WADDELL & REED FINANCIAL INC - FORM 10-Q

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EX-32.2 - EX-32.2 - WADDELL & REED FINANCIAL INC	wdr-20170331ex32291670f.htm
EX-32.1 - EX-32.1 - WADDELL & REED FINANCIAL INC	wdr-20170331ex3216fbe9a.htm
EX-31.2 - EX-31.2 - WADDELL & REED FINANCIAL INC	wdr-20170331ex312189efc.htm
EX-31.1 - EX-31.1 - WADDELL & REED FINANCIAL INC	wdr-20170331ex3111624d0.htm

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

☒QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2017

☐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 001-13913

WADDELL & REED FINANCIAL, INC.

(Exact name of registrant as specified in its charter)

Delaware		51-0261715
(State or other jurisdiction		(I.R.S. Employer
of incorporation or organization)		Identification No.)

6300 Lamar Avenue

Overland Park, Kansas 66202

(Address, including zip code, of Registrant’s principal executive offices)

(913) 236-2000

(Registrant’s telephone number, including area code)

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

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

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

Large accelerated filer ☒		Accelerated filer ☐

Non-accelerated filer ☐		Smaller reporting company ☐
(Do not check if a smaller reporting company)
		Emerging growth company ☐

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐

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

Shares outstanding of each of the registrant’s classes of common stock as of the latest practicable date:


Class		Outstanding as of April 30, 2017
Class A common stock, $.01 par value		83,614,514

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WADDELL & REED FINANCIAL, INC.

INDEX TO QUARTERLY REPORT ON FORM 10-Q

Quarter Ended March 31, 2017

			Page No.

Part I.	Financial Information

Item 1.		Financial Statements (unaudited)

		Consolidated Balance Sheets at March 31, 2017 and December 31, 2016	3

		Consolidated Statements of Income for the three months ended March 31, 2017 and March 31, 2016	4

		Consolidated Statements of Comprehensive Income for the three months ended March 31, 2017 and March 31, 2016	5

		Consolidated Statement of Stockholders’ Equity and redeemable noncontrolling interests for the three months ended March 31, 2017	6

		Consolidated Statements of Cash Flows for the three months ended March 31, 2017 and March 31, 2016	7

		Notes to the Unaudited Consolidated Financial Statements	8

Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations	21

Item 3.		Quantitative and Qualitative Disclosures About Market Risk	32

Item 4.		Controls and Procedures	32

Part II.	Other Information

Item 1.		Legal Proceedings	33

Item 1A.		Risk Factors	33

Item 2.		Unregistered Sales of Equity Securities and Use of Proceeds	33

Item 6.		Exhibits	34

		Signatures	35

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PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

WADDELL & REED FINANCIAL, INC. AND SUBSIDIARIES

Consolidated Balance Sheets

(in thousands)


	March 31,
	2017		December 31,
	(Unaudited)		2016
Assets:
Cash and cash equivalents	$	565,171	555,102
Cash and cash equivalents - restricted		45,533	31,137
Investment securities		309,303	328,750
Receivables:
Funds and separate accounts		23,948	27,181
Customers and other		111,025	128,095
Prepaid expenses and other current assets		28,587	21,574
Total current assets		1,083,567	1,091,839

Property and equipment, net		99,070	102,449
Goodwill and identifiable intangible assets		147,969	148,569
Deferred income taxes		29,512	31,430
Other non-current assets		27,910	31,985
Total assets	$	1,388,028	1,406,272

Liabilities:
Accounts payable	$	25,281	28,023
Payable to investment companies for securities		69,819	53,691
Payable to third party brokers		27,601	31,735
Payable to customers		60,294	82,918
Short-term notes payable		94,920	—
Accrued compensation		32,980	38,764
Other current liabilities		69,883	61,847
Total current liabilities		380,778	296,978

Long-term debt		94,729	189,605
Accrued pension and postretirement costs		30,215	38,379
Other non-current liabilities		24,906	26,655
Total liabilities		530,628	551,617

