• Section 1 – PGL’s risk governance strategy, structure and process
• Section 2 – PGL’s categorisations of risk and the principal factors that drive each type of risk faced by the Group
• Section 3 – Monitoring and Reporting of Risk
• Section 4 – Consolidation principles for regulatory capital
• Section 5 – Capital resources

Section 1. Risk Governance, Strategy and Structure

Risk Governance Strategy

As part of its strategy, PGL accepts calculated risks that it deems can result in positive consequences while attempting to mitigate as far as possible those risks that can have a negative impact.

Risk Governance Structure and Process

The Board of Directors of PGL has the ultimate responsibility for deciding on limits for and monitoring the Group’s risk exposure. The Board of Directors also has ultimate responsibility for setting the targets for the capital ratios and risk appetite.  Risk in PGL is measured and reported according to common principles and policies approved by the Board of Directors.  The Board of Directors decides on policies for risk management as well as the internal capital adequacy assessment.  All policies are reviewed annually.

The Executive Committee is responsible for determining the business strategy and establishing the risk management strategy for the Group and each Subsidiary.

The Financial Controls Committee (“FCC”), whose members include the Group Chief Executive Officer, Chief Operating Officer and Chief Financial Officer, meets on a quarterly basis and has responsibility for overseeing the overall risk infrastructure.  All reports to the FCC are reviewed and findings are further reported to the Board of Directors of PGL and the Executive Committee on a periodic basis.

The Financial and Operational Risk Function (“FinOps Risk Function”) is responsible for establishing guidelines and reporting related to the risk process, and reports to the FCC. The Governing Board of each Subsidiary is responsible for deciding the level of risk the Subsidiary is prepared to accept in respect of each risk faced by the Subsidiary and what, if any additional steps the Subsidiary will take to mitigate the potential impact from the risk, should it crystallize.  The Department Heads in conjunction with the Principal Officers of each Subsidiary are responsible for identifying and assessing risk in their business areas and reporting such information to the FinOps Risk Function and the Subsidiary’s Governing Board.

The Audit Groups, which are comprised of the internal audit department of Legg Mason Inc., PGL’s external auditors, the Group’s Compliance Department and the FinOps Risk Function undertake relevant monitoring checks to confirm that each Subsidiary’s risk policies and procedures are being implemented satisfactorily. 

Section 2.  Risk Types

PGL has identified different risks that could impact directly or indirectly on the Group’s financial position. PGL aims to mitigate the impact of each of the risks noted below by implementing control policies and procedures.

Credit Risk is the possibility that the Group may suffer a loss from the failure of counterparties, customers, borrowers or issuers to meet their financial obligations to the Group, including failing to meet them in a timely manner. It can also include the risks that the Group may suffer a loss as a result of guarantees issued or commitments given to third parties, as a result of settlement failure or because of country risk. Credit risk is not a central feature of the Group’s business and PGL’s exposure to credit risk is limited: because (1) the majority of the Group’s lending activity is restricted to inter-company loans: (2) more than 90% in value of the Group’s receivables originate from investment funds sponsored by the Permal Group; (3) cash balances are placed with financial institutions that are rated as investment grade; and (4) any third party loans which is a non-core activity to the Group, are monitored by a credit committee.

Market Risk is the risk that arises from fluctuation in values of investment assets due to changes in market prices or exchange rates. PGL’s direct market risk typically arises from the use of Group cash to seed new investment funds sponsored or managed by the Group. PGL’s reduction in fee revenues is an indirect market risk, which may result from adverse performance in investment portfolios.  Direct market risk is mitigated by limiting and diversifying seed investments.  Indirect market risk is mitigated by providing a large selection of diversified investment products with performance that is not correlated.

Operational Risk is the risk of loss resulting from inadequate or failed processes, people and systems from external events. Due to the importance of maintaining effective operational controls in respect of its business activities, PGL will usually only regard “low degree” as an acceptable level of post control operational risk. Major services are outsourced to specialty providers to reduce risks associated with back office work necessary in connection with our asset management services (i.e. hedging services, administration services).

Liquidity Risk is the risk from loss of mismatch of assets and liabilities maturities and risk that PGL cannot maintain adequate capital in the foreseeable future. PGL actively monitors its financial position to verify that it has sufficient capital to meet its requirements at all times and to take action where necessary. PGL’s liquidity needs do not require significant capital on a daily basis and based on the business model capital requirements do not unexpectedly vary.

