q211pzena10q.htm


SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-Q

x
Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the Quarterly Period Ended June 30, 2011

Or

o
Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period from                to                 

Commission file number 001-33761

PZENA INVESTMENT MANAGEMENT, INC.
(Exact Name of Registrant as Specified in its Charter)

Delaware
 
20-8999751
(State or Other Jurisdiction of
 
(I.R.S. Employer
Incorporation or Organization)
 
Identification No.)

120 West 45th Street
New York, New York 10036
(Address of Principal Executive Offices) (Zip Code)

Registrant’s telephone number, including area code: (212) 355-1600

Not Applicable
(Former name, former address, and former fiscal year if changed since last report)

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate web site, if any, every Interactive Date File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o

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

Large accelerated filer o
 
Accelerated filer x
     
Non-accelerated filer o
 
Smaller reporting company o
(Do not check if a smaller reporting company)
   

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

As of August 3, 2011, there were 9,904,187 outstanding shares of the registrant’s Class A common stock, par value $0.01 per share.

As of August 3, 2011, there were 54,667,832 outstanding shares of the registrant’s Class B common stock, par value $0.000001 per share.





 
 

 


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


       
Page
   
PART I — FINANCIAL INFORMATION
   
   
     
     
     
     
   
Item 3.   Quantitative and Qualitative Disclosures About Market Risk    30
   
         
   
PART II — OTHER INFORMATION
   
   
   
   
   
   
   
   
         
SIGNATURES       32

 
 

 


CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

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

Forward-looking statements are subject to known and unknown risks and uncertainties and are based on potentially inaccurate assumptions that could cause actual results to differ materially from those expected or implied by the forward-looking statements.  Our actual results could differ materially from those anticipated in forward-looking statements for many reasons, including the factors described in Item 1A, “Risk Factors” in Part I of our Annual Report on Form 10-K for our fiscal year ended December 31, 2010.  Accordingly, you should not unduly rely on these forward-looking statements, which speak only as of the date of this Quarterly Report.  We undertake no obligation to publicly revise any forward-looking statements to reflect circumstances or events after the date of this Quarterly Report, or to reflect the occurrence of unanticipated events.  You should, however, review the factors and risks we describe in the reports we will file from time to time with the Securities and Exchange Commission, or SEC, after the date of this Quarterly Report on Form 10-Q.

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

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

·      our business strategies and investment policies;

·      our financing plans and the availability of short- or long-term borrowing, or equity financing;

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

·      potential growth opportunities available to us;

·      the recruitment and retention of our employees;

·      our expected levels of compensation for our employees;

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

·      our expected tax rate;

·      changes in interest rates;

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

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

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

 
ii

 


PART I. FINANCIAL INFORMATION

Item 1. Financial Statements.

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

   
As of
 
   
June 30,
   
December 31,
 
   
2011
   
2010
 
   
(unaudited)
       
             
 Assets
           
 Cash and Cash Equivalents
  $ 25,196     $ 16,381  
 Restricted Cash
    1,422       1,420  
 Due from Broker
    2,095       30  
 Advisory Fees Receivable
    17,329       15,275  
 Investments, at Fair Value
    6,339       3,323  
 Receivable from Related Parties
    41       63  
 Other Receivables
    118       210  
 Prepaid Expenses and Other Assets
    697       914  
 Deferred Tax Asset, Net of Valuation Allowance of
               
 $58,661 and $59,431, respectively
    10,559       8,834  
 Property and Equipment, Net of Accumulated Depreciation
               
  of $2,934 and $2,727, respectively
    1,896       1,952  
 TOTAL ASSETS
  $ 65,692     $ 48,402  
                 
 LIABILITIES AND EQUITY
               
 Liabilities:
               
 Accounts Payable and Accrued Expenses
  $ 9,551     $ 3,879  
 Due to Broker
    9        
 Liability to Selling and Converting Shareholders
    11,720       9,287  
 Deferred Compensation Liability
    681       875  
 Other Liabilities
    530       565  
 TOTAL LIABILITIES
    22,491       14,606  
                 
 Equity:
               
 Preferred Stock (Par Value $0.01; 200,000,000 Shares
               
 Authorized; None Outstanding)
           
 Class A Common Stock (Par Value $0.01; 750,000,000
               
 Shares Authorized;  9,904,187 and 9,367,659 Shares
               
 Issued and Outstanding in 2011 and 2010, respectively)
    98       93  
 Class B Common Stock (Par Value $0.000001; 750,000,000
               
 Shares Authorized;  54,484,796 and 55,012,324 Shares
               
 Issued and Outstanding in 2011 and 2010, respectively)
           
 Additional Paid-In Capital
    11,360       10,836  
 Retained Earnings/(Accumulated Deficit)
    1,581       (357 )
 Total Pzena Investment Mangement, Inc.'s Equity
    13,039       10,572  
 Non-Controlling Interests
    30,162       23,224  
 TOTAL EQUITY
    43,201       33,796  
 TOTAL LIABILITIES AND EQUITY
  $ 65,692     $ 48,402  




See accompanying notes to consolidated financial statements.

 
1

 


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

   
For the Three Months
   
For the Six Months
 
   
Ended June 30,
   
Ended June 30,
 
   
2011
   
2010
   
2011
   
2010
 
                         
 REVENUE
  $ 22,371     $ 19,388     $ 44,159     $ 38,538  
                                 
 EXPENSES
                               
 Compensation and Benefits Expense
    8,260       7,263       16,648       14,651  
 General and Administrative Expense
    2,056       2,169       4,003       4,090  
 TOTAL OPERATING EXPENSES
    10,316       9,432       20,651       18,741  
 Operating Income
    12,055       9,956       23,508       19,797  
                                 
 OTHER INCOME/(EXPENSE)
                               
 Interest Income
    44       46       72       86  
 Dividend Income
    60       66       71       99  
 Interest Expense
          (77 )           (232 )
 Net Realized and Unrealized Gain/(Loss) from Investments
    186       (871 )     441       (407 )
 Change in Liability to Selling and Converting Shareholders
    (2,140 )     1,118       (2,257 )     92  
 Other Income/(Expense)
    (121 )     90       (171 )     69  
 Total Other Income/(Expense)
    (1,971 )     372       (1,844 )     (293 )
 Income Before Income Taxes
    10,084       10,328       21,664       19,504  
 Income Tax Expense/(Benefit)
    (516 )     2,547       67       2,448  
 Net Income
    10,600       7,781       21,597       17,056  
 Less: Net Income Attributable to Non-Controlling Interests
    9,741       7,308       19,081       15,599  
 Net Income Attributable to Pzena Investment Management, Inc.
  $ 859     $ 473     $ 2,516     $ 1,457  
                                 
                                 
 Net Income for Basic Earnings per Share
  $ 859     $ 473     $ 2,516     $ 1,457  
 Basic Earnings per Share
  $ 0.09     $ 0.05     $ 0.26     $ 0.16  
 Basic Weighted Average Shares Outstanding
    9,904,187       9,367,659       9,646,298       9,002,379  
                                 
 Net Income for Diluted Earnings per Share
  $ 859     $ 473     $ 13,390     $ 10,464  
 Diluted Earnings per Share
  $ 0.09     $ 0.05     $ 0.21     $ 0.16  
 Diluted Weighted Average Shares Outstanding
    9,904,187       9,367,659       65,070,712       65,012,960  
                                 
 Cash Dividends per Share of Class A Common Stock
  $ 0.03     $ 0.03     $ 0.06     $ 0.03  












 See accompanying notes to consolidated financial statements.


 
2

 


PZENA INVESTMENT MANAGEMENT, INC.
 
UNAUDITED CONSOLIDATED STATEMENT OF CHANGES IN EQUITY
 
(in thousands, except share amounts)
 
                                           
                                           
    Shares of     Shares of                  Retained              
   
Class A
   
Class B
     Class A      Additional    
Earnings/
     Non-        
    Common     Common     Common     Paid-In    
(Accumulated
   
Controlling
       
   
Stock
   
Stock
   
Stock
   
Capital
   
Deficit)
   
Interests
   
Total
 
                                           
 Balance at December 31, 2010
    9,367,659       55,012,324     $ 93     $ 10,836     $ (357 )   $ 23,224     $ 33,796  
 Unit Conversion
    536,528       (536,528 )     5       299             (258 )     46  
 Directors' Shares
                      21             119       140  
 Amortization of Non-Cash Compensation
          9,000             252             1,431       1,683  
 Net Income
                            2,516       19,081       21,597  
 Contributions from Non-Controlling Interests
                                  250       250  
 Distributions to Non-Controlling Interests
                      (48 )           (16,103 )     (16,151 )
 Effect of Consolidation of Affiliates
                                  2,418       2,418  
 Class A Cash Dividends Declared and Paid                                                        
      ($0.06 per share)
                            (578 )           (578 )
 Balance at June 30, 2011
    9,904,187       54,484,796     $ 98     $ 11,360     $ 1,581     $ 30,162     $ 43,201  




















See accompanying notes to consolidated financial statements.


