UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K/A
(Amendment No. 1)
(Mark One)
| x | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the fiscal year ended December 31, 2007
| ¨ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the transition period from ________________ to ________________
Commission file number 000-51682
HIGHBURY FINANCIAL INC.
(Exact Name of Registrant as Specified in Its Charter)
Delaware (State or other jurisdiction of incorporation or organization) | | 20-3187008 (I.R.S. Employer Identification No.) |
| | | |
999 Eighteenth Street, Ste. 3000, Denver, CO (Address of principal executive offices) | | 80202 (Zip Code) |
Issuer’s telephone number (303) 357-4802
Securities registered under Section 12(b) of the Exchange Act:
None
Securities registered under Section 12(g) of the Exchange Act:
Title of Each Class:
Units consisting of one share of Common Stock, $.0001 par value per share, and two Warrants
Common Stock, $.0001 par value per share
Warrants to purchase shares of Common Stock
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 periods as 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 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. ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (check one)
Large accelerated filer ¨ Accelerated filer ¨
Non-accelerated filer x (Do not check if a smaller reporting company) Smaller reporting company ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). YES ¨ NO x
As of June 30, 2007, the aggregate market value of the Common Stock held by non-affiliates of the Registrant was approximately $19,512,627, computed by reference to the closing sales price of such Common Stock on June 30, 2007, as reported on the OTC Bulletin Board. In determining the market value of the voting stock held by any non-affiliates, shares of Common Stock of the Registrant beneficially owned by directors, officers, stockholders who acquired their shares of common stock prior to the Registrant’s initial public offering, and holders of more than 10% of the outstanding shares of common stock of the Registrant have been excluded. This determination of affiliate status is not necessarily a conclusive determination for other purposes.
As of March 18, 2008, there were 9,126,628 shares of common stock, $0.0001 par value per share, outstanding.
DOCUMENTS INCORPORATED BY REFERENCE: None
EXPLANATORY NOTE
The purpose of this Amendment No. 1 on Form 10-K/A to our Form 10-K filed with the Securities and Exchange Commission on March 28, 2008 (the “Original Filing”), is to amend the second sentence of the second paragraph under the heading “Year ended December 31, 2007 for the Company compared to year ended December 31, 2006 combined results” in the “Results of Operations” section of Item 7. This amendment reflects the recharacterization of reinvested distributions as an “other adjustment” rather than an inflow of client assets.
Other than the amendment described above, no attempt has been made in this Amendment No. 1 on Form 10-K/A to modify or update the disclosures presented in, and it does not reflect events occurring after the filing of, the Original Filing. Therefore, all unamended portions of the Company’s Original Filing remain in effect and have not been amended to reflect events and developments since the original March 28, 2008 filing date. Accordingly, this Amendment No. 1 on Form 10-K/A should be read in conjunction with the Original Filing and the Company’s other filings.
As required by Rule 12b-15 promulgated under the Securities and Exchange Act of 1934, our Chief Executive Officer and Chief Financial Officer are providing Rule 13a-14(a) certifications in connection with this Amendment No. 1 on Form 10-K/A and written statements pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
You should read this discussion and analysis of our financial condition and results of operations in conjunction with our audited consolidated financial statements and the related notes and the audited combined financial statements for the U.S. Mutual Fund Business of ABN AMRO Asset Management Holdings, Inc. and the related notes appearing elsewhere in this Annual Report on Form 10-K. The information in this section contains forward-looking statements (see “Forward-Looking Statements”). Our actual results may differ significantly from the results suggested by these forward-looking statements and our historical results. Some factors that may cause our results to differ are described in “Risk Factors” under Item 1A of this Annual Report on Form 10-K. We wish to caution you not to place undue reliance on these forward-looking statements, which speak only as of the date made.
Overview
Highbury is an investment management holding company providing permanent capital solutions to mid-sized investment management firms. We pursue acquisition opportunities and seek to establish accretive partnerships with high quality investment management firms. Highbury’s strategy is to provide permanent equity capital to fund buyouts from corporate parents, buyouts of founding or departing partners, growth initiatives, or exit strategies for private equity funds. This strategy includes leaving material equity interests with management teams to align the interests of management and Highbury’s shareholders and, in general, does not include integrating our acquisitions, although Highbury may execute add-on acquisitions for its current or future affiliates. We seek to augment and diversify our sources of revenue by asset class, investment style, distribution channel, client type and management team. We intend to fund future acquisitions with our revolving credit facility, other external borrowings, retained earnings (if any), additional equity and other sources of capital, including seller financing and contingent payments.
Highbury was formed on July 13, 2005, and closed its initial public offering on January 31, 2006. After deducting the underwriting discounts and commissions and the offering expenses, the total net proceeds to Highbury from the offering and the private placement that Highbury closed contemporaneously with its initial public offering, were approximately $43.8 million.
Business Combination. On April 20, 2006, Highbury and Aston entered into an asset purchase agreement with the sellers. Pursuant to the asset purchase agreement, on November 30, 2006, we acquired substantially all of the sellers’ business of providing investment advisory, administration, distribution and related services to the target funds specified in the asset purchase agreement. In connection with the consummation of the acquisition, Aston entered into agreements with each of the sellers that managed the target funds prior to the acquisition, pursuant to which each such seller now acts as a sub-adviser to the applicable target fund, each of which is now rebranded an Aston Fund. Pursuant to the asset purchase agreement, the sellers have agreed not to terminate these agreements prior to November 30, 2011.
Pursuant to the asset purchase agreement, Highbury and Aston paid $38.6 million in cash to AAAMHI. The asset purchase agreement provides for a contingent adjustment payment in cash on the second anniversary of the date of the closing of the acquisition, as follows: in the event the annualized investment advisory fee revenue generated under investment advisory contracts between Aston and the sellers applicable to the target funds for the six months prior to the second anniversary of the date of the closing of the acquisition, or the target revenue, (x) exceeds $41.8 million, we will pay to AAAMHI the difference between the target revenue and $41.8 million, up to a total aggregate payment of $3.8 million, or (y) is less than $34.2 million, AAAMHI will pay to us the difference between the $34.2 million and the target revenue, up to a total aggregate payment of $3.8 million.
The acquired business was founded in 1993 within Alleghany Corporation by employees of Aston to manage open-end investment funds for retail and institutional clients in the United States. Originally, the acquired business employed investment advisers affiliated with its parent to manage the assets of the funds, while it centralized the distribution, marketing, reporting and other operations of the fund family. As the business developed, the acquired business created new mutual funds managed by experienced independent investment advisers. Historically, the acquired business utilized seven different entities to manage the equity funds, of which five were current or former affiliates of the sellers and two were independent. Upon consummation of the acquisition, Aston entered into long-term contracts with each of these entities pursuant to which they will sub-advise the funds. The contracts with the sellers’ current and former affiliates will not be terminable by the sub-advisers until November 30, 2011. In general, sub-advisers unaffiliated with the sellers may terminate their sub-advisory contracts upon 60 days' written notice. One existing fixed income manager and two new managers were retained to manage three fixed income funds. Between the consummation of the acquisition and December 31, 2007, Aston opened ten new mutual funds, and now employs 15 different sub-advisors of which five are current or former affiliates of the sellers and ten are independent. Since December 31, 2007, Aston has created an additional three mutual funds with three new sub-advisors. Aston’s relationship with the sub-advisers is supported by limited non-compete provisions and certain capacity guarantees in certain products to benefit Aston. This arrangement is intended to ensure that the investment philosophies and processes guiding the mutual funds in the future are consistent with their historical investment philosophies and processes.
As of December 31, 2007, Aston managed 27 no-load mutual funds, comprised of 24 equity funds and 3 fixed income funds, with approximately $5.0 billion of mutual fund assets under management. As of December 31, 2007, 10 of the mutual funds carried an overall Morningstar RatingTM of three stars or better, including four four-star funds and one five-star fund. Twelve funds are relatively new and are not currently rated by Morningstar. The 24 equity funds are classified in eight of the nine Morningstar RatingTM style boxes, giving Aston wide coverage of the public equity investment spectrum and multiple sources of revenue. Aston intends to expand its assets under management with a combination of internal growth, new product development and accretive acquisitions. The Company believes the development of new products will provide growth in the future.
Between the consummation of the acquisition and December 31, 2007, Aston opened ten new equity mutual funds. These funds are set forth in the table below.
Fund | | Morningstar Category |
| | | |
| Aston/River Road Small-Mid Cap Fund | | Small Value |
| Aston/Optimum Large Cap Opportunity | | Large Growth |
| Aston/ABN AMRO Global Real Estate | | Specialty-Real Estate |
| Aston/Resolution Global Equity | | World Stock |
| Aston/Neptune International | | Foreign Large Growth |
| Aston/Barings International | | Foreign Large Blend |
| Aston/Montag & Caldwell Mid Cap Growth | | Mid-Cap Growth |
| Aston/SGA International Small-Mid Cap | | Foreign Small/Mid Growth |
| Aston/Cardinal Mid Cap Value | | Mid-Cap Value |
| Aston/ClariVest Mid Cap Growth | | Mid-Cap Growth |
During the first quarter of 2008, Aston opened three new equity mutual funds: the Aston/Smart Allocation ETF Fund, the Aston/MB Enhanced Equity Income Fund and the Aston/New Century Absolute Return ETF Fund.
