**SECURITIES ANDEXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q**

 
| **x**      | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934**                                                                                                                                             |
|------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |       |                                                                                                                                                                                                                                                |
| ** ** | ** ** | **For the quarterly  period ended March 31, 2008**                                                                                                                                                                                             |
|       |       |                                                                                                                                                                                                                                                |
| **OR**     |
|       |       |                                                                                                                                                                                                                                                |
| **o**      | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934**                                                                                                                                            |
|       |       |                                                                                                                                                                                                                                                |
| ** ** | ** ** | **For the transition  period  from:                 to                 ** |

 

**Commission File Number 001-33761**

 

**PZENA INVESTMENTMANAGEMENT, INC.**

(Exact name of registrant as specified in its charter)

 

| **Delaware**                                                    | ** ** | **20-8999751**                       |
|-----------------------------------------------------------------|------------|--------------------------------------|
| (State or  other jurisdiction ofincorporation or  organization) |       | (I.R.S.  EmployerIdentification No.) |

 

| **120  West 45th Street**                 | ** ** | ** ** |
|-------------------------------------------|------------|------------|
| **New  York, New York**                   | ** ** | **10036**  |
| (Address of principal  executive offices) |       | (Zip Code) |

 

**(212)355-1600**

(Registrant’s telephonenumber including area code)

 

**Not Applicable**

(Former name, former address, and former fiscal year if changed sincelast report)

 

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or forsuch shorter period that the registrant was required to file such reports), and(2) has been subject to such filing requirements for the past90 days. Yes x     No o

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, anon-accelerated filer, or a smaller reporting company. See definitions of“large accelerated filer,” “accelerated filer,” and “smaller reporting company”in Rule 12b-2 of the Exchange Act. (Check one):

 

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

 

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

 

As of  May 14, 2008 there were 6,123,494 outstanding shares of the registrant’s Class Acommon stock, par value $0.01 per share.

 

As of  May 14, 2008 there were 57,950,910 outstandingshares of the registrant’s Class B common stock, par value $0.000001 pershare.

 

 

----

 

**PZENA INVESTMENT MANAGEMENT, INC.**

**FORM 10-Q**

**TABLE OF CONTENTS**

 
| ** **                                | ** **                                                                                                                                                                  | **Page**   |
|-------------------------------------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                | ** **                                                                                                                                                                  | ** ** |
| PART I  — FINANCIAL INFORMATION |                                                                                                                                                                        | 3          |
|                                      |                                                                                                                                                                        |       |
| Item 1.                                   | Consolidated  Statements of Financial Condition of Pzena Investment Management, Inc.  as of March 31, 2008 (unaudited) and December 31, 2007                 |       | 3 |
|                                      |                                                                                                                                                                        |       |   |
|                                      | Consolidated  Statements of Operations (unaudited) of Pzena Investment  Management, Inc. for the Three Months Ended March 31, 2008 and  March 31, 2007       |       | 4 |
|                                      |                                                                                                                                                                        |       |   |
|                                      | Consolidated  Statements of Cash Flows (unaudited) of Pzena Investment  Management, Inc. for the Three Months Ended March 31, 2008 and March 31,  2007       |       | 5 |
|                                      |                                                                                                                                                                        |       |   |
|                                      | Consolidated Statements of Changes in Equity  (unaudited) of Pzena Investment Management, Inc. for the Three Months  Ended March 31, 2008 and March 31, 2007 |       | 6 |
|                                      |                                                                                                                                                                        |       |   |
|                                      | Notes to Consolidated Financial Statements (unaudited)                                                                                                                      |       | 7 |
|                                      |                                                                                                                                                                        |       |   |
| Item 2.                                   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                                                                 |       | 27 |
|                                      |                                                                                                                                                                        |       |   |
| Item 3.                                   | Quantitative  and Qualitative Disclosures About Market Risk                                                                                                                 |       | 40 |
|                                      |                                                                                                                                                                        |       |   |
| Item 4T.                                  | Controls and Procedures                                                                                                                                                     |       | 40 |
|                                      |                                                                                                                                                                        |       |   |
| PART II  — OTHER INFORMATION    |                                                                                                                                                                        | 41         |
|                                      |                                                                                                                                                                        |       |
| Item 1.                                   | Legal Proceedings                                                                                                                                                           |       | 41 |
|                                      |                                                                                                                                                                        |       |   |
| Item 1A.                                  | Risk Factors                                                                                                                                                                |       | 41 |
|                                      |                                                                                                                                                                        |       |   |
| Item 2.                                   | Unregistered Sales  of Equity Securities and Use of Proceeds                                                                                                                |       | 41 |
|                                      |                                                                                                                                                                        |       |   |
| Item 3.                                   | Defaults Upon Senior  Securities                                                                                                                                            |       | 41 |
|                                      |                                                                                                                                                                        |       |   |
| Item 4.                                   | Submission of Matters  to a Vote of Security Holders                                                                                                                        |       | 41 |
|                                      |                                                                                                                                                                        |       |   |
| Item 5.                                   | Other Information                                                                                                                                                           |       | 41 |
|                                      |                                                                                                                                                                        |       |   |
| Item 6.                                   | Exhibits                                                                                                                                                                    |       | 42 |

 

----

 

**EXPLANATORY NOTE**

** **

On October 30,2007, Pzena Investment Management, Inc. (the “Company”) consummated aninitial public offering of 6,100,000 shares of its Class A commonstock in which it received net proceeds of approximately $98.9 millionthat it used to purchase 6,100,000 membership units of Pzena InvestmentManagement, LLC, representing 9.5% of the then outstanding membership units ofPzena Investment Management, LLC. Concurrently with the consummation of thisinitial public offering, (i) the operating agreement of Pzena InvestmentManagement, LLC (the “Operating Agreement”) was amended and restated such that,among other things, Pzena Investment Management, Inc. became the solemanaging member of Pzena Investment Management, LLC and (ii) relatedreorganization transactions were consummated. Accordingly, as of and subsequentto October 30, 2007, (i) Pzena Investment Management, Inc. willconsolidate the financial results of Pzena Investment Management, LLC with itsown and reflect the remaining membership interest in Pzena InvestmentManagement, LLC as a non-controlling interest in its consolidated financialstatements, and (ii) Pzena Investment Management, Inc.’s income willbe generated by its economic interest in Pzena Investment Management, LLC’s netincome. As ofMarch 31, 2008, the holders of Class A common stock (through theCompany) and the holders of Class B units of the operating company heldapproximately 9.6% and 90.4%, respectively, of the economic interests in theoperations of the business.  Therefore, this Quarterly Report on Form 10-Qpresents the following financial statements:

 

1)              the consolidated statement of operations, theconsolidated statement of cash flows and the consolidated statement of changesin equity, of Pzena Investment Management, LLC for the three months ended March 31,2007; and

 

2)              the consolidated financial statements of PzenaInvestment Management, Inc. as of and for the three months ended March 31,2008 and the consolidated statement of financial condition of Pzena InvestmentManagement, Inc. as of December 31, 2007.

 

“We,” “us,” “our,” and the “Company” refer to: (i)Pzena Investment Management, Inc. and its subsidiaries, including Pzena InvestmentManagement, LLC and all of its subsidiaries, following the consummation of theabove-referenced initial public offering, amendment and restatement of the OperatingAgreement and related reorganization transactions on October 30, 2007, and (ii)to Pzena Investment Management, LLC and all of its subsidiaries prior to theconsummation of these transactions. The “operating company” refers to PzenaInvestment Management, LLC.

 

1

----

 

**CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS**

 

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

 

Forward-looking statements are subject to known andunknown risks and uncertainties and are based on potentially inaccurateassumptions that could cause actual results to differ materially from thoseexpected or implied by the forward-looking statements. Our actual results coulddiffer materially from those anticipated in forward-looking statements for manyreasons, including the factors described in Item 1A, “Risk Factors” in Part Iof our Annual Report on Form 10-K for our fiscal year ended December 31, 2007.Accordingly, you should not unduly rely on these forward-looking statements,which speak only as of the date of this Quarterly Report on Form 10-Q. Weundertake no obligation to publicly revise any forward-looking statements toreflect circumstances or events after the date of this Quarterly Report on Form10-Q, or to reflect the occurrence of unanticipated events. You should,however, review the factors and risks we describe in the reports we will filefrom time to time with the SEC after the date of this Quarterly Report on Form10-Q.

 

Forward-looking statements include, but are notlimited to, statements about:

 

·    our anticipated future results of operations andoperating cash flows;

 

·    our business strategies and investment policies;

 

·    our financing plans and the availability of short-termborrowing;

 

·    our competitive position and the effects of competitionon our business;

 

·    potential growth opportunities available to us;

 

·    the recruitment and retention of our employees;

 

·    our expected levels of compensation for our employees;

 

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

 

·    our expected tax rate;

 

·    changes in interest rates;

 

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

 

·    the benefits to our business resulting from the effectsof the reorganization we consummated on October 30, 2007; and

 

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

 

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

 

2

----

 

**PART I. FINANCIAL INFORMATION          **

 

**Item 1.  Financial Statements.**

 

**PZENA INVESTMENT MANAGEMENT, INC.**

** **

**CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION**

**(in thousands, except share and per-share amounts)**

 
| ** **                                                                                                                                                               | ** ** | **As of**     | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|
| ** **                                                                                                                                                               | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
| ** **                                                                                                                                                               | ** ** | **2008**           | ** ** | **2007** | ** ** |
| ** **                                                                                                                                                               | ** ** | **(unaudited)**    | ** ** | ** ** | ** ** |
| **ASSETS**                                                                                                                                                               |       |               |       |   |   |
| Cash and Cash Equivalents                                                                                                                                                |       | $                  | 36,000     |   | $ | 27,184 |   |
| Due from Broker                                                                                                                                                          |       | 77                 |       | 268 |   |
| Advisory Fees Receivable                                                                                                                                                 |       | 21,625             |       | 26,061 |   |
| Investments in Marketable  Securities, at Fair Value                                                                                                                     |       | 36,545             |       | 27,465 |   |
| Receivable from Related  Parties                                                                                                                                         |       | 418                |       | 351 |   |
| Other Receivables                                                                                                                                                        |       | 175                |       | 1,040 |   |
| Prepaid Expenses and Other  Assets                                                                                                                                       |       | 635                |       | 881 |   |
| Deferred Tax Assets                                                                                                                                                      |       | 67,632             |       | 68,233 |   |
| Property and Equipment, Net of  Accumulated Depreciation of $1,527 and $1,412, respectively                                                                              |       | 3,098              |       | 3,163 |   |
| TOTAL ASSETS                                                                                                                                                             |       | $                  | 166,205    |   | $ | 154,646 |   |
|                                                                                                                                                                     |       |               |       |   |   |
| **LIABILITIES AND EQUITY**                                                                                                                                               |       |               |       |   |   |
| Liabilities:                                                                                                                                                             |       |               |       |   |   |
| Accounts Payable and Accrued  Expenses                                                                                                                                   |       | $                  | 10,003     |   | $ | 8,542 |   |
| Securities Sold Short, at Fair  Value                                                                                                                                    |       | 3,518              |       | 1,028 |   |
| Due to Broker                                                                                                                                                            |       | 126                |       | 4,101 |   |
| Dividends Payable                                                                                                                                                        |       | 7,058              |       | 7,045 |   |
| Long Term Debt                                                                                                                                                           |       | 60,000             |       | 60,000 |   |
| Liability to Selling  Shareholders                                                                                                                                       |       | 58,391             |       | 58,391 |   |
| Other Liabilities                                                                                                                                                        |       | 1,772              |       | 1,105 |   |
| TOTAL LIABILITIES                                                                                                                                                        |       | 140,868            |       | 140,212 |   |
|                                                                                                                                                                     |       |               |       |   |   |
| Commitments and Contingencies                                                                                                                                            |       | —             |       | — |   |
| Non-Controlling Interests                                                                                                                                                |       | 20,208             |       | 16,355 |   |
|                                                                                                                                                                     |       |               |       |   |   |
| Equity:                                                                                                                                                                  |       |               |       |   |   |
| Preferred Stock (Par Value  $0.01; 200,000,000 Shares Authorized; None Outstanding)                                                                                      |       | —             |       | — |   |
| Class A Common Stock (Par  Value $0.01; 750,000,000 Shares Authorized; 6,123,494 and 6,111,118 Shares  Issued and Outstanding in 2008 and 2007, respectively)       |       | 61                 |       | 61 |   |
| Class B Common Stock (Par  Value $0.000001; 750,000,000 Shares Authorized; 57,950,910 and 57,937,910  Shares Issued and Outstanding in 2008 and 2007, respectively) |       | —             |       | — |   |
| Additional Paid-In Capital                                                                                                                                               |       | 4,907              |       | (2,043 | ) |
| Accumulated Other  Comprehensive Income                                                                                                                                  |       | (46                | )          | — |   |
| Retained Earnings                                                                                                                                                        |       | 207                |       | 61 |   |
| TOTAL EQUITY                                                                                                                                                             |       | 5,129              |       | (1,921 | ) |
| TOTAL LIABILITIES AND EQUITY                                                                                                                                             |       | $                  | 166,205    |   | $ | 154,646 |   |

 

See accompanying notes to consolidatedfinancial statements

 

3

----

 

**PZENA INVESTMENT MANAGEMENT, INC.**

**(Prior toOctober 30, 2007 - Pzena Investment Management, LLC)**

** **

**UNAUDITED CONSOLIDATED STATEMENTS OF OPERATIONS**

**(in thousands, exceptshare and per-share amounts)**

 
| ** **                                                                            | ** ** | **For the Three Months Ended March 31,** | ** ** |
|---------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                                                                            | ** ** | **2008**                                                               | ** ** | **2007** | ** ** |
| **REVENUE**                                                                           |       | $                                                                      | 30,012     |   | $ | 35,298 |   |
|                                                                                  |       |                                                                   |       |   |   |
| **EXPENSES**                                                                          |       |                                                                   |       |   |   |
| Compensation and Benefits Expense                                                     |       | 8,951                                                                  |       | 103,824 |   |
| General and Administrative Expenses                                                   |       | 3,043                                                                  |       | 2,089 |   |
| TOTAL OPERATING EXPENSES                                                              |       | 11,994                                                                 |       | 105,913 |   |
| Operating Income/(Loss)                                                               |       | 18,018                                                                 |       | (70,615 | ) |
|                                                                                  |       |                                                                   |       |   |   |
| **OTHER INCOME/(EXPENSE)**                                                            |       |                                                                   |       |   |   |
| Interest Income                                                                       |       | 197                                                                    |       | 286 |   |
| Interest Expense                                                                      |       | (963                                                                   | )          | — |   |
| Dividend Income, Net                                                                  |       | 281                                                                    |       | 129 |   |
| Realized and Unrealized Loss, Net on Marketable Securities and  Securities Sold Short |       | (3,580                                                                 | )          | (170 | ) |
| Equity in Loss of Affiliates                                                          |       | —                                                                 |       | (42 | ) |
| Other                                                                                 |       | (14                                                                    | )          | 32 |   |
| Total Other Income/(Expense)                                                          |       | (4,079                                                                 | )          | 235 |   |
|                                                                                  |       |                                                                   |       |   |   |
| Income/(Loss) Before Income Taxes and Non-Controlling Interests                       |       | 13,939                                                                 |       | (70,380 | ) |
|                                                                                  |       |                                                                   |       |   |   |
| Provision for Income Taxes                                                            |       | 1,542                                                                  |       | 1,129 |   |
| Non-Controlling Interests                                                             |       | 11,577                                                                 |       | (9 | ) |
| Income/(Loss) Before Interest on Mandatorily Redeemable Units                         |       | 820                                                                    |       | (71,500 | ) |
|                                                                                  |       |                                                                   |       |   |   |
| Interest on Mandatorily Redeemable Units                                              |       | —                                                                 |       | 16,575 |   |
|                                                                                  |       |                                                                   |       |   |   |
| Net Income/(Loss)                                                                     |       | $                                                                      | 820        |   | $ | (88,075 | ) |
|                                                                                  |       |                                                                   |       |   |   |
| Net Income for Basic Earnings per Share                                               |       | $                                                                      | 820        |   |   |   |
| Basic Earnings per Share                                                              |       | $                                                                      | 0.13       |   |   |   |
| Basic Weighted Average Shares Outstanding                                             |       | 6,119,686                                                              |       |   |   |
|                                                                                  |       |                                                                   |       |   |   |
| Net Income for Diluted Earnings per Share                                             |       | $                                                                      | 8,597      |   |   |   |
| Diluted Earnings per Share                                                            |       | $                                                                      | 0.13       |   |   |   |
| Diluted Weighted Average Shares Outstanding                                           |       | 64,070,596                                                             |       |   |   |

 

See accompanying notes to consolidatedfinancial statements

 

4

----

 

**PZENA INVESTMENT MANAGEMENT, INC.**

**(Prior toOctober 30, 2007 - Pzena Investment Management, LLC)**

 

**UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(in thousands)**

 
| ** **                                                                            | ** ** | **For the Three Months Ended March 31,** | ** ** |
|---------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                                                                            | ** ** | **2008**                                                               | ** ** | **2007** | ** ** |
| **OPERATING ACTIVITIES**                                                              |       |                                                                   |       |   |   |
| Net Income/(Loss)                                                                     |       | $                                                                      | 820        |   | $ | (88,075 | ) |
| Adjustments to Reconcile Net Income/(Loss) to Cash Provided by  Operating Activities: |       |                                                                   |       |   |   |
| Depreciation                                                                          |       | 115                                                                    |       | 74 |   |
| Non-Cash Compensation                                                                 |       | 344                                                                    |       | 81,884 |   |
| Director Share Grant                                                                  |       | 140                                                                    |       | — |   |
| Realized and Unrealized Loss, Net on Marketable Securities and  Securities Sold Short |       | 3,580                                                                  |       | 170 |   |
| Non-Controlling Interests                                                             |       | 11,577                                                                 |       | (9 | ) |
| Equity in Loss of Affiliates                                                          |       | —                                                                 |       | 42 |   |
| Deferred Income Taxes                                                                 |       | 547                                                                    |       | (231 | ) |
| Changes in Operating Assets and Liabilities:                                          |       |                                                                   |       |   |   |
| Advisory Fees Receivable                                                              |       | 4,436                                                                  |       | (1,689 | ) |
| Due from Broker                                                                       |       | 191                                                                    |       | 765 |   |
| Restricted Cash                                                                       |       | —                                                                 |       | (22 | ) |
| Prepaid Expenses and Other Assets                                                     |       | 1,111                                                                  |       | 493 |   |
| Due to Broker                                                                         |       | (3,975                                                                 | )          | (2,691 | ) |
| Accrued Expenses, Accounts Payable and Other Liabilities                              |       | 1,508                                                                  |       | 5,022 |   |
| Purchases of Marketable Securities and Securities Sold Short                          |       | (16,836                                                                | )          | (6,986 | ) |
| Proceeds from Sale of Marketable Securities and Securities Sold Short                 |       | 6,667                                                                  |       | 7,453 |   |
| **Net Cash Provided by/(Used in) Operating Activities**                               | ** ** | **10,225**                                                             | ** ** | **(3,800** | **)** |
|                                                                                  |       |                                                                   |       |   |   |
| **INVESTING ACTIVITIES**                                                              |       |                                                                   |       |   |   |
| Receivable from Related Parties                                                       |       | (67                                                                    | )          | 76 |   |
| Purchases of Property and Equipment                                                   |       | (50                                                                    | )          | (32 | ) |
| **Net Cash Provided by/(Used in) Investing Activities**                               | ** ** | **(117**                                                               | **)**      | **44** | ** ** |
|                                                                                  |       |                                                                   |       |   |   |
| **FINANCING ACTIVITIES**                                                              |       |                                                                   |       |   |   |
| Contributions from Non-Controlling Interests                                          |       | 6,833                                                                  |       | 1,462 |   |
| Distributions to Non-Controlling Interests                                            |       | (1,080                                                                 | )          | (2,067 | ) |
| Dividends                                                                             |       | (672                                                                   | )          | — |   |
| Distributions to Members                                                              |       | (6,373                                                                 | )          | — |   |
| **Net Cash Used in Financing Activities**                                             | ** ** | **(1,292**                                                             | **)**      | **(605** | **)** |
| ** **                                                                            | ** ** | ** **                                                             | ** ** | ** ** | ** ** |
| **NET CHANGE IN CASH**                                                                | ** ** | **$**                                                                  | **8,816**  | ** ** | **$** | **(4,361** | **)** |
|                                                                                  |       |                                                                   |       |   |   |
| **CASH AND CASH EQUIVALENTS - Beginning of Period**                                   |       | $                                                                      | 27,184     |   | $ | 30,920 |   |
| Net Change in Cash                                                                    |       | 8,816                                                                  |       | (4,361 | ) |
| **CASH AND CASH EQUIVALENTS - End of Period**                                         |       | $                                                                      | 36,000     |   | $ | 26,559 |   |
|                                                                                  |       |                                                                   |       |   |   |
| Supplementary Cash Flow Information:                                                  |       |                                                                   |       |   |   |
| Interest Paid:                                                                        |       |                                                                   |       |   |   |
| On Mandatorily Redeemable Units                                                       |       | $                                                                      | —     |   | $ | 18,995 |   |
| Other                                                                                 |       | $                                                                      | 982        |   | $ | — |   |
| Income Taxes Paid                                                                     |       | $                                                                      | —     |   | $ | — |   |

 

Seeaccompanying notes to consolidated financial statements

 

5

----

**PZENA INVESTMENT MANAGEMENT, INC.**

**(Prior to October 30, 2007 - PzenaInvestment Management, LLC)**

 

**UNAUDITED CONSOLIDATED STATEMENTS OF CHANGESIN EQUITY**

**(in thousands, except share and per-shareamounts)**

** **
| ** **                                                                   | ** ** | **Capital  Units** | ** ** | **Shares  of  Class A  Common Stock** | ** ** | **Shares  of  Class B  Common Stock** | ** ** | **Members’  Capital** | ** **  | **Class A  Common Stock** | ** ** | **Class B  Common Stock** | ** ** | **Additional  Paid-In Capital** | ** ** | **Accumulated  Other  Comprehensive  Income** | ** ** | **Retained  Earnings** | ** ** | **Excess  of Liabilities  Over Assets** | ** ** | **Total**   | ** ** |
|------------------------------------------------------------------------------|------------|--------------------|------------|---------------------------------------|------------|---------------------------------------|------------|----------------------------|-------------|---------------------------|------------|---------------------------|------------|---------------------------------|------------|-----------------------------------------------|------------|------------------------|------------|-----------------------------------------|------------|-------------|------------|
| **Balance  at December 31, 2007**                                            | ** ** | **—**         | ** ** | **6,111,118**                         | ** ** | **57,937,910**                        | ** ** | **$**                      | **—**  | ** **                | **$**      | **61**                    | ** ** | **$**                           | **—** | ** **                                    | **$**      | **(2,043**             | **)**      | **$**                                   | **—** | ** **  | **$**      | **61** | ** ** | **$** | **—** | ** ** | **$** | **(1,921** | **)** |
|                                                                         | ** ** | ** **         | ** ** | ** **                            | ** ** | ** **                            | ** ** | ** **                 | ** **  | ** **                | ** ** | ** **                | ** ** | ** **                      | ** ** | ** **                                    | ** ** | ** **             | ** ** | ** **                              | ** ** | ** **  | ** ** |
| Issuance of Class  A Common Stock                                            |       | —             |       | 12,376                                |       | —                                |       | —                     |        | —                    |       | —                    |       | 11                              | ** ** | —                                        |       | —                 |       | —                                  | ** ** | **11**      | ** ** |
|                                                                         | ** ** | ** **         | ** ** | ** **                            | ** ** | ** **                            | ** ** | ** **                 | ** **  | ** **                | ** ** | ** **                | ** ** | ** **                      | ** ** | ** **                                    | ** ** | ** **             | ** ** | ** **                              | ** ** | ** **  | ** ** |
| Issuance of Class  B Common Stock                                            |       | —             |       | —                                |       | 13,000                                |       | —                     |        | —                    |       | —                    |       | —                          | ** ** | —                                        |       | —                 |       | —                                  | ** ** | **—**  | ** ** |
|                                                                         | ** ** | ** **         | ** ** | ** **                            | ** ** | ** **                            | ** ** | ** **                 | ** **  | ** **                | ** ** | ** **                | ** ** | ** **                      | ** ** | ** **                                    | ** ** | ** **             | ** ** | ** **                              | ** ** | ** **  | ** ** |
| Net Income                                                                   |       | —             |       | —                                |       | —                                |       | —                     |        | —                    |       | —                    |       | —                          | ** ** | —                                        |       | 820                    |       | —                                  | ** ** | **820**     | ** ** |
|                                                                         | ** ** | ** **         | ** ** | ** **                            | ** ** | ** **                            | ** ** | ** **                 | ** **  | ** **                | ** ** | ** **                | ** ** | ** **                      | ** ** | ** **                                    | ** ** | ** **             | ** ** | ** **                              | ** ** | ** **  | ** ** |
| Amortization of  Deferred Compensation                                       |       | —             |       | —                                |       | —                                |       | —                     |        | —                    |       | —                    |       | 16                              | ** ** | —                                        |       | —                 |       | —                                  | ** ** | **16**      | ** ** |
|                                                                         | ** ** | ** **         | ** ** | ** **                            | ** ** | ** **                            | ** ** | ** **                 | ** **  | ** **                | ** ** | ** **                | ** ** | ** **                      | ** ** | ** **                                    | ** ** | ** **             | ** ** | ** **                              | ** ** | ** **  | ** ** |
| Accumulated Other  Comprehensive Income                                      |       | —             |       | —                                |       | —                                |       | —                     |        | —                    |       | —                    |       | —                          | ** ** | (46                                           | )          | —                 |       | —                                  | ** ** | **(46**     | **)**      |
|                                                                         | ** ** | ** **         | ** ** | ** **                            | ** ** | ** **                            | ** ** | ** **                 | ** **  | ** **                | ** ** | ** **                | ** ** | ** **                      | ** ** | ** **                                    | ** ** | ** **             | ** ** | ** **                              | ** ** | ** **  | ** ** |
| Equity Effect of  Operating Company Net Deficit on Non-Controlling Interests |       | —             |       | —                                |       | —                                |       | —                     |        | —                    |       | —                    |       | 6,923                           | ** ** | —                                        |       | —                 |       | —                                  | ** ** | **6,923**   | ** ** |
|                                                                         | ** ** | ** **         | ** ** | ** **                            | ** ** | ** **                            | ** ** | ** **                 | ** **  | ** **                | ** ** | ** **                | ** ** | ** **                      | ** ** | ** **                                    | ** ** | ** **             | ** ** | ** **                              | ** ** | ** **  | ** ** |
| Class A Cash  Dividends Declared ($0.11 per share)                           |       | —             |       | —                                |       | —                                |       | —                     |        | —                    |       | —                    |       | —                          | ** ** | —                                        |       | (674                   | )          | —                                  | ** ** | **(674**    | **)**      |
|                                                                         | ** ** | ** **         | ** ** | ** **                            | ** ** | ** **                            | ** ** | ** **                 | ** **  | ** **                | ** ** | ** **                | ** ** | ** **                      | ** ** | ** **                                    | ** ** | ** **             | ** ** | ** **                              | ** ** | ** **  | ** ** |
| **Balance  at March 31, 2008**                                               | ** ** | **—**         | ** ** | **6,123,494**                         | ** ** | **57,950,910**                        | ** ** | **$**                      | **—**  | ** **                | **$**      | **61**                    | ** ** | **$**                           | **—** | ** **                                    | **$**      | **4,907**              | ** ** | **$**                                   | **(46**    | **)**       | **$**      | **207** | ** ** | **$** | **—** | ** ** | **$** | **5,129** | ** ** |
| ** **                                                                   | ** ** | ** **         | ** ** | ** **                            | ** ** | ** **                            | ** ** | ** **                 | ** **  | ** **                | ** ** | ** **                | ** ** | ** **                      | ** ** | ** **                                    | ** ** | ** **             | ** ** | ** **                              | ** ** | ** **  | ** ** |
| **Balance  at December 31, 2006**                                            | ** ** | **—**         | ** ** | **—**                            | ** ** | **—**                            | ** ** | **$**                      | **—**  | ** **                | **$**      | **—**                | ** ** | **$**                           | **—** | ** **                                    | **$**      | **—**             | ** ** | **$**                                   | **—** | ** **  | **$**      | **—** | ** ** | **$** | **(729,966** | **)** | **$** | **(729,966** | **)** |
|                                                                         | ** ** | ** **         | ** ** | ** **                            | ** ** | ** **                            | ** ** | ** **                 | ** **  | ** **                | ** ** | ** **                | ** ** | ** **                      | ** ** | ** **                                    | ** ** | ** **             | ** ** | ** **                              | ** ** | ** **  | ** ** |
| Net Loss Before  Interest on Mandatorily Redeemable Units                    |       | —             |       | —                                |       | —                                |       | —                     |        | —                    |       | —                    |       | —                          | ** ** | —                                        |       | —                 |       | (71,500                                 | )          | **(71,500** | **)**      |
|                                                                         | ** ** | ** **         | ** ** | ** **                            | ** ** | ** **                            | ** ** | ** **                 | ** **  | ** **                | ** ** | ** **                | ** ** | ** **                      | ** ** | ** **                                    | ** ** | ** **             | ** ** | ** **                              | ** ** | ** **  | ** ** |
| Interest on  Mandatorily Redeemable Units                                    |       | —             |       | —                                |       | —                                |       | —                     |        | —                    |       | —                    |       | —                          | ** ** | —                                        |       | —                 |       | (16,575                                 | )          | **(16,575** | **)**      |
|                                                                         | ** ** | ** **         | ** ** | ** **                            | ** ** | ** **                            | ** ** | ** **                 | ** **  | ** **                | ** ** | ** **                | ** ** | ** **                      | ** ** | ** **                                    | ** ** | ** **             | ** ** | ** **                              | ** ** | ** **  | ** ** |
| Amortization of  Deferred Compensation                                       |       | —             |       | —                                |       | —                                |       | —                     |        | —                    |       | —                    |       | —                          | ** ** | —                                        |       | —                 |       | 1,901                                   | ** ** | **1,901**   | ** ** |
|                                                                         | ** ** | ** **         | ** ** | ** **                            | ** ** | ** **                            | ** ** | ** **                 | ** **  | ** **                | ** ** | ** **                | ** ** | ** **                      | ** ** | ** **                                    | ** ** | ** **             | ** ** | ** **                              | ** ** | ** **  | ** ** |
| Reclassification  of Liabilities to Capital Units                            |       | 12,755,744         |       | —                                |       | —                                |       | 875,096                    |        | —                    |       | —                    |       | —                          | ** ** | —                                        |       | (816,140               | )          | 816,140                                 | ** ** | **875,096** | ** ** |
|                                                                         | ** ** | ** **         | ** ** | ** **                            | ** ** | ** **                            | ** ** | ** **                 | ** **  | ** **                | ** ** | ** **                | ** ** | ** **                      | ** ** | ** **                                    | ** ** | ** **             | ** ** | ** **                              | ** ** | ** **  | ** ** |
| **Balance  at March 31, 2007**                                               | ** ** | **12,755,744**     | ** ** | **—**                            | ** ** | **—**                            | ** ** | **$**                      | **875,096** | ** **                | **$**      | **—**                | ** ** | **$**                           | **—** | ** **                                    | **$**      | **—**             | ** ** | **$**                                   | **—** | ** **  | **$**      | **(816,140** | **)** | **$** | **—** | ** ** | **$** | **58,956** | ** ** |

 

See accompanyingnotes to consolidated financial statements

 

6

----

 

**PZENA INVESTMENT MANAGEMENT, INC**

**(Prior to October 30, 2007, Pzena Investment Management, LLC)**

 

**UNAUDITED NOTES TO THE FINANCIALSTATEMENTS**

 

**Note 1—Organization**

 

Pzena Investment Management, Inc. (the “Company”) functions as theholding company through which the business of its operating company, PzenaInvestment Management, LLC, is conducted. The Company was incorporated in the State of Delaware on May 8,2007.  On May 10, 2007, the Companyissued 100 shares of its common stock for $100 to Richard S. Pzena, the soledirector of the Company as of that date. On October 30, 2007, the Company consummated an initial publicoffering of 6,100,000 shares of its Class A common stock, par value $0.01per share, for net proceeds of approximately $98.9 million, after paymentof underwriting discounts and offering expenses.  These net proceeds were used to purchase6,100,000 membership units of Pzena Investment Management, LLC,representing 9.5% of its then outstanding membership units, from its twooutside investors and one former employee. Concurrently with the consummationof the Company’s initial public offering, the Operating Agreement of PzenaInvestment Management, LLC (the “Operating Agreement”) was amended andrestated such that, among other things, the Company became the sole managingmember of Pzena Investment Management, LLC.  The acquisition of the operating company’smembership interests by Pzena Investment Management, Inc. has been treatedas a reorganization of entities under common control pursuant to the guidanceset forth in Financial Accounting Standards Board Technical Bulletin No. 85-5,*Issues Relating to Accounting for BusinessCombinations* (“FTB 85-5”). Accordingly, the net assets assumed by the Company through the offeringhave been reported at Pzena Investment Management, LLC’s historical costbasis.  As a result of thesetransactions, as of and subsequent to October 30, 2007, (i) theCompany has consolidated the financial results of Pzena InvestmentManagement, LLC with its own and reflected the membership interest in itthat it does not own as a non-controlling interest in its consolidatedfinancial statements, and (ii) the Company’s income will be generated byits economic interest in Pzena Investment Management, LLC’s netincome.  Reported results for the periodsprior to October 30, 2007 reflect solely the operations of PzenaInvestment Management, LLC.

 

Pzena Investment Management, LLC is an investment adviser which isregistered under the Investment Advisers Act of 1940 and is headquartered inNew York, New York.  As of March 31,2008, the Company managed assets in a variety of value-oriented investmentstrategies across a wide range of market capitalizations in both U.S. andinternational capital markets.

 

The Company, though its investment in its operating company, hasconsolidated the results of operations and financial condition of the followingprivate investment partnerships as of March 31, 2008:

 
| **Entity**                                   | ** ** | **Type of Entity (Date of Formation)** | ** ** | **Ownership at  March 31,  2008** | ** ** |
|----------------------------------------------|------------|-----------------------------------------------------------------|------------|---------------------------------------------|------------|
| Pzena Large Cap Value Fund                   |       | Massachusetts Trust  (11/1/2002)                                |       | 99.6%                                       |       |
| Pzena Large Cap Value Fund II                |       | Massachusetts Trust  (8/1/2006)                                 |       | 99.9%                                       |       |
| Pzena International Value Service            |       | Delaware Limited Liability  Company (12/22/2003)                |       | 2.2%                                        |       |
| Pzena Global Value Service                   |       | Delaware Limited Liability  Company (12/22/2003)                |       | 0.0%                                        |       |
| Pzena Emerging Markets Value Service         |       | Delaware Limited Liability  Company (12/28/2006)                |       | 21.0%                                       |       |
| Pzena Mega Cap Value Fund                    |       | Massachusetts Trust  (2/23/2007)                                |       | 99.9%                                       |       |
| Pzena Value Partners                         |       | Limited Partnership (1/22/2008)                                 |       | 16.8%                                       |       |
| Pzena Emerging Markets Country Value Service |       | Delaware Limited Liability  Company (12/28/2007)                |       | 99.9%                                       |       |
| Pzena Emerging Markets Focused Value Service |       | Delaware Limited Liability  Company (12/28/2007)                |       | 99.9%                                       |       |

 

7

----

 

**PZENA INVESTMENT MANAGEMENT, INC**

**(Prior to October 30, 2007, Pzena Investment Management, LLC)**

 

**UNAUDITED NOTES TO THE FINANCIAL STATEMENTS (CONTINUED)**

 

Pursuant to its Operating Agreement, the operating company willcontinue until December 31, 2026, unless a terminating event, as definedin the Operating Agreement, occurs prior to this date. Operating companymembers are not liable for repayment, satisfaction or discharge of any debts,liabilities or obligations of the operating company, except to the extent oftheir capital accounts.

