Affiliated Managers Group, Inc. 600 Hale Street Prides Crossing, MA 01965 617 747 3300 www.amg.com Affiliated Managers Group, Inc. Annual Repor t 2006 Affiliated Managers Group, Inc. (NYSE: AMG) is an asset management company which operates through a diverse group of high quality boutique asset management firms (its “Affiliates”). AMG’s unique partnership approach with its Affiliates preserves the entrepreneurial orientation that distinguishes the most successful investment management firms. AMG promotes the continued growth and strong performance of its Affiliates by: • Maintaining and enhancing Affiliate managers’ equity incentives in their firms; • Preserving each Affiliate’s distinct culture and investment focus; and • Leveraging AMG’s scale to expand the product offerings and distribution capabilities of its Affiliates, and to provide its Affiliates access to the highest quality operations, compliance and technology resources. AMG seeks to achieve earnings growth through the internal growth of its Affiliates, growth and development initiatives designed to enhance its Affiliates’ businesses, and investments in new Affiliates. AMG’s Affiliates collectively manage approximately $250 billion (as of March 31, 2007) in more than 300 investment products across the institutional, mutual fund and high net worth distribution channels. AMG has achieved strong long-term growth in earnings, with compound annual growth in Cash Earnings Per Share of over 21 percent since its initial public offering in 1997. Contents Financial Highlights and Quarterly Earnings Letter to Shareholders AMG Overview Financial Information Endnotes Shareholder Information 1 2 8 33 88 Inside back cover Corporate Offices Affiliated Managers Group, Inc. 600 Hale Street Prides Crossing, Massachusetts 01965 617 747 3300 www.amg.com Independent Registered Public Accounting Firm PricewaterhouseCoopers LLP Boston, Massachusetts Transfer Agent and Registrar LaSalle Bank, NA Chicago, Illinois Stock Exchange Listing New York Stock Exchange Ticker Symbol: AMG Annual Meeting The Annual Meeting of Stockholders will be held at AMG’s offices in Prides Crossing, Massachusetts, on May 31, 2007. Form 10-K and Management Certifications Copies of the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission, including the certifications required by Section 302 of the Sarbanes-Oxley Act with respect to the Company’s fiscal year ended December 31, 2006, may be obtained without charge by requesting them from: Investor Relations Affiliated Managers Group, Inc. 600 Hale Street Prides Crossing, Massachusetts 01965 ir@amg.com This Annual Report to Stockholders contains forward-looking statements. There are a number of important factors that could cause AMG’s actual results to differ materially from those indicated by such forward-looking statements including, but not limited to, those listed elsewhere in this Annual Report and in the Section titled “Business–Cautionary Statements” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006 as filed with the Securities and Exchange Commission. On June 23, 2006, AMG’s Section 303A Annual CEO certification by Sean M. Healey was filed with the NYSE in accordance with Section 303A.12(a). Board of Directors Richard E. Floor Partner, Goodwin Procter LLP Sean M. Healey President and Chief Executive Officer Harold J. Meyerman Former Senior Executive, The Chase Manhattan Bank and First Interstate Bank, Ltd. William J. Nutt Chairman Rita M. Rodriguez Former Director, Export-Import Bank of the United States Patrick T. Ryan President and Chief Executive Officer, PolyMedica Corporation Jide J. Zeitlin Former General Partner, Goldman, Sachs & Co. Executive Officers William J. Nutt Chairman Sean M. Healey President and Chief Executive Officer Darrell W. Crate Executive Vice President and Chief Financial Officer Nathaniel Dalton Executive Vice President and Chief Operating Officer John Kingston, lll Executive Vice President and General Counsel F i n a n c i a l H i g h l i g h t s (in millions, except as indicated and per share data) 2004 2005 2006 Years ended December 31, Operating Results Revenue Net Income Cash Net Income(1) EBITDA(2) Earnings Per Share – diluted Cash Earnings Per Share – diluted(3) Balance Sheet Data Total Assets Senior Indebtedness Mandatory Convertible Securities Junior Convertible Securities Stockholders’ Equity Other Financial Data $ 660.0 $ 916.5 $ 1,170.4 77.1 126.5 186.4 2.02 3.95 $ 119.1 186.1 267.5 2.81 4.85 $ 151.3 222.5 342.1 3.74 5.68 $ $ 1,933.4 $ 2,321.6 $ 2,665.9 550.7 300.0 0 707.7 665.5 300.0 0 817.4 779.9 300.0 300.0 499.2 Assets Under Management (at period end, in billions) $ 129.8 $ 184.3 $ 241.1 Average Shares Outstanding – diluted Average Shares Outstanding – adjusted diluted(4) 39.6 32.0 44.7 38.4 45.2 39.2 *For the Financial Highlights notes referenced above, please see page 88. Q u a r t e l y E a r n i n g s $1.79 $1.50 $1.00 $0.50 1 T o O u r S h a r e h o l d e r s AMG had an excellent year in 2006, with record organic growth from outstanding investment performance and strong net client cash flows. We also grew our business by making an accretive investment in Chicago Equity Partners, a quantitative investment firm with an excellent performance record. The successful execution of our growth strategy has generated outstanding results for our shareholders. Since our initial public offering in 1997, our stock price has increased at a compound annual rate of 23 percent, for a total increase of 591 percent through March 31, 2007. We’ve reached an important milestone in the Company’s history — in 2007, AMG will celebrate its 10th anniversary as a public company. Over the past decade, we have established a strong track record of earnings growth and shareholder value creation. During periods of both challenging and favorable market environments, our Affiliates’ broad exposure across distribution channels and asset classes has provided consistency to our earnings growth. AMG has successfully implemented a clear and defined strategy of partnering with managers of top-performing asset management firms using direct equity ownership in a framework that closely aligns our interests with those of our Affiliate partners. In addition, we leveraged the scale of AMG to enhance the growth and capabilities of our existing Affiliates’ businesses without interfering with their autonomy or entrepreneurial culture. Through the disciplined execution of this strategy, AMG has built a diversified asset management company that includes some of the highest quality investment boutiques in the world. AMG’s earnings growth has significantly outpaced equity market returns — since our IPO, Cash Earnings Per Share have grown at a compound annual rate of 21 percent, compared to four percent compounded annual appreciation in the S&P 500 Index over the same period. AMG’s Affiliates, which are recognized for their outstanding long-term performance records and high quality investment products, maintained strong momentum in 2006. Organic growth among our Affiliates added $46 billion to AMG’s assets under management, which increased to over $240 billion by year end. Most importantly, strong net client cash flows contributed a record $19.4 billion to AMG’s internal growth and added over $26 million to our Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA). 6 0 0 2 t r o p e R l a u n n A . c n I , p u o r G s r e g a n a M d e t a i l i f f A 2 A M G E x e c u t i v e M a n a g e m e n t Nathaniel Dalton Executive Vice President and Chief Operating Officer Darrell W. Crate Executive Vice President and Chief Financial Officer William J. Nutt Chairman John Kingston, III Executive Vice President and General Counsel Jay C. Horgen Executive Vice President, New Investments Sean M. Healey President and Chief Executive Officer 3 T o O u r S h a r e h o l d e r s c o n t i n u e d Our Affiliates’ outstanding performance was evident across several investment product categories, with excellent returns in growth and value equities, international equities and alternative products. In a year of solid growth in most equity market indices, AMG was well-positioned for strong results, particularly in some of the fastest-growing areas of the industry, such as international and alternative investments. Our international equity products demonstrated exceptional growth and contributed approximately 35 percent of our EBITDA during the year. AMG’s Affiliates, particularly Tweedy, Browne Company, Third Avenue Management, First Quadrant, Genesis Investment Management and AQR Capital Management, are widely recognized for their experience investing in equity markets outside the United States. We believe that strong secular trends favor the continued growth and outperformance of international equities and with our Affiliates’ outstanding products, AMG is in an excellent position to participate in this growing market. The strong internal growth of our Affiliates drove excellent earnings results during the year, as we generated EBITDA of $342 million, a 28 percent increase over last year, and Cash Earnings Per Share of $5.68, a 17 percent increase. AMG also achieved outstanding growth in alternative investments, which contributed over 15 percent of our EBITDA. Our Affiliates’ product offerings in this category are broad-based, with high quality products across a number of different investment strategies. AQR and First Quadrant, two of the industry’s most highly regarded quantitative asset managers, offer alternative investment products which are increasingly sought after by sophisticated institutional investors. These investment strategies are exceptionally adaptable and provide our Affiliates with substantial growth opportunities going forward. Given the strong results of our Affiliates’ alternative products, we have meaningfully increased the potential contribution of performance fees to our earnings growth. A number of our Affiliates, including AQR, First Quadrant, Third Avenue and Genesis, offer performance fee-based products that are in significant demand from institutional and high net worth clients. The breadth and relative performance of our Affiliates’ products is excellent, and we expect performance fees will continue to make a substantial contribution to our earnings in the periods ahead. Domestic equities, which contributed approximately 45 percent of our EBITDA, represented a significant area of growth in the mutual fund, institutional and high net worth channels. Our Affiliates’ U.S. equity products generated strong performance across a wide range of investment styles and asset classes. In this segment, growth products offered by Affiliates such as Friess Associates, TimesSquare Capital Management and Frontier Capital Management had 6 0 0 2 t r o p e R l a u n n A . c n I , p u o r G s r e g a n a M d e t a i l i f f A 4 particularly strong results, while value-oriented Affiliates such as Tweedy, Browne, Third Avenue and Systematic Financial Management, recorded solid performance and attracted positive net client cash flows during the year. In 2006, AMG made excellent progress in broadening the array of strategic support services we offer to our Affiliates. We have successfully used the scale and resources of the holding company to bring the advantages of a larger business to our Affiliates, including a number of initiatives designed to broaden our Affiliates’ product offerings and distribution capabilities. More than half of our Affiliates, including our largest Affiliates, now use AMG as part of their product distribution strategy. Our domestic retail distribution platform, Managers Investment Group, offers our Affiliates the opportunity to cost-effectively distribute their investment products in intermediary-driven channels. Managers had a successful year in 2006, attracting over $2.5 billion in incremental net flows for our Affiliates in its second year of operations. We continue to identify distribution opportunities that allow us to capitalize on the world-class investment capabilities of our Affiliates. As a first step in building an international platform, we recently opened a sales and client service office in Australia, which enables our Affiliates to efficiently distribute to institutional investors in one of the world’s fastest-growing markets. The office provides investors with excellent client service and access to our Affiliates’ broad and diverse array of outstanding products. AMG’s centralized legal and compliance initiative offers our Affiliates access to a team of experienced professionals with the leading-edge legal and compliance capabilities necessary to navigate today’s challenging regulatory environment. Over half of AMG’s Affiliates rely on our legal and compliance support in this important aspect of the asset management industry. In addition to providing cost-effective legal and compliance services, AMG’s commitment allows our Affiliates to draw on the strength of our deep pool of resources and broad industry expertise. The resources AMG provides directly benefit our Affiliates through increased revenue, more efficient operations and a broader set of strategic relationships and shared opportunities. The progress we have made in building our growth and development initiatives has significantly enhanced AMG’s attractiveness to prospective Affiliates. We remain focused on this key component of our business strategy and will continue to expand the range of support services we offer to our Affiliates. With more investments in boutique asset management firms over the past decade than any other entity, AMG has a long and successful track record of partnering with top-performing firms. In 2006, AMG welcomed Chicago Equity Partners to our Affiliate group. Chicago Equity Partners is a leading manager of quantitative equity and fixed income 5 T o O u r S h a r e h o l d e r s c o n t i n u e d products with over $12 billion in assets under management. The firm is widely recognized for strong investment performance and superior client service, generating compound annual growth in assets under management of 27 percent since 2002. As our business has grown, so has the scope and breadth of our new investment opportunities. With an established reputation as the institutional partner of choice for boutique asset management firms, our prospects for continued growth through new investments are excellent. We have enhanced our resources within the Company to execute a broader range of investment prospects. While we continue to pursue attractive investments in traditional boutique asset management firms, the success of our business has expanded the set of investment opportunities we are exploring. We believe that AMG’s outstanding results in 2006 reflect the strength of our business model and the success of our growth strategy. Through the record organic growth among our Affiliates, our expanded distribution capabilities and our broad range of investment opportunities, we are confident about our prospects going forward. In closing, we would like to thank those responsible for our continued success: the management and employees of our Affiliates; the employees of AMG and our service providers; our Board of Directors; and our shareholders for their ongoing support. William J. Nutt Chairman Sean M. Healey President and Chief Executive Officer 6 0 0 2 t r o p e R l a u n n A . c n I , p u o r G s r e g a n a M d e t a i l i f f A 6 A M G B o a r d o f D i r e c t o r s Harold J. Meyerman Former Senior Executive, The Chase Manhattan Bank and First Interstate Bank, Ltd. Patrick T. Ryan President and Chief Executive Officer, PolyMedica Corporation Jide J. Zeitlin Former General Partner, Goldman, Sachs & Co. Richard E. Floor Partner, Goodwin Procter LLP Rita M. Rodriguez Former Director, Export-Import Bank of the United States William J. Nutt Chairman Sean M. Healey President and Chief Executive Officer 7 A M G O v e r v i e w AMG follows a proven, disciplined strategy for growing its business: invest in excellent boutique asset management businesses; allow management to retain equity in their firm as a powerful incentive for growth through a partnership structure that preserves the unique culture and investment approach that has led to their success; and then provide these Affiliates with a range of growth and development initiatives designed to enhance their businesses. AMG’s success in executing its growth strategy has established a strong foundation for continued growth. With the diversity and strong performance of AMG’s Affiliates, a proven ability and capacity to execute its growth initiatives and AMG’s established position as a leading institutional partner for growing boutique asset management firms, AMG is well-positioned to continue to generate shareholder value in the future. Investment Products ■ AMG’s Affiliates include some of the best boutique investment management firms in the industry. As a group, AMG Affiliates manage more than 300 investment products across a broad array of categories. AMG’s Affiliates are leading investors in their disciplines, with years of successful application of their investment processes demonstrated in their outstanding long-term performance records. 6 0 0 2 t r o p e R l a u n n A . c n I , p u o r G s r e g a n a M d e t a i l i f f A 8 AMG’s Affiliates predominantly offer active portfolio management of domestic and international equities, which, combined with a growing emphasis on alternative investments, gives AMG a significant presence in the most dynamic and fastest growing areas of the investment management industry. Approximately 35 percent of AMG’s EBITDA is derived from global, international and emerging markets equity products, 15 percent from alternative products and 45 percent from domestic equity products, including both growth and value styles. The remaining five percent is derived from fixed income and balanced products. This diverse array of products enables AMG to participate broadly in the most attractive segments of the investment management industry, while generating incremental growth by introducing Affiliate products into additional distribution channels. Global, International and Emerging Markets Equities ■ AMG’s Affiliates include leading boutique firms which manage global, international and emerging markets equities across a wide variety of products with distinct styles. Tweedy, Browne Company, Third Avenue Management, Genesis Investment Management, AQR Capital Management, First Quadrant, and Foyston, Gordon & Payne are well-known for their experience investing in international markets, and have outstanding near- and long-term performance records. Tweedy, Browne’s Global Value product is among the largest and most distinguished global value equity products, and follows a diversified, Graham and Dodd approach to global investing. The Global Value fund has an excellent long-term track record and continues to generate strong results for its investors. In 2006, Tweedy, Browne launched a new global high dividend product that focuses on combining a strict valuation discipline with a concentration on companies with significant dividend yields. Third Avenue also applies a disciplined value philosophy to investing in international equities. The firm has generated outstanding recent and longer- term results utilizing its “safe and cheap” investment approach. Third Avenue’s international value equity portfolios seek long-term capital appreciation by Earnings Contribution By Product Category 35% International Equities 15% Alternative 30% U.S. Growth Equities 15% U.S. Value Equities 5% Fixed Income, Balanced, Other 6 0 0 2 t r o p e R l a u n n A . c n I , p u o r G s r e g a n a M d e t a i l i f f A 10 investing in the securities of well-financed, products to develop diversified portfolios similar impact upon the equity markets. well-managed foreign companies believed that are overweight on cheap (and, in The firm’s diversified equity portfolios to be priced below their intrinsic values. turn, underweight on expensive) include European and Japanese market- Genesis is a specialist manager of emerging markets equities for institutional clients. The firm aims to achieve capital growth over the medium- to long-term by adding value to conventional international equity investments through a process of stock selection, while mitigating country risk through extensive geographical diversification. AQR employs a disciplined and systematic global research process through its Enhanced Value International Equity international securities, countries and neutral products, both of which have currencies to achieve long-term success in excellent long-term performance records. both investment performance and risk management. AQR manages international products on behalf of a wide range of leading global institutional investors through collective investment vehicles and separate accounts, and has generated outstanding near- and long-term results in this area. Foyston, Gordon & Payne, one of AMG’s Canadian Affiliates, is a rapidly growing manager of value equity products for institutional and private clients. Foyston’s investment approaches — Canadian equities, U.S. equities and international equities — have each generated strong long-term investment results, significantly First Quadrant employs its highly regarded outperforming their respective peers and quantitative investment strategies to benchmarks. identify stocks with shared fundamental characteristics that are likely to have a AMG’s Affiliates include some of the best boutique investment management firms in the industry. Alternative Products ■ AMG is well-positioned with strong participation in alternative products through leading firms such as AQR, First Quadrant, Third Avenue and Genesis. Alternative products are among the most rapidly growing segments of the asset management industry, with many products designed to generate strong returns with low correlation to traditional asset classes and the potential to earn incremental fees based upon their performance. AMG’s Affiliates offer innovative alternative investment strategies across a wide range of areas, including domestic and international equities, real estate, distressed securities and other special situations. With 10 Affiliates offering approximately 30 alternative investment products with performance fee components, AMG realized a material contribution to its earnings from performance fees in 2006. The strength of AMG’s results in this area reflects its Affiliates’ broad expertise in their respective investment disciplines, and the Company expects that performance fees will continue to provide a meaningful contribution to its earnings. 6 0 0 2 t r o p e R l a u n n A . c n I , p u o r G s r e g a n a M d e t a i l i f f A 14 AMG’s larger Affiliates in the alternative offers products ranging from aggressive area, including AQR, First Quadrant, high volatility, market-neutral hedge Third Avenue and Genesis, have funds to low volatility, benchmark-driven outstanding near- and long-term traditional portfolios. investment performance records and continue to generate strong growth in assets through excellent investment performance and substantial net client cash flows. First Quadrant offers investment management strategies in two main areas, equities and global macro, while paying close attention to risk management. In addition, First Quadrant’s Global AQR employs a disciplined, multi-asset, Alternatives mutual fund offers retail global research process. The firm employs investors access to the firm’s proven global more than 20 distinct investment asset allocation strategies focused on strategies in managing its portfolios, and uncorrelated alpha sources across the globe. Earnings Contribution By Product Category 35% International Equities 15% Alternative 30% U.S. Growth Equities 15% U.S. Value Equities 5% Fixed Income, Balanced, Other Third Avenue applies its disciplined value investing in distressed and other special U.S. Growth approach to products investing in real situations through private investment estate securities, as well as distressed partnerships. Equity ■ securities and other special situations. For example, the highly rated Third Avenue Real Estate Value Fund invests primarily in equity and debt securities of companies in the real estate industry or related industries, using bottom-up, fundamental analysis to identify undervalued securities. Third Avenue also has a long history of including investments in distressed debt securities within its equity mutual funds and has extended this expertise to Genesis, a leading investment firm in emerging markets equities, introduced the Genesis Smaller Companies Fund in 2006. The fund invests primarily in equity securities of firms that operate in emerging markets and have market capitalizations of less than $1 billion. AMG’s Affiliates are among the leading boutique managers in the active management of U.S. equities. Among the Company’s larger Affiliates providing growth equity expertise, Friess Associates, TimesSquare Capital Management and Frontier Capital Management have strong market positions and are well-respected as leading growth investors. Friess uses a time-tested investment strategy that relies on exhaustive, company-by-company research to identify AMG’s Affiliates are among the leading investors in their disciplines, with years of successful application of their investment processes demonstrated in their outstanding long-term performance records. Earnings Contribution By Distribution Channel 50% – Institutional 40% – Mutual Fund 10% – High Net Worth I N S T I T U T I O N A L D I S T R I B U T I O N C H A N N E L AMG’s Affiliates offer more than 150 investment products across more than 35 different investment styles in the institutional distribution channel, including small-, small/mid-, mid-, and large-cap value, growth equity and emerging markets. In addition, AMG’s Affiliates offer quantitative, alternative and fixed income products. AMG’s Affiliates manage assets for a broad range of clients in this channel, including foundations and endowments, defined benefit and defined contribution plans for corporations and municipalities, and Taft-Hartley plans, with disciplined and focused investment styles that address the specialized needs of institutional clients. AMG’s institutional investment products are distributed by over 50 sales and marketing professionals at its Affiliates who develop new institutional business through direct sales efforts and established relationships with pension consultants. AMG works with its Affiliates in executing and enhancing their marketing and client service initiatives, with a focus on ensuring that its Affiliates’ products and services successfully address the specialized needs of their clients and are responsive to the evolving demands of the marketplace. AMG also provides its Affiliates with resources to improve sales and marketing materials, network with the pension consultant and plan sponsor communities, and further expand and establish new distribution alternatives. Earnings Contribution By Product Category 35% International Equities 15% Alternative 30% U.S. Growth Equities 15% U.S. Value Equities 5% Fixed Income, Balanced, Other companies with promising earnings bottom-up process of selecting companies growth potential that have yet to be that meet its definition of superior growth recognized by the broader investment businesses. community. Friess’ highly rated Brandywine mutual fund family is one of the most well-respected and best performing families of mutual funds, and it continues to generate superior results. Friess also has expanded its institutional and high net worth businesses, with significant growth resulting from the outstanding performance of its products, several of which are now sold in the intermediary channels through AMG’s Managers Investment Group platform. Friess’ investment products were previously unavailable in this segment of the market, and Managers has had broad success in expanding Friess’ client base and generating substantial new business in the intermediary channels. TimesSquare is among the industry’s leading growth equity managers, specializing in small-, small/mid-, and mid-cap strategies, and the firm has Frontier offers a wide range of high quality investment products, including strategies focused on small-, small/mid-, mid-, and large-cap growth equities. The firm uses a highly disciplined stock selection process driven by intensive internal research to generate excellent returns for its clients. U.S. Value Equity ■ AMG’s Affiliates also include some of the industry’s most experienced and respected practitioners of value investing, such as Tweedy, Browne, Third Avenue and Systematic Financial Management. AMG’s value equity products span a wide range of market capitalizations and include many of the industry’s most highly rated investment products. achieved excellent returns for its investors Tweedy, Browne, a renowned practitioner through its proprietary research driven, of deep value investing, manages U.S. equity products including the Tweedy, Browne Value Fund, as well as individual accounts for institutional and high net worth investors. Tweedy, Browne’s research seeks to appraise the intrinsic value of a company, and uses a disciplined buy and sell process to guide its investment decisions. 