 
3

 

PZENA INVESTMENT MANAGEMENT, INC.
 
UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS
 
(in thousands)
 
                         
   
For the Three Months
   
For the Six Months
 
   
Ended June 30,
   
Ended June 30,
 
   
2011
   
2010
   
2011
   
2010
 
                         
 OPERATING ACTIVITIES
                       
 Net Income
  $ 10,600     $ 7,781     $ 21,597     $ 17,056  
 Adjustments to Reconcile Net Income to Cash
                               
 Provided by Operating Activities:
                               
 Depreciation
    104       107       207       214  
 Non-Cash Compensation
    1,180       822       2,363       1,664  
 Director Share Grant
    70       14       140       27  
 Net Realized and Unrealized Loss/(Gain) from Investments
    (186 )     871       (441 )     407  
 Change in Liability to Selling and Converting Shareholders
    2,140       (1,118 )     2,257       (92 )
 Deferred Income Taxes
    (1,254 )     1,869       (1,439 )     1,098  
                                 
 Changes in Operating Assets and Liabilities:
                               
 Advisory Fees Receivable
    (1,187 )     134       (2,054 )     58  
 Due from Broker
    (1,115 )     (55 )     (1,663 )     45  
 Restricted Cash
    (1 )     (5 )     (2 )     (9 )
 Prepaid Expenses and Other Assets
    4       (3 )     316       (136 )
 Due to Broker
    (1,765 )     88       3       (636 )
 Accounts Payable, Accrued Expenses, and Other Liabilities
    3,744       3,070       4,782       4,363  
 Tax Receivable Agreement Payments
                (84 )      
 Purchases of Investments
    (9,015 )     (2,358 )     (20,415 )     (3,511 )
 Proceeds from Sale of Investments
    9,755       3,284       20,393       4,151  
 Net Cash Provided by Operating Activities
    13,074       14,501       25,960       24,699  
                                 
 INVESTING ACTIVITIES
                               
 Purchases of Deferred Compensation Investments
                (1,433 )      
 Proceeds from Sale of Deferred Compensation Investments
                847        
 Proceeds from Sale of Investments
          2,824             2,824  
 Receivable from Related Parties
    3             22       40  
 Purchase of Property and Equipment
    (34 )     (3 )     (151 )     (10 )
 Net Cash Provided by/(Used In) Investing Activities
    (31 )     2,821       (715 )     2,854  
                                 
 FINANCING ACTIVITIES
                               
 Distributions to Non-Controlling Interests
    (9,854 )     (9,927 )     (16,150 )     (13,903 )
 Contributions from Non-Controlling Interests
    250       4,321       250       4,321  
 Retirement of B Units
                      (2 )
 Term Loan and Senior Subordinated Notes Repayment
          (7,500 )           (10,000 )
 Dividends
    (297 )     (281 )     (578 )     (281 )
 Net Cash Used in Financing Activities
    (9,901 )     (13,387 )     (16,478 )     (19,865 )
 NET CHANGE IN CASH
  $ 3,142     $ 3,935     $ 8,767     $ 7,688  
                                 
 CASH AND CASH EQUIVALENTS - Beginning of Period
  $ 22,054     $ 19,661     $ 16,381     $ 15,908  
 Effect of Consolidation of Affiliates
                48        
 Net Change in Cash
    3,142       3,935       8,767       7,688  
 CASH AND CASH EQUIVALENTS - End of Period
  $ 25,196     $ 23,596     $ 25,196     $ 23,596  
                                 
 Supplementary Cash Flow Information:
                               
 Interest Paid
  $     $ 77     $     $ 232  
 Income Taxes Paid
  $ 1,239     $ 1,131     $ 2,120     $ 1,954  
                                 
                                 
See accompanying notes to consolidated financial statements.
 


 
4

 
Pzena Investment Management, Inc.
Unaudited Notes to the Consolidated Financial Statements



Note 1—Organization

Pzena Investment Management, Inc. (the “Company”) functions as the holding company through which the business of its operating company, Pzena Investment Management, LLC (the “operating company”), is conducted.  Concurrently with the consummation of the Company’s initial public offering on October 30, 2007, the operating agreement of the operating company was amended and restated such that, among other things, the Company became the sole managing member of the operating company.  As a result of these transactions: (i) the Company has consolidated the financial results of the operating company with its own, and reflected the membership interest in it that it does not own as a non-controlling interest in its consolidated financial statements; and (ii) the Company recognizes income generated from its economic interest in the operating company’s net income.
 
Pzena Investment Management, LLC is an investment adviser which is registered under the Investment Advisers Act of 1940 and is headquartered in New York, New York.  As of June 30, 2011, the operating company managed assets in a variety of value-oriented investment strategies across a wide range of market capitalizations in both U.S. and non-U.S. capital markets.

The Company, through its investment in its operating company, has consolidated the results of operations and financial condition of the following entities as of June 30, 2011:

       
 Operating Company's
       
 Ownership  at
 Legal Entity
 
 Type of Entity (Date of Formation)
 
 June 30, 2011
 Pzena Investment Management, PTY
 
 Australian Proprietary Limited Company (12/16/2009)
 
100.0%
 Pzena Investment Management Special Situations, LLC
 
 Delaware Limited Liability Company (12/01/2010)
 
99.9%
 Pzena Large Cap Value Fund
 
 Massachusetts Trust (11/01/2002)
 
0.0%
 Pzena International Value Service
 
 Delaware Limited Liability Company (12/22/2003)
 
0.0%


Note 2—Significant Accounting Policies

Basis of Presentation:

The consolidated financial statements are prepared in conformity with U.S. generally accepted accounting principles (“GAAP”) and related Securities and Exchange Commission (“SEC”) rules and regulations.  The Company’s policy is to consolidate all majority-owned subsidiaries in which it has a controlling financial interest, which includes the Pzena Investment Management Special Situations, LLC, and the Pzena Investment Management, PTY, as well as variable-interest entities (“VIEs”) where the Company is deemed to be the primary beneficiary, which includes the Pzena Large Cap Value Fund and the Pzena International Value Service.  These majority-owned subsidiaries in which the Company has a controlling financial interest and VIEs where the Company is deemed to be the primary beneficiary are collectively referred to as “consolidated subsidiaries.”  As required by the Consolidation Topic of the Financial Accounting Standards Board Accounting Standards Codification (“FASB ASC”), the Company also consolidates or consolidated non-variable-interest entities in which it acts or acted as the general partner or managing member.  All of these entities represent or represented private investment partnerships over which the Company exercises or exercised control.  Non-controlling interests recorded on the consolidated financial statements of the Company include the non-controlling interests of the outside investors in each of these entities, as well as those of the operating company.  All significant inter-company transactions and balances have been eliminated.
 
The operating company is the managing member of the Europe, Australasia, and Far East (EAFE) Value Service (legally known as Pzena International Value Service), a limited liability company.  Neither the Company, nor the operating company, holds an equity ownership percentage in this entity at June 30, 2011, or held an equity ownership percentage during the periods presented.  Since the holders of the equity investment in this partnership lack a controlling financial interest, this entity is deemed a VIE.  As of February 1, 2011, as a result of a shift in the equity ownership of the entity on that date, the operating company was considered the primary beneficiary of this entity.  Correspondingly, the EAFE Value Service was consolidated as of February 1, 2011.  At June 30, 2011, EAFE Value Service’s $2.2 million in net assets were included in the Company's consolidated statements of financial condition.
 
5

 
 
Pzena Large Cap Value Fund is a Massachusetts Trust in which a majority of the trustees are members of the executive committee of the operating company.  A majority of the trustees are not the holders of the equity investment in this Trust.  Since the holders of the equity investment in this partnership lack a controlling financial interest, this entity is deemed a VIE.  The Company is considered the primary beneficiary of this VIE.  At June 30, 2011, Pzena Large Cap Value Fund’s $0.9 million of net assets were included in the Company’s consolidated statements of financial condition.
 
