FRANKLIN RESOURCES INC (BEN) FY 2021 MD&A

Item 7.    Management’s Discussion and Analysis of Financial Condition and Results of Operations.

FORWARD-LOOKING STATEMENTS

The following discussion and analysis of the results of operations and financial condition of Franklin Resources, Inc. (“Franklin”) and its subsidiaries (collectively, the “Company”) should be read in conjunction with the “Forward-looking Statements” disclosure set forth in Part I and the “Risk Factors” set forth in Item 1A of Part I of this Annual Report on Form 10‑K (this “Annual Report”) and in any more recent filings with the U.S. Securities and Exchange Commission (the “SEC”), each of which describe our risks, uncertainties and other important factors in more detail.

OVERVIEW

Franklin is a holding company with subsidiaries operating under our Franklin Templeton® and/or subsidiary brand names. We are a global investment management organization that derives operating revenues and net income from providing investment management and related services to investors in jurisdictions worldwide. We deliver our investment capabilities through a variety of investment products, which include our sponsored funds, as well as institutional and high-net-worth separate accounts, retail separately managed account programs, sub-advised products, and other investment vehicles. In addition to investment management, our services include fund administration, sales and distribution, and shareholder servicing. We may perform services directly or through third parties. We offer our services and products under our various distinct brand names, including, but not limited to, Franklin®, Templeton®, Legg Mason®, Benefit Street Partners®, Brandywine Global Investment Management®, Clarion Partners®, ClearBridge Investments®, Fiduciary Trust International™, Franklin Bissett®, Franklin Mutual Series®, K2®, LibertyShares®, Martin Currie®, Royce® Investment Partners and Western Asset Management Company®. We offer a broad product mix of fixed income, equity, multi-asset, alternative and cash management asset classes and solutions that meet a wide variety of specific investment goals and needs for individual and institutional investors. We also provide sub-advisory services to certain investment products sponsored by other companies which may be sold to investors under the brand names of those other companies or on a co-branded basis.

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The level of our revenues depends largely on the level and relative mix of assets under management (“AUM”). As noted in the “Risk Factors” section set forth above in Item 1A of Part I of this Annual Report, the amount and mix of our AUM are subject to significant fluctuations that can negatively impact our revenues and income. The level of our revenues also depends on the fees charged for our services, which are based on contracts with our funds and customers, fund sales, and the number of shareholder transactions and accounts. These arrangements could change in the future.

As further noted in the “Risk Factors” section, the outbreak and spread of contagious diseases such as the coronavirus disease 2019 (“COVID-19”), a highly transmissible and pathogenic disease, has adversely affected, and may continue to adversely affect, our business, financial condition and results of operations. Ongoing global health concerns, and uncertainty regarding the impact of COVID-19, could lead to further and/or increased volatility in global capital and credit markets, adversely affect our key executives and other personnel, clients, investors, providers, suppliers, lessees, and other third parties, and negatively impact our AUM, revenues, income, business and operations. As of the time of this filing, as the COVID-19 pandemic continues to evolve, it is not possible to predict the full extent to which the pandemic may adversely impact our business, liquidity, capital resources, financial results and operations, which impacts will depend on numerous developing factors that remain uncertain and subject to change.

During the fiscal year ended September 30, 2021 (“fiscal year 2021”), the global equity markets continued to provide strong positive returns, reflecting among other things, an accelerated rollout of COVID-19 vaccines in most developed economies, government stimulus and other support in many countries, and a decline in U.S. 10-year treasury yields. The S&P 500 Index and MSCI World Index increased 30.0% and 29.4% for the fiscal year. The global bond markets declined as the Bloomberg Barclays Global Aggregate Index decreased 0.9% for the fiscal year.

Our total AUM was $1,530.1 billion at September 30, 2021, which was 8% higher than at September 30, 2020 driven by $148.0 billion from net market change, distributions and other, and $3.5 billion from an acquisition, partially offset by $25.2 billion of long-term net outflows and $15.1 billion of cash management net outflows. Simple monthly average AUM (“average AUM”) increased 81% during fiscal year 2021, reflecting a full year of AUM from the acquisition of Legg Mason.

The business and regulatory environments in which we operate globally remain complex, uncertain and subject to change. We are subject to various laws, rules and regulations globally that impose restrictions, limitations, registration, reporting and disclosure requirements on our business, and add complexity to our global compliance operations.

Uncertainties regarding the global economy remain for the foreseeable future. As we continue to confront the challenges of the current economic and regulatory environments, we remain focused on the investment performance of our products and on providing high quality service to our clients. We continuously perform reviews of our business model. While we remain focused on expense management, we will also seek to attract, retain and develop personnel and invest strategically in systems and technology that will provide a secure and stable environment. We will continue to seek to protect and further our brand recognition while developing and maintaining broker-dealer and client relationships. The success of these and other strategies may be influenced by the factors discussed in the “Risk Factors” section.

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RESULTS OF OPERATIONS

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1Defined as operating income divided by total operating revenues.

2“Adjusted operating income,” “adjusted operating margin,” “adjusted net income” and “adjusted diluted earnings per share” are based on methodologies other than generally accepted accounting principles. See “Supplemental Non-GAAP Financial Measures” for definitions and reconciliations of these measures.

Operating income increased $826.1 million in fiscal year 2021 as a 51% increase in operating revenues was partially offset by a 45% increase in operating expenses. The increase in operating revenues and operating expenses was primarily due to the acquisition of Legg Mason. Net income attributable to Franklin Resources, Inc. increased $1,032.3 million due to the increase in operating income and higher other income, net, less the portion attributable to noncontrolling interests, partially offset by higher taxes on income.

The Company acquired Legg Mason effective July 31, 2020, and the results of operations for the fiscal year ended September 30, 2020 (“fiscal year 2020”) include two months of Legg Mason’s results. Operating income decreased $418.0 million in fiscal year 2020 due to a 2% decrease in operating revenues and a 7% increase in operating expenses which reflected higher levels of compensation and benefits expense, including acquisition-related retention costs, other acquisition-related expenses, and amortization and impairments of intangible assets and goodwill. Net income attributable to Franklin Resources, Inc. decreased $396.8 million primarily due to the decrease in operating income, as the impact of declines in market valuations amid global concerns about the COVID-19 pandemic resulted in net investment and other losses of $38.4 million, as compared to net gains of $141.4 million in the prior year, less the portion attributable to noncontrolling interests, which was largely offset by lower taxes on income.

Diluted earnings per share increased in fiscal year 2021 and decreased in fiscal year 2020, consistent with the changes in net income attributable to Franklin Resources, Inc.

Adjusted operating income increased $888.2 million in fiscal year 2021 primarily due to a 66% increase in investment management fees, partially offset by a 69% increase in compensation and benefits expense. The increase in investment management fees and compensation and benefits expenses was primarily due to the acquisition of Legg Mason. Adjusted net income increased $604.2 million primarily due to the increase in adjusted operating income, partially offset by lower other income, net, less the portion attributable to noncontrolling interests.

Adjusted operating income decreased $163.1 million in fiscal year 2020 primarily due to a 10% increase in compensation and benefits expense, excluding non-GAAP adjustments. Adjusted net income decreased $20.3 million primarily due to the decrease in adjusted operating income substantially offset by lower taxes on income, excluding the net income tax expense of non-GAAP adjustments.

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Adjusted diluted earnings per share increased in fiscal year 2021 and decreased in fiscal year 2020, consistent with the changes in adjusted net income.

ASSETS UNDER MANAGEMENT

AUM by asset class was as follows:

In the first quarter of the fiscal year 2021, we revised our presentation of AUM to reflect changes in asset class of certain legacy Legg Mason AUM as part of our post-acquisition onboarding process.