6 0 0 2 t r o p e R l a u n n A . c n I , p u o r G s r e g a n a M d e t a i l i f f A 18 Third Avenue is among the leading value market capitalization spectrum. The firm’s managers in the investment management investment philosophy focuses on industry, with strong-performing products identifying companies that exhibit a including the Third Avenue Value and combination of attractive valuation and Third Avenue Small-Cap Value mutual a positive earnings catalyst. This strategy funds. The firm seeks to invest in has produced superior near- and long- securities and companies at a deep term results for its clients. Earnings Contribution By Product Category discount to the intrinsic value of their assets, and has created superior returns for its investors over the long-term. Systematic specializes in the management of value equity portfolios across the 35% International Equities 15% Alternative 30% U.S. Growth Equities 15% U.S. Value Equities 5% Fixed Income, Balanced, Other 19 Earnings Contribution By Distribution Channel M U T U A L F U N D D I S T R I B U T I O N C H A N N E L AMG has a strong presence in the mutual fund channel, with Affiliates providing advisory or sub-advisory services to more than 100 mutual funds. These funds are distributed to retail and institutional clients directly and through intermediaries, including independent investment advisors, retirement plan sponsors, broker-dealers, major fund marketplaces and bank trust departments. By utilizing the distribution, sales and client service capabilities of Managers Investment Group, AMG offers its Affiliates access to the mutual fund distribution channel. For an Affiliate with a predominantly institutional or high net worth clientele, a presence in the mutual fund channel can be established by leveraging Managers’ operational infrastructure and marketing capabilities. Managers also offers those Affiliates with an existing presence in the mutual fund channel the opportunity to expand their distribution, by operating as a single point of contact for retail intermediaries such as banks, brokerage firms and other sponsored platforms. AMG’s growth and development strategy is focused on offering Affiliates the advantages of scale where such opportunities exist. While Affiliates maintain the flexibility and freedom to determine the initiatives in which they participate, nearly all have elected to participate in one or more of these initiatives. Earnings Contribution By Distribution Channel H I G H N E T W O R T H D I S T R I B U T I O N C H A N N E L AMG’s Affiliates serve two principal client groups in the high net worth distribution channel. The first group consists mostly of direct relationships with ultra high net worth and affluent individuals and families and charitable foundations. For these clients, AMG’s Affiliates provide investment management or customized investment counseling and fiduciary services. The second group consists of individual managed account client relationships established through intermediaries, which 50% – Institutional 40% – Mutual Fund 10% – High Net Worth are generally brokerage firms or similar sponsors. AMG’s Affiliates provide investment management services through more than 90 managed account programs. Through Managers Investment Group, AMG provides its Affiliates with enhanced managed account distribution and administration capabilities for the distribution of single- and multi-manager separate account products and mutual funds through brokerage firms. Earnings Contribution By Product Category 35% International Equities 15% Alternative 30% U.S. Growth Equities 15% U.S. Value Equities 5% Fixed Income, Balanced, Other Fixed Income, Balanced and Other Products ■ In addition to their specialized expertise in equity and alternative products, a number of AMG’s Affiliates, such as Foyston and Managers Investment Group, offer fixed income and other products to their institutional, mutual fund and high net worth clients. Together, these products account for approximately five percent of AMG’s EBITDA. Growth and Development Initiatives ■ AMG’s growth and development strategy is focused on preserving each Affiliate’s distinct operating and investment culture while offering Affiliates the advantages of scale. While the internal growth of AMG’s Affiliates does not depend on AMG’s involvement, AMG has implemented a number of strategic initiatives to further enhance the growth and profitability of its Affiliates’ businesses. AMG makes available to its Affiliates a broad array of opportunities and services, including initiatives designed to expand an Affiliate’s product offerings and distribution capabilities, as well as cross-Affiliate initiatives that enable Affiliates to streamline operations and obtain high quality services at cost-effective rates. While Affiliates maintain the flexibility and freedom to determine their participation, nearly all have elected to participate in one or more of these initiatives. 6 0 0 2 t r o p e R l a u n n A . c n I , p u o r G s r e g a n a M d e t a i l i f f A 24 AMG has successfully built industry- leading platforms for Affiliates to expand the distribution of their investment products through cost-effective access to a broader marketplace. More than half of AMG’s Affiliates, including its largest Affiliates, use AMG as part of their product distribution strategy. AMG’s Managers distribution platform provides its Affiliates with the opportunity to meaningfully expand their product offerings and distribution capabilities in the U.S. retail marketplace, where scale and quality of execution in sales, client service, support and back-office requirements are essential for success. With a team of experienced sales professionals, the Managers platform services and distributes single- and multi-manager Affiliate mutual fund and separate account products to broker- dealers, banks and independent advisors. AMG opened an office in Australia in February 2007: the first step in building an international platform to provide its Affiliates with the opportunity to sell their product offerings to institutional investors in international markets. In many of these markets, including Australia, a local presence is an important aspect of providing high quality execution in sales, client services and support. For investors seeking leading boutique firms with excellent long-term performance, AMG’s Affiliates offer a broad and diverse array of outstanding products, including global and U.S. equities, real estate, currency and global asset allocation products. By providing its Affiliates with efficient and superior distribution capabilities for international investors, AMG will generate significant incremental client cash flows over time. 6 0 0 2 t r o p e R l a u n n A . c n I , p u o r G s r e g a n a M d e t a i l i f f A 26 With a proven track record of value creation, a disciplined investment strategy, and a strong, flexible balance sheet to support further growth, AMG is well-positioned for continued success in executing accretive investments in new Affiliates. AMG has also leveraged the benefits of scale to offer Affiliates cost-effective access to high quality resources in areas such as compliance and technology. As the regulatory climate in the investment management industry has grown more complex, AMG has significantly expanded the centralized resources it offers to Affiliates. By bringing the knowledge and experience of senior AMG attorneys and compliance professionals to the Affiliate level, AMG provides industry expertise and robust, leading-edge compliance capabilities at a level well beyond that which would be typically available to mid-sized firms. Most importantly, AMG works closely with its Affiliates to maintain and enhance the equity incentives that are critical to each Affiliate’s continued growth. AMG engages in an ongoing process with its Investments in New Affiliates ■ In addition to the strong organic growth generated by AMG’s existing Affiliates, AMG has generated significant growth through accretive investments in new Affiliates. AMG’s investment strategy provides Affiliate managers with direct equity ownership in their firm, creating a powerful incentive for long-term growth and investment performance. This approach preserves the entrepreneurial culture that characterizes the best boutique asset management firms, while also providing access to the resources and distribution capabilities of a larger asset management company. It also attracts new Affiliates that value their autonomy and continued participation in their firm’s Affiliates to manage each firm’s succession future growth. and transition process, with a focus on ensuring that equity incentives are properly allocated and aligned among key members of each firm. 6 0 0 2 t r o p e R l a u n n A . c n I , p u o r G s r e g a n a M d e t a i l i f f A 28 AMG continues to identify and develop relationships with high quality domestic and international boutique firms, and is well-positioned to execute new investments, having established relationships with many of the best firms in the industry. Within its target universe, AMG is widely recognized as the preeminent succession planning alternative for owners, clients and employees of firms that seek to facilitate ownership transitions, while maintaining their unique culture and approach and providing next generation of management with key growth incentives through direct equity ownership. With a proven track record of value creation, a disciplined investment strategy, and a strong, flexible balance sheet to support further growth, AMG is well-positioned for continued success in executing accretive investments in new Affiliates. In addition, AMG has enhanced its resources to identify and capitalize on an expanded set of investment opportunities that are beyond the Company’s traditional approach to investing in boutique asset management firms. Financial Strength ■ AMG’s operations generate strong and recurring free cash flow, and the Company’s broad exposure across various investment styles and distribution channels provides balance and stability to this cash flow. AMG takes a disciplined approach to investing its free cash flow, and adheres to well-defined return flexibility. AMG manages its capital objectives in making investments in resources and cash flow to achieve growth initiatives for existing Affiliates, superior long-term results for shareholders as well as in executing acquisitions of by financing new investments, repaying interests in new Affiliates. existing indebtedness and repurchasing its stock, when appropriate. AMG supports its growth strategy by maintaining a strong balance sheet and diverse sources of long-term capital. The Company maintains an investment grade rating, and strives to maintain substantial liquidity and financial 29 I n v e s t m e n t P r o d u c t s International Equit y Alternative U.S. Growth Equity U.S. Value Equity AQR Beutel Deans Knight First Quadrant Foyston Genesis Managers Montrusco Bolton Renaissance Third Avenue Tweedy, Browne AQR Genesis Covington J.M. Hartwell Deans Knight Essex First Quadrant Montrusco Bolton Renaissance Third Avenue Chicago Equity Partners Davis Hamilton Essex Foyston Friess Frontier AQR J.M. Hartwell Managers Renaissance TimesSquare Chicago Equity Partners First Quadrant Foyston Frontier Managers Rorer Skyline Systematic Third Avenue Tweedy, Browne D i s t r i b u t i o n C h a n n e l s Davis Hamilton Deans Knight Essex First Quadrant Foyston Friess Frontier Genesis Gofen and Glossberg J.M. Hartwell Montrusco Bolton Renaissance Rorer Skyline Systematic Third Avenue TimesSquare Tweedy, Browne Welch & Forbes Institutional AQR Beutel Chicago Equity Partners Mutual Fund Beutel Davis Hamilton Foyston Chicago Equity Partners Covington Deans Knight Friess Essex First Quadrant Managers Montrusco Bolton Renaissance Skyline Systematic Third Avenue TimesSquare Tweedy, Browne High Net Worth Beutel Chicago Equity Partners Davis Hamilton Deans Knight Essex First Quadrant Foyston Friess Frontier Gofen and Glossberg J.M. Hartwell Managers Montrusco Bolton Renaissance Rorer Systematic Third Avenue Tweedy, Browne Welch & Forbes Fixed Income , Balanced , Other Beutel J.M. Hartwell Davis Hamilton Managers Deans Knight Essex Foyston Frontier Montrusco Bolton Renaissance Rorer AMG Stock Price Performance Since IPO Cumulative Total Return November 21, 1997 – December 31, 2006 $700 $600 $500 $400 $300 $200 $100 12/97 12/98 12/99 12/00 12/01 12/02 12/03 12/04 12/05 12/06 Affiliated Managers Group, Inc. Peer Group S&P 500 Index S&P 500 Financials Sector Index The stock performance graph assumes an investment of $100 in the common stock of AMG (at the per share closing price of its common stock on November 21, 1997) and each of the indices described above, and the reinvestment of any dividends. The historical information set forth above is not necessarily indicative of future performance. The Peer Group index is comprised of the following entities: BlackRock, Inc., Eaton Vance Corp., Federated Investors, Inc., Franklin Resources, Inc., GAMCO Investors, Inc., Janus Capital Group Inc., Nuveen Investments, Inc., T. Rowe Price Group, Inc., Waddell & Reed Financial, Inc. and W.P. Stewart & Co., Ltd. F i n a n c i a l I n f o r m a t i o n Affiliated Managers Group, Inc. Contents 34 Management’s Discussion and Analysis of Financial Condition and Results of Operations 56 Selected Financial Data 57 Management’s Report on Internal Control Over Financial Reporting 58 Report of Independent Registered Public Accounting Firm 60 Consolidated Financial Statements 64 Notes to Consolidated Financial Statements 88 Common Stock and Corporate Organization Information 33 M a n a g e m e n t ’ s D i s c u s s i o n a n d A n a l y s i s o f F i n a n c i a l C o n d i t i o n a n d R e s u l t s o f O p e r a t i o n s Forward-Looking Statements When used in this Annual Report and in our other filings with the United States Securities and Exchange Commission, in our press releases and in oral statements made with the approval of an executive officer, the words or phrases “will likely result,” “are expected to,” “will continue,” “is antici- pated,” “may,” “intends,” “believes,” “estimate,” “project” or similar expressions are intended to identify “forward-looking and those presently anticipated and projected. We will not undertake and we specifically disclaim any obligation to release publicly the result of any revisions which may be made to any forward-looking statements to reflect events or circumstances after the date of such statements or to reflect the occurrence of events, whether or not anticipated. In that respect, we wish to caution readers not to place undue reliance on any such forward- looking statements, which speak only as of the date made. statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements are subject Overview to certain risks and uncertainties, including, among others, the following: ■ our performance is directly affected by changing conditions in global financial markets generally and in the equity markets particularly, and a decline or a lack of sustained growth in these markets may result in decreased advisory fees or performance fees and a corresponding decline (or lack of growth) in our operating results and in the cash flow distributable to us from our Affiliates; ■ we cannot be certain that we will be successful in finding or investing in additional investment management firms on favorable terms, that we will be able to consummate announced investments in new investment management firms, or that existing and new Affiliates will have favorable operating results; We are an asset management company with equity invest- ments in a diverse group of mid-sized investment management firms (our “Affiliates”). We pursue a growth strategy designed to generate shareholder value through the internal growth of our existing business, additional investments in mid-sized investment management firms and strategic transactions and relationships designed to enhance our Affiliates’ businesses and growth prospects. Through our Affiliates, we manage approximately $241.1 billion in assets (as of December 31, 2006) in more than 300 investment products across a broad range of asset classes and investment styles in three principal distribution channels: Mutual Fund, Institutional and High Net Worth. We believe that our diversification across asset classes, investment styles and distribution channels helps to mitigate our exposure to the risks created by changing market environments. The ■ we may need to raise capital by making long-term or short- following summarizes our operations in our three principal term borrowings or by selling shares of our common stock or distribution channels. other securities in order to finance investments in addi- tional investment management firms or additional ■ Our Affiliates provide advisory or sub-advisory services to investments in our existing Affiliates, and we cannot be sure more than 100 mutual funds. These funds are distributed that such capital will be available to us on acceptable terms, to retail and institutional clients directly and through if at all; and ■ those certain other factors discussed under the caption “Risk Factors,” which are set forth in our 2006 Annual intermediaries, including independent investment advi- sors, retirement plan sponsors, broker/dealers, major fund marketplaces and bank trust departments. Report on Form 10-K. ■ In the Institutional distribution channel, our Affiliates These factors (as well as those discussed under “Risk Factors”) could affect our financial performance and cause actual results to differ materially from historical earnings offer more than 150 investment products across more than 35 different investment styles, including small, small/mid, mid and large capitalization value, growth 6 0 0 2 t r o p e R l a u n n A . c n I , p u o r G s r e g a n a M d e t a i l i f f A 34 equity and emerging markets. In addition, our Affiliates We have revenue sharing arrangements with most of our offer quantitative, alternative and fixed income prod- Affiliates. Under these arrangements, a percentage of ucts. Through this distribution channel, our Affiliates revenue is generally allocated for use by management of manage assets for foundations and endowments, defined that Affiliate in paying operating expenses of the Affiliate, benefit and defined contribution plans for corporations including salaries and bonuses. We call this the “Operating and municipalities, and Taft-Hartley plans, with disci- Allocation.” The portion of the Affiliate’s revenue that is plined and focused investment styles that address the allocated to the owners of that Affiliate (including us) is specialized needs of institutional clients. called the “Owners’ Allocation.” Each Affiliate allocates its ■ The High Net Worth distribution channel is comprised broadly of two principal client groups. The first group consists principally of direct relationships with high net worth individuals and families and charitable founda- tions. For these clients, our Affiliates provide investment management or customized investment counseling and fiduciary services. The second group consists of indi- vidual managed account client relationships established through intermediaries, generally brokerage firms or other sponsors. Our Affiliates provide investment management services through more than 90 managed account and wrap programs. In December 2006, we acquired a majority equity interest in Chicago Equity Partners, a firm that manages a wide range of U.S. equity and fixed income products across multiple capitalization sectors and investment styles. Chicago Equity Partners’ client base includes over 120 institutional investors, including public funds, corpora- tions, endowments and foundations, Taft-Hartley plan Owners’ Allocation to its managers and to us generally in proportion to their and our respective ownership interests in that Affiliate. Where we hold a minority equity interest, our revenue sharing arrangement generally allocates a percentage of the revenue to us, with the balance to be used to pay operating expenses and profit distributions to the Affiliate management owners. One of the purposes of our revenue sharing arrangements is to provide ongoing incentives for Affiliate managers by allowing them to: ■ participate in the growth of their firm’s revenue, which may increase their compensation from the Operating Allocation and their distributions from the Owners’ Allocation; and ■ control operating expenses, thereby increasing the portion of the Operating Allocation that is available for growth initiatives and compensation. sponsors and certain mutual fund advisors. An Affiliate’s managers therefore have incentives to increase revenue (thereby increasing the Operating Allocation and We operate our business through our Affiliates in our three their share of the Owners’ Allocation) and to control principal distribution channels, maintaining each Affiliate’s expenses (thereby increasing the amount of Operating distinct entrepreneurial culture and independence through Allocation available for their compensation). If actual oper- our investment structure. In each case, our Affiliates are ating expenses are less than an Affiliate’s Operating organized as separate firms, and their operating or share- Allocation, the profits allocated to the managers will holder agreements are tailored to provide appropriate increase. These profits are referred to as “Minority interest” incentives for our Affiliate management owners and to on our Consolidated Statements of Income. address the particular characteristics of that Affiliate while enabling us to protect our interests. 35 An Affiliate’s Operating Allocation is structured to cover its Our Net Income reflects the revenue of our consolidated operating expenses. However, should actual operating Affiliates and our share of income from Affiliates which we expenses exceed the Operating Allocation, our contractual account for under the equity method, reduced by: share of cash under the Owners’ Allocation generally has priority over the allocations and distributions to the ■ the operating expenses of our consolidated Affiliates; Affiliate’s managers. As a result, the excess expenses first reduce the portion of the Owners’ Allocation allocated to the Affiliate’s managers until that portion is eliminated, before reducing the portion allocated to us. Any such reduction in our portion of the Owners’ Allocation is required to be paid back to us out of the portion of future Owners’ Allocation allocated to the Affiliate’s managers. Nevertheless, we may agree to adjustments to revenue sharing arrangements to accommodate our business needs or those of our Affiliates if we believe that doing so will maximize the long-term benefits to us. In addition, a revenue sharing arrangement may be modified to a profit- based arrangement (as described below) to better accommodate our business needs or those of our Affiliates. Certain of our Affiliates operate under profit-based arrange- ments through which we receive a share of profits as cash flow. As a result, we participate fully in any increase or decrease in the revenue or expenses of such firms. In these ■ our operating expenses (i.e., our holding company expenses, including interest, depreciation and amortiza- tion, income taxes and compensation for our employees); and ■ the profits allocated to managers of our consolidated Affiliates (i.e., minority interest). As discussed above, for consolidated Affiliates with revenue sharing arrangements, the operating expenses of the Affiliate as well as its managers’ minority interest generally increase (or decrease) as the Affiliate’s revenue increases (or decreases) because of the direct relationship established in many of our agreements between the Affiliate’s revenue and its Operating Allocation and Owners’ Allocation. At our consolidated profit-based Affiliates, expenses may or may not correspond to increases or decreases in the Affiliates’ revenues. Our level of profitability will depend on a variety of factors, cases, we participate in a budgeting process and generally including: provide incentives to management through compensation arrangements based on the performance of the Affiliate. In recent periods, approximately 15% of our earnings has been generated through our profit-based arrangements. For the year ended December 31, 2006, approximately $266.5 million was reported as compensation to our Affiliate managers under these revenue sharing arrange- ments. Additionally, during this period we allocated approximately $212.5 million of our Affiliates’ profits to their managers (referred to in our Consolidated Statements of Income as “Minority interest”). ■ those affecting the global financial markets generally and the equity markets particularly, which could potentially result in considerable increases or decreases in the assets under management at our Affiliates; ■ the level of Affiliate revenue, which is dependent on the ability of our existing and future Affiliates to maintain or increase assets under management by maintaining their existing investment advisory relationships and fee structures, marketing their services successfully to new clients and obtaining favorable investment results; 6 0 0 2 t r o p e R l a u n n A . c n I , p u o r G s r e g a n a M d e t a i l i f f A 36 ■ our receipt of Owners’ Allocation from Affiliates with Clients in the Mutual Fund distribution channel are billed revenue sharing arrangements, which depends on the based upon average daily assets under management. ability of our existing and future Affiliates to maintain Advisory fees billed in advance will not reflect subsequent certain levels of operating profit margins; changes in the market value of assets under management ■ the increases or decreases in the revenue and expenses of Affiliates that operate on a profit-based model; ■ the availability and cost of the capital with which we finance our existing and new investments; ■ our success in making new investments and the terms upon which such transactions are completed; ■ the level of intangible assets and the associated amortiza- tion expense resulting from our investments; for that period but may reflect changes due to client withdrawals. Conversely, advisory fees billed in arrears will reflect changes in the market value of assets under manage- ment for that period. In addition to generating asset-based fees, over 30 Affiliate products, representing approximately $28 billion of assets under management, also bill on the basis of absolute or relative investment performance (“performance fees”). These products, which are primarily in the Institutional distribution channel, are generally structured to have returns that are not directly correlated to changes in broader equity indices and, if earned, the ■ the level of expenses incurred for holding company performance fee component is typically billed less operations, including compensation for our employees; frequently than an asset-based fee. Although performance and ■ the level of taxation to which we are subject. Through our affiliated investment management firms, we derive most of our revenue from the provision of invest- ment management services. Investment management fees (“asset-based fees”) are usually determined as a percentage fee charged on periodic values of a client’s assets under management; most asset-based advisory fees are billed by our Affiliates quarterly. Certain clients are billed for all or a portion of their accounts based upon assets under manage- ment valued at the beginning of a billing period (“in advance”). Other clients are billed for all or a portion of their accounts based upon assets under management valued at the end of the billing period (“in arrears”). Most client accounts in the High Net Worth distribution channel are billed in advance, and most client accounts in the Institutional distribution channel are billed in arrears. fees inherently depend on investment results and will vary from period to period, we anticipate performance fees to be a recurring component of our revenue. We also anticipate that, within any calendar year, the majority of performance fees will typically be realized in the fourth quarter. For certain of our Affiliates, generally where we own a minority interest, we are required to use the equity method of accounting. Consistent with this method, we have not consolidated the operating results of these firms (including their revenue) in our Consolidated Statements of Income. Our share of these firms’ profits (net of intangible amorti- zation) is reported in “Income from equity method investments,” and is therefore reflected in our Net Income and EBITDA. As a consequence, increases or decreases in these firms’ assets under management (which totaled $46.1 billion as of December 31, 2006) will not affect reported revenue in the same manner as changes in assets under management at our other Affiliates. 37 Results of Operations The following tables present our Affiliates’ reported assets under management by operating segment (which are also referred to as distribution channels in this Annual Report). The operating segment analysis presented in the following table is based on average assets under management. For the Mutual Fund distribution channel, average assets under management represents an average of the daily net assets under management. For the Institutional and High Net Worth distribution channels, average assets under manage- ment represents an average of the assets at the beginning and end of each calendar quarter during the applicable Assets under Management Statement of Changes (in billions) December 31, 2003 Net client cash flows New investments(1) Investment performance December 31, 2004 Net client cash flows New investments(1) Other Affiliate transactions(2) Investment performance December 31, 2005 Net client cash flows New investments(1) Other Affiliate transactions(2) Investment performance Mutual Fund $ 25.4 2.0 0.4 6.1 33.9 4.1 6.9 — 5.4 50.3 0.4 0.6 — 6.9 Institutional High Net Worth Total period. We believe that this analysis more closely correlates to the billing cycle of each distribution channel and, as such, provides a more meaningful relationship to revenue. $ 43.2 1.6 24.8 6.5 76.1 8.7 15.0 (3.6) 13.1 109.3 18.5 11.1 $ 22.9 $ 91.5 (0.8) 25.2 13.9 (4.4) — 1.3 19.8 (2.0) 6.1 129.8 10.8 28.0 — 0.8 24.7 0.5 0.2 (3.6) 19.3 184.3 19.4 11.9 (0.3) 16.1 (0.6) 3.4 (0.9) 26.4 December 31, 2006 $ 58.2 $154.7 $ 28.2 $ 241.1 (1) In 2004, we completed new Affiliate investments in Genesis Fund Managers, LLP; TimesSquare Capital Management, LLC and AQR Capital Management, LLC. Additionally, in 2004, we acquired the retail mutual fund business of Conseco Capital Management, Inc. through Managers Investment Group LLC. In 2005, we acquired the mutual fund business of Fremont Investment Advisors Inc. through Managers Investment Group LLC and completed new Affiliate invest- ments in Foyston, Gordon & Payne Inc.; Beutel, Goodman & Company Ltd.; Montrusco Bolton Investments Inc.; Deans Knight Capital Management Ltd.; Triax Capital Corporation; and Covington Capital Corporation. In December 2006, we completed a new Affiliate investment in Chicago Equity Partners. (2) In 2005 and 2006, we transferred our interests in certain affiliated investment management firms. These transactions were not material to our financial position or results of operations. 