News Column

LEGG MASON, INC. - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

May 23, 2014

EXECUTIVE OVERVIEW

Legg Mason, Inc., a holding company, with its subsidiaries (which collectively comprise "Legg Mason") is a global asset management firm. Acting through our subsidiaries, we provide investment management and related services to institutional and individual clients, company-sponsored mutual funds and other investment vehicles. We offer these products and services directly and through various financial intermediaries. We have operations principally in the United States of America ("U.S.") and the United Kingdom ("U.K.") and also have offices in Australia, Bahamas, Brazil, Canada, Chile, China, Dubai, France, Germany, Italy, Japan, Luxembourg, Poland, Singapore, Spain, Switzerland and Taiwan. All references to fiscal 2014, 2013 or 2012, refer to our fiscal year ended March 31 of that year. Terms such as "we," "us," "our," and "Company" refer to Legg Mason. Our operating revenues primarily consist of investment advisory fees from separate accounts and funds, and distribution and service fees. Investment advisory fees are generally calculated as a percentage of the assets of the investment portfolios that we manage. In addition, performance fees may be earned under certain investment advisory contracts for exceeding performance benchmarks. The largest portion of our performance fees is earned based on 12-month performance periods that end in differing quarters during the year, with a portion based on quarterly performance periods. Distribution and service fees are received for distributing investment products and services, or for providing other support services to investment portfolios, and are generally calculated as a percentage of the assets in an investment portfolio or as a percentage of new assets added to an investment portfolio. Our revenues, therefore, are dependent upon the level of our assets under management ("AUM") and fee rates, and thus are affected by factors such as securities market conditions, our ability to attract and maintain AUM and key investment personnel, and investment performance. Our AUM primarily vary from period to period due to inflows and outflows of client assets as well as market performance. Client decisions to increase or decrease their assets under our management, and decisions by potential clients to utilize our services, may be based on one or more of a number of factors. These factors include our reputation in the marketplace, the investment performance (both absolute and relative to benchmarks or competitive products) of our products and services, the fees we charge for our investment services, the client or potential client's situation, including investment objectives, liquidity needs, investment horizon and amount of assets managed, our relationships with distributors and the external economic environment, including market conditions. The fees that we charge for our investment services vary based upon factors such as the type of underlying investment product, the amount of AUM, the asset management affiliate that provides the services, and the type of services (and investment objectives) that are provided. Fees charged for equity asset management services are generally higher than fees charged for fixed income and liquidity asset management services. Accordingly, our revenues and average advisory revenue yields will be affected by the composition of our AUM, with changes in the relative level of equity assets more significantly impacting our revenues and average advisory revenue yields. Average advisory revenue yields are calculated as the ratio of annualized investment advisory fees, excluding performance fees, to average AUM. In addition, in the ordinary course of our business, we may reduce or waive investment management fees, or limit total expenses, on certain products or services for particular time periods to manage fund expenses, or for other reasons, and to help retain or increase managed assets. We have revenue sharing agreements in place with most of our asset management affiliates, under which specified percentages of the affiliates' revenues are required to be distributed to us and the balance of the revenues is retained to pay operating expenses, including compensation expenses, but excluding certain expenses and income taxes. Under these agreements, our asset management affiliates retain different percentages of revenues to cover their costs. As such, our Net Income (Loss) Attributable to Legg Mason, Inc., operating margin and compensation as a percentage of operating revenues are impacted based on which affiliates generate our revenues, and a change in AUM at one affiliate can have a dramatically different effect on our revenues and earnings than an equal change at another affiliate. In addition, from time to time, we may agree to changes in revenue sharing agreements and other arrangements with our asset management personnel, which may impact our compensation expenses and profitability. The most significant component of our cost structure is employee compensation and benefits, of which a majority is variable in nature and includes incentive compensation that is primarily based upon revenue levels, non-compensation related operating expense levels at revenue share-based affiliates, and our overall profitability. The next largest component of our cost structure is distribution and servicing expense, which consists primarily of fees paid to third-party distributors for selling our asset management products and services and are largely variable in nature. Certain other operating costs are quasi-fixed in nature, such as occupancy, depreciation and amortization, and fixed contract commitments for market data, communication 28 --------------------------------------------------------------------------------



and technology services, and usually do not decline with reduced levels of business activity or, conversely, usually do not rise proportionately with increased business activity.

Our financial position and results of operations are materially affected by the overall trends and conditions of the financial markets, particularly in the U.S., but increasingly in the other countries in which we operate. Results of any individual period should not be considered representative of future results. Our profitability is sensitive to a variety of factors, including the amount and composition of our AUM, and the volatility and general level of securities prices and interest rates, among other things. Periods of unfavorable market conditions are likely to have an adverse effect on our profitability. In addition, the diversification of services and products offered, investment performance, access to distribution channels, reputation in the market, attracting and retaining key employees and client relations are significant factors in determining whether we are successful in attracting and retaining clients. In the last few years, the industry has seen flows into products for which we do not currently garner significant market share. The financial services business in which we are engaged is extremely competitive. Our competition includes numerous global, national, regional and local asset management firms, broker-dealers, commercial banks and other financial services companies. The industry has been impacted by continued economic uncertainty, the constant introduction of new products and services, and the consolidation of financial services firms through mergers and acquisitions. The industry in which we operate is also subject to extensive regulation under federal, state, and foreign laws. Like most firms, we have been impacted by regulatory and legislative changes. Responding to these changes and keeping abreast of regulatory developments, has required, and will continue to require, us to incur costs that continue to impact our profitability. Our strategic priorities are focused on four primary areas listed below. Management keeps these strategic priorities in mind when it evaluates our operating performance and financial condition. Consistent with this approach, we have also presented in the table below the most important initiatives on which management currently focuses in evaluating our performance and financial condition. Strategic Priorities Initiatives ÿ Products ÿ Create an innovative portfolio of investment products and promote revenue growth through new product development and leveraging the capabilities of our affiliates ÿ Identify and execute strategic acquisitions to increase product offerings and fill gaps in products and services ÿ Performance ÿ Deliver compelling and consistent performance against both relevant benchmarks and the products and services of our competitors ÿ Distribution ÿ Evaluate and reallocate resources within and to our distribution platform to continue to maintain and enhance our top tier distribution function with the capability to offer solutions to relevant investment challenges and grow market share worldwide ÿ Productivity ÿ Operate with a high level of effectiveness and improve ongoing efficiency ÿ Manage expenses ÿ Align affiliate economic relationships The strategic priorities discussed above are designed to drive improvements in our operating margin, net flows, earnings, cash flows, assets under management and other key metrics. Certain of these key metrics are discussed in our annual results discussion to follow. In connection with these strategic priorities, during the year ended March 31, 2014, we incurred $29.4 million in expenses related to various corporate initiatives, including the closing down or reorganizing of certain businesses and ongoing efforts to increase efficiency and effectiveness. Beginning in fiscal 2015, we plan to invest in our centralized global distribution business, which will include the reinvestment of savings from these various corporate initiatives. In March 2014, we entered into an agreement to acquire QS Investors Holdings, LLC ("QS Investors"), a leading customized solutions and global quantitative equities provider with approximately $5 billion in AUM and nearly $100 billion in assets under advisement ("AUA") as of March 31, 2014. This acquisition is expected to close in the first quarter of fiscal 2015. In connection with the completion of this acquisition, beginning in the first quarter of fiscal 2015, we will begin reporting AUA. Two of our existing affiliates, Batterymarch Financial Management, Inc. ("Batterymarch") and Legg Mason Global 29 -------------------------------------------------------------------------------- Asset Allocation, LLC ("LMGAA"), will be integrated over time into QS Investors to leverage the best aspects of each subsidiary. In connection with the integration, we expect to incur restructuring and transition costs of approximately $35 million, approximately $2.5 million of which was incurred in the year ended March 31, 2014. Approximately $30 million of the anticipated remaining costs associated with the integration are expected to be incurred in the year ending March 31, 2015. Net Income Attributable to Legg Mason, Inc. for fiscal 2014 was $284.8 million, or $2.33 per diluted share, as compared to Net Loss Attributable to Legg Mason, Inc. of $353.3 million, or $2.65 per diluted share, for fiscal 2013. The prior year loss was primarily attributable to $734.0 million, or $3.81 per diluted share, of non-cash impairment charges related to intangible assets and a $69.0 million, or $0.34 per diluted share, non-operating charge from the extinguishment of debt. Average AUM, and total revenues, increased in fiscal 2014, as compared to fiscal 2013. Strong overall investment performance and the improvement of our global distribution function contributed to a continued reduction in long-term asset outflows. Increases in AUM due to market performance and new product launches in fiscal 2014, offset modest outflows in long-term assets.



The following discussion and analysis provides additional information regarding our financial condition and results of operations.

BUSINESS ENVIRONMENT AND RESULTS OF OPERATIONS

The business environment in fiscal 2014 was marked by a slow, steady growth in the U.S. economy. The economy experienced steady growth despite a broad range of mixed economic news including improvements in the housing sector and consumer confidence and uncertainty regarding the Federal Reserve's bond buying program. All three major U.S. equity market indices increased during fiscal 2014 while two of the major U.S. equity market indices reached record highs during the final quarter of fiscal 2014. The fixed income markets experienced a more difficult year as longer-term market interest rates increased, due in part to the Federal Reserve tapering its bond buying program. While the economic outlook has remained more positive than in recent years, the financial environment in which we operate still reflects a heightened level of sensitivity as we move into fiscal 2015. All three major U.S. equity market indices and the Barclays Capital Global Aggregate Bond Index increased during the past three fiscal years, while the Barclays Capital U.S. Aggregate Bond Index was slightly negative in fiscal 2014, after increasing during fiscal 2012 and 2013, as illustrated in the table below: % Change for the year ended March 31: Indices(1) 2014 2013 2012 Dow Jones Industrial Average 12.9 % 10.3 % 7.2 % S&P 500 19.3 % 11.4 % 6.2 % NASDAQ Composite Index 28.5 % 5.7 % 11.2 % Barclays Capital U.S. Aggregate Bond Index (0.1 )% 3.8 % 7.7 % Barclays Capital Global Aggregate Bond Index 1.9 % 1.3 % 5.3 % (1) Indices are trademarks of Dow Jones & Company, McGraw-Hill Companies, Inc., NASDAQ Stock Market, Inc., and Barclays Capital, respectively, which are not affiliated with Legg Mason. 30 --------------------------------------------------------------------------------



The following table sets forth, for the periods indicated, amounts in the Consolidated Statements of Income (Loss) as a percentage of operating revenues and the increase (decrease) by item as a percentage of the amount for the previous period:

Percentage of Operating Revenues Period to Period Change(1) Years Ended 2014 2013 March 31, Compared Compared 2014 2013 2012 to 2013 to 2012 Operating Revenues Investment advisory fees Separate accounts 28.4 % 28.0 % 29.1 % 6.4 % (5.8 )% Funds 54.7 55.3 56.0 3.8 (3.0 ) Performance fees 3.9 3.8 1.9 8.6 99.2 Distribution and service fees 12.7 12.6 12.8 5.2 (3.1 ) Other 0.3 0.3 0.2 16.7 35.8 Total Operating Revenues 100.0 100.0 100.0 4.9 (1.9 ) Operating Expenses Compensation and benefits 44.1 45.5 41.7 1.8 7.1 Transition-related compensation - - 1.3 n/m n/m Total Compensation and Benefits 44.1 45.5 43.0 1.8 3.9 Distribution and servicing 22.6 23.0 24.4 3.1 (7.6 ) Communications and technology 5.8 5.7 6.2 5.5 (9.1 ) Occupancy 4.2 6.6 5.8 (33.0 ) 11.0 Amortization of intangible assets 0.4 0.5 0.7 (12.1 ) (28.6 ) Impairment of intangible assets - 28.1 - n/m n/m Other 7.2 7.2 7.2 4.0 (1.2 ) Total Operating Expenses 84.3 116.6 87.3 (24.2 ) 31.1 Operating Income (Loss) 15.7 (16.6 ) 12.7 n/m n/m Other Non-Operating Income (Expense) Interest income 0.2 0.3 0.4 (15.8 ) (33.9 ) Interest expense (1.9 ) (2.4 ) (3.3 ) (15.9 ) (28.2 )

Other income (expense), net 1.2 (0.7 ) 0.8 n/m n/m Other non-operating income (expense) of consolidated investment vehicles, net 0.1 (0.1 ) 0.8 n/m n/m Total other non-operating expense (0.4 ) (2.9 ) (1.3 ) (85.2 ) n/m Income (Loss) before Income Tax Provision (Benefit) 15.3 (19.5 ) 11.4 n/m n/m Income tax provision (benefit) 5.0 (5.7 ) 2.7 n/m n/m Net Income (Loss) 10.3 (13.8 ) 8.7 n/m n/m Less: Net income (loss) attributable to noncontrolling interests (0.1 ) (0.3 ) 0.4 (54.1 ) n/m Net Income (Loss) Attributable to Legg Mason, Inc. 10.4 % (13.5 )% 8.3 % n/m n/m n/m-not meaningful (1) Calculated based on the change in actual amounts between fiscal years as a percentage of the prior year amount. 31 --------------------------------------------------------------------------------



ASSETS UNDER MANAGEMENT

Our AUM is primarily managed across the following asset classes: Equity Fixed Income Liquidity Large Cap Growth ÿ U.S. Intermediate ÿ U.S. Managed Cash ÿ Investment Grade ÿ Small Cap Core ÿ Global Government ÿ U.S. Municipal Cash ÿ Large Cap Value ÿ U.S. Credit Aggregate ÿ Equity Income ÿ Global Opportunistic Fixed Income ÿ Global Equity ÿ U.S. Municipal ÿ Sector Equity ÿ Global Fixed Income ÿ International Equity ÿ U.S. Long Duration ÿ Mid Cap Core ÿ U.S. Limited Duration ÿ Global Emerging Market ÿ U.S. High Yield Equity ÿ Emerging Markets The components of the changes in our AUM (in billions) for the years ended March 31, were as follows: 2014 2013 2012 Beginning of period $ 664.6$ 643.3$ 677.6 Investment funds, excluding liquidity funds(1) Subscriptions 52.1 44.9 46.9 Redemptions (58.1 ) (49.0 ) (51.1 ) Separate account flows, net 2.5 (27.4 ) (35.9 ) Liquidity fund flows, net 11.8 19.8 12.6 Net client cash flows 8.3 (11.7 ) (27.5 ) Market performance and other (2) 30.2 34.2



17.1

Acquisitions (dispositions), net (1.3 ) (1.2 ) (23.9 ) End of period $ 701.8$ 664.6$ 643.3



(1) Subscriptions and redemptions reflect the gross activity in the funds and include assets transferred between funds and between share classes. (2) Includes the negative impact of foreign exchange movements, primarily on

fixed income securities, of $4.9 billion, $8.3 billion, and $1.8 billion

for the years ended March 31, 2014, 2013 and 2012, respectively. Also includes reinvestment of dividends and other. AUM at March 31, 2014 was $701.8 billion, an increase of $37.2 billion, or 6%, from March 31, 2013. The increase in AUM was attributable to net client inflows of $8.3 billion and market performance and other of $30.2 billion, partially offset by the disposition of $1.3 billion resulting from the sale of a small affiliate. Market performance and other includes $4.9 million resulting from the negative impact of foreign currency exchange fluctuations. There were $12.1 billion of net client inflows into the liquidity asset class and $3.8 billion of net outflows from long-term asset classes. Equity outflows of $5.0 billion were partially offset by fixed income inflows of $1.2 billion. Equity outflows occurred in products managed at Royce & Associates ("Royce"), Batterymarch, The Permal Group, Ltd. ("Permal"), and ClearBridge, LLC, formerly Legg Mason Capital Management ("LMCM"), and were partially offset by equity inflows at ClearBridge Investments, LLC ("ClearBridge"). Due in part to product investment performance, we have experienced net annual outflows in our equity asset class since fiscal 2007. Fixed income inflows were primarily in products managed by Brandywine Global Investment Management, LLC ("Brandywine"), and were partially offset by outflows principally at Western Asset Management Company ("Western Asset"), including $4.8 billion in outflows from a single, low-fee global sovereign mandate managed by Western Asset. As previously discussed, in the first quarter of fiscal 2015, we will begin reporting AUA, which will primarily be related to QS Investors. In addition, approximately $13 billion of fixed income assets classified as AUM as of March 31, 2014 will be reclassified to AUA in the first quarter of fiscal 2015, including the assets related to this low-fee global sovereign mandate. We experienced net fixed income inflows in fiscal 2014, after experiencing net fixed income outflows during the prior five fiscal years. We generally earn higher fees and profits on equity AUM, and outflows in the equity asset class will more negatively impact our revenues and Net Income (Loss) Attributable to Legg Mason, Inc. than would outflows in other asset classes. During the month ended April 30, 2014, we experienced liquidity outflows of 32 --------------------------------------------------------------------------------



approximately $20 billion, primarily from a low-fee money market fund. We do not expect this outflow to have a material impact on our revenues or net income.