Changes in average AUM are generally more indicative of trends in revenue for providing investment management services than the year-over-year change in ending AUM.

Average AUM and the mix of average AUM by asset class are shown below.

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Components of the change in AUM are shown below. Net market change, distributions and other includes appreciation (depreciation), distributions to investors that represent return on investments and return of capital, and foreign exchange revaluation.

Components of the change in AUM by asset class were as follows:

AUM increased $111.2 billion or 8% during fiscal year 2021 due to $148.0 billion of net market change, distributions and other, and $3.5 billion from an acquisition, partially offset by $25.2 billion of long-term net outflows and $15.1 billion of cash management net outflows. Net market change, distributions and other primarily consists of $176.3 billion of market appreciation, partially offset by $29.1 billion of long-term distributions. The market appreciation occurred in all asset classes, most significantly in the equity and multi-asset asset classes and reflected positive returns in global equity markets.

Long-term inflows increased 100% to $364.7 billion, as compared to the prior year, and long-term outflows increased 60% to $389.9 billion due to higher inflows and outflows in all long-term asset classes primarily due to the acquisition of Legg Mason. Long-term net outflows included outflows of $35.7 billion from sixteen institutional products, including two fixed income redemptions of $5.9 billion and $2.0 billion and two equity redemptions of $3.7 billion and $2.2 billion, $12.5 billion from seven fixed income funds, including $3.3 billion from five India credit funds that were non-management fee earning which are in the process of winding up, $5.4 billion from a 529 plan redemption, $3.9 billion from two equity funds and $3.1 billion from a multi-asset fund, partially offset by inflows of $12.3 billion in three fixed income funds, $6.7 billion in three institutional products, $3.7 billion in an equity fund, $3.1 billion in a multi-asset fund and $3.0 billion in two alternative funds.

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AUM increased $726.3 billion or 105% during fiscal year 2020 as $806.5 billion from acquisitions was partially offset by $61.6 billion of long-term net outflows, $9.9 billion of cash management net outflows and $8.7 billion of net market change, distributions and other. Acquisitions included $797.4 billion from the acquisition of Legg Mason and $9.1 billion from other acquisitions. Long-term inflows increased 4% to $182.4 billion due to higher inflows in all the long-term asset classes except multi-asset. Long-term outflows increased 18% to $244.0 billion due to higher outflows in all long-term asset classes except multi-asset, most significantly in fixed income products. Long-term net outflows included outflows of $27.6 billion from six fixed income funds, $7.3 billion from seven institutional products, $6.2 billion from three equity funds, and $3.6 billion from a multi-asset fund, partially offset by inflows of $6.0 billion in two equity funds, $4.0 billion in three fixed income funds, $2.0 billion in two institutional products and $1.3 billion in a private open-end product. Net market change, distributions and other primarily consists of $24.8 billion of long-term distributions, partially offset by $15.8 billion of market appreciation. The market appreciation occurred primarily in the equity asset class and reflected positive returns in global equity markets.

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AUM by sales region was as follows:

Average AUM by sales region was as follows:

The region in which investment products are sold may differ from the geographic area in which we provide investment management and related services to the products.

Investment Performance Overview

A key driver of our overall success is the long-term investment performance of our investment products. A measure of the performance of these products is the percentage of AUM exceeding peer group medians and benchmarks. We compare the relative performance of our mutual funds against peers, and of our strategy composites against benchmarks. Higher long-term relative performance of our mutual fund AUM during fiscal year 2021 resulted in a significant increase from September 30, 2020 to the peer group comparison for the one-, three- and five-year periods. Approximately half of our mutual fund AUM and at least 69% of our strategy composite AUM exceeded the peer group median comparisons for all periods presented, primarily driven by the performance of our fixed income products.

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The performance of our mutual fund products against peer group medians and of our strategy composites against benchmarks is presented in the table below.

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1Mutual fund performance is sourced from Morningstar and measures the percent of ranked AUM in the top two quartiles versus peers. Total mutual fund AUM measured for the 1-, 3-, 5- and 10-year periods represents 42%, 42%, 41% and 39% of our total AUM as of September 30, 2021.

2Strategy composite performance measures the percent of composite AUM beating its benchmark. The benchmark comparisons are based on each account’s/composite’s (strategy composites may include retail separately managed accounts and mutual fund assets managed as part of the same strategy) return as compared to a market index that has been selected to be generally consistent with the asset class of the account/composite. Total strategy composite AUM measured for the 1-, 3-, 5- and 10-year periods represents 69%, 68%, 68% and 62% of our total AUM as of September 30, 2021.

3Total mutual fund AUM includes performance of our multi-asset and alternative AUM, and total strategy composite AUM includes performance of our alternative AUM. Multi-asset and alternative AUM represent 10% and 9% of our total AUM at September 30, 2021.

Mutual fund performance data includes U.S. and cross-border domiciled mutual funds and exchange-traded funds, and excludes cash management and fund of funds. These results assume the reinvestment of dividends, are based on data available as of October 7, 2021 and are subject to revision. While we remain focused on achieving strong long-term performance, our future peer group and benchmarking rankings may vary from our past performance.

Past performance is not indicative of future results. For AUM included in institutional and retail separate accounts and investment funds managed in the same strategy as separate accounts, performance comparisons are based on gross-of-fee performance. For investment funds which are not managed in a separate account format, performance comparisons are based on net-of-fee performance. These performance comparisons do not reflect the actual performance of any specific separate account or investment fund; individual separate account and investment fund performance may differ. The information in this presentation is provided solely for use in connection with this document, and is not directed toward existing or potential clients of Franklin.

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OPERATING REVENUES

The table below presents the percentage change in each operating revenue category.

The Legg Mason acquisition had a significant impact on operating revenues in fiscal year 2021; however, due to the continued integration of the combined businesses, it is no longer practicable to separately quantify the impact of the legacy Legg Mason business.

Investment Management Fees

Investment management fees are generally calculated under contractual arrangements with our investment products and the products for which we provide sub-advisory services as a percentage of AUM. Annual fee rates vary by asset class and type of services provided. Fee rates for products sold outside of the U.S. are generally higher than for U.S. products.

Investment management fees increased $2,559.9 million in fiscal year 2021 primarily due to the acquisition of Legg Mason, a 5% increase in average AUM and higher performance fees. The increase in average AUM occurred primarily in the equity and multi-asset asset classes, partially offset by decreases in the fixed income asset class. The increase occurred primarily in U.S. sales regions, partially offset by a decline in Asia-Pacific sales region.

Investment management fees decreased $3.5 million in fiscal year 2020 primarily due to a 7% decrease in average AUM, lower effective investment management fee rate and lower performance fees of the legacy Franklin business, largely offset by $427.6 million of revenue earned by Legg Mason subsequent to the acquisition. The decrease in average AUM of the legacy Franklin business occurred primarily in the fixed income and equity asset classes, partially offset by an increase in the alternative asset class, and across all sales regions except Europe, Middle East and Africa.

Our effective investment management fee rate excluding performance fees (investment management fees excluding performance fees divided by average AUM) was 41.8, 47.3 and 56.4 basis points for fiscal years 2021, 2020 and 2019. The rate decrease in fiscal year 2021 was primarily due to the Legg Mason acquisition, as Legg Mason generally had a lower overall effective fee rate due to a higher mix of institutional and fixed income AUM.

Performance-based investment management fees were $258.6 million, $44.0 million and $52.9 million for fiscal years 2021, 2020 and 2019. The increase in fiscal year 2021 was primarily due to the acquisition of Legg Mason as well as strong performance, while the decrease in fiscal year 2020 was primarily due to the lower performance fees earned from a private debt fund, separate accounts and a real estate fund, partially offset by $15.0 million of performance fees earned by Legg Mason subsequent to the acquisition.