6 0 0 2 t r o p e R l a u n n A . c n I , p u o r G s r e g a n a M d e t a i l i f f A 38 (in millions, except as noted) 2004 2005 % Change 2006 % Change Average Assets under Management (in billions)(1) Mutual Fund Institutional High Net Worth Total Revenue(2)(3) Mutual Fund Institutional High Net Worth Total Net Income(2) Mutual Fund Institutional High Net Worth Total EBITDA(2)(3) Mutual Fund Institutional High Net Worth Total $ 27.8 51.8 21.3 $ 43.0 88.8 20.9 $ 100.9 $ 152.7 $ 261.9 262.3 135.8 $ 660.0 $ $ $ 37.8 26.9 12.4 77.1 78.7 71.5 36.2 $ 186.4 $ 400.9 385.7 129.9 $ 916.5 $ 56.8 51.3 11.0 $ 119.1 $ 110.3 125.2 32.0 $ 267.5 55% 71% (2)% 51% 53% 47% (4)% 39% 50% 91% (11)% 54% 40% 75% (12)% 44% $ 54.4 125.1 26.8 $ 206.3 $ 501.7 514.8 153.9 $ 1,170.4 $ 68.0 65.8 17.5 $ 151.3 $ 138.2 162.3 41.6 $ 342.1 27% 41% 28% 35% 25% 33% 18% 28% 20% 28% 59% 27% 25% 30% 30% 28% (1) Assets under management attributable to investments that were completed during the relevant periods are included on a weighted average basis for the period from the closing date of the respective investment. Average assets under management includes assets managed by affiliated investment management firms that we do not consolidate for financial reporting purposes of $1.6 billion, $20.6 billion and $39.1 billion for 2004, 2005 and 2006, respectively. (2) Note 23 to the Consolidated Financial Statements describes the basis of presentation of the financial results of our three operating segments. As discussed in Note 1 to the Consolidated Financial Statements, we are required to use the equity method of accounting for certain investments and as such do not consolidate their revenue for financial reporting purposes. Our share of profits from these investments is reported in “Income from equity method investments” and is therefore reflected in Net Income and EBITDA. (3) EBITDA represents earnings before interest expense, income taxes, depreciation and amortization. As a measure of liquidity, we believe that EBITDA is useful as an indicator of our ability to service debt, make new investments and meet working capital requirements. EBITDA is not a measure of liquidity under generally accepted accounting principles and should not be considered an alternative to cash flow from operations. EBITDA, as calculated by us, may not be consistent with computations of EBITDA by other companies. Our use of EBITDA, including a reconciliation to cash flow from operations, is discussed in greater detail in “Liquidity and Capital Resources.” For purposes of our distribution channel operating results, holding company expenses have been allocated based on the proportion of aggregate cash flow distributions reported by each Affiliate in the particular distribution channel. 39 Revenue The increase in revenue of $139.0 million (or 53%) in 2005 Our revenue is generally determined by the level of our assets from 2004 resulted principally from a 55% increase in under management, the portion of our assets across our average assets under management. The increase in average products and three operating segments, which realize different assets under management was primarily attributable to fee rates, and the recognition of any performance fees. positive investment performance and net client cash flows, and, to a lesser extent, from investments in new Affiliates. Our revenue increased $253.9 million (or 28%) in 2006 from 2005, primarily as a result of a 35% increase in average assets under management. The increase in assets under management resulted principally from positive investment performance and net client cash flows and, to a lesser extent, our 2005 investments in new Affiliates. The increase in revenue was proportionately less than the growth in assets under management primarily as a result of our equity method investments, as we do not consolidate the revenue or expenses of these Affiliates. The increase in revenue of $256.5 million (or 39%) in 2005 from 2004 resulted principally from a 51% increase in average assets under management. The increase in average assets under management was primarily attribut- able to our investments in new Affiliates in 2004 and 2005 and, to a lesser extent, positive investment performance and cash flows. The increase in revenue was proportionately less than the growth in assets under management primarily as a result of our equity method investments, as we do not consolidate the revenue or expenses of these Affiliates. Unrelated to the change in assets under management, the increase in revenue was also a result of higher performance fees in 2005 as compared to 2004. The following discusses the changes in our revenue by operating segments. Institutional Distribution Channel The increase in revenue of $129.1 million (or 33%) in the Institutional distribution channel in 2006 from 2005 resulted principally from a 41% increase in average assets under management. The increase in average assets under management resulted principally from positive investment performance and net client cash flows and, to a lesser extent, our 2005 investments in new Affiliates. The increase in revenue was proportionately less than the increase in assets under management primarily as a result of our equity method investments, as we do not consolidate revenue or expenses of such Affiliates. Our revenue increased $123.4 million (or 47%) in 2005 from 2004, primarily as a result of a 71% increase in average assets under management. The increase in assets under management resulted principally from our invest- ments in new Affiliates in 2004 and 2005, and to a lesser extent, from positive investment performance and net client cash flows. The increase in revenue was proportion- ately less than the growth in assets under management primarily as a result of our equity method investments, as we do not consolidate the revenue or expenses of these Affiliates. Unrelated to the change in assets under manage- ment, the increase in revenue was also a result of higher performance fees in 2005 as compared to 2004. Mutual Fund Distribution Channel High Net Worth Distribution Channel The increase in revenue of $100.8 million (or 25%) in the The increase in revenue of $24.0 million (or 18%) in the Mutual Fund distribution channel in 2006 from 2005 High Net Worth distribution channel in 2006 from 2005 resulted principally from a 27% increase in average assets resulted principally from a 28% increase in average assets under management. The increase in average assets under under management. The increase in average assets under management resulted principally from positive investment management resulted principally from our 2005 invest- performance, our 2005 investments in new Affiliates, and ments in new Affiliates and positive investment positive net client cash flows. 6 0 0 2 t r o p e R l a u n n A . c n I , p u o r G s r e g a n a M d e t a i l i f f A 40 performance. The increase in revenue was proportionately management. The decline in average assets under manage- less than the increase in assets under management primarily ment was primarily attributable to net client cash outflows as a result of our equity method investments, as we do not at Rorer Asset Management, LLC and was substantially consolidate the revenue or expenses of these Affiliates, and offset by investments in new Affiliates and positive invest- increases in assets under management that realize a compar- ment performance. The change in revenue was atively lower fee rate. proportionately less than the change in assets under management primarily as a result of our equity method Revenue decreased $5.9 million (or 4%) in 2005 from investments, as we do not consolidate the revenue or 2004 in the High Net Worth distribution channel, princi- expenses of these Affiliates. pally from a 2% decline in average assets under Operating Expenses The following table summarizes our consolidated operating expenses: (in millions) Compensation and related expenses Selling, general and administrative Amortization of intangible assets Depreciation and other amortization Other operating expenses Total operating expenses 2004 $ 241.6 109.1 18.3 6.4 16.7 $ 392.1 2005 % Change 2006 % Change $ 365.9 162.1 24.9 7.0 21.5 $ 581.4 51% 49% 36% 9% 29% 48% $ 472.4 184.0 27.4 8.7 23.9 $ 716.4 29% 14% 10% 24% 11% 23% The substantial portion of our operating expenses is Compensation and related expenses increased 29% in 2006, incurred by our Affiliates, the majority of which is incurred following a 51% increase in 2005. The increase in 2006 was by Affiliates with revenue sharing arrangements. For primarily a result of the relationship between revenue and Affiliates with revenue sharing arrangements, an Affiliate’s operating expenses at our Affiliates with revenue sharing Operating Allocation percentage generally determines its arrangements, which experienced aggregate increases in operating expenses. Accordingly, our compensation expense revenue and accordingly, reported higher compensation is generally impacted by increases or decreases in each expenses, including $12.8 million of additional compensa- Affiliate’s revenue and the corresponding increases or tion expense from our new investments in 2005 (and the decreases in their respective Operating Allocations. During inclusion of the compensation expense for those Affiliates). 2006, approximately $266.5 million, or about 56% of our The increase in 2005 was also primarily a result of the rela- consolidated compensation expense, was attributable to our tionship between revenue and operating expenses at our Affiliate managers. The percentage of revenue allocated to Affiliates with revenue sharing arrangements, which experi- operating expenses varies from one Affiliate to another and may vary within an Affiliate depending on the source or enced aggregate increases in revenue, and accordingly, reported higher compensation expenses, including $52.0 amount of revenue. As a result, changes in our aggregate million in additional compensation expenses from our new revenue may not impact our consolidated operating investments in 2004 and 2005 (and the inclusion of the expenses to the same degree. compensation expense for those Affiliates). This increase was 41 also related to a $16.9 million increase in holding company Amortization of intangible assets increased 10% in compensation (relating to equity based and incentive 2006 and 36% in 2005, principally from an increase in compensation, as well as increases in the number of holding definite-lived intangible assets resulting from our invest- company personnel), with the remainder associated with ments in new and existing Affiliates during 2005. our formation of Managers. Selling, general and administrative expenses increased 14% 24% in 2006 and 9% in 2005. The increase in 2006 was in 2006. The increase was principally attributable to the principally attributable to our 2005 investments in new growth in assets under management at our Affiliates in the Affiliates and other spending on depreciable assets during Mutual Fund distribution channel, including the $6.9 2005 and 2006. In 2005, the increase was principally Depreciation and other amortization expenses increased billion of assets under management from our 2005 invest- attributable to new investments. ments in new Affiliates. Selling, general and administrative expenses increased 49% in 2005. The increase was princi- Other operating expenses increased 11% in 2006 princi- pally attributable to increases in expenses that resulted from pally as a result of a $1.1 million increase in operating the growth in assets under management at our Affiliates in expenses from our new investments in 2005 and expenses the Mutual Fund distribution channel, and the $20.1 related to other Affiliate transactions. Other operating million increase in additional Affiliate expenses from our expenses increased 29% in 2005, principally as a result of a new investments in 2004 and 2005 (and the inclusion of $2.7 million increase in operating expenses from our new the additional expenses for those Affiliates). investments in 2004 and 2005 (and the inclusion of the additional expenses for those Affiliates). Other Income Statement Data The following table summarizes non-operating income and expense data: (in millions) Income from equity method investments Investment and other income Investment income from Affiliate investments in partnerships Minority interest in Affiliate investments in partnerships Minority interest Interest expense Income tax expense $ 2004 1.3 6.9 0.3 — 115.5 31.7 51.9 $ 2005 27.0 8.9 0.4 — 144.3 37.4 70.6 % Change 1,977% 29% $ 33% — 25% 18% 36% 2006 38.3 16.9 3.4 3.4 212.5 58.8 86.6 % Change 42% 90% 750% — 47% 57% 23% Income from equity method investments consists of our increase in assets under management, including our 2005 share of income from Affiliates that are accounted for under investments in new Affiliates ($5.7 million increase in the equity method of accounting, net of any related intan- income in 2006). The increase in 2005 was attributable to gible amortization. Income from equity method new investments in Affiliates that are accounted for under investments increased 42% in 2006 as a result of an the equity method of accounting. 6 0 0 2 t r o p e R l a u n n A . c n I , p u o r G s r e g a n a M d e t a i l i f f A 42 Investment and other income primarily consists of earnings Interest expense increased 57% in 2006, principally attrib- on cash and cash equivalent balances and earnings that utable to the April 2006 issuance of $300 million of junior Affiliates realize on investments in marketable securities. convertible trust preferred securities ($11.4 million in Investment and other income increased 90% in 2006 2006) and increases in borrowings under our senior primarily as a result of an increase in Affiliate investment revolving credit facility ($7.2 million in 2006). The earnings of $6.4 million, and earnings of $1.6 million on increase in 2005 was principally attributable to our floating investments held by new Affiliates. Our agreements generally rate convertible securities ($5.6 million), borrowings under allocate Affiliate earnings on marketable securities to our our credit facility ($5.0 million) and our 2004 PRIDES management partners. The increase in 2005 was attributable ($1.4 million). to a $1.5 million increase in aggregate Affiliate investment income from our new investments in 2004 and 2005 (and Income taxes increased 23% in 2006 principally as a result the inclusion of the investment income for those Affiliates). of the 25% increase in net income before taxes. The In 2005, the increase in investment and other income increase was partially offset by a $1.4 million reduction in resulting from the non-recurrence of a $2.5 million loss in income taxes from a decrease in Canadian federal income 2004 on our repurchase of $154.3 million of the senior tax rates. The 36% increase in income tax expense in 2005 notes component of our 2001 PRIDES was partially offset was principally attributable to an increase in income before by a $1.7 million decrease in interest income. taxes and was partially offset by a decrease in the effective tax rate from 40.2% to 37.2%. In 2006 we adopted EITF 04-05, which requires us to consolidate certain Affiliate investment partnerships in our Net Income financial statements. Investment income from Affiliate The following table summarizes Net Income for the past investments in partnerships and Minority interest in three years: Affiliate investments in partnerships results from the consolidation of these partnerships. For 2006, the income from Affiliate investments in partnerships was $3.4 million, which was principally attributable to investors who are unrelated to us and is reported as Minority interest in Affiliate investments in partnerships. Minority interest increased 47% in 2006, principally as a result of the previously discussed increase in revenue. This increase was proportionately greater than the increase in revenue because certain Affiliates reported expenses that were less than their Operating Allocation. Minority interest increased 25% in 2005, principally as a result of the previously discussed increase in revenue. The percentage increase in minority interest was proportion- ately less than the percentage increase in revenue because of $9.0 million in investment spending by certain Affiliates in 2005 and our November 2004 purchase of an additional 19% interest in Friess Associates, which decreased minority interest by $9.4 million. (in millions) 2004 2005 % Change 2006 % Change Net Income $ 77.1 $ 119.1 54% $ 151.3 27% Net Income increased 27% in 2006 and 54% in 2005, principally as a result of increases in revenue and income from equity method investments, partially offset by increases in reported operating, interest, minority interest and tax expenses, as described above. Supplemental Performance Measure As supplemental information, we provide a non-GAAP performance measure that we refer to as Cash Net Income. This measure is provided in addition to, but not as a substi- tute for, Net Income. Cash Net Income is defined as Net Income plus amortization and deferred taxes related to intan- gible assets plus Affiliate depreciation. We consider Cash Net Income an important measure of our financial performance, as we believe it best represents operating performance before non-cash expenses relating to our acquisition of interests in 43 our Affiliates. Cash Net Income is used by our management Cash Net Income increased 20% in 2006 and 47% in and Board of Directors as a principal performance bench- 2005, primarily as a result of the previously described mark, including as a measure for aligning executive factors affecting Net Income. compensation with stockholder value. Since our acquired assets do not generally depreciate or require replacement by us, and since they generate deferred tax expenses that are unlikely to reverse, we add back these non-cash expenses to Net Income to measure operating Liquidity and Capital Resources The following table summarizes certain key financial data relating to our liquidity and capital resources: 2004 December 31, 2005 2006 $ 140.3 21.2 126.8 $ 140.4 — 241.3 $ 201.7 — 365.5 performance. We add back amortization attributable to (in millions) acquired client relationships because this expense does not correspond to the changes in value of these assets, which do not diminish predictably over time. The portion of deferred taxes generally attributable to intangible assets (including goodwill) that we no longer amortize but which continues to generate tax deductions is added back, because these accruals would be used only in the event of a future sale of an Affiliate Balance Sheet Data Cash and cash equivalents Short-term investments Senior debt Zero coupon or an impairment charge, which we consider unlikely. We add Mandatory back the portion of consolidated depreciation expense incurred by our Affiliates because under our Affiliates’ operating agreements we are generally not required to replenish these depreciating assets. Conversely, we do not add back the deferred taxes relating to our floating rate senior convertible securities or other depreciation expenses. convertible notes 124.0 Floating rate convertible securities 300.0 convertible securities Junior convertible trust preferred securities 300.0 — 124.2 300.0 300.0 — 113.4 300.0 300.0 300.0 Cash Flow Data Operating cash flows Investing cash flows Financing cash flows EBITDA(1) $ 177.9 (478.3) 215.2 186.4 $ 204.1 (82.0) (122.3) 267.5 $ 301.0 (165.1) (75.1) 342.1 The following table provides a reconciliation of Net Income (1) The definition of EBITDA is presented in Note 3 on page 39. to Cash Net Income: (in millions) Net Income Intangible amortization Intangible amortization- 2004 $ 77.1 18.3 2005 $ 119.1 24.9 2006 $ 151.3 27.4 equity method investments(1) Intangible-related deferred taxes Affiliate depreciation 0.9 25.8 4.4 8.5 28.8 4.8 9.3 28.8 5.7 Cash Net Income $ 126.5 $ 186.1 $ 222.5 (1) As discussed in Note 1 to the Consolidated Financial Statements, we are required to use the equity method of accounting for our investments in AQR, Beutel and Deans Knight and, as such, do not consolidate their revenue or expenses (including intangible amortization expenses) in our income statement. Our share of these investments’ amortization is reported in “Investment and other income.” We view our ratio of debt to EBITDA (our “leverage ratio”) as an important gauge of our ability to service debt, make new investments and access capital. Consistent with industry practice, we do not consider our mandatory convertible secu- rities or our junior convertible trust preferred securities as debt for the purpose of determining our leverage ratio. We also view our leverage on a “net debt” basis by deducting our cash and cash equivalents from our debt balance. The leverage covenant of our senior revolving credit facility is generally consistent with our treatment of our mandatory convertible securities and our junior convertible trust preferred securities and our net debt approach. As of December 31, 2006, our leverage ratio was 1.7:1. 6 0 0 2 t r o p e R l a u n n A . c n I , p u o r G s r e g a n a M d e t a i l i f f A 44 Supplemental Liquidity Measure common stock, make investments in new and existing As supplemental information, we provide information Affiliates, repay senior debt and make distributions to regarding our EBITDA, a non-GAAP liquidity measure. Affiliate managers. We expect that our principal uses of This measure is provided in addition to, but not as a substi- cash for the foreseeable future will be for investments in tute for, cash flow from operations. EBITDA represents new and existing Affiliates, distributions to Affiliate earnings before interest expense, income taxes, depreciation managers, payment of principal and interest on and amortization. EBITDA, as calculated by us, may not be outstanding debt, the repurchase of debt securities, the consistent with computations of EBITDA by other compa- repurchase of shares of our common stock and for working nies. As a measure of liquidity, we believe that EBITDA is capital purposes. useful as an indicator of our ability to service debt, make new investments and meet working capital requirements. Senior Revolving Credit Facility We further believe that many investors use this information We entered into an amended and restated senior revolving when analyzing the financial position of companies in the credit facility (the “Facility”) in February 2007, which investment management industry. allows us to borrow up to $650 million at rates of interest (based either on the Eurodollar rate or the prime rate as in The following table provides a reconciliation of cash flow effect from time to time) that vary depending on our credit 2.2 18.9 1.6 rate changes. Borrowings under the Facility are from operations to EBITDA: (in millions) Cash Flow 2004 2005 2006 from Operations $ 177.9 $ 204.1 $ 301.0 26.9 20.3 32.5 38.9 53.6 55.2 Interest expense, net of non-cash items(1) Current tax provision Income from equity method investments, net of distributions(2) Changes in assets and liabilities and other adjustments (40.9) (26.9) (69.3) EBITDA(3) $ 186.4 $ 267.5 $ 342.1 (1) Non-cash items represent amortization of issuance costs and interest accretion ($4.8, $4.9 and $5.2 million in 2004, 2005 and 2006, respectively). (2) Distributions from equity method investments were $0, $16.6 and $46.0 million for 2004, 2005 and 2006, respectively. (3) The definition of EBITDA is presented in Note 3 on page 39. In 2006, we met our cash requirements primarily through cash generated by operating activities, the issuance of convertible securities and borrowings of senior debt. Our principal uses of cash were to repurchase shares of our ratings. Subject to the agreement of the lenders (or prospec- tive lenders) to increase their commitments, we have the option to borrow up to an aggregate of $800 million under this Facility. The Facility will mature in February 2012, and contains financial covenants with respect to leverage and interest coverage. The Facility also contains customary affir- mative and negative covenants, including limitations on indebtedness, liens, cash dividends and fundamental corpo- collateralized by pledges of the substantial majority of our capital stock or other equity interests owned by us. As of December 31, 2006, we had $365.5 million outstanding under our prior Facility. Zero Coupon Senior Convertible Notes In May 2001, we issued $251 million principal amount at maturity of zero coupon senior convertible notes due 2021 (“zero coupon convertible notes”), with each note issued at 90.50% of such principal amount and accreting at a rate of 0.50% per year. Following the repurchase and conversion of $129.2 million principal amount of such notes, $121.8 million principal amount at maturity of zero coupon convertible notes remains outstanding. Each security is 45 convertible into 17.429 shares of our common stock (at a exceeds the base conversion price at the time of conversion, current base conversion price of $53.34) upon the occur- holders will receive additional shares of common stock rence of certain events, including the following: (i) if the based on the stock price at that time. Based on the trading closing price of a share of our common stock is more than a price of our common stock as of December 31, 2006, upon specified price over certain periods (initially $62.36 and conversion a holder of each security would receive an addi- increasing incrementally at the end of each calendar quarter tional 5.453 shares. The holders of the floating rate to $63.08 in April 2021); (ii) if the credit rating assigned by convertible securities may require us to repurchase such Standard & Poor’s to the securities is below BB-; or (iii) if we securities in February 2008, 2013, 2018, 2023 and 2028, call the securities for redemption. The holders may require at their principal amount. We may choose to pay the us to repurchase the securities at their accreted value in May, purchase price for such repurchases with cash, shares of our 2011 and 2016. If the holders exercise this option in the common stock or some combination thereof. We may future, we may elect to repurchase the securities with cash, redeem the convertible securities for cash at any time on or shares of our common stock or some combination thereof. after February 25, 2008, at their principal amount. Under We have the option to redeem the securities for cash at their the terms of the indenture governing the floating rate accreted value. Under the terms of the indenture governing convertible securities, a holder may convert such security the zero coupon convertible notes, a holder may convert into common stock by following the conversion procedures such security into common stock by following the conver- in the indenture; subject to changes in the price of our sion procedures in the indenture; subject to changes in the common stock, the floating rate convertible securities may price of our common stock, the zero coupon convertible not be convertible in certain future periods. notes may not be convertible in certain future periods. As further described in Note 11 to the Consolidated Financial In February 2006, we amended the zero coupon convert- Statements, we have entered into interest rate swap contracts ible notes. Under the terms of this amendment, we will pay that effectively exchange the variable interest rate for a fixed interest through May 7, 2008 at a rate of 0.375% per year interest rate on $150 million of the floating rate convertible on the principal amount at maturity of the notes in addi- securities. Through February 2008, we will pay a weighted tion to the accrual of the original issue discount. average fixed rate of 3.28% on that notional amount. Floating Rate Senior Convertible Securities The floating rate senior convertible securities are consid- In February 2003, we issued $300 million of floating rate ered contingent payment debt instruments under federal senior convertible securities due 2033 (“floating rate income tax regulations. These regulations require us to convertible securities”). The floating rate convertible secu- deduct interest in an amount greater than our reported rities bear interest at a rate equal to 3-month LIBOR minus interest expense, and results in annual deferred tax liabilities 0.50%, payable in cash quarterly. Each security is convert- of $3.9 million. These deferred tax liabilities will not reverse ible into shares of our common stock (at a base conversion if our common stock is trading above certain thresholds at price of $54.17) upon the occurrence of certain events, the time of the securities’ conversion. For example, if the including the following: (i) if the closing price of a share of securities converted on February 22, 2007, all of the related our common stock exceeds $65.00 over certain periods; (ii) deferred taxes would have been reclassified to equity if our if the credit rating assigned by Standard & Poor’s is below BB-; or (iii) if we call the securities for redemption. Upon common stock was trading at, or above, $60.90. As of February 22, 2007, the closing price of our common stock conversion, holders of the securities will receive 18.462 was $117.41 per share. shares of our common stock for each convertible security. In addition, if the market price of our common stock 6 0 0 2 t r o p e R l a u n n A . c n I , p u o r G s r e g a n a M d e t a i l i f f A 46 2004 Mandatory Convertible Securities Junior Convertible Trust Preferred Securities In February 2004, we issued $300 million of mandatory In April 2006, we issued $300 million of junior subordi- convertible securities (“2004 PRIDES”). As described nated convertible debentures due 2036 to a wholly-owned below, these securities are structured to provide $300 trust simultaneous with the issuance, by the trust, of $291 million of additional proceeds to us following a successful million of convertible trust preferred securities to investors. remarketing and the exercise of forward purchase contracts Under FASB Interpretation No. 46 (revised), in February 2008. “Consolidation of Variable Interest Entities,” the trust is not consolidated in our financial statements. The junior Each unit of the 2004 PRIDES consists of (i) a senior note subordinated convertible debentures and convertible trust due February 2010 with a principal amount of $1,000 per preferred securities (together, the “junior convertible trust note, on which we pay interest quarterly at the annual rate preferred