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Section 1: 10-K (10-K)

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Table of Contents

 
United States
Securities and Exchange Commission
Washington, D.C. 20549
 
 
Form 10-K
 
 
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2017
Commission file number 000-24498
 
 

392302317_diamondhillinvgroup4ca01a06.jpg

DIAMOND HILL INVESTMENT GROUP, INC.

(Exact name of registrant as specified in its charter)
 
 
Ohio
 
65-0190407
(State of
incorporation)
 
(I.R.S. Employer
Identification No.)
325 John H. McConnell Blvd., Suite 200,
Columbus, Ohio 43215
 
43215
(Address of principal executive offices)
 
(Zip Code)
Registrant's telephone number, including area code: (614) 255-3333
Securities registered pursuant to Section 12(b) of the Act:
Title of each class
 
Name of each exchange on which registered
Common shares, no par value
 
The NASDAQ Stock Market LLC
Securities registered pursuant to Section 12(g) of the Act: None
 
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  ¨    No  x
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.     Yes  ¨    No  x
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  ¨
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 (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K  x
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth 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
 
¨
  
Accelerated filer
 
x
 
 
 
 
 
 
 
Non-accelerated filer
 
¨ (Do not check if a smaller reporting company)
  
Smaller reporting company
 
¨
 
 
 
 
 
 
 
Emerging growth company
 
¨
 
 
 
 

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. ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x
Aggregate market value of the registrant’s common shares (the only common equity of the registrant) held by non-affiliates of the registrant, based on the closing price of $199.40 on June 30, 2017 on the NASDAQ Global Select Market was $640,892,537. Calculation of holdings by non-affiliates is based upon the assumption, for these purposes only, that the registrant’s executive officers and directors are affiliates.
The number of shares outstanding of the issuer's common stock, as of February 22, 2018, is 3,488,752 shares.
Documents Incorporated by Reference
Portions of the registrant’s definitive proxy statement for the 2018 Annual Meeting of Shareholders to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934, as amended, are incorporated by reference into Part III of this report.
 



Table of Contents

Diamond Hill Investment Group, Inc.
Form 10-K
For the Fiscal Year Ended December 31, 2017
Index
 
Required Information
Page
 
 
 
 
 
 
 
 

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Table of Contents

PART I
Item 1.
Business
Forward-Looking Statements
Throughout this Annual Report on Form 10-K, Diamond Hill Investment Group, Inc. (the "Company," "we," "us" and "our") may make forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, relating to such matters as anticipated operating results, prospects and levels of assets under management, technological developments, economic trends (including interest rates and market volatility), expected transactions and similar matters. The words “believe,” “expect,” “anticipate,” “estimate,” “should,” “hope,” “seek,” “plan,” “intend” and similar expressions identify forward-looking statements that speak only as of the date thereof. While we believe that the assumptions underlying our forward-looking statements are reasonable, investors are cautioned that any of the assumptions could prove to be inaccurate and, accordingly, our actual results and experiences could differ materially from the anticipated results or other expectations expressed in our forward-looking statements. Factors that could cause such actual results or experiences to differ from results discussed in the forward-looking statements include, but are not limited to: the adverse effect from a decline in the securities markets; a decline in the performance of our products; changes in interest rates; changes in national and local economic and political conditions; the continuing economic uncertainty in various parts of the world; changes in government policy and regulation, including monetary policy; changes in our ability to attract or retain key employees; unforeseen costs and other effects related to legal proceedings or investigations of governmental and self-regulatory organizations; and other risks identified from time-to-time in other public documents on file with the U. S. Securities and Exchange Commission (“SEC”), including those discussed below in Item 1A. Throughout this Annual Report on Form 10-K, when we use the terms the “Company,” “management,” “we,” “us,” and “our,” we mean Diamond Hill Investment Group, Inc. and its subsidiaries.
Overview
The Company, an Ohio corporation organized in April 1990, derives its consolidated revenue and net income from investment advisory and fund administration services provided by its subsidiary, Diamond Hill Capital Management, Inc. (“DHCM”). DHCM is a registered investment adviser under the Investment Advisers Act of 1940. DHCM sponsors, distributes, and provides investment advisory and related services to clients through Diamond Hill Funds (the "Funds"), institutional accounts, an exchange traded fund, and private investment funds. In July of 2016, the Company sold two former wholly owned operating subsidiaries, Beacon Hill Fund Services, Inc. (“BHFS”) and BHIL Distributors, Inc. (“BHIL” and collectively "Beacon Hill"). Until its sale, Beacon Hill provided fund administration and statutory underwriting services.
The Company’s primary objective is to fulfill our fiduciary duty to our clients. Our secondary objective is to grow the intrinsic value of the Company in order to achieve an adequate long-term return for our shareholders.
Investment Advisory Activities
Clients
The Company provides investment advisory services to a broad range of clients, including corporations, mutual funds, retirement plans, public pension funds, endowments, foundations, financial institutions and high net worth individuals. We strive to expand our client base by attracting new clients and earning additional business from existing clients.
Investment Philosophy
We believe intrinsic value is independent of market price and that competitive long-term returns can be achieved by identifying meaningful differences between the two. We believe we can identify those market opportunities and deliver value through our shared commitment to an intrinsic value-based investment philosophy, long-term perspective, and disciplined approach to active investment management.
Investment Process
DHCM’s equity investment process begins with fundamental research focusing on estimating a company’s intrinsic value independent of its current stock price. Bottom-up analysis, which takes into consideration earnings, revenue growth, operating margins and other economic factors, is of primary importance in estimating the intrinsic value of an individual company. A five-year discounted cash flow analysis is the primary methodology we use to determine whether there is a discrepancy between the current market price and DHCM’s estimate of intrinsic value. To forecast the amount and timing of cash flows, our research analysts concentrate on the fundamental economic drivers of the business, including competitive positioning, quality of management, and balance sheet strength. Research analysts also evaluate each company within the context of sector and

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industry secular trends. Key factors in analyzing sectors and industries include relative pricing power, ability to earn excess returns, long-term capital flow, and other fundamental factors.
DHCM also applies an intrinsic value philosophy and process to the analysis of fixed income securities. Our fixed income investment process is driven by security selection, sector allocation, yield curve positioning, and duration management in concert with the overall management of a high quality portfolio. We seek to generate excess return through the selection of undervalued securities and spread sectors that offer incremental yield and total return in comparison to a benchmark index. We believe that our team of industry specialists and their focus on the entire capital structure of a business often give us an information advantage over our peers.
DHCM believes that many investors’ short-term focus hinders their long-term results, which creates market inefficiencies and therefore opportunities. In addition, not all investors are valuation sensitive. We believe that we can exploit these market anomalies/inefficiencies by possessing a long-term investment temperament and practicing a consistent and repeatable intrinsic value-focused approach to investing.
Investment Advisory Fees
The Company’s principal source of revenue is investment advisory fee income earned from managing client accounts under investment advisory and sub-advisory agreements. The fees earned depend on the type of investment strategy, account size and servicing requirements. Revenues depend on the total value and composition of assets under management (“AUM”). Accordingly, net cash flows from clients, market fluctuations in client portfolios, and the composition of AUM impact our revenues and results of operations. We also have certain agreements which allow us to earn variable rate fees in the event that investment returns exceed targeted amounts during a measurement period.
Investment Strategies
The Company offers several traditional and alternative investment strategies, which are all based on the same intrinsic value philosophy. As of December 31, 2017, we offered the following representative investment strategies to our clients:
1.
Small Cap - Pursues long-term capital appreciation by investing in a portfolio of primarily small capitalization U.S. equity securities.
2.
Small-Mid Cap - Pursues long-term capital appreciation by investing in a portfolio of primarily small and medium capitalization U.S. equity securities.
3.
Mid Cap - Pursues long-term capital appreciation by investing in a portfolio of primarily medium capitalization U.S. equity securities.
4.
Large Cap - Pursues long-term capital appreciation by investing in a portfolio of primarily large capitalization U.S. equity securities.
5.
All Cap Select - Pursues long-term capital appreciation by investing in a concentrated portfolio of primarily U.S. equity securities across a broad range of market capitalizations.
6.
Long-Short - Pursues long-term capital appreciation by investing long and selling short primarily U.S. equity securities across a broad range of market capitalizations.
7.
Research Opportunities - Pursues long-term capital appreciation by investing long and selling short U.S. equity securities across a broad range of market capitalizations, as well as by investing up to 20% in international equity securities and up to 20% in fixed income securities.
8.
Financial Long-Short - Pursues long-term capital appreciation by investing long and selling short primarily U.S. financial services equity securities across a broad range of market capitalizations.
9.
Valuation-Weighted 500 - Pursues long-term capital appreciation by investing in large capitalization U.S. equity securities that seek to track the price and total return of the Diamond Hill Valuation-Weighted 500 Index.
10.
Short Duration Total Return - Pursues maximization of total return consistent with the preservation of capital by investing in high, medium, and low-grade fixed income securities.
11.
Core Bond - Pursues maximization of total return consistent with the preservation of capital by investing in a diversified portfolio of intermediate and long-term fixed income securities.
12.
Corporate Credit - Pursues high current income, preservation of capital, and total return over a five-year time horizon by investing primarily in corporate bonds across the credit spectrum.
13.
High Yield - Pursues high current income with the opportunity for capital appreciation by investing primarily in below-investment grade corporate bonds.

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As of January 1, 2018, the Company converted the Diamond Hill Global Fund, L.P. into the Diamond Hill Global Fund. The Diamond Hill Global Fund pursues long-term capital appreciation by investing in U.S. and foreign equity securities of any size, or from any country, including emerging markets.
Investment Results
The Company believes that one of the most important characteristics exhibited by the best investment firms is excellent investment returns for their clients over a long period of time. We are pleased that during our history as an investment advisory firm, we have delivered what we believe are strong long-term investment returns for our clients. Investment returns have been a key driver in the long-term success we have achieved in growing AUM.
Absolute returns for all of our investment strategies were positive in 2017, and as of December 31, 2017, the since-inception returns for nearly all of our strategies exceeded their respective benchmark returns. Our Mid Cap, Short Duration Total Return, Core Bond, and High Yield strategies have less than a five-year track record and, as always, we remain focused on a minimum of five-year periods to evaluate our results.
The following is a summary of the investment returns for each of our Funds as of December 31, 2017, relative to its respective passive benchmark.
 