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U.S. industry asset-weighted average management fee rates were as follows:

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1U.S. industry asset-weighted average management fee rates were calculated using information available from Lipper, a Refinitiv Company, as of September 30, 2021, 2020 and 2019 and include all U.S.-registered open-end funds and exchange traded funds that reported expense data to Lipper as of the funds’ most recent annual report date, and for which expenses were equal to or greater than zero. As defined by Lipper, management fees include fees from providing advisory and fund administration services. The averages combine retail and institutional funds data and include all share classes and distribution channels, without exception. Variable annuity and fund of fund products are not included.

2The decreases in the average rate in fiscal years 2021 and 2020 reflect higher weightings of two large low-fee passive funds and lower weightings of two large higher-fee actively managed funds for fiscal year 2020.

3The decreases in the average rate in fiscal years 2021 and 2020 reflect higher weightings of two large low-fee passive funds.

4The increase in the average rate in fiscal year 2021 reflect higher weightings of one large actively managed fund and lower weightings of one large low-fee passive fund, while decrease in the average rate in fiscal year 2020 reflect higher weightings of one large low-fee passive fund.

The declines in U.S. industry average management fee rates for long-term asset classes generally reflect increased investor demand for lower-fee passive funds. Our actual effective investment management fee rates are generally higher than the U.S. industry average rates as we actively manage substantially all of our products and have a significant amount of international AUM, both of which generate higher fees. Our fiscal year 2021 effective fee rates in the U.S. generally decreased to a greater extent than the average industry rates due to the acquisition of Legg Mason, as Legg Mason generally had a lower overall effective fee rate due to a higher mix of institutional and fixed income AUM .

Our product offerings and global operations are diverse. As such, the impact of future changes in AUM on investment management fees will be affected by the relative mix of asset class, geographic region, distribution channel and investment vehicle of the assets.

Sales and Distribution Fees

Sales and distribution fees primarily consist of upfront sales commissions and ongoing distribution fees. Sales commissions are earned from the sale of certain classes of sponsored funds at the time of purchase (“commissionable sales”) and may be reduced or eliminated depending on the amount invested and the type of investor. Therefore, sales fees generally will change with the overall level of gross sales, the size of individual transactions, and the relative mix of sales between different share classes and types of investors.

Our sponsored mutual funds generally pay us distribution fees in return for sales, marketing and distribution efforts on their behalf. The majority of our U.S. mutual funds, with the exception of certain money market funds and certain other funds specifically designed for purchase through separately managed account programs, have adopted distribution plans under Rule 12b-1 (the “Rule 12b-1 Plans”) promulgated under the Investment Company Act of 1940. The Rule 12b-1 Plans permit the funds to pay us for marketing, marketing support, advertising, printing and sales promotion services relating to the distribution of their shares, subject to the Rule 12b-1 Plans’ limitations on amounts based on daily average AUM. We earn distribution fees from our non-U.S. funds based on daily average AUM.

Contingent sales charges are earned from investor redemptions within a contracted period of time. Substantially all of these charges are levied on certain shares sold without a front-end sales charge, and vary with the mix of redemptions of these shares.

We pay substantially all of our sales and distribution fees to the financial advisers, broker-dealers and other intermediaries that sell our funds on our behalf. See the description of sales, distribution and marketing expenses below.

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Sales and distribution fees by revenue driver are presented below.

Asset-based distribution fees increased $206.0 million in fiscal year 2021 primarily due to the acquisition of Legg Mason and $53.1 million from a 5% increase in the related average AUM, partially offset by $33.2 million from a higher mix of lower-fee U.S. assets. Asset-based distribution fees decreased $91.9 million in fiscal year 2020 primarily due to decreases of $79.2 million from a 7% decrease in the related average AUM and $38.6 million from a higher mix of lower-fee U.S. assets, partially offset by $35.3 million from fees earned by Legg Mason subsequent to the acquisition.

Sales-based fees increased $68.7 million in fiscal year 2021 primarily due to the acquisition of Legg Mason and $13.0 million from higher commissionable sales. Sales-based fees increased $1.9 million in fiscal year 2020 primarily due to increases of $9.8 million from fees earned by Legg Mason subsequent to the acquisition, $7.2 million from higher U.S. product commissionable sales and, $2.9 million from a higher mix of equity sales, which typically generate higher sales fees than fixed income products. The increases were substantially offset by a decrease of $18.7 million from lower non-U.S. product commissionable sales.

Shareholder Servicing Fees

Substantially all shareholder servicing fees are earned from our sponsored funds for providing transfer agency services, which include providing shareholder statements, transaction processing, customer service and tax reporting. These fees are primarily determined based on a percentage of AUM and either the number of transactions in shareholder accounts or the number of shareholder accounts, while fees from certain funds are based only on AUM. Shareholder servicing fees also include fund reimbursements of expenses incurred while providing transfer agency services.

Shareholder servicing fees increased $16.1 million in fiscal year 2021 primarily due to the acquisition of Legg Mason and higher levels of related AUM, partially offset by lower levels of transactions. Shareholder servicing fees decreased $21.2 million in fiscal year 2020 primarily due to lower levels of related AUM and transactions.

Other

Other revenue increased $9.5 million and $4.4 million in fiscal years 2021 and 2020 primarily due to higher miscellaneous fee revenues.

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OPERATING EXPENSES

The table below presents the percentage change in each operating expense category.

The Legg Mason acquisition had a significant impact on operating expenses in fiscal year 2021; however, due to the continued integration of the combined businesses, it is no longer practicable to separately quantify the impact of the legacy Legg Mason business.

Compensation and Benefits

The components of compensation and benefits expenses are presented below.

Salaries, wages and benefits increased $363.8 million in fiscal year 2021, primarily due to the acquisition of Legg Mason. Salaries, wages and benefits increased $91.1 million in fiscal year 2020, primarily due to increases of $56.9 million from higher average staffing levels primarily resulting from acquisitions, $19.3 million for an annual salary increase that was effective December 1 of the fiscal year and $16.2 million related to other termination benefits, partially offset by a decrease of $5.9 million from favorable foreign currency impacts.

Variable compensation increased $793.4 million in fiscal year 2021, primarily due to the acquisition of Legg Mason, which includes $25.3 million from acquisition-related pass through performance fees. Variable compensation increased $66.7 million in fiscal year 2020, primarily due to increases of $67.7 million related to acquired firms’ bonus plans and $10.0 million related to private equity and other product performance fees, partially offset by decreases of $11.3 million related to unvested mutual fund awards and $9.6 million related to bonus expense primarily due to lower expectations of our annual performance.

Acquisition-related retention expenses decreased $32.1 million in fiscal year 2021 and increased $132.1 million in fiscal year 2020 primarily due to the acquisition of Legg Mason.

Special termination benefits primarily relate to workforce optimization initiatives related to the acquisition of Legg Mason in fiscal years 2021 and 2020, and voluntary separation and workforce reduction initiatives of 4.5% of our global workforce in the fiscal year ended September 30, 2019 (“fiscal year 2019”).

We expect to incur acquisition-related retention expenses of approximately $130 million during the fiscal year ending September 30, 2022 (“fiscal year 2022”), and decreasing over the following two fiscal years by approximately $15 million and $25 million. At September 30, 2021, our global workforce had decreased to approximately 10,300 employees from approximately 11,800 at September 30, 2020.

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We continue to place a high emphasis on our pay for performance philosophy. As such, any changes in the underlying performance of our investment products or changes in the composition of our incentive compensation offerings could have an impact on compensation and benefits expenses going forward. However, in order to attract and retain talented individuals, our level of compensation and benefit expenses may increase more quickly or decrease more slowly than our revenue.

