Federated Hermes, Inc. (FHI) Earnings Call Transcript & Summary

Good morning, everyone, and welcome to the Bank of America Securities Future of Financials Virtual Conference. I'm Mike Carrier, the research analyst at BofA, covering the brokers, asset managers and exchanges. And I hope you're all doing well. Our next company up is Federated Hermes. And with us today are Chris Donahue, President and CEO; and Ray Hanley, who heads up Investor Relations. Chris and Ray, thanks for being with us today.

Doing very well. [indiscernible] We're doing it.

Thanks, Chris. I want to start out, just a bigger-picture question, since there's been more M&A in the sector of late, and you guys were early with Hermes. Just like stepping back on the Hermes transaction, what were some of the factors that drove Federated to first consider that transaction and then ultimately to do the Hermes deal?

Well, Michael, back years ago, as many as 6 or 7 years ago, I've been telling The Street, all the analysts, that we were looking for such a partner. To us, the key was the culture and the people. And we were looking for an international footprint that included excellence in both investment management and in sales. We also wanted complementary products because we weren't after one of these synergy deals that basically means shooting people. And the ESG elements were very, very timely and pervade the entire market. So we basically had 5.5 years of cultural due diligence in looking at Hermes. We started talking to them at the end of 2012 and knew that the culture and the people matched up and gave us the things that we were looking for. So that's what drove us, and that's how we looked at that deal.

Got it. That makes sense. It's been -- you guys just start this year, you had kind of a rebranding effort. Obviously it's been a tougher year for those efforts given the dynamic. But how is the strategic relationship with Hermes been playing out versus expectations? And where are you seeing some of the more attractive product or distribution opportunities going forward?

Well, we were very grateful that we got our rebranding effort kicked off pre-COVID. So we had an exciting, delightful time of ringing the bell on the New York Stock Exchange, just like when we went public in '98. And that gave a quite a successful message to the marketplace and to our friends at Hermes in the U.K. that what we were working on was what I termed a reverse transformational merger. And that gets into how the strategic relationship has blossomed, so that we have launched 5 funds and an SMA for distribution in the U.S. on Hermes strategy. So we put up an engagement fund, which is a -- pretty much a $1 billion fund they have; a high-yield credit, which is a $500 million fund they have; a global equity, which is over $1 billion; a small cap -- global small-cap fund; and a SMID product of $700 million and put all those products together. So that was a pretty good step right there. And then we combined the distribution so that we took our Frankfurt office and sales on the continent and turned it over to our U.K. partners, and took the Asia Pacific and did the same thing. Whereas in Latin America, we just recently approved hiring an individual for that, being run out of the United States. Importantly, we've continued on the integration of ESG into the various investment teams at Federated. And this is a serious effort that goes through 3 different stages, so that you can really tell the story about the legitimacy of this effort to investors that are interested in this. And we go through an analysis and a customization [Audio Gap] competing for these type of mandates. So we think that the Hermes relationship has done very, very well, and we are very pleased with how it's going.

Okay. Great. That was helpful. And then one of the areas that are -- that Hermes has more exposure relative to what Federated had before within like the alternative area. And earlier this year, there were 2 transactions, the MEPC and then the HGPE. And so just wanted to get -- like how are you guys are thinking about that part of the business and incorporating that more into Federated in your distribution channels, and where you see the opportunity longer term?

Well, using the letters, of course, HGPE and MEPC, GP is the private equity business. And there, we also include infrastructure. And the MPC is the real estate business. And longer term, not now but starting in '21, we would start to expect to see some activity. In terms of the private equity, we're thinking of raising some money in [ PEC 5 ] next year. I don't know how much it will be, but it will be in the hundreds of millions, but that's on the scoreboard for entry in 2021. And on infrastructure and real estate, it will take a longer time before those things come into play. But notice that we're building these things for the long haul. These are not going to be catalysts for 2021, but they are very strong ingredients for the future of Federated Hermes.

Okay. Great. And then one other one on Hermes. They have the EOS business, and there's a lot of kind of opportunity, whether it's for strategic and growth opportunities there. And then with investors, really around the world, the focus on sustainable and ESG investing has picked up more traction. And it seems like there's a lot of kind of structural demand over the coming years. And so how have you integrated like ESG throughout the organization? And then on the EOS side, how do you think about that as -- like a -- I don't know, sort of a unique kind of strategic opportunity for the firm?