AUM at March 31, 2013, was $664.6 billion, an increase of $21.3 billion, or 3%, from March 31, 2012. The increase in AUM was attributable to market performance and other of $34.2 billion and $5.4 billion related to the acquisition of Fauchier Partners Management Limited ("Fauchier"). Market performance and other includes $8.3 billion resulting from the negative impact of foreign currency exchange fluctuations. These increases were offset in part by net client outflows of $11.7 billion and dispositions of $6.6 billion. The dispositions were in liquidity assets which resulted from the amendment of historical Smith Barney brokerage programs providing for investment in liquidity funds that our asset managers manage. Long-term asset classes accounted for the net client outflows, with $20.4 billion and $11.0 billion in equity and fixed income outflows, respectively, partially offset by liquidity inflows of $19.7 billion. Equity outflows were primarily experienced by products managed at Batterymarch, Royce, Permal, and LMCM. The majority of fixed income outflows were in products managed by Western Asset, including $6.4 billion in outflows from the low-fee global sovereign mandate discussed above. Fixed income outflows at Western Asset were offset in part by fixed income inflows at Brandywine. Our investment advisory and administrative contracts are generally terminable at will or upon relatively short notice, and investors in the mutual funds that we manage may redeem their investments in the funds at any time without prior notice. Institutional and individual clients can terminate their relationships with us, reduce the aggregate amount of assets under management, or shift their funds to other types of accounts with different rate structures for any number of reasons, including investment performance, changes in prevailing interest rates, changes in our reputation in the marketplace, changes in management or control of clients or third-party distributors with whom we have relationships, loss of key investment management personnel or financial market performance. AUM by Asset Class AUM by asset class (in billions) for the years ended March 31 were as follows: % Change % of % of % of 2014 Compared to 2013 Compared to 2014 Total 2013 Total 2012 Total 2013 2012 Equity $ 186.4 27 % $ 161.8 24 % $ 163.4 26 % 15 % (1 )% Fixed Income 365.2 52 365.1 55 356.1 55 - 3 Liquidity 150.2 21 137.7 21 123.8 19 9 11 Total $ 701.8 100 % $ 664.6 100 % $ 643.3 100 % 6 % 3 % Average AUM by asset class (in billions) for the years ended March 31 were as follows: % Change % of % of % of 2014 Compared to 2014 Total 2013 Total 2012 Total 2013 2013 Compared to 2012 Equity $ 172.8 26 % $ 152.1 24 % $ 168.4 26 % 14 % (10 )% Fixed Income 358.7 54 364.5 56 359.8 56 (2 ) 1 Liquidity 135.9 20 128.9 20 116.6 18 5 11 Total $ 667.4 100 % $ 645.5 100 % $ 644.8 100 % 3 % - % 33

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The component changes in our AUM by asset class (in billions) for the fiscal years ended March 31, 2014, 2013 and 2012, were as follows:

Fixed Equity Income Liquidity Total March 31, 2011 $ 189.6$ 356.6$ 131.4$ 677.6 Investment funds, excluding liquidity funds Subscriptions 21.7 25.2 - 46.9 Redemptions (30.4 ) (20.7 ) - (51.1 ) Separate account flows, net (12.6 ) (23.1 ) (0.2 ) (35.9 ) Liquidity fund flows, net - - 12.6 12.6 Net client cash flows (21.3 ) (18.6 ) 12.4 (27.5 ) Market performance and other (2.1 ) 19.3 (0.1 ) 17.1 Acquisitions (dispositions), net (2.8 ) (1.2 ) (19.9 ) (23.9 ) March 31, 2012 163.4 356.1 123.8 643.3 Investment funds, excluding liquidity funds Subscriptions 18.9 26.0 - 44.9 Redemptions (26.4 ) (22.6 ) - (49.0 ) Separate account flows, net (12.9 ) (14.4 ) (0.1 ) (27.4 ) Liquidity fund flows, net - - 19.8 19.8 Net client cash flows (20.4 ) (11.0 ) 19.7 (11.7 ) Market performance and other 13.4 20.0 0.8 34.2 Acquisitions (dispositions), net 5.4 - (6.6 ) (1.2 ) March 31, 2013 161.8 365.1 137.7 664.6 Investment funds, excluding liquidity funds Subscriptions 27.0 25.1 - 52.1 Redemptions (30.1 ) (28.0 ) - (58.1 ) Separate account flows, net (1.9 ) 4.1 0.3 2.5 Liquidity fund flows, net - - 11.8 11.8 Net client cash flows (5.0 ) 1.2 12.1 8.3 Market performance and other 30.9 (1.1 ) 0.4 30.2 Acquisitions (dispositions), net (1.3 ) - - (1.3 ) March 31, 2014 $ 186.4$ 365.2$ 150.2$ 701.8 AUM by Distribution Channel We have two principal distribution channels, Global Distribution and Affiliate/Other, through which we sell a variety of investment products and services. Global Distribution, which consists of our centralized global distribution operations, principally sells U.S. and international mutual funds and other commingled vehicles, retail separately managed account programs, and sub-advisory accounts for insurance companies and similar clients. Affiliate/Other consists of the distribution operations within our asset managers which principally sell institutional separate accounts and liquidity (money market) funds. 34

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The component changes in our AUM by distribution channel (in billions) for the years ended March 31, 2014, 2013 and 2012, were as follows:

Global Distribution Affiliate/Other Total March 31, 2011 $ 220.3 $ 457.3 $ 677.6 Net client cash flows, excluding liquidity funds (2.3 ) (37.8 ) (40.1 ) Liquidity fund flows, net - 12.6 12.6 Net client cash flows (2.3 ) (25.2 ) (27.5 ) Market performance and other 2.6 14.5 17.1 Acquisitions (dispositions), net - (23.9 ) (23.9 ) March 31, 2012 220.6 422.7 643.3 Net client cash flows, excluding liquidity funds 2.2 (33.7 ) (31.5 ) Liquidity fund flows, net - 19.8 19.8 Net client cash flows 2.2 (13.9 ) (11.7 ) Market performance and other 9.3 24.9 34.2 Acquisitions (dispositions), net - (1.2 ) (1.2 ) March 31, 2013 232.1 432.5 664.6 Net client cash flows, excluding liquidity funds (1.2 ) (2.3 ) (3.5 ) Liquidity fund flows, net - 11.8 11.8 Net client cash flows (1.2 ) 9.5 8.3 Market performance and other 16.5 13.7 30.2 Acquisitions (dispositions), net - (1.3 ) (1.3 ) March 31, 2014 $ 247.4 $ 454.4 $ 701.8 Our overall effective fee rate across all asset classes and distribution channels was 34 basis points for each of the years ended March 31, 2014 and 2013, and was 35 basis points for the year ended March 31, 2012. Fees for managing equity assets are generally higher, averaging approximately 70 basis points for the year ended March 31, 2014, and 75 basis points for each of the years ended March 31, 2013 and 2012. This compares to fees for managing fixed income assets, which averaged approximately 25 basis points for each of the years ended March 31, 2014, 2013 and 2012, and liquidity assets, which averaged under 10 basis points (reflecting the impact of current advisory fee waivers due to the low interest rate environment) for each of the years ended March 31, 2014, 2013 and 2012. Equity assets are primarily managed by ClearBridge, Royce, Batterymarch, and Permal; fixed income assets are primarily managed by Western Asset, Brandywine, and Permal; and liquidity assets are primarily managed by Western Asset. Fee rates for assets distributed through Legg Mason Global Distribution, which are predominately retail in nature, averaged approximately 50 basis points for each of the years ended March 31, 2014, 2013 and 2012, while fee rates for assets distributed through the Affiliate/Other channel averaged approximately 30 basis points for each of the years ended March 31, 2014, 2013 and 2012. 35

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Investment Performance

Overall investment performance of our AUM for the years ended March 31, 2014, 2013 and 2012, was generally positive compared to relevant benchmarks.

Year ended March 31, 2014 For the year ended March 31, 2014, most U.S. indices produced positive returns. The best performing was the NASDAQ Composite, returning 28.5%. These returns were achieved in an economic environment characterized by uneven global growth and heightened sensitivity to economic news such as concerns for economic growth in China and the ongoing Ukraine/Russia crisis. In the fixed income markets, the Federal Reserve kept the target rate and discount rate steady while tapering the bond-buying program. The yield curve steepened over the year but flattened in the last quarter as many long-dated yields declined. The lowest yielding fixed income sector for the year was U.S. Treasury Inflation Protected Securities ("TIPS"), as measured by the Barclays U.S. TIPS Index which returned (6.5)%. The best performing fixed income sector for the year was high yield bonds as measured by the Barclays U.S. High Yield Bond Index which returned 7.5% as of March 31, 2014. Year ended March 31, 2013 For the year ended March 31, 2013, most U.S. indices produced positive returns. The best performing was the S&P 400 Mid Cap Index, which returned 17.8% for the year ended March 31, 2013. These returns were achieved in an economic environment characterized by uneven domestic growth and heightened sensitivity to economic news which included improving unemployment and housing figures, the anticipation and implementation of the sequestration, concerns surrounding the fiscal cliff, and periodic developments in the continuing European sovereign debt crisis. In the fixed income markets, the Federal Reserve affirmed its commitment to hold the federal funds rate at historic lows, by beginning a third round of quantitative easing and continuing support of the secondary mortgage market. These actions were taken to keep interest rates low and stimulate economic growth, and resulted in a downward shift in the yield curve over the year. The lowest yielding fixed income sector for the year was U.S. government bonds, as measured by the Barclays U.S. Government Bond Index, which returned 3.0%. The best performing fixed income sector for the year was high yield bonds as measured by the Barclays U.S. High Yield Bond Index, which returned 13.1% as of March 31, 2013. Year ended March 31, 2012 For the year ended March 31, 2012, the equity markets ended a difficult year on a positive note, responding favorably to improving unemployment figures, the conclusion of bank stress tests resulting in certain banks increasing dividends, and reduced fears of a European debt fallout. As a result, most U.S. indices produced positive returns for our full fiscal year. The most notable was the NASDAQ Composite, which returned 11.2% for the year ended March 31, 2012. In the fixed income markets, improved economic data suggested that the recovery was strengthening. Flights-to-safety ebbed as the European debt crisis eased, allowing U.S. Treasury rates to climb from historically low levels. The yield curve steepened over the year as economic releases from the Federal Reserve Board painted an increasingly optimistic picture and talk of a third round of quantitative easing diminished.



The worst performing fixed income sector for the year was high yield bonds, as measured by the Barclays High Yield Index, which returned 6.5%. The best performing fixed income sector for the year was TIPS, as measured by the Barclays U.S. TIPS Index, which returned 12.2% as of March 31, 2012.

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The following table presents a summary of the percentages of our AUM by strategy(1) that outpaced their respective benchmarks as of March 31, 2014, 2013 and 2012, for the trailing 1-year, 3-year, 5-year, and 10-year periods:

As of March 31, 2014 As of March 31, 2013 As of March 31, 2012 1-year 3-year 5-year 10-year 1-year 3-year 5-year 10-year 1-year 3-year 5-year 10-year Total (includes liquidity) 75 % 87 % 84 % 92 % 84 % 85 % 88 % 91 % 62 % 81 % 70 % 87 % Equity: Large cap 67 % 91 % 52 % 76 % 65 % 68 % 88 % 80 % 66 % 43 % 66 % 78 % Small cap 33 % 26 % 29 % 82 % 13 % 15 % 27 % 62 % 49 % 63 % 88 % 89 % Total equity (includes other equity) 54 % 69 % 45 % 77 % 48 % 50 % 62 % 71 % 53 % 52 % 66 % 80 % Fixed income: U.S. taxable 94 % 94 % 94 % 97 % 96 % 94 % 91 % 90 % 66 % 95 % 61 % 89 % U.S. tax-exempt 0 % 100 % 100 % 100 % 100 % 100 % 100 % 100 % 2 % 2 % 2 % 1 % Global taxable 54 % 82 % 98 % 93 % 89 % 94 % 95 % 98 % 38 % 93 % 70 % 97 % Total fixed income 74 % 91 % 96 % 96 % 94 % 94 % 93 % 94 % 51 % 87 % 60 % 84 %



The following table presents a summary of the percentages of our U.S. mutual fund assets(2) that outpaced their Lipper category averages as of March 31, 2014, 2013 and 2012, for the trailing 1-year, 3-year, 5-year, and 10-year periods:

As of March 31, 2014 As of March 31, 2013 As of March 31, 2012 1-year 3-year 5-year 10-year 1-year 3-year 5-year 10-year 1-year 3-year 5-year 10-year Total (includes liquidity) 44 % 63 % 56 % 68 % 59 % 57 % 70 % 64 % 67 % 66 % 78 % 74 % Equity: Large cap 49 % 86 % 55 % 54 % 90 % 79 % 77 % 40 % 78 % 51 % 48 % 45 % Small cap 27 % 19 % 25 % 72 % 27 % 16 % 48 % 68 % 44 % 63 % 93 % 98 % Total equity (includes other equity) 39 % 55 % 42 % 60 % 56 % 44 % 59 % 53 % 57 % 56 % 73 % 71 % Fixed income: U.S. taxable 80 % 85 % 92 % 85 % 74 % 92 % 85 % 90 % 76 % 91 % 82 % 83 % U.S. tax-exempt 27 % 61 % 68 % 86 % 50 % 57 % 86 % 84 % 91 % 70 % 91 % 82 % Global taxable 27 % 86 % 84 % 86 % 71 % 74 % 95 % 54 % 96 % 81 % 87 % 83 % Total fixed income 54 % 78 % 83 % 86 % 64 % 76 % 87 % 85 % 84 % 81 % 87 % 83 %



(1) For purposes of investment performance comparisons, strategies are an

aggregation of discretionary portfolios (separate accounts, investment

funds, and other products) into a single group that represents a

particular investment objective. In the case of separate accounts, the

investment performance of the account is based upon the performance of the

strategy to which the account has been assigned. Each of our asset

managers has its own specific guidelines for including portfolios in their

strategies. For those managers which manage both separate accounts and

investment funds in the same strategy, the performance comparison for all

of the assets is based upon the performance of the separate account.

As of March 31, 2014, 2013 and 2012, 91%, 90% and 91% of total AUM is included in strategy AUM, respectively, although not all strategies have three-, five-, and ten-year histories. Total strategy AUM includes liquidity assets. Certain assets are not included in reported performance comparisons. These include: accounts that are not managed in accordance with the guidelines outlined above; accounts in strategies not marketed to potential clients; accounts that have not yet been assigned to a strategy; and certain smaller products at some of our affiliates. Past performance is not indicative of future results. For AUM included in institutional and retail separate accounts and investment funds included in the same strategy as separate accounts, performance comparisons are based on gross-of-fee performance. For investment funds (including fund-of-hedge funds) which are not managed in a separate account format, performance comparisons are based on net-of-fee performance. These performance comparisons do not reflect the actual performance of any specific separate account or investment fund; individual separate account and investment fund performance may differ.



Certain prior year amounts have been updated to conform to the current year presentation.

(2) Source: Lipper Inc. includes open-end, closed-end, and variable annuity

funds. As of March 31, 2014, 2013 and 2012, the U.S. long-term mutual fund

assets represented in the data accounted for 20%, 19% and 18%,

respectively, of our total AUM. The performance of our U.S. long-term

mutual fund assets is included in the strategies. 37

-------------------------------------------------------------------------------- The following table presents a summary of the absolute and relative performance compared to the applicable benchmark for a representative sample of funds within our AUM, net of management and other fees as of the end of the period presented, for the 1-year, 3-year, 5-year, and 10-year periods, and from each fund's inception. The table below includes a representative sample of funds from each significant subclass of our investment strategies (i.e., large cap equity, small cap equity, etc.). The funds within this group are representative of the performance of significant investment strategies we offer, that as of March 31, 2014, constituted an aggregate of approximately $410 billion, or approximately 58% of our total AUM. The only meaningful exclusions are our funds-of-hedge funds strategies, which involve privately placed hedge funds, and represent only 3% of our total assets under management as of March 31, 2014, for which investment performance is not made publicly available. Providing investment returns of funds provides a relevant representation of our performance while avoiding the many complexities relating to factors such as multiple fee structures, bundled pricing, and asset level break points, that would arise in reporting performance for strategies or other product aggregations. Annualized



Absolute/Relative Total Return (%) vs. Benchmark

Performance Fund Name/Index Inception Date Type(1) 1-year 3-year 5-year 10-year Inception Equity Large Cap ClearBridge Appreciation Fund 3/10/1970 Absolute 18.42% 13.56% 18.47% 7.46% 10.44% S&P 500 Relative (3.43)% (1.10)% (2.69)% 0.04% (0.06)% ClearBridge All Cap Value 11/12/1981 Absolute 18.34% 9.70% 18.86% 5.34% 10.44% Russell 3000 Value Relative (3.32)% (4.93)% (3.02)% (2.28)% (1.73)% Legg Mason Capital Management Value Trust 4/16/1982 Absolute 27.64% 14.94% 21.69% 2.25% 12.15% S&P 500 Relative 5.78% 0.29% 0.53% (5.16)% 0.20% ClearBridge Aggressive Growth Fund 10/24/1983 Absolute 32.29% 19.97% 26.69% 8.50% 12.66% Russell 3000 Growth Relative 8.76% 5.44% 4.75% 0.55% 2.69% ClearBridge Large Cap Value Fund 12/31/1988 Absolute 21.75% 15.22% 20.51% 7.37% 9.70% Russell 1000 Value Relative 0.18% 0.42% (1.25)% (0.22)% (0.87)% ClearBridge Equity Income 11/6/1992 Absolute 15.20% 14.02% 18.12% 6.70% 8.66% Russell 3000 Value Relative (6.46)% (0.61)% (3.76)% (0.91)% (1.60)% ClearBridge Large Cap Growth Fund 8/29/1997 Absolute 24.40% 16.70% 19.81% 6.18% 7.67% Russell 1000 Growth Relative 1.18% 2.07% (1.87)% (1.69)% 2.14% Legg Mason Brandywine Diversified Large Cap Value Fund 9/7/2010 Absolute 21.33% 14.97% n/a n/a 18.74% Russell 1000 Value Relative (0.24)% 0.17% n/a n/a 0.82% Small Cap Royce Pennsylvania Mutual 6/30/1967 Absolute 23.18% 10.95% 23.36% 9.36% 12.23% Russell 2000 Relative (1.72)% (2.23)% (0.95)% 0.82% n/a Royce Premier Fund 12/31/1991 Absolute 21.85% 9.27% 22.07% 10.99% 12.61% Russell 2000 Relative (3.05)% (3.91)% (2.24)% 2.46% 2.58% Royce Total Return Fund 12/15/1993 Absolute 20.65% 12.19% 21.61% 8.70% 11.60% Russell 2000 Relative (4.25)% (0.99)% (2.70)% 0.17% 2.39% Royce Special Equity 5/1/1998 Absolute 18.15% 11.95% 19.99% 8.86% 10.12% Russell 2000 Relative (6.75)% (1.24)% (4.33)% 0.33% 2.57% ClearBridge Small Cap Growth 7/1/1998 Absolute 26.46% 16.88% 26.18% 9.85% 11.23% Russell 2000 Growth Relative (0.74)% 3.27% 0.94% 0.99% 4.69% 38

