Pzena Investment Management, Inc.

Income Taxes

The operating company is a limited liability company that has elected to be treated as a partnership for tax purposes. Neither it nor the Company’s other consolidated subsidiaries have made a provision for federal or state income taxes because it is the individual responsibility of each of these entities’ members (including the Company) to separately report their proportionate share of the respective entity’s taxable income or loss. The operating company has made a provision for New York City UBT and its U.K. consolidated subsidiary has made a provision for U.K. corporate taxes. The Company, as a “C” corporation under the Internal Revenue Code, is liable for federal, state and local taxes on the income derived from its economic interest in its operating company, which is net of UBT and U.K. taxes. Correspondingly, in its consolidated financial statements, the Company reports both the operating company’s provision for UBT and U.K. taxes, as well as its provision for federal, state and local corporate taxes. The components of the income tax expense/ (benefit) are as follows:



	For the Year Ended December 31,
	2017			2016¹			2015
	(in thousands)
Current Provision:
Unincorporated and Other Business Taxes	$	2,846		$	1,583		$	2,204
Local Corporate Tax	—			—			—
State Corporate Tax	—			—			—
Federal Corporate Tax	5			—			—
Total Current Provision	$	2,851		$	1,583		$	2,204
Deferred Provision:
Unincorporated and Other Business Taxes	$	16		$	5		$	24
Local Corporate Tax	423			258			321
State Corporate Tax	263			199			200
Federal Corporate Tax	5,497			3,478			3,639
Total Deferred Provision	$	6,199		$	3,940		$	4,184
Impact of Tax Cuts and Jobs Act²	26,468			—			—
Impact of Change in Historical 754 Step-Up Calculations³	(1,006		)	—			—
Change in Valuation Allowance	—			(61,942		)	(1,274		)
Net Adjustment to Deferred Tax Asset⁴	—			1,944			—
Total Income Tax Expense/ (Benefit)	$	34,512		$	(54,475	)	$	5,114


¹	^{During the year ended December 31, 2016, the operating company recognized a}^{$0.7 million}^{tax benefit associated with the reversal of uncertain tax position liabilities and interest related to unincorporated and other business tax expenses.}


²	^{Reflects income tax expense resulting from the re-measurement of the deferred tax asset related to the Tax Cuts and Jobs Act enacted in the United States during the fourth quarter of 2017.}


³	^{Reflects the net impact of a change in the historical calculation of the 754 step-ups and related deferred tax asset and corresponding liability to selling and converting shareholders recognized during the year-ended December 31, 2017.}


⁴	^{During 2016, the Company recognized the net impact of the changes in the deferred tax asset and valuation allowance assessed against the deferred tax asset associated with the changes in expected future tax benefits.}

A reconciliation between the provision for income taxes reported for financial reporting purposes, and the application of the statutory U.S. Federal tax rate to the reported income before income taxes for the years ended December 31, 2017, 2016, and 2015, were as follows:



	For the Year Ended December 31,
	2017					2016¹					2015¹
	Amount			% of Pretax Income		Amount			% of Pretax Income		Amount			% of Pretax Income
	(in thousands, except % amounts)
Federal Corporate Tax	$	32,185		34.0	%	$	(280	)	34.0	%	$	17,720		34.0	%
State and Local Corporate Tax, net of Federal Benefit	686			0.7	%	457			(55.5	)%	1,631			3.1	%
Unincorporated and Other Business Tax²	1,889			2.0	%	1,048			(127.2	)%	1,401			2.7	%
Non-Controlling Interests	(18,102		)	(19.1	)%	(12,740		)	1,546.2	%	(14,601		)	(28.0	)%
Increase/(Decrease) in Liability to Selling and Converting Shareholders	(7,078		)	(7.5	)%	17,490			(2,122.6	)%	144			0.3	%
Impact of Tax Cuts and Jobs Act³	26,468			28.0	%	—			—	%	—			—	%
Impact of Change in Historical 754 Step-Up Calculations⁴	(1,006		)	(1.1	)%	—			—	%	—			—	%
Deferred Income Tax Valuation Allowance	—			—	%	(61,942		)	7,517.2	%	(1,274		)	(2.5	)%
Net Adjustment to Deferred Tax Asset⁵	—			—	%	1,944			(235.9	)%	—			—	%
Other	(530		)	(0.5	)%	(452		)	54.8	%	93			0.2	%
Income Tax Expense	$	34,512		36.5	%	$	(54,475	)	6,611.0	%	$	5,114		9.8	%