Commitments and contingencies

Redeemable noncontrolling interests		8,516	10,653

Stockholders’ equity:
Preferred stock—$1.00 par value: 5,000 shares authorized; none issued		—	—
Class A Common stock—$0.01 par value: 250,000 shares authorized; 99,701 shares issued; 83,709 shares outstanding (83,118 at December 31, 2016)		997	997
Additional paid-in capital		274,146	291,908
Retained earnings		1,127,735	1,135,694
Cost of 15,991 common shares in treasury (16,583 at December 31, 2016)		(505,050)	(531,268)
Accumulated other comprehensive loss		(48,944)	(53,329)
Total stockholders’ equity		848,884	844,002

Total liabilities, redeemable noncontrolling interests and stockholders’ equity	$	1,388,028	1,406,272

See accompanying notes to the unaudited consolidated financial statements.

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WADDELL & REED FINANCIAL, INC. AND SUBSIDIARIES

Consolidated Statements of Income

(Unaudited, in thousands, except for per share data)


	For the three months ended March 31,
	2017		2016

Revenues:
Investment management fees	$	130,436		144,778
Underwriting and distribution fees		128,831		146,658
Shareholder service fees		27,297		32,380
Total		286,564		323,816

Operating expenses:
Underwriting and distribution		150,324		173,836
Compensation and related costs (including share-based compensation of $14,185 and $13,522, respectively)		49,406		52,940
General and administrative		25,724		19,152
Subadvisory fees		2,697		2,093
Depreciation		5,221		4,362
Intangible asset impairment		600		—
Total		233,972		252,383

Operating income		52,592		71,433
Investment and other income (loss)		2,129		(10,218)
Interest expense		(2,786)		(2,768)

Income before provision for income taxes		51,935		58,447
Provision for income taxes		18,399		20,978
Net income		33,536		37,469
Net income attributable to redeemable noncontrolling interests		480		501
Net income attributable to Waddell & Reed Financial, Inc.	$	33,056		36,968

Net income per share attributable to Waddell and Reed Financial, Inc. common shareholders, basic and diluted:	$	0.39		0.45

Weighted average shares outstanding, basic and diluted:		84,077		82,104

See accompanying notes to the unaudited consolidated financial statements.

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WADDELL & REED FINANCIAL, INC. AND SUBSIDIARIES

Consolidated Statements of Comprehensive Income

(Unaudited, in thousands)


	For the three months ended March 31,
	2017		2016

Net income	$	33,536		37,469

Other comprehensive income:

Unrealized appreciation of available for sale investment securities during the period, net of income tax expense (benefit) of $(1,481) and $0, respectively		3,599		76

Pension and postretirement benefit, net of income tax expense of $465 and $619, respectively		786		1,077

Comprehensive income		37,921		38,622
Comprehensive income attributable to redeemable noncontrolling interests		480		501
Comprehensive income attributable to Waddell & Reed Financial, Inc.	$	37,441		38,121

See accompanying notes to the unaudited consolidated financial statements.

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WADDELL & REED FINANCIAL, INC. AND SUBSIDIARIES

Consolidated Statement of Stockholders’ Equity and redeemable noncontrolling interests

For the Three Months Ended March 31, 2017

(Unaudited, in thousands)


									Redeemable
							Accumulated Other	Total	Non
	Common Stock			Additional	Retained	Treasury	Comprehensive	Stockholders’	Controlling
	Shares	Amount		Paid-in Capital	Earnings	Stock	Income (Loss)	Equity	interest
Balance at December 31, 2016	99,701		997	291,908	1,135,694	(531,268)	(53,329)	844,002	10,653
Adoption of share-based compensation guidance on January 1, 2017	—		—	3,504	(2,200)	—	—	1,304	—
Net income	—		—	—	33,056	—	—	33,056	480
Net redemption and deconsolidation of redeemable noncontrolling interests in sponsored funds	—		—	—	—	—	—	—	(2,617)
Recognition of equity compensation	—		—	12,928	228	—	—	13,156	—
Issuance of restricted share and other	—		—	(34,194)		34,194		—	—
Dividends accrued, $0.46 per share	—		—	—	(39,043)	—	—	(39,043)	—
Repurchase of common stock	—		—	—	—	(7,976)	—	(7,976)	—
Other comprehensive income	—		—	—	—	—	4,385	4,385	—
Balance at March 31, 2017	99,701	$	997	274,146	1,127,735	(505,050)	(48,944)	848,884	8,516

See accompanying notes to the unaudited consolidated financial statements.