Aston intends to manage its family of mutual funds in response to client demands, and may open new funds or close existing funds over time, as appropriate.
In addition, Aston may be able to develop new distribution channels including:
| | · | arrangements with banks and insurance companies which, like ABN AMRO, elect to divest their mutual fund operations but enter into agreements with Aston to service their customers; and |
| | · | wholesalers focused on the traditional retail broker channel. |
Revenue Sharing Arrangement with Aston. Highbury formed Aston on April 19, 2006 and became the sole member of Aston. In connection with Highbury and Aston entering into the asset purchase agreement, the limited liability company agreement of Aston was amended and eight employees of the acquired business and ABN AMRO were admitted as members of Aston (collectively referred to herein as the Aston management members). Highbury owns 65% of the membership interests of Aston, and the Aston management members own 35% of the membership interests of Aston.
Pursuant to the limited liability company agreement, 72% of the revenues, or the operating allocation, of Aston is used to pay operating expenses of Aston, including salaries and bonuses of all employees of Aston (including the Aston management members). The remaining 28% of the revenues, or owners’ allocation, of Aston is allocated to the owners of Aston. The owners’ allocation is allocated among the members of Aston according to their relative ownership interests. Currently, 18.2% of total revenue is allocated to Highbury and 9.8% of total revenue is allocated to the Aston management members.
Highbury’s contractual share of revenues has priority over the distributions to the Aston management members in the event Aston’s actual operating expenses exceed the operating allocation. As a result, excess expenses first reduce the portion of the owners’ allocation allocated to the Aston management members until the Aston management members’ allocation is eliminated, then Highbury’s allocation is reduced. Any reduction in the distribution of revenues to be paid to Highbury is required to be paid to Highbury out of any future excess operating allocation and the portion of future owners’ allocation allocated to the Aston management members, with interest.
Business Overview. Commencing with the acquisition on November 30, 2006 of the acquired business, we derive most of our revenue from the provision of investment management and related services. Aston generates revenue by charging mutual funds an advisory fee and an administrative fee based on a percentage of invested assets. A portion of the fees are paid to the sub-advisers, to a third-party sub-administrator and to third-party distribution partners. Each fund typically bears all expenses associated with its operation and the issuance and redemption of its securities. In particular, each fund pays investment advisory fees (to Aston), shareholder servicing fees and expenses, fund accounting fees and expenses, transfer agent fees, custodian fees and expenses, legal and auditing fees, expenses of preparing, printing and mailing prospectuses and shareholder reports, registration fees and expenses, proxy and annual meeting expenses and independent trustee fees and expenses. Aston has guaranteed many of the funds that their expenses will not exceed a specified percentage of their net assets. Aston absorbs all advisory fees and other mutual fund expenses in excess of these self-imposed limits in the form of expense reimbursements or fee waivers and collects as revenue the advisory fee less reimbursements and waivers. As of December 31, 2007, Aston was reimbursing 22 mutual funds whose expenses exceed the applicable expense cap.
Relationships with a limited number of clients account for a significant majority of our revenue. We expect that Aston’s relationships with these clients will continue to account for a substantial portion of our total revenue in future periods. Aston’s client, the Aston Funds, a Delaware business trust, which accounts for approximately 97% of our assets under management, is comprised of 27 mutual funds that are currently managed by Aston. Because all these funds have the same trustees, it is possible that the contracts with them could be terminated simultaneously. Of these 27 funds, the Aston/Montag & Caldwell Growth Fund and the Aston/Optimum Mid Cap Fund account for approximately 36% and 18%, respectively, of the revenues of Aston. The assets under management that Aston sources through independent financial advisers using Schwab and Fidelity, as custodians, each generate more than 10% of revenues received by Aston. Additionally, as of December 31, 2007, approximately 20% of our assets under management and 23% of our revenues are generated by customers sourced through a firm which was previously affiliated with the sellers but was subsequently sold to an unaffiliated third party. These various client concentrations leave us vulnerable to any adverse change in the financial condition of any of our major clients. The loss of any of these relationships may have a material adverse impact on our revenues.
Our level of profitability will depend on a variety of factors, including:
| | · | those affecting the global financial markets generally and the equity markets particularly, which could potentially result in considerable increases or decreases in our assets under management; |
| | · | the level of revenue, which is dependent on our ability to maintain or increase assets under management by maintaining existing investment advisory relationships and fee structures, marketing our services successfully to new clients and obtaining favorable investment results; |
| | · | our ability to maintain certain levels of operating profit margins; |
| | · | the availability and cost of the capital with which we finance our existing and new acquisitions; |
| | · | our success in making new acquisitions and the terms upon which such transactions are completed; |
| | · | the level of intangible assets and the associated amortization expense resulting from our acquisitions; |
| | · | the level of expenses incurred for holding company operations; and |
| | · | the level of taxation to which we are subject. |
Key Operating Measures
We use the following key measures to evaluate and assess our business:
| | · | Assets Under Management. As of December 31, 2007, Aston is the investment manager for 27 open-end mutual funds, comprised of 24 equity and 3 fixed income funds. Aston generates revenues by charging each fund investment advisory and administrative fees (collected in monthly installments), each of which are equal to a percentage of the daily weighted average assets under management of the fund. Assets under management change on a daily basis as a result of client investments and withdrawals and changes in the market value of securities held in the mutual funds. We carefully review net asset flows into the mutual funds, trends in the equity markets and the investment performance of the mutual funds, both absolutely and relative to their peers, to monitor their effects on the overall level of assets under management. |
| | · | Total Revenue. Total revenue for Aston is equal to the sum of the advisory fees, administrative fees and money market service fees earned by the business in a given period. We operate Aston under a revenue sharing structure through which Highbury receives a fixed percentage (18.2%) of the total revenue, net of sub-administrative fees, earned by Aston. In addition, Highbury earns interest income on its cash balances which we recognize as non-operating income on the financial statements. |
| | · | Weighted Average Fee Basis. The weighted average fee basis is equal to the total revenue earned in a specific period divided by the weighted average assets under management for that period. Because each fund has a different fee schedule, the weighted average fee basis provides us with a single indicator of the business’ ability to generate fees on its total assets under management across all products. |
| | · | Total Operating Expenses. The total operating expenses include the operating expenses of Aston as well as Highbury. At the Aston level, we monitor total operating expenses relative to Aston’s total revenue to ensure there is sufficient operating margin to cover expenses. We expect total operating expenses (including distribution and sub-advisory costs and excluding certain non-cash, non-recurring items) to equal approximately 72% of the total revenue of Aston, as provided in Aston’s limited liability company agreement. At the Highbury level, we incur operating expenses in connection with our pursuit of accretive acquisitions, including expenses for travel, entertainment and due diligence. We also incur legal and accounting expenses in connection with our SEC filing requirements and expenses of directors’ and officers’ insurance. |
Description of Certain Line Items
Following is a description of the components of certain line items from our consolidated financial statements:
| | · | Operating Revenue. Aston generates advisory fees based on a fixed percentage of the daily weighted average assets under management for each fund and receives these fees on a monthly basis. For many funds, Aston provides an expense cap which guarantees to investors that the total expenses of a fund will not exceed a fixed percentage of the total assets under management. For small funds, the fixed expenses for fund accounting, client reporting, printing and other expenses, when combined with the investment advisory fees and administrative fees, cause a fund’s total expenses to exceed the expense cap. In such cases, Aston reimburses the funds for the excess fixed expenses or waives a portion of the investment advisory fee, so as to keep the total expenses of the fund at or below the expense cap. Aston’s advisory fees include investment advisory fees from all of the funds, net of all fee waivers and expense reimbursements. Additionally, Aston generates administration fees for providing administration services. Such services include marketing and customer relations, bookkeeping and internal accounting functions, and legal, regulatory and board of trustees support. Finally, Aston earns monthly fees from AAAMHI in return for providing administration services to six money market funds which continue to be advised by AAAMHI. |
| | · | Distribution and Sub-advisory Costs. Aston has contracted on a non-exclusive basis with approximately 400 different institutions to sell its mutual funds, in exchange for a distribution fee, to retail and institutional investors. These distribution fees are generally equal to a fixed percentage of the assets invested by the retail or institutional investor. In addition, Aston employs third-party investment managers, or sub-advisers, to perform the security research and investment selection processes for each of its mutual funds. Under this arrangement, Aston pays the third-party investment manager a sub-advisory fee, generally equal to 50% of the advisory fees for the mutual fund, net of fee waivers, expense reimbursements, and applicable distribution fees paid under the distribution agreements discussed above. Total distribution and sub-advisory fees represent the largest component of expenses for Aston. Since these fees are generally based on total assets under management, they increase or decrease proportionately with total assets under management. |
| | · | Compensation and Related Expenses. As of December 31, 2007, Aston employed 37 full-time employees. The compensation and related expenses of Aston include the base salaries, incentive compensation, health insurance, retirement benefits and other costs related to the employees. These expenses increase and decrease with the addition or termination of employees. Highbury currently has no employees and provides no compensation to its officers or directors. |
| | · | Impairment of Intangibles. We recorded an impairment charge to the identifiable intangible related to Aston's advisory contract with the Aston Funds of $4,110,000 in the fourth quarter of 2007 as a result of net asset outflows from the Aston Funds and recent negative market performance. Highbury also determined that the identifiable intangible continued to meet the criteria for indefinite life. |
| | · | Other Operating Expenses. The most significant components of other operating expenses include professional fees, insurance, occupancy, marketing and advertising, voice and data communication and travel and entertainment expenses. |
Critical Accounting Policies
The Company’s discussion and analysis of its financial condition and results of operations for the purposes of this document are based upon its consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America, or GAAP. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosures. Actual results could differ from those estimates.