 

**Note 2—Significant Accounting Policies**

 

***Basis of Presentation:***

 

The consolidated financial statements are prepared in conformity withU.S. generally accepted accounting principles and related Securities andExchange Commission rules and regulations. The Company’s policy is to consolidate all majority-owned subsidiariesin which it has a controlling financial interest and variable interest entitieswhere the Company is deemed to be the primary beneficiary.  The Company also consolidatesnon-variable-interest entities in which it acts as the general partner ormanaging member.  All significant inter-companytransactions and balances have been eliminated.

 

In addition to the results of its operating company, the consolidatedfinancial statements of the Company include the results of operations andfinancial condition of the Pzena Large Cap Value Fund, the Pzena Large CapValue Fund II, the Pzena Emerging Markets Value Service, the Pzena EmergingMarkets Country Value Service, the Pzena Emerging Markets Focused ValueService, Pzena Value Partners and the Pzena Mega Cap Value Fund as of, andfrom, the dates of their formation. Pursuant to the guidance of Emerging Issues Task Force Issue 04-5, *Determining Whether a General Partner, or the GeneralPartners as a Group, Controls a Limited Partnership or Similar Entity When theLimited Partners Have Certain Rights* (“EITF 04-5”), the resultsof operations and financial condition of the Pzena International Value Serviceand the Pzena Global Value Service were consolidated January 1, 2006,while the Pzena Emerging Markets Value Service was consolidated since December 31,2007.  Pzena Value Partners was similarlyconsolidated as of and from the date of its formation.  The Pzena Investment Management Select Fund wasconsolidated through January 23, 2007, the date of its liquidation.  All of these entities represent privateinvestment partnerships over which the Company exercises or exercisedcontrol.  Non-controlling interestsrecorded on the consolidated financial statements of the Company includes thenon-controlling interests of the outside investors in each of these entities aswell as that of the operating company.

 

These consolidated investment partnerships are investment companiesunder the American Institute of Certified Public Accountants Audit andAccounting Guide for Investment Companies (the “AICPA Guide”).  The Company has retained the specializedaccounting for these partnerships pursuant to Emerging Issues Task Force Issue No. 85-12,*Retention of Specialized Accounting forInvestments in Consolidation* (“EITF 85-12”).  Thus, the Company reports the investmentpartnerships’ investments in marketable securities and securities sold short atfair value, with net realized and unrealized gains and losses reported inearnings in the consolidated statements of operations.

 

Non-controlling interests in the operations of the Company’sconsolidated subsidiaries are comprised of the following:

 

8

----

 

**PZENA INVESTMENT MANAGEMENT, INC**

**(Prior to October 30, 2007, Pzena Investment Management, LLC)**

 

**UNAUDITEDNOTES TO THE FINANCIAL STATEMENTS (CONTINUED)**

 
| ** **                                                   | ** ** | **For the Three Months  Ended March 31,** | ** ** |
|--------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                   | ** ** | **2008**                                                           | ** ** | **2007** | ** ** |
| ** **                                                   | ** ** | **(in thousands)**                                            | ** ** |
|                                                         |       |                                                               |       |   |   |
| Non-Controlling Interest of Pzena Investment Management, LLC |       | $                                                                  | 13,477     |   | $ | — |   |
| Non-Controlling Interest in Consolidated Subsidiaries        |       | (1,900                                                             | )          | (9 | ) |
| Non-Controlling Interests                                    |       | $                                                                  | 11,577     |   | $ | (9 | ) |

 

As discussed further in Note 15, the Company has not recorded anon-controlling interest associated with the acquisition of its operatingcompany, as the post offering net equity of the operating company was less thanzero.  Pursuant to the guidance inEmerging Issues Task Force Issue No. 95-7, *Implementation Issues Related to theTreatment of Minority Interest in Certain Real Estate Trusts*(“EITF 95-7”), an operating company non-controlling interest will not berecorded until the initial deficit that existed at acquisition is extinguished.

 

The Company acts as the investment manager for four trusts and oneoffshore investment company, each of which are considered variable-interestentities.  All of these entities arevehicles through which the Company offers its Global Value and/or InternationalValue strategies.  The Company is notconsidered the primary beneficiary of any of these entities.  Correspondingly, their results of operationsand financial condition are not consolidated by the Company.  The total net assets of thesevariable-interest entities were approximately $809.6 million and$902.8 million at March 31, 2008 and December 31, 2007,respectively.  The Company is not exposedto losses as a result of its involvement with these entities because it has nodirect investment in them.

 

Investments in private investment partnerships in which the Company hasa minority interest and exercises significant influence are accounted for usingthe equity method.  Such investments, ifany, are reflected on the consolidated statements of financial condition asinvestments in affiliates and are recorded at the amount of capital reported bythe respective private investment partnerships. Such capital accounts reflect the contributions paid to, distributionsreceived from, and the equity earnings of, the private investmentpartnerships.  The earnings of theseprivate investment partnerships are included in equity in earnings/(loss) ofaffiliates in the consolidated statements of operations.

 

Prior to March 31, 2007, the operating company’s membership unitswere categorized as either Compensatory Units or Capital Units.  Because both types of units had features ofboth debt and equity, the operating company accounted for them pursuant toStatement of Financial Accounting Standards No. 123(R), *Share-Based Payment* (“FAS 123(R)”),and Statement of Financial Accounting Standards No. 150, *Accounting for Certain Financial Instruments WithCharacteristics of Both Liabilities and Equity* (“FAS 150”), asdescribed further below.

 

Compensatory Units consisted of units that were granted to employeesand members for services rendered. Through March 31, 2007, the distributions associated with theseunits, and the subsequent incremental increase or decrease in their redemptionvalue, were accounted for as part of compensation and benefits expense on theconsolidated statements of operations, as further discussed below.

 

Capital Units included units issued to founders and those purchased bycertain employees. Through March 31, 2007, the distributions associatedwith these units, and the subsequent incremental increase or decrease in theirredemption value, were accounted for as part of interest in mandatorilyredeemable units on the consolidated statements of operations.

 

9

----

 

**PZENA INVESTMENT MANAGEMENT, INC**

**(Prior to October 30, 2007, Pzena Investment Management, LLC)**

 

**UNAUDITED NOTES TO THE FINANCIAL STATEMENTS (CONTINUED)**

 

Effective March 31, 2007, the operating company amended itsOperating Agreement to remove all mandatory redemption provisions.  As all of its membership units thereafter hadonly equity characteristics, neither distributions, nor subsequent incrementalchanges to their value, were charged against income from the effective date ofthe amendment.

 

***Management’s Use of Estimates:***

 

The preparation of financial statements in conformity with U.S.generally accepted accounting principles requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities,disclosure of contingent assets and liabilities at the date of the financialstatements, and the reported amounts of revenues and expenses for theperiod.  Actual results could differ fromthose estimates.

 

***Fair Values of FinancialInstruments:***

 

The carrying amount of all financial instruments in the consolidatedstatements of financial condition, including marketable securities,approximates their fair values.

 

***Revenue Recognition:***

 

Revenue, comprised of advisory fee income, is recognized over theperiod in which investment management services are provided.  Advisory fee income includes management feesthat are calculated based on percentages of assets under management, generallybilled quarterly, either in arrears or advance, depending on their contractualterms.  Advisory fee income also includesincentive fees that may be earned by the Company depending on the investmentreturn of the assets under management. Incentive fee arrangements generallyentitle the Company to participate, on a fixed-percentage basis, in any returnsgenerated in excess of an agreed-upon benchmark.  The Company’s participation percentage insuch return differentials is then multiplied by assets under management todetermine the incentive fees earned. Returns are calculated on an annualized basis over the contract’smeasurement period, which may extend up to three years.  Incentive fees are generally payableannually.  Pursuant to the preferredaccounting method under Emerging Issues Task Force Issue D-96, *Accounting for Management Fees Based on a Formula*(“EITF D-96”), such incentive fee income is recorded at the conclusion of thecontractual performance period when all contingencies are resolved.  The Company recognized no such incentive feesfor the three months ended March 31, 2008 and 2007.

 

***Unit-based Compensation:***

 

Until March 31, 2007, compensation and benefits expense includedthe distributions made on Compensatory Units outstanding, as well as theincremental increases or decreases in the redemption values of these unitssubsequent to their grant date over their vesting period.  Distributions were generally paid on theoperating company’s income before non-cash compensation charges.  Redemption values were determined based onfair value.

 

The Operating Agreement was amended as of March 31, 2007 toeliminate the obligation to redeem units under any circumstance.  Since all Compensatory Units thereafter hadonly equity characteristics, neither distributions, nor subsequent incrementalchanges to these units’ value, were charged against income subsequent to March 31,2007.  In addition, as of March 31,2007, the operating company accelerated the vesting of all Compensatory Unitsthen subject to vesting.  The operatingcompany recorded a $65.0 million one-time charge in compensation and benefitsexpense which was associated with this acceleration as of March 31, 2007.

 

10

----

 

**PZENA INVESTMENT MANAGEMENT, INC**

**(Prior to October 30, 2007, Pzena Investment Management, LLC)**

 

**UNAUDITEDNOTES TO THE FINANCIAL STATEMENTS (CONTINUED)**

 

***Interest on Mandatorily RedeemableUnits:***

 

Until the amendment of its Operating Agreement on March 31, 2007,the operating company recorded a net liability for its Capital Units equal tothe accumulated redemption value as of the balance sheet date of all suchoutstanding units.  This liability alsoincluded any undistributed earnings attributable to such units. As such,interest on mandatorily redeemable units included distributions made on CapitalUnits outstanding, as well as the incremental increases or decreases in theredemption values of these units. Distributions are generally paid on the operating company’s incomebefore non-cash compensation charges. Redemption values were determined basedon fair value.

 

Prior to March 31, 2007, Capital Units were required to beredeemed on the death of a member. Effective March 31, 2007, the OperatingAgreement was amended to eliminate the obligation to redeem units under anycircumstance.  Since all Capital Unitsthereafter had only equity characteristics, neither distributions, norsubsequent incremental changes to these units’ value, were charged againstincome subsequent to the effective date of the amendment.  The $16.6 million charge recorded in2007 represents the distributions and incremental changes to these units’ fairvalue through March 31, 2007.

 

***Compensatory Units Subject toMandatory Redemption:***

 

Until the amendment of its Operating Agreement on March 31, 2007,the operating company recorded a net liability for its Compensatory Units equalto the accumulated redemption value as of the balance sheet date of all suchoutstanding units.  This liability alsoincluded any undistributed earnings attributable to such units.

 

Prior to March 31, 2007, vested Compensatory Units were requiredto be redeemed on the death of a member. Effective March 31, 2007, theoperating company amended its Operating Agreement to remove all mandatoryredemption provisions.  As of that date,the liability associated with these units was reclassified as equity.  Further, as of March 31, 2007, theoperating company accelerated the vesting of all Compensatory Units thensubject to vesting.

 

***Earnings per Share:***

 

Prior to October 30, 2007, reported results of operations aresolely those of Pzena Investment Management, LLC.  As the operating company is a private limitedliability corporation, no historical earnings per share calculations have beenreported prior to this date.  Subsequentto October 30, 2007, earnings per share reflect the per share allocationof the Company’s economic interest in its operating company.

 

Basic earnings per share is computed by dividing the Company’s netincome by the weighted-average number of shares outstanding during thereporting period.  Diluted net income pershare adjusts this calculation to reflect the impact of all outstandingoperating company membership units as well as outstanding options and phantomoperating units to the extent that they would have a dilutive effect on netincome per share for the reporting period. Net income for diluted earnings per share assumes all operating companymembership units are converted into Company stock at the beginning of thereporting period and the resulting change to Company net income associated withits increased interest in the operating company is taxed at the Company’seffective tax rate.  For the three monthsended March 31, 2008, approximately 954,310 options to purchase operatingcompany units freely convertible into Company common stock and 89,826 phantomoperating units were excluded from the calculation of diluted net income pershare, as their inclusion would have had an antidilutive effect for the period.

 

11

----

 

**PZENA INVESTMENT MANAGEMENT, INC**

**(Prior to October 30, 2007, Pzena Investment Management, LLC)**

 

**UNAUDITED NOTES TO THE FINANCIAL STATEMENTS (CONTINUED)**

 

TheCompany’s  basic and diluted earnings pershare, generated from its economic interest in the operating company, weredetermined as follows (in thousands, except for share and per-share amounts):

 
| Net Income for Basic Earnings per Share     |   | $          | 820    |   |
|---------------------------------------------|--------|------------|--------|--------|
| Basic Weighted Average Shares Outstanding   |   | 6,119,686  |   |
| Basic Earnings per Share                    |   | $          | 0.13   |   |
|                                        |   |       |   |
| Net Income for Diluted Earnings per Share   |   | $          | 8,597  |   |
| Basic Weighted Average Shares Outstanding   |   | 6,119,686  |   |
| Dilutive Effect of Operating Company Units  |   | 57,950,910 |   |
| Diluted Weighted Average Shares Outstanding |   | 64,070,596 |   |
| Diluted Earnings per Share                  |   | $          | 0.13   |   |

 

***Cash and Cash Equivalents:***

 

The Company considers all highly-liquid debt instruments with anoriginal maturity of three months or less at the time of purchase to be cashequivalents.

 

Interest on cash and cash equivalents is recorded as interest income onthe consolidated statements of operations.

 

***Due to/from Broker:***

 

Due to/from broker consists primarily of cash balances and amountsreceivable/payable for unsettled securities transactions held/initiated at theclearing brokers of the Company’s consolidated investment partnerships.

 

***Investments in Securities:***

 

Investments in marketable securities and securities sold shortrepresent primarily the securities held by the Company’s consolidatedinvestment partnerships.  All suchsecurities are recorded at fair value, with net realized and unrealized gainsand losses reported in earnings in the consolidated statements of operations.

 

The Company adopted the provisions of Statement of Financial AccountingStandard No. 157, *Fair Value Measurements*(“FAS 157”), on January 1, 2008.  FAS157 defines fair value as the price that would be received to sell an asset orpaid to transfer a liability in an orderly transaction between marketparticipants at the measurement date. FAS 157 also establishes a framework for measuring fair value and avaluation hierarchy based upon the transparency of inputs used in the valuationof an asset or liability.  Classificationwithin the hierarchy is based upon the lowest level of input that issignificant to the fair value measurement. The valuation hierarchy containsthree levels:(i) valuation inputs are unadjustedquoted market prices for identical assets or liabilities in active markets(Level 1); (ii) valuation inputs are quoted prices for identical assets orliabilities in markets that are not active, quoted market prices for similarassets and liabilities in active markets and other observable inputs directlyor indirectly related to the asset or liability being measured (Level 2) and; (iii) valuationinputs are unobservable and significant to the fair value measurement (Level 3).

 

The Company’s fair value measurements relate to its interest rate swapas well as its investments in marketable securities and securities sold short,which are primarily exchange-traded securities with quoted prices in activemarkets. The fair value measurements of the securities have been classified asLevel 1. The fair value measurement of the interest rate swap has been determinedprimarily based upon the market prices for interest rate swaps with similarprovisions and forward interest rate curves, and has been classified asLevel 2.

 

12

----

 

**PZENA INVESTMENT MANAGEMENT, INC**

**(Prior to October 30, 2007, Pzena Investment Management, LLC)**

 

**UNAUDITED NOTES TO THE FINANCIAL STATEMENTS (CONTINUED)**

 

The following table presents these instruments’ fair value at March 31,2008 (in thousands):

 
| ** **            | ** ** | **Level 1** | ** ** | **Level 2** | ** ** | **Level 3** | ** ** |
|-----------------------|------------|------------------|------------|------------------|------------|------------------|------------|
|                  |       |             |       |             |       |             |       |
| Marketable Securities |       | $                | 36,545     |             | $          | —           |       | $ | — |   |
| Securities Sold Short |       | (3,518           | )          | —           |       | —           |       |
| Interest Rate Swap    |       | —           |       | (477             | )          | —           |       |
| Total Fair Value      |       | $                | 33,027     |             | $          | (477             | )          | $ | — |   |

 

***Securities Valuation:***

 

Investments in marketable equity securities and securities sold shortwhich are traded on a national securities exchange are carried at fair valuebased on the last reported sales price on the valuation date.  If no reported sales occurred on thevaluation date, investments in securities are valued at the bid price andsecurities sold short are valued at the ask price. Securities transactions arerecorded on the trade date.

 

The net realized gain or loss on sales of securities and securities soldshort is determined on a specific identification basis and is included inrealized and unrealized gain/(loss), net on marketable securities andsecurities sold short in the consolidated statements of operations.

