and Other Liabilities
4,678

 
5,066

 
(1,308
)
 
9,433

Purchases of Equity Securities and Securities Sold Short
(8,265
)
 
(6,857
)
 
(33,456
)
 
(20,218
)
Proceeds from Equity Securities and Securities Sold Short
7,777

 
6,911

 
30,858

 
18,082

Net Cash Provided by Operating Activities
23,783

 
14,851

 
46,888

 
42,382

INVESTING ACTIVITIES
 
 
 
 
 
 
 
Purchases of Investments
(129
)
 
(225
)
 
(614
)
 
(2,097
)
Proceeds from Sale of Investments
718

 
220

 
1,047

 
2,383

Payments from/ (to) Related Parties
15

 
217

 
(462
)
 
(76
)
Purchases of Property and Equipment
(177
)
 

 
(222
)
 
(95
)
Net Cash Provided by/ (Used in) Investing Activities
427

 
212

 
(251
)
 
115

FINANCING ACTIVITIES
 
 
 
 
 
 
 
Repurchase and Retirement of Class A Common Stock

 
(501
)
 
(708
)
 
(2,007
)
Repurchase and Retirement of Class B Units

 

 
(39
)
 
(66
)
Sale of Shares under Equity Incentive Plan
107

 
55

 
187

 
377

Option Exercise

 
51

 

 
51

Distributions to Non-Controlling Interests
(11,052
)
 
(7,993
)
 
(39,841
)
 
(39,695
)
Contributions from Non-Controlling Interests
415

 
115

 
4,054

 
584

Dividends
(519
)
 
(491
)
 
(5,902
)
 
(5,794
)
Net Cash Used in Financing Activities
(11,049
)
 
(8,764
)
 
(42,249
)
 
(46,550
)
NET CHANGE IN CASH
$
13,161

 
$
6,299

 
$
4,388

 
$
(4,053
)
CASH AND CASH EQUIVALENTS - Beginning of Period
$
34,749

 
$
24,838

 
$
43,522

 
$
35,417

Adjustment for the Cumulative Effect of Applying ASU 2015-02


 

 

 
(227
)
Effect of Deconsolidation

 
(75
)
 

 
(75
)
Net Change in Cash
13,161

 
6,299

 
4,388

 
(4,053
)
CASH AND CASH EQUIVALENTS - End of Period
$
47,910

 
$
31,062

 
$
47,910

 
$
31,062

Supplementary Cash Flow Information:
 
 
 
 
 
 
 
Issuances of Shares under Equity Incentive Plan
$

 
$

 
$
4,413

 
$

Income Taxes Paid
$
253

 
$
295

 
$
797

 
$
665


See accompanying notes to unaudited consolidated financial statements.

5

Table of Contents
Pzena Investment Management, Inc.
Notes to Unaudited Consolidated Financial Statements


Note 1—Organization
 
Pzena Investment Management, Inc. (the “Company”) is the sole managing member of its operating company, Pzena Investment Management, LLC (the “operating company”).  As a result, the Company: (i) consolidates the financial results of the operating company and reflects the membership interests in the operating company that it does not own as a non-controlling interest in its consolidated financial statements; and (ii) recognizes income generated from its economic interest in the operating company’s net income.
 
The operating company is an investment adviser registered under the Investment Advisers Act of 1940 and is headquartered in New York, New York. As of September 30, 2017, the operating company managed assets in a variety of value-oriented investment strategies across a wide range of market capitalizations in both U.S. and non-U.S. capital markets.

The Company also serves as the general partner of Pzena Investment Management, LP, a partnership formed with the objective of aggregating employee ownership in the operating company into one entity.
 
The Company, through its interest in the operating company, has consolidated the results of operations and financial condition of the following entities as of September 30, 2017
 
 
 
 Ownership at
Legal Entity
Type of Entity (Date of Formation)
 
September 30, 2017
Pzena Investment Management, Pty
Australian Proprietary Limited Company (12/16/2009)
 
100.0%
Pzena Financial Services, LLC
Delaware Limited Liability Company (10/15/2013)
 
100.0%
Pzena Investment Management, LTD
England and Wales Private Limited Company (01/08/2015)
 
100.0%
Pzena Investment Management Special Situations, LLC
Delaware Limited Liability Company (12/01/2010)
 
99.9%
Pzena International Value Service, a series of Pzena Investment Management International, LLC
Delaware Limited Liability Company (12/22/2003)
 
67.2%
Pzena Long/Short Value Fund, a series of Advisors Series Trust
Open-end Management Investment Company, series of Delaware Statutory Trust (3/31/2014)
 
62.5%
Pzena Mid Cap Value Fund, a series of Advisors Series Trust
Open-end Management Investment Company, series of Delaware Statutory Trust (3/31/2014)
 
55.8%
 
Note 2—Significant Accounting Policies
 
Basis of Presentation:
 
Principles of Consolidation:

The consolidated financial statements are prepared in conformity with accounting principles generally accepted in the United States of America (“U.S. GAAP”) and related Securities and Exchange Commission (“SEC”) rules and regulations.  The Company’s policy is to consolidate those entities in which it has a direct or indirect controlling financial interest based on either the voting interest model or the variable interest model. As such, the Company consolidates majority-owned subsidiaries in which it has a controlling financial interest, and certain investment vehicles the operating company sponsors for which it is the investment adviser that are considered to be variable-interest entities (“VIEs”), and for which the Company is deemed to be the primary beneficiary.

Pursuant to the Consolidation Topic of the FASB Accounting Standards Codification (“FASB ASC”), for legal entities evaluated for consolidation, the Company determines whether interests it holds and fees paid to the entity qualify as a variable interest. If it is determined that the Company does not have a variable interest in the entity, no further analysis is required and the Company does not consolidate the entity. If it is determined that the Company has a variable interest, it considers its direct economic interests and the proportionate indirect interests through related parties to determine if it is the primary beneficiary of the VIE.


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Table of Contents
Pzena Investment Management, Inc.
Notes to Unaudited Consolidated Financial Statements (Continued)


For equity investments where the Company does not control the investee, and where it is not the primary beneficiary of a VIE, but can exert significant influence over the financial and operating policies of the investee, the Company follows the equity method of accounting. The evaluation of whether the Company exerts control or significant influence over the financial and operating policies of the investee requires significant judgment based on the facts and circumstances surrounding each investment. Factors considered in these evaluations may include the type of investment, the legal structure of the investee, the terms of the investment agreement, or other agreements with the investee.

The Company analyzes entities structured as series funds which comply with the requirements included in the Investment Company Act of 1940 for registered mutual funds as voting interest entities because the shareholders are deemed to have the ability to direct the activities of the fund that most significantly impact the fund's economic performance.

Consolidated Entities

The Company consolidates the financial results of the operating company and records in its own equity its pro-rata share of transactions that impact the operating company’s net equity, including unit and option issuances, repurchases, and retirements.  The operating company’s pro-rata share of such transactions are recorded as an adjustment to additional paid-in capital or non-controlling interests, as applicable, on the consolidated statements of financial condition.

The majority-owned subsidiaries in which the Company, through its interest in the operating company, has a controlling financial interest and the VIEs for which the Company is deemed to be the primary beneficiary are collectively referred to as “consolidated subsidiaries.”  Non-controlling interests recorded on the consolidated financial statements of the Company include the non-controlling interests of the outside investors in each of these entities, as well as those of the operating company.  All significant inter-company transactions and balances have been eliminated through consolidation.

During 2014, the Company provided the initial cash investment for three Pzena mutual funds in an effort to generate an investment performance track record to attract third-party investors. During 2016, the Company provided the initial cash investment for the launch of a fourth Pzena mutual fund: the Pzena Small Cap Value Fund. Due to their series fund structure, registration, and compliance with the requirements of the Investment Company Act of 1940, these funds are analyzed for consolidation under the voting interest model. As a result of the Company's initial interests, it consolidated the Pzena Mid Cap Value Fund, Pzena Long/Short Value Fund, Pzena Emerging Markets Value Fund, and Pzena Small Cap Value Fund. On July 11, 2016, due to additional subscriptions into the Pzena Small Cap Value Fund, the Company's ownership decreased to 36.1%. As the entity was no longer deemed to control the fund, the Company deconsolidated the entity, removed the related assets, liabilities and non-controlling interest from its balance sheet and classified the Company's remaining investment as an equity method investment. Upon adoption of ASU No. 2015-02 as of January 1, 2016, the Company was deemed to not have a controlling interest in the Pzena Emerging Markets Value Fund. The Pzena Mid Cap Value Fund and Pzena Long/Short Value Fund will continue to be consolidated to the extent the Company has a majority ownership interest in them. At September 30, 2017, the aggregate of these funds' $12.5 million in net assets was included in the Company's consolidated statements of financial condition.