-------------------------------------------------------------------------------- Annualized



Absolute/Relative Total Return (%) vs. Benchmark

Performance Fund Name/Index Inception Date Type(1) 1-year 3-year 5-year 10-year Inception Fixed Income U.S. Taxable Western Asset Core Bond Fund 9/4/1990 Absolute 0.85% 4.37% 10.86% 4.95% 7.26% Barclays US Aggregate Relative 0.94% 0.62% 6.06% 0.49% 0.68% Western Asset Short Term Bond Fund 11/11/1991 Absolute 0.58% 1.50% 5.38% 1.94% 3.87% Citi Treasury Gov't/Credit 1-3 YR Relative (0.09)% 0.33% 3.46% (0.88)% (0.71)% Western Asset Adjustable Rate Income 6/22/1992 Absolute 0.85% 1.75% 5.29% 1.79% 2.97% Citi T-Bill 6-Month Relative 0.76% 1.65% 5.13% 0.08% (0.11)% Western Asset Corporate Bond Fund 11/6/1992 Absolute 3.47% 6.75% 14.52% 4.52% 6.76% Barclays US Credit Relative 2.46% 0.94% 5.63% (0.68)% 0.04% Western Asset Intermediate Bond Fund 7/1/1994 Absolute 0.26% 3.84% 7.63% 4.79% 7.62% Barclays Intermediate Gov't/Credit Relative 0.39% 0.71% 3.45% 0.85% 2.06% Western Asset Core Plus Fund 7/8/1998 Absolute 1.13% 5.06% 10.90% 5.80% 6.55% Barclays US Aggregate Relative 1.23% 1.31% 6.10% 1.34% 1.13% Western Asset Inflation Index Plus Bond 3/1/2001 Absolute (6.47)% 3.26% 5.38% 4.41% 5.82% Barclays US TIPS Relative 0.02% (0.24)% 0.48% (0.11)% (0.17)% Western Asset High Yield Fund 9/28/2001 Absolute 6.79% 8.40% 18.85% 7.98% 8.46% Barclays US Corp High Yield Relative (0.75)% (0.60)% 0.60% (0.71)% (1.20)% Western Asset Total Return Unconstrained 7/6/2006 Absolute 1.75% 3.50% 9.83% n/a 5.42% Barclays US Aggregate Relative 1.84% (0.25)% 5.03% n/a 0.19% Western Asset Mortgage Defined Opportunity Fund Inc. 2/24/2010 Absolute 13.77% 16.03% n/a n/a 18.55% BOFAML Floating Rate Home Loan Index Relative 10.37% 10.44% n/a n/a 11.34% U.S. Tax-Exempt Western Asset Managed Municipals Fund 3/4/1981 Absolute (0.96)% 7.55% 7.42% 4.97% 7.98% Barclays Municipal Bond Relative (1.35)%



1.76% 1.71% 0.52% 0.50%

Global Taxable Legg Mason Western Asset Australian Bond Trust 6/30/1983 Absolute 4.36% 7.66% 8.14% 6.70% 6.42% UBS Australian Composite Bond Index Relative 1.04% 0.92% 2.19% 0.65% 0.64% Western Asset Global High Yield Bond Fund 2/22/1995 Absolute 5.53% 7.77% 17.78% 7.21% 7.95% Barclays Global High Yield Relative (3.47)% (1.54)% (0.96)% (2.17)% (1.98)% Legg Mason Western Asset Core Plus Global Bond Trust 2/28/1995 Absolute 2.94% 8.24% 11.72% 5.91% 5.98% Barclays Global Aggregate (AUD Hedged) Relative (0.74)% 0.22% 3.38% (1.36)% (1.02)% Western Asset Emerging Markets Debt 10/17/1996 Absolute (3.75)% 4.63% 12.67% 8.20% 10.44% JPM EMBI Global Relative (2.70)% (2.52)% 1.13% (0.11)% 0.83% Legg Mason Western Asset Global Multi Strategy Fund 8/31/2002 Absolute (1.02)% 2.80% 9.51% 5.37% 7.24% 50% Bar. Global Agg./ 25% Bar. HY 2%/25% JPM EMBI + Relative (3.37)% (2.53)% (0.27)% (1.22)% (0.96)% Legg Mason Brandywine Global Fixed Income 10/31/2003 Absolute (0.50)% 4.22% 9.09% 5.02% 5.46% Citi World Gov't Bond Relative (1.87)% 2.31% 5.25% 0.79% 0.65% Legg Mason Brandywine Global Opportunities Bond 11/1/2006 Absolute 0.60% 6.22% 11.51% n/a 7.24% Citi World Gov't Bond Relative (0.78)% 4.31% 7.67% n/a 2.67% Liquidity Western Asset Institutional Liquid Reserves Ltd. 12/31/1989 Absolute 0.08% 0.14% 0.21% 1.89% 3.57% Citi 3-Month T-Bill Relative 0.03% 0.08% 0.12% 0.32% 0.31%



(1) Absolute performance is the actual performance (i.e., rate of return) of

the fund. Relative performance is the difference (or variance) between the

performance of the fund and its stated benchmark. 39

--------------------------------------------------------------------------------



BUSINESS MODEL STREAMLINING INITIATIVE

In May 2010, we announced an initiative to streamline our business model to drive increased profitability and growth that primarily involved transitioning certain shared services to our investment affiliates who are closer to the actual client relationships. The initiative resulted in over $140 million in annual cost savings, substantially all of which were cash savings. These cost savings consisted of (i) over $80 million in compensation and benefits cost reductions resulting from eliminating positions in certain corporate shared services functions as a result of transitioning such functions to the affiliates, and charging affiliates for other centralized services that have continued to be provided to them without any corresponding adjustment in revenue sharing or other compensation arrangements; (ii) approximately $50 million in non-compensation costs from eliminating and streamlining activities in our corporate and distribution business units, including savings associated with consolidating office space; and (iii) approximately $10 million from our global distribution group sharing in affiliate revenues from retail assets under management without any corresponding adjustment in revenue sharing or other compensation arrangements. The initiative involved $127.5 million in transition-related costs that primarily included charges for employee termination benefits and incentives to retain employees during the transition period. The transition-related costs also included charges for consolidating leased office space, early contract terminations, accelerated depreciation of fixed assets, asset disposals and professional fees. During the year ended March 31, 2012, transition-related costs totaled $73.1 million. All transition-related costs were accrued as of the completion of the initiative on March 31, 2012. We achieved total annual cost savings from the initiative of approximately $140 million and $97 million as of March 31, 2013 and 2012, respectively, when compared to similar expenses prior to the commencement of the streamlining initiative. A portion of the estimated transition-related savings in fiscal 2013 were incremental to fiscal 2012, and are explained, where applicable, in the results of operations discussion to follow. See Note 15 of Notes to Consolidated Financial Statements for additional information on our business streamlining initiative.



RESULTS OF OPERATIONS

In accordance with financial accounting standards on consolidation, we consolidate and separately identify certain sponsored investment vehicles, the most significant of which is a collateralized loan obligation entity ("CLO"). The consolidation of these investment vehicles has no impact on Net Income (Loss) Attributable to Legg Mason, Inc. and does not have a material impact on our consolidated operating results. We also hold investments in other consolidated sponsored investment funds and the change in the value of these investments, which is recorded in Other non-operating income (expense), is reflected in our Net Income (Loss), net of amounts allocated to noncontrolling interests, if any. See Notes 1, 3, and 17 of Notes to Consolidated Financial Statements for additional information regarding the consolidation of investment vehicles. Operating Revenues The components of total operating revenues (in millions), and the dollar and percentage changes between periods were as follows: Years Ended March 31, 2014



Compared to 2013 2013 Compared to 2012

2014 2013 2012 $ Change % Change $ Change % Change Investment advisory fees: Separate accounts $ 777.4$ 730.3$ 775.5$ 47.1 6.4 % $ (45.2 ) (5.8 )% Funds 1,501.3 1,446.1 1,491.3 55.2 3.8 (45.2 ) (3.0 ) Performance fees 107.1 98.6 49.5 8.5 8.6 49.1 99.2 Distribution and service fees 347.6 330.5 341.0 17.1 5.2 (10.5 ) (3.1 ) Other 8.4 7.2 5.3 1.2 16.7 1.9 35.8 Total operating

revenues $ 2,741.8$ 2,612.7$ 2,662.6$ 129.1 4.9 % $ (49.9 ) (1.9 )% Total operating revenues for the year ended March 31, 2014, were $2.74 billion, an increase of 4.9% from $2.61 billion for the year ended March 31, 2013. This increase was primarily due to the impact of a 3% increase in average long-term AUM and an increase in average AUM advisory revenue yields, from 33.7 basis points in the year ended March 31, 2013 to 34.1 basis points in the year ended March 31, 2014. The increase in average AUM advisory revenue yields was the result of a 40 -------------------------------------------------------------------------------- slightly more favorable average asset mix, with equity assets, which generally earn higher fees than fixed income and liquidity assets, comprising a slightly higher percentage of our total average AUM for the year ended March 31, 2014, as compared to the year ended March 31, 2013. Total operating revenues for the year ended March 31, 2013, were $2.61 billion, a decrease of 1.9% from $2.66 billion for the year ended March 31, 2012, despite average AUM remaining essentially flat. This decrease was primarily due to the impact of a reduction in average AUM advisory revenue yields, from 35.2 basis points in the year ended March 31, 2012, to 33.7 basis points in the year ended March 31, 2013. The reduction in average AUM advisory revenue yields was the result of a less favorable average asset mix, with equity assets, which generally earn higher fees than fixed income and liquidity assets, comprising a lower percentage of our total average AUM for the year ended March 31, 2013, as compared to the year ended March 31, 2012. This decrease was offset in part by a $49.1 million increase in performance fees. Investment Advisory Fees from Separate Accounts For the year ended March 31, 2014, investment advisory fees from separate accounts increased $47.1 million, or 6.4%, to $777.4 million, as compared to $730.3 million for the year ended March 31, 2013. Of this increase, $32.8 million was the result of higher average equity assets managed by ClearBridge, $23.2 million resulted from higher revenues at Permal, including those resulting from the acquisition of Fauchier in March 2013, and $7.9 million was due to higher average fixed income assets managed by Brandywine. These increases were offset in part by a decrease of $17.6 million due to lower average equity assets managed by Batterymarch and a decrease of $6.8 million due to the sale of a small affiliate in August 2013. For the year ended March 31, 2013, investment advisory fees from separate accounts decreased $45.2 million, or 5.8%, to $730.3 million, as compared to $775.5 million for the year ended March 31, 2012. Of this decrease, $41.5 million was the result of lower average equity assets managed by Batterymarch, LMCM and Legg Mason Global Equities Group ("LMGE"), and $12.3 million was due to the divestiture of an affiliate in February 2012. These decreases were offset in part by an increase of $9.6 million due to higher average fixed income assets managed by Brandywine. Investment Advisory Fees from Funds For the year ended March 31, 2014, investment advisory fees from funds increased $55.2 million, or 3.8%, to $1.5 billion, as compared to $1.4 billion for the year ended March 31, 2013. Of this increase, $85.6 million was due to higher average equity assets managed by ClearBridge and $16.5 million was due to higher average fixed income assets managed by Brandywine, offset in part by a decrease of $48.7 million due to lower average fixed income assets managed by Western Asset. For the year ended March 31, 2013, investment advisory fees from funds decreased $45.2 million, or 3.0%, to $1.4 billion, as compared to $1.5 billion for the year ended March 31, 2012. Of this decrease, $52.9 million was due to lower average assets managed by Permal, and $48.7 million was due to lower average equity assets managed by Royce, LMCM and LMGE. These decreases were offset in part by a $39.1 million increase as a result of higher average fixed income assets managed by Western Asset and Brandywine, and a $16.7 million increase as a result of higher average equity assets at ClearBridge. Performance Fees Of our total AUM as of March 31, 2014, 2013, and 2012, approximately 6% was in accounts that were eligible to earn performance fees. For the year ended March 31, 2014, performance fees increased $8.5 million to $107.1 million, as compared to $98.6 million for the year ended March 31, 2013, primarily due to higher fees earned on assets managed at Permal, including those resulting from the Fauchier acquisition, offset in part by the impact of $32.0 million of fees received by Western Asset in the prior year, related to the wind-down of its participation in the U.S. Treasury's Public-Private Investment Program ("PPIP"). Strong performance fees were heavily influenced by strong equity markets in fiscal 2014. For the year ended March 31, 2013, performance fees increased $49.1 million to $98.6 million, as compared to $49.5 million for the year ended March 31, 2012, primarily due to $32.0 million of fees received by Western Asset related to the wind-down of its participation in the PPIP. Higher fees earned on assets managed at Permal and Brandywine also contributed to the increase. 41 -------------------------------------------------------------------------------- Distribution and Service Fees For the year ended March 31, 2014, distribution and service fees increased $17.1 million, or 5.2%, to $347.6 million, as compared to $330.5 million for the year ended March 31, 2013, resulting from an increase in average fee rates received on mutual fund AUM subject to distribution and service fees. For the year ended March 31, 2013, distribution and service fees decreased $10.5 million, or 3.1%, to $330.5 million, as compared to $341.0 million for the year ended March 31, 2012, resulting from a decline in average fee rates received on mutual fund AUM subject to distribution and service fees. Operating Expenses The components of total operating expenses (in millions), and the dollar and percentage changes between periods were as follows: Years Ended March 31, 2014 Compared to 2013 2013 Compared to 2012 2014 2013 2012 $ Change % Change $ Change % Change Compensation and benefits $ 1,210.4$ 1,188.5$ 1,144.3$ 21.9 1.8 % $ 44.2 3.9 % Distribution and servicing 619.1 600.6 649.7 18.5 3.1 (49.1 ) (7.6 ) Communications and technology 157.9 149.7 164.7 8.2 5.5 (15.0 ) (9.1 ) Occupancy 115.2 171.9 154.8 (56.7 ) (33.0 ) 17.1 11.0 Amortization of intangible assets 12.3 14.0 19.6 (1.7 ) (12.1 ) (5.6 ) (28.6 ) Impairment of intangible assets - 734.0 - (734.0 ) n/m 734.0 n/m Other 196.0 188.4 190.7 7.6 4.0 (2.3 ) (1.2 ) Total operating expenses $ 2,310.9$ 3,047.1$ 2,323.8 $

(736.2 ) (24.2 )% $ 723.3 31.1 % n/m - not meaningful Total operating expenses for the year ended March 31, 2014, were $2.31 billion, a decrease of 24.2% from $3.05 billion, for the year ended March 31, 2013. Total operating expenses for the year ended March 31, 2013, were $3.05 billion, an increase of 31.1% from $2.32 billion for the year ended March 31, 2012. The change in total operating expenses for both fiscal 2014 and fiscal 2013, was primarily the result of $734.0 million of intangible asset impairment charges recorded during fiscal 2013, as further discussed below. Operating expenses for the years ended March 31, 2014, 2013, and 2012, incurred at the investment management affiliate level comprised approximately 70% of total operating expenses in each year, excluding the impairment charges, which are deemed to be corporate expenses. The remaining operating expenses are comprised of corporate and distribution costs. 42 -------------------------------------------------------------------------------- Compensation and Benefits The components of Total Compensation and Benefits (in millions) for the years ended March 31 were as follows: Years Ended March 31, 2014 Compared to 2013 2013 Compared to 2012 $ 2014 2013 2012 Change % Change $ Change % Change Salaries and incentives $ 952.9$ 924.5$ 895.0$ 28.4 3.1 % $ 29.5 3.3 % Benefits and payroll taxes 219.7 204.5 196.7 15.2 7.4 7.8 4.0 Transition-related costs - - 34.6 - n/m (34.6 ) n/m Management transition compensation costs 4.0 17.9 - (13.9 ) (77.7 ) 17.9 n/m Other 33.8 41.6 18.0 (7.8 ) (18.8 ) 23.6 131.1 Total Compensation and Benefits $ 1,210.4$ 1,188.5$ 1,144.3$ 21.9 1.8 % $ 44.2 3.9 % n/m - not meaningful Total Compensation and Benefits for the year ended March 31, 2014, increased 1.8% to $1.21 billion, as compared to $1.19 billion for the year ended March 31, 2013; and for the year ended March 31, 2013, increased 3.9% to $1.19 billion, as compared to $1.14 billion for the year ended March 31, 2012:



Salaries and incentives increased $28.4 million, to $952.9 million for the

year ended March 31, 2014, as compared to $924.5 million for the year

ended March 31, 2013, principally due to an increase of $11.7 million in

incentive-based compensation at investment affiliates, primarily resulting

from higher revenues, and an increase of $11.7 million in incentive-based

compensation for corporate and distribution personnel, partially as a result of increased retail sales.



Salaries and incentives increased $29.5 million, to $924.5 million for the

year ended March 31, 2013, as compared to $895.0 million for the year

ended March 31, 2012, principally due to an increase of $38.5 million in

incentive-based compensation at investment affiliates, primarily resulting

from costs associated with the modification of employment and other

arrangements, most significantly with the management of Permal, and the

impact of reductions in other non-compensation related operating expenses

at revenue share based affiliates, which create an offsetting increase in

compensation per the applicable revenue share agreements. Additional

salary and incentive costs of $12.2 million, resulting from market-based

compensation increases among retained staff and new hires to support

ongoing growth initiatives, also contributed to the increase. These

increases were offset in part by a $23.7 million decrease in corporate

salaries primarily due to headcount reductions resulting from our business

streamlining initiative.



Benefits and payroll taxes increased $15.2 million, to $219.7 million for

the year ended March 31, 2014, as compared to $204.5 million for the year ended March 31, 2013, primarily as a result of $4.4 million of costs associated with the previously discussed corporate initiatives, a $3.5



million increase in costs associated with certain employee benefit plans,

a $2.5 million increase in health insurance expense, and a $2.2 million

increase in payroll-related taxes.