Business Risk is the risk of loss from the Group’s business activities. This would include earnings volatility inherent in all business due to the uncertainty of revenues and costs due to changes in economic and competitive environment. PGL’s exposure to business risk is reduced by means of the diversity inherent in our business model. All Group investment mandates look to protect investor capital in down markets via diversification. To mitigate business risk, the Group has a disciplined and rigorous investment selection process, including an Investment Committee that unanimously approves all investments and a Risk Management Team that scrutinises investment returns and consequent risk by quantitative and qualitative analysis. Further, the Group’s investor and client base is diversified across regions and client segment (i.e. institutional, High Net Worth).

Interest Rate Risk is the risk that arises from fluctuation in values of assets and liabilities from changes in interest rates. PGL’s indirect interest rate risk is mainly related to clients’ investment portfolio exposure to fixed income securities. To mitigate interest rate risk, the Group has a disciplined and rigorous investment selection process, including an Investment Committee that unanimously approves all investments and a Risk Management Team that scrutinises investment returns and consequent risk by quantitative and qualitative analysis. The Group activities that relate directly to interest rate risk include inter-company loans and cash management exposure, and the Group limits its interest rate risk by maintaining low loan balances and cash management exposure.

Pension Obligation Risk is the risk of loss or liability from pension scheme obligations. PGL’s subsidiaries have defined contribution plans. The accrual and payments of contributions are made on due date, there is no under-accrual or any unpaid due obligations or liabilities. 

Concentration Risk is the risk of loss to assets and/or income from exposure to a limited range of customers, i.e., the risk inherent in doing business with large customers or not being equally exposed across regions. Distribution channels and the target markets for the Permal Family of Funds are diversified globally. Accordingly, PGL’s exposure to concentration risk is, therefore, reduced.

Section 3. Monitoring and Reporting

The PGL risk governance structure is designed to provide independent and objective assessments and monitoring of risks. 

PGL’s risk monitoring and reporting processes involves risk and policy reviews which are conducted at least once every twelve months, the generation of risk reports and FCC reviews, the results of which are reported to the Board of Directors of PGL.  The reviews are conducted, giving consideration to the amount and type of risk that the Group regards as appropriate for it to accept in order to fulfill its business objectives and to operate within regulatory constraints.

Section 4. Consolidation principles for regulatory capital

The Group does not prepare consolidated statutory accounts, on the grounds that the Group is consolidated into the accounts of Legg Mason, Inc, PGL’s parent company.

PGL is subject to consolidated supervision under the FSA’s rules.  The following table sets out the Subsidiaries which are consolidated for the purpose of regulatory capital, and those which are deducted from the capital base:

Group undertakings included in the capital base

Group undertakings deducted from the capital base

Permal Investment Management Services Limited (“PIMSL”), the Group’s UK-regulated Subsidiary, accounts for the majority of the turnover of the Group and is, therefore, deemed to be a significant Subsidiary.  As a result, information is also presented in respect of PIMSL on an individual basis.

Section 5. Capital Resources

Group financial and strategic positions

PIMSL and PGL current capital positions

PIMSL’s turnover from management fees for the financial year 10/11 was USD 402.6 million (FY 09/10: USD 383.3 million). The assets under management increased from USD 17.5 billion at March 31st, 2010 to USD 20.7 billion at March 31st, 2011.

The unearned incentive fee revenue in respect of performance periods ending after March 31st, 2011 amounted to $1.7 million (2010: $1.8 million).

The regulatory capital base of PIMSL, calculated based on the FSA Rules applicable to investment firms, is as follows:

In USD’000s

The following table sets out the calculation of Group’s regulatory capital base, calculated based on the FSA Rules that apply to Banks as at 31 March 2011 and 2010:

In USD’000s

The Group has the ability to transfer capital within its Subsidiaries without material restrictions.

Regulatory capital requirements (Pillar 1)

Permal Group forms a UK consolidation Group and because the Group includes The St James Bank and Trust Company Ltd. it must apply the FSA’s Prudential Rules that apply to Banks. However, PIMSL is treated as an Investment Firm and must apply the applicable FSA Prudential Rules.  As the FSA’s Rules are not the same, the calculations vary.

Capital requirements for PIMSL

Based upon its regulatory permissions and scope of activities, PIMSL is subject to the capital requirements for an investment firm.  Its capital resources requirement is calculated as the higher of:

·            The sum of the credit and market risk charges; and

·            The fixed overheads requirement (FOR).