 

As of December 31, 2017
 
Inception
 
1 Year
 
3 Year
 
5 Year
 
10 Year
 
Since Inception
Diamond Hill Small Cap Fund
12/29/2000
 
10.95
%
 
7.02
%
 
12.48
%
 
8.45
%
 
11.02
%
Russell 2000 Index

 
14.65
%
 
9.96
%
 
14.12
%
 
8.71
%
 
8.47
%
Diamond Hill Small-Mid Cap Fund
12/30/2005
 
8.63
%
 
9.16
%
 
14.61
%
 
10.43
%
 
9.46
%
Russell 2500 Index

 
16.81
%
 
10.07
%
 
14.33
%
 
9.22
%
 
9.10
%
Diamond Hill Mid Cap Fund
12/31/2013
 
10.47
%
 
9.68
%
 
 NA

 
 NA

 
9.24
%
Russell Midcap Index
 
 
18.52
%
 
9.58
%
 
 NA

 
 NA

 
10.48
%
Diamond Hill Large Cap Fund
6/29/2001
 
20.30
%
 
10.99
%
 
15.64
%
 
8.54
%
 
8.96
%
Russell 1000 Index

 
21.69
%
 
11.23
%
 
15.71
%
 
8.59
%
 
7.22
%
Diamond Hill All Cap Select Fund
12/30/2005
 
20.33
%
 
9.25
%
 
16.00
%
 
8.61
%
 
8.84
%
Russell 3000 Index

 
21.13
%
 
11.12
%
 
15.58
%
 
8.60
%
 
8.88
%
Diamond Hill Long-Short Fund
6/30/2000
 
5.99
%
 
4.93
%
 
8.89
%
 
4.55
%
 
6.93
%
60% Russell 1000 Index / 40% ICE BofAML U.S. T-Bill 0-3 Mo Index

 
12.92
%
 
6.88
%
 
9.39
%
 
5.52
%
 
4.36
%
Diamond Hill Research Opportunities Fund
3/31/2009
 
13.34
%
 
5.77
%
 
10.99
%
 
 NA

 
13.49
%
75% Russell 3000 Index / 25% ICE BofAML U.S. T-Bill 0-3 Mo Index
 
 
15.74
%
 
8.44
%
 
11.65
%
 
 NA

 
13.05
%
Diamond Hill Financial Long-Short Fund
8/1/1997
 
11.90
%
 
8.41
%
 
13.66
%
 
5.42
%
 
7.79
%
80% Russell 3000 Financials Index / 20% ICE BofAML U.S. T-Bill 0-3 Mo Index

 
15.92
%
 
10.12
%
 
13.51
%
 
4.57
%
 
5.63
%
Diamond Hill Short Duration Total Return Fund
7/5/2016
 
4.33
%
 
 NA

 
 NA

 
 NA

 
3.76
%
Bloomberg Barclays U.S. 1-3 Yr. Gov./Credit Index
 
 
0.84
%
 
 NA

 
 NA

 
 NA

 
0.26
%
Diamond Hill Core Bond Fund
7/5/2016
 
4.17
%
 
 NA

 
 NA

 
 NA

 
1.29
%
Bloomberg Barclays U.S. Aggregate Index
 
 
3.54
%
 
 NA

 
 NA

 
 NA

 
0.15
%
Diamond Hill Corporate Credit Fund
9/30/2002
 
7.87
%
 
7.10
%
 
5.78
%
 
7.07
%
 
7.28
%
ICE BofAML U.S. Corporate & High Yield Index

 
6.66
%
 
4.34
%
 
3.94
%
 
6.02
%
 
6.26
%
Diamond Hill High Yield Fund
12/4/2014
 
10.36
%
 
8.25
%
 
 NA

 
 NA

 
8.17
%
ICE BofAML U.S. High Yield Index
 
 
7.48
%
 
6.39
%
 
 NA

 
 NA

 
6.02
%
________________________
-
Fund returns are Class I shares net of fees
-
Index returns do not reflect any fees

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Assets Under Management
The following tables show AUM by product and investment objective, as well as net client cash flows, for the past five years ended December 31, 2017:

 
Assets Under Management
As of December 31,
(in millions)
2017
 
2016
 
2015
 
2014
 
2013
Proprietary funds
$
15,974

 
$
13,618

 
$
11,505

 
$
9,863

 
$
7,600

Sub-advised funds
1,518

 
1,445

 
665

 
665

 
444

Institutional accounts
4,825

 
4,318

 
4,671

 
5,128

 
4,142

Total AUM
$
22,317

 
$
19,381

 
$
16,841

 
$
15,656

 
$
12,186

 
 
Assets Under Management
by Investment Strategy
As of December 31,
(in millions)
2017
 
2016
 
2015
 
2014
 
2013
Small Cap
$
1,525

 
$
1,843

 
$
1,703

 
$
1,575

 
$
1,402

Small-Mid Cap
3,528

 
3,329

 
2,070

 
1,279

 
780

Mid Cap
130

 
59

 
18

 
16

 

Large Cap
10,867

 
8,497

 
7,547

 
7,926

 
6,254

All Cap Select
450

 
404

 
545

 
432

 
327

Long-Short
4,980

 
4,613

 
4,597

 
4,179

 
3,213

Corporate bonds
699

 
581

 
361

 
249

 
210

Core fixed income
357

 
237

 

 

 

  (Less: Investments in affiliated funds)(a)
(219
)
 
(182
)
 

 

 

Total AUM
$
22,317

 
$
19,381

 
$
16,841

 
$
15,656

 
$
12,186

(a) Certain Diamond Hill Funds own shares of the Diamond Hill Short Duration Total Return Fund. The Company reduces its total AUM by these investments held in this affiliated fund.
 
Change in Assets Under Management
For the Year Ended December 31,
(in millions)
2017
 
2016
 
2015
 
2014
 
2013
AUM at beginning of the year
$
19,381

 
$
16,841

 
$
15,656

 
$
12,186

 
$
9,429

Net cash inflows (outflows)

 

 

 

 

proprietary funds
843

 
548

 
1,916

 
1,618

 
713

sub-advised funds
(164
)
 
639

 
(6
)
 
166

 
(758
)
institutional accounts
(254
)
 
(1,023
)
 
(443
)
 
478

 
(263
)

425

 
164

 
1,467

 
2,262

 
(308
)
Net market appreciation/(depreciation) and income
2,511

 
2,376

 
(282
)
 
1,208

 
3,065

Increase during the year
2,936

 
2,540

 
1,185

 
3,470

 
2,757

AUM at end of the year
$
22,317

 
$
19,381

 
$
16,841

 
$
15,656

 
$
12,186

Capacity
The Company’s primary goal is to fulfill our fiduciary duty to clients. We understand that our ability to retain and grow assets as a firm has been, and will be, driven primarily by delivering attractive long-term investment results to our clients. When we have determined that the size of any of our strategies hinders our ability to add value over a passive alternative, we have closed those strategies to new clients and we will continue to do so, which will impact our ability to grow AUM. We have prioritized, and will continue to prioritize, investment results over asset accumulation. Currently, the Long-Short, Small Cap, and Small-Mid Cap strategies are closed to new investors.
We estimate capacity of $25 - 35 billion for our existing equity strategies ($21.3 billion as of December 31, 2017) and capacity of at least $40 billion for our existing fixed income strategies ($1.0 billion as of December 31, 2017).  Determining our AUM

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capacity requires evaluating each of our investment strategies and estimating individual strategy capacity, given market capitalization and concentration constraints as well as investment objectives.  Total firm capacity is not simply a sum of the individual strategies and is affected by overlap between strategies.  With the development of new products or strategies, our firm level capacity could increase.
Distribution Channels
The Company’s investment advisory services are distributed through multiple channels. Our institutional sales efforts include building relationships with institutional consultants and also establishing direct relationships with institutional clients. Our sales efforts for the Funds include wholesaling to third-party financial intermediaries, including independent registered investment advisers, brokers, financial planners, and wealth advisers, who utilize the Funds in investment programs they construct for their clients.
AUM by Channel
Below is a summary of our AUM by distribution channel for the five years ended December 31, 2017:
 
 
AUM by Distribution Channel
As of December 31,
(in millions)
2017
 
2016
 
2015
 
2014
 
2013
Proprietary funds:
 
 
 
 
 
 
 
 
 
Registered investment advisers
$
4,010

 
$
3,508

 
$
2,723

 
$
2,363

 
$
1,678

Independent broker/dealers
3,581

 
2,922

 
2,329

 
1,862

 
1,400

Wirehouse broker/dealers
2,660

 
2,011

 
1,963

 
1,760

 
1,261

Banks
3,456

 
3,175

 
2,735

 
2,176

 
1,668

Defined contribution
1,840

 
1,535

 
1,218

 
1,232

 
1,226

Other
427

 
467

 
537

 
470

 
367

Total proprietary funds
15,974

 
13,618

 
11,505

 
9,863

 
7,600

Sub-advised funds
1,518

 
1,445

 
665

 
665

 
444

Institutional accounts:
 
 
 
 
 
 
 
 
 
Institutional consultant
2,357

 
2,074

 
2,370

 
2,681

 
1,965

Financial intermediary
1,691

 
1,358

 
1,474

 
1,573

 
1,488

Direct
777

 
886

 
827

 
874

 
689

Total institutional accounts
4,825

 
4,318

 
4,671

 
5,128

 
4,142

Total AUM
$
22,317

 
$
19,381

 
$
16,841

 
$
15,656

 
$
12,186

Growth Strategy
The Company’s growth strategy will remain focused on achieving excellent investment results in all our strategies and providing the highest level of client service. We will continue to focus on the development of distribution channels to enable us to offer our various investment strategies to a broad array of clients. We seek to continue to grow our AUM through our proprietary funds, institutional accounts, and sub-advised funds. We have a targeted strategic business plan to further penetrate our existing distribution channels. Our business development efforts are focused on expanding the institutional consultant channel and plan sponsor network on the institutional side, as well as our intermediary network on the fund side.
Fund Administration Activities
The Company provides fund administration services to the Funds. Fund administration services are broadly defined as portfolio and regulatory compliance, treasury and financial oversight, oversight of back-office service providers such as the custodian, fund accountant, and transfer agent, and general business management and governance of the mutual fund complex. Prior to the sale of Beacon Hill, the Company also provided fund administration services to other third party mutual fund companies and investment advisers.

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Competition
Competition in the area of investment management is intense, and our competitors include investment management firms, broker-dealers, banks and insurance companies, some of whom offer various investment alternatives, including passive index strategies. Many competitors are better known than the Company, offer a broader range of investment products and have more offices, employees and business development representatives. We compete primarily on the basis of philosophy, performance and client service.
Regulation
The Company and our business are subject to various federal, state and foreign laws and regulations. As a matter of public policy, regulatory bodies are charged with safeguarding the integrity of the securities and other financial markets and with protecting the interests of participants in those markets, including investment advisory clients and shareholders of investment funds. Under these laws and regulations, agencies that regulate investment advisers have broad administrative powers, including the power to limit, restrict or prohibit an investment adviser from carrying on its business in the event the adviser fails to comply with such laws and regulations. Possible sanctions that may be imposed include civil and criminal liability, the suspension of individual employees, limitations on engaging in certain lines of business for specified periods of time, revocation of investment adviser, broker/dealer, and other registrations, censures and fines.
DHCM is registered with the SEC under the Investment Advisers Act of 1940 (the “Advisers Act”) and operates in a highly regulated environment. The Advisers Act imposes numerous obligations on registered investment advisers, including fiduciary duties, recordkeeping requirements, operational requirements and disclosure obligations. All Diamond Hill Funds are registered with the SEC under the Investment Company Act of 1940 and are required to make notice filings with all states where the Funds are offered for sale. Virtually all aspects of our investment advisory and fund administration business are subject to various federal and state laws and regulations.