 

***Concentrations of Credit Risk:***

 

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

 

The concentration of credit risk with respect to advisory feesreceivable is generally limited due to the short payment terms extended toclients by the Company.  On a periodicbasis, the Company evaluates its advisory fees receivable and establishes anallowance for doubtful accounts, if necessary, based on a history of pastwrite-offs and collections and current credit conditions.  For the three months  ended March 31, 2008 and 2007,approximately 16% and 22%, respectively, of the Company’s advisory fees weregenerated from an advisory agreement with one client.  At March 31, 2008 and December 31,2007, no allowance for doubtful accounts has been deemed necessary.

 

***Financial Instruments:***

 

The operating company has entered into an interest rate swap agreementto manage its exposure to changes in interest rates associated with itsthree-year, $60.0 million term loan facility. This instrument was not entered into for trading purposes.  The counterparty to this agreement is a majorfinancial institution.    Pursuant toStatement of Financial Accounting Standards No. 133, *Accounting for Derivative Instruments and CertainHedging Activities*(“FAS 133”), the Company records this cashflow hedge at fair value as a component of other liabilities on theconsolidated statement of financial position. The Company’s pro rata share of the changes in the fair value of thisagreement are recorded as a component of accumulated other comprehensiveincome.  At March 31, 2008, theapproximate fair value of this swap agreement was negative $0.5 million.

 

***Property and Equipment:***

 

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

 

13

----

 

**PZENA INVESTMENT MANAGEMENT, INC**

**(Prior to October 30, 2007, Pzena Investment Management, LLC)**

 

**UNAUDITEDNOTES TO THE FINANCIAL STATEMENTS (CONTINUED)**

 

***Business Segments:***

 

The Company views its operations as comprising one operating segment.

 

***Income Taxes:***

 

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

 

The Company and its consolidated subsidiaries account for all state,local and federal taxation pursuant to the asset and liability method, whichrequires deferred income tax assets and liabilities to be recorded fortemporary differences between the financial statement and tax bases of assetsand liabilities that will result in taxable or deductible amounts in thefuture, based on enacted tax laws and rates applicable to the periods in whichthe temporary differences are expected to affect taxable income. Valuationallowances are established, when necessary, to reduce deferred tax assets tothe amount expected to be realized. At March 31, 2008 and December 31,2007, no such valuation allowances were deemed necessary.  The income tax provision, or credit, is thetax payable or refundable for the period, plus or minus the change during theperiod in deferred tax assets and liabilities.

 

***Foreign Currency:***

 

Investment securities and other assets and liabilities denominated inforeign currencies are translated into U.S. dollar amounts at the date ofvaluation.  Purchases and sales ofinvestment securities and income and expense items denominated in foreigncurrencies are translated into U.S. dollar amounts on the respective dates ofsuch transactions.

 

The Company does not isolate that portion of the results of itsoperations resulting from changes in foreign exchange rates on investments fromthe fluctuations arising from changes in market prices of securities held.  Such fluctuations are included in the netrealized and unrealized gain/(loss), net on marketable securities and securitiessold short.

 

Reported net realized foreign exchange gains or losses arise from salesof foreign currencies, currency gains or losses realized between the trade andsettlement dates on securities transactions, and the difference between theamounts of dividends, interest, and foreign withholding taxes recorded on theCompany’s books and the U.S. dollar equivalent of the amounts actually receivedor paid.  Net unrealized foreign exchangegains and losses arise from changes in the fair values of assets andliabilities resulting from changes in exchange rates.

 

***New Accounting Pronouncements:***

 

In February 2007, the FASB issued Statement of FinancialAccounting Standards No. 159, *The Fair Value Option forFinancial Assets and Financial Liabilities*(*“*FAS159”).  FAS 159 permits an entity toelect to measure certain financial instruments and certain other items at fairvalue with changes in fair value recognized in earnings.  FAS 159 is effective for fiscal yearsbeginning after November 15, 2007. Since the Company chose not to elect this fair value option, the impactof the adoption of this statement was not material.

 

14

----

 

**PZENA INVESTMENT MANAGEMENT, INC**

**(Prior to October 30, 2007, Pzena Investment Management, LLC)**

 

**UNAUDITEDNOTES TO THE FINANCIAL STATEMENTS (CONTINUED)**

 

In December 2007, the FASB issued Statement of FinancialAccounting Standards No. 141 (revised 2007), *Business Combinations* (“FAS 141R”) which replacesStatement of Financial Accounting Standards No. 141, *Business Combinations*. FAS 141Restablishes the principles and requirements for how an acquirer: (i) recognizesand measures in its financial statements the identifiable assets acquired, theliabilities assumed, and any noncontrolling interest in the acquiree; (ii) recognizesand measures the goodwill acquired in the business combination or a gain from abargain purchase; and (iii) discloses the business combination.  FAS 141R applies to all transactions in whichan entity obtains control of one or more businesses, including transactionsthat occur without the transfer of any type of consideration. FAS 141R iseffective on a prospective basis for all business combinations on or after December 15,2008, with the exception of the accounting for valuation allowances on deferredtaxes and acquired tax contingencies. Early adoption is not allowed. The Company is in the process of assessing the impact of this standardon its consolidated financial statements.

 

In December 2007, the FASB issued Statement of FinancialAccounting Standards No. 160, *NoncontrollingInterests in Consolidated Financial Statements—an amendment of ARB No. 51*(“FAS 160”). FAS 160 amends ARB No. 51 and establishesaccounting and reporting standards that require noncontrolling interests(previously referred to as minority interest) to be reported as a component ofequity, changes in a parent’s ownership interest while the parent retains itscontrolling interest be accounted for as equity transactions, and upon a lossof control, retained ownership interest will be remeasured at fair value, withany gain or loss recognized in earnings. FAS 160 is effective for theCompany on January 1, 2009, except for the presentation and disclosurerequirements, which will be applied retrospectively.  Early adoption is not allowed.  The Company is in the process of assessingthe impact of this standard on its consolidated financial statements.

 

In March 2008, the FASB issued Statement of Financial AccountingStandards No. 161, *Disclosures aboutDerivative Instruments and Hedging Activities*(“FAS 161”)*.*FAS 161 is intended to improve financial reporting about derivativeinstruments and hedging activities by requiring enhanced disclosures to enableinvestors to better understand their effects on an entity’s financial position,financial performance, and cash flows. It is effective for financial statements issued for fiscal years andinterim periods beginning after November 15, 2008.  The Company is in the process of assessingthe impact of this standard on its consolidated financial statements.

 

**Note 3—Property and Equipment**

 

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

 

15

----

 

**PZENA INVESTMENT MANAGEMENT, INC**

**(Prior to October 30, 2007, Pzena Investment Management, LLC)**

 

**UNAUDITED NOTES TO THE FINANCIAL STATEMENTS (CONTINUED)**

 
| ** **                                      | ** ** | **As of**          | ** ** |
|-------------------------------------------------|------------|-------------------------|------------|
| ** **                                      | ** ** | **March 31,**      | ** ** | **December 31,** | ** ** |
| ** **                                      | ** ** | **2008**                | ** ** | **2007** | ** ** |
| ** **                                      | ** ** | **(in thousands)** | ** ** |
|                                            |       |                    |       |   |   |
| Computer Hardware                               |       | $                       | 836        |   | $ | 796 |   |
| Computer Software                               |       | 156                     |       | 152 |   |
| Furniture and Fixtures                          |       | 1,162                   |       | 1,156 |   |
| Office Equipment                                |       | 243                     |       | 243 |   |
| Leasehold Improvements                          |       | 2,228                   |       | 2,228 |   |
| Total                                           |       | 4,625                   |       | 4,575 |   |
| Less: Accumulated Depreciation and Amortization |       | (1,527                  | )          | (1,412 | ) |
| Total                                           |       | $                       | 3,098      |   | $ | 3,163 |   |

 

Depreciation and amortization expense, included in general andadministrative expenses, totaled $0.1 million and $0.1 million for thethree months ended March 31, 2008 and 2007, respectively.

 

**Note 4—Related Party Transactions**

 

For the three months ended March 31, 2008 and 2007, the Companyearned $1.8 million and $1.5 million, respectively, in investmentadvisory fees from unconsolidated entities for which it acts as the investmentmanager.

 

At March 31, 2008 and December 31, 2007, the Company hadadvanced $0.1 million and $0.1 million, respectively, to aninternational investment company for organization and start-up costs, which areincluded in receivable from related parties on the consolidated statements offinancial condition.  The Company is thesponsor and investment manager of this entity.

 

At March 31, 2008 and December 31, 2007, receivable fromrelated parties included $0.1 million and $0.1 million, respectively,of loans to employees.  These loans arein the form of forgivable promissory notes which are amortized throughcompensation expense pursuant to their terms.

 

Employees of the Company who are considered accredited investors havethe ability to open separately-managed accounts, or invest in certain of theCompany’s consolidated investment partnerships, without being assessed advisoryfees.  Investments by employees inseparately-managed accounts are permitted only at the discretion of theExecutive Committee of the Company, but are generally not subject to the sameminimum investment levels that are required of outside investors.  Some of the investment advisory fees that arewaived on separately managed accounts for employees are for strategies thattypically have account fee minimums, which vary by strategy, but typicallyaverage approximately $50,000 per account per year.

 

**Note 5—Investments in Affiliates**

 

The Company held an investment in, and acted as manager of, anunconsolidated investment partnership which was accounted for under the equitymethod.  Summary financial informationrelated to this entity is as follows:

 

16

----

 

**PZENA INVESTMENT MANAGEMENT, INC**

**(Prior to October 30, 2007,Pzena Investment Management, LLC)**

 

**UNAUDITED NOTES TO THE FINANCIALSTATEMENTS (CONTINUED)**

 
| ** **                       | ** ** | **PAI Hedged Value Fund, LLC**                 | ** ** |
|----------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                       | ** ** | **For the Three Months  Ended March 31,** | ** ** |
| ** **                       | ** ** | **2008**                                                           | ** ** | **2007** | ** ** |
| ** **                       | ** ** | **(in thousands)**                                            | ** ** |
|                             |       |                                                               |       |   |   |
| Net Investment Income            |       | $                                                                  | —     |   | $ | 5 |   |
| Net Realized and Unrealized Loss |       | —                                                             |       | (145 | ) |
| Net Loss                         |       | $                                                                  | —     |   | $ | (140 | ) |
| Company’s Equity in Loss    |       | $                                                                  | —     |   | $ | (42 | ) |
| Ownership Percentage             |       | 0                                                                  | %          | 29 | % |

 

 In the fourth quarter of 2007, the decisionwas made to dissolve the PAI Hedged Value Fund, LLC. This entity wasconsolidated beginning October 1, 2007, the effective date of thewithdrawal of the external joint venture partner, until it was fully liquidatedon December 28, 2007.

** **

**Note 6—Commitments and Contingencies**

 

Inthe normal course of business, the Company enters into agreements that includeindemnities in favor of third parties, such as engagement letters with advisorsand consultants.  In certain cases, theCompany may have recourse against third parties with respect to theseindemnities.  The Company maintainsinsurance policies that may provide coverage against certain claims under theseindemnities. FASB issued Interpretation No. 45, *Guarantor’s Accounting and Disclosure Requirements for Guarantees, IncludingIndirect Guarantees of Indebtedness of Others* (“FIN 45”),providing accounting and disclosure requirements for certain guarantees.  The Company has had no claims or paymentspursuant to these agreements, and it believes the likelihood of a claim beingmade is remote.  Utilizing themethodology in FIN 45, the Company’s estimate of the value of suchguarantees is de minimis, and, therefore, an accrual has not been made in theconsolidated financial statements.

 

Inthe normal course of business, the Company may be subject to various legal andadministrative proceedings. On November 21, 2007 and January 16,2008, respectively, substantively identical putative class action lawsuits werecommenced in the United States District Court for the Southern District of NewYork against the Company and Richard S. Pzena, our chief executive officer,seeking remedies under Section 11 of the Securities Act of 1933, asamended. The Court consolidated the lawsuits and appointed co-lead plaintiffs,who filed a consolidated amended complaint.  The consolidated amendedcomplaint names as defendants the Company, Richard S. Pzena, and two of theunderwriters of our initial public offering, Goldman Sachs &Co., Inc. and UBS Securities LLC. Plaintiffs seek to represent a class of all persons who purchased orotherwise acquired Class A common stock issued pursuant or traceable tothe Company’s initial public offering.  The consolidated amended complaintalleges that the registration statement and prospectus relating to the initial publicoffering of the Company’s Class A common stock contained materialmisstatements and omissions and wrongfully failed to disclose net redemptionsin the John Hancock Classic Value Fund for which the Company acts assub-investment advisor.  The consolidated amended complaint seeks damagesin an unspecified amount including rescission or rescissory damages.  TheCompany believes that the allegations and claims are without merit and intendsto contest these claims vigorously.

 

17

----

 

**PZENA INVESTMENT MANAGEMENT, INC**

**(Prior to October 30, 2007,Pzena Investment Management, LLC)**

 

**UNAUDITED NOTES TO THE FINANCIALSTATEMENTS (CONTINUED)**

 

TheCompany leases office space under a non-cancelable operating lease agreementwhich expires on October 31, 2015. The Company reflects lease expense over the lease term on astraight-line basis. In early 2007, the Company agreed to lease additionaloffice space at the Company’s headquarters at 120 West 45th Street, NewYork, New York.  The Company tookpossession of this space on March 1, 2007. The new lease is co-terminuswith the Company’s existing lease.

 

Leaseexpenses for the three months ended March 31, 2008 and 2007 were$0.6 million and $0.3 million, respectively.

 

**Note 7—Retirement Plan**

 

TheCompany maintains a defined contribution pension plan which coverssubstantially all members and employees. The Company may make contributions to the plan at the discretion ofmanagement. Under the terms of the plan, all such contributions vestimmediately.  Company contributions forthe three months ended March 31, 2008 and 2007 were $0.5 million and$0.4 million, respectively.  Theseexpenses are included in compensation and benefits expense in the consolidatedstatements of operations.

 

**Note 8—Compensation and Benefits**

 

Asdiscussed further in Note 14, the operating company issued CompensatoryUnits to employees and members which had redemption features that required themto be classified as liabilities in the consolidated statements of financialcondition prior to March 31, 2007. Until this date, distributions on the Compensatory Units outstanding,and changes in these units’ redemption values, were recorded as compensationand benefits expense.

 

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

 
| ** **                                       | ** ** | **For the Three Months  Ended March 31,** | ** ** |
|--------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                       | ** ** | **2008**                                                           | ** ** | **2007** | ** ** |
|                                             |       | **(in thousands)**                                            |       |
|                                             |       | ** **                                                         |       |   |   |
| Cash Compensation and Other Benefits             |       | $                                                                  | 8,607      |   | $ | 8,899 |   |
| Distributions on Compensatory Units              |       | —                                                             |       | 12,087 |   |
| Change in Redemption Value of Compensatory Units |       | —                                                             |       | 15,969 |   |
| Acceleration of Vesting of Compensatory Units    |       | —                                                             |       | 64,968 |   |
| Other Non-Cash Compensation                      |       | 344                                                                |       | 1,901 |   |
| Total Compensation and Benefits Expense          |       | $                                                                  | 8,951      |   | $ | 103,824 |   |

 

 Distributions on Compensatory Units includescash distributions paid on, as well as the net increase or decrease inundistributed earnings attributable to, Compensatory Units.

 

Asof March 31, 2007, the effective date of the amendment to the OperatingAgreement to eliminate the operating company’s obligation to redeem units underany circumstance, the unit-based compensation awards

 

18

----

 

**PZENA INVESTMENT MANAGEMENT, INC**

**(Prior to October 30, 2007,Pzena Investment Management, LLC)**

 

**UNAUDITED NOTES TO THE FINANCIALSTATEMENTS (CONTINUED)**

 

previouslycategorized as liabilities were reclassified as equity.  Further, as of March 31, 2007, theoperating company accelerated the vesting of all Compensatory Units thensubject to vesting. Subsequent to this date, distributions on these units arenot considered a component of compensation and benefits expense and are insteadrecorded as a direct reduction of members’ capital.

 

Thechange in liability for the redemption of Compensatory Units, through the dateof the amendment of the Operating Agreement described above, is as follows:

 
| ** **                                               | ** ** | **(in thousands)** | ** ** |
|----------------------------------------------------------|------------|-------------------------|------------|
|                                                     |       |                    |       |
| Balance at December 31, 2006                        |       | $                       | 263,980    |   |
| Value of Units Vested During the Year                    |       | 79,199                  |       |
| Increase in Value of Units Previously Vested             |       | 1,738                   |       |
| Change in Undistributed Earnings                         |       | —                  |       |
| Compensation Expense Associated with Unvested Units      |       | —                  |       |
| Payment of Liabilities                                   |       | (953                    | )          |
| Reclassification due to Amendment of Operating Agreement |       | (343,964                | )          |
| Balance at March 31, 2007                           |       | $                       | —     |   |

 

Forthe three months ended March 31, 2008 and 2007, the operating companygranted 446,000 and 630,000, respectively, options to purchase Capital Units tocertain members pursuant to the Pzena Investment Management, LLC 2006Equity Incentive Plan.  These options hadvarying vesting schedules and were issued at strike prices equal to theassessed fair market value per unit at the time of award issuance.  The Company determined that the totalgrant-date fair value of the options awarded during the three months endedMarch 31, 2008 and 2007 was approximately $1.2 million and$1.9 million, respectively.   Forthe three months ended March 31, 2008 and 2007, the Company recognizedapproximately $0.1 million and $1.9 million, respectively, in compensation andbenefits expense associated with the amortization of these awards.

