Table of Contents

 

 

 

**UNITED STATES**

**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

**FORM 10-Q**

 

**x****      Quarterly report pursuant to Section 13 or 15(d) of theSecurities Exchange Act of 1934**

 

**For the Quarterly Period Ended September 30, 2010**

 

**Or**

** **

**o****         Transition report pursuant to Section 13 or 15(d) of theSecurities Exchange Act of 1934**

 

**For the transition periodfrom                to                **

 

**Commissionfile number 001-33761**

 

**PZENA INVESTMENT MANAGEMENT, INC.**

(Exact Name of Registrant asSpecified in its Charter)

 

| **Delaware**                    | ** ** | **20-8999751**      |
|---------------------------------|------------|---------------------|
| (State or Other Jurisdiction of |       | (I.R.S. Employer    |
| Incorporation or Organization)  |       | Identification No.) |

 

**120 West45th Street**

**New York, New York 10036**

(Address of PrincipalExecutive Offices) (Zip Code)

 

Registrant’s telephonenumber, including area code: **(212) 355-1600**

 

**Not Applicable**

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

 

Indicate by check mark whether the registrant: (1) has filed allreports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorterperiod that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past90 days. Yes x  No o

 

Indicate by check markwhether the registrant has submitted electronically and posted on its corporateweb site, if any, every Interactive Date File required to be submitted andposted pursuant to Rule 405 of Regulation S-T during the preceding 12months (or for such shorter period that the registrant was required to submitand post such files). Yes o  No o

 

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

 

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

 

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

 

As of November 4, 2010, there were 9,367,659 outstanding shares ofthe registrant’s Class A common stock, par value $0.01 per share.

 

As of November 4, 2010, there were 54,960,418 outstanding sharesof the registrant’s Class B common stock, par value $0.000001 per share.

 

 

 

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**PZENA INVESTMENT MANAGEMENT, INC.**

**FORM 10-Q**

**TABLE OF CONTENTS**

 
| ** **    | ** ** | ** **                                                                                                                                                                                    | ** ** | **Page** |
|---------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|
| ** **    | ** ** | **PART I  — FINANCIAL INFORMATION**                                                                                                                                                 |       |     |
| Item 1.  |       | Consolidated  Statements of Financial Condition of Pzena Investment Management, Inc.   as of September 30, 2010 (unaudited) and December 31, 2009                              |       | 1        |
|          |       | Consolidated  Statements of Operations (unaudited) of Pzena Investment  Management, Inc.   for the Three and Nine Months Ended September 30, 2010 and September 30,  2009 |       | 2        |
|          |       | Consolidated  Statements of Cash Flows (unaudited) of Pzena Investment  Management, Inc.   for the Three and Nine Months Ended September 30, 2010 and  September 30, 2009 |       | 3        |
|          |       | Consolidated Statement of Changes in Equity  (unaudited) of Pzena Investment Management, Inc.    for the Nine Months Ended September 30, 2010                                  |       | 4        |
|          |       | Notes  to the Consolidated Financial Statements (unaudited)                                                                                                                                   |       | 5        |
| Item 2.  |       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                                                                                   |       | 19       |
| Item 3.  |       | Quantitative  and Qualitative Disclosures About Market Risk                                                                                                                                   |       | 31       |
| Item 4.  |       | Controls and  Procedures                                                                                                                                                                      |       | 32       |
|          |       |                                                                                                                                                                                          |       |     |
| ** **    | ** ** | **PART II  — OTHER INFORMATION**                                                                                                                                                    |       |     |
| Item 1.  |       | Legal Proceedings                                                                                                                                                                             |       | 33       |
| Item 1A. |       | Risk Factors                                                                                                                                                                                  |       | 33       |
| Item 2.  |       | Unregistered  Sales of Equity Securities and Use of Proceeds                                                                                                                                  |       | 33       |
| Item 3.  |       | Defaults  Upon Senior Securities                                                                                                                                                              |       | 33       |
| Item 4.  |       | (Removed and  Reserved)                                                                                                                                                                       |       | 33       |
| Item 5.  |       | Other Information                                                                                                                                                                             |       | 33       |
| Item 6.  |       | Exhibits                                                                                                                                                                                      |       | 33       |

 

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**CAUTIONARYSTATEMENT REGARDING FORWARD-LOOKING STATEMENTS**

 

This Quarterly Report on Form 10-Q contains forward-lookingstatements.  Forward-looking statementsprovide our current expectations, or forecasts, of future events.  Forward-looking statements include statementsabout 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 thosewords or phrases, may identify forward-looking statements, but the absence ofthese words does not necessarily mean that a statement is not forward-looking.

 

Forward-looking statements are subject to known and unknown risks anduncertainties and are based on potentially inaccurate assumptions that couldcause actual results to differ materially from those expected or implied by theforward-looking statements. Our actual results could differ materially fromthose anticipated in forward-looking statements for many reasons, including thefactors described in Item 1A, “Risk Factors” in Part I of our AnnualReport on Form 10-K for our fiscal year ended December 31, 2009.  Accordingly, you should not unduly rely onthese forward-looking statements, which speak only as of the date of thisQuarterly Report.  We undertake noobligation to publicly revise any forward-looking statements to reflectcircumstances or events after the date of this Quarterly Report, or to reflectthe occurrence of unanticipated events. You should, however, review the factors and risks we describe in thereports we will file from time to time with the Securities and ExchangeCommission, or SEC, after the date of this Quarterly Report on Form 10-Q.

 

Forward-looking statements include, but are not limited to, statementsabout:

 

·      ouranticipated future results of operations and operating cash flows;

 

·      ourbusiness strategies and investment policies;

 

·      ourfinancing plans and the availability of short- or long-term borrowing, orequity financing;

 

·      ourcompetitive position and the effects of competition on our business;

 

·      potentialgrowth opportunities available to us;

 

·      therecruitment and retention of our employees;

 

·      ourexpected levels of compensation for our employees;

 

·      ourpotential operating performance, achievements, efficiency, and cost reductionefforts;

 

·      ourexpected tax rate;

 

·      changesin interest rates;

 

·                  our expectation with respectto the economy, capital markets, the market for asset management services, andother industry trends; and

 

·      the impact of future legislation andregulation, and changes in existing legislation and regulation, on ourbusiness.

 

The reports that we file with the SEC, accessible on the SEC’s websiteat *www.sec.gov*, identifyadditional factors that can affect forward-looking statements.

 

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**PART I. FINANCIALINFORMATION**

 

**Item 1. Financial Statements.**

** **

**PZENAINVESTMENT MANAGEMENT, INC.**

**CONSOLIDATEDSTATEMENTS OF FINANCIAL CONDITION**

**(inthousands, except share and per-share amounts)**

 
| ** **                                                                                                                                                               | ** ** | **As of**         | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                                                                                                               | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
| ** **                                                                                                                                                               | ** ** | **2010**               | ** ** | **2009** | ** ** |
| ** **                                                                                                                                                               | ** ** | **(unaudited)**        | ** ** | ** ** | ** ** |
|                                                                                                                                                                     |       |                   |       |   |   |
| **ASSETS**                                                                                                                                                               |       |                   |       |   |   |
| Cash and Cash Equivalents                                                                                                                                                |       | $                      | 26,801     |   | $ | 15,908 |   |
| Restricted Cash                                                                                                                                                          |       | 1,420                  |       | 1,407 |   |
| Due from Broker                                                                                                                                                          |       | 13                     |       | 116 |   |
| Advisory Fees Receivable                                                                                                                                                 |       | 14,248                 |       | 13,378 |   |
| Investments, at Fair Value                                                                                                                                               |       | 3,058                  |       | 7,951 |   |
| Receivable from Related Parties                                                                                                                                          |       | 80                     |       | 149 |   |
| Other Receivables                                                                                                                                                        |       | 53                     |       | 36 |   |
| Prepaid Expenses and Other Assets                                                                                                                                        |       | 637                    |       | 504 |   |
| Deferred Tax Asset, Net of Valuation Allowance of $61,366  and $60,252, respectively                                                                                     |       | 7,554                  |       | 6,754 |   |
| Property and Equipment, Net of Accumulated  Depreciation of $2,686 and $2,385, respectively                                                                              |       | 2,005                  |       | 2,315 |   |
| TOTAL ASSETS                                                                                                                                                             |       | $                      | 55,869     |   | $ | 48,518 |   |
|                                                                                                                                                                     |       |                   |       |   |   |
| **LIABILITIES AND EQUITY**                                                                                                                                               |       |                   |       |   |   |
| Liabilities:                                                                                                                                                             |       |                   |       |   |   |
| Accounts Payable and Accrued Expenses                                                                                                                                    |       | $                      | 11,455     |   | $ | 3,644 |   |
| Due to Broker                                                                                                                                                            |       | 16                     |       | 731 |   |
| Senior Subordinated Notes                                                                                                                                                |       | —                 |       | 10,000 |   |
| Liability to Selling and Converting Shareholders                                                                                                                         |       | 7,608                  |       | 5,642 |   |
| Other Liabilities                                                                                                                                                        |       | 1,245                  |       | 1,143 |   |
| TOTAL LIABILITIES                                                                                                                                                        |       | 20,324                 |       | 21,160 |   |
|                                                                                                                                                                     |       |                   |       |   |   |
| 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; 9,367,659 and 8,633,041 Shares Issued and  Outstanding in 2010 and 2009, respectively)       |       | 93                     |       | 86 |   |
| Class B Common Stock (Par Value $0.000001;  750,000,000 Shares Authorized; 54,931,418 and 55,659,236 Shares Issued and  Outstanding in 2010 and 2009, respectively) |       | —                 |       | — |   |
| Additional Paid-In Capital                                                                                                                                               |       | 10,689                 |       | 10,104 |   |
| Retained Earnings/(Accumulated Deficit)                                                                                                                                  |       | 194                    |       | (1,920 | ) |
| Total Pzena Investment Mangement, Inc.’s  Equity                                                                                                               |       | 10,976                 |       | 8,270 |   |
| Non-Controlling Interests                                                                                                                                                |       | 24,569                 |       | 19,088 |   |
| TOTAL EQUITY                                                                                                                                                             |       | 35,545                 |       | 27,358 |   |
| TOTAL LIABILITIES AND EQUITY                                                                                                                                             |       | $                      | 55,869     |   | $ | 48,518 |   |

 

See accompanying notes to consolidatedfinancial statements.

 

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**PZENAINVESTMENT MANAGEMENT, INC.**

**UNAUDITEDCONSOLIDATED STATEMENTS OF OPERATIONS**

**(inthousands, except share and per-share amounts)**

 
| ** **                                                         | ** ** | **For the Three Months** | ** ** | **For the Nine Months** | ** ** |
|--------------------------------------------------------------------|------------|-----------------------------------------|------------|----------------------------------------|------------|
| ** **                                                         | ** ** | **Ended September 30,**       | ** ** | **Ended September 30,**      | ** ** |
| ** **                                                         | ** ** | **2010**                                | ** ** | **2009**                               | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                                         | ** ** | ** **                              | ** ** | ** **                             | ** ** | ** ** | ** ** | ** ** | ** ** |
| **REVENUE**                                                        |       | $                                       | 18,482     |                                   | $          | 16,813 |   | $ | 57,020 |   | $ | 44,717 |   |
|                                                               |       |                                    |       |                                   |       |   |   |   |   |
| **EXPENSES**                                                       |       |                                    |       |                                   |       |   |   |   |   |
| Compensation  and Benefits Expense                                 |       | 7,375                                   |       | 6,232                                  |       | 22,026 |   | 18,255 |   |
| General  and Administrative Expenses                               |       | 1,837                                   |       | 1,904                                  |       | 5,927 |   | 6,330 |   |
| TOTAL  OPERATING EXPENSES                                          |       | 9,212                                   |       | 8,136                                  |       | 27,953 |   | 24,585 |   |
| Operating  Income                                                  |       | 9,270                                   |       | 8,677                                  |       | 29,067 |   | 20,132 |   |
|                                                               |       |                                    |       |                                   |       |   |   |   |   |
| **OTHER INCOME/(EXPENSE)**                                         |       |                                    |       |                                   |       |   |   |   |   |
| Interest  and Dividend Income                                      |       | 85                                      |       | 116                                    |       | 270 |   | 363 |   |
| Interest  Expense                                                  |       | —                                  |       | (376                                   | )          | (232 | ) | (1,231 | ) |
| Net  Realized and Unrealized Gain from Investments                 |       | 544                                     |       | 4,152                                  |       | 137 |   | 6,061 |   |
| Increase  in Liability to Selling and Converting Shareholders      |       | (1,725                                  | )          | (2,382                                 | )          | (1,633 | ) | (3,586 | ) |
| Other  Expense                                                     |       | 3                                       |       | 41                                     |       | 72 |   | 149 |   |
| Total  Other Income/(Expense)                                      |       | (1,093                                  | )          | 1,551                                  |       | (1,386 | ) | 1,756 |   |
| Income  Before Income Taxes                                        |       | 8,177                                   |       | 10,228                                 |       | 27,681 |   | 21,888 |   |
| Income  Tax Provision/(Benefit)                                    |       | (1,075                                  | )          | (2,040                                 | )          | 1,373 |   | (2,379 | ) |
| Consolidated  Net Income                                           |       | 9,252                                   |       | 12,268                                 |       | 26,308 |   | 24,267 |   |
| Less:  Net Income Attributable to Non-Controlling Interests        |       | 8,033                                   |       | 10,836                                 |       | 23,632 |   | 21,531 |   |
| Net  Income Attributable to Pzena Investment Management, Inc. |       | $                                       | 1,219      |                                   | $          | 1,432 |   | $ | 2,676 |   | $ | 2,736 |   |
|                                                               |       |                                    |       |                                   |       |   |   |   |   |
| Net  Income for Basic Earnings per Share                           |       | $                                       | 1,219      |                                   | $          | 1,432 |   | $ | 2,676 |   | $ | 2,736 |   |
| Basic  Earnings per Share                                          |       | $                                       | 0.13       |                                   | $          | 0.17 |   | $ | 0.29 |   | $ | 0.34 |   |
| Basic  Weighted Average Shares Outstanding                         |       | 9,367,659                               |       | 8,633,041                              |       | 9,125,477 |   | 8,077,545 |   |
|                                                               |       |                                    |       |                                   |       |   |   |   |   |
| Net  Income for Diluted Earnings per Share                         |       | $                                       | 5,632      |                                   | $          | 6,051 |   | $ | 16,096 |   | $ | 12,889 |   |
| Diluted  Earnings per Share                                        |       | $                                       | 0.09       |                                   | $          | 0.09 |   | $ | 0.25 |   | $ | 0.20 |   |
| Diluted  Weighted Average Shares Outstanding                       |       | 64,993,746                              |       | 64,994,278                             |       | 65,006,198 |   | 64,756,331 |   |
|                                                               |       |                                    |       |                                   |       |   |   |   |   |
| Cash  Dividends per Share of Class A Stock                    |       | $                                       | 0.03       |                                   | $          | — |   | $ | 0.06 |   | $ | — |   |

 

See accompanying notes toconsolidated financial statements.

 

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**PZENAINVESTMENT MANAGEMENT, INC.**

**UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(in thousands)**

 
| ** **                                                                     | ** ** | **For the Three Months** | ** ** | **For the Nine Months** | ** ** |
|--------------------------------------------------------------------------------|------------|-----------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                     | ** ** | **Ended September 30,**       | ** ** | **Ended September 30,**      | ** ** |
| ** **                                                                     | ** ** | **2010**                                | ** ** | **2009**                               | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                                                     | ** ** | ** **                              | ** ** | ** **                             | ** ** | ** ** | ** ** | ** ** | ** ** |
| **OPERATING ACTIVITIES**                                                       |       |                                    |       |                                   |       |   |   |   |   |
| Consolidated  Net Income                                                       |       | $                                       | 9,252      |                                   | $          | 12,268 |   | $ | 26,308 |   | $ | 24,267 |   |
| Adjustments  to Reconcile Net Income to Cash Provided by Operating Activities: |       |                                    |       |                                   |       |   |   |   |   |
| Depreciation                                                                   |       | 108                                     |       | 121                                    |       | 322 |   | 362 |   |
| Non-Cash  Compensation                                                         |       | 901                                     |       | 255                                    |       | 2,565 |   | 816 |   |
| Director  Share Grant                                                          |       | 14                                      |       | —                                 |       | 41 |   | 280 |   |
| Net  Realized and Unrealized Gain from Investments                             |       | (544                                    | )          | (4,152                                 | )          | (137 | ) | (6,061 | ) |
| Increase  in Liability to Selling and Converting Shareholders                  |       | 1,725                                   |       | 2,382                                  |       | 1,633 |   | 3,586 |   |
| Deferred  Income Taxes                                                         |       | (1,677                                  | )          | (2,611                                 | )          | (579 | ) | (3,804 | ) |
|                                                                           |       |                                    |       |                                   |       |   |   |   |   |
| Changes  in Operating Assets and Liabilities:                                  |       |                                    |       |                                   |       |   |   |   |   |
| Advisory  Fees Receivable                                                      |       | (928                                    | )          | (2,113                                 | )          | (870 | ) | 881 |   |
| Due  from Broker                                                               |       | 58                                      |       | (19                                    | )          | 103 |   | (13 | ) |
| Prepaid  Expenses and Other Assets                                             |       | 16                                      |       | (1,550                                 | )          | (120 | ) | (1,544 | ) |
| Due  to Broker                                                                 |       | (79                                     | )          | (1                                     | )          | (715 | ) | (18 | ) |
| Due  to Principles                                                             |       | —                                  |       | (653                                   | )          | — |   | — |   |
| Accounts  Payable, Accrued Expenses, and Other Liabilities                     |       | 3,110                                   |       | 2,790                                  |       | 7,473 |   | 5,115 |   |
| Purchases  of Investments                                                      |       | (2,336                                  | )          | (2,913                                 | )          | (5,847 | ) | (7,771 | ) |
| Proceeds  from Sale of Equity Securities                                       |       | 304                                     |       | 3,891                                  |       | 7,279 |   | 9,507 |   |
| **Net Cash Provided by Operating Activities**                                  | ** ** | **9,924**                               | ** ** | **7,695**                              | ** ** | **37,456** | ** ** | **25,603** | ** ** |
|                                                                           |       |                                    |       |                                   |       |   |   |   |   |
| **INVESTING ACTIVITIES**                                                       |       |                                    |       |                                   |       |   |   |   |   |
| Restricted  Cash                                                               |       | (4                                      | )          | —                                 |       | (13 | ) | — |   |
| Receivable  from Related Parties                                               |       | (13                                     | )          | (43                                    | )          | 27 |   | 6 |   |
| Purchases  of Property and Equipment                                           |       | (3                                      | )          | —                                 |       | (13 | ) | (6 | ) |
| **Net Cash Provided by/(Used In) Investing Activities**                        | ** ** | **(20**                                 | **)**      | **(43**                                | **)**      | **1** | ** ** | **—** | ** ** |
|                                                                           |       |                                    |       |                                   |       |   |   |   |   |
| **FINANCING ACTIVITIES**                                                       |       |                                    |       |                                   |       |   |   |   |   |
| Distributions  to Non-Controlling Interests                                    |       | (6,322                                  | )          | (4,719                                 | )          | (20,225 | ) | (12,199 | ) |
| Contributions  from Non-Controlling Interests                                  |       | —                                  |       | 322                                    |       | 4,321 |   | 322 |   |
| Retirement  of B Units                                                         |       | —                                  |       | —                                 |       | (2 | ) | — |   |
| Term  Loan and Senior Subordinated Notes Repayment                             |       | —                                  |       | (10,000                                | )          | (10,000 | ) | (22,000 | ) |
| Dividends                                                                      |       | (281                                    | )          | —                                 |       | (562 | ) | — |   |
| **Net Cash Used in Financing Activities**                                      | ** ** | **(6,603**                              | **)**      | **(14,397**                            | **)**      | **(26,468** | **)** | **(33,877** | **)** |
| **NET CHANGE IN CASH**                                                         | ** ** | **$**                                   | **3,301**  | ** **                             | **$**      | **(6,745** | **)** | **$** | **10,989** | ** ** | **$** | **(8,274** | **)** |
|                                                                           |       |                                    |       |                                   |       |   |   |   |   |
| **CASH AND CASH EQUIVALENTS - Beginning of Period**                            |       | $                                       | 23,596     |                                   | $          | 25,892 |   | $ | 15,908 |   | $ | 27,421 |   |
| Effect  of Deconsolidation of Affiliates                                       |       | (96                                     | )          | —                                 |       | (96 | ) | — |   |
| Net  Change in Cash                                                            |       | 3,301                                   |       | (6,745                                 | )          | 10,989 |   | (8,274 | ) |
| **CASH AND CASH EQUIVALENTS - End of Period**                                  |       | $                                       | 26,801     |                                   | $          | 19,147 |   | $ | 26,801 |   | $ | 19,147 |   |
|                                                                           |       |                                    |       |                                   |       |   |   |   |   |
| Supplementary  Cash Flow Information:                                          |       |                                    |       |                                   |       |   |   |   |   |
| Interest  Paid                                                                 |       | $                                       | —     |                                   | $          | 332 |   | $ | 232 |   | $ | 1,191 |   |
| Income  Taxes Paid                                                             |       | $                                       | 643        |                                   | $          | 535 |   | $ | 2,597 |   | $ | 1,907 |   |

 

See accompanying notes toconsolidated financial statements.

 

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**PZENA INVESTMENT MANAGEMENT, INC.**

**UNAUDITED CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY**

**(in thousands, except share amounts)**

 
| ** **                                          | ** ** | **Shares of**    | ** ** | **Shares of**    | ** ** | ** **            | ** ** | ** **               | ** ** | **Retained Earnings/** | ** ** | ** **          | ** ** | ** **  | ** ** |
|-----------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|-----------------------|------------|--------------------------|------------|-----------------------------|------------|---------------------|------------|-------------|------------|
| ** **                                          | ** ** | **Class A**      | ** ** | **Class B**      | ** ** | **Class A**      | ** ** | **Additional**           | ** ** | **(Accumulated**            | ** ** | **Non-Controlling** | ** ** | ** **  | ** ** |
| ** **                                          | ** ** | **Common Stock** | ** ** | **Common Stock** | ** ** | **Common Stock** | ** ** | **Paid-In Capital** | ** ** | **Deficit)**                | ** ** | **Interests**       | ** ** | **Total**   | ** ** |
|                                                |       |                  |       |                  |       |                  |       |                     |       |                        |       |                |       |        |       |
| **Balance at December 31, 2009**               | ** ** | **8,633,041**         | ** ** | **55,659,236**        | ** ** | **$**                 | **86**     | ** **               | **$**      | **10,104**                  | ** ** | **$**               | **(1,920** | **)**       | **$**      | **19,088** | ** ** | **$** | **27,358** | ** ** |
| Unit  Conversion                                    |       | 734,618               |       | (734,618              | )          | 7                     |       | 368                      |       | —                      |       | (318                | )          | **57**      | ** ** |
| Retirement  of Class B Units                   |       | —                |       | (700                  | )          | —                |       | —                   |       | —                      |       | (2                  | )          | **(2**      | **)**      |
| Directors’  Shares                             |       | —                |       | —                |       | —                |       | 4                        |       | —                      |       | 37                  | ** ** | **41**      | ** ** |
| Amortization  of Non-Cash Compensation              |       | —                |       | 7,000                 |       | —                |       | 276                      |       | —                      |       | 1,679               | ** ** | **1,955**   | ** ** |
| Net  Income                                         |       | —                |       | —                |       | —                |       | —                   |       | 2,676                       |       | 23,632              | ** ** | **26,308**  | ** ** |
| Contributions  from Non-Controlling Interests       |       | —                |       | —                |       | —                |       | —                   |       | —                      |       | 4,321               | ** ** | **4,321**   | ** ** |
| Distributions  to Non-Controlling Interests         |       | —                |       | —                |       | —                |       | (63                      | )          | —                      |       | (20,162             | )          | **(20,225** | **)**      |
| Effect  of Deconsolidation of Affiliates            |       | —                |       | —                |       | —                |       | —                   |       | —                      |       | (3,706              | )          | **(3,706**  | **)**      |
| Class A  Cash Dividends Paid ($0.06 per share) |       | —                |       | —                |       | —                |       | —                   |       | (562                        | )          | —              | ** ** | **(562**    | **)**      |
| **Balance at September 30, 2010**              | ** ** | **9,367,659**         | ** ** | **54,930,918**        | ** ** | **$**                 | **93**     | ** **               | **$**      | **10,689**                  | ** ** | **$**               | **194**    | ** **  | **$**      | **24,569** | ** ** | **$** | **35,545** | ** ** |

 

See accompanying notes to consolidatedfinancial statements.

 

4

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Table of Contents

 

**Pzena Investment Management, Inc.**

**Unaudited Notes to theConsolidated Financial Statements**

 

**Note 1—Organization**

 

Pzena Investment Management, Inc. (the “Company”)functions as the holding company through which the business of its operatingcompany, Pzena Investment Management, LLC, is conducted.  The Company was incorporated in the State ofDelaware on May 8, 2007.  OnOctober 30, 2007, the Company consummated an initial public offering.  Concurrently with the consummation of theCompany’s initial public offering, the operating agreement of Pzena InvestmentManagement, LLC (the “operating agreement”) was amended and restated suchthat, among other things, the Company became the sole managing member of PzenaInvestment Management, LLC.  Theacquisition of the operating company’s membership interests by the Company wastreated as a reorganization of entities under common control.  As a result of these transactions, as of andsubsequent to October 30, 2007, (i) the Company has consolidated thefinancial results of Pzena Investment Management, LLC with its own andreflected the membership interest in it that it does not own as anon-controlling interest in its consolidated financial statements, and(ii) the Company recognizes income generated from its economic interest inPzena Investment Management, LLC’s net income.

 

PzenaInvestment Management, LLC is an investment adviser which is registeredunder the Investment Advisers Act of 1940 and is headquartered in New York, NewYork.  As of September 30, 2010, theCompany managed assets in a variety of value-oriented investment strategiesacross a wide range of market capitalizations in both U.S. and non-U.S. capitalmarkets.

 

TheCompany, through its investment in its operating company, has consolidated theresults of operations and financial condition of the following privateinvestment partnership as of September 30, 2010:

 
| ** **                  | ** ** | ** **                                                      | ** ** | **Company’s**               | ** ** |
|-----------------------------|------------|-----------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                  | ** ** | ** **                                                      | ** ** | **Ownership at**            | ** ** |
| **Entity**                  | ** ** | **Type of Entity (Date of Formation)** | ** ** | **September 30, 2010** | ** ** |
| Pzena  Large Cap Value Fund |       | Massachusetts  Trust (11/01/2002)                               |       | 0.0%                             |       |

 

**Note 2—Significant Accounting Policies**

 

***Basis of Presentation:***

 

Theconsolidated financial statements are prepared in conformity with U.S.generally accepted accounting principles (“GAAP”) and related Securities andExchange Commission (“SEC”) rules and regulations.  The Company’s policy is to consolidate allmajority-owned subsidiaries in which it has a controlling financial interestand variable-interest entities (“VIEs”) where the Company is deemed to be theprimary beneficiary (“consolidated subsidiaries”).  As required by the *Consolidation Topic* of the Financial Accounting StandardsBoard Accounting Standards Codification (“FASB ASC”), the Company alsoconsolidates non-variable-interest entities in which it acts as the generalpartner or managing member.  All of theseentities represent private investment partnerships over which the Companyexercises or exercised control. Non-controlling interests recorded on the consolidated financialstatements of the Company include the non-controlling interests of the outsideinvestors in each of these entities, as well as those of the operatingcompany.  All significant inter-companytransactions and balances have been eliminated.

 

ThePzena Global Value Service and the Pzena Europe, Australasia, and Far East (“EAFE”)Value Service (formerly known as the International Value Service) are limitedliability companies whose managing members are or were members of the executivecommittee of the operating company, or the operating company itself.  Until December 31, 2009, neither ofthese entities were considered VIEs, as the members of the executive committeeof the operating company and/or the operating company were the majority holdersof the equity investments and had controlling financial interests as managingmembers of the partnerships.  Each ofthese limited liability companies was considered an entity “similar” to alimited partnership, and was subject to the guidance of the *Consolidation Topic* of the FASB ASC.  Under each of their respective operatingagreements, none of these entities’ non-managing members had the ability toremove the managing member under any circumstance, nor did they have any participatingrights.  As a result, nothing substantiveexisted to overcome the presumption of control by the managing member, asrequired by the *Consolidation Topic*of the FASB ASC.  Since the managingmembers of these entities were either the operating company, or one of thecontrolling persons of the operating company, their results of operations andfinancial position had been consolidated through December 30, 2009.

 

Effective December 31, 2009, substantially all of the Company’sinvestments in the Pzena Global Value Service and the Pzena EAFE Value Service,held to satisfy the Company’s obligations under its deferred compensationprogram, were reallocated to the Pzena Large Cap Value Fund.  Also effective December 31, 2009, theinvestments of the operating company’s executive committee members in the PzenaGlobal Value Service and the Pzena EAFE Value Service were transferred to aseparately-managed account.  Since theremaining holders of the equity investments in the partnerships subsequent tothese transactions lacked a controlling financial interest in thesepartnerships, as of December 31, 2009, these entities were deemed VIEs.  The Company is not 

 

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Table of Contents

 

**Pzena InvestmentManagement, Inc.**

**Unaudited Notes to theConsolidated Financial Statements (Continued)**

 

consideredthe primary beneficiary of these entities. Correspondingly, the Pzena Global Value Service and the Pzena EAFE ValueService were deconsolidated effective December 31, 2009.  The results of operations and financialposition of each of these entities were consolidated up until December 30,2009.  The Pzena Global Value Service andthe Pzena EAFE Value Service, and other VIEs that are not consolidated,continue to receive investment management services from the Company, and arevehicles through which the Company offers its Global Value and/or its EAFEValue strategies.  The total net assetsof these VIEs was approximately $535.1 million and $522.1 million at September 30,2010 and December 31, 2009, respectively. The Company is not exposed to losses as a result of its involvement withthese entities, since it has no direct investment in them.

 

Duringthe three months ended June 30, 2010, the Company redeemed its investmentsin the Pzena Large Cap Value Fund, the Pzena Emerging Markets Focused ValueService, and the Pzena Emerging Market Countries Value Service.  Theoperating company maintained its controlling financial interest as the managingmember of these entities. Correspondingly, these entities were deemed VIEs.  Since certain members of the operating company’sexecutive committee were majority holders of the equity investments in thepartnerships, the Company continued to be considered the primary beneficiary ofthese entities.  As such, the results ofoperations and financial position of these entities were consolidated by theCompany in accordance with the *ConsolidationTopic* of the FASB ASC at June 30, 2010.

 

Duringthe three months ended September 30, 2010, the holder of the equityinvestments in the Pzena Emerging Markets Focused Value Service and the PzenaEmerging Market Countries Value Service became the managing member of theseentities.  This appointment gave theholder of the equity investments a controlling financial interest in theseentities.  Correspondingly, the Companywas no longer deemed to control these entities. Each of these limited liability companies is considered an entity “similar”to a limited partnership, and is subject to the guidance of the *Consolidation Topic* of the FASB ASC.  As a result, the Pzena Emerging MarketsFocused Value Service and the Pzena Emerging Market Countries Value Servicewere deconsolidated during the three months ended September 30, 2010.

 

TheCompany’s investments previously held in the Pzena Large Cap Value Fund tosatisfy the Company’s obligations under its deferred compensation program havebeen transferred to third-party mutual funds and are included in investments inmutual funds at September 30, 2010.

 

Theconsolidated investment partnership, the Pzena Large Cap Value Fund, is aninvestment company under the American Institute of Certified Public AccountantsAudit and Accounting Guide for Investment Companies.  The Company has retained the specializedaccounting for this partnership pursuant to the *Consolidation Topic* of the FASB ASC.  Thus, the Company reports the investmentpartnership’s investments in equity securities at fair value, with net realizedand unrealized gains and losses reported in earnings in the consolidatedstatements of operations.

 

TheCompany records in its own equity its pro-rata share of transactions thatimpact the operating company’s net equity, including equity and optionissuances and adjustments to accumulated other comprehensive income.  The operating company’s pro-rata share ofsuch transactions are recorded as adjustments to additional paid-in capital ornon-controlling interests, as applicable, on the consolidated statements offinancial position.

 

***Management’s Use of Estimates:***

 

Thepreparation of financial statements in conformity with GAAP requires managementto make estimates and assumptions that affect the reported amounts of assetsand liabilities, disclosure of contingent assets and liabilities at the date ofthe financial statements, and the reported amounts of revenues and expenses forthe period.  Actual results could differfrom those estimates.

 

***Fair Values of Financial Instruments:***

 

Thecarrying amounts of all financial instruments in the consolidated statements offinancial condition, including investments in equity securities and mutualfunds, approximate their fair value.

 

***Revenue Recognition:***

 

Revenue,comprised of advisory fee income, is recognized over the period in whichadvisory services are provided.  Advisoryfee income includes management fees that are calculated based on percentages ofassets under management (“AUM”), generally billed quarterly, either in arrearsor advance, depending on their contractual terms.  Advisory fee income also includes incentivefees that may be earned by the Company depending on the investment return ofthe AUM.  Incentive fee arrangementsgenerally entitle the Company to participate, on a fixed-percentage basis, inany returns generated in excess of an agreed-upon benchmark. The Company’s

 

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Table of Contents

 

**Pzena Investment Management, Inc.**

**Unaudited Notes to theConsolidated Financial Statements (Continued)**

 

participationpercentage in such return differentials is then multiplied by AUM to determinethe incentive fees earned.  In general,returns are calculated on an annualized basis over the contract’s measurementperiod, which usually extends up to three years.  Incentive fees are generally payableannually.  Following the preferred methodidentified in the *Revenue Recognition Topic*of the FASB ASC, such incentive fee income is recorded at the conclusion of thecontractual performance period, when all contingencies are resolved.

 

***Earnings per Share:***

 

Basicearnings per share is computed by dividing the Company’s net income or lossattributable to the Company’s common stockholders by the weighted averagenumber of shares outstanding during the reporting period.  Diluted earnings per share adjusts thiscalculation to reflect the impact of all outstanding operating company Class Bunits, outstanding operating company phantom Class B units, andoutstanding options granted under the Pzena Investment Management, LLC 2006Equity Incentive Plan (the “2006 Plan”) and the Pzena InvestmentManagement, Inc. 2007 Equity Incentive Plan (the “2007 Plan”), to theextent they would have a dilutive effect on net income per share for thereporting period.  Net income for dilutedearnings per share generally assumes all operating company Class B unitsare converted into Company stock at the beginning of the reporting period andthe resulting change to Company net income associated with its increasedinterest in the operating company is taxed at the Company’s effective tax rate.

 

Forthe three and nine months ended September 30, 2010 and 2009, the Company’sdiluted net income was determined as follows:

 
| ** **                                                     | ** ** | **For the Three Months** | ** ** | **For the Nine Months** | ** ** |
|----------------------------------------------------------------|------------|-----------------------------------------|------------|----------------------------------------|------------|
| ** **                                                     | ** ** | **Ended September 30,**       | ** ** | **Ended September 30,**      | ** ** |
| ** **                                                     | ** ** | **2010**                                | ** ** | **2009**                               | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                                     | ** ** | **(in thousands)**                 | ** ** |
|                                                           |       |                                    |       |                                   |       |   |   |   |   |
| Non-Controlling Interests of Pzena Investment  Management, LLC |       | $                                       | 7,722      |                                   | $          | 8,082 |   | $ | 23,483 |   | $ | 17,767 |   |
| Less: Assumed Corporate Income Taxes                           |       | 3,309                                   |       | 3,463                                  |       | 10,063 |   | 7,614 |   |
| Assumed After-Tax Income of Pzena Investment  Management, LLC  |       | $                                       | 4,413      |                                   | $          | 4,619 |   | $ | 13,420 |   | $ | 10,153 |   |
|                                                           |       |                                    |       |                                   |       |   |   |   |   |
| Assumed After-Tax Income of Pzena Investment  Management, LLC  |       | $                                       | 4,413      |                                   | $          | 4,619 |   | $ | 13,420 |   | $ | 10,153 |   |
| Net Income of Pzena Investment  Management, Inc.          |       | 1,219                                   |       | 1,432                                  |       | 2,676 |   | 2,735 |   |
| Diluted Net Income                                             |       | $                                       | 5,632      |                                   | $          | 6,051 |   | $ | 16,096 |   | $ | 12,888 |   |

 

For each of the three and nine months ended September 30, 2010,1,620,060 options to purchase operating company units, 961,750 options topurchase Class A common stock, and 44,916 phantom operating company unitswere excluded from the calculation of diluted net income per share, as theirinclusion would have had an antidilutive effect for each period.  For each of the three and nine months ended September 30,2009, 954,310 options to purchase operating company units were excluded fromthe calculation of diluted net income per share, as their inclusion also wouldhave had an antidilutive effect.

 

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**Pzena InvestmentManagement, Inc.**

**Unaudited Notes to theConsolidated Financial Statements (Continued)**

 

Forthe three and nine months ended September 30, 2010 and 2009, the Company’sbasic and diluted earnings per share were determined as follows:

 
| ** **                                               | ** ** | **For the Three Months**                                              | ** ** | **For the Nine Months** | ** ** |
|----------------------------------------------------------|------------|--------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                               | ** ** | **Ended September 30,**                                                    | ** ** | **Ended September 30,**      | ** ** |
| ** **                                               | ** ** | **2010**                                                                             | ** ** | **2009**                               | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                               | ** ** | **(in thousands, except share and per-share amounts)** | ** ** |
|                                                     |       |                                                                                 |       |                                   |       |   |   |   |   |
| Net Income for Basic Earnings per Share                  |       | $                                                                                    | 1,219      |                                   | $          | 1,432 |   | $ | 2,676 |   | $ | 2,736 |   |
| Basic Weighted Average Shares Outstanding                |       | 9,367,659                                                                            |       | 8,633,041                              |       | 9,125,477 |   | 8,077,545 |   |
| Basic Earnings per Share                                 |       | $                                                                                    | 0.13       |                                   | $          | 0.17 |   | $ | 0.29 |   | $ | 0.34 |   |
|                                                     |       |                                                                                 |       |                                   |       |   |   |   |   |
| Net Income for Diluted Earnings per Share                |       | $                                                                                    | 5,632      |                                   | $          | 6,051 |   | $ | 16,096 |   | $ | 12,889 |   |
| Dilutive Effect of Operating Company Class B  Units |       | 54,960,418                                                                           |       | 55,559,751                             |       | 55,202,995 |   | 56,131,004 |   |
| Dilutive Effect of Phantom Units                         |       | 26,890                                                                               |       | 586,068                                |       | 21,188 |   | 547,782 |   |
| Dilutive Effect of Options                               |       | 638,779                                                                              |       | —                                 |       | 656,538 |   | — |   |
| Diluted Weighted Average Shares Outstanding              |       | 64,993,746                                                                           |       | 64,994,278                             |       | 65,006,198 |   | 64,756,331 |   |
| Diluted Earnings per Share                               |       | $                                                                                    | 0.09       |                                   | $          | 0.09 |   | $ | 0.25 |   | $ | 0.20 |   |

 

***Cash and Cash Equivalents:***

 

AtSeptember 30, 2010, cash and cash equivalents was $26.8 million.  The Company considers all money market fundsand highly-liquid debt instruments with an original maturity of three months orless at the time of purchase to be cash equivalents.  The Company maintains its cash in bankdeposit and other accounts whose balances, at times, exceed federally insuredlimits.

 

Intereston cash and cash equivalents is recorded as interest income on an accrual basison the consolidated statements of operations.

 

***Restricted Cash:***

 

TheCompany maintains a compensating balance of $1.4 million at September 30,2010 as collateral for a letter of credit issued by a third party in lieu of acash security deposit, as required by the Company’s lease for its New Yorkoffice space.  Such amounts are recordedin restricted cash on the consolidated statements of financial condition.

 

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

 

Dueto/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:***

 

Investmentsin equity securities represent the securities held by the Company and itsconsolidated investment partnerships. All such securities are recorded at fair value, with net realized andunrealized gains and losses reported in earnings in the consolidated statementsof operations.

 

The*Fair Value Measurements and DisclosuresTopic* of the FASB ASC defines fair value as the price that would bereceived to sell an asset, or paid to transfer a liability, in an orderlytransaction between market participants at the measurement date.  The *FairValue Measurements and Disclosures Topic* of the FASB ASC alsoestablishes a framework for measuring fair value and a valuation hierarchybased upon the transparency of inputs used in the valuation of an asset orliability.  Classification within thehierarchy is based upon the lowest level of input that is significant to thefair value measurement.  The valuationhierarchy contains three 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 identicalassets or liabilities in markets that are not active, quoted market prices forsimilar assets and liabilities in active markets, and other observable inputsdirectly or indirectly related to the asset or liability being measured(Level 2); and (iii) valuation inputs are unobservable andsignificant to the fair value measurement (Level 3).  Additionally, entities are required todisclose in interim and annual periods the inputs and valuation techniques usedto measure fair value and define assets and liabilities measured at fair valueby major class.

 

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**Pzena Investment Management, Inc.**

**Unaudited Notes to the ConsolidatedFinancial Statements (Continued)**

 

TheCompany’s fair value measurements relate to its consolidated investmentpartnerships’ investments in equity securities, which are exchange-tradedsecurities with quoted prices in active markets, as well as investments inmutual funds.  The fair valuemeasurements of the securities have been classified as Level 1.

 

Thefollowing table presents these instruments’ fair value at September 30,2010:

 
| ** **                  | ** ** | **Level 1**        | ** ** | **Level 2** | ** ** | **Level 3** | ** ** |
|-----------------------------|------------|-------------------------|------------|------------------|------------|------------------|------------|
| ** **                  | ** ** | **(in thousands)** | ** ** |
| ** **                  | ** ** | ** **              | ** ** | ** **       | ** ** | ** **       | ** ** |
| Assets:                     |       |                    |       |             |       |             |       |
| Equity Securities           |       | $                       | 759        |             | $          | —           |       | $ | — |   |
| Investments in Mutual Funds |       | 2,299                   |       | —           |       | —           |       |
|                        |       |                    |       |             |       |             |       |
| Total Fair Value            |       | $                       | 3,058      |             | $          | —           |       | $ | — |   |

 

The following table presents these instruments’ fair value atDecember 31, 2009:

 
| ** **        | ** ** | **Level 1**        | ** ** | **Level 2** | ** ** | **Level 3** | ** ** |
|-------------------|------------|-------------------------|------------|------------------|------------|------------------|------------|
| ** **        | ** ** | **(in thousands)** | ** ** |
| ** **        | ** ** | ** **              | ** ** | ** **       | ** ** | ** **       | ** ** |
| Assets:           |       |                    |       |             |       |             |       |
| Equity Securities |       | $                       | 7,951      |             | $          | —           |       | $ | — |   |
|              |       |                    |       |             |       |             |       |
| Total Fair Value  |       | $                       | 7,951      |             | $          | —           |       | $ | — |   |

 

***Securities Valuation:***

 

Investmentsin equity securities and mutual funds which are traded on a national securitiesexchange are carried at fair value based on the last reported sales price onthe valuation date.  If no reported salesoccurred on the valuation date, investments in securities are valued at the bidprice.  Securities transactions arerecorded on the trade date.

 

Thenet realized gain or loss on sales of securities is determined on a specificidentification basis and is included in net realized and unrealized gain/(loss)from investments in the consolidated statements of operations.

 

***Concentrations of Credit Risk:***

 

Financialinstruments that potentially subject the Company to concentrations of creditrisk consist principally of cash and cash equivalents, amounts due frombrokers, and advisory fees receivable. The Company maintains its cash and temporary cash investments in bankdeposits and other accounts whose balances, at times, exceed federally insuredlimits.

 

Theconcentration of credit risk with respect to advisory fees receivable isgenerally limited due to the short payment terms extended to clients by theCompany.  On a periodic basis, theCompany evaluates its advisory fees receivable and establishes an allowance fordoubtful accounts, if necessary, based on a history of past write-offs andcollections and current credit conditions. For the three months ended September 30, 2010 and 2009,approximately 10.4% and 10.6%, respectively, of the Company’s advisory feeswere generated from an advisory agreement with one client.  For the nine months ended September 30,2010 and 2009, fees generated from this agreement comprised 10.1% and 11.4%,respectively, of the Company’s total advisory fees.  At September 30, 2010 andDecember 31, 2009, no allowance for doubtful accounts has been deemednecessary.

 

***Financial Instruments:***

 

OnFebruary 28, 2008, the operating company entered into an interest rateswap agreement, as discussed further in Note 9.  This interest rate swap was subsequentlyunwound in conjunction with the termination of the credit agreement inSeptember 2009.  The counterparty tothis agreement was a major financial institution.  The Company’s swap agreement was designatedas a trading derivative and the fair value was recorded in other liabilities,with changes to the swap’s fair value recognized as a component of otherincome/(expense).  For each of the threeand nine months ended September 30, 2009, the Company recognized less than$0.1 million in other income related to such changes.

 

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**Pzena InvestmentManagement, Inc.**

**Unaudited Notes to theConsolidated Financial Statements (Continued)**

 

Pursuantto the guidance in the *Derivatives andHedging Topic* of the FASB ASC, it is a requirement to disclosebalance sheet and income statement amounts of derivatives, as well as theirlocations within the consolidated financial statements.  The following table summarizes the impact ofthe Company’s derivative financial instruments on its results of operations forthe three and nine months ended September 30, 2009:

 
| ** **                                                            | ** ** | ** **                  | ** ** | **Amount of Income Recognized** | ** ** |
|-----------------------------------------------------------------------|------------|-----------------------------|------------|------------------------------------------------|------------|
| **Derivatives Not Accounted For As Hedging** | ** ** | ** **                  | ** ** | **in Income of Derivative**     | ** ** |
| **Instruments Under the Derivatives and**         | ** ** | **Statement of**       | ** ** | **For the Three Months**        | ** ** | **For the Nine Months** | ** ** |
| **Hedging Topic of the FASB ASC**            | ** ** | **Operations Account** | ** ** | **Ended September 30, 2009**    | ** ** | **Ended September 30, 2009** | ** ** |
| ** **                                                            | ** ** | ** **                  | ** ** | **(in thousands)**                        | ** ** |
| ** **                                                            | ** ** | ** **                  | ** ** | ** **                                     | ** ** |
| Interest Rate Contracts                                               |       | Other Income                |       | $                                              | 20         |   | $ | 88 |   |
| Total                                                                 |       |                        |       | $                                              | 20         |   | $ | 88 |   |

 

***Property and Equipment:***

 

Propertyand equipment is carried at cost, less accumulated depreciation andamortization.  Depreciation is providedon a straight-line basis over the estimated useful lives of the respectiveassets, which range from three to seven years. Leasehold improvements are amortized on a straight-line basis over theshorter of the useful life of the improvements or the remaining lease term.

 

***Business Segments:***

 

TheCompany views its operations as comprising one operating segment.

 

***Income Taxes:***

 

TheCompany is a “C” corporation under the Internal Revenue Code, and thus liablefor federal, state, and local taxes on the income derived from its economicinterest in its operating company.  Theoperating company is a limited liability company that has elected to be treatedas a partnership for tax purposes.  Ithas not made a provision for federal or state income taxes because it is theindividual responsibility of each of the operating company’s members (includingthe Company) to separately report their proportionate share of the operatingcompany’s taxable income or loss. Similarly, the income of the Company’s consolidated investmentpartnerships is not subject to income taxes, since it is allocated to eachpartnership’s individual partners.  Theoperating company has made a provision for New York City UnincorporatedBusiness Tax (“UBT”).

 

TheCompany and its 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 temporary differencesbetween the financial statement and tax bases of assets and liabilities thatwill result in taxable or deductible amounts in the future, based on enactedtax laws and rates applicable to the periods in which the temporary differencesare expected to affect taxable income. Valuation allowances are established, when necessary, to reduce deferredtax assets to the amount more likely than not to be realized.  At September 30, 2010, the Company had a$61.4 million valuation allowance against the deferred tax asset recorded aspart of the Company’s initial public offering and the subsequent exchanges ofClass B units for shares of its Class A common stock.  At December 31, 2009, the Company had a$60.3 million valuation allowance against this deferred tax asset.  The income tax provision, or benefit, is thetax payable or refundable for the period, plus or minus the change during theperiod in deferred tax assets and liabilities. The Company records its deferred tax liabilities as a component of otherliabilities on the consolidated statements of financial condition.

 

***Foreign Currency:***

 

Investmentsecurities and other assets and liabilities denominated in foreign currenciesare remeasured into U.S. dollar amounts at the date of valuation.  Purchases and sales of investment securities,and income and expense items denominated in foreign currencies, are remeasuredinto U.S. dollar amounts on the respective dates of such transactions.

 

TheCompany does not isolate that portion of the results of its operationsresulting from changes in foreign exchange rates on investments from thefluctuations arising from changes in market prices of securities held.  Such fluctuations are included in therealized and unrealized gain/(loss), net on equity securities in the consolidatedstatements of operations.

 

Reportednet realized foreign exchange gains or losses arise from sales of foreigncurrencies, currency gains or losses realized between the trade and settlementdates on securities transactions, and the difference between the amounts ofdividends, interest, and foreign withholding taxes recorded on the Company’sbooks and the U.S. dollar equivalent of the amounts actually received orpaid.  Net realized foreign exchangegains and losses arise from changes in the fair values of assets andliabilities resulting 

 

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**Pzena InvestmentManagement, Inc.**

**Unaudited Notes to the ConsolidatedFinancial Statements (Continued)**

 

fromchanges in exchange rates.

 

***Recent Accounting Pronouncements:***

 

InSeptember 2009, the FASB issued a new standard that requires an enterpriseto perform a qualitative analysis to determine whether its variable-interestsgive it a controlling financial interest in a VIE.  Under the standard, an enterprise has acontrolling financial interest when it has (a) the power to direct theactivities of a VIE that most significantly impact the entity’s economicperformance, and (b) the obligation to absorb losses of the entity or theright to receive benefits from the entity that could potentially be significantto the VIE.  An enterprise that holds asubstantive interest and a controlling financial interest in a VIE is deemed tobe the primary beneficiary of the VIE and is required to consolidate the VIE.  The standard also requires an ongoingassessment of whether an enterprise is the primary beneficiary of a VIE, andadditional disclosures about an enterprise’s involvement in VIEs, and anysignificant changes in risk exposure due to that involvement.  The standard is effective for fiscal yearsbeginning after November 15, 2009. In November 2009, the FASB issued a proposed standard update, whichdefers the consolidation criteria requirements of this new standard for assetsmanagers’ interests in entities that apply the specialized accounting guidancefor investment companies, or that have the attributes of investmentcompanies.  In February 2010, theFASB issued further guidance which provided a limited scope deferral for areporting entity’s interest in an entity that meets all of the followingconditions: (a) the entity has all the attributes of an investment companyas defined under AICPA Audit and Accounting Guide, Investment Companies,or does not have all the attributes of an investment company but is an entityfor which it is acceptable based on industry practice to apply measurementprinciples that are consistent with the AICPA Audit and Accounting Guide, InvestmentCompanies, (b) the reporting entity does not have explicit or implicitobligations to fund any losses of the entity that could potentially besignificant to the entity, and (c) the entity is not a securitizationentity, asset-backed financing entity or an entity that was formerly considereda qualifying special-purpose entity.  The reporting entity isrequired to perform a consolidation analysis for entities that qualify for thedeferral in accordance with previously issued guidance on VIEs.  TheCompany has evaluated the deferral guidelines and determined that the standardis applicable for the Company’s investment in its operating company, but thatthe Company meets the criteria for deferral provided in this standard for itsVIEs.  The Company adopted the updatedguidance on January 1, 2010, and it had no impact on the Company’sconsolidated financial statements.  TheCompany is monitoring future guidance for updates on the treatment of itsinterests in its VIEs.

 

**Note 3—Property and Equipment**

 

Propertyand equipment, net, is comprised of the following:

 
| ** **                                      | ** ** | **As of**          | ** ** |
|-------------------------------------------------|------------|-------------------------|------------|
| ** **                                      | ** ** | **September 30,**  | ** ** | **December 31,** | ** ** |
| ** **                                      | ** ** | **2010**                | ** ** | **2009** | ** ** |
| ** **                                      | ** ** | **(in thousands)** | ** ** |
|                                            |       |                    |       |   |   |
| Leasehold Improvements                          |       | $                       | 2,145      |   | $ | 2,145 |   |
| Furniture and Fixtures                          |       | 1,164                   |       | 1,163 |   |
| Computer Hardware                               |       | 930                     |       | 948 |   |
| Office Equipment                                |       | 240                     |       | 243 |   |
| Computer Software                               |       | 212                     |       | 201 |   |
| Total                                           |       | 4,691                   |       | 4,700 |   |
| Less: Accumulated Depreciation and Amortization |       | (2,686                  | )          | (2,385 | ) |
| Total                                           |       | $                       | 2,005      |   | $ | 2,315 |   |

 

Depreciation is included in general and administrative expenses andtotaled $0.1 million for each of the three months ended September 30,2010 and 2009.  Such expenses totaled$0.3 million and $0.4 million for the nine months ended September 30, 2010and 2009, respectively.

 

**Note 4—Related Party Transactions**

 

Forthe three and nine months ended September 30, 2010, the Company earned$1.4 million and $4.1 million, respectively, in investment advisoryfees from unconsolidated entities for which it acts as the investmentmanager.  For the three and nine monthsended September 30, 2009, such advisory fees totaled $1.1 million and $2.7million, respectively.

 

11

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Table ofContents

 

**Pzena InvestmentManagement, Inc.**

**Unaudited Notes to theConsolidated Financial Statements (Continued)**

 

At both September 30, 2010 and December 31, 2009, the Companyhad less than $0.1 million remaining of an advance to an internationalinvestment company for organization and start-up costs, which is included inreceivable from related parties on the consolidated statements of financialcondition.  The Company is the sponsorand investment manager of this entity.

 

At December 31, 2009, receivables from related parties includedless than $0.1 million of loans to employees.  These loans were in the form of forgivablepromissory notes, which were amortized through compensation expense pursuant totheir terms.  For the three months ended September 30,2010, no amortization was recognized as compensation and benefits expense.  For the three months ended September 30,2009, and the three and nine months ended September 30, 2010, less than$0.1 million of such amortization was recognized as compensation andbenefits expense.  At September 30,2010, receivables from related parties included less than $0.1 million of loansto employees.

 

Certain qualified employees of the Company have the ability to openindividual accounts, or invest in certain of the Company’s consolidatedinvestment partnerships, without being assessed advisory fees.  Investments by employees in individualaccounts are permitted only at the discretion of the executive committee of theCompany, but are generally not subject to the same minimum investment levelsthat are required of outside investors.

 

On October 28, 2008, the Company issued an aggregate of$16.0 million principal amount of Senior Subordinated Notes to entitiesestablished by Richard S. Pzena, the Company’s Chief Executive Officer, for thebenefit of certain of his family members, an entity controlled by a CompanyDirector, and a former employee.  OnDecember 31, 2009, the Company repaid a total of $6.0 millionprincipal amount outstanding of Senior Subordinated Notes to the entitycontrolled by the Company Director and a former employee.  During the nine months ended September 30,2010, the Company repaid the remaining $10.0 million principal amountoutstanding of the Senior Subordinated Notes to the entities established byRichard S. Pzena.

 

**Note 5—Commitments and Contingencies**

 

In the normal course of business, the Company enters into agreementsthat include indemnities in favor of third parties, such as engagement letterswith advisors and consultants.  Incertain cases, the Company may have recourse against third parties with respectto these indemnities.  The Companymaintains insurance policies that may provide coverage against certain claimsunder these indemnities.  The *Guarantees Topic* of the FASB ASC providesaccounting 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 the *Guarantees Topic*of the FASB ASC, the Company’s estimate of the value of such guarantees is deminimis; therefore, no accrual has been made in the consolidated financialstatements.

 

The Company leases office space under a non-cancelable operating leaseagreement which expires on October 31, 2015.  The Company reflects minimum lease expense ona straight-line basis over the lease term. Lease expenses totaled $0.4 million and $0.5 million for the three monthsended September 30, 2010 and 2009, respectively, and are included ingeneral and administrative expenses. Such expenses totaled $1.5 million and $1.6 million for the nine monthsended September 30, 2010 and 2009, respectively.

 

**Note 6—Compensation and Benefits**

 

Compensation and benefits expense to employees and members is comprisedof the following:

 
| ** **                              | ** ** | **For the Three Months** | ** ** | **For the Nine Months** | ** ** |
|-----------------------------------------|------------|-----------------------------------------|------------|----------------------------------------|------------|
| ** **                              | ** ** | **Ended September 30,**       | ** ** | **Ended September 30,**      | ** ** |
| ** **                              | ** ** | **2010**                                | ** ** | **2009**                               | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                              | ** ** | **(in thousands)**                 | ** ** |
|                                    |       |                                    |       |                                   |       |   |   |   |   |
| Cash Compensation and Other Benefits    |       | $                                       | 6,474      |                                   | $          | 5,977 |   | $ | 19,461 |   | $ | 17,439 |   |
| Non-Cash Compensation                   |       | 901                                     |       | 255                                    |       | 2,565 |   | 816 |   |
| Total Compensation and Benefits Expense |       | $                                       | 7,375      |                                   | $          | 6,232 |   | $ | 22,026 |   | $ | 18,255 |   |

 

For the three and nine months ended September 30,2010 and 2009, the Company granted no options to purchase capital units of theoperating company and no options to purchase shares of Class A commonstock pursuant to its 2006 Plan and 2007 Plan.

 

For the nine months ended September 30, 2010 and 2009, theoperating company granted 7,000 and 30,000, respectively, restrictedClass B units to certain members pursuant to its 2006 Plan.  These unit grants each vest ratably over afour-year period commencing January 1, 2010 and 2009, respectively.  The amortization of these awards was notmaterial for the three and nine months 

 

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Table of Contents

 

**Pzena InvestmentManagement, Inc.**

**Unaudited Notes to theConsolidated Financial Statements (Continued)**

 

ended September 30, 2010 and 2009.  For the three months ended September 30,2010 and 2009, no such options were granted.

 

Pursuant to the Pzena Investment Management, LLC Amended and RestatedBonus Plan (the “Bonus Plan”), which became effective January 1, 2007,eligible employees whose cash compensation is in excess of certain thresholdshave a portion of that excess mandatorily deferred.  Amounts deferred may take the form of phantomClass B units, or be invested in third-party funds at the employee’sdiscretion, and vest ratably over four years. At both September 30, 2010 and December 31, 2009, theliability associated with deferred compensation investment accounts wasapproximately $0.6 million, and has been included as a component of otherliabilities on the consolidated statements of financial condition.  For the three months ended September 30,2010 and 2009, the Company recognized approximately $0.4 million and$0.3 million, respectively, in compensation and benefits expenseassociated with the amortization of all deferred compensation awards.  For the nine months ended September 30,2010 and 2009, the Company recognized approximately $0.9 million and$0.6 million, respectively, in such expense.

 

As of September 30, 2010 and December 31, 2009, the Companyhad approximately $3.4 million and $5.3 million, respectively, inunrecorded compensation expense related to unvested operating company phantomunits issued pursuant to our deferred compensation plan, operating company Class Bunit and option grants issued under the Company’s 2006 Plan, and Class Astock option grants issued under our 2007 Plan.

 

**Note 7—Short Term Borrowings**

 

The operating company had a $1.8 million revolving credit facility thatwas terminated in September 2009. No balance was outstanding and no amounts were drawn down against thefacility over the course of its existence.

 

**Note 8—Term Loan**

 

During the year ended December 31, 2009, the Company repaid theremaining $22.0 million of the principal amount outstanding under its termloan.  Concurrently with the terminationof this term loan, the security interest previously granted in the accountsreceivable of the Company was released in September 2009.

 

**Note 9—Interest Rate Swap**

 

The Company manages its exposure to changes in market rates ofinterest.  The Company’s use ofderivative instruments was limited to an interest rate swap used to manage theinterest rate exposure related to the credit agreement, referenced above, whichwas terminated in September 2009.

 

On February 28, 2008, the Company entered into an interest rateswap agreement that commenced on July 23, 2008.  This interest rate swap was subsequentlyunwound in conjunction with the termination of the credit agreement inSeptember 2009.  The swap obligatedthe Company to pay a 2.825% fixed rate of interest on the notional amount andrequired the counterparty to pay the Company a floating interest rate based onthe monthly LIBOR interest rate.  Thespread on the credit agreement was in addition to these amounts.

 

During 2009, the Company reduced the notional amount of its interestrate swap in tandem with the reductions in principal amounts outstanding underthe credit agreement.  The amounts paidto the counterparty in exchange for these reductions for the three and ninemonths ended September 30, 2009 were approximately $0.2 million and$0.5 million, respectively.  For each ofthe three and nine months ended September 30, 2009, the Company recognizedless than $0.1 million in other expense associated with the change in fairvalue of the swap agreement.

 

**Note 10—Income Taxes**

 

The operating company is a limited liability company that has elected tobe treated as a partnership for tax purposes. Neither it, nor the Company’s other consolidated subsidiaries, has madea provision for federal or state income taxes because it is the individualresponsibility 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 company, which is net of UBT.  Correspondingly, in its consolidatedfinancial statements, the Company reports both the operating company’sprovision for UBT, as well as its provision for federal, state, and localcorporate taxes.

 

13

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**Pzena InvestmentManagement, Inc.**

**Unaudited Notes to theConsolidated Financial Statements (Continued)**

 

The components of the income tax provision/(benefit) are as follows:

 
| ** **                           | ** ** | **For the Three Months** | ** ** | **For the Nine Months** | ** ** |
|--------------------------------------|------------|-----------------------------------------|------------|----------------------------------------|------------|
| ** **                           | ** ** | **Ended September 30,**       | ** ** | **Ended September 30,**      | ** ** |
| ** **                           | ** ** | **2010**                                | ** ** | **2009**                               | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                           | ** ** | **(in thousands)**                 | ** ** |
| Current Provision:                   |       |                                    |       |                                   |       |   |   |   |   |
| Unincorporated Business Taxes        |       | $                                       | 602        |                                   | $          | 572 |   | $ | 1,951 |   | $ | 1,426 |   |
| Local Corporate Tax                  |       | —                                  |       | —                                 |       | — |   | — |   |
| State Corporate Tax                  |       | —                                  |       | —                                 |       | — |   | — |   |
| Federal Corporate Tax                |       | —                                  |       | —                                 |       | — |   | — |   |
| Total Current Provision              |       | $                                       | 602        |                                   | $          | 572 |   | $ | 1,951 |   | $ | 1,426 |   |
|                                 |       |                                    |       |                                   |       |   |   |   |   |
| Deferred Provision:                  |       |                                    |       |                                   |       |   |   |   |   |
| Unincorporated Business Taxes        |       | $                                       | (56        | )                                      | $          | (56 | ) | $ | (168 | ) | $ | (167 | ) |
| Local Corporate Tax                  |       | 60                                      |       | 57                                     |       | 176 |   | 121 |   |
| State Corporate Tax                  |       | 114                                     |       | 108                                    |       | 335 |   | 231 |   |
| Federal Corporate Tax                |       | 391                                     |       | 372                                    |       | 1,152 |   | 793 |   |
| Total Deferred Provision             |       | $                                       | 509        |                                   | $          | 481 |   | $ | 1,495 |   | $ | 978 |   |
|                                 |       |                                    |       |                                   |       |   |   |   |   |
| Change in Valuation Allowance        |       | (2,186                                  | )          | (3,093                                 | )          | (2,073 | ) | (4,783 | ) |
|                                 |       |                                    |       |                                   |       |   |   |   |   |
| Total Income Tax Provision/(Benefit) |       | $                                       | (1,075     | )                                      | $          | (2,040 | ) | $ | 1,373 |   | $ | (2,379 | ) |

 

For the three and nine months ended September 30,2010 and 2009, the Company’s taxable income was determined as follows:

 
| ** **                           | ** ** | **For the Three Months** | ** ** | **For the Nine Months** | ** ** |
|--------------------------------------|------------|-----------------------------------------|------------|----------------------------------------|------------|
| ** **                           | ** ** | **Ended September 30,**       | ** ** | **Ended September 30,**      | ** ** |
| ** **                           | ** ** | **2010**                                | ** ** | **2009**                               | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                           | ** ** | **(in thousands)**                 | ** ** |
|                                 |       |                                    |       |                                   |       |   |   |   |   |
| Income Before Taxes                  |       | $                                       | 8,177      |                                   | $          | 10,228 |   | $ | 27,681 |   | $ | 21,888 |   |
| Unincorporated Business Taxes        |       | (546                                    | )          | (516                                   | )          | (1,783 | ) | (1,259 | ) |
| Non-Controlling Interests            |       | (8,033                                  | )          | (10,836                                | )          | (23,632 | ) | (21,531 | ) |
| Income Before Corporate Income Taxes |       | $                                       | (402       | )                                      | $          | (1,124 | ) | $ | 2,266 |   | $ | (902 | ) |

 

The *IncomeTaxes Topic* of the FASB ASC establishes the minimum threshold forrecognizing, and a system for measuring, the benefits of tax return positionsin financial statements.  It is theCompany’s policy to recognize accrued interest, and penalties associated withuncertain tax positions, as part of the tax provision.  For the three and nine months ended September 30,2010 and 2009, no such expenses were recognized.  As of September 30, 2010 andDecember 31, 2009, no such accruals were recorded.

 

The Company and the operating company are generally no longer subjectto U.S. Federal or state and local income tax examinations by tax authoritiesfor any year prior to 2007.  All taxyears subsequent to, and including, 2007 are considered open and subject toexamination by tax authorities.

 

Prior to October 30, 2007, the operating company was a cash basistaxpayer.  As a result of the Company’sacquisition of Class B units in conjunction with the offering, theoperating company was required to become an accrual basis taxpayer.  Pursuant to Section 481 of the InternalRevenue Code, the cumulative difference between the two methods of taxpayingare amortizable over four years.  Thesedifferences generated approximately $0.1 million and $0.2 million indeferred tax liabilities as of September 30, 2010 and December 31,2009, respectively.  Such amounts arerecorded in other liabilities in the consolidated statements of financialcondition.

 

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**Pzena InvestmentManagement, Inc.**

**Unaudited Notes to theConsolidated Financial Statements (Continued)**

 

The acquisition of the operating company Class B units noted abovehas allowed the Company to make an election under Section 754 of theInternal Revenue Code (“Section 754”) to step up its tax basis in the netassets acquired.  This step up isdeductible for tax purposes over a 15-year period.  Pursuant to a Tax Receivable Agreement signedbetween the members of the operating company and the Company, 85% of the cashsavings generated by this election will be distributed to the selling andconverting shareholders upon the realization of this benefit.

 

Based on the net proceeds of the offering and tax basis of theoperating company as of October 30, 2007, this election gave rise to adeferred tax asset of approximately $68.7 million.  In December 2008, the Companyestablished a $62.7 million valuation allowance to reduce the net deferred taxasset to an amount more likely than not to be realized.  This deferred tax asset remains available tothe Company and can be used to reduce taxable income in future years.  The Company similarly reduced the associatedliability to selling and converting shareholders to reflect this change in theestimated realization of the asset.

 

As discussed further in Note 14, Shareholders’ Equity, below, on March 31,2010, and March 3, 2009, certain of the operating company’s membersexchanged an aggregate of 734,618 and 2,445,973, respectively, of theirClass B units for an equivalent number of shares of Company Class Acommon stock.  The Company elected tostep up its tax basis in the incremental assets acquired in accordance withSection 754.  Based on theexchange-date fair values of the Company’s common stock and the tax basis ofthe operating company, this election gave rise to a $3.6 million deferred taxasset and a corresponding $3.0 million liability to converting shareholders on March 31,2010, and a $2.5 million deferred tax asset and a corresponding$2.2 million liability to converting shareholders on March 3,2009.  The Company assessed therealizability of the deferred tax asset associated with each of these exchangesand determined that a portion of their benefits would go unutilized.  Consequently, at March 31, 2010 and March 3,2009, the Company established valuation allowances of $3.2 million and$2.4 million, respectively, to reduce the deferred tax asset to, an amount morelikely than not to be realized, at each date. These deferred tax assets remain available to the Company and can beused to reduce taxable income in future years. The Company similarly reduced the associated liability to selling andconverting shareholders by $2.7 million and $2.0 million at March 31,2010 and March 3, 2009, respectively, to reflect this change in theestimated realization of the asset.  Asrequired by the *Income Taxes Topic*of the FASB ASC, the Company recorded the effects of these transactions inequity.

 

During the three months ended September 30, 2010 and 2009, theCompany reduced its valuation allowance by approximately $2.2 million and$3.1 million, respectively, due to revised estimates of future taxableincome.  To reflect this change in theestimated realization of the asset, the Company correspondingly increased itsliability to selling and converting shareholders by $1.7 million and $2.4million for the three months ended September 30, 2010 and 2009,respectively.  During the nine monthsended September 30, 2010 and 2009, including the effects of the conversiondiscussed earlier, the Company’s valuation allowance was reduced byapproximately $2.1 million and $4.8 million, respectively, due to revisedestimates of future taxable income.  Toreflect this change in the estimated realization of the asset, the Companycorrespondingly increased its liability to selling and converting shareholdersby $1.6 million and $3.6 million for the nine months ended September 30,2010 and 2009, respectively.  The effectsof these changes to the deferred tax asset and liability to selling andconverting shareholders were recorded as a component of the income taxprovision and other expense, respectively, on the consolidated statements ofoperations.  As of September 30,2010 and December 31, 2009, the net values of all deferred tax assets wereapproximately $7.6 million and $6.8 million, respectively.

 

As of September 30, 2010 and December 31, 2009, the net valueof the liability to selling and converting shareholders was approximately$7.6 million and $5.6 million, respectively.

 

The change in the Company’s net deferred tax assets for the three andnine months ended September 30, 2010 is summarized as follows:

 

15

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**Pzena InvestmentManagement, Inc.**

**Unaudited Notes to theConsolidated Financial Statements (Continued)**

 
| ** **                         | ** ** | ** **              | ** ** | ** ** | ** ** | **Valuation** | ** ** | ** ** | ** ** |
|------------------------------------|------------|-------------------------|------------|------------|------------|---------------|------------|------------|------------|
| ** **                         | ** ** | **Section 754**    | ** ** | **Other**  | ** ** | **Allowance** | ** ** | **Total**  | ** ** |
| ** **                         | ** ** | **(in thousands)** | ** ** |
|                               |       |                    |       |       |       |          |       |       |       |
| Balance at December 31, 2009  |       | $                       | 65,006     |       | $          | 2,001         |       | $          | (60,253    | ) | $ | 6,754 |   |
| Deferred Tax Expense               |       | (726                    | )          | 173        |       | —        |       | (553       | )          |
| Unit Conversion                    |       | 3,577                   |       | —     |       | (3,186        | )          | 391        |       |
| Change in Valuation Allowance      |       | —                  |       | —     |       | 1,266         |       | 1,266      |       |
| Balance at March 31, 2010     |       | $                       | 67,857     |       | $          | 2,174         |       | $          | (62,173    | ) | $ | 7,858 |   |
| Deferred Tax Expense               |       | (849                    | )          | 303        |       | —        |       | (546       | )          |
| Change in Valuation Allowance      |       | —                  |       | —     |       | (1,379        | )          | (1,379     | )          |
| Balance at June 30, 2010      |       | $                       | 67,008     |       | $          | 2,477         |       | $          | (63,552    | ) | $ | 5,933 |   |
| Deferred Tax Expense               |       | (801                    | )          | 236        |       | —        |       | (565       | )          |
| Change in Valuation Allowance      |       | —                  |       | —     |       | 2,186         |       | 2,186      |       |
| Balance at September 30, 2010 |       | $                       | 66,207     |       | $          | 2,713         |       | $          | (61,366    | ) | $ | 7,554 |   |

 

The change in the Company’s net deferred taxassets for the three and nine months ended September 30, 2009 issummarized as follows:

 
| ** **                         | ** ** | ** **              | ** ** | ** ** | ** ** | **Valuation** | ** ** | ** ** | ** ** |
|------------------------------------|------------|-------------------------|------------|------------|------------|---------------|------------|------------|------------|
| ** **                         | ** ** | **Section 754**    | ** ** | **Other**  | ** ** | **Allowance** | ** ** | **Total**  | ** ** |
| ** **                         | ** ** | **(in thousands)** | ** ** |
|                               |       |                    |       |       |       |          |       |       |       |
| Balance at December 31, 2008  |       | $                       | 65,368     |       | $          | 785           |       | $          | (62,709    | ) | $ | 3,444 |   |
| Deferred Tax Expense               |       | (714                    | )          | 512        |       | —        |       | (202       | )          |
| Unit Conversion                    |       | 2,532                   |       | —     |       | (2,380        | )          | 152        |       |
| Change in Valuation Allowance      |       | —                  |       | —     |       | 814           |       | 814        |       |
| Balance at March 31, 2009     |       | $                       | 67,186     |       | $          | 1,297         |       | $          | (64,275    | ) | $ | 4,208 |   |
| Deferred Tax Expense               |       | (726                    | )          | 320        |       | —        |       | (406       | )          |
| Change in Valuation Allowance      |       | —                  |       | —     |       | 876           |       | 876        |       |
| Balance at June 30, 2009      |       | $                       | 66,460     |       | $          | 1,617         |       | $          | (63,399    | ) | $ | 4,678 |   |
| Deferred Tax Expense               |       | (727                    | )          | 190        |       | —        |       | (537       | )          |
| Change in Valuation Allowance      |       | —                  |       | —     |       | 3,093         |       | 3,093      |       |
| Balance at September 30, 2009 |       | $                       | 65,733     |       | $          | 1,807         |       | $          | (60,306    | ) | $ | 7,234 |   |

 

**Note 11—Investments, at Fair Value**

 

Investments consisted of the following at September 30, 2010:

 
| ** **  | ** ** | **Cost**                | ** ** | **Unrealized Gain** | ** ** | **Fair Value** | ** ** |
|-------------|------------|-------------------------|------------|--------------------------|------------|---------------------|------------|
| ** **  | ** ** | **(in thousands)** | ** ** |
| ** **  | ** ** | ** **              | ** ** | ** **               | ** ** | ** **          | ** ** |
| Investments |       | $                       | 2,777      |                     | $          | 281                 |       | $ | 3,058 |   |
|             |            |                         |            |                          |            |                     |            |  |  |  |

 

Investments consisted of the following atDecember 31, 2009:

 
| ** **  | ** ** | **Cost**                | ** ** | **Unrealized Gain** | ** ** | **Fair Value** | ** ** |
|-------------|------------|-------------------------|------------|--------------------------|------------|---------------------|------------|
| ** **  | ** ** | **(in thousands)** | ** ** |
| ** **  | ** ** | ** **              | ** ** | ** **               | ** ** | ** **          | ** ** |
| Investments |       | $                       | 7,321      |                     | $          | 630                 |       | $ | 7,951 |   |
|             |            |                         |            |                          |            |                     |            |  |  |  |

 

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Table of Contents

 

**Pzena InvestmentManagement, Inc.**

**Unaudited Notes to theConsolidated Financial Statements (Continued)**

 

**Note 12—Non-Controlling Interests**

 

Non-controlling interests in the operations of the Company’s operatingcompany and consolidated subsidiaries are comprised of the following:

 

 
| ** **                                                    | ** ** | **For the Three Months** | ** ** | **For the Nine Months** | ** ** |
|---------------------------------------------------------------|------------|-----------------------------------------|------------|----------------------------------------|------------|
| ** **                                                    | ** ** | **Ended September 30,**       | ** ** | **Ended September 30,**      | ** ** |
| ** **                                                    | ** ** | **2010**                                | ** ** | **2009**                               | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                                    | ** ** | **(in thousands)**                 | ** ** |
| ** **                                                    | ** ** | ** **                              | ** ** | ** **                             | ** ** | ** ** | ** ** | ** ** | ** ** |
| Non-Controlling Interest of Pzena Investment  Management, LLC |       | $                                       | 7,722      |                                   | 8,082      |   | $ | 23,483 |   | 17,767 |   |
| Non-Controlling Interest of Consolidated  Subsidiaries        |       | 311                                     |       | 2,754                                  |       | 149 |   | 3,764 |   |
| Non-Controlling Interests                                     |       | $                                       | 8,033      |                                   | $          | 10,836 |   | $ | 23,632 |   | $ | 21,531 |   |
|                                                               |            |                                         |            |                                        |            |  |  |  |  |  |  |  |  |

 

**Note 13—Members’ Equity Interests of OperatingCompany**

 

Except as otherwise provided by law, the liability of a member of theoperating company is limited to the amount of its capital account.  A member may transfer or assign all or anypart of its membership interest with the prior written consent of PzenaInvestment Management, Inc., which may be withheld at its solediscretion.  Any transferee admitted as amember shall succeed to the capital account, or portion thereof, transferred orassigned, as if no such transfer or assignment had occurred.

 

**Note 14—Shareholders’ Equity**

 

The Company was incorporated in the State of Delaware on May 8,2007.  On October 30, 2007, theCompany consummated an initial public offering of shares of its Class Acommon stock, par value $0.01 per share. These net proceeds were used to purchase Class B units of the operatingcompany.  Concurrently with theconsummation of the Company’s initial public offering, the operating agreementof the operating company was amended and restated such that, among otherthings, (i) the Company became the sole managing member of the operatingcompany, (ii) the Class B units of the operating company that theCompany acquired were reclassified as Class A units of the operatingcompany, and (iii) the holders of the remaining outstanding Class Bunits of the operating company were reclassified as Class B units of theoperating company.  Class A andClass B units of the operating company have the same economic rights perunit.  As of September 30, 2010, theholders of Class A common stock (through the Company) and the holders ofClass B units of the operating company held approximately 14.6% and 85.4%,respectively, of the economic interests in the operations of the business.  As of December 31, 2009, the holders ofClass A common stock (through the Company) and the holders of Class Bunits of the operating company held approximately 13.4% and 86.6%,respectively, of the economic interests in the operations of the business.

 

Each holder of a Class B unit of the operating company is issued acorresponding share of the Company’s Class B common stock, par value$0.000001 per share, in exchange for payment of this par value.  Each share of the Company’s Class Bcommon stock entitles its holder to five votes, until the first time that thenumber of shares of Class B common stock outstanding constitutes less than20% of the number of all shares of the Company’s common stock outstanding.  From this time and thereafter, each share ofthe Company’s Class B common stock entitles its holder to one vote.  When a Class B unit is exchanged for ashare of the Company’s Class A common stock or forfeited, a correspondingshare of the Company’s Class B common stock will automatically be redeemedand cancelled.  Conversely, to the extentthat the Company causes the operating company 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).

 

All holders of the Company’s Class B common stock have enteredinto a stockholders’ agreement, pursuant to which they agreed to vote allshares of Class B common stock then held by them, and acquired in thefuture, together on all matters submitted to a vote of the common stockholders.

 

The outstanding shares of the Company’s Class A common stockrepresent 100% of the rights of the holders of all classes of the Company’scapital stock to receive distributions, except that holders of Class Bcommon stock will have the right to receive the class’s par value upon theCompany’s liquidation, dissolution or winding up.

 

Pursuant to the 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.

 

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**Pzena InvestmentManagement, Inc.**

**Unaudited Notes to theConsolidated Financial Statements (Continued)**

 

On March 31, 2010, and March 3, 2009, certain of theoperating company’s members exchanged an aggregate of 734,618 and 2,445,973,respectively, of their Class B units for an equivalent number of shares ofCompany Class A common stock.  Theseacquisitions of additional operating company membership interests were treatedas reorganizations of entities under common control as required by the *Business Combinations Topic* of the FASBASC.

 

The incremental assets and liabilities assumed in the exchanges wererecorded on March 31, 2010 and March 3, 2009 as follows:

 
| ** **                                              | ** ** | **March 31,**      | ** ** | **March 3,** | ** ** |
|---------------------------------------------------------|------------|-------------------------|------------|-------------------|------------|
| ** **                                              | ** ** | **2010**                | ** ** | **2009**          | ** ** |
| ** **                                              | ** ** | **(in thousands)** | ** ** |
| ** **                                              | ** ** | ** **              | ** ** | ** **        | ** ** |
| Pzena Investment Management, LLC Members’ Capital  |       | $                       | 10,140     |              | $          | 33,788 |   |
| Pzena Investment Management, LLC Accumulated  Deficit   |       | (9,824                  | )          | (33,679           | )          |
| Realizable Deferred Tax Asset                           |       | 391                     |       | 152               |       |
| Net Tax Receivable Liability to Converting  Unitholders |       | (332                    | )          | (129              | )          |
| Total                                                   |       | $                       | 375        |              | $          | 132 |   |
|                                                    |       |                    |       |              |       |
| Common Stock, at Par                                    |       | $                       | 7          |              | $          | 25 |   |
| Additional Paid-in Capital                              |       | 368                     |       | 107               |       |
| Total                                                   |       | $                       | 375        |              | $          | 132 |   |

 

**Note 15—Subsequent Events**

 

As required by the *Subsequent EventsTopic* of the FASB ASC, the Company evaluated subsequent eventsthrough the issuance date of its consolidated financial statements.

 

On October 26, 2010, the Company’s Board of Directors declared aquarterly dividend of $0.03 per share of Class A common stock, payable onDecember 2, 2010 to shareholders of record as of November 18, 2010.

 

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**Item 2. Management’s Discussion and Analysis of Financial Condition and Resultsof Operations.**

 

**Overview**

 

Weare an investment management firm that utilizes a classic value investmentapproach in each of our investment strategies. We currently manage assets in avariety of value-oriented investment strategies across a wide range of marketcapitalizations in both U.S. and non-U.S. capital markets.  At September 30, 2010, our assets undermanagement, or AUM, was $14.3 billion. We manage separate accounts on behalf of institutions and high net worthindividuals and act as a sub-investment adviser for a variety of SEC-registeredmutual funds and offshore funds.

 

Wefunction as the holding company through which the business of our operatingcompany, Pzena Investment Management, LLC, is conducted.  Following our initial public offering andreorganization on October 30, 2007, we became the sole managing member ofPzena Investment Management, LLC. As such, we now control its business and affairs and, therefore,consolidate its financial results with ours. In light of our employees’ and other investors’ collective membershipinterest in our operating company, we reflect their ownership as anon-controlling interest in our consolidated financial statements.  As a result, subsequent to October 30,2007, our income is generated by our economic interest in our operating company’snet income.  As of September 30,2010, the holders of Class A common stock (through the Company) and theholders of Class B units of the operating company held approximately 14.6%and 85.4%, respectively, of the economic interests in the operations of thebusiness.

 

**Revenue**

 

Wegenerate revenue primarily from management fees and incentive fees, which wecollectively refer to as our advisory fees, by managing assets on behalf ofinstitutional accounts and for retail clients, which are generally open-endmutual funds catering primarily to retail clients.  Our advisory fee income is recognized overthe period in which investment management services are provided.  Following the preferred method identified inthe *Revenue Recognition Topic* ofthe Financial Accounting Standards Board Accounting Standards Codification (“FASBASC”), income from incentive fees is recorded at the conclusion of thecontractual performance period, when all contingencies are resolved.

 

Ouradvisory fees are primarily driven by the level of our AUM.  Our AUM increases or decreases with the netinflows or outflows of funds into our various investment strategies and withthe 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 our AUM, and our ability to continue toattract clients, will depend on a variety of factors including, among otherthings:

 

·                  our ability toeducate our target clients about our classic value investment strategies andprovide them with exceptional client service;

 

·                  the relativeinvestment performance of our investment strategies, as compared to competingproducts and market indices;

 

·                  competitiveconditions in the investment management and broader financial services sectors;

 

·                  generaleconomic conditions;

 

·                  investorsentiment and confidence; and

 

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

 

Forour institutional accounts, we are paid fees according to a schedule, whichvaries by investment strategy.  Thesubstantial majority of these accounts pay us management fees pursuant to aschedule in which the rate we earn on the AUM declines as the amount of AUMincreases.  Certain of these clients payus fees according to the performance of their accounts relative to certainagreed-upon benchmarks, which results in a slightly lower base fee, but allowsus to earn higher fees if the relevant investment strategy outperforms theagreed-upon benchmark.

 

Pursuantto our sub-investment advisory agreements with our retail clients, we aregenerally paid a management fee according to a schedule in which the rate weearn on the AUM declines as the amount of AUM increases.  Certain of these funds pay us fixed ratemanagement fees.  Due to thesubstantially larger account size of certain of these accounts, the average advisoryfees we earn on them, as a percentage of AUM, are lower than the advisory feeswe earn on our institutional accounts.

 

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Themajority of advisory fees we earn on institutional accounts are based on thevalue of AUM at a specific date on a quarterly basis, either in arrears oradvance.  Generally, advisory fees oncertain of our institutional accounts, and with respect to most of our retailaccounts, are calculated based on the average of the monthly or daily marketvalues.  Advisory fees are generallyadjusted for any cash flows into or out of a portfolio, where the cash flowrepresents greater than 10% of the value of the portfolio.  While a specific group of accounts may usethe same fee rate, the method used to calculate the fee according to the feerate schedule may differ as described above.

 

Ouradvisory fees may fluctuate based on a number of factors, including thefollowing:

 

·                  changes in AUMdue to appreciation or depreciation of our investment portfolios, and thelevels of the contribution and withdrawal of assets by new and existingclients;

 

·                  distribution ofAUM among our investment strategies, which have different fee schedules;

 

·                  distribution ofAUM between institutional accounts and retail accounts, for which we generallyearn lower overall advisory fees; and

 

·                  the level ofour performance with respect to accounts on which we are paid incentive fees.

 

**Expenses**

 

Ourexpenses consist primarily of compensation and benefits expenses, as well asgeneral and administrative expenses. These expenses may fluctuate due to a number of factors, including thefollowing:

 

·                  variations inthe level of total compensation expense due to, among other things, bonuses,awards of equity to our employees and members of our operating company, changesin our employee count and mix, and competitive factors; and

 

·                  expenses, suchas rent, professional service fees and data-related costs, incurred, asnecessary, to run our business.

 

**Compensation and Benefits Expense**

 

Ourlargest expense is compensation and benefits, which includes the salaries,bonuses, equity-based compensation and related benefits and payroll costsattributable to our members and employees. Compensation and benefits packages are benchmarked against relevantindustry and geographic peer groups in order to attract and retain qualifiedpersonnel.  The table included in thesection below describes the components of our compensation expense for thethree and nine months ended September 30, 2010 and 2009:

 
| ** **                              | ** ** | **For the Three Months** | ** ** | **For the Nine Months** | ** ** |
|-----------------------------------------|------------|-----------------------------------------|------------|----------------------------------------|------------|
| ** **                              | ** ** | **Ended September 30,**       | ** ** | **Ended September 30,**      | ** ** |
| ** **                              | ** ** | **2010**                                | ** ** | **2009**                               | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                              | ** ** | **(in thousands)**                 | ** ** |
|                                    |       |                                    |       |                                   |       |   |   |   |   |
| Cash Compensation and Other Benefits    |       | $                                       | 6,474      |                                   | $          | 5,977 |   | $ | 19,461 |   | $ | 17,439 |   |
| Other Non-Cash Compensation             |       | 901                                     |       | 255                                    |       | 2,565 |   | 816 |   |
| Total Compensation and Benefits Expense |       | $                                       | 7,375      |                                   | $          | 6,232 |   | $ | 22,026 |   | $ | 18,255 |   |

 

Pursuant to the Pzena Investment Management, LLC 2006 Equity IncentivePlan (the “2006 Plan”) and the Pzena Investment Management, Inc. 2007Equity Incentive Plan (“the 2007 Plan,” together the “2006 and 2007 Plans”), wehave issued restricted Class B units and options to acquire Class Bunits in our operating company, and options to acquire shares of ourClass A common stock, all of which vest ratably over the respective award’svesting period.  We used a fair-valuemethod in recording the compensation expense associated with the granting ofthese stock-based compensation awards. Under this method, compensation expense is measured at the grant datebased on the estimated fair value of the award and is recognized over the award’svesting period.  The fair value of theunits is determined by reference to the market price of our Class A commonstock on the date of grant, since these units are exchangeable for shares ofour Class A common stock on a one-for-one basis.  The fair value of the options to acquireClass B units and options to acquire shares of our Class A commonstock is determined by using an appropriate option pricing model on the grantdate.

 

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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 amounts may take the form ofphantom Class B units, or be invested in a variety of third-party mutualfunds at the employee’s discretion, and vest ratably over four years.  Amounts deferred in any period reduce thatperiod’s cash compensation expense and vest ratably over a four-year periodbeginning on January 1 of the next year.  Should additional amounts be deferred infuture periods, we would expect the non-cash portion of our compensationexpense to increase as the existing and subsequently deferred amounts areamortized through income.

 

Asof September 30, 2010, we had approximately $3.4 million inunrecorded compensation expense related to unvested operating company phantomunits issued pursuant to our deferred compensation plan, operating companyClass B unit and option grants issued under our 2006 Plan, and Class Astock and option grants issued under our 2007 Plan.  We expect that the amortization of theseamounts will be approximately $0.7 million for the remainder of 2010, $2.6million for 2011, and $0.1 million for 2012, with a negligible amount amortizedthereafter.

 

**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.  Our occupancy-related costs and professionalservices expenses, in particular, generally increase or decrease in relativeproportion to the overall size and scale of our business operations.

 

Asa result of our offering on October 30, 2007, we have incurred, and expectto continue to incur, additional expenses associated with being a publiccompany for, among other things, director and officer insurance, director fees,SEC reporting and compliance (including Sarbanes-Oxley compliance),professional fees, transfer agent fees, and other similar expenses.  These additional expenses have and willcontinue to reduce our net income.

 

**Other Income/(Expense)**

 

Otherincome/(expense) is derived primarily from changes in our estimates of theliability due to our selling and converting shareholders associated withpayments owed to them under the tax receivable agreement which was executed inconnection with our reorganization and offering on October 30, 2007.  As discussed further below, under “TaxReceivable Agreement,” this liability represents 85% of the amount of cashsavings, if any, in U.S. federal, state, and local income tax that we realizeas a result of the amortization of the increases in tax basis generated fromthe Company’s acquisitions of operating company units from its selling andconverting shareholders.  Amounts waivedby our selling and converting shareholders have, and would, reduce thisliability.  Other income/(expense) isalso affected by the investment income or loss which arose from our investmentsin various private investment vehicles that we employed to incubate newstrategies prior to their redemption during the three months ended September 30,2010, the non-controlling interest allocation of the income or loss of ourconsolidated investment partnerships to their outside investors, interestexpense on our outstanding debt prior to its extinguishment, mark-to-marketmovements on our swap agreement prior to its termination, net realized andunrealized gains and losses from our investments in mutual funds, and interestincome generated on our excess cash balances. We expect the interest and investment components, if any, of otherincome/(expense), in the aggregate, to fluctuate based on market conditions.

 

**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, webecame the sole managing member of our operating company and now control itsbusiness and affairs and, therefore, consolidate its financial results withours.  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, our income is generated by our economicinterest in our operating company’s net income. As of September 30, 2010, the holders of Class A common stock(through the Company) and the holders of Class B units of the operatingcompany held approximately 14.6% and 85.4%, respectively, of the economicinterests in the operations of the business.

 

**Income Tax Provision/(Benefit)**

 

Whileour operating company has historically not been subject to U.S. federal andcertain state income taxes, it has been subject to New York City UnincorporatedBusiness Tax.  As a result of ourreorganization, we are subject to taxes applicable to C-corporations.  As such, our effective tax rate has increasedas a result of our reorganization. Valuation allowances are established, when necessary, to reduce deferredtax assets to the amount more likely than not to be realized.  As of September 30, 2010 and December 31,2009, the Company’s valuation allowance against the deferred tax assetassociated with our acquisition of operating company units in conjunction withthe offering and subsequent exchanges was $61.4 million and$60.3 million, respectively.

 

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**Operating Results**

 

***General***

 

Ourearnings and cash flows are heavily dependent upon prevailing financial marketconditions.  Significant increases ordecreases in the various securities markets, particularly the equities markets,can have a material impact on our results of operations, financial condition,and cash flows.

 

Beginningin the second half of 2007 and continuing through the quarter endedMarch 31, 2009, the performance of our investment strategies wasnegatively impacted by significant volatility in the equity markets.  Performance prior to March 31, 2009 wasinfluenced by our overweight investment exposure to the financial servicessector in particular.  Subsequent toMarch 31, 2009, all of our investment strategies experienced improvementin their performance, and outperformed their respective benchmarks.  As a result, our assets under managementincreased by $0.4 billion, or 2.9%, from $13.9 billion at September 30,2009, to $14.3 billion at September 30, 2010, due to positiveperformance of $0.9 billion, offset by net outflows of $0.5 billion.

 

Forthe three months ended September 30, 2010, we experienced net outflows of$0.3 billion, consisting of gross outflows of $1.2 billion, offset by grossinflows of $0.9 billion.  For thenine months ended September 30, 2010, we experienced net outflows of $0.7billion, consisting of gross outflows of $3.0 billion, offset by grossinflows of $2.3 billion.

 

Forthe three months ended September 30, 2010, our institutional accountsexperienced gross inflows of $0.6 billion, which were offset by $0.5 billion ingross outflows.  For the nine monthsended September 30, 2010, our institutional accounts experienced grossinflows of $1.3 billion, which were offset by $1.3 billion in gross outflows.

 

Forthe three months ended September 30, 2010, our retail accounts experienced$0.7 billion in gross outflows and $0.3 billion in gross inflows.  For the nine months ended September 30,2010, our retail accounts experienced $1.7 billion in gross outflows and$1.0 billion in gross inflows.

 

Ouraverage AUM fluctuates based on changes in the market value of accounts advisedand managed by us, and on fund flows. Accordingly, given our higher average AUM levels, our revenues for thethree and nine months ended September 30, 2010 increased compared to ourrevenues for the three and nine months ended September 30, 2009.  An increase in revenue typically results inhigher operating income and net income.

 

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*** ***

***Assets Under Management and Flows***

 

Thechange in AUM in our institutional accounts and our retail accounts for thethree and nine months ended September 30, 2010 and 2009 and the twelvemonths ended September 30, 2010 is described below:

 
| ** **                            | ** ** | **For the Three Months** | ** ** | **For the Nine Months** | ** ** | **For the Twelve  Months Ended** | ** ** |
|---------------------------------------|------------|-----------------------------------------|------------|----------------------------------------|------------|--------------------------------------------|------------|
| ** **                            | ** ** | **Ended September 30,**       | ** ** | **Ended September 30,**      | ** ** | **September 30,**                     | ** ** |
| **Assets Under Management** | ** ** | **2010**                                | ** ** | **2009**                               | ** ** | **2010**                                   | ** ** | **2009** | ** ** | **2010** | ** ** |
| ** **                            | ** ** | **(in billions)**                  | ** ** |
| Institutional Accounts                |       |                                    |       |                                   |       |                                       |       |   |   |   |   |
| Beginning of Period Assets            |       | $10.0                                   |       | $7.5                                   |       | $10.7                                      |       | $7.4 |   | $10.2 |   |
| *Inflows*                             | * *   | *0.6*                                   | * *   | *0.9*                                  | * *   | *1.3*                                      | * *   | *1.8* | * * | *2.2* | * * |
| *Outflows*                            | * *   | *(0.5*                                  | *)*        | *(0.3*                                 | *)*        | *(1.3*                                     | *)*        | *(1.5* | *)* | *(1.8* | *)* |
| Net Flows                             |       | 0.1                                     |       | 0.6                                    |       | 0.0                                        |       | 0.3 |   | 0.4 |   |
| Market Appreciation                   |       | 1.2                                     |       | 2.1                                    |       | 0.6                                        |       | 2.5 |   | 0.7 |   |
| End of Period Assets                  |       | $11.3                                   |       | $10.2                                  |       | $11.3                                      |       | $10.2 |   | $11.3 |   |
| Retail Accounts                       |       |                                    |       |                                   |       |                                       |       |   |   |   |   |
| Beginning of Period Assets            |       | $3.1                                    |       | $3.1                                   |       | $3.6                                       |       | $3.3 |   | $3.7 |   |
| *Inflows*                             | * *   | *0.3*                                   | * *   | *0.3*                                  | * *   | *1.0*                                      | * *   | *0.9* | * * | *1.5* | * * |
| *Outflows*                            | * *   | *(0.7*                                  | *)*        | *(0.4*                                 | *)*        | *(1.7*                                     | *)*        | *(1.5* | *)* | *(2.4* | *)* |
| Net Flows                             |       | (0.4                                    | )          | (0.1                                   | )          | (0.7                                       | )          | (0.6 | ) | (0.9 | ) |
| Market Appreciation                   |       | 0.3                                     |       | 0.7                                    |       | 0.1                                        |       | 1.0 |   | 0.2 |   |
| End of Period Assets                  |       | $3.0                                    |       | $3.7                                   |       | $3.0                                       |       | $3.7 |   | $3.0 |   |
| Total                                 |       |                                    |       |                                   |       |                                       |       |   |   |   |   |
| Beginning of Period Assets            |       | $13.1                                   |       | $10.6                                  |       | $14.3                                      |       | $10.7 |   | $13.9 |   |
| *Inflows*                             | * *   | *0.9*                                   | * *   | *1.2*                                  | * *   | *2.3*                                      | * *   | *2.7* | * * | *3.7* | * * |
| *Outflows*                            | * *   | *(1.2*                                  | *)*        | *(0.7*                                 | *)*        | *(3.0*                                     | *)*        | *(3.0* | *)* | *(4.2* | *)* |
| Net Flows                             |       | (0.3                                    | )          | 0.5                                    |       | (0.7                                       | )          | (0.3 | ) | (0.5 | ) |
| Market Appreciation                   |       | 1.5                                     |       | 2.8                                    |       | 0.7                                        |       | 3.5 |   | 0.9 |   |
| End of Period Assets                  |       | $14.3                                   |       | $13.9                                  |       | $14.3                                      |       | $13.9 |   | $14.3 |   |
|                                       |            |                                         |            |                                        |            |                                            |            |  |  |  |  |  |  |  |

 

At September 30, 2010, our $14.3 billion of AUM was invested invarious value-oriented investment strategies representing distinct geographicalsegments.  The following table describesthe allocation of our AUM, as of September 30, 2010 and 2009, among ourinvestment strategies:

 
| ** **                                                             | ** ** | **AUM at September 30,** | ** ** |
|------------------------------------------------------------------------|------------|-----------------------------------------|------------|
| **Investment Strategy**                                           | ** ** | **2010**                                | ** ** | **2009** | ** ** |
| ** **                                                             | ** ** | **(in billions)**                  | ** ** |
| ** **                                                             | ** ** | ** **                              | ** ** | ** ** | ** ** |
| U.S. Value Strategies                                                  |       | $                                       | 9.2        |   | $ | 9.9 |   |
| Global Value Strategies                                                |       | 3.2                                     |       | 2.4 |   |
| Europe, Australasia, and Far East (“EAFE”) Value  Strategies |       | 1.9                                     |       | 1.6 |   |
| Total                                                                  |       | $                                       | 14.3       |   | $ | 13.9 |   |

 

*Three Months Ended September 30, 2010 versus September 30,2009*

 

AtSeptember 30, 2010, we managed $14.3 billion in total assets, anincrease of $0.4 billion, or 2.9%, from $13.9 billion at September 30,2009.  The year-over-year increase in AUMwas primarily due to $0.9 billion in market appreciation and $3.7 millionin gross inflows, offset by $4.2 billion in gross outflows.  Improving overall economic conditionscontributed to the performance-related increase in our AUM.

 

AtSeptember 30, 2010, we managed $11.3 billion in institutionalaccounts and $3.0 billion in retail accounts, for a total of$14.3 billion in assets.  For thethree months ended September 30, 2010, assets in institutional accountsincreased by $1.3 billion, or 13.0%, due to $1.2 billion in marketappreciation and $0.6 billion in gross inflows, offset by $0.5 billion in grossoutflows.  For the three months ended September 30,2010, assets in retail accounts decreased by $0.1 billion, or 3.2%, as a resultof $0.7 billion in gross outflows, offset by $0.3 billion in grossinflows and $0.3 billion in market appreciation.

 

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*Nine Months Ended September 30, 2010 versus September 30,2009*

 

AtSeptember 30, 2010, we managed $14.3 billion in total assets, anincrease of $0.4 billion, or 2.9%, from $13.9 billion at September 30,2009.  The year-over-year increase in AUMwas primarily due to $0.9 billion in market appreciation and $3.7 millionin gross inflows, offset by $4.2 billion in gross outflows.  Improving overall economic conditionscontributed to the performance-related increase in our AUM.

 

AtSeptember 30, 2010, we managed $11.3 billion in institutionalaccounts and $3.0 billion in retail accounts, for a total of$14.3 billion in assets.  For thenine months ended September 30, 2010, assets in institutional accountsincreased by $0.6 billion, or 5.6%, due to $0.6 billion in marketappreciation and $1.3 billion in gross inflows, offset by $1.3 billion in grossoutflows.  For the nine months ended September 30,2010, assets in retail accounts decreased by $0.6 billion, or 16.7%, as aresult of $1.7 billion in gross outflows, offset by $1.0 billion ingross inflows and $0.1 billion in market appreciation.

 

AtSeptember 30, 2010, institutional accounts represented 79.0% of our totalAUM, compared to 73.4% at September 30, 2009.  At September 30, 2010, our Global Valueand EAFE Value investment strategies accounted for 35.7% of our AUM, comparedto 28.8% at September 30, 2009.

 

***Revenues***

 

Ourrevenues from advisory fees earned on our institutional and retail accounts forthe three and nine months ended September 30, 2010 and 2009 is describedbelow:

 
| ** **             | ** ** | **For the Three Months** | ** ** | **For the Nine Months** | ** ** |
|------------------------|------------|-----------------------------------------|------------|----------------------------------------|------------|
| ** **             | ** ** | **Ended September 30,**       | ** ** | **Ended September 30,**      | ** ** |
| **Revenue**            | ** ** | **2010**                                | ** ** | **2009**                               | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **             | ** ** | **(in thousands)**                 | ** ** |
| ** **             | ** ** | ** **                              | ** ** | ** **                             | ** ** | ** ** | ** ** | ** ** | ** ** |
| Institutional Accounts |       | $                                       | 15,491     |                                   | $          | 13,839 |   | $ | 47,756 |   | $ | 36,466 |   |
| Retail Accounts        |       | 2,991                                   |       | 2,974                                  |       | 9,264 |   | 8,251 |   |
| Total                  |       | $                                       | 18,482     |                                   | $          | 16,813 |   | $ | 57,020 |   | $ | 44,717 |   |

 

*Three Months Ended September 30, 2010 versus September 30,2009*

 

Ourtotal revenue increased $1.7 million, or 10.1%, to $18.5 million for thethree months ended September 30, 2010, from $16.8 million for thethree months ended September 30, 2009. This change was driven primarily by an increase in weighted average AUM,which increased $1.4 billion, or 11.5%, to $13.6 billion for thethree months ended September 30, 2010, from $12.2 billion for thethree months ended September 30, 2009.

 

Ourweighted average fee rate was 0.544% and 0.550% for the three months ended September 30,2010 and 2009, respectively.  Thedecrease in the weighted average fee rate was due in part to largeinstitutional inflows in our newly launched Europe, Australasia, and Far East (“EAFE”)Diversified Value and Global Diversified Value strategies in the fourth quarterof 2009.  We typically offer reduced feerates to initial clients in our new product offerings.  The decrease in the weighted average fee ratewas also due to an increase in the average size of our institutionalaccounts.  Our tiered fee schedules typicallycharge lower rates as account size increases. Weighted average assets in institutional accounts increased$1.7 billion, or 19.3%, to $10.5 billion for the three months ended September 30,2010, from $8.8 billion for the three months ended September 30,2009, and had a weighted average fee rate of 0.589% and 0.630% for the threemonths ended September 30, 2010 and 2009, respectively.  This decline was primarily due toinstitutional inflows in our EAFE Diversified Value and Global DiversifiedValue strategies, and a higher average institutional account size.  Weighted average assets in retail accounts decreased$0.3 billion, or 8.8%, to $3.1 billion for the three months ended September 30,2010, from $3.4 billion for the three months ended September 30,2009, and had a weighted average fee rate of 0.389% and 0.346% for the threemonths ended September 30, 2010 and 2009, respectively.  The year-over-year increase was due to thetiming of asset flows in our retail accounts and the expiration of thevoluntary partial fee waiver on the John Hancock Classic Value Fund, for whichwe act as sub-investment advisor, which ended in May 2010.

 

*Nine Months Ended September 30, 2010 versus September 30,2009*

 

Ourtotal revenue increased $12.3 million, or 27.5%, to $57.0 million for thenine months ended September 30, 2010, from $44.7 million for the ninemonths ended September 30, 2009. This change was driven primarily by an increase in weighted average AUM,which increased $3.5 billion, or 32.7%, to $14.2 billion for the ninemonths ended September 30, 2010, from $10.7 billion for the ninemonths ended September 30, 2009.

 

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Ourweighted average fee rate was 0.537% and 0.559% for the nine months ended September 30,2010 and 2009, respectively.  Thedecrease in the weighted average fee rate was due primarily to an increase inthe average size of our institutional accounts. Our tiered fee schedules typically charge lower rates as account sizeincreases.  Weighted average assets ininstitutional accounts increased $3.2 billion, or 42.1%, to$10.8 billion for the nine months ended September 30, 2010, from$7.6 billion for the nine months ended September 30, 2009, and had aweighted average fee rate of 0.590% and 0.642% for the nine months ended September 30,2010 and 2009, respectively.  Weightedaverage assets in retail accounts increased $0.3 billion, or 9.7%, to$3.4 billion for the nine months ended September 30, 2010, from$3.1 billion for the nine months ended September 30, 2009, and had aweighted average fee rate of 0.367% and 0.355% for the nine months ended September 30,2010 and 2009, respectively.  Theyear-over-year increase in weighted average fee rate for retail assets was dueto the timing of asset flows in our retail accounts and the effects of thevoluntary partial fee waiver on the John Hancock Classic Value Fund, for whichwe act as sub-investment advisor, which commenced in May 2009 and expiredin May 2010.

 

***Expenses***

 

Ouroperating expenses are driven primarily by our compensation costs.  The table below describes the components ofour compensation expense for the three and nine months ended September 30,2010 and 2009:

 
| ** **                              | ** ** | **For the Three Months** | ** ** | **For the Nine Months** | ** ** |
|-----------------------------------------|------------|-----------------------------------------|------------|----------------------------------------|------------|
| ** **                              | ** ** | **Ended September 30,**       | ** ** | **Ended September 30,**      | ** ** |
| ** **                              | ** ** | **2010**                                | ** ** | **2009**                               | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                              | ** ** | **(in thousands)**                 | ** ** |
|                                    |       |                                    |       |                                   |       |   |   |   |   |
| Cash Compensation and Other Benefits    |       | $                                       | 6,474      |                                   | $          | 5,977 |   | $ | 19,461 |   | $ | 17,439 |   |
| Other Non-Cash Compensation             |       | 901                                     |       | 255                                    |       | 2,565 |   | 816 |   |
| Total Compensation and Benefits Expense |       | $                                       | 7,375      |                                   | $          | 6,232 |   | $ | 22,026 |   | $ | 18,255 |   |

 

*Three Months Ended September 30, 2010 versus September 30,2009*

 

Totaloperating expenses increased by $1.1 million, or 13.6%, to $9.2 million for thethree months ended September 30, 2010, from $8.1 million for the threemonths ended September 30, 2009. This increase was primarily attributable to increases in discretionarybonus accruals and employee headcount, which increased from 65 at September 30,2009 to 71 at September 30, 2010.

 

Compensationand benefits expense increased by $1.2 million, or 19.4%, to$7.4 million for the three months ended September 30, 2010, from$6.2 million for the three months ended September 30, 2009.  This increase was primarily a result ofincreases in discretionary bonus accruals and employee headcount, whichincreased from 65 at September 30, 2009 to 71 at September 30, 2010,as discussed above.

 

Generaland administrative expenses decreased by $0.1 million, or 5.3%, to$1.8 million for the three months ended September 30, 2010, from$1.9 million for the three months ended September 30, 2009.  This decrease was mainly attributable todecreases in insurance fees.

 

*Nine Months Ended September 30, 2010 versus September 30,2009*

 

Totaloperating expenses increased by $3.4 million, or 13.8%, to $28.0 million forthe nine months ended September 30, 2010, from $24.6 million for the ninemonths ended September 30, 2009. This increase was primarily attributable to increases in discretionarybonus accruals and employee headcount, which increased from 65 at September 30,2009 to 71 at September 30, 2010.

 

Compensationand benefits expense increased by $3.7 million, or 20.2%, to$22.0 million for the nine months ended September 30, 2010, from$18.3 million for the nine months ended September 30, 2009.  This increase was primarily a result ofincreases in discretionary bonus accruals and employee headcount, whichincreased from 65 at September 30, 2009 to 71 at September 30, 2010,as discussed above.

 

Generaland administrative expenses decreased by $0.4 million, or 6.3%, to$5.9 million for the nine months ended September 30, 2010, from$6.3 million for the nine months ended September 30, 2009.  This decrease was mainly attributable todecreases in professional fees and insurance fees.

 

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

 

*Three Months Ended September 30, 2010 versus September 30,2009*

 

Otherincome/(expense) was an expense of $1.1 million for the three months ended September 30,2010.  Exclusive of $1.7 million in otherexpense associated with a decrease in our liability to our selling andconverting shareholders associated with changes in the realizability of ourrelated deferred tax asset, other income/(expense) was income of $0.6 million.  This income consisted primarily of $0.5million in unrealized and realized gains and losses from investments.  Net realized and unrealized gain/(loss) frominvestments represents both the Company’s and external investors’ allocation ofthe gain/(loss) from the Company’s consolidated investments.  At September 30, 2010, the Company hadtotal assets of $0.8 million in such investments.  Of the net realized and unrealizedgain/(loss) from investments for the three months ended September 30,2010, $0.3 million was attributable to the outside interests of our investmentpartnerships.  The external investors’allocation of net realized and unrealized gain/(loss) is also included as acomponent of net income from non-controlling interests.  Interest and dividend income was income of$0.1 million.

 

Otherincome/(expense) was income of $1.6 million for the three months ended September 30,2009.  Exclusive of $2.4 million in otherexpense associated with an increase in our liability to our selling andconverting shareholders associated with changes in the realizability of ourrelated deferred tax asset, other income/(expense) was income of $4.0million.  This income consisted primarilyof $4.2 million in income related to the positive performance of investments inour own products, offset by $0.2 million in net interest expense.  Net realized and unrealized gain/(loss) frominvestments represents both the Company’s and external investors’ allocation ofthe gain/(loss) from the Company’s consolidated investments.  At September 30, 2009, the Company hadtotal assets of $18.4 million in such investments.  Of the $4.2 million in income related to thepositive performance of our investments in our own products, $2.8 million wasattributable to the outside interests of our investment partnerships.  The external investors’ allocation of netrealized and unrealized gain/(loss) is also included as a component of netincome from non-controlling interests.

 

*Nine Months Ended September 30, 2010 versus September 30,2009*

 

Otherincome/(expense) was an expense of $1.4 million for the nine months ended September 30,2010.  Exclusive of $1.6 million in otherexpense associated with an increase in our liability to our selling andconverting shareholders associated with changes in the realizability of ourrelated deferred tax asset, other income/(expense) was income of $0.2million.  This income consisted primarilyof $0.1 million in miscellaneous income and $0.1 million in income related tothe positive performance of our investments in our own products, all of whichwas attributable to the outside interests of our investment partnerships.  At September 30, 2010, the Company hadtotal assets of $0.8 million in such investments.  The external investors’ allocation of netrealized and unrealized gain/(loss) is also included as a component of netincome from non-controlling interests.

 

Otherincome/(expense) was income of $1.8 million for the nine months ended September 30,2009.  Exclusive of $3.6 million in otherexpense associated with an increase in our liability to our selling andconverting shareholders associated with changes in the realizability of ourrelated deferred tax, other income/(expense) was income of $5.4 million.  This income consisted primarily of $6.1million in income related to the positive performance of our investments in ourown products and $0.2 million in miscellaneous income, offset by $0.9 millionin net interest expense.  Net realizedand unrealized gain/(loss) from investments represents both the Company’s andexternal investors’ allocation of the gain/(loss) from the Company’sconsolidated investments.  At September 30,2009, the Company had total assets of $18.4 million in such investments.  Of the $6.1 million in income related to thepositive performance of our investments in our own products, $3.8 million wasattributable to the outside interests of our investment partnerships.  The external investors’ allocation of netrealized and unrealized gain/(loss) is also included as a component of netincome from non-controlling interests.

 

***Income Tax Provision/(Benefit)***

 

*Three Months Ended September 30, 2010 versus September 30,2009*

 

Theincome tax provision/(benefit) was a benefit of $1.1 million for the threemonths ended September 30, 2010. This benefit was generated primarily due to a $2.2 million reduction ofthe valuation allowance against our deferred tax asset associated with our taxreceivable agreement.  Exclusive of thisadjustment, the remaining income tax provision for the three months ended September 30,2010 consisted of $0.5 million in operating company unincorporated businesstaxes and $0.6 million in corporate income taxes.   The income tax provision/(benefit) for thethree months ended September 30, 2009 was a benefit of $2.0 million andwas generated primarily due to a reduction of $3.1 million to the valuationallowance against our deferred tax asset associated with our tax receivableagreement.  Exclusive of this adjustment, the remaining income taxprovision for the three months ended September 30, 2009 consisted of $0.5million in operating company unincorporated business taxes and $0.5 million incorporate income taxes.  A comparison of the effective tax rate for thethree months ended September 30, 2010 to that of the three months ended September 30,2009 is not meaningful due to the valuation allowance adjustments.

 

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*Nine Months Ended September 30, 2010 versus September 30,2009*

 

Theincome tax provision/(benefit) was a provision of $1.4 million for the ninemonths ended September 30, 2010. Exclusive of a reduction of $2.1 million to the income tax provisionrelated to an increase to the valuation allowance against our deferred taxasset associated with our tax receivable agreement, the remaining income taxprovision for the nine months ended September 30, 2010 consisted of $1.8million in operating company unincorporated business taxes and $1.7 million incorporate income taxes.  The income taxprovision/(benefit) for the nine months ended September 30, 2009 was abenefit of $2.4 million and was generated primarily due to a reduction of $4.8million to the valuation allowance against our deferred tax asset associated withour tax receivable agreement.  Exclusive of this adjustment, the remainingincome tax provision for the nine months ended September 30, 2009consisted of $1.3 million in operating company unincorporated business taxesand $1.1 million in corporate income taxes.  A comparison of the effectivetax rate for the nine months ended September 30, 2010 to that of the ninemonths ended September 30, 2009 is not meaningful due to the valuationallowance adjustments.

 

***Non-Controlling Interests***

 

*Three Months Ended September 30, 2010 versus September 30,2009*

 

Netincome attributable to non-controlling interests was $8.0 million for thethree months ended September 30, 2010, and consisted of $7.7 millionassociated with our employees’ and outside investors’ interest in the income ofthe operating company and $0.3 million of income from our consolidatedsubsidiaries’ interest in the earnings of our consolidated investmentpartnerships.  Net income attributable tonon-controlling interests was $10.8 million for the three months ended September 30,2009, and consisted of $8.1 million associated with our employees’ andoutside investors’ interest in the income of the operating company and$2.8 million of income from our consolidated subsidiaries’ interest in theearnings of our consolidated investment partnerships.  The increase in the interest in the earningsof the operating company is primarily a result of the increase in our weightedaverage AUM, which had a corresponding positive impact on revenues andincome.  The decrease in our consolidatedsubsidiaries’ interest in the earnings of our consolidated investmentpartnerships is primarily a result of the deconsolidation of the Pzena GlobalValue Service and the Pzena EAFE Value Service on December 31, 2009, andthe deconsolidation of the Pzena Emerging Market Countries Value Service andthe Pzena Emerging Markets Focused Value Service during the three months ended September 30,2010.

 

*Nine Months Ended September 30, 2010 versus September 30,2009*

 

Netincome attributable to non-controlling interests was $23.6 million for thenine months ended September 30, 2010, and consisted of $23.5 millionassociated with our employees’ and outside investors’ interest in the income ofthe operating company and $0.1 million of income from our consolidatedsubsidiaries’ interest in the earnings of our consolidated investmentpartnerships.  Net income attributable tonon-controlling interests was $21.5 million for the nine months ended September 30,2009, and consisted of approximately of $17.7 million associated with ouremployees’ and outside investors’ interest in the income of the operatingcompany and $3.8 million of income from our consolidated subsidiaries’interest in the earnings of our consolidated investment partnerships.  The increase in the interest in the earningsof the operating company is primarily a result of the increase in our weightedaverage AUM, which had a corresponding positive impact on revenues andincome.  The decrease in our consolidatedsubsidiaries’ interest in the earnings of our consolidated investmentpartnerships is primarily a result of the deconsolidation of the Pzena GlobalValue Service and the Pzena EAFE Value Service on December 31, 2009, andthe deconsolidation of the Pzena Emerging Market Countries Value Service andthe Pzena Emerging Markets Focused Value Service during the three months ended September 30,2010.

 

***Non-GAAP Net Income***

 

Our results for the three and nine months ended September 30, 2010and 2009 included adjustments related to our tax receivable agreement and theassociated liability to our selling and converting shareholders.  Excluding these adjustments, diluted netincome and diluted net income per share was $5.2 million and $0.08,respectively, for the three months ended September 30, 2010, and$5.3 million and $0.08, respectively, for the three months ended September 30,2009.  On a similar basis, diluted netincome and diluted net income per share was $15.7 million and $0.24,respectively, for the nine months ended September 30, 2010, and$11.7 million and $0.18, respectively, for the nine months ended September 30,2009.  We believe that excluding theseadjustments provides information to better analyze our operations betweenperiods and over time. Investors should consider these non-GAAP measures inaddition to, and not as a substitute for, financial measures prepared inaccordance with GAAP.

 

A reconciliation of the non-GAAP measures to the most comparable GAAPmeasures is included below:

 

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| ** **                                                                                                       | ** ** | **For the Three Months**                                              | ** ** | **For the Nine Months** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                                                       | ** ** | **Ended September 30,**                                                    | ** ** | **Ended September 30,**      | ** ** |
| ** **                                                                                                       | ** ** | **2010**                                                                             | ** ** | **2009**                               | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                                                                                       | ** ** | **(in thousands, except share and per-share amounts)** | ** ** |
|                                                                                                             |       |                                                                                 |       |                                   |       |   |   |   |   |
| GAAP Net Income                                                                                                  |       | $                                                                                    | 1,219      |                                   | $          | 1,432 |   | $ | 2,676 |   | $ | 2,736 |   |
| Net Effect of Tax Receivable Agreement                                                                           |       | 461                                                                                  |       | 711                                    |       | 440 |   | 1,197 |   |
| Non-GAAP Net Income                                                                                              |       | $                                                                                    | 758        |                                   | $          | 721 |   | $ | 2,236 |   | $ | 1,539 |   |
|                                                                                                             |       |                                                                                 |       |                                   |       |   |   |   |   |
| GAAP Non-Controlling Interest of Pzena Investment  Management, LLC                                               |       | $                                                                                    | 7,722      |                                   | $          | 8,082 |   | $ | 23,483 |   | $ | 17,767 |   |
| Less: Assumed Corporate Income Taxes                                                                             |       | 3,309                                                                                |       | 3,463                                  |       | 10,063 |   | 7,613 |   |
| Assumed After-Tax Income of Pzena Investment  Management, LLC                                                    |       | $                                                                                    | 4,413      |                                   | $          | 4,619 |   | $ | 13,420 |   | $ | 10,154 |   |
| Non-GAAP Net Income of Pzena Investment  Management, Inc.                                                   |       | 758                                                                                  |       | 721                                    |       | 2,236 |   | 1,539 |   |
| Non-GAAP Diluted Net Income                                                                                      |       | $                                                                                    | 5,171      |                                   | $          | 5,340 |   | $ | 15,656 |   | $ | 11,693 |   |
|                                                                                                             |       |                                                                                 |       |                                   |       |   |   |   |   |
| Non-GAAP Diluted Earnings Per Share Attributable  to Pzena Investment Management, Inc. Common Stockholders: |       |                                                                                 |       |                                   |       |   |   |   |   |
| Non-GAAP Net Income for Diluted Earnings per Share                                                               |       | $                                                                                    | 5,171      |                                   | $          | 5,340 |   | $ | 15,656 |   | $ | 11,693 |   |
| Non-GAAP Diluted Earnings per Share                                                                              |       | $                                                                                    | 0.08       |                                   | $          | 0.08 |   | $ | 0.24 |   | $ | 0.18 |   |
| Non-GAAP Diluted Weighted Average Shares  Outstanding                                                            |       | 64,993,746                                                                           |       | 64,994,278                             |       | 65,006,198 |   | 64,756,331 |   |

 

**Liquidityand Capital Resources**

 

Historically, the working capital needs of our business have primarilybeen met through cash generated by our operations.  Distributions to members of our operatingcompany and loan amortization payments have been our largest use of cash fromfinancing activities.  Investingactivities have historically been investments in our own investment strategiesand, to a lesser extent, capital expenditures.

 

AtSeptember 30, 2010, our cash and cash equivalents was $26.8 million.  Advisory fees receivable were$14.2 million.

 

We expect to fund the liquidity needs of our business in the nexttwelve months, and over the long term, primarily through cash generated fromoperations.  As an investment managementfirm, our business has been materially affected by conditions in the globalfinancial markets and economic conditions throughout the world.  Our liquidity is highly dependent on therevenue and income from our operations, which is directly related to our levelsof AUM.  As of and for the three monthsended September 30, 2010, our weighted average AUM and revenues increasedby 11.5% and 10.1%, respectively, compared to the three months ended September 30,2009.  These increases contributed to a28.6% increase in our cash provided by operating activities for the comparableperiod.  As of and for the nine monthsended September 30, 2010, our weighted average AUM and revenues increasedby 32.7% and 27.5%, respectively, compared to the nine months ended September 30,2009.  These increases contributed to a35.2% increase in our cash provided by operating activities for the comparableperiod.

 

In determining the sufficiency of liquidity and capital resources tofund our business, we regularly monitor our liquidity position, including, amongother things, cash, working capital, investments, long-term liabilities, leasecommitments, debt obligations, and operating company distributions.  Further, we consider cash compensation, oneof our largest expenses, as sufficiently variable such that it can be adjustedto mitigate any potential decline in revenue we may experience in the nexttwelve months.  We continuously evaluateour staffing requirements and compensation levels with reference to our ownliquidity position and external peer benchmarking data.  The result of this review directly influencesmanagement’s recommendations to our Board of Directors with respect to suchstaffing and compensation levels.

 

We anticipate that distributions to the members of our operatingcompany, which consisted of 34 of our employees, certain unaffiliated persons,two former employees, and us, will continue to be a material financingactivity.

 

During the nine months ended September 30, 2010, we repaid theremaining $10.0 million principal amount outstanding of the Senior SubordinatedNotes held by the entities established by Richard S. Pzena.  Although we are comfortable with our currentcapital structure, in the current economic environment, it is uncertain whetheradditional or alternative sources of debt or equity financing, if required,would be available on acceptable terms.

 

We do not anticipate meaningful outlays for internal investment orcapital expenditures over the next twelve months.

 

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We believe that the repayment of our term loan and Senior SubordinatedNotes, and our ability to vary cash compensation levels, have provided us withan appropriate degree of flexibility in providing for our liquidity needs.

 

**DividendPolicy**

 

We are a holding company and have no material assets other than ourownership of membership interests in our operating company.  As a result, we depend upon distributionsfrom our operating company to pay any dividends that our Board of Directors maydeclare to be paid to our Class A common stockholders.  When, and if, our Board of Directors declaresany such dividends, we then cause our operating company to make distributions tous in an amount sufficient to cover the amount of the dividends declared.  Our dividend policy has certain risks andlimitations, particularly with respect to liquidity.  We may not pay dividends to our Class Acommon shareholders in amounts that have been paid to them in the past, or atall, if, among other things, we do not have the cash necessary to pay ourintended dividends.  To the extent we donot have cash on hand sufficient to pay dividends in the future, we may decidenot 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.

 

**Term Loan and Senior Subordinated Notes**

 

During the year ended December 31, 2009, we used cash generatedfrom operations to repay the remaining $22.0 million of the principalamount outstanding under our term loan. Concurrently with the termination of this term loan, a security interestin our accounts receivable and one of our subsidiaries was released by thelender in September 2009.

 

During the nine months ended September 30, 2010, we used cash onhand to repay the remaining $10.0 million principal amount outstanding of theSenior Subordinated Notes held by the entities established by Richard S. Pzena.

 

**TaxReceivable Agreement**

 

Our purchase of Class B units of our operating companyconcurrently with our initial public offering, and the subsequent and futureexchanges by holders of Class B units of our operating company for sharesof our Class A common stock (pursuant to the exchange rights provided forin the operating company’s operating agreement), has resulted in, and isexpected to continue to result in, increases in our share of the tax basis ofthe tangible and intangible assets of our operating company at the time of ouracquisitions and these subsequent and future exchanges, which will increase thetax depreciation and amortization deductions that otherwise would not have beenavailable 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 be requiredto pay in the future.  We have enteredinto a tax receivable agreement with the current members of our operatingcompany, the one member of our operating company immediately prior to ourinitial public offering who sold all of its Class B units to us inconnection with our initial public offering, and any future holders ofClass B units, that requires us to pay them 85% of the amount of cashsavings, if any, in U.S. federal, state and local income tax that we actuallyrealize (or are deemed to realize in the case of an early termination paymentby us, or a change in control, as described in the tax receivable agreement) asa result of the increases in tax basis described above and certain other taxbenefits related to entering into the tax receivable agreement, including taxbenefits attributable to payments under the tax receivable agreement.

 

In October 2008, the selling unitholders agreed to waive anypayments that we were required to make to them for the 2008 and 2009 tax yearspursuant to the tax receivable agreement.

 

**Cash Flows**

 

Operating activities provided cash of $9.9 million and$7.7 million for the three months ended September 30, 2010 and 2009,respectively.  Operating activitiesprovided $37.5 million and $25.6 million for the nine months ended September 30,2010 and 2009, respectively.  Theyear-over-year increase in cash flows from operating activities was drivenprimarily by an increase in weighted average AUM from $12.2 billion forthe three months ended September 30, 2009, to $13.6 billion for thethree months ended September 30, 2010, and an increase in weighted average AUMfrom $10.7 billion for the nine months ended September 30, 2009, to$14.2 billion for the nine months ended September 30, 2010, which hada corresponding positive impact on total revenues.

 

Investing activities consist primarily of investments in affiliates andother investment partnerships, as well as capital expenditures.  Investing activities used less than $0.1million for each of the three months ended September 30, 2010 and2009.  Investing activities provided lessthan $0.1 million for the nine months ended September 30, 2010, and had nonet effect for the nine months ended September 30, 2009.

 

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Financing activities consist primarily of borrowing arrangements anddistributions to and contributions from non-controlling interests.  Financing activities used $6.6 millionand $14.4 million of cash for the three months ended September 30, 2010and 2009, respectively.  The $7.8 milliondecrease in financing activities is primarily attributable to a $10.0 milliondecrease in principal repayments associated with our debt obligations, offsetby a $1.6 million increase in distributions to non-controlling interests, a$0.3 million decrease in contributions from non-controlling interests, and a$0.3 million increase in dividends paid.

 

Financing activities used $26.5 million and $33.9 million for the ninemonths ended September 30, 2010 and 2009, respectively.  The $7.4 million decrease in financingactivities is primarily attributable to a $12.0 million decrease in principalrepayments associated with our debt obligations and a $4.0 million increase incontributions from non-controlling interests, offset by a $8.0 million increasein distributions to non-controlling interests and a $0.6 million increase individends paid.

 

**Off-Balance Sheet Arrangements**

 

We did not have any off-balance sheet arrangements as of September 30,2010.

 

**Critical Accounting Policies andEstimates**

 

The preparation of our consolidated financial statements in accordancewith U.S. generally accepted accounting principles (“GAAP”) requires managementto make estimates and judgments that affect our reported amounts of assets,liabilities, revenues and expenses and related disclosure of contingent assetsand liabilities.  We base our estimateson historical experience and on various other assumptions that are believed tobe reasonable under current circumstances, the results of which form the basisfor making judgments about the carrying value of assets and liabilities thatare not readily available from other sources. We evaluate our estimates on an ongoing basis.  Actual results may differ from theseestimates under different assumptions or conditions.

 

Accounting policies are an integral part of our financialstatements.  A thorough understanding ofthese accounting policies is essential when reviewing our reported results ofoperations and our financial condition. Management believes that the critical accounting policies discussedbelow involve additional management judgment due to the sensitivity of themethods and assumptions used.

 

***Consolidation***

 

Our policy is to consolidate all majority-owned subsidiaries in whichwe have a controlling financial interest and VIEs of which we are deemed to bethe primary beneficiary.  We alsoconsolidate non-VIEs which we control as the general partner or managingmember.  We assess our consolidationpractices regularly, as circumstances dictate. All significant inter-company transactions and balances have beeneliminated.

 

***Income Taxes***

 

We are a C-corporation under the Internal Revenue Code, and thus liablefor federal, state and local taxes on the income derived from our economicinterest in our operating company.  Theoperating company is a limited liability company that has elected to be treatedas a partnership for tax purposes.  Ouroperating company has not made a provision for federal or state income taxesbecause it is the responsibility of each of the operating company’s members(including us) to separately report their proportionate share of the operatingcompany’s taxable income or loss. Similarly, the income of our consolidatedinvestment partnerships is not subject to income taxes, as such income isallocated to each partnership’s individual partners.  The operating company has made a provisionfor New York City Unincorporated Business Tax (“UBT”).

 

We recognize deferred tax assets and liabilities for the future taxconsequences attributable to differences between the financial statementcarrying amounts of existing assets and liabilities and their respective taxbases, net operating loss carryforwards and tax credits.  A valuation allowance is maintained fordeferred tax assets that we estimate are more likely than not to beunrealizable based on available evidence at the time the estimate is made.  Determining the valuation allowance requiressignificant management judgments and assumptions.  In determining the valuation allowance, weuse historical and forecasted future operating results, based upon approvedbusiness plans, including a review of the eligible carryforward periods, taxplanning opportunities and other relevant considerations.  Each quarter, we re-evaluate our estimaterelated to the valuation allowance, including our assumptions about futureprofitability.

 

We believe that the accounting estimate related to the$61.4 million valuation allowance, assessed as of September 30, 2010against the deferred tax asset associated with our acquisitions of operatingcompany Class B units, is a critical accounting estimate because theunderlying assumptions can change from period to period.  For example, tax law changes, or variances infuture projected operating performance, could result in a change in thevaluation allowance.  If we were not ableto realize all or part of our net deferred tax assets in the future, anadjustment to our deferred tax assets valuation allowance would be charged toincome tax expense in the period such determination was made.

 

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Management judgment is required in determining our provision for incometaxes, evaluating our tax positions and establishing deferred tax assets andliabilities.  The calculation of our taxliabilities involves dealing with uncertainties in the application of complextax regulations.  If our estimate of taxliabilities proves to be less than the ultimate assessment, a further charge toearnings would result.

 

**RecentAccounting Pronouncements**

 

InSeptember 2009, the FASB issued a new standard that requires an enterpriseto perform a qualitative analysis to determine whether its variable-interestsgive it a controlling financial interest in a VIE.  Under the standard, an enterprise has acontrolling financial interest when it has (a) the power to direct theactivities of a VIE that most significantly impact the entity’s economicperformance, and (b) the obligation to absorb losses of the entity or theright to receive benefits from the entity that could potentially be significantto the VIE.  An enterprise that holds asubstantive interest and a controlling financial interest in a VIE is deemed tobe the primary beneficiary of the VIE and is required to consolidate theVIE.  The standard also requires anongoing assessment of whether an enterprise is the primary beneficiary of aVIE, and additional disclosures about an enterprise’s involvement in VIEs, andany significant changes in risk exposure due to that involvement.  The standard is effective for fiscal yearsbeginning after November 15, 2009.  InNovember 2009, the FASB issued a proposed standard update, which defersthe consolidation criteria requirements of this new standard for assetsmanagers’ interests in entities that apply the specialized accounting guidancefor investment companies, or that have the attributes of investmentcompanies.  In February 2010, theFASB issued further guidance which provided a limited scope deferral for areporting entity’s interest in an entity that meets all of the followingconditions: (a) the entity has all the attributes of an investment companyas defined under AICPA Audit and Accounting Guide, Investment Companies,or does not have all the attributes of an investment company but is an entityfor which it is acceptable based on industry practice to apply measurementprinciples that are consistent with the AICPA Audit and Accounting Guide, InvestmentCompanies, (b) the reporting entity does not have explicit or implicitobligations to fund any losses of the entity that could potentially besignificant to the entity, and (c) the entity is not a securitizationentity, asset-backed financing entity or an entity that was formerly considereda qualifying special-purpose entity.  The reporting entity isrequired to perform a consolidation analysis for entities that qualify for thedeferral in accordance with previously issued guidance on VIEs.  Wehave evaluated the deferral guidelines and determined that the standard isapplicable for our investment in our operating company, but that we meet thecriteria for deferral provided in this standard for our VIEs.  We adopted the updated guidance on January 1,2010, and it had no impact on our consolidated financial statements.  We are monitoring future guidance for updateson the treatment of our interests in our VIEs.

 

**Item 3.Quantitative and Qualitative Disclosures About Market Risk.**

 

**Market Risk**

 

Our exposure to market risk is directlyrelated to our role as investment adviser for the institutional separateaccounts we manage and the retail clients for which we act as a sub-investmentadviser.  Global markets have experiencedunprecedented volatility, and the current economic environment ischallenging.  Market conditions have, inthe recent past, resulted in a significant reduction in our AUM, which in turndirectly impacted our revenues and net income. A resumption of the economic downturn, and volatility in the globalfinancial markets, could also significantly affect the estimates, judgments,and assumptions used in the valuation of our financial instruments.

 

All of our revenue for the three and ninemonths ended September 30, 2010 and 2009 was derived from advisory fees,which are typically based on the market value of AUM, which can be affected byadverse changes in interest rates, foreign currency exchange and equityprices.  Accordingly, a decline in theprices of securities would cause our revenue and earnings to decline due to adecrease in the value of the assets we manage. In addition, such a decline could cause our clients to withdraw theirfunds in favor of investments offering higher returns or lower risk, whichwould cause our revenue and earnings to decline further.

 

We are also subject to market risk due to a decline in the value ofholdings in mutual funds.  At September30, 2010, the fair value of these assets was $2.3 million.  Assuming a 10% increase or decrease, the fairvalue would have increased or decreased by $0.2 million at September 30, 2010.

 

***Interest RateRisk***

 

We have no exposure to interest rate risk at September 30, 2010.

 

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**Item 4.   Controls and Procedures.**

 

During the course of their review of ourconsolidated financial statements as of September 30, 2010, ourmanagement, including our Chief Executive Officer and Chief Financial Officer,evaluated the effectiveness of our disclosure controls and procedures pursuantto Rule 13a-15 under the Securities Exchange Act of 1934, as amended(the “Exchange Act”).  Based on thatevaluation, our Chief Executive Officer and Chief Financial Officer haveconcluded that, as of September 30, 2010, our disclosure controls andprocedures (as defined in Rule 13a-15(e) under the Exchange Act) wereeffective to ensure that information we are required to disclose in reportsthat 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 have not been any changes in ourinternal control over financial reporting during the three and nine monthsended September 30, 2010 that have materially affected, or are reasonablylikely to materially affect, our internal control over financial reporting.

 

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**PART II. OTHER INFORMATION**

 

**Item 1.  Legal Proceedings.**

 

In the normal course of business, we may be subject to various legaland administrative proceedings.

 

Currently, there are no material legal proceedings pending against us.

 

**Item 1A.  Risk Factors.**

 

There are no material changes from the risk factors set forth inPart 1, Item 1A of the Company’s 2009 Annual Report on Form 10-K.

 

**Item 2.  Unregistered Sales of Equity Securities andUse of Proceeds.**

 

None.

 

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

 

None.

 

**Item 4.****(Removed and Reserved).**

 

**Item 5.  Other Information.**

 

None.

 

**Item 6.  Exhibits.**

 
| **Exhibit** | ** ** | **Description of Exhibit**                                                                                                                          |
|-------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 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 |

 

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**SIGNATURES**

 

Pursuant to the requirements of the Securities Exchange Act of 1934,the registrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

 

Dated: November 4, 2010

 
|   | PZENA  INVESTMENT MANAGEMENT, INC. |
|--------|-----------------------------------------|
|   |                                    |
|   |                                    |
|   | By:                                     | /s/  RICHARD S. PZENA |
|   |                                    | Name: | Richard  S. Pzena |
|   |                                    | Title: | *Chief Executive Officer* |
|   |                                    |   |
|   |                                    |   |
|   | By:                                     | /s/  GREGORY S. MARTIN |
|   |                                    | Name: | Gregory  S. Martin |
|   | * *                                | Title: | *Chief Financial Officer and Principal Accounting Officer* |

 

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