The operating company is the managing member of Pzena International Value Service, a series of Pzena Investment Management International, LLC.  The operating company is considered the primary beneficiary of this entity. At September 30, 2017, Pzena International Value Service’s $4.9 million in net assets was included in the Company’s consolidated statements of financial condition.

These consolidated mutual funds and investment partnerships are investment companies and apply specialized industry accounting for investment companies. The Company has retained this specialized accounting for these mutual funds and investment partnerships pursuant to U.S. GAAP.

Non-Consolidated Variable Interest Entities

VIEs that are not consolidated receive investment management services from the operating company and are generally private investment partnerships sponsored by the operating company.  The total net assets of these VIEs was approximately $48.9 million and $44.3 million at September 30, 2017 and December 31, 2016, respectively.  

As of September 30, 2017 and December 31, 2016, in order to satisfy certain of the Company's obligations under its deferred compensation programs, the operating company had $2.5 million and $3.2 million in investments, respectively, in certain of these firm-sponsored vehicles, for which the Company was not deemed to be the primary beneficiary. The Company's exposure to risk in the non-consolidated VIEs is generally limited to any equity investment and any uncollected

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Pzena Investment Management, Inc.
Notes to Unaudited Consolidated Financial Statements (Continued)


management fees. As of September 30, 2017 and December 31, 2016, the Company's maximum exposure to loss as a result of its involvement with the non-consolidated VIEs was $2.6 million and $3.3 million, respectively.

Accounting Pronouncements Adopted in 2017:

In March 2016, the FASB issued ASU No. 2016-09, "Compensation - Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting." The Company adopted ASU No. 2016-09 as of January 1, 2017. This standard requires excess tax benefits and tax deficiencies to be recorded in the consolidated statements of operations as a component of Income Tax Expense when equity awards vest or are settled. The Company is no longer required to delay recognition of an excess tax benefit until it reduces current taxes payable. The standard also requires excess tax benefits to be classified as operating activities along with other income tax cash flows within the consolidated statements of cash flows. In addition, ASU No. 2016-09 allows entities to make an accounting policy election to either estimate the number of forfeitures expected to occur, as was previously required, or to account for actual forfeitures as they occur. The Company has elected to account for forfeitures as they occur, rather than estimate expected forfeitures.

The adoption of ASU No. 2016-09 resulted in a net cumulative effect adjustment reflecting a $1.4 million increase to retained earnings and the deferred tax asset as of January 1, 2017, related to the recognition of the previously unrecognized excess tax benefits using the modified retrospective method. Estimates of forfeitures in prior periods were immaterial, and therefore are not included in the cumulative effect adjustment. The amendments related to the classification of the excess tax benefits in the consolidated statements of cash flows were adopted on a prospective basis, which did not require the restatement of prior periods.

Management’s Use of Estimates:
 
The preparation of consolidated financial statements in conformity with U.S. GAAP 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 consolidated financial statements, and the reported amounts of revenues and expenses for the period.  Actual results could materially differ from those estimates.
 
Revenue Recognition:
 
Revenue, comprised of advisory fee income, is recognized over the period in which advisory services are provided.  Advisory fee income includes management fees that are calculated based on percentages of assets under management (“AUM”), generally billed quarterly, either in arrears or advance, depending on the applicable contractual terms.  Advisory fee income also includes performance fees that may be earned by the Company depending on the investment return of the AUM, as well as fulcrum fee arrangements.  Performance 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 AUM to determine the performance fees earned. In general, returns are calculated on an annualized basis over the contract’s measurement period, which usually extends to three years.  Performance fees are generally payable annually or quarterly.  Fulcrum fee arrangements require a reduction in the base fee, or allow for a performance fee if the relevant investment strategy underperforms or outperforms, respectively, the agreed-upon benchmark over the contract's measurement period, which extends to three years.  Fulcrum fees are generally payable quarterly. Following the preferred method identified in the Revenue Recognition Topic of the FASB ASC, performance fee income is recorded at the conclusion of the contractual performance period, when all contingencies are resolved.  For the three and nine months ended September 30, 2017, the Company recognized $0.9 million and $1.6 million in performance fee income. The Company did not recognize performance fee income during three months ended September 30, 2016. For the nine months ended September 30, 2016 the Company recognized approximately $0.1 million in performance fee income. For the three months ended September 30, 2017, the Company did not recognize a reduction in base fees related to fulcrum fee arrangements. For the nine months ended September 30, 2017, the Company recognize a $0.1 million reduction in base fees related to fulcrum fee arrangements. For the three and nine months ended September 30, 2016, the Company recognized a $0.7 million reduction in base fees related to fulcrum fee arrangements.


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Table of Contents
Pzena Investment Management, Inc.
Notes to Unaudited Consolidated Financial Statements (Continued)


Cash and Cash Equivalents:
 
At September 30, 2017 and December 31, 2016, Cash and Cash Equivalents was $47.9 million and $43.5 million, respectively.  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.  The Company maintains its cash in bank deposits and other accounts whose balances often exceed federally insured limits.
 
Interest on cash and cash equivalents is recorded as Interest Income on an accrual basis in the consolidated statements of operations.
 
Restricted Cash:
 
At September 30, 2017 and December 31, 2016, the Company had $4.6 million and $3.6 million, respectively, of compensating balances recorded in Restricted Cash in the consolidated statements of financial condition.

Included in these balances at September 30, 2017 and December 31, 2016, is a $1.0 million letter of credit issued by a third party in lieu of a cash security deposit, as required by the Company’s lease for its corporate headquarters.  

Also included in these balances at September 30, 2017 and December 31, 2016, were amounts of cash collateral for margin accounts established by the Pzena Long/Short Value Fund required to maintain to support securities sold short, not yet purchased of $3.6 million and $2.6 million, respectively.

Due to/from Broker:
 
Due to/from Broker consists primarily of amounts payable/receivable for unsettled securities transactions held/initiated at the clearing brokers of the Company’s consolidated subsidiaries.
 
Non-Cash Compensation:

All non-cash compensation awards granted have varying vesting schedules and are issued at prices equal to the assessed fair market value at the time of issuance. Expenses associated with these awards are recognized over the period during which employees are required to provide service. The Company accounts for forfeitures as they occur.

Investments:
 
Investment Securities, trading

Investments classified as trading securities consist of equity securities held by the Company and its consolidated subsidiaries. Dividends associated with the Company's investments and the investments of the Company's consolidated subsidiaries are recognized as dividend income on an ex-dividend basis in the consolidated statements of operations.

Securities Sold Short represents securities sold short, not yet purchased by the Pzena Long/Short Value Fund, which is consolidated with the Company's financial statements. Dividend expense associated with these investments is recognized in Other Income on an ex-dividend basis in the consolidated statements of operations.
 
All such investments are recorded at fair value, with net realized and unrealized gains and losses recognized as a component of Net Realized and Unrealized Gains from Investments in the consolidated statements of operations.

Investments in equity method investees

During the three and nine months ended September 30, 2017, the Company accounted for its investments in certain private investment partnerships, the Pzena Emerging Markets Value Fund, and the Pzena Small Cap Value Fund, each of which the Company has non-controlling interests and exercises significant influence, using the equity method. These investments are included in Equity Method Investments in the Company's consolidated statements of financial condition. The carrying value of these investments are recorded at the amount of capital reported by the private investment partnership or mutual fund. The capital account for each entity reflects any contributions paid to, distributions received from, and equity earnings of, the relevant entity. The earnings of these investments are recognized in Equity in Earnings of Affiliates in the consolidated statements of operations.

