Affiliated Managers Group Annual Report 2007

Plain-text annual report

Affiliated Managers Group, Inc. Annual Repor t 200 7 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, development initiatives designed to enhance its Afﬁliates’ businesses, and investments in new Afﬁliates. AMG’s Afﬁliates collectively manage approximately $275 billion (as of December 31, 2007) in more than 300 investment products across the institutional, mutual fund and high net worth distribution channels for investors around the world. AMG has achieved strong long-term growth in earnings, with compound annual growth in Cash Earnings Per Share of 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 29 87 88 Unless otherwise noted, data presented is as of December 31, 2007. 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) 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 2005 916.5 119.1 186.1 267.5 2.81 4.85 $ $ Years ended December 31, 2006 2007 $ 1,170.4 $ 1,369.9 151.3 222.5 342.1 3.74 5.68 $ 182.0 258.7 418.2 4.58 6.65 $ $ 2,321.6 $ 2,665.9 $ 3,395.7 665.5 300.0 0 817.4 778.9 300.0 300.0 499.2 897.6 300.0 800.0 469.2 Assets Under Management (at period end, in billions) $ 184.3 $ 241.1 $ 274.8 Average Shares Outstanding – diluted Average Shares Outstanding – adjusted diluted(4) 44.7 38.4 45.2 39.2 44.9 38.9 *For the Financial Highlights notes referenced above, please see page 87. Q u a r t e r l y E a r n i n g s $2.15 $2.00 $1.50 $1.00 $0.50 4Q 97 4Q 98 4Q 99 4Q 00 4Q 01 4Q 02 4Q 03 4Q 04 4Q 05 4Q 06 4Q 07 Cash Earnings Per Share Earnings Per Share (diluted) 1 T o O u r S h a r e h o l d e r s In November 2007, we marked the milestone of our 10th We have created substantial value for our shareholders over anniversary as a public company. Over the past decade, we the long term by building a strong and diverse business that have successfully executed our growth strategy of partnering includes many of the world’s leading boutique asset managers. with outstanding boutique asset managers and leveraging our Our Afﬁliates have outstanding performance records in their scale to enhance the growth and operations of our Affiliates. investment disciplines and established reputations for Through the strong organic growth of our Affiliates, as well as providing excellent client service, and they are well-positioned accretive new investments, we have generated compound to continue to deliver superior results for their clients and annual growth of 21 percent in Cash Earnings Per Share over generate organic growth at their firms. We have increased our that time, as compared to four percent growth in the S&P exposure to fast-growing asset classes, such as international 500 Index. equities and alternative investments (including through our 2007 investments in two high quality alternative managers), which now account for 30 percent and 20 percent of our AMG Executive Management 7 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 Sean M. Healey President and Chief Executive Ofﬁcer Nathaniel Dalton Executive Vice President and Chief Operating Officer Darrell W. Crate Executive Vice President and Chief Financial Ofﬁcer John Kingston, III Executive Vice President and General Counsel Jay C. Horgen Executive Vice President, New Investments In 2007, our participation across a range of investment styles and asset classes around the globe generated strong earnings growth, with Cash Earnings Per Share of $6.65, or growth of 17%, and EBITDA of $418 million, or growth of 22%. earnings, respectively. We also continue to increase our exposure and scale of our business has positioned us to continue to to fast-growing client segments worldwide — non-U.S. client deliver strong results for our shareholders. In the United States, assets at our Affiliates are approximately $85 billion, or 30 we participate broadly in domestic equity investment styles, percent of our total assets under management. from deep value to aggressive growth, as well as quantitative, AMG has a proven history of delivering strong and consistent earnings growth even in challenging market environments, such as those from 2000 to 2003, and the volatile markets in the second half of 2007. With over 300 products across a wide array of investment styles and asset classes around the globe, AMG is highly diversified, and the increased breadth real estate and other alternative strategies. Our earnings stability is enhanced by our substantial international client base, as well as the increasingly global profile of our investment products, including international developed market equities, emerging markets equities, and multi-strategy, currency and market neutral strategies. Finally, our increasing exposure to alternative investments provides us with earnings that are generally less correlated to the broader equity markets. 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 We believe international equities will continue to benefit from continued to build on their impressive one-, three- and five- long-term secular growth trends, and our participation in year performance records. Most notably, Friess Associates, this area will generate strong growth going forward. Two of manager of the Brandywine Funds, was a finalist for our largest Affiliates, Tweedy, Browne Company and Third Morningstar’s Domestic-Stock Manager of the Year award. Avenue Management, recently reopened highly regarded international equity products based on their view that the current market environment has produced a growing number of new investment opportunities worldwide. In addition, our Affiliate Genesis Investment Management is one of the largest and most experienced emerging markets equities managers In the domestic value equity area, which contributes 20 percent of our EBITDA, we have an outstanding array of products managed by such highly regarded and experienced managers as Tweedy, Browne, Third Avenue and Systematic Financial Management. in the industry, with outstanding long-term investment In the growing alternative investments segment of our performance and excellent prospects for continued growth. business, we have enhanced the diversity of our product mix The environment for domestic growth equities products, which contribute 25 percent of our EBITDA, was strong for much of the year, and we had excellent results among our growth equities managers. Affiliates specializing in this area offer a broad range of outstanding products with superior absolute and relative performance over the long term. As a group, our Affiliates, including Friess Associates, TimesSquare Capital Management, Frontier Capital Management Company, and Renaissance Investment Management, to include more than 40 distinct investment strategies, many of which have low correlation to the equity markets. Our alternative investment products are focused on a range of strategies, including distressed securities, quantitative global macro, activist investing and credit alternatives. Given the breadth of our alternative product offerings, we have significantly increased the potential contribution of 7 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 Over the past decade, we have successfully executed our growth strategy of partnering with outstanding boutique asset managers and leveraging our scale to enhance the growth and operations of our Affiliates. performance fees to our earnings, and we expect that asset managers. Over the past year, we launched our global performance fees will continue to provide a meaningful distribution platform with the opening of our Sydney office contribution to our earnings growth in the future. (in early 2007) to support institutional marketing initiatives We further expanded our exposure in the alternatives area during 2007 by completing accretive investments in two high quality firms with outstanding performance records, in Australia, followed by the opening of our London office (in early 2008) to support marketing efforts throughout the Middle East. BlueMountain Capital Management and ValueAct Capital. In the U.S. intermediary-driven marketplace, Managers BlueMountain, a leading global credit alternatives manager, has Investment Group continues to provide AMG Affiliates a proven track record of delivering exceptional absolute returns with a platform to meaningfully expand the distribution of for its clients. ValueAct is a premier active value investment their products to retail investors. Managers’ team of manager with strong prospects for continued growth. Both of experienced sales professionals distributes single- and multi- these firms offer products with little correlation to our current manager Affiliate mutual fund and separate account products portfolio of performance-fee products. to intermediaries, including broker-dealers, banks and We continue to enhance our Affiliates’ growth and profitability through our distribution platforms both in the independent advisors, as well as in the sub-advisory and defined contribution marketplaces. United States and internationally. Around the globe, our In addition to the growth of our existing Affiliates, AMG Affiliates have already demonstrated their strong appeal to continues to grow through accretive investments in new non-U.S. clients, but we see additional opportunities to Affiliates. We have an established track record of successful support client relationships in key international markets, investments, and an excellent reputation as an innovative and particularly markets where institutional investors are supportive partner to our Affiliates. AMG is widely regarded increasingly demanding the expertise of outstanding boutique 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 as the succession planning partner of choice among growing We have also positioned our capital structure to support our boutique firms, and prospective partners are also increasingly growth opportunities. Our business generates strong and attracted to the range of strategic support services we offer, recurring free cash flow, and we are disciplined in our from initiatives that can help firms expand their product approach to allocating our capital when making investments offerings and broaden their distribution capabilities, to our in new Affiliates, investing in growth initiatives on behalf legal and compliance resources. Our success in partnering of our existing Affiliates, and repurchasing our stock. AMG with boutique firms positions us to execute upon a range of maintains an investment grade rating and a strong balance very attractive investment opportunities within the universe sheet, with substantial liquidity and financial flexibility. of both traditional and alternative managers. In 2007, we enhanced our financial capacity through the AMG Board of Directors Sean M. Healey President and Chief Executive Ofﬁcer William J. Nutt Chairman Patrick T. Ryan Former Chief Executive Ofﬁcer, PolyMedica Corporation 7 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 With more than 300 products across a wide array of investment styles and asset classes, AMG is highly diversified, and the increased breadth and scale of our business has positioned AMG to continue to deliver strong results to our shareholders. issuance of a $500 million convertible trust preferred security we will generate substantial value for our shareholders in the and an increase in our credit facility, to $950 million. More future. We are grateful to our Affiliates, employees, Board of recently, in early 2008, we further strengthened our balance Directors and service providers for their contributions to our sheet through the conversion to equity of our $300 million ongoing success, and to our shareholders for their support. floating rate convertible securities and $300 million mandatory convertible securities. In conclusion, through the continued execution of our business strategy — partnering with the highest quality boutique asset managers in the world, and leveraging our scale to support and enhance their growth — we are confident that Sean M. Healey President and Chief Executive Ofﬁcer 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 Harold J. Meyerman Former Senior Executive, The Chase Manhattan Bank and First Interstate Bank, Ltd. A M G O v e r v i e w A M G O v e r v i e w AMG follows a proven, disciplined AMG’s success in executing its growth strategy for growing its business: invest in strategy has established a strong foundation excellent boutique asset management for continued growth. With the diversity businesses; allow management to retain and strong performance of AMG’s equity in their ﬁrm as a powerful incentive Afﬁliates, a proven ability and capacity for growth through a partnership structure to execute its growth initiatives, and that preserves the unique culture and AMG’s established position as a leading approach that has led to their success; and institutional partner for growing boutique then provide these Afﬁliates with a range asset management ﬁrms, AMG is of growth and development initiatives well-positioned to continue to generate designed to enhance their businesses. shareholder value in the future. 7 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 Investment Products combined with a growing emphasis on of the investment management industry, AMG’s Afﬁliates include some of the highest quality boutique investment alternative investments, gives AMG a while generating incremental growth signiﬁcant presence in some of the most by introducing Afﬁliate products into dynamic and fastest growing areas of the additional distribution channels. management ﬁrms in the industry. As a investment management industry. group, AMG Afﬁliates manage more Approximately 30 percent of AMG’s than 300 investment products across a EBITDA is derived from global, interna- broad array of investment styles. AMG’s tional and emerging markets equity Afﬁliates are leading investors in their products, 20 percent from alternative disciplines, with years of successful application of their investment processes demonstrated through their outstanding long-term performance records. AMG’s Afﬁliates predominantly offer active portfolio management of domestic and international equities, which, 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 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 investment 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 9 A M G ’ s E x p a n d i n g G l o b a l P r e s e n c e Diverse Global and International Products $150 Billion in Non-U.S. Investments International Developed Market Equities Emerging Markets Equities Currency, Market Neutral and Multi-Strategy Global Fixed Income U.S. Equities Growing International Client Base $85 Billion in Non-U.S. Clients Non-U.S. AUM U.S. AUM $275 Billion in total AUM as of December 31, 2007 7 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 11 in international markets, and have out- well-managed foreign companies believed investment vehicles and separate standing long-term performance records. to be priced below their intrinsic values. accounts, and has generated outstanding Tweedy, Browne’s Global Value product is among the largest and most distin- guished global value equity products, and follows a diversiﬁed, Graham and Dodd approach to global investing. The Global The Third Avenue International Value results in this area. Fund has delivered strong, long-term results by successfully applying the firm’s investment strategy and also reopened to new investors in 2007. First Quadrant employs its highly regarded quantitative investment strategies to identify stocks with shared fundamen- tal characteristics that are likely to have Value fund, which reopened to investors Genesis is a specialist manager of a similar impact upon the equity markets. in 2008, has an excellent long-term track emerging markets equities for institu- The ﬁrm’s diversiﬁed equity portfolios record and continues to generate strong tional clients. The ﬁrm aims to achieve include global long and long/short results for its investors. In 2007, the firm capital growth over the medium- to products, as well as regional products launched the Tweedy, Browne Worldwide long-term through a company-based such as a European market neutral High Dividend Yield Value Fund, which approach while mitigating country risk product, which has an excellent long- seeks long-term growth of capital by through extensive diversiﬁcation. term performance record. investing in companies around the globe that have above-average dividend yields and are reasonably valued in the market in relation to their underlying intrinsic value. AQR employs a disciplined and system- atic global research process through its global and international equity products to develop diversiﬁed portfolios that Third Avenue also applies a disciplined are overweight on cheap (and, in turn, value philosophy to investing in interna- underweight on expensive) international tional equities. The firm has generated securities, countries and currencies to solid long-term results utilizing its “safe achieve long-term success in both invest- and cheap” investment approach. Third ment performance and risk management. Avenue’s international value equity portfo- AQR manages international products on lios seek long-term capital appreciation by behalf of a wide range of leading global investing in the securities of well-ﬁnanced, institutional investors through collective Earnings Contribution By Product Category International Equities 30% Alternative Strategies 20% U.S. Growth Equities 25% U.S. Value Equities 20% Fixed Income 5% 7 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 12 Foyston, Gordon & Payne manages designed to generate strong returns to provide a meaningful contribution to value equity products for institutional with low correlation to traditional asset its earnings. and private clients. Foyston’s investment classes and the potential to earn incremen- products — Canadian equities, U.S. tal fees based upon their performance. equities and international equities — have With 14 Afﬁliates offering investment each generated strong, long-term invest- products with performance fee compo- ment results, signiﬁcantly outperforming nents, AMG realized a material their respective peers and benchmarks. contribution to its earnings from perform- Alternative Strategies Alternative products are among the most rapidly growing segments of the asset management industry, with many products ance fees in 2007. 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 AMG has substantially increased the breadth and diversity of its alternative product offerings through investments in leading firms such as First Quadrant, AQR, BlueMountain Capital Management, Genesis, Third Avenue and ValueAct Capital. Overall, the Company offers more than 40 distinct investment strategies, including distressed securities, quantitative global macro, active value and credit alternatives. A M G D i s t r i b u t i o n C h a n n e l s Earnings Contribution By Distribution Channel Institutional 50% Mutual Fund 40% High Net Worth 10% Institutional Distribution Channel AMG’s Affiliates offer approximately 200 investment products across more than 50 different investment styles in the institutional distribution channel, including small-, small/mid-, mid-, and large-capitalization value, growth equity and emerging markets. In addition, AMG’s Affiliates offer quantitative, alternative, credit arbitrage and fixed income products. AMG’s Affiliates manage assets for 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. In addition, AMG 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. AMG has also worked with its Affiliates to enhance their marketing and client service capabilities by establishing a global distribution platform. Through this platform, AMG provides institutional investors in fast-growing international marketplaces a single point of contact to access a broad range of investment products offered by its Affiliates. Mutual Fund Distribution Channel 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 both 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, client service and back-office capabilities of Managers Investment Group, AMG’s Affiliates are provided access to the mutual fund distribution channel and wrap sponsor platforms. Managers offers Affiliates a single point of contact for retail intermediaries such as banks, brokerage firms and other sponsored platforms. Within this distribution channel, Managers is presently servicing and distributing approximately 40 mutual funds, including funds managed by eight Affiliates. High Net Worth Distribution Channel AMG’s Affiliates serve two principal client groups in the high net worth distribution channel. The first group consists principally of direct relationships with high net worth 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 are generally brokerage firms or similar sponsors. AMG’s Affiliates provide investment management services through more than 90 managed account programs. AMG has undertaken several initiatives to provide its Affiliates with enhanced managed account distribution and administration capabilities. Through Managers Investment Group, AMG is presently distributing more than 40 investment products managed by nine Affiliates. Managers distributes single- and multi-manager separate account products and mutual funds through brokerage firms. 7 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 15 7 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 16 AMG's Affiliates have outstanding performance records in their investment disciplines and established reputations for providing excellent client service, and are well-positioned to continue to deliver superior results for their clients and generate organic growth at their firms. 