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WADDELL & REED FINANCIAL, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows

(Unaudited, in thousands)


	For the three months ended March 31,
	2017		2016

Cash flows from operating activities:
Net income	$	33,536		37,469
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		5,221		4,367
Write-down of impaired assets		600		—
Amortization of deferred sales commissions		1,436		7,635
Share-based compensation		13,156		13,522
Excess tax benefits from share-based payment arrangements		—		(312)
Investments gain, net		(2,975)		(5,144)
Net purchases and sales or maturities of trading securities		—		(25,000)
Deferred income taxes		4,239		2,350
Net change in trading securities held by consolidated sponsored funds		12,434		(43,991)
Other		43		118
Changes in assets and liabilities:
Cash and cash equivalents - restricted		(14,396)		27,539
Customer and other receivables		17,070		30,484
Payable to investment companies for securities and payable to customers		(6,496)		(71,613)
Receivables from funds and separate accounts		3,233		5,890
Other assets		(5,307)		(4,565)
Accounts payable and payable to third party brokers		(6,876)		(22,483)
Other liabilities		(5,749)		(3,547)
Net cash provided by (used in) operating activities	$	49,169		(47,281)

Cash flows from investing activities:
Proceeds from sales of available for sale and equity method securities		12,105		100
Additions to property and equipment		(1,885)		(5,741)
Net cash of sponsored funds on consolidation		—		6,887
Other		—		(298)
Net cash provided by investing activities	$	10,220		948

Cash flows from financing activities:
Dividends paid		(38,771)		(38,115)
Repurchase of common stock		(7,976)		(25,598)
Net redemptions, distributions and deconsolidations of redeemable noncontrolling interests in sponsored funds		(2,617)		(1,692)
Excess tax benefits from share-based payment arrangements		—		312
Other		44		43
Net cash used in financing activities	$	(49,320)		(65,050)

Net increase (decrease) in cash and cash equivalents		10,069		(111,383)
Cash and cash equivalents at beginning of period		555,102		558,495
Cash and cash equivalents at end of period	$	565,171		447,112

See accompanying notes to the unaudited consolidated financial statements.

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WADDELL & REED FINANCIAL, INC.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

1.Description of Business and Significant Accounting Policies

Waddell & Reed Financial, Inc. and Subsidiaries

Waddell & Reed Financial, Inc. (hereinafter referred to as the “Company,” “we,” “our” or “us”) is a holding company, incorporated in the state of Delaware in 1981, that conducts business through its subsidiaries. Founded in 1937, we are one of the oldest mutual fund complexes in the United States, having introduced the Waddell & Reed Advisors group of mutual funds (the “Advisors Funds”) in 1940. Over time, we added additional mutual funds: Ivy Funds (the “Ivy Funds”); Ivy Variable Insurance Portfolios, our variable product offering (“Ivy VIP”); InvestEd Portfolios, our 529 college savings plan (“InvestEd”); Ivy High Income Opportunities Fund, a closed-end mutual fund (“IVH”); and the Ivy Global Investors Fund Société d’Investissement à Capital Variable (the “SICAV”) and its Ivy Global Investors sub‑funds (the “IGI Funds”), an undertaking for the collective investment in transferable securities (“UCITS”). In 2016, we introduced the Ivy NextShares® exchange-traded managed funds (“Ivy NextShares”) (collectively, the Advisors Funds, Ivy Funds, Ivy VIP, InvestEd, IVH and Ivy NextShares are referred to as the “Funds”). As of March 31, 2017, we had $81.1 billion in assets under management.

We derive our revenues from providing investment management, investment advisory, investment product underwriting and distribution, and shareholder services administration to the Funds, the IGI Funds, and institutional and separately managed accounts. Investment management fees are based on the amount of average assets under management and are affected by sales levels, financial market conditions, redemptions and the composition of assets. Our underwriting and distribution revenues consist of fees earned on fee‑based asset allocation products and related advisory services, asset‑based service and distribution fees promulgated under Rule 12b-1 of the Investment Company Act of 1940, as amended (“Rule 12b-1”), commissions derived from sales of investment and insurance products, and distribution fees on certain variable products. The products sold have various commission structures and the revenues received from those sales vary based on the type and dollar amount sold. Shareholder service fee revenue includes transfer agency fees, custodian fees from retirement plan accounts, and portfolio accounting and administration fees, and is earned based on assets under management or number of client accounts.