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Pzena Investment Management, Inc.
Notes to Unaudited Consolidated Financial Statements (Continued)



Investments in equity method investees are evaluated for impairment as events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. If the carrying amounts of the assets exceed their respective fair values, additional impairment tests are performed to measure the amounts of impairment losses, if any. During the three and nine months ended September 30, 2017 and 2016, no impairment losses were recognized.

Securities Valuation:
 
Investments in equity securities and securities sold short for which market quotations are available are valued at the last reported price or closing price on the primary market or exchange on which they trade.  If no reported equity sales occurred on the valuation date, equity investments are valued at the bid price. Transactions are recorded on a trade date basis.

The net realized gain or loss on sales of equity securities and securities sold short is determined on a specific identification basis and is included in Net Realized and Unrealized Gains from Investments 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 and cash equivalents in bank deposits and other accounts whose balances often 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, collections, and current credit conditions.  For both the three and nine months ended September 30, 2017, approximately 11.2% of the Company's advisory fees were generated from advisory agreements with one client relationship. For the three and nine months ended September 30, 2016, approximately 8.7% and 10.1% of the Company's advisory fees, respectively, were generated from advisory agreements with one client relationship. At September 30, 2017 and December 31, 2016, there was no allowance for doubtful accounts.
 
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, except for leasehold improvements, 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.
 
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 a provision for federal or state income taxes because it is the individual 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.  The operating company has made a provision for New York City Unincorporated Business Tax (“UBT”) and its consolidated subsidiary Pzena Investment Management, LTD has made a provision for U.K. income taxes. The effective tax rate for interim periods represents the Company’s best estimate of the effective tax rate expected to be applied to the full fiscal year, adjusted for discrete items recognized during the quarter.

Judgment is required in evaluating the Company's uncertain tax positions and determining its provision for income taxes. The Company establishes liabilities for tax-related uncertainties based on estimates of whether, and the extent to which, additional taxes will be due. These liabilities are established when the Company believes that certain positions might be challenged despite its belief that its tax return positions are in accordance with applicable tax laws. The Company adjusts these liabilities in light of changing facts and circumstances, such as the closing of a tax audit, new tax legislation or the change of an estimate. To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences will

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Pzena Investment Management, Inc.
Notes to Unaudited Consolidated Financial Statements (Continued)


affect the provision for income taxes in the period in which such determination is made. The provision for income taxes includes the effect of reserve provisions and changes to reserves that are considered appropriate. It is also the Company’s policy to recognize accrued interest, and penalties associated with uncertain tax positions in Income Tax Expense on the consolidated statements of operations.
 
The Company and its consolidated subsidiaries account for all U.S. federal, state, local, and U.K. taxation pursuant to the asset and liability method, which requires deferred income tax assets and liabilities to be recorded for temporary differences between the carrying amount 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 more-likely-than-not to be realized.  At September 30, 2017, the Company did not have a valuation allowance recorded against its deferred tax assets.
    
The income tax expense, or benefit, is the tax payable or refundable for the period, plus or minus the change during the period in deferred tax assets and liabilities. The Company records its deferred tax liabilities as a component of other liabilities in the consolidated statements of financial condition.

Upon adoption of ASU No. 2016-09 as of January 1, 2017, all excess tax benefits or tax deficiencies related to stock- and unit-transactions are reflected in the consolidated statements of operations as a component of the provision for income taxes. Previously, these excess tax benefits were not recognized until they resulted in a reduction of cash taxes payable, and were subsequently recorded in equity when they reduced cash taxes payable. The Company only recognized a tax benefit from stock- and unit-based awards in Additional Paid-In Capital if an incremental tax benefit was realized after all other tax benefits available had been utilized. The adoption of ASU No. 2016-09 resulted in a net cumulative effect adjustment reflecting a $1.4 million increase to retained earnings and the deferred tax asset as of January 1, 2017, related to the recognition of the previously unrecognized excess tax benefits using the modified retrospective method.

Tax Receivable Agreement:

The Company’s purchase of membership units of the operating company concurrent with the initial public offering, and the subsequent and future exchanges by holders of Class B units of the operating company for shares of Class A common stock (pursuant to the exchange rights provided for in the operating company’s operating agreement), have resulted in, and are expected to continue to result in, increases in the Company’s share of the tax basis of the tangible and intangible assets of the operating company, which will increase the tax depreciation and amortization deductions that otherwise would not have been available to the Company. These increases in tax basis and tax depreciation and amortization are each deductible for tax purposes over a period of 15 years and have reduced, and are expected to continue to reduce, the amount of cash taxes that the Company would otherwise be required to pay in the future. The Company has entered into a tax receivable agreement with past, current, and future members of the operating company that requires the Company to pay to any member involved in any exchange transaction 85% of the amount of cash tax savings, if any, in U.S. federal, state and local income tax or foreign or franchise tax that it realizes as a result of these increases in tax basis and, in limited cases, transfers or prior increases in tax basis. The Company expects to benefit from the remaining 15% of cash tax savings, if any, in income tax it realizes. Payments under the tax receivable agreement will be based on the tax reporting positions that the Company will determine. The Company will not be reimbursed for any payments previously made under the tax receivable agreement if a tax basis increase is successfully challenged by the Internal Revenue Service.
The Company records an increase in deferred tax assets for the estimated income tax effects of the increases in tax basis based on enacted federal and state tax rates at the date of the exchange. The Company records 85% of the estimated realizable tax benefit (which is the recorded deferred tax asset less any recorded valuation allowance) as an increase to the liability due under the tax receivable agreement, which is reflected as the liability to selling and converting shareholders in the accompanying consolidated financial statements. The remaining 15% of the estimated realizable tax benefit is initially recorded as an increase to the Company’s additional paid-in capital. All of the effects to the deferred tax asset of changes in any of the estimates after the tax year of the exchange will be reflected in the provision for income taxes. Similarly, the effect of subsequent changes in the enacted tax rates will be reflected in the provision for income taxes.
If the Company exercises its right to terminate the tax receivable agreement early, the Company will be obligated to make an early termination payment to the selling and converting shareholders, based upon the net present value (based upon certain assumptions and deemed events set forth in the tax receivable agreement) of all payments that would be required to be paid by the Company under the tax receivable agreement.  If certain change of control events were to occur, the Company would be obligated to make an early termination payment.

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Pzena Investment Management, Inc.
Notes to Unaudited Consolidated Financial Statements (Continued)



Foreign Currency:
 
The functional currency of the Company is the U.S. Dollar.  Assets and liabilities of foreign operations whose functional currency is not the U.S. Dollar are translated at the exchange rate in effect at the applicable reporting date, and the consolidated statements of operations are translated at the average exchange rates in effect during the applicable period.  A charge or credit is recorded to other comprehensive income/ (loss) to reflect the translation of these amounts to the extent the non-U.S. currency is designated the functional currency of the subsidiary. Non-functional currency related transaction gains and losses are immediately recorded in the consolidated statements of operations. For the three and nine months ended September 30, 2017 and 2016, the Company recorded less than $0.1 million and $0.1 million, respectively, of other comprehensive income associated with foreign currency translation adjustments.

Investment securities and other assets and liabilities denominated in foreign currencies are remeasured 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 remeasured into U.S. Dollar amounts on the respective dates of such transactions.
 
The Company does not isolate the portion of the results of its operations resulting from the impact of fluctuations in foreign exchange rates on its non-U.S. investments.  Such fluctuations are included in Net Realized and Unrealized Gains from Investments in the consolidated statements of operations.
 
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, foreign withholding taxes, and other receivables and payables recorded on the Company’s consolidated statements of financial condition 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.

Recently Issued Accounting Pronouncements Not Yet Adopted:

In November 2016, the FASB issued ASU No. 2016-18, "Statement of Cash Flows (Topic 230): Restricted Cash." This update requires entities to show the changes in the total cash, cash equivalents, restricted cash, and restricted cash equivalents in the statement of cash flows. This guidance is effective for the fiscal years and interim periods within those years beginning after December 15, 2017. The guidance should be applied using a retrospective approach. Upon adoption, the net change in cash presented in the consolidated statement of cash flows will reflect the total of cash, cash equivalents, and restricted cash.
    