17 First Quadrant offers investment global asset allocation strategies focused offers products ranging from aggressive management strategies in two main areas, on uncorrelated alpha sources across high volatility, market neutral hedge equities and global macro, while paying the globe. funds to low volatility, benchmark-driven close attention to risk management. In addition, First Quadrant’s Global Alternatives mutual fund offers retail investors access to the firm’s proven AQR employs a disciplined, multi-asset, traditional portfolios. global research process. The ﬁrm employs BlueMountain is a relative value more than 20 distinct investment investor in the global credit and equity strategies in managing its portfolios, and derivatives markets. The ﬁrm identifies 7 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 investment strategies using a combination Genesis, a leading investment firm in Third Avenue applies its disciplined of fundamental research and quantitative emerging markets equities, introduced value approach to products investing in and technical analysis. BlueMountain’s the Genesis Smaller Companies Fund in real estate securities, as well as distressed investment team operates in a highly 2006. The fund invests primarily in securities and other special situations. integrated manner, with risk management equity securities of firms that operate For example, the Third Avenue Real as a key element of the firm’s investment in emerging markets and have market Estate Value Fund invests primarily in process. capitalizations of less than $1 billion. equity and debt securities of companies in the real estate industry or related 19 7 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 20 industries, using bottom-up, fundamental and board of directors to implement Management and Renaissance analysis to identify undervalued securities. business strategies that enhance Investment Management have strong Third Avenue also has a long history shareholder value and create a return market positions and are well-respected of including investments in distressed independent of the market. as leading growth investors. debt securities within its equity mutual funds and has extended this expertise to investing in distressed and other special situations through private investment partnerships. ValueAct establishes substantial owner- ship positions in companies it believes to be fundamentally undervalued, and then works with the company’s management U.S. Growth Equity AMG’s Afﬁliates are among the leading boutique managers in the active manage- ment of U.S. equities. Among the Company’s larger Afﬁliates providing growth equity expertise, Friess Associates, TimesSquare Capital Management, Frontier Capital Friess uses a time-tested investment strategy that relies on exhaustive, company-by-company research to identify companies with dynamic earn- ings growth potential and a high probability for earnings surprises that have yet to be recognized by the broader investment community. Friess’ highly rated Brandywine mutual fund family is one of the most well-respected and best strategies. The ﬁrm has achieved excellent industry, with strong-performing products returns for its investors through its propri- including the Third Avenue Value and etary research driven, bottom-up process Third Avenue Small-Cap Value mutual of selecting companies that meet its funds. The ﬁrm seeks to invest in securities deﬁnition of superior growth businesses. and companies at a deep discount to Frontier offers a wide range of high quality investment products, including strategies focused on small-, small/mid-, the intrinsic value of their assets, and has created superior returns for its investors over the long term. mid-, and large-cap growth equities. Systematic specializes in the management The ﬁrm uses a highly disciplined stock of value equity portfolios across the selection process driven by intensive market capitalization spectrum. The internal research to generate excellent ﬁrm’s investment philosophy focuses on returns for its clients. Renaissance employs disciplined, systematic investment processes in the management of small-, mid-, and large- cap growth stocks. Renaissance’s portfolios follow specific investment disciplines designed to maximize return and control risk, and have generated strong, long-term results for the firm’s 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 domestic value equity products span a wide range of market capitalizations and include many of the industry’s most highly rated investment products. performing families of mutual funds, and Tweedy, Browne, a renowned practitioner it continues to generate superior results. In 2007, the firm was nominated for Morningstar’s Domestic-Stock Manager of the Year award. Friess also has of deep value investing, manages U.S. equity products including the Tweedy, Browne Value Fund, which reopened to investors in 2007, as well as individual identifying companies that exhibit a combination of attractive valuation and a positive earnings catalyst. This strategy has produced superior near- and long- term results for its clients. Fixed Income In addition to their specialized expertise in equity and alternative products, a num- ber 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. expanded its distribution internally in the accounts for institutional and high net While AMG’s Affiliates have independ- institutional channel, as well as in the retail and defined contribution channels through AMG’s Managers Investment Group platform. worth investors. Tweedy, Browne’s research ently demonstrated an ability to achieve seeks to appraise the intrinsic value of a company, and uses a disciplined buy strong organic growth, AMG has imple- mented a number of strategic initiatives and sell process to guide its investment to further enhance the growth and TimesSquare is among the industry’s leading growth equity managers, special- izing in small-, small/mid-, and mid-cap Third Avenue is among the leading value managers in the investment management decisions. proﬁtability of its Afﬁliates’ businesses. AMG makes available to its Afﬁliates a broad array of opportunities and services, 21 including initiatives designed to expand provide superior execution in sales, client an Afﬁliate’s product offerings and service and support. By providing its distribution capabilities, as well as cross- Affiliates with efficient and superior Afﬁliate initiatives that enable Afﬁliates distribution capabilities for international to streamline operations and obtain high investors in these regions, AMG expects quality services at cost-effective rates. to generate significant incremental client While Affiliates maintain the flexibility cash flows over time. AMG has identified and freedom to determine their participa- additional, fast-growing markets where its tion, nearly all have elected to participate high quality investment products appeal in one or more of these initiatives. to sophisticated institutional investors, Multi-Affiliate Distribution Platforms AMG’s Affiliates, like high quality boutique asset managers generally, integrate their specific investment process in every func- tion of the firm, including both sales and client service, which provides these firms with competitive advantages in bringing their products and services to certain dis- tribution channels in the marketplace, such as direct or consultant-driven institu- tional channels. In other channels, which require a breadth of product offerings and depth of marketing capacity, AMG has created distribution platforms that offer Affiliates the benefits of scale where they exist, while preserving each Affiliate’s dis- tinct operating and investment culture, as well as its unique set of relationships and marketing expertise. More than half of AMG’s Affiliates, including most of its and expects to further develop this plat- form in other regions around the world. In the United States, AMG’s Managers Investment Group distribution platform offers Affiliates the opportunity to mean- ingfully expand their product offerings and distribution capabilities through intermediaries in the 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 intermedi- aries, including broker-dealers, banks and independent advisors. In addition, the Managers Investment Group platform distributes Affiliate mutual funds in the defined contribution marketplace. largest Affiliates, use AMG as part of their Legal and Compliance Resources product distribution strategy. AMG has also leveraged the beneﬁts As institutional investors worldwide of scale to offer Afﬁliates cost-effective increasingly seek high quality investment access to high quality resources in areas managers, AMG has identified a number such as compliance and technology. As of opportunities to meet the global the regulatory climate in the investment demand for boutique asset managers. management industry continues to create AMG has recently established offices in complexity, Affiliates can take advantage Sydney and London to provide its Affiliates with access to institutional of AMG’s centralized resources as a source of support, providing a full range of investors in Australia and the Middle customized assistance across the universe of East. AMG’s experienced professionals requirements. By bringing the knowledge have broad expertise in serving these and experience of senior AMG attorneys markets and a demonstrated capacity to and compliance professionals to its 7 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 22 23 Afﬁliates, AMG provides industry expertise and robust, leading-edge com- pliance capabilities at a level well beyond that which would be typically available to boutique ﬁrms. Ongoing Succession Planning 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 Afﬁliates to manage each ﬁrm’s succession and transition process, with a focus on ensuring that equity incen- tives are properly allocated and aligned among key members of each ﬁrm. Investments in New Affiliates In addition to the strong organic growth of AMG’s existing Afﬁliates, AMG has generated substantial growth through accretive investments in additional high quality boutique firms. AMG’s investment strategy provides Afﬁliate managers with direct equity 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. AMG’s investment structure is attractive to successful asset managers who value their autonomy and continued participa- tion in their ﬁrm’s future growth. AMG continues to identify and develop relationships with high quality domestic and international boutique ﬁrms, and is well-positioned to execute new invest- ments, 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 7 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 and employees of ﬁrms that seek to facilitate ownership transitions, while maintaining their unique culture and approach and providing next generation management with key growth incentives through direct equity ownership. With a proven track record of value 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 creation, a disciplined investment strategy, approach to investing its free cash flow, and a strong, flexible balance sheet to sup- and adheres to well-deﬁned return port further growth, AMG is well-positioned for continued success in executing accretive investments in new Afﬁliates. objectives in making investments in growth initiatives for existing Afﬁliates, as well as in executing acquisitions of interests in new Afﬁliates. 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 flexibility. AMG manages its capital resources and cash flow to achieve superior long-term results for shareholders by ﬁnancing new investments, repaying existing indebtedness, and repurchasing its stock, when appropriate. 25 D i s t r i b u t i o n C h a n n e l s Institutional AQR Beutel BlueMountain Chicago Equity Partners Friess Frontier Genesis Gofen and Glossberg Davis Hamilton J.M. Hartwell Deans Knight Essex First Quadrant Foyston Montrusco Bolton Renaissance Rorer Skyline Systematic Third Avenue TimesSquare Tweedy, Browne ValueAct Welch & Forbes Mutual Fund Beutel First Quadrant Chicago Equity Partners Covington Davis Hamilton Deans Knight Essex Foyston Friess Frontier Genesis Managers High Net Worth BlueMountain Beutel Chicago Equity Partners Davis Hamilton Foyston Friess Frontier Gofen and Glossberg Montrusco Bolton Renaissance Skyline Systematic Third Avenue TimesSquare Tweedy, Browne Montrusco Bolton Renaissance Rorer Systematic Deans Knight J.M. Hartwell Third Avenue Essex First Quadrant Managers Tweedy, Browne ValueAct Welch & Forbes 7 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 I n v e s t m e n t P r o d u c t s International Equit ies Alternative Strategies Fixed Income AQR Beutel Deans Knight First Quadrant Foyston Genesis Managers Montrusco Bolton Renaissance Systematic Third Avenue Tweedy, Browne AQR BlueMountain Essex First Quadrant Genesis J.M. Hartwell Montrusco Bolton Renaissance Third Avenue ValueAct Beutel Chicago Equity Partners Davis Hamilton Deans Knight Essex Foyston Managers Montrusco Bolton U.S. Growth Equit ies U.S. Value Equit ies Chicago Equity Partners Davis Hamilton Essex Friess Frontier J.M. Hartwell Managers Montrusco Bolton Renaissance TimesSquare Welch & Forbes AQR Beutel Chicago Equity Partners First Quadrant Foyston Frontier Gofen & Glossberg Managers Rorer Skyline Systematic Third Avenue Tweedy, Browne 27 AMG Stock Price Performance Since IPO Cumulative Total Return November 21, 1997 – December 31, 2007 $800 $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 12/07 Afﬁliated Managers Group, Inc. Peer Group S&P 500 Index S&P 500 Financials Sector Index FPO-Last year’s copy for style only 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., T. Rowe Price Group, Inc., Waddell & Reed Financial, Inc. and W.P. Stewart & Co., Ltd. 7 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 Financial Information 30 Management’s Discussion and Analysis of Financial Condition and Results of Operations 53 Selected Financial Data 54 Management’s Report on Internal Control Over Financial Reporting 55 Report of Independent Registered Public Accounting Firm 56 Consolidated Financial Statements 60 Notes to Consolidated Financial Statements 86 Common Stock and Corporate Organization Information 29 Management’s Discussion and Analysis of Financial Condition and Results of Operations 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 anticipated,” “may,” “intends,” “believes,” “estimate,” “project” or similar expressions are intended to identify “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements are subject to certain risks and uncer- tainties, including, among others, the following: These factors (as well as those discussed above under “Risk Factors”) could affect our financial performance and cause actual results to differ materially from historical earnings 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 for- ward-looking statements, which speak only as of the date made. 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 may need to raise capital by making long-term or short-term borrowings or by selling shares of our common stock or other securities in order to finance investments in additional investment management firms or additional investments in our existing Affiliates, and we cannot be sure that such capital will be available to us on acceptable terms, if at all; and Overview We are an asset management company with equity invest- ments in a diverse group of boutique investment manage- ment firms (our “Affiliates”). We pursue a growth strategy designed to generate shareholder value through the internal growth of our existing business, additional investments in boutique investment management firms and strategic trans- actions and relationships designed to enhance our Affiliates’ businesses and growth prospects. Through our Affiliates, we manage approximately $274.8 billion in assets (as of December 31, 2007) 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 following summarizes our operations in our three principal distribution channels. those certain other factors discussed under the caption Our Affiliates provide advisory or sub-advisory services “Risk Factors,” which are set forth in our 2007 Annual to more than 100 mutual funds. These funds are distrib- Report on Form 10-K. uted to retail and institutional clients directly and 7 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 30 through intermediaries, including independent invest- ValueAct has over 250 clients, including endowments, ment advisors, retirement plan sponsors, broker/dealers, foundations, corporations, family offices, high net major fund marketplaces and bank trust departments. worth investors and funds of funds. In the Institutional distribution channel, our Affiliates In December 2007, we acquired a minority interest in offer approximately 200 investment products across BlueMountain Capital Management (“BlueMountain”), approximately 50 different investment styles, including a leading global credit alternatives manager specializing small, small/mid, mid and large capitalization value, in relative value strategies in the corporate loan, bond, growth equity and emerging markets. In addition, our credit and equity derivatives markets. BlueMountain has Affiliates offer quantitative, alternative, credit arbitrage and fixed income products. Through this distribution offices in New York and London, and manages assets on behalf of predominantly institutional and high net channel, our Affiliates manage assets for foundations worth clients. and endowments, defined benefit and defined contri- bution plans for corporations and municipalities, and Taft-Hartley plans, with disciplined and focused investment styles that address the specialized needs of institutional clients. 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 individ- ual 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. We operate our business through our Affiliates in our three principal distribution channels, maintaining each Affiliate’s distinct entrepreneurial culture and independence through our investment structure. In each case, our Affiliates are organized as separate firms, and their operating or share- holder agreements are tailored to provide appropriate incentives for our Affiliate management owners and to address the particular characteristics of that Affiliate while enabling us to protect our interests. In making investments in boutique asset management firms, we seek to partner with the highest quality firms in the industry, with outstanding management teams, strong long-term performance records and a demonstrated com- mitment to continued growth and success. Fundamental to our investment approach is the belief that Affiliate manage- ment equity ownership (along with AMG’s ownership) aligns our interests and provides Affiliate managers with a In 2007, we enhanced the diversity of our product offerings powerful incentive to continue to grow their business. Our across these channels through investments in two alternative investment structure provides a degree of liquidity and investment managers: diversification to principal owners of boutique investment management firms, while at the same time expanding equity In November, we acquired a minority interest in ownership opportunities among the firm’s management ValueAct Capital (“ValueAct”), a San Francisco–based and allowing management to continue to participate in the investment firm that establishes ownership interests in firm’s future growth. Our partnership approach also ensures undervalued companies and works with each company’s that Affiliates maintain operational autonomy in managing management and Board of Directors to implement their business, thereby preserving their firm’s entrepreneurial business strategies that enhance shareholder value. culture and independence. 31 Although the specific structure of each investment is highly share of cash under the Owners’ Allocation generally has tailored to meet the needs of a particular Affiliate, in all priority over the allocations and distributions to the cases, AMG establishes a meaningful equity interest in the Affiliate’s managers. As a result, the excess expenses first firm, with the remaining equity interests retained by the reduce the portion of the Owners’ Allocation allocated to management of the Affiliate. Each Affiliate is organized as the Affiliate’s managers until that portion is eliminated, a separate firm, and its operating or shareholder agreement before reducing the portion allocated to us. Any such is structured to provide appropriate incentives for Affiliate reduction in our portion of the Owners’ Allocation is management owners and to address the Affiliate’s particular required to be paid back to us out of the portion of future characteristics while also enabling us to protect our inter- Owners’ Allocation allocated to the Affiliate’s managers. ests, including through arrangements such as long-term employment agreements with key members of the firm’s Our minority investments are also structured to align our management team. interests with those of the Affiliate’s management through shared equity ownership, as well as to preserve the Affiliate’s In most cases, we own a majority of the equity interests of entrepreneurial culture and independence by maintaining a firm and structure a revenue sharing arrangement, in the Affiliate’s operational autonomy. In cases where we hold which a percentage of revenue is allocated for use by a minority interest, the revenue sharing arrangement management of that Affiliate in paying operating expenses generally allocates a percentage of the Affiliate’s revenue. of the Affiliate, including salaries and bonuses. We call this The remaining revenue is used to pay operating expenses the “Operating Allocation.” The portion of the Affiliate’s and profit distributions to the other owners. revenue that is allocated to the owners of that Affiliate (including us) is called the “Owners’ Allocation.” Each Certain of our Affiliates operate under profit-based arrange- Affiliate allocates its Owners’ Allocation to its managers ments through which we own a majority of the equity in and to us generally in proportion to their and our the firm and receive a share of profits as cash flow, rather respective ownership interests in that Affiliate. than a percentage of revenue through a typical revenue One of the purposes of our revenue sharing arrangements is increase or decrease in the revenue or expenses of such to provide ongoing incentives for Affiliate managers by firms. In these cases, we participate in a budgeting process allowing them to participate in the growth of their firm’s and generally provide incentives to management through revenue, which may increase their compensation from both compensation arrangements based on the performance of sharing agreement. As a result, we participate fully in any the Operating Allocation and the Owners’ Allocation. the Affiliate. These arrangements also provide incentives to control operating expenses, thereby increasing the portion of the We are focused on establishing and maintaining long- Operating Allocation that is available for growth initiatives term partnerships with our Affiliates. Our shared equity and compensation. ownership gives both AMG and our Affiliate partners meaningful incentives to manage their businesses for strong An Affiliate’s Operating Allocation is structured to cover its future growth. From time to time, we may consider changes operating expenses. However, should actual operating to the structure of our relationship with an Affiliate in order expenses exceed the Operating Allocation, our contractual to better support the firm’s growth strategy. 7 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 32 Through our affiliated investment management firms, we that, within any calendar year, the majority of performance derive most of our revenue from the provision of investment fees will typically be realized in the fourth quarter. management services. Investment management fees (“asset- based fees”) are usually determined as a percentage fee For certain of our Affiliates, generally where we own a charged on periodic values of a client’s assets under manage- minority interest, we are required to use the equity method ment; most asset-based advisory fees are billed by our of accounting. Consistent with this method, we have not Affiliates quarterly. Certain clients are billed for all or a por- consolidated the operating results of these firms (including tion of their accounts based upon assets under management their revenue) in our Consolidated Statements of Income. valued at the beginning of a billing period (“in advance”). Our share of these firms’ profits (net of intangible amorti- 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. Clients in the Mutual Fund dis- tribution channel are billed based upon average daily assets under management. Advisory fees billed in advance will not reflect subsequent changes in the market value of assets under management 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 management for that period. zation) is reported in “Income from equity method invest- ments,” and is therefore reflected in our Net Income and EBITDA. As a consequence, increases or decreases in these firms’ assets under management (which totaled $64.0 billion as of December 31, 2007) will not affect reported revenue in the same manner as changes in assets under management at our other Affiliates. Our recent investments in ValueAct and BlueMountain are both accounted for under the equity method of accounting. Our Net Income reflects the revenue of our consolidated Affiliates and our share of income from Affiliates which we account for under the equity method, reduced by: our expenses, including the operating expenses of our In addition, over 50 Affiliate alternative investment and consolidated Affiliates; and equity products, representing approximately $45 billion of assets under management (as of December 31, 2007), also bill on the basis of absolute or relative investment performance (“performance fees”). These products, which are primarily in the Institutional distribution channel, are often structured to have returns that are not directly corre- lated to changes in broader equity indices and, if earned, the performance fee component is typically billed less 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 frequently than an asset-based fee. Although performance agreements between the Affiliate’s revenue and its Operating fees inherently depend on investment results and will vary Allocation and Owners’ Allocation. At our consolidated from period to period, we anticipate performance fees to be profit-based Affiliates, expenses may or may not correspond a recurring component of our revenue. We also anticipate to increases or decreases in the Affiliates’ revenues. 33 Our level of profitability will depend on a variety of factors, Assets under Management including: Statement of Changes those affecting the global financial markets generally and (in billions) 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; our receipt of Owners’ Allocation from Affiliates with revenue sharing arrangements, which depends on the ability of our existing and future Affiliates to maintain certain levels of operating profit margins; 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; December 31, 2004 Net client cash flows New investments(1) Investment performance Other(2) December 31, 2005 Net client cash flows New investments(1) Investment performance Other(2) December 31, 2006 Net client cash flows New investments(1) Investment performance Other(2) Mutual Fund $33.9 4.1 6.9 5.4 — 50.3 0.4 0.6 6.9 — 58.2 (0.2) — 4.6 (0.4) Institutional High Net Worth $ 76.1 8.7 15.0 13.1 (3.6) 109.3 18.5 11.1 16.1 (0.3) 154.7 0.7 8.8 15.9 0.3 $19.8 (2.0) 6.1 0.8 — 24.7 0.5 0.2 3.4 (0.6) 28.2 (0.9) 2.0 3.9 (1.0) Total $129.8 10.8 28.0 19.3 (3.6) 184.3 19.4 11.9 26.4 (0.9) 241.1 (0.4) 10.8 24.4 (1.1) December 31, 2007 $ 62.2 $180.4 $32.2 $274.8 (1) In 2005, we acquired the mutual fund business of Fremont Investment Advisors Inc. through Managers Investment Group LLC and completed new Affiliate investments in a group of Canadian asset management firms. In 2006, we completed a new Affiliate investment in Chicago Equity Partners. In 2007, we completed new investments in ValueAct and BlueMountain. (2) We transferred our interests in certain affiliated investment manage- ment firms in each of the periods presented. Additionally, during 2007, we reclassified $0.6 billion and $0.4 billion of existing assets under management to the Mutual Fund and Institutional distribution channels, respectively, from the High Net Worth distribution channel. These changes were not material to our financial position or results of operations. the level of intangible assets and the associated amortiza- The operating segment analysis presented in the following tion expense resulting from our investments; table is based on average assets under management. For the the level of our expenses, including compensation for our employees; and the level of taxation to which we are subject. Results of Operations Mutual Fund distribution channel, average assets under management generally represent an average of the daily net assets under management. For the Institutional and High Net Worth distribution channels, average assets under man- agement represents an average of the assets at the beginning and end of each calendar quarter during the applicable period. We believe that this analysis more closely correlates The following tables present our Affiliates’ reported assets to the billing cycle of each distribution channel and, as such, under management by operating segment (which are also provides a more meaningful relationship to revenue. referred to as distribution channels in this Annual Report). 