All of the consolidated investment partnerships are, or were, investment companies under the American Institute of Certified Public Accountants Audit and Accounting Guide for Investment Companies.  The Company has retained the specialized accounting for these partnerships pursuant to the Consolidation of Partnerships and Similar Entities Subtopic of the FASB ASC.  Thus, the Company reports these investment partnerships’ investments in equity securities at fair value, with net realized and unrealized gains and losses reported in earnings in the consolidated statements of operations.

VIEs that are not consolidated continue to receive investment management services from the Company, and are vehicles through which the Company offers its Global Value and/or EAFE Value strategies.  The total net assets of these VIEs was approximately $270.5 million and $515.6 million at June 30, 2011 and December 31, 2010, respectively.  Neither the Company nor the operating company were exposed to losses as a result of its involvement with these entities because they had no direct investment in them.

The Company records in its own equity its pro-rata share of transactions that impact the operating company’s net equity, including equity and option issuances and adjustments to accumulated other comprehensive income.  The operating company’s pro-rata share of such transactions are recorded as adjustments to additional paid-in capital or non-controlling interests, as applicable, on the consolidated statements of financial position.

Management’s Use of Estimates:

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

Fair Values of Financial Instruments:

The carrying amounts of all financial instruments in the consolidated statements of financial condition are presented at their fair value.
 
Revenue Recognition:

Revenue, comprised of advisory fee income, is recognized over the period in which advisory services are provided.  Advisory fee income includes management fees that are calculated based on percentages of assets under management (“AUM”), generally billed quarterly, either in arrears or advance, depending on their contractual terms.  Advisory fee income also includes incentive fees that may be earned by the Company depending on the investment return of the assets under management.  Incentive fee arrangements generally entitle the Company to participate, on a fixed-percentage basis, in any returns generated in excess of an agreed-upon benchmark.  The Company’s participation percentage in such return differentials is then multiplied by AUM to determine the incentive fees earned.  In general, returns are calculated on an annualized basis over the contract’s measurement period, which usually extends to three years.  Incentive fees are generally payable annually.  Following the preferred method identified in the Revenue Recognition Topic of the FASB ASC, such incentive fee income is recorded at the conclusion of the contractual performance period, when all contingencies are resolved.  For the three months ended June 30, 2011 and 2010, the Company recognized approximately $1.0 million and $0.1 million in incentive fee income.  For the six months ended June 30, 2011 and 2010, the Company recognized approximately $1.3 million and $0.3 million, respectively, in incentive fee income.
 
Earnings per Share:

Basic earnings per share is computed by dividing the Company’s net income or loss attributable to its common stockholders by the weighted average number of shares outstanding during the reporting period.  Diluted earnings per share adjusts this calculation to reflect the impact of all outstanding operating company membership units, as well as operating company phantom units and outstanding operating company unit options and options to purchase Class A Common Stock, to the extent they would have a dilutive effect on net income per share for the reporting period.  Net income or loss for diluted earnings per share generally assumes all operating company membership units are converted into Company stock at the beginning of the reporting period and the resulting change to Company net income associated with its increased interest in the operating company is taxed at the Company’s effective tax rate, exclusive of adjustments associated with both the valuation allowance and the liability to selling and converting shareholders.  When this conversion results in an increase in earnings per share or a decrease in loss per share, diluted net income and diluted earnings per share are assumed to be equal to basic net income and basic earnings per share for the reporting period.
 
 
6

 
For the three and six months ended June 30, 2011 and 2010, the Company’s diluted net income was determined as follows:

     
For the Three Months
   
For the Six Months
 
     
Ended June 30,
   
Ended June 30,
 
     
2011
   
2010
   
2011
   
2010
 
     
(in thousands)
 
                           
 Non-Controlling Interests of Pzena Investment Management, LLC
  $ 9,740     $ 7,470     $ 19,030     $ 15,761  
 
 Less: Assumed Corporate Income Taxes
    4,177       3,201       8,156       6,754  
 Assumed After-Tax Income of Pzena Investment Management, LLC
  $ 5,563     $ 4,269     $ 10,874     $ 9,007  
                                   
 Assumed After-Tax Income of Pzena Investment Management, LLC
  $ 5,563     $ 4,269     $ 10,874     $ 9,007  
 Net Income of Pzena Investment Management, Inc.
    859       473       2,516       1,457  
 
 Diluted Net Income (1)
  $ 6,422     $ 4,742     $ 13,390     $ 10,464  
                                   
          (1)     Since the assumed incremental income results in an increase in per share income for the three months ended June 30, 2011 and 2010, diluted net income
                    and diluted earnings per share are assumed to be equal to basic net income and basic earnings per share for the reporting period.

For the three and six months ended June 30, 2011 and 2010, the following units and options to purchase operating company unit, shares of Class A common stock and options to purchase Class A common stock, and phantom operating company units were excluded from the calculation of diluted net income per share, as their inclusion would have had an antidilutive effect for the respective periods:
 
   
For the Three Months
   
For the Six Months
 
   
Ended June 30,
   
Ended June 30,
 
   
2011
   
2010
   
2011
   
2010
 
                         
 Operating Company Units
    54,484,796       54,931,418              
 Options to Purchase Operating Company Units
    3,648,117       3,618,872       989,476       1,620,060  
 Options to Purchase Shares of Class A Common Stock
    961,750       961,750             961,750  
 Phantom Operating Company Units
    152,701       142,555       30,000       84,916  
 Total
    59,247,364       59,654,595       1,019,476       2,666,726  


For the three and six months ended June 30, 2011 and 2010, the Company’s basic and diluted earnings per share were determined as follows:

   
For the Three Months
   
For the Six Months
 
   
Ended June 30,
   
Ended June 30,
 
   
2011
   
2010
   
2011
   
2010
 
   
(in thousands, except share and per-share amounts)
 
             
 Net Income for Basic Earnings per Share
  $ 859     $ 473     $ 2,516     $ 1,457  
 Basic Weighted Average Shares Outstanding
    9,904,187       9,367,659       9,646,298       9,002,379  
 Basic Earnings per Share
  $ 0.09     $ 0.05     $ 0.26     $ 0.16  
                                 
 Net Income for Diluted Earnings per Share
  $ 859     $ 473     $ 13,390     $ 10,464  
 Dilutive Effect of Operating Company B Units (1)
                54,742,805       55,326,546  
 Dilutive Effect of Phantom Units (1)
                14,415       19,057  
 Dilutive Effect of Options (1)
                667,194       664,978  
 Diluted Weighted Average Shares Outstanding
    9,904,187       9,367,659       65,070,712       65,012,960  
 Diluted Earnings per Share
  $ 0.09     $ 0.05     $ 0.21     $ 0.16  
                                 
                      (1)     Since the assumed incremental income results in an increase in per share income for the three months ended June 30, 2011 and 2010, the
                               assumed effects of the conversion of operating company Class B units, options to purchase operating company units, options to purchase Class
                               A common stock, and phantom operating company units are excluded from the calculation of diluted income per share.

 
 
7

 
Cash and Cash Equivalents:

At June 30, 2011, cash and cash equivalents was $25.2 million.  The Company considers all money market funds and highly-liquid debt instruments with an original maturity of three months or less at the time of purchase to be cash equivalents.  The Company maintains its cash in bank deposit and other accounts whose balances, at times, exceed federally insured limits.
 
Interest on cash and cash equivalents is recorded as interest income on an accrual basis in the consolidated statements of operations.
 
Restricted Cash:

The Company maintains a compensating balance of $1.4 million at June 30, 2011 as collateral for a letter of credit issued by a third party in lieu of a cash security deposit, as required by the Company’s lease for its New York office space.  Such amount is recorded in restricted cash in the consolidated statements of financial condition.
 
Due to/from Broker:
 
Due to/from broker consists primarily of cash balances and amounts receivable/payable for unsettled securities transactions held/initiated at the clearing brokers of the Company’s consolidated investment partnerships.
 
Investments, at Fair Value:
 
Investments, at Fair Value represents the securities held by the Company and its consolidated investment partnerships, as well as investments in mutual funds.  All such investments are recorded at fair value, with net realized and unrealized gains and losses reported in earnings in the consolidated statements of operations.
 