In August 2016, the FASB issued ASU No. 2016-15, "Statement of Cash Flows (Topic 230)."  This update provides specific guidance on cash flow classification issues, which is intended to reduce the diversity in practice in how certain cash receipts and cash payments are presented and classified in the statement of cash flows.  The guidance is effective for the fiscal years and interim periods within those years beginning after December 15, 2017.  The guidance should be applied using a modified retrospective approach.  The Company is assessing the impact this standard will have on the consolidated financial statements and related disclosures.
    
In June 2016, the FASB issued ASU No. 2016-13, "Financial Instruments - Credit Losses (Topic 326)."  This new guidance requires the use of an “expected loss” model, rather than an “incurred loss” model, for financial instruments measured at amortized cost and also requires companies to record allowances for available-for-sale debt securities rather than reduce the carrying amount.  The guidance is effective for the fiscal years and interim periods within those years beginning after December 15, 2019.  The guidance should be applied using a retrospective approach.  The Company is currently assessing the impact of this standard, however, does not expect the standard to have a material impact on the consolidated financial statements.

In February 2016, the FASB issued ASU No. 2016-02, "Leases (Topic 842)." This amended standard was written to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. The new standard requires lessees to recognize a right-of-use asset and lease liability for all leases with terms of more than 12 months. Recognition, measurement and presentation of expenses will depend on classification as a finance or operating lease. The amendments also require certain quantitative and qualitative disclosure. Accounting guidance for lessors is largely unchanged. This guidance is effective for the fiscal years and interim periods within those years beginning after December 15, 2018, and requires a modified retrospective approach to adoption. The Company is currently evaluating the impact of adoption on its consolidated financial statements. The standard is expected to result in an increase in total assets and total liabilities, but will not have a significant impact on the consolidated statement of operations.

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Pzena Investment Management, Inc.
Notes to Unaudited Consolidated Financial Statements (Continued)



In May 2014, the FASB issued ASU No. 2014-09, "Revenue from Contracts with Customers (Topic 606)." The core principle of the revenue model is that an entity recognizes revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for the goods or services. In July 2015, the FASB postponed the effective date of this new guidance from January 1, 2017 to January 1, 2018. Early application is not permitted. The standard permits the use of either the retrospective or cumulative effect transition method. The Company anticipates that it will adopt ASU No. 2014-09 on January 1, 2018 using the modified retrospective method of transition, which requires a cumulative-effect adjustment as of the date of adoption. While we have not identified material changes in the timing of revenue recognition, we continue to evaluate the presentation of certain revenue related costs on a gross versus net basis as well as the additional disclosures required by the standard. However, based on current evaluations, the Company does not expect the adoption to have a material impact on its consolidated financial statements.
 
Note 3—Compensation and Benefits
 
Compensation and benefits expense to employees and members is comprised of the following:


For the Three Months Ended September 30,
 
For the Nine Months Ended September 30,
 
2017
 
2016
 
2017
 
2016
 
(in thousands)
Cash Compensation and Other Benefits
$
11,826

 
$
10,002

 
$
36,813

 
$
31,017

Non-Cash Compensation
2,937

 
1,765

 
7,868

 
4,947

Total Compensation and Benefits Expense
$
14,763

 
$
11,767

 
$
44,681

 
$
35,964

   
All non-cash compensation awards granted have varying vesting schedules and are issued at prices equal to the assessed fair market value at the time of issuance, as discussed below.  No new non-cash compensation awards were issued during the three months ended September 30, 2017 and 2016. Details of non-cash compensation awards granted during the nine months ended September 30, 2017 and 2016 are as follows:
 
For the Nine Months Ended September 30,
 
2017
 
2016
 
Amount
 
Fair
Value
1
 
Amount
 
Fair
Value
1
Restricted Class B Units
40,500

 
$
11.11

 
5,812

 
$
8.60

Options to Purchase Shares of Class A Common Stock2
50,000

 
$
3.04

 

 
$

Options to Purchase Delayed Exchange Class B Units3
2,630,000

 
$
2.30

 

 
$

Options to Purchase Class B Units2
320,000

 
$
3.04

 

 
$

Deferred Compensation Phantom Delayed Exchange Class B Units4

 
$

 
149,533

 
$
5.12

1
Represents the grant date fair value per share, unit, or option.
2
Represents options to purchase shares of Class A common stock or Class B units. These options become exercisable five years from the date of grant.
3
Represents options to purchase Delayed Exchange Class B units issued under 2006 Equity Incentive Plan (as defined below). These options become exercisable five years from the date of grant. Upon exercise, the resulting Delayed Exchange Class B units may not be exchanged pursuant the Amended and Restated Operating Agreement until the seventh anniversary of the exercise date and are not entitled to any benefits under the Tax Receivable Agreement.
4
Represents phantom Delayed Exchange Class B units issued under the Bonus Plan (as defined below). These units vest ratably over four years and become Delayed Exchange Class B units upon vesting which may not be exchanged pursuant the Amended and Restated Operating Agreement until the seventh anniversary of the vesting date and are not entitled to any benefits under the Tax Receivable Agreement.

As part of the Company's year-end bonus structure, certain employee members may elect to have all or part of year-end cash compensation paid in the form of cash, or equity issued pursuant to Pzena Investment Management, LLC Amended and Restated 2006 Equity Incentive Plan (“the 2006 Equity Incentive Plan”). For the year ended December 31, 2016, $4.5 million of cash compensation was elected to be paid in the form of equity, which was issued and vested immediately on January 1, 2017. Details of awards associated with these elections issued on January 1, 2017 are as follows:

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Pzena Investment Management, Inc.
Notes to Unaudited Consolidated Financial Statements (Continued)


 
January 1,
 
2017
 
Amount
 
Fair Value1
Phantom Class B Units2
5,200

 
$
9.61

Delayed Exchange Class B Units3
620,023

 
$
7.11

1
Represents the grant date fair value per share or unit.
2
Represents phantom Class B units issued under the 2006 Equity Incentive Plan. These phantom units vest ratably over ten years starting immediately and are not entitled to receive dividend or dividend equivalents until vested.
3
Represents Class B units issued under the 2006 Equity Incentive Plan. These units vest immediately upon grant, but may not be exchanged pursuant to the Amended and Restated Operating Agreement of the operating company until the seventh anniversary of the date of grant. These units are also not entitled to any benefits under the Tax Receivable Agreement between the Company and members of the operating company.
    
Pursuant to the 2006 Equity Incentive Plan, the operating company issues Class B units, phantom Class B units and options to purchase Class B units.  The operating company also issues Delayed Exchange Class B units pursuant to the 2006 Equity Incentive Plan. These Delayed Exchange Class B units vest immediately upon grant, but may not be exchanged pursuant to the Amended and Restated Operating Agreement of the operating company until at least the seventh anniversary of the date of grant. These Delayed Exchange Class B units are also not entitled to any benefit under the Tax Receivable Agreement between the Company and members of the operating company. Under the Pzena Investment Management, Inc. 2007 Equity Incentive Plan (“the 2007 Equity Incentive Plan”), the Company issues shares of restricted Class A common stock and contingently vesting options to acquire shares of Class A common stock. During the three and nine months ended September 30, 2017, 1,000,000 contingently vesting options were forfeited in connection with an employee departure. Sadly, the Company's Executive Vice President and Executive Committee member passed away on July 22, 2017. As a result, 549,888 phantom Class B units did not vest and were forfeited. During the three and nine months ended September 30, 2016, 48,000 phantom Class B units were forfeited in connection with an employee departure. During each of the three and nine months ended September 30, 2017 and 2016, no contingently vesting options vested. During the three months ended September 30, 2017 and 2016, 15,749 and 11,893 Delayed Exchange Class B units were issued to certain employee members, respectively, for $0.1 million in cash. During the nine months ended September 30, 2017 and 2016, 29,426 and 81,871 Delayed Exchange Class B units were issued to certain employee members, respectively, for approximately $0.2 million and $0.4 million in cash, respectively.