7 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 (in millions, except as noted) 2005 2006 % Change 2007 % 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 $ 43.0 88.8 20.9 $ 152.7 $ 400.9 385.7 129.9 $ 916.5 $ 56.8 51.3 11.0 $ 119.1 $ 110.3 125.2 32.0 $ 267.5 $ 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% $ 61.9 168.9 30.5 $ 261.3 $ 558.3 645.6 166.0 $1,369.9 $ 72.5 87.9 21.6 $ 182.0 $ 153.9 211.3 53.0 $ 418.2 14% 35% 14% 27% 11% 25% 8% 17% 7% 34% 23% 20% 11% 30% 27% 22% (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 $20.6 billion, $39.1 billion and $53.7 billion for 2005, 2006 and 2007, respectively. (2) Note 26 to the Consolidated Financial Statements describes the basis of presentation of the financial results of our three operating segments. As dis- cussed 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 reconcil- iation to cash flow from operations, is discussed in greater detail in “Liquidity and Capital Resources.” 35 Revenue Our revenue is generally determined by the level of our assets under management, the portion of our assets across our products and three operating segments, which realize differ- ent fee rates, and the recognition of any performance fees. The increase in revenue of $100.8 million (or 25%) in 2006 from 2005 resulted principally from a 27% increase in average assets under management. The increase in average assets under management resulted principally from positive investment performance, our 2005 investments in new Affiliates, and positive net client cash flows. Our revenue increased $199.5 million (or 17%) in 2007 from 2006, primarily as a result of a 27% increase in Institutional Distribution Channel average assets under management. The increase in average The increase in revenue of $130.8 million (or 25%) in the assets under management resulted principally from positive Institutional distribution channel in 2007 from 2006 investment performance in 2006 and 2007, net client cash resulted principally from a 35% increase in average assets flows in 2006 and, to a lesser extent, our 2006 investment in under management. The increase in average assets under a new Affiliate. The increase in revenue was proportionately management resulted principally from positive investment less than the growth in assets under management primarily as performance in 2006 and 2007, net client cash flows in a result of our equity method investments, as we do not 2006 and, to a lesser extent, our 2006 investment in a new consolidate the revenue or expenses of these Affiliates. Affiliate. The increase in revenue was proportionately less than the increase in assets under management primarily as The increase in revenue of $253.9 million (or 28%) in a result of our equity method investments, as we do not 2006 from 2005 resulted principally from a 35% increase consolidate revenue or expenses of such Affiliates. in average assets under management. The increase in average assets under management was primarily attributable to Our revenue increased $129.1 million (or 33%) in positive investment performance and net client cash flows 2006 from 2005, primarily as a result of a 41% increase in and, to a lesser extent, our 2005 investments in new average assets under management. The increase in average Affiliates. The increase in revenue was proportionately less assets under management resulted principally from positive than the growth in assets under management primarily as investment performance and net client cash flows and, to a a result of our equity method investments, as we do not lesser extent, our 2005 investments in new Affiliates. The consolidate the revenue or expenses of these Affiliates. increase in revenue was proportionately less than the increase in assets under management primarily as a result of The following discusses the changes in our revenue by our equity method investments, as we do not consolidate operating segments. revenue or expenses of such Affiliates. Mutual Fund Distribution Channel High Net Worth Distribution Channel The increase in revenue of $56.6 million (or 11%) in the The increase in revenue of $12.1 million (or 8%) in the Mutual Fund distribution channel in 2007 from 2006 High Net Worth distribution channel in 2007 from 2006 resulted principally from a 14% increase in average assets resulted principally from a 14% increase in average assets under management. The increase in average assets under management resulted principally from positive investment under management. The increase in average assets under management resulted principally from positive investment performance. performance. The increase in revenue was proportionately 7 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 less than the increase in assets under management primari- under management resulted principally from our 2005 ly as a result of our equity method investments, as we do investments in new Affiliates and positive investment per- not consolidate the revenue or expenses of these Affiliates, formance. The increase in revenue was proportionately less and increases in assets under management that realize a than the increase in assets under management primarily as comparatively lower fee rate. a result of our equity method investments, as we do not consolidate the revenue or expenses of these Affiliates, and Our revenue increased $24.0 million (or 18%) in 2006 increases in assets under management that realize a compar- from 2005 primarily as a result of a 28% increase in aver- atively lower fee rate. age assets under management. The increase in average assets 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 2005 $365.9 162.1 24.9 7.0 21.5 $581.4 2006 % Change 2007 % Change $ 472.4 184.0 27.4 8.7 23.9 $ 716.4 29% 14% 10% 24% 11% 23% $579.4 198.0 31.7 10.4 18.8 $838.3 23% 8% 16% 20% (21)% 17% The substantial portion of our operating expenses is Compensation and related expenses increased 23% in 2007 incurred by our Affiliates, the majority of which is incurred and 29% in 2006. These increases were primarily a result of by Affiliates with revenue sharing arrangements. For the relationship between revenue and operating expenses at Affiliates with revenue sharing arrangements, an Affiliate’s our Affiliates with revenue sharing arrangements, which Operating Allocation percentage generally determines its experienced aggregate increases in revenue and accordingly, operating expenses. Accordingly, our compensation expense reported higher compensation expense. The increases were is generally impacted by increases or decreases in each also related to increases in aggregate Affiliate expenses from Affiliate’s revenue and the corresponding increases or our new investments ($13.4 million in 2007 and $12.8 decreases in their respective Operating Allocations. During million in 2006). In 2007, the increase in compensation 2007, approximately $322.6 million, or about 56% of our was proportionately greater than the increase in revenue consolidated compensation expense, was attributable to our because of an increase in revenue at Affiliates with higher Affiliate managers. The percentage of revenue allocated to Operating Allocations. Unrelated to the changes in revenue, operating expenses varies from one Affiliate to another and the increase in 2007 was also attributable to a $7.4 million may vary within an Affiliate depending on the source or amount of revenue. As a result, changes in our aggregate revenue may not impact our consolidated operating expenses to the same degree. increase in share-based compensation. 37 Selling, general and administrative expenses increased 8% Depreciation and other amortization increased 20% in in 2007 and 14% in 2006, principally as a result of the 2007 and 24% in 2006. These increases were principally growth in assets under management at our Affiliates in the attributable to spending on depreciable assets in recent Mutual Fund distribution channel. Selling, general and periods. The increase in 2006 was also attributable to our administrative expenses also increased in 2007 as a result of 2005 investments in new Affiliates. $1.0 million of expenses related to our global distribution initiatives. These increases were partially offset by a $6.7 Other operating expenses decreased 21% in 2007 princi- million decrease in aggregate Affiliate expenses from the pally as a result of benefits realized upon the transfer of transfer of our interests in certain Affiliates during 2006 Affiliate interests during 2007 as well as a $0.8 million and 2007. recovery of Affiliate expenses that previously reduced our share of Owners’ Allocation. These decreases were partially Amortization of intangible assets increased 16% in 2007 offset by a $0.7 million increase in aggregate Affiliate and 10% in 2006, principally from an increase in definite- expenses from our 2006 investment in Chicago Equity lived intangible assets resulting from our investments in Partners. Other operating expenses increased 11% in 2006 new and existing Affiliates during 2005 and 2006. principally as a result of a $1.1 million increase in operat- ing expenses from our new investments in 2005 and expenses related to other Affiliate transactions. 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 2005 $ 27.0 8.9 0.4 — 144.3 37.4 70.6 $ 2006 38.3 16.9 3.4 3.4 212.5 58.8 86.6 % Change 2007 % Change 42% 90% 750% — 47% 57% 23% $ 58.2 17.1 52% 1% 38.9 1,044% 38.1 242.0 76.9 106.9 1,021% 14% 31% 23% Income from equity method investments consists of our Investment and other income primarily consists of earnings share of income from Affiliates that are accounted for under on cash and cash equivalent balances and earnings that the equity method of accounting, net of any related intangi- Affiliates realize on investments in marketable securities. ble amortization. Income from equity method investments Investment and other income increased 1% in 2007 and increased 52% in 2007 and 42% in 2006 principally as a result of increases in assets under management and revenue 90% in 2006. The increase in 2006 resulted principally from an increase in Affiliate investment earnings of $6.4 attributable to Affiliates that are accounted for under the million, and earnings of $1.6 million on investments held equity method of accounting, including investments in our by new Affiliates. new Affiliates. 7 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 As discussed in Note 1 to the Consolidated Financial Net Income Statements, Investment income from Affiliate investments The following table summarizes Net Income for the past in partnerships and Minority interest in Affiliate invest- three years: ments in partnerships relate to the consolidation of certain investment partnerships in which our Affiliates serve as the (in millions) 2005 2006 % Change 2007 % Change general partner. For 2007 and 2006, the income from Affiliate investments in partnerships was $38.9 million and $3.4 million, respectively, which was principally attributable to investors who are unrelated to us. Minority interest increased 14% in 2007 and 47% in 2006, principally as a result of the previously discussed increases in revenue. In 2006, the increase was proportionately Net Income $119.1 $151.3 27% $182.0 20% Net Income increased 20% in 2007 and 27% in 2006, prin- cipally 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. greater than the increase in revenue because certain Supplemental Performance Measure Affiliates reported expenses that were less than their As supplemental information, we provide a non-GAAP Operating Allocation, resulting in higher profits attributable performance measure that we refer to as Cash Net Income. to our Affiliate management partners. In 2007, these This measure is provided in addition to, but not as a Affiliates reported expenses that were equal to their substitute for, Net Income. Cash Net Income is defined as Operating Allocation. Net Income plus amortization and deferred taxes related to intangible assets plus Affiliate depreciation. We consider Interest expense increased 31% in 2007, principally from Cash Net Income an important measure of our financial borrowings under our senior credit facility ($11.5 million in performance, as we believe it best represents operating 2007), the October 2007 issuance of $500 million of junior performance before non-cash expenses relating to our convertible trust preferred securities ($5.4 million in 2007) acquisition of interests in our Affiliates. Cash Net Income and the April 2006 issuance of $300 million of junior is used by our management and Board of Directors as a convertible trust preferred securities ($3.5 million in 2007). principal performance benchmark, including as a measure These increases were partially offset by a $3.1 million for aligning executive compensation with stockholder value. decrease in interest expense from repayment of our Senior Notes due 2006. The increase in 2006 was principally Since our acquired assets do not generally depreciate or attributable to the $300 million junior convertible trust require replacement by us, and since they generate deferred preferred securities ($11.4 million in 2006) and increases in tax expenses that are unlikely to reverse, we add back these borrowings under our senior credit facility ($7.2 million non-cash expenses to Net Income to measure operating in 2006). performance. We add back amortization attributable to acquired client relationships because this expense does not Income taxes increased 23% in 2007 and 2006 principally correspond to the changes in value of these assets, which as a result of the increases in net income before taxes of do not diminish predictably over time. The portion of 21% and 25%, respectively. The increase in 2006 was deferred taxes generally attributable to intangible assets partially offset by a $1.4 million reduction in income taxes (including goodwill) that we no longer amortize but which from a decrease in Canadian federal income tax rates, which continues to generate tax deductions is added back, reduction did not recur in 2007. because these accruals would be used only in the event of 39 a future sale of an Affiliate or an impairment charge, which Liquidity and Capital Resources we consider unlikely. We add back the portion of consoli- dated 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. The following table provides a reconciliation of Net Income to Cash Net Income: (in millions) 2005 2006 2007 Net Income Intangible amortization Intangible amortization— $119.1 24.9 $151.3 27.4 $182.0 31.6 equity method investments(1) Intangible-related deferred taxes Affiliate depreciation 8.5 28.8 4.8 9.3 28.8 5.7 10.4 28.6 6.1 Cash Net Income $186.1 $222.5 $258.7 (1) As discussed in Note 1 to the Consolidated Financial Statements, we are required to use the equity method of accounting for our invest- ments in AQR, Beutel, Deans Knight, ValueAct and BlueMountain 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 “Income from equity method investments.” Cash Net Income increased 16% in 2007 and 20% in 2006, primarily as a result of the previously described factors affecting Net Income. The following table summarizes certain key financial data relating to our liquidity and capital resources: (in millions) 2005 Balance Sheet Data Cash and cash equivalents $ 140.4 Senior debt 241.3 Zero coupon convertible notes 124.2 Floating rate convertible securities 300.0 Mandatory convertible securities Junior convertible trust preferred securities Cash Flow Data Operating cash flows Investing cash flows Financing cash flows EBITDA(1) 300.0 — $ 204.1 (82.0) (122.3) 267.5 December 31, 2006 2007 $ 201.7 365.5 $ 223.0 519.5 113.4 300.0 300.0 300.0 78.1 300.0 300.0 800.0 $ 301.0 (165.1) (75.1) 342.1 $ 326.7 (580.8) 272.5 418.2 (1) The definition of EBITDA is presented in Note 3 on page 35. 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 securities 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 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, 2007, our leverage ratio was 1.6:1. Supplemental Liquidity Measure As supplemental information, we provide information regarding our EBITDA, a non-GAAP liquidity measure. This measure is provided in addition to, but not as a substitute for, cash flow from operations. EBITDA 7 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 represents earnings before interest expense, income taxes, of debt securities, the repurchase of shares of our common depreciation and amortization. EBITDA, as calculated by stock and for working capital purposes. us, may not be consistent with computations of EBITDA by other companies. As a measure of liquidity, we believe Senior Credit Facility that EBITDA is useful as an indicator of our ability to serv- ice debt, make new investments and meet working capital requirements. We further believe that many investors use this information when analyzing the financial position of companies in the investment management industry. The following table provides a reconciliation of cash flow from operations to EBITDA: On November 27, 2007, we entered into an amended and restated senior credit facility (the “Facility”). The Facility allows us to borrow an aggregate of $950 million. The Facility is comprised of a $750 million revolving credit facility (the “Revolver”) and a $200 million term loan (the “Term Loan”). We pay interest on these obligations at spec- ified rates (based either on the Eurodollar rate or the prime rate as in effect from time to time) that vary depending on 2005 2006 2007 our credit rating. The Term Loan requires principal pay- (in millions) Cash Flow from Operations $204.1 $301.0 $326.7 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(3) EBITDA(4) 32.5 38.9 53.6 55.2 70.9 74.6 18.9 1.6 15.0 (26.9) $267.5 (69.3) $342.1 (69.0) $418.2 (1) Non-cash items represent amortization of issuance costs and interest accretion ($4.9, $5.2 and $6.0 million in 2005, 2006 and 2007, respectively). (2) Distributions from equity method investments were $16.6, $46.0 and $53.6 million for 2005, 2006 and 2007, respectively. (3) Other adjustments include stock option expenses, tax benefits from stock options and other adjustments to reconcile Net Income to cash flow from operating activities. (4) The definition of EBITDA is presented in Note 3 on page 35. ments to be made at specified dates until maturity. Subject to the agreement of lenders to provide additional commit- ments, we have the option to increase the Facility by up to an additional $250 million. The Facility will mature in February 2012, and contains financial covenants with respect to leverage and interest cov- erage. 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 our capital stock or other equity interests owned by us. As of December 31, 2007, we had $519.5 million outstanding under our Facility. Zero Coupon Senior Convertible Notes In 2001, we issued $251 million principal amount at matu- In 2007, we met our cash requirements primarily through rity of zero coupon senior convertible notes due 2021 cash generated by operating activities, the issuance of con- (“zero coupon convertible notes”), with each note issued at vertible securities and borrowings of senior debt. Our prin- 90.50% of such principal amount and accreting at a rate of cipal uses of cash were to repurchase shares of our common 0.50% per year. As of December 31, 2007, $83.5 million stock, make investments in new and existing Affiliates, principal amount at maturity remain outstanding. Each repay senior debt and make distributions to Affiliate man- agers. We expect that our principal uses of cash for the fore- security is convertible into 17.429 shares of our common stock (at a current base conversion price of $53.68) upon seeable future will be for investments in new and existing the occurrence of certain events, including the following: (i) Affiliates, distributions to Affiliate managers, payment of if the closing price of a share of our common stock is more principal and interest on outstanding debt, the repurchase than a specified price over certain periods (initially $62.36 41 and increasing incrementally at the end of each calendar income tax regulations. These regulations required us to quarter to $63.08 in April 2021); (ii) if the credit rating deduct interest in an amount greater than our reported assigned by Standard & Poor’s to the securities is below interest expense, and resulted in annual deferred taxes of BB-; or (iii) if we call the securities for redemption. The approximately $3.7 million. Because the trading price of holders may require us to repurchase the securities at their our common stock exceeded $60.90 at the time of the accreted value in May 2011 and 2016. If the holders conversions described above, $18.3 million of deferred tax exercise this option in the future, we may elect to liabilities attributable to these securities will be reclassified repurchase the securities with cash, shares of our common to stockholders’ equity in the first quarter of 2008. stock or some combination thereof. We have the option to redeem the securities for cash at their accreted value. Under 2004 Mandatory Convertible Securities the terms of the indenture governing the zero coupon convertible notes, a holder may convert such security into common stock by following the conversion procedures in the indenture; subject to changes in the price of our com- mon stock, the zero coupon convertible notes may not be convertible in certain future periods. In 2006, we amended the zero coupon convertible notes. Under the terms of this amendment, we 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. In 2004, we issued $300 million of mandatory convertible securities (“2004 PRIDES”), each unit consisting of (i) a senior note due February 2010 with a principal amount of $1,000 per note, with interest payable quarterly at the annual rate of 4.125%, and (ii) a forward equity purchase contract pursuant to which the holder agreed to purchase shares of our common stock in February 2008. The holders’ obligations under the forward equity purchase contracts were collateralized by the pledge to us of the senior notes. In the first quarter of 2008, we repurchased the outstanding senior notes component of our 2004 PRIDES. The repur- chase proceeds were used by the original holders to fulfill Floating Rate Senior Convertible Securities their obligations under the related forward equity purchase In 2003, we issued $300 million of floating rate senior convertible securities due 2033 (“floating rate convertible securities”) bearing interest at a rate equal to 3-month LIBOR minus 0.50%, payable in cash quarterly. In the first quarter of 2008, we called the outstanding floating rate convertible securities for redemption at their principal amount plus accrued and unpaid interest. In lieu of contracts. Pursuant to the settlement of the forward equity purchase contracts and other privately negotiated exchanges, we have issued approximately 4.0 million shares of common stock. All of our 2004 PRIDES have been cancelled and retired. Junior Convertible Trust Preferred Securities redemption, substantially all of the holders elected to convert In 2006, we issued $300 million of junior subordinated their securities. Pursuant to these conversions and other convertible debentures due 2036 to a wholly-owned privately negotiated exchanges, we will issue approximately trust simultaneous with the issuance, by the trust, of 7.0 million shares of common stock and all of our floating $291 million of convertible trust preferred securities to rate convertible securities will be cancelled and retired. investors. The junior subordinated convertible deben- tures and convertible trust preferred securities (together, The floating rate senior convertible securities are consid- the “2006 junior convertible trust preferred securities”) ered contingent payment debt instruments under federal have substantially the same terms. 