To the extent that DHCM is a “fiduciary” under the Employee Retirement Income Security Act of 1974 (“ERISA”) with respect to benefit plan clients, it is subject to ERISA regulations. ERISA and applicable provisions of the Internal Revenue Code impose certain duties on persons who are fiduciaries, prohibit certain transactions involving ERISA plan clients, and provide monetary penalties for violations of these prohibitions. The U.S. Department of Labor, which administers ERISA, has been increasingly active in proposing and adopting regulations affecting the asset management industry.
The Company’s trading activities for client accounts are regulated under the Securities Exchange Act of 1934 (the “Exchange Act”), including laws governing trading on inside information, market manipulation and a broad number of trading requirements (e.g., volume limitations, reporting obligations) and market regulation policies in the United States.
The preceding descriptions of the regulatory and statutory provisions applicable to us are not complete and are qualified in their entirety by reference to their respective statutory or regulatory provisions. Failure to comply with these requirements could have a material adverse effect on our business.
Contractual Relationships with the Diamond Hill Funds
The Company is highly dependent on our contractual relationships with the Funds. In the event our advisory or administration agreements with the Funds are terminated, not renewed, or amended to reduce fees, we would be materially and adversely affected. We generated approximately 80%, 74% and 75% of our 2017, 2016 and 2015 revenues, respectively, from our advisory and administrative contracts with the Funds. We consider our relationship with the Funds and their board of trustees to be good, and have no reason to believe that these advisory or administration contracts will not be renewed in the future; however, there is no assurance that the Funds will choose to continue their relationships with the Company. Please see Item 1A for risk factors regarding this relationship.
Employees
As of December 31, 2017, the Company employed 118 full-time equivalent employees. As of December 31, 2016, the number of full-time equivalent employees was 112. We believe that our relationship with our employees is good. Our employee count has grown year-over-year and we expect that general trend to continue.

SEC Filings
The Company maintains an Internet website at www.diamond-hill.com. Our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, XBRL instance documents, Current Reports on Form 8-K and amendments to those reports that we file or furnish pursuant to Section 13(a) or 15(d) of the Exchange Act, are made available free of charge, on or through our website, as soon as reasonably practicable after such material is electronically filed with, or furnished to, the SEC. The contents of our

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website are not incorporated into, or otherwise made a part of, this Annual Report on Form 10-K. Our filings with the Commission may be read and copied at the Commission's Public Reference Room at 100F Street, NE, Washington, DC 20549. These filings are also available on the Commission's web-site at http://www.sec.gov free of charge.

ITEM 1A.
Risk Factors
Our future results of operations, financial condition, and liquidity, and the market price of our common shares are subject to various risks, including those mentioned below and those that are discussed from time-to-time in our other periodic filings with the SEC. Investors should carefully consider these risks, along with the other information contained in this report, before making an investment decision regarding our common shares. There may be additional risks of which we are currently unaware, or which we currently consider immaterial. The occurrence of any of these risks could have a material adverse effect on our financial condition, results of operations, and liquidity, and the value of our common shares. Please see “Forward Looking Statements” within Item 1 of Part I of this Form 10-K. We assume no obligation to update any forward looking statements as a result of new information, future events or other factors.
Poor investment results of our products could affect our ability to attract new clients or reduce the amount of assets under management, potentially negatively impacting revenue and net income.
If we fail to deliver acceptable investment results for our clients, both in the short and long term, we will likely experience diminished investor interest and a decreased level of AUM. Adverse opinions of the funds we advise published by third parties, including rating agencies and industry analysts, could also decrease our AUM and our revenues.
Investment funds are assessed and rated by independent third parties, including rating agencies, industry analysts and publications. Investors can be influenced by such ratings. If any of the funds we advise receives an adverse report, it could negatively influence the amount of money invested into the fund and increase withdrawals from the fund reducing our AUM and our revenue.
Our success depends on our key personnel, and our financial performance could be negatively affected by the loss of their services.
Our success depends on highly skilled personnel, including portfolio managers, research analysts, and management, many of whom have specialized expertise and extensive experience in the investment management industry. Financial services professionals are in high demand, and we face significant competition for qualified employees. With the exception of R. H. Dillon, our Chairman and a portfolio manager, our employees do not have employment contracts and generally can terminate their employment at any time. We cannot assure that we will be able to retain or replace key personnel. In order to retain or replace our key personnel, we may be required to increase compensation, which would decrease net income. The loss of key personnel could damage our reputation and make it more difficult to retain and attract new employees and clients. A loss of client assets resulting from the departure of key personnel may materially decrease our revenues and net income.
Our AUM, which impacts revenue, is subject to significant fluctuations.
A large majority of our revenue is calculated as a percentage of AUM or is related to the general performance of the equity securities market. A decline in securities prices or in the sale of investment products, or an increase in fund redemptions, generally would reduce revenue and net income. Financial market declines would generally negatively impact the level of our AUM and consequently our revenue and net income. A recession or other economic or political events, both in the United States as well as globally, could also adversely impact our revenue, if such events led to a decreased demand for products, a higher redemption rate, or a decline in securities prices.
Our investment results and/or the growth in our AUM may be constrained if appropriate investment opportunities are not available or if we close certain of our portfolios to new investors.
Our ability to deliver strong investment results depends in large part on our ability to identify appropriate investment opportunities in which to invest client assets. If we are unable to identify sufficient investment opportunities for existing and new client assets on a timely basis, our investment results could be adversely affected. The risk that appropriate investment opportunities may be unavailable is influenced by a number of factors, including general market conditions, and is likely to increase if our AUM increases rapidly. In addition, if we determine that sufficient investment opportunities are not available for a portfolio strategy, or we believe that it is necessary in order to continue to produce attractive returns from a portfolio, we will consider closing the portfolio to new investors. As of December 31, 2017, we have closed three investment strategies to new investors. If we misjudge the point at which it would be optimal to close a portfolio, the investment results of the portfolio could be negatively impacted.

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Our investment approach may underperform other investment approaches during certain market conditions.
Our investment strategies are best suited for investors with long-term investment horizons.  Our investment strategies may not perform well during certain periods of time, including during periods when the market is more narrowly focused on growth-oriented stocks. 
Additionally, since we apply the same intrinsic value investment process across all of our strategies, utilizing the same analyst team, and due to overlap in many of our investment strategies, we could have common positions and industry concentrations across many of our strategies at the same time.  As such, factors leading one of our investment strategies to underperform may lead other strategies to underperform at the same time.
We are subject to substantial competition in all aspects of our business.
Our investment products compete against a number of investment products and services from:
asset management firms;
mutual fund companies;
commercial banks and thrift institutions;
insurance companies;
exchange traded funds;
hedge funds; and
brokerage and investment banking firms.
Many of our competitors have substantially greater resources than we have and may operate in more markets or offer a broader range of products, including passively managed or “index” products. Some of these institutions operate in a different regulatory environment, which may give them certain competitive advantages in the investment products and portfolio structures that they offer. We compete with other providers of investment services primarily based upon our philosophy, performance and client service. Some institutions have a broad array of products and distribution channels that make it more difficult for us to compete with them. If current or potential customers decide to use one of our competitors, we could face a significant decline in market share, AUM, revenues, and net income. If we are required to lower our fees in order to remain competitive, our net income could be significantly reduced because some of our expenses are fixed, especially over shorter periods of time, and our expenses may not decrease in proportion to the decrease in revenues. Additionally, over the past several years, investors have generally shown a preference for passive investment products, such as index and exchange traded funds, over actively managed strategies. If this trend continues, our AUM may be negatively impacted.
Market and competitive pressures in recent years have created a trend towards lower management fees in the asset management industry and there can be no assurance that we will be able to maintain our current fee structure. As a result, a shift in our AUM from higher to lower fee generating clients and strategies would result in a decrease in profitability even if our AUM increases or remains unchanged.
The loss of access to or increased fees required by third-party distribution sources to market our portfolios and access our client base could adversely affect our results of operations.
Our ability to attract additional AUM is dependent on our relationship with third-party financial intermediaries. We compensate some of these intermediaries for access to investors and for various marketing services provided. These distribution sources and client bases may not continue to be accessible to us for reasonable terms, or at all. If such access is restricted or eliminated, it could have an adverse effect on our results of operations. Fees paid to financial intermediaries for investor access and marketing services have generally increased in recent years. If such fee increases continue, refusal to pay them could restrict our access to those client bases while paying them could adversely affect our profitability.
A significant portion of the Company’s revenues are based on contracts with the Funds that are subject to termination without cause and on short notice.
The Company is very dependent on our contractual relationships with the Funds. If our advisory or administration agreements with the Funds were terminated, not renewed, or amended to reduce fees, we would be materially and adversely affected. Generally, these agreements are terminable by either party upon 60 days written notice without penalty. The agreements are subject to annual approval by either (i) the board of trustees of the Funds or (ii) a vote of the majority of the outstanding voting securities of each Fund. The agreements automatically terminate in the event of their assignment by either the Company or the Fund. We generated approximately 80%, 74%, and 75% of our 2017, 2016 and 2015 revenues, respectively, from our advisory and administrative contracts with the Funds, including 29%, 17%, and 12% from the advisory contracts with the Diamond Hill Long-Short Fund, Large Cap Fund, and Small-Mid Cap Fund, respectively, during 2017. The loss of the Long-Short Fund,

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Large Cap Fund, or Small-Mid Cap Fund contracts would have a material adverse effect on the Company. We consider our relationship with the Funds and their board of trustees to be good, and we have no reason to believe that these advisory or administration contracts will not be renewed in the future; however, there can be no assurance that the Funds will choose to continue their relationships with us.
Our investment income and asset levels may be negatively impacted by fluctuations in our investment portfolio.
We currently have a substantial portion of our assets invested in Company sponsored investments. All of these investments are subject to market risk and our non-operating investment income could be adversely affected by adverse market performance. Fluctuations in investment income are expected to occur in the future.
Changes in tax laws and unanticipated tax obligations could have an adverse impact on our financial condition, results of operations and cash flow.
We are subject to federal, state and local income taxes in the United States. Tax authorities may disagree with certain positions we have taken or implement changes in tax policy, which may result in the assessment of additional taxes. We regularly assess the appropriateness of our tax positions and reporting. We cannot provide assurance, however, that we will accurately predict the outcomes of audits, and the actual outcomes of these audits could be unfavorable.
Unauthorized disclosure of sensitive or confidential client or customer information, whether through a breach of our computer systems or otherwise, or other breaches in the security of our systems could severely harm our business.
As part of our business, we collect, process and transmit sensitive and confidential information about our clients and employees, as well as proprietary information about our business. We have policies and procedures pursuant to which we take numerous security measures to prevent cyber-attacks of various kinds as well as fraudulent and inadvertent activity by persons who have been granted access to such confidential information. Nevertheless, our systems, like all technology systems, remain vulnerable to unauthorized access, which can result in theft or corruption of information. In addition, we share information with third parties upon whom we rely for various functions. The systems of such third parties also are vulnerable to cyber threats. Attacks can come from unrelated third parties through the internet, from access to hardware removed from our premises or those of third parties or from employees acting intentionally or inadvertently.
Cyber incidents can involve deliberate attacks designed to corrupt our information systems and make them unusable by us to operate our business; thefts of information used by the perpetrators for gain in numerous ways; or inadvertent releases of information by employees or third parties with whom we do business.
Cyber-attacks that corrupt our information systems and make them unusable by us could impair our ability to advise our clients on investments to be made. Corruption of the systems of our third-party vendors could impact the Company to the same extent as corruption of our own systems. If information about our employees is intentionally stolen or inadvertently made public, that information could be used to commit identity theft, obtain credit in an employee's name or steal from an employee. If information about our business is obtained by unauthorized persons, whether through intentional attacks or inadvertent releases of information, it could be used to harm our competitive position.
Whether information is corrupted, stolen or inadvertently disclosed, and regardless of the nature of the information, whether it be proprietary information or personal information about clients or employees, the results could be multiple and materially harmful to us.
Our reputation could be harmed, resulting in the loss of clients, vendors and employees or making payments or concessions to such persons to maintain our relationships with them. The loss of key personnel or contracts with the Funds would be particularly harmful to our business.
Our inability to operate our business fully, even if temporarily, and thus fulfill contracts with clients or vendors could result in terminations of contracts and loss of revenue.
Harm suffered by clients or vendors whose contracts we have breached, or by clients, vendors or employees whose information is compromised, could result in costly litigation against us.
Our need to focus attention on remediation of a cyber problem could take our attention away from the operation of our business, resulting in lost revenue.
We could incur costs to repair systems made inoperable by a cyber-attack and to make changes to our systems to reduce future cyber threats. Those changes could include obtaining additional technologies as well as employing additional personnel and training employees.

