Invesco - Q2 2023
July 25, 2023
Transcript
Operator (participant)
Welcome to Invesco's Q2 earnings conference call. All participants will be in a listen-only mode until the question and answer session. At that time, to ask a question, press star one. This call will last one hour. To allow more participants to ask questions, one question and a follow-up can be submitted per participant. Today's call is also being recorded. Now, let's turn today's meeting over to your host, Mr. Greg Ketron, Invesco's Head of Investor Relations. Thank you. You may begin.
Greg Ketron (Global Head of Treasury and Investor Relations)
Thanks, operator, and to all of you joining us on Invesco's Quarterly Earnings Call. In addition to today's press release, we've provided a presentation that covers the topics we plan to address. The press release and presentation are available on our website, invesco.com. This information can be found by going to the Investor Relations section of the website. Our presentation today will include forward-looking statements and certain non-GAAP financial measures. Please review the disclosures on slide two of the presentation regarding these statements and measures, as well as the appendix for the appropriate reconciliations to GAAP. Invesco is not responsible for and does not edit nor guarantee the accuracy of our earnings teleconference transcripts provided by third parties. The only authorized webcasts are located on our website.
Andrew Schlossberg, President and CEO, and Allison Dukes, Chief Financial Officer, will present our results this morning, and then we'll open the call up for questions. First, however, I'd like to turn the call over to Marty Flanagan, Chairman Emeritus, who retired as CEO on June thirtieth after 18 years, to provide a few comments before we get into the Q2 results. Marty?
Marty Flanagan (Chairman Emeritus)
Thank you, Greg. Before I turn the call over to Andrew and Allison, I want to say it's been a pleasure to work with all of you over the years. It's really been an exciting, challenging board, and participate in a fascinating industry that has continued to evolve and change, but always seeking to create better outcomes for clients and shareholders. Over the years, I've learned from my engagement with all of you, all the key stakeholders, clients, analysts, and shareholders, which has been instrumental in the success of Invesco. I'm immensely proud of this organization and the talented people around the world that make Invesco what it is. There's a tremendous opportunity for the firm going forward. Invesco has the right strategy, the right team leading this organization into the future while navigating a challenging current market environment.
The reality is that the strategies across firms in our industry are not very different. What separates winners and losers are those organizations that can execute effectively across all cycles and market conditions. Andrew, Allison, and the rest of the executive leadership team and our broader senior leadership team represent the most talented and experienced team Invesco has ever had. They're laser focused on accelerating the approach, strategy, and making the necessary changes for the benefit of clients and shareholders. This is a team very well prepared and knows how to execute and deliver for all stakeholders. I'm confident in Andrew's and the leadership team's ability to achieve the full potential, and I look forward to seeing the firm do great things in the years ahead. Thank you. Andrew, turn it over to you.
Andrew Schlossberg (President and CEO)
Thanks very much, Marty, and good morning to everyone. I'm pleased to be speaking with you today, and I look forward to continuing to work with all of you on the call. It's an absolute privilege to lead a global investment management organization built with such a solid, client-centered foundation and which possesses significant potential as we focus on delivering value for clients while innovating to meet their evolving needs. We have exceptional talent, robust investment capabilities, deep relationships with clients, and a strong presence in key markets across the globe, all of which positions us well to stay in front of and lead during a period of growth and change in the asset management industry. At our core, we will be focused on delivering investment excellence for our clients.
While we're pleased to have a strong foundation, we're not at all satisfied with our results to date, and we're committed to improving our performance by simplifying our organizational model, aligning our expense base, strengthening our strategic focus, being agile and innovative in advancing our use of technology, and executing at pace. We believe this will lead to outstanding client experience, attraction and retention of top talent, and an enhanced ability to generate profitable growth for the future. I could not be more confident in the talented, experienced, and collaborative team we have in place to take advantage of opportunities in the market and address the challenges confronting our clients and our industry. I want to again thank Marty for his visionary leadership that has provided Invesco the foundation to capitalize on the opportunities that lie ahead.
With that, I'll start today's presentation of Q2 results on slide three for those following along. In the Q2, financial markets showed signs of recovery even as investors continued to grapple with significant uncertainty. Recovery was uneven across sectors and geographies, and while the headline moves in market indices were positive, the underlying client environment continued to be relatively cautious given the uncertain economic backdrop. Market gains were narrowly distributed. U.S. equity market increases were concentrated in large cap technology stocks, while non-U.S. equity markets, most notably Emerging, International, and China, as well as most long-dated bond index returns, were flat or negative. Client actions, in the quarter remained risked off, resulting in slower industry growth in long-term assets, while cash strategies continued to account for a historically large proportion of client portfolios.
We did see an uptick in investor appetite for risk assets in June, providing some optimism for a broader recovery on the horizon. Across our investment platform, performance is steadily improving in several of our key global equity capabilities, and our fixed income performance remains robust across the board. Building on the delivery and quality of investment performance remains a key focus for me and for the management team. From an asset flow perspective in the Q2, Invesco's diversified business continues to deliver for our clients and prove resilient against market and industry challenges, with sustained organic growth in several key capability areas where there's continued high client demand. The largest driver of growth in the quarter was our global ETF business.
Net long-term inflows accelerated to $5.7 billion, more than double the growth we experienced in the Q1 and higher than our AUM market share. Our ETF capabilities have demonstrated the ability to sustain growth through the full market cycle with organic growth in 11 of the past 12 quarters. Our business maintains a revenue profile that is differentiated from competitors, with a concentration in strategies, including things like alternative beta, commodities, senior loans, and laddered maturity products. I'm also pleased to note that our business in Greater China returned to organic growth this quarter with $1.6 billion in net long-term inflows.
While the higher fixed income redemptions the industry experienced earlier this year have abated, organic growth in China's asset management industry has remained slower so far this year, and overall, assets raised by new fund launches across the industry sank to their lowest levels since 2019. Despite this, Invesco Great Wall raised $1.4 billion from six new product launches in the Q2, which ranked us fifth amongst all asset managers in China, which is well above our overall number 12 ranking in that market. As the China economy recovers, we are extremely well-positioned to capture additional market share in the world's fastest-growing asset management market. Client preferences for risk-off assets did continue to benefit our fixed income franchise across both institutional and retail channels, including mutual funds and SMAs.