7 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 The 2006 junior convertible trust preferred securities bear redeemed if the closing price of our common stock exceeds interest at 5.1% per annum, payable quarterly in cash. Each $260 per share for a specified period of time. The trust’s $50 security is convertible, at any time, into 0.333 shares of only assets are the 2007 junior convertible subordinated our common stock, which represents a conversion price of debentures. To the extent that the trust has available funds, $150 per share (or a 48% premium to the then prevailing we are obligated to ensure that holders of the 2007 junior share price of $101.45). Upon conversion, investors will convertible trust preferred securities receive all payments receive cash or shares of our common stock (or a combina- due from the trust. tion of cash and common stock) at our election. The 2006 junior convertible trust preferred securities may not be The 2006 and 2007 junior convertible trust preferred secu- redeemed by us prior to April 15, 2011. On or after April rities are considered contingent payment debt instruments 15, 2011, they may be redeemed if the closing price of our under the federal income tax regulations. We are required common stock exceeds $195 per share for a specified peri- to deduct interest in an amount greater than our reported od of time. The trust’s only assets are the junior convertible interest expense. In 2008, these deductions will generate subordinated debentures. To the extent that the trust has deferred taxes of approximately $8.5 million. available funds, we are obligated to ensure that holders of the 2006 junior convertible trust preferred securities receive all payments due from the trust. In October 2007, we issued an additional $500 million of junior subordinated convertible debentures due 2037 to a wholly-owned trust simultaneous with the issuance, by the trust, of $500 million of convertible trust preferred securities to investors. The junior subordinated convertible debentures and convertible trust preferred securities (together, the “2007 junior convertible trust preferred securities”) have substantially the same terms. The 2007 junior convertible trust preferred securities bear interest at 5.15% per annum, payable quarterly in cash. Each $50 security is convertible, at any time, into 0.25 shares of our common stock, which represents a conversion price of $200 per share (or a 53% premium to the then prevailing share price of $130.77). Upon conversion, Call Spread Option Agreements In 2006, we entered into a series of contracts that provided the option, but not the obligation, to repurchase up to 917,000 shares of our common stock at a weighted average price of $99.59 per share at specified times. Upon exercise, we could elect to receive the intrinsic value of a contract in cash or common stock. During 2007, we exercised 917,000 options with a total intrinsic value of $21.1 million. We elected to receive approximately 116,000 shares of common stock and used the remaining proceeds ($6.8 million) to enter into another series of contracts that provide the option, but not the obligation, to repurchase up to 800,000 shares of its common stock at a weighted average price of $120.89 per share. These options may be exercised or will expire during the first quarter of 2008. Forward Purchase Contract investors will receive cash or shares of our common stock In October 2007, we entered into a prepaid forward pur- (or a combination of cash and common stock) at our chase contract, pursuant to which we purchased 1,578,300 election. The 2007 junior convertible trust preferred shares of common stock for approximately $206 million. securities may not be redeemed by us prior to October 15, 2012. On or after October 15, 2012, they may be We have the option to settle the forward purchase contract on or before October 15, 2012. 43 Purchases of Affiliate Equity Many of our Affiliate operating agreements provide our Affiliate managers the conditional right to require us to purchase their retained equity interests at certain intervals. These agreements also provide us a conditional right to require Affiliate managers to sell their retained equity approval or other restrictions. These potential purchases, combined with our other cash needs, may require more cash than is available from operations, and therefore, we may need to raise capital by making borrowings under our Facility, by selling shares of our common stock or other equity or debt securities, or to otherwise refinance a portion interests to us upon their death, permanent incapacity or of these purchases. termination of employment and provide Affiliate man- agers a conditional right to require us to purchase such Operating Cash Flow retained equity interests upon the occurrence of specified events. These purchases may occur in varying amounts over a period of approximately 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. These purchases are generally calculated based upon a multiple of the Affiliate’s cash flow distributions at the time the right is exercised, 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, 2007, the aggregate amount of these payments would have totaled approximately $1,470.1 million. In the event that all such transactions were consummated, we would own the cash flow distributions attributable to the additional equity interests purchased from our Affiliate managers. As of December 31, 2007, this amount would represent approxi- mately $204.4 million on an annualized basis. We may pay for these purchases in cash, shares of our common stock or other forms of consideration. Affiliate management partners Cash flow from operations generally represents Net Income plus non-cash charges for amortization, deferred taxes, equity-based compensation and depreciation, as well as increases and decreases in our consolidated working capital. The increase in cash flow from operations in 2007 as com- pared to 2006 resulted principally from increased Net Income of $30.7 million and increased minority interest of $29.1 million, partially offset by a $44.8 million increase in payments of liabilities. The increase in cash flow from operations for the year ended 2006 as compared to 2005 resulted principally from increased Net Income of $32.2 million and increased net distributions from our equity method investments of $18.1 million, partially offset by a decrease in minority interest of $16.1 million. In accordance with EITF 04-05, we consolidated $134.7 and $108.4 million of client assets held in partnerships controlled by our Affiliates as of December 31, 2007 and 2006, respectively. Sales of client assets generated $12.8 and $7.7 million of operating cash flow in 2007 and 2006, are also permitted to sell their equity interests to other respectively. individuals or entities in certain cases, subject to our 7 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 Investing Cash Flow Changes in net cash flow used in investing activities result primarily from our investments in new and existing Affiliates. Net cash flow used to make investments was $556.7 million, $123.3 million and $85.2 million for the years ended December 31, 2007, 2006 and 2005, respec- tively. These investments were funded with borrowings under our senior credit facility and existing cash. The increase in net cash flows used in investing activities in 2007 was partially offset by decreased purchases by our Affiliates in investment securities. We may make payments in connection with our future investments. We are also contingently liable, upon achieve- ment of specified financial targets, to make additional pur- chase payments of up to $232 million through 2011. The specified financial targets for certain agreements are meas- ured beginning December 31, 2007, and we expect we will make payments of up to $70 million in 2008. Financing Cash Flow Net cash flows from financing activities increased $347.6 million in 2007 as compared to 2006, primarily as a result of our $500 million issuance of junior convertible trust pre- ferred securities and a net increase in borrowings under our Revolver of $154.0 million, partially offset by $436.0 mil- lion of repurchases of our common stock. The decrease in cash flows used in financing activities in 2006 from 2005 was primarily as a result of $536.5 million of repurchases of our common stock, a use of cash that was financed by our $300 million issuance of junior convertible trust preferred securities and a net increase of borrowings under our Facility of $190.0 million. In accordance with Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (“FAS 123R”), beginning in 2006, certain tax benefits asso- ciated with stock options have been reported as financing cash flows in the amount of $36.5 million and $23.0 mil- lion as of December 31, 2007 and 2006, respectively. As more fully discussed in “Liquidity and Capital Resources,” in the first quarter of 2008 we retired $300 million of our 2004 PRIDES and will retire $300 million of floating rate convertible securities principally through the issuance of approximately 11.0 million shares of common stock. 45 Contractual Obligations The following table summarizes our contractual obligations as of December 31, 2007: (in millions) Senior debt(1) Senior convertible securities(1)(2) Mandatory convertible securities(1)(3)(4) Junior convertible trust preferred securities(1)(3) Purchases of Affiliate equity(5) Leases Other liabilities(6) Total Total $ 519.5 384.4 327.4 2,000.2 1,470.1 110.5 71.1 $4,883.2 Payments Due 2008 2009–2010 2011–2012 Thereafter $ 20.0 0.9 13.4 41.1 120.3 20.2 70.0 $285.9 $ 60.0 — 314.0 82.1 688.0 37.1 1.1 $1,182.3 $439.5 — — 82.1 230.3 25.7 — $777.6 $ — 383.5 — 1,794.9 431.5 27.5 — $2,637.4 (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) In the first quarter of 2008, we will issue approximately 7.0 million shares of our common stock in connection with conversions and privately negotiated exchanges of our floating rate convertible securities. Following consummation of these transactions, all of our floating rate convertible securities will be cancelled and retired and no further obligations will remain with respect thereto. (3) As more fully discussed on page 40, 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. (4) In the first quarter of 2008, we issued approximately 4.0 million shares of common stock in connection with privately negotiated exchanges of our mandatory convertible securities and the settlement of the forward equity purchase contracts by holders of these securities. All of our mandatory convertible securities have been cancelled and retired and no further obligations remain with respect thereto. (5) 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 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, 2007, the aggregate purchase amount would have totaled approximately $1,470.1 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 $204.4 million on an annualized basis as of December 31, 2007. (6) Other liabilities reflect amounts payable to Affiliate managers related to our purchase of additional Affiliate equity interests. This table does not include liabilities for uncertain tax positions ($22.5 million as of December 31, 2007) as we cannot predict when such liabilities will be paid. Market Risk Our revenue is derived primarily from fees which are based on the market values of assets under management. Such values are affected by changes in financial markets, and accordingly declines in the financial markets will negatively impact our revenue and Net Income. The broader financial markets are affected, in part, by changing interest rates. We cannot predict the effects that interest rates or changes in interest rates may have on either the broader financial markets or our Affiliates’ assets under management and associated fees. interest on our floating rate senior convertible securities. We have fixed rates of interest on our zero coupon senior con- vertible notes and on both of our junior convertible trust preferred securities. We have also paid fixed rates of interest on the senior notes component of our 2004 PRIDES. From time to time, we seek to manage our exposure to changing interest rates by entering into interest rate hedg- ing contracts. For example, through February 2008, we were a party to interest rate hedging contracts with a $150 million notional amount, which fixed the interest rate on a We pay a variable rate of interest on our senior credit portion of our floating rate senior convertible securities to facility ($519.5 million outstanding as of December 31, a weighted average interest rate of approximately 3.28% for 2007) and, until February 2008, have paid a variable rate of the period from February 2005 to February 2008. As of 7 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 December 31, 2007, the unrealized gain on these contracts (“FAS 157”). FAS 157 establishes a framework for measur- was $0.3 million. ing fair value applicable to other accounting standards that use fair value measurements. In February 2008, the FASB We estimate that a 100 basis point (1%) change in interest issued FASB Staff Position No. FAS 157-2, “Effective Date rates would result in a net annual change to interest expense of FASB Statement No. 157,” which deferred the effective related to our variable rate borrowings of approximately date of FAS 157 for one year for nonfinancial assets and $6.7 million. While a change in market interest rates would liabilities, except those that are recognized or disclosed at fair not affect the interest expense incurred on our fixed rate value in the financial statements on a recurring basis. We securities, such a change may affect the fair value of these will be subject to certain of the provisions of FAS 157 in the securities. We estimate that a 100 basis point (1%) change first quarter of 2008. This standard is not expected to have in interest rates would result in a net change in the value of a material impact on our consolidated financial statements, our fixed rate securities of approximately $20.5 million. We but will require certain additional disclosures. estimate that a 100 basis point (1%) change in interest rates would result in a net change in the unrealized value of our In February 2007, the FASB issued Statement of Financial current hedging contracts of approximately $8.0 million. Accounting Standards No. 159, “The Fair Value Option for There can be no assurance that our hedging contracts will Financial Assets and Financial Liabilities — Including meet their overall objective of reducing our interest expense an amendment of FASB Statement No. 115” (“FAS 159”). or that we will be successful in obtaining hedging contracts FAS 159 permits companies to measure many financial in the future on our existing or any new indebtedness. instruments and certain other items at fair value. We will We operate primarily in the United States, and accordingly not expected to have a material impact on our consolidated adopt FAS 159 in the first quarter of 2008. This standard is most of our consolidated revenue and associated expenses are financial statements. denominated in U.S. dollars. We also provide services and earn revenue outside of the United States; therefore, the In December 2007, the FASB issued Statement of Financial portion of our revenue and expenses denominated in foreign Accounting Standards No. 141 (revised 2007), “Business currencies may be impacted by movements in currency Combinations” (“FAS 141R”). FAS 141R will change the exchange rates. The valuations of our foreign Affiliates are accounting for business combinations in a number of impacted by fluctuations in foreign exchange rates, which respects, including the way entities account for business could be recorded as a component of stockholders’ equity. To combinations achieved in stages by requiring the identifi- illustrate the effect of possible changes in currency exchange able assets and liabilities to be measured at their full fair rates, as of December 31, 2007, we estimate that a 1% change values on the acquisition date. In addition, FAS 141R will in the Canadian dollar to U.S. dollar exchange rate would change the treatment of contingent consideration, contin- result in approximately a $3.4 million change to stockholders’ gencies, acquisition costs, and restructuring costs. FAS equity and a $0.5 million change to income before income 141R will be applied prospectively to any business combi- taxes. During 2007, changes in currency exchange rates nation completed after December 31, 2008. The impact of increased stockholders’ equity by $51.5 million. this standard will depend upon the nature, terms and size of business combinations completed after the effective date. Recent Accounting Developments In December 2007, the FASB issued Statement of Financial In September 2006, the FASB issued Statement of Financial Accounting Standards No. 160, “Noncontrolling Interests Accounting Standards No. 157, “Fair Value Measurements” in Consolidated Financial Statements, an amendment of 47 ARB No. 51” (“FAS 160”). FAS 160 will change the Additionally, we make assumptions of, among other factors, accounting and reporting for minority or noncontrolling projected future earnings and cash flow, valuation multiples, interests. Upon adoption, these interests will be classified as tax benefits and discount rates. In certain instances, we a separate component within stockholders’ equity and engage third party consultants to perform independent transactions between controlling interest and minority evaluations. The impact of many of these assumptions is interest holders will be accounted for within stockholders’ material to our financial condition and operating perform- equity. We will adopt FAS 160 in the first quarter of 2009 ance and, at times, is subjective. If we used different and are currently evaluating the impact that this standard assumptions, the carrying value of our equity method will have on our consolidated financial statements. investments, our intangible assets and the related amorti- Critical Accounting Estimates and Judgments 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- zation could be stated differently and our impairment conclusions could be modified. Additionally, the use of different assumptions to value our minority interests could change the amount of compensation expense, if any, we report upon their transfer. ments, assumptions, and estimates that affect the amounts Intangible Assets reported in the Consolidated Financial Statements and At December 31, 2007, the carrying amounts of our accompanying notes. Note 1 to the Consolidated Financial intangible asset balances are as follows: Statements describes the significant accounting policies and methods used in the preparation of the Consolidated (in millions) 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 Definite-lived acquired client relationships Indefinite-lived acquired client relationships Goodwill $ 233.2 263.4 1,230.4 These amounts exclude $234.7 million of definite-lived acquired client relationships, and $572.3 million of goodwill that are reported within Equity investments in Affiliates. We amortize our definite-lived acquired client relationships In allocating the purchase price of our investments and test- over their expected useful lives. We reassess these lives each ing our assets for impairment, we make estimates and quarter based on historical and projected attrition rates and assumptions to determine the value of our acquired client other events and circumstances that may influence the relationships, operating segments, and equity method expected future economic benefit we will derive from the investments. We also assess the value of minority interests relationships. Significant judgment is required to estimate held by our Affiliate managers in establishing the terms for their transfer. 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 In these valuations, we make assumptions of the growth rates could have a significant impact on the amount of our and useful lives of existing and prospective client accounts. amortization expense. For example, if we reduced the 7 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 weighted average remaining life of our definite-lived Equity Method Investments acquired client relationships by one year, our amortization expense would increase by approximately $4.8 million per year. We assess each of our definite-lived acquired client relationships for impairment at least annually by comparing their carrying value to their projected undiscounted cash flows. In the fourth quarter of 2007, we performed our most recent annual impairment test, and no impairments were identified. For certain of our Affiliates, where we own a minority inter- est and have the ability to participate in decision making, we apply the equity method of accounting. Accordingly, we evaluate these investments for impairment by assessing whether the fair value of the investment has declined below its carrying value for a period considered to be other than temporary. Additionally, we would consider the magnitude of any decline in market value and the expected holding period of the investment. We do not amortize our indefinite-lived acquired client relationships because we expect these contracts will con- If we determine that a decline in market value below our tribute to our cash flows indefinitely. Each quarter, we carrying value is other than temporary, an impairment charge assess whether events and circumstances have occurred that would be recognized in the Consolidated Statements of indicate these relationships might have a definite life. We Income to write down the carrying value of the investment test the carrying amount of each of our indefinite-lived to its fair value. In the fourth quarter of 2007, we completed acquired client relationships at least annually, or at such our evaluation of investments accounted for under the time that we conclude the assets no longer have an indefinite equity method and no impairments were identified. life by comparing the carrying amount of each asset to its fair value. We derive the fair value of each of our indefinite- Income Taxes lived acquired client relationships primarily based on dis- counted cash flow analysis. Our valuation analysis reflects assumptions of the growth of the assets, discount rates and other factors. Changes in the estimates used in these valua- tions could materially affect the impairment conclusion. In the fourth quarter of 2007, we performed our most recent annual impairment test and no impairments were identified. Our overall tax position requires analysis by management to estimate the expected realization of income tax assets and liabilities. Tax regulations often require items of income and expense to be included in our tax returns in different amounts and in different periods than are reflected in the financial statements. Additionally, we must assess whether to recognize the benefit of an uncertain tax position, and, if so, the appropriate amount of the benefit. We test the carrying amount of the goodwill in each of our three operating segments at least annually by comparing In our assessment of whether to recognize the benefit of their carrying amount to an estimate of fair value. We an uncertain tax position, we consider the probability that establish the fair value of each of our operating segments a tax authority would sustain the tax position in an primarily based on price-earnings multiples. Changes in the examination. For tax positions meeting a “more-likely- estimates used in this test could materially affect our than-not” threshold, the amount recognized in the financial impairment conclusion. In the third quarter of 2007, we statements is the benefit expected to be realized upon performed our most recent annual impairment test and no impairments were identified. ultimate settlement with the tax authority. For tax positions not meeting this threshold, no benefit is recognized. 