Sales, Distribution and Marketing

Sales, distribution and marketing expenses primarily relate to services provided by financial advisers, broker-dealers and other intermediaries to our sponsored funds, including marketing support services. Substantially all distribution expenses are incurred from assets that generate distribution fees and are determined as a percentage of AUM. Substantially all sales expenses are incurred from the same commissionable sales transactions that generate sales fee revenues and are determined as a percentage of sales. Marketing support expenses are based on AUM, sales or a combination thereof. Also included is the amortization of deferred sales commissions related to upfront commissions on shares sold without a front-end sales charge. The deferred sales commissions are amortized over the periods in which commissions are generally recovered from related revenues.

Sales, distribution and marketing expenses by cost driver are presented below.

Asset-based expenses increased $345.7 million in fiscal year 2021 primarily due to the acquisition of Legg Mason and $59.7 million from a 5% increase in the related average AUM. Asset-based expenses decreased $107.0 million in fiscal year 2020 primarily due to decreases of $107.4 million from an 8% decrease in the related average AUM and $53.4 million from a higher mix of lower-fee U.S. assets, partially offset by a $58.6 million increase in expenses incurred by Legg Mason subsequent to the acquisition. Distribution expenses are generally not directly correlated with distribution fee revenues due to certain fee structures that do not provide full recovery of distribution costs.

Sales-based expenses increased $59.1 million in fiscal year 2021 primarily due to the acquisition of Legg Mason and $12.1 million from higher commissionable sales. Sales-based expenses decreased $4.0 million in fiscal year 2020 primarily due to a $20.3 million decrease from lower non-U.S. product commissionable sales, largely offset by an $8.6 million increase in expenses incurred by Legg Mason subsequent to the acquisition and a $7.5 million increase from higher U.S. product commissionable sales. U.S. products typically generate higher sales commissions than non-U.S. products.

Information Systems and Technology

Information systems and technology expenses increased $197.7 million in fiscal year 2021 primarily due to higher external data service and software costs and technology consulting as a result of the Legg Mason acquisition. Information systems and technology expenses increased $29.9 million in fiscal year 2020 primarily due to expenses of Legg Mason subsequent to closing of the acquisition.

Occupancy

Occupancy expenses increased $70.2 million and $14.3 million in fiscal years 2021 and 2020 primarily due to an increase in leased office space as a result of the Legg Mason acquisition.

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Amortization of intangible assets

Amortization of intangible assets increased $178.0 million and $39.3 million in fiscal years 2021 and 2020 primarily related to the intangible assets recognized as part of the acquisition of Legg Mason. See Note 9 – Goodwill and Other Intangible Assets in the notes to consolidated financial statements in Item 8 of Part II of this Annual Report for information on definite-lived intangible assets.

General, Administrative and Other

General, administrative and other operating expenses primarily consist of professional fees, fund-related service fees payable to external parties, advertising and promotion, travel and entertainment, and other miscellaneous expenses.

General, administrative and other operating expenses increased $86.9 million in fiscal year 2021, primarily due to the acquisition of Legg Mason and $43.0 million of closed-end fund product launch costs. The increase was also due to increases of $35.0 million third-party fund administration and sub-advisory service fees and $12.9 million placement and platform fees. The increases were partially offset by $55.4 million prior year impairments of intangible assets and goodwill primarily related to assets recognized from the acquisitions of Benefit Street Partners, L.L.C. (“BSP”) and Onsa, Inc., (formally known as TokenVault, Inc).

General, administrative and other operating expenses increased $58.9 million in fiscal year 2020, primarily due to increases of $48.0 million in acquisition-related professional fees and $19.3 million of post-acquisition general and administrative expenses, both related to Legg Mason. Additionally, impairments of intangible assets and goodwill increased $42.1 million primarily related to assets recognized from the acquisitions of BSP and Onsa, Inc., (formally known as TokenVault, Inc.). The increases were partially offset by decreases of $24.6 million in travel and entertainment expenses and $13.8 million in advertising and promotion expenses, both primarily due to lower activity levels, and by a prior year litigation settlement.

OTHER INCOME (EXPENSES)

Other income (expenses) consisted of the following:

Investment and other income (losses), net consists primarily of income (losses) from equity method investees, gains (losses) on investments held by the Company, rental income from excess owned space in our San Mateo, California corporate headquarters and other office buildings which we lease to third parties, gains (losses) on derivatives, foreign currency exchange gains (losses) and dividend income.

Investment and other income (losses), net increased $303.1 million in fiscal year 2021 primarily due to income from equity method investees and gains on investments held by the Company, partially offset by a decrease in dividend income and losses on derivatives. Investment and other income (losses), net decreased $179.8 million in fiscal year 2020 primarily due to the impact of steep declines in market valuations on investment income, lower dividend and interest income, and foreign exchange losses, partially offset by an increase in rental income.

Equity method investees generated income of $154.3 million, as compared to losses of $98.1 million in the prior year. The current year reflects continued recovery in market valuations of investments held by various global equity funds. Losses from equity method investees increased $87.7 million in fiscal year 2020, primarily related to investments in two global equity funds.

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Investments held by the Company generated net gains of $90.9 million, as compared to net losses of $16.8 million in the prior year, primarily from various nonconsolidated funds, and in the current year, assets invested for Legg Mason deferred compensation plans.

Dividend income decreased $40.1 million in fiscal year 2021 and $48.1 million in fiscal year 2020 primarily due to lower yields on money market funds.

Interest expense increased $52.0 million in fiscal year 2021 primarily due to interest expense recognized on debt of Legg Mason and on the senior unsecured unsubordinated notes issued during fiscal year 2021, partially offset by the redemption of the junior notes issued by Legg Mason. Interest expense increased $11.0 million in fiscal year 2020 primarily due to interest expense recognized on debt of Legg Mason subsequent to the acquisition.

Investment and other income of consolidated investment products, net consists of dividend and interest income and investment gains (losses) on investments held by CIPs. Expenses of consolidated investment products primarily consists of fund-related expenses, including professional fees and other administrative expenses, and interest expense. Significant portions of the investment and other income of consolidated investment products, net and expenses of consolidated investment products are offset in noncontrolling interests in our consolidated statements of income.

Investment and other income of consolidated investment products, net increased $350.9 million in fiscal year 2021 primarily due to net gains on investments held by various alternative funds. Investment and other income of consolidated investment products, net decreased $8.6 million in fiscal year 2020 primarily due to net losses on investments held by various alternative funds, partially offset by net gains from holdings of various equity funds and a U.S. fixed income fund and an increase in dividend and interest income of CIPs.

Expenses of consolidated investment products increased $1.8 million in fiscal year 2021 and $12.5 million in fiscal year 2020, primarily due to activity of the funds.

Our investments in sponsored funds include initial cash investments made in the course of launching mutual fund and other investment product offerings, as well as investments for other business reasons. The market conditions that impact our AUM similarly affect the investment income earned or losses incurred on our investments in sponsored funds.

Our cash, cash equivalents and investments portfolio by asset class and accounting classification at September 30, 2021, excluding third-party assets of CIPs, was as follows:

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1See Note 1 – Significant Accounting Policies and Note 6 – Investments in the notes to consolidated financial statements in Item 8 of Part II of this Annual Report for information on investment accounting classifications.