We generated positive $1 billion in net long-term fixed income flows this quarter, extending our streak to 18 consecutive positive flow quarters. Our money market business continues to show strong growth and market share gains. We brought in $15 billion of net new assets this quarter, and we've moved into the top 10 of money market managers in the US institutional channel. We expect our overall fixed income franchise to continue to grow and benefit from our strong investment performance and the greater clarity we expect on the horizon as the interest rate picture becomes more clear in coming quarters. Within active equity strategies, we did experience net long-term outflows of $4.5 billion in the Q2. Global and emerging market equities, where client demand has been slow to recover and industry flows remain negative.
This accounted for nearly 70% of our active equity net outflows. While headwinds have persisted in the asset class, net outflows for Invesco in developing markets were $1.2 billion. This is consistent with our experience last quarter, meaningfully lower than last year. I'm optimistic for further stabilization of net flows in these key investment strategies as performance continues to improve and when client demand for risk-on assets returns. As we discussed on our last earnings call, growth in private markets has been more challenging this year due to overall market conditions, we experienced $1.7 billion in net outflows in these areas during the Q2.
Despite the near-term headwinds, we have an excellent track record in both private real estate and private credit sectors, and we're well positioned to capture long-term growth in these asset classes, particularly in the under-penetrated wealth management channels in both the U.S. and globally. We expect our private markets and alternative capabilities to be an engine of growth in our future years. Allison's going to provide much more color on that business later in her comments. From a client and channel perspective, retail and wealth management flows were modestly positive in the Q2, while our institutional channel had $2.2 billion in net outflows. This is the first outflow quarter in three years, this comes following an especially strong quarter for fundings in the Q1, where we had $6.6 billion of net inflows.
As Allison will discuss later, our pipeline remains robust, and a significant portion of our one not funded mandates are in higher fee-yielding equity and alternative strategies. The longer-term growth of our institutional channels is a testament to our strength of that business and the depth of our client relationships that we have built over many years. As such, I am confident that we will again see robust growth in this channel as client caution abates and as reallocations begin to occur across this part of the industry. Building balance sheet strength, continuing to invest in key growth areas, and returning capital to shareholders are top priorities for us. To that end, I'm pleased to note that in the first half of June, we repurchased $150 million in common stock.
We are able to capitalize on an attractive valuation because of the strong balance sheet position that the firm has worked hard to build over the last several years. We are determined to continue to build on that progress. We're also committed to driving a high level of financial performance in Invesco. We will keep our clients and service levels front and center, while also striving for accelerated profit growth. The leadership changes we announced in February have put us in a position to unlock more opportunity for the firm, and we continue to implement related organizational changes in the Q2. We're taking action to simplify the company and eliminate sources of complexity that were necessary in the past, but may no longer be appropriate today....
This will help us shift investment to our strategic priorities and areas of growth, while ensuring our clients continue to receive investment quality and the exceptional service that's one of the hallmarks of Invesco. The primary benefits of these changes will be seen over time as revenue growth recovers, and we take advantage of our further scale. At the same time, we're taking action that will enhance our near-term profitability and have identified an initial set of cost savings. Work will continue to identify and action additional efficiencies and enhancement opportunities, and Allison's going to provide further detail on those efforts shortly. Although there is lots of work to do, Invesco is well positioned to take advantage of opportunities and address the challenges confronting the marketplace.
I could not be more confident in the team that we have in place to execute on the opportunities that Marty created over his 18 years as CEO of Invesco. With that, I'm going to turn the call over to Allison for a closer look at our results, and I look forward to your questions.
Allison Dukes (CFO and Senior Managing Director)
Thank you, Andrew, I also want to convey my appreciation to Marty for his leadership. Good morning to everybody joining us today. I'm going to begin on slide four. Overall investment performance improved in the Q2, with 66% of actively managed funds in the top half of peers or beating benchmark on both a three-year and a five-year basis. This is an improvement from 64% for both time frames in the Q1. We have excellent performance in fixed income across nearly all capabilities and time horizons. Performance lagged benchmark in certain U.S. core and growth equity funds. Performance in global and emerging markets equities has been a headwind, but we're encouraged to see steady and meaningful improvement emerging in this asset class.
Turning to slide five, AUM was $1.54 trillion at the end of the Q2, which was $55 billion higher than last quarter. Technology stocks surged in the Q2. As a result, QQQ AUM reached $200 billion, an increase of $27 billion as compared to the end of the Q1. Market increases and additional products, foreign exchange movements, and reinvested dividends combined to increase assets under management by a further $15 billion. Net inflows into money market products were $15 billion. Net long-term outflows were $2 billion. Despite the net long-term outflows for the quarter, we exited the quarter with strong momentum after more than $2 billion of net inflows for the month of June.
We expect that we outperformed most peers on a net flow basis, another data point demonstrating the value of our breadth of capabilities in a difficult environment for organic asset growth. Client demand for passive capabilities was strong, and as a result, we garnered $6.4 billion of net long-term inflows in the Q2. Offsetting the growth in passive was $8.4 billion of net outflows in active strategies. Through growth in our key capability areas, we are recapturing client demand as it moves to favored capabilities, led this quarter by growth in ETFs and our business in Greater China. Our global ETF franchise delivered a strong quarter, growing at a 9% annualized organic growth rate with $5.7 billion of net inflows.
Our top-selling ETFs included the S&P 500 Equal Weight and the QQQM, which grew to over $13 billion in AUM after posting $3.3 billion net inflows. Innovation remains a key strength in this area. The QQQM, which was launched less than three years ago, now representing the fifth-largest ETF in our lineup. Currency and commodity ETF, part of our alternative asset class, experienced net outflows of $1.1 billion during the quarter. We delivered net inflows of $200 million from retail clients in the Q2, an improvement from $3.7 billion in net outflows in the prior quarter. A rebound in Asia-Pacific net flows was the primary driver of growth. More specifically, we've experienced strong growth in Japan for several quarters now, ending the Q2 with $54 billion of AUM.
Our Henley Global Equity and Income Fund garnered $1.6 billion of net inflows from Japanese clients, making it the top-selling retail fund in Japan on both a quarterly and year-to-date basis. Moving forward, we are well positioned in this important market. Japanese markets are experiencing some of the most constructive conditions for risk-on assets in many years. Offsetting growth in the retail channel was $2.2 billion of net long-term outflows in the institutional channel, primarily in the Americas. The channel remains a net inflows year to date, after $6.6 billion of net inflows in the Q1. Further, we have a robust and diversified, one not funded pipeline. Moving to slide six.