The FOR is calculated as 13 weeks’ expenditure (excluding certain discretionary expenses) based on the most recent accounts.

The capital resources requirement of PIMSL as at 31 March 2011 is USD 6,985,000 (2010: USD 8,391,000).

As such, the regulatory capital base of PIMSL is in excess of the capital resources requirement.

Capital requirements for the Group

The capital requirement for PGL is composed of the sum of credit risk, market risk and operational risk requirements according to the FSA Rules applied to Banks.  The following table summarizes these as at 31 March 2011 and 2010:

In USD’000s

The total capital base of PGL as at 31 March 2011 is USD 432,920,000 (2010: USD 369,899,000).  As such, the capital base of PGL is in excess of the regulatory capital requirement.

Credit risk capital requirement

PGL uses the standardised approach to credit risk, under which the capital requirement is calculated as 8% of the risk weighted exposure amounts. Risk weighted exposures are obtained by multiplying the exposures by the risk weights set out in the FSA’s rules.

The following table analyses the calculation between the standardized credit risk exposure classes:

In USD’000s

Market risk capital requirement

PGL calculates its market risk capital requirement using the interest rate PRR, equity PRR, ICU PRR and foreign currency PRR methods set out in the FSA’s rules. The following table analyses the market risk capital requirement:

In USD’000s

The capital requirements are calculated as a percentage of the exposure according to FSA handbook. For example, the CIU is 32% and the foreign currency PRR is 8%.

Operational risk capital requirement (ORCR)

PGL calculates its operational risk capital requirement according to the basic indicator approach (BIA). Under this method, the ORCR is calculated by taking 15% of the 3-year average of the sum of net interest income and net non-interest income.

The capital requirement for operational risk amounts to USD 40,903,000 as of March 31, 2011 (2010: USD 51,668,000)

Internal Capital Adequacy Assessment Process (“ICAAP”)

Under Pillar 2 of the FSA’s capital requirements, the Group has undertaken an assessment of the adequacy of capital based upon all the risks to which the business is exposed (“ICAAP”).

The Executive Committee has determined that the following material risks are faced by the Group and could potentially, in the case of them crystallizing, result in the need for additional capital:

• Operational risk – Loss of key business members
• Business risk – poor client portfolio performance resulting, for example, from:

-          Poor investment decisions

-          Unanticipated changes in the markets and/or exchange rates

• Business risk – redemptions resulting, for example, from:

-          Liquidity needs of investors

-          Poor performance of client portfolios

-          Reputational issues relating to the industry or the Group

Methodology

Senior Management believes that in the case of one or all of the risks crystallizing, the outcome would be the same: a decrease in assets under management due to either negative client investment performance and / or a dramatic increase in net redemptions from the clients.  As a result, senior management of the Group has decided to perform a sensitivity analysis of PIMSL’s and PGL’s respective capital requirements based on the variation of the above two sensitivity factors over a 12-month period.

Results

PIMSL has a positive working capital (i.e., it receives its revenues before having to pay its counterparties).  This is due to the fact that fee revenues are generally received monthly, whereas fee payments for third party distribution are paid quarterly.  Additionally, PIMSL has a fairly small balance sheet structure to finance in comparison with its gross margin (the majority of client fee revenues and Permal’s fees for distribution are booked under PIMSL’s books).

In summary, PGL’s business model finances itself.  PGL’s only capital financing need is related to its balance sheet financing.  As a result, in an unchanging balance sheet structure, a combined identical decrease in client portfolio performance and an increase of net redemptions in client accounts will have the same effect whether the variation is 10% or 50%. 

Conclusion on PIMSL and PGL respective capital requirements

As at March 31^st, 2011 on the basis of unchanged operating fixed costs, financial investments, off balance sheet investments and preferred share dividend:

• PIMSL’s current capital structure would be sufficient, even in the event of risks crystallizing at the same time over a 12-month period as set out above in the Results section. PIMSL’s excess of capital after consumption of capital required to finance operations for the next 12 months would be sufficient.

• PGL’s current capital structure would be sufficient even in the event of a combined identical variation over a 12-month period as set out above in the Results section.  PGL’s excess of capital after consumption of capital required to finance operations for the next 12 months would be sufficient.