49 Deferred taxes are established to reflect the differences in realize the benefit of a deferred tax asset, we would establish timing between the inclusion of items of income and a valuation allowance that would increase our tax expense expense in the financial statements and their reporting on in the period of such determination. As of December 31, our tax returns. Our deferred tax liabilities are generated 2007, we had a valuation allowance for all state tax loss primarily from tax-deductible intangible assets and from carryforwards. our convertible securities. As more fully described below, we generally believe that our intangible-related deferred Changes in our tax position could have a material impact on taxes are unlikely to reverse, and that our deferred tax liabil- our earnings. For example, a 1% increase to our statutory ities for convertible securities may not reverse. As such, we tax rate attributable to our deferred tax liabilities would currently believe the economic benefit we realize from these result in an increase of approximately $6.9 million in our sources will be permanent. tax expense in the period of such determination. Most of our intangible assets are tax-deductible because we generally structure our Affiliate investments as cash transac- tions that are taxable to the sellers. We record deferred taxes because a substantial majority of our intangible assets do not amortize for financial statement purposes, but do amortize for tax purposes, thereby creating tax deductions that reduce our current cash taxes. These liabilities will reverse only in the event of a sale of an 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, 2007, our estimate of the tax liability associated with such a sale or impairment charge was approximately $193.3 million. Share-Based Compensation We have share-based compensation plans covering senior management, employees and directors. Prior to 2006, we accounted for share-based compensation using the intrinsic value method described in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) and related Interpretations. Accordingly, prior to 2006, no compensation expense was recognized from share-based compensation plans as the exercise price of all stock options granted equaled the market price of the underlying stock on the grant date of the award. In 2006, we adopted the fair value recognition provisions of During 2008, our convertible securities will generate FAS 123R which requires a company to recognize share- deferred taxes of approximately $8.5 million because our based compensation, based on the fair value of the awards interest deductions for tax purposes are greater than our on the grant date. As a result, compensation is recognized reported interest expense. We believe that some or all of in the financial statements for all share-based payments these deferred tax liabilities will be reclassified to equity as granted after the date of adoption, and for all awards that the securities are likely to convert to common stock when are unvested after that date. our stock price exceeds specified levels. Under FAS 123R, we estimate the fair value of stock option In addition, we also regularly assess our deferred tax assets, awards using the Black-Scholes option pricing model. The which consist primarily of state tax loss carryforwards, in Black-Scholes model requires us to make assumptions order to determine the need for valuation allowances. In about the volatility of our common stock and the expected our assessment we make assumptions about future taxable life of our stock options based on past experience and income that may be generated to utilize these assets, which anticipated future exercise behavior. As an example, we have limited lives. If we determine that we are unlikely to considered both the historical volatility of our common 7 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 stock and the implied volatility from traded options in Economic and Market Conditions determining expected volatility. Global Asset Management Industry Our options typically vest and become fully exercisable The asset management industry has been a key driver of over three to five years of continued employment and do growth in financial services over the last decade. According not include performance-based or market-based vesting to the most recent available data, assets under management conditions. For grants that are subject to graded vesting across all distribution channels total approximately $53.4 over a service period, we recognize expense net of expected trillion globally, of which $25.7 trillion is managed in the forfeitures on a straight-line basis over the requisite service United States. We believe long-term prospects for overall period for the entire award. industry growth (which have compounded at an annual rate of 16% globally over the past four years) remain strong. As of December 31, 2007, we had $55.3 million in remain- We expect that this growth will be driven by market-related ing unrecognized compensation cost related to stock option increases in assets under management, broad demographic grants, which will be recognized over a weighted-average trends and wealth creation related to growth in gross period of approximately four years (assuming no forfeitures). domestic product, and will be experienced in varying Revenue Recognition degrees across each of the principal distribution channels for our Affiliates’ products. The majority of our consolidated revenue represents advi- sory fees (asset-based and performance-based). Our U.S. Asset Management Industry Affiliates recognize asset-based advisory fees quarterly as In the Mutual Fund distribution channel, according to a they render services to their clients. In addition to generat- 2007 industry report, more than 88 million individuals in ing asset-based fees, over 50 Affiliate products, representing almost 51 million households in the United States are approximately $45 billion of assets under management, invested in mutual funds. In 2007, net cash flows to equity also bill on the basis of absolute investment performance mutual funds totaled over $233 billion, and aggregate (“performance fees”). These products, which are primarily mutual fund assets totaled $11.6 trillion at the end of 2007. in the Institutional distribution channel, are generally We anticipate that inflows to mutual funds will continue structured to have returns that are not directly correlated to and that aggregate mutual fund assets, particularly those in changes in broader equity indices and, if earned, the perform- equity mutual funds, will continue to increase in line with ance fee component is typically billed less frequently than the long-term market growth. asset-based fee. Our Affiliates recognize performance fees when they are earned (i.e. when they become billable to Assets in the Institutional distribution channel in the United customers) based on the contractual terms of agreements and States are primarily in retirement plans, including both when collection is reasonably assured. Although performance defined benefit and defined contribution plans, endow- fees inherently depend on investment results and will vary ments and foundations, and totaled approximately $14.4 from period to period, we anticipate performance fees to be a trillion as of December 31, 2006. Although the majority of recurring component of our revenue. Institutional assets are in equities (estimated to be 60% in 51 2006), allocations to alternative investments have continued part of their investment management services to non-U.S. to increase. According to a recent study of institutional clients. In the future, we may open additional offices, or investors, allocations of institutional assets to hedge funds (a invest in other investment management firms which con- core component of alternative investments) have grown duct a significant part of their operations outside of the from 2.5% of assets in 2001 to 7.5% in 2007, and are United States. There are certain risks inherent in doing expected to increase to 8.9% by 2009. We anticipate that business internationally, such as changes in applicable laws the combination of an aging work force and long-term and regulatory requirements, difficulties in staffing and market growth should contribute to the ongoing strength of managing foreign operations, longer payment cycles, diffi- this distribution channel. culties in collecting investment advisory fees receivable, dif- ferent and in some cases, less stringent, regulatory and The High Net Worth distribution channel is comprised accounting regimes, political instability, fluctuations in cur- broadly of high net worth and affluent individuals, family rency exchange rates, expatriation controls, expropriation trusts and managed accounts. Within this channel, high net risks and potential adverse tax consequences. There can be worth families and individuals (those having at least $1 mil- no assurance that one or more of such factors will not have lion in investable assets) in the United States had aggregate a material adverse effect on our affiliated investment man- assets of $11.3 trillion at the end of 2006; industry experts agement firms that have international operations or on expect assets in this segment of the channel to grow to other investment management firms in which we may $15.8 trillion by the end of 2011. We believe that affluent invest in the future and, consequently, on our business, individuals (those having between $250,000 and $1 mil- financial condition and results of operations. lion 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 Inflation assets increases, and the popularity of separately managed account investment products for affluent individuals con- tinues to grow. According to a recent industry report, assets in separately managed accounts totaled approximately $1.1 trillion at the end of 2007 (a nearly 20% increase over year end 2006). International Operations We do not believe that inflation or changing prices have had a material impact on our results of operations. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Market Risk.” Quantitative and Qualitative Disclosures About Market Risk For quantitative and qualitative disclosures about how we In connection with our international initiatives, we have are affected by market risk, see “Management’s Discussion offices in Sydney, Australia; London, England; and and Analysis of Financial Condition and Results of Toronto, Canada. In addition, we have international oper- Operations—Market Risk.” ations through Affiliates who provide some or a significant 7 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 Selected Financial Data Set forth below are selected financial data for the last five years. This data should be read in conjunction with, and is qual- ified 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) 2003 2004 2005 2006 2007 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(3) Affiliate investments in partnerships(4) Minority interest in Affiliate investments in partnerships(4) Senior debt(5) Senior convertible securities(6) Mandatory convertible securities Junior convertible trust preferred securities(7) Other long-term obligations(8) Stockholders’ equity(9) $ 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 $1,369,866 181,961 4.58 44,922 $ 91,524 $ 129,802 $ 184,310 $ 241,140 $ 274,764 $ 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 $ 326,654 (580,755) 272,548 418,229 258,749 $ 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 $ 3,395,705 1,726,989 842,490 134,657 — — 423,340 230,000 — 108,851 614,769 — 126,750 423,958 300,000 — 155,565 707,692 — 241,250 424,232 300,000 — 202,772 817,381 104,096 365,500 413,358 300,000 300,000 229,793 499,222 127,397 519,500 378,083 300,000 800,000 290,538 469,202 (1) The definition of EBITDA is presented in Note 3 on page 35. 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.” (3) Total assets, Intangible assets and Equity investments in Affiliates have increased as we have made new or additional investments in affiliated invest- ment management firms. (4) In 2006, we implemented Emerging Issues Task Force Issue 04-05, “EITF 04-05” (see Note 1 to the Consolidated Financial Statements). In accordance with EITF 04-05, we have consolidated client assets held in partnerships controlled by our Affiliates. These assets are reported as “Affiliate investments in partnerships;” a majority of these assets are held by investors that are unrelated to us, and are reported as “Minority interest in Affiliate investments in partnerships.” (5) Senior debt consists of outstanding borrowings under our senior credit facility and, through November 2006, our senior notes due 2006. (6) Senior convertible securities consists of our zero coupon senior convertible notes and our floating rate senior convertible securities. (7) In 2006 and 2007, we completed private placements of junior convertible trust preferred securities of $300 million and $500 million, respectively. (8) Other long-term obligations consist principally of income taxes and payables to related parties. (9) During 2006 and 2007, we repurchased $537,777 and $426,479 of our common stock, respectively, including $206,394 pursuant to the prepaid forward purchase contract described on page 43. 53 Management’s Report on Internal Control Over Financial Reporting Management of Affiliated Managers Group, Inc. (the reasonable assurance regarding prevention or timely detec- “Company”) is responsible for establishing and maintain- tion of unauthorized acquisition, use or disposition of the ing adequate internal control over financial reporting. The Company’s assets that could have a material effect on our Company’s internal control over financial reporting financial statements. processes are designed under the supervision of the Company’s chief executive and chief financial officers to As of December 31, 2007, management conducted an provide reasonable assurance regarding the reliability of assessment of the effectiveness of the Company’s internal financial reporting and the preparation of the Company’s control over financial reporting based on the framework financial statements for external reporting purposes in established in Internal Control—Integrated Framework accordance with accounting principles generally accepted in issued by the Committee of Sponsoring Organizations of the United States. the Treadway Commission (“COSO”). Based on this assess- ment, management has determined that the Company’s The Company’s internal control over financial reporting internal control over financial reporting as of December 31, includes policies and procedures that pertain to the mainte- 2007 was effective. nance of records that, in reasonable detail, accurately and fairly reflect transactions and dispositions of assets; provide The Company’s internal control over financial reporting reasonable assurances that transactions are recorded as nec- as of December 31, 2007 has been audited by essary to permit preparation of financial statements in PricewaterhouseCoopers LLP, an independent registered accordance with accounting principles generally accepted in public accounting firm, as stated in their report appearing the United States, and that receipts and expenditures are on page 55, which expresses an unqualified opinion on the being made only in accordance with authorizations of man- effectiveness of the firm’s internal control over financial agement and the directors of the Company; and provide reporting as of December 31, 2007. 7 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 Report of Independent Registered Public Accounting Firm To the Board of Directors and Stockholders and testing and evaluating the design and operating effective- of Affiliated Managers Group, Inc.: ness of internal control based on the assessed risk. Our audits In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income, changes in stockholders’ equity and cash flows present fairly, in all material respects, the financial position of Affiliated Managers Group, Inc. (the “Company”) at December 31, 2007 and 2006, and the results of its opera- tions and its cash flows for each of the three years in the period ended December 31, 2007 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company main- tained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). The Company’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting and for its assessment of the effective- ness of internal control over financial reporting, included in Management’s Report on Internal Control Over Financial Reporting appearing on page 54 of this Annual Report. Our responsibility is to express opinions on these financial statements, and on the Company’s internal control over financial reporting based on our integrated audits. We con- ducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and also included performing such other procedures as we con- sidered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions. A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those poli- cies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transac- tions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with 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 material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstate- ments. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or proce- whether effective internal control over financial reporting dures may deteriorate. was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and Boston, Massachusetts evaluating the overall financial statement presentation. Our February 29, 2008 audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, 55 Consolidated Statements of Income (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, 2005 2006 2007 $ 916,492 $ 1,170,353 $ 1,369,866 365,960 162,078 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 $ $ $ $ $ 579,365 197,967 31,653 10,444 18,822 838,251 531,615 (17,133) (58,197) (38,877) 76,919 (37,288) 568,903 (241,987) (38,089) 288,827 74,634 28,576 3,656 181,961 6.18 4.58 29,464,764 44,921,784 181,961 50,071 232,032 $ $ $ $ $ 7 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 56 Consolidated Balance Sheets (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 Payables to related party Total current liabilities Senior debt Senior convertible securities Mandatory convertible securities Junior convertible trust preferred securities Deferred income taxes Other long-term liabilities Total liabilities Commitments and contingencies (Note 15) 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 2006 and 2007) Additional paid-in capital Accumulated other comprehensive income Retained earnings Less: treasury stock, at cost (9,428 shares in 2006 and 10,865 shares in 2007) Total stockholders’ equity Total liabilities and stockholders’ equity The accompanying notes are an integral part of the Consolidated Financial Statements. December 31, 2006 2007 $ 201,729 201,385 108,350 15,516 27,299 554,279 63,984 293,440 502,066 1,177,227 74,924 $ 222,954 237,636 134,657 21,237 33,273 649,757 69,879 842,490 496,602 1,230,387 106,590 $ 2,665,920 $ 3,395,705 $ 246,727 41,086 $ 246,400 69,952 287,813 365,500 413,358 300,000 300,000 218,584 11,209 316,352 519,500 378,083 300,000 800,000 257,022 33,516 $ 1,896,464 — 166,138 104,096 $ 2,604,473 — 194,633 127,397 390 609,369 14,666 654,465 390 662,454 64,737 836,426 1,278,890 (779,668) 1,564,007 (1,094,805) 499,222 469,202 $ 2,665,920 $ 3,395,705 57 Consolidated Statements of Changes in Stockholders’ Equity (dollars in thousands) December 31, 2004 Stock issued for option exercises Tax benefit of option exercises Issuance of Affiliate equity interests Settlement of forward equity sale agreement Conversion of zero coupon convertible notes Stock issued in connection with Affiliate investment Repurchase of stock Net Income Other comprehensive income Common Shares Common Stock 38,680,454 — — $ 387 — — — — — 343,204 — — — — — — 3 — — — Additional Paid-In Capital $ 566,776 (34) 13,942 2,231 (14,378) — 24,553 — — — Accumulated Other Comprehensive Income (Loss) $ 1,537 — — Retained Earnings Treasury Shares Treasury Shares at Cost $384,119 (5,394,730) $ (245,127) 39,269 — — 1,152,947 — — — — — — — — — — 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) Stock issued under option and other incentive plans Tax benefit of option exercises Issuance of Affiliate equity interests Settlement of call spread option agreements Cost of call spread option agreements Conversions of zero coupon convertible notes Repurchase of stock, including prepaid forward purchase contract Net Income Other comprehensive income — — — — — — — — — — — — — — — — — — (23,443) 42,308 27,508 15,564 (6,800) — (2,052) — — — — — — — — — 1,504,143 — — 84,333 — — — — — (115,789) (8,764) — — — — 667,826 35,773 — — 50,071 — (3,493,605) — — 181,961 — (426,479) — — December 31, 2007 39,023,658 $ 390 $ 662,454 $64,737 $836,426 (10,865,199) $(1,094,805) The accompanying notes are an integral part of the Consolidated Financial Statements. 7 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 Consolidated Statements of Cash Flows (in thousands) Cash flow from operating activities: Net Income Adjustments to reconcile Net Income to net 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 investment securities Sale of investment securities 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 Repayment of senior debt Repurchase of senior debt Issuance of common stock Repurchase of common stock, including prepaid forward purchase contract 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 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 for zero coupon senior convertible note conversions Payables recorded for Affiliate equity purchases 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, 2006 2005 2007 $ 119,069 $ 151,277 $ 181,961 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 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 31,653 3,250 10,444 32,232 2,772 (58,197) 53,612 5,780 9,039 5,979 (35,963) 12,766 (4,722) (3,178) 21,035 58,191 326,654 (556,683) (16,821) (13,648) 6,397 (580,755) 727,000 (573,000) 500,000 — — — 53,324 (435,997) (19,999) — 36,528 — (2,542) (12,766) 272,548 2,778 21,225 201,729 $ 222,954 $ 39,381 29,290 $ 59,526 29,003 $ 77,735 30,243 347 4,567 24,556 150,811 11,458 36,736 — — 35,773 18,308 — — 59 Notes to Consolidated Financial Statements 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 boutique investment management firms (“Affiliates”). AMG’s Affiliates currently provide investment management services globally 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 allocable 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 to AMG a percentage of the Affiliate’s revenue. The remaining revenue is 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 determine 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 limit- ed partnerships), managing partner (in the case of Affiliates which are limited liability partnerships), 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 con- solidated 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 7 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 budgets, major financings, selection of senior management, held by investors that are unrelated to the Company, and etc.). For equity method investments, AMG’s or the reported as “Minority interest in Affiliate investments in Affiliate’s portion of income before taxes is included in partnerships.” Income from these partnerships is presented Income from equity method investments. Other investments as “Investment income from Affiliate investments in in which AMG or an Affiliate owns less than a 20% interest partnerships” in the Consolidated Statements of Income. and does not exercise significant influence are accounted for The portion of this income or loss that is attributable to under the cost method. Under the cost method, income is investors that are unrelated to the Company is reported as a recognized as dividends when, and if, declared. “Minority interest in Affiliate investments in partnerships.” Effective January 1, 2006, the Company implemented Emerging Issues Task Force Issue 04-05, “Determining Whether a General Partner, or the General Partners as a Group, Controls a Limited Partnership or Similar Entity When the Limited Partners Have Certain Rights” (“EITF 04-05”). Under EITF 04-05, the Company or an Affiliate consolidates any partnership that it controls, including those interests in the partnerships in which the Company does not have ownership rights. A general partner is presumed to control a partnership unless the limited partners have certain rights to remove the general partner or other substantive rights to participate in partnership operations. Partnerships that are not controlled by the Company or an Affiliate are (e) Affiliate Investments in Marketable Securities Affiliate investments in marketable securities are classified as either trading or available-for-sale and carried at fair value. Unrealized holding gains or losses on investments classified as available-for-sale are reported net of deferred tax as a separate component of accumulated other compre- hensive income in stockholders’ equity until realized. If a decline in the fair value of these investments is determined to be other than temporary, the carrying amount of the asset is reduced to its fair value, and the difference is charged to income in the period incurred. accounted for using the equity method of accounting. (f) Fixed Assets The effect of any changes in the Company’s equity interests in its Affiliates resulting from the issuance of an Affiliate’s equity by the Company or one of its Affiliates is included as a component of stockholders’ equity, net of the related income tax effect in the period of the change. (c) Cash and Cash Equivalents The Company considers all highly liquid investments, including money market mutual funds, with original matu- rities of three months or less to be cash equivalents. Cash equivalents are stated at cost, which approximates market Fixed assets are recorded at cost and depreciated using the straight-line method over their estimated useful lives. The estimated useful lives of office equipment and furniture and fixtures range from three to ten years. Computer software developed or obtained for internal use is amortized using the straight-line method over the estimated useful life of the software, generally three years or less. Leasehold improve- ments are amortized over the shorter of their estimated use- ful lives or the term of the lease, and the building is amor- tized over 39 years. The costs of improvements that extend the life of a fixed asset are capitalized, while the cost of repairs and maintenance are expensed as incurred. Land is value due to the short-term maturity of these investments. not depreciated. (d) Affiliate Investments in Partnerships (g) Leases Assets of consolidated partnerships are reported as “Affiliate The Company and its Affiliates currently lease office space investments in partnerships.” A majority of these assets are and equipment under various leasing arrangements. As these 61 leases expire, it can be expected that in the normal course of a decline in value below the book value of the investment is business they will be renewed or replaced. All leases and sub- other than temporary, then a charge would be recognized in leases are accounted for under Statement of Financial the Consolidated Statements of Income. Accounting Standard (“FAS”) No. 13, “Accounting for Leases.” These leases are classified as either capital leases or operating leases, as appropriate. Most lease agreements clas- sified as operating leases contain renewal options, rent esca- lation clauses or other inducements provided by the land- lord. Rent expense is accrued to recognize lease escalation provisions and inducements provided by the landlord, if any, on a straight-line basis over the lease term. (h) Equity Investments in Affiliates (i) 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 acquired, primarily acquired client relationships. In