The Fair Value Measurements and Disclosures Topic of the FASB ASC defines fair value as the price that would be received to sell an asset, or paid to transfer a liability, in an orderly transaction between market participants at the measurement date.  The Fair Value Measurements and Disclosures Topic of the FASB ASC also establishes a framework for measuring fair value and a valuation hierarchy based upon the transparency of inputs used in the valuation of an asset or liability.  Classification within the hierarchy is based upon the lowest level of input that is significant to the fair value measurement.  The valuation hierarchy contains three levels: (i) valuation inputs are unadjusted quoted market prices for identical assets or liabilities in active markets (Level 1); (ii) valuation inputs are quoted prices for identical assets or liabilities in markets that are not active, quoted market prices for similar assets and liabilities in active markets, and other observable inputs directly or indirectly related to the asset or liability being measured (Level 2); and (iii) valuation inputs are unobservable and significant to the fair value measurement (Level 3).  Additionally, entities are required to disclose in interim and annual periods the inputs and valuation techniques used to measure fair value and define assets and liabilities measured at fair value by major class.
 
The Company’s fair value measurements relate to its consolidated investments in equity securities, which are primarily exchange-traded securities with quoted prices in active markets, and its investments in mutual funds.  The fair value measurements of the equity securities and mutual funds have been classified as Level 1.
 
The following table presents these instruments’ fair value at June 30, 2011:
 

   
Level 1
   
Level 2
   
Level 3
 
   
(in thousands)
 
                   
 Assets:
                 
 Equity Securities
  $ 3,112     $     $  
 Investments in Mutual Funds
    3,227              
 Total Fair Value
  $ 6,339     $     $  


The following table presents these instruments’ fair value at December 31, 2010:

   
Level 1
   
Level 2
   
Level 3
 
   
(in thousands)
 
                   
 Assets:
                 
 Equity Securities
  $ 842     $     $  
 Investments in Mutual Funds
    2,481              
 Total Fair Value
  $ 3,323     $     $  

 
8

 

Securities Valuation:

Investments in equity securities and mutual funds which are traded on a national securities exchange are carried at fair value based on the last reported price on the valuation date.  If no reported equity sales occurred on the valuation date, equity investments are valued at the bid price.  Transactions are recorded on the trade date.
 
The net realized gain or loss on sales of securities and mutual funds is determined on a specific identification basis and is included in net realized and unrealized gain/(loss) from investments in the consolidated statements of operations.
 
Concentrations of Credit Risk:

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

The concentration of credit risk with respect to advisory fees receivable is generally limited due to the short payment terms extended to clients by the Company.  On a periodic basis, the Company evaluates its advisory fees receivable and establishes an allowance for doubtful accounts, if necessary, based on a history of past write-offs and collections and current credit conditions.  For the three months ended June 30, 2011 and 2010, approximately 8.1% and 10.5%, respectively, of the Company’s advisory fees were generated from an advisory agreement with one client.  For the six months ended June 30, 2011 and 2010, approximately 8.3% and 10.0%, respectively, of the Company’s advisory fees were generated from an advisory agreement with one client.  At June 30, 2011 and December 31, 2010, no allowance for doubtful accounts has been deemed necessary.

Property and Equipment:

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

Business Segments:

The Company views its operations as comprising one operating segment.

Income Taxes:

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

The Company and its consolidated subsidiaries account for all federal, state, and local taxation pursuant to the asset and liability method, which requires deferred income tax assets and liabilities to be recorded for temporary differences between the financial statement and tax bases of assets and liabilities that will result in taxable or deductible amounts in the future, based on enacted tax laws and rates applicable to the periods in which the temporary differences are expected to affect taxable income.  Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount more likely than not to be realized.  At June 30, 2011, the Company had a $58.7 million valuation allowance against the deferred tax asset recorded as part of the Company’s initial public offering and the subsequent exchanges of Class B units for shares of its Class A common stock.  At December 31, 2010, the Company had a $59.4 million valuation allowance against this deferred tax asset.  The income tax expense, or benefit, is the tax payable or refundable for the period, plus or minus the change during the period in deferred tax assets and liabilities.  The Company records its deferred tax liabilities as a component of other liabilities in the consolidated statements of financial condition.

Foreign Currency:

Investment securities and other assets and liabilities denominated in foreign currencies are remeasured into U.S. dollar amounts at the date of valuation.  Purchases and sales of investment securities, and income and expense items denominated in foreign currencies, are remeasured into U.S. dollar amounts on the respective dates of such transactions.
 
The Company does not isolate the portion of the results of its operations resulting from the impact of changes in foreign exchange rates on its investments, from the fluctuations arising from changes in market prices of securities held.  Such fluctuations are included in net realized and unrealized gain/(loss) on investments in the consolidated statements of operations.
 
 
9

 
Reported net realized foreign exchange gains or losses arise from sales of foreign currencies, currency gains or losses realized between the trade and settlement dates on securities transactions, and the difference between the amounts of dividends, interest, and foreign withholding taxes recorded on the Company’s books and the U.S. dollar equivalent of the amounts actually received or paid.  Net realized foreign exchange gains and losses arise from changes in the fair values of assets and liabilities resulting from changes in exchange rates.
 
    The functional currency of the Company is the United States Dollar.  The functional currency of the Company’s representative office in Australia is the Australian Dollar.  Assets and liabilities of this office are translated at the spot rate in effect at the applicable reporting date, and the consolidated statements of operations are translated at the average exchange rates in effect during the applicable period.  Any resulting unrealized cumulative translation adjustment is recorded net of taxes as a component of accumulated other comprehensive income in equity.  As of June 30, 2011, the Company did not record any accumulated other comprehensive income.
 
Note 3—Property and Equipment

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

   
As of
 
   
June 30,
   
December 31,
 
   
2011
   
2010
 
   
(in thousands)
 
             
 Leasehold Improvements
  $ 2,145     $ 2,145  
 Furniture and Fixtures
    1,164       1,164  
 Computer Hardware
    1,036       887  
 Office Equipment
    271       271  
 Computer Software
    214       212  
 Total
    4,830       4,679  
 Less: Accumulated Depreciation and Amortization
    (2,934 )     (2,727 )
 Total
  $ 1,896     $ 1,952  


Depreciation is included in general and administrative expense and totaled $0.1 million for each of the three months ended June 30, 2011 and 2010.  Such expenses totaled $0.2 million for each of the six months ended June 30, 2011 and 2010.

Note 4—Related Party Transactions

For the three months ended June 30, 2011 and 2010, the Company earned $0.7 million and $1.0 million, respectively, in investment advisory fees from unconsolidated VIEs which receive investment management services from the Company.  For the six months ended June 30, 2011 and 2010, the Company earned $1.7 million and $2.1 million, respectively, in such fees.  The Company is not the primary beneficiary of these VIEs.

At both June 30, 2011 and December 31, 2010, the Company had less than $0.1 million remaining of an advance to an international investment company for organization and start-up costs, which is included in receivable from related parties on the consolidated statements of financial condition.  The Company is the sponsor and investment manager of this entity.  This entity is included in the previously mentioned unconsolidated VIEs, of which the Company is not considered the primary beneficiary.

At June 30, 2011 and December 31, 2010, receivables from related parties included less than $0.1 million of loans to employees.  The Company has, in the past, issued loans that were in the form of forgivable promissory notes, which were amortized through compensation expense pursuant to their terms.  For the six months ended June 30, 2010, less than $0.1 million of such amortization was recognized through compensation and benefits expense.   No such amortization was recognized for the three months ended June 30, 2010.  The Company did not have any forgivable promissory notes at June 30, 2011 or December 31, 2010.
 
On October 28, 2008, the operating company issued an aggregate of $16.0 million principal amount of Senior Subordinated Notes to entities established by Richard S. Pzena, the Company’s Chief Executive Officer, for the benefit of certain of his family members, an entity controlled by a Company Director, and a former employee.  The Notes were repaid in full during the year ended December 31, 2010.
 
 
10

 
Note 5—Commitments and Contingencies

In the normal course of business, the Company enters into agreements that include indemnities in favor of third parties, such as engagement letters with advisors and consultants.  In certain cases, the Company may have recourse against third parties with respect to these indemnities.  The Company maintains insurance policies that may provide coverage against certain claims under these indemnities.  The Guarantees Topic of the FASB ASC provides accounting and disclosure requirements for certain guarantees.  The Company has had no claims or payments pursuant to these agreements, and it believes the likelihood of a claim being made is remote.  Utilizing the methodology in the Guarantees Topic of the FASB ASC, the Company’s estimate of the value of such guarantees is de minimis, and, therefore, no accrual has been made in the consolidated financial statements.
 
The Company leases office space under a non-cancelable operating lease agreement which expires on October 31, 2015.  The Company reflects minimum lease expense for its headquarters on a straight-line basis over the lease term.  Lease expenses totaled $0.5 million for each of the three months ended June 30, 2011 and 2010, and are included in general and administrative expense.  Such expenses totaled $1.1 million for each of the six months ended June 30, 2011 and 2010.  Lease expenses are presented net of sublease income.
 