The Company’s significant accounting policies are presented in Note 1 to its audited consolidated financial statements included elsewhere herein, and the following summaries should be read in conjunction with the consolidated financial statements and the related notes. While all accounting policies affect the consolidated financial statements, certain policies may be viewed as critical. Critical accounting policies are those that are both most important to the portrayal of the consolidated financial statements and results of operations and that require management’s most subjective or complex judgments and estimates. We believe the policies that fall within this category are the policies related to principles of consolidation, investments, goodwill and intangible assets, valuation, compensation and related expenses and income taxes.
Principles of Consolidation. The consolidated financial statements include the accounts of Highbury and Aston, in which Highbury has a controlling financial interest. Generally, an entity is considered to have a controlling financial interest when it owns a majority of the voting interest in an entity. Highbury is the manager member of Aston and owns 65% of Aston. Highbury has a contractual arrangement with Aston whereby a percentage of revenue is allocable to fund Aston’s operating expenses (referred to as the operating allocation), while the remaining portion of revenue (referred to as the owners’ allocation) is allocable to Highbury and the other members, with a priority to Highbury. The portion of the income of Aston allocated to owners other than Highbury is included in minority interest in the Consolidated Statements of Operations. Minority interest on the Consolidated Balance Sheets includes capital and undistributed income owned by the management members of Aston. All material intercompany balances and transactions have been eliminated in consolidation.
Investments. In 2007, the Company elected to adopt early the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 157 “Fair Value Measurements” (“SFAS 157”) and SFAS No. 159 “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS 159”). The Company carries its investments in government securities, primarily 6-month Treasury bills and its investments in certain mutual funds managed by Aston at fair value based on quoted market prices. The Company reflects interest paid and accrued on Treasury bills in interest income and changes in fair value of mutual funds in Investment income.
Goodwill and Intangible Assets. The purchase price and the capitalized transaction costs incurred in connection with the acquisition of the acquired business are allocated based on the fair value of the assets acquired, which is primarily the acquired mutual fund advisory contract. In determining the allocation of the purchase price to the acquired mutual fund advisory contract, we have analyzed the present value of the acquired business’ existing mutual fund advisory contracts based on a number of factors including: the acquired business’ historical and potential future operating performance; the historical and potential future rates of new business from new and existing clients and attrition among existing clients; the stability and longevity of existing advisory and sub-advisory relationships; the acquired business’ recent, as well as long-term, investment performance; the characteristics of the acquired business’ products and investment styles; the stability and depth of the management team; and the acquired business’ history and perceived franchise or brand value. During 2007, the Company revised its original purchase price allocation by allocating an additional $2,627,000 to indefinite-lived indentifiable intangibles with a corresponding reduction to goodwill.
We have determined that the acquired mutual fund advisory contract meets the indefinite life criteria outlined in Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”), because we expect both the contract and the cash flows generated by the contract to continue indefinitely due to the likelihood of continued renewal at little or no cost. Accordingly, we do not amortize this intangible asset, but instead review this asset at least annually for impairment. If the carrying amount of this intangible asset exceeds the fair value, an impairment loss is recorded in an amount equal to that excess. Additionally, each reporting period, we assess whether events or circumstances have occurred which indicate that the indefinite life criteria are no longer met. If the indefinite life criteria are no longer met, we will amortize the intangible asset over its remaining useful life.
The excess of purchase price for the acquisition of the acquired business over the fair value of net assets acquired, including the acquired mutual fund advisory contract, is reported as goodwill. Goodwill is not amortized, but is instead reviewed for impairment. Highbury assesses goodwill for impairment at least annually, or more frequently whenever events or circumstances occur indicating that the recorded goodwill may be impaired. If the carrying amount of goodwill exceeds the fair value, an impairment loss would be recorded in an amount equal to that excess.
In allocating the purchase price of the acquisition and testing our assets for impairment, we make estimates and assumptions to determine the value of our acquired client relationships. In these valuations, we make assumptions of the growth rates and useful lives of existing and prospective client accounts. Additionally, we make assumptions of, among other factors, projected future earnings and cash flow, valuation multiples, tax benefits and discount rates. The impacts of many of these assumptions are material to our financial condition and operating performance and, at times, are subjective. If we used different assumptions, the carrying values of our intangible assets and goodwill and the related amortization could be stated differently and our impairment conclusions could be modified.
We recorded an impairment charge to the identifiable intangible related to Aston's advisory contract with the Aston Funds of $4,110,000 in the fourth quarter of 2007 as a result of net asset outflows from the Aston Funds and recent negative market performance. Highbury also determined that the identifiable intangible continued to meet the criteria for indefinite life.
Income Taxes. Deferred tax assets and liabilities are primarily the result of timing differences between the carrying value of assets and liabilities and the deductibility of operating expenses for financial reporting and income tax purposes. Deferred tax assets and liabilities are primarily the result of tax deductions for the Company’s intangible assets. We amortize acquired intangible assets over a 15-year period for tax purposes only, reducing their tax basis below their carrying value for financial statement purposes and generating deferred taxes each reporting period. We amortized $2,428,427 related to goodwill and intangible assets in 2007 for income tax purposes. Additionally, at November 30, 2006, when Highbury ceased to be a corporation in the development stage, we had total deferred expenses of $440,342 that will be amortized for tax purposes over a 15-year period. These expenses were currently expensed for financial statement purposes during Highbury’s development stage but were not deductible for tax purposes. Highbury amortized $29,356 of this deferred expense in 2007.
The discussion and analysis of the acquired business’ financial condition and results of operations for the purposes of this document are based upon its consolidated financial statements, which have been prepared in accordance with GAAP. The acquired business’ significant accounting policies are presented in Note 2 to its audited combined financial statements included elsewhere herein, and the following summaries should be read in conjunction with the financial statements and the related notes included in this Form 10-K. The acquired business’ management believes the policies that fall within this category are the policies related to principles of combination and goodwill and intangible assets.
Principles of Combination. The accompanying combined statements of operations, cash flows and owner’s equity for the acquired business for the years ended December 31, 2003, 2004, and 2005 and for the 11 months ended November 30, 2006 have been prepared on a carve-out basis. The combined financial statements have been prepared from AAAMHI’s historical accounting records on a carve-out basis to include the historical financial position, results of operations and cash flows applicable to the acquired business. The combined financial statements have been prepared as if the business had been a stand-alone operation, though they are not necessarily representative of results had the acquired business operated as a stand-alone operation. Revenues, expenses, assets and liabilities were derived from amounts associated with the acquired business in the AAAMHI financial records. The financial results include allocations based on methodologies that management believes are reasonable of corporate expenses from AAAMHI and allocations of other corporate expenses from AAAMHI’s parent company that may be different from comparable expenses that would have been incurred if the acquired business operated as a stand-alone business. Specifically, ABN AMRO Services Company, Inc., a wholly-owned subsidiary of ABN AMRO North America Holding Company, or AANAHC, provided the acquired business with certain IT, infrastructure and e-mail services. LaSalle Bank Corporation, also a wholly-owned subsidiary of AANAHC, provided the acquired business with payroll, benefits, general ledger maintenance, internal audit and accounts payable services. These services were charged based upon utilized quantities (typically number of employees, number of transactions processed, or hours worked). AAAMHI provided the acquired business with executive management, finance, human resources and personal trade compliance services. These services were charged based upon employee count or management time incurred. AAAMHI’s parent and its parent companies provided other executive management, technology, sales support, finance, compliance and human resources support services. These services were charged out on a formula basis that considers assets under management, number of employees and non-interest expense. The cost of these services is included under the caption “Related-party expense allocations” in the accompanying combined statements of operations. Certain cash receipts and cash payments related to the acquired business were handled through AAAMHI and affiliate cash accounts which are not included in the carve-out financial statements. “Net transfers from AAAMHI” in the combined statements of changes in owner’s equity reflects these cash transactions.
Recently Issued Pronouncements
The FASB has issued interpretation No. 48, “Accounting for Uncertainty in Income Taxes—An Interpretation of FASB Statement No. 109” (“FIN 48”), regarding accounting for, and disclosure of, uncertain tax positions. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes.” FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. The adoption of FIN 48 had no impact on the Company’s results of operations and financial position.