deter- mining the allocation of the purchase price to acquired client relationships, the Company analyzes the net present value of each acquired Affiliate’s existing client relationships based on a number of factors including: the Affiliate’s historical and potential future operating performance; the For equity method investments, the Company’s portion of Affiliate’s historical and potential future rates of attrition income before taxes is included in Income from equity among existing clients; the stability and longevity of method investments. The Company’s share of income taxes existing client relationships; the Affiliate’s recent, as well as incurred directly by Affiliates accounted for under the equi- long-term, investment performance; the characteristics of ty method are recorded within Income taxes—current in the firm’s products and investment styles; the stability and the Consolidated Statements of Income because these taxes depth of the Affiliate’s management team and the Affiliate’s generally represent the Company’s share of the taxes history and perceived franchise or brand value. incurred by the Affiliate. Deferred income taxes incurred as a direct result of the Company’s investment in Affiliates The Company has determined that certain of its mutual accounted for under the equity method have been included fund acquired client relationships meet the indefinite life in Income taxes—intangible-related deferred in the criteria outlined in FAS No. 142, “Goodwill and Other Consolidated Statements of Income. The associated Intangible Assets” (“FAS 142”), because the Company deferred tax liabilities have been classified as a component expects both the renewal of these contracts and the cash of deferred income taxes in the Consolidated Balance Sheet. flows generated by these assets to continue indefinitely. Accordingly, the Company does not amortize these intangi- As is consistent with the equity method of accounting, for ble assets, but instead reviews these assets at least annually one of its equity method Affiliates based outside the United for impairment. Each reporting period, the Company States, the Company has elected to record financial results assesses whether events or circumstances have occurred one quarter in arrears to allow for the receipt of financial which indicate that the indefinite life criteria are no longer information. The Company converts the financial informa- met. If the indefinite life criteria are no longer met, the tion of foreign investments to U.S. GAAP. Company assesses whether the carrying value of the assets The Company periodically evaluates its equity method investments for impairment. In such impairment evalua- exceeds its fair value, and an impairment loss would be recorded in an amount equal to any such excess. tions, the Company assesses if the value of the investment As of December 31, 2007, the cost assigned to all other has declined below its book value for a period considered to acquired client relationships was being amortized over a be other than temporary. If the Company determines that weighted average life of approximately 12 years. The 7 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 expected useful lives of acquired client relationships are Affiliates for managing the assets of clients. Asset-based analyzed each period and determined based on an analysis advisory fees are recognized monthly as services are ren- of the historical and projected attrition rates of each dered and are based upon a percentage of the market value Affiliate’s existing clients, and other factors that may influ- of client assets managed. Any fees collected in advance are ence the expected future economic benefit the Company deferred and recognized as income over the period earned. will derive from the relationships. The Company tests for Performance-based advisory fees are generally assessed as a the possible impairment of definite-lived intangible assets percentage of the investment performance realized on a annually or more frequently whenever events or changes in client’s account, generally over an annual period. circumstances indicate that the carrying amount of the asset Performance-based advisory fees are recognized when they is not recoverable. If such indicators exist, the Company are earned (i.e. when they become billable to customers) compares the undiscounted cash flows related to the asset to based on the contractual terms of agreements and when the carrying value of the asset. If the carrying value is collection is reasonably assured. Also included in revenue greater than the undiscounted cash flow amount, an are commissions earned by broker dealers, recorded on a impairment charge is recorded in the Consolidated trade date basis, and other service fees recorded as earned. Statements of Income for amounts necessary to reduce the carrying value of the asset to fair value. (k) Issuance Costs The excess of purchase price for the acquisition of interests in Affiliates over the fair value of net assets acquired, including acquired client relationships, is reported as good- will within the operating segments in which the Affiliate operates. Goodwill is not amortized, but is instead reviewed for impairment. The Company assesses goodwill for impairment at least annually, or more frequently whenever events or circumstances occur indicating that the recorded goodwill may be impaired. Fair value is determined for each operating segment primarily based on price-earnings multi- ples. If the carrying amount of goodwill exceeds the fair value, an impairment loss would be recorded in an amount equal to that excess. As further described in Note 16, the Company periodically purchases additional equity interests in Affiliates from minority interest owners. Resulting payments made to such owners are generally considered purchase price for these acquired interests. (j) Revenue Recognition Issuance costs incurred in securing credit facility financing are amortized over the remaining term of the credit facility. Costs incurred to issue the zero coupon senior convertible securities, the floating rate senior convertible securities and junior convertible trust preferred securities are amortized over the earlier of the period to the first investor put date or the stated term of the security. Costs incurred to issue the Company’s mandatory convertible securities are allocated between the senior notes and the purchase contracts based upon the relative cost to issue each instrument separately. Costs allocated to the senior notes are recognized as inter- est expense over the period of the forward equity purchase contract component of such securities. Costs allocated to the prepaid forward purchase contract and call spread option agreements are charged directly to stockholders’ equity and not amortized. (l) Derivative Financial Instruments 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 interest rate swap contracts, to hedge certain interest rate The Company’s consolidated revenue primarily represents exposures. For example, the Company may agree with a advisory fees billed monthly, quarterly and annually by counter party (typically a major commercial bank) to 63 exchange the difference between fixed-rate and floating-rate “more-likely-than-not” threshold, the amount recognized in interest amounts calculated by reference to an agreed the financial statements is the benefit expected to be realized notional principal amount. In entering into these contracts, upon settlement with the tax authority. For tax positions the Company intends to offset cash flow gains and losses not meeting the threshold, no financial statement benefit that occur on its existing debt obligations with cash flow is recognized. gains and losses on the contracts hedging these obligations. The Company records all derivatives on the balance sheet at fair value. If the Company’s derivatives qualify as cash flow hedges, the effective portion of the unrealized gain or loss is recorded in accumulated other comprehensive income as a separate component of stockholders’ equity and reclassified into earnings when periodic settlement of variable rate liabilities are recorded in earnings. Hedge effectiveness is generally measured by comparing the present value of the cumulative change in the expected future variable cash flows of the hedged contract with the present value of the cumulative change in the expected future variable cash flows of the hedged item. To the extent that the critical terms of the hedged item and the derivative are not identical, hedge ineffectiveness would be reported in earnings as interest expense. Hedge ineffectiveness was not material in 2005, 2006 or 2007. (m) Income Taxes On January 1, 2007, the Company adopted the provisions The Company accounts for income taxes using the liability method. Under this method, deferred taxes are recognized for the expected future tax consequences of temporary differ- ences between the book carrying amounts and tax bases of the Company’s assets and liabilities. Historically, deferred taxes have been comprised primarily of deferred tax liabilities attributable to intangible assets and convertible securities and deferred tax assets from state credits and loss carryforwards. In measuring the amount of deferred taxes each period, the Company must project the impact on its future tax payments of any reversal of deferred tax liabilities (which would increase the Company’s tax payments), and any use of its state credits and carryforwards (which would decrease its tax payments). In forming these estimates, the Company makes assumptions about future federal, state and foreign income tax rates and the apportionment of future taxable income to jurisdictions in which the Company has opera- tions. An increase or decrease in federal or state income tax rates could have a material impact on the Company’s deferred income tax liabilities and assets and would result in of Financial Interpretation No. 48, “Accounting for a current income tax charge or benefit. Uncertainty in Income Taxes” (“FIN 48”). FIN 48 clarifies the accounting for uncertain tax positions recognized in financial statements in accordance with FASB Statement No. 109 “Accounting for Income Taxes” (“FAS 109”). FIN 48 prescribes a recognition threshold and measurement criteria for evaluating tax positions. As allowed by FIN 48, the Company recognizes interest and other charges relating to unrecognized tax benefits as additional tax expense. In the case of the Company’s deferred tax assets, the Company regularly assesses the need for valuation allowances, which would reduce these assets to their recov- erable amounts. In forming these estimates, the Company makes assumptions of future taxable income that may be generated to utilize these assets, which have limited lives. If the Company determines that these assets will be realized, the Company records an adjustment to the valuation As required by FIN 48, the Company recognizes the finan- allowance, which would decrease tax expense in the period cial statement benefit of an uncertain tax position only after such determination was made. Likewise, should the considering the probability that a tax authority would sustain Company determine that it would be unable to realize the position in an examination. For tax positions meeting a additional amounts of deferred tax assets, an adjustment to 7 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 the valuation allowance would be charged to tax expense in expense for all options granted subsequent to January 1, the period such determination was made. For example, if 2006. Compensation expense recognized under FAS 123R, the Company was to make an investment in a new Affiliate net of tax, was $1,042 and $5,694 for the years ended located in a state where it has operating loss carryforwards, December 31, 2006 and 2007, respectively. This additional the projected taxable income from the new Affiliate could compensation expense decreased basic and diluted earnings be offset by these operating loss carryforwards, justifying a per share by $0.03 and $0.02, respectively, for the year reduction to the valuation allowance. ended December 31, 2006, and $0.19 and $0.13, respec- (n) 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 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 tively, for the year ended December 31, 2007. The following table presents Net Income and earnings per share as if the Company had applied the fair value recogni- tion provisions of FAS 123 to stock-based employee com- pensation for the year ended December 31, 2005. investments, net translation exchange gains and losses are Net Income—as reported excluded from Net Income but are recorded in other com- prehensive income. Foreign currency transaction gains and losses are reflected in Investment and other income. (o) Share-Based Compensation Plans Effective January 1, 2006, the Company adopted the fair value recognition provisions of FAS No. 123 (revised 2004), “Share-Based Payment” (“FAS 123R”). FAS 123R revises 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 Net Income—FAS 123 pro forma Earnings per share— basic—as reported Earnings per share— SFAS No. 123, “Accounting for Stock-Based Compensation” basic—FAS 123 pro forma (“FAS 123”) and supersedes Accounting Principles Board Earnings per share— (“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 diluted—as reported Earnings per share— diluted—FAS 123 pro forma Year Ended December 31, 2005 $ 119,069 — 709 $ 118,360 $ 3.54 3.52 2.81 2.80 in the financial statements based on their fair values over the FAS 123R also requires the Company to report any tax requisite service period. In addition, FAS 123R requires benefits realized upon the exercise of stock options that are in unrecognized costs related to options vesting after the date of excess of the expense recognized for reporting purposes as a initial adoption to be recognized as an expense in the finan- financing activity in the company’s Consolidated Statements cial statements over the remaining requisite service period. of Cash Flows. Prior to the adoption of FAS 123R, these tax benefits were presented as operating cash flows in the The Company adopted FAS 123R using the modified Consolidated Statements of Cash Flows. If the tax benefit prospective transition method. Under this method, com- realized is less than the expense, the tax shortfall is recog- pensation expense includes: (i) an expense for all unvested nized in stockholders’ equity. To the extent the expense options outstanding on January 1, 2006, and (ii) an exceeds available windfall tax benefits, it is recognized in the 65 Consolidated Statements of Income. Under FAS 123R, the In December 2007, the FASB issued Statement of Financial Company was permitted to calculate its cumulative windfall Accounting Standards No. 141 (revised 2007), “Business tax benefits for the purposes of accounting for future tax Combinations” (“FAS 141R”). FAS 141R will change the shortfalls. The Company elected to apply the long-form accounting for business combinations in a number of method for determining the pool of windfall tax benefits. respects, including the way entities account for business (p) 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. (q) Recent Accounting Developments In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (“FAS 157”). FAS 157 establishes a framework for measuring fair value applicable to other accounting standards that use fair value measurements. In February 2008, the FASB issued FASB Staff Position No. 157-2, “Effective Date of FASB Statement No. 157,” which deferred the effective date of FAS 157 for one year for nonfinancial assets and liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis. The Company will be subject to certain of the provisions of FAS 157 in the first quarter of 2008. This standard is not expected to have a material impact on the Company’s consolidated financial statements, but will require certain additional disclosures. combinations achieved in stages by requiring the identifi- able assets and liabilities to be measured at their full fair values on the acquisition date. In addition, FAS 141R will change the treatment of contingent consideration, contin- gencies, acquisition costs, and restructuring costs. FAS 141R will be applied prospectively to any business combi- nation completed after December 31, 2008. The impact of this standard will depend upon the nature, terms and size of business combinations completed after the effective date. In December 2007, the FASB issued Statement of Financial Accounting Standards No. 160, “Noncontrolling Interests in Consolidated Financial Statements, an amendment of ARB No. 51” (“FAS 160”). FAS 160 will change the accounting and reporting for minority or noncontrolling interests. Upon adoption, these interests will be classified as a separate component within stockholders’ equity and transactions between controlling interest and minority interest holders will be accounted for within stockholders’ equity. The Company will adopt FAS 160 in the first quar- ter of 2009 and is currently evaluating the impact that this standard will have on the consolidated financial statements. 2 Concentrations of Credit Risk In February 2007, the FASB issued Statement of Financial Financial instruments that potentially subject the Company Accounting Standards No. 159, “The Fair Value Option for to significant concentrations of credit risk consist principally Financial Assets and Financial Liabilities—Including an of cash investments. The Company maintains cash and cash amendment of FASB Statement No. 115” (“FAS 159”). equivalents, investments and, at times, certain financial FAS 159 permits companies to measure many financial instruments with various financial institutions. These finan- instruments and certain other items at fair value. The Company will adopt FAS 159 in the first quarter of 2008. cial institutions are typically located in cities in which AMG and its Affiliates operate. For AMG and certain Affiliates, This standard is not expected to have a material impact on cash deposits at a financial institution may exceed Federal the Company’s consolidated financial statements. Deposit Insurance Corporation insurance limits. 7 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 3 Affiliate Investments in Partnerships 5 Fixed Assets and Lease Commitments Purchases and sales of investments (principally equity Fixed assets consisted of the following: securities) and gross client subscriptions and redemptions relating to Affiliate investments in partnerships were as follows: Building and leasehold improvements $ 44,495 $ 49,767 At December 31, 2006 2007 Purchase of investments $158,311 $ 285,001 Land and improvements At December 31, Office equipment 2006 2007 Furniture and fixtures Computer software Fixed assets, at cost Accumulated depreciation and amortization Fixed assets, net 22,786 13,345 13,403 8,965 30,457 14,741 15,203 9,314 102,994 119,482 (39,010) (49,603) $ 63,984 $ 69,879 Sale of investments Gross subscriptions Gross redemptions 167,246 295,799 498 8,205 4,523 17,289 Management fees earned by the Company on partnership assets were $1,148 and $1,309 for the years ended December 31, 2006 and 2007, respectively. As of December 31, 2006 and December 31, 2007, the Company’s investments in partnerships that are not controlled by its Affiliates were $21,449 and $19,799, respectively. These assets are reported within “Other assets” in the Consolidated Balance Sheets. The income or loss relat- ed to these investments is classified within “Investment and other income” in the Consolidated Statements of Income. 4 Affiliate Investments in Marketable Securities The cost of Affiliate investments in marketable securities, gross unrealized gains and losses were as follows: Cost of Affiliate investments in marketable securities Gross unrealized gains Gross unrealized losses At December 31, 2006 2007 $14,342 $20,272 1,379 205 1,866 901 The Company and its Affiliates lease office space and com- puter equipment for their operations. At December 31, 2007, the Company’s aggregate future minimum payments for operating leases having initial or noncancelable lease terms greater than one year are payable as follows: Year Ending December 31, Required Minimum Payments 2008 2009 2010 2011 2012 Thereafter $ 20,194 19,965 17,125 14,265 11,386 27,552 Consolidated rent expense for 2005, 2006 and 2007 was $18,151, $19,574 and $20,283, respectively. 67 6 Accounts Payable and Accrued Liabilities Accounts payable and accrued liabilities consisted of the following: Accrued compensation Accrued income taxes Accrued interest Accrued professional services Accrued subadvisory fees Accounts payable Accrued rent Deferred revenue Accrued share repurchases Contract adjustment payments Other At December 31, 2006 2007 $ 156,674 $ 169,382 29,550 6,402 7,287 5,218 9,359 2,635 953 9,518 6,025 13,106 22,960 12,542 10,978 5,541 4,971 3,029 1,487 — 1,263 14,247 $ 246,727 $ 246,400 irrevocable. In addition, the Company has established a Deferred Compensation Plan that provides officers and directors of the Company the opportunity to voluntarily defer base salary, bonus payments and director fees, as applicable, 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 opportunity 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 2005, 2006 and 2007 were $20,864, $10,336 and $10,374, respectively. 8 Senior Debt Senior debt is comprised of: 7 Benefit Plans The Company has three defined contribution plans consist- At December 31, 2006 2007 ing of a qualified employee profit-sharing plan covering Senior credit facility $ 365,500 $ 519,500 substantially all of its full-time employees and several of its Affiliates, and non-qualified plans for certain senior On November 27, 2007, the Company entered into an employees. AMG’s other Affiliates generally have separate amended and restated senior credit facility (the “Facility”). defined contribution retirement plans. Under each of the The Facility allows the Company to borrow an aggregate of qualified plans, AMG and each participating Affiliate, as the $950,000. The Facility is comprised of a $750,000 revolv- case may be, are able to make discretionary contributions for ing credit facility (the “Revolver”) and a $200,000 term loan the benefit of qualified plan participants up to IRS limits. (the “Term Loan”). The Company pays interest on these obligations at specified rates (based either on the Eurodollar The Company’s non-qualified Executive Retention Plan (the rate or the prime rate as in effect from time to time) that “ERP”) is designed to work in concert with the Company’s vary depending on the Company’s credit rating. The Term stockholder-approved Long-Term Executive Incentive Plan, Loan requires principal payments to be made at specified dates providing a trust vehicle for long-term compensation awards until maturity. Subject to the agreement of lenders to provide based upon the Company’s performance and growth. The additional commitments, the Company has the option to ERP permits the Compensation Committee to make awards increase the Facility by up to an additional $250,000. that may be invested by the recipient in the Company’s common stock, in Affiliate investment products, and in The Facility will mature in February 2012, and contains cash accounts, in each case subject to vesting and forfeiture financial covenants with respect to leverage and interest provisions. The Company’s contributions to the ERP are coverage. The Facility also contains customary affirmative 7 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 and negative covenants, including limitations on indebted- securities with cash, shares of its common stock or some ness, liens, cash dividends and fundamental corporate combination thereof. The Company has the option to changes. Borrowings under the Facility are collateralized by redeem the securities for cash at their accreted value. Under pledges of the substantial majority of capital stock or other the terms of the indenture governing the zero coupon equity interests owned by the Company. The Company convertible notes, a holder may convert such security into pays a quarterly commitment fee on the daily unused por- common stock by following the conversion procedures in tion of the Facility, which amounted to $676, $602 and the indenture. Subject to changes in the price of the $443 in 2005, 2006 and 2007, respectively. Company’s common stock, the zero coupon convertible notes may not be convertible in certain future periods. 