Well, I've already mentioned about the integration of the ESG into the various investment teams at Federated through that 3-stage mechanism maturing in the proof statement. And there are several of our teams that are already fully integrated to include liquidity, high-yield and Strategic Value Dividend. Now as we talk about EOS, we even have a slide at Page 11 on this. And some of the things we're proud of here is that we have been at this for 15 years, and that gives you a lot of data that is very, very sound on this subject. We've increased the staff to 65, and those are 65 people dedicated to EOS efforts. And those are not the regular equity analysts being double counted. And we've got $1.2 trillion, that's up $100 billion since we looked at this before last year. And we engaged over 1,000 companies a year with 2 to 3 various engagement subjects. But all those are just the numbers. What's really important that this is taking a long-term view and engagement activities, where we're looking in the 5- to 10-year range of what's being accomplished in the subjects that we're engaging on. And it is also investor-driven. And what that means is that this group of investors who put the $1.2 trillion together are determining which companies to engage with and what subjects to engage on. So this is not a pontifical decision that's made. It's made by a real live investor group for the long haul. And we think that it gives a unique aspect to the Federated Hermes enterprise and gives us a set of data this...

Chris, are you still there?

Yes, sir.

Okay. I think you cut out for a little bit, but I think I got the gist of it. Maybe just shifting over to fixed income. So flows at Federated have been robust, and you guys talked about the institutional pipeline remaining healthy. I think there's a lot of kind of debate or conversations on the outlook for fixed income because on one hand, you've got this low-rate backdrop; on the other hand, you do have kind of demographic and risk tolerance trends that still favor some of these products. So I wanted to get your perspective on what you guys are seeing, and if you're starting to see more of a shift into -- whether it's the higher yielding, the riskier areas? Or do you still see a decent amount of demand in the rate or the short duration type of product as well?

Well, let's just go right out the curve. We still see a lot of interest in the money markets. And I know we'll probably get into that in a moment, but we're looking for higher highs and higher lows. Obviously then you go to the next step, and that's the Ultrashorts. And here, we had over $1 billion of net sales in the third quarter. And the interest in Ultrashorts is continuing. As you move further out on Total Return Bond Fund and Short-Intermediate Total Return Bond Fund, again, over $1 billion of positive sales in the third quarter. And then you throw in some high-yield at about $400 million in net positives. But overall, we've got 23 funds with positive flows in the third quarter. And I'm pretty sure this was an all-time high, and it's in all sections. And this is what we're seeing from clients. They are talking about it, and they are investing in it. And on the separate count side, we're seeing the highest interest in short duration and actual core. And so that's been pretty good. And we have an outstanding record on the fixed income SMAs, which are doing well also. So overall, the fixed income picture is pretty strong. And as we mentioned on the call, we have about $1.8 billion of pipeline that's coming in, that includes a number of the things I've already talked about, but it also includes the Absolute Return Credit mandates that have been won by U.K. Hermes. And that makes for a real diversified strong package of fixed income products that have attracted a lot of interest in the marketplace.

Okay. That's helpful. And maybe if the environment does start to shift, given how much stimulus has been used globally and if we do start to get more inflation and higher interest rates, how do you expect that to impact the fixed income business? And how would Federated perform in that backdrop?

Well, if you have more stimulus, that will increase shorter-term rates, which will obviously help the money market fund business in general and help to further diminish waivers. And we already talked about with the waivers. We told everybody it were $9 million and then looking forward to that. So if you -- and that's based on decent stimulus. So that's what would happen there. The key for Federated is to have a franchise for all seasons. So that whatever the marketplace is going, whatever the Fed is doing, what's ever going on in the marketplace, we have an array of product solutions for the customers. So we are looking forward to continued strong fixed income activities here in the near future but are well-prepared for the alternative side of that as well.

Okay. And just shifting over to the equity side of business. Whether it's the industry or Federated, there's been more challenges there just given some of the industry trends. And so when you step back and you look at like Federated lineup of products, how -- where do you see some of the strategies where there's more like differentiation and you're seeing demand versus some of the areas that may be impacted by more -- the -- what we're seeing in terms of the industry headwinds and the shift to passive across the different offerings that you have?