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The interruption of our business or theft of proprietary information could harm our ability to compete.
All of the above potential results of a cyber incident could have a material adverse effect on the Company's business, financial condition and results of operations.
Operational risks may disrupt our business, result in losses or limit our growth.
We are dependent on the capacity and reliability of the communications, information and technology systems supporting our operations, whether developed, owned and operated by the Company or by third parties. Operational risks such as trading or operational errors, interruption of our financial, accounting, trading, compliance and other data processing systems, the loss of data contained in the systems, or compromised systems due to cyber-attack, could result in a disruption of our business, liability to clients, regulatory intervention or reputational damage, and thus adversely affect our business.
Our business is subject to substantial governmental regulation, which can change frequently and may increase costs of compliance; reduce revenue; result in fines, penalties and lawsuits for noncompliance; and adversely affect our results of operations and financial condition.
Our business is subject to a variety of federal securities laws, including the Investment Advisers Act of 1940, the Investment Company Act of 1940, the Securities Exchange Act of 1934, the Sarbanes-Oxley Act of 2002, and the U.S. PATRIOT Act of 2001 and the Dodd-Frank Wall Street Reform and Consumer Protection Act. In addition, we are subject to significant regulation and oversight by the SEC. Changes in legal, regulatory, accounting, tax and compliance requirements could have a significant effect on our operations and results, including but not limited to increased expenses and reduced investor interest in certain funds and other investment products we offer. We continually monitor legislative, tax, regulatory, accounting, and compliance developments that could impact our business. We and our directors, officers and employees could be subject to lawsuits or regulatory proceedings for violations of such laws and regulations, which could result in the payment of fines or penalties and cause reputational harm to us. Such harm could negatively affect our financial condition and results of operations, as well as divert management's attention from operations.
We continue to seek to understand, evaluate and, when possible, manage and control these and other business risks.
Trading in our common shares is limited, which may adversely affect the time and the price at which you can sell your shares of the Company.
Although our common shares are listed on the NASDAQ Global Select Market, the shares are held by a relatively small number of shareholders, and trading in our common shares is not active. The spread between the bid and the asked prices is often wide. As a result, you may not be able to sell your shares on short notice, and the sale of a large number of shares at one time could temporarily depress the market price. In addition, certain shareholders, including certain directors and officers of the Company, own a significant number of shares. The sale of a large number of shares by any such individual could temporarily depress the market price.

ITEM 1B.
Unresolved Staff Comments
None.

ITEM 2.
Properties
The Company leases office space at one location in Columbus, Ohio.
The Company does not own any real estate or interests in real estate.

ITEM 3.
Legal Proceedings
From time to time, the Company is party to ordinary routine litigation that is incidental to its business. There are currently no such matters pending that the Company believes could have a material adverse effect on its consolidated financial statements.

ITEM 4.
Mine Safety Disclosures
Not applicable.

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Table of Contents

PART II
ITEM 5.
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
The following performance graph compares the total shareholder return of an investment in our common shares to that of the Russell Microcap® Index, and to a peer group index of publicly traded asset management firms for the five-year period ended on December 31, 2017. The graph assumes that the value of the investment in our common shares and each index was $100 on December 31, 2012. Total return includes reinvestment of all dividends. The Russell Microcap® Index makes up less than 3% of the U.S. equity market and is a market-value-weighted index of the smallest 1,000 securities in the small-cap Russell 2000® Index plus the next 1,000 smallest securities. Peer Group returns are weighted by the market capitalization of each firm at the beginning of the measurement period. The historical information set forth below is not necessarily indicative of future performance. We do not make or endorse any predictions as to future stock performance.

392302317_dhil-201712chart.jpg
 
12/31/2012
 
12/31/2013
 
12/31/2014
 
12/31/2015
 
12/31/2016
 
12/31/2017
Cumulative 5 Year Total Return
Diamond Hill Investment Group, Inc.
$100
 
$179
 
$215
 
$302
 
$345
 
$351
251
%
Russell Microcap® Index
$100
 
$146
 
$151
 
$143
 
$172
 
$195
95
%
Peer Group*
$100
 
$166
 
$166
 
$126
 
$110
 
$134
34
%

* The Peer Group is based upon all asset managers with market cap of less than $5 billion excluding (i) firms whose primary business is hedge fund or private equity, and (ii) firms with multiple lines of business. The following companies are included in the Peer Group: Alliance Bernstein Holding L.P.; Cohen & Steers, Inc.; Federated Investors, Inc.; GAMCO Investors, Inc.; Hennessy Advisors, Inc.; Legg Mason, Inc.; Manning & Napier, Inc.; Pzena Investment Management, Inc.; Teton Advisors, Inc.; U.S. Global Investors, Inc.; Virtus Investment Partners, Inc.; Waddell & Reed Financial, Inc.; Wisdomtree Investments, Inc.; and Westwood Holdings Group, Inc.

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The Company’s common shares trade on the NASDAQ Global Select Market under the symbol DHIL. The following table sets forth the high and low sales prices during each quarter of 2017 and 2016:
 
 
2017
 
2016
 
High
Price
 
Low
Price
 
Dividend
Per Share
 
High
Price
 
Low
Price
 
Dividend
Per Share
Quarter ended:
 
 
 
 
 
 
 
 
 
 
 
March 31
$
210.95

 
$
183.60

 
$

 
$
192.91

 
$
154.21

 
$

June 30
$
207.40

 
$
188.34

 
$

 
$
198.11

 
$
167.00

 
$

September 30
$
214.66

 
$
188.71

 
$

 
$
198.40

 
$
179.71

 
$

December 31
$
217.83

 
$
204.87

 
$
7.00

 
$
212.79

 
$
172.30

 
$
6.00

Due to the relatively low trading volume of our shares, bid/ask spreads can be wide at times and, therefore, quoted prices may not be indicative of the price a shareholder may receive in an actual transaction. During the years ended December 31, 2017 and 2016, approximately 2,697,958 and 2,360,037, respectively, of our common shares were traded. The dividends indicated above were special dividends. We have not paid regular quarterly dividends in the past, and have no present intention of paying regular quarterly dividends in the future. The approximate number of record holders of our common shares at December 31, 2017 was 212, although we believe that the number of beneficial owners of our common shares is substantially greater.
Purchases of Equity Securities by the Issuer and Affiliated Purchasers
The Company did not purchase any of our common shares through the repurchase program during the year ended December 31, 2017. The following table sets forth information regarding our repurchase program of our common shares and shares withheld for tax payments due upon vesting of employee restricted stock units and restricted stock awards which vested during the fourth quarter of fiscal year 2017:
 
Period
Total Number
of Shares Purchased
(a)
 
Average Price
Paid Per Share
 
Total Number
of Shares Purchased
as part of Publicly
Announced Plans
or Programs
 
Maximum Number
of Shares That May
Yet Be Purchased
Under the Plans or
Programs
(b)
October 1, 2017 through October 31, 2017
1,729

 
$
212.35

 

 
318,433

November 1, 2017 through November 30, 2017

 
$

 

 
318,433

December 1, 2017 through December 31, 2017
8,777

 
$
206.10

 

 
318,433

Total
10,506

 
$
207.13

 

 
318,433

 
(a)
All of the 10,506 shares of the Company's common shares purchased during the quarter ended December 31, 2017 represented shares withheld for tax payments due upon the vesting of employee restricted stock units and restricted stock awards which vested during the quarter.
(b)
The Company currently has a share repurchase program where the Board of Directors has authorized management to repurchase up to 350,000 of the Company's Common Shares in the open market and in private transactions in accordance with applicable securities laws. Our share repurchase program is not subject to an expiration date.

We sold no equity securities of the Company during 2017 that were not registered under the Securities Act of 1933.


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Table of Contents

ITEM 6.
Selected Financial Data
The following selected financial data should be read in conjunction with our Consolidated Financial Statements and related notes and Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in this Annual Report on Form 10-K. 
 
For the Years Ended December 31,
(in thousands, except per share data)
2017
 
2016
 
2015
 
2014
 
2013
Income Statement Data:
 
 
 
 
 
 
 
 
 
Total revenues
$
145,202

 
$
136,103

 
$
124,426

 
$
104,559

 
$
81,432

Compensation and related costs
54,856

 
52,265

 
47,951

 
43,892

 
40,852

Other expenses
23,345

 
20,769

 
17,755

 
13,207

 
9,898

Total expenses
78,201

 
73,034

 
65,706

 
57,099

 
50,750

Net operating income
67,001

 
63,069

 
58,720

 
47,460

 
30,682

Operating profit margin
46
%
 
46
%
 
47
%
 
45
%
 
38
%
Net income
51,602

 
46,594

 
37,074

 
31,581

 
22,155

Net income attributable to common shareholders
49,989

 
46,052

 
37,074

 
31,581

 
22,155

Per Share Information:
 
 
 
 
 
 
 
 
 
Basic earnings
$
14.49

 
$
13.52

 
$
11.31

 
$
9.88

 
$
7.05

Diluted earnings
14.48

 
13.49

 
11.03

 
9.67

 
6.94

Cash dividend declared
7.00

 
6.00

 
5.00

 
4.00

 
3.00

Weighted Average Shares Outstanding
 
 
 
 
 
 
 
 
 
Basic
3,449

 
3,407

 
3,278

 
3,196

 
3,142

Diluted
3,452

 
3,413

 
3,360

 
3,266

 
3,194

 
At December 31,
 
2017
 
2016
 
2015
 
2014
 
2013
Balance Sheet Data (in thousands):
 
 
 
 
 
 
 
 
 
Total assets
$
250,388

 
$
199,718

 
$
145,187

 
$
107,709

 
$
75,353

Long-term debt

 

 

 

 

Shareholders equity
172,444

 
139,224

 
105,314

 
74,319

 
44,943

Book value per share
$
49.69

 
$
40.81

 
$
30.84

 
$
22.40

 
$
13.80

Assets Under Management (in millions)
$
22,317

 
$
19,381

 
$
16,841

 
$
15,656

 
$
12,186

Net Client Inflows (Outflows) (in millions)
425

 
164

 
1,467

 
2,262

 
(308
)

ITEM 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
In this section, we discuss and analyze the consolidated results of operations for the past three fiscal years and other factors that may affect future financial performance. This discussion should be read in conjunction with our Consolidated Financial Statements, Notes to Consolidated Financial Statements, and Selected Financial Data contained in this Form 10-K.
Business Environment
U.S. equity markets were strong throughout 2017, with all major indices finishing the year at all-time highs. A major theme in 2017 was the performance of growth over value, a gap which continued to widen as the year went on. Investors placed a premium on growth, which propelled the Russell 1000 Growth Index to a significant outperformance compared to the Russell 1000 Value Index. This environment makes it more challenging for long-term intrinsic value managers like DHCM to outperform our respective benchmarks.
Additionally, the ongoing discussion around active versus passive management continued in 2017. We continue to believe that Diamond Hill strategies will outperform their respective passive benchmarks over a full market cycle, driven by a shared commitment to our intrinsic value-based investment philosophy, long-term perspective, disciplined approach, and alignment with our clients’ interests.