Net long-term inflows resumed in Asia-Pacific, with one and a half billion dollars in the Q2 due to the growth I just discussed in Japan and a rebound to net inflows in our China joint venture. Net outflows were modestly negative in the Americas and in EMEA. Looking at flows by asset class, fixed income capabilities experienced net inflows for the 18th straight quarter with $1 billion. Drivers of growth this quarter included China, where we launched an institutional fixed income product and our tax-managed SMA capability, partially offset by net outflows in EMEA ETFs. Net outflows in global and emerging market equities continued to be a headwind in the Q2, with $3 billion of net outflows, including $1.2 billion from our emerging markets funds.
Encouragingly, this is similar to the net outflows experienced last quarter from emerging markets and below the redemption rates we experienced last year. We're optimistic that headwinds appear to be further diminishing in emerging markets. Alternative net outflows were $3.4 billion in the Q2. Public alternatives accounted for $1.9 billion, with $1.1 billion concentrated in commodity and currency ETFs, as commodities have been out of favor across the industry in recent quarters. Private markets net outflows were one and a half billion dollars, inclusive of $1 billion of net outflows in direct real estate strategies. We move to slide 7, I'd like to take a few minutes to highlight our global alternatives platform, which had $182 billion in assets under management as of June 30th.
Although market conditions have made it a challenging year for organic growth in the asset class, we have high conviction that alternatives will be one of the key pillars of our long-term success. Within alternatives, we have a diverse range of capabilities, including $72 billion of public alternatives, spanning commodity strategies, listed real estate, and hedged and macro strategies. Real estate is the largest component of our private alternatives platform, with $72 billion in direct real estate AUM at the end of the Q2. Invesco competes throughout the capital stack by investing in direct real estate and originating real estate debt. Our direct real estate business offers a range of investment styles, including core and core plus strategies, as well as funds with higher return strategies.
Our private credit platform is the second component of our private alternatives business, with $38 billion in assets under management, anchored by our bank loan capability that holds U.S. and European securities. We have over 30 years of experience managing senior corporate loans, relationships with over 2,000 unique companies, and more than 200 private equity firms. More recently, we began to offer direct lending to middle-market companies, as well as opportunistic investments in special situations and distressed credits. On slide eight, we want to provide a deeper look at our direct real estate portfolio, where we have 40 years of experience investing on behalf of our clients worldwide. Our direct real estate holdings are well-diversified by product, property type. Commercial office properties comprise about 35% of our AUM.
Apartments and other residential properties account for approximately 23%, and the AUM share of industrial properties about 22% at the end of the Q2. The final 20% of our AUM is invested in retail and specialty sectors, including mixed-use developments, self-storage, and medical. Focusing on office properties specifically, since the beginning of the COVID-19 pandemic, we've been deliberately managing our exposure down, particularly in the Americas and EMEA, as market dynamics have shifted with attitudes towards remote work. In the Q1 of 2020, 42% of our institutional open-end AUM in core and core plus strategies was comprised of traditional office properties. At the end of the Q2, it was 27%, and our exposure in the Americas was reduced by about one-third.
Several of our direct real estate funds use leverage, but we're measured in our approach, and the average loan-to-value across our direct real estate funds was approximately 35% as of March 31st, 2023. These figures may fluctuate over time and vary across specific funds. We serve our clients through a range of vehicle types and manage liquidity in accordance with the established bylaws of each fund. Approximately half of our AUM is in institutional separate accounts or closed-end funds with a predetermined life. The remainder in open-end vehicles that manage redemptions on a best efforts basis. In our open-end funds, redemption requests go into a queue and are mainly met by net investors into the fund. Investors in our open-end strategies are highly sophisticated institutional investors that understand it may take several quarters to work down a redemption queue while preserving the fund's performance for all investors.
Over a full business cycle, we would expect funds to average a redemption queue of 5% to 6% of NAV. This can fluctuate higher in times of market volatility, like we've been experiencing recently. As of the end of the Q2, all of our open-end funds were operating according to normal redemption protocols, and our real estate team have successfully navigated market cycles for 4 decades. Real estate activity has been slower during the first half of 2023, and we would expect activity to be muted in the near term until market conditions improve. In the long run, we expect that investor demand for private markets capabilities will grow significantly, we're well positioned to capitalize on that growth. Next, I'll move to slide 9. Our institutional pipeline was $22 billion at quarter end, consistent with last quarter.
Although we experienced net outflows in the Q2, our institutional business remains in net inflows for the year to date, and we continue to win new mandates. Our pipelines have been running in the $mid-20 billion-$mid-30 billion range, dating back to late 2019. This is on the lower end of that range. We view our pipeline as strong, given the market volatility we've been experiencing and the $6.6 billion in net inflows that occurred in the Q1. As we've noted previously, some mandates are taking longer to fund in this environment. We would estimate the funding cycle of our pipeline is running in the 3-4 quarter range versus 2-3 quarters prior to the market downturn.
Our solutions capability enabled 35% of the global institutional pipeline in Q2. We're pleased to see this share increase from 14% last quarter. We invest solutions into our client interactions. We have ongoing engagements about new opportunities. The pipeline reflects a diverse business mix, with alternatives and active equity accounting for 40% of the total associated assets. Turning to slide ten, net revenue of $1.09 billion in the Q2 was $83 million lower than the Q2 of 2022, and $15 million or 1% higher than the Q1. The decline from the Q2 of last year was due largely to lower investment management fees, driven by asset mix favoring lower-yielding strategies. The sequential quarter increase was primarily due to higher performance fees earned on private real estate mandates.
A $4 million decline in other revenues partially offset the increase in performance fees. A shift in asset mix has had a meaningful impact on our revenue due to the uneven performance across key market indices, as well as investor preferences for passive and risk-off strategies, including demand for money market products. Total average AUM for the Q2 of $1.49 trillion, was $32 billion or 2% higher than the Q1. $25 billion of the increase was in QQQ average AUM, for which we do not earn management fees. A further $4 billion of the increase was in money market AUM. Meanwhile, average passive AUM ex-QQQ was up $3 billion, and average active AUM was flat to last quarter. As compared to the Q2 of 2022, total average AUM increased by $38 billion or 3%.