Under the Pzena Investment Management, LLC Amended and Restated Bonus Plan (the “Bonus Plan”), eligible employees whose compensation is in excess of certain thresholds are required to defer a portion of that excess.  These deferred amounts may be invested, at the employee’s discretion, in certain investment options designated by the Compensation Committee of the Company's Board of Directors.  Amounts deferred in any calendar year reduce that year’s compensation expense and are amortized and vest ratably over a four-year period commencing the following year.  The Company also issued to certain of its employees deferred compensation with certain investment options that also vest ratably over a four-year period. During the three and nine months ended September 30, 2017, the vesting of 5,739 deferred compensation phantom Class B units and $1.5 million in deferred compensation investments was accelerated due to both the passing of the Company's Executive Vice President and an employee departure. As of September 30, 2017 and December 31, 2016, the liability associated with all deferred compensation investment accounts was $3.1 million and $4.2 million, respectively.

Pursuant to the Pzena Investment Management, Inc. Non-Employee Director Deferred Compensation Plan (the “Director Plan”), non-employee directors may elect to have all or part of their compensation otherwise payable in cash, deferred in the form of phantom shares of Class A common stock of the Company issued under the 2007 Equity Incentive Plan.  Elections to defer compensation under the Director Plan are made on a year-to-year basis.  Distributions under the Director Plan are made in a single distribution of shares of Class A common stock at such time as elected by the participant when the deferral was made.  Since inception of the Director Plan in 2009, the Company’s directors have elected to defer 100% of their compensation in the form of phantom shares of Class A common stock.  Amounts deferred in any calendar year are amortized over the calendar year and reflected as General and Administrative Expense.  As of September 30, 2017 and December 31, 2016, there were 335,138 and 291,230 phantom shares of Class A common stock outstanding, respectively. For the three and nine months ended September 30, 2017 and 2016, no distributions were made under the Director Plan.

As of September 30, 2017 and December 31, 2016, the Company had approximately $27.8 million and $30.0 million, respectively, in unrecorded compensation expense related to unvested awards issued pursuant to its Bonus Plan and certain agreements; Class B units, Delayed Exchange Class B units, and phantom Class B units issued under the 2006 Equity Incentive Plan; and restricted Class A common stock and contingently vesting option grants issued under the 2007 Equity Incentive Plan. The Company anticipates that this unrecorded cost will amortize over the respective vesting periods of the awards.


14

Table of Contents
Pzena Investment Management, Inc.
Notes to Unaudited Consolidated Financial Statements (Continued)


Note 4—Employee Benefit Plans
 
The operating company has a Profit Sharing and Savings Plan for the benefit of substantially all employees.  The Profit Sharing and Savings Plan is a defined contribution profit sharing plan with a 401(k) deferral component.  All full-time employees and certain part-time employees who have met the age and length of service requirements are eligible to participate in the plan.  The plan allows participating employees to make elective deferrals of compensation up to the annual limits which are set by law.  The plan provides for a discretionary annual contribution by the operating company which is determined by a formula based on the salaries of eligible employees as defined by the plan.  For the three and nine months ended September 30, 2017, the expense recognized in connection with this plan was $0.1 million and $0.9 million, respectively. For the three and nine months ended September 30, 2016, the expense recognized in connection with this plan was $0.2 million and $0.7 million, respectively.

Note 5—Earnings per Share
 
Basic earnings per share is computed by dividing the Company’s net income attributable to its common stockholders by the weighted average number of shares outstanding during the reporting period.  

Under the two-class method of computing basic earnings per share, basic earnings per share is calculated by dividing net income for basic earnings per share by the weighted average number of common shares outstanding during the period.  The two-class method includes an earnings allocation formula that determines earnings per share for each participating security according to dividends declared and undistributed earnings for the period.  The Company’s net income for basic earnings per share is reduced by the amount allocated to participating restricted shares of Class A common stock which participate for purposes of calculating earnings per share.  

For the three and nine months ended September 30, 2017 and 2016, the Company’s basic earnings per share was determined as follows:
 
For the Three Months Ended September 30,
 
For the Nine Months Ended September 30,
 
2017
 
2016
 
2017
 
2016
 
(in thousands, except share and per share amounts)
Net Income for Basic Earnings per Share Allocated to:
 
 
 
 
 
 

Class A Common Stock
$
2,989

 
$
2,163

 
$
7,952

 
$
5,187

Participating Shares of Restricted Class A Common Stock

 
2

 
2

 
6

Total Net Income for Basic Earnings per Share
$
2,989

 
$
2,165

 
$
7,954

 
$
5,193

Basic Weighted-Average Shares Outstanding
17,285,307

 
16,375,364

 
17,316,392

 
15,788,809

Add: Participating Shares of Restricted Class A Common Stock1

 
14,934

 
3,556

 
18,531

Total Basic Weighted-Average Shares Outstanding
17,285,307

 
16,390,298

 
17,319,948

 
15,807,340

Basic Earnings per Share
$
0.17

 
$
0.13

 
$
0.46

 
$
0.33

1
Certain unvested shares of Class A common stock granted to employees have nonforfeitable rights to dividends and therefore participate fully in the results of the Company from the date they are granted. They are included in the computation of basic earnings per share using the two-class method for participating securities.

Diluted earnings per share adjusts this calculation to reflect the impact of all outstanding membership units of the operating company, phantom Class B units, phantom Delayed Exchange Class B units, phantom Class A common stock, outstanding Class B unit options, options to purchase Class A common stock, and restricted Class A common stock, to the extent they would have a dilutive effect on net income per share for the reporting period.  Net income for diluted earnings per share assumes that all outstanding operating company membership units are converted into Company stock at the beginning of the reporting period and the resulting change to the Company's net income associated with its increased interest in the operating company is taxed at the Company’s effective tax rate, exclusive of one-time charges and adjustments associated with both the valuation allowance and the liability to selling and converting shareholders and other one-time charges.
 

15

Table of Contents
Pzena Investment Management, Inc.
Notes to Unaudited Consolidated Financial Statements (Continued)


For the three and nine months ended September 30, 2017 and 2016, the Company’s diluted net income was determined as follows: 
 
For the Three Months Ended September 30,
 
For the Nine Months Ended September 30,
 
2017
 
2016
 
2017
 
2016
 
(in thousands)
Net Income Attributable to Non-Controlling Interests of Pzena Investment Management, LLC
$
14,013

 
$
9,547

 
$
36,518

 
$
25,307

Less: Assumed Corporate Income Taxes
5,140

 
3,520

 
13,395

 
9,333

Assumed After-Tax Income of Pzena Investment Management, LLC
8,873

 
6,027

 
23,123

 
15,974

Net Income of Pzena Investment Management, Inc.
2,989

 
2,165

 
7,954

 
5,193

Diluted Net Income
$
11,862

 
$
8,192

 
$
31,077

 
$
21,167

 
Under the two-class method of computing diluted earnings per share, diluted earnings per share is calculated by dividing net income for diluted earnings per share by the weighted average number of common shares outstanding during the period, plus the dilutive effect of any potential common shares outstanding during the period using the more dilutive of the treasury method or two-class method.  The two-class method includes an earnings allocation formula that determines earnings per share for each participating security according to dividends declared and undistributed earnings for the period.  The Company’s net income for diluted earnings per share is reduced by the amount allocated to participating restricted Class B units for purposes of calculating earnings per share.  Dividend equivalent distributions paid per share on the operating company’s unvested restricted Class B units are equal to the dividends paid per Company Class A common stock.