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 is effective in the first quarter of 2008 and establishes a framework for measuring fair value.
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS 159”). SFAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value. The objective of the statement is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. The provisions of SFAS 159 are effective for fiscal years beginning after November 15, 2008. The early adoption of SFAS 157 and SFAS 159 has not had a material impact on the Company’s results of operations and financial position.
In December 2007, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 141 (revised 2007), Business Combinations (“SFAS 141R”), which replaces SFAS No. 141. The statement retains the purchase method of accounting for acquisitions, but requires a number of changes, including changes in the way assets and liabilities are recognized in the purchase accounting. It also changes the recognition of assets acquired and liabilities assumed arising from contingencies and requires the expensing of acquisition-related costs as incurred. SFAS 141R is effective for us beginning January 1, 2009 and will apply prospectively to business combinations completed on or after that date.
In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements, an amendment of ARB 51 (“SFAS 160”), which changes the accounting and reporting for minority interests. Minority interests will be recharacterized as noncontrolling interests and will be reported as a component of equity separate from the parent’s equity, and purchases or sales of equity interests that do not result in a change in control will be accounted for as equity transactions. In addition, net income attributable to the noncontrolling interest will be included in consolidated net income on the face of the income statement and, upon a loss of control, the interest sold, as well as any interest retained, will be recorded at fair value with any gain or loss recognized in earnings. SFAS 160 is effective for us beginning January 1, 2009 and will apply prospectively, except for the presentation and disclosure requirements, which will apply retrospectively. We are currently assessing the potential impact that adoption of SFAS 160 would have on our consolidated financial statements.
Management does not believe that any other recently issued, but not yet effective, accounting standards if adopted in their current form would have a material effect on the accompanying consolidated financial statements.
Basis of Presentation
Since the business combination was consummated on November 30, 2006, the combined financial statements for prior periods (other than Highbury’s financial statements) relate to the U.S. mutual fund business of AAAMHI, which we refer to as the acquired business. These financial statements are presented on a carve-out basis. We believe that the combined financial statements for the acquired business are not comparable to the financial statements for the Company for periods following the business combination.
Prior to the completion of the business combination, the acquired business was a division of AAAMHI and was not a separate legal entity. Historically, the acquired business utilized two independent sub-advisers and five advisers affiliated with AAAMHI. Because the Aston Funds were introduced over a period of 13 years and are managed by five different affiliates of AAAMHI, the historical fee sharing agreements between the acquired business and each investment adviser with respect to each Aston Fund varied among the funds and over time. In addition, since the acquired business and the investment advisers were part of a commonly controlled corporate entity, the historical fee sharing arrangements were not reflective of market terms but rather internal allocations that also varied.
Subsequent to the completion of the business combination, the investment adviser affiliates of AAAMHI continue to perform the same investment management services for the Aston Funds as they had previously provided but in the role of sub-advisers. However, as a result of the new sub-advisory agreements, they receive a smaller share of the net advisory fees after payments of third-party distribution fees than they received historically. These new sub-advisory agreements were determined based on arm’s length negotiation between the sub-advisers affiliated with AAAMHI and us and reflected market terms at the date of the agreements.
In addition, certain amounts included in the acquired business’ financial statements were allocated from AAAMHI or other related entities. We believe that these allocations are reasonable, but not necessarily indicative of costs that would have been incurred by the acquired business had it operated as a stand alone business for the same periods.
In the “Results of Operations” section to follow, we discuss the actual consolidated financial results for the Company for 2007 and the actual consolidated financial results for the Company for 2006, which include the operations of the acquired business from December 1, 2006 through December 31, 2006. In addition we discuss the 2006 combined results for the Company and the acquired business compared to the actual consolidated financial results for the Company for 2007 and the results for the acquired business for 2005, as presented in our selected financial data in Item 6. For the reasons cited in Note 5 to Item 6, the revenue and expenses of the acquired business as it operates within the Company are not consistent with the revenue and expenses of the acquired business on a historical basis. As such, it may be difficult to draw conclusions from a comparison of operating results from before and after the business combination.
Results of Operations
Year ended December 31, 2007 for the Company compared to year ended December 31, 2006 for the Company
For the year ended December 31, 2007, the Company generated net income of $852,892, as compared to a net loss of $12,463,206 for the year ended December 31, 2006. The net loss in 2006 resulted primarily from a one-time, non-cash compensation charge of $20,784,615 related to the grant of Aston membership interests to the Aston management members. The Company generated total operating revenue of $42,063,995 in 2007, as compared to $3,828,100 in 2006. The 2006 results, however, include only one month of operations subsequent to the closing of our acquisition of the acquired business on November 30, 2006.
The following table summarizes the total fees, weighted average assets under management and the weighted average fee basis for the three months ended December 31, 2007.
| | | For the three months ended December 31, 2007 | |
| | | Total Fees | | Weighted Average Assets Under Management ($M) | | Weighted Average Fee Basis (Annualized) | |
| Net advisory fees | | $ | 9,000,405 | | $ | 5,173 | (1) | | 0.70% | |
Net administrative fees(2) | | | 538,378 | | | 8,052 | (3) | | 0.03% | |
| Money market service fees | | | 139,714 | | | 3,025 | | | 0.02% | (4) |
| | | $ | 9,678,497 | | | 5,173 | (5) | | 0.75% | (5) |
| (1) | Includes long-term mutual fund and separate account assets under management. |
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| (2) | Administrative fees are presented net of sub-administration fees paid to a third party to be consistent with the methodology used in calculating the revenue sharing arrangement with Aston. |
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| (3) | Aston provides administrative services to the Aston Funds, as well as six money market mutual funds managed by affiliates of AAAMHI. |
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| (4) | Aston receives a money market service fee from AAAMHI equal to $550,000 per annum plus 0.0001% of the weighted average assets under management in the six money market mutual funds in excess of $3 billion. The fee is accrued and paid monthly. |
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| (5) | For an estimate of the overall weighted average fee basis, we use the total fees from all sources and the weighted average assets under management for which we provide investment advisory services (Note 1 above). |
The Company incurred $36,559,940 of total operating costs for the year ended December 31, 2007, as compared to $24,069,116 for the year ended December 31, 2006. Our 2007 operating costs include $19,857,033 of total distribution and sub-advisory expenses, including $16,124,192 payable to the sub-advisers (approximately 43% of the net advisory fees for the period) and $3,732,841 payable pursuant to third-party distribution agreements (approximately 10% of the net advisory fees for the period). In 2006, Aston incurred total distribution and sub-advisory expenses of $1,796,910, including $1,467,496 payable to the sub-advisers (approximately 44% of the net advisory fees for the period) and $329,414 payable pursuant to third-party distribution agreements (approximately 10% of the net advisory fees for the period). The Company incurred $6,643,587 of compensation and related expense in 2007 which was entirely attributable to Aston’s operations. In 2006, the Company incurred $21,109,331 of compensation and related expense which consisted primarily of a one-time, non-cash compensation charge of $20,784,615 related to the grant of Aston membership interests to the management members. We recorded an impairment charge to the identifiable intangible related to Aston's advisory contract with the Aston Funds of $4,110,000 in the fourth quarter of 2007 as a result of net asset outflows from the Aston Funds and recent negative market performance. We also incurred $222,114 of depreciation and amortization expense in 2007. There were no comparable charges for depreciation and amortization or impairment in 2006.
The Company incurred other operating expenses of $5,727,206 in 2007 as compared to $1,162,875 in 2006. These expenses include the operating expenses of Aston and Highbury for the period and consist primarily of legal, accounting, insurance, occupancy and administrative fees. Highbury’s direct operating expenses for these two years were as follows:
| | | 2006 | | 2007 | |
| Professional fees | | $ | 320,195 | | $ | 1,461,040 | |
| Insurance | | | 89,970 | | | 243,759 | |
| Administrative fees | | | 83,952 | | | 95,000 | |
| Travel and entertainment | | | 70,701 | | | 145,607 | |
| Other expenses | | | 182,243 | | | 168,884 | |
| | | $ | 747,061 | | $ | 2,114,290 | |
Other income consists of interest income (earnings on cash and cash equivalent balances) and investment income (realized and unrealized gains and losses on investments in U.S. treasury bills and Aston mutual funds). In 2007, Highbury earned interest income of $458,105 and incurred investment losses of $121,300. For the year ended December 31, 2006, Highbury earned interest income of $1,744,907 on cash balances. Prior to the consummation of the acquisition on November 30, 2006 for which Highbury paid cash, Highbury’s cash balances were significantly higher than during 2007.