Note 6—Compensation and Benefits

Compensation and benefits expense to employees and members is comprised of the following:

   
For the Three Months
   
For the Six Months
 
   
Ended June 30,
   
Ended June 30,
 
   
2011
   
2010
   
2011
   
2010
 
   
(in thousands)
 
                         
 Cash Compensation and Other Benefits
  $ 7,080     $ 6,441     $ 14,285     $ 12,987  
 Non-Cash Compensation
    1,180       822       2,363       1,664  
 Total Compensation and Benefits Expense
  $ 8,260     $ 7,263     $ 16,648     $ 14,651  


For the three and six months ended June 30, 2011 and 2010, the Company awarded no options to acquire Class B units under the Pzena Investment Management, LLC 2006 Equity Incentive Plan (the “2006 Equity Incentive Plan”) and no options to acquire Class A common stock under the Pzena Investment Management, Inc. 2007 Equity Incentive Plan (the “2007 Equity Incentive Plan”).

For the three months ended June 30, 2011 and 2010, the Company recognized approximately $0.7 million and $0.5 million, respectively, in compensation and benefits expense associated with the amortization of all operating company Class B units and options to acquire Class B units under the 2006 Equity Incentive Plan, and options to acquire Class A common stock issued under the 2007 Equity Incentive Plan.  For the six months ended June 30, 2011 and 2010, the Company recognized approximately $1.4 million and $1.0 million in such compensation and benefits expense.

For the six months ended June 30, 2011 and 2010, the operating company granted 6,000 and 7,000, respectively, restricted Class B units and the related shares of Class B common stock to certain members pursuant to the 2006 Equity Incentive Plan.  No such units were granted for the three months ended June 30, 2011 and 2010.  These unit grants each vest ratably over a four-year period commencing January 1, 2011 and 2010, respectively.  The amortization of all unit-based awards was not material for either of the three and six months ended June 30, 2011 and 2010.

Pursuant to the Pzena Investment Management, LLC Amended and Restated Bonus Plan (the “Bonus Plan”), which became effective January 1, 2007, was amended and restated as of October 30, 2007, and was further amended as of October 31, 2008, eligible employees whose cash compensation is in excess of certain thresholds have a portion of that excess mandatorily deferred.  Amounts deferred may be credited to an investment account, take the form of phantom Class B units, or be invested in money market funds at the employee’s discretion, and vest ratably over four years.  At June 30, 2011 and December 31, 2010, the liability associated with deferred compensation investment accounts was approximately $0.7 million and $0.9 million, respectively, which is recorded in the deferred compensation liability on the consolidated statement of financial condition.  For the three months ended June 30, 2011 and 2010, the Company recognized approximately $0.5 million and $0.3 million, respectively, in compensation and benefits expense associated with the amortization of all deferred compensation awards.  For the six months ended June 30, 2011 and 2010, the Company recognized approximately $1.0 million and $0.6 million in such expense.

    As of June 30, 2011 and December 31, 2010, the Company had approximately $2.9 million and $4.5 million, respectively, in unrecorded compensation expense related to unvested operating company phantom Class B units issued pursuant to our deferred compensation plan, operating company Class B unit and option grants issued under the 2006 Equity Incentive Plan, and Class A common stock option grants issued under the 2007 Equity Incentive Plan.

 
11

 
Note 7—Income Taxes

The operating company is a limited liability company that has elected to be treated as a partnership for tax purposes.  Neither it nor the Company’s other consolidated subsidiaries has made a provision for federal or state income taxes because it is the individual responsibility of each of these entities’ members (including the Company) to separately report their proportionate share of the respective entity’s taxable income or loss.  The operating company has made a provision for New York City UBT.  The Company, as a “C” corporation under the Internal Revenue Code, is liable for federal, state and local taxes on the income derived from its economic interest in its operating company, which is net of UBT.  Correspondingly, in its consolidated financial statements, the Company reports both the operating company’s provision for UBT, as well as its provision for federal, state and local corporate taxes.
 

The components of the income tax expense/(benefit) are as follows:

   
For the Three Months
   
For the Six Months
 
   
Ended June 30,
   
Ended June 30,
 
   
2011
   
2010
   
2011
   
2010
 
   
(in thousands)
 
 Current Provision:
                       
 Unincorporated Business Taxes
  $ 737     $ 678     $ 1,505     $ 1,349  
 Local Corporate Tax
                       
 State Corporate Tax
                       
 Federal Corporate Tax
                       
 Total Current Provision
  $ 737     $ 678     $ 1,505     $ 1,349  
                                 
 Deferred Provision:
                               
 Unincorporated Business Taxes
  $ (38 )   $ (56 )   $ (39 )   $ (112 )
 Local Corporate Tax
    87       58       164       116  
 State Corporate Tax
    153       110       289       221  
 Federal Corporate Tax
    525       378       993       761  
 Total Deferred Provision
  $ 727     $ 490     $ 1,407     $ 986  
                                 
 Change in Valuation Allowance
    (1,980 )     1,379       (2,845 )     113  
                                 
 Total Income Tax Expense/(Benefit)
  $ (516 )   $ 2,547     $ 67     $ 2,448  


For the three and six months ended June 30, 2011 and 2010, the Company’s pre-tax income was determined as follows:

   
For the Three Months
   
For the Six Months
 
   
Ended June 30,
   
Ended June 30,
 
   
2011
   
2010
   
2011
   
2010
 
   
(in thousands)
 
                         
 Income Before Income Taxes
  $ 10,084     $ 10,328     $ 21,663     $ 19,504  
 Unincorporated Business Taxes
    (699 )     (622 )     (1,466 )     (1,237 )
 Non-Controlling Interests
    (9,741 )     (7,308 )     (19,081 )     (15,599 )
 Income/(Loss) Before Corporate Taxes
  $ (356 )   $ 2,398     $ 1,116     $ 2,668  


    The Income Taxes Topic of the FASB ASC establishes the minimum threshold for recognizing, and a system for measuring, the benefits of tax return positions in financial statements.  It is the Company’s policy to recognize accrued interest, and penalties associated with uncertain tax positions in total income tax expense/(benefits) on the consolidated statement of operations.  For the three and six months ended June 30, 2011 and 2010, no such expenses were recognized.  As of June 30, 2011 and December 31, 2010, no such accruals were recorded.

The Company and the operating company are generally no longer subject to U.S. Federal or state and local income tax examinations by tax authorities for any year prior to 2007.  All tax years subsequent to, and including, 2007 are considered open and subject to examination by tax authorities.

    The acquisition of the operating company Class B units, noted below, has allowed the Company to make an election under Section 754 of the Internal Revenue Code (“Section 754”) to step up its tax basis in the net assets acquired.  This step up is deductible for tax purposes over a 15-year period.  Based on the net proceeds of the initial public offering and tax basis of the operating company, this election has given rise to a deferred tax asset of approximately $68.7 million.

 
12

 
Pursuant to a tax receivable agreement signed between the members of the operating company and the Company, 85% of the cash savings generated by this election will be distributed to the selling and converting shareholders upon the realization of this benefit.
 
If the Company exercises its right to terminate the tax receivable agreement early, the Company will be obligated to make an early termination payment to the selling and converting shareholders, based upon the net present value (based upon certain assumptions and deemed events set forth in the tax receivable agreement) of all payments that would be required to be paid by the Company under the tax receivable agreement.  If certain change of control events were to occur, the Company would be obligated to make an early termination payment.
 
As discussed further in Note 11, Shareholders’ Equity, below, on March 28, 2011, and March 31, 2010, certain of the operating company’s members exchanged an aggregate of 536,528 and 734,618, respectively, of their Class B units for an equivalent number of shares of Company Class A common stock.  The Company elected to step up its tax basis in the incremental assets acquired in accordance with Section 754.  Based on the exchange-date fair values of the Company’s common stock and the tax basis of the operating company, this election gave rise to a $2.4 million deferred tax asset and a corresponding $2.0 million liability to converting shareholders on March 28, 2011, and a $3.6 million deferred tax asset and a corresponding $3.0 million liability to converting shareholders on March 31, 2010.  The Company assessed the realizability of the deferred tax asset associated with each of these exchanges and determined that a portion of each of their benefits would go unutilized.  Consequently, the Company established a $2.1 million and a $3.2 valuation allowance on March 28, 2011 and March 31, 2010, respectively, to reduce the deferred tax asset to an amount more likely than not to be realized.  These deferred tax assets remain available to the Company and can be used to reduce taxable income in future years.  The Company similarly reduced the associated liability to selling and converting shareholders by $1.8 million and $2.7 million at March 28, 2011 and March 31, 2010, respectively, to reflect this change in the estimated realization of these assets.  As required by the Income Taxes Topic of the FASB ASC, the Company recorded the effects of these transactions in equity.