9 Senior Convertible Securities The components of senior convertible securities are as follows: In 2006, the Company amended the zero coupon convert- ible notes. Under the terms of this amendment, the Company will pay interest through May 7, 2008 at a rate of At December 31, 0.375% per year on the principal amount at maturity of the 2006 2007 notes in addition to the accrual of the original issue discount. Zero coupon senior convertible notes $ 113,358 $ 78,083 Floating rate senior convertible securities 300,000 300,000 $ 413,358 $ 378,083 Zero Coupon Senior Convertible Notes Floating Rate Senior Convertible Securities (See also Note 27—Subsequent Events) In 2003, the Company issued $300,000 of floating rate senior convertible securities due 2033 (“floating rate con- vertible securities”), bearing interest at a rate equal to 3-month LIBOR minus 0.50%, payable quarterly in cash. In 2001, the Company issued $251,000 of principal Each security is convertible into shares of the Company’s amount at maturity of zero coupon senior convertible notes common stock (at a base conversion price of $54.17) upon due 2021 (“zero coupon convertible notes”), with each note the occurrence of certain events, including the following: issued at 90.50% of such principal amount and accreting at (i) if the closing price of a share of the Company’s common a rate of 0.50% per year. As of December 31, 2007, stock exceeds $65.00 over certain periods; (ii) if the credit $83,452 principal amount at maturity remains outstand- rating assigned by Standard & Poor’s to the securities is ing. Each security is convertible into 17.429 shares of the below BB-; or (iii) if the Company calls the securities for Company’s common stock (at a current base conversion redemption. Upon conversion, holders of the securities will price of $53.68) upon the occurrence of certain events, receive 18.462 shares of the Company’s common stock for including the following: (i) if the closing price of a share of each convertible security. In addition, if the market price of its common stock is more than a specified price over certain the Company’s common stock exceeds the base conversion periods (initially $62.36 and increasing incrementally at the price at the time of conversion, holders will receive end of each calendar quarter to $63.08 in April 2021); (ii) additional shares of common stock based on the stock price if the credit rating assigned by Standard & Poor’s to the at that time. Based on the trading price of the Company’s securities is below BB-; or (iii) if the Company calls the common stock as of December 31, 2007, upon conversion, securities for redemption. The holders may require the a holder of each security would receive an additional 6.062 Company to repurchase the securities at their accreted value shares. The holders of the floating rate convertible securities in May 2011 and 2016. If the holders exercise this option may require the Company to repurchase such securities in the future, the Company may elect to repurchase the in February 2008, 2013, 2018, 2023 and 2028, at their 69 principal amount. The Company may choose to pay the The holder’s obligations under the forward equity purchase purchase price for such repurchases with cash, shares of the contracts were collateralized by the pledge of the senior Company’s common stock or some combination thereof. notes to the Company. The number of shares to be issued in The Company has rights to redeem the convertible securities February 2008 will be determined based upon the average for cash at any time on or after February 25, 2008, at their trading price of the Company’s common stock for a period principal amount plus accrued and unpaid interest. Under preceding that date. Depending on the average trading price the terms of the indenture governing the floating rate con- in that period, the settlement rate will range from 11.785 vertible securities, a holder may convert such security into to 18.031 shares per $1,000 purchase contract. Based on common stock by following the conversion procedures in the trading price of the Company’s common stock as of the indenture; subject to changes in the price of the December 31, 2007, the purchase contracts would have a Company’s common stock, floating rate convertible securi- settlement rate of 13.519. ties may not be convertible in certain future periods. In the first quarter of 2008, the Company called the out- outstanding senior notes component of its 2004 PRIDES. standing floating rate convertible securities for redemption. Following the consummation of these transactions, all of In lieu of redemption, substantially all of the holders the 2004 PRIDES have been cancelled and retired. In the first quarter of 2008, the Company repurchased the elected to convert their securities. Following the consum- mation of these transactions, all of the Company’s floating rate convertible securities will be cancelled and retired. 11 Junior Convertible Trust Preferred Securities In 2006, the Company issued $300,000 of junior subordi- The floating rate senior convertible securities are consid- nated convertible debentures due 2036 to a wholly-owned ered contingent payment debt instruments under federal trust simultaneous with the issuance, by the trust, of income tax regulations. These regulations required the $291,000 of convertible trust preferred securities to Company to deduct interest in an amount greater than its investors. The junior subordinated convertible debentures reported interest expense, and resulted in annual deferred and convertible trust preferred securities (together, the tax liabilities of $3,700. Because the trading price of the “2006 junior convertible trust preferred securities”) have Company’s common stock exceeded $60.90 at the time of substantially the same terms. the conversions, $18,292 of accumulated deferred tax liabilities attributable to these securities will be reclassified The 2006 junior convertible trust preferred securities bear to stockholders’ equity. 10 Mandatory Convertible Securities (See also Note 27—Subsequent Events) interest at a rate of 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 conversion price of $150 per share (or a 48% premium to the then prevailing share price of $101.45). Upon conversion, In 2004, the Company issued $300,000 of mandatory con- investors will receive cash or shares of the Company’s vertible securities (“2004 PRIDES”), each unit consisting of common stock (or a combination of cash and common (i) a senior note due February 2010 with a principal amount stock) at the election of the Company. The 2006 junior of $1,000 per note, with interest payable quarterly at the convertible trust preferred securities may not be redeemed by annual rate of 4.125%, and (ii) a forward equity purchase the Company prior to April 15, 2011. On or after April 15, contract pursuant to which the holder agreed to purchase 2011, they may be redeemed if the closing price of the shares of the Company’s common stock in February 2008. Company’s common stock exceeds $195 per share for a 7 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 specified period of time. The trust’s only assets are the junior deemed to be uncertain. On January 1, 2007 the Company convertible subordinated debentures. To the extent that the carried a liability for uncertain tax positions of $21,315, trust has available funds, the Company is obligated to ensure including $3,761 for interest and related charges. On that holders of the 2006 convertible trust preferred securities December 31, 2007, this liability was $22,506, including receive all payments due from the trust. interest and related charges of $3,877. The adoption of FIN 48 did not result in an adjustment to the Company’s In October 2007, the Company issued an additional liability for uncertain tax positions or retained earnings. $500,000 of junior subordinated convertible debentures These liabilities at January 1, 2007 and December 31, 2007 which are due 2037 to a wholly-owned trust simultaneous included $11,847 and $12,619, respectively, for tax positions with the issuance, by the trust, of $500,000 of convertible that, if recognized, would affect the Company’s effective tax trust preferred securities to investors. The junior subordi- rate. A reconciliation of the beginning and ending amount nated convertible debentures and convertible trust pre- of unrecognized tax benefits is as follows: ferred securities (together, the “2007 junior convertible trust preferred securities”) have substantially the same terms as the 2006 junior subordinated convertible debentures. Balance at January 1, 2007 The 2007 junior convertible trust preferred securities bear interest at 5.15% per annum, payable quarterly in cash. Each $50 security is convertible, at any time, into 0.25 shares of the Company’s common stock, which represents a conversion price of $200 per share (or a 53% premium to the then prevailing share price of $130.77). Upon conver- sion, investors will receive cash or shares of the Company’s common stock (or a combination of cash and common stock) at the election of the Company. The 2007 junior convertible trust preferred securities may not be redeemed by the Company prior to October 15, 2012. On or after October 15, 2012, they may be redeemed if the closing price of the Company’s common stock exceeds $260 purchase for a specified period of time. The trust’s only assets are the 2007 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. 12 Income Taxes Effective January 1, 2007, the Company adopted FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”). FIN 48 clarifies the accounting for liabilities related to tax return positions that may be Additions based on tax positions related to current year Additions based on tax positions of prior years Reductions for tax provisions of prior years Settlements $ 21,315 4,381 116 — — Reductions related to lapses of statutes of limitations (3,306) Balance at December 31, 2007 $ 22,506 The Company or its subsidiaries files income tax returns in federal, various state, and foreign jurisdictions. With few exceptions, the Company is no longer subject to income tax examinations by any tax authorities for years before 2004. A summary of the provision for income taxes is as follows: Current: Federal State Foreign Deferred: Federal State Foreign Year Ended December 31, 2005 2006 2007 $ 31,399 2,005 5,491 $38,971 6,344 9,952 $ 52,012 8,124 14,498 30,424 2,158 (894) 33,261 1,900 (3,818) 33,582 1,954 (3,304) $ 70,583 $86,610 $106,866 71 The components of income before income taxes consisted Deferred tax liabilities are primarily the result of tax deduc- of the following: Year Ended December 31, tions for the Company’s intangible assets and convertible securities. The Company amortizes most of its intangible 2005 2006 2007 assets for tax purposes only, reducing its tax basis below its Domestic Foreign $ 163,912 $ 186,249 $ 221,798 25,740 51,638 67,029 $ 189,652 $ 237,887 $ 288,827 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, 2005 2006 2007 35.0% 35.0% 35.0% 1.4 0.2 0.6 2.9 2.2 — 0.8 2.6 1.6 0.2 1.3 3.9 (2.9) 37.2% (4.2) 36.4% (5.0) 37.0% The components of deferred tax assets and liabilities are as follows: carrying value for financial statement purposes and generating deferred taxes each reporting period. In contrast, the intangi- ble 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 securities, 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. At December 31, 2007, the Company had state net operat- ing loss carryforwards that will expire over a 15-year period beginning in 2006. The valuation allowances at December 31, 2006 and 2007 are related to the uncertainty of the real- ization 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, 2007 is principally attributable to state net operating losses during At December 31, this period and a provision for loss carryforwards that the 2006 2007 Company does not expect to realize. Deferred assets (liabilities): Intangible asset amortization $ (170,216) $ (193,275) Convertible securities interest (19,807) (28,215) 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. 13 Derivative Financial Instruments (26,946) (26,668) 14,126 — (1,956) 739 (398) 18,023 (8,005) (3,562) 2,196 507 Non-deductible intangible amortization State net operating loss and credit carryforwards Deferred compensation Fixed asset depreciation Accrued expenses Deferred income Valuation allowance Net deferred income taxes $ (218,584) $ (257,022) interest rates. As of December 31, 2007, the Company was (204,458) (238,999) (14,126) (18,023) The Company periodically uses interest rate hedging con- tracts to manage market exposures associated with changing 7 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 a party to interest rate hedging contracts with a $150 The components of accumulated other comprehensive million notional amount, which fixed the interest rate on a income, net of taxes, were as follows: portion of 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 At December 31, 2006 2007 Foreign currency translation adjustment $ 13,081 $ 64,556 Unrealized gain on derivative instruments 1,508 77 180 1 unrealized gain or loss on the derivative instruments is Unrealized gain recorded in accumulated other comprehensive income as a on investment securities separate component of stockholders’ equity. At December Accumulated other 31, 2006 and 2007, the unrealized gain, before taxes, on the derivative instruments was $2,392 and $283, respectively. The Company expects no portion of the unrealized gain to be reclassified from accumulated other comprehensive income to Net Income over the next 12 months. 14 Comprehensive Income A summary of comprehensive income, net of applicable taxes, is as follows: comprehensive income $ 14,666 $ 64,737 15 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 Year Ended December 31, probable and can be reasonably estimated. Management 2005 2006 2007 believes that any liability in excess of these accruals upon the Net Income $ 119,069 $ 151,277 $ 181,961 ultimate resolution of these matters will not have a material Foreign currency translation adjustment 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 Comprehensive income 13,781 (1,832) 51,475 adverse effect on the consolidated financial condition or results of operations of the Company. Certain Affiliates operate under regulatory authorities which require that they maintain minimum financial or capital 2,098 (358) (1,328) requirements. Management is not aware of any violations of such financial requirements occurring during the period. (50) 100 (76) (610) — — 16 Business Combinations The Company’s Affiliate investments totaled $267,169, $144,580 and $610,235 in the years ended December 31, 2005, 2006 and 2007, respectively. These investments were $ 134,288 $ 149,187 $ 232,032 made pursuant to the Company’s growth strategy designed to generate shareholder value by making investments in boutique investment management firms and other strategic 73 transactions designed to expand the Company’s participa- transaction was financed through borrowings under the tion in its three principal distribution channels. Company’s senior credit facility. In December 2007, the Company acquired a minority interest In 2005, the Company completed the acquisition of a in BlueMountain Capital Management (“BlueMountain”), group of Canadian asset management firms. These firms a leading global credit alternatives manager specializing in manage approximately 100 investment products, including relative value strategies in the corporate loan, bond, credit and Canadian, U.S. and international value and growth equity equity derivatives markets. BlueMountain has offices in New products, as well as balanced, fixed income, venture capital York and London, and manages assets on behalf of predomi- and structured products. These firms operate in each of the nantly institutional and high net worth clients. This transac- Company’s three distribution channels. The transaction tion was financed through borrowings under the Company’s was financed through borrowings under the Company’s senior credit facility. senior credit facility, the issuance of common stock, and In November 2007, the Company acquired a minority available cash. interest in ValueAct Capital (“ValueAct”), a San Francisco– In 2005, through Managers Investment Group LLC, the based alternative investment firm that establishes owner- Company completed the acquisition of approximately $3.0 ship interests in undervalued companies and works with billion of assets under management from Fremont Investment each company’s management and Board of Directors to Advisors, Inc. (“FIA”). The acquisition included the Fremont implement business strategies that enhance shareholder Funds, a diversified family of no load mutual funds managed value. ValueAct has over 250 clients, including endow- by independent sub advisors and professionals at FIA, as well ments, foundations, corporations, family offices, high net as FIA assets in separate accounts and 401(k) plans. The worth investors and funds of funds. This transaction was transaction was financed through available cash. financed through borrowings under the Company’s senior credit facility. The assets and liabilities of the investments in acquired businesses are accounted for under the purchase method of In 2006, the Company expanded its product offerings in the accounting and recorded at their fair values at the dates of Institutional distribution channel through the acquisition of acquisition. The excess of the purchase price over the a majority equity interest in Chicago Equity Partners, LLC estimated fair values of the net assets acquired is recorded as (“Chicago Equity”), which manages a wide range of U.S. an increase in goodwill. The results of operations of equity and fixed income products across multiple capital- acquired businesses have been included in the Consolidated ization sectors and investment styles. The firm’s client base Financial Statements beginning as of the date of acquisi- includes over 120 institutional investors, including public tion. The following table summarizes the net assets funds, corporations, endowments and foundations, Taft- acquired as of the respective acquisition dates during the Hartley plan sponsors and certain mutual fund advisers. The years ended December 31, 2006 and 2007: 7 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 Current assets, net Fixed assets Definite-lived acquired client relationships Indefinite-lived acquired client relationships Equity investments in Affiliates(2) Goodwill 2006(1) $ 11,488 $ 2,045 2007 — — 43,481 19,876 2,611 — 87,040 4,577 541,377 18,262 Net assets acquired $ 146,665 $ 584,092 (1) In 2007, the Company finalized the purchase price allocation of Chicago Equity. (2) The Company’s 2007 investments in BlueMountain and ValueAct are accounted for under the equity method of accounting. The Company’s purchase price allocations of these investments are subject to the final- ization of the valuations of acquired client relationships. As a result, these preliminary amounts may be revised in future periods. Unaudited pro forma financial results are set forth below, giving consideration to the investments and acquisitions in 2006 and 2007, as if such transactions occurred as of the beginning of 2006, assuming revenue sharing arrangements had been in effect for the entire period and after making certain other pro forma adjustments. In addition to the investments described above, in the years ended December 31, 2005, 2006, and 2007, the Company completed additional investments in existing Affiliates and transferred interests in certain affiliated investment man- agement firms. The financial effect of these transactions 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 interests to the Company at certain intervals and upon their death, permanent incapacity or termination of employment and provide Affiliate managers a conditional right to require the Company to purchase such retained equity interests upon the occurrence of specified events. The pur- chase price of these conditional purchases are generally cal- culated 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 Revenue Net Income Year Ended December 31, occurred with respect to all such retained equity interests as 2006 2007 of December 31, 2007, the aggregate amount of these pay- $ 1,201,686 $ 1,369,866 ments would have totaled approximately $1,470,100. In 167,000 172,581 the event that all such transactions were closed, AMG Earnings per share—basic $ Earnings per share—diluted $ 5.34 4.09 5.86 4.37 In connection with certain investments in Affiliates, the Company is contingently liable, upon achievement of speci- fied financial targets, to make additional purchase payments of up to $232,000 through 2011. The Company expects it will make payments of up to $70,000 in 2008. If these pay- ments occur, the Company will record incremental goodwill. As of December 31, 2007 the Company has recorded would own the prospective cash flow distributions of all equity interests that would be purchased from the Affiliate managers. As of December 31, 2007, this amount would represent approximately $204,400 on an annualized basis. 17 Goodwill and Acquired Client Relationships In 2006 and 2007, the Company acquired interests from and transferred interests to Affiliate management partners. Most of the goodwill acquired during the year is tax $50,000 of these payments because certain of these targets had been achieved. deductible. 75 The following table presents the change in goodwill during 2006 and 2007: Balance, as of December 31, 2005 Goodwill acquired, net Foreign currency translation Balance, as of December 31, 2006 Goodwill acquired, net Foreign currency translation Balance, as of December 31, 2007 Mutual Fund $ 437,309 17,490 (238) 454,561 3,881 15,893 Institutional $ 445,609 58,692 (233) 504,068 9,604 15,523 High Net Worth $210,331 8,350 (83) 218,598 2,715 5,544 Total $1,093,249 84,532 (554) 1,177,227 16,200 36,960 $ 474,335 $ 529,195 $226,857 $1,230,387 In connection with the Company’s equity method investments, approximately $185,300 and $572,323 of goodwill has been classified within Equity investments in Affiliates as of December 31, 2006 and 2007, respectively. The following table reflects the components of intangible assets of the Company’s Affiliates that are consolidated as of December 31, 2006 and 2007: Amortized intangible assets: Acquired client relationships 2006 2007 Carrying Amount Accumulated Amortization Carrying Amount Accumulated Amortization $ 379,703 $136,486 $ 401,303 $ 168,139 Non-amortized intangible assets: Acquired client relationships—mutual fund management contracts Goodwill 258,849 1,177,227 — — 263,438 1,230,387 — — For the Company’s Affiliates that are consolidated, definite- approximately $20,000 for the next five years, assuming no lived acquired client relationships are amortized over their useful life changes. expected useful lives. As of December 31, 2007, these rela- tionships were being amortized over a weighted average life of 11 years. The Company estimates that its consolidated 18 Minority Interest annual amortization expense will be approximately $31,500 Minority interest in the Consolidated Statements of Income for the next five years, assuming no useful life changes or includes the income allocated to owners of consolidated additional investments in new or existing Affiliates. Affiliates, other than AMG. For the years ended December 31, 2005, 2006 and 2007, this income was $144,263, The definite-lived acquired client relationships attributable $212,523 and $241,987, respectively. Minority interest on to the Company’s equity method investments are amortized the Consolidated Balance Sheets includes capital and undis- over their expected useful lives. As of December 31, 2007, tributed profits owned by the managers of the consolidated these relationships were being amortized over approximately 13 years. Amortization expense for these relationships was Affiliates (including profits allocated to managers from the Owners’ Allocation and Operating Allocation). For the years $9,290 and $10,386 for 2006 and 2007, respectively. The ended December 31, 2005, 2006 and 2007, profit distribu- Company estimates that the annual amortization expense tions to management owners were $185,732, $287,899 and attributable to its current equity-method Affiliates will be $321,505, respectively. 7 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 19 Stockholders’ Equity Preferred Stock share. In the year ended December 31, 2007, the Company repurchased 3,609,394 shares of common stock at an average price of $120.59 per share (including 1,578,300 shares The Company is authorized to issue up to 5,000,000 shares of through its prepaid forward purchase agreement and Preferred Stock in classes or series and to fix the designations, 115,789 shares of common stock upon the settlement of powers, preferences and the relative, participating, optional or certain call spread option agreements). As of December 31, other special rights of the shares of each series and any qualifi- 2007, the Company had the ability to acquire up to cations, limitations and restrictions thereon as set forth in the 1,880,106 shares of common stock under its authorized stock certificate. Any such Preferred Stock issued by the share repurchase program. Company may rank prior to common stock as to dividend rights, liquidation preference or both, may have full or In the first quarter of 2008, the Company will issue an limited voting rights and may be convertible into shares of aggregate of approximately 11,000,000 shares of voting 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 connection with certain private exchanges and conversions of its floating rate convertible securities and certain private exchanges and the settlement of the forward equity purchase contracts related to its 2004 PRIDES, as more fully discussed in Note 27. Common Stock. Financial Instruments In recent periods, the Company’s Board of Directors has equity contracts that required holders to purchase shares of authorized the following share repurchase programs: the Company’s common stock in February 2008. The Company’s 2004 PRIDES contain freestanding forward in March 2006 in connection with the issuance of the 2006 junior convertible trust preferred securities, up to an additional 4,000,000 shares of common stock; in July 2006, up to an additional 1,516,943 shares of common stock; in February 2007, up to an additional 3,000,000 shares of common stock; and in October 2007, in connection with the issuance of the 2007 junior convertible trust preferred securities up to an additional 2,500,000 shares pursuant to a prepaid forward purchase contract which the Company may elect to settle on or before October 15, 2012. Additionally, the Company’s zero coupon convertible notes, floating rate convertible securities and junior convertible trust preferred securities 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, the forward equity purchase contract and call spread option agreements 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 required to be accounted for separately as derivative instruments. Stock Option and Incentive Plans The timing and amount of purchases are determined at the The Company established the 1997 Stock Option and discretion of AMG’s management. In the year ended Incentive Plan (as amended and restated, the “1997 Plan”), December 31, 2006, the Company repurchased 5,482,047 under which it is authorized to grant options to employees shares of common stock at an average price of $98.10 per and directors. In 2002, stockholders approved an amend- 77 ment to increase the number of shares of common stock The following table summarizes the transactions of the authorized for issuance under this plan to 7,875,000. Company’s stock option and incentive plans: In 2002, the Company’s Board of Directors established the 2002 Stock Option and Incentive Plan (as amended and 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 plan was approved by the Company’s Board of Directors. There are 3,375,000 shares of the Company’s common stock authorized for issuance under this plan. 