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TAXES ON INCOME

Our effective income tax rate for fiscal year 2021 was 14.3% as compared to 22.7% in fiscal year 2020 and 26.8% in fiscal year 2019. The rate decrease in fiscal year 2021 was primarily due to the release of a tax reserve following the close of an IRS audit of the U.S. taxation of deemed foreign dividends (“Transition Tax”) for fiscal year 2018 and net income attributable to noncontrolling interests as compared to a net loss in the prior fiscal year. The rate decrease in fiscal year 2020 was primarily due to the prior-year reversal of the tax benefit included in the Transition Tax upon issuance of final regulations by the U.S. Department of Treasury for the Tax Cuts and Jobs Act (“Tax Act”), tax benefits from capital losses subsequent to the change in corporate tax structure of a foreign holding company to a U.S. branch, and a statutory rate reduction enacted in India in December 2019. These decreases were partially offset by an increase in the tax rate due to a lower mix of earnings in lower tax jurisdictions. Our effective income tax rate excluding the one-time impact of the Tax Act was 21.6% for fiscal year 2019.

Our effective income tax rate reflects the relative contributions of earnings in the jurisdictions in which we operate, which have varying tax rates. Changes in our pre-tax income mix, tax rates or tax legislation in such jurisdictions may affect our effective income tax rate and net income.

SUPPLEMENTAL NON-GAAP FINANCIAL MEASURES

As supplemental information, we are providing performance measures for “adjusted operating income,” “adjusted operating margin,” “adjusted net income” and “adjusted diluted earnings per share,” each of which is based on methodologies other than generally accepted accounting principles (“non-GAAP measures”). Management believes these non-GAAP measures are useful indicators of our financial performance and may be helpful to investors in evaluating our relative performance against industry peers as these measures exclude the impact of CIPs and mitigate the margin variability related to sales and distribution revenues and expenses across multiple distribution channels globally. These measures also exclude performance-based investment management fees which are fully passed through as compensation and benefits expense per the terms of a previous acquisition by Legg Mason and have no impact on net income. These non-GAAP measures also exclude acquisition-related expenses, certain items which management considers to be nonrecurring, unrealized investment gains and losses included in investment and other income (losses), net, and the related income tax effect of these adjustments, as applicable. These non-GAAP measures also exclude the impact on compensation and benefits expense from gains and losses on investments made to fund deferred compensation plans and on seed investments under certain historical revenue sharing arrangements, which is offset in investment and other income (losses), net.

“Adjusted operating income,” “adjusted operating margin,” “adjusted net income” and “adjusted diluted earnings per share” are defined below, followed by reconciliations of operating income, operating margin, net income attributable to Franklin Resources, Inc. and diluted earnings per share on a U.S. GAAP basis to these non-GAAP measures. Non-GAAP measures should not be considered in isolation from, or as substitutes for, any financial information prepared in accordance with U.S. GAAP, and may not be comparable to other similarly titled measures of other companies. Additional reconciling items may be added in the future to these non-GAAP measures if deemed appropriate.

Adjusted Operating Income

We define adjusted operating income as operating income adjusted to exclude the following:

•Elimination of operating revenues upon consolidation of investment products.

•Acquisition-related retention compensation.

•Impact on compensation and benefits expense from gains and losses on investments related to Legg Mason deferred compensation plans and seed investments, which is offset in investment and other income (losses), net.

•Other acquisition-related expenses including professional fees, technology costs and fair value adjustments related to contingent consideration liabilities.

•Amortization and impairment of intangible assets and goodwill.

•Special termination benefits related to workforce optimization initiatives related to past acquisitions and specific initiatives announced by the Company.

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Adjusted Operating Margin

We calculate adjusted operating margin as adjusted operating income divided by adjusted operating revenues. We define adjusted operating revenues as operating revenues adjusted to exclude the following:

•Acquisition-related performance-based investment management fees which are passed through as compensation and benefits expense.

•Sales and distribution fees and a portion of investment management fees allocated to cover sales, distribution and marketing expenses paid to the financial advisers and other intermediaries who sell our funds on our behalf.

•Elimination of operating revenues upon consolidation of investment products.

Adjusted Net Income

We define adjusted net income as net income attributable to Franklin Resources, Inc. adjusted to exclude the following:

•Activities of CIPs, including investment and other income (losses), net, and income (loss) attributable to noncontrolling interests, net of revenues eliminated upon consolidation of investment products.

•Acquisition-related retention compensation.

•Other acquisition-related expenses including professional fees, technology costs and fair value adjustments related to contingent consideration liabilities.

•Amortization and impairment of intangible assets.

•Impairment of goodwill and write off of noncontrolling interests related to the wind down of an acquired business.

•Special termination benefits related to workforce optimization initiatives related to past acquisitions and specific initiatives announced by the Company.

•Net gains or losses on investments related to Legg Mason deferred compensation plans which are not offset by compensation and benefits expense.

•Unrealized investment gains and losses other than those that are offset by compensation and benefits expense.

•Interest expense for amortization of Legg Mason debt premium from acquisition-date fair value adjustment.

•Net income tax expense of the above adjustments based on the respective blended rates applicable to the adjustments.

Adjusted Diluted Earnings Per Share

We define adjusted diluted earnings per share as diluted earnings per share adjusted to exclude the per share impacts of the adjustments applied to net income in calculating adjusted net income.

In calculating adjusted operating income, adjusted operating margin, adjusted net income and adjusted diluted earnings per share, we adjust for activities of CIPs because the impact of consolidated products is not considered reflective of the underlying results of our operations. We adjust for acquisition-related retention compensation, other acquisition-related expenses, amortization and impairment of intangible assets and goodwill, the write-off of noncontrolling interests, and interest expense for amortization of the Legg Mason debt premium to facilitate comparability of our operating results with the results of other asset management firms. We adjust for special termination benefits related to workforce optimization initiatives related to past acquisitions and specific initiatives announced by the Company because these items are deemed nonrecurring. In calculating adjusted net income and adjusted diluted earnings per share, we adjust for unrealized investment gains and losses included in investment and other income (losses), net and net gains or losses on investments related to Legg Mason deferred compensation plans which are not offset by compensation and benefits expense because these items primarily relate to seed and strategic investments which have been and are generally expected to be held long term.

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The calculations of adjusted operating income, adjusted operating margin, adjusted net income and adjusted diluted earnings per share are as follows:

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__________________

1The impact of consolidated investment products is summarized as follows:

LIQUIDITY AND CAPITAL RESOURCES

Cash flows were as follows:

Net cash provided by operating activities increased in fiscal year 2021 primarily due to higher net income, a higher adjustment for amortization of intangible assets and increases in accrued compensation and benefits, partially offset by a lower change in investments, net, adjustments for gains of CIPs as compared to losses in the prior year, increases in receivables and other assets and income from investments in equity method investees as compared to losses in the prior year. Net cash used in investing activities decreased as compared to the prior year primarily due to lower cash paid for acquisitions, partially offset by net deconsolidation of CIPs as compared to net consolidation in the prior year, higher net purchases of investments by CLOs and net purchases of investments as compared to net liquidations in the prior year. Net cash provided by financing activities increased as compared to the prior year primarily due to proceeds from debt of CIPs, proceeds from issuance of debt and higher net subscriptions in CIPs by noncontrolling interests, partially offset by higher payments on debt by CIPs and debt.

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Net cash provided by operating activities increased in fiscal year 2020 primarily due to lower net purchases of investments by CIPs, decreases in investments, net, decreases in receivables and other assets, and a smaller decline in taxes payable, partially offset by decreases in net income and decreases in accounts payable and accrued expenses. Net cash used in investing activities increased as compared to the prior year primarily due to higher cash paid for acquisitions, and net purchases of investments by CLOs, partially offset by net consolidation of CIPs as compared to net deconsolidation in the prior year, higher net liquidation of our investments as compared to the prior year, and lower net additions of property, plant and equipment. Net cash provided by financing activities, as compared to net cash used in the prior year, primarily resulted from proceeds from debt of CIPs and lower repurchases of stock, partially offset by lower net subscriptions in CIPs by noncontrolling interests and payments on debt by CIPs.