The primary driver was a $58 billion increase in average money market AUM, given the risk-off investor sentiment of the past 12 months. Average assets in the QQQ were $12 billion higher than the Q2 of 2022. Average passive AUM, excluding the Qs, increased by $9 billion, while average active AUM declined by 5%. We believe that a meaningful portion of the asset mix shift that has occurred is a product of market movements and risk-off sentiment, and those pressures should abate as preference for risk assets returns and conditions improve. That said, growth in investor preference for passive exposure and solutions capabilities is a long-term secular trend, and we continue to reposition our cost base to align with changes in our business mix as we build greater scale in key capability areas.
Total adjusted operating expenses in the Q2 were $789 million, $27 million higher than the Q2 of 2022, an increase of $40 million from the prior quarter. Included in our Q2 operating expenses were $27 million of compensation expenses related to executive retirements and organizational changes. In the Q2 of 2022, expenses of this nature were not included in our non-GAAP results, as they were included in transaction, integration, and restructuring expenses. We recognized $13 million of such expenses in the Q1 of 2023. Also impacting Q2 compensation expense was higher incentive pay on $22 million of performance fees, partially offset by seasonal decline in payroll taxes. As Andrew noted, we are simplifying the organization to position the firm for greater scale and profitability as we grow our revenue base.
The majority of the $27 million of compensation expense I mentioned was related to executive retirements, the balance was a result of other organizational actions taken in the quarter. We will action further adjustments to our operating model over the remainder of 2023 and would expect to recognize approximately $20 million of additional costs associated with these decisions in the Q3. The full benefits from our simplification efforts will be seen over time as we generate revenue growth and margin recovery. To this point, we have identified $50 million of annual run rate expense savings that will be realized by the beginning of 2024. Work is ongoing to quantify and action additional opportunities, we will keep you informed on our progress. As we've discussed, we manage variable compensation to a full-year outcome in line with company performance and competitive industry practices.
Historically, our compensation to net revenue ratio has been in the 38%-42% range, trending towards the upper end of that range in periods of revenue decline. At current AUM levels, we would expect the ratio to continue to be at or slightly above the high end of the range for 2023, when excluding the costs pertaining to executive retirements and other organizational changes. Marketing expenses of $32 million, $4 million higher than the prior quarter, indicative of the seasonally higher activity we typically see in Q2. Marketing expenses were $4 million lower than the Q2 of last year, as we are tightly managing discretionary spend in this revenue environment.
Property, office, and technology expenses were $2 million higher than the Q1, primarily due to higher software costs, partially offset by the end of overlapping rent now that we have completed the move to our new Atlanta headquarters. G&A expenses of $114 million increased $19 million from the prior quarter. Q2 expenses included approximately $7 million in spending on our Alpha Next Gen program, which was previously included in transaction, integration, and restructuring expenses. Going forward, these costs will be reflected in our non-GAAP results. We would expect quarterly average spending on Alpha Next Gen to remain at the same level for the next few quarters. As we mentioned on our last call, we benefited from indirect tax credits in the Q1. A reduction in credits received drove a $3 million increase in expenses quarter-over-quarter.
The remaining increase in G&A expenses related to higher project spending for ongoing technology improvement initiatives, as well as normal fluctuation that we can see in G&A period to period after relatively lower spending in Q1. Looking ahead, we expect G&A expenses in the Q3 to be flat to modestly lower than the Q2. We're balancing continued investment in our key growth areas and technology programs while diligently managing discretionary spend, and we are limiting hiring to key growth areas and critical positions. We've also been increasing our use of lower-cost locations where it makes sense to do so. As an executive leadership team, we are committed to driving profitable growth in the coming quarters. Moving to slide eleven, adjusted operating income was $302 million in the Q2, which included the costs related to executive retirements and other organizational changes.
Adjusted operating margin was 27.7% for the Q2. Excluding the costs related to retirement and other org changes, Q2 operating margin would've been 250 basis points higher. Earnings per share was $0.31 in the Q2, excluding those same expenses related to executive retirement and organizational changes, Q2 earnings per share would've been $0.05 higher. The effective tax rate was 24.7% in the Q2. We estimate our non-GAAP effective tax rate to be between 23% and 25% for the Q3 of 2023. The actual effective rate may vary from this estimate due to the impact of non-recurring items on pre-tax income and discrete tax items. I'll finish on slide 12.
Building balance sheet strength has been an unwavering priority, and I'm pleased to note that our cash balance increased in the Q2 to $1.01 billion, and that with one and a half billion dollars of outstanding debt, this lowered our net debt to less than $500 million. We were able to achieve this reduction in net debt while also repurchasing $150 million of common stock in the quarter, or 9.6 million shares, equivalent to 2% of the total common shares outstanding. The share buybacks occurred at an average price of $15.65, which we viewed as a very attractive opportunity. The improvements we have made on the balance sheet in the past several years facilitated our ability to take advantage of this opportunity.
Our leverage ratio, as defined under our credit facility agreement, was 0.7 times at the end of the Q2, modestly lower than last quarter. We are committed to building an even stronger balance sheet, and our goal is to bring net debt, excluding the preferred shares, down to zero in 2024. We have an opportunity to further address outstanding debt with the maturity of the $600 million in senior notes at the end of January. We ended the Q2 with nothing drawn on our revolving credit facility. To conclude, the resiliency of our firm's net flows performance in a difficult market for organic growth is evident again this quarter, and I'm pleased with the progress we're making to simplify the organization and build a stronger balance sheet while continuing to invest in key capability areas.
As a firm, we're committed to driving profitable growth and a high level of financial performance, and we're confident we have the right talent, mindset, and strategic positioning to do so. With that, I'll ask the operator to open up the line to Q&A.
Operator (participant)
Thank you. At this time, if you'd like to ask a question, excuse me, please press star one. You will be announced prior to asking your question. Please pick up your headset and when asking your question. To withdraw your request, please press star two. Our first question comes from Glenn Schorr with Evercore. Your line is open.
Glenn Schorr (Senior Managing Director and Senior Research Analyst)
Hi, thanks. Appreciate it. Just a follow-up question on real estate. Obviously not unique to Invesco, but just given higher rates, some problem areas, and long tail workouts across parts of real estate, demand is low, as you mentioned. Curious if you could just sum up what's the overall message on the health of the current portfolio? I think you put all that extra disclosure to tell us it's good, but, I wonder if you could just comment that. Two, more importantly, what do you think the environment does need to look like for demand for real estate-related products to improve? Because that would be a big growth driver for when we get there.