 

Pursuantto the operating company’s bonus plan, which became effective January 1,2007, eligible employees whose cash compensation is in excess of certainthresholds have a portion of that excess mandatorily deferred.  Amounts deferred may be credited to aninvestment account or take the form of phantom Class B Units, at theemployee’s discretion, and vest ratably over four years commencing January 1,2008.  At March 31, 2008, theliability associated with such investment accounts was approximately $0.2million, and has been included as a component of other liabilities on theconsolidated statement of financial position. For the three months ended March 31, 2008, the Company recognizedapproximately $0.3 million in compensation and benefits expense associatedwith the amortization of these awards.

 

**Note 9—Short Term Borrowings**

 

Simultaneouslywith the three year term loan agreement described below, on July 23, 2007,the Company obtained a $20.0 million revolving credit facility, which willexpire on July 23, 2010, in order to finance its short term workingcapital needs.  This facility carries acommitment fee of 0.2% on any unused amounts. On February 11, 2008, the operating company entered into AmendmentNo.1 to its three-year-term loan facility.  The amendment changed a number of credit agreement provisions, includingreducing the capacity of the revolving credit facility from $20.0 million to$5.0 million.   As of and for the periodended March 31, 2008 and as of December 31, 2007, no balance wasoutstanding against the facility.

 

19

----

 

**PZENA INVESTMENT MANAGEMENT, INC**

**(Prior to October 30, 2007,Pzena Investment Management, LLC)**

 

**UNAUDITED NOTES TO THE FINANCIALSTATEMENTS (CONTINUED)**

 

**Note 10—Long Term Debt**

 

OnJuly 23, 2007, the operating company entered into a $60.0 million,three-year term loan agreement, the proceeds of which were used to finance aone-time distribution to its members at the time of exchange.  The principal amount borrowed bears interestat a variable rate based, at the Company’s option, on (i) the one, two,three, six, nine or twelve-month LIBOR plus 1.00%, or (ii) the higher ofthe lender’s prime rate and the Federal Funds Rate.  The principal amount is payable in full atthe end of the three-year term, with no penalty for prepayment.  On February 11, 2008, the operatingcompany entered into Amendment No.1 to its three-year-term loan facility.  The agreement, as amended, requires theoperating company to maintain assets under management of at least$15.0 billion and generate consolidated earnings before interest, taxes,depreciation and amortization (“EBITDA”), as defined, of at least$40.0 million in any consecutive four fiscal quarter period.  Pursuant to the terms of the amendedagreement, term loan amortization is required beginning in any period whenassets under management are less than $20 billion and ending when assets undermanagement are greater than $21.5 billion. Further, an excess cash flow sweep is required if assets undermanagement are below $17.5 billion.  For theperiod from February 11, 2008 through July 23, 2008, the interestrate in effect will be 6.91%, which is equal to the twelve-month LIBOR rate ineffect at the time of the closing of the agreement of 5.41%, plus 1.50%.  Approximately $0.1 million in debtissuance costs were incurred in association with this loan.  Such costs have been recorded in prepaidexpenses and other assets and are being amortized over the term of the loan.

 

**Note 11– Interest Rate Swap**

 

TheCompany manages its exposure to changes in market rates of interest.  The Company’s use of derivative instrumentsis limited to a highly effective interest rate swap used to manage the interestrate exposure related to its three-year, $60.0 million term loan facility.  The Company monitors its position and thecredit rating of the counterparty and does not anticipate non-performance bysuch counterparty.  The interest rateswap agreement was not entered into for trading purposes.

 

OnFebruary 28, 2008, the operating company entered into a $60.0 millionnotional amount interest rate swap agreement that commences on July 23,2008.  The swap, which expires on thesame date as the operating company’s three-year, $60.0 million term loanfacility, obligates the Company to pay a 2.825% fixed rate of interest on thenotional amount and requires the counterparty to pay the Company a floatinginterest rate based on the monthly LIBOR interest rate.  The 1.50% spread on the term loan is inaddition to these amounts, resulting in an aggregate annualized fixed paymentof 4.325% of the notional amount for the term of the swap agreement.  For the three months ended March 31,2008, the Company recognized less than $0.1 million in other accumulatedcomprehensive loss associated with its pro rata share of the change in fairvalue of this swap agreement.

 

**Note 12—Income Taxes**

 

Theoperating company is a limited liability company that has elected to be treatedas a partnership for tax purposes. Neither it nor the Company’s other consolidated subsidiaries has madeprovision for federal or state income taxes because it is the personalresponsibility of each of these entities’ members (including the Company) toseparately report their proportionate share of the respective entity’s taxableincome or loss.  The operating companyhas made a provision for New York City UBT. Subsequent to the offering and reorganization on October 30, 2007,the Company, as a “C” corporation under the Internal Revenue Code, is liablefor federal, state and local taxes on the income derived from its economicinterest in its operating 

 

20

----

 

**PZENA INVESTMENT MANAGEMENT, INC**

**(Prior to October 30, 2007,Pzena Investment Management, LLC)**

 

**UNAUDITED NOTES TO THE FINANCIALSTATEMENTS (CONTINUED)**

 

company,which is net of UBT.  Correspondingly, inits consolidated financial statements, the Company reports both the operatingcompany’s provision for UBT as well as its provision for federal, state andlocal corporate taxes.  The components ofthe provision for income taxes are as follows:

 
| ** **                       | ** ** | **For the Three Months  Ended March 31,** | ** ** |
|----------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                       | ** ** | **2008**                                                           | ** ** | **2007** | ** ** |
| ** **                       | ** ** | **(in thousands)**                                            | ** ** |
| Current Provision:               |       |                                                               |       |   |   |
| Unincorporated Business Tax      |       | $                                                                  | 995        |   | $ | 1,360 |   |
| Local Corporate Tax              |       | —                                                             |       | — |   |
| State Corporate Tax              |       | —                                                             |       | — |   |
| Federal Corporate Tax            |       | —                                                             |       | — |   |
| Total Current Provision          |       | $                                                                  | 995        |   | $ | 1,360 |   |
|                             |       |                                                               |       |   |   |
| Deferred Provision:              |       |                                                               |       |   |   |
| Unincorporated Business Tax      |       | $                                                                  | (55        | ) | $ | (231 | ) |
| Local Corporate Tax              |       | 64                                                                 |       | — |   |
| State Corporate Tax              |       | 115                                                                |       | — |   |
| Federal Corporate Tax            |       | 423                                                                |       | — |   |
| Total Deferred Provision         |       | $                                                                  | 547        |   | $ | (231 | ) |
|                             |       |                                                               |       |   |   |
| Total Provision for Income Taxes |       | $                                                                  | 1,542      |   | $ | 1,129 |   |

 

Priorto October 30, 2007, the operating company was a cash basis taxpayer. As theresult of the Company’s acquisition of membership units in conjunction with theoffering, the operating company was required to become an accrual basistaxpayer.  Pursuant to Section 481of the Internal Revenue Code, the cumulative difference between the two methodsof taxpaying are amortizable over four years. These differences generated approximately $0.6 and $0.7 million indeferred tax liabilities as of March 31, 2008 and December 31, 2007,respectively.  Such amounts are recordedin other liabilities in the consolidated statements of financial condition.

 

Theacquisition of the operating company membership units noted above has allowedthe Company to make an election under Section 754 of the Internal RevenueCode to step up its tax basis in the net assets acquired.  This step up is deductible for tax purposesover a 15-year period.  Based on the netproceeds of the offering and tax basis of the operating company as of October 30,2007, this election gave rise to a deferred tax asset of approximately $68.7 million.  As of March 31, 2008 andDecember 31, 2007, the value of this election was approximately$67.6 million and $68.2 million, respectively. Pursuant to a TaxReceivable Agreement signed between the members of the operating company andthe Company, 85% of the cash savings generated by this election will bedistributed to the selling unitholders upon this benefit’s realization.  As of March 31, 2008 andDecember 31, 2007, this liability was approximately $58.4 million.

 

21

----

 

**PZENA INVESTMENT MANAGEMENT, INC**

**(Prior to October 30, 2007,Pzena Investment Management, LLC)**

 

**UNAUDITED NOTES TO THE FINANCIALSTATEMENTS (CONTINUED)**

 

Forthe three months ended March 31, 2008, the Company’s income, derived solelyfrom its economic interest in its operating company, was determined as follows(in thousands):

 
| Income Before Taxes and Minority and Non-Controlling Interests |   | $       | 13,939 |   |
|----------------------------------------------------------------|--------|---------|--------|--------|
| Unincorporated Business Tax                                    |   | (940    | )      |
| Minority and Non-Controlling Interests                         |   | (11,577 | )      |
| Income Before Corporate Income Taxes                           |   | $       | 1,422  |   |

 

InJune 2006, the Financial Accounting Standards Board issued InterpretationNo. 48, *Accounting for Uncertainty inIncome Taxes* (“FIN 48”). FIN 48 establishes the minimum threshold for recognizing, and asystem for measuring, the benefits of tax return positions in financialstatements.  It is the Company’s policyto recognize accrued interest and penalties associated with uncertain taxpositions as part of tax expense.  Forthe three months ended March 31, 2008 and 2007, no such expenses wererecognized, and as of March 31, 2008 and December 31, 2007, noaccruals were recorded.

 

TheCompany and the operating company are generally no longer subject to U.Sfederal, or state and local income tax examinations by tax authorities for anyyear prior to 2004.  All tax yearssubsequent to this date are considered open and subject to examination by taxauthorities.

 

**Note 13—Investments in Marketable Securities**

 

Investmentsin marketable securities and securities sold short consisted of the followingat March 31, 2008:

 
| ** ** | ** ** | **Cost**   | ** ** | **Unrealized  Gain/(Loss)** | ** ** | **Fair Value** | ** ** |
|------------|------------|------------|------------|-----------------------------|------------|---------------------|------------|
| ** ** | ** ** | ** ** | ** ** | **(in thousands)**     | ** ** | ** **          | ** ** |
|       |       |       |       |                        |       |                |       |
| Equities   |       | $          | 41,022     |                        | $          | (4,477              | )          | $ | 36,545 |   |
|            |            |            |            |                             |            |                     |            |  |  |  |

 
| ** **                   | ** ** | ** **   | ** ** | **Unrealized**     | ** ** | ** **     | ** ** |
|------------------------------|------------|--------------|------------|--------------------|------------|----------------|------------|
| ** **                   | ** ** | **Proceeds** | ** ** | **Loss/(Gain)**    | ** ** | **Fair Value** | ** ** |
| ** **                   | ** ** | ** **   | ** ** | **(in thousands)** | ** ** | ** **     | ** ** |
|                         |       |         |       |               |       |           |       |
| Equity Securities Sold Short |       | $            | 3,718      |               | $          | (200           | )          | $ | 3,518 |   |
|                              |            |              |            |                    |            |                |            |  |  |  |

 

22

----

 

**PZENA INVESTMENT MANAGEMENT, INC**

**(Prior to October 30, 2007,Pzena Investment Management, LLC)**

 

**UNAUDITED NOTES TO THE FINANCIALSTATEMENTS (CONTINUED)**

 

Investmentsin marketable securities and securities sold short consisted of the followingat December 31, 2007:

 
| ** ** | ** ** | **Cost**   | ** ** | **Unrealized  Gain/(Loss)** | ** ** | **Fair Value** | ** ** |
|------------|------------|------------|------------|-----------------------------|------------|---------------------|------------|
| ** ** | ** ** | ** ** | ** ** | **(in thousands)**     | ** ** | ** **          | ** ** |
|       |       |       |       |                        |       |                |       |
| Equities   |       | $          | 28,738     |                        | $          | (1,273              | )          | $ | 27,465 |   |
|            |            |            |            |                             |            |                     |            |  |  |  |

 
| ** **                         | ** ** | **Proceeds** | ** ** | **Unrealized  Loss/(Gain)** | ** ** | **Fair Value** | ** ** |
|------------------------------------|------------|--------------|------------|-----------------------------|------------|---------------------|------------|
| ** **                         | ** ** | ** **   | ** ** | **(in thousands)**     | ** ** | ** **          | ** ** |
|                               |       |         |       |                        |       |                |       |
|  Equity Securities Sold Short |       | $            | 1,047      |                        | $          | (19                 | )          | $ | 1,028 |   |
|                                    |            |              |            |                             |            |                     |            |  |  |  |

 

**Note 14—Members’ Equity Interests of Operating Company**

 

Priorto March 31, 2007, all operating company ownership interests were requiredto be repurchased in the event of the holder’s death or, if applicable,termination of employment.  Theseredemption features caused all of the operating company’s units to beclassified as liabilities as of the effective date of FAS 150 with respectto the operating company, which was July 1, 2003.

 

Priorto March 31, 2007, distributions made with respect to Compensatory Unitswere classified as compensation and benefits expense.  Incremental changes to these units’redemption values subsequent to the grant date were also included as acomponent of compensation and benefits expense at each reporting period.  For the operating company’s non-compensatoryunits (Capital Units), distributions and incremental changes in the netliability associated with these units’ redemption values have been recorded ascomponents of interest on mandatorily redeemable units in the consolidatedstatements of operations for all periods prior to March 31, 2007.

 

TheOperating Agreement was amended as of March 31, 2007 to eliminate itsobligation to redeem units under any circumstance. As a result, all units thatwere categorized as liabilities in the consolidated financial statements werereclassified as equity as of March 31, 2007. Subsequent to this date,distributions paid on unit-based compensation and incremental changes to theseunits’ value are not considered a component of compensation and benefitsexpense and are instead recorded as a direct reduction of undistributedearnings. As of March 31, 2007, the operating company accelerated thevesting of all Compensatory Units then subject to vesting.  The one-time charge associated with thisacceleration, approximately $65.0 million, was recorded on March 31,2007.

 

23

----

 

**PZENA INVESTMENT MANAGEMENT, INC**

**(Prior to October 30, 2007,Pzena Investment Management, LLC)**

 

**UNAUDITED NOTES TO THE FINANCIALSTATEMENTS (CONTINUED)**

 

Compensationand benefits expense associated with the operating company’s Compensatory Unitsis comprised of the following:

 
| ** **                                       | ** ** | **For the Three Months  Ended March 31,** | ** ** |
|--------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                       | ** ** | **2008**                                                           | ** ** | **2007** | ** ** |
| ** **                                       | ** ** | **(in thousands)**                                            | ** ** |
|                                             |       |                                                               |       |   |   |
| Distributions on Compensatory Units              |       | $                                                                  | —     |   | $ | 12,087 |   |
| Change in Redemption Value of Compensatory Units |       | —                                                             |       | 15,969 |   |
| Acceleration of Vesting of Compensatory Units    |       | —                                                             |       | 64,968 |   |
| Other Non-Cash Compensation                      |       | 344                                                                |       | 1,901 |   |
| Total Compensation and Benefits Expense          |       | $                                                                  | 344        |   | $ | 94,925 |   |

 

Forthe three months ended March 31, 2008 and 2007, the operating companygranted 446,000 and 630,000, respectively, options to purchase Capital Units tocertain members pursuant to the Pzena Investment Management, LLC 2006Equity Incentive Plan.  These options hadvarying vesting schedules and were issued at strike prices equal to the assessedfair market value per unit at the time of award issuance.  The Company determined that the totalgrant-date fair value of these options was approximately $1.2 million and$1.9 million, respectively, using the Black-Scholes option pricing model.The weighted-average grant date fair value of options issued for the threemonths ended March 31, 2008 and 2007 was $2.64  and $3.02, respectively.

 

OnJanuary 1, 2008, the operating company granted 13,000 restrictedClass B Units to certain members pursuant to the Pzena InvestmentManagement, LLC 2006 Equity Incentive Plan.  On January 1, 2008, the operatingcompany also issued 89,826 phantom Class B Units as part of its Bonus Plan.These grants each vest ratably over a four-year period commencingJanuary 1, 2008.

 

Asof March 31, 2007, the operating company accelerated the vesting of alloptions then subject to vesting.  Thenon-cash compensation charge associated with this accelerated amortization wasapproximately $1.9 million.

 

Exceptas otherwise provided by law, the liability of a member of the operatingcompany is limited to the amount of its capital account.  A member may transfer or assign all, or anypart of, its membership interest to any other party (a “Transferee”).  A Transferee of such membership interestshall not become a member unless its membership in the operating company isunanimously approved by the then existing member(s) in writing.  Any Transferee admitted as a member shallsucceed to the capital account or portion thereof transferred or assigned, asif no such transfer or assignment had occurred.

 

OnFebruary 13, 2007, the operating company accelerated the vesting of285,000 of the 315,500 Class A Units that were granted on January 1,2007 pursuant to its 2006 Equity Incentive Plan and repurchased them from adeparting employee.  The chargeassociated with this acceleration was approximately $3.8 million and hasbeen included in compensation and benefits expense for the three months endedMarch 31, 2007.

 

OnJuly 17, 2007, the operating company effected a 5-for-1 unit split.  All unit and per unit amounts have beenadjusted to reflect these splits.

 

**Note 15—Shareholders’ Equity**

 

TheCompany was incorporated in the State of Delaware on May 8, 2007. OnMay 10, 2007, the Company issued 100 shares of its common stock, par value$0.01 per share (the “Old Common Stock”), for $100 to Richard S. Pzena, thesole director of the Company as of that date. On October 5, 2007, the Company effected 

 

24

----

 

**PZENA INVESTMENT MANAGEMENT, INC**

**(Prior to October 30, 2007,Pzena Investment Management, LLC)**

 

**UNAUDITED NOTES TO THE FINANCIALSTATEMENTS (CONTINUED)**

 

a100-for-6 reverse stock split of all shares of its Old Common Stock thenoutstanding.  All share amounts have beenadjusted to reflect this split.  As ofthe effectiveness of the amendment and restatement of the Company’s certificateof incorporation on October 30, 2007, each share of the Old Common Stockoutstanding immediately prior to effectiveness was reclassified as one share ofthe Company’s Class A common stock, par value $0.01 per share (the“Class A Common Stock”).