Basis of Presentation

We have prepared the accompanying unaudited consolidated financial statements pursuant to the rules and regulations of the SEC. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted pursuant to such rules and regulations, although we believe that the disclosures are adequate to enable a reasonable understanding of the information presented. The information in this Quarterly Report on Form 10-Q should be read in conjunction with Part I, Item 2 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our audited financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2016 (the “2016 Form 10-K”). Certain amounts in the prior year’s financial statements have been reclassified for consistent presentation.

The accompanying unaudited consolidated financial statements are prepared consistent with the accounting policies described in Note 1 to the consolidated financial statements included in our 2016 Form 10-K with the exception of the adoption of Accounting Standards Update (“ASU”) 2016-09, “Improvements to Employee Share-Based Payment Accounting,” effective January 1, 2017. As required by this ASU, excess tax benefits and tax shortfalls are recognized as income tax benefit or expense in the income statement on a prospective basis. Additionally, excess tax benefits or shortfalls recognized on share-based compensation are classified as an operating activity in the statement of cash flows. The Company has applied this provision prospectively, and thus, the prior period presented in the statement of cash flows has not been adjusted. This ASU allows entities to withhold shares issued during the settlement of a stock award or option, as means of meeting minimum tax withholding due by the employee, in an amount up to the employees’ maximum individual tax rate in the relevant jurisdiction without resulting in a liability classification of the award (versus an equity classification). The value of the withheld shares is then remitted by the Company in cash to the taxing authorities on the employees’ behalf. The Company’s historical policy to withhold shares equivalent to the minimum individual tax rate is consistent with the thresholds meeting the classification of an equity award and, therefore, a retrospective classification

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adjustment was not required. This ASU requires that all cash payments made to taxing authorities on the employees’ behalf for withheld shares be presented as financing activities on the statement of cash flows. As this requirement is consistent with the Company’s historical accounting policy, a retrospective adjustment to presentation of the statement of cash flows was not required. This standard also allows for the option to account for forfeitures as they occur when determining the amount of share-based compensation expense to be recognized, rather than estimating expected forfeitures over the course of a vesting period. The Company elected to account for forfeitures as they occur. The net cumulative effect to the Company from the adoption of this ASU was an increase to additional paid-in capital of $3.5 million, a reduction to retained earnings of $2.2 million and an increase to the non-current deferred tax asset of $1.3 million as of January 1, 2017. In our opinion, the accompanying unaudited consolidated financial statements reflect all adjustments (consisting of only a normal and recurring nature) necessary to present fairly our financial position at March 31, 2017, and the results of operations and cash flows for the three months ended March 31, 2017 and 2016 in conformity with accounting principles generally accepted in the United States.

2.New Accounting Guidance

Accounting Guidance Adopted During The First Quarter of 2017

On January 1, 2017 the Company adopted ASU 2016-07, “Investments-Equity Method and Joint Ventures”. This ASU eliminates the requirement that when an investment qualifies for the use of equity method as a result of an increase in the level of ownership interest or degree of influence, an investor must adjust the investment, results of operations, and retained earnings retroactively as if the equity method had been in effect during all previous periods that the investment had been held. This ASU also requires that an entity that has an available for sale equity security that becomes qualified for the equity method recognize through earnings the unrealized holding gain or loss in accumulated other comprehensive income at the date the investment becomes qualified for use of the equity method. We have concluded that the adoption of this ASU will have an immaterial impact on our consolidated financial statements and related disclosures.

