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

Good afternoon, everyone, and welcome to the RBC Capital Markets Global Financial Institutions Conference. My name is Kenneth Lee, and I'm the Senior Equity Analyst, covering U.S. Asset Manager sector. And welcome to our fireside chat with Federated Hermes. I am very pleased to have with us Chris Donahue, President, CEO and Chairman; as well as Ray Hanley, President, Federated Investors Management Company responsible for Investor Relations. Mr. Donahue has served as President and CEO of the company since 1998. And as a reminder, Federated Hermes is an asset manager with roughly $620 billion of AUM and one of the top players in the money market fund industry. The company manages assets across the spectrum, including equity, fixed income, alternatives and multi-asset categories. Mr. Donahue, Mr. Hanley, thank you for joining us.

Well, thank you, Ken. It's a pleasure to be here.

Thank you, Ken.

Now we're going to keep this discussion relatively interactive. For those of you who are participating on our webcast, you may submit questions at any time online, and we will try to address them throughout the session. I'll start off with a few questions. Chris, let's talk about ESG. It's an area we've seen gaining a lot more interest from clients. Federated Hermes has an extensive lineup of offerings, including the EOS business as well as several ESG-focused funds. What are you seeing in terms of demand from clients? And perhaps, could you tell us how Federated is integrating ESG into its investment processes? And then what do you think is a longer-term outlook for ESG?

Well, thank you, Ken. You packed a lot in that one. And I'll go through it, looking at client interest, integration, EOS and longer-term outlook. And so on the client interest side, we did a survey last summer to find out what the lay of the land was. And 9 out of 10 of our financial advisers reported being asked about ESG by their clients. And almost 90% of those underlying investors were asking about the E factor. 2/3 were asking about the S factor and more than half on the governance factor. And so we thought that was quite interesting from a client viewpoint. Interestingly, we also discovered that people are becoming more sophisticated, that it just isn't a negative screening or exclusionary thing, declare victory and move on. And that 2/3 of the high net worth investors from our survey and 3/4 of the institutions focused on positive screenings because everybody now knows that you can catch companies doing it right. So that was sort of a client interest from our own survey. There has been many surveys, but one in particular was released last month where $7 trillion of assets were analyzed. And basically, almost 2/3 of the respondent said that ESG criteria are important in selecting a manager. And then when you add up whether people think it's highly important or moderately important, for analyzing ESG, 90% of the investors felt that way. So it's an increasing situation. And in terms of EOS, this is our service for doing engagement. And now we're at $1.4 trillion of assets under advisement for engagement purposes. Importantly, with 67 people with field and subject matter expertise and 15 years of proprietary data, which give us a real leg up on being able to make a forward-looking judgment about a company. And this has led us to enthusiastically integrate the ESG into all of our teams state side. Hermes, for its part, was always ESG throughout, through and through. But we created a responsibility investment office and that has been their job over the last 18 months. This effort was really led first to accomplish the task was liquidity and then high yield and strategic value and bond fund -- to return bond fund. And what's involved here is an authentic integration of ESG, which means you have the ESG tools and data. You've got documentation, ways to measure active engagement. You have proof statements, prospectus language and sales literature. And so you take this whole package of client interest, our EOS, the integration. And our long-term outlook is that this is going to be pervasive and for the long term. And it's going to impact all investments as we go forward. And one important distinction to maintain is the difference between a fiduciary and an impact view of these products. And yes, we have excellent impact ESG funds and a few of them are on the Hermes side with excellent flows so far this year and last year for that matter. And then the distinction about a fiduciary. And most of our clients are fiduciaries, who are looking to maximize the returns. And you can do that with a positive look at ESG as long as your goal is to maximize return to the investor. And so it's good to keep in mind the distinction between a fiduciary and an impact fund, and we're able to score on both streets. That's a little long for that question. But Ken, you put a lot in that one.

I hear you. That is great color. That is great color that. Let's move on to the topic of money market funds, given very low short-term interest rates, there's been a lot of focus on minimum yield fee waivers for money market funds. And so far, the impact to pretax operating income has been relatively benign, and you've given some guidance for a potential impact in the first quarter. Wondering if you could outline how recent move in short-term rates, including repo rates, could be potentially impacting that guidance?

Well, we're not altering the guidance. We said on the calls that we were about $14 million of waiver, maintaining yield waivers for Q1. We had said it was $9 million for the fourth quarter, and we're not really going to make a projection for the second quarter until our next earnings call. And so that's where we are. Now in terms of the guts of the question though is to what's going on with recent moves in short rates to influence all that? Well, there's been a lot. There've been a lot of noise that overall, what you have is a lot of money and not as much supply of paper like T-bills on the short end. So therefore, you have lower overnight repo rates. And over the last couple of weeks, they've been near the bottom of 1 to 3 basis points. And the T-bills, if you go out the curve just a little bit, they're in the 3 to 8 basis point range. So they're low rates. And what do we think this does? Well, come the second half of the year, we're thinking this thing is all going to improve, and it could improve earlier if the following occurs. For example, we figure it's about a 50-50 shot, throw a coin flip that the Fed will put 5 basis points on the reverse repo and maybe add 5 to the IOER. That would be a meaningful move. And part of the reason for that is to get more rate on the short side to keep the machinery well greased and proceeding ahead. Another one that could happen is moving the tax date from April 15 to July 15, like they did last year. This would basically diminish the amount of money that washes up on the treasury's beach. And therefore, would be a better deal for them issuing more supply. And maybe they keep what's known as the SLR impact for the rest of the year. They haven't said what they're going to do. So there are a few things like that. Then you have the stimulus that's coming out. Over time, we'd expect that would both add assets to our assets under management and add a couple of bps down the road to the basic interest rates as well. So that's kind of a quick survey.