The Company recorded net income of $5,840,860 before provisions for minority interest and income taxes for the year ended December 31, 2007, as compared to a net loss of $18,496,109 for the year ended December 31, 2006. Highbury recorded minority interest expense attributable to the Aston management members’ interest in Aston of $4,489,176 and ($6,647,715) in 2007 and 2006, respectively. As discussed above, the loss in 2006 resulted primarily from the one-time non-cash compensation charge recorded in connection with the grant of Aston membership interests to the management members. We have determined that there is no equivalent expense, either currently or in the future, to be recognized for income tax purposes. The following table outlines Highbury’s income tax expenses.
| | | Year Ended December 31, 2006 | | Year Ended December 31, 2007 | |
| Current | | $ | 702,088 | | $ | 1,363,725 | |
| Deferred - intangible related | | | 74,989 | | | (648,507 | ) |
| Deferred - other | | | (162,265 | ) | | (216,426 | ) |
| Total | | $ | 614,812 | | $ | 498,792 | |
The sources of the Company’s deferred tax asset (liability) are as follows:
| | | Year Ended December 31, 2006 | | Year Ended December 31, 2007 | |
| (Amortization) impairment of intangibles | | $ | (74,989 | ) | $ | 568,340 | |
| Expenses deferred for income tax purposes | | | 162,265 | | | 383,869 | |
| Total | | $ | 87,276 | | $ | 952,209 | |
For further discussion of the Company’s income taxes, please refer to Note 12 of the consolidated financial statements included herewith.
Year ended December 31, 2007 for the Company compared to year ended December 31, 2006 combined results
The combined results for the year ended December 31, 2006 represent the sum of the operating results for the acquired business for the 11 months ended November 30, 2006 and for the Company for the year then ended. The Company’s consolidated results for this period include the operations of the acquired business for the period from December 1, 2006 through December 31, 2006. The results are compared to the results of operations for the acquired business in 2007.
In 2007, mutual fund assets under management declined nearly $500 million (8.8%) from just under $5.5 billion at the end of 2006 to approximately $5.0 billion as of December 31, 2007. During this period Aston experienced net client redemptions of approximately $965 million which were partially offset by positive market appreciation and other adjustments, including distributions of income and gains, reinvestments of distributions, and other items, of approximately $486 million. The net client redemptions in 2007 were lower than in 2006 when Aston experienced net client redemptions of approximately $1.1 billion. A significant proportion of Aston’s assets under management are managed in a large cap growth style. We believe the general underperformance of the large cap growth investment style relative to the market has been a factor in the recent high level of client redemptions. Furthermore, we believe investors are concerned about the high level of volatility in equity markets.
As a result of lower average asset levels, net advisory fees declined in 2007 to $37.1 million from $40.5 million in 2006. Administrative fees increased from $1.8 million in 2006 to $4.4 million in 2007 primarily as a result of the additional services provided to the money market mutual funds and a change in the presentation of the administration fees. Following the business combination, Aston provides administration, marketing and compliance services to six money market mutual funds advised by AAAMHI. While the acquired business performed these functions historically, the revenue from such activities is not reflected in the carve out financial statements because, at the time the transaction was negotiated and the carve out financial statements were prepared, it was not contemplated that Aston would provide these services to the money market mutual funds after the business combination. Additionally, the acquired business accrued revenue from administration fees net of certain sub-administration fees paid to a third-party provider. The Company has determined it is appropriate to record the revenues on a gross basis and include the associated sub-administration expenses within other operating costs. The administration fees earned by the Company in 2007, net of all sub-administration fees paid, were $2.2 million. This represents an increase of approximately $0.4 million, on a comparable basis, over the fees earned in 2006. This increase is primarily attributable to the additional administrative services provided to the money market mutual funds. The increase in administrative fees resulting from the administration, marketing and compliance services offset the effect of the decline in total assets under management on total administrative fees. In 2007, total revenues decreased by $0.2 million to $42.1 million from $42.3 million in 2006.
Distribution and advisory costs declined by $10.7 million, or 35.2%, to $19.9 million in 2007 from $30.6 million in 2006. This decline is attributable, in part, to the decline in mutual fund assets under management during 2007, as these expenses are directly related to the value of assets under management. The new sub-advisory agreements into which Aston entered at the closing of the business combination provide for substantially lower payments to the sub-advisers affiliated with AAAMHI than the historical fee-sharing agreements. Since the results for 2006 include only one month of operations under the new sub-advisory agreements, the effect of this change is substantial in 2007.
Combined compensation expense was $25.1 million in 2006, primarily attributable to the $20.8 million charge incurred in connection with the grant of a 35% membership interest in Aston to the management members. Excluding this expense, total compensation in 2006 was $4.3 million compared to $6.6 million in 2007. This increase is primarily attributable to the excess operating allocation paid to Aston’s employees in 2007.
Highbury recorded an impairment charge to the identifiable intangible related to Aston's advisory contract with the Aston Funds of $4,110,000 in the fourth quarter of 2007 as a result of net asset outflows from the Aston Funds and recent negative market performance. There was no similar charge incurred in 2006.
Other operating expenses rose to $5.9 million in 2007 from $4.7 million in 2006. This increase is attributable to an increase in Highbury’s 2007 operating expenses of approximately $1.4 million relative to 2006, offset by a reduction in Aston’s operating expenses.
Highbury reported operating income of $5.5 million in 2007, as compared to an operating loss of $18.1 million in 2006. The difference is due primarily to the $20.8 million compensation charge recorded in 2006. Furthermore, the substantial decline in distribution and advisory costs, which more than offset the decline in operating revenue, improved the operating results.
Because of the different capital structures and ownership structures of the acquired business before and after the business combination, comparisons of the differences in interest income, minority interest and income taxes are not meaningful.
Year ended December 31, 2006 for the Company compared to year ended December 31, 2005 for the Company
For the year ended December 31, 2006, the Company had a net loss of $12,463,206 which resulted primarily from a one-time, non-cash compensation charge of $20,784,615 related to the grant of Aston membership interests to the Aston management members. Following the consummation of the acquisition on November 30, 2006, Aston earned total revenue of $3,828,100 in the month of December. The following table summarizes the total fees, weighted average assets under management and the weighted average fee basis for the month of December 2006.
| | | | For the month ended December 31, 2006 | |
| | | | Total Fees | | | Weighted Average Assets Under Management ($M) | | | Weighted Average Fee Basis (Annualized) | |
| Net advisory fees | | $ | 3,337,351 | | $ | 5,645 | (1) | | 0.70 | % |
Net administrative fees(2) | | | 222,341 | | | 9,930 | (3) | | 0.03 | % |
| Money market service fees | | | 57,863 | | | 4,444 | | | 0.02 | % (4) |
| | | $ | 3,617,555 | | | 5,645 | (5) | | 0.77 | %(5) |
| (1) | Includes long-term mutual fund and separate account assets under management. |
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| (2) | Administrative fees are presented net of sub-administration fees paid to a third party to be consistent with the methodology used in calculating the revenue sharing arrangement with Aston. |
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| (3) | Aston provides administrative services to the Aston Funds, as well as six money market mutual funds managed by affiliates of AAAMHI. |
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| (4) | Aston receives a money market service fee from AAAMHI equal to $550,000 per annum plus 0.0001% of the weighted average assets under management in the six money market mutual funds in excess of $3 billion. The fee is accrued and paid monthly. |
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| (5) | For an estimate of the overall weighted average fee basis, we use the total fees from all sources and the weighted average assets under management for which we provide investment advisory services (Note 1 above). |
The Company incurred $24,069,116 of total operating costs for the year ended December 31, 2006. This total consisted primarily of the one-time, non-cash compensation charge of $20,784,615 related to the grant of Aston membership interests to the management members. In the month of December, Aston incurred total distribution and sub-advisory expenses of $1,796,910, including $1,467,496 payable to the sub-advisers (approximately 44% of the net advisory fees for the period) and $329,414 payable pursuant to third-party distribution agreements (approximately 10% of the net advisory fees for the period). Excluding the one-time compensation charge, Aston incurred employee compensation and related expenses of $324,716 in 2006. Highbury has no employees and did not pay compensation of any kind to its directors or officers in 2006. Highbury also incurred $1,162,875 of other operating expenses in 2006. These expenses include the operating expenses of Aston and Highbury for the period and consist primarily of legal, accounting, insurance, occupancy and administrative fees. Highbury’s direct operating expenses for the year were as follows:
| Professional fees | | $ | 320,195 | |
| Insurance | | | 89,970 | |
| Administrative fees | | | 83,952 | |
| Travel and entertainment | | | 70,701 | |
| Other expenses | | | 182,243 | |
| | | $ | 747,061 | |
Non-operating income consists primarily of earnings on cash and cash equivalent balances. For the year ended December 31, 2006, Highbury earned interest income on cash balances held outside the trust account of $14,470 and investment income on the balance held in the trust account of $1,730,437. Prior to the consummation of the acquisition on November 30, 2006, Highbury did not generate any operating revenues. Highbury did not earn income of any kind in 2005.