16

Table of Contents
Pzena Investment Management, Inc.
Notes to Unaudited Consolidated Financial Statements (Continued)


For the three and nine months ended September 30, 2017 and 2016, the Company’s diluted earnings per share were determined as follows:
 
For the Three Months Ended September 30,
 
For the Nine Months Ended September 30,
 
2017
 
2016
 
2017
 
2016
 
(in thousands, except share and
per share amounts)
Diluted Net Income Allocated to:
 
 
 
 
 
 
 
Class A Common Stock
$
11,851

 
$
8,185

 
$
31,047

 
$
21,148

Participating Shares of Restricted Class A Common Stock

 
2

 
2

 
6

Participating Class B Units
11

 
5

 
28

 
13

Total Diluted Net Income Attributable to Shareholders
$
11,862

 
$
8,192

 
$
31,077

 
$
21,167

 
 
 
 
 
 
 
 
Total Basic Weighted-Average Shares Outstanding
17,285,307

 
16,390,298

 
17,319,948

 
15,807,340

Dilutive Effect of Class B Units
51,123,950

 
50,828,791

 
51,108,273

 
51,442,921

Dilutive Effect of Options 1
579,881

 
150,991

 
474,785

 
160,067

Dilutive Effect of Phantom Class B Units & Phantom Shares of Class A Common Stock
1,636,784

 
1,205,981

 
1,808,570

 
1,121,225

Dilutive Effect of Restricted Shares of Class A Common Stock 2
72,405

 
38,924

 
69,430

 
37,057

Dilutive Weighted-Average Shares Outstanding
70,698,327

 
68,614,985

 
70,781,006

 
68,568,610

Add: Participating Class B Units3
64,886

 
41,057

 
64,886

 
41,057

Total Dilutive Weighted-Average Shares Outstanding
70,763,213

 
68,656,042

 
70,845,892

 
68,609,667

Diluted Earnings per Share
$
0.17

 
$
0.12

 
$
0.44

 
$
0.31

1
Represents the dilutive effect of options to purchase operating company Class B units and Company Class A common stock.
2
Certain restricted shares of Class A common stock granted to employees are not entitled to dividend or dividend equivalent payments until they are vested and are therefore non-participating securities and are not included in the computation of basic earnings per share. They are included in the computation of diluted earnings per share when the effect is dilutive using the treasury stock method.
3
Unvested Class B Units granted to employees have nonforfeitable rights to dividend equivalent distributions and therefore participate fully in the results of the operating company's operations from the date they are granted. They are included in the computation of diluted earnings per share using the two-class method for participating securities.

Approximately 0.7 million options to purchase Class B units, 0.1 million options to purchase shares of Class A common stock, and 2.0 million contingent options to purchase shares of Class A common stock were excluded from the calculation of diluted earnings per share for the three and nine months ended September 30, 2017, as their inclusion would have had an antidilutive effect based on current market prices or because the option had contingent vesting requirements that were not met. Approximately 1.0 million options to purchase Class B units were excluded from the calculation of diluted earnings per share for the three and nine months ended September 30, 2016, respectively, as their inclusion would have had an antidilutive effect based on current market prices. Approximately 0.7 million options to purchase shares of Class A common stock and 3.0 million contingent options to purchase shares of Class A common stock were also excluded from the calculation of diluted earnings per share for the three and nine months ended September 30, 2016, as their inclusion would have had an antidilutive effect based on current market prices or because the option had contingent vesting requirements that were not met.

Note 6—Shareholders’ Equity
 
The Company functions as the sole managing member of the operating company.  As a result, the Company: (i) consolidates the financial results of the operating company and reflects the membership interest in it that it does not own as a non-controlling interest in its consolidated financial statements; and (ii) recognizes income generated from its economic interest in the operating company’s net income.  Class A and Class B units of the operating company have the same economic rights per unit.  As of September 30, 2017, the holders of Class A common stock of the Company and the holders of Class B units of the operating company held approximately 25.2% and 74.8%, respectively, of the economic interests in the operations of the business. As of December 31, 2016, the holders of Class A common stock of the Company and the holders of Class B units of the operating company held approximately 25.6% and 74.4%, respectively, of the economic interests in the operations of the business.


17

Table of Contents
Pzena Investment Management, Inc.
Notes to Unaudited Consolidated Financial Statements (Continued)


Each Class B unit of the operating company is issued with a corresponding share of the Company’s Class B common stock, par value $0.000001 per share.  Holders of Class B common stock have the right to receive the par value of the Class B common stock held by them upon our liquidation, dissolution or winding up, but do not share in dividends. Each share of the Company’s Class B common stock entitles its holder to five votes, until the first time that the number of shares of Class B common stock outstanding constitutes less than 20% of the number of all shares of the Company’s common stock outstanding.  From such time and thereafter, each share of the Company’s Class B common stock entitles its holder to one vote.  When a Class B unit is exchanged for a share of the Company’s Class A common stock or forfeited, a corresponding share of the Company’s Class B common stock will automatically be redeemed and canceled.  Conversely, to the extent that the Company causes the operating company to issue additional Class B units to employees pursuant to its equity incentive plan, these additional holders of Class B units would be entitled to receive a corresponding number of shares of the Company’s Class B common stock (including if the Class B units awarded are subject to vesting).
 
All holders of the Company’s Class B common stock have entered into a stockholders’ agreement, pursuant to which they agreed to vote all shares of Class B common stock then held by them, with the majority of votes of Class B common stockholders taken in a preliminary vote of the Class B common stockholders.
 
The outstanding shares of the Company’s Class A common stock represent 100% of the rights of the holders of all classes of the Company’s capital stock to receive distributions, except that holders of Class B common stock will have the right to receive the class’s par value upon the Company’s liquidation, dissolution or winding up.
 
Pursuant to the operating agreement of the operating company, each vested Class B unit is exchangeable for a share of the Company’s Class A common stock, subject to certain exchange timing and volume limitations. These acquisition of additional operating company membership was treated as a reorganization of entities under common control as required by the Business Combinations Topic of the FASB ASC.

The Company’s share repurchase program was announced on April 24, 2012.  The Board of Directors authorized the Company to repurchase up to an aggregate of $10 million of the Company’s outstanding Class A common stock and the operating company’s Class B units on the open market and in private transactions in accordance with applicable securities laws.  On February 11, 2014, the Company announced that its Board of Directors approved an increase of $20 million in the aggregate amount authorized under the program. The timing, number and value of common shares and units repurchased are subject to the Company’s discretion.  The Company’s share repurchase program is not subject to an expiration date and may be suspended, discontinued, or modified at any time, for any reason.

During the nine months ended September 30, 2017, the Company purchased and retired 79,717 shares of Class A common stock and 2,897 Class B units under the current repurchase authorization at a weighted average price per share of $8.88 and $11.11, respectively.  During the nine months ended September 30, 2016, the Company purchased and retired 258,279 shares of Class A common stock and 8,574 Class B units under the repurchase authorization at a weighted average price per unit of $7.77 and $7.81, respectively. The Company records the repurchase of shares and units at cost based on the trade date of the transaction.

During the nine months ended September 30, 2016, 47,490 Class B unit options exercised resulted in the issuance of 24,027 net Class B units as a result of the redemption of 23,463 Class B units for the cashless exercise of options and $0.1 million in cash. No options were exercised during the nine months ended September 30, 2017.

Note 7—Non-Controlling Interests
 
Net Income Attributable to Non-Controlling Interests in the operations of the Company’s operating company and consolidated subsidiaries is comprised of the following:
 
For the Three Months Ended September 30,
 
For the Nine Months Ended September 30,
 
2017
 
2016
 
2017
 
2016
 
(in thousands)
Non-Controlling Interests of Pzena Investment Management, LLC
$
14,013

 
$
9,547

 
$
36,518

 
$
25,307

Non-Controlling Interests of Consolidated Subsidiaries
215

 
209

 
592

 
136

Net Income Attributable to Non-Controlling Interests
$
14,228

 
$
9,756

 
$
37,110

 
$
25,443


18

Table of Contents
Pzena Investment Management, Inc.
Notes to Unaudited Consolidated Financial Statements (Continued)


 
Distributions to non-controlling interests represent tax allocations and dividend equivalents paid to the members of the operating company, as well as withdrawals from the Company’s consolidated subsidiaries. Contributions from non-controlling interests represent contributions to the Company's consolidated subsidiaries.