The assets and liabilities of CIPs attributable to third-party investors do not impact our liquidity and capital resources. We have no right to the CIPs’ assets, other than our direct equity investment in them and investment management and other fees earned from them. The debt holders of the CIPs have no recourse to our assets beyond the level of our direct investment, therefore we bear no other risks associated with the CIPs’ liabilities. Accordingly, the assets and liabilities of CIPs, other than our direct investments in them, are excluded from the amounts and discussion below.

Our liquid assets and debt consisted of the following:

Liquidity

Liquid assets consist of cash and cash equivalents, receivables and certain investments. Cash and cash equivalents at September 30, 2021 primarily consist of deposits with financial institutions and money market funds. Liquid investments consist of investments in sponsored and other funds, direct investments in redeemable CIPs, other equity and debt securities, and time deposits with maturities greater than three months.

We utilize a significant portion of our liquid assets to satisfy operational and regulatory requirements and fund capital contributions to sponsored and other products. Certain of our subsidiaries are required by our internal policy or regulation to maintain minimum levels of cash and/or capital, and may be restricted in their ability to transfer cash to their parent companies. Liquid assets used to satisfy these purposes were $4,059.6 million at September 30, 2021 and $3,290.9 million at September 30, 2020, including $262.6 million and $316.6 million that was restricted by regulatory requirements. Should we require more capital than is available for use, we could elect to reduce the level of discretionary activities, such as share repurchases or investments in sponsored and other products, or we could raise capital through debt or equity issuance. These alternatives could result in increased interest expense, decreased dividend or interest income, or other dilution to our earnings.

Capital Resources

We believe that we can meet our present and reasonably foreseeable operating cash needs and future commitments through existing liquid assets, continuing cash flows from operations, the ability to issue debt or equity securities and borrowing capacity under our uncommitted commercial paper private placement program.

On September 15, 2021, we redeemed all of the outstanding $500.0 million 5.450% junior notes due in September 2056 issued by Legg Mason at the principal amount plus accrued and unpaid interest of $6.8 million.

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On August 12, 2021, we completed the offering and sale of the 2.950% senior unsecured unsubordinated notes due 2051 with an aggregate principal amount of $350.0 million.

On March 15, 2021, we redeemed all of the outstanding $250.0 million 6.375% junior notes due in March 2056 issued by Legg Mason at the principal amount plus accrued and unpaid interest of $4.0 million.

On October 19, 2020, we completed the offering and sale of the 1.600% senior unsecured unsubordinated notes due 2030 with a principal amount of $750.0 million. On August 12, 2021, the Company issued an additional $100.0 million in aggregate principal amount of 1.600% senior notes due October 2030. The notes contain an optional redemption feature that allows us to redeem each series of notes prior to maturity in whole or in part at any time, at a make-whole redemption price.

Prior to fiscal year 2021, we issued senior unsecured unsubordinated notes for general corporate purposes, to redeem outstanding notes and to finance an acquisition. At September 30, 2021, $699.6 million of the notes issued by Franklin in prior fiscal years were outstanding with an aggregate principal amount due of $700.0 million. The notes were issued at fixed interest rates and consist of $300.0 million at 2.800% per annum which mature in 2022, $400.0 million at 2.850% per annum which mature in 2025. At September 30, 2021, a total of $1,893.7 million of the notes issued by Franklin were outstanding with an aggregate principal amount due of $1,900.0 million.

At September 30, 2021, Legg Mason’s outstanding senior unsecured unsubordinated notes had an aggregate principal amount due of $1,250.0 million. The notes have fixed interest rates from 3.950% to 5.625% with interest payable semi-annually and have an aggregate carrying value, inclusive of unamortized premium, of $1,518.3 million at September 30, 2021. Effective August 2, 2021, Franklin has agreed to unconditionally and irrevocably guarantee all of the outstanding notes issued by Legg Mason.

The Franklin and Legg Mason senior notes contain an optional redemption feature that allows us to redeem each series of notes prior to maturity in whole or in part at any time, at a make-whole redemption price. The indentures governing the senior notes contain limitations on our ability and the ability of our subsidiaries to pledge voting stock or profit participating equity interests in our subsidiaries to secure other debt without similarly securing the notes equally and ratably. In addition, the indentures include requirements that must be met if we consolidate or merge with, or sell all of our assets to, another entity. We were in compliance with all debt covenants at September 30, 2021.

At September 30, 2021, we had $500.0 million of short-term commercial paper available for issuance under an uncommitted private placement program which has been inactive since 2012 and is unrated.

Our ability to access the capital markets in a timely manner depends on a number of factors, including our credit rating, the condition of the global economy, investors’ willingness to purchase our securities, interest rates, credit spreads and the valuation levels of equity markets. If we are unable to access capital markets in a timely manner, our business could be adversely impacted.

Uses of Capital

We expect that our main uses of cash will be to invest in and grow our business including through acquisitions, pay stockholder dividends, invest in our products, pay income taxes and operating expenses of the business, enhance technology infrastructure and business processes, repurchase shares of our common stock, and repay and service debt. While we expect to continue to repurchase shares to offset dilution from share-based compensation, and expect to continue to repurchase shares opportunistically from time to time, we will likely spend more of our post-dividend free cash flow investing in our business, including seed capital and acquiring resources to help grow our investment teams and operations.

In the ordinary course of business, we enter into contracts or purchase obligations with third parties whereby the third parties provide goods or services to or on behalf of the Company. Purchase obligations include contractual amounts that will be due to purchase goods and services to be used in our operations and are recorded as liabilities in the consolidated financial statements when services are provided. At September 30, 2021, we had $471.8 million of purchase obligations.

We typically declare cash dividends on a quarterly basis, subject to approval by our Board of Directors. We declared regular dividends of $1.12 per share ($0.28 per share per quarter) in fiscal year 2021, and of $1.08 per share ($0.27 per share per quarter) in fiscal year 2020. We currently expect to continue paying comparable regular dividends on a quarterly basis to holders of our common stock depending upon earnings and other relevant factors.

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We maintain a stock repurchase program to manage our equity capital with the objective of maximizing shareholder value. Our stock repurchase program is effected through regular open-market purchases and private transactions in accordance with applicable laws and regulations, and is not subject to an expiration date. The size and timing of these purchases will depend on business conditions, price, market and other factors. During fiscal years 2021 and 2020, we repurchased 7.3 million and 9.0 million shares of our common stock at a cost of $208.2 million and $219.4 million. At September 30, 2021, 30.9 million shares remained available for repurchase under the authorization of 80.0 million shares approved by our Board of Directors in April 2018.

We routinely make cash investments in the course of launching sponsored funds. At September 30, 2021, we had $285.1 million of committed capital contributions which relate to discretionary commitments to invest in sponsored funds and other investment products and entities, including CIPs. These unfunded commitments are not recorded in the consolidated balance sheet.

We invested $182.2 million, net of redemptions, in our sponsored products during fiscal year 2021, and redeemed $636.6 million, net of investments, during fiscal year 2020.

On November 1, 2021, we entered into an acquisition agreement to acquire all of the outstanding ownership interests in Lexington Partners L.P. for cash consideration of approximately $1.0 billion to be paid at closing and additional cash payments totaling $750.0 million to be paid over the next three years. The acquisition is expected to be completed in the second quarter of the fiscal year 2022 and is expected to be funded from available cash.

On September 29, 2021, we entered into an acquisition agreement to acquire all of the outstanding ownership interests in O'Shaughnessy Asset Management for cash consideration of approximately $300.0 million, excluding future payments to be made upon the attainment of certain performance measures. The acquisition is expected to be completed in the first quarter of fiscal year 2022 and is expected to be funded from available cash.