The Company recorded a net loss of $18,496,109 before provisions for minority interest and income taxes for the year ended December 31, 2006. As a result of the Aston management members’ interest in Aston, the Company recorded a minority interest benefit of $6,647,715 for the year. As discussed above, this loss resulted primarily from the one-time non-cash compensation charge recorded in connection with the grant of Aston membership interests to the management members. We have determined that there is no equivalent expense, either currently or in the future, to be recognized for income tax purposes. The following table outlines Highbury’s income tax expenses.
| | | July 13, 2005 (inception) to December 31, 2005 | | Year Ended December 31, 2006 | |
| Current | | $ | — | | $ | 702,088 | |
| Deferred - intangible related | | | — | | | 74,989 | |
| Deferred - other | | | — | | | (162,265 | ) |
| Total | | $ | — | | $ | 614,812 | |
The sources of the Company’s deferred taxes are as follows:
| | | July 13, 2005 (inception) to December 31, 2005 | | Year Ended December 31, 2006 | |
| (Amortization) impairment of intangibles | | $ | — | | $ | (74,989 | ) |
| Expenses deferred for income tax purposes | | | — | | | 162,265 | |
| Total | | $ | — | | $ | 87,276 | |
For further discussion of the Company’s income taxes, please refer to Note 12 of the consolidated financial statements included herewith.
For the period from July 13, 2005, the date of Highbury’s inception, to December 31, 2005, Highbury had a net loss of $2,452. Total expenses for this period were $2,452, consisting of $456 in formation costs and $1,996 in franchise tax expenses. Additionally, we incurred deferred offering costs of approximately $483,492 in 2005. During this period, Highbury’s activities were limited to organizational activities. We had no revenue in 2005.
The Company had a net loss of $12,463,206 for the year ended December 31, 2006 compared to a net loss of $2,452 for the period from July 13, 2005 (inception) to December 31, 2005.
Year ended December 31, 2006 combined results compared to year ended December 31, 2005 for the acquired business
The combined results for the year ended December 31, 2006 represent the sum of the operating results for the acquired business for the 11 months ended November 30, 2006 and for the Company for the year then ended. The Company’s consolidated results for this period include the operations of the acquired business for the period from December 1, 2006 through December 31, 2006. The results are compared to the results of operations for the acquired business in 2005.
In 2006, mutual fund assets under management declined nearly $900 million (13.8%) from just over $6.3 billion at the end of 2005 to approximately $5.5 billion. During this period the acquired business experienced net client redemptions of approximately $1.1 billion balanced by approximately $200 million of positive market appreciation. Positive market appreciation means that the total net asset value of a fund, when excluding the effects of net client contributions, increased over a given period as a result of changes in the market value of securities held by the fund. After approximately $1.0 billion of net client redemptions in 2005, the high level of redemptions continued in 2006. For the year, the broader equity markets posted solid gains with the S&P 500 advancing 15.8% though the Russell Large Cap Growth Index rose only 9.2%. In 2004, for comparison, the S&P 500 advanced 10.9% and the Russell Large Cap Growth Index grew 6.7%. A majority of the acquired business’ assets under management are managed in a large cap growth style. We believe the general underperformance of the large cap growth investment style relative to the market has been a factor in the recent high level of client redemptions. Furthermore, we believe investors continued to be concerned about relative investment performance in several of the acquired business’ large cap growth funds.
As a result of lower average asset levels, net advisory fees declined in 2006 to $40.5 million from $47.4 million in 2005. The weighted average fee basis remained approximately constant at 0.72% in 2005 and 2006. Administrative fees increased from $1.5 million in 2005 to $1.8 million in 2006. Following the business combination, Aston provides administration, marketing and compliance services to six money market mutual funds advised by AAAMHI. While the acquired business performed these functions historically, the revenue from such activities is not reflected in the carve out financial statements because, at the time the transaction was negotiated and the carve out financial statements were prepared, it was not contemplated that Aston would provide these services to the money market mutual funds after the business combination. The increase in administrative fees resulting from the administration, marketing and compliance services offset the effect of the decline in total assets under management on total administrative fees. For the year, total revenues decreased by $6.6 million, or 13.5%, to $42.3 million from $48.9 million in 2005.
Distribution and advisory costs declined by $9.8 million, or 24.2%, to $30.6 million in 2006 from $40.4 million in 2005. This decline is primarily attributable to the 13.8% decline in mutual fund assets under management during 2006, as these expenses are directly related to the value of assets under management. The new sub-advisory agreements into which Aston entered at the closing of the business combination provide for substantially lower payments to the sub-advisers affiliated with AAAMHI than the historical fee-sharing agreements. Since the results for 2006 include only one month of operations under the new sub-advisory agreements, the effect of this change is not substantial in 2006. However, we expect these new agreements to substantially decrease the sub-advisory costs from pre-acquisition levels.
Combined compensation expense was $25.1 million in 2006, primarily attributable to the $20.8 million charge incurred in connection with the grant of a 35% membership interest in Aston to the management members. Excluding this expense, total compensation in 2006 was $4.3 million compared to $5.2 million in 2005. This decline is primarily attributable to a reduction in sales commissions paid in 2006 relative to 2005 as a result of lower net asset flows and to the termination of three employees at the beginning of 2006.
In 2005, the acquired business recorded a goodwill impairment of $13.3 million and an intangible asset impairment of $10.4 million. The facts and circumstances leading to the impairment charges to goodwill and intangible assets relate to AAAMHI’s assessment of declines in net assets in the target funds resulting from net share redemptions and unfavorable investment performance trends in 2005. The fair value of the acquired business used to determine the impairment of goodwill was determined with reference to the expected proceeds to be received upon the sale of the acquired business to Highbury. The fair value of the intangible asset related to the investment management contracts used to determine the amount of impairment of the intangible asset was determined based on a discounted cash flow analysis of the acquired contracts. No impairment of goodwill or intangibles was determined to be required for periods prior to 2005.
The acquired business adopted the provisions of SFAS No. 142, “Goodwill and Other Intangible Assets”. Intangible assets, comprising the estimated value of investment management contracts, and goodwill, included in the combined financial statements of the acquired business relate to the acquisition of certain AAAMHI affiliates including the acquired business in 2001. These amounts reflect management’s best estimate of a reasonable allocation to the acquired business of such amounts included in the financial records of AAAMHI. The provisions of SFAS No. 142 require that goodwill and other intangible assets with indefinite lives no longer be amortized, but instead be tested at least annually for impairment and require reporting units to be identified for the purpose of assessing potential future impairments of goodwill. The acquired business’ acquired intangible management contract asset relates to the provision of investment advisory services to the target funds in exchange for fees that are based on a percentage of the average daily net assets of the funds. This management contract was acquired in 2001 as part of the acquisition of certain AAAMHI affiliates. The management contract is subject to annual renewal by the mutual funds’ board of trustees which is expected to continue indefinitely since this has been the experience for the target funds as well as for the mutual fund industry as a whole. Accordingly, the acquired business’ acquired intangible assets related to the target funds are considered to be of an indefinite life as there is no foreseeable limit on the contract period. We conduct annual testing of goodwill and intangible assets for impairment in the fourth quarter, unless events warrant more frequent testing.
Other operating expenses rose to $4.7 million in 2006 from $3.3 million in 2005. Approximately half of this increase is attributable to Highbury’s 2006 operating expenses of approximately $0.7 million. There were no corresponding expenses incurred in 2005.
The operating loss declined to $18.1 million in 2006 from a loss of $23.8 million in 2005. The $20.8 million compensation charge is approximately $2.9 million less than the aggregate impairment charges incurred in 2005. This difference accounts for more than half of the difference in the losses between these years. Furthermore, the substantial decline in distribution and advisory costs, which more than offset the decline in operating revenue, improved the operating results.
Because of the different capital structures and ownership structures of the acquired business before and after the business combination, comparisons of the differences in interest income, minority interest and income taxes are not meaningful.
Supplemental Non-GAAP Performance Measure
As supplemental information, we provide a non-GAAP performance measure that we refer to as Cash Net Income. This measure is provided in addition to, but not as a substitute for, GAAP Net Income. Cash Net Income means the sum of (a) net income determined in accordance with GAAP, plus (b) amortization of intangible assets, plus (c) deferred taxes related to intangible assets, plus (d) affiliate depreciation, plus (e) other non-cash expenses. We consider Cash Net Income an important measure of our financial performance, as we believe it best represents operating performance before non-cash expenses relating to the acquisition of our interest in Aston. Cash Net Income is not a measure of financial performance under GAAP and, as calculated by us, may not be consistent with computations of Cash Net Income by other companies. Cash Net Income is used by our management and board of directors as a principal performance benchmark.
