12. Variable Interest Entities and Consolidation of Investment Vehicles

In the normal course of its business, Legg Mason sponsors and is the manager of various types of investment vehicles. For its services, Legg Mason is entitled to receive management fees and may be eligible, under certain circumstances, to receive additional subordinate management fees or other incentive fees. Legg Mason's exposure to risk in these entities is generally limited to any equity investment it has made or is required to make and any earned but uncollected management fees. Certain of these investment vehicles are considered to be VIEs (further described below) while others are considered to be voting rights entities (“VREs”) subject to traditional consolidation concepts based on ownership rights. Investment vehicles that are considered VREs are consolidated if Legg Mason has a controlling financial interest in the investment vehicle, absent substantive kick-out rights. Legg Mason held a controlling financial interest in one sponsored investment fund VRE with third-party investments which was consolidated as of June 30, 2013 and 2012.

Investment Company VIEs

For most sponsored investment funds deemed to be investment companies, including money market funds, Legg Mason determines it is the primary beneficiary of a VIE if it absorbs a majority of the VIE's expected losses, or receives a majority of the VIE's expected residual returns, if any. Legg Mason's determination of expected residual returns excludes gross fees paid to a decision maker if certain criteria are met. In determining whether it is the primary beneficiary of an investment company VIE, Legg Mason considers both qualitative and quantitative factors such as the voting rights of the equity holders, economic participation of all parties, including how fees are earned and paid to Legg Mason, related party ownership, guarantees and implied relationships.

Legg Mason concluded it was the primary beneficiary of one sponsored investment fund VIE, which was consolidated as of June 30, 2013, March 31, 2013 and June 30, 2012, despite significant third-party investments in this product.

Other VIEs

For other sponsored investment funds that do not meet the investment company criteria, if Legg Mason has a significant variable interest, it determines it is the primary beneficiary of the VIE if it has both the power to direct the activities of the VIE that most significantly impact the entity's economic performance and the obligation to absorb losses, or the right to receive benefits, that potentially could be significant to the VIE.

Legg Mason concluded that it was the primary beneficiary of one of two CLOs in which it has a variable interest. Although it holds no equity interest in either of these investment vehicles, it had both the power to control and had a significant variable interest in one CLO because of the level of its expected subordinated fees. As of June 30, 2013, March 31, 2013 and June 30, 2012, the balances related to this CLO were consolidated on the Company's consolidated financial statements. The other CLO is not consolidated, as its level of expected subordinated fees is insignificant.

Legg Mason's investment in CIVs as of June 30, 2013 and March 31, 2013, was $39,346 and $39,056, respectively, which represents its maximum risk of loss, excluding uncollected advisory fees. The assets of these CIVs are primarily comprised of investment securities. Investors and creditors of these CIVs have no recourse to the general credit or assets of Legg Mason beyond its investment in these funds.

The following tables reflect the impact of CIVs on the Consolidated Balance Sheets as of June 30, 2013 and March 31, 2013, respectively, and the Consolidated Statements of Income for the three months ended June 30, 2013 and 2012, respectively:

Consolidating Balance Sheets



	June 30, 2013									March 31, 2013
	Balance Before Consolidation of CIVs		CIVs		Eliminations			Consolidated Totals		Balance Before Consolidation of CIVs		CIVs		Eliminations			Consolidated Totals
Current Assets	$	1,645,035	$	67,871	$	(42,120	)	$	1,670,786	$	1,908,932	$	73,320	$	(39,390	)	$	1,942,862
Non-current assets	5,087,526		158,842		—			5,246,368		5,115,181		211,617		—			5,326,798
Total Assets	$	6,732,561	$	226,713	$	(42,120	)	$	6,917,154	$	7,024,113	$	284,937	$	(39,390	)	$	7,269,660
Current Liabilities	$	545,783	$	6,588	$	(2,774	)	$	549,597	$	692,261	$	10,539	$	(334	)	$	702,466
Long-term debt of CIVs	—		153,676		—			153,676		—		207,835		—			207,835
Other non-current liabilities	1,445,039		2,573		—			1,447,612		1,517,069		2,930		—			1,519,999
Total Liabilities	1,990,822		162,837		(2,774		)	2,150,885		2,209,330		221,304		(334		)	2,430,300
Redeemable Non-controlling Interests	1,273		—		19,209			20,482		1,355		—		19,654			21,009
Total Stockholders’ Equity	4,740,466		63,876		(58,555		)	4,745,787		4,813,428		63,633		(58,710		)	4,818,351
Total Liabilities and Stockholders' Equity	$	6,732,561	$	226,713	$	(42,120	)	$	6,917,154	$	7,024,113	$	284,937	$	(39,390	)	$	7,269,660