Allison Dukes (CFO and Senior Managing Director)
Sure. Why don't I start? I'd say the overall message on the health of the portfolio is, yes, as you said, it's good. Look, it is, in terms of where we are from a cyclicality perspective, it's been a challenging environment, that's not unique to us. That has a lot to do with some of the, just the backup in transactions in that market. As rates have increased, the return profile, the ability to put leverage on some of these transactions, it's more difficult, and that's caused a backup, a slowdown in some of the transactions, which slows down activity overall. That said, as we tried to highlight in some of the detail we provided, our portfolio is performing very well.
We are long-term, very optimistic about how we're positioned, and I would say everything is performing as one would expect in an environment like this. We think we've made a lot of good, strong decisions to diversify that portfolio, especially managing down the office exposure, in advance of some of the downturn of the last year. We feel good about where we're positioned overall. What does it take to see activity pick back up? I definitely think, normalization in the leverage markets will help quite a bit. That has been, you know, obviously, with the, some of the bank, challenges that started in the Q1 and progressed into the Q2, that wasn't helpful.
As you start to see, I think, some conviction around the rate environment stabilize, and you see banks, and leverage markets performing at a more normal level, we'll start to see activity pick back up. I think demand remains strong. I guess the last thing I would say is certainly we saw some challenges as it relates to institutional allocations. When you saw equity markets and fixed income markets decline pretty significantly over the past year, that caused a lot of institutions to be overexposed in real estate. As equity markets and fixed income markets improve, the denominator effect is less of a concern, and some of the allocations there, come back in line with what's expected, and that's gonna be, that portends well for the future pipeline.
Andrew Schlossberg (President and CEO)
Glenn, I'd just add that as we look forward to opportunities, recall our portfolio's fairly global, so the dynamics are pretty different outside the U.S. than the U.S., and it's a pretty diverse national footprint as well in the United States. I'd say is, real estate debt is something we're hearing increased demand for and have capability there, and we're gonna continue to focus on opportunities in the debt side of the market. The last thing I'd say is, while the institutional market is fairly well penetrated, the wealth management markets in the U.S. and globally, we see tremendous opportunity where, you know, portfolio allocations are less than 1% to things like real assets at the moment.
Glenn Schorr (Senior Managing Director and Senior Research Analyst)
I appreciate all that. Allison, one other quickie. On the comments on the $20 million in the Q3 and $50 million by the end of 2024 in identified efficiency savings, should we be thinking that is all falling to the bottom line? Like or is there a netting effect in terms of the ongoing investments that you're making? Thank you.
Allison Dukes (CFO and Senior Managing Director)
Yes, sure. Good question. Thank you. Let me clean that up a little bit. $20 million in additional costs that we expect to incur in the Q3, with $50 million of net realized savings that we expect to be realized in the beginning of 2024, not the end. Yes, to answer your question, that would be net savings that we would expect to fall on the bottom line, tax affected, of course.
Glenn Schorr (Senior Managing Director and Senior Research Analyst)
Thank you.
Operator (participant)
Thank you. Our next question comes from Brennan Hawken with UBS. Your line is open.
Brennan Hawken (Senior Equity Research Analyst)
Good morning. Thanks for taking my question. I'd like to touch on, sort of at a high level here, Andrew. You referenced changes you wanted to make to simplify the organization. Allison added some additional color in the context of costs. Could you maybe either give us a frame of reference around what you think could help to simplify the organization? You know, is this an opening salvo and something you intend to approach over the course of many years? How should we think about maybe, like, incremental updates on your approach as you get your hands around and get settled into the seat? Thanks.
Andrew Schlossberg (President and CEO)
Sure. Thanks, Brennan. Good questions. Maybe just to start at a high level of what we're trying to achieve. Our aim of simplifying and streamlining the organization, obviously, is to generate better profit growth, but it's also to improve quality of investment performance. We want to simplify the organization so we can accelerate more quickly strategic execution, and we want to be able to use our scale and leverage that we have in the business. What we did was we started this process earlier this year. To answer your question, it's going to continue through the course of this year and going forward. This is an ongoing effort to continue to reposition our business for where client demand is.
A few examples of some things that we've been working on and will continue to work and work on. One is around investment team simplification and quality improvements. For instance, we brought together three multi-asset strategy teams into one. We're further bringing together our fixed income platform around the world. We've enhanced leadership, global leadership with our co-CIO structure and fundamental equity. Things like that around investment team simplification, we'll continue to focus on. We're also looking to globalize core elements of our client engagement and client delivery. We combined leadership in the Americas and EMEA. We established a single marketing organization. We're globalizing digital platforms, and we're taking out complexity in our product platform.
We combined our ETF and SMA and custom index leadership and reduced our product line by over 150 products. Lots going on in the client delivery side. We're simplifying and reviewing our operating and enterprise model, sort of end-to-end, looking for ways to take advantage of those front-end changes and move them through the cost base and be more efficient. The last thing I'd say, which I think speaks to what we're going to continue to do going forward, is, evolve the culture. We're going to be tightening our execution edge as a team. We're going to be simplifying our operating and organizational models, which we've started, and we're going to enhance the accountability around profit growth. You should expect to continue to hear updates from me and Allison regularly about these efforts.
Brennan Hawken (Senior Equity Research Analyst)
Thanks, thanks for all that color, Andrew. Much appreciated. For my follow-up question on real estate, you know, sort of following on to Glenn's question. You break out traditional office, traditional U.S. office, which is great, but how would you define non-traditional office, I guess? What would that do to those numbers? Then when we look at the difference in the allocation to traditional office from 20% down to 13 in the Americas over that three-year, sorry, you know, 1Q 20 to 2Q 23, how much of that were disposals versus price declines in the assets?
Allison Dukes (CFO and Senior Managing Director)
Let me take maybe the second one first. That would primarily be dispositions. You know, I think the vast majority would that, of that would be deliberate choices that were made, not declining asset values there. It's been a rocky environment, but not an entire, not an entirely terrible one to try to exit and reposition that portfolio. I think our timing was good. In a lot of ways, we moved quickly, and we've been able to, I think, show the results very quickly. There's a good news story there, not a bad news story. In terms of what's I'm not sure I followed your question on traditional office versus not traditional office.