Since our acquired assets do not generally depreciate or require replacement by us, and since they generate deferred tax expenses that are unlikely to reverse, we add back these non-cash expenses to Net Income to measure operating performance. We will add back amortization attributable to acquired client relationships because this expense does not correspond to the changes in value of these assets, which do not diminish predictably over time. The portion of deferred taxes generally attributable to intangible assets (including goodwill) that we do not amortize but which generates tax deductions is added back, because these accruals would be used only in the event of a future sale of Aston or an impairment charge, which we consider unlikely. We will add back the portion of consolidated depreciation expense incurred by Aston because under Aston’s operating agreement we are not required to replenish these depreciating assets. We also add back expenses that we incur for financial reporting purposes for which there is no corresponding cash expense because such expenses cause our Net Income to be understated relative to our ability to generate cash flow to service debt, if any, finance accretive acquisitions, and repurchase securities, if appropriate.
| | | Year Ended December 31, 2006 | | Year Ended December 31, 2007 | |
| Net income (loss) | | $ | (12,463,206 | ) | $ | 852,892 | |
| Impairment of intangibles | | | — | | | 4,110,000 | |
| Intangible-related deferred taxes | | | 74,989 | | | (648,507 | ) |
| Affiliate depreciation | | | — | | | 222,114 | |
| Other non-cash expense | | | | | | | |
| Compensation charge for 35% interest in Aston | | | 20,784,615 | | | — | |
| Adjustment for minority interest | | | (7,274,615 | ) | | — | |
| Cash Net Income | | $ | 1,121,783 | | $ | 4,536,499 | |
Agreements with Berkshire Capital
Highbury occupies office space provided by Berkshire Capital Securities LLC, or Berkshire Capital, pursuant to an office services agreement. Messrs. Cameron, Foote and Forth, our executive officers, are affiliated with Berkshire Capital. On October 31, 2007, we entered into an office services agreement with Berkshire Capital Securities LLC which replaces the office services agreement entered into between us and Berkshire Capital dated December 21, 2005 and amended on November 30, 2006. The office services agreement provides for a monthly fixed fee of $10,000, as compared to a monthly fixed fee of $7,500 under the prior agreement, for office and secretarial services including use and access to our office in Denver, Colorado and those other office facilities of Berkshire Capital as we may reasonably require. In addition, certain employees of Berkshire Capital will provide us with financial reporting support on a daily basis. The term of the agreement is indefinite. The agreement is terminable by either party upon six months’ prior notice. The consolidated statements of operations for the years ended December 31, 2007 and 2006 include $95,000 and $83,952, respectively, related to this agreement.
We have engaged Berkshire Capital to act as our non-exclusive financial advisor in connection with possible future acquisitions. In such capacity, Berkshire Capital will assist us in structuring, negotiating and completing acquisitions of targets identified by us and acknowledged by both us and Berkshire Capital as being subject to Berkshire Capital’s engagement. If we enter into an agreement to acquire such a target company during the term of Berkshire Capital’s engagement or within two years thereafter, and such acquisition is completed, then we will pay Berkshire Capital a success fee at closing equal to the greater of (a) the sum of 3.0% of the first $15 million of the aggregate consideration in such transaction and 1.0% of the aggregate consideration in such transaction in excess of $15 million, and (b) $600,000. Upon the execution of a definitive agreement with respect to an acquisition, we will pay Berkshire Capital $200,000 which will be credited against the success fee. We will also reimburse Berkshire Capital for its reasonable expenses in performing its services under the engagement letter and will indemnify Berkshire Capital for liabilities it incurs in performing such services, unless such liabilities are attributable to Berkshire Capital’s gross negligence or willful misconduct. As of December 31, 2007, we had made no payments pursuant to this engagement. We engaged Berkshire Capital in the first quarter of 2007 and, accordingly, as of December 31, 2006, we had not incurred any expenses related to this agreement.
Impact of Inflation
Our revenue is directly linked to the total assets under management within the 27 mutual funds and the separate accounts managed by Aston. Our total assets under management increase or decrease on a daily basis as a result of fluctuations in the financial markets and net asset flows from investors. While long-term returns in the financial markets have historically exceeded the rate of inflation, this may not be the case going forward. Our operating expenses are likely to be directly affected by inflation. Furthermore, we earn interest income on our cash balances. While the current interest rates available to us exceed the rate of inflation, this may not be the case going forward. In such cases, the impact of inflation will erode our purchasing power.
Liquidity and Capital Resources
Since its inception, Highbury has funded its business activities almost exclusively through cash flows from financing, including the debt and equity provided by the initial shareholders and the funds raised in our initial public offering. Going forward, Highbury expects to fund its business activities with a combination of operating income, the interest income earned on its cash and cash equivalent balances and the investment income earned on its investments and to fund future acquisitions with retained net income or the issuance of debt or equity. As of December 31, 2007 and 2006, Highbury had no borrowings outstanding. In the future, however, we will closely review our ratio of debt to Adjusted EBITDA (our “leverage ratio”) as an important gauge of our ability to service debt, make new investments and access capital. The leverage covenant of our credit facility currently limits our borrowings under the credit facility to 2.0 times Adjusted EBITDA and our total leverage ratio to 5.0 times Adjusted EBITDA. We believe this level is prudent for our business, although substantially higher levels of senior and subordinated debt in relation to Adjusted EBITDA may also be prudent to fund future acquisitions.
Current market conditions may make it more difficult for us to complete an acquisition through the use of debt financing because of the reduced availability of debt at appropriate terms. If we issue debt to finance an acquisition, a decrease in our assets under management caused by negative market conditions could have an adverse effect on the distributions we receive from Aston and potential future affiliates and limit our ability to repay our borrowings. In addition, our ability to make accretive acquisitions through the issuance of additional equity is dependent upon the relationship between the market value of our outstanding common stock and the pricing of any transaction. If the price of our common stock remains at or near its current level, it may be more difficult for us to issue additional equity to finance an acquisition. The inability to complete accretive acquisitions may negatively impact our growth, results of operations or financial condition.
Historically, the acquired business funded its business activities almost exclusively with operating cash flow. We expect Aston will also fund its business activities almost exclusively with operating cash flow. Highbury may occasionally provide capital to Aston to help finance the development of new products or execute accretive acquisitions. Because Aston, like most investment management businesses, does not require a high level of capital expenditures, such as for purchases of inventory, property, plant or equipment, liquidity is less of a concern than for a company that sells physical assets. Historically, the amount of cash and cash equivalents held on the balance sheet of the acquired business was primarily influenced by the policies of its parent, AAAMHI. Prior to the acquisition, AAAMHI owned 100% of the acquired business, and it continues to own several other affiliates which also have low capital requirements. As such, cash balances often accumulated in the affiliates until AAAMHI decided to transfer them. These periodic cash transfers caused the value of cash and equivalents held by the business to fluctuate widely and without correlation to the underlying operations of the acquired business.
As of December 31, 2007, the Company had $7,276,545 of cash and cash equivalents, $4,635,507 of investments and $3,502,142 of accounts receivable as compared to $6,248,705 of cash and cash equivalents, $0 of investments and $3,646,422 of accounts receivable as of December 31, 2006. The accounts receivable are primarily related to the investment advisory fees, administrative fees and money market service fees earned by Aston in December. Aston receives payment of its revenues generally within the first week of the month following the month in which they are earned. At December 31, 2007, the Company had accounts payable of $4,549,216, primarily attributable to the revenue sharing payments owed to Aston’s distribution partners and the investment sub-advisers, as compared to accounts payable of $2,269,470 at December 31, 2006. These payments are generally paid shortly after the receipt of the revenue discussed above. Because Aston is able to finance its day-to-day operations with operating cash flow, it does not need to retain a significant amount of cash on its balance sheet. Going forward, we expect Aston will distribute all of its excess cash on a monthly basis to its owners, so we do not expect large cash balances to accrue within Aston. Highbury will retain its cash and cash equivalents and investments, and we expect these balances will increase over time until used to pay operating expenses, fund acquisitions, service debt, if any, or repurchase our securities, if appropriate.
Management believes our existing liquid assets, together with the expected continuing cash flow from operations, our borrowing capacity under the current credit facility and our ability to issue debt or equity securities will be sufficient to meet our present and reasonably foreseeable operating cash needs and future commitments. In particular, we expect to finance future acquisitions through operating cash flows and the issuance of debt or equity securities.
Cash Flow from Operating Activities. Cash flow from operations generally represents net income plus non-cash charges for deferred taxes, depreciation and impairment as well as the changes in our consolidated working capital. In 2007, Highbury received $11,376,820 of net cash flow from its operating activities as compared to a use of $12,229 of net cash flow in 2006. We recorded a non-cash impairment charge to the identifiable intangible related to Aston's advisory contract with the Aston Funds of $4,110,000 in the fourth quarter of 2007 as a result of net asset outflows from the Aston Funds and recent negative market performance. In 2006, our net loss of $12,463,206 primarily resulted from the non-cash compensation charge we incurred in connection with the grant of a 35% interest in Aston to the Aston management members. In the reconciliation to cash flow, we added back this charge which was $20,784,615. We established a minority interest, equal to 35% of the non-cash compensation charge, in 2006 related to this grant of interests in Aston. In 2007, accounts payable increased by $2,279,746 as compared to a 2006 increase of $2,190,576. This is primarily a result of an increase in the distributions payable to the Aston management team and an increase in distribution costs owed relative to the prior year. Because we completed our acquisition on November 30, 2006, the balance sheet as of December 31, 2006 includes only one month worth of payables, whereas the consolidated balance sheet as of December 31, 2007 includes payables accrued over a longer period.
Cash Flow from Investing Activities. Net cash flow from investing activities will result primarily from investments in new affiliates, U.S treasury securities and Aston mutual funds. In 2007, Highbury invested a total of $9,932,233 in U.S. treasury securities and Aston mutual funds. A portion of the investments subsequently matured or were sold, generating proceeds to Highbury of $5,296,274. We also paid $19,464 for costs indirectly related to our initial acquisition and spent $117,480 on purchases of property and equipment. In 2006, Highbury used net cash flow of $36,882,869 to purchase the acquired business from AAAMHI. We also spent $40,634 for leasehold improvements related to Aston’s new location in 2006.