Consolidating Statements of Income (Loss)



	Three Months Ended
	June 30, 2013												June 30, 2012
	Balance Before Consolidation of CIVs			CIVs			Eliminations			Consolidated Totals			Balance Before Consolidation of CIVs			CIVs			Eliminations			Consolidated Totals
Total Operating Revenues	$	671,032		$	—		$	(615	)	$	670,417		$	631,277		$	—		$	(585	)	$	630,692
Total Operating Expenses	586,825			673			(615		)	586,883			554,523			677			(585		)	554,615
Operating Income (Loss)	84,207			(673		)	—			83,534			76,754			(677		)	—			76,077
Total other non-operating income (expense)	(10,515		)	2,696			(828		)	(8,647		)	(91,029		)	(4,134		)	1,105			(94,058		)
Income (Loss) Before Income Tax Provision (Benefit)	73,692			2,023			(828		)	74,887			(14,275		)	(4,811		)	1,105			(17,981		)
Income tax provision (benefit)	25,792			—			—			25,792			(4,997		)	—			—			(4,997		)
Net Income (Loss)	47,900			2,023			(828		)	49,095			(9,278		)	(4,811		)	1,105			(12,984		)
Less: Net income (loss) attributable to noncontrolling interests	85			—			1,195			1,280			180			—			(3,706		)	(3,526		)
Net Income (Loss) Attributable to Legg Mason, Inc.	$	47,815		$	2,023		$	(2,023	)	$	47,815		$	(9,458	)	$	(4,811	)	$	4,811		$	(9,458	)

Other non-operating income (expense) includes interest income, interest expense and net gains (losses) on investments and long-term debt determined on an accrual basis.

The consolidation of CIVs has no impact on Net Income (Loss) Attributable to Legg Mason, Inc.

The fair value of the financial assets and (liabilities) of CIVs were determined using the following categories of inputs:



	As of June 30, 2013
	Quoted prices in active markets (Level 1)		Significant other observable inputs (Level 2)			Significant unobservable inputs (Level 3)			Total
Assets:
Trading investments:
Hedge funds	$	2,238	$	3,296		$	20,189		$	25,723
Investments:
CLO loans	—		119,673			—			119,673
CLO bonds	—		8,701			—			8,701
Private equity funds	—		—			29,729			29,729
Total investments	—		128,374			29,729			158,103
Total	$	2,238	$	131,670		$	49,918		$	183,826

Liabilities:
CLO debt	$	—	$	—		$	(153,676	)	$	(153,676	)
Derivative liabilities	—		(2,573		)	—			(2,573		)
Total	$	—	$	(2,573	)	$	(153,676	)	$	(156,249	)



	As of March 31, 2013
	Quoted prices in active markets (Level 1)		Significant other observable inputs (Level 2)			Significant unobservable inputs (Level 3)			Total
Assets:
Trading investments:
Hedge funds	$	2,076	$	3,268		$	19,448		$	24,792
Investments:
CLO loans	—		172,519			—			172,519
CLO bonds	—		11,052			—			11,052
Private equity funds	—		—			26,982			26,982
Total investments	—		183,571			26,982			210,553
Total	$	2,076	$	186,839		$	46,430		$	235,345

Liabilities:
CLO debt	$	—	$	—		$	(207,835	)	$	(207,835	)
Derivative liabilities	—		(2,930		)	—			(2,930		)
Total	$	—	$	(2,930	)	$	(207,835	)	$	(210,765	)

Except for the CLO debt, substantially all of the above financial instruments where valuation methods rely on other than observable market inputs as a significant input utilize the NAV practical expedient, such that measurement uncertainty has little relevance. The following table provides a summary of qualitative information relating to the valuation of CLO debt:



Value as of June 30, 2013			Valuation technique	Unobservable input	Range (weighted average)
$	(153,676	)	Discounted cash flow	Discount rate	0.9	%	-	9.0	%	(2.1	%)
				Default rate	3.0	%	-	4.0	%	(3.5	%)
				Constant prepayment rate				25.0	%



Value as of March 31, 2013			Valuation technique	Unobservable input	Range (weighted average)
$	(207,835	)	Discounted cash flow	Discount rate	1.1	%	-	11.0	%	(2.3	%)
				Default rate	3.0	%	-	4.0	%	(3.5	%)
				Constant prepayment rate				25.0	%

Significant increases (decreases) in any of these inputs in isolation could result in a significantly lower (higher) fair value measurement. Generally, both the constant rate of prepayment and default rate are driven by market conditions related to interest rates, credit ratings, and other factors. Each of the inputs noted could move independently depending on specific market conditions, making it possible for varying market conditions to drive changes in these inputs with a positive, negative, or zero correlation.

The changes in assets and (liabilities) of CIVs measured at fair value using significant unobservable inputs (Level 3) are presented in the tables below:



	Value as of March 31, 2013			Purchases		Sales			Settlements/Other		Transfers		Realized and unrealized gains/(losses), net			Value as of June 30, 2013
Assets:
Hedge funds	$	19,448		$	2,000	$	(2,405	)	$	—	$	—	$	1,146		$	20,189
Private equity funds	26,982			2,300		—			—		—		447			29,729
	$	46,430		$	4,300	$	(2,405	)	$	—	$	—	$	1,593		$	49,918
Liabilities:
CLO debt	$	(207,835	)	$	—	$	—		$	54,289	$	—	$	(130	)	$	(153,676	)
Total realized and unrealized gains (losses), net													$	1,463



	Value as of March 31, 2012			Purchases		Sales			Settlements/Other		Transfers		Realized and unrealized gains/(losses), net			Value as of June 30, 2012
Assets:
Hedge funds	$	24,116		$	434	$	(830	)	$	—	$	—	$	(1,513	)	$	22,207
Private equity	25,071			—		(878		)	—		—		(5		)	24,188
	$	49,187		$	434	$	(1,708	)	$	—	$	—	$	(1,518	)	$	46,395
Liabilities:
CLO debt	$	(271,707	)	$	—	$	—		$	—	$	—	$	(1,853	)	$	(273,560	)
Total realized and unrealized gains (losses), net													$	(3,371	)

Realized and unrealized gains and losses recorded for Level 3 assets and liabilities of CIVs are included in Other non-operating income (expense) of CIVs on the Consolidated Statements of Income. Total unrealized gains (losses) for Level 3 investments and liabilities of CIVs relating only to those assets and liabilities still held at the reporting date were $1,686 and $(3,492) for the three months ended June 30, 2013 and 2012, respectively.

There were no transfers between Level 1 and Level 2 during either of the three months ended June 30, 2013 and 2012.

The NAV values used as a practical expedient by CIVs have been provided by the investees and have been derived from the fair values of the underlying investments as of the respective reporting date. The following table summarizes, as of June 30, 2013 and March 31, 2013, the nature of these investments and any related liquidation restrictions or other factors which may impact the ultimate value realized:



		Fair Value Determined Using NAV						As of June 30, 2013
Category of Investment	Investment Strategy	June 30, 2013			March 31, 2013			Unfunded Commitments		Remaining Term
Hedge funds	Global macro, fixed income, long/short equity, systematic, emerging market, U.S. and European hedge	$	25,723	(1)	$	24,792	(2)	n/a		n/a
Private equity funds	Long/short equity	29,729		(3)	26,982		(3)	$	3,654	6 years
Total		$	55,452		$	51,774		$	3,654

n/a – not applicable


(1)	12% daily redemption; 7% monthly redemption; 2% quarterly redemption; and 79% are subject to three to five year lock-up or side pocket provisions.


(2)	11% daily redemption; 8% monthly redemption; 2% quarterly redemption; and 79% are subject to three to five year lock-up or side pocket provisions.


(3)	Liquidations are expected over the remaining term.

There are no current plans to sell any of these investments held as of June 30, 2013.