During the three and six months ended June 30, 2011, after giving effect to the exchange discussed earlier, the Company’s valuation allowance was reduced by approximately $2.0 million and $2.8 million, respectively, due to revised estimates of future taxable income.  To reflect this change in the estimated realization of the asset, the Company correspondingly increased its liability to selling and converting shareholders by $2.1 million and $2.3 million, respectively, for the three and six months ended June 30, 2011.  During the three and six months ended June 30, 2010, after giving effect to the exchange discussed earlier, the Company’s valuation allowance was increased by approximately $1.4 million and $0.1 million, respectively, due to revised estimates of future taxable income.  To reflect this change in the estimated realization of the asset, the Company correspondingly decreased its liability to selling and converting shareholders by $1.1 million and $0.1 million, respectively, for the three and six months ended June 30, 2010.  The effects of these changes to the deferred tax asset and liability to selling and converting shareholders were recorded as a component of the income tax expense/(benefit) and other expense, respectively, on the consolidated statements of operations.  As of June 30, 2011 and December 31, 2010, the net values of all deferred tax assets were approximately $10.6 million and $8.8 million, respectively.

As of June 30, 2011 and December 31, 2010, the net values of the liability to selling and converting shareholders were approximately $11.7 million and $9.3 million, respectively.

The change in the Company’s deferred tax assets, net of valuation allowance, for the three and six months ended June 30, 2011 is summarized as follows:

                   
Valuation
         
   
Section 754
     
Other
     
Allowance
     
Total
 
   
(in thousands)
 
               
 Balance at December 31, 2010
  $ 65,468       $ 2,797       $ (59,431 )     $ 8,834  
 Deferred Tax Expense
    (777 )       96                 (681 )
 Unit Exchange
    2,381                 (2,075 )       306  
 Change in Valuation Allowance
                    865         865  
 Balance at March 31, 2011
  $ 67,072       $ 2,893       $ (60,641 )     $ 9,324  
 Deferred Tax Expense
    (816 )       71                 (745 )
 Change in Valuation Allowance
                    1,980         1,980  
 Balance at June 30, 2011
  $ 66,256       $ 2,964       $ (58,661 )     $ 10,559  

 
13

 

The change in the Company’s deferred tax liabilities, which is included in other liabilities on the Company’s consolidated statements of financial condition, for the three and six months ended June 30, 2011 is summarized as follows:

   
Total
 
   
(in thousands)
 
       
 Balance at December 31, 2010
  $ (51 )
 Deferred Tax Expense
    1  
 Balance at March 31, 2011
  $ (50 )
 Deferred Tax Expense
    19  
 Balance at June 30, 2011
  $ (31 )
 
   
The change in the Company’s deferred tax assets, net of valuation allowance, for the three and six months ended June 30, 2010 is summarized as follows:

               
Valuation
       
   
Section 754
   
Other
   
Allowance
   
Total
 
   
(in thousands)
 
             
 Balance at December 31, 2009
  $ 65,006     $ 2,001     $ (60,253 )   $ 6,754  
 Deferred Tax Expense
    (726 )     173             (553 )
 Unit Exchange
    3,577             (3,186 )     391  
 Change in Valuation Allowance
                1,266       1,266  
 Balance at March 31, 2010
  $ 67,587     $ 2,174     $ (62,173 )   $ 7,858  
 Deferred Tax Expense
    (849 )     303             (546 )
 Change in Valuation Allowance
                (1,379 )     (1,379 )
 Balance at June 30, 2010
  $ 67,008     $ 2,477     $ (63,552 )   $ 5,933  


The change in the Company’s deferred tax liabilities, which is included in other liabilities on the Company’s consolidated statements of financial condition, for the three and six months ended June 30, 2010 is summarized as follows:

   
Total
 
   
(in thousands)
 
       
 Balance at December 31, 2009
  $ (275 )
 Deferred Tax Expense
    56  
 Balance at March 31, 2010
  $ (219 )
 Deferred Tax Expense
    56  
 Balance at June 30, 2010
  $ (163 )


Note 8—Investments, at Fair Value

Investments in equity securities consisted of the following at June 30, 2011:

   
Cost
   
Unrealized Gain
   
Fair Value
 
   
(in thousands)
 
                   
 Equity Securities
  $ 2,796     $ 316     $ 3,112  
 Mutual Funds
    2,839       388       3,227  
 Total
  $ 5,635     $ 704     $ 6,339  

 
14

 

Investments in equity securities consisted of the following at December 31, 2010:

   
Cost
   
Unrealized Gain
   
Fair Value
 
   
(in thousands)
 
                   
 Equity Securities
  $ 736     $ 106     $ 842  
 Mutual Funds
    2,043       438       2,481  
 Total
  $ 2,779     $ 544     $ 3,323  

 
Note 9—Non-Controlling Interests

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

   
For the Three Months
   
For the Six Months
 
   
Ended June 30,
   
Ended June 30,
 
   
2011
   
2010
   
2011
   
2010
 
   
(in thousands)
 
                         
 Non-Controlling Interest of Pzena Investment Management, LLC
  $ 9,740     $ 7,470     $ 19,030       15,761  
 Non-Controlling Interest of Consolidated Investment Partnerships
    1       (162 )     51       (162 )
 Non-Controlling Interests
  $ 9,741     $ 7,308     $ 19,081     $ 15,599  


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

Note 10—Members’ Equity Interests of Operating Company

Except as otherwise provided by law, the liability of a member of the operating company is limited to the amount of its capital account.  A member may transfer or assign all or any part of its membership interest with the prior written consent of Pzena Investment Management, Inc., which may be withheld at its sole discretion.  Any transferee admitted as a member shall succeed to the capital account, or portion thereof, transferred or assigned, as if no such transfer or assignment had occurred.

Note 11—Shareholders’ Equity

The Company functions as the holding company through which the business of its operating company is conducted.  Concurrently with the consummation of the Company’s initial public offering on October 30, 2007, the operating agreement of the operating company was amended and restated such that, among other things, the Company became the sole managing member of the operating company.  As a result of these transactions: (i) the Company has consolidated the financial results of the operating company with its own and reflected the membership interest in it that it does not own as a non-controlling interest in its consolidated financial statements; and (ii) the Company recognizes income generated from its economic interest in the operating company’s net income.  Additionally, the Class B units of the operating company that the Company acquired were reclassified as Class A units of the operating company.  Class A and Class B units of the operating company have the same economic rights per unit.  As of June 30, 2011, the holders of Class A common stock (through the Company) and the holders of Class B units of the operating company held approximately 15.4% and 84.6%, respectively, of the economic interests in the operations of the business.  As of December 31, 2010, the holders of Class A common stock (through the Company) and the holders of Class B units of the operating company held approximately 14.5% and 85.5%, respectively, of the economic interests in the operations of the business.
 
Each Class B unit of the operating company has a corresponding share of the Company’s Class B common stock, par value $0.000001 per share, that was issued in exchange for payment of this par value.  Each share of the Company’s Class B common stock entitles its holder to five votes, until the first time that the number of shares of Class B common stock outstanding constitutes less than 20% of the number of all shares of the Company’s common stock outstanding.  From this time and thereafter, each share of the Company’s Class B common stock entitles its holder to one vote.  When a Class B unit is exchanged for a share of the Company’s Class A common stock or forfeited, a corresponding share of the Company’s Class B common stock will automatically be redeemed and cancelled.  Conversely, to the extent that the Company causes the operating company to issue additional Class B units to employees pursuant to its equity incentive plan, these additional holders of Class B units would be entitled to receive a corresponding number of shares of the Company’s Class B common stock (including if the Class B units awarded are subject to vesting).
 
 
15

 
All holders of the Company’s Class B common stock have entered into a stockholders’ agreement, pursuant to which they agreed to vote all shares of Class B common stock then held by them, and acquired in the future, together on all matters submitted to a vote of the common stockholders.
 
The outstanding shares of the Company’s Class A common stock represent 100% of the rights of the holders of all classes of the Company’s capital stock to receive distributions, except that holders of Class B common stock will have the right to receive the class’s par value upon the Company’s liquidation, dissolution or winding up.
 
Pursuant to the operating agreement of the operating company, each vested Class B unit is exchangeable for a share of the Company’s Class A common stock, subject to certain exchange timing and volume limitations.
 