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Table of Contents

Assessing the impact of macroeconomic factors has been a more important part of estimating the long-term intrinsic value of companies in recent years; however, it is still just one of many factors that we consider. As always, bottom-up analysis is of primary importance in estimating the intrinsic value of an individual company, which includes both valuation and business fundamentals.
Low interest rates, high corporate profit margins, and steady economic growth with low inflation have continued to contribute to historically high stock valuations. Despite high valuations and extremely low volatility, we see no immediate signs of fundamental excess. Corporate tax reform is likely to boost earnings growth in the near term with most U.S. companies benefiting from a reduced tax burden. In addition, repatriation of cash held overseas and a more competitive tax regime may lead to increased levels of investment in the United States.
Given current valuation levels, we expect positive but below-average equity market returns over the next five years. Prospective returns are likely to be tempered by the combination of above-average price/earnings multiples applied to already very strong levels of corporate profit margins.
Spread levels in both the investment grade and high yield credit markets remain compressed as investors continue their search for yield. As such, we believe strong fundamental analysis and a focus on long-term company and collateral performance are the keys to security selection in our fixed income strategies.
We believe we can achieve better-than-market returns over the next five years through active portfolio management, and our primary focus is always on achieving value-added results for our clients. Our intrinsic value investment philosophy is shared by all of our portfolio managers and research analysts, allowing us to apply our investment discipline consistently across all strategies.
A large majority of our revenue is calculated as a percentage of AUM and is therefore impacted by the overall business and economic environment described above. Financial market declines or deterioration in the economic environment would generally negatively impact the level of our AUM, and consequently our revenue and net income.
Key Financial Performance Indicators
There are a variety of key performance indicators the Company monitors in order to evaluate our business results. The following table presents the results of certain key performance indicators over the past three fiscal years:
 
For the Years Ended December 31,
 
2017
 
2016
 
2015
Ending AUM (in millions)
$
22,317

 
$
19,381

 
$
16,841

Average AUM (in millions)
20,876

 
17,780

 
16,415

Net cash inflows (in millions)
425

 
164

 
1,467

 
 
 
 
 
 
Total Revenue (in thousands)
145,202

 
136,103

 
124,426

Total Expenses (in thousands)
78,201

 
73,034

 
65,706

Average Advisory Fee Rate, excluding variable rate fees(a)
0.64
%
 
0.64
%
 
0.66
%
Operating Profit Margin
46
%
 
46
%
 
47
%
Operating Profit Margin, as adjusted(b)
48
%
 
48
%
 
47
%
(a) Average advisory fee rates, including variable rate fees, were 0.64%, 0.68% and 0.66% for past three fiscal years respectively.
(b) Operating profit margin, as adjusted is a non-GAAP performance measure. See Use of Supplemental Data as Non-GAAP Performance Measure section within this report.
Assets Under Management
Our revenue is derived primarily from investment advisory and administration fees. Investment advisory and administration fees paid to the Company are generally based on the value of the investment portfolios we manage and fluctuate with changes in the total value of the AUM. Substantially all of our AUM (95.4%) is valued based on readily available market quotations. AUM in our fixed income strategies (4.6%) is valued using evaluated prices from independent third-party providers. Fees are recognized in the period that the Company manages these assets.
Our revenues are highly dependent on both the value and composition of AUM. The following is a summary of our AUM by product, investment objective, and a roll-forward of the change in AUM for the years ended December 31, 2017, 2016, and 2015:

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Table of Contents

 
 
Assets Under Management
As of December 31,
(in millions)
2017
 
2016
 
2015
Proprietary funds
$
15,974


$
13,618


$
11,505

Sub-advised funds
1,518


1,445


665

Institutional accounts
4,825


4,318


4,671

Total AUM
$
22,317

 
$
19,381

 
$
16,841

 
 
Assets Under Management
by Investment Strategy
As of December 31,
(in millions)
2017
 
2016
 
2015
Small Cap
$
1,525

 
$
1,843

 
$
1,703

Small-Mid Cap
3,528

 
3,329

 
2,070

Mid Cap
130

 
59

 
18

Large Cap
10,867

 
8,497

 
7,547

All Cap Select
450

 
404

 
545

Long-Short
4,980

 
4,613

 
4,597

Corporate bonds
699

 
581

 
361

Core fixed income
357

 
237

 

  (Less: Investments in affiliated funds) (a)
(219
)
 
(182
)
 

Total AUM
$
22,317

 
$
19,381

 
$
16,841

(a) Certain Diamond Hill Funds own shares of the Diamond Hill Short Duration Total Return Fund. The Company reduces its total AUM by these investments held in this affiliated fund.

 
Change in Assets Under Management
For the Year Ended December 31,
(in millions)
2017
 
2016
 
2015
AUM at beginning of the year
$
19,381

 
$
16,841

 
$
15,656

Net cash inflows (outflows)
 
 
 
 
 
proprietary funds
843

 
548

 
1,916

sub-advised funds
(164
)
 
639

 
(6
)
institutional accounts
(254
)
 
(1,023
)
 
(443
)
 
425

 
164

 
1,467

Net market appreciation (depreciation) and income
2,511

 
2,376

 
(282
)
Increase during the year
2,936

 
2,540

 
1,185

AUM at end of the year
$
22,317

 
$
19,381

 
$
16,841


17

Table of Contents

Consolidated Results of Operations
The following is a discussion of our consolidated results of operations.

(in thousands, except per share amounts and percentages)
2017

2016

% Change

2016

2015

% Change
Total revenue
$
145,202

 
$
136,103

 
7%
 
$
136,103

 
$
124,426

 
9%
Net operating income
$
67,001

 
$
63,069


6%

$
63,069

 
$
58,720


7%
Net income attributable to common shareholders
$
49,989

 
$
46,052


9%

$
46,052

 
$
37,074


24%
Earnings per share attributable to common shareholders (Diluted)
$
14.48

 
$
13.49


7%

$
13.49

 
$
11.03


22%
Operating profit margin
46
%
 
46
%

NM

46
%
 
47
%

NM
Operating profit margin, as adjusted(a)
48
%
 
48
%
 
NM
 
48
%
 
47
%
 
NM
(a) Operating profit margin, as adjusted is a non-GAAP performance measure. See Use of Supplemental Data as Non-GAAP Performance Measure section within this report.
Year Ended December 31, 2017 compared with Year Ended December 31, 2016
The Company generated net income attributable to common shareholders of $50.0 million ($14.48 per diluted share) for the year ended December 31, 2017, compared with net income attributable to common shareholders of $46.1 million ($13.49 per diluted share) for the year ended December 31, 2016. Revenue increased $9.1 million period over period primarily due to a 17% increase in average AUM year over year, partially offset by $6.4 million in performance fees recognized on the early termination of a variable rate fee contract in 2016 compared to $0.2 million in 2017. Operating expenses year-over-year increased $5.2 million, primarily related to increases in compensation and related expenses and general and administrative expenses.
The Company recorded non-operating income of $14.0 million in 2017 due to market appreciation and dividend income from our investment portfolio compared to non-operating income of $10.2 million in 2016 due to $7.5 million in market appreciation and dividend income from our investment portfolio and a $2.7 million gain on the sale of Beacon Hill.
Income tax expense increased $2.7 million from 2016 to 2017 due to the overall increase in income before taxes. The Tax Cuts and Jobs Act was passed on December 22, 2017. Among other federal tax law changes, for taxable years beginning after December 31, 2017, the new law establishes a flat corporate income tax rate of 21% to replace our current rate of 35% and eliminates the corporate alternative minimum tax. In accordance with ASC 740, the Company has recorded tax expense of $3.6 million resulting from the re-measurement of the Company's net deferred tax assets as of December 31, 2017. This additional tax expense in the current year was partially offset by $2.4 million of excess tax benefits on restricted stock units and restricted stock awards and $0.4 million of tax benefits on dividends paid on restricted stock awards. The Company currently expects its full year 2018 effective income tax rate to range between 23 and 25 percent.
Operating profit margin was 46% for both 2017 and 2016. Operating profit margin, as adjusted, was 48% for both 2017 and 2016. See Use of Supplemental Data as Non-GAAP Performance Measure section within this report. We expect that our operating margin will fluctuate, sometimes substantially, from year to year based on various factors including revenues; investment results; employee performance; staffing levels; development of investment strategies, products, or channels; and industry comparisons.