Benefits and payroll taxes increased $7.8 million, to $204.5 million for

the year ended March 31, 2013, as compared to $196.7 million for the year

ended March 31, 2012, primarily as a result of an increase in non-cash

amortization expense and other costs associated with certain deferred

compensation plans. Transition-related costs of $34.6 million for the year ended March 31,



2012, represent costs related to our business streamlining initiative,

which was completed in March 2012. Management transition compensation costs of $4.0 million for the year



ended March 31, 2014, represent amortization expense related to retention

awards granted to certain executives and key employees in the prior year. Management transition compensation costs of $17.9 million for the year



ended March 31, 2013, were associated with our Chief Executive Officer

stepping down in September 2012 and the subsequent reorganization of our

executive committee. These costs were primarily comprised of $7.5 million

of cash severance and $6.4 million of 43

-------------------------------------------------------------------------------- net non-cash accelerated vesting of stock based awards. Also included in this line item was $3.0 million of non-cash amortization expense related to retention awards granted to certain executives and key employees.



Other compensation and benefits decreased $7.8 million, to $33.8 million

for the year ended March 31, 2014, as compared to $41.6 million for the year ended March 31, 2013, primarily due to a $19.5 million decrease in deferred compensation and revenue-share based incentive obligations resulting from a reduction in net market gains on assets invested for deferred compensation plans and seed capital investments, which were



partially offset by corresponding decreases in Other non-operating income

(expense). These decreases were offset, in part, by an $11.7 million increase in severance expense to $16.8 million, primarily related to the previously discussed corporate initiatives.



Other compensation and benefits increased $23.6 million, to $41.6 million,

as compared to $18.0 million for the year ended March 31, 2012, primarily

due to an increase in revenue-share based incentive obligations resulting

from a $22.7 million increase in net market gains on assets invested for

deferred compensation plans and seed capital investments, which were

offset by corresponding increases in Other non-operating income (expense).

For the year ended March 31, 2014, compensation as a percentage of operating revenues decreased to 44.1% from 45.5% for the year ended March 31, 2013, due to the impact of compensation decreases related to a reduction in net market gains on assets invested for deferred compensation plans and seed capital investments and the compensation impact of the wind-down of Western Asset's participation in the PPIP in fiscal 2013. For the year ended March 31, 2013, compensation as a percentage of operating revenues increased to 45.5% from 43.0% for the year ended March 31, 2012, due to the impact of reductions in other non-compensation related operating expenses at revenue share based affiliates, the impact of the modification of employment and other arrangements, as well as the impact of quasi-fixed compensation costs of administrative and distribution personnel which do not typically vary with revenues. These increases were offset in part by the impact of transition-related compensation recorded in fiscal 2012, as well as the impact of lower corporate compensation costs, principally attributable to our business streamlining initiative. Distribution and Servicing For the year ended March 31, 2014, distribution and servicing expenses increased 3.1% to $619.1 million, as compared to $600.6 million for the year ended March 31, 2013, with $15.2 million of the increase due to an increase in average AUM in certain products for which we pay fees to third-party distributors. For the year ended March 31, 2013, distribution and servicing expenses decreased 7.6% to $600.6 million, as compared to $649.7 million for the year ended March 31, 2012, driven by a $53.8 million decrease due to a reduction in average AUM in certain products for which we pay fees to third-party distributors. Communications and Technology For the year ended March 31, 2014, communications and technology expense increased 5.5% to $157.9 million, as compared to $149.7 million for the year ended March 31, 2013, primarily as a result of an increase in technology consulting, market data, and telephone expenses. For the year ended March 31, 2013, communications and technology expense decreased 9.1% to $149.7 million, as compared to $164.7 million for the year ended March 31, 2012, driven by the impact of $8.4 million in transition-related costs recognized in fiscal 2012, as well as $4.4 million in cost savings as a result of our business streamlining initiative.



Occupancy

For the year ended March 31, 2014, occupancy expense decreased 33.0% to $115.2 million, as compared to $171.9 million for the year ended March 31, 2013, primarily due to the impact of real estate related charges totaling $52.8 million recognized in fiscal 2013 and a $4.6 million decrease in rent expense, primarily as a result of lease reserves taken on vacant space in fiscal 2013. These decreases were offset in part by $7.9 million in real estate related charges taken during fiscal 2014 in connection with the previously discussed corporate initiatives. For the year ended March 31, 2013, occupancy expense increased 11.0% to $171.9 million, as compared to $154.8 million for the year ended March 31, 2012, primarily due to real estate related charges totaling $52.8 million, recorded during fiscal 2013 related to further space consolidation which resulted in savings of approximately $10.0 million per year beginning in fiscal 2014. This increase was offset in part by the impact of $11.9 million of lease reserves recorded in fiscal 2012, as well 44 -------------------------------------------------------------------------------- as the acceleration of $10.3 million of depreciation in fiscal 2012, both primarily related to certain office space permanently vacated as a part of our business streamlining initiative. The increase was also offset in part by $6.0 million in cost savings, also as a result of our business streamlining initiative. Amortization and Impairment of Intangible Assets For the year ended March 31, 2014, amortization of intangible assets decreased 12.1% to $12.3 million, as compared to $14.0 million for the year ended March 31, 2013, primarily due to certain management contracts becoming fully amortized in December 2013. For the year ended March 31, 2013, amortization of intangible assets decreased 28.6% to $14.0 million, as compared to $19.6 million for the year ended March 31, 2012, primarily due to certain management contracts becoming fully amortized during fiscal 2012. Impairment of intangible assets was $734.0 million in the year ended March 31, 2013. The impairment charges related to our domestic mutual fund contracts asset, Permal funds-of-hedge fund contracts asset, and Permal trade name. The impairment charges resulted from a number of trends and factors, which resulted in a reduction of the projected cash flows and our overall assessment of fair value of the assets, such that the domestic mutual fund contracts asset, Permal funds-of-hedge funds contracts asset, and Permal trade name asset, declined below their carrying values, and accordingly were impaired by $396.0 million, $321.0 million, and $17.0 million, respectively in fiscal 2013. See Note 5 of Notes to Consolidated Financial Statements for further discussion of the impairment charges.



Other

For the year ended March 31, 2014, other expenses increased $7.6 million, or 4.0%, to $196.0 million, as compared to $188.4 million for the year ended March 31, 2013, primarily due to a $14.7 million increase in expense reimbursements paid to certain mutual funds and a $5.0 million charge for a fair value adjustment to increase the contingent consideration liability related to the acquisition of Fauchier, as the acquired business has performed better than initially projected. These increases were offset in part by an $8.0 million decrease in franchise taxes, as well as a $5.3 million decrease in professional fees. For the year ended March 31, 2013, other expenses decreased $2.3 million, or 1.2%, to $188.4 million, as compared to $190.7 million for the year ended March 31, 2012, primarily due to a $4.1 million reduction in charges for trading errors. A $2.5 million decrease in expense reimbursements paid to certain mutual funds, and the impact of $1.7 million of transition-related costs recognized in fiscal 2012, also contributed to the decrease. These decreases were offset in part by a $5.0 million increase in litigation-related expenses as a result of certain resolved regulatory investigations. A $1.8 million increase in professional fees, primarily related to initiatives with Permal, including the acquisition of Fauchier during fiscal 2013, also offset the decrease. Non-Operating Income (Expense) The components of total other non-operating income (expense) (in millions), and the dollar and percentage changes between periods were as follows: Years Ended March 31, 2014 Compared to 2013 2013 Compared to 2012 2014 2013 2012 $ Change % Change $ Change % Change Interest income $ 6.4$ 7.6$ 11.5$ (1.2 ) (15.8 )% $ (3.9 ) (33.9 )% Interest expense (52.9 ) (62.9 ) (87.6 ) 10.0 (15.9 ) 24.7 (28.2 ) Other income (expense), net 32.8 (18.0 ) 22.1 50.8 n/m (40.1 ) n/m Other non-operating income (loss) of consolidated investment vehicles, net 2.4 (2.8 ) 18.3 5.2 n/m (21.1 ) n/m Total other non-operating expense $ (11.3 )$ (76.1 )$ (35.7 )$ 64.8 (85.2 )% $ (40.4 ) n/m n/m - not meaningful Interest Income For the year ended March 31, 2014, interest income decreased 15.8% to $6.4 million, as compared to $7.6 million for the year ended March 31, 2013, driven by the impact of lower average interest-bearing investment balances. 45 -------------------------------------------------------------------------------- For the year ended March 31, 2013, interest income decreased 33.9% to $7.6 million, as compared to $11.5 million for the year ended March 31, 2012, driven by a $2.6 million decrease due to lower yields earned on investment balances and a $1.8 million decrease due to lower average investment balances. Interest Expense For the year ended March 31, 2014, interest expense decreased 15.9% to $52.9 million, as compared to $62.9 million for the year ended March 31, 2013, primarily as a result of a $5.6 million decrease in the interest accruals for uncertain tax positions and a $4.4 million decrease due to the refinancing of the 2.5% Convertible Senior Notes (the "Convertible Notes") in May 2012 and the five-year term loan in January 2014.



For the year ended March 31, 2013, interest expense decreased 28.2% to $62.9 million, as compared to $87.6 million for the year ended March 31, 2012, primarily as a result of the refinancing of the Convertible Notes in May 2012.

Other Income (Expense), Net For the year ended March 31, 2014, other income (expense), net, improved $50.8 million, to income of $32.8 million, from an expense of $18.0 million in fiscal 2013. This increase was primarily a result of the impact of a $69.0 million loss on debt extinguishment recognized in connection with the repurchase of the Convertible Notes in May 2012, offset in part by a $19.5 million decrease in net market gains on seed capital investments and assets invested for deferred compensation plans, which are offset by corresponding decreases in compensation discussed above. For the year ended March 31, 2013, other income (expense), net, decreased $40.1 million, to an expense of $18.0 million, from income of $22.1 million in fiscal 2012. This decrease was primarily a result of the $69.0 million loss on debt extinguishment recognized in connection with the repurchase of the Convertible Notes in May 2012. The impact of an $8.6 million gain related to an assigned bankruptcy claim, and a $7.5 million gain on the sale of a small affiliate, both recognized in the fiscal 2012, also contributed to the decrease. These decreases were offset in part by a $22.7 million increase in net market gains on seed capital investments and assets invested for deferred compensation plans, which are offset by corresponding increases in compensation discussed above, as well as a $20.8 million increase in net market gains on corporate investments in proprietary fund products, which are not offset in compensation. Other Non-Operating Income (Loss) of Consolidated Investment Vehicles For the year ended March 31, 2014, other non-operating income (loss) of consolidated investment vehicles ("CIVs"), net, improved $5.2 million to income of $2.4 million, from a loss of $2.8 million in fiscal 2013, primarily due to net market gains on investments of certain CIVs. For the year ended March 31, 2013, other non-operating income (expense) of CIVs, net, decreased $21.1 million to an expense of $2.8 million, from income of $18.3 million in fiscal 2012, primarily due to net market losses on investments of certain CIVs, as well as the impact of market gains recognized in fiscal 2012 related to a previously consolidated CIV that was redeemed in that fiscal year. Income Tax Provision (Benefit) For the year ended March 31, 2014, the provision for income taxes was $137.8 million, compared to an income tax benefit of $150.9 million in the year ended March 31, 2013. The effective tax rate was 32.8% for the year ended March 31, 2014, compared to an effective benefit rate of 29.5% in the year ended March 31, 2013. The change in the effective rate was primarily related to a higher relative proportion of pre-tax income (loss) in jurisdictions with higher tax rates, substantially offset by adjustments to deferred tax balances and other reserves. In July 2012, the U.K. Finance Act 2012 was enacted, which reduced the main U.K. corporate tax rate from 25% to 24% effective April 1, 2012 and to 23% effective April 1, 2013. In July 2013, the Finance Bill 2013 was enacted, further reducing the main U.K. corporate tax rate to 21% effective April 1, 2014 and to 20% effective April 1, 2015. The impact of tax rate changes on certain existing deferred tax assets and liabilities resulted in a tax benefit of $19.2 million and $18.1 million on the revaluation of deferred tax assets and liabilities for the years ended March 31, 2014 and 2013, respectively; and impacted the effective rate by 4.6 percentage points in the year ended March 31, 2014, and 3.5 percentage points in the year ended March 31, 2013. The impact of CIVs increased the effective rate by 0.2 percentage points for the year ended March 31, 2014, and reduced the effective rate by 0.5 percentage points for the year ended March 31, 2013. 46

-------------------------------------------------------------------------------- For the year ended March 31, 2013, the benefit for income taxes was $150.9 million, compared to a provision of $72.1 million in the prior year. The effective benefit rate was 29.5% for the year ended March 31, 2013, compared to an effective tax rate of 23.8% in the year ended March 31, 2012. The change in the effective rate was primarily related to a lower tax benefit associated with the intangible asset impairment charge recorded in fiscal 2013, due to the lower statutory rates in the jurisdictions where certain intangible assets were held, partially offset by adjustments to reserves and the impact of certain tax planning initiatives recorded in fiscal 2012. In July 2011, The U.K. Finance Act 2011 was enacted, which reduced the main U.K. corporate tax rate from 27% to 26% effective April 1, 2011, and from 26% to 25% effective April 1, 2012. As discussed above, in July 2012, the U.K. Finance Act 2012 was enacted, further reducing the main U.K. corporate tax rate to 24% effective April 1, 2012 and 23% effective April 1, 2013. The impact of the tax rate changes on certain existing deferred tax assets and liabilities resulted in a tax benefit of $18.1 million and $18.3 million for the years ended March 31, 2013 and 2012, respectively, and impacted the effective rate by 3.5 percentage points in the year ended March 31, 2013, and 6.0 percentage points in the year ended March 31, 2012. The impact of changes in the U.K. tax rate was more substantial for the year ended March 31, 2012, due to the higher level of pre-tax income in that fiscal year. The impact of CIVs reduced the effective rate by 0.5 and 0.8 percentage points for the years ended March 31, 2013 and 2012, respectively. Net Income (Loss) Attributable to Legg Mason, Inc. and Operating Margin Net Income Attributable to Legg Mason, Inc. for the year ended March 31, 2014, totaled $284.8 million, or $2.33 per diluted share, compared to Net Loss Attributable to Legg Mason, Inc. of $353.3 million, or $2.65 per diluted share, in the year ended March 31, 2013. The increase was primarily attributable to the impact of the pre-tax impairment charges of $734.0 million ($508.3 million, net of income tax benefits, or $3.81 per diluted share), recorded in the prior year, the impact of the $69.0 million pre-tax loss ($44.8 million, net of income tax benefits, or $0.34 per diluted share) on debt extinguishment recognized in connection with the repurchase of the Convertible Notes in May 2012, the impact of $52.8 million of real estate related charges recognized in fiscal 2013, and the net impact of increased operating revenues, as previously discussed. In addition, Net Income Attributable to Legg Mason, Inc. per diluted share benefited from a reduction in weighted-average shares outstanding as a result of share repurchases. Operating margin was 15.7% for the year ended March 31, 2014, compared to (16.6)% for the year ended March 31, 2013. Net Loss Attributable to Legg Mason, Inc. for the year ended March 31, 2013, totaled $353.3 million, or $2.65 per diluted share, compared to Net Income Attributable to Legg Mason, Inc. of $220.8 million, or $1.54 per diluted share, in the year ended March 31, 2012. The decrease was primarily attributable to the impact of the pre-tax impairment charges of $734.0 million ($508.3 million, net of income tax benefits, or $3.81 per diluted share), recorded in fiscal 2013, related to our indefinite-life intangible assets, as well as the $69.0 million pre-tax loss ($44.8 million, net of income tax benefits, or $0.34 per diluted share) on debt extinguishment recognized in connection with the repurchase of the Convertible Notes in May 2012. Real estate related charges of $52.8 million recognized in fiscal 2013 also contributed to the decrease. These decreases were offset in part by the impact of transition-related costs recorded in fiscal 2012, and the impact of increased cost savings in fiscal 2013, both in connection with our business streamlining initiative. These items were previously discussed above. Operating margin was (16.6)% for the year ended March 31, 2013, compared to 12.7% for the year ended March 31, 2012. Supplemental Non-GAAP Financial Information As supplemental information, we are providing performance measures that are based on methodologies other than generally accepted accounting principles ("non-GAAP") for "Adjusted Income" and "Operating Margin, As Adjusted" that management uses as benchmarks in evaluating and comparing our period-to-period operating performance. Adjusted Income increased to $417.8 million, or $3.41 per diluted share, for the year ended March 31, 2014, from $347.2 million, or $2.61 per diluted share, for the year ended March 31, 2013. Operating Margin, as Adjusted, for the years ended March 31, 2014 and 2013, was 22.0% and 17.5%, respectively. Operating Margin, as Adjusted, for the year ended March 31, 2014, was reduced by 1.5 percentage points due to expenses recognized during the fiscal year related to the previously discussed corporate initiatives and restructuring charges related to the QS Investors acquisition, and by 1.0 percentage point due to structuring fees related to a closed-end fund launch during the fiscal year. Operating Margin, as Adjusted, for the year ended March 31, 2013, was reduced by 3.5 percentage points due to real estate related charges and management transition compensation costs recorded during that fiscal year, and by 1.0 percentage point due to structuring fees related to closed-end fund and real estate investment trust launches during that fiscal year. 47 -------------------------------------------------------------------------------- Adjusted Income decreased to $347.2 million, or $2.61 per diluted share, for the year ended March 31, 2013, from $397.0 million, or $2.77 per diluted share, for the year ended March 31, 2012. Operating Margin, as Adjusted, for the years ended March 31, 2013 and 2012, was 16.8% and 21.3%, respectively. Operating Margin, as Adjusted, for the year ended March 31, 2013 was reduced by 3.5 percentage points due to real estate related charges and management transition compensation costs recorded during fiscal 2013. Adjusted Income We define "Adjusted Income" as Net Income (Loss) Attributable to Legg Mason, Inc., plus amortization and deferred taxes related to intangible assets and goodwill, imputed interest and tax benefits on contingent convertible debt less deferred income taxes on goodwill and indefinite-life intangible asset impairment, if any. We also adjust for non-core items that are not reflective of our economic performance, such as intangible asset impairments, the impact of fair value adjustments of contingent consideration liabilities, if any, the impact of tax rate adjustments on certain deferred tax liabilities related to indefinite-life intangible assets, and loss on extinguishment of contingent convertible debt. We believe that Adjusted Income provides a useful representation of our operating performance adjusted for non-cash acquisition related items and other items that facilitate comparison of our results to the results of other asset management firms that have not issued/extinguished contingent convertible debt or made significant acquisitions. We also believe that Adjusted Income is an important metric in estimating the value of an asset management business. Adjusted Income only considers adjustments for certain items that relate to operating performance and comparability, and therefore, is most readily reconcilable to Net Income (Loss) Attributable to Legg Mason, Inc. determined under GAAP. This measure is provided in addition to Net Income (Loss) Attributable to Legg Mason, Inc., but is not a substitute for Net Income (Loss) Attributable to Legg Mason, Inc. and may not be comparable to non-GAAP performance measures, including measures of adjusted earnings or adjusted income, of other companies. Further, Adjusted Income is not a liquidity measure and should not be used in place of cash flow measures determined under GAAP. Fair value adjustments of contingent consideration liabilities may or may not provide a tax benefit, depending on the tax attributes of the acquisition transaction. Our current fair value adjustment of the contingent consideration liability does not provide a current tax benefit. We consider Adjusted Income to be useful to investors because it is an important metric in measuring the economic performance of asset management companies, as an indicator of value, and because it facilitates comparison of our operating results with the results of other asset management firms that have not issued/extinguished contingent convertible debt or made significant acquisitions. In calculating Adjusted Income, we adjust for the impact of the amortization of management contract assets and impairment of indefinite-life intangible assets, and add (subtract) the impact of fair value adjustments on contingent consideration liabilities, if any, all of which arise from acquisitions, to Net Income (Loss) Attributable to Legg Mason, Inc. to reflect the fact that these items distort comparisons of our operating results with the results of other asset management firms that have not engaged in significant acquisitions. Deferred taxes on indefinite-life intangible assets and goodwill include actual tax benefits from amortization deductions that are not realized under GAAP absent an impairment charge or the disposition of the related business. Because we fully expect to realize the economic benefit of the current period tax amortization, we add this benefit to Net Income (Loss) Attributable to Legg Mason, Inc. in the calculation of Adjusted Income. However, because of our net operating loss carry-forward, we will receive the benefit of the current tax amortization over time. Conversely, we subtract the non-cash income tax benefits on goodwill and indefinite-life intangible asset impairment charges and U.K. tax rate adjustments on excess book basis on certain acquired indefinite-life intangible assets, if applicable, that have been recognized under GAAP. We also add back non-cash imputed interest and the extinguishment loss on contingent convertible debt adjusted for amounts allocated to the conversion feature, as well as adding the actual tax benefits on the imputed interest that are not realized under GAAP. These adjustments reflect that these items distort comparisons of our operating results to other periods and the results of other asset management firms that have not engaged in significant acquisitions, including any related impairments, or issued/extinguished contingent convertible debt. Should a disposition, impairment charge or other non-core item occur, its impact on Adjusted Income may distort actual changes in the operating performance or value of our firm. Accordingly, we monitor these items and their related impact, including taxes, on Adjusted Income to ensure that appropriate adjustments and explanations accompany such disclosures. Although depreciation and amortization of fixed assets are non-cash expenses, we do not add these charges in calculating Adjusted Income because these charges are related to assets that will ultimately require replacement. 48 --------------------------------------------------------------------------------