securities”) have substantially the same terms. of 4.125%, and (ii) a forward purchase contract pursuant to which the holder has agreed to purchase shares of our The junior convertible trust preferred securities bear common stock in February 2008. Holders of the purchase interest at 5.1% per annum, payable in cash quarterly. Each contracts receive a quarterly contract adjustment payment $50 security is convertible, at any time, into 0.333 shares of at the annual rate of 2.525% per $1,000 purchase contract. our common stock, which represents a conversion price of The current portion of the contract adjustment payments, $150 per share. Upon conversion, investors will receive approximately $6.0 million, is recorded in current liabili- cash or shares of our common stock (or a combination of ties. The number of shares to be issued in February 2008 cash and common stock) at our election. The junior will be determined based upon the average trading price of convertible trust preferred securities may not be redeemed our common stock for a period preceding that date. by us prior to April 15, 2011. On or after April 15, 2011, Depending on the average trading price in that period, the the junior convertible trust preferred securities may be settlement rate will range from 11.785 to 18.031 shares per redeemed if the closing price of our common stock exceeds $1,000 purchase contract. Based on the trading price of our $195 for a specified period of time. The trust’s only assets common stock as of December 31, 2006, the purchase are the junior convertible subordinated debentures. To the contracts would have a settlement rate of 12.990. extent the trust has available funds, we are obligated to ensure that holders of the convertible trust preferred securi- Each of the senior notes is pledged to us to collateralize the ties receive all payments due from the trust. holder’s obligations under the forward purchase contracts. Under the terms of the 2004 PRIDES, the senior notes are The junior convertible trust preferred securities are consid- expected to be remarketed to new investors. A successful ered contingent payment debt instruments under the remarketing will generate $300 million of gross proceeds to federal income tax regulations. As with our floating rate be used by the original holders of the 2004 PRIDES to convertible securities, we are required to deduct interest in fulfill their obligations on the forward purchase contracts. an amount greater than our reported interest expense. In exchange for the additional $300 million payment on These deductions generate deferred taxes of approximately the forward purchase contracts, we will issue shares of our $2.6 million per year. common stock to the original holders of the senior notes. As referenced above, the number of shares of common stock to be issued will be determined by the market price of Call Spread Option Agreements In March 2006, we entered into a series of call spread our common stock at that time. Assuming a successful option agreements with a major securities firm. The agree- remarketing, the senior notes will remain outstanding until ments provide us the option, but not the obligation, to at least February 2010. repurchase up to 917,000 shares of our common stock, 47 beginning in June 2007 and ending in December 2007, at other forms of consideration. Affiliate management part- a weighted-average price of $99.59 per share. If our ners are also permitted to sell their equity interests to other prevailing share price exceeds $132.74, on a weighted- individuals or entities in certain cases, subject to our average basis during this period, the net number of shares approval or other restrictions. These potential purchases, available for repurchase under the agreements will be less combined with our other cash needs, may require more than 917,000. cash than is available from operations, and therefore, we may need to raise capital by making borrowings under our In the event we elect to exercise our option, we may elect to Facility, by selling shares of our common stock or other receive cash proceeds rather than shares of common stock. equity or debt securities, or to otherwise refinance a portion In connection with this arrangement, we made payments of of these purchases. approximately $13.3 million, which were recorded as a reduction of stockholders’ equity. Operating Cash Flow Purchases of Affiliate Equity Cash flow from operations generally represents net income plus non-cash charges and changes from our consolidated Many of our Affiliate operating agreements provide our working capital. The increase in cash flow from operations Affiliate managers the conditional right to require us to in 2006 and 2005 resulted principally from increases in net purchase their retained equity interests at certain intervals. income and distributions from our equity method affiliates. These agreements also provide us a conditional right to require Affiliate managers to sell their retained equity inter- In 2006, in accordance with EITF 04-05, we consolidated ests to us upon their death, permanent incapacity or $108.4 million of client assets held in partnerships controlled termination of employment and provide Affiliate managers by our Affiliates. Purchases and sales of these client assets a conditional right to require us to purchase such retained generated $7.7 million of operating cash flow in 2006. This equity interests upon the occurrence of specified events. operating cash flow was offset by a corresponding financing These purchases may occur in varying amounts over a cash flow to the minority partners. period of approximately 15 years (or longer), and the actual timing and amounts of such purchases (or the actual occur- Investing Cash Flow rence of such purchases) generally cannot be predicted with Changes in net cash flow from investing activities result any certainty. These purchases are generally calculated primarily from our investments in new and existing based upon a multiple of the Affiliate’s cash flow distribu- Affiliates. Net cash flow used to make investments was tions at the time the right is exercised, which is intended to $474.1 million, $85.2 million and $123.3 million for represent fair value. As one measure of the potential magni- 2004, 2005 and 2006, respectively. In 2004, we acquired tude of such purchases, in the event that a triggering event interests in Genesis, TimesSquare and AQR, and additional and resulting purchase occurred with respect to all such interests in existing Affiliates. In 2005, we acquired inter- retained equity interests as of December 31, 2006, the ests in a group of Canadian Affiliates, as well as additional aggregate amount of these payments would have totaled equity interests in existing Affiliates. In 2006, we acquired approximately $1,324.8 million. In the event that all such an interest in Chicago Equity Partners, LLC, as well as transactions were consummated, we would own the cash additional equity interests in existing Affiliates. flow distributions attributable to the additional equity interests purchased from our Affiliate managers. As of In conjunction with certain acquisitions, we have entered December 31, 2006, this amount would represent approx- into agreements and are contingently liable, upon achieve- imately $170.4 million on an annualized basis. We may pay ment of specified financial targets, to make additional for these purchases in cash, shares of our common stock or purchase payments of up to $165 million through 2011. 6 0 0 2 t r o p e R l a u n n A . c n I , p u o r G s r e g a n a M d e t a i l i f f A 48 The specified financial targets for certain agreements will be In accordance with Statement of Financial Accounting measured beginning December 31, 2007. In the event the Standards No. 123 (revised 2004), “Share-Based Payment” first financial target is achieved, we will make a payment of (“FAS 123R”), beginning in 2006, certain tax benefits asso- up to $50 million in 2008. ciated with stock options ($23.0 million) have been reported as financing cash flows. Financing Cash Flow Net cash flows used in financing activities decreased $47.2 The change in net cash flow from financing activities in 2005 million in 2006 from 2005, primarily as a result of $536.5 from 2004 was primarily attributable to the repayment of million of repurchases of our common stock, a use of cash $150.8 million of debt at AMG Canada in connection with that was financed by our $300 million issuance of junior our 2005 investment, as well as the net effect of higher convertible trust preferred securities and a net increase of common stock repurchases relative to issuances of common borrowings under our facility. stock. This increase was partially offset by $124.5 million of net borrowings under our Facility. Contractual Obligations The following table summarizes our contractual obligations as of December 31, 2006: (in millions) Senior debt(1) Senior convertible debt(1) Mandatory convertible securities(1)(2) Junior convertible trust preferred securities(1)(2) Purchases of Affiliate equity(3) Leases Other liabilities(4) Total Total $ 365.5 428.1 347.5 748.2 1,324.8 114.5 42.4 $ 3,371.0 Payments Due 2007 2008-2009 2010-2011 Thereafter $ — 5.4 20.0 15.3 121.6 18.7 41.1 $ 222.1 $ — 0.9 25.8 30.6 529.4 35.6 1.3 $ 623.6 $ 365.5 — 301.7 30.6 259.2 27.0 — $ 984.0 $ — 421.8 — 671.7 414.6 33.2 — $1,541.3 (1) The timing of debt payments assumes that outstanding debt is settled for cash or common stock at the applicable maturity dates. The amounts include the cash payment of fixed interest. (2) As more fully discussed on page 44, consistent with industry practice, we do not consider our mandatory convertible securities or our junior convert- ible trust preferred securities as debt for the purpose of determining our leverage ratio. (3) Purchases of Affiliate equity reflect our estimates of conditional purchases of additional equity in our Affiliates and assume that all conditions to such purchases are met and that such purchases will all be effected on the date that they are first exercisable. As described previously, these purchases may occur in varying amounts over the next 15 years (or longer), and the actual timing and amounts of such purchases (or the actual occurrence of such purchases) generally cannot be predicted with any certainty. Additionally, in many instances we have the discretion to settle these purchases with our common stock and in all cases can consent to the transfer of these interests to other individuals or entities. As one measure of the potential magni- tude of such purchases, assuming that all such purchases had been effected as of December 31, 2006, the aggregate purchase amount would have totaled approximately $1,324.8 million. Assuming the closing of such additional purchases, we would own the prospective cash flow distributions associated with all additional equity so purchased, estimated to be approximately $170.4 million on an annualized basis as of December 31, 2006. (4) Other liabilities reflect amounts payable to Affiliate managers related to our purchase of additional Affiliate equity interests. 49 Interest Rate Sensitivity February 2008. The unrealized gain on these interest rate Our revenue is derived primarily from fees which are based swap contracts as of December 31, 2006 was $2.4 million. on the values of assets managed. Such values are affected by We estimate that a 100 basis point (1%) change in interest changes in the broader financial markets which are, in part, rates as of December 31, 2006 would result in a net change affected by changing interest rates. We cannot predict the in the unrealized value of approximately $1.8 million. effects that interest rates or changes in interest rates may There can be no assurance that our hedging contracts will have on either the broader financial markets or our meet their overall objective of reducing our interest expense Affiliates’ assets under management and associated fees. or that we will be successful in obtaining hedging contracts in the future on our existing or any new indebtedness. We pay a variable rate of interest on our senior revolving credit facility ($365.5 million outstanding as of December We operate primarily in the United States, and accordingly 31, 2006) and on $150 million of our floating rate senior most of our consolidated revenue and associated expenses convertible securities. Based on these variable rate borrow- are denominated in U.S. dollars. We also provide services ings, we estimate that a 100 basis point (1%) change in and earn revenue outside of the United States; therefore, interest rates would result in a net annual change to interest the portion of our revenue and expenses denominated in expense of approximately $5.2 million. foreign currencies may be impacted by movements in currency exchange rates. The valuations of our foreign We have fixed rates of interest on the senior notes compo- Affiliates are impacted by fluctuations in foreign exchange nent of our 2004 PRIDES, our zero coupon senior rates, which could be recorded as a component of convertible notes and our junior convertible trust preferred Stockholders’ equity. To illustrate the effect of possible securities. While a change in market interest rates would changes in currency exchange rates, as of December 31, not affect the interest expense incurred on these securities, 2006, we estimate that a 1% change in the Canadian dollar such a change may affect the fair value of these securities. to U.S. dollar exchange rate would result in a change to We estimate that a 100 basis point (1%) change in interest Stockholders’ equity of approximately $3.0 million. rates as of December 31, 2006 would result in a net change in the fair value of our securities of approximately $6.0 million at December 31, 2006. Market Risk Our revenue is based on the market value of assets under management. Declines in the financial markets will nega- tively impact our revenue and net income. From time to time, we seek to offset our exposure to changing interest rates under our debt financing arrange- ments by entering into interest rate hedging contracts. As of December 31, 2006, we were a party, with three major commercial banks as counterparties, to $150 million notional amount interest rate swap contracts which fix the interest rate on a portion of our floating rate senior convert- ible securities to a weighted average interest rate of approximately 3.28% for the period from February 2005 to Recent Accounting Developments In July 2006, the Financial Accounting Standards Board (“FASB”) released FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpre- tation of FASB Statement No. 109” (“FIN 48”), which will become effective in the first quarter of 2007. FIN 48 provides a comprehensive model for the accounting and disclosure of uncertain income tax return positions. We have completed our initial evaluation of the impact of FIN 48 and believe that it will not have a material impact on our financial position or results of operations. In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (“FAS 157”), which will become effective in the first quarter 6 0 0 2 t r o p e R l a u n n A . c n I , p u o r G s r e g a n a M d e t a i l i f f A 50 of 2008. FAS 157 establishes a framework for measuring fair In these valuations, we make assumptions of the growth value. We are in the process of evaluating the potential future rates and useful lives of existing and prospective client effect of FAS 157 on our financial statements. accounts. Additionally, we make assumptions of, among other factors, projected future earnings and cash flow, valu- In February 2007, the FASB issued Statement of Financial ation multiples, tax benefits and discount rates. In certain Accounting Standards No. 159, “The Fair Value Option for instances, we engage third-party consultants to perform Financial Assets and Financial Liabilities - Including an independent evaluations. The impact of many of these amendment of FASB Statement No. 115” (“FAS 159”). assumptions are material to our financial condition and FAS 159 permits companies to measure many financial operating performance and, at times, are subjective. If we instruments and certain other items at fair value. We can used different assumptions, the carrying value of our equity elect to adopt the provisions of FAS 159 either in the first method investments, our intangible assets and the related quarter of 2007 or the first quarter of 2008. We are in the amortization could be stated differently and our impair- process of evaluating the potential future effect of FAS 159 ment conclusions could be modified. Additionally, the use on our financial statements. of different assumptions to value our minority interests could change the amount of compensation expense, if any, Critical Accounting Estimates and Judgments we report upon their transfer. The preparation of financial statements and related disclo- sures in conformity with accounting principles generally accepted in the United States requires us to make judg- ments, assumptions, and estimates that affect the amounts Intangible Assets At December 31, 2006, the carrying amounts of our intan- gible asset balances are as follows: reported in the Consolidated Financial Statements and (in millions) accompanying notes. Note 1 to the Consolidated Financial Statements describes the significant accounting policies and methods used in the preparation of the Consolidated Financial Statements. We consider the accounting policies described below to be our critical accounting estimates and judgments. These policies are affected significantly by judg- ments, assumptions, and estimates used in the preparation of the Consolidated Financial Statements and actual results could differ materially from the amounts reported based on these policies. Valuation In allocating the purchase price of our investments and testing our assets for impairment, we make estimates and assumptions to determine the value of our acquired client relationships, operating segments, and equity method investments. We also assess the value of minority interests held by our Affiliate managers in establishing the terms for their transfer. Definite-lived acquired client relationships Indefinite-lived acquired client relationships Goodwill $ 243.3 258.8 1,177.2 These amounts exclude $86.3 million of definite-lived acquired client relationships, and $185.3 million of goodwill that are reported within Equity investments in Affiliates. We amortize our definite-lived acquired client relationships over their expected useful lives. We reassess these lives each quarter based on historical and projected attrition rates and other events and circumstances that may influence the expected future economic benefit we will derive from the relationships. Significant judgment is required to estimate the period that these assets will contribute to our cash flows and the pattern over which these assets will be consumed. A change in the remaining useful life of any of these assets could have a significant impact on the amount of our amor- tization expense. For example, if we reduced the weighted average remaining life of our definite-lived acquired client 51 relationships by one year, our amortization expense would fair value of the investment has declined below its carrying increase by approximately $2.4 million per year. We assess value for a period considered to be other than temporary. each of our definite-lived acquired client relationship for Additionally, we would consider the magnitude of any impairment at least annually by comparing their carrying decline in market value and the expected holding period of value to their projected undiscounted cash flows. In the the investment. fourth quarter of 2006, we performed our most recent annual impairment test, and no impairments were identified. If we determine that a decline in market value below our carrying value is other than temporary, an impairment We do not amortize our indefinite-lived acquired client charge would be recognized in the Consolidated Statements relationships because we expect these contracts will of Income to write down the carrying value of the invest- contribute to our cash flows indefinitely. Each quarter, we ment to its fair value. In the fourth quarter of 2006, we assess whether events and circumstances have occurred that completed our evaluation of investments accounted for indicate these relationships might have a definite life. We under the equity method and no impairment was identified. test the carrying amount of each of our indefinite-lived acquired client relationships at least annually, or at such Deferred Taxes time that we conclude the assets no longer have an indefi- Our deferred tax liabilities are generated primarily from nite life by comparing the carrying amount of each asset to tax-deductible intangible assets and from our convertible its fair value. We derive the fair value of each of our indefi- securities. As more fully described below, we generally nite-lived acquired client relationships primarily based on believe that our intangible-related deferred taxes are discounted cash flow analysis. Our valuation analysis unlikely to reverse, and believe that the deferred tax liabili- reflects assumptions of the growth of the assets, discount ties for our floating rate convertible securities and the rates and other factors. Changes in the estimates used in junior convertible trust preferred securities may not reverse. these valuations could materially affect the impairment As such, we currently believe the economic benefit we conclusion. In the fourth quarter of 2006, we performed realize from these sources will be permanent. our most recent annual impairment test and no impair- ments were identified. Most of our intangible assets are tax-deductible because we generally structure our Affiliate investments as cash transac- We test the carrying amount of the goodwill in each of our tions that are taxable to the sellers. Intangible assets three operating segments at least annually by comparing associated with our 2005 investment in AMG Canada, their carrying amount to an estimate of fair value. We however, are not deductible for tax purposes. We record establish the fair value of each of our operating segments deferred taxes because a substantial majority of our intan- primarily based on price-earnings multiples. Changes in the gible assets do not amortize for financial statement estimates used in this test could materially affect our purposes, but do amortize for tax purposes, thereby impairment conclusion. In the third quarter of 2006, we creating tax deductions that reduce our current cash taxes. performed our most recent annual impairment test and no These liabilities will reverse only in the event of a sale of an impairment was identified. Equity Method Investments We account for certain of our Affiliate investments under Affiliate or an impairment charge, events we consider unlikely to occur. Under current accounting rules, we are required to accrue the estimated cost of such a reversal as a deferred tax liability. As of December 31, 2006, our esti- the equity method of accounting. Accordingly, we evaluate mate of the tax liability associated with such a sale or these investments for impairment by assessing whether the impairment charge was approximately $170.2 million. 6 0 0 2 t r o p e R l a u n n A . c n I , p u o r G s r e g a n a M d e t a i l i f f A 52 As discussed above, our floating rate convertible securities the exercise price of all stock options granted equaled the and our junior convertible trust preferred securities market price of the underlying stock on the grant date of generate deferred tax liabilities ($6.5 million annually) the award. because our interest deductions for tax purposes are greater than our reported interest expense. We believe that some or In 2006, we adopted the fair value recognition provisions of all of these deferred tax liabilities will be reclassified to FAS 123R using the modified prospective transition equity as the securities are likely to convert to common method. FAS 123R requires a company to recognize share- stock when our stock price exceeds specified levels. If the based compensation, based on the fair value of the awards floating rate convertible securities had converted on on the grant date. Under the modified prospective method, February 22, 2007, all of the deferred liabilities ($13.7 compensation is recognized in the financial statements for million as of December 31, 2006) would be reclassified to all share-based payments granted after that date, and for all equity if our stock price was at, or above, $60.90 per share. awards that are unvested upon adoption of FAS 123R. As of February 22, 2007, the closing price of our common stock was $117.41 per share. Under FAS 123R, we estimate the fair value of stock option awards using the Black-Scholes option pricing model. The In addition, we also regularly assess our deferred tax assets, Black-Scholes model requires us to make assumptions about which consist primarily of state tax loss carryforwards, in the volatility of our common stock and the expected life of order to determine the need for valuation allowances. In our our stock options based on past experience and anticipated assessment we make assumptions about future taxable income future trends. As an example, we considered both the histor- that may be generated to utilize these assets, which have ical volatility of our common stock and the implied volatility limited lives. If we determine that we are unlikely to realize from traded options in determining expected volatility. the benefit of a deferred tax asset, we would establish a valua- tion allowance that would increase our tax expense in the Our options typically vest and become fully exercisable over period of such determination. As of December 31, 2006, we three to four years of continued employment and do not had a valuation allowance for all state tax loss carryforwards. include performance-based or market-based vesting condi- Changes in our tax position could have a material impact service period, we recognize expense, net of expected forfei- on our earnings. For example, a 1% increase to our statu- tures, on a straight-line basis over the requisite service tions. For grants that are subject to graded vesting over a tory tax rate attributable to our deferred tax liabilities period for the entire award. would result in an increase of approximately $5.9 million in our tax expense in the period of such determination. As of December 31, 2006, we had $28.2 million in Share-Based Compensation remaining unrecognized compensation cost related to stock option grants, which will be recognized over a We have share-based compensation plans covering senior weighted-average period of approximately three years management, employees and directors. Prior to 2006, we (assuming no forfeitures). accounted for stock-based compensation using the intrinsic value method described in Accounting Principles Board Revenue Recognition Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) and related Interpretations. The majority of our consolidated revenue represents advisory fees (asset-based and performance-based). Our Affiliates Accordingly, no compensation expense was recognized recognize asset-based advisory fees quarterly as they render during this period from share-based compensation plans as services to their clients. In addition to generating asset-based 53 fees, over 30 Affiliate products, representing approximately and that aggregate mutual fund assets, particularly those in $28 billion of assets under management, also bill on the basis equity mutual funds, will continue to increase in line with of absolute investment performance (“performance fees”). long-term market growth. These products, which are primarily in the Institutional distribution channel, are generally structured to have returns Assets in the Institutional distribution channel in the that are not directly correlated to changes in broader equity United States are primarily in retirement plans, including indices and, if earned, the performance fee component is both defined benefit and defined contribution plans, typically billed less frequently than the asset-based fee. Our endowments and foundations, and totaled approximately Affiliates recognize performance fees only when the fee $8.9 trillion as of June 30, 2006. Although the majority of becomes billable. Although performance fees inherently Institutional assets are in equities (estimated to be 60% in depend on investment results and will vary from period to 2005), allocations to alternative investments have period, we anticipate performance fees to be a recurring continued to increase. According to a recent study of insti- component of our revenue. Economic and Market Conditions Global Asset Management Industry The asset management industry has been a key driver of growth in financial services over the last decade. According to the most recent available data, assets under management across all distribution channels globally total approximately $49.6 trillion, of which $24.7 trillion is managed in the United States. We believe prospects for overall industry growth (which have compounded at an annual rate of 9% globally over the past five years) remain strong. We expect that this growth will be driven by market-related increases in assets under management, broad demographic trends and wealth creation related to growth in gross domestic product, and will be experienced in varying degrees across each of the principal distribution channels for our Affiliates’ products. U.S. Asset Management Industry In the Mutual Fund distribution channel, according to a 2006 industry report, more than 96 million individuals in almost 55 million households in the United States are invested in mutual funds. In 2006, net cash flows to equity mutual funds totaled over $232 billion, and aggregate mutual fund assets totaled $9.9 trillion at the end of 2006. We anticipate that inflows to mutual funds will continue tutional investors, allocations of institutional assets to hedge funds (a core component of alternative investments) have grown from 2.5% of assets in 2001 to 7.7% in 2005, and are expected to increase to 9.1% by 2007. We antici- pate that the combination of an aging work force and long-term market growth should contribute to the ongoing strength of this distribution channel. The High Net Worth distribution channel is comprised broadly of high net worth and affluent individuals, family trusts and managed accounts. Within this channel, high net worth families and individuals (those having at least $1 million in investable assets) in the United States had aggre- gate assets of $10.2 trillion at the end of 2005; industry experts expect assets in this segment of the channel to grow to $14.5 trillion by the end of 2010. We believe that affluent individuals (those having between $250,000 and $1 million in investable assets) represent an important source of asset growth within the High Net Worth channel, as the number of such individuals and the amount of investable assets increases, and the popularity of separately managed account investment products for affluent individ- uals continues to grow. According to a recent industry report, assets in separately managed accounts totaled approximately $805.8 billion at the end of 2006 (a nearly 25% increase over year end 2005) and are expected to reach $1.5 trillion by 2011. 