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Year Ended December 31, 2016 compared with Year Ended December 31, 2015
The Company generated net income attributable to common shareholders of $46.1 million ($13.49 per diluted share) for the year ended December 31, 2016, compared with net income attributable to common shareholders of $37.1 million ($11.03 per diluted share) for the year ended December 31, 2015. Revenue increased $11.7 million period over period primarily due to an 8% increase in average AUM year over year, as well as $6.4 million in variable rate fees earned upon the termination of a variable fee agreement in 2016 versus no variable rate fees realized in 2015. The revenue increase was partially offset by an increase in operating expenses of $7.3 million, primarily related to increases in compensation and related expenses, general and administrative expenses, and mutual fund administration expenses. The Company had $7.5 million in investment income due to market appreciation in 2016 compared to investment losses of $0.7 million in 2015. In addition, the Company recognized a $2.7 million gain on the sale of Beacon Hill during 2016. Income tax expense increased $5.8 million from 2015 to 2016 due to the overall increase in income before taxes.
Operating profit margin decreased to 46% for 2016 from 47% for 2015. Operating profit margin, as adjusted, increased to 48% for 2016 from 47% for 2015. See Use of Supplemental Data as Non-GAAP Performance Measure section within this report. We expect that our operating margin will fluctuate, sometimes substantially, from year to year based on various factors, including revenues; investment results; employee performance; staffing levels; development of investment strategies, products, or channels; and industry comparisons.
Revenue 
(in thousands)
2017
 
2016
 
% Change
 
2016
 
2015
 
% Change
Investment advisory
$
132,689

 
$
121,645

 
9%
 
$
121,645

 
$
107,916

 
13%
Mutual fund administration, net
12,513

 
14,458

 
(13)%
 
14,458

 
16,510

 
(12)%
Total
145,202

 
136,103

 
7%
 
136,103

 
124,426

 
9%
Revenue for the Year Ended December 31, 2017 compared with Year Ended December 31, 2016
As a percent of total annual revenues for 2017 and 2016, investment advisory fees accounted for 91% and 89%, respectively, and mutual fund administration fees made up the remaining 9% and 11%, respectively.
Investment Advisory Fees. Investment advisory fees increased by $11.0 million, or 9%, from the year ended December 31, 2016 to the year ended December 31, 2017. Investment advisory fees are calculated as a percentage of the market value of client accounts at contractual fee rates, which vary by investment product. The increase in investment advisory fees was driven by an increase of 17% in average AUM year-over-year, partially offset by $6.4 million in performance fees recognized on the early termination of a variable rate fee contracts in 2016 compared to $0.2 million in 2017. The average advisory fee rate excluding variable rate fees in both 2017 and 2016 was 0.64%.
Mutual Fund Administration Fees. Mutual fund administration fees decreased $1.9 million, or 13%, from the year ended December 31, 2016 to the year ended December 31, 2017. Mutual fund administration fees include administration fees received from the Funds, which are calculated as a percentage of average Funds' AUM. Mutual fund administration fees for the year ended December 31, 2016 included Beacon Hill administration fees of $2.5 million, which were absent in 2017. Absent Beacon Hill revenue, mutual fund administration fees related to the Funds increased $0.6 million period over period. This increase is primarily driven by a 20% increase in average Funds' AUM from the year ended December 31, 2016 to the year ended December 31, 2017, partially offset by a decrease of two basis points in the net administration fee rate from 0.10% for the year ended December 31, 2016 to 0.08% for the year ended December 31, 2017. Effective June 1, 2017, the Company reduced the administration fee rate charged on all Fund assets by one basis point. The decrease in the net administration fee rate was due to the following fee reductions that occurred during the periods indicated:
 
Class A & C
Class I
Class Y
1/1/2016 - 7/31/2016
0.24%
0.20%
0.10%
8/1/2016 - 12/31/2016
0.24%
0.19%
0.09%
1/1/2017 - 5/31/2017
0.24%
0.19%
0.09%
6/1/2017 - 12/31/2017
0.23%
0.18%
0.08%


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Effective February 28, 2018, the Company will reduce the administration fee rate across all share classes of the Funds. The following table summarizes the scheduled changes:
 
Fee Rate
AUM as of December 31, 2017 (in millions)
Class A and C
0.21%
$
2,797

Class I
0.17%
10,443

Class Y
0.05%
2,825

Revenue for the Year Ended December 31, 2016 compared with Year Ended December 31, 2015
As a percent of total annual revenues for 2016 and 2015, investment advisory fees accounted for 89% and 87%, respectively, and mutual fund administration fees made up the remaining 11% and 13%, respectively.
Investment Advisory Fees. Investment advisory fees increased by $13.7 million, or 13%, from the year ended December 31, 2015 to the year ended December 31, 2016. Investment advisory fees are calculated as a percentage of the market value of client accounts at contractual fee rates that vary by investment product. The increase in investment advisory fees was driven by an increase of 8% in average AUM year over year and an increase of two basis points in the average advisory fee rate. The average advisory fee rate in 2016 and 2015 was 0.68% and 0.66%, respectively. The average advisory fee rate for 2016 included variable rate fees of $6.4 million earned upon the termination of a variable fee agreement during the fourth quarter. No variable rate fees were realized in 2015. The average advisory fee rate excluding variable rate fees in 2016 and 2015 was 0.64% and 0.66%, respectively. This decrease of two basis points in the advisory fee rate excluding variable rate fees from 2015 to 2016 was primarily due to a 0.05% reduction in the Large Cap Fund advisory fee effective January 1, 2016 and the closing of certain strategies with higher average fees to new investors. Effective April 30, 2016, the Diamond Hill Small-Mid Cap strategy was closed to new investors.
Mutual Fund Administration Fees. Mutual fund administration fees decreased by $2.1 million, or 12%, from the year ended December 31, 2015 to the year ended December 31, 2016. Mutual fund administration fees include administration fees received from the Funds, which are calculated as a percentage of average Funds' AUM, and all Beacon Hill fee revenue. The decrease in the mutual fund administration fee was primarily due to the sale of Beacon Hill effective July 31, 2016, resulting in five less months of Beacon Hill revenue recognized during 2016.
In addition, while the net mutual fund administration fee rate decreased two basis points from 0.12% for the year ended 2015 to 0.10% for the year ended 2016, the impact of this fee rate decrease was offset by a 15% increase in average Funds' AUM from $10.7 billion for the year ended 2015 to $12.3 billion for the year ended 2016. The decrease in the net administration fee rate was due to fee reductions that occurred during the period.

Expenses
(in thousands)
2017
 
2016
 
% Change
 
2016
 
2015
 
% Change
Compensation and related costs
$
54,856

 
$
52,265

 
5%
 
$
52,265

 
$
47,951

 
9%
General and administrative
14,037

 
12,622

 
11%
 
12,622

 
10,246

 
23%
Sales and marketing
4,994

 
4,263

 
17%
 
4,263

 
4,179

 
2%
Mutual fund administration
4,313

 
3,884

 
11%
 
3,884

 
3,330

 
17%
Total
78,200

 
73,034

 
7%
 
73,034

 
65,706

 
11%

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Table of Contents


Expenses for the Year Ended December 31, 2017 compared with Year Ended December 31, 2016
Compensation and Related Costs. Employee compensation and benefits increased by $2.6 million, or 5%, from the year ended December 31, 2016 to the year ended December 31, 2017, due to an increase of $2.8 million in incentive compensation during fiscal year 2017, an increase of $0.5 million in deferred compensation expense and an increase of $0.3 million in restricted stock expense. These increases were offset by a decrease of $1.0 million in salaries and related benefits due to the sale of Beacon Hill in 2016. Incentive compensation expense can fluctuate significantly period over period as we evaluate incentive compensation by reviewing investment performance, individual performance, Company performance and other factors.
General and Administrative. General and administrative expenses increased by $1.4 million, or 11%, from the year ended December 31, 2016 to the year ended December 31, 2017. This increase is primarily due to an increase in IT consulting expense of $0.7 million, primarily to enhance our enterprise data management and customer relationship management software, an increase in investment research expenses of $0.5 million, and an increase in depreciation expense of $0.2 million.
Sales and Marketing. Sales and marketing expenses increased by $0.7 million, or 17%, from the year ended December 31, 2016 to the year ended December 31, 2017. This increase was primarily due to additional payments made to third party intermediaries related to the sale of our proprietary funds. For the years ended December 31, 2017 and 2016, approximately 65% and 63% of sales and marketing expense is related to revenue sharing payments made to third party intermediaries.
Mutual Fund Administration. Mutual fund administration expenses increased by $0.4 million, or 11%, from the year ended December 31, 2016 to the year ended December 31, 2017. Mutual fund administration expenses consist of both variable and fixed expenses. The variable expenses are based on Fund AUM and the number of shareholder accounts. The increase was primarily due to the 20% increase in average Funds' AUM from the year ended 2016 to the year ended 2017.
Expenses for the Year Ended December 31, 2016 compared with Year Ended December 31, 2015
Compensation and Related Costs. Employee compensation and benefits increased by $4.3 million, or 9%, from the year ended December 31, 2015 to the year ended December 31, 2016, due to an increase of $1.7 million in salaries and related benefits due to an increase in staffing and merit increases and an increase of $0.5 million in incentive compensation during fiscal year 2016. Incentive compensation expense can fluctuate significantly period over period as we evaluate incentive compensation by reviewing investment performance, individual performance, Company performance and other factors. In addition, the Company recognized unrealized gains on deferred compensation investments, which increased deferred compensation expense by $1.8 million in 2016 compared to unrealized losses on deferred compensation investments, which decreased deferred compensation expense by $0.2 million in 2015.
General and Administrative. General and administrative expenses increased by $2.4 million, or 23%, from the year ended December 31, 2015 to the year ended December 31, 2016. This increase was due to a $1.4 million increase in charitable donations, a $0.4 million increase in research expenses to support our investment team, a $0.4 million increase in legal and other costs related to the sale of Beacon Hill, increased information technology expense of $0.1 million, and $0.1 million of additional depreciation expense year over year.
Sales and Marketing. Sales and marketing expenses increased by $0.1 million, or 2%, from the year ended December 31, 2015 to the year ended December 31, 2016. This increase was primarily due to additional payments made to third party intermediaries related to the sale of our proprietary funds.
Mutual Fund Administration. Mutual fund administration expenses increased by $0.6 million, or 17%, from the year ended December 31, 2015 to the year ended December 31, 2016. Mutual fund administration expenses consist of both variable and fixed expenses. The variable expenses are based on Fund AUM and the number of shareholder accounts. The increase was consistent with the 15% increase in average Funds' AUM from the year ended 2015 to the year ended 2016.

Liquidity and Capital Resources
Sources of Liquidity
Our current financial condition is highly liquid, with a significant amount of our assets comprised of cash and cash equivalents, investments and accounts receivable. The Company's main source of liquidity is cash flows from operating activities, which are generated from investment advisory and fund administration fees. Our investment portfolio is invested in readily marketable

21

Table of Contents

securities, which provide for cash liquidity, if needed. Inflation is expected to have no material impact on our financial position. Cash and cash equivalents, accounts receivable, and investments represented approximately 94% and 92% of total assets as of December 31, 2017 and 2016 respectively. We believe these sources of liquidity, as well as our continuing cash flows from operating activities, will be sufficient to meet our current and future operating needs for at least the next 12 months.

Uses of Liquidity
In line with the Company’s primary objective to fulfill our fiduciary duty to clients and secondary objective to achieve an adequate long-term return for shareholders, we anticipate our main uses of cash will be operating expenses and seed capital to fund new and existing investment strategies.
The Board of Directors and management regularly review various factors to determine whether we have capital in excess of that required for the business and the appropriate use of any excess capital. The factors considered include our investment opportunities, capital needed for investment strategies, risks, and future dividend and capital gain tax rates. Evaluating management’s stewardship of capital for shareholders is a central part of our investment discipline that we practice for our clients. We hold ourselves to the same standard.
While 2017 was the tenth consecutive year that the Company has paid a special dividend, there can be no assurance that we will pay a dividend in the future. We have paid out special dividends totaling $71.00 per share from 2008 through 2017. These special dividends reduced shareholders’ equity by $211.9 million over the past ten years. The 2017, 2016, and 2015 special dividends reduced shareholders' equity by $24.3 million, $20.5 million, and $17.0 million, respectively.
Working Capital
As of December 31, 2017, the Company had working capital of approximately $162.5 million, compared to $126.0 million at December 31, 2016. Working capital includes cash, securities owned by common shareholders, prepaid expenses and current receivables, net of liabilities. On October 26, 2017, our Board of Directors declared a $7.00 per share dividend payable on December 11, 2017 to shareholders of record on December 1, 2017. The payment of the special cash dividend reduced our working capital balance by approximately $24.3 million. The Company has no debt, and we believe our available working capital is sufficient to cover current expenses and presently anticipated capital expenditures.
Below is a summary of securities owned by the Company as of December 31, 2017 and 2016.
 