Furthermore, note that Permal Group holds with Societe Generale an unused committed credit revolving facility of USD 15 million with maturity date August 31st, 2012, which could be drawn down by any Subsidiary if necessary.

A 12-month period is expected to provide Senior Management with sufficient time to take the appropriate action in terms of balance sheet and profit and loss restructuring (for example, liquidation of seed money investments, among other liquid asset sales and fixed cost reductions).

As a result of the above, Senior Management has assessed that PIMSL and PGL are sufficiently capitalised for the risks to which they are exposed.

Pillar 3 remuneration disclosures for the Permal Group (“Permal”)

April 2010 – March 2011

Decision making process for remuneration policy

Permal has a Compensation Committee which meets regularly to consider human resource issues relating to terms and conditions of employment, compensation and retirement benefits. Within the authority delegated by the Board, the Compensation Committee is responsible for:

• Reviewing and approving remuneration policy and structures for all employees designed to ensure alignment with the Company’s business strategy, objectives, values, risk appetite and long-term interests.
• Overseeing implementation of the remuneration policy and an annual review of the implementation of remuneration policy is conducted.
• Reviewing and approving all remuneration decisions for Executive Committee members, Permal’s Code Staff and employees with remuneration over a pre-determined amount.
• Approving all individual bonus awards taking into account both current and future risks to Permal’s prudential soundness.
• Remuneration of senior officers working in control functions designed to ensure that their remuneration aligns to remuneration policy.
• Variable remuneration decisions designed to ensure that decisions consider financial and non-financial metrics, and the performance of the individual and Permal.
• Review and approval of severance payments, guarantees and buyouts.
• Approval of any disclosure that is made from time to time to a regulator or any other relevant authority relating to the remuneration policy.

There were seven (7) meetings of the Compensation Committee during the financial year ending 31 March 2011.

The members of the Compensation Committee throughout the period were Isaac Souede, Thomas DeLitto and Edmond de La Haye Jousselin, Chairman and CEO, Senior EVP, and Director of Permal respectively. Isaac Souede was chairman of the Committee throughout that period.

External consultants

The Committee received independent advice on executive remuneration issues from PricewaterhouseCoopers. Other consultants are used from time to time to advise on specific issues.

During the year, the EVP – COO – CFO provided regular briefings to the Committee and from April 2011, the Committee received advice on the implications of the remuneration policy on risk and risk management from the Head of Risk Management and Quantitative Research, the VP – Director of Global Compliance and the Human Resources Director.

Role of the relevant stakeholders

The Compensation Committee takes full account of the company’s strategic objectives in setting remuneration policy and is mindful of its duties to its shareholder and other stakeholders. The Committee seeks to preserve shareholder value by ensuring the successful retention, recruitment and motivation of employees.

Code Staff criteria

In line with the Financial Services Authority (“FSA”) regulations, 11 employees were designated as “Code Staff”, defined as SIFs, heads of significant business functions, heads of support and control functions and risk takers.

This group is defined with reference to managerial responsibility to influence Permal’s overall risk profile. This does not include portfolio managers or sales staff without wider executive responsibilities, as these are not deemed to have a material impact on Permal’s risk profile given the control structures in place and the agency nature of the Permal’s business.

The Code Staff list is reviewed annually or following a material change in personnel.

The link between pay and performance for Code Staff

The Executive Committee and Compensation Committee take into account, when determining remuneration awards, the need to ensure an appropriate ratio between fixed and variable pay to ensure that Permal can operate a fully flexible incentive policy.  This includes the potential non-payment of bonuses should Permal’s performance and/or the performance of specific individuals require it.

If all or part of the business has made a loss, or if an employee’s behaviour breaches accepted risk or compliance behaviors and the Compensation Committee believe it to be appropriate, Permal has the ability to withhold a bonus payment.

The bonus pool is calculated as a percentage of the Group pre-tax income after the deduction for Net Revenue Sharing “NRS” with the Group’s parent company, Legg Mason Inc.

Legg Mason Inc. may issue stock options to certain directors and key employees of Permal. Options under Legg Mason’s employee stock plans have been granted at prices not less than 100% of the fair market value. Options are generally exercisable in equal increments over 3 to 5 years and expire within 5 to 10 years from the date of grant.

Aggregate remuneration cost for Code Staff

The aggregate remuneration expenditure in respect of Code Staff was £11.9m for the period (all Code Staff being classified as senior management). These individuals have overall responsibility for Fund Management and Private Equity.