6 0 0 2 t r o p e R l a u n n A . c n I , p u o r G s r e g a n a M d e t a i l i f f A 54 International Operations Inflation We have international operations through Affiliates who We do not believe that inflation or changing prices have provide some or a significant part of their investment had a material impact on our results of operations. See management services to non-U.S. clients. In February “Market Risk”. Quantitative and Qualitative Disclosures About Market Risk For quantitative and qualitative disclosures about how we are affected by market risk, see “Market Risk.” 2007, we established a subsidiary, AMG Pty Ltd (“AMG Australia”) and opened an office in Sydney, Australia. Through AMG Australia, we provide client and marketing services to participating Affiliates with respect to their busi- ness interests in Australia and New Zealand. In the future, we may invest in other investment management firms which conduct a significant part of their operations outside of the United States. There are certain risks inherent in doing business internationally, such as changes in appli- cable laws and regulatory requirements, difficulties in staffing and managing foreign operations, longer payment cycles, difficulties in collecting investment advisory fees receivable, different and in some cases, less stringent, regu- latory and accounting regimes, political instability, fluctuations in currency exchange rates, expatriation controls, expropriation risks and potential adverse tax consequences. There can be no assurance that one or more of such factors will not have a material adverse effect on our affiliated investment management firms that have international operations or on other investment manage- ment firms in which we may invest in the future and, consequently, on our business, financial condition and results of operations. 55 S e l e c t e d F i n a n c i a l D a t a Set forth below are selected financial data for the last five years. This data should be read in conjunction with, and is qualified in its entirety by reference to, the Consolidated Financial Statements and accompanying notes included elsewhere in this Annual Report. (in thousands, except as indicated and per share data) 2002 2003 2004 2005 2006 For the Years Ended December 31, Statement of Income Data Revenue Net Income Earnings per share—diluted Average shares outstanding—diluted Other Financial Data Assets under Management (at period end, in millions) Cash Flow from (used in): Operating activities Investing activities Financing activities EBITDA(1) Cash Net Income(2) Balance Sheet Data Total assets(3) Intangible assets(3) Equity investments in Affiliates(4) Affiliate investments in partnerships(5) Minority interest in Affiliate investments in partnerships(5) Senior debt(6) Senior convertible debt(7) Mandatory convertible securities Junior convertible trust preferred securities Other long-term obligations(8) Stockholders’ equity $ 482,536 55,942 1.52 38,241 $ 495,029 60,528 1.57 40,113 $ 659,997 77,147 2.02 39,645 $ 916,492 119,069 2.81 44,690 $ 1,170,353 151,277 3.74 45,159 $ 70,809 $ 91,524 $ 129,802 $ 184,310 $ 241,140 $ 127,300 (138,917) (34,152) 138,831 99,552 $ 116,515 (73,882) 153,697 147,215 104,944 $ 177,886 (478,266) 215,243 186,434 126,475 $ 204,078 (82,029) (122,267) 267,463 186,103 $ 301,003 (165,079) (75,082) 342,118 222,454 $ 1,242,994 1,113,064 — 1,034 $ 1,519,205 1,116,036 — 2,303 $ 1,933,421 1,328,976 252,597 4,594 $ 2,321,636 1,576,941 301,476 5,079 $ 2,665,920 1,679,293 293,440 108,350 — — 229,023 230,000 — 87,860 571,861 — — 423,340 230,000 — 108,851 614,769 — 126,750 423,958 300,000 — 155,565 707,692 — 241,250 424,232 300,000 — 202,772 817,381 104,096 365,500 413,358 300,000 300,000 229,793 499,222 (1) The definition of EBITDA is presented in Note 3 on page 39. Our use of EBITDA, including a reconciliation to cash flow from operations, is discussed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” (2) Cash Net Income is defined as Net Income plus amortization and deferred taxes related to intangible assets plus Affiliate depreciation. We consider Cash Net Income an important measure of our financial performance, as we believe it best represents operating performance before non-cash expenses relating to the acquisition of interests in our affiliated investment management firms. Cash Net Income is not a measure of financial performance under generally accepted accounting principles and, as calculated by us, may not be consistent with computations of Cash Net Income by other companies. Our use of Cash Net Income, including a reconciliation of Cash Net Income to Net Income, is discussed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” In 2003, in connection with our issuance of convertible securities, we modified this definition to clarify that deferred taxes relating to convertible securities and certain depreciation are not added back for the calculation of Cash Net Income. If we had used our current definition for 2002, Cash Net Income would have been $97.6 million. (3) Intangible and total assets have increased as we have made new or additional investments in affiliated investment management firms. (4) In 2004 and 2005, we acquired minority interests in certain Affiliates that are accounted for under the equity method of accounting. This balance consists primarily of intangible assets associated with these investments. (5) In 2006, we implemented Emerging Issues Task Force Issue 04-05, “EITF 04-05” (see Note 1 to the Consolidated Financial Statements). In accor- dance with EITF 04-05, we have consolidated $108,350 of client assets held in partnerships controlled by its Affiliates. These assets are reported as “Affiliate investments in partnerships;” substantially all of these assets, $104,096, are held by investors that are unrelated to us, and are reported as “Minority interest in Affiliate investments in partnerships.” (6) Senior debt consists of outstanding borrowings under our senior revolving credit facility and, until November 2006, our Senior Notes due 2006. As further discussed in Note 24 to the Consolidated Financial Statements, we entered into an amended and restated credit facility in February 2007. (7) Senior convertible debt consists of our zero coupon senior convertible notes, and beginning in 2003, our floating rate senior convertible securities. (8) Other long-term obligations consist principally of deferred income taxes, payables to related parties and the contract adjustment payment liability of our 2004 mandatory convertible securities. 6 0 0 2 t r o p e R l a u n n A . c n I , p u o r G s r e g a n a M d e t a i l i f f A 5656 M a n a g e m e n t ’ s R e p o r t o n I n t e r n a l C o n t r o l O v e r F i n a n c i a l R e p o r t i n g Management of Affiliated Managers Group, Inc. (the As of December 31, 2006, management conducted an “Company”), is responsible for establishing and main- assessment of the effectiveness of the Company’s internal taining adequate internal control over financial reporting. control over financial reporting based on the framework The Company’s internal control over financial reporting established in Internal Control—Integrated Framework processes are designed under the supervision of the issued by the Committee of Sponsoring Organizations of Company’s chief executive and chief financial officers to the Treadway Commission (“COSO”). Based on this assess- provide reasonable assurance regarding the reliability of ment, management has determined that the Company’s financial reporting and the preparation of the Company’s internal control over financial reporting as of December 31, financial statements for external reporting purposes in 2006 was effective. accordance with accounting principles generally accepted in the United States. As permitted by the Sarbanes-Oxley Act of 2002, the Company has excluded Chicago Equity Partners, LLC Our internal control over financial reporting includes poli- from its assessment of internal control over financial cies and procedures that pertain to the maintenance of reporting because the Company acquired its interest in this records that, in reasonable detail, accurately and fairly Affiliate in December 2006. The total assets and revenue of reflect transactions and dispositions of assets; provide Chicago Equity Partners, LLC represent 4% and 0.1%, reasonable assurances that transactions are recorded as respectively, of the related consolidated financial statement necessary to permit preparation of financial statements in amounts as of and for the year ended December 31, 2006. accordance with accounting principles generally accepted in the United States, and that receipts and expenditures are Management’s assessment of the effectiveness of the being made only in accordance with authorizations of Company’s internal control over financial reporting as of management and the directors of the Company; and December 31, 2006 has been audited by provide reasonable assurance regarding prevention or PricewaterhouseCoopers LLP, an independent registered timely detection of unauthorized acquisition, use or dispo- public accounting firm, as stated in their report beginning sition of the Company’s assets that could have a material on page 58 of this Annual Report. effect on our financial statements. 57 R e p o r t o f I n d e p e n d e n t R e g i s t e r e d P u b l i c A c c o u n t i n g F i r m To the Board of Directors and Stockholders of Affiliated Managers Group, Inc.: We have completed integrated audits of Affiliated Managers significant estimates made by management, and evaluating Group, Inc.’s consolidated financial statements and of its the overall financial statement presentation. We believe that internal control over financial reporting as of December 31, our audits provide a reasonable basis for our opinion. 2006, in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our Internal control over financial reporting opinions, based on our audits, are presented below. Also, in our opinion, management’s assessment, included in Consolidated financial statements Management’s Report on Internal Control Over Financial Reporting appearing on page 57 of this Annual Report, that In our opinion, the accompanying consolidated balance the Company maintained effective internal control over sheets and the related consolidated statements of income, financial reporting as of December 31, 2006, based on changes in stockholders’ equity and cash flows present fairly, criteria established in Internal Control—Integrated in all material respects, the financial position of Affiliated Framework issued by the Committee of Sponsoring Managers Group, Inc. (the "Company") at December 31, Organizations of the Treadway Commission (“COSO”), is 2006 and December 31, 2005, and the results of its opera- fairly stated, in all material respects, based on those criteria. tions and its cash flows for each of the three years in the Furthermore, in our opinion, the Company maintained, in period ended December 31, 2006 in conformity with all material respects, effective internal control over financial accounting principles generally accepted in the United reporting as of December 31, 2006, based on criteria estab- States of America. These financial statements are the respon- lished in Internal Control—Integrated Framework issued by sibility of the Company’s management. Our responsibility is the COSO. The Company’s management is responsible for to express an opinion on these financial statements based on maintaining effective internal control over financial reporting our audits. We conducted our audits of these statements in and for its assessment of the effectiveness of internal control accordance with the standards of the Public Company over financial reporting. Our responsibility is to express opin- Accounting Oversight Board (United States). Those stan- ions on management’s assessment and on the effectiveness of dards require that we plan and perform the audit to obtain the Company’s internal control over financial reporting reasonable assurance about whether the financial statements based on our audit. We conducted our audit of internal are free of material misstatement. An audit of financial state- control over financial reporting in accordance with the stan- ments includes examining, on a test basis, evidence dards of the Public Company Accounting Oversight Board supporting the amounts and disclosures in the financial (United States). Those standards require that we plan and statements, assessing the accounting principles used and perform the audit to obtain reasonable assurance about 6 0 0 2 t r o p e R l a u n n A . c n I , p u o r G s r e g a n a M d e t a i l i f f A 58 whether effective internal control over financial reporting Because of its inherent limitations, internal control over was maintained in all material respects. An audit of internal financial reporting may not prevent or detect misstatements. control over financial reporting includes obtaining an under- Also, projections of any evaluation of effectiveness to future standing of internal control over financial reporting, periods are subject to the risk that controls may become inad- evaluating management’s assessment, testing and evaluating equate because of changes in conditions, or that the degree of the design and operating effectiveness of internal control, compliance with the policies or procedures may deteriorate. and performing such other procedures as we consider neces- sary in the circumstances. We believe that our audit provides As described in Management’s Report on Internal Control a reasonable basis for our opinions. Over Financial Reporting, management has excluded Chicago Equity Partners, LLC from its assessment of A company’s internal control over financial reporting is a internal control over financial reporting as of December 31, process designed to provide reasonable assurance regarding 2006 because the Company acquired the affiliate in a the reliability of financial reporting and the preparation of purchase business combination during 2006. We have also financial statements for external purposes in accordance excluded Chicago Equity Partners, LLC from our audit of with generally accepted accounting principles. A company’s internal control over financial reporting. Chicago Equity internal control over financial reporting includes those poli- Partners, LLC is a consolidated affiliate whose total assets cies and procedures that (i) pertain to the maintenance of and total revenues represent 4% and 0.1%, respectively, of records that, in reasonable detail, accurately and fairly reflect the related consolidated financial statement amounts as of the transactions and dispositions of the assets of the and for the year ended December 31, 2006. company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial As discussed in Note 1 to the consolidated financial state- statements in accordance with generally accepted ments, the Company adopted Statement of Financial accounting principles, and that receipts and expenditures of Accounting Standards No. 123 (revised 2004), Share-Based the company are being made only in accordance with Payment, effective January 1, 2006. authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a Boston, Massachusetts material effect on the financial statements. March 1, 2007 59 C o n s o l i d a t e d S t a t e m e n t s o f I n c o m e (dollars in thousands, except per share data) Revenue Operating expenses: Compensation and related expenses Selling, general and administrative Amortization of intangible assets Depreciation and other amortization Other operating expenses Operating income Non-operating (income) and expenses: Investment and other income Income from equity method investments Investment income from Affiliate investments in partnerships Interest expense Income before minority interest and income taxes Minority interest Minority interest in Affiliate investments in partnerships Income before income taxes Income taxes—current Income taxes—intangible-related deferred Income taxes—other deferred Net Income Earnings per share—basic Earnings per share—diluted Average shares outstanding—basic Average shares outstanding—diluted Supplemental disclosure of total comprehensive income: Net Income Other comprehensive income (loss) Total comprehensive income The accompanying notes are an integral part of the Consolidated Financial Statements. For the Years Ended December 31, 2004 2005 2006 $ 659,997 $ 916,492 $ 1,170,353 241,633 109,066 18,339 6,369 16,708 392,115 267,882 (6,926) (1,265) (269) 31,725 23,265 244,617 (115,524) — 129,093 20,330 25,791 5,825 77,147 2.57 2.02 29,994,560 39,644,676 77,147 593 77,740 $ $ $ $ $ 365,960 162,078 24,873 7,029 21,497 581,437 335,055 (8,871) (26,970) (445) 37,426 1,140 333,915 (144,263) — 189,652 38,895 28,791 2,897 119,069 3.54 2.81 33,667,542 44,689,655 119,069 15,219 134,288 $ $ $ $ $ 472,400 184,019 27,378 8,763 23,880 716,440 453,913 (16,943) (38,318) (3,400) 58,800 139 453,774 (212,523) (3,364) 237,887 55,267 28,779 2,564 151,277 4.83 3.74 31,289,005 45,159,002 151,277 (2,090) 149,187 $ $ $ $ $ 6 0 0 2 t r o p e R l a u n n A . c n I , p u o r G s r e g a n a M d e t a i l i f f A 60 C o n s o l i d a t e d B a l a n c e S h e e t s (in thousands) Assets Current assets: Cash and cash equivalents Investment advisory fees receivable Affiliate investments in partnerships Affiliate investments in marketable securities Prepaid expenses and other current assets Total current assets Fixed assets, net Equity investments in Affiliates Acquired client relationships, net Goodwill Other assets Total assets Liabilities and Stockholders’ Equity Current liabilities: Accounts payable and accrued liabilities Senior debt Payables to related party Total current liabilities Senior debt Senior convertible debt Mandatory convertible securities Junior convertible trust preferred securities Deferred income taxes Other long-term liabilities Total liabilities Commitments and contingencies (Note 13) Minority interest Minority interest in Affiliate investments in partnerships Stockholders’ equity: Common stock ($.01 par value; 153,000 shares authorized; 39,024 shares outstanding in 2005 and 2006) Additional paid-in capital Accumulated other comprehensive income Retained earnings Less: treasury stock, at cost (5,425 shares in 2005 and 9,428 shares in 2006) Total stockholders’ equity Total liabilities and stockholders’ equity The accompanying notes are an integral part of the Consolidated Financial Statements. December 31, 2005 2006 $ 140,423 148,850 5,079 5,902 35,115 335,369 50,592 301,476 483,692 1,093,249 57,258 $ 201,729 201,385 108,350 15,516 27,299 554,279 63,984 293,440 502,066 1,177,227 74,924 $ 2,321,636 $ 2,665,920 $ $ 176,711 65,750 14,127 256,588 175,500 424,232 300,000 — 182,623 20,149 246,727 — 41,086 287,813 365,500 413,358 300,000 300,000 218,584 11,209 $ 1,359,092 — 145,163 — $ 1,896,464 — 166,138 104,096 390 593,090 16,756 503,188 390 609,369 14,666 654,465 1,113,424 (296,043) 1,278,890 (779,668) 817,381 499,222 $ 2,321,636 $ 2,665,920 61 C o n s o l i d a t e d S t a t e m e n t s o f C h a n g e s i n S t o c k h o l d e r s ’ E q u i t y (dollars in thousands) December 31, 2003 Stock issued for option exercises Tax benefit of option exercises Issuance costs 2004 PRIDES contract adjustment payment Issuance of Affiliate equity interests Stock split Cash in lieu of fractional shares Stock issued to settle 2001 PRIDES Repurchase of stock Net Income Other comprehensive income Common Shares Common Stock 35,276,712 — — — $ 235 — — — Additional Paid-In Capital $ 408,449 (3,132) 8,027 (9,263) — — — — 3,403,742 — — — — (24,000) — 118 — 34 — — — (7,519) (118) (103) 194,435 — — — Accumulated Other Comprehensive Income (Loss) $ 944 — — — — — — — — — — 593 Retained Earnings Treasury Shares Treasury Shares at Cost $ 306,972 — — — (3,270,438) 714,516 — — $ (101,831) 22,521 — — — — — — — — — — — — — — 647,704 — — (3,486,512) — — 77,147 — 28,499 (194,316) — — December 31, 2004 38,680,454 $ 387 $ 566,776 $ 1,537 $ 384,119 (5,394,730) $ (245,127) Stock issued under option and other incentive plans Tax benefit of option exercises Issuance of Affiliate equity interests Settlement of forward equity sale agreement Conversions of zero coupon convertible notes Stock issued in connection with Affiliate investment Repurchase of stock Net Income Other comprehensive income — — — — — 343,204 — — — — — — — — 3 — — — (34) 13,942 2,231 (14,378) — 24,553 — — — — — — — — — 1,152,947 — — 39,269 — — — — — — 6,533 — — 347 — — — 15,219 — — — (1,189,700) — — 119,069 — — (90,532) — — December 31, 2005 39,023,658 $ 390 $ 593,090 $ 16,756 $ 503,188 (5,424,950) $ (296,043) Stock issued under option and other incentive plans Tax benefit of option exercises Issuance of Affiliate equity interests Cost of call spread option agreements Conversions of zero coupon convertible notes Repurchase of stock Net Income Other comprehensive loss — — — — — — — — — — — — — — — — (991) 28,529 2,031 (13,290) — — — — — — — — — 1,263,873 — — 42,694 — — — — — — — — — — (2,090) — 215,350 — (5,482,047) — — 151,277 — 11,458 (537,777) — — December 31, 2006 39,023,658 $ 390 $ 609,369 $14,666 $ 654,465 (9,427,774) $ (779,668) The accompanying notes are an integral part of the Consolidated Financial Statements. 6 0 0 2 t r o p e R l a u n n A . c n I , p u o r G s r e g a n a M d e t a i l i f f A 62 C o n s o l i d a t e d S t a t e m e n t s o f C a s h F l o w s (in thousands) Cash flow from operating activities: Net Income Adjustments to reconcile Net Income to cash flow from operating activities: Amortization of intangible assets Amortization of issuance costs Depreciation and other amortization Deferred income tax provision Accretion of interest Income from equity method investments, net of amortization Distributions received from equity method investments Tax benefit from exercise of stock options Stock option expense Other adjustments Changes in assets and liabilities: Increase in investment advisory fees receivable Decrease in Affiliate investments in partnerships (Increase) decrease in prepaids and other current assets (Increase) decrease in other assets Increase in accounts payable, accrued liabilities and other long-term liabilities Increase in minority interest Cash flow from operating activities Cash flow used in investing activities: Costs of investments in Affiliates, net of cash acquired Purchase of fixed assets Purchase of investments Sale of investments Increase in other assets Cash flow used in investing activities Cash flow from (used in) financing activities: Borrowings of senior bank debt Repayments of senior bank debt Issuance of junior convertible trust preferred securities Repayment of debt assumed in new investment Issuance of convertible securities Repurchase of convertible securities Repayment of senior debt Repurchase of senior debt Issuance of common stock Repurchase of common stock Issuance costs Settlement of forward equity sale agreement Excess tax benefit from exercise of stock options Cost of call spread option agreements Repayment of notes payable and other liabilities Redemptions of Minority interest—Affiliate investments in partnerships Cash flow from (used in) financing activities Effect of foreign exchange rate changes on cash and cash equivalents Net increase (decrease) in cash and cash equivalents Cash and cash equivalents at beginning of period Cash and cash equivalents at end of period Supplemental disclosure of cash flow information: Interest paid Income taxes paid Supplemental disclosure of non-cash financing activities: Stock issued to settle 2001 PRIDES Stock issued for zero coupon senior convertible note conversions Payables recorded for Affiliate equity purchases Notes received for Affiliate equity sales Stock received for the exercise of stock options Gain realized from settlement of forward purchase contracts Stock issued in new investment Debt assumed in new investment The accompanying notes are an integral part of the Consolidated Financial Statements. For the Years Ended December 31, 2004 2005 2006 $ 77,147 $ 119,069 $ 151,277 18,339 3,641 6,369 31,616 1,155 (1,265) — 8,027 — 2,493 (26,199) — 1,827 (9,992) 16,386 48,342 177,886 (474,104) (6,977) (37,080) 39,955 (60) (478,266) 134,000 (83,000) — — 300,000 (124,525) — — 210,232 (194,420) (12,800) — — — (14,244) — 215,243 1,132 (84,005) 224,282 140,277 30,913 12,240 28,499 — 18,518 — 206 3,719 — — $ $ 24,873 3,018 7,029 31,688 1,896 (26,971) 16,565 13,942 — (2,231) (53,846) — (8,258) (126) 32,217 45,213 204,078 (85,175) (14,523) (6,393) 24,062 — (82,029) 224,500 (100,000) — (150,811) — — — (10,000) 28,892 (82,317) (2,660) (14,008) — — (15,863) — (122,267) 364 146 140,277 140,423 39,381 29,290 — 347 4,567 5,205 800 — 24,556 150,811 $ $ 27,378 2,862 8,763 31,343 2,360 (38,318) 46,033 5,482 1,654 8,528 (52,281) 7,707 150 3,159 65,814 29,092 301,003 (123,262) (21,510) (29,522) 9,215 — (165,079) 602,000 (412,000) 300,000 — — — (65,750) — 52,765 (536,478) (9,982) — 23,047 (13,290) (7,687) (7,707) (75,082) 464 61,306 140,423 201,729 59,526 29,003 — 11,458 36,736 12,060 607 — — — $ $ 63 N o t e s t o C o n s o l i d a t e d F i n a n c i a l S t a t e m e n t s 1 Business and Summary of Significant Accounting Policies (a) Organization and Nature of Operations Affiliated Managers Group, Inc. (“AMG” or the “Company”) is an asset management company with equity investments in a diverse group of mid-sized investment management firms (“Affiliates”). AMG’s Affiliates currently provide investment management services in the United States and internationally to mutual funds, institutional clients and high net worth individuals. Fees for services are largely asset-based and, as a result, the Company’s revenue may fluctuate based on the performance of financial markets. Affiliates are either organized as limited partnerships, limited liability partnerships, limited liability companies, or corpora- tions. AMG generally has contractual arrangements with its Affiliates whereby a percentage of revenue is customarily allo- cable to fund Affiliate operating expenses, including compensation (the “Operating Allocation”), while the remaining portion of revenue (the “Owners’ Allocation”) is allocable to AMG and the other partners or members, gener- ally with a priority to AMG. In certain other cases, the Affiliate is not subject to a revenue sharing arrangement, but instead operates on a profit-based model. In these cases, AMG participates fully in any increase or decrease in the revenue or expenses of such firms. In situations where AMG holds a minority equity interest, the revenue sharing arrange- ment generally allocates a percentage of the Affiliate’s revenue with the balance to be used to pay operating expenses and profit distributions to the other owners. The financial statements are prepared in accordance with accounting principles generally accepted in the United States (“U.S. GAAP”). All dollar amounts except per share data in the text and tables herein are stated in thousands unless otherwise indicated. Certain reclassifications have been made to prior years’ financial statements to conform to the current year’s presentation. (b) Principles of Consolidation The Company evaluates the risk, rewards, and significant terms of each of its Affiliate and other investments to deter- mine the appropriate method of accounting. Majority-owned or otherwise controlled investments are consolidated. In many of its Affiliate investments, AMG is, directly or indirectly, the sole general partner (in the case of Affiliates which are limited partnerships), managing partner (in the case of Affiliates which are limited liability partner- ships), sole manager member (in the case of Affiliates which are limited liability companies) or principal shareholder (in the case of Affiliates which are corporations). As a result, the Company generally consolidates its Affiliate investments. Investments that are determined to be Variable Interest Entities as defined by FASB Interpretation No. 46 (revised), “Consolidation of Variable Interest Entities” (“FIN46R”), are consolidated if AMG or a consolidated Affiliate is the primary beneficiary of the investment. For Affiliate operations consolidated into these financial statements, the portion of the income allocated to owners other than AMG is included in Minority interest in the Consolidated Statements of Income. As Affiliates are gener- ally structured as pass-through entities for tax purposes, minority interest has been presented before income taxes in the Consolidated Statements of Income. Minority interest on the Consolidated Balance Sheets includes capital and undistributed income owned by the managers of the consolidated Affiliates. All material intercompany balances and transactions have been eliminated. AMG applies the equity method of accounting to invest- ments where AMG or an Affiliate does not hold a majority equity interest but has the ability to exercise significant influ- ence (generally at least a 20% interest or a general partner interest) over operating and financial matters. AMG or an Affiliate also applies the equity method when their minority shareholders or partners have certain rights to remove their ability to control the entity or rights to participate in substan- tive operating decisions (e.g. approval of annual operating budgets, major financings, selection of senior management, etc.). For equity method investments, AMG’s or the 6 0 0 2 t r o p e R l a u n n A . c n I , p u o r G s r e g a n a M d e t a i l i f f A 64 Affiliate’s portion of income before taxes is included in reduced to its fair value, and the difference is charged to Income from equity method investments. Other investments income in the period incurred. The cost of Affiliate invest- in which AMG or an Affiliate own less than a 20% interest ments in marketable securities was $5,403 and $14,342 as of and does not exercise significant influence are accounted for December 31, 2005 and 2006, respectively. Gross unrealized under the cost method. Under the cost method, income is gains on these investments were $608 and $1,379 as of recognized as dividends when, and if, declared. December 31, 2005 and 2006, respectively. Effective January 1, 2006, the Company implemented In accordance with EITF 04-05, the Company has consol- Emerging Issues Task Force Issue 04-05, “Determining idated $108,350 of client assets held in partnerships Whether a General Partner, or the General Partners as a controlled by its Affiliates. These assets are classified as Group, Controls a Limited Partnership or Similar Entity trading securities and reported as “Affiliate investments in When the Limited Partners Have Certain Rights” (“EITF partnerships” in the consolidated balance sheet. 