As of December 31,
 
2017
 
2016
Corporate Investments:
 
 
 
Diamond Hill Core Bond Fund
$
30,529,852

 
$
29,293,308

  Diamond Hill Mid Cap Fund
19,270,451

 
17,754,640

  Diamond Hill Research Opportunities Fund
15,409,571

 
10,921,540

Diamond Hill High Yield Fund
14,200,885

 
6,210,304

Diamond Hill Valuation-Weighted 500 ETF
12,096,719

 
13,329,549

Diamond Hill Global Fund, L.P.
2,055,196

 
1,570,965

Diamond Hill International Equity Fund, L.P.
1,173,870

 

Diamond Hill Short Duration Total Return Fund

 
20,245

Total Corporate Investments
94,736,544

 
79,100,551

Deferred Compensation Plan Investments in the Funds
20,480,790

 
14,182,470

Total investments held by DHCM
115,217,334

 
93,283,021

Redeemable noncontrolling interest in Consolidated Funds
23,258,688

 
14,732,614

Total Investment Portfolio
$
138,476,022

 
$
108,015,635

Cash Flow Analysis
Cash Flows from Operating Activities
The Company’s cash flows from operating activities are calculated by adjusting net income to reflect other significant operating sources and uses of cash, certain significant non-cash items such as share-based compensation, and timing differences in the cash settlement of operating assets and liabilities.

22

Table of Contents

For the year ended December 31, 2017, net cash provided by operating activities totaled $60.9 million. The changes in net cash provided by operating activities were primarily driven by net income of $51.6 million, the add back of share-based compensation of $8.6 million and depreciation of $0.9 million, and the effect of non-cash items and timing differences in the cash settlement of assets and liabilities of $5.4 million. These cash inflows were partially offset by the net change in trading securities held in our Consolidated Funds underlying investment portfolios of $5.5 million. Absent the operating cash flows of the Consolidated Funds, cash flow from operations would have been approximately $64.3 million (see "Supplemental Consolidated Cash Flow Statement" below). We expect that cash flows provided by operating activities will continue to serve as our primary source of working capital in the near future.

For the year ended December 31, 2016, net cash provided by operating activities totaled $20.1 million. The changes in net cash provided by operating activities were primarily driven by net income of $46.6 million and the add back of share-based compensation of $8.2 million and depreciation of $0.7 million and the effect of noncash items and timing differences in the cash settlement of assets and liabilities of $6.2 million. These cash inflows were significantly offset by the net change in trading securities held in our Consolidated Funds underlying investment portfolios of $41.7 million. Absent the operating cash flows of the Consolidated Funds, cash flow from operations would have been approximately $60.7 million.
For the year ended December 31, 2015, net cash provided by operating activities totaled $52.0 million. The changes in net cash provided by operating activities were primarily driven by net income of $37.1 million, the add back of share-based compensation of $8.6 million and depreciation of $0.6 million, and the effect of noncash items and timing differences in the cash settlement of assets and liabilities of $5.8 million.

Cash Flows from Investing Activities
The Company’s cash flows from investing activities consist primarily of purchases and redemptions in our investment portfolio, capital expenditures and proceeds from the sale of Beacon Hill.
Cash flows used in investing activities totaled $18.6 million for the year ended December 31, 2017. The Company purchased corporate investments of $21.0 million, inclusive of $3.9 million of corporate investments into our deferred compensation plans, and made $1.1 million of property and equipment purchases during the period. These cash outflows were partially offset by redemptions of corporate investments of $2.6 million and $1.0 million of proceeds from the scheduled collection of the promissory note received from the sale of Beacon Hill.
Cash flows used in investing activities totaled $5.7 million for the year ended December 31, 2016. The Company purchased corporate investments of $26.0 million, inclusive of $4.4 million of corporate investments into our deferred compensation plans. This cash outflow was partially offset by redemptions of corporate investments of $19.5 million and net proceeds received of $1.2 million from the sale of Beacon Hill. The Company also purchased $0.5 million of property and equipment.
Cash flows used in investing activities totaled $11.9 million for the year ended December 31, 2015. The Company purchased $22.1 million of corporate investments, inclusive of $4.3 million of purchases into our deferred compensation plans, during 2015. This cash outflow was partially offset by redemptions of corporate investments of $11.8 million. The Company also purchased $1.6 million of property and equipment related to our office space expansion.
Cash Flows from Financing Activities
The Company’s cash flows from financing activities consist primarily of the payment of special dividends, shares withheld related to employee tax withholding and distributions to or contributions from redeemable noncontrolling interest holders.
For the year ended December 31, 2017, net cash used by financing activities totaled $23.0 million, consisting of the payment of special dividends of $24.3 million and the value of shares withheld related to employee tax withholding of $5.0 million, partially offset by net subscriptions received from redeemable noncontrolling interest holders of $6.3 million.

For the year ended December 31, 2016, net cash used by financing activities totaled $14.6 million, consisting of the payment of special dividends of $20.5 million and the value of shares withheld related to employee tax withholding of $10.0 million, partially offset by net subscriptions received from redeemable noncontrolling interest holders of $9.6 million, excess income tax benefit from share-based compensation of $4.9 million, and income tax benefit from dividends paid on restricted stock of$1.4 million.
For the year ended December 31, 2015, net cash used by financing activities totaled $18.5 million, consisting of the payment of special dividends of $17.0 million and the value of shares withheld related to employee tax withholding of $4.3 million, partially offset by excess income tax benefit from share-based compensation of $2.5 million and the income tax benefit from dividends paid on restricted stock of $0.4 million.

23

Table of Contents

Supplemental Consolidated Cash Flow Statement
On January 1, 2016, the Company implemented the new consolidation accounting guidance that resulted in the consolidation of the Company's exchange traded fund ("ETF") and the Diamond Hill Core Bond Fund, one of our individual mutual funds (collectively the "Consolidated Funds") in which we have controlling interests. Our consolidated balance sheet now reflects the investments and other assets and liabilities of the Consolidated Funds, as well as redeemable noncontrolling interests for the portion of the Consolidated Funds that are held by third party investors. Although we can redeem our net interest in the Consolidated Funds at any time, we cannot directly access or sell the assets held by the Consolidated Funds to obtain cash for general operations. Additionally, the assets of the Consolidated Funds are not available to general creditors.
The following table summarizes the condensed cash flows for the year ended December 31, 2017, that are attributable to Diamond Hill Investment Group, Inc. and to the Consolidated Funds, and the related eliminations required in preparing the consolidated statements.
 
Year Ended December 31, 2017
 
Cash flow attributable to Diamond Hill Investment Group, Inc.
 
Cash flow attributable to Consolidated Funds
 
Eliminations
 
As reported on the Consolidated Statement of Cash Flows
Cash flows from Operating Activities:
 
 
 
 
 
 
 
Net Income
$
49,988,957

 
$
5,665,511

 
$
(4,052,799
)
 
$
51,601,669

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
 
 
 

Depreciation
888,197

 

 

 
888,197

Share-based compensation
8,582,069

 

 

 
8,582,069

Net (gains)/losses on investments
(8,118,039
)
 
(5,665,511
)
 
4,052,799

 
(9,730,751
)
Net change in trading securities held by Consolidated Funds

 
(5,511,669
)
 

 
(5,511,669
)
Other changes in assets and liabilities
12,912,965

 
2,177,279

 

 
15,090,244

Net cash provided by (used in) operating activities
64,254,149

 
(3,334,390
)
 

 
60,919,759

Net cash used in investing activities
(15,485,455
)
 

 
(3,068,364
)
 
(18,553,819
)
Net cash provided by (used in) financing activities
(29,243,784
)
 
3,221,712

 
3,068,364

 
(22,953,708
)
Net change during the period
19,524,910

 
(112,678
)
 

 
19,412,232

Cash and cash equivalents at beginning of year
57,077,198

 
112,678

 

 
57,189,876

Cash and cash equivalents at end of year
$
76,602,108

 
$

 
$

 
$
76,602,108


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Table of Contents

Selected Quarterly Information
Our unaudited quarterly results of operations for the years ended December 31, 2017 and 2016 are summarized below:
 
At or For the Quarter Ended
 
2017
 
2016
(in thousands, except per share data)
12/31
 
09/30
 
06/30
 
03/31
 
12/31
 
09/30
 
06/30
 
03/31
Assets under management
(in millions)
$
22,317

 
$
21,455

 
$
20,924

 
$
20,333

 
$
19,381

 
$
18,068

 
$
17,584

 
$
17,391

Total revenue(a)
37,753

 
36,772

 
35,543

 
35,134

 
40,039

 
32,937

 
32,669

 
30,458

Total operating expenses
19,443

 
19,884

 
19,576

 
19,298

 
20,512

 
17,799

 
17,970

 
16,753

Operating income
18,310

 
16,888


15,967

 
15,836

 
19,527

 
15,138

 
14,699

 
13,705

Investment income, net
4,439

 
2,768

 
3,025

 
3,786

 
2,522

 
3,555

 
693

 
747

Gain on sale of subsidiary

 

 

 

 

 
2,676

 

 

Income before taxes
$
22,749

 
$
19,656

 
$
18,992

 
$
19,622

 
$
22,049

 
$
21,369

 
$
15,392

 
$
14,452

Income tax expense(b)
$
(10,398
)
 
$
(6,498
)
 
$
(6,025
)
 
$
(6,496
)
 
$
(8,171
)
 
$
(7,700
)
 
$
(5,625
)
 
$
(5,172
)
Net income
$
12,351

 
$
13,158

 
$
12,967

 
$
13,126

 
$
13,878

 
$
13,669

 
$
9,767

 
$
9,280

Net income attributable to common shareholders
$
11,895

 
$
12,699

 
$
12,638

 
$
12,757

 
$
13,645

 
$
13,427

 
$
9,715

 
$
9,265

Diluted EPS
$
3.43

 
$
3.67

 
$
3.66

 
$
3.71

 
$
3.99

 
$
3.93

 
$
2.84

 
$
2.73

Diluted weighted shares outstanding
3,471

 
3,461

 
3,449

 
3,435

 
3,422

 
3,420

 
3,415

 
3,393

(a) Total revenue in the fourth quarter of 2016 includes variable rate fees of $6.4 million earned upon the termination of a variable rate fee agreement.
(b) The Company’s fourth quarter income tax provision was $10.4 million (45.7% Effective Tax Rate) and reflected the impact of the Tax Act, including additional tax expense of $3.6 million resulting from the re-measurement of the Company's estimated net deferred tax asset as of December 31, 2017.
Contractual Obligations
The following table presents a summary of the Company’s future obligations under the terms of operating leases and lease commitments, other contractual purchase obligations, and deferred compensation obligations at December 31, 2017. Other purchase obligations include contractual amounts that will be due for the purchase of services to be used in our operations, such as mutual fund sub-administration and investment related research software. These obligations may be cancelable at earlier times than those indicated and, under certain conditions, may involve termination fees. Because these obligations are primarily of a normal recurring nature, we expect to fund them from future cash flows from operations. The deferred compensation obligations includes compensation that will be paid out in future years and which will be funded by the related deferred compensation investments currently held on our consolidated balance sheets (see Note 6). The information presented does not include operating expenses or capital expenditures that will be committed in the normal course of operations in 2018 and future years:
 