Legg Mason has elected the fair value option for certain eligible assets and liabilities, including corporate loans and debt, of the consolidated CLO. Management believes that the use of the fair value option eliminates certain timing differences and better matches the changes in fair value of assets and liabilities related to the CLO.

The following table presents the fair value and unpaid principal balance of CLO loans, bonds and debt carried at fair value under the fair value option as of June 30, 2013 and March 31, 2013:



	June 30, 2013			March 31, 2013
CLO loans and bonds
Unpaid principal balance	$	131,496		$	186,839
Unpaid principal balance in excess of fair value	(3,122		)	(3,268		)
Fair value	$	128,374		$	183,571

Unpaid principal balance of loans that are more than 90 days past due and also in nonaccrual status	$	—		$	—
Unpaid principal balance in excess of fair value for loans that are more than 90 days past due and also in nonaccrual status	—			—
Fair value of loans more than 90 days past due and in nonaccrual status	$	—		$	—

CLO debt
Principal amounts outstanding	$	170,872		$	225,161
Excess unpaid principal over fair value	(17,196		)	(17,326		)
Fair value	$	153,676		$	207,835

During the three months ended June 30, 2013 and 2012, total net losses of $166 and $3,264, respectively, were recognized in Other non-operating income of CIVs in the Consolidated Statements of Income (Loss) related to assets and liabilities for which the fair value option was elected. CLO loans and CLO debt measured at fair value have floating interest rates, therefore, substantially all of the estimated gains and losses included in earnings for the three months ended June 30, 2013 and 2012, were attributable to instrument specific credit risk.

The CLO debt bears interest at variable rates based on LIBOR plus a pre-defined spread, which ranges from 25 basis points to 400 basis points. All outstanding debt matures on July 15, 2018. The CLO commenced its wind-down in July 2012, such that proceeds from securities cannot be reinvested and are applied to reduce the debt outstanding in the quarter subsequent to receipt, after other required payments.

Total derivative liabilities of CIVs of $2,573 and $2,930 as of June 30, 2013 and March 31, 2013, respectively, are primarily recorded in Other liabilities of CIVs. Gains and (losses) of $357 and $(315), respectively, for the three months ended June 30, 2013, related to derivative assets and liabilities of CIVs are included in Other non-operating income (loss) of CIVs. Gains and (losses) of $252 and $(299), respectively, for the three months ended June 30, 2012, related to derivative assets and liabilities of CIVs are included in Other non-operating income (expense) of CIVs. There is no risk to Legg Mason in relation to the derivative assets and liabilities of the CIVs in excess of its investment in the funds, if any.

As of June 30, 2013 and March 31, 2013, for VIEs in which Legg Mason holds a variable interest or is the sponsor and holds a variable interest, but for which it was not the primary beneficiary, Legg Mason's carrying value, the related VIE assets and liabilities and maximum risk of loss were as follows:



	As of June 30, 2013				As of March 31, 2013
	Equity Interests on the Consolidated Balance Sheet⁽¹⁾		Maximum Risk of Loss⁽²⁾		Equity Interests on the Consolidated Balance Sheet⁽¹⁾		Maximum Risk of Loss⁽²⁾
CLO	$	—	$	623	$	—	$	496
Real Estate Investment Trust	1,102		3,928		989		2,644
Other sponsored investment funds	34,326		79,824		43,104		87,121
Total	$	35,428	$	84,375	$	44,093	$	90,261


(1)	Includes $25,166 and $33,918 related to investments in proprietary funds products as of June 30, 2013, and March 31, 2013, respectively.


(2)	Includes equity investments the Company has made or is required to make and any earned but uncollected management fees.

The Company's total AUM of unconsolidated VIEs was $17,318,223 and $17,090,267 as of June 30, 2013 and March 31, 2013, respectively.

The assets of these VIEs are primarily comprised of cash and cash equivalents and investment securities, and the liabilities are primarily comprised of debt and various expense accruals. These VIEs are not consolidated because either 1) Legg Mason does not have the power to direct significant economic activities of the entity and rights/obligations associated with benefits/losses that could be significant to the entity, or 2) Legg Mason does not absorb a majority of each VIE's expected losses or does not receive a majority of each VIE's expected residual returns.