A reconciliation of Net Income (Loss) Attributable to Legg Mason, Inc. to Adjusted Income (in thousands except per share amounts) is as follows:

For the Years Ended



March 31,

2014 2013



2012

Net Income (Loss) Attributable to Legg Mason, Inc. $ 284,784$ (353,327 )$ 220,817 Plus (less): Amortization of intangible assets 12,314 14,019



19,574

Loss on extinguishment of 2.5% senior notes - 54,873 - Impairment of intangible assets - 734,000 - Contingent consideration fair value adjustment 5,000 - - Deferred income taxes on intangible assets: Impairment charges - (225,748 ) - Tax amortization benefit 134,871 135,588 135,830 U.K. tax rate adjustment (19,164 ) (18,075 ) (18,268 ) Imputed interest on convertible debt (2.5% senior notes) - 5,839



39,077

Adjusted Income $ 417,805$ 347,169$ 397,030 Net Income (Loss) per diluted share Attributable to Legg Mason, Inc. common shareholders $ 2.33$ (2.65 )$ 1.54 Plus (less): Amortization of intangible assets 0.10 0.11



0.14

Loss on extinguishment of 2.5% senior notes - 0.41 - Impairment of intangible assets - 5.51 - Contingent consideration fair value adjustment 0.04 - - Deferred income taxes on intangible assets: Impairment charges - (1.69 ) - Tax amortization benefit 1.10 1.02 0.95 U.K. tax rate adjustment (0.16 ) (0.14 ) (0.13 ) Imputed interest on convertible debt (2.5% senior notes) - 0.04



0.27

Adjusted Income per diluted share $ 3.41$ 2.61$ 2.77 Operating Margin, as Adjusted We calculate "Operating Margin, as Adjusted," by dividing (i) Operating Income (Loss), adjusted to exclude the impact on compensation expense of gains or losses on investments made to fund deferred compensation plans, the impact on compensation expense of gains or losses on seed capital investments by our affiliates under revenue sharing agreements, amortization related to intangible assets, transition-related costs of streamlining our business model, if any, income (loss) of CIVs, the impact of fair value adjustments of contingent consideration liabilities, if any, and impairment charges by (ii) our operating revenues, adjusted to add back net investment advisory fees eliminated upon consolidation of investment vehicles, less distribution and servicing expenses which we use as an approximate measure of revenues that are passed through to third parties, which we refer to as "Operating Revenues, as Adjusted." The compensation items, other than transition-related costs, are removed from Operating Income (Loss) in the calculation because they are offset by an equal amount in Other non-operating income (expense), and thus have no impact on Net Income (Loss) Attributable to Legg Mason, Inc. We adjust for the impact of amortization of management contract assets and the impact of fair value adjustments of contingent consideration liabilities, if any, which arise from acquisitions to reflect the fact that these items distort comparison of our operating results with results of other asset management firms that have not engaged in significant acquisitions. Transition-related costs, if any, impairment charges and income (loss) of CIVs are removed from Operating Income (Loss) in the calculation because these items are not reflective of our core asset management operations. We use Operating Revenues, as Adjusted in the calculation to show the operating margin without distribution and servicing expenses, which we use to approximate our distribution revenues that are passed through to third parties as a direct cost of selling our products, although distribution and servicing expenses may include commissions paid in connection with the launching of closed-end funds for which there is no corresponding revenue in the period. Operating Revenues, as Adjusted, also include our advisory revenues we receive from CIVs that are eliminated in consolidation under GAAP. 49 -------------------------------------------------------------------------------- We believe that Operating Margin, as Adjusted, is a useful measure of our performance because it provides a measure of our core business activities. It excludes items that have no impact on Net Income (Loss) Attributable to Legg Mason, Inc. and indicates what our operating margin would have been without the distribution revenues that are passed through to third parties as a direct cost of selling our products, amortization related to intangible assets, changes in the fair value of contingent consideration liabilities, if any, transition-related costs, if any, and impairment charges, and the impact of the consolidation of certain investment vehicles described above. The consolidation of these investment vehicles does not have an impact on Net Income (Loss) Attributable to Legg Mason, Inc. This measure is provided in addition to our operating margin calculated under GAAP, but is not a substitute for calculations of margins under GAAP and may not be comparable to non-GAAP performance measures, including measures of adjusted margins of other companies. Effective April 1, 2013, we revised our definition of Operating Margin, as Adjusted, to add back the amortization of intangible assets. We have applied this change to all periods presented, The impact on results for the years ended March 31, 2013 and 2012 were increases of 0.7 and 1.0 percentage points, respectively.



The calculation of Operating Margin and Operating Margin, as Adjusted, is as follows (dollars in thousands):

For the Years Ended



March 31,

2014 2013



2012

Operating Revenues, GAAP basis $ 2,741,757$ 2,612,650$ 2,662,574 Plus (less): Operating revenues eliminated upon consolidation of investment vehicles 1,950 2,397



3,094

Distribution and servicing expense excluding consolidated investment vehicles (619,022 ) (600,582 ) (649,679 ) Operating Revenues, as Adjusted $ 2,124,685$ 2,014,465



$ 2,015,989

Operating Income (Loss), GAAP basis $ 430,893$ (434,499 )

$ 338,753 Plus (less): Gains (losses) on deferred compensation and seed investments 16,987 36,497



13,809

Transition-related costs - -



73,066

Impairment of intangible assets - 734,000 - Contingent consideration fair value adjustment 5,000 - - Amortization of intangible assets 12,314 14,019



19,574

Operating income and expenses of consolidated investment vehicles 2,370 2,959 3,702 Operating Income, as Adjusted $ 467,564$ 352,976$ 448,904 Operating Margin, GAAP basis 15.7 % (16.6 )% 12.7 % Operating Margin, as Adjusted 22.0 17.5 22.3 50

--------------------------------------------------------------------------------



LIQUIDITY AND CAPITAL RESOURCES

The primary objective of our capital structure is to appropriately support our business strategies and to provide needed liquidity at all times, including maintaining required capital in certain subsidiaries. Liquidity and the access to liquidity is important to the success of our ongoing operations. Our overall funding needs and capital base are continually reviewed to determine if the capital base meets the expected needs of our businesses. We intend to continue to explore potential acquisition opportunities as a means of diversifying and strengthening our asset management business. These opportunities may from time to time involve acquisitions that are material in size and may require, among other things, and subject to existing covenants, the raising of additional equity capital and/or the issuance of additional debt. The consolidation of variable interest entities discussed above does not impact our liquidity and capital resources. We have no rights to the benefits from, nor do we bear the risks associated with, the assets and liabilities of the CIVs beyond our investments in and investment advisory fees generated from these vehicles, which are eliminated in consolidation. Additionally, creditors of the CIVs have no recourse to our general credit beyond the level of our investment, if any, so we do not consider these liabilities to be our obligations. Our assets consist primarily of intangible assets, goodwill, cash and cash equivalents, investment securities, and investment advisory and related fee receivables. Our assets have been principally funded by equity capital, long-term debt and the results of our operations. At March 31, 2014, cash and cash equivalents, total assets, long-term debt and stockholders' equity were $0.9 billion, $7.1 billion, $1.0 billion and $4.7 billion, respectively. Total assets include amounts related to CIVs of $0.2 billion. Cash and cash equivalents are primarily invested in liquid domestic and non-domestic money market funds that hold principally domestic and non-domestic corporate commercial paper and bonds, government and agency securities, and bank deposits. We have not recognized any losses on these investments. Our monitoring of cash and cash equivalents mitigates the potential that material risks may be associated with these balances.



The following table summarizes our Consolidated Statements of Cash Flows for the years ended March 31 (in millions):

2014 2013



2012

Cash flows provided by operating activities $ 437.3$ 303.3

$ 496.8 Cash flows provided by/(used in) investing activities 137.6 (11.0 ) 2.3 Cash flows used in financing activities (639.0 ) (735.9 ) (481.8 ) Effect of exchange rate changes (10.9 ) (5.7 ) (10.9 ) Net change in cash and cash equivalents (75.0 ) (449.3 ) 6.4 Cash and cash equivalents, beginning of period 933.0 1,382.3