Got you. That's very helpful. That's very helpful. Now we've seen very strong money market fund asset growth in 2019 and the year 2020 was a year of 2 halves, so to speak. What's your outlook on money market funds asset growth this year? And perhaps, could you give us a sense of what will be the key factors that can determine that asset growth this year?

Yes. The -- we expect the money fund assets to be up. Some of the reasons for that are, you still have increasing money supply numbers, look at any chart, look at M2, people have been writing about it. So that's more money. With this stimulus, you're going to print a lot of more money, and that money has to float around. And we saw it the last time that some of that money ends up in our funds, at least for a certain amount of time. Overall, the money funds are already willing to enable a cash management service. And that gets a little bit into what's going on on the deposit side. And if you look at it all during corona time from March to March, the deposits are up $3 trillion. When banks don't want the money, that's about 23%. And the money funds were up about $650 billion, and that's about 18%. So everybody is up because everybody's got a lot of cash. And I think that will continue on. The banks are lowering their rates on deposits because they don't want them for a whole host of reasons. And the money funds, even though we are waiving will still be a warm and loving home as a cash management service.

Got you. Got you. That's very helpful. That's very helpful. And then moving on to fixed income net flows or net flows in general, I mean, fixed income net flows have been very strong for Federated Hermes recently. And your company has posted 3 quarters of very strong net inflows. What would be the key drivers that you're seeing that's driving that kind of trend? And do you think this is sustainable, especially as you look out recent changes in interest rates?

Well, on the fixed income flows, let's talk about the numbers first and then about its sustainability. On the fixed income side, the flows of quarter-to-date as of March 5, were $2.75 billion. That's to the good. And that is occasioned by 2 dozen fund products with positive flows. And 8 of those in different varieties with more than $100 million. So you've got an across-the-board thing from munis, even some high yield, the short, short intermediates. And of course, ultrashorts. So this sets a stepping stone to the sustainability of it. Just because Buffett says bonds aren't the best, doesn't mean that everybody goes to 0. The pension funds and the advisers are committed to a certain portion of their assets in fixed income. So there's going to be a lot of bond buying in any event. Then there are products that worked very well, depending on how you think rates are going to move or inflation. Our chips product has been getting increasing attention from our clientele. The total return bond fund has excellent downside protection. And as I mentioned a bunch of those products with positive flows are in the short and short intermediate area as people search for yield. So the fixed income business for us for decades has been sustainable. And we think that we have the product offerings to keep that going. And that's sort of the plan for a franchise for all seasons.

Got you. And you mentioned the net flows quarter-to-date on the fixed income side. Just wondering, more broadly, what are you seeing in terms of net flows elsewhere within the business so far quarter-to-date.

So far, quarter-to-date, on the equity side, Ken, the funds, the funds are up $650 million and the SMAs on the equity side are down about $400 million. So a net of a positive flow of $250 million. Obviously, if you combine that with the $2.75 billion in fixed income, you have a $3 billion number year-to-date. And just to make the same kind of comments I made on the fixed income side, there are 19 funds with positive flows, which include 4 of the -- of our U.K. compatriots managed out of London on -- that are -- many of them -- several of them are impact funds. And we're proud to have them as part of the whole group. So that's sort of the rest of the story there. On the rest of the funds, it's not enough to move the dial. The alts are up a little bit, but not in those kinds of numbers and not enough to move off of the $3 billion number.

Got you. That's very helpful. That's very helpful. And Chris, you've talked recently about potentially generating more institutional mandates, at least down the line with Hermes products and you've been adding to your institutional sales force as well. Wondering if you could just give us any kind of updates on the progress so far.

Well, our Hermes U.K. is gaining with its GEMS product, which is global emerging markets. We are working on mandates here in the U.S. I can't announce any at this point, but there are some live ones on our 4 and these are worthwhile things. I know it's not exactly on point to what you're asking, but we also have some pretty good things where some of the former Hermes people are able to present our trade finance overseas. And we're liking what we're seeing there as well.

Got it. And then moving over to the alternative side. The acquisition of Hermes had given you a meaningful presence within the alternative side on namely private markets, and multi-asset categories as well. What's your latest view on growth opportunities in these areas? And where could we see -- potentially see some meaningful asset growth every single year term?

Okay. The most likely places to see asset growth in this calendar year would be on the alternative side in the unconstrained credit, and we're seeing good flows there where the flows have been $50 million, $90 million