Note 8—Investments

The following is a summary of Investments:
 
As of
 
September 30, 2017
 
December 31, 2016
 
(in thousands)
Investment Securities, Trading
 

 
 

Equity Securities
$
20,254

 
$
14,323

Total Investment Securities, Trading
20,254

 
14,323

Investments in Equity Method Investees
7,955

 
7,987

Total
$
28,209

 
$
22,310


Investment Securities, Trading
 
Investments, at Fair Value consisted of the following at September 30, 2017:
 
 
Cost
 
Unrealized
Gain/(Loss)
 
Fair Value
 
(in thousands)
Equity Securities
$
17,986

 
$
2,268

 
$
20,254

Total
$
17,986

 
$
2,268

 
$
20,254


    Securities Sold Short, at Fair Value consisted of the following at September 30, 2017:
 
Proceeds
 
Unrealized
(Gain)/ Loss
 
Fair Value
 
(in thousands)
Securities Sold Short
$
3,526

 
$
60

 
$
3,586

Total
$
3,526

 
$
60

 
$
3,586


    
Investments, at Fair Value consisted of the following at December 31, 2016:
 
 
Cost
 
Unrealized
Gain/(Loss)
 
Fair Value
 
(in thousands)
Equity Securities
$
13,105

 
$
1,218

 
$
14,323

Total
$
13,105

 
$
1,218

 
$
14,323



19

Table of Contents
Pzena Investment Management, Inc.
Notes to Unaudited Consolidated Financial Statements (Continued)


Securities Sold Short, at Fair Value consisted of the following at December 31, 2016:

 
Proceeds
 
Unrealized
(Gain)/ Loss
 
Fair Value
 
(in thousands)
Securities Sold Short
$
2,646

 
$
(24
)
 
$
2,622

Total
$
2,646

 
$
(24
)
 
$
2,622


Investments in Equity Method Investees

The operating company sponsors and provides investment management services to certain private investment partnerships and Pzena mutual funds through which it offers its investment strategies. The Company has made investments in certain of these private investment partnerships and mutual funds to satisfy its obligations under the Company's deferred compensation program and provide the initial cash investment in our mutual funds. The Company holds a non-controlling interest and exercises significant influence in these entities, and accounts for its investments as equity method investments which are included in Investments on the consolidated statements of financial condition. On July 11, 2016, due to additional subscriptions into the Pzena Small Cap Value Fund, the Company's ownership decreased to 36.1%. As the entity was no longer deemed to control the fund, the Company deconsolidated the entity, removed the related assets, liabilities and non-controlling interest from its balance sheet and classified the Company's remaining investment as an equity method investment. As of September 30, 2017, the Company's investments range between 4% and 17% of the capital of these entities and have an aggregate carrying value of $8.0 million.

Note 9—Fair Value Measurements
 
The Fair Value Measurements and Disclosures Topic of the FASB ASC 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.  The Fair Value Measurements and Disclosures Topic of the FASB ASC 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).
 
Included in the Company’s consolidated statements of financial condition are investments in equity securities and securities sold short, both of which are exchange-traded securities with quoted prices in active markets. The fair value measurements of the equity securities, securities sold short, have been classified as Level 1. The investments in equity method investees are held at their carrying value.

20

Table of Contents
Pzena Investment Management, Inc.
Notes to Unaudited Consolidated Financial Statements (Continued)


    
The following table presents these instruments’ fair value at September 30, 2017:
 
Level 1
 
Level 2
 
Level 3
 
Total
 
(in thousands)
Assets:
 
 
 
 
 
 
 
Equity Securities
$
20,254

 
$

 
$

 
$
20,254


 
Level 1
 
Level 2
 
Level 3
 
Total
 
(in thousands)
Liabilities:
 
 
 
 
 
 
 
Securities Sold Short
$
3,586

 
$

 
$

 
$
3,586



The following table presents these instruments’ fair value at December 31, 2016:
 
Level 1
 
Level 2
 
Level 3
 
Total
 
(in thousands)
Assets:
 
 
 
 
 
 
 
Equity Securities
$
14,323

 
$

 
$

 
$
14,323


 
Level 1
 
Level 2
 
Level 3
 
Total
 
(in thousands)
Liabilities:
 
 
 
 
 
 
 
Securities Sold Short
$
2,622

 
$

 
$

 
$
2,622



For each of the three and nine months ended September 30, 2017 and 2016, there were no transfers between levels. In addition, the Company did not hold any Level 2 or Level 3 securities during these periods.


21

Table of Contents
Pzena Investment Management, Inc.
Notes to Unaudited Consolidated Financial Statements (Continued)


Note 10—Property and Equipment
 
Property and Equipment, Net of Accumulated Depreciation is comprised of the following:
 
 
As of
 
September 30,
2017
 
December 31,
2016
 
(in thousands)
Leasehold Improvements
$
6,832

 
$
6,832

Furniture and Fixtures
1,190

 
1,190

Computer Hardware
681

 
756

Computer Software
272

 
238

Office Equipment
245

 
209

Total
9,220

 
9,225

Less: Accumulated Depreciation and Amortization
(2,796
)
 
(2,260
)
Total
$
6,424

 
$
6,965


Depreciation is included in general and administrative expense and totaled approximately $0.3 million and $0.8 million for the three and nine months ended September 30, 2017, respectively. For the three and nine months ended September 30, 2016, depreciation totaled approximately $0.3 million and $0.8 million, respectively.

Note 11—Related Party Transactions
 
For the three and nine months ended September 30, 2017, the Company earned $0.1 million and $0.3 million, respectively, in investment advisory fees from unconsolidated VIEs that receive investment management services from the Company. For the three and nine months ended September 30, 2016, the Company earned $0.1 million and $0.2 million, respectively, in such fees.
 
The Company offers loans to employees, excluding executive officers, for the purpose of financing tax obligations associated with compensatory stock and unit vesting. Loans are generally written for a seven-year period, at an interest rate equivalent to the Applicable Federal Rate, payable in annual installments, and collateralized by shares and units held by the employee. As of September 30, 2017 and December 31, 2016, the Company had approximately $1.3 million and $0.9 million, respectively, of such loans outstanding.

The operating company, as investment adviser for certain Pzena branded SEC-registered mutual funds, private placement funds, and non-U.S. funds, has contractually agreed to waive a portion or all of its management fees and pay fund expenses to ensure that the annual operating expenses of the funds stay below certain established total expense ratio thresholds. For the three and nine months ended September 30, 2017, the Company recognized $0.2 million and $0.8 million of such expenses, respectively. For the three and nine months ended September 30, 2016, the Company recognized $0.3 million and $0.8 million of such expenses.

The operating company manages personal funds of certain of the Company’s employees, including the CEO, its two Presidents, and its Executive Vice President.  The operating company also manages accounts beneficially owned by a private fund in which certain of the Company’s executive officers invest.  Investments by employees in individual accounts are permitted only at the discretion of the executive committee of the operating company, but are generally not subject to the same minimum investment levels that are required of outside investors.  The operating company also manages personal funds of some of its employees’ family members.  Pursuant to the respective investment management agreements, the operating company waives or reduces its regular advisory fees for these accounts and personal funds. In addition, the operating company pays custody and administrative fees for certain of these accounts and personal funds in order to incubate products or preserve performance history.  The aggregate value of the fees that the Company waived related to the Company’s executive officers, other employees, and family members, was approximately $0.2 million and $0.6 million for the three and nine months ended September 30, 2017, respectively. For each of the three and nine months ended September 30, 2016, the Company waived $0.2 million and $0.5 million in such fees, respectively.

22

Table of Contents
Pzena Investment Management, Inc.
Notes to Unaudited Consolidated Financial Statements (Continued)


 
Note 12—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 advisers 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. 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 the Guarantees Topic of the FASB ASC, the Company’s estimate of the value of such guarantees is de minimis, therefore, no accrual has been made in the consolidated financial statements.

The Company leases office space under a non-cancelable operating lease agreement, which expires on December 31, 2025. The Company recognizes minimum lease expense for its headquarters on a straight-line basis over the lease term. During the third quarter of 2016, the Company terminated its five-year sublease agreement which commenced on May 1, 2015.  The Company entered into a new four-year sublease agreement commencing on October 1, 2016 that is cancelable by either the Company or sublessee given appropriate notice after the thirty-first month following the commencement of the sublease agreement. The sublease agreement is for certain office space associated with the Company's operating lease agreement in its corporate headquarters. Sublease income will continue to decrease annual lease expense by approximately $0.4 million per year.