On March 28, 2011, and March 31, 2010, certain of the operating company’s members exchanged an aggregate of 536,528 and 734,618, respectively, of their Class B units for an equivalent number of shares of Company Class A common stock.  These acquisitions of additional operating company membership interests were treated as reorganizations of entities under common control as required by the Business Combinations Topic of the FASB ASC.
 
The incremental assets and liabilities assumed in the exchanges were recorded on March 28, 2011 and March 31, 2010 as follows:
 

   
March 28,
   
March 31,
 
   
2011
   
2010
 
   
(in thousands)
 
             
 Pzena Investment Management, LLC Members' Capital
  $ 7,425     $ 10,140  
 Pzena Investment Management, LLC Accumulated Deficit
    (7,167 )     (9,824 )
 Realizable Deferred Tax Asset
    306       391  
 Net Tax Receivable Liability to Converting Unitholders
    (260 )     (332 )
 Total
  $ 304     $ 375  
                 
 Common Stock, at Par
  $ 5     $ 7  
 Additional Paid-in Capital
    299       368  
 Total
  $ 304     $ 375  


Note 12—Subsequent Events

The Company evaluated the need for disclosures and/or adjustments resulting from subsequent events through the date the financial statements were issued. This evaluation did not result in any subsequent events that necessitated disclosures and/or adjustments.

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

Overview

We are a public-equity investment management firm that utilizes a classic value investment approach across all of our investment strategies.  We currently manage assets in a variety of value-oriented investment strategies across a wide range of market capitalizations in both U.S. and non-U.S. capital markets.  At June 30, 2011, our assets under management, or AUM, was $15.9 billion.  We manage separate accounts on behalf of institutions and high net worth individuals, and act as sub-investment adviser for a variety of SEC-registered mutual funds and offshore funds.
 
We function as the holding company through which the business of our operating company, Pzena Investment Management, LLC (the “operating company”), is conducted.  Concurrently with the consummation of our initial public offering and reorganization on October 30, 2007, we became the sole managing member of the operating company.  As such, we now control its business and affairs and, therefore, consolidate its financial results with ours.  In light of our employees’ and other investors’ collective membership interest in our operating company, we reflect their ownership as a non-controlling interest in our consolidated financial statements.  As a result, we have consolidated the financial results of the operating company with our own and reflected the membership interest in it that we do not own as a non-controlling interest in our consolidated financial statements and we recognize income generated from our economic interest in the operating company’s net income.  As of June 30, 2011, the holders of Class A common stock (through the Company) and the holders of Class B units of our operating company held approximately 15.4% and 84.6%, respectively, of the economic interests in the operations of our business.
 
Non-GAAP Net Income
 
 
Our results for the three and six months ended June 30, 2011 and 2010 included adjustments related to our tax receivable agreement and the associated liability to selling and converting shareholders.  We believe that these accounting adjustments add a measure of non-operational complexity which partially obscures the underlying performance of the business.  In evaluating the financial condition and results of operations, we also review certain non-GAAP measures of earnings, which exclude these items.  Excluding these adjustments, non-GAAP diluted net income and non-GAAP diluted net income per share were $6.6 million and $0.10, respectively, for the three months ended June 30, 2011, and $5.0 million and $0.08, respectively, for the three months ended June 30, 2010.  Excluding the same adjustments, non-GAAP diluted net income and non-GAAP diluted net income per share were $12.8 million and $0.20, respectively, for the six months ended June 30, 2011, and $10.5 million and $0.16, respectively, for the six months ended June 30, 2010.  GAAP and non-GAAP net income for diluted earnings per share generally assumes all operating company membership units are converted into Company stock at the beginning of the reporting period, and the resulting change to our net income associated with our increased interest in the operating company is taxed at our effective tax rate.  When this conversion results in an increase in earnings per share or a decrease in loss per share, diluted net income and diluted earnings per share are assumed to be equal to basic net income and basic earnings per share for the reporting period.  The Company’s effective tax rate, exclusive of adjustments related to our tax receivable agreement and the associated liability to selling and converting shareholders, was 42.9% for each of the three and six months ended June 30, 2011 and 42.7% for each of the three and six months ended June 30, 2010 as noted in the section “Operating Results—Income Tax Expense/(Benefit),” below.
 
We use these non-GAAP measures to assess the strength of the underlying operations of the business.  We believe that these adjustments, and the non-GAAP measures derived from them, provide information to better analyze our operations between periods, and over time.  Investors should consider these non-GAAP measures in addition to, and not as a substitute for, financial measures prepared in accordance with GAAP.
 
 
17

 
A reconciliation of the non-GAAP measures to the most comparable GAAP measures is included below:
 
   
For the Three Months
   
For the Six Months
 
   
Ended June 30,
   
Ended June 30,
 
   
2011
   
2010
   
2011
   
2010
 
   
(in thousands, except share and per-share amounts)
 
                         
GAAP Net Income
  $ 859     $ 473     $ 2,516     $ 1,457  
Net Effect of Tax Receivable Agreement
    160       261       (588 )     21  
Non-GAAP Net Income
  $ 1,019     $ 734     $ 1,928     $ 1,478  
                                 
GAAP Non-Controlling Interest of Pzena Investment Management, LLC
  $ 9,740     $ 7,470     $ 19,030     $ 15,761  
Less: Assumed Corporate Income Taxes
    4,177       3,201       8,156       6,754  
Assumed After-Tax Income of Pzena Investment Management, LLC
  $ 5,563     $ 4,269     $ 10,874     $ 9,007  
Non-GAAP Net Income of Pzena Investment Management, Inc.
    1,019       734       1,928       1,478  
Non-GAAP Diluted Net Income
  $ 6,582     $ 5,003     $ 12,802     $ 10,485  
                                 
Diluted Earnings Per Share Attributable to
                               
Pzena Investment Management, Inc. Common Stockholders:
                               
Non-GAAP Net Income for Diluted Earnings per Share
  $ 6,582     $ 5,003     $ 12,802     $ 10,485  
Non-GAAP Diluted Earnings per Share
  $ 0.10     $ 0.08     $ 0.20     $ 0.16  
Non-GAAP Diluted Weighted Average Shares Outstanding
    65,054,033       65,021,332       65,070,712       65,012,960  
 
 
Revenue
 
We generate revenue primarily from management fees and incentive fees, which we collectively refer to as our advisory fees, by managing assets on behalf of institutional accounts and for retail clients, which are generally open-end mutual funds catering primarily to retail investors.  Our advisory fee income is recognized over the period in which investment management services are provided.  Following the preferred method identified in the Revenue Recognition Topic of the Financial Accounting Standards Board Accounting Standards Codification (“FASB ASC”), income from incentive fees is recorded at the conclusion of the contractual performance period, when all contingencies are resolved.
 
Our advisory fees are primarily driven by the level of our AUM.  Our AUM increases or decreases with the net inflows or outflows of funds into our various investment strategies and with the investment performance thereof.  In order to increase our AUM and expand our business, we must develop and market investment strategies that suit the investment needs of our target clients, and provide attractive returns over the long term.  The value and composition of our AUM, and our ability to continue to attract clients, will depend on a variety of factors including, among other things:
 
 
our ability to educate our target clients about our classic value investment strategies and provide them with exceptional client service;
 
 
the relative investment performance of our investment strategies, as compared to competing products and market indices;
 
 
competitive conditions in the investment management and broader financial services sectors;
 
 
general economic conditions;
 
 
investor sentiment and confidence; and
 
 
our decision to close strategies when we deem it to be in the best interests of our clients.
 
For our institutional accounts, we are paid fees according to a schedule, which varies by investment strategy.  The substantial majority of these accounts pay us management fees pursuant to a schedule in which the rate we earn on the AUM declines as the amount of AUM increases.
 
Pursuant to our sub-investment advisory agreements with our retail clients, we are generally paid a management fee according to a schedule in which the rate we earn on the AUM declines as the amount of AUM increases.  Certain of these funds pay us fixed-rate management fees.  Due to the substantially larger account size of certain of these accounts, the average advisory fees we earn on them, as a percentage of AUM, are lower than the advisory fees we earn on our institutional accounts.
 
Certain of our clients pay us fees according to the performance of their accounts relative to certain agreed-upon benchmarks, which results in a slightly lower base fee, but allows us to earn higher fees if the relevant investment strategy outperforms the agreed-upon benchmark.
 