1,375.9

Cash and cash equivalents, end of period $ 858.0$ 933.0

$ 1,382.3

Cash inflows provided by operating activities during fiscal 2014 were $437.3 million, primarily related to Net Income, adjusted for non-cash items, offset in part by net sales (purchases) of trading and other current investments and a decrease in net activity related to CIVs, primarily due to the wind-down of the CLO. See Note 17 of Notes to Consolidated Financial Statements for additional information regarding the CLO. Cash inflows provided by operating activities during fiscal 2013 were $303.3 million, primarily related to net sales of trading and other current investments and results of operations, adjusted for non-cash items, offset in part by the allocation of extinguished debt repayment and payments for accrued compensation. Cash inflows provided by operating activities during fiscal 2012 were $496.8 million, primarily related to Net Income, adjusted for non-cash items. Cash inflows provided by investing activities during fiscal 2014, were $137.6 million, primarily related to net activity related to CIVs, offset in part by payments for fixed assets. Cash outflows used in investing activities during fiscal 2013, were $11.0 million, primarily related to payments related to the acquisition of Fauchier and payments made for fixed assets, offset in part by net activity related to CIVs. Cash inflows provided by investing activities during fiscal 2012, were $2.3 million, primarily related to $20.2 million of net activity related to CIVs and a release of restricted cash required for market hedge arrangements, offset in part by payments made for fixed assets. 51 -------------------------------------------------------------------------------- Cash outflows used in financing activities during fiscal 2014 were $639.0 million, primarily related to the repayment of long-term debt of $500.4 million, the repayment of long-term debt of CIVs of $133.0 million, the repurchase of 9.7 million shares of our common stock for $360.0 million, and dividends paid of $62.0 million, offset in part by the proceeds from the long-term debt issuances of $393.7 million. Cash outflows used in financing activities during fiscal 2013 were $735.9 million, primarily related to the repayment of long-term debt of $1,049.2 million, the repurchase of 16.2 million shares of our common stock for $425.5 million, the $250.0 million repayment of short-term debt, and dividends paid of $55.3 million, offset in part by the proceeds from the subsequent long-term debt issuances of $1,143.2 million. Cash outflows used in financing activities during fiscal 2012, were $481.8 million, primarily due to the repurchase of 13.6 million shares of our common stock for $401.8 million and dividends paid of $43.6 million. Financing Transactions The table below reflects our primary sources of financing (in thousands) as of March 31, 2014: Total Amount Outstanding at at March 31, March 31, Type 2014 2014 2013 Interest Rate Maturity 5.5% senior notes $ 650,000$ 650,000$ 650,000 5.50% May 2019 January 5.625% senior notes 400,000 400,000 N/A 5.625% 2044 LIBOR + 1.5% + 0.20% annual Revolving credit commitment agreements 750,000 - - fee June 2017 Repaid Five-year amortizing January term loan - - 500,000 LIBOR + 1.5% 2014 Capital Plan and Other Financing Transactions In May 2012, we announced a capital plan that included refinancing the Convertible Notes. The refinancing was effected through the issuance of $650 million of 5.5% senior notes, the net proceeds of which, together with cash on hand and $250 million of remaining borrowing capacity under a then existing revolving credit facility, were used to repurchase all $1.25 billion of the Convertible Notes. The terms of the repurchase included the repayment of the Convertible Notes at par plus accrued interest, a prepayment fee of $6.3 million, and the issuance of warrants to the holders of the Convertible Notes. The warrants replace a conversion feature of the Convertible Notes, and provide for the purchase, in the aggregate and subject to adjustment, of 14.2 million shares of our common stock, on a net share settled basis, at an exercise price of $88 per share. The warrants expire in July 2017 and can be settled, at our election, in either shares of common stock or cash. The $650 million 5.5% senior notes are due May 2019 and were sold at a discount of $6.8 million, which is being amortized to interest expense over the seven-year term. Also, pursuant to the capital plan, in June 2012, we entered into an unsecured credit agreement which provides for a $500 million revolving credit facility and a $500 million term loan, which was repaid in fiscal 2014, as further discussed below. The proceeds of the term loan were used to repay the $500 million of outstanding borrowings under the previous revolving credit facility, which was then terminated. In January 2014, we issued $400 million of 5.625% senior notes, the net proceeds of which, together with cash on hand, were used to repay the $450 million of outstanding borrowings under the five-year term loan entered into in conjunction with the unsecured credit agreement noted above. The 5.625% senior notes are due January 2044 and were sold at a discount of $6.3 million, which is being amortized to interest expense over the 30 year term. In January 2014, we entered into a $250 million incremental revolving credit facility, which was contemplated in, and is in addition to the $500 million revolving credit facility available under, the existing credit agreement. These revolving credit facilities are available to fund working capital needs and for general corporate purposes and expire in June 2017. There were no borrowings outstanding under either of our revolving credit facilities as of March 31, 2014. In connection with the extinguishment of the Convertible Notes, hedge transactions (purchased call options and warrants) executed in connection with the initial issuance of the Convertible Notes were also terminated. 52 -------------------------------------------------------------------------------- The financial covenants under our bank agreements include: maximum net debt to EBITDA ratio of 2.5 to 1 and minimum EBITDA to interest expense ratio of 4.0 to 1. Debt is defined to include all obligations for borrowed money, excluding non-recourse debt of CIVs, and capital leases. Under these net debt covenants, our debt is reduced by the amount of our unrestricted cash in excess of the greater of subsidiary cash or $375 million. EBITDA is defined as consolidated net income (loss) plus/minus tax expense (benefit), interest expense, depreciation and amortization, amortization of intangibles, any extraordinary expense or losses, and any non-cash charges, as defined in the agreements. As of March 31, 2014, our net debt to EBITDA ratio was 1.2 to 1 and EBITDA to interest expense ratio was 12.5 to 1, and, therefore, we have maintained compliance with the applicable covenants. In addition, the 5.5% senior notes are subject to certain nonfinancial covenants, including provisions relating to dispositions of certain assets, which could require a percentage of any related proceeds to be applied to accelerated repayments. If our net income (loss) significantly declines, or if we spend our available cash, it may impact our ability to maintain compliance with the financial covenants. If we determine that our compliance with these covenants may be under pressure, we may elect to take a number of actions, including reducing our expenses in order to increase our EBITDA, using available cash to repay all or a portion of our outstanding debt subject to these covenants or seeking to negotiate with our lenders to modify the terms or to restructure our debt. We anticipate that we will have available cash to repay our bank debt, should it be necessary. Using available cash to repay indebtedness would make the cash unavailable for other uses and might affect the liquidity discussions and conclusions. Entering into any modification or restructuring of our debt would likely result in additional fees or interest payments. Our outstanding bank debt agreement is currently impacted by the ratings of two rating agencies. The interest rate and annual commitment fee on our revolving lines of credit are based on the higher credit rating of the two rating agencies. In June 2011, our rating by one of these agencies was downgraded one notch below the other. Should the other agency downgrade our rating, absent an upgrade from the former agency, our interest costs will rise modestly. In addition, under the terms of the 5.5% senior notes, the interest rate paid on these notes will increase modestly if our credit ratings are reduced below investment grade. Also in connection with the capital plan, our board of directors authorized $1.0 billion for additional purchases of our common stock, $370 million of which remained available as of March 31, 2014. The capital plan authorizes using up to 65% of cash generated from future operations to purchase shares of our common stock. Other Transactions In March 2013, we completed the acquisition of all of the outstanding share capital of Fauchier, a leading European based manager of funds-of-hedge funds, from BNP Paribas Investment Partners, S.A. The transaction included an initial cash payment of $63.4 million, which was funded from existing cash resources. In addition, contingent consideration of up to approximately $25 million and approximately $33 million (using the exchange rate between the British pound and U.S. dollar as of March 31, 2014), may be due on or about the second and fourth anniversaries of closing, respectively, dependent on achieving certain levels of revenue, net of distribution costs, and subject to a potential catch-up adjustment in the fourth anniversary payment for any second anniversary payment shortfall. The fair value of the contingent consideration liability was approximately $29.6 million as of March 31, 2014, an increase of $7.7 million from March 31, 2013, with $5.0 million attributable to revised estimates of amounts payable and $2.7 million attributable to changes in the exchange rate and interest amortization. We have executed currency forwards to economically hedge the risk of movements in the exchange rate between the U.S. dollar and the British pound in which the estimated contingent liability payment amounts are denominated. In March 2014, we entered into an agreement to acquire QS Investors, a leading customized solutions and global quantitative equities provider, for an initial purchase price of $11 million and contingent consideration of up to $10 million and $20 million due on or about the second and fourth anniversaries of the closing, respectively, dependent on the achievement of certain net revenue targets, and subject to a potential catch-up adjustment in the fourth anniversary payment for any second anniversary payment shortfall. This acquisition is expected to close in the first quarter of fiscal 2015. Certain of our asset management affiliates maintain various credit facilities for general operating purposes. Certain affiliates are also subject to the capital requirements of various regulatory agencies. All such affiliates met their respective capital adequacy requirements during the periods presented. See Notes 2 and 6 of Notes to Consolidated Financial Statements for additional information related to the acquisitions of Fauchier and QS Investors and our capital plan, respectively. 53 -------------------------------------------------------------------------------- Future Outlook We expect that over the next 12 months cash generated from our operating activities will be adequate to support our operating and investing liquidity needs, and planned share repurchases. We currently intend to utilize our other available resources for any number of potential activities, including, but not limited to, acquisitions, seed capital investments in new products, repurchase of shares of our common stock, repayment of outstanding debt, or payment of increased dividends. In June 2013 and March 2014, we implemented management equity plans that will entitle certain key employees of Permal and ClearBridge, respectively, to participate in 15% of the future growth of the respective enterprise value (subject to appropriate discounts), if any, as further discussed in Notes 1 and 11 of Notes to Consolidated Financial Statements. Repurchases of units granted under the plans may impact future liquidity requirements. In connection with the planned integration over time of two existing affiliates, Batterymarch and LMGAA, with QS Investors after the acquisition closes, we expect to incur restructuring and transition costs of approximately $35 million, of which approximately 25% are non-cash charges. Approximately $2.5 million of these charges were accrued as of March 31, 2014. A significant portion of these costs will be paid in the year ending March 31, 2015. See Note 2 for additional information. As described above, we currently project that our cash flows from operating activities will be sufficient to fund our liquidity needs. As of March 31, 2014, we had over $500 million in cash and cash equivalents in excess of our working capital requirements. As previously discussed, and in accordance with our capital plan, we intend to utilize up to 65% of cash generated from future operations to purchase shares of our common stock in the year ending March 31, 2015. As of March 31, 2014, we also had undrawn revolving credit facilities totaling $750 million, expiring June 2017. We do not currently expect to raise incremental debt or equity financing over the next 12 months beyond our current levels. However, there can be no assurances of these expectations as our projections could prove to be incorrect, events may occur that require additional liquidity, such as an acquisition opportunity or an opportunity to refinance indebtedness, or market conditions might significantly worsen, affecting our results of operations and generation of available cash. If these events result in our operations and available cash being insufficient to fund liquidity needs, we would likely seek to manage our available resources by taking actions such as reducing future share repurchases, cost-cutting, reducing our expected expenditures on investments, selling assets (such as investment securities), repatriating earnings from foreign subsidiaries, reducing our dividend, or modifying arrangements with our affiliates and/or employees. Should these types of actions prove insufficient, or should a large acquisition or refinancing opportunity arise, we may seek to raise additional equity or debt. At March 31, 2014, our total cash and cash equivalents of $858 million included $306 million held by foreign subsidiaries. During fiscal 2014, in order to increase our cash available in the U.S. for general corporate purposes, we implemented plans developed in prior years to repatriate accumulated foreign earnings for which deferred taxes had been previously accrued, and repatriated $301 million. We plan to repatriate an additional $245 million of foreign cash over the next several years. Due to certain tax planning strategies, we anticipate that we will generate a tax benefit of approximately $12 million with respect to future repatriation of accumulated earnings. We have adjusted the tax reserve accordingly. No further repatriation of accumulated prior period foreign earnings is currently planned. However, if circumstances change, we will provide for and pay any applicable additional U.S. taxes in connection with repatriation of offshore funds. It is not practical at this time to determine the income tax liability that would result from any further repatriation of accumulated foreign earnings. Credit and Liquidity Risk Cash and cash equivalent deposits involve certain credit and liquidity risks. We maintain our cash and cash equivalents with a number of high quality financial institutions or funds and from time to time may have concentrations with one or more of these institutions. The balances with these financial institutions or funds and their credit quality are monitored on an ongoing basis. Off-Balance Sheet Arrangements Off-balance sheet arrangements, as defined by the Securities and Exchange Commission ("SEC"), include certain contractual arrangements pursuant to which a company has an obligation, such as certain contingent obligations, certain guarantee contracts, retained or contingent interest in assets transferred to an unconsolidated entity, certain derivative instruments classified as equity or material variable interests in unconsolidated entities that provide financing, liquidity, market risk or credit risk support. Disclosure is required for any off-balance sheet arrangements that have, or are reasonably likely to have, a material current or future effect on our financial condition, results of operations, liquidity or capital resources. We generally do not enter into off-balance sheet arrangements, as defined, other than those described in the Contractual Obligations section 54 --------------------------------------------------------------------------------



that follows and Consolidation discussed in Critical Accounting Policies and Notes 1 and 17 of Notes to Consolidated Financial Statements.

CONTRACTUAL AND CONTINGENT OBLIGATIONS

We have contractual obligations to make future payments, principally in connection with our long-term debt, non-cancelable lease agreements, acquisition agreements and service agreements. See Notes 6 and 8 of Notes to Consolidated Financial Statements for additional disclosures related to our commitments.



The following table sets forth these contractual obligations (in millions) by fiscal year, and excludes contractual obligations of CIVs, as we are not responsible or liable for these obligations:

2015 2016 2017 2018 2019 Thereafter Total Contractual Obligations Long-term borrowings by contract maturity(1) $ 0.4 $ - $ - $ - $ - $ 1,050.0$ 1,050.4 Interest on long-term borrowings and credit facility commitment fees(1) 59.8 59.8 59.8 58.7 58.3 580.4 876.8 Minimum rental and service commitments 134.3 115.7 97.6 87.1 72.9 351.2 858.8 Total Contractual Obligations 194.5 175.5 157.4 145.8 131.2 1,981.6 2,786.0 Contingent Obligation Payments related to business acquisitions(2) - 25.0 10.0 33.0 20.0 - 88.0 Total Contractual and Contingent Obligations(3)(4)(5)(6) $ 194.5$ 200.5$ 167.4$ 178.8$ 151.2$ 1,981.6$ 2,874.0 (1) Excludes current portion of long-term borrowings of the consolidated CLO of $79.2 million and interest on these borrowings, as applicable. (2) The amount of contingent payments reflected for any year represents the



maximum amount that could be payable, using the exchange rate between the

British pound and U.S. dollar as of March 31, 2014, for the amounts due in

fiscal 2016 and fiscal 2018, at the earliest possible date under the terms

of the business purchase agreements. The contingent obligation had a fair

value of $29.6 million as of March 31, 2014.

(3) The table above does not include approximately $34.5 million in capital

commitments to investment partnerships in which Legg Mason is a limited

partner. These obligations will be funded, as required, through the end of

the commitment periods running through fiscal 2021. (4) The table above does not include amounts for uncertain tax positions of



$55.7 million (net of the federal benefit for state tax liabilities),

because the timing of any related cash outflows cannot be reliably estimated.



(5) The table above does not include redeemable noncontrolling interests,

primarily related to CIVs, of $45.1 million, because the timing of any related cash outflows cannot be reliably estimated.



(6) The table above excludes potential obligations arising from the ultimate

settlement of awards under the management equity plans with key employees

of Permal and ClearBridge due to the uncertainty of the timing and amounts

ultimately payable. See Notes 1 and 11 of Notes to Consolidated Financial

Statements for additional information regarding management equity plans.

MARKET RISK We maintain an enterprise risk management program to oversee and coordinate risk management activities of Legg Mason and its subsidiaries. Under the program, certain risk activities are managed at the subsidiary level. The following describes certain aspects of our business that are sensitive to market risk. Revenues and Net Income (Loss) The majority of our revenue is calculated from the market value of our AUM. Accordingly, a decline in the value of the underlying securities will cause our AUM, and thus our revenues, to decrease. In addition, our fixed income and liquidity AUM are subject to the impact of interest rate fluctuations, as rising interest rates may tend to reduce the market value of bonds held in various mutual fund portfolios or separately managed accounts. In the ordinary course of our business, we may also reduce or waive investment management fees, or limit total expenses, on certain products or services for particular time periods to manage fund expenses, or for other reasons, and to help retain or increase managed assets. Performance fees may be earned on certain investment advisory contracts for exceeding performance benchmarks, and strong markets tend to increase these fees. Declines in market values of AUM will result in reduced fee revenues and net income. We generally earn higher fees on equity assets than fees charged for fixed income and liquidity assets. Declines in market values of AUM in this asset class will disproportionately impact our revenues. In addition, under revenue sharing agreements, 55 -------------------------------------------------------------------------------- certain of our affiliates retain different percentages of revenues to cover their costs, including compensation. Our net income (loss), profit margin and compensation as a percentage of operating revenues are impacted based on which affiliates generate our revenues, and a change in AUM at one subsidiary can have a dramatically different effect on our revenues and earnings than an equal change at another subsidiary.



Trading and Non-Trading Assets Our trading and non-trading assets are comprised of investment securities, including seed capital in sponsored mutual funds and products, limited partnerships, limited liability companies and certain other investment products.

Trading and other current investments, excluding CIVs, at March 31, 2014 and 2013, subject to risk of security price fluctuations are summarized below (in thousands). 2014



2013

Investment securities, excluding CIVs: Trading investments relating to long-term incentive compensation plans

$ 109,648



$ 86,583 Trading investments of proprietary fund products and other trading investments

335,456



228,156

Equity method investments relating to long-term incentive compensation plans, proprietary fund products and other investments

22,622



56,341

Total current investments, excluding CIVs $ 467,726



$ 371,080

Approximately $33.7 million and $39.2 million of trading and other current investments related to long-term incentive compensation plans as of March 31, 2014 and 2013, respectively, have offsetting liabilities such that fluctuation in the market value of these assets and the related liabilities will not have a material effect on our net income (loss) or liquidity. However, it will have an impact on our compensation expense with a corresponding offset in other non-operating income (expense). Trading and other current investments of $90.0 million and $91.1 million at March 31, 2014 and 2013, respectively, relate to other long-term incentive plans for which the related liabilities do not completely offset due to vesting provisions. Therefore, fluctuations in the market value of these trading investments will impact our compensation expense, non-operating income (expense) and net income (loss). Approximately $344.0 million and $240.8 million of trading and other current investments at March 31, 2014 and 2013, respectively, are investments in proprietary fund products and other investments for which fluctuations in market value will impact our non-operating income (expense). Of these amounts, the fluctuations in market value related to approximately $19.9 million and $13.8 million of proprietary fund products as of March 31, 2014 and 2013, respectively, have offsetting compensation expense under revenue share agreements. The fluctuations in market value related to approximately $109.8 million and $71.9 million in proprietary fund products as of March 31, 2014 and 2013, respectively, are substantially offset by gains (losses) on market hedges and therefore do not materially impact Net Income (Loss) Attributable to Legg Mason, Inc. Investments in proprietary fund products are not liquidated before the related fund establishes a track record, has other investors, or a decision is made to no longer pursue the strategy.



Non-trading assets, excluding CIVs, at March 31, 2014 and 2013, subject to risk of security price fluctuations are summarized below (in thousands).

2014 2013 Investment securities, excluding CIVs: Available-for-sale $ 12,072$ 12,400 Investments in partnerships, LLCs and other 24,464 31,143



Equity method investments in partnerships and LLCs 62,973 68,780 Other investments

90 99 Total non-trading assets, excluding CIVs $ 99,599$ 112,422 Investment securities of CIVs totaled $50.5 million and $24.8 million as of March 31, 2014 and 2013, respectively, and investments of CIVs totaled $31.8 million and $210.6 million as of March 31, 2014 and 2013, respectively. As of March 31, 2014 and 2013, we held equity investments in the CIVs of $39.4 million and $39.1 million, respectively. Fluctuations in the market value of investments of CIVs in excess of our equity investment will not impact Net Income (Loss) Attributable 56 -------------------------------------------------------------------------------- to Legg Mason, Inc. However, it may have an impact on other non-operating income (expense) of CIVs with a corresponding offset in Net income (loss) attributable to non-controlling interests.



Valuation of trading and non-trading investments is described below within Critical Accounting Policies under the heading "Valuation of Financial Instruments." See Notes 1 and 14 of Notes to Consolidated Financial Statements for further discussion of derivatives.

The following is a summary of the effect of a 10% increase or decrease in the market values of our financial instruments subject to market valuation risks at March 31, 2014 (in thousands): Fair Value Fair Value Assuming a Assuming a Carrying Value 10% Increase(1) 10% Decrease(1) Investment securities, excluding CIVs: Trading investments relating to long-term incentive compensation plans $ 109,648 $ 120,613 $ 98,683 Trading investments of proprietary fund products and other trading investments 335,456 369,002 301,910 Equity method investments relating to long-term incentive compensation plans, proprietary fund products and other investments 22,622 24,884 20,360 Total current investments, excluding CIVs 467,726 514,499 420,953 Investments in CIVs 39,434 43,377 35,491 Available-for-sale investments 12,072 13,279 10,865 Investments in partnerships, LLCs and other 24,464 26,910 22,018 Equity method investments in partnerships and LLCs 62,973 69,270 56,676 Other investments 90 99 81 Total investments subject to market risk $ 606,759 $ 667,434 $ 546,084



(1) Gains and losses related to certain investments in deferred compensation

plans and proprietary fund products are directly offset by a corresponding

adjustment to compensation expense and related liability. In addition,

investments in proprietary fund products of approximately $109.8 million

have been economically hedged to limit market risk. As a result, a 10% increase or decrease in the unrealized market value of our financial instruments subject to market valuation risks would result in a



$32.8 million increase or decrease in our pre-tax earnings as of March 31,

2014.



Also, as of March 31, 2014 and 2013, cash and cash equivalents included $456.6 million and $485.8 million, respectively, of money market funds.

Foreign Exchange Sensitivity We operate primarily in the U.S., but provide services, earn revenues and incur expenses outside the U.S. Accordingly, fluctuations in foreign exchange rates for currencies, principally in the U.K., Brazil, Japan, Canada, Singapore, Australia, and those denominated in the euro, may impact our comprehensive income (loss) and net income (loss). We and certain of our affiliates have entered into forward contracts to manage a portion of the impact of fluctuations in foreign exchange rates on their results of operations. We do not expect foreign currency fluctuations to have a material effect on our net income (loss) or liquidity. Interest Rate Risk Exposure to interest rate changes on our outstanding debt is substantially mitigated as our $650 million of 5.5% senior notes and $400 million of 5.625% senior notes are at fixed interest rates. See Note 6 of Notes to Consolidated Financial Statements for additional disclosures regarding debt. 57 --------------------------------------------------------------------------------



CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Accounting policies are an integral part of the preparation of our financial statements in accordance with accounting principles generally accepted in the United States of America. Understanding these policies, therefore, is a key factor in understanding our reported results of operations and financial position. See Note 1 of Notes to Consolidated Financial Statements for a discussion of our significant accounting policies and other information. Certain critical accounting policies require us to make estimates and assumptions that affect the amounts of assets, liabilities, revenues and expenses reported in the financial statements. Due to their nature, estimates involve judgment based upon available information. Therefore, actual results or amounts could differ from estimates and the difference could have a material impact on the consolidated financial statements.



We consider the following to be our critical accounting policies that involve significant estimates or judgments.