Brennan Hawken (Senior Equity Research Analyst)
Oh, I guess I was.
Allison Dukes (CFO and Senior Managing Director)
Sorry.
Brennan Hawken (Senior Equity Research Analyst)
I was just trying to understand office. Like, is the overall office exposure actually larger than what you guys define as traditional? Did you just use the term traditional just to define the office sector broadly?
Allison Dukes (CFO and Senior Managing Director)
No, it's not larger than what we would define. If you think about what's outside of what we would consider traditional, think things like medical office buildings, and things that we would truly consider to be different than mid-rise, high-rise kind of office exposure.
Brennan Hawken (Senior Equity Research Analyst)
Got it. Okay. Thanks for that.
Operator (participant)
Thank you. Our next question comes from Brian Bedell with Deutsche Bank. Your line is open.
Brian Bedell (Director)
Great, thanks. Good morning, folks. Thanks for taking my question. Just staying with the private alternative platform theme, I guess as we sort of look forward, just a couple of some of the potential bigger drivers within this bucket. Maybe if you could just size the redemptions that you're currently running at for the open-end strategies that you talked about in real estate, and then the opportunity going forward, particularly in direct lending. You know, to what extent do you think you can expand these strategies given, you know, potential pullback in banks? Is that something that's more of a near-term development or really more longer term?
Allison Dukes (CFO and Senior Managing Director)
Yeah, I'll take the first one. I'd say the redemption rates and the open-end strategies. Again, what we tried to do was narrow down the percentage of our portfolio that is in an open-end strategy. With that, you know, normal redemption rates through a cycle would be kind of 5%-6%. As we noted, we'd be on the higher side of that. We would be above that range. It varies, though. It varies quite a bit across the different products. You know, on average, it's a touch higher than where we are today. Operating, though, very normally, and very consistent with what we've experienced in cycles like this over our 40 years in the business.
More than anything, I think what we hope to convey is, it's quite normal and quite manageable, and there are no liquidity issues or concerns across any of those individual funds. I'd say maybe Andrew, you want to take direct lending?
Andrew Schlossberg (President and CEO)
Sure. Yeah. In private credit, you know, we've been building out our capabilities over the last few years in distressed and in direct lending. Demand, both from institutions and emerging from high-net-worth retail or wealth management, we continue to see it. We continue to have asset raises and focus both in the U.S. and in Europe. We expect to continue to see that demand for the reasons you described. I'd say given that we're a relatively new entrant into that space and we're building our reputation, it'll be a driver, but it'll take some time for it to be, I think, a meaningful part of the private markets enterprise like our private real estate franchise is.
Brian Bedell (Director)
Got it. Great. That's great color. Just on the cost side, Allison, maybe on the Alpha Gen program, it sounds like that $7 million run rate is sort of a cost number, but I guess, should we be considering that to be like a net cost number of savings? I guess, do we have any idea yet longer term as you get that platform completely onto and integrated with Alpha, any sense of sizing what potential cost savings can come from that initiative longer term?
Allison Dukes (CFO and Senior Managing Director)
Yeah, great. Thanks for the question, Brian. On ANG, just a reminder of one thing I said that, you know, we've had ANG costs for the last year plus in our transaction integration and restructuring expense. With that, you've discontinued after the Q1. You do see our cost base now fully loaded through our GAAP financials with the cost that we are incurring for Alpha Next Gen and some of these organizational related changes as well. It is a difference that does cause, you know, changes in our overall operating expense base. I noted that it was about $7 million in the Q2, and that we would expect it to be at about that level for the next few quarters.
We will be hard at work on Alpha Next Gen, really through 2024, and into 2025. We will be providing ongoing updates, but I think that's a reasonable expectation for this, for the cost right now. In terms of savings will come, once we are able to go live. We will not be going live until we are into 2024. Then we will be running parallel for some time. Then savings and rationalization really is something that would occur on the other side of that, so as we get closer to 2025.
We're a ways off from providing you estimates on, you know, how our expense base could improve over time, but, we are entirely focused on a successful execution right now, and we do expect the costs that we saw in the Q2 to remain in our cost base for some time as we really focus on the execution here.
Brian Bedell (Director)
Yeah, okay. It's great color. Thank you.
Andrew Schlossberg (President and CEO)
Thanks.
Operator (participant)
Thank you. Our next question comes from Craig Siegenthaler with Bank of America. Your line is open.
Craig Siegenthaler (Managing Director)
Thanks. Good morning, everyone. Buyback activity was quite strong in the quarter. You paid out 170% of your earnings power, I think most of the buybacks just came in the month of June. How should we expect your share repurchase effort going forward to trend? Will it be more consistent than in the past or more episodic?
Allison Dukes (CFO and Senior Managing Director)
Thanks, Craig. I think, you know, look, as we've noted all along, we've had several priorities that we've been working really hard on making parallel progress on, and one of which has been improving the balance sheet overall. Improving the balance sheet is what gave us the capacity and the flexibility to be opportunistic in the Q2 and execute on those buybacks. We were pleased that we were able to do so, and to do so without any additional borrowings on our credit facility, and continuing to manage our net debt down. Those are the types of things we need to see to put us in a position to be opportunistic going forward. We were not particularly pleased and with our price when we were staring at something that started with, you know, $14.
We did have the opportunity in the Q2 to make some progress there. I think you should expect over time, that we're going to be disciplined, and diligent in continuing to improve our balance sheet, but where we see opportunities to return capital to shareholders, we're going to do so as well.
Craig Siegenthaler (Managing Director)
Thank you, Allison. Just as my follow-up, money market flows continue to be strong. You've doubled this business in less than three years. Can you just update us on the drivers? Can this trajectory continue even if overall trends like broker cash sorting, slows?
Andrew Schlossberg (President and CEO)
I'll make a couple of comments, maybe then Allison can jump in. We're really pleased with the growth, and it was deliberate. I mean, we focused on quality in the cash management, money market side, client engagement and pricing, and it paid off. We saw $15 billion in inflows this quarter. It's important to remember, 85% of our business is institutional, and we don't expect that to change. We're very strong there. We've moved into the top 10, and we're taking market share. I think with high yields continuing for some time, it's gonna continue to be a drive on demand, and we expect to continue to take share. Allison, I don't know if-
Allison Dukes (CFO and Senior Managing Director)
Got it.