The funds that we manage have their own resources available for purposes of providing liquidity to meet shareholder redemptions, including securities that can be sold or provided to investors as in-kind redemptions, and lines of credit. Increased liquidity risks and redemptions have required, and may continue to require, increased cash in the form of loans or other lines of credit to help settle redemptions and for other related purposes. While we have no legal or contractual obligation to do so, we have in certain instances voluntarily elected to provide the funds with direct or indirect financial support based on our business objectives. In April 2020, we authorized loans aggregating up to 5.0 billion Indian Rupees (approximately $66.2 million) to certain sponsored funds in India that had experienced increased liquidity risks and redemptions and are in the process of winding up. The loans were fully repaid during the second quarter of fiscal year 2021. See Note 16 – Commitments and Contingencies in the notes to consolidated financial statements in Item 8 of Part II of this Annual Report for further information. We did not provide financial or other support to our sponsored funds during fiscal year 2021 or 2020.

CRITICAL ACCOUNTING POLICIES

Our consolidated financial statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the United States of America, which require the use of estimates, judgments and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. These estimates, judgments and assumptions are affected by our application of accounting policies. Further, global concerns about the COVID-19 pandemic have adversely affected and may continue to adversely affect, our business, financial condition and results of operations including the estimates and assumptions made by management. Actual results could differ from the estimates. Described below are the accounting policies that we believe are most critical to understanding our financial position and results of operations. For additional information about our accounting policies, see Note 1 – Significant Accounting Policies in the notes to consolidated financial statements in Item 8 of Part II of this Annual Report.

Consolidation

We consolidate our subsidiaries and investment products in which we have a controlling financial interest. We have a controlling financial interest when we own a majority of the voting interest in a voting interest entity (“VOE”) or are the primary beneficiary of a variable interest entity (“VIE”).

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A VIE is an entity in which the equity investment holders have not contributed sufficient capital to finance its activities or do not have defined rights and obligations normally associated with an equity investment. The assessment of whether an entity is a VIE or VOE involves judgment and analysis on a structure by structure basis. When performing the assessment, we consider factors such as the entity’s legal organization, design and capital structure, the rights of the equity investment holders and our contractual involvement with and ownership interest in the entity. Our VIEs are primarily investment products and our variable interests consist of our equity ownership interests in and investment management fees earned from these products.

We are the primary beneficiary of a VIE if we have the power to direct the activities that most significantly impact the VIE’s economic performance and the obligation to absorb losses of or right to receive benefits from the VIE that could potentially be significant to the VIE. Investment management fees earned from VIEs are excluded from the primary beneficiary determination if they are deemed to be at market and commensurate with service. The key assumption used in the analysis includes the amount of AUM. These estimates and assumptions are subject to variability. For example, AUM is impacted by market volatility and the level of sales, redemptions, distributions to investors and reinvested distributions. There is judgment involved in assessing whether we have the power to direct the activities that most significantly impact VIEs’ economic performance and the obligation to absorb losses of or right to receive benefits from VIEs that could potentially be significant to the VIEs. As of September 30, 2021, we were the primary beneficiary of 50 investment product VIEs.

Business Combinations

Business combinations are accounted for by recognizing the acquired assets, including separately identifiable intangible assets, and assumed liabilities at their acquisition-date estimated fair values. Any excess of the purchase consideration over the acquisition-date fair values of these identifiable assets and liabilities is recognized as goodwill. Determining the fair value of assets acquired and liabilities assumed involves the use of significant estimates and assumptions. During the measurement period, which is not to exceed one year from the acquisition date, we may record adjustments to the assets acquired and liabilities assumed, with the corresponding offset to goodwill. Upon the conclusion of the measurement period, any subsequent adjustments are recorded in earnings.

Intangible assets acquired in business combinations consist primarily of investment management contracts and trade names. The fair values of the acquired management contracts are based on the net present value of estimated future cash flows attributable to the contracts, which include significant assumptions about forecasts of the AUM growth rate, pre-tax profit margin, discount rate, average effective fee rate and effective tax rate. The fair value of trade names is determined using the relief from royalty method based on net present value of estimated future cash flows, which include significant assumptions about royalty rate, revenue growth rate, discount rate and effective tax rate. Our estimates are based on assumptions believed to be reasonable, but are inherently uncertain and unpredictable and, as a result, may differ from actual results.

Our management contract intangible assets are amortized over their estimated useful lives, which range from three to fifteen years, using the straight-line method, unless the asset is determined to have an indefinite useful life. Indefinite-lived intangible assets represent contracts to manage investment assets for which there is no foreseeable limit on the contract period. Trade names are amortized over their estimated useful lives which range from five to twenty years using the straight-line method.

Goodwill and indefinite-lived intangible assets are tested for impairment annually and when an event occurs or circumstances change that more likely than not reduce the fair value of the related reporting unit or indefinite-lived intangible asset below its carrying value. We have one reporting unit, investment management and related services, consistent with our single operating segment, to which all goodwill has been assigned. We make significant estimates and assumptions when evaluating goodwill and other intangible assets for impairment.

We may first assess goodwill and indefinite-lived intangible assets for qualitative factors to determine whether it is necessary to perform a quantitative impairment test. The qualitative analysis considers entity-specific and macroeconomic factors and their potential impact on key assumptions used in the determination of the fair value of the reporting unit or indefinite-lived intangible asset. A quantitative impairment test is performed if the results of the qualitative assessment indicate that it is more likely than not that the fair value of the reporting unit is less than its carrying value or an indefinite-lived intangible asset is impaired, or if a qualitative assessment is not performed. Quantitative tests compare the fair value of the asset to its carrying value.

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The fair values of the reporting unit and indefinite-lived intangible assets are based on the net present value of estimated future cash flows, which include significant assumptions about the AUM growth rate, pre-tax profit margin, discount rate, average effective fee rate and effective tax rate. The most relevant of these assumptions to the determination of estimated fair value are the AUM growth rate, pre-tax profit margin and the discount rate.

We performed a qualitative annual impairment test for goodwill and all indefinite-lived intangible assets as of August 1, 2021 and concluded it is more likely than not that the fair values of the reporting unit and the indefinite-lived intangible assets exceed their carrying values.

We subsequently monitored market conditions and their potential impact on the assumptions used in the annual assessment to determine whether circumstances have changed that would more likely than not reduce the fair value of the reporting unit below its carrying value, or indicate that the other indefinite-lived intangible assets might be impaired. We considered, among other things, changes in our AUM and weighted-average cost of capital by assessing whether these changes would impact the reasonableness of our impairment assessment as of August 1, 2021. We also monitored fluctuations of our common stock per share price to evaluate our market capitalization relative to the reporting unit as a whole. Subsequent to August 1, 2021, there were no impairments of goodwill or indefinite-lived intangible assets as no events occurred or circumstances changed that would indicate these assets might be impaired.

We test definite-lived intangible assets for impairment quarterly. Impairment is indicated when the carrying value of an asset is not recoverable and exceeds its fair value. Recoverability is evaluated based on estimated undiscounted future cash flows using assumptions about the AUM growth rate, pre-tax profit margin, average effective fee rate and expected useful life as well as royalty rate for trade name intangible assets. The most relevant of these assumptions to determine future cash flows is the AUM growth rate. If the carrying value of an asset is not recoverable through undiscounted cash flows, impairment is recognized in the amount by which the carrying value exceeds the asset’s fair value, as determined by discounted cash flows or other methods as appropriate for the asset type. There were no impairments of definite-lived intangible assets during fiscal year 2021.

While we believe that the assumptions used to estimate fair value in our impairment tests are reasonable and appropriate, future changes in the assumptions could result in recognition of impairment.