Yes. So in terms of overall, then I'll talk about specifics. In terms of overall, some of the industry strategies that are running into challenges are index-hugging. And as you know, our whole ethos is high active share-type investments. And the second general point I would make is that ESG and the analysis of the risk involved there pervades all of the strategies. And so these are things that are very helpful to us. Now on this -- on specific ones, you look at the top quartile 3-year records that we have, and it's a good gang of funds. Obviously the Kaufmann Small Cap, but we have an emerging market equity and international growth; a Global Emerging Market, Europe, ex-U.K., international; and a global allocation fund; the regular Kaufmann fund, an MDT balanced fund, such that we had 16 equity funds that had positive sales in the quarter, even though the flows on equity were negative for the quarter. So it's a very strong array of quality solution. And then part of the secret sauce that Federated offers is long-term, build-up relationships. And that's one of the reasons why we had $45 billion worth of overall sales throughout the enterprise in the first 3 quarters, an all-time record, even during corona times and you couldn't travel. So we're in an anomalous situation where the travel budget is just they're down, but the sales bonus allocations are up. And part of the reason is that these relationships are strong, and the quality of the solutions being offered was strong, meaning the funds themselves, the mandates, the portfolio construction and risk analysis that is available and all of the thought leadership videos and webinars that we provided during these times. So that [Audio Gap] the fall, even during a pandemic.

Great. Okay. And then maybe just one more on the equity side. If I look at Strategic Value Dividend -- and on one hand, you have an attracted yield and the lower rate backdrop. So you expect that, that would be fairly interesting and in demand. But we've still seen the -- on the net flow side, still a muted new environment. Just curious, when you talk to the sales folks and the clients and the distribution, what's the main like pushback, I mean, on that product in this environment?

Well, the main pushback is a belief that this fund would have done better in these kinds of circumstances. But if you look at it on a year-to-date basis against the Dow Jones Dividend Index, that fund is beating that index by 400 basis points and the same on a year-over-year basis. And if you get a turn to value versus growth, that fund is going to do quite well. But the main response we have, the challenge of that fund is that it's put in the wrong Morningstar category, which we've mentioned 100 times, and that it continues to do what it says it does, which is invest in high-dividend companies that are -- we think, are very high-quality businesses. So we're going to stick to the knitting there, and we think it's a very, very valuable part of the franchise.

Okay. That's helpful. And then maybe -- you hit on money markets. We first started talking about fixed income, but maybe just a few other questions on that front. So if I look over the past few years, Federated has done a very good job in terms of growing the money market assets and gaining market share. In this past quarter, we started to see some normalization as some of that cash is put to work and some clients re-risk. So how do you think about the impact on asset levels when you come off of these big growth [indiscernible] ? And when you think about the different distribution channels or the client types, where do you kind of expect to see more of that kind of modernization or normalization versus areas that you could continue to see some growth?

Part of the strength of this entire franchise is the diversification of the client base so that you have a lot of different people moving a lot of different ways, from state pools to trust departments, to broker-dealers, to institutions, to individuals coming in, in different ways. And so since we put this money market business together back in the '70, interestingly enough, I was the one involved as a lawyer writing the prospectus for money market management back then. We have seen consistently higher highs and higher lows, and you can see that on our charts. So that is what we expect. We also expect more favorable conditions in 2021. And this comes from our investment team headed up by Debbie Cunningham, and I am repeating her and her team's view of that. And so the beauty of the business underneath is that cash management is needed all the time. Remember that even in a trust department, there's 20% of the money in cash all the time even if you're fully invested. And so there's a tremendous need for these products. And we have been able to maintain market share during this time frame at about a little over 8%, and we would expect to continue to do that. And then periodically, you have opportunities to make jumps in market share, as we did with the PNC deal last year, where people decided to get out of that business and come to what I call a warm and loving home at the Federated liquidity franchise.

Okay. Great. And then maybe just one more on the money market side. There's some seasonality in that business that we typically see like throughout the year. And just curious, in this environment, when you have these elevated like asset levels or given the rate environment, does that tend to like be different in this environment? Or do you still tend to see some of that seasonality?

Well, even though you have elevated levels, remember that the cash is a portion of the overall investment portfolio. So if you look at the entire market going up and you take a percent of that, it's going to be in cash, it goes up per force. If you take a look at the money supply, the money market and the cash part of that whole machinery, it's going up as well. So you have underlying strengths to the buildup of that business. And then you have, as I said, the diversification of the kinds of clients that we have. So over the decades, we've seen a lot of ups and downs and a lot of crazy stuff. And you've still got a very, very, very resilient business. And in this circumstance, I think that the money market funds showed themselves to be a net additive to liquidity because the government funds were up, oh, I don't know, $300 billion or $400 billion. Even if you take all of the money that was in prime over there, there was more than that added to the government funds. And so the money funds were a welcome addition to the liquidity profile of the marketplace even during COVID times.