04-05”). Under EITF 04-05, a general partner is required to Substantially all of these assets, $104,096, are held by consolidate any partnership that it controls, including those investors that are unrelated to the Company, and reported interests in the partnerships in which the Company does not as “Minority interest in Affiliate investments in partner- have ownership rights. A general partner is presumed to ships.” For the year ended December 31, 2006, these control a partnership unless the limited partners have certain partnerships reported income of $3,400, which is presented rights to remove the general partner or other substantive as “Investment income from Affiliate investments in part- rights to participate in partnership operations. nerships” in the consolidated statements of income. The portion of this income that is attributable to investors that The effect of any changes in the Company’s equity interests are unrelated to the Company, $3,364, is reported as a in its Affiliates resulting from the issuance of an Affiliate’s “Minority interest in Affiliate investments in partnerships.” equity by the Company or one of its Affiliates is included Management fees earned by the Company on these assets as a component of stockholders’ equity, net of the related were $1,148 for the year ended December 31, 2006, and income tax effect in the period of the change. are reported within “Investment and other income.” (c) Cash and Cash Equivalents During the year ended December 31, 2006, the partner- ships purchased investments (principally equity securities) The Company considers all highly liquid investments, totaling $158,311 and sold investments totaling $167,246, including money market mutual funds, with original maturi- and had gross subscriptions and redemptions of client assets ties of three months or less to be cash equivalents. Cash totaling $498 and $8,205, respectively. equivalents are stated at cost, which approximates market value due to the short-term maturity of these investments. (e) Equity Investments in Affiliates (d) Affiliate Investments Under the equity method of accounting, the Company records its proportionate share of income or loss currently Affiliate investments in marketable securities are classified as in earnings within a single row on the income statement, either trading or available-for-sale securities and carried at Income from equity method investments. As is consistent fair value. Unrealized holding gains or losses on investments with the equity method of accounting, for one of its equity classified as available-for-sale are reported net of deferred tax as a separate component of accumulated other comprehen- method Affiliates based outside the United States, the Company has elected to record financial results one quarter sive income in stockholders’ equity until realized. If a decline in arrears to allow for the receipt of financial information. in the fair value of these investments is determined to be The Company converts the financial information of foreign other than temporary, the carrying amount of the asset is investments to U.S. GAAP. 65 The Company’s share of income taxes incurred directly by subleases are accounted for under Statement of Financial Affiliates accounted for under the equity method are Accounting Standard (“FAS”) No. 13, “Accounting for recorded within Income taxes—current in the Leases.” These leases are classified as either capital leases or Consolidated Statements of Income because these taxes operating leases, as appropriate. Most lease agreements classi- generally represent the Company’s share of the taxes fied as operating leases contain renewal options, rent incurred by the Affiliate. Deferred income taxes incurred as escalation clauses or other inducements provided by the a direct result of the Company’s investment in Affiliates landlord. Rent expense is accrued to recognize lease escala- accounted for under the equity method have been included tion provisions and inducements provided by the landlord, if in Income taxes—deferred in the Consolidated Statements any, on a straight-line basis over the lease term. of Income. The associated deferred tax liabilities have been classified as a component of Deferred income taxes in the Consolidated Balance Sheet. (h) Acquired Client Relationships and Goodwill The purchase price for the acquisition of interests in Affiliates is allocated based on the fair value of net assets The Company periodically evaluates its equity method acquired, primarily acquired client relationships. In deter- investments for impairment. In such impairment evalua- mining the allocation of the purchase price to acquired tions, the Company assesses if the value of the investment client relationships, the Company analyzes the net present has declined below its book value for a period considered to value of each acquired Affiliate’s existing client relationships be other than temporary. If the Company determines that based on a number of factors including: the Affiliate’s a decline in value below the book value of the investment is historical and potential future operating performance; the other than temporary, then a charge would be recognized in Affiliate’s historical and potential future rates of attrition the Consolidated Statements of Income. among existing clients; the stability and longevity of (f) Fixed Assets existing client relationships; the Affiliate’s recent, as well as long-term, investment performance; the characteristics of Fixed assets are recorded at cost and depreciated using the the firm’s products and investment styles; the stability and straight-line method over their estimated useful lives. The depth of the Affiliate’s management team and the Affiliate’s estimated useful lives of office equipment and furniture and history and perceived franchise or brand value. fixtures range from three to ten years. Computer software developed or obtained for internal use is amortized using The Company has determined that certain of its mutual the straight-line method over the estimated useful life of the fund acquired client relationships meet the indefinite life software, generally three years or less. Leasehold improve- criteria outlined in FAS No. 142, “Goodwill and Other ments are amortized over the shorter of their estimated Intangible Assets” (“FAS 142”), because the Company useful lives or the term of the lease, and the building is expects both the renewal of these contracts and the cash amortized over 39 years. The costs of improvements that flows generated by these assets to continue indefinitely. extend the life of a fixed asset are capitalized, while the cost Accordingly, the Company does not amortize these intan- of repairs and maintenance are expensed as incurred. Land gible assets, but instead reviews these assets at least annually is not depreciated. (g) Leases The Company and its Affiliates currently lease office space for impairment. Each reporting period, the Company assesses whether events or circumstances have occurred which indicate that the indefinite life criteria are no longer met. If the indefinite life criteria are no longer met, the and equipment under various leasing arrangements. As these Company assesses whether the carrying value of the assets leases expire, it can be expected that in the normal course of exceeds its fair value, and an impairment loss would be business they will be renewed or replaced. All leases and recorded in an amount equal to any such excess. 6 0 0 2 t r o p e R l a u n n A . c n I , p u o r G s r e g a n a M d e t a i l i f f A 66 As of December 31, 2006, the cost assigned to all other (i) Revenue Recognition acquired client relationships was being amortized over a The Company’s consolidated revenue represents advisory weighted average life of approximately 12 years. The fees billed monthly, quarterly and annually by Affiliates for expected useful lives of acquired client relationships are managing the assets of clients. Asset-based advisory fees are analyzed each period and determined based on an analysis recognized monthly as services are rendered and are based of the historical and projected attrition rates of each upon a percentage of the market value of client assets Affiliate’s existing clients, and other factors that may influ- managed. Any fees collected in advance are deferred and ence the expected future economic benefit the Company recognized as income over the period earned. Performance will derive from the relationships. The Company tests for based advisory fees are generally assessed as a percentage of the possible impairment of definite-lived intangible assets the investment performance realized on a client’s account, annually or more frequently whenever events or changes in generally over an annual period. Performance-based advi- circumstances indicate that the carrying amount of the asset sory fees are recognized when they are earned (i.e. when is not recoverable. If such indicators exist, the Company they become billable to customers) based on the contractual compares the undiscounted cash flows related to the asset to terms of agreements and when collection is reasonably the carrying value of the asset. If the carrying value is assured. Also included in revenue are commissions earned greater than the undiscounted cash flow amount, an by broker dealers, recorded on a trade date basis, and other impairment charge is recorded in the Consolidated service fees recorded as earned. Statements of Income for amounts necessary to reduce the carrying value of the asset to fair value. (j) Issuance Costs Issuance costs incurred in securing credit facility financing The excess of purchase price for the acquisition of interests are amortized over the remaining term of the credit facility. in Affiliates over the fair value of net assets acquired, Costs incurred to issue the zero coupon senior convertible including acquired client relationships, is reported as good- securities, the floating rate senior convertible securities and will within the operating segments in which the Affiliate junior convertible trust preferred securities are amortized operates. Goodwill is not amortized, but is instead reviewed over the earlier of the period to the first investor put date or for impairment. The Company assesses goodwill for the stated term of the security. Costs incurred to issue the impairment at least annually, or more frequently whenever Company’s mandatory convertible securities are allocated events or circumstances occur indicating that the recorded between the senior notes and the purchase contracts based goodwill may be impaired. Fair value is determined for each upon the relative cost to issue each instrument separately. operating segment primarily based on price-earnings multi- Costs allocated to the senior notes are recognized as interest ples. If the carrying amount of goodwill exceeds the fair expense over the period of the forward purchase contract value, an impairment loss would be recorded in an amount component of such securities. Costs allocated to the equal to that excess. forward purchase contract and call spread option agree- ments are charged directly to additional paid-in capital and As further described in Note 14, the Company periodically not amortized. purchases additional equity interests in Affiliates from minority interest owners. Resulting payments made to such (k) Derivative Financial Instruments owners are generally considered purchase price for these acquired interests. The Company is exposed to interest rate risk inherent in its variable rate debt obligations. The Company’s risk manage- ment strategy may utilize financial instruments, specifically 67 interest rate swap contracts, to hedge certain interest rate In measuring the amount of deferred taxes each period, the exposures. For example, the Company may agree with a Company must project the impact on its future tax counter party (typically a major commercial bank) to payments of any reversal of deferred tax liabilities (which exchange the difference between fixed-rate and floating-rate would increase the Company’s tax payments), and any use interest amounts calculated by reference to an agreed of its state credits and carryforwards (which would decrease notional principal amount. In entering into these contracts, its tax payments). In forming these estimates, the Company the Company intends to offset cash flow gains and losses makes assumptions about future federal and state income that occur on its existing debt obligations with cash flow tax rates and the apportionment of future taxable income to gains and losses on the contracts hedging these obligations. states in which the Company has operations. An increase or The Company records all derivatives on the balance sheet material impact on the Company’s deferred income tax at fair value. If the Company’s derivatives qualify as cash liabilities and assets and would result in a current income decrease in federal or state income tax rates could have a flow hedges, the effective portion of the unrealized gain or tax charge or benefit. loss is recorded in accumulated other comprehensive income as a separate component of stockholders’ equity and In the case of the Company’s deferred tax assets, the reclassified into earnings when periodic settlement of vari- Company regularly assesses the need for valuation able rate liabilities are recorded in earnings. For interest rate allowances, which would reduce these assets to their recov- swaps, hedge effectiveness is measured by comparing the erable amounts. In forming these estimates, the Company present value of the cumulative change in the expected makes assumptions of future taxable income that may be future variable cash flows of the hedged contract with the generated to utilize these assets, which have limited lives. If present value of the cumulative change in the expected the Company determines that these assets will be realized, future variable cash flows of the hedged item. To the extent the Company records an adjustment to the valuation that the critical terms of the hedged item and the derivative allowance, which would decrease tax expense in the period are not identical, hedge ineffectiveness would be reported such determination was made. Likewise, should the in earnings as interest expense. Hedge ineffectiveness was Company determine that it would be unable to realize not material in 2004, 2005 or 2006. additional amounts of deferred tax assets, an adjustment to (l) Deferred Taxes the valuation allowance would be charged to tax expense in the period such determination was made. For example, if Deferred taxes reflect the expected future tax consequences the Company was to make an investment in a new Affiliate of temporary differences between the book carrying located in a state where it has operating loss carryforwards, amounts and tax bases of the Company’s assets and liabili- the projected taxable income from the new Affiliate could ties. Historically, deferred taxes have been comprised be offset by these operating loss carryforwards, justifying a primarily of deferred tax liabilities attributable to intangible reduction to the valuation allowance. assets and convertible securities and deferred tax assets from state credits and loss carryforwards. (m) Foreign Currency Translation The assets and liabilities of Affiliates that are not based in the United States are translated into U.S. dollars using exchange rates in effect as of the balance sheet date. The 6 0 0 2 t r o p e R l a u n n A . c n I , p u o r G s r e g a n a M d e t a i l i f f A 68 revenue and expenses of these Affiliates are translated into U.S. dollars using average exchange rates for the relevant period. Because of the permanent nature of the Company’s investments, net translation exchange gains and losses are excluded from net income but are recorded in other comprehensive income. Foreign currency transaction gains and losses are reflected in Investment and other income. Year Ended December 31, 2004 2005 Net Income—as reported $ 77,147 $ 119,069 Add: Total stock-based employee compensation expense included in reported net income, net of tax Less: Stock-based compensation expense determined under fair value method net of tax — — 14,326 709 (n) Equity Based Compensation Plans Net Income—FAS 123 pro forma $ 62,821 $ 118,360 Effective January 1, 2006, the Company adopted the fair value recognition provisions of FAS No. 123 (revised Earnings per share— basic—as reported Earnings per share— 2004), “Share-Based Payment” (“FAS 123R”). FAS 123R basic—FAS 123 pro forma Earnings per share— diluted—as reported Earnings per share— diluted—FAS 123 pro forma $ 2.57 $ 3.54 2.09 2.02 1.66 3.52 2.81 2.80 revises FAS No. 123, “Accounting for Stock-Based Compensation” (“FAS 123”) and supersedes Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”). FAS 123R requires as an expense the cost of all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values over the requisite service period. In addition, FAS 123R requires unrecognized costs related to options vesting after the date of initial adoption to be recognized as an expense in the financial statements over the remaining requisite service period. The Company adopted FAS 123R using the modified prospective transition method. Under this method, compensation expense includes: (i) an expense for all unvested options outstanding on January 1, 2006, and (ii) an expense for all options granted subsequent to January 1, 2006. Compensation expense recognized under FAS 123R, net of tax, was $1,042 for the year ended December 31, 2006. This additional compensation expense decreased basic and diluted earnings per share by $0.03 and $0.02, respectively, for the year ended December 31, 2006. The following table presents net income and earnings per share as if the Company had applied the fair value recognition provisions of FAS 123 to stock-based employee compensation for the years ended December 31, 2005 and 2004. FAS 123R also requires the Company to report any tax bene- fits realized upon the exercise of stock options that are in excess of the expense recognized for reporting purposes as a financing activity in the Company’s consolidated statement of cash flows. Prior to the adoption of FAS 123R, these tax benefits were presented as operating cash flows in the consol- idated statements of cash flows. If the tax benefit realized is less than the expense, the tax shortfall is recognized in stock- holders’ equity. To the extent the expense exceeds available windfall tax benefits, it is recognized in the Consolidated Statements of Income. Under FAS 123R, the Company was permitted to calculate its cumulative windfall tax benefits for the purposes of accounting for future tax shortfalls. The Company has elected to apply the long-form method for determining the pool of windfall tax benefits. (o) Use of Estimates The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts included in the financial statements and disclosure of contingent assets and liabilities at the date of the financial statements. Actual results could differ from those estimates. 69 (p) Recent Accounting Developments institutions. These financial institutions are typically In July 2006, the Financial Accounting Standards Board located in cities in which AMG and its Affiliates operate. (“FASB”) released FASB Interpretation No. 48, For AMG and certain Affiliates, cash deposits at a finan- “Accounting for Uncertainty in Income Taxes, an interpre- cial institution may exceed Federal Deposit Insurance tation of FASB Statement No. 109” (“FIN 48”). FIN 48 is Corporation insurance limits. effective in the first quarter of 2007 and provides a compre- hensive model for the accounting and disclosure of uncertain income tax return positions. The Company has 3 Fixed Assets and Lease Commitments completed its initial evaluation of the impact of FIN 48 and Fixed assets consisted of the following: believes that it will not have a material impact on its finan- cial position or results of operations. In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (“FAS 157”). FAS 157 is effective in the first quarter of 2008 and establishes a framework for meas- uring fair value. The Company is in the process of evaluating the effect of FAS 157 on its financial statements. Building and leasehold improvements $ 31,830 $ 44,495 At December 31, 2005 2006 Office equipment Furniture and fixtures Land and improvements Computer software Fixed assets, at cost Accumulated depreciation and amortization 23,867 15,161 12,607 5,613 89,078 22,786 13,345 13,403 8,965 102,994 (38,486) (39,010) $ 50,592 $ 63,984 In February 2007, the FASB issued Statement of Financial Fixed assets, net Accounting Standards No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities—Including an The Company and its Affiliates lease office space and amendment of FASB Statement No. 115” (“FAS 159”). FAS computer equipment for their operations. At December 31, 159 permits companies to measure many financial instru- 2006, the Company’s aggregate future minimum payments ments and certain other items at fair value. The Company for operating leases having initial or noncancelable lease can elect to adopt the provisions of FAS 159 either in the terms greater than one year are payable as follows: first quarter of 2007 or the first quarter of 2008. The Company is in the process of evaluating the potential future effect of FAS 159 on its financial statements. Year Ending December 31, 2 Concentrations of Credit Risk Financial instruments that potentially subject the Company to significant concentrations of credit risk 2007 2008 2009 2010 2011 consist principally of cash investments. The Company Thereafter Required Minimum Payments $ 18,696 18,117 17,424 14,910 12,100 33,219 maintains cash and cash equivalents, investments and, at times, certain financial instruments with various financial Consolidated rent expense for 2004, 2005 and 2006 was $16,708, $21,497 and $23,880, respectively. 6 0 0 2 t r o p e R l a u n n A . c n I , p u o r G s r e g a n a M d e t a i l i f f A 70 4 Accounts Payable and Accrued Liabilities Deferred Compensation Plan that provides officers and Accounts payable and accrued liabilities consisted of the following: Accrued compensation Accrued income taxes Accounts payable Accrued share repurchases Deferred acquisition purchase price Contract adjustment payments Accrued professional services Accrued interest Deferred revenue Other At December 31, 2005 2006 $ 80,510 $ 151,788 19,542 29,550 8,800 8,215 7,849 6,588 4,666 3,336 886 9,359 9,518 — 6,025 7,287 6,402 953 directors of the Company the opportunity to voluntarily defer base salary, bonus payments and director fees, as appli- cable, on a pre-tax basis, and invest such deferred amounts in one or more specified measurement funds. While the Company has no obligation to do so, the Deferred Compensation Plan also provides the Company the oppor- tunity to make discretionary contributions; in the event any such contributions are made, contributed amounts will be subject to vesting and forfeiture provisions. Consolidated expenses related to the Company’s benefit plans in 2004, 2005 and 2006 were $9,055, $20,864 and $10,336, respectively. 36,319 25,845 $ 176,711 $ 246,727 6 Senior Debt The components of senior debt are as follows: 5 Benefit Plans The Company has three defined contribution plans consisting of a qualified employee profit-sharing plan covering substantially all of its full-time employees and several of its Affiliates, and non-qualified plans for certain At December 31, 2005 2006 Senior revolving credit facility $ 175,500 $ 365,500 Senior notes due 2006 65,750 — $ 241,250 $ 365,500 senior employees. AMG’s other Affiliates generally have sepa- Senior Revolving Credit Facility rate defined contribution retirement plans. Under each of the qualified plans, AMG and each participating Affiliate, as the case may be, are able to make discretionary contributions for the benefit of qualified plan participants up to IRS limits. The Company’s non-qualified Executive Retention Plan (the “ERP”) is designed to work in concert with the Company’s stockholder-approved Long-Term Executive Incentive Plan, providing a trust vehicle for long-term compensation awards based upon the Company’s performance and growth. The ERP permits the Compensation Committee to make awards that may be invested by the recipient in the Company’s common stock, in Affiliate investment products, and in cash accounts, in each case subject to vesting and forfeiture provi- sions. The Company’s contributions to the ERP are irrevocable. In addition, the Company has established a The Company entered into an amended and restated senior revolving credit facility (the “Facility”) in December 2005, which allows for borrowings of up to $550 million at rates of interest (based either on the Eurodollar rate or the prime rate as in effect from time to time) that vary depending on the Company’s credit ratings. Subject to the agreement of the lenders (or prospective lenders) to increase their commitments, the Company has the option to borrow up to an aggregate of $650 million under this Facility. Following the successful remarketing of the Company’s 2004 PRIDES (as described in Note 8), the Facility will mature in December 2010. The Facility contains financial covenants with respect to net worth, leverage and interest coverage. The Facility also contains customary affirmative and negative covenants, including limitations on indebted- ness, liens, cash dividends and fundamental corporate 71 changes. Borrowings under the Facility are collateralized by Zero Coupon Senior Convertible Notes pledges of all capital stock or other equity interests owned In May 2001, the Company issued $251,000 of principal by the Company. The Company pays a quarterly commit- amount at maturity of zero coupon senior convertible notes ment fee on the daily unused portion of the Facility, which due 2021 (“zero coupon convertible notes”), with each note fee amounted to $717, $676 and $602 for the years ended issued at 90.50% of such principal amount and accreting at December 31, 2004, 2005 and 2006, respectively (see Note a rate of 0.50% per year. Following the repurchase and 24—Subsequent Events). Senior Notes due 2006 conversion of $129,231 principal amount of such notes, $121,769 principal amount at maturity of zero coupon convertible notes remains outstanding. Each security is In December 2001, the Company issued $230,000 of convertible into 17.429 shares of the Company’s common mandatory convertible securities (“2001 PRIDES”). Each stock (at a current base conversion price of $53.34) upon the unit of the 2001 PRIDES initially consisted of (i) a senior occurrence of certain events, including the following: (i) if note due November 2006 with a principal amount of $25 the closing price of a share of its common stock is more than per note, and (ii) a forward purchase contract pursuant to a specified price over certain periods (initially $62.36 and which the holder agreed to purchase shares of the increasing incrementally at the end of each calendar quarter Company’s common stock in November 2004. The to $63.08 in April 2021); (ii) if the credit rating assigned by Company repurchased $154,250 in aggregate principal Standard & Poor’s to the securities is below BB-; or (iii) if the amount of the senior notes component of the 2001 Company calls the securities for redemption. The holders PRIDES (“Senior Notes due 2006”) and settled the forward may require the Company to repurchase the securities at purchase contracts in 2004. The Company reported a loss of their accreted value in May 2011 and 2016. If the holders $2,493 on its repurchase of these notes, which was recorded exercise this option in the future, the Company may elect to in Investment and other income, and the Company realized repurchase the securities with cash, shares of its common a gain of $3,719 relating to the settlement of the forward stock or some combination thereof. The Company has the purchase contracts, which was recorded directly to stock- option to redeem the securities for cash at their accreted holders’ equity. Also in 2004, the Company issued 3.4 value. Under the terms of the indenture governing the zero million shares of common stock and received proceeds of coupon convertible notes, a holder may convert such security $190,750. In 2005, the Company repurchased $10,000 of into common stock by following the conversion procedures the Senior Notes due 2006; the remaining $65,750 matured in the indenture. Subject to changes in the price of the and was repaid in November 2006. 