 

OnOctober 30, 2007, the Company consummated an initial public offering of6,100,000 shares of its Class A common stock, par value $0.01 per share,for net proceeds of approximately $98.9 million, after payment ofunderwriting discounts and estimated offering expenses.  These net proceeds were used to purchase6,100,000 membership units of the operating company, representing 9.5% of itsthen outstanding membership units, from its two outside investors and oneformer employee. Concurrently with the consummation of the Company’s initialpublic offering, the Operating Agreement of the operating company was amendedand restated such that, among other things, (i) the Company became thesole managing member of the operating company, (ii) the 6,100,000membership units of the operating company that the Company acquired werereclassified as Class A Units of the operating company, (iii) anadditional 11,118 Class A Units were issued to the Company in respect ofits issuance of 11,112 shares of Class A Common Stock to certain directorsof the Company on October 30, 2007, and contribution of the $100 initialinvestment the Company received in exchange for issuance of six shares ofClass A Common Stock on May 10, 2007, and (iv) the holders ofthe remaining 90.5% of the outstanding membership units of the operatingcompany were reclassified as Class B Units of the operating company.  Class A and Class B units of theoperating company have the same economic rights per unit.  Accordingly, immediately following theconsummation of the offering and reorganization, the holders of Class Acommon stock (through the Company) and the holders of Class B units of theoperating company held approximately 9.5% and 90.5%, respectively, of theeconomic interests in the operations of the business.  As of March 31, 2008, the holders ofClass A common stock (through the Company) and the holders of Class Bunits of the operating company held approximately 9.6% and 90.4%, respectively,of the economic interests in the operations of the business.

 

Foreach membership unit of the operating company that was reclassified as aClass B unit in the reorganization, the Company issued the holder oneshare of its Class B common stock, par value $0.000001 per share, inexchange for the payment of this par value. Each share of the Company’s Class B common stock entitles itsholder to five votes, until the first time that the number of shares ofClass B common stock outstanding constitutes less than 20% of the numberof all shares of our common stock outstanding. From this time and thereafter, each share of the Company’s Class Bcommon stock entitles its holder to one vote. When a Class B unit is exchanged for a share of the Company’sClass A common stock or forfeited, a corresponding share of the Company’sClass B common stock will automatically be redeemed and cancelled.  Conversely, to the extent that the Companycauses Pzena Investment Management, LLC to issue additional Class Bunits to employees pursuant to its equity incentive plan, these additionalholders of Class B units would be entitled to receive a correspondingnumber of shares of the Company’s Class B common stock (including if theClass B units awarded are subject to vesting).

 

Simultaneouslywith the consummation of the offering and reorganization, all holders of theCompany’s Class B common stock entered into a stockholders’ agreement,pursuant to which they agreed to vote all shares of Class B common stockthen held by them, and acquired in the future, together on all matterssubmitted to a vote of the common stockholders.

 

Theoutstanding shares of the Company’s Class A common stock represent 100% ofthe rights of the holders of all classes of the Company’s capital stock toreceive distributions, except that holders of Class B common stock willhave the right to receive the class’s par value upon the Company’s liquidation,dissolution or winding up.

 

25

----

 

**PZENA INVESTMENT MANAGEMENT, INC**

**(Prior to October 30, 2007,Pzena Investment Management, LLC)**

 

**UNAUDITED NOTES TO THE FINANCIALSTATEMENTS (CONTINUED)**

 

Pursuantto the amended and restated Operating Agreement of the operating company, eachvested Class B unit is exchangeable for a share of the Company’sClass A common stock, subject to certain exchange timing and volumelimitations.

 

Theacquisition of the operating company’s membership interests by the Company hasbeen treated as a reorganization of entities under common control pursuant tothe guidance set forth in FTB 85-5. Accordingly, the net assets assumed by theCompany through the offering have been reported at the operating company’shistorical cost basis.  As a result of thesetransactions, as of and subsequent to October 30, 2007, (i) theCompany has consolidated the financial results of the operating company withits own and reflected the membership interest in it that it does not own as anon-controlling interest in its consolidated financial statements, and (ii) theCompany’s income will be generated by its economic interest in the operatingcompany’s net income.

 

Thisacquisition of membership units in the operating company has allowed theCompany to make an election to step up its tax basis in the net assetsacquired. This step up is deductible for tax purposes over a 15-yearperiod.  Based on the net proceeds of theoffering and tax basis of the operating company as of October 30, 2007,this election gave rise to a deferred tax asset of approximately$68.7 million. Pursuant to a tax receivable agreement between the Companyand the operating company, 85% of the benefits of this election will bereturned to the selling unitholders of the operating company as they are realized.  This liability of $58.4 million isrecorded as liability to selling shareholders on the consolidated statement offinancial condition.

 

TheCompany has not recorded a non-controlling interest associated with theacquisition of its operating company, as the post offering net equity of theoperating company was less than zero. Pursuant to the guidance inEITF 95-7, no operating company non-controlling interest will be recordeduntil the initial deficit attributable to the non-controlling interest, approximately$10.7 million, is extinguished.

 

OnMarch 4, 2008, the Company’s Board of Directors declared a quarterlydividend of $0.11 per share of Class A common stock, payable onApril 11, 2008 to shareholders of record as of March 27, 2008.  The liability associated with this payment,and the corresponding obligation to the operating company members, is recordedin dividends payable on the consolidated statements of financial condition.

 

 

26

----

 

**Item 2.*  Management’sDiscussion and Analysis of Financial Condition and Results of Operations.***

 

**Overview**

 

**Overview**

 

We are an investment management firm that utilizes a classic valueinvestment approach in each of our investment strategies. We currently manageassets in ten value-oriented investment strategies across a wide range ofmarket capitalizations in both U.S. and international capital markets. At March 31,2008 our assets under management, or AUM, were $20.4 billion. We manageseparate accounts on behalf of approximately 370 institutions and high networth individuals and act as sub-investment adviser for twelve SEC-registeredmutual funds and ten offshore funds.

 

We function as the holding company through which the business of ouroperating company, Pzena Investment Management, LLC, is conducted.Following our initial public offering and reorganization on October 30,2007, we became the sole managing member of Pzena InvestmentManagement, LLC. As such, we now control its business and affairs and, therefore,consolidate its financial results with ours. In light of our employees’ andother investors’ collective membership interest in our operating company, wereflect their interests as a non-controlling interest in our consolidatedfinancial statements. As a result, subsequent to October 30, 2007, ourincome is generated by our economic interest in our operating company’s netincome.  Results for the periods prior toOctober 30, 2007 reflect solely the operations of Pzena InvestmentManagement, LLC.  As of March 31,2008, the holders of Class A common stock (through the Company) and theholders of Class B units of the operating company held approximately 9.6%and 90.4%, respectively, of the economic interests in the operations of thebusiness.

 

**Revenue**

 

We generate revenue from management fees and incentive fees, which wecollectively refer to as our advisory fees, by managing assets on behalf ofseparate accounts and acting as a sub-investment adviser for mutual funds andcertain other investment funds. Our advisory fee income is recognized over theperiod in which investment management services are provided. Pursuant to thepreferred accounting method under Emerging Issues Task Force Issue D-96, *Accounting for Management Fees Based on a Formula*(“EITF D-96”), income from incentive fees is recorded at the conclusion of thecontractual performance period, when all contingencies are resolved.

 

Our advisory fees are primarily driven by the level of our AUM. Our AUMincreases or decreases with the net inflows or outflows of funds into ourvarious investment strategies and with the investment performance thereof. Inorder to increase our AUM and expand our business, we must develop and marketinvestment strategies that suit the investment needs of our target clients andprovide attractive returns over the long term. The value and composition of ourAUM, and our ability to continue to attract clients, will depend on a varietyof factors including, among other things:

 

·      our ability to educate ourtarget clients about our classic value investment strategies and provide themwith exceptional client service;

 

·      the relative investmentperformance of our investment strategies, as compared to competing products andmarket indices;

 

·      competitive conditions inthe investment management and broader financial services sectors;

 

·      investor sentiment andconfidence; and

 

27

----

 

·      our decision to closestrategies when we deem it to be in the best interests of our clients.

 

For our separately-managed accounts, we are paid fees according to aschedule, which varies by investment strategy. The substantial majority ofthese accounts pay us management fees pursuant to a schedule in which the ratewe earn on the AUM declines as the amount of AUM increases, subject to aminimum fee to manage each account. Certain of these clients pay us feesaccording to the performance of their accounts relative to certain agreed-uponbenchmarks, which results in a slightly lower base fee, but allows us to earnhigher fees if the relevant investment strategy outperforms the agreed-uponbenchmark.

 

Pursuant to our sub-investment advisory agreements, we are generallypaid a management fee according to a schedule, in which the rate we earn on theAUM declines as the amount of AUM increases. Certain of these funds pay usfixed rate management fees. Due to the substantially larger account size ofcertain of these accounts, the average advisory fees we earn on them, as apercentage of AUM, are lower than the advisory fees we earn on ourseparately-managed accounts.

 

The majority of advisory fees we earn on separately-managed accountsare based on the value of AUM at a specific date on a quarterly basis, eitherin arrears or advance. Advisory fees on certain of our separately-managedaccounts, and with respect to most of the mutual funds that we sub-advise, arecalculated based on the average of the monthly or daily market value. Advisoryfees are also adjusted for any cash flows into or out of a portfolio, where thecash flow represents greater than 10% of the value of the portfolio. While aspecific group of accounts may use the same fee rate, the method used tocalculate the fee according to the fee rate schedule may differ as describedabove.

 

Our advisory fees may fluctuate based on a number of factors, includingthe following:

 

·      changes in AUM due toappreciation or depreciation of our investment portfolios, and the levels ofthe contribution and withdrawal of assets by new and existing clients;

 

·      distribution of AUM amongour investment strategies, which have different fee schedules;

 

·      distribution of AUM betweenseparately-managed accounts and sub-advised funds, for which we generally earnlower overall advisory fees; and

 

·      the level of our performancewith respect to accounts on which we are paid incentive fees.

 

**Expenses**

 

Our expenses consist primarily of compensation and benefits expenses,as well as general and administrative expenses. These expenses may fluctuatedue to a number of factors, including the following:

 

·      variations in the level oftotal compensation expense due to, among other things, bonuses, awards ofequity to our employees and members of our operating company, changes in ouremployee count and mix, and competitive factors; and

 

·      expenses, such as rent,professional service fees and data-related costs, incurred, as necessary, torun our business.

 

**Compensation and Benefits Expense**

 

Our largest expense is compensation and benefits, which includes thesalaries, bonuses, equity-based compensation and related benefits and payrollcosts attributable to our members and employees. All compensation and benefitspackages, including those of our executive officers, are benchmarked againstrelevant industry and geographic peer groups in order to attract and retainqualified personnel. We have experienced, and expect to continue to experience,a general rise in cash compensation and benefits expense commensurate withgrowth in headcount and with the need to maintain competitive compensationlevels. The table included in the section below describes the components of ourcompensation expense for the three months ended March 31, 2008 and 2007:

 

 

28

----

 
| ** **                                            | ** ** | **For the Three Months Ended** | ** ** |
|-------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                            | ** ** | **March 31,**                                 | ** ** |
| ** **                                            | ** ** | **2008**                                           | ** ** | **2007** | ** ** |
| ** **                                            | ** ** | **(in thousands)**                            | ** ** |
| ** **                                            | ** ** | **(unaudited)**                                    | ** ** |
| ** **                                            | ** ** | ** **                                         | ** ** |
| Cash Compensation and Benefits                        |       | $                                                  | 8,607      |   | $ | 8,899 |   |
| Distributions on Compensatory Units                   |       | —                                             |       | 12,087 |   |
| Change in Redemption Value of Compensatory Units |       | —                                             |       | 15,969 |   |
| Acceleration of Vesting of Compensatory Units         |       | —                                             |       | 64,968 |   |
| Other Non-Cash Compensation                           |       | 344                                                |       | 1,901 |   |
| Total Compensation and Benefits Expense               |       | $                                                  | 8,951      |   | $ | 103,824 |   |

 

As discussed further in Note 14 to our consolidated financialstatements, the operating company issued Compensatory Units to employees andmembers which had redemption features that required them to be classified asliabilities in the consolidated statements of financial condition prior to March 31,2007.  Until this date, distributions onthe Compensatory Units outstanding, and changes in these units’ redemptionvalues, were recorded as compensation and benefits expense.  As of March 31, 2007, the effective dateof the amendment to the Operating Agreement to eliminate the operatingcompany’s obligation to redeem units under any circumstance, the unit-basedcompensation awards previously categorized as liabilities were reclassified asequity.  Further, as of March 31,2007, the operating company accelerated the vesting of all Compensatory Unitsthen subject to vesting. Subsequent to this date, distributions on these unitsare not considered a component of compensation and benefits expense and areinstead recorded as a direct reduction of members’ capital.

 

On January 1, 2007, we adopted the PIM LLC 2006 EquityIncentive Plan, pursuant to which we have issued restricted Capital Units, andoptions to acquire Capital Units, in our operating company, both of which wereto vest ratably over a four-year period. We used a fair-value method inrecording the compensation expense associated with the granting of theserestricted Capital Units, and options to acquire Capital Units, to new andexisting members under the PIM LLC 2006 Equity Incentive Plan. Under thismethod, compensation expense is measured at the grant date based on theestimated fair value of the award and is recognized over the award’s vestingperiod. The fair value for the Capital Units will be determined by reference tothe market price of our Class A common stock on the date of grant, sincethese units are exchangeable for shares of our Class A common stock on aone-for-one basis. The fair value for the options to acquire Capital Units willbe determined by using an appropriate option pricing model on the grant date.

 

OnJanuary 1, 2007, we instituted a deferred compensation plan, in whichemployees who earn in excess of $600,000 per year are required to defer aportion of their compensation in excess of this amount. These deferred amountsmay be invested, at the employee’s discretion, in certain of our investmentstrategies, restricted Capital Units of our operating company, or money marketfunds. All of these deferred amounts vest ratably over a four-year periodbeginning January 1, 2008 and, therefore, will be reflected in ourexpenses over this period. Accordingly, our 2007 cash compensation expense waslower than it would have been had we not instituted a deferred compensationplan. For the four-year period beginning January 1, 2008, we expect thenon-cash portion of our compensation expense associated with this deferredcompensation plan to increase each successive year as these and subsequentlydeferred amounts are amortized through income.

 

**General and Administrative Expenses**

 

Generaland administrative expenses include professional and outside services fees,office expenses, depreciation and the costs associated with operating andmaintaining our research, trading and portfolio accounting systems. Ouroccupancy-related costs and professional services expenses, in particular,generally

 

29

----

 

increaseor decrease in relative proportion to the number of employees retained by us,and the overall size and scale of our business operations.

 

As a result of our offering on October 30, 2007, we have incurredand expect to incur, additional expenses associated with being a public companyfor, among other things, director and officer insurance, director fees, SECreporting and compliance (including Sarbanes-Oxley compliance), transfer agentfees, professional fees and other similar expenses. These additional expenseswill reduce our net income.

 

**Other Income/Expense**

 

Otherincome/(expense) is derived primarily from interest income generated on ourexcess cash balances, interest expense on our term loan agreement andinvestment income arising from our investments in various private investmentvehicles that we employ to incubate new strategies. We expect the interest andinvestment components of other income, in the aggregate, to fluctuate based onmarket conditions, the success of our investment strategies and our dividendpolicy.

 

**Non-Controlling Interests**

 

Ouroperating company has historically consolidated the results of operations ofthe private investment partnerships over which we exercise a controllinginfluence. After our reorganization, we became the sole managing member of ouroperating company and now control its business and affairs and, therefore,consolidate its financial results with ours. In light of our employees’ andoutside investors’ interest in our operating company, we have reflected theirmembership interests as a non-controlling interest in our consolidatedfinancial statements. As a result, subsequent to October 30, 2007, ourincome is generated by our economic interest in our operating company’s netincome. As of March 31, 2008, the holders of Class A common stock(through the Company) and the holders of Class B units of the operatingcompany held approximately 9.6% and 90.4%, respectively, of the economicinterests in the operations of the business.

 

**Provision for Income Tax**

 

While our operating company has historically not been subject to U.S. federaland certain state income taxes, it has been subject to the New York City UBT.As a result of our reorganization, we are now subject to taxes applicable toC-corporations. As such, our effective tax rate, and the absolute dollar amountof our tax expense has increased as a result of our reorganization.

 

**Interest on Mandatorily Redeemable Units**

 

Until the amendment of its Operating Agreement on March 31, 2007,the operating company recorded a net liability for its Capital Units equal tothe accumulated redemption value as of the balance sheet date of all suchoutstanding units.  This liability alsoincluded any undistributed earnings attributable to such units. As such,interest on mandatorily redeemable units included distributions made on CapitalUnits outstanding, as well as the incremental increases or decreases in theredemption values of these units. Distributions are generally paid on the operating company’s incomebefore non-cash compensation charges. Redemption values were determined basedon fair value.

 

Prior to March 31, 2007, Capital Units were required to beredeemed on the death of a member. Effective March 31, 2007, the operatingcompany’s Operating Agreement was amended to eliminate its obligation to redeemunits under any circumstance.  Since allCapital Units thereafter had only equity characteristics, neitherdistributions, nor subsequent incremental changes to these units’ value, werecharged against income subsequent

 

30

----

 

tothe effective date of the amendment.  The$16.6 million charge recorded in 2007 represents the distributions andincremental changes to these units’ fair value through March 31, 2007.

 

**Operating Results**

 

***General***

 

Our earnings and cash flows are heavily dependent upon prevailingfinancial market conditions. Significant increases or decreases in the varioussecurities markets, particularly the equities markets, can have a materialimpact on our results of operations, financial condition, and cash flows.