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 Stock Options Weighted Average Exercise Price Weighted Average Remaining Contractual Life (years) Unexercised options outstanding— January 1, 2007 7,404,822 $ 50.49 Options granted 1,480,500 115.85 Options exercised (1,514,912) Options forfeited (189,624) 35.40 71.63 Unexercised options outstanding— December 31, 2007 Exercisable at 7,180,786 66.59 December 31, 2007 4,967,459 46.88 5.0 4.2 Exercisable and free from restrictions on transfer at December 31, 2007 4,424,228 45.04 3.8 remain subject to restrictions on transfer which lapse The Company generally uses treasury stock to settle stock according to specified schedules, for so long as the option option exercises. The total intrinsic value of options exer- holder remains employed by the Company. In the event the cised during the years ended December 31, 2005, 2006 and option holder ceases to be employed by the Company, the 2007 was $41,442, $78,371 and $115,568, respectively. As transfer restrictions will remain outstanding until the later of December 31, 2007, the intrinsic value of options that of December 2010, or seven years after the date of grant. were vested and free from restrictions on transfer was $320,403. As of that date, the total intrinsic value of all In May 2006, the stockholders of the Company approved vested options (including those subject to restrictions on the 2006 Stock Option and Incentive Plan (the “2006 transfer) was $350,603, and the intrinsic value of unvested Plan”), under which the Company is authorized to grant options was $14,683. stock options and stock appreciation rights to senior man- agement, employees and directors. There are 3,000,000 During the year ended December 31, 2007, the cash shares of the Company’s common stock authorized for received and the actual tax benefit recognized for options issuance under this plan. exercised were $52,417 and $42,308, respectively. During the year ended December 31, 2007, the excess tax benefit The plans are administered by a committee of the Board of classified as a financing cash flow was $36,528. During the Directors. Under the plans, options generally vest over a year ended December 31, 2006, the cash received and the period of three to five years and expire seven to ten years actual tax benefit recognized for options exercised were after the grant date. All options have been granted with $41,886 and $28,529, respectively. During the year ended exercise prices equal to the fair market value of the December 31, 2006, the excess tax benefit classified as a Company’s common stock on the date of grant. financing cash flow was $23,047. 7 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 The Company’s Net Income for the year ended December is recorded as compensation expense over the service period 31, 2007 includes $9,039 of compensation expense and as equity-based compensation. $3,345 of income tax benefits, related to the share-based compensation arrangements. The Company’s Net Income for the year ended December 31, 2006 includes $1,654 of compensation expense and $612 of income tax benefits, related to the share-based compensation arrangements. As of December 31, 2007, there was $55,315 of deferred compensation expense related to stock options which will be recognized over a weighted average period of approxi- mately four years (assuming no forfeitures). 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, 2005, 2006 and 2007 was $20.95, $28.66 and $26.88 per option, respectively, based on the assump- tions stated below. 20 Call Spread Option Agreements In 2006, the Company entered into a series of contracts that provided the option, but not the obligation, to repur- chase up to 917,000 shares of its common stock at a weighted average price of $99.59 per share at specified times. Upon exercise, the Company could elect to receive the intrinsic value of a contract in cash or common stock. During 2007, the Company exercised 917,000 options with a total intrinsic value of $21,149. The Company elected to receive approximately 116,000 shares of common stock and used the remaining proceeds ($6,800) to enter into another series of contracts that provide the option, but not the obligation, to repurchase up to 800,000 shares of its common stock at a weighted average price of $120.89 per share. These options may be exercised or will expire during Year Ended December 31, 2005 2006 2007 the first quarter of 2008. Dividend yield Expected volatility(1) Risk-free interest rate(2) Expected life of options (in years)(3) Forfeiture rate(3) 0.0% 19.9% 4.4% 5.0 0.0% 0.0% 22.6% 4.9% 4.4 5.0% 0.0% 23.8% 3.1% 3.8 5.0% (1) Based on the historical and implied volatility of the Company’s com- mon stock. 21 Earnings Per Share The calculation of basic earnings per share is based on the weighted average number of shares of the Company’s com- mon stock outstanding during the period. Diluted earnings per share is similar to basic earnings per share, but adjusts for the effect of the potential issuance of incremental shares of the (2) Based on the U.S. Treasury yield curve in effect at the date of grant. Company’s common stock. The following is a reconciliation (3) Based on historical data and expected exercise behavior. of the numerator and denominator used in the calculation of basic and diluted earnings per share available to common The Company periodically issues Affiliate equity interests stockholders. Unlike all other dollar amounts in these to certain Affiliate employees. The estimated fair value of Notes, the amounts in the numerator reconciliation are not equity granted in these awards, net of estimated forfeitures, presented in thousands. 79 Year Ended December 31, As more fully discussed in Notes 9, 10 and 11, the Company 2005 2006 2007 had convertible securities outstanding during the years ended December 31, 2005, 2006 and 2007. The aggregate number $119,069,000 $151,277,000 $181,961,000 of shares of common stock that could be issued in the future to settle these securities is deemed outstanding for the purposes of the calculation of diluted earnings per share. This approach, referred to as the if-converted method, requires 6,693,000 17,618,000 23,787,000 that such shares be deemed outstanding regardless of whether $125,762,000 $168,895,000 $205,748,000 the securities are then contractually convertible into the Company’s common stock. For this if-converted calculation, the interest expense (net of tax) attributable to these securities Year Ended December 31, is added back to Net Income, reflecting the assumption that 2005 2006 2007 the securities have been converted. 33,667,542 31,289,005 29,464,764 For the years ended December 31, 2005, 2006 and 2007, the Company repurchased approximately 1.2, 5.5 and 3.6 million shares of common stock, respectively, under various stock repurchase programs. The Company has repurchased Numerator: Net Income Interest expense on contingently convertible securities, net of taxes Net income, as adjusted Denominator: Average shares outstanding— basic Effect of dilutive instruments: Stock options 2,244,874 2,542,878 2,117,478 an additional 100,000 shares, from January 1 through 88,654 — — February 26, 2008. 8,688,585 9,238,255 9,276,218 22 Financial Instruments and Risk Management The Company is exposed to market risks brought on by changes in interest and currency exchange rates. The — 599,853 1,540,226 Company has not entered into foreign currency transac- Forward equity agreement Senior convertible securities Mandatory convertible securities Junior convertible trust preferred securities — 1,489,011 2,523,098 Average shares outstanding— diluted 44,689,655 45,159,002 44,921,784 The calculation of diluted earnings per share for 2005, 2006 and 2007 excludes the potential exercise of options to purchase approximately 0.1, 0.9 and 2.3 million common shares, respectively, because their effect would be anti- dilutive. In addition, the calculation of diluted earnings per share excludes the effect of the outstanding call spread option agreements for all periods presented because their effect would be anti-dilutive. 7 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 tions or derivative financial instruments to reduce risks associated with changes in currency exchange rates. The Company uses derivative financial instruments to reduce risks associated with changes in interest rates. Notional amounts and credit exposures of derivatives The notional amount of derivatives does not represent amounts that are exchanged by the parties, and thus are not a measure of the Company’s exposure. The amounts exchanged are calculated on the basis of the notional or contract amounts, as well as on other terms of the interest rate swap derivatives and the volatility of these rates and prices. The Company would be exposed to credit-related losses in Fair value of a financial instrument is the amount at which the event of nonperformance by the counter parties that the instrument could be exchanged in a current transaction issued the financial instruments, although the Company between willing parties, other than in a forced or liquidation does not expect that the counter parties to interest rate swaps sale. Quoted market prices are used when available; other- will fail to meet their obligations, given their typically high wise, management estimates fair value based on prices of credit ratings. The credit exposure of derivative contracts is financial instruments with similar characteristics or by using represented by the positive fair value of contracts at the valuation techniques such as discounted cash flow models. reporting date, reduced by the effects of master netting Valuation techniques involve uncertainties and require agreements. The Company generally does not give or receive assumptions and judgments regarding prepayments, credit collateral on interest rate swaps because of its own credit rat- risk and discount rates. Changes in these assumptions will ing and that of its counter parties. result in different valuation estimates. The fair value presented Interest Rate Risk Management From time to time, the Company enters into derivative financial instruments to reduce exposure to interest rate risk. The Company does not hold or issue derivative finan- cial instruments for trading purposes. Derivative financial instruments are intended to enable the Company to achieve a level of variable-rate or fixed-rate debt that is 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 principal amount. Fair Value would not necessarily be realized in an immediate sale nor are there typically plans to settle liabilities prior to con- tractual maturity. Additionally, FAS 107 allows companies to use a wide range of valuation techniques; therefore, it may be difficult to compare the Company’s fair value informa- tion 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 credit facility with variable interest based on selected Financial Accounting Standard No. 107 (“FAS 107”), short-term rates. The fair market value of the zero coupon “Disclosures about Fair Value of Financial Instruments,” senior convertible securities, the floating rate senior con- requires the Company to disclose the estimated fair values for vertible securities, the 2004 mandatory convertible debt, certain of its financial instruments. Financial instruments and the junior convertible trust preferred securities at include items such as loans, interest rate contracts, notes December 31, 2007 was $171,076, $866,625, $479,625 payable and other items as defined in FAS 107. and $746,790, respectively. 81 23 Selected Quarterly Financial Data (Unaudited) 24 Related Party Transactions The following is a summary of the quarterly results of oper- The Company periodically records amounts receivable and ations of the Company for the years ended December 31, payable to Affiliate partners in connection with the transfer 2006 and 2007. Revenue Operating income Income before income taxes Net Income Earnings per 2006 First Quarter Second Quarter Third Quarter Fourth Quarter $278,042 103,706 $ 283,108 104,474 $ 280,440 102,059 $ 328,763 143,674 55,937 35,240 51,632 33,936 52,613 33,146 77,705 48,955 of Affiliate equity interests. As of December 31, 2006 and 2007, the total receivable (reported in “Other assets”) was $18,365 and $35,510, respectively. The total payable as of December 31, 2006 was $42,364, of which $41,086 is included in current liabilities. The total payable as of December 31, 2007 was $70,915, of which $69,952 is included in current liabilities. In certain cases, Affiliate management owners and Company share—diluted $ 0.81 $ 0.86 $ 0.87 $ 1.21 officers may serve as trustees or directors of certain mutual funds from which the Affiliate earns advisory fee revenue. 2007 First Quarter Second Quarter Third Quarter Fourth Quarter $309,837 112,302 $ 331,464 123,944 $ 345,605 127,620 $382,960 167,749 58,130 36,622 66,487 41,887 67,596 42,585 96,614 60,867 Revenue Operating income Income before income taxes Net Income Earnings per share—diluted $ 0.93 $ 1.04 $ 1.07 $ 1.53 In each of the quarters in 2007, 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 2006, 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 2006 and 2007. In addition, the Company earns the majority of its performance fees in the fourth quarter of each year, resulting in higher revenue and Net Income when compared to earlier quarters. 25 Summarized Financial Information of Equity Method Affiliates The following table presents summarized financial informa- tion for Affiliates accounted for under the equity method. 2005 2006 2007 Revenue(1)(2) Net Income $ 1,031,024 $1,476,488 $ 747,240 276,470 485,959 214,876 Current assets(2) Noncurrent assets Current liabilities Noncurrent liabilities and minority interest(2) 2006 2007 $7,386,894 $ 9,306,440 159,699 147,511 1,731,477 2,368,160 5,170,993 6,679,065 (1) Revenue includes advisory fees for asset management services, invest- ment income and gains and losses on investments from consolidated investment partnerships. (2) In the 2007 investments in BlueMountain and ValueAct, the Company acquired a share of revenue but no portion of the assets held by investors that are unrelated to the Company (which include consol- idated investment partnerships). 7 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 The Company’s share of undistributed earnings from equity Revenue earned from client relationships managed by method investments totaled $32,154 as of December 31, Affiliates accounted for under the equity method is not 2007. This footnote has been amended for changes to the consolidated with the Company’s reported revenue but historical financial statements of an equity method Affiliate. instead is included (net of operating expenses, including Such changes had no impact on the Company’s financial amortization) in “Income from equity method invest- position or results of operations. 26 Segment Information 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. Financial Accounting Standard No. 131, “Disclosures about Segments of an Enterprise and Related Information” (“FAS In firms with revenue sharing arrangements, a certain per- 131”) establishes disclosure requirements relating to operating centage of revenue is allocated for use by management of an segments in annual and interim financial statements. Affiliate in paying operating expenses of that Affiliate, Management has assessed the requirements of FAS 131 and including salaries and bonuses, and is called an “Operating determined that the Company operates in three business Allocation.” In reporting segment operating expenses, segments representing the Company’s three principal distri- Affiliate expenses are allocated to a particular segment on a bution channels: Mutual Fund, Institutional and High Net pro rata basis with respect to the revenue generated by that Worth, each of which has different client relationships. Affiliate in such segment. Generally, as revenue increases, additional compensation is typically paid to Affiliate man- Revenue in the Mutual Fund distribution channel is earned agement partners from the Operating Allocation. As a result, from advisory and sub-advisory relationships with all the contractual expense allocation pursuant to a revenue domestically registered investment products as well as non- sharing arrangement may result in the characterization of any institutional investment products that are registered growth in profit margin beyond the Company’s Owners’ abroad. Revenue in the Institutional distribution channel is Allocation as an operating expense. All other operating earned from relationships with foundations and endow- expenses (excluding intangible amortization) and interest ments, defined benefit and defined contribution plans and expense have been allocated to segments based on the pro- Taft-Hartley plans. Revenue in the High Net Worth distri- portion of cash flow distributions reported by Affiliates in bution channel is earned from relationships with wealthy each segment. individuals, family trusts and managed account programs. 83 2005 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 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 2007 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 7 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 Mutual Fund Institutional $ 400,859 $ 385,681 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 High Net Worth $ 129,952 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 Total $ 916,492 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 $ 558,257 $ 645,613 $ 165,996 $ 1,369,866 10,356 317,582 327,938 230,319 (7,121) (1,651) — 28,317 19,545 210,774 (95,720) — 115,054 42,570 $ 72,484 $ 986,308 $ 474,335 23,543 381,165 404,708 240,905 (6,587) (51,214) (10) 38,772 (19,039) 259,944 (120,506) (10) 139,428 51,589 $ 87,839 $ 1,832,951 $ 529,195 8,198 97,407 105,605 60,391 (3,425) (5,332) (38,867) 9,830 (37,794) 98,185 (25,761) (38,079) 34,345 12,707 $ 21,638 $ 576,446 $ 226,857 42,097 796,154 838,251 531,615 (17,133) (58,197) (38,877) 76,919 (37,288) 568,903 (241,987) (38,089) 288,827 106,866 $ 181,961 $ 3,395,705 $ 1,230,387 As of December 31, 2005, equity method investments of convert their securities into shares of the Company’s $8,717, $282,189 and $10,570 are included in the total common stock and the $300,000 principal amount was assets of the Mutual Fund, Institutional and High Net reclassified to stockholders’ equity. Pursuant to these conver- Worth segments, respectively. As of December 31, 2006, sions and other privately negotiated exchanges, the Company equity method investments of $6,451, $273,170 and will issue approximately 7.0 million shares of common stock $13,819 are included in the total assets of the Mutual Fund, and all of the Company’s floating rate convertible securities Institutional and High Net Worth segments, respectively. As will be cancelled and retired. of December 31, 2007, equity method investments of $8,704, $755,107 and $78,679 are included in the total In the first quarter of 2008, the Company repurchased the assets of the Mutual Fund, Institutional and High Net outstanding senior notes component of its 2004 PRIDES. Worth segments, respectively. 27 Subsequent Events The repurchase proceeds were used by the original holders to fulfill their obligations under the related forward equity purchase contracts. Pursuant to the settlement of the forward equity purchase contracts and other privately negotiated In the first quarter of 2008, the Company called the out- exchanges, the Company has issued approximately 4.0 standing floating rate convertible securities for redemption at million shares of common stock. All of the Company’s 2004 their principal amount plus accrued and unpaid interest. In PRIDES securities have been cancelled and retired. lieu of redemption, substantially all of the holders elected to 85 Common Stock and Corporate Organization Information Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities Issuer Purchases of Equity Securities Our common stock is traded on the New York Stock Exchange (symbol: AMG). The following table sets forth the high and low prices as reported on the New York Stock Exchange composite tape since January 1, 2006 for the periods indicated. Period Total Number of Shares Purchased(1) October 1–31, 2007 1,673,300 November 1–30, 2007 115,000 42,005 December 1–31, 2007 Average Price Paid Per Share $ 130.66 $ 126.31 $ 92.15 Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs(2) Maximum Number of Shares that May Yet Be Purchased Under the Plans or Programs(3) 95,000 115,000 1,995,106 1,880,106 — 1,880,106 2006 First Quarter Second Quarter Third Quarter Fourth Quarter 2007 First Quarter Second Quarter Third Quarter Fourth Quarter High Low $ 108.58 $ 79.58 107.46 101.81 105.97 81.56 84.00 92.09 Total 1,830,305 $ 129.50 210,000 1,880,106 (1) In October 2007, we agreed to purchase 1,578,300 shares of our com- mon stock pursuant to a prepaid forward purchase contract which we may elect to settle at any time on or before October 15, 2012. In December 2007, we received 42,005 shares of common stock upon the settlement of certain of our call spread option agreements. (2) Notes 19 and 21 to the Consolidated Financial Statements provide additional detail with respect to our share repurchase programs. (3) As of February 26, 2008, there were 1,780,106 shares that could be $ 119.78 $ 103.00 purchased under our share repurchase programs. 131.84 135.02 136.51 106.70 98.67 114.15 Employees and Corporate Organization As of December 31, 2007, we employed approximately 80 persons and our Affiliates employed approximately 1,500 persons, the substantial majority of which were full-time employees. Neither we nor any of our Affiliates is subject to any collective bargaining agreements, and we believe that our labor relations are good. We were formed in 1993 as a corporation under the laws of the State of Delaware. The closing price for a share of our common stock as reported on the New York Stock Exchange composite tape on February 26, 2008 was $98.88. As of February 26, 2008, there were 39 stockholders of record. We have not declared a cash dividend with respect to the periods presented. We do not anticipate paying cash divi- dends on our common stock as we intend to retain earnings to finance investments in new Affiliates, repay indebted- ness, pay interest and income taxes, repurchase debt securi- ties and shares of our common stock when appropriate, and develop our existing business. Furthermore, our credit facil- ity prohibits us from making cash dividend payments to our stockholders. 7 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 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 below). (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 (1) Unless otherwise noted, data presented is as of December 31, 2007. (2) 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. 87 Corporate Data 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 June 3, 2008. 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, 2007, 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-Risk Factors” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2007 as ﬁled with the Securities and Exchange Commission. On July 2, 2007, AMG’s Section 303A Annual CEO certification by Sean M. Healey was filed with the NYSE in accordance with Section 303A.12(a). 7 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 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 Former Chief Executive Ofﬁcer, PolyMedica Corporation Jide J. Zeitlin Former General Partner, Goldman, Sachs & Co. Executive Officers 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 Jay C. Horgen Executive Vice President, New Investments 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

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