Fair Value Measurements

Our investments are primarily recorded at fair value or amounts that approximate fair value on a recurring basis. We use a three-level fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value based on whether the inputs to those valuation techniques are observable or unobservable. The assessment of the hierarchy level of the assets or liabilities measured at fair value is determined based on the lowest level input that is significant to the fair value measurement in its entirety. See Note 1 – Significant Accounting Policies in the notes to consolidated financial statements in Item 8 of Part II of this Annual Report for more information on the fair value hierarchy.

As of September 30, 2021, Level 3 assets represented 9% of total assets measured at fair value, substantially all of which related to CIPs’ investments in equity and debt securities, and real estate. There were $23.1 million of transfers into and $5.0 million of transfers out of Level 3 during fiscal year 2021.

The following are descriptions of the significant assets measured at fair value and their fair value methodologies.

Sponsored funds and separate accounts consist primarily of investments in nonconsolidated sponsored funds and to a lesser extent, separate accounts. Changes in the fair value of the investments are recognized as gains and losses in earnings. The fair values of fund products are determined based on their published NAV or estimated using NAV as a practical expedient. The fair values of the underlying investments in the separate accounts are determined using quoted market prices, or independent third-party broker or dealer price quotes if quoted market prices are not available.

Investments related to long-term incentive plans consist primarily of investments in sponsored funds related to certain compensation plans that have certain vesting provisions. Changes in fair value are recognized as gains and losses in earnings. The fair values of the investments are determined based on the fund products’ published NAV or estimated using NAV as a practical expedient.

Other equity and debt securities consist of other equity investment securities and trading debt securities. Changes in the fair value are recognized as gains and losses in earnings. The fair values of equity securities other than fund products are determined using independent third-party broker or dealer price quotes or based on discounted cash flows using

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significant unobservable inputs. The fair values of debt securities are determined using independent third-party broker or dealer price quotes or based on discounted cash flows using significant unobservable inputs.

Investments of CIPs consist of marketable debt and equity securities and other investments that are not generally traded in active markets. Changes in the fair value of the investments are recognized as gains and losses in earnings. The fair values of marketable securities are determined using quoted market prices, or independent third-party broker or dealer price quotes if quoted market prices are not available. The investments that are not generally traded in active markets consist of loans, other equity and debt securities of entities in emerging markets, fund products and real estate. The fair values are determined using significant unobservable inputs in either a market-based or income-based approach, except for fund products, for which fair values are estimated using NAV as a practical expedient.

Noncontrolling interests consist of third-party equity interests in CIPs and minority interests in certain subsidiaries. Noncontrolling interests that are redeemable or convertible for cash or other assets at the option of the noncontrolling interest holders and are classified as temporary equity at fair value, except when the fair value is less than the issuance date fair value, the reported amount is the issuance date fair value. Changes in fair value of redeemable noncontrolling interest is recognized as an adjustment to retained earnings. Nonredeemable noncontrolling interests do not permit the noncontrolling interest holders to request settlement, are reported at their issuance value and undistributed net income (loss) attributable to noncontrolling interests.

The fair value of third-party equity interests in CIPs are determined based on the published NAV or estimated using NAV a practical expedient. The fair value of redeemable noncontrolling interests related to minority interest in certain subsidiaries are derived using discounted cash flows and guideline public company methodology, which include significant assumptions about forecasts of the AUM growth rate, pre-tax profit margin, discount rate and operating income multiples.

Revenues

We earn revenue primarily from providing investment management and related services to our customers. In addition to investment management, services include fund administration, sales and distribution, and shareholder servicing. Revenues are recognized when our obligations related to the services are satisfied and it is probable that a significant reversal of the revenue amount would not occur in future periods. The obligations are satisfied over time as the services are rendered, except for the sales and distribution obligations for the sale of shares of sponsored funds, which are satisfied on trade date. Multiple services included in customer contracts are accounted for separately when the obligations are determined to be distinct. Management judgment is involved in assessing the probability of significant revenue reversal and in the identification of distinct services.

Fees from providing investment management and fund administration services (“investment management fees”), other than performance-based investment management fees, are determined based on a percentage of AUM, primarily on a monthly basis using daily average AUM, and are recognized as the services are performed over time. Performance-based investment management fees are generated when investment products’ performance exceeds targets established in customer contracts. These fees are recognized when significant reversal of the amount is no longer probable and may relate to investment management services that were provided in prior periods.

Sales and distribution fees primarily consist of upfront sales commissions and ongoing distribution fees. Sales commissions are based on contractual rates for sales of certain classes of sponsored funds and are recognized on trade date. Distribution service fees are determined based on a percentage of AUM, primarily on a monthly basis using daily average AUM. As the fee amounts are uncertain on trade date, they are recognized over time as the amounts become known and may relate to sales and distribution services provided in prior periods.

AUM is generally based on the fair value of the underlying securities held by investment products and is calculated using fair value methods derived primarily from unadjusted quoted market prices, unadjusted independent third-party broker or dealer price quotes in active markets, or market prices or price quotes adjusted for observable price movements after the close of the primary market. The fair values of securities for which market prices are not readily available are valued internally using various methodologies which incorporate significant unobservable inputs as appropriate for each security type. Pricing of the securities is governed by our global valuation and pricing policy, which defines valuation and pricing conventions for each security type, including practices for responding to unexpected or unusual market events.

As substantially all of our AUM is valued based on observable market prices or inputs, market risk is the most significant risk underlying the valuation of our AUM.

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Income Taxes

Deferred tax assets and liabilities are recorded for temporary differences between the tax basis of assets and liabilities and the reported amounts in the consolidated financial statements using the statutory tax rates in effect for the year when the reported amount of the asset or liability is expected to be recovered or settled, respectively. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income tax expense in the period that includes the enactment date. A valuation allowance is recorded to reduce the carrying values of deferred tax assets to the amount that is more likely than not to be realized. In assessing whether a valuation allowance should be established against a deferred income tax asset, we consider all positive and negative evidence, which includes timing of expiration, projected sources of taxable income, limitations on utilization under the statute and the effectiveness of prudent and feasible tax planning strategies among other factors. For each tax position taken or expected to be taken in a tax return, we utilize significant judgment related to the range of possible favorable or unfavorable outcomes to determine whether it is more likely than not that the position will be sustained upon examination based on the technical merits of the position, including resolution of any related appeals or litigation. A tax position that meets the more likely than not recognition threshold is measured at the largest amount of benefit that is greater than 50% likely of being realized upon settlement.

We operate in numerous countries, states and other taxing jurisdictions. The income tax laws are complex and subject to different interpretations by the taxpayer and the relevant taxing authorities. Significant judgment is required in the determination of our annual income tax provisions, which includes the assessment of deferred tax assets and uncertain tax positions, as well as the interpretation and application of existing and newly enacted tax laws, regulation changes, and new judicial rulings. We repatriate foreign earnings that are in excess of regulatory, capital or operational requirements of all of our non-U.S. subsidiaries.

It is possible that actual results will vary from those recognized in our consolidated financial statements due to changes in the interpretation of applicable guidance or as a result of examinations by taxing authorities.

Loss Contingencies

We are involved in various lawsuits and claims encountered in the normal course of business. When such a matter arises and periodically thereafter, we consult with our legal counsel and evaluate the merits of the claims based on the facts available at that time. In management’s opinion, an adequate accrual has been made as of September 30, 2021 to provide for any probable losses that may arise from such matters for which we could reasonably estimate an amount. See also Note 16 – Commitments and Contingencies in the notes to consolidated financial statements in Item 8 of Part II of this Annual Report.

NEW ACCOUNTING GUIDANCE

See Note 2 – New Accounting Guidance in the notes to consolidated financial statements in Item 8 of Part II of this Annual Report.

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