7 Senior Convertible Debt Company’s common stock, the zero coupon convertible notes may not be convertible in certain future periods. In February 2006, the Company amended the zero coupon The components of senior convertible debt are as follows: convertible notes. Under the terms of this amendment, the Zero coupon At December 31, 2005 2006 Company will pay interest through May 7, 2008 at a rate of 0.375% per year on the principal amount at maturity of the notes in addition to the accrual of the original issue discount. senior convertible notes $ 124,232 $ 113,358 Floating rate Floating Rate Senior Convertible Securities senior convertible securities 300,000 300,000 In February 2003, the Company issued $300,000 of $ 424,232 $ 413,358 floating rate senior convertible securities due 2033 (“floating rate convertible securities”). The floating rate 6 0 0 2 t r o p e R l a u n n A . c n I , p u o r G s r e g a n a M d e t a i l i f f A 72 convertible securities bear interest at a rate equal to 8 Mandatory Convertible Securities 3-month LIBOR minus 0.50%, payable in cash quarterly. Each security is convertible into shares of the Company’s common stock (at a base conversion price of $54.17) upon the occurrence of certain events, including the following: (i) if the closing price of a share of the Company’s common stock exceeds $65.00 over certain periods; (ii) if the credit rating assigned by Standard & Poor’s is below BB-; or (iii) if the Company calls the securities for redemption. Upon conversion, holders of the securities will receive 18.462 shares of the Company’s common stock for each convert- ible security. In addition, if the market price of the Company’s common stock exceeds the base conversion price at the time of conversion, holders will receive addi- tional shares of common stock based on the stock price at that time. Based on the trading price of the Company’s common stock as of December 31, 2006, upon conversion a holder of each security would receive an additional 5.453 shares. The holders of the floating rate convertible securities may require the Company to repurchase such securities in February 2008, 2013, 2018, 2023 and 2028, at their prin- cipal amount. The Company may choose to pay the purchase price for such repurchases with cash, shares of its common stock or some combination thereof. The Company may redeem the convertible securities for cash at any time on or after February 25, 2008, at their principal amount. Under the terms of the indenture governing the floating rate convertible securities, a holder may convert such security into common stock by following the conver- sion procedures in the indenture. Subject to changes in the price of the Company’s common stock, the floating rate convertible securities may not be convertible in certain future periods. As further described in Note 11, the Company has entered into interest rate swap contracts that effectively exchange the variable interest rate for a fixed interest rate on $150,000 of the floating rate convertible securities. Through February 2008, the Company will pay a weighted average fixed rate of 3.28% on that notional amount. In February 2004, the Company issued $300,000 of mandatory convertible securities (“2004 PRIDES”). As described below, these securities are structured to provide $300,000 of additional proceeds to the Company following a successful remarketing and the exercise of forward purchase contracts in February 2008. Each unit of the 2004 PRIDES consists of (i) a senior note due February 2010 with a principal amount of $1,000 per note, on which the Company pays interest quarterly at the annual rate of 4.125%, and (ii) a forward purchase contract pursuant to which the holder has agreed to purchase shares of the Company’s common stock in February 2008. Holders of the purchase contracts receive a quarterly contract adjustment payment at the annual rate of 2.525% per $1,000 purchase contract. The current portion of the contract adjustment payments, approximately $6,025, is recorded in current liabilities. The number of shares to be issued in February 2008 will be determined based upon the average trading price of the Company’s common stock for a period preceding that date. Depending on the average trading price in that period, the settlement rate will range from 11.785 to 18.031 shares per $1,000 purchase contract. Based on the trading price of the Company’s common stock as of December 31, 2006, the purchase contracts would have a settlement rate of 12.990. Each of the senior notes is pledged to the Company to collateralize the holder’s obligations under the forward purchase contracts. Beginning in August 2007, under the terms of the 2004 PRIDES, the senior notes are expected to be remarketed to new investors. A successful remarketing will generate $300,000 of gross proceeds to be used by the original holders of the 2004 PRIDES to fulfill their obliga- tions on the forward purchase contracts. In exchange for the additional $300,000 payment on the forward purchase contracts, the Company will issue shares of its common stock to the original holders of the senior notes. As refer- enced above, the number of shares of common stock to be 73 issued will be determined by the market price of the 10 Income Taxes Company’s common stock at that time. Assuming a successful remarketing, the senior notes will remain outstanding until at least February 2010. A summary of the provision for income taxes is as follows: 9 Junior Convertible Trust Preferred Securities In April 2006, the Company issued $300,000 of junior subordinated convertible debentures due 2036 to a wholly- owned trust simultaneous with the issuance, by the trust, of $291,000 of convertible trust preferred securities to investors. Under FIN 46R, the trust is not consolidated in the Company’s financial statements. The junior subordi- nated convertible debentures and convertible trust Current: Federal State Foreign Deferred: Federal State Foreign Year Ended December 31, 2004 2005 2006 $ 17,791 2,539 — $ 31,399 2,005 5,491 $ 38,971 6,344 9,952 28,283 3,333 — 30,424 2,158 (894) 33,261 1,900 (3,818) $ 51,946 $ 70,583 $ 86,610 preferred securities (together, the “junior convertible trust The components of income before income taxes consisted preferred securities”) have substantially the same terms. of the following: The junior convertible trust preferred securities bear interest at 5.1% per annum, payable quarterly in cash. Each $50 security is convertible, at any time, into 0.333 shares of the Company’s common stock, which represents a conver- sion price of $150 per share. Upon conversion, investors will receive cash or shares of the Company’s common stock (or a combination of cash and common stock) at the elec- tion of the Company. The junior convertible trust preferred securities may not be redeemed by the Company prior to April 15, 2011. On or after April 15, 2011, the junior convertible trust preferred securities may be redeemed if the closing price of the Company’s common stock exceeds $195 for a specified period of time. The trust’s only assets are the junior convertible subordinated debentures. To the extent that the trust has available funds, the Company is obligated to ensure that holders of the convertible trust preferred securities receive all payments due from the trust. Domestic Foreign Year Ended December 31, 2004 2005 2006 $ 123,722 $ 163,912 $ 186,249 5,371 25,740 51,638 $ 129,093 $ 189,652 $ 237,887 The Company’s effective income tax rate differs from the amount computed by using income before income taxes and applying the U.S. federal income tax rate to such amount because of the effect of the following items: Tax at U.S. federal income tax rate State income taxes, net of federal benefit Non-deductible expenses Valuation allowance Foreign taxes Foreign tax credits Year Ended December 31, 2004 2005 2006 35.0% 35.0% 35.0% 1.6 0.7 2.9 0.5 (0.5) 40.2% 1.4 0.2 0.6 2.9 (2.9) 37.2% 2.2 — 0.8 2.6 (4.2) 36.4% 6 0 0 2 t r o p e R l a u n n A . c n I , p u o r G s r e g a n a M d e t a i l i f f A 74 The components of deferred tax assets and liabilities are At December 31, 2006, the Company had state net oper- as follows: Deferred assets (liabilities): State net operating loss and credit carryforwards At December 31, 2005 2006 $ 12,097 $ 14,126 Intangible asset amortization (139,866) (170,216) Non-deductible intangible amortization Deferred compensation Convertible securities interest Fixed asset depreciation Deferred income Accrued expenses (27,727) 1,712 (12,854) (1,806) (2,271) 189 (19,807) (1,956) (398) 739 Valuation allowance (170,526) (204,458) (12,097) (14,126) Net deferred income taxes $ (182,623) $ (218,584) ating loss carryforwards that will expire over a 15-year period beginning in 2006. The valuation allowance at December 31, 2005 and 2006 is related to the uncertainty of the realization of most of these loss carryforwards, which realization depends upon the Company’s generation of sufficient taxable income prior to their expiration. The change in the valuation allowance for the year ended December 31, 2006 is attributable to state net operating (26,946) losses during this period and a provision for loss carryfor- — wards that the Company does not expect to realize. In 2006, the Company reduced its deferred tax liabilities for non-deductible intangible amortization by $1,408 to reflect a reduction in Canadian federal income tax rates that was enacted in June 2006 and will become effective begin- ning in 2008. The reduction of these deferred tax liabilities was recorded as a benefit in the 2006 income tax provision. Deferred tax liabilities are primarily the result of tax deduc- tions for the Company’s intangible assets and convertible 11 Derivative Financial Instruments securities. The Company amortizes most of its intangible assets for tax purposes only, reducing its tax basis below its carrying value for financial statement purposes and gener- ating deferred taxes each reporting period. In contrast, the intangible assets associated with the Company’s recent investment in its Canadian Affiliates are not deductible for tax purposes, but certain of these assets are amortized for book purposes. As such, at the time of its investment, the Company recorded a deferred tax liability that represents the tax effect of the future book amortization of these assets. The Company’s floating rate senior convertible secu- rities, mandatory convertible securities and junior convertible trust preferred securities also currently generate tax deductions that are higher than the interest expense recorded for financial statement purposes. The Company periodically uses interest rate derivative contracts to manage market exposures associated with its variable interest rate debt by creating offsetting fixed rate market exposures. As of December 31, 2006, the Company had $150 million notional amount of interest rate swap contracts that fix the interest rate on the floating rate senior convertible securities to a weighted average interest rate of approximately 3.28% through February 2008. The Company records all derivatives on the balance sheet at fair value. As cash flow hedges, the effective portion of the unrealized gain or loss on the derivative instruments is recorded in accumulated other comprehensive income as a separate component of stockholders’ equity. At December 31, 2005 and 2006, the unrealized gain, before taxes, on the derivative instruments was $2,962 and $2,392, respec- tively. The Company expects no portion of the unrealized gain to be reclassified from accumulated other comprehen- sive income to net income over the next 12 months. 75 12 Comprehensive Income A summary of comprehensive income, net of applicable taxes, is as follows: probable and can be reasonably estimated. Management believes that any liability in excess of these accruals upon the ultimate resolution of these matters will not have a material adverse effect on the consolidated financial condi- For the year ended December 31, tion or results of operations of the Company. 2004 2005 2006 Net Income $ 77,147 $ 119,069 $ 151,277 Federal and state regulators have ongoing investigations of (232) 2,098 (358) Affiliates of the Company. The Company believes there will Foreign currency translation adjustment 1,132 13,781 (1,832) Change in net unrealized gain (loss) on derivative instruments Change in unrealized gain (loss) on investment securities Reclassification of unrealized gain on investment securities to realized gain 11 (50) 100 (318) (610) — Comprehensive income $ 77,740 $ 134,288 $ 149,187 the mutual fund industry that focus on a number of issues, including late trading and market timing, and have sent requests for information to a number of mutual fund compa- nies, broker/dealers and mutual fund distributors, including be no material adverse effects resulting from these investiga- tions on the financial condition of the Company. Certain Affiliates operate under regulatory authorities which require they maintain minimum financial or capital requirements. Management is not aware of any violations of such financial requirements occurring during the year. The components of accumulated other comprehensive income, net of taxes, were as follows: 14 Business Combinations Foreign currency translation adjustment Unrealized gain (loss) on investment securities Unrealized gain on derivative instruments Accumulated other At December 31, 2005 2006 The Company’s Affiliate investments in the years ended December 31, 2004, 2005 and 2006 totaled $508,781, $267,169 and $144,580, respectively. These investments $ 14,913 $ 13,081 were made pursuant to the Company’s growth strategy (23) 77 1,866 1,508 designed to generate shareholder value by making invest- ments in mid-sized investment management firms and other strategic transactions designed to expand the Company’s participation in its three principal distribution channels. comprehensive income $ 16,756 $ 14,666 13 Commitments and Contingencies The Company and its Affiliates are subject to claims, legal proceedings and other contingencies in the ordinary course of their business activities. Each of these matters is subject to various uncertainties, and it is possible that some of these matters may be resolved in a manner unfavorable to the Company or its Affiliates. The Company and its Affiliates establish accruals for matters for which the outcome is In December 2006, the Company expanded its product offerings in the Institutional distribution channel through the acquisition of a majority equity interest in Chicago Equity Partners, LLC, which manages a wide range of U.S. equity and fixed income products across multiple capital- ization sectors and investment styles. The firm’s client base includes over 120 institutional investors, including public funds, corporations, endowments and foundations, Taft- Hartley plan sponsors and certain mutual fund advisers. The transaction was financed through borrowings under the Company’s senior revolving credit facility. 6 0 0 2 t r o p e R l a u n n A . c n I , p u o r G s r e g a n a M d e t a i l i f f A 76 In 2005, the Company completed the acquisition of a group Company’s available cash. Friess is the advisor to the of Canadian asset management firms. These firms manage Brandywine family of no-load mutual funds and also approximately 100 investment products, including Canadian, advises separate portfolios for charitable foundations, major U.S. and international value and growth equity products, as corporations and high net worth individuals. well as balanced, fixed income, venture capital and structured products. The transaction was financed through borrowings In 2004, the Company acquired a controlling interest in under the Company’s senior revolving credit facility, the Genesis Fund Managers, LLP (“Genesis”). Genesis manages issuance of common stock, and available cash. emerging markets equity investment products, primarily for institutional clients in the United States, United In 2005, through Managers Investment Group LLC, the Kingdom, Europe and Australia. Genesis’ management Company completed the acquisition of approximately $3.0 team holds the remaining interest. The transaction was billion of assets under management from Fremont financed through the Company’s available cash. Investment Advisors, Inc. (“FIA”). The acquisition included the Fremont Funds, a diversified family of no load The assets and liabilities of the investments in acquired mutual funds managed by independent sub advisors and businesses are accounted for under the purchase method of professionals at FIA, as well as FIA assets in separate accounting and recorded at their fair values at the dates of accounts and 401(k) plans. The transaction was financed acquisition. The excess of the purchase price over the esti- through available cash. mated fair values of the net assets acquired is recorded as an increase in goodwill. The results of operations of acquired In 2004, the Company acquired a minority equity interest businesses have been included in the Consolidated in AQR Capital Management, LLC (“AQR”). Based in Financial Statements beginning as of the date of acquisi- Greenwich, Connecticut, AQR offers quantitatively tion. The following table summarizes the net assets managed hedge funds and long-only international equity acquired as of the respective acquisition dates during the products provided through collective investment vehicles years ended December 31, 2005 and 2006: and separate accounts. This transaction is accounted for under the equity method of accounting. The transaction was financed through the Company’s available cash and borrowings under its senior revolving credit facility. In 2004, the Company acquired a controlling interest in the growth equity business of TimesSquare Capital Current assets, net Fixed assets Definite-lived acquired client relationships Indefinite-lived acquired client relationships Management, LLC (“TimesSquare”). TimesSquare Equity investments in Affiliates manages growth-oriented small and mid-cap investment Deferred income taxes products in the Institutional and Mutual Fund distribution Deferred purchase price channels. TimesSquare’s management team holds the Goodwill 2005(1) 2006(2) $ 7,679 $ 11,488 2,145 2,045 54,069 43,481 11,200 36,199 (27,086) (10,015) 193,796 2,611 — — — 87,040 remaining interest. The transaction was financed through Net assets acquired $ 267,987 $ 146,665 the Company’s available cash. The Company purchased an additional interest in its Affiliate, Friess Associates, LLC (“Friess”) in 2004 pursuant to the terms of the Company’s original investment in Friess in 2001. The transaction was financed through the (1) In connection with the Company’s investment in equity method Affiliates in 2005, approximately $22,000 of acquired client relation- ships and $14,200 of goodwill have been classified within Equity investments in Affiliates. (2) The Company’s purchase price allocation of Chicago Equity Partners is subject to the finalization of the valuation of acquired client relationships. As a result, these preliminary amounts may be revised in future periods. 77 Unaudited pro forma financial results are set forth below, interests to the Company at certain intervals and upon their giving consideration to the investments and acquisitions in death, permanent incapacity or termination of employment 2005 and 2006, as if such transactions occurred as of the and provide Affiliate managers a conditional right to beginning of 2005, assuming revenue sharing arrangements require the Company to purchase such retained equity had been in effect for the entire period and after making interests upon the occurrence of specified events. The certain other pro forma adjustments. purchase price of these conditional purchases are generally Revenue Net Income Year Ended December 31, 2005 2006 $ 976,751 $1,201,686 123,153 152,460 Earnings per share—basic $ Earnings per share—diluted $ 3.64 2.93 4.87 3.77 In conjunction with certain acquisitions, the Company has entered into agreements and is contingently liable, upon achievement of specified financial targets, to make addi- tional purchase payments of up to $165,000 through 2011. The specified financial targets for certain agreements will be measured beginning December 31, 2007. In the event the first financial target is achieved, the Company will make a payment of up to $50 million in 2008. In addition to the investments described above, in the years ended December 31, 2004, 2005, and 2006, the Company completed additional investments in existing Affiliates and transferred interests in certain affiliated investment management firms. The financial effect of these transac- tions was not material to the Company’s results. Many of the Company’s operating agreements provide Affiliate managers a conditional right to require AMG to purchase their retained equity interests at certain intervals. Certain agreements also provide AMG a conditional right to require Affiliate managers to sell their retained equity Balance, as of December 31, 2004 Goodwill acquired, net Foreign currency translation Balance, as of December 31, 2005 Goodwill acquired, net Foreign currency translation Balance, as of December 31, 2006 calculated based upon a multiple of the Affiliate’s cash flow distributions, which is intended to represent fair value. As one measure of the potential magnitude of such purchases, in the event that a triggering event and resulting purchase occurred with respect to all such retained equity interests as of December 31, 2006, the aggregate amount of these payments would have totaled approximately $1,324,800. In the event that all such transactions were closed, AMG would own the prospective cash flow distributions of all equity interests that would be purchased from the Affiliate managers. As of December 31, 2006, this amount would represent approximately $170,400 on an annualized basis. 15 Goodwill and Acquired Client Relationships In 2005 and 2006, the Company completed new invest- ments, acquired additional interests in existing Affiliates and transferred certain interests to Affiliate management. The goodwill resulting from the acquisition of a group of Canadian firms is not deductible for tax purposes. The other goodwill generated during this period is deductible for tax purposes. The increase in goodwill associated with transac- tions with consolidated investments, net of the cost of transferred interests, the carrying amounts of goodwill, as well as the impact of foreign currency translation, are reflected in the following table for each of the Company’s operating segments, which are discussed in greater detail in Note 23: Mutual Fund $ 345,731 86,897 4,681 437,309 17,490 (238) $ 454,561 Institutional $ 356,849 84,188 4,572 445,609 58,692 (233) $ 504,068 High Net Worth $ 185,987 22,711 1,633 210,331 8,350 (83) $ 218,598 Total $ 888,567 193,796 10,886 1,093,249 84,532 (554) $ 1,177,227 6 0 0 2 t r o p e R l a u n n A . c n I , p u o r G s r e g a n a M d e t a i l i f f A 78 In connection with the Company’s equity method investments, approximately $186,600 and $185,300 of goodwill have been classified within Equity investments in Affiliates as of December 31, 2005 and 2006, respectively. The following table reflects the components of intangible assets of consolidated investments as of December 31, 2005 and 2006: Amortized intangible assets: Acquired client relationships 2005 2006 Carrying Amount Accumulated Amortization Carrying Amount Accumulated Amortization $ 336,549 $ 109,108 $ 379,703 $ 136,486 Non-amortized intangible assets: Acquired client relationships—mutual fund management contracts Goodwill 256,251 1,093,249 — — 258,849 1,177,227 — — For the Company’s consolidated investments, definite-lived As a result of the sale of Affiliate equity interests to certain acquired client relationships are amortized over their expected employees, the Company’s Affiliate ownership percentage useful lives. As of December 31, 2006, these relationships in those Affiliates varies. Accordingly, the Company were being amortized over a weighted average life of approxi- reported an increase in its stockholders’ equity and the mately 12 years. Amortization expense was $18,339, $24,873 carrying value of its investments (primarily goodwill and and $27,378 for the years ended December 31, 2004, 2005 acquired client relationships) of approximately $2,200 in and 2006, respectively. The Company estimates that amorti- 2005, and a decrease in stockholders’ equity and the zation expense will be approximately $32,000 per year from carrying value of its investments of approximately $11,569 2007 through 2011, assuming no additional investments in in 2006. new or existing Affiliates. In connection with the Company’s equity method invest- 16 Minority Interest ments, approximately $93,800 and $86,300 of amortizable Minority interest in the Consolidated Statements of acquired client relationships have been classified within Income includes the income allocated to owners of consol- Equity investments in Affiliates, as of December 31, 2005 idated Affiliates, other than AMG. For the years ended and 2006, respectively. These acquired client relationships December 31, 2004, 2005 and 2006, this income was are amortized over their expected useful lives. As of $115,524, $144,263 and $212,523, respectively. Minority December 31, 2006, these relationships were being amor- interest on the Consolidated Balance Sheets includes capital tized over a weighted average life of approximately 11 years. and undistributed profits owned by the managers of the Amortization expense of $8,483 and $9,290 was recorded consolidated Affiliates (including profits allocated to relating to these acquired client relationships in 2005 and managers from the Owners’ Allocation and Operating 2006, respectively. The Company estimates that amortiza- Allocation). For the years ended December 31, 2004, 2005 tion expense will be approximately $9,300 per year from and 2006, profit distributions to management owners were 2007 through 2011, assuming no additional investment in equity method affiliates. $121,714, $185,732 and $287,899, respectively. 79 17 Stockholders’ Equity Preferred Stock The Company is authorized to issue up to 5,000,000 shares of Preferred Stock in classes or series and to fix the designa- tions, powers, preferences and the relative, participating, optional or other special rights of the shares of each series and any qualifications, limitations and restrictions thereon as set forth in the stock certificate. Any such Preferred Stock issued by the Company may rank prior to common stock as to dividend rights, liquidation preference or both, may have full or limited voting rights and may be convertible into shares of common stock. Common Stock The Company’s Board of Directors has authorized the issuance of up to 150,000,000 shares of Voting Common Stock and 3,000,000 shares of Class B Non-Voting Common Stock. In 2004, the Company’s Board of Directors authorized share repurchase programs in connec- In 2005, the Company net settled a forward equity sale agreement for approximately $14,000 in cash, which was recorded as a reduction to stockholders’ equity. In March 2006, the Company entered into a series of call spread option agreements with a major securities firm. The agreements provide the Company the option, but not the obligation, to repurchase up to 0.9 million shares of its common stock, beginning in June 2007 and ending in December 2007, at a weighted-average price of $99.59 per share. If the Company’s prevailing share price exceeds $132.74, on a weighted-average basis during this period, the net number of shares available for repurchase under the agreements will be reduced. In the event the Company elects to exercise its option, the Company may elect to receive cash proceeds rather than shares of common stock. In connection with these agreements, the Company made payments of $13,290, which were recorded as a reduction of stockholders’ equity. tion with the issuance of the Company’s 2004 PRIDES, Convertible Securities pursuant to which the Company was authorized to repur- chase (i) up to 3.0 million shares of common stock at the time of the closing of the Company’s 2004 PRIDES and (ii) an additional 1.5 million shares in 2005. The Company’s Board of Directors established share repurchase programs permitting the repurchase of up to an additional 4 million shares of common stock in March 2006, and a share repurchase program permitting for the repurchase of up to an additional 1.6 million shares of common stock in July 2006. The timing and amount of purchases are deter- mined at the discretion of AMG’s management. In the year ended December 31, 2005, the Company repurchased 1.2 million shares of common stock at an average price of $76.10 per share. In the year ended December 31, 2006, the Company repurchased 5.5 million shares of common stock at an average price of $98.10 per share. As of The Company’s 2004 PRIDES contain freestanding forward contracts that require holders to purchase shares of the Company’s common stock at a certain date in the future. Additionally, the Company’s zero coupon and floating rate convertible securities both contain an embedded right for holders to receive shares of the Company’s common stock under certain conditions. All of these arrangements, the forward equity sale agreement and call spread option agreements (described above) meet the definition of equity under FASB Emerging Issues Task Force Issue No. 