 
18

 
The majority of advisory fees we earn on institutional accounts is based on the value of our AUM at a specific date on a quarterly basis, either in arrears or advance.  Advisory fees on certain of our institutional accounts, and with respect to most of our retail accounts, are calculated based on the average of the monthly or daily market value.  Advisory fees are also generally adjusted for any cash flows into or out of a portfolio, where the cash flow represents greater than 10% of the value of the portfolio.  While a specific group of accounts may use the same fee rate, the method used to calculate the fee according to the fee rate schedule may differ as described above.
 
Our advisory fees may fluctuate based on a number of factors, including the following:
 
 
changes in AUM due to appreciation or depreciation of our investment portfolios, and the levels of the contribution and withdrawal of assets by new and existing clients;
 
 
distribution of AUM among our investment strategies, which have differing fee schedules;
 
 
distribution of AUM between institutional accounts and retail accounts, for which we generally earn lower overall advisory fees; and
 
 
the level of our performance with respect to accounts on which we are paid incentive fees.
 
Expenses
 
Our expenses consist primarily of compensation and benefits expenses, as well as general and administrative expenses.  These expenses may fluctuate due to a number of factors, including the following:
 
 
variations in the level of total compensation expense due to, among other things, bonuses, awards of equity to our employees and members of our operating company, changes in our employee count and mix, and competitive factors; and
 
 
expenses, such as rent, professional service fees and data-related costs, incurred, as necessary, to run our business.
 
Compensation and Benefits Expense
 
Our largest expense is compensation and benefits, which includes the salaries, bonuses, equity-based compensation, and related benefits and payroll costs attributable to our members and employees.  Compensation and benefits packages are benchmarked against relevant industry and geographic peer groups in order to attract and retain qualified personnel.
 
Pursuant to the Pzena Investment Management, LLC Amended and Restated 2006 Equity Incentive Plan (the “2006 Equity Incentive Plan”), we have issued restricted units and options to purchase units in the operating company.  We use a fair-value method in recording the compensation expense associated with the granting of these restricted units, and options to purchase units, to new and existing members under the 2006 Equity Incentive Plan.  Under this method, compensation expense is measured at the grant date based on the estimated fair value of the award and is recognized over the award’s vesting period.  The fair value of the units is determined by reference to the market price of our Class A common stock on the date of grant, since these units are exchangeable for shares of our Class A common stock on a one-for-one basis.  The fair value of the options to purchase units is determined by using an appropriate option pricing model on the grant date.
 
Pursuant to the Pzena Investment Management, LLC Amended and Restated Bonus Plan (the “Bonus Plan”), eligible employees whose cash compensation is in excess of certain thresholds have a portion of that excess mandatorily deferred.  These deferred amounts may be invested, at the employee’s discretion, in certain third-party mutual funds, restricted phantom units of our operating company, or money market funds.  Amounts deferred in any calendar year reduce that year’s cash compensation expense and vest ratably over a four-year period beginning on January 1st of the next year.  At June 30, 2011 and December 31, 2010, the liability associated with deferred compensation investment accounts was approximately $0.7 million and $0.9 million, respectively, which is recorded in the deferred compensation liability on the consolidated statement of financial condition.  For the three months ended June 30, 2011 and 2010, the Company recognized approximately $0.7 million and $0.5 million, respectively, in compensation and benefits expense associated with the amortization of all operating company Class B units and options to acquire Class B units issued under the 2006 Equity Incentive Plan, and options to acquire Class A common stock issued under the 2007 Equity Incentive Plan.  For the six months ended June 30, 2011 and 2010, the Company recognized approximately $1.4 million and $1.0 million in such compensation and benefits expense.  Should additional amounts be deferred in future years, we would expect the non-cash portion of our compensation expense to increase as the previously and subsequently deferred amounts are amortized through income.

As of June 30, 2011, we had approximately $2.9 million in total unrecorded compensation expense related to unvested operating company phantom units issued pursuant to our Bonus Plan, operating company unit and option grants issued under the 2006 Equity Incentive Plan, and stock and option grants issued under our Pzena Investment Management, Inc. 2007 Equity Incentive Plan (the “2007 Equity Incentive Plan”).  We expect that the amortization of these amounts will be approximately $1.6 million in the remainder of 2011, $0.9 million in 2012, $0.2 million in 2013, and $0.2 million in 2014.
 
 
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General and Administrative Expense
 
General and administrative expense includes office rent and other expenses, professional and outside services fees, depreciation, and the costs associated with operating and maintaining our research, trading, and portfolio accounting systems.  Our occupancy-related costs and professional services expenses, in particular, generally increase or decrease in relative proportion to the overall size and scale of our business operations.
 
We incur additional expenses associated with being a public company for, among other things, director and officer insurance, director fees, SEC reporting and compliance (including Sarbanes-Oxley and Dodd-Frank compliance), professional fees, transfer agent fees, and other similar expenses.  These additional expenses have and will continue to reduce our net income.
 
Other Income/(Expense)
 
Other income/(expense) is derived primarily from investment income or loss arising from our consolidated investment partnerships, our investments in various private investment vehicles that we employ to incubate new strategies, income or loss arising from our investments in third-party mutual funds, interest expense on our outstanding debt prior to its repayment, and interest income generated on our cash balances.  Other income/(expense) is also affected by changes in our estimates of the liability due to our selling and converting shareholders associated with payments owed to them under the tax receivable agreement which was executed in connection with our reorganization and offering on October 30, 2007.  As discussed further below, under “Tax Receivable Agreement,” this liability represents 85% of the amount of cash savings, if any, in U.S. federal, state, and local income tax that we realize as a result of the amortization of the increases in tax basis generated from our acquisitions of our operating company’s units from our selling and converting shareholders.  Amounts waived by our selling and converting shareholders, if any, reduce this liability. We expect the interest and investment components of other income/(expense), in the aggregate, to fluctuate based on market conditions and the performance of our consolidated investment partnerships and other investments.
 
Non-Controlling Interests
 
Our operating company has historically consolidated the results of operations of the private investment partnerships over which we exercise a controlling influence.  After our reorganization, we became the sole managing member of our operating company and now control its business and affairs and, therefore, consolidate its financial results with ours.  In light of our employees’ and outside investors’ interest in our operating company, we have reflected their membership interests as a non-controlling interest in our consolidated financial statements.  As a result, subsequent to October 30, 2007, our income is generated by our economic interest in our operating company’s net income.  As of June 30, 2011, the holders of Class A common stock (through the Company) and the holders of Class B units of the operating company held approximately 15.4% and 84.6%, respectively, of the economic interests in the operations of the business.
 
Income Tax Expense/(Benefit)
 
While our operating company has historically not been subject to U.S. federal and certain state income taxes, it has been subject to New York City Unincorporated Business Tax.  As a result of our reorganization, we are now subject to taxes applicable to C-corporations.  Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount more likely than not to be realized.  As of June 30, 2011 and December 31, 2010, our valuation allowance against the deferred tax asset associated with our acquisition of operating company units in conjunction with the offering and subsequent exchanges was $58.7 million and $59.4 million, respectively.
 
 
20

 
Operating Results
 
Assets Under Management and Flows
 
As of June 30, 2011, our approximately $15.9 billion of AUM was invested in a variety of value-oriented investment strategies, representing distinct capitalization segments of U.S. and non-U.S. equity markets.  The performance and AUM of our five largest investment strategies as of June 30, 2011 are further described below.  We follow the same investment process for each of these strategies.  Our investment strategies are distinguished by the market capitalization ranges from which we select securities for their portfolios, which we refer to as each strategy’s investment universe, as well as the regions in which we invest.  While our investment process includes ongoing review of companies in the investment universes described below, our actual investments may include companies outside of the relevant market capitalization range at the time of our investment.  In addition, the number of holdings typically found in the portfolios of each of our investment strategies may vary, as described below.
 
Our earnings and cash flows are heavily dependent upon prevailing financial market conditions.  Significant increases or decreases in the various securities markets, particularly the equities markets, can have a material impact on our results of operations, financial condition, and cash flows.
 
The change in AUM in our institutional accounts and our retail accounts for the three and six months ended June 30, 2011 and 2010, and for the six and twelve months ended June 30, 2011, is described below.  Inflows are composed solely of the investment of new or additional assets by new or existing clients.  Outflows consist solely of redemptions of assets by existing clients.
 

                     
For the
 
   
For the Three Months
   
For the Six Months
   
Twelve Months
 
   
Ended June 30,
   
Ended June 30,
   
Ended June 30,
 
Assets Under Management
 
2011
   
2010
   
2011
   
2010
   
2011
 
   
(in billions)
 
 Institutional Accounts