During the three and nine months ended September 30, 2017, lease expenses were $0.5 million and $1.6 million, respectively, and are included in general and administrative expense. During the three and nine months ended September 30, 2016, lease expenses were $0.5 million and $1.4 million, respectively. This lease expense includes expenses associated with the Company's office spaces in the U.K. and Australia. Lease expenses for the three and nine months ended September 30, 2017 were net of $0.1 million and $0.3 million of sublease income, respectively. Lease expenses for the three and nine months ended September 30, 2016 were net of $0.1 million and $0.3 million of sublease income, respectively.

Note 13—Income Taxes
 
The operating company is a limited liability company that has elected to be treated as a partnership for tax purposes. The Company's provision for income taxes reflects U.S. federal, state, and local incomes taxes on its allocable portion of the operating company's income. The Company's effective tax rate for the nine months ended September 30, 2017 and 2016 was 12.5% and 8.8%, respectively. The effective tax rate includes a rate benefit attributable to the fact that approximately 74.7% and 76.5% of the operating company's earnings were not subject to corporate-level taxes for the nine months ended September 30, 2017 and 2016, respectively. Income before income taxes includes net income attributable to non-controlling interests and not taxable to the Company, which reduces the effective tax rate. This favorable impact is partially offset by the impact of certain permanently non-deductible items. Income taxes for the nine months ended September 30, 2016, included $1.7 million in income tax benefit associated with changes in the valuation allowance recorded against the Company's deferred tax asset. No changes in the realizability of the deferred tax asset were recorded during the nine months ended September 30, 2017.

The Income Taxes Topic of the FASB ASC establishes the minimum threshold for recognizing, and a system for measuring, the benefits of tax return positions in financial statements.  

As of September 30, 2017 and December 31, 2016, the Company had $4.1 million and $2.8 million in unrecognized tax benefits that, if recognized, would affect the provision for income taxes. As of both September 30, 2017 and December 31, 2016, the Company had interest related to unrecognized tax benefits of $0.4 million. As of September 30, 2017 and December 31, 2016, no penalty accruals were recorded.

As of September 30, 2017 and December 31, 2016, the net values of all deferred tax assets were approximately $70.4 million and $73.4 million, respectively. These deferred tax assets primarily reflect the future tax benefits associated with the Company's initial public offering, and the subsequent and future exchanges by holders of Class B units of the operating company for shares of Class A common stock. At September 30, 2017 and December 31, 2016, the Company did not have a valuation allowance recorded against its deferred tax assets.


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Pzena Investment Management, Inc.
Notes to Unaudited Consolidated Financial Statements (Continued)


Note 14—Subsequent Events

On October 17, 2017, the Company declared a quarterly dividend of $0.03 per share of its Class A common stock that will be paid on November 22, 2017 to holders of record on October 27, 2017.

No other subsequent events necessitated disclosures and/or adjustments.

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Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

Overview
 
We are an investment management firm that utilizes a classic value investment approach across all of our investment strategies.  We currently manage assets in a variety of value-oriented investment strategies across a wide range of market capitalizations in both U.S. and non-U.S. capital markets.  At September 30, 2017, our assets under management, or AUM, was $35.4 billion.  We manage separate accounts on behalf of institutions, act as sub-investment adviser for a variety of SEC-registered mutual funds and non-U.S. funds, and act as investment adviser for the Pzena mutual funds, private placement funds and non-U.S. funds.
 
We function as the sole managing member of our operating company, Pzena Investment Management, LLC (the “operating company”).  As a result, we: (i) consolidate the financial results of our operating company with our own, and reflect the membership interest in it that we do not own as a non-controlling interest in our consolidated financial statements; and (ii) recognize income generated from our economic interest in our operating company’s net income.  As of September 30, 2017, the holders of Class A common stock (through the Company) and the holders of Class B units of our operating company held approximately 25.2% and 74.8%, respectively, of the economic interests in the operations of our business.

The Company also serves as the general partner of Pzena Investment Management, LP, a partnership formed with the objective of aggregating employee ownership in one entity.

Certain of our named executive officers and employees have interests in Pzena Investment Management, LP and certain estate planning vehicles through which they indirectly own Class B units of our operating company. As of September 30, 2017, through direct and indirect interests, our five named executive officers; 38 other employee members; and certain other members of our operating company, including one of our directors, his related entities, and certain former employees, collectively held 50.5%, 4.7%, and 19.6% of the economic interests in our operating company, respectively.
 
GAAP and Non-GAAP Net Income
 
GAAP diluted net income and GAAP diluted earnings per share were $11.9 million and $0.17, respectively, for the three months ended September 30, 2017, and $8.2 million and $0.12, respectively, for the three months ended September 30, 2016. GAAP diluted net income and GAAP diluted earnings per share were $31.1 million and $0.44, respectively, for the nine months ended September 30, 2017, and $21.2 million and $0.31, respectively, for the nine months ended September 30, 2016. Our results for the three and nine months ended September 30, 2016 include accounting adjustments related to our deferred tax asset generated by the Company's initial public offering and subsequent Class B unit conversions, as well as our tax receivable agreement and the associated liability to our selling and converting shareholders.  We believe that these accounting adjustments add a measure of non-operational complexity that partially obscures a clear understanding of the underlying performance of our business.  Therefore, in evaluating our financial condition and results of operations, we also review certain non-GAAP measures of earnings, which are adjusted to exclude these items.  As adjusted, non-GAAP diluted net income and non-GAAP diluted earnings per share were $8.0 million and $0.12, respectively, for the three months ended September 30, 2016. As adjusted, non-GAAP diluted net income and non-GAAP diluted earnings per share were $20.9 million and $0.30, respectively, for the nine months ended September 30, 2016. No such adjustments were made to the GAAP results for the three and nine months ended September 30, 2017 due to the release of the valuation allowance recorded against the deferred tax assets during the fourth quarter of 2016.  

GAAP and non-GAAP net income for diluted earnings per share generally assumes all operating company membership units are converted into Company stock at the beginning of the reporting period, and the resulting change to our net income associated with our increased interest in the operating company is taxed at our historical effective tax rate, exclusive of the adjustments related to changes in the valuation allowance recorded against the deferred tax asset and other discrete and permanently non-deductible items.  Our effective tax rate, exclusive of these adjustments, was 36.7% for each of the three and nine months ended September 30, 2017, and 36.9% for each of the three and nine months 36.9% for the September 30, 2016.  See “Operating Results - Income Tax Expense” below.
 
We use these non-GAAP measures to assess the strength of the underlying operations of the business. We believe that these adjustments, and the non-GAAP measures derived from them, provide information to further analyze our operations between

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periods and over time. We also use non-GAAP net income as one factor in determining the amount of dividends we pay.  See “Dividend Policy” below.  Investors should consider these non-GAAP measures in addition to, and not as a substitute for, financial measures prepared in accordance with U.S. GAAP.

A reconciliation of the most comparable GAAP measures to the non-GAAP measures is included below:
 
For the Three Months Ended September 30,
 
For the Nine Months Ended September 30,
 
2017
 
2016
 
2017
 
2016
 
(in thousands, except share and per share data)
GAAP Net Income
$
2,989

 
$
2,165

 
$
7,954

 
$
5,193

Net Effect of Tax Receivable Agreement

 
(211
)
 

 
(269
)
Non-GAAP Net Income
$
2,989

 
$
1,954

 
$
7,954

 
$
4,924

 
 
 
 
 
 
 
 
Basic Weighted Average Shares Outstanding
17,285,307

 
16,390,298

 
17,319,948

 
15,807,340

GAAP Basic Earnings per Share
$
0.17

 
$
0.13

 
$
0.46

 
$
0.33

Net Effect of Tax Receivable Agreement

 
(0.01
)
 

 
(0.02
)
Non-GAAP Basic Earnings per Share
$
0.17

 
$
0.12

 
$
0.46

 
$
0.31

 
 
 
 
 


 


GAAP Net Income for Diluted Earnings per Share
$
11,862

 
$
8,192

 
$
31,077

 
$
21,167

Net Effect of Tax Receivable Agreement

 
(211
)