¹	^{The impact related to the use of net operating losses as presented in the 2016 and 2015 consolidated notes to financial statements have been reclassified to be included with Other tax rate items.}


²	^{During the year ended December 31, 2016, the operating company recognized a}^{$0.7 million}^{tax benefit associated with the reversal of uncertain tax position liabilities and interest related to unincorporated and other business tax expenses.}


³	^{Reflects income tax expense resulting from the re-measurement of the deferred tax asset related to the Tax Cuts and Jobs Act enacted in the United States during the fourth quarter of 2017.}


⁴	^{Reflects the net impact of a change in the calculation of historical 754 step-ups and related deferred tax assets and corresponding liability to selling and converting shareholders recognized during the year-ended December 31, 2017.}


⁵	^{During 2016, the Company recognized adjustments to the deferred tax asset and valuation allowance assessed against the deferred tax asset associated with a change in the effective tax rate.}

The Income Taxes Topic of the FASB ASC establishes the minimum threshold for recognizing, and a system for measuring, the benefits of tax return positions in financial statements.

A reconciliation of the beginning and ending amount of total unrecognized tax benefits for the years ended December 31, 2017 and 2016 are as follows:



	For the Year Ended December 31, 2017
	(in thousands)
Balance at December 31, 2016	$	2,802
Increases Related to Current Year Tax Positions	1,870
Balance at December 31, 2017	$	4,672



	For the Year Ended December 31, 2016
	(in thousands)
Balance at December 31, 2015	$	2,318
Decreases Related to Prior Year Tax Positions	(664		)
Increases Related to Current Year Tax Positions	1,210
Decreases Related to Settlements with Taxing Authorities	(62		)
Balance at December 31, 2016	$	2,802

The Company recognizes accrued interest and penalties related to unrecognized tax benefits as a component of Income Tax Expense/ (Benefit) on the consolidated statements of operations. As of December 31, 2017 and 2016, the Company had $4.7 million and $2.8 million in unrecognized tax benefits, that, if recognized, would affect the provision for income taxes. As of December 31, 2017 and 2016, the Company had interest related to unrecognized tax benefits of $0.5 million and $0.3 million, respectively. As a result of legislative changes, changes in judgment related to recognition or measurement, or potential settlements with taxing authorities, it is reasonably possible that the company's gross unrecognized tax benefits balance may change within the next twelve months by a range of zero to $3.4 million.

The Company and the operating company are generally no longer subject to U.S. Federal or state and local income tax examinations by tax authorities for any year prior to 2014. All tax years subsequent to, and including, 2014 are considered open and subject to examination by tax authorities.

As of both December 31, 2017 and 2016, the Company had available for U.S. Federal, state and local income tax reporting purposes, a net operating loss carryforward of $5.3 million and $10.2 million, respectively, which expires in varying amounts during the tax years 2029 through 2035.

The acquisition of the Class B units of the operating company, noted below, has allowed the Company to make an election under Section 754 of the Internal Revenue Code (“Section 754”) to step up its tax basis in the net assets acquired. This step up is deductible for tax purposes over a 15-year period.

Pursuant to a tax receivable agreement signed between the members of the operating company and the Company, 85% of the cash savings generated by this election will be distributed to the selling and converting shareholders upon the realization of this benefit.

If the Company exercises its right to terminate the tax receivable agreement early, the Company will be obligated to make an early termination payment to the selling and converting shareholders, based upon the net present value (based upon certain assumptions and deemed events set forth in the tax receivable agreement) of all payments that would be required to be paid by the Company under the tax receivable agreement. If certain change of control events were to occur, the Company would be obligated to make an early termination payment.