Craig Siegenthaler (Managing Director)
Thank you, Andrew.
Andrew Schlossberg (President and CEO)
No problem.
Operator (participant)
Thank you. The next question comes from Alex Blostein with Goldman Sachs. Your line is open.
Alex Blostein (Managing Director)
Thanks. Good morning, everybody. Maybe we can just kind of wrap up the private markets growth strategy through a couple of questions here. I guess when you look at the real estate business, to your point, there are a number of challenges facing over the next several quarters. In private credit, some of the growthy areas, whether it's direct lending and kind of distressed or opportunistic credit, are newer and, you know, you highlighted that it's gonna take a little bit of time for them to contribute. How are you thinking about organically turning this business into positive net flow mode over the near term? Or do you think it'll require some inorganic opportunities to add more product breadth as well?
Andrew Schlossberg (President and CEO)
Yeah, I'll start by saying we're very focused organically. We think the spaces we're in private real estate, and in the private debt side of the markets are the places we want to be. We'll continue to look over time, obviously, to grow that organically, and if things present themselves to extend off of that, we'll pay attention. Our focus right now is growing them organically. In addition to some of the things Allison already covered on the recovery on the institutional side of things, which will, you know, we think will happen in time. The real growth driver for our real estate business is going to be through the wealth management channels. We started that effort several years ago.
We've seen strong placements for our non-traded REIT strategy, and we're going to be and continue to be in market with strategies like those, including on the debt side of real estate. As I mentioned, the penetration in wealth management for the industry is less than 1%, with, you know, most expectations, getting it to 10%-15%. That'll take some time. We think with an offering like we have and a pedigree, combined with our wealth management distribution, strength in the U.S. and in Europe, that that's gonna be an amazing opportunity. We've invested in those areas already, the growth is gonna come to us in the next couple of years, and we think it could be meaningful.
Those are the areas that we're going to be focused on in addition to the institutional space.
Alex Blostein (Managing Director)
Got it. Thanks. For my follow-up, Allison, just around alternate next gen. Obviously, it's been taking longer. It's a complicated transaction, so that's all fair. What has gone right? What has gone wrong? Why do you think it's taken longer than sort of original expectations? On the other end of that, do you think there's gonna be room for you guys to negotiate fees down at the ultimate kind of end game of this transaction, given the fact that it's taken longer than expected? Thanks.
Allison Dukes (CFO and Senior Managing Director)
Well, I would say, look, it's been a strong partnership with State Street. We've worked closely on the execution of this for the last couple of years, and we have been negotiating around the ultimate cost of this. It is an important partnership on both sides. I would say both parties have been responsive and thoughtful as to both the cost and the time that's involved here. You should expect that's ongoing, not something that happens on the back end. What's gone right or wrong? You know, I think that's harder to answer, and I guess I would say in many respects, it is large, and it is a bit uncharted for both parties.
We've been working together to try to do this in a way that's very thoughtful, and provides the benefits we're looking for for our business. You know, I think, if I could say anything, I would say probably everything's going harder and longer than you expect in large-scale technology implementations. I don't think that's unusual, but one that we are certainly making our way through. We feel good about where we are right now. We feel good about the attention of all teams from both parties, and the work that's underway. The fact that it's taking a little longer than we expected, I don't see it as a huge negative, but one that is just, you know, something that we're figuring it out as we go along on both sides.
Andrew Schlossberg (President and CEO)
Yeah, the commitment's high from, obviously, from both parties and other related parties that are working on it. We're really heads down, trying to get the execution and implementation done. You know, we feel good about that.
Alex Blostein (Managing Director)
Got it. All right. Thanks very much.
Operator (participant)
Thank you. The next question comes from Mike Brown with KBW. Your line is open.
Mike Brown (Equity Research Analyst)
Great. Thank you very much. In China, it looks like there's been a regulatory mandate to limit the fee rates for products there to 1.2%. Has that already begun to impact China Great Wall, or is that something that will kind of come through later this year? As you look to next quarter, can you just expand on maybe some of the puts and takes we should consider here for the fee rate when we think about next quarter, maybe that exit fee rate, if you will?
Allison Dukes (CFO and Senior Managing Director)
Sure. Let me start with China. That was just announced in early July, so just a couple of weeks ago. We are evaluating what that means for our portfolio right now. Our estimates right now is that those fee cuts will impact about $24 billion of AUM, so about 28% of our portfolio there. It's early, and we are still working through a lot of this in terms of both timing and overall impact. The timing is, you know, perhaps, here in the Q3, but certainly into the Q4, as we anticipate revenue being on a net basis, lower somewhere between $5 million-$10 million per quarter. Now, that's for all of the JV. Of course, we own a 49% share of that.
With that lower revenue, there's also lower compensation changes that come with it. The ultimate impact to net income will be much lower than that, and I think we'll be able to provide a clearer guidance around all of that at the end of the Q3. Overall, I'd say we actually are really well positioned with that change, just given our more mature market positioning in China overall. As a reminder, we're the 12th largest asset manager there, the largest foreign owner, and we have a very mature business, having just celebrated our 20th anniversary there. We actually think this reform is really gonna facilitate high quality development of the overall mutual fund industry in China, and that's going to just serve to accelerate growth and really better serve investor needs.
While there is a near-term impact, we actually think this portends well for the overall growth of the industry in China, and that we are well positioned to capture some of that growth. To your question around fee rate and what that means or what we could expect from an exit perspective going into the Q3, we've definitely seen continued declines in our overall net revenue yield, and that's really a function of mix shift dynamics. We gave a lot of color of that in the prepared remarks around just the uneven recovery across asset classes and the particular impact of the risk-off sentiment in our overall net revenue yield. I'll say we are not seeing fee pressure, but we are seeing high demand for some of our lower fee assets.
Even within our passive assets, we see high demand for some of our lower fee capabilities there. As an example, our two largest selling ETFs in the Q2 were the QQQM and the S&P Equal Weight 500, and those would both be on the lower end of kind of our fee range for our passive capabilities. On the one hand, we're incredibly pleased that we continue to capture flows, and we're well positioned in areas of client demand. On the other hand, that does continue to put some pressure on our fee on our fee rates. What does it mean going forward? I think we expect some mix shift dynamics to continue.