Cash Flow from Financing Activities. Net cash flow from financing activities will result primarily from the issuance of equity or debt and the repayment of any obligations which may arise thereunder, the repurchase of our outstanding securities and minority interest distributions paid to Aston’s management members. In 2007, we entered into Unit Purchase Option Repurchase Agreements with the underwriters of our initial public offering pursuant to which we repurchased the underwriters’ unit purchase option for aggregate cash payments of $1,300,000. The unit purchase option was cancelled upon its repurchase. We also paid distributions of $4,276,077 to Aston’s management members related to their minority interest in Aston. In 2006, Highbury received net cash flow of $43,147,535 from financing activities as a result of our initial public offering and private placement in January. Historically, cash flows from financing activities for the acquired business were primarily influenced by the policies of its parent, AAAMHI. Prior to the acquisition, AAAMHI owned 100% of the acquired business and continues to own several other affiliates which also have low capital requirements. As such, cash balances often accumulated in the affiliates until AAAMHI decided to transfer them. These periodic cash transfers between AAAMHI and the acquired business, which resulted in cash flows from financing activities, fluctuated widely and without correlation to the underlying operations of the acquired business.
Credit Facility
We have available a credit agreement with City National Bank expiring on October 31, 2008, which provides for a revolving line of credit of up to $12.0 million. The credit agreement provides for a maximum total leverage ratio (including debt from all sources) of 5.0 times Adjusted EBITDA, although borrowings under the credit agreement are limited to 2.0 times Adjusted EBITDA, and incorporates a minimum fixed charge coverage ratio of 1.25x and a minimum net worth of $20 million. The credit facility will be used for working capital, general corporate purposes and repurchases of our outstanding securities, if appropriate.
Borrowings under our credit facility will bear interest, at our option, at either the fluctuating prime rate minus one-half of one percent (0.50%) per year or the LIBOR interest rate plus one and one-half percent (1.50%) per year. In addition, we will be required to pay annually a fee of one quarter of one percent (0.25%) on the average daily balance of the unused portion of the credit facility. We will have to make interest payments monthly for any prime rate borrowings. For any LIBOR borrowings, interest payments will be made at the end of any LIBOR contract or quarterly, whichever is sooner. Any outstanding principal is due at maturity on October 31, 2008. For so long as certain events of default continue, upon notice by City National Bank, the interest rate on any outstanding loans will increase by three percent (3%). As of December 31, 2007, we had no borrowings outstanding.
Our credit facility is secured by all of our assets. Our credit facility contains customary negative covenants which, among other things, limit indebtedness, asset sales, loans, investments, liens, mergers and acquisitions, sale and leaseback transactions and purchases of equity, other than repurchases of our outstanding securities. Our credit facility also contains affirmative covenants as to, among other things, financial statements, taxes, corporate existence and legal compliance. As of December 31, 2007, we were in compliance with all of the covenant requirements under this credit facility.
Contractual Obligations
A summary of the Company’s contractual obligations as of December 31, 2007 and future periods in which such obligations are expected to be settled in cash is as follows:
| | | Payment due by period | |
Contractual Obligations | | Total | | Less than 1 year | | 1-3 years | | 3-5 years | | More than 5 years | |
| Long-term debt | | $ | — | | $ | — | | $ | — | | $ | — | | $ | — | |
| Operating leases | | | 2,174,324 | | | 215,474 | | | 450,536 | | | 476,654 | | | 1,031,660 | |
| Capital leases | | | — | | | — | | | — | | | — | | | — | |
| Purchase Obligations | | | — | | | — | | | — | | | — | | | — | |
| Other Long-Term Liabilities | | | — | | | — | | | — | | | — | | | — | |
| Total | | $ | 2,174,324 | | $ | 215,474 | | $ | 450,536 | | $ | 476,654 | | $ | 1,031,660 | |
Supplemental Non-GAAP Liquidity Measure
As supplemental information, we provide information regarding Adjusted EBITDA, a non-GAAP liquidity measure. This measure is provided in addition to, but not as a substitute for, cash flow from operations. Adjusted EBITDA means the sum of (a) net income determined in accordance with GAAP, plus (b) amortization of intangible assets, plus (c) interest expense, plus (d) depreciation, plus (e) other non-cash expenses, plus (f) income tax expense. This definition of Adjusted EBITDA is consistent with the definition of EBITDA used in our credit facility. Adjusted EBITDA, as calculated by us, may not be consistent with computations of Adjusted EBITDA by other companies. As a measure of liquidity, we believe that Adjusted EBITDA is useful as an indicator of our ability to service debt, make new investments and meet working capital requirements. We further believe that many investors use this information when analyzing the financial position of companies in the investment management industry.
The following table provides a reconciliation of net income to Adjusted EBITDA for fiscal years 2007 and 2006:
| | | Year Ended December 31, 2006 | | Year Ended December 31, 2007 | |
| | | | | | |
Net Income | | $ | (12,463,206 | ) | $ | 852,892 | |
| Income tax expense | | | 614,812 | | | 498,792 | |
| Interest expense | | | — | | | — | |
| Impairment of intangibles | | | — | | | 4,110,000 | |
| Depreciation and other amortization | | | — | | | 222,114 | |
| Other non-cash expenses | | | | | | | |
| Compensation charge for 35% interest in Aston | | | 20,784,615 | | | — | |
| Adjustment for minority interest | | | (7,274,615 | ) | | — | |
Adjusted EBITDA | | $ | 1,661,606 | | $ | 5,683,798 | |
The following table provides a reconciliation of cash flow from operations to Adjusted EBITDA for fiscal years 2007 and 2006:
| | | Year Ended December 31, 2006 | | Year Ended December 31, 2007 | |
Cash Flow from Operations | | $ | (12,229 | ) | $ | 11,376,820 | |
| Interest expense | | | — | | | — | |
| Current income tax provision | | | 702,088 | | | 1,363,725 | |
| Changes in assets and liabilities and other adjustments to reconcile Net Income to net Cash Flow from Operations | | | 1,598,648 | | | (6,843,648 | ) |
| Changes in minority interest | | | (626,901 | ) | | (213,099 | ) |
Adjusted EBITDA | | $ | 1,661,606 | | $ | 5,683,798 | |
Quantitative and Qualitative Disclosures About Market Risk
The investment management business is, by its nature, subject to numerous and substantial risks, including volatile trading markets and fluctuations in the volume of market activity. Our revenue, which is based on a percentage of our assets under management, is largely dependent on the total value and composition of our assets under management. Consequently, our net income and revenues are likely to be subject to wide fluctuations, reflecting the effect of many factors, including: general economic conditions; securities market conditions; the level and volatility of interest rates and equity prices; competitive conditions; liquidity of global markets; international and regional political conditions; regulatory and legislative developments; monetary and fiscal policy; investor sentiment; availability and cost of capital; technological changes and events; outcome of legal proceedings; changes in currency values; inflation; credit ratings; and the size, volume and timing of transactions. These and other factors could affect the stability and liquidity of securities and future markets, and the ability of Highbury, Aston and other financial services firms and counterparties to satisfy their obligations.
Highbury is also exposed to market risk as it relates to changes in interest rates applicable to borrowings under Highbury’s line of credit and investment of Highbury’s cash balances. Because Highbury had no outstanding debt under its line of credit as of December 31, 2007, it does not view this interest rate risk as a material risk. Certain of Highbury’s outstanding cash balances are invested in 100% U.S. treasury money market mutual funds. We do not have significant exposure to changing interest rates on invested cash at December 31, 2007. As a result, the interest rate market risk implicit in these investments at December 31, 2007, if any, is low.
Off-Balance Sheet Arrangements
Options and warrants issued in conjunction with our initial public offering are equity linked derivatives and accordingly represent off-balance sheet arrangements. The options and warrants meet the scope exception in paragraph 11(a) of SFAS No. 133 and are accordingly not accounted for as derivatives for purposes of SFAS No. 133, but instead are accounted for as equity. See Notes 2 and 10 to the consolidated financial statements for a discussion of the options and warrants.
SIGNATURES
Pursuant to the requirements of the Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
| | HIGHBURY FINANCIAL INC. |
| | | |
| Dated: May 1, 2008 | By: | /s/ Richard S. Foote |
| | | Richard S. Foote President and Chief Executive Officer (Principal Executive Officer) |
| | | |
| Dated: May 1, 2008 | By: | /s/ R. Bradley Forth |
| | | R. Bradley Forth Executive Vice President, Chief Financial Officer and Secretary (Principal Financial and Accounting Officer) |
EXHIBIT INDEX
Exhibit Number | | Description of Document |
| 31.1 | | Section 302 Certification by CEO. |
| 31.2 | | Section 302 Certification by CFO. |
| 32 | | Section 906 Certification by CEO and CFO. |