As discussed in Note 6, Shareholders’ Equity, on December 21, 2017, December 22, 2016, May 12, 2016, and July 27, 2015, certain of the operating company’s members exchanged an aggregate of 855,535, 1,056,929, 1,369,811, and 2,772,171,

respectively, of their Class B units for an equivalent number of shares of Class A common stock of the Company. The Company elected to step up its tax basis in the incremental assets acquired in accordance with Section 754. Based on the exchange-date fair values of the Company’s common stock and the tax basis of the operating company, this election gave rise to a $2.1 million deferred tax asset and corresponding $1.5 million liability to converting shareholders on December 21, 2017, a $5.5 million deferred tax asset and corresponding $4.7 million liability to converting shareholders on December 22, 2016, a $6.1 million deferred tax asset and corresponding $5.2 million liability on May 12, 2016, and a $14.3 million deferred tax asset and a corresponding $12.2 million liability on July 27, 2015. The Company assessed the realizability of the deferred tax asset associated with the exchanges during the years ended 2016 and 2015 and determined that a portion of each of their benefits would go unutilized. Consequently, the Company established a $4.4 million, a $4.9 million, and a $11.0 million valuation allowance on December 22, 2016, May 12, 2016, and July 27, 2015, respectively, to reduce the deferred tax asset to amounts more-likely-than-not to be realized. These deferred tax assets remain available to the Company and can be used to reduce taxable income in future years. The Company similarly reduced the associated liability to selling and converting shareholders by $3.7 million, $4.1 million, and $9.4 million, at December 22, 2016, May 12, 2016, and July 27, 2015, respectively, to reflect this change in the estimated realization of these assets. As required by the Income Taxes Topic of the FASB ASC, the Company recorded the effects of these transactions in equity.

After giving effect to the exchanges discussed earlier, as of December 31, 2016, the Company evaluated the need for the valuation allowance associated with the Section 754 tax elections as assets under management ("AUM") returned to pre-financial crisis levels, and brought revenue projections to a point at which the Company would generate sufficient taxable income to realize its deferred tax asset. Other positive evidence reviewed included: (i) the general positive economic environment, which has been reflected in stock markets and had a corresponding impact on AUM and revenue levels; (ii) performance records of almost all of the Company's strategies with 1, 3, and 5 year records that outperformed vs. their relevant benchmarks; (iii) the accelerating positive trends affecting the asset management industry in particular; (iv) the Company's history of positive operating and taxable income since 2007; and (v) the Company has no history of tax benefits expiring unused. These factors were moderated by negative evidence reviewed which included: (i) a high concentration of AUM in the three top client relationships; (ii) the difficulty of projecting AUM in the current volatile environment; (iii) market and competitive pressures in recent years that have created a trend towards lower management fees in the asset management industry; and (iv) the size and expected timing of Section 754 amortization and NOL carryovers.

As of December 31, 2016, the Company concluded that, after weighing both the positive and negative evidence, it was more-likely-than-not that it will generate sufficient taxable income in the future to realize its deferred tax asset. The reversal of the valuation allowance was based primarily upon the Company's sustained profitability in certain tax jurisdictions as well as projections of future assets under management levels. To reflect this change in the estimated realization of the asset and its liability for future payments, the Company increased its liability to selling and converting shareholders by $51.4 million for the year ended December 31, 2016. The effects of these changes to the deferred tax asset and liability to selling and converting shareholders were recorded as a component of the Income Tax Expense/ (Benefit) and Other Income/ (Expense), respectively, on the consolidated statements of operations for the year ended December 31, 2016. If evidence in future periods changes such that it is more-likely-than-not that part or all of the net deferred tax asset will not be realized, the Company will reestablish a valuation allowance at that time.

On December 22, 2017, President Trump signed the Tax Cuts and Jobs Act into legislation. The Company has recorded a deferred tax expense of $26.5 million due to the re-measurement of the deferred tax assets due to a decrease in the federal corporate tax rate from 34% to 21% beginning in fiscal year 2018. The Company similarly reduced the associated liability to selling and converting shareholders by $20.8 million.