 

During the latter half of 2007, and continuing through March 31,2008, performance of our investment strategies was negatively impacted bysignificant volatility in the equity markets, and in the financial servicessector in particular. Our AUM declined by $8.1 billion, or 28.4%, from$28.5 billion at March 31, 2007 to $20.4 billion at March 31,2008, due to negative performance of $5.8 billion and net outflows of$2.3 billion. This decline in AUM occurred primarily during the secondhalf of 2007 and the first quarter of 2008. We experienced net outflows of AUMfrom our sub-advised accounts of $0.8 billion for the three months ended March 31,2008, attributable to the weaker performance of our sub-advised funds comparedto that of their peers. We also experienced net outflows of $0.2 billionin our separately-managed accounts for the three months March 31, 2008.Prior to 2007, our AUM had grown significantly as a result of several factorsincluding, among others, the exceptional investment performance for the sinceinception, five-year and three-year periods for each of our investmentstrategies through the end of 2006.

 

Our average AUM fluctuates based on fund flows and changes in themarket value of accounts advised and sub-advised by us. Accordingly, revenuesduring 2008 are expected to decline from the comparable 2007 periods to theextent that the markets continue to be unfavorable for our value investmentstrategy and results in our inability to increase our AUM. A decrease inrevenue would result in lower operating income and net income.

 

We expect that we will experience continued pressure on our operatingmargins in the future if AUM continue to decline. In addition, we expect ouroperating expenses to rise modestly in 2008 from the comparable 2007 periods,as we experience the full-year expense impact of personnel hired during 2007,as well as additional expenses related to our becoming a public company on October 30,2007. We are reviewing areas of expense reduction to partially offset theseincreases, and expect that cost savings, to the extent they are achieved, willoccur principally in non-compensation operating expenses.

 

***Assets under Management and Flows***

 

The change in AUM in our separately-managed accounts and oursub-advised accounts for the three months ended March 31, 2008 and 2007 isdescribed below:

 

31

----

 
| ** **                            | ** ** | **Three Months Ended** | ** ** |
|---------------------------------------|------------|------------------------|------------|
| ** **                            | ** ** | **March 31,**     | ** ** |
| **Assets Under Management** | ** ** | **2008**               | ** ** | **2007** | ** ** |
| ** **                            | ** ** | **(in billions)** | ** ** |
| ** **                            | ** ** | ** **             | ** ** |
| Separately-Managed Accounts           |       |                   |       |   |   |
| Beginning of Period Assets            |       | $                      | 14.0       |   | $ | 14.5 |   |
| Net Flows                             |       | (0.2                   | )          | 0.7 |   |
| Appreciation                          |       | (1.3                   | )          | 0.1 |   |
| End of Period Assets                  |       | $                      | 12.5       |   | $ | 15.3 |   |
| Sub-Advised Accounts                  |       |                   |       |   |   |
| Beginning of Period Assets            |       | $                      | 9.6        |   | $ | 12.8 |   |
| Net Flows                             |       | (0.8                   | )          | 0.5 |   |
| Appreciation                          |       | (0.9                   | )          | (0.1 | ) |
| End of Period Assets                  |       | $                      | 7.9        |   | $ | 13.2 |   |
| Total                                 |       |                   |       |   |   |
| Beginning of Period Assets            |       | $                      | 23.6       |   | $ | 27.3 |   |
| Net Flows                             |       | (1.0                   | )          | 1.2 |   |
| Appreciation                          |       | (2.2                   | )          | 0.0 |   |
| End of Period Assets                  |       | $                      | 20.4       |   | $ | 28.5 |   |

 

At March 31, 2008, our $20.4 billion of AUM were invested inten value-oriented investment strategies which represent distinctcapitalization segments of the U.S. and international markets. The followingtable describes the allocation of our AUM as of March 31, 2008 among ourseven largest investment strategies and the aggregate of our other investmentstrategies:

 
| ** **                   | ** ** | **AUM at**              | ** ** |
|------------------------------|------------|------------------------------|------------|
| **Investment Strategy** | ** ** | **March 31, 2008** | ** ** |
| ** **                   | ** ** | **(in billions)**       | ** ** |
| ** **                   | ** ** | ** **                   | ** ** |
| Large Cap Value              |       | $                            | 11.2       |   |
| Value Service                |       | 4.4                          |       |
| Global Value                 |       | 2.5                          |       |
| Small Cap Value              |       | 0.9                          |       |
| International Value          |       | 0.5                          |       |
| Mid Cap Value                |       | 0.4                          |       |
| All Cap Value                |       | 0.2                          |       |
| Other Strategies(1)          |       | 0.3                          |       |
| Total                        |       | $                            | 20.4       |   |

 

----

(1) Our three other investment strategies are:Financial Opportunities Service, Diversified Value, and Mega Cap Value.

 

*Three Months Ended March 31, 2008 versus March 31,2007*

 

At March 31, 2008, the Company managed $20.4 billion in totalassets, a decrease of $8.1 billion, or 28.4%, from $28.5 billion at March 31,2007. The decrease year-over-year in AUM was due largely to $5.8 billion inmarket depreciation, with net inflows of $0.5 billion into ourseparately-managed accounts and net outflows of $2.8 billion from oursub-advised accounts.

 

32

----

 

The Company managed $12.5 billion in separately managed accounts and$7.9 billion in sub-advised accounts, for a total of $20.4 billion in assets atMarch 31, 2008.  Assets in separatelymanaged accounts decreased by $1.5 billion or 10.7% during the first quarter of2008 due to $1.3 billion in market depreciation and $0.2 billion in netoutflows.  This compared to an increasein separately managed accounts of $0.8 billion or 5.5% during the first quarterof 2007, which resulted from $0.7 billion in net inflows and $0.1 billion inappreciation.  Assets in our sub-advisedfunds decreased by $1.7 billion or 17.7% during the first quarter of 2008, as aresult of $0.9 billion of depreciation, and $0.8 billion in net outflows.  This compares to an increase in sub-advisedaccounts of $0.4 billion or 3.1% during the first quarter of 2007, due to netinflows of $0.5 billion, offset by $0.1 billion of market depreciation.

 

At March 31, 2008, separately managed accounts represented 61.3% of ourtotal AUM, as compared to 53.7% at March 31, 2007.  At March 31, 2008, our International Valueand Global Value investment strategies accounted for 14.7% of our AUM, comparedto 7.0% at March 31, 2007.

 

***Revenues***

 

Our revenues from advisory fees earned on our separately-managedaccounts and our sub-advised accounts for the three months ended March 31,2008 and 2007 is described below:

 
| ** **                  | ** ** | **As of March 31,** | ** ** |
|-----------------------------|------------|------------------------------------|------------|
| **Revenue**                 | ** ** | **2008**                           | ** ** | **2007** | ** ** |
| ** **                  | ** ** | **(in millions)**             | ** ** |
| ** **                  | ** ** | **(unaudited)**                    | ** ** |
| ** **                  | ** ** | ** **                         | ** ** |
| Separately-Managed Accounts |       | $                                  | 21.6       |   | $ | 23.6 |   |
| Sub-Advised Accounts        |       | 8.4                                |       | 11.7 |   |
| Total                       |       | $                                  | 30.0       |   | $ | 35.3 |   |

 

*Three Months Ended March 31, 2008 versus March 31,2007*

 

Our total revenue decreased $5.3 million, or 15.0%, to$30.0 million for the three months ended March 31, 2008 from$35.3 million for the three months ended March 31, 2007. Thisdecrease was driven primarily by a decrease in weighted-average AUM, whichdecreased $6.0 billion, or 21.4%, to $22.0 billion for the threemonths ended March 31, 2008 from $28.0 billion for the three months ended March 31,2007.

 

Our weighted average fee was 0.545% and 0.505% for the three monthsended March 31, 2008 and 2007, respectively. Weighted-average assets inseparately-managed accounts decreased $1.5 billion, or 10.1%, to$13.4 billion for the three months ended March 31, 2008 from$14.9 billion for the three months ended March 31, 2007, and hadweighted average fees of 0.646% and 0.634% for the three months ended March 31,2008 and 2007, respectively. Weighted-average assets in sub-advised accounts decreased$4.5 billion, or 34.4%, to $8.6 billion for the three months ended March 31,2008 from $13.1 billion for the three months ended March 31, 2007,and had weighted average fees of 0.389% and 0.358% for the three months ended March 31,2008 and 2007, respectively.

 

***Expenses***

 

Ouroperating expenses are driven primarily by our compensation costs. The tablebelow describes the components of our compensation expense for the three monthsended March 31, 2008 and 2007. Much of the variability in our compensationcosts had been driven by distributions made on our Compensatory Units thenoutstanding, and the incremental increases or decreases in their redemptionvalue subsequent to their grant date. As of March 31, 2007, these itemsare no longer reflected in compensation expense.

 

33

----

 
| ** **                                            | ** ** | **For the Three Months Ended** | ** ** |
|-------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                            | ** ** | **March 31,**                                 | ** ** |
| ** **                                            | ** ** | **2008**                                           | ** ** | **2007** | ** ** |
| ** **                                            | ** ** | **(in thousands)**                            | ** ** |
| ** **                                            | ** ** | **(unaudited)**                                    | ** ** |
| ** **                                            | ** ** | ** **                                         | ** ** |
| Cash Compensation and Benefits                        |       | $                                                  | 8,607      |   | $ | 8,899 |   |
| Distributions on Compensatory Units                   |       | —                                             |       | 12,087 |   |
| Change in Redemption Value of Compensatory Units |       | —                                             |       | 15,969 |   |
| Acceleration of Vesting of Compensatory Units         |       | —                                             |       | 64,968 |   |
| Other Non-Cash Compensation                           |       | 344                                                |       | 1,901 |   |
| Total Compensation and Benefits Expense               |       | $                                                  | 8,951      |   | $ | 103,824 |   |

 

*Three Months Ended March 31, 2008 versus March 31,2007*

 

Total operating expenses decreased by $93.9 million, or 88.7%, to$12.0 million for the three months ended March 31, 2008 from$105.9 million for the three months ended March 31, 2007. Thisdecrease was primarily attributable to a decrease in compensation and benefitsexpense resulting from the $65.0 million charge taken in March 2007 associatedwith the acceleration of Compensatory Unit vesting that was not replicated in2008. This decrease was also attributable to the amendment of the Operating Agreement,on March 31, 2007, that removed all mandatory redemption provisionsrelated to our membership units.

 

Compensation and benefits expense decreased by $94.8 million, or91.3%, to $9.0 million for the three months ended March 31, 2008 from$103.8 million for the three months ended March 31, 2007. Thisdecrease was primarily attributable to a difference of $94.6 million inunit-based compensation charges incurred in the three months ended March 31,2007, as compared to those incurred for the three months ended March 31,2008.

 

General and administrative expenses increased by $0.9 million, or42.9%, to $3.0 million for the three months ended March 31, 2008 from$2.1 million for the three months ended March 31, 2007. This increasewas mainly attributable to a $0.6 million increase in professional andoutside services fees associated with our reorganization and becoming a publiccompany, and a $0.1 million increase in insurance costs associated withbeing a public company.  General officeand facility related expenses also increased by $0.2 million in the threemonths ended March 31, 2008 compared to the three months ended March 31,2007, primarily as a result of an increase in headcount and the lease ofadditional office space in 2007.

 

***Other Income/(Expense)***

 

*Three Months Ended March 31, 2008 versus March 31,2007*

 

Other income/(expense) decreased by $4.3 million to a loss of$4.1 million for the three months ended March 31, 2008 from income of$0.2 million for the three months ended March 31, 2007. The primaryreasons for

 

34

----

 

thisdecline were a $3.6 million charge due to negative investment performance ofthe private investment vehicles we manage, as well as $1.0 million in interestexpense associated with the $60.0 million term loan entered into in the thirdquarter of 2007, offset by interest and dividend income.

 

***Provision for Income Taxes***

 

*Three Months Ended March 31, 2008 versus March 31,2007*

 

The provision for income taxes increased by $0.4 million, or36.4%, to $1.5 million for the three months ended March 31, 2008 from$1.1 million for the three months ended March 31, 2007, due to anincrease in taxable income, as well as the effect of our obligation to paytaxes applicable to C-corporations subsequent to the reorganization and ourinitial public offering. Our effective corporate tax rate for the three monthsended March 31, 2008, exclusive of our pro rata share of our operatingcompany’s provision for the New York City UBT, was approximately 42.3%. Acomparison of the effective tax rate for the three months ended March 31,2008 to the effective tax rate for the three months ended March 31, 2007is not meaningful due to the effect of our liability for C-corporation taxationin 2008, and the equity-based compensation charges of $65.0 million in2007. This charge was not deductible for tax purposes.

 

***Non-Controlling Interests***

 

*Three Months Ended March 31, 2008 versus March 31,2007*

 

Non-controlling interests increased to $11.6 million for the threemonths ended March 31, 2008, compared to a charge of $0.0 million forthe three months ended March 31, 2007. This change primarily reflects ouremployees’ and outside investors’ interest in our operating company subsequent to the consummation of ourreorganization on October 30, 2007. This change also reflects, to a lesserextent, the less favorable investment performance of the private investmentvehicles we manage during the three months ended March 31, 2008 comparedto the three months ended March 31, 2007.

 

***Interest on Mandatorily RedeemableUnits***

 

*Three Months Ended March 31, 2008 versus March 31,2007*

 

Interest on mandatorily redeemable units decreased by$16.6 million to zero for the three months ended March 31, 2008compared to the three months ended March 31, 2007. The decrease was due tothe amendment of the Operating Agreement as of March 31, 2007 to removeall mandatory redemption provisions related to our membership units. Theremoval of these provisions caused our membership units to be classified asequity, and neither distributions nor subsequent changes to these units’ valuewere charged to income following the amendment.

 

**Liquidity and Capital Resources**

 

Historically, the working capital needs of our business have primarilybeen met through cash generated by our operations. We expect that our cash andliquidity requirements in the next twelve months, and over the long term, willbe met primarily through cash generated by our operations and, to a lesserextent, from borrowings under our current revolving credit facility describedbelow. On July 23, 2007, our operating company borrowed $60.0 millionpursuant to a three-year term loan facility, the proceeds of which were used tofinance a special one-time distribution to the members of our operating companyas of that date. Concurrently, our operating company also obtained a$20.0 million revolving credit facility to finance our short-term workingcapital needs. On February 11, 2008, our operating company entered intoAmendment No.1 to the loan facilities. The amendment changed a number of creditagreement provisions, including: (i) the minimum AUM financial covenantwas reduced from $20.0 billion to $15.0 billion; (ii) theminimum Earnings Before Interests, Taxes, Depreciation and Amortization, orEBITDA, financial covenant for each four quarter period was reduced from

 

35

----

 

$60.0 millionto $40.0 million; (iii) the capacity of the revolving credit facilitywas reduced from $20.0 million to $5.0 million; and (iv) theinterest rate was increased from LIBOR plus 1.0% to LIBOR plus 1.5%. Inaddition, two mandatory prepayment provisions were added: (a) term loanamortization is required beginning in any period when AUM are less than$20 billion and ending when AUM are greater than $21.5 billion and (b) anexcess cash flow sweep is required if AUM are below $17.5 billion. Futureprincipal repayment obligations on this loan will depend upon our future AUMlevels, pursuant to the terms of the credit agreement, as amended. As of April 30,2008, our AUM was approximately $21.5 billion.

 

We expect to fund the working capital needs of our business in the nexttwelve months, and over the long term, primarily through cash generated fromoperations, as well as from potential borrowings under the revolving creditfacility described above. We currently expect that the development of newinvestment strategies will continue, and require funding not in excess of$10 million per year. We expect to fund this development from cashgenerated from operations.

 

Prior to its reorganization on October 30, 2007, Pzena InvestmentManagement, LLC made a distribution to its existing members representingall of the remaining undistributed earnings generated through the date of thereorganization, less any amounts required to fund its working capital needs.

 

We anticipate that distributions to the members of our operatingcompany, which consisted of 26 of our employees as of March 31, 2008, twooutside investors and us, will continue to be a material use of our cashresources and will vary in amount and timing based on our operating results anddividend policy. We are a holding company and have no material assets otherthan our ownership of membership interests in our operating company. As aresult, we depend upon distributions from our operating company to pay any dividendsto our Class A stockholders. We cause our operating company to makedistributions to us in an amount sufficient to cover dividends, if any,declared by us. Our dividend policy has certain risks and limitations,particularly with respect to liquidity. Although we expect to pay dividendsaccording to our dividend policy, we may not pay dividends according to ourpolicy, or at all, if, among other things, we do not have the cash necessary topay our intended dividends. To the extent we do not have cash on handsufficient to pay dividends, we may decide not to pay dividends. By paying cashdividends rather than investing that cash in our future growth, we risk slowingthe pace of our growth, or not having a sufficient amount of cash to fund ouroperations or unanticipated capital expenditures, should the need arise.

 

Our purchase of membership units of our operating company concurrentlywith our initial public offering, and the future exchanges by holders of Class Bunits of our operating company for shares of our Class A common stock(pursuant to the exchange rights provided for in the Operating Company’soperating agreement), has resulted in, and are expected to continue to resultin, increases in our share of the tax basis of the tangible and intangibleassets of our operating company at the time of our acquisition and these futureexchanges, which will increase the tax depreciation and amortization deductionsthat otherwise would not have been available to us. These increases in taxbasis and tax depreciation and amortization deductions have reduced and areexpected to continue to reduce, the amount of tax that we would otherwise berequired to pay in the future. We have entered into a tax receivable agreementwith the current members of our operating company, the one member of ouroperating company immediately prior to our initial public offering who sold allof its membership units to us in connection with our initial public offering,and any future holders of Class B units, that requires us to pay them 85%of the amount of cash savings, if any, in U.S. federal, state and local incometax that we actually realize (or are deemed to realize in the case of an earlytermination payment by us, or a change in control, as described in the taxreceivable agreement) as a result of the increases in tax basis described aboveand certain other tax benefits related to entering into the tax receivableagreement, including tax benefits attributable to payments under the taxreceivable agreement. Assuming that there are no material changes in therelevant tax law, and that we earn sufficient taxable income to realize thefull tax benefit of the increased depreciation and amortization of our assets,we expect that future payments under the tax receivable agreement in respect ofour initial purchase of membership units of Pzena InvestmentManagement, LLC will aggregate $58.4 million and range fromapproximately $0.5 million to $6.5 million per year over the next15 years. Future payments under the tax receivable agreement in respect ofsubsequent exchanges will be in addition to these amounts and are expected tobe substantial.