Consolidation

In the normal course of our business, we sponsor and are the manager of various types of investment vehicles. For our services, we are entitled to receive management fees and may be eligible, under certain circumstances, to receive additional subordinate management fees or other incentive fees. Our exposure to risk in these entities is generally limited to any equity investment we have made or are required to make and any earned but uncollected management fees. Uncollected management fees from managed investment vehicles were not material at March 31, 2014, and we have not issued any investment performance guarantees to these investment vehicles or their investors. In accordance with financial accounting standards on consolidation, we consolidate various sponsored investment vehicles, some of which are separately identified as CIVs. Certain investment vehicles we sponsor and are the manager of are considered to be variable interest entities ("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 we have a controlling financial interest in the investment vehicle, absent substantive investor rights to replace the manager of the entity (kick-out rights). We may also fund the initial cash investment in certain VRE investment vehicles to generate an investment performance track record in order to attract third-party investors in the product. These "seed capital investments" are consolidated as long as Legg Mason maintains a controlling financial interest in the product, but they are not included as CIVs. We may also hold a longer-term controlling financial interest in sponsored investment fund VREs which have third-party investors and are consolidated and included as CIVs. A VIE is an entity which does not have adequate equity to finance its activities without additional subordinated financial support; or the equity investors, as a group, do not have the normal characteristics of equity for a potential controlling financial interest. Investment Company VIEs For most sponsored investment funds deemed to be investment companies, including money market funds, we determine if we are the primary beneficiary of a VIE if we absorb a majority of the VIE's expected losses, or receive a majority of the VIE's expected residual returns, if any. Our determination of expected residual returns excludes gross fees paid to a decision maker if certain criteria are met. In determining whether we are the primary beneficiary of an investment company VIE, we consider 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 us; related party (including employees') ownership; guarantees and implied relationships. In determining the primary beneficiary, we must make assumptions and estimates about, among other things, the future performance of the underlying assets held by the VIE, including investment returns, cash flows, and credit and interest rate risks. In determining whether a VIE is significant for disclosure purposes, we consider the same factors used for determination of the primary beneficiary. Other VIEs For other sponsored investment funds that do not meet the investment company criteria, such as collateralized debt obligation entities and CLO entities, if we have a significant variable interest, we determine if we are the primary beneficiary of the VIE if we have 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. We determine whether we have a variable interest in a VIE by considering if, among other things, we have the obligation to absorb losses, or the right to receive benefits, that are expected to be significant to the VIE. We consider the management fee structure, including the seniority level of our fees, the current and expected economic performance of the entity, as well as other provisions included in the governing documents that might restrict or guarantee an expected loss or residual return. 58 -------------------------------------------------------------------------------- In evaluating whether we have the obligation to absorb losses, or the right to receive benefits, that could potentially be significant to the VIE, we consider factors regarding the design, terms, and characteristics of the investment vehicles, including the following qualitative factors: if we have involvement with the investment vehicle beyond providing management services; if we hold equity or debt interests in the investment vehicle; if we have transferred any assets to the investment vehicle; if the potential aggregate fees in future periods are insignificant relative to the potential cash flows of the investment vehicle; and if the variability of the expected fees in relation to the potential cash flows of the investment vehicle is more than insignificant.



We must consolidate any VIE for which we are deemed to be the primary beneficiary.

See Note 17 of Notes to Consolidated Financial Statements for additional discussion of CIVs and other VIEs.

Revenue Recognition The vast majority of our revenues are calculated as a percentage of the fair value of our AUM. The underlying securities within the portfolios we manage, which are not reflected within our consolidated financial statements, are generally valued as follows: (i) with respect to securities for which market quotations are readily available, the market value of such securities; and (ii) with respect to other securities and assets, fair value as determined in good faith. For most of our mutual funds and other pooled products, their boards of directors or similar bodies are responsible for establishing policies and procedures related to the pricing of securities. Each board of directors generally delegates the execution of the various functions related to pricing to a fund valuation committee which, in turn, may rely on information from various parties in pricing securities such as independent pricing services, the fund accounting agent, the fund manager, broker-dealers, and others (or a combination thereof). The funds have controls reasonably designed to ensure that the prices assigned to securities they hold are accurate. Management has established policies to ensure consistency in the application of revenue recognition. As manager and advisor for separate accounts, we are generally responsible for the pricing of securities held in client accounts (or may share this responsibility with others) and have established policies to govern valuation processes similar to those discussed above for mutual funds that are reasonably designed to ensure consistency in the application of revenue recognition. Management relies extensively on the data provided by independent pricing services and the custodians in the pricing of separate account AUM. Separate account customers typically select the custodian. Valuation processes for AUM are dependent on the nature of the assets and any contractual provisions with our clients. Equity securities under management for which market quotations are available are usually valued at the last reported sales price or official closing price on the primary market or exchange on which they trade. Debt securities under management are usually valued at bid, or the mean between the last quoted bid and asked prices, provided by independent pricing services that are based on transactions in debt obligations, quotations from bond dealers, market transactions in comparable securities and various other relationships between securities. Short-term debt obligations are generally valued at amortized cost, which is designed to approximate fair value. The vast majority of our AUM is valued based on data from third parties such as independent pricing services, fund accounting agents, custodians and brokers. This varies slightly from time to time based upon the underlying composition of the asset class (equity, fixed income and liquidity) as well as the actual underlying securities in the portfolio within each asset class. Regardless of the valuation process or pricing source, we have established controls reasonably designed to assess the reasonableness of the prices provided. Where market prices are not readily available, or are determined not to reflect fair value, value may be determined in accordance with established valuation procedures based on, among other things, unobservable inputs. Management fees on AUM where fair values are based on unobservable inputs are not material. As of March 31, 2014, equity, fixed income and liquidity AUM values aggregated $186.4 billion, $365.2 billion and $150.2 billion, respectively. As the vast majority of our AUM is valued by independent pricing services based upon observable market prices or inputs, we believe market risk is the most significant risk underlying the value of our AUM. Economic events and financial market turmoil have increased market price volatility; however, the valuation of the vast majority of the securities held by our funds and in separate accounts continues to be derived from readily available market price quotations. As of March 31, 2014, less than 1% of total AUM is valued based on unobservable inputs. 59 -------------------------------------------------------------------------------- Valuation of Financial Instruments Substantially all financial instruments are reflected in the financial statements at fair value or amounts that approximate fair value, except our long-term debt. Trading investments, investment securities and derivative assets and liabilities included in the Consolidated Balance Sheets include forms of financial instruments. Unrealized gains and losses related to these financial instruments are reflected in Net Income (Loss) or Other Comprehensive Income (Loss), depending on the underlying purpose of the instrument. For equity investments where we do not control the investee, and where we are not the primary beneficiary of a variable interest entity, but can exert significant influence over the financial and operating policies of the investee, we follow the equity method of accounting. The evaluation of whether we exert control or significant influence over the financial and operational policies of an investee requires significant judgment based on the facts and circumstances surrounding each individual investment. Factors considered in these evaluations may include investor voting or other rights, any influence we may have on the governing board of the investee, the legal rights of other investors in the entity pursuant to the fund's operating documents and the relationship between us and other investors in the entity. Substantially all of our equity method investees are investment companies which record their underlying investments at fair value. Therefore, under the equity method of accounting, our share of the investee's underlying net income or loss predominantly represents fair value adjustments in the investments held by the equity method investee. Our share of the investee's net income or loss is based on the most current information available and is recorded as a net gain (loss) on investments within non-operating income (expense). For investments, we value equity and fixed income securities using closing market prices for listed instruments or broker or dealer price quotations, when available. Fixed income securities may also be valued using valuation models and estimates based on spreads to actively traded benchmark debt instruments with readily available market prices. We evaluate our non-trading investment securities for "other than temporary" impairment. Impairment may exist when the fair value of an investment security has been below the adjusted cost for an extended period of time. If an "other than temporary" impairment is determined to exist, the difference between the adjusted cost of the investment security and its current fair value is recognized as a charge to earnings in the period in which the impairment is determined. For investments in illiquid or privately-held securities for which market prices or quotations are not readily available, the determination of fair value requires us to estimate the value of the securities using a variety of methods and resources, including the most current available financial information for the investment and the industry. As of March 31, 2014 and 2013, excluding investments in CIVs, we owned approximately $0.3 million and $0.4 million, respectively, of financial investments that were valued on our assumptions or estimates and unobservable inputs. At March 31, 2014 and 2013, we also had approximately $87.4 million and $99.9 million, respectively, of other investments, such as investment partnerships, that are included in Other noncurrent assets on the Consolidated Balance Sheets, of which approximately $63.0 million and $68.8 million, respectively, are accounted for under the equity method. The remainder is accounted for under the cost method, which considers if factors indicate there may be an impairment in the value of these investments. In addition, as of March 31, 2014 and 2013, we had $22.6 million and $56.3 million, respectively, of equity method investments that are included in Investment securities on the Consolidated Balance Sheets. The accounting guidance for fair value measurements and disclosures defines fair value and establishes a framework for measuring fair value. The accounting guidance defines fair value as the exchange price that would be received for an asset or paid to transfer a liability in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. A fair value measurement should reflect all of the assumptions that market participants would use in pricing the asset or liability, including assumptions about the risk inherent in a particular valuation technique, the effect of a restriction on the sale or use of an asset, and the risk of non-performance. The accounting guidance for fair value measurements establishes a hierarchy that prioritizes the inputs for valuation techniques used to measure fair value. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. 60 --------------------------------------------------------------------------------



Our financial instruments measured and reported at fair value are classified and disclosed in one of the following categories:

Level 1 - Financial instruments for which prices are quoted in active markets, which, for us, include investments in publicly traded mutual funds with quoted market prices and equities listed in active markets. Level 2 - Financial instruments for which prices are quoted for similar assets and liabilities in active markets; prices are quoted for identical or similar assets in inactive markets; or prices are based on observable inputs, other than quoted prices, such as models or other valuation methodologies. For us, this category may include repurchase agreements, fixed income securities and certain proprietary fund products. This category also includes CLO loans and derivative liabilities of a CIV.



Level 3 - Financial instruments for which values are based on unobservable inputs, including those for which there is little or no market activity. This category includes investments in partnerships, limited liability companies, private equity funds and CLO debt of a CIV. This category may also include certain proprietary fund products with redemption restrictions.

The valuation of an asset or liability may involve inputs from more than one level of the hierarchy. The level in the fair value hierarchy within which a fair value measurement in its entirety falls is determined based on the lowest level input that is significant to the fair value measurement in its entirety. Proprietary fund products and certain investments held by CIVs are valued at net asset value ("NAV") determined by the fund administrator. These funds are typically invested in exchange traded investments with observable market prices. Their valuations may be classified as Level 1, Level 2 or Level 3 based on whether the fund is exchange traded, the frequency of the related NAV determinations and the impact of redemption restrictions. For investments in illiquid and privately-held securities (private equity and investment partnerships) for which market prices or quotations may not be readily available, including certain investments held by CIVs, management must estimate the value of the securities using a variety of methods and resources, including the most current available financial information for the investment and the industry to which it applies in order to determine fair value. These valuation processes for illiquid and privately-held securities inherently require management's judgment and are therefore classified in Level 3. The fair values of CLO loans and bonds are determined based on prices from well-recognized third-party pricing services that utilize available market data and are therefore classified as Level 2. Legg Mason has established controls designed to assess the reasonableness of the prices provided. The fair value of CLO debt is valued using a discounted cash flow methodology. Inputs used to determine the expected cash flows include assumptions about forecasted default and recovery rates that a market participant would use in determining the fair value of the CLO's underlying collateral assets. Given the significance of the unobservable inputs to the fair value measurement, the CLO debt valuation is classified as Level 3. Exchange traded options are valued using the last sale price or in the absence of a sale, the last offering price. Options traded over the counter are valued using dealer supplied valuations. Options are classified as Level 1. Futures contracts are valued at the last settlement price at the end of each day on the exchange upon which they are traded and are classified as Level 1. As a practical expedient, we rely on the NAVs of certain investments as their fair value. The NAVs that have been provided by investees are derived from the fair values of the underlying investments as of the reporting date. As of March 31, 2014, approximately 2% of total assets (11% of financial assets measured at fair value) and 5% of total liabilities meet the definition of Level 3. Excluding the assets and liabilities of CIVs, approximately 1% of total assets (7% of financial assets measured at fair value) and 1% of liabilities meet the definition of Level 3.



Any transfers between categories are measured at the beginning of the period.

See Note 3 of Notes to Consolidated Financial Statements for additional information.

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Intangible Assets and Goodwill

Balances as of March 31, 2014, are as follows (in thousands): Amortizable asset management contracts $ 9,969 Indefinite-life intangible assets 3,109,004 Trade names

52,800 Goodwill 1,240,523 $ 4,412,296 Our identifiable intangible assets consist primarily of asset management contracts, contracts to manage proprietary mutual funds or funds-of-hedge funds, and trade names resulting from acquisitions. Asset management contracts are amortizable intangible assets that are capitalized at acquisition and amortized over the expected life of the contract. Contracts to manage proprietary mutual funds or funds-of-hedge funds are indefinite-life intangible assets because we assume that there is no foreseeable limit on the contract period due to the likelihood of continued renewal at little or no cost. Similarly, trade names are considered indefinite-life intangible assets because they are expected to generate cash flows indefinitely. In allocating the purchase price of an acquisition to intangible assets, we must determine the fair value of the assets acquired. We determine fair values of intangible assets acquired based upon projected future cash flows, which take into consideration estimates and assumptions including profit margins, growth or attrition rates for acquired contracts based upon historical experience, estimated contract lives, discount rates, projected net client flows and market performance. The determination of estimated contract lives requires judgment based upon historical client turnover and attrition rates and the probability that contracts with termination provisions will be renewed. The discount rate employed is a weighted-average cost of capital that takes into consideration a premium representing the degree of risk inherent in the asset, as more fully described below.



Goodwill represents the residual amount of acquisition cost in excess of identified tangible and intangible assets and assumed liabilities.

Given the relative significance of our intangible assets and goodwill to our consolidated financial statements, on a quarterly basis we consider if triggering events have occurred that may indicate a significant change in fair values. Triggering events may include significant adverse changes in our business, legal or regulatory environment, loss of key personnel, significant business dispositions, or other events, including changes in economic arrangements with our affiliates that will impact future operating results. If a triggering event has occurred, we perform quantitative tests, which include critical reviews of all significant factors and assumptions, to determine if any intangible assets or goodwill are impaired. We consider factors such as projected cash flows and revenue multiples, to determine whether the value of the assets is impaired and the indefinite-life assumptions are appropriate. If an asset is impaired, the difference between the value of the asset reflected on the consolidated financial statements and its current fair value is recognized as an expense in the period in which the impairment is determined. If a triggering event has not occurred, we perform quantitative tests annually at December 31, for indefinite-life intangible assets and goodwill, unless we can qualitatively conclude that it is more likely than not that the respective fair values exceed the related carrying values. We completed our annual impairment tests of goodwill and indefinite-life intangible assets as of December 31, 2013, and determined that there were no impairments in the value of these assets as of that date. Further, no impairments in the values of amortizable intangible assets was recognized during the year ended March 31, 2014, as our estimates of the related future cash flows exceeded the asset carrying values. We have also determined that no triggering events have occurred as of March 31, 2014, therefore, no additional indefinite-life intangible asset and goodwill impairment testing was necessary. As a result of uncertainty regarding future market conditions, assessing the fair value of the reporting unit and intangible assets requires management to exercise significant judgment. Amortizable Intangible Assets Intangible assets subject to amortization are considered for impairment at each reporting period using an undiscounted cash flow analysis. Significant assumptions used in assessing the recoverability of management contract intangible assets include projected cash flows generated by the contracts and the remaining lives of the contracts. Projected cash flows are based on fees generated by current AUM for the applicable contracts. Contracts are generally assumed to turnover evenly throughout the life of the intangible asset. The remaining life of the asset is based upon factors such as average client retention and client turnover rates. If the amortization periods are not appropriate, the expected lives are adjusted and the impact on the 62 --------------------------------------------------------------------------------



fair value is assessed. Actual cash flows in any one period may vary from the projected cash flows without resulting in an impairment charge because a variance in any one period must be considered in conjunction with other assumptions that impact projected cash flows.

The estimated remaining useful lives of amortizable intangible assets currently range from one to five years with a weighted-average life of approximately 3.2 years.