 
 
 
Payments Due by Period
(in thousands)
Total
 
2018
 
2019
 
2020
 
2021
 
2022
 
Thereafter
Operating lease obligations
$
4,146

 
$
586

 
$
596

 
$
624

 
$
624

 
$
624

 
$
1,092

Purchase obligations
4,824

 
3,265

 
1,279

 
273

 
5

 
2

 

Deferred compensation obligations
20,480

 

 
1,793

 
3,171

 
2,215

 
2,701

 
10,600

Total
$
29,450

 
$
3,851

 
$
3,668

 
$
4,068

 
$
2,844

 
$
3,327

 
$
11,692


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Table of Contents

Use of Supplemental Data as Non-GAAP Performance Measures
As supplemental information, we are providing performance measures that are based on methodologies other than U.S. generally accepted accounting principles (“non-GAAP”). We believe the non-GAAP measures below are useful measures of our core business activities, are important metrics in estimating the value of an asset management business and may enable more appropriate comparison to our peers. These non-GAAP measures should not be a substitute for financial measures calculated in accordance with U.S. generally accepted accounting principles (“GAAP”) and may be calculated differently by other companies. The following schedule reconciles GAAP measures to non-GAAP measures for the years ended December 31, 2017, 2016, and 2015, respectively.
 
Year Ended December 31,
(in thousands, except percentages and per share data)
2017
 
2016
 
2015
Total revenue
$
145,202


$
136,103

 
$
124,426







 
 
Net operating income, GAAP basis
$
67,001


$
63,069

 
$
58,720

Non-GAAP adjustments:



 
 
Gains (losses) on deferred compensation plan investments, net(1)
2,382


1,837

 
(234
)
Net operating income, as adjusted, non-GAAP basis(2)
69,383


64,906

 
58,486

Non-GAAP Adjustment:
 
 
 
 
 
Tax provision on net operating income, as adjusted, non-GAAP basis(3)
(25,192
)

(23,626
)
 
(21,090
)
Net operating income, as adjusted, after tax, non-GAAP basis(4)
$
44,191


$
41,280

 
$
37,396

 
 
 
 
 
 
Net operating income, as adjusted after tax per diluted share, non-GAAP basis(5)
$
12.80


$
12.09

 
$
11.13

Diluted weighted average shares outstanding, GAAP basis
3,452


3,413

 
3,360

 





 
 
Operating profit margin, GAAP basis
46
%

46
%
 
47
%
Operating profit margin, as adjusted, non-GAAP basis(6)
48
%

48
%
 
47
%
(1) Gains (losses) on deferred compensation plan investments, net: The gain (loss) on deferred compensation plan investments which increases (decreases) deferred compensation expense included in operating income is removed from operating income in the calculation because it is offset by an equal amount in investment income (loss) below net operating income on the income statement, and thus has no impact on net income attributable to the Company.
(2) Net operating income, as adjusted: This non-GAAP measure was calculated by taking the Company’s net operating income adjusted to exclude the impact on compensation expense of gains and losses on investments in the deferred compensation plan.
(3) Tax provision on net operating income, as adjusted: This non-GAAP measure represents the tax provision excluding the impact of investment related activity and the sale of subsidiary and is calculated by applying the tax rate from the actual tax provision to net operating income, as adjusted.
(4) Net operating income, as adjusted, after tax: This non-GAAP measure was calculated by taking the net operating income, as adjusted less the tax provision on net operating income, as adjusted.
(5) Net operating income, as adjusted after tax per diluted share: This non-GAAP measure was calculated by dividing the net operating income, as adjusted after tax, by diluted weighted average shares outstanding.
(6) Operating profit margin, as adjusted: This non-GAAP measure was calculated by dividing the net operating income, as adjusted, by total revenue.
Off-Balance Sheet Arrangements
The Company has no off-balance sheet arrangements. We do not have any obligation under a guarantee contract, or a retained or contingent interest in assets or similar arrangement that serves as credit, liquidity or market risk support for such assets, or any other obligation, including a contingent obligation, under a contract that would be accounted for as a derivative instrument or arising out of a variable interest.

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Critical Accounting Policies and Estimates
Consolidation. We consolidate all subsidiaries and certain investments in which we have a controlling interest. We are generally deemed to have a controlling interest when we own the majority of the voting interest of an entity or are deemed to be the primary beneficiary of a variable interest entity ("VIE"). VIEs are entities that lack sufficient equity to finance its activities or the equity holders do not have defined power to direct the activities of the entity normally associated with an equity investment. Our analysis to determine whether an entity is a VIE or a voting rights entity ("VRE") involves judgment and considers several factors, including an entity's legal organization, equity structure, the rights of the investment holders, our ownership interest in the entity, and our contractual involvement with the entity. We continually review and reconsider our VIE or VRE conclusions upon the occurrence of certain events, such as changes to our ownership interest, or amendments to contract documents. Our VIEs are primarily sponsored investment entities and our variable interest consists of our equity ownership in these entities. The Company concluded we are not the primary beneficiary of any of these VIEs as of December 31, 2017 as we lack the power to control these entities.
Provisions for Income Taxes. The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity’s financial statements or tax returns. Judgment is required in assessing the future tax consequences of events that have been recognized in our financial statements or tax returns.
Revenue Recognition on Performance-Based Advisory Contracts. We have certain investment advisory contracts in which a portion of the fees are based on investment performance achieved in the respective client portfolio in excess of a specified hurdle rate. These fees are calculated based on client investment results over rolling five-year periods. The Company records variable performance fees at the end of the contract measurement period.
Revenue Recognition when Acting as an Agent vs. Principal. The Funds have selected and contractually engaged certain vendors to fulfill various services to benefit the Funds’ shareholders or to satisfy regulatory requirements of the Funds. These services include, among others, required fund shareholder mailings, registration services, and legal and audit services. DHCM, in fulfilling a portion of its role under the administration agreement with the Funds, acts as agent to pay these obligations of the Funds. Each vendor is independently responsible for fulfillment of the services it has been engaged to provide and negotiates fees and terms with the management and board of trustees of the Funds. The fee that the Funds pay to DHCM is reviewed annually by the Funds’ board of trustees and specifically takes into account the contractual expenses that DHCM pays on behalf of the Funds. As a result, DHCM is not involved in the delivery or pricing of these services and bears no risk related to these services. Revenue has been recorded net of these Fund expenses, as it is the appropriate accounting treatment for this agency relationship.

ITEM 7A.
Quantitative and Qualitative Disclosures About Market Risk
The Company’s revenues and net income are based primarily on the value of AUM. Accordingly, declines in financial market values directly and negatively impact our investment advisory revenues and net income.
We invest in the Funds and our private investment funds, which are market risk sensitive financial instruments. These investments have inherent market risk in the form of price risk; that is, the potential future loss of value that would result from a decline in their fair value. Market prices fluctuate and the amount realized upon subsequent sale may differ significantly from the reported market value.
The table below summarizes our market risks as of December 31, 2017, and shows the effects of a hypothetical 10% increase and decrease in investments.
 
 
Fair Value as of December 31, 2017
 
Fair Value
Assuming a
Hypothetical
10% Increase
 
Fair Value
Assuming a
Hypothetical
10% Decrease
Equity investments
$
73,704,312

 
$
81,074,743

 
$
66,333,881

Fixed Income investments
64,771,710

 
71,248,881

 
58,294,539

Total
$
138,476,022

 
$
152,323,624

 
$
124,628,420



27


ITEM 8.
Financial Statements and Supplementary Data
Report of Independent Registered Public Accounting Firm

To the Shareholders and Board of Directors
Diamond Hill Investment Group, Inc.:
Opinion on the Consolidated Financial Statements
We have audited the accompanying consolidated balance sheets of Diamond Hill Investment Group, Inc. and subsidiaries (the “Company”) as of December 31, 2017 and 2016, the related consolidated statements of income, shareholders’ equity and redeemable noncontrolling interest, and cash flows for each of the years in the three‑year period ended December 31, 2017, and the related notes (collectively, the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2017 and 2016, and the results of its operations and its cash flows for each of the years in the three‑year period ended December 31, 2017, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (“PCAOB”), the Company’s internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 22, 2018 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
Changes in Accounting Principles
As discussed in Note 2 to the consolidated financial statements, the Company changed its method of accounting for investments in investment funds in 2016 due to the adoption of ASU 2015-02 - Consolidation (Topic 810): Amendments to the Consolidation Analysis. As discussed in Note 8 to the consolidated financial statements, the Company changed its method of accounting for excess tax benefits or deficiencies from the vesting of stock awards in 2017 due to the adoption of ASU 2016-09 - Improvements to Employee Share-Based Payment Accounting.
Basis for Opinion
These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that our audits provide a reasonable basis for our opinion.

/s/ KPMG LLP
We have served as the Company's auditor since 2012.

Columbus, Ohio
February 22, 2018


28


Report of Independent Registered Public Accounting Firm

To the Shareholders and Board of Directors
Diamond Hill Investment Group, Inc.:
Opinion on Internal Control Over Financial Reporting
We have audited Diamond Hill Investment Group, Inc.’s and subsidiaries’ (the “Company”) internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (“PCAOB”), the consolidated balance sheets of the Company as of December 31, 2017 and 2016, the related consolidated statements of income, shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2017, and the related notes (collectively, the consolidated financial statements), and our report dated February 22, 2018 expressed an unqualified opinion on those consolidated financial statements.
Basis for Opinion
The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Annual Report on Internal Control over Financial Reporting appearing under Item 9A of the Company’s December 31, 2017 annual report on Form 10-K. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
Definition and Limitations of Internal Control Over Financial Reporting
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

/s/ KPMG LLP
Columbus, Ohio
February 22, 2018



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Diamond Hill Investment Group, Inc.
Consolidated Balance Sheets
 
 
December 31,
 
2017
 
2016
ASSETS
 
 
 
Cash and cash equivalents
$
76,602,108

 
$
57,189,876

Investment portfolio
138,476,022

 
108,015,635

Accounts receivable
19,220,279

 
18,605,209

Prepaid expenses
2,073,343

 
2,032,726

Income taxes receivable
4,114,962

 
1,111,890

Property and equipment, net of depreciation
4,057,901

 
4,025,758

Deferred taxes
5,843,704

 
8,736,767

Total assets
$
250,388,319

 
$
199,717,861

LIABILITIES AND SHAREHOLDERS’ EQUITY
 
 
 
Liabilities
 
 
 
Accounts payable and accrued expenses
$
11,890,403

 
$
9,787,048

Accrued incentive compensation
25,496,500

 
22,683,500

Deferred compensation
20,480,790

 
14,182,470

Total liabilities
57,867,693

 
46,653,018

Redeemable noncontrolling interest
20,076,806