 

36

----

 

**Cash Flows**

 

Operatingactivities provided $10.2 million for the three months ended March 31,2008, and used $3.8 million for the three months ended March 31,2007. This change is due primarily to the fact that beginning on March 31,2007, the effective date of an amendment to the Operating Agreement, toeliminate its obligation to redeem a member’s units therein under anycircumstance, as well as the acceleration of the vesting of all Compensatory Unitsthen subject to vesting, distributions on all membership units are classifiedas financing activities in our consolidated statements of cash flows.  As a result of this reclassification, netcash provided by operating activities has increased, and net cash provided byfinancing activities has decreased beginning on March 31, 2007.

 

Investing activities consist primarily of investments in affiliates andother investment partnerships, as well as capital expenditures. Investingactivities used $0.1 million for the three months ended March 31,2008 and provided $0.0 million for the three months ended March 31, 2007.This change was driven primarily by capital expenditures associated with thebuild out of additional space in our New York office.

 

Financing activities consist primarily of contributions from membersand contributions from, and distributions to, non-controlling interests.Financing activities used $1.3 million for the three months ended March 31,2008 and used $0.6 million for the three months ended March 31, 2007.The increase in cash used in financing activities is due primarily to the factthat the amendment to the Operating Agreement of our operating company, asexplained above, reclassifies distributions on all membership units as financingactivities in our consolidated statements of cash flows.

 

**Critical Accounting Policies and Estimates**

 

The preparation of our consolidated financial statements in accordancewith U.S. generally accepted accounting principles requires management to makeestimates and judgments that affect our reported amounts of assets,liabilities, revenues and expenses and related disclosure of contingent assetsand liabilities. We base our estimates on historical experience and on variousother assumptions that are believed to be reasonable under currentcircumstances, the results of which form the basis for making judgments aboutthe carrying value of assets and liabilities that are not readily availablefrom other sources. We evaluate our estimates on an ongoing basis. Actualresults may differ from these estimates under different assumptions orconditions.

 

Accountingpolicies are an integral part of our financial statements. A thoroughunderstanding of these accounting policies is essential when reviewing our reportedresults of operations and our financial condition. Management believes that thecritical accounting policies and estimates discussed below involve additionalmanagement judgment due to the sensitivity of the methods and assumptions used.

 

37

----

 

**Unit-based Compensation**

 

OnJanuary 1, 2006, we adopted Statement of Financial Accounting Standards No. 123(R),Share-Based Payment (“FAS 123(R)”), which requires the recognition of thecost of equity-based compensation based on the fair value of the award as ofits grant date. Prior to the adoption of FAS 123(R), we accounted for ourunit-based compensation in accordance with the provisions of AccountingPrinciples Board Opinion No. 25, *Accountingfor Stock Issued to Employees* (“APB 25”), and related interpretations.The adoption of FAS 123(R) did not have a material effect on theresults of operations or financial condition of the Company. Pursuant toFAS 123(R), we recognize compensation expense associated with the grantingof equity-based compensation based on the fair value of the award as of itsgrant date if it is classified as an equity instrument, and on the changes insettlement amount for awards that are classified as liabilities. Prior to March 31,2007, our compensatory membership unit-based awards had repurchase featuresthat required us to classify them as liabilities. Accordingly, distributionspaid on these membership units were classified as compensation expense. Inaddition, changes to their redemption values subsequent to their grant dateshave been included in compensation expense. As of March 31, 2007, we acceleratedthe vesting of all Compensatory Units then subject to vesting. The one-timecharge associated with this acceleration, approximately $65.0 million, wasrecorded on March 31, 2007. Our Operating Agreement was further amended asof March 31, 2007, such that our operating company will no longer berequired to redeem any membership units for cash upon a member’s termination ordeath. Accordingly, beginning with our interim financial statements for thethree months ended June 30, 2007, our operating company is no longerrequired to include in compensation expense the distributions in respect ofthese membership units or the change in their redemption value

 

**Consolidation**

 

Our policy is to consolidate all majority-owned subsidiaries in whichwe have a controlling financial interest and variable-interest entities wherewe are deemed to be the primary beneficiary. We also consolidatenon-variable-interest entities which we control as the general partner ormanaging member. We assess our consolidation practices regularly, ascircumstances dictate. All significant inter-company transactions and balanceshave been eliminated.

 

Investments in private investment partnerships in which we have aminority interest and exercise significant influence are accounted for usingthe equity method. Such investments are reflected on the consolidatedstatements of financial condition as investments in affiliates and are recordedat the amount of capital reported by the respective private investmentpartnerships. Such capital accounts reflect the contributions paid to,distributions received from, and the equity earnings of, the private investmentpartnerships. The earnings of these private investment partnerships areincluded in equity in earnings of affiliates in the consolidated statements ofoperations.

 

**Income Taxes**

 

We are a “C” corporationunder the Internal Revenue Code, and thus liable for federal, state and localtaxes on the income derived from our economic interest in our operatingcompany. The operating company is a limited liability company that has electedto be treated as a partnership for tax purposes. Our operating company has notmade provision for federal or state income taxes because it is theresponsibility of each of the operating company’s members (including us) toseparately report their proportionate share of the operating company’s taxableincome or loss. Similarly, the income of our consolidated investmentpartnerships is not subject to income taxes, as such income is allocated toeach partnership’s individual partners. The operating company has made aprovision for New York City UBT.

 

We and our consolidated subsidiaries account for all federal, state andlocal taxation pursuant to the asset and liability method, which requiresdeferred income tax assets and liabilities to be recorded for temporarydifferences between the financial statement and tax bases of assets andliabilities that will result in taxable or deductible amounts in the future,based on enacted tax laws and rates applicable to the periods in which thetemporary differences are expected to affect taxable income. Valuationallowances are established, when 

 

38

----

 

necessary, to reduce deferredtax assets to the amount expected to be realized. The income tax provision, orcredit, is the tax payable, or refundable, for the period, plus or minus thechange during the period in deferred tax assets and liabilities.

 

Management judgment is required in determining our provision for incometaxes, evaluating our tax positions and establishing deferred tax assets andliabilities. The calculation of our tax liabilities involves dealing withuncertainties in the application of complex tax regulations. If our estimate oftax liabilities proves to be less than the ultimate assessment, a furthercharge to earnings would result.

 

**Recently Issued Accounting Pronouncements**

 

We adopted the provisions of Statement of Financial Accounting StandardsNo. 157, *Fair Value Measurements*(“FAS 157”), on January 1, 2008. Our fair value measurements relate to our interest rate swap, as well asour investments in marketable securities and securities sold short, which areprimarily exchange-traded securities with quoted prices in active markets.  The fair value measurements of the securitieshave been classified as Level 1. The fair value measurement of the interest rate swap has been classifiedas Level 2, based upon the market prices for interest rate swaps withsimilar provisions and forward interest rate curves.

 

In February 2007, the FASB issued Statement of Financial AccountingStandards No. 159, *The Fair Value Option forFinancial Assets and Financial Liabilities*(“FAS 159”).  FAS 159 permits an entity to elect to measurecertain financial instruments and certain other items at fair value withchanges in fair value recognized in earnings. FAS 159 is effective for fiscal years beginning after November 15, 2007.  Since we chose not to elect this fair valueoption, the impact of the adoption of this statement was not material.

 

InDecember 2007, the FASB issued Statement of Financial Accounting StandardsNo. 141 (revised 2007), *BusinessCombinations* (“FAS 141R”) which replaces Statement of FinancialAccounting Standards No. 141, *BusinessCombinations*. FAS 141R establishes the principles and requirementsfor how an acquirer: (i) recognizes and measures in its financialstatements the identifiable assets acquired, the liabilities assumed, and anynoncontrolling interest in the acquiree; (ii) recognizes and measures thegoodwill acquired in the business combination or a gain from a bargainpurchase; and (iii) discloses the business combination. This Statementapplies to all transactions in which an entity obtains control of one or morebusinesses, including transactions that occur without the transfer of any typeof consideration. FAS 141R is effective for us on a prospective basis forall business combinations on or after January 1, 2009, with the exceptionof the accounting for valuation allowances on deferred taxes and acquired taxcontingencies. Early adoption is not allowed. We are in the process ofassessing the impact of this standard on the consolidated financial statementsof the Company.

 

In December 2007, the FASB issued Statement of FinancialAccounting Standards No. 160, *NoncontrollingInterests in Consolidated Financial Statements—an amendment of ARB No. 51*(“FAS 160”). FAS 160 amends ARB No. 51 and establishesaccounting and reporting standards that require noncontrolling interests(previously referred to as minority interest) to be reported as a component ofequity, changes in a parent’s ownership interest while the parent retains itscontrolling interest be accounted for as equity transactions, and upon a lossof control, retained ownership interest will be remeasured at fair value, withany gain or loss recognized in earnings. FAS 160 is effective for us on January 1,2009, except for the presentation and disclosure requirements, which will beapplied retrospectively. Early adoption is not allowed. We are in the processof assessing the impact of this standard on the consolidated financialstatements of the Company.

 

In March 2008, the FASB issued Statement of Financial AccountingStandards No. 161, *Disclosures aboutDerivative Instruments and Hedging Activities (“*FAS 161*”).* FAS 161 is intended to improve financialreporting about derivative instruments and hedging activities by requiringenhanced disclosures to enable investors to better understand their effects onan entity’s financial position, financial performance, and cash flows. It iseffective for financial statements issued for fiscal years and interim periodsbeginning after November 15, 2008. We are in the process of assessing theimpact of this standard on the consolidated financial statements of theCompany.

 

39

----

 

**Item 3. *Quantitative and Qualitative Disclosures About MarketRisk***

 

**Market Risk**

 

Our exposure to market risk is directly related to our role asinvestment adviser for the separate accounts we manage and the funds for whichwe act as sub-investment adviser. All of our revenue for the three months endedMarch 31, 2008 was derived from advisory fees, which are typically basedon the market value of AUM. Accordingly, a decline in the prices of securitieswould cause our revenue and income to decline due to a decrease in the value ofthe assets we manage. In addition, such a decline could cause our clients towithdraw their funds in favor of investments offering higher returns or lowerrisk, which would cause our revenue and income to decline further.

 

We are also subject to market risk due to a decline in the prices ofour investments in affiliates and the value of the holdings of our consolidatedsubsidiaries, both of which consist primarily of marketable securities. At March 31,2008, the fair value of these assets was $33.0 million. Assuming a 10%increase or decrease, the fair value would have increased or decreased by$3.3 million at March 31, 2008.

 

**Interest Rate Risk**

 

The $60.0 million that our operating company borrowed in 2007pursuant to the three-year term loan agreement described above, and any amountsour operating company borrows under the amended $5.0 million revolvingcredit facility, will accrue interest at variable rates. The operating companyentered into a $60.0 million notional amount interest rate swap agreementthat commences on July 23, 2008. The swap, which expires on the same dateas the operating company’s three-year, $60.0 million term loan facility,obligates us to pay a 2.825% fixed rate of interest on the notional amount andrequires the counterparty to pay us a floating interest rate based on themonthly LIBOR interest rate. The 1.50% spread on the term loan is in additionto these amounts, resulting in an aggregate annualized fixed payment of 4.325%of the notional amount for the term of the swap agreement. Interest ratechanges may, therefore, affect the amount of our interest payments related toany potential differential between the notional amount of the interest rateswap and amounts outstanding under the term loan agreement, as well as anyamounts borrowed under the revolving credit agreement. Such changes wouldcorrespondingly affect our future earnings and cash flows. Based on theconsolidated debt obligations that we have as of March 31, 2008, webelieve that our cash flow hedge is effective, and, therefore, would beunaffected in the event that interest rates were to increase by one percentagepoint.

 

**Item 4T.        *Controls and Procedures.***

*** ***

During the course of their review of our consolidated financialstatements as of March 31, 2008, our management, including our ChiefExecutive Officer and Chief Financial Officer, evaluated the effectiveness ofour disclosure controls and procedures pursuant to Rule 13a-15 under theExchange Act as of March 31, 2008. Based on that evaluation, our ChiefExecutive Officer and Chief Financial Officer have concluded that, as of March 31,2008, our disclosure controls and procedures (as defined in Rule 13a-15(e) underthe Exchange Act) were effective to ensure that information we are required todisclose in reports that we file or submit under the Exchange Act is recorded,processed, summarized and reported within the time periods specified in SEC rules andforms, and that such information is accumulated and communicated to ourmanagement, including our Chief Executive Officer and Chief Financial Officer,as appropriate, to allow timely decisions regarding required disclosure.

 

There was no change in our internal control over financial reportingthat occurred during the first quarter of 2008 that has materially affected, oris reasonably likely to materially affect, our internal control over financialreporting.

 

40

----

 

**PART II.  OTHERINFORMATION**

 

**Item 1.*  *Legal Proceedings.**

 

In the normalcourse of business, we may be subject to various legal and administrativeproceedings. On November 21, 2007 and January 16, 2008, respectively, substantivelyidentical putative class action lawsuits were commenced in the United StatesDistrict Court for the Southern District of New York against us and Richard S.Pzena, our chief executive officer, seeking remedies under Section 11 of theSecurities Act of 1933, as amended. The Court consolidated the lawsuits andappointed co-lead plaintiffs, who filed a consolidated amended complaint.  The consolidated amended complaint names asdefendants us, Richard S. Pzena, and two of the underwriters of our initialpublic offering, Goldman Sachs & Co., Inc. and UBS Securities LLC.  Plaintiffs seek to represent a class of allpersons who purchased or otherwise acquired Class A common stock issuedpursuant or traceable to our initial public offering.  The consolidated amended complaint allegesthat the registration statement and prospectus relating to the initial publicoffering of our Class A common stock contained material misstatements andomissions and wrongfully failed to disclose net redemptions in the John HancockClassic Value Fund for which we act as sub-investment advisor.  The consolidated amended complaint seeksdamages in an unspecified amount including rescission or rescissory damages.  We believe that the allegations and claimsare without merit and we intend to contest these claims vigorously.

 

**Item 1A.  Risk Factors.**

 

There are no materialchanges from the risk factors set forth in Part 1, Item 1A of theCompany’s 2007 Form 10-K.

 

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

 

During the first quarter of 2008, we issued to certain of our employeesan aggregate of 13,000 restricted Class B units which are subject tovesting in four equal annual installments beginning on January 1, 2009,and an equivalent number of shares of Class B common stock subject to thesame restrictions.  We also issued anaggregate of 446,000 options to acquire Class B units with an exerciseprice of $11.40 per share, which are subject to vesting in four equal annualinstallments beginning on January 1, 2009. The issuances did not involve any public offering, general advertisingor general solicitation. Each person to whom securities were issued, by virtueof his or her relationship with us, had knowledge of and access to sufficientinformation about us to make an informed investment decision. The certificatesrepresenting the securities bear a restrictive legend. On the basis of thesefacts, the securities were issued in a transaction not involving a publicoffering and were issued in reliance upon the exemption from registrationprovided by Section 4(2) of the Securities Act of 1933.

 

**Item 3.*  *Defaults Upon Senior Securities.**

 

None.

 

**Item 4.*  *Submission of Matters to a Vote of Security Holders.**

 

Not applicable

 

**Item 5.*  *Other Information.**

 

None.

 

41

----

 

**Item 6.     Exhibits.**

** **
| **Exhibit** | ** ** | **Description  of Exhibit**                                                                                                                                                                                                                              |
|-------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1        |       | Amendment No.1 to Credit Agreement, dated as of February 11, 2008  among Pzena Investment Management, LLC, as the Borrower, Pzena Alternative  Investments, LLC, as the Guarantor and Bank of America, N.A., as  Administrative Agent and as a Lender(1) |
| 31.1        |       | Certification  of Chief Executive Officer pursuant to Exchange Act Rule 13a-14(a)/15(d)-14(a)                                                                                                                                                            |
| 31.2        |       | Certification  of Chief Financial Officer pursuant to Exchange Act Rule 13a-14(a)/15(d)-14(a)                                                                                                                                                            |
| 32.1        |       | Certification  of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                                                                                                      |
| 32.2        |       | Certification  of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                                                                                                      |

 

----

(1) Previouslyfiled as an exhibit to the Company’s current report on Form 8-K filed withthe Securities and Exchange Commission on February 12, 2008.

 

42

----

 

**SIGNATURES**

 

Pursuant tothe requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 
| Dated: May 14, 2008 |   |   |
|--------------------------|--------|--------|
|                     |   |   |

 
|   | PZENA  INVESTMENT MANAGEMENT, INC. |
|--------|------------------------------------|
|   |                               |   |
|   | By:                                | /s/  Richard  S. Pzena |
|   |                               | Name:   Richard S. Pzena |
|   |                               | Title:     Chief Executive Officer |
|   |                               |   |
|   |                               |   |
|   | By:                                | /s/  Wayne A. Palladino |
|   |                               | Name:   Wayne A. Palladino |
|   |                               | Title:     Chief Financial Officer |

 

----