That said, we're pleased with some of the recovery we're seeing in some of our active equity strategies, both in terms of market recovery and diminished headwinds as it relates to redemptions and improving sales, particularly as we see performance recover in areas like our developing markets strategy. Net-net, I think you should expect, you know, continued modest pressure, certainly dependent on market recovery dynamics from here.
Andrew Schlossberg (President and CEO)
Yeah, if I can just go back to China just to add a couple of comments, a couple additional comments. I mean, certainly market sentiment post-COVID has been a little more negative and it's been slow, but I think the Chinese government's pro-growth reforms and the things that policies and actions underway, we're starting to see some of that demand come back. I'll just reemphasize something Allison said, which is our strong position there and our conviction about the Chinese asset management markets growth. It is very early days in terms of an investor's sophistication in asset classes.
It's very early days in retirement markets. Our position being there for 20 years with close to $100 billion in assets under management, good performance, a good reputation, and a bit of a moat around competition coming in, really bodes well for long-term success in China. We are, you know, we're looking forward to seeing that for the years to come.
Mike Brown (Equity Research Analyst)
Great. Appreciate all the color there. Just as a follow-up on the other revenue line that was down again sequentially, I know last quarter was impacted by lower real estate transaction activity. Was that kind of a similar story here this quarter? Any view on, you know, the near term there, as well? I appreciate all the comments in your prepared remarks on the real estate side. Just kind of interested in that line, near term.
Allison Dukes (CFO and Senior Managing Director)
Sure. Well, some puts and takes in that line item. Real estate transaction fees were actually a little bit higher in that line item in the Q2 as compared to the Q1. The negative, what was offsetting that was, lower front-end fees. You really just saw a decrease in some of the transaction fees that were driven by a decrease in equity sales. Puts and takes, always a little bit of, a lot of discrete items in that line item.
Mike Brown (Equity Research Analyst)
Okay. Is it fair to assume that next quarter or maybe the next couple of quarters would be semi-similar to that level?
Allison Dukes (CFO and Senior Managing Director)
You know, I think that's a reasonable expectation. I mean, it moves so modestly, up and down. It's hard to predict that at that kind of discrete level, but you could probably look at the average over the last couple of quarters, and that would be reasonable.
Mike Brown (Equity Research Analyst)
Okay, that's fair. Thank you very much.
Operator (participant)
Thank you. The next question comes from Daniel Fannon with Jefferies. Your line is open.
Daniel Fannon (Managing Director and Research Analyst)
thanks for squeezing me in. I wanted to take a little bit longer view on the fee rate. Obviously, the mix shift trend has been happening for some time. Allison, you mentioned the current dynamics, but as you look out over the multiple-year period, how do you see that trend stabilizing, accelerating, or kind of continuing? Then, as you announced on the cost side, are you adjusting the expense base fast enough to deal with that trend? Because clearly there's been some lag effect of expenses in some of this mix shift. Excluding beta, you know, kind of as you think about that fee rate and then ultimately the expense base, how we should think about the appropriate use of scale and margin in that context.
Allison Dukes (CFO and Senior Managing Director)
Yeah. Thanks, Dan. I do think over time, you start to see the decline in the fee rate start to abate. I don't know where that is exactly, but you can look at where the demand is for, you know, some of our higher growth capabilities. Those fee rates, you know, if you look at, let's take the ETF portfolio and our passive fee rate, that has declined, and that's, you know, is all available in our disclosures. That declined to just under 16 basis points in the Q2, which was down about 1 basis point. Again, that's because of what I just pointed to and the growth in some of our capabilities that are in high demand that are around a 15 basis point fee rate.
If you look at some of the areas of our ETF capabilities that were trending off in the last couple of quarters, that would be around commodity and currency ETFs that are going to be on the higher side. Once we see, you know, more of a return to a risk-on mentality, we would expect that to come back. I think, you know, look, our passive fee rate, I think it probably is in that 16-ish basis points over, you know, a long-term horizon. China's obviously has some pressure given the fee cuts we just talked about, but that is on the, you know, much higher side, much higher than the firm average, and we expect to see continued strong growth in China as the economy recovers there. Our private markets capabilities would be on the higher side, too.
You kind of take all of that, you think about the barbelling. One would think that, yes, the fee rate starts to even out roughly, maybe diminishes a bit more as we continue to see some of this mix shift, and we continue to see the growth of our passive capabilities. Over time, over a longer-term high time horizon, it should start to abate and even out a bit. Scale, getting to scale in our passive capabilities has been something we've talked about a lot, something we continue to be very focused on. Getting to the second part of your question, aligning our expenses around that.
You know, it takes some time to reposition an expense base that was built to support who the company was 7, 8, 10 years ago, to where we think it will be 7, 8, 10 years from now. It's really part of the methodical work we are undertaking now as we continue to simplify the organization and continue to look at how we can reposition our overall organizational structure, as well as our technology and operational structure to support where the business is going, and continue to really create scale there and focus on the marginal profitability improvements we think we can garner as we get to scale in some of those asset classes.
Andrew Schlossberg (President and CEO)
I think as Allison was alluding to on the revenue yield, you know, client demands and broadening of markets, which we talked about in our comments, are two of the things that have a, you know, a major impact on the revenue yield, and Allison pointed some of those. In terms of the scale and the expense base, the scale of the company, we're certainly going to benefit from our size. I think as Allison was alluding to, we're going to continue to look at the different component parts of our business, and what's required from an expense base standpoint, in an ETF franchise versus a private markets franchise are obviously different. We're going to continue to look business by business, not just our global scale.
Allison Dukes (CFO and Senior Managing Director)
In that, I think, you know, the concluding comments, as I would say, we feel very confident we can improve operating margin from here. That remains our area of focus. The challenge and the really fast remixing of our asset base over the last 12 to 18 months has been a pretty tough challenge to contend with. At the same time, we've been making deliberate changes along the way, and we think we're really well positioned to capture, you know, really start to improve operating leverage over time, and make sure that the expense structure of the business is repositioned to really support what we think the revenue environment will be for the next few years.
Daniel Fannon (Managing Director and Research Analyst)
Great. Thank you.
Operator (participant)
I'll turn it back over to you.
Andrew Schlossberg (President and CEO)
All right, well, we'll just wrap it up by saying thank you, and we look forward to speaking with everybody next quarter. Have a great rest of the day.
Allison Dukes (CFO and Senior Managing Director)
Thank you.
Operator (participant)
Thank you. That concludes today's conference. You may all disconnect at this time.