As disclosed in Note 1 above, on January 1, 2017, the Company adopted ASU 2016-09. This ASU requires recognition of all excess tax benefits and tax shortfalls as income tax expense or benefit in the income statement and classification of excess tax benefits along with other income tax cash flows as an operating activity; allows an entity to either estimate the number of awards that are expected to vest or account for forfeitures when they occur; and permits withholding up to the maximum statutory tax rates in the applicable jurisdictions. The Company accounts for forfeitures when they occur. Recognition of excess tax benefits as income tax benefit and tax shortfalls as income tax expense in the income statement may result in increased volatility in our provision for income taxes and effective tax rate. See Note 1 – Description of Business and Significant Accounting Policies – Basis of Presentation for description of the financial statement impact of adopting this ASU.

New Accounting Guidance Not Yet Adopted

In May 2014, the Financial Accounting Standards Board (“FASB”) issued ASU 2014-09, “Revenue from Contracts with Customers,” which requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. This standard also specifies the accounting for certain costs to obtain or fulfill a contract with a customer. This ASU will supersede much of the existing revenue recognition guidance in accounting principles generally accepted in the United States and is effective for annual reporting periods beginning after December 15, 2017, including interim periods within that reporting period; early application is permitted for the first interim period within annual reporting periods, beginning after December 15, 2016. This ASU permits the use of either the retrospective or cumulative effect transition method. We have evaluated our population of contracts and concluded that the adoption of this ASU will have an immaterial impact on our consolidated financial statements and related disclosures.

In February 2016, FASB issued ASU 2016-02, “Leases,” which increases transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. This ASU will be presented using a modified retrospective approach, which includes a number of optional practical expedients that entities may elect to apply. This ASU is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years, with early adoption permitted. Although the Company is evaluating the estimated impact the adoption of this ASU will have on our consolidated financial statements and related disclosures, the Company currently believes the most significant changes will be related to the recognition of new right-of-use assets and lease liabilities on the Company’s consolidated balance sheet for real estate operating leases.

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In August 2016, FASB issued ASU 2016-15, “Classification of Certain Cash Receipts and Cash Payments.” This ASU eliminates the diversity in practice related to the classification of certain cash receipts and payments for debt prepayment or extinguishment costs, the maturing of a zero coupon bond, the settlement of contingent liabilities arising from a business combination, proceeds from insurance settlements, distributions from certain equity method investees and beneficial interests obtained in a financial asset securitization. This ASU designates the appropriate cash flow classification, including requirements to allocate certain components of these cash receipts and payments among operating, investing and financing activities. This ASU is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2017, with early adoption permitted. We are evaluating the estimated impact the adoption of this ASU will have on our consolidated financial statements and related disclosures.

In November 2016, FASB issued ASU 2016-18, “Statement of Cash Flows: Restricted Cash.” This ASU is intended to reduce diversity in practice by adding or clarifying guidance on classification and presentation of changes in restricted cash on the statement of cash flows. The amendments in this ASU require that a statement of cash flows explain the change during the period in the total of cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents. This ASU is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2017, with early adoption permitted. The amendments in this ASU should be applied retrospectively to all periods presented. We are evaluating the estimated impact the adoption of this ASU will have on our consolidated financial statements and related disclosures.

In March 2017, FASB issued ASU 2017-04, “Intangibles-Goodwill and Other: Simplifying the Test for Goodwill Impairment.” This ASU eliminates the second step from the goodwill impairment test. An entity should perform its goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount. An entity will recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value, but the loss cannot exceed the total amount of goodwill allocated to the reporting unit. This ASU is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019, with early adoption permitted. We have concluded that the adoption of this ASU will have an immaterial impact on our consolidated financial statements and related disclosures.

In March 2017, FASB issued ASU 2017-07, “Compensation-Retirement Benefits: Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost.” This ASU changes the income statement presentation of defined benefit plan expense by requiring separation between operating expense (service cost component) and non-operating expense (all other components, including interest cost, amortization of prior service cost, curtailments and settlements, etc.). The operating expense component is reported with similar compensation costs while the non-operating components are reported in a separate line item outside of operating items. In addition, only the service cost component is eligible for capitalization as part of an asset. This ASU is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2017, with early adoption permitted. We are evaluating the estimated impact the adoption of this ASU will have on our consolidated financial statements and related disclosures.