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock” and are not considered deriv- ative instruments under FAS 133 or required to be accounted for separately. December 31, 2006, the Company had the ability to Stock Option and Incentive Plans acquire up to 0.8 million shares of common stock under its The Company established the 1997 Stock Option and authorized share repurchase program (see Note 24— Incentive Plan (as amended and restated, the “1997 Plan”), Subsequent Events). under which it is authorized to grant options to employees 6 0 0 2 t r o p e R l a u n n A . c n I , p u o r G s r e g a n a M d e t a i l i f f A 80 and directors. In 2002, stockholders approved an amend- after the grant date. All options have been granted with ment to increase the number of shares of common stock exercise prices equal to the fair market value of the authorized for issuance under this plan to 7,875,000. Company’s common stock on the date of grant. In 2002, the Company’s Board of Directors established the The following table summarizes the transactions of the 2002 Stock Option and Incentive Plan (as amended and Company’s stock option and incentive plans: restated, the “2002 Plan”), under which the Company is authorized to grant non-qualified stock options and certain other awards to employees and directors. This plan requires that the majority of grants under the plan in any three-year period must be issued to employees of the Company who are not executive officers or directors of the Company. This Stock Options Weighted Average Exercise Price Weighted Average Remaining Contractual Life (years) Unexercised options outstanding— January 1, 2006 7,808,389 $ 41.26 plan was approved by the Company’s Board of Directors. Options granted 967,094 101.89 There are 3,375,000 shares of the Company’s common Options exercised (1,287,781) stock authorized for issuance under this plan. Options forfeited (82,880) 33.00 52.13 In December 2003, the Board of Directors approved an amendment to each of the 1997 Plan and 2002 Plan to accelerate the vesting of the then-outstanding unvested options (other than options granted to directors). The shares issuable upon the exercise of the accelerated options remain subject to restrictions on transfer which lapse according to specified schedules, for so long as the option holder remains employed by the Company. In the event the option holder ceases to be employed by the Company, the transfer restrictions will remain outstanding until the later of December 2010, or seven years after the date of grant. All shares received upon exercise remain the property of the holder under any circumstance subject to transfer restrictions. In May 2006, the stockholders of the Company approved the 2006 Stock Option and Incentive Plan (the “2006 Plan”), under which the Company is authorized to grant stock options and stock appreciation rights to senior management, employees and directors. There are 3,000,000 shares of the Company’s common stock author- ized for issuance under this plan. The plans are administered by a committee of the Board of Directors. Under the plans, options generally vest over a period of three to four years and expire seven to ten years Unexercised options outstanding— December 31, 2006 Exercisable at 7,404,822 50.49 December 31, 2006 6,387,093 42.51 5.1 4.8 Exercisable and free from restrictions on transfer at December 31, 2006 5,196,266 39.59 4.2 The Company generally uses treasury stock to settle stock option exercises. The total intrinsic value of options exercised during the years ended December 31, 2004, 2005 and 2006 was $23,640, $41,442 and $78,371. As of December 31, 2006, the intrinsic value of options that were vested and free from restrictions on transfer was $340,563. As of that date, the total intrinsic value of all vested options (including those subject to restrictions on transfer) was $399,960, and the intrinsic value of unvested options was $4,640. During the year ended December 31, 2006, the cash received and the actual tax benefit recognized for options exercised were $41,886 and $28,529, respectively. During the year ended December 31, 2006, the excess tax benefit classified as a financing cash flow was $23,047. 81 The Company’s Net Income for the year ended December following is a reconciliation of the numerator and denomi- 31, 2006 includes $1,042 of compensation expense and nator used in the calculation of basic and diluted earnings $612 of income tax benefits, related to our equity-based per share available to common stockholders. Unlike all compensation arrangements. As of December 31, 2006, other dollar amounts in these Notes, the amounts in the there was $28,247 of deferred compensation expense numerator reconciliation are not presented in thousands. related to stock options which will be recognized over a weighted average period of approximately three years (assuming no forfeitures). The Company periodically issues Affiliate equity interests to certain Affiliate employees. The estimated fair value of equity granted in these awards, net of estimated forfeitures, is recorded as compensation expense over the service period as equity based compensation. The fair value of options granted is estimated using the Black-Scholes option pricing model. The weighted average fair value of options granted during the years ended December 31, 2004, 2005 and 2006 was $12.77, $20.95 and $28.66 per option, respectively, based on the assump- tions stated below. Year Ended December 31, Dividend yield Expected volatility(1) Risk-free interest rate(2) Expected life of options (in years)(3) Forfeiture rate(3) 2004 0.0% 20.4% 3.3% 4.4 0.0% 2005 0.0% 19.9% 4.4% 5.0 0.0% 2006 0.0% 22.6% 4.9% 4.4 5.0% (1) Based on the implied volatility of the Company’s common stock. (2) Based on the U.S. Treasury yield curve in effect at the date of grant. (3) Based on historical data. 18 Earnings Per Share Year Ended December 31, 2004 2005 2006 $ 77,147,000 $ 119,069,000 $ 151,277,000 3,016,000 6,693,000 17,618,000 $ 80,163,000 $ 125,762,000 $ 168,895,000 Year Ended December 31, 2004 2005 2006 Numerator: Net Income Interest expense on contingently convertible securities, net of taxes Net income, as adjusted Denominator: Average shares outstanding—basic 29,994,560 33,667,542 31,289,005 Effect of dilutive instruments: Stock options 1,552,613 2,244,874 2,542,878 Forward equity agreement Contingently convertible securities Mandatory convertible securities Average shares outstanding— diluted 41,550 88,654 — 8,055,953 8,688,585 10,727,266 — — 599,853 39,644,676 44,689,655 45,159,002 The calculation of diluted earnings per share in the years ended December 31, 2004, 2005, and 2006 excludes the The calculation of basic earnings per share is based on the effect of the call spread option agreements and the poten- weighted average number of shares of the Company’s common stock outstanding during the period. Diluted tial exercise of options to purchase approximately 0.9, 0.1 and 0.9 million common shares, respectively, because the earnings per share is similar to basic earnings per share, but effect would be anti-dilutive. This calculation also excludes adjusts for the effect of the potential issuance of incre- the effect of any potential exercise of the forward purchase mental shares of the Company’s common stock. The contract component of the 2004 PRIDES and the 2001 6 0 0 2 t r o p e R l a u n n A . c n I , p u o r G s r e g a n a M d e t a i l i f f A 82 PRIDES (prior to the August 2004 exercise) because the Notional amounts and credit exposures of derivatives effect would have been anti-dilutive. The notional amount of derivatives does not represent amounts that are exchanged by the parties, and thus are not a In 2005, the Company net settled its forward equity sale measure of the Company’s exposure. The amounts exchanged agreement for approximately $14,000 in cash, which was are calculated on the basis of the notional or contract recorded as a reduction to stockholders’ equity. Prior to the amounts, as well as on other terms of the interest rate swap settlement of the forward equity sale agreement, the derivatives and the volatility of these rates and prices. Company was required to use the treasury stock method to measure potentially issuable shares. The Company would be exposed to credit-related losses in the event of nonperformance by the counter parties that As more fully discussed in Notes 7, 8, and 9, the Company issued the financial instruments, although the Company had convertible securities outstanding during the years ended does not expect that the counter parties to interest rate December 31, 2004, 2005 and 2006. The aggregate number swaps will fail to meet their obligations, given their typi- of shares of common stock that could be issued in the future cally high credit ratings. The credit exposure of derivative to settle these securities are deemed outstanding for the contracts is represented by the positive fair value of purposes of the calculation of diluted earnings per share. This contracts at the reporting date, reduced by the effects of approach, referred to as the if-converted method, requires master netting agreements. The Company generally does that such shares be deemed outstanding regardless of whether not give or receive collateral on interest rate swaps because the notes are then contractually convertible into the of its own credit rating and that of its counter parties. Company’s common stock. For this if-converted calculation, the interest expense (net of tax) attributable to these securi- Interest Rate Risk Management ties is added back to Net Income, reflecting the assumption From time to time, the Company enters into interest rate that the securities have been converted. swaps to reduce exposure to interest rate risk connected to existing liabilities. The Company does not hold or issue For the years ended December 31, 2004, 2005 and 2006, derivative financial instruments for trading purposes. the Company repurchased approximately 3.5, 1.2 and 5.5 Interest rate swaps are intended to enable the Company to million shares of common stock, respectively, under various achieve a level of variable-rate and fixed-rate debt that is stock repurchase programs. 19 Financial Instruments and Risk Management acceptable to management and to limit interest rate expo- sure. The Company agrees with another party to exchange the difference between fixed-rate and floating rate interest amounts calculated by reference to an agreed notional The Company is exposed to market risks brought on by principal amount. changes in interest and currency exchange rates. The Company does not enter into foreign currency transactions Fair Value or derivative financial instruments to reduce risks associated Financial Accounting Standard No. 107 (“FAS 107”), with changes in currency exchange rates. The Company “Disclosures about Fair Value of Financial Instruments,” uses derivative financial instruments to reduce risks associ- requires the Company to disclose the estimated fair values ated with changes in interest rates. for certain of its financial instruments. Financial instru- ments include items such as loans, interest rate contracts, notes payable and other items as defined in FAS 107. 83 Fair value of a financial instrument is the amount at which the instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquida- tion sale. Quoted market prices are used when available; otherwise, management estimates fair value based on prices of financial instruments with similar characteristics or by using valuation techniques such as discounted cash flow Revenue Operating income Income before income taxes Net Income Earnings per 2005 First Quarter Second Quarter Third Quarter Fourth Quarter $ 201,612 $ 208,257 $ 234,126 $ 272,497 104,011 75,783 74,492 80,769 41,215 25,553 41,653 26,241 45,254 28,510 61,530 38,764 models. Valuation techniques involve uncertainties and share—diluted $ 0.61 $ 0.63 $ 0.67 $ 0.90 require assumptions and judgments regarding prepayments, credit risk and discount rates. Changes in these assump- tions will result in different valuation estimates. The fair value presented would not necessarily be realized in an immediate sale nor are there typically plans to settle liabili- ties prior to contractual maturity. Additionally, FAS 107 allows companies to use a wide range of valuation tech- niques; therefore, it may be difficult to compare the Company’s fair value information to other companies’ fair value information. The carrying amount of cash, cash equivalents and short- term investments approximates fair value because of the short-term nature of these instruments. The carrying value of notes receivable approximate fair value because interest rates and other terms are at market rates. The carrying value of notes payable approximates fair value principally because of the short-term nature of the notes. The carrying value of senior bank debt approximates fair value because the debt is a revolving credit facility with variable interest based on selected short-term rates. The fair market value of the zero coupon senior convertible debt, the floating rate senior convertible securities, the 2004 mandatory convertible debt, and the junior convertible trust preferred securities at December 31, 2006 was $223,446, $777,750, $450,267 and $321,900, respectively. 2006 First Quarter Second Quarter Third Quarter Fourth Quarter $ 278,042 $ 283,108 $ 280,440 $ 328,763 143,674 104,474 102,059 55,937 35,240 51,632 33,936 52,613 33,146 77,705 48,955 Revenue Operating income 103,706 Income before income taxes Net Income Earnings per share—diluted $ 0.81 $ 0.86 $ 0.87 $ 1.21 In each of the quarters in 2006, the Company experienced an increase in revenue (and consequently operating income, income before income taxes, Net Income and Earnings per share) from the same period in 2005, primarily as a result of the growth in assets under management resulting from positive investment performance and cash flows and, to a lesser extent, from the Company’s investments in new Affiliates in 2005. 21 Related Party Transactions The Company recorded amounts payable to Affiliate part- ners of $4,567 and $36,736 in connection with the purchase of additional Affiliate equity interests in 2005 and 2006, respectively. The total amount due to Affiliate partners as of December 31, 2006 was $42,364, of which $41,086 is due in 2007 and is included as a current liability. 20 Selected Quarterly Financial Data (Unaudited) The following is a summary of the quarterly results of oper- ations of the Company for the years ended December 31, 2005 and 2006. The Company recorded recourse notes receivable from Affiliate partners of $12,060 in connection with the transfer of Affiliate equity interests in 2006. The total amount due from Affiliate partners as of December 31, 2006 was $18,365. 6 0 0 2 t r o p e R l a u n n A . c n I , p u o r G s r e g a n a M d e t a i l i f f A 84 In certain cases, Affiliate management owners and Revenue in the Mutual Fund distribution channel is earned Company officers may serve as trustees or directors of from advisory and sub-advisory relationships with all certain mutual funds from which the Affiliate earns advi- domestically registered investment products as well as non- sory fee revenue. 22 Summarized Financial Information of Equity Affiliates The following table presents summarized financial infor- mation for the years ended December 31, 2005 and 2006 on a combined 100 percent basis of the Affiliate invest- ments accounted for under the equity method. Investments accounted for under the equity method were not significant in years prior to 2005. Current assets Noncurrent assets Current liabilities Noncurrent liabilities Revenue Net Income 2005 2006 $ 158,676 $ 154,755 108,028 115,361 23,612 1,741 269,004 211,985 41,175 1,221 345,852 240,371 The Company’s share of undistributed earnings from equity method investments totaled $22,638 as of December 31, 2006. 23 Segment Information Financial Accounting Standard No. 131, “Disclosures about Segments of an Enterprise and Related Information” (“FAS 131”) establishes disclosure requirements relating to oper- ating segments in annual and interim financial statements. Management has assessed the requirements of FAS 131 and determined that the Company operates in three business segments representing the Company’s three principal distri- bution channels: Mutual Fund, Institutional and High Net Worth, each of which has different client relationships. institutional investment products that are registered abroad. Revenue in the Institutional distribution channel is earned from relationships with foundations and endow- ments, defined benefit and defined contribution plans and Taft-Hartley plans. Revenue in the High Net Worth distri- bution channel is earned from relationships with wealthy individuals, family trusts and managed account programs. Revenue earned from client relationships managed by Affiliates accounted for under the equity method is not consolidated with the Company’s reported revenue but instead is included (net of operating expenses, including amortization) in “Income from equity method invest- ments”, and reported in the distribution channel in which the Affiliate operates. Income tax attributable to the profits of the Company’s equity method Affiliates is reported within the Company’s consolidated income tax provision. In firms with revenue sharing arrangements, a certain percentage of revenue is allocated for use by management of an Affiliate in paying operating expenses of that Affiliate, including salaries and bonuses, and is called an “Operating Allocation.” In reporting segment operating expenses, Affiliate expenses are allocated to a particular segment on a pro rata basis with respect to the revenue generated by that Affiliate in such segment. Generally, as revenue increases, additional compensation is typically paid to Affiliate management partners from the Operating Allocation. As a result, the contractual expense allocation pursuant to a revenue sharing arrangement may result in the characteriza- tion of any growth in profit margin beyond the Company’s Owners’ Allocation as an operating expense. All other oper- ating expenses (excluding intangible amortization) and interest expense have been allocated to segments based on the proportion of cash flow distributions reported by Affiliates in each segment. 85 2004 Revenue Operating expenses: Depreciation and other amortization Other operating expenses Operating income Non-operating (income) and expenses: Investment and other income Income from equity method investments Investment income from Affiliate investments in partnerships Interest expense Income before minority interest and income taxes Minority interest Income before income taxes Income taxes Net Income Total assets Goodwill 2005 Revenue Operating expenses: Depreciation and amortization Other operating expenses Operating income Non-operating (income) and expenses: Investment and other income Income from equity method investments Investment income from Affiliate investments in partnerships Interest expense Income before minority interest and income taxes Minority interest Income before income taxes Income taxes Net Income Total assets Goodwill 2006 Revenue Operating expenses: Depreciation and amortization Other operating expenses Operating income Non-operating (income) and expenses: Investment and other income Income from equity method investments Investment income from Affiliate investments in partnerships Interest expense Income before minority interest and income taxes Minority interest Minority interest in Affiliate investments in partnerships Income before income taxes Income taxes Net Income Total assets Goodwill 6 0 0 2 t r o p e R l a u n n A . c n I , p u o r G s r e g a n a M d e t a i l i f f A 86 Mutual Fund Institutional $ 261,858 $ 262,356 1,854 143,592 145,446 116,412 (4,361) — — 13,515 9,154 107,258 (43,948) 63,310 25,478 $ 37,832 $779,824 $345,731 13,715 144,704 158,419 103,937 (1,601) (1,265) — 11,961 9,095 94,842 (49,872) 44,970 18,081 $ 26,889 $ 791,300 $ 356,849 High Net Worth $ 135,783 9,139 79,111 88,250 47,533 (964) — (269) 6,249 5,016 42,517 (21,704) 20,813 8,387 $ 12,426 $ 362,297 $ 185,987 Total $ 659,997 24,708 367,407 392,115 267,882 (6,926) (1,265) (269) 31,725 23,265 244,617 (115,524) 129,093 51,946 $ 77,147 $ 1,933,421 $ 888,567 $ 400,859 $ 385,681 $ 129,952 $ 916,492 4,185 235,795 239,980 160,879 (4,379) (516) — 15,657 10,762 150,117 (59,658) 90,459 33,674 $ 56,785 $873,386 $437,309 17,863 231,779 249,642 136,039 (3,797) (25,719) — 17,264 (12,252) 148,291 (66,616) 81,675 30,386 $ 51,289 $1,106,187 $ 445,609 9,854 81,961 91,815 38,137 (695) (735) (445) 4,505 2,630 35,507 (17,989) 17,518 6,523 $ 10,995 $ 342,063 $ 210,331 31,902 549,535 581,437 335,055 (8,871) (26,970) (445) 37,426 1,140 333,915 (144,263) 189,652 70,583 $ 119,069 $ 2,321,636 $ 1,093,249 $ 501,739 $ 514,761 $ 153,853 $ 1,170,353 6,734 291,571 298,305 203,434 (7,088) (1,087) — 24,360 16,185 187,249 (80,333) — 106,916 38,869 $ 68,047 $898,150 $454,561 22,511 295,733 318,244 196,517 (6,584) (34,503) — 27,606 (13,481) 209,998 (106,536) — 103,462 37,715 $ 65,747 $1,279,981 $ 504,068 6,896 92,995 99,891 53,962 (3,271) (2,728) (3,400) 6,834 (2,565) 56,527 (25,654) (3,364) 27,509 10,026 $ 17,483 $ 487,789 $ 218,598 36,141 680,299 716,440 453,913 (16,943) (38,318) (3,400) 58,800 139 453,774 (212,523) (3,364) 237,887 86,610 $ 151,277 $ 2,665,920 $ 1,177,227 As of December 31, 2004, an equity method investment of $252,597 is included in the total assets of the Institutional segment. As of December 31, 2005, equity method invest- ments of $8,717, $282,189 and $10,570 are included in the total assets of the Mutual Fund, Institutional and High Net Worth segments, respectively. As of December 31, 2006, equity method investments of $6,451, $273,170 and $13,819 are included in the total assets of the Mutual Fund, Institutional and High Net Worth segments, respectively. 24 Subsequent Events The Company entered into an amended and restated senior revolving credit facility (the “Facility”) in February 2007, which allows for borrowings of up to $650 million at rates of interest (based either on the Eurodollar rate or the prime rate as in effect from time to time) that vary depending on our credit ratings. Subject to the agreement of the lenders (or prospective lenders) to increase their commitments, the Company has the option to borrow up to an aggregate of $800 million under this Facility. The Facility will mature in February 2012, and contains financial covenants with respect to leverage and interest coverage. The Facility also contains customary affirmative and negative covenants, including limitations on indebtedness, liens, cash dividends and fundamental corporate changes. Borrowings under the Facility are collateralized by pledges of the substantial majority of capital stock or other equity interests owned by the Company. On February 23, 2007, the Board of Directors approved a share repurchase program permitting the Company to repurchase 3.0 million shares of common stock, in addition to those shares that may be purchased pursuant to the Company’s previously authorized share repurchase programs. Purchases may be made from time to time, at management’s discretion, in the open market or in privately negotiated transactions, including through the use of deriv- ative instruments. As of February 23, 2007, there were 3.2 million shares that could be purchased under the Company’s share repurchase programs. 87 C o m m o n S t o c k a n d C o r p o r a t e O r g a n i z a t i o n I n f o r m a t i o n Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities and shares of our common stock when appropriate, and develop our existing business, and since our credit facility Our common stock is traded on the New York Stock prohibits us from making cash dividend payments to our Exchange (symbol: AMG). The following table sets forth stockholders, we do not anticipate paying cash dividends the high and low prices as reported on the New York Stock on our common stock in the foreseeable future. Exchange composite tape since January 1, 2005 for the Issuer Purchases of Equity Securities periods indicated. 2005 First Quarter Second Quarter Third Quarter Fourth Quarter 2006 First Quarter Second Quarter Third Quarter Fourth Quarter High Low $ 68.09 $ 59.82 69.30 74.84 83.20 57.08 68.40 68.60 $ 108.58 $ 79.58 107.46 101.81 105.97 81.56 84.00 92.09 The closing price for a share of our common stock as Period Total Number of Shares Purchased Average Price Paid Per Share — $ October 1-31, 2006 November 1-30, 2006 570,400 244,500 December 1-31, 2006 814,900 Total — $ 101.04 $ 104.05 $ 101.94 Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs(1) Maximum Number of Shares that May Yet Be Purchased Under the Plans or Programs(2) — 1,610,311 1,039,911 795,411 795,411 570,400 814,900 814,900 (1) Notes 17 and 24 to the Consolidated Financial Statements provide additional detail with respect to our share repurchase programs. (2) On February 23, 2007, our Board of Directors authorized a new share repurchase program permitting us to repurchase 3.0 million shares of our common stock. As of February 23, 2007, there were 3.2 million shares that could be purchased under our share repurchase programs. reported on the New York Stock Exchange composite tape Employees and Corporate Organization on February 22, 2007 was $117.41. As of February 22, As of December 31, 2006, we employed approximately 75 2007, there were 35 stockholders of record. persons and our Affiliates employed approximately 1,200 We have not declared a cash dividend with respect to the employees. Neither we nor any of our Affiliates is subject to periods presented. Since we intend to retain earnings to any collective bargaining agreements, and we believe that finance investments in new Affiliates, repay indebtedness, our labor relations are good. We were formed in 1993 as a pay interest and income taxes, repurchase debt securities corporation under the laws of the State of Delaware. persons, the substantial majority of which were full-time Endnotes Notes to Financial Highlights (1) Cash Net Income is defined as Net Income plus amortization and deferred taxes related to intangible assets plus Affiliate depreciation. AMG’s use of Cash Net Income, including a reconciliation to Net Income, is discussed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” (2) Earnings before interest expense, income taxes, depreciation and amortization. (3) Cash Net Income (as described in Note 1, above) divided by the adjusted diluted average shares outstanding (see Note 4). (4) In the calculation of adjusted diluted average shares outstanding, the potential share issuance in connection with the Company’s convertible securities measures net shares using a “treasury stock” method. Under this method, only the net number of shares of common stock equal to the value of the contingently convertible securities and the junior convertible trust preferred securities in excess of par, if any, are deemed to be outstanding. The Company believes the inclusion of net shares under a treasury stock method best reflects the benefit of the increase in available capital resources (which could be used to repurchase shares of common stock) that occurs when these securities are converted and the Company is relieved of its debt obligation. This method does not take into account any increase or decrease in the Company’s cost of capital in an assumed conversion. Other Notes - Unless otherwise noted, data presented is as of December 31, 2006. - Investment product and performance information has been provided by each Affiliate to AMG, and is provided in this Annual Report for reference purposes only and not for investment or solicitation purposes. The investment performance of Affiliate products is compared to benchmarks deemed by the Affiliates and AMG to be the appropriate benchmarks for such products. 6 0 0 2 t r o p e R l a u n n A . c n I , p u o r G s r e g a n a M d e t a i l i f f A 88 Affiliated Managers Group, Inc. (NYSE: AMG) is an asset management company which operates through a diverse group of high quality boutique asset management firms (its “Affiliates”). AMG’s unique partnership approach with its Affiliates preserves the entrepreneurial orientation that distinguishes the most successful investment management firms. AMG promotes the continued growth and strong performance of its Affiliates by: • Maintaining and enhancing Affiliate managers’ equity incentives in their firms; • Preserving each Affiliate’s distinct culture and investment focus; and • Leveraging AMG’s scale to expand the product offerings and distribution capabilities of its Affiliates, and to provide its Affiliates access to the highest quality operations, compliance and technology resources. AMG seeks to achieve earnings growth through the internal growth of its Affiliates, growth and development initiatives designed to enhance its Affiliates’ businesses, and investments in new Affiliates. AMG’s Affiliates collectively manage approximately $250 billion (as of March 31, 2007) in more than 300 investment products across the institutional, mutual fund and high net worth distribution channels. AMG has achieved strong long-term growth in earnings, with compound annual growth in Cash Earnings Per Share of over 21 percent since its initial public offering in 1997. Contents Financial Highlights and Quarterly Earnings Letter to Shareholders AMG Overview Financial Information Endnotes Shareholder Information 1 2 8 33 88 Inside back cover Corporate Offices Affiliated Managers Group, Inc. 600 Hale Street Prides Crossing, Massachusetts 01965 617 747 3300 www.amg.com Independent Registered Public Accounting Firm PricewaterhouseCoopers LLP Boston, Massachusetts Transfer Agent and Registrar LaSalle Bank, NA Chicago, Illinois Stock Exchange Listing New York Stock Exchange Ticker Symbol: AMG Annual Meeting The Annual Meeting of Stockholders will be held at AMG’s offices in Prides Crossing, Massachusetts, on May 31, 2007. Form 10-K and Management Certifications Copies of the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission, including the certifications required by Section 302 of the Sarbanes-Oxley Act with respect to the Company’s fiscal year ended December 31, 2006, may be obtained without charge by requesting them from: Investor Relations Affiliated Managers Group, Inc. 600 Hale Street Prides Crossing, Massachusetts 01965 ir@amg.com This Annual Report to Stockholders contains forward-looking statements. There are a number of important factors that could cause AMG’s actual results to differ materially from those indicated by such forward-looking statements including, but not limited to, those listed elsewhere in this Annual Report and in the Section titled “Business–Cautionary Statements” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006 as filed with the Securities and Exchange Commission. On June 23, 2006, AMG’s Section 303A Annual CEO certification by Sean M. Healey was filed with the NYSE in accordance with Section 303A.12(a). Board of Directors Richard E. Floor Partner, Goodwin Procter LLP Sean M. Healey President and Chief Executive Officer Harold J. Meyerman Former Senior Executive, The Chase Manhattan Bank and First Interstate Bank, Ltd. William J. Nutt Chairman Rita M. Rodriguez Former Director, Export-Import Bank of the United States Patrick T. Ryan President and Chief Executive Officer, PolyMedica Corporation Jide J. Zeitlin Former General Partner, Goldman, Sachs & Co. Executive Officers William J. Nutt Chairman Sean M. Healey President and Chief Executive Officer Darrell W. Crate Executive Vice President and Chief Financial Officer Nathaniel Dalton Executive Vice President and Chief Operating Officer John Kingston, lll Executive Vice President and General Counsel Affiliated Managers Group, Inc. 600 Hale Street Prides Crossing, MA 01965 617 747 3300 www.amg.com Affiliated Managers Group, Inc. Annual Repor t 2006