Indefinite-Life Intangible Assets For intangible assets with lives that are indeterminable or indefinite, fair value is determined from a market participant's perspective based on projected discounted cash flows, taking into account the values market participants would pay in a taxable transaction to acquire the respective assets. We have two primary types of indefinite-life intangible assets: proprietary fund contracts and, to a lesser extent, trade names. We determine the fair value of our intangible assets based upon discounted projected cash flows, which take into consideration estimates of future fees, profit margins, growth rates, taxes, and discount rates. An asset is determined to be impaired if the current implied fair value is less than the recorded carrying value of the asset. The determination of the fair values of our indefinite-life intangible assets is highly dependent on these estimates and changes in these inputs could result in a material impairment of the related carrying values. If an asset is impaired, the difference between the current implied fair value and the carrying value of the asset reflected on the financial statements is recognized as an expense in the period in which the impairment is determined to exist. Contracts that are managed and operated as a single unit, such as contracts within the same family of funds, are reviewed in aggregate and are considered interchangeable because investors can transfer between funds with limited restrictions. Similarly, cash flows generated by new funds added to the fund group are included when determining the fair value of the intangible asset. The Fauchier acquisition completed by Permal in March 2013 included a funds-of-hedge fund business, which, as intended, has been merged with the existing Permal fund business through common management, shared resources (including infrastructure, employees and processes) and co-branding initiatives. Accordingly, the related carrying values and cash flows of these funds have been aggregated for impairment testing. Projected cash flows are based on annualized cash flows for the applicable contracts projected forward 40 years, assuming annual cash flow growth from estimated net client flows and projected market performance. To estimate the projected cash flows, projected AUM growth rates by affiliate are used. Cash flow growth rates consider estimates of both AUM flows and market expectations by asset class (equity, fixed income and liquidity) and by investment manager based upon, among other things, historical experience and expectations of future market and investment performance from internal and external sources. Currently, our market growth assumptions are 6% for equity, 3% for fixed income, and 0% for liquidity products, with a general assumption of 2% organic growth for all products, subject to exceptions for organic growth or contraction in near-term periods. The starting point for these assumptions is our corporate planning process that includes three-year AUM projections from the management of each operating affiliate that consider the specific business circumstances of each affiliate, with near-year flow assumptions for certain affiliates adjusted, as appropriate, to reflect a market participant view. Beyond year three, the estimates move towards our general organic growth assumption of 2%, as appropriate for each affiliate and asset class, through year 20. The resulting cash flow growth rate for year 20 is held constant and used to further project cash flows through year 40. Based on projected AUM by affiliate and asset class, affiliate advisory fee rates are applied to determine projected revenues. The domestic mutual fund contracts projected revenues are applied to a weighted-average margin for the applicable affiliates that manage the AUM. Margins are based on arrangements currently in place at each affiliate. Projected operating income is further reduced by an appropriate tax rate to calculate the projected cash flows. We believe our growth assumptions are reasonable given our consideration of multiple inputs, including internal and external sources, although our assumptions are subject to change based on fluctuations in our actual results and market conditions. Our assumptions are also subject to change due to, among other factors, poor investment performance by one or more of our operating affiliates, the withdrawal of AUM by clients, changes in business climate, adverse regulatory actions, or loss of key personnel. We consider these risks in the development of our growth assumptions and discount rates, discussed further below. Further, actual cash flows in any one period may vary from the projected cash flows without resulting in an impairment charge because a variance in any one period must be considered in conjunction with other assumptions that impact projected cash flows. 63 -------------------------------------------------------------------------------- Our process includes comparison of actual results to prior growth projections. However, differences between actual results and our prior projections are not necessarily indicative of a need to reassess our estimates given that: our discounted projected cash flow analyses include projections well beyond three years and variances in the near-years may be offset in subsequent years; fair value assessments are point-in-time, and the consistency of a fair value assessment with other indicators of value that reflect expectations of market participants at that point-in-time is critical evidence of the soundness of the estimate of value. In subsequent periods, we consider the differences in actual results from our prior projections in considering the reasonableness of the growth assumptions used in our current impairment testing. Discount rates are based on appropriately weighted estimated costs of debt and equity capital using a market participant perspective. We estimate the cost of debt based on published debt rates. We estimate the cost of equity capital based on the Capital Asset Pricing Model, which considers the risk-free interest rate, peer-group betas, and company and equity risk premiums. The equity risk is further adjusted to consider the relative risk associated with each Legg Mason indefinite-life intangible asset and our reporting unit. The discount rates are also calibrated based on an assessment of relevant market values.



Consistent with standard valuation practices for taxable transactions, the projected discounted cash flow analysis also factors in a tax benefit value, as appropriate. This tax benefit represents the discounted tax savings a third party that purchased an asset on a given valuation date would receive from future tax deductions for the amortization of the purchase price over 15 years.

The domestic mutual fund contracts acquired in the Citigroup Asset Management ("CAM") transaction of $2,106 million, account for approximately 65% of our indefinite-life intangible assets. As of December 31, 2013, approximately $138 billion of AUM, primarily managed by ClearBridge and Western Asset, are associated with this asset, with approximately 40% in equity AUM and 30% in each of long-term fixed AUM and liquidity AUM. Although our domestic mutual funds overall have maintained strong recent market performance, previously disclosed uncertainties regarding market conditions and asset flows and more recent assessments of related risk, including risks related to potential regulatory changes in the liquidity business, are reflected in our projected discounted cash flow analyses. Based on our projected discounted cash flow analyses, the related fair value exceeded its carrying value by approximately $450 million. For our impairment test, cash flows from the domestic mutual fund contracts are assumed to have annual growth rates that average approximately 6%, but given current uncertainties, reflect only moderate AUM inflows in years 1 and 2. Projected cash flows of the domestic mutual fund contracts are discounted at 14.0%, reflecting the business factors noted above. Results for the 12 months through December 31, 2013, generally compared favorably to the growth assumptions related to the domestic mutual fund contracts asset impairment testing at December 31, 2012. We believe that investment performance also has a significant influence on our domestic mutual fund contract long-term flows, and that continued out-performance will favorably impact our flows. In aggregate, 61% of our domestic mutual fund long-term AUM is in funds that have outpaced their three-year Lipper category average at December 31, 2013, which has improved from 33% at September 30, 2008. Generally, there tends to be a four to five-year lag before improved investment performance results in increased asset flows. In addition, we believe a recent reorganization of our distribution platform, which provides an improved focus on the growth of our business, has also favorably impacted our flows. The improvement in investment performance has assisted distribution personnel in selling more products. As a result of improved performance and the reorganization of the distribution platform, our U.S. distribution group has had net inflows for the 12 months through December 31, 2013. Assuming all other factors remain the same, our actual results and/or changes in assumptions for the domestic mutual fund contracts cash flow projections over the long-term would have to deviate approximately 20% or more from previous projections, or the discount rate would have to be raised from 14.0% to 16.0%, for the asset to be deemed impaired. Given the current uncertainty regarding future market conditions, it is reasonably possible that fund performance, flows and AUM levels may decrease in the near term such that actual cash flows from the domestic mutual funds contracts could deviate from the projections by approximately 20% or more and the asset could be deemed to be impaired by a material amount. The Permal funds-of-hedge funds contracts of $692 million account for approximately 20% of our indefinite-life intangible assets. Permal has experienced recent outflows and increased risk associated with its business. The past several years have seen declines in the traditional high net worth client fund-of-hedge funds business, Permal's historical focus, which Permal has offset to some extent with new institutional business. Despite these factors, the impact of the acquired Fauchier business, 64 -------------------------------------------------------------------------------- which has experienced better revenues, including performance fees, than originally projected, contributed to actual results which marginally exceeded previous projections for the Permal funds-of-hedge funds contracts used in the asset impairment testing at December 31, 2012. As a result of continued risk with its business, in our December 2013 testing, the near-term growth assumptions for these contracts were reduced. Further, fund-of-hedge fund managers are subject to unique market and regulatory influences, adding additional uncertainty to our estimates. Based upon our projected discounted cash flow analyses, the fair value of the Permal funds-of-hedge funds contracts asset exceeded its carrying value by $70 million. Cash flows on the Permal funds-of-hedge funds contracts are assumed to have an average annual growth rate of approximately 7%. However, given current experience, projected cash flows reflect moderate AUM outflows in year one, and no net AUM flows in year two, trending to moderate AUM inflows in year three. Investment performance, including its expected impact on future asset flows, is a significant factor in our growth projections for the Permal funds-of-hedge funds contracts. Our market performance projections are supported by the fact that Permal's two largest funds that comprise approximately half of the contracts asset AUM have 10-year average returns exceeding 5%. Our market projections are further supported by industry statistics. The projected cash flows from the Permal funds-of-hedge funds contracts are discounted at 15.5%, reflecting the factors noted above. Assuming all other factors remain the same, our actual results and/or changes in assumptions for the Permal funds-of-hedge funds contracts cash flow projections over the long-term would have to deviate approximately 10% or more from previous projections, or the discount rate would have to be raised from 15.5% to 16.5%, for the asset to be deemed impaired. Given the current uncertainty regarding future market conditions, it is reasonably possible that fund performance, flows and AUM levels may decrease in the near term such that actual cash flows from the Permal funds-of-hedge funds contracts could deviate from the projections by approximately 10% or more and the asset could be deemed to be impaired by a material amount. Trade names account for 2% of indefinite-life intangible assets and are primarily related to Permal. We tested these intangible assets using assumptions similar to those described above for indefinite-life contracts. The resulting fair values of the trade names significantly exceeded the related carrying amounts.



Goodwill

Goodwill is evaluated at the reporting unit level and is considered for impairment when the carrying amount of the reporting unit exceeds the implied fair value of the reporting unit. In estimating the implied fair value of the reporting unit, we use valuation techniques based on discounted projected cash flows and EBITDA multiples, similar to techniques employed in analyzing the purchase price of an acquisition. Legg Mason continues to be managed as one Global Asset Management operating segment. Internal management reporting of discrete financial information regularly received by the chief operating decision maker, our Chief Executive Officer, is at the consolidated Global Asset Management business level. As a result, goodwill is recorded and evaluated at one Global Asset Management reporting unit level. Our Global Asset Management reporting unit consists of the operating businesses of our asset management affiliates and our centralized global distribution operations. In our impairment testing process, all consolidated assets (except for certain tax benefits) and liabilities are allocated to our single Global Asset Management reporting unit. Similarly, the projected operating results of the reporting unit include our holding company corporate costs and overhead, including costs associated with executive management, finance, human resources, legal and compliance, internal audit and other central corporate functions. Goodwill principally originated from the acquisitions of CAM, Permal and Royce. The value of the reporting unit is based in part, on projected consolidated net cash flows, including all cash flows of assets managed in our mutual funds, closed-end funds and other proprietary funds, in addition to separate account assets of our managers. Significant assumptions used in assessing the implied fair value of the reporting unit under the discounted cash flow method are consistent with the methodology discussed above for indefinite-life intangible assets. Also, at the reporting unit level, future corporate costs are estimated and consolidated with the projected operating results of all our affiliates. Actual cash flows in any one period may vary from the projected cash flows without resulting in an impairment charge because a variance in any one period must be considered in conjunction with other assumptions that impact projected cash flows. For the reporting unit discounted projected cash flow analysis, projected cash flows, on an aggregate basis across all asset classes, are assumed to have an average annual growth rate of approximately 8%. 65 -------------------------------------------------------------------------------- Discount rates are based on appropriately weighted estimated costs of debt using a market participant perspective, also consistent with the methodology discussed above for indefinite-life intangible assets. For our impairment test as of December 31, 2013, the projected cash flows were discounted at 14.5% to determine their present value, reflecting the company/asset specific factors noted above. We also perform a market-based valuation of our reporting unit value, which applies an average of EBITDA multiples paid in change of control transactions for peer companies to our EBITDA. The observed average EBITDA multiple utilized was 11.0x, from 11 asset management transactions dated January 2010 through December 2012. The results of our two estimates of value for the reporting unit (the discounted cash flow and EBITDA multiple analyses) are compared and any significant difference is assessed to determine the reasonableness of each value and whether any adjustment to either result is warranted. Once the values are accepted, the appropriately weighted average of the two reporting unit valuations (the discounted cash flow and EBITDA multiple analyses) is used as the implied fair value of our Global Asset Management reporting unit, which at December 31, 2013, exceeded the carrying value by a material amount. Considering the relative merits of the details involved in each valuation process, we used an equal weighting of the two values for the December 2013 testing. We further assess the accuracy of the reporting unit value determined from these valuation methods by comparing their results to our market capitalization to determine an implied control premium. The reasonableness of this implied control premium is considered by comparing it to control premiums that have been paid in relevant actual change of control transactions. This assessment provides evidence that our underlying assumptions in our analyses of our reporting unit fair value are reasonable. In calculating our market capitalization for these purposes, market volatility can have a significant impact on our capitalization, and if appropriate, we may consider the average market prices of our stock for a period of one or two months before the test date to determine market capitalization. A control premium arises from the fact that in an acquisition, there is typically a premium paid over current market prices of publicly traded companies that relates to the ability to control the operations of an acquired company. Further, assessments of control premiums in the asset management industry are difficult because many acquisitions involve privately held companies, or involve only portions of a public company, such that no control premium can be calculated. Asset manager transactions are often valued on EBITDA multiples which, absent unusual circumstances, have generally been consistently priced in a range of 8x to 13x EBITDA over the past several years. Recent market evidence regarding control premiums suggest values of 13% to 79% as realistic and common and we believe such premiums to be a reasonable range of estimation for our equity value. Based on our analysis and consideration, we believe the implied control premium determined by our reporting unit value estimation at December 31, 2013, which is at the lower end of the observed range, is reasonable.



Stock-Based Compensation Our stock-based compensation plans include stock options, an employee stock purchase plan, market-based performance shares payable in common stock, restricted stock awards and units, management equity plans and deferred compensation payable in stock. Under our stock compensation plans, we issue equity awards to directors, officers, and key employees.

In accordance with the applicable accounting guidance, compensation expense for the years ended March 31, 2014, 2013 and 2012, includes compensation cost for all non-vested share-based awards at their grant date fair value amortized over the respective vesting periods on the straight-line method. Also, under the accounting guidance, cash flows related to income tax deductions in excess of or less than the stock-based compensation expense are classified as financing cash flows. We granted 1.2 million, 1.0 million, and 0.8 million stock options in fiscal 2014, 2013 and 2012, respectively. During fiscal 2014, we also implemented management equity plans for two of our affiliates and granted units to certain of their employees that entitle them to participate in 15% of the future growth of the respective affiliate's enterprise value (subject to appropriate discounts). For additional information on share-based compensation, see Note 11 of Notes to Consolidated Financial Statements. We determine the fair value of each option grant using the Black-Scholes option-pricing model, except for market-based grants, for which we use a Monte Carlo option-pricing model. Both models require management to develop estimates regarding certain input variables. The inputs for the Black-Scholes model include: stock price on the date of grant, exercise price of the option, dividend yield, volatility, expected life and the risk-free interest rate, all of which, with the exception of the grant date stock price and the exercise price, require estimates or assumptions. We calculate the dividend yield based 66 -------------------------------------------------------------------------------- upon the average of the historical quarterly dividend payments over a term equal to the expected life of the options. We estimate volatility equally weighted between the historical prices of our stock over a period equal to the expected life of the option and the implied volatility of market listed options at the date of grant. The expected life is the estimated length of time an option will be held before it is either exercised or canceled, based upon our historical option exercise experience. The risk-free interest rate is the rate available for zero-coupon U.S. Government issues with a remaining term equal to the expected life of the options being valued. If we used different methods to estimate our variables for the Black-Scholes and Monte Carlo models, or if we used a different type of option-pricing model, the fair value of our option grants might be different. We also determine the fair value of affiliate management equity plan grants using the Black-Scholes option-pricing model, subject to any post-vesting illiquidity discounts. Inputs to the Black-Scholes model are generally determined in a fashion similar to the fair value of grants of options in our own stock, described above. However, because our affiliates are private companies without quoted stock prices, we utilize discounted cash flow analyses and market-based valuations, similar to those discussed above under the heading "Intangible Assets and Goodwill", to determine the respective business enterprise values, subject to appropriate discounts for lack of control and marketability. Income Taxes We are subject to the income tax laws of the federal, state and local jurisdictions of the U.S. and numerous foreign jurisdictions in which we operate. We file income tax returns representing our filing positions with each jurisdiction. Due to the inherent complexities arising from conducting business and being taxed in a substantial number of jurisdictions, we must make certain estimates and judgments in determining our income tax provision for financial statement purposes. These estimates and judgments are used in determining the tax basis of assets and liabilities and in the calculation of certain tax assets and liabilities that arise from differences in the timing of revenue and expense recognition for tax and financial statement purposes. Management assesses the likelihood that we will be able to realize our deferred tax assets. If it is more likely than not that the deferred tax asset will not be realized, then a valuation allowance is established with a corresponding increase to deferred tax provision. Substantially all of our deferred tax assets relate to U.S. and U.K. taxing jurisdictions. As of March 31, 2014, U.S. federal deferred tax assets aggregated $763 million, realization of which is expected to require $3.8 billion of future U.S. earnings, approximately $673 million of which must be in the form of foreign source income. Deferred tax assets generated in U.S. jurisdictions resulting from net operating losses generally expire 20 years after they are generated and those resulting from foreign tax credits generally expire 10 years after they are generated. Based on estimates of future taxable income, using assumptions consistent with those used in our goodwill impairment testing, it is more likely than not that current federal tax benefits relating to net operating losses are realizable and no valuation allowance is necessary at this time. With respect to those resulting from foreign tax credits, it is more likely than not that tax benefits relating to the utilization of $39.9 million foreign tax credits as credits will not be realized and an additional valuation allowance of $2.3 million was recorded in fiscal 2014 with respect thereto. In addition, a valuation allowance was established in prior years for the substantial portion of our deferred tax assets relating to U.K. taxing jurisdictions. While tax planning may enhance our positions, the realization of current tax benefits is not dependent on any significant tax strategies. As of March 31, 2014, U.S. state deferred tax assets aggregated $180 million. Due to limitations on the utilization of net operating loss carryforwards and taking into consideration state tax planning strategies, we recognized an additional valuation allowance of $8.6 million during fiscal 2014. Additionally, $34.8 million of fully reserved deferred tax assets relating to U.S. state capital loss carryforwards expired unused during fiscal 2014. Due to the uncertainty of future state apportionment factors and future effective state tax rates, the value of state net operating loss benefits ultimately realized may vary. An increase in the valuation allowance against certain U.K. deferred tax assets of $0.5 million, which resulted in a full valuation allowance, was also recorded in fiscal 2014. To the extent our analysis of the realization of deferred tax assets relies on deferred tax liabilities, we have considered the timing, nature and jurisdiction of reversals, as well as, future increases relating to the tax amortization of goodwill and indefinite-life intangible assets. In the event we determine all or any portion of our deferred tax assets that are not already subject to a valuation allowance are not realizable, we will be required to establish a valuation allowance by a charge to the income tax provision in the period in which that determination is made. Depending on the facts and circumstances, the charge could be material to our earnings. 67 -------------------------------------------------------------------------------- The calculation of our tax liabilities involves uncertainties in the application of complex tax regulations. We recognize liabilities for anticipated tax uncertainties in the U.S. and other tax jurisdictions based on our estimate of whether, and the extent to which, additional taxes will be due.



RECENT ACCOUNTING DEVELOPMENTS

See discussion of Recent Accounting Developments in Note 1 of Notes to Consolidated Financial Statements.

EFFECTS OF INFLATION

The rate of inflation can directly affect various expenses, including employee compensation, communications and technology and occupancy, which may not be readily recoverable in charges for services provided by us. Further, to the extent inflation adversely affects the securities markets, it may impact revenues and recorded intangible asset and goodwill values. See discussion of "Market Risk - Revenues and Net Income (Loss)" and "Critical Accounting Policies - Intangible Assets and Goodwill" previously discussed.



ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - Market Risk" for disclosures about market risk.

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