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3.Investment Securities

Investment securities at March 31, 2017 and December 31, 2016 are as follows:


	March 31,		December 31,
	2017		2016
		(in thousands)
Available for sale securities:
Sponsored funds	$	120,756	122,806
Sponsored privately offered funds		—	570
Total available for sale securities		120,756	123,376
Trading securities:
Mortgage-backed securities		12	13
Common stock		104	101
Consolidated sponsored funds		133,276	145,710
Sponsored funds		30,555	29,541
Sponsored privately offered funds		614	—
Total trading securities		164,561	175,365
Equity method securities:
Sponsored funds		20,441	26,775
Sponsored privately offered funds		3,545	3,234
Total equity method securities		23,986	30,009
Total securities	$	309,303	328,750

Mortgage-backed securities accounted for as trading and held as of March 31, 2017 mature in 2022.

The following is a summary of the gross unrealized gains (losses) related to securities classified as available for sale at March 31, 2017:


	Amortized		Unrealized	Unrealized
	cost		gains	losses	Fair value
	(in thousands)
Available for sale securities:
Sponsored funds	$	124,954	1,258	(5,456)	120,756

The following is a summary of the gross unrealized gains (losses) related to securities classified as available for sale at December 31, 2016:


	Amortized		Unrealized	Unrealized
	cost		gains	losses	Fair value
	(in thousands)
Available for sale securities:
Sponsored funds	$	129,427	828	(7,449)	122,806
Sponsored privately offered funds		265	305	—	570
	$	129,692	1,133	(7,449)	123,376

A summary of available for sale sponsored funds with fair values below carrying values at March 31, 2017 and December 31, 2016 is as follows:

Less than 12 months

12 months or longer

Total

Unrealized

March 31, 2017

Fair value

losses

Fair value

losses

Fair value

losses

(in thousands)

Sponsored Privately Offered Funds

The Company holds interests in privately offered funds structured in the form of limited liability companies. The members of these entities have the substantive ability to remove the Company as managing member or dissolve the entity upon a simple majority vote. These entities do not meet the criteria of a VIE and are considered to be VOEs.

Consolidated Sponsored Funds

The following table details the balances related to consolidated sponsored funds at March 31, 2017, and at December 31, 2016, as well as the Company’s net interest in these funds:


	March 31,		December 31,
	2017		2016
	(in thousands)
Cash	$	3,638	6,885
Investments		133,276	145,710
Other assets		3,346	763
Other liabilities		(2,253)	(390)
Redeemable noncontrolling interests		(8,516)	(10,653)
Net interest in consolidated sponsored funds	$	129,491	142,315

During the three months ended March 31, 2017, we consolidated certain of the Ivy Funds in which we provided initial seed capital at the time of the fund’s formation. When we no longer have a controlling financial interest in a sponsored fund, it is deconsolidated from our financial statements. During the first quarter of 2017, we closed three of the IGI Funds that were previously consolidated. Accordingly, we deconsolidated $2.6 million from Cash and cash equivalents and $2.6 million from Redeemable noncontrolling interests. There was no impact to the Consolidated Statements of Income as a result of this deconsolidation, as the IGI Funds were carried at fair value.

Accounting standards establish a framework for measuring fair value and a three-level hierarchy for fair value measurements based upon the transparency of inputs to the valuation of the asset. Inputs may be observable or unobservable and refer broadly to the assumptions that market participants would use in pricing the asset. An individual investment’s fair value measurement is assigned a level based upon the observability of the inputs that are significant to the overall valuation. The three-level hierarchy of inputs is summarized as follows:

Level 1 – Investments are valued using quoted prices in active markets for identical securities.

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Level 2 – Investments are valued using other significant observable inputs, including quoted prices in active markets for similar securities.

Level 3 – Investments are valued using significant unobservable inputs, including the Company’s own assumptions in determining the fair value of investments.

Assets classified as Level 2 can have a variety of observable inputs. These observable inputs are collected and utilized, primarily by an independent pricing service, in pricing approaches evaluated differently depending upon the specific asset to determine a value. The fair value of municipal bonds is measured based on pricing models that take into account, among other factors, information received from market makers and broker-dealers, current trades, bid-wants lists, offerings, market movements, the callability of the bond, state of issuance and benchmark yield curves. The fair value of corporate bonds is measured using various techniques, which consider recently executed trades in securities of the issuer or comparable issuers, market price quotations (where observable), bond spreads and fundamental data relating to the issuer.

Securities’ values classified as Level 3 are primarily determined through the use of a single quote (or multiple quotes) from dealers in the securities using proprietary valuation models. These quotes involve significant unobservable inputs, and thus, the related securities are classified as Level 3 securities.

The following tables summarize our investment securities as of March 31, 2017 and December 31, 2016 that are recognized in our consolidated balance sheets using fair value measurements based on the differing levels of inputs.


March 31, 2017	Level 1		Level 2	Level 3	Other Assets Not Held at Fair Value	Total
	(in thousands)
Available for sale securities:
Sponsored funds	$	120,756	—	—	—	120,756
Trading securities:
Mortgage-backed securities		—	12	—	—	12
Common stock		104	—	—	—	104
Consolidated sponsored funds		94,945	38,331	—	—	133,276
Sponsored funds		30,555	—	—	—	30,555
Sponsored privately offered funds measured at net asset value (1)		—	—	—	614	614
Equity method securities: (2)
Sponsored funds		20,441	—	—	—	20,441
Sponsored privately offered funds measured at net asset value (1)		—	—	—	3,545	3,545
Total	$	266,801	38,343	—	4,159	309,303

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December 31, 2016	Level 1		Level 2	Level 3	Other Assets Not Held at Fair Value	Total
	(in thousands)
Available for sale securities:
Sponsored funds	$	122,806	—	—	—	122,806
Sponsored privately offered funds measured at net asset value (1)		—	—	—	570	570
Trading securities:
Mortgage-backed securities		—	13	—	—	13
Common stock		101	—	—	—	101
Consolidated sponsored funds		100,847	44,863	—	—	145,710
Sponsored funds		29,541	—	—	—	29,541
Equity method securities: (2)
Sponsored funds		26,775	—	—	—	26,775
Sponsored privately offered funds measured at net asset value (1)		—	—	—	3,234	3,234
Total	$	280,070	44,876	—	3,804	328,750

(1)

Certain investments that are measured at fair value using the net asset value per share (or its equivalent) practical expedient have not been categorized in the fair value hierarchy. The fair value amounts presented in this table are intended to permit reconciliation of the fair value hierarchy to the amounts presented in the consolidated balance sheets.

(2)

Substantially all of the Company’s equity method investments are investment companies that record their underlying investments at fair value.

4.Derivative Financial Instruments

In 2016, the Company implemented an economic hedge program that uses total return swap contracts to hedge market risk with its investments in certain sponsored funds. As of March 31, 2017, we had 97% of our investments in sponsored funds, excluding our available for sale portfolio, hedged, 83% of which were hedged with total return swap contracts. Certain of the consolidated sponsored funds may utilize derivative financial instruments within their portfolios in pursuit of their stated investment objectives. We do not hedge for speculative purposes.

Excluding derivative financial instruments held in certain consolidated sponsored funds, the Company was party to three total return swap contracts with a combined notional value of $153.1 million and $160.2 million as of March 31, 2017 and December 31, 2016, respectively. These derivative financial instruments are not designated as hedges for accounting purposes. Changes in fair value of the total return swap contracts are recognized in investment and other income (loss), net on the Company’s consolidated statement of income.

The Company posted $5.4 million and $7.1 million in cash collateral with the counterparties of the total return swap contracts as of March 31, 2017 and December 31, 2016, respectively. The cash collateral is included in customers and other receivables on the Company’s consolidated balance sheet. The Company does not record its fair value in derivative transactions against the posted collateral.

The following table presents the fair value of the derivative financial instruments, excluding derivative financial instruments held in certain consolidated sponsored funds as of March 31, 2017 and December 31, 2016:


			March 31,	December 31,
			2017	2016
	Balance sheet
	location	Fair value		Fair value
		(in thousands)
Total return swap contracts	Other current liabilities	$	476	475

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The following is a summary of net losses recognized in income for the three months ended March 31, 2017 and March 31, 2016:


		Income statement		Three months ended			Three months ended

WADDELL & REED FINANCIAL INC - FORM 10-Q - May 5, 2017

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