The Company identified an adjustment related to a change in the calculation of the 754 step-up in tax basis impacting the deferred tax assets and corresponding liability to selling and converting shareholders. As a result, the adjustment was made during the year-ended December 31, 2017, resulting in a $4.6 million decrease to the deferred tax assets and a $5.6 million decrease to the corresponding liability to selling and converting shareholders. The cumulative impact of the adjustment is a net tax benefit of $1.0 million which was recognized as a component of Income Tax Expense/(Benefit) in the consolidated statements of operations for the year-ended December 31, 2017 and did not affect the net cash provided by operating activities, net cash provided by/(used in) investing activities or net cash used in financing activities for the fiscal year ended December 31, 2017.

As of December 31, 2017 and 2016, the net values of all deferred tax assets were approximately $39.6 million and $73.4 million, respectively. These deferred tax assets primarily reflect the future tax benefits associated with the Company's initial public offering, and the subsequent and future exchanges by holders of Class B units of the operating company for shares of Class A common stock. At December 31, 2017 and 2016, the Company did not have a valuation allowance recorded against its deferred tax assets.

The change in the Company’s deferred tax assets, net of valuation allowance, for the year ended December 31, 2017, is summarized as follows:



	Section 754			Other			Valuation Allowance		Total
	(in thousands)
Balance at December 31, 2016	$	68,427		$	5,014		$	—	$	73,441
Impact of Tax Cuts and Jobs Act	(24,114		)	(2,354		)	—		(26,468		)
Adoption of ASU 2016-09	—			1,377			—		1,377
Deferred Tax (Expense)	(5,139		)	756			—		(4,383		)
Unit Exchange	1,810			280			—		2,090
Impact of Change in Historical 754 Step-Up Calculations	(6,271		)	1,669			—		(4,602		)
Operating Loss Carryforward	—			(1,816		)	—		(1,816		)
Balance at December 31, 2017	$	34,713		$	4,926		$	—	$	39,639

The change in the Company’s deferred tax liabilities, which is included in other liabilities on the Company’s consolidated statements of financial condition, for the year ended December 31, 2017, is summarized as follows:



	Total
	(in thousands)
Balance at December 31, 2016	$	(1	)
Deferred Tax Expense	(1		)
Balance at December 31, 2017	$	(2	)

The change in the Company’s deferred tax assets, net of valuation allowance, for the year ended December 31, 2016 is summarized as follows:



	Section 754			Other			Valuation Allowance			Total
	(in thousands)
Balance at December 31, 2015	$	64,877		$	4,086		$	(53,968	)	$	14,995
Deferred Tax (Expense)	(4,854		)	1,284			—			(3,570		)
Unit Exchange	11,605			—			(9,231		)	2,374
Change in Valuation Allowance	—			—			61,942			61,942
Operating Loss Carryforward	—			(356		)	—			(356		)
Net Adjustment to Deferred Tax Asset¹	(3,201		)	—			1,257			(1,944		)
Balance at December 31, 2016	$	68,427		$	5,014		$	—		$	73,441


¹	^{During 2016, the Company recognized adjustments to the deferred tax asset and valuation allowance assessed against the deferred tax asset associated with a change in the effective tax rate.}

The change in the Company’s deferred tax liabilities for the year ended December 31, 2016 is summarized as follows:



	Total
	(in thousands)
Balance at December 31, 2015	$	(4	)
Deferred Tax Expense	3
Balance at December 31, 2016	$	(1	)

As of December 31, 2017 and 2016, the net values of the liability to selling and converting shareholders were approximately $36.4 million and $65.5 million, respectively. The change in the Company’s liability to selling and converting shareholders for the years ended December 31, 2017 and 2016, is summarized as follows:



	For the Year Ended December 31,
	2017			2016
	(in thousands)
Beginning Balance	$	65,485		$	15,075
Impact of Tax Cuts and Jobs Act	(20,819		)	—
Impact of Change in Historical 754 Step-Up Calculations	(5,608		)	—
Release of the Valuation Allowance	—			51,442
Unit Exchanges	1,538			2,018
Tax Receivable Agreement Payments	(4,155		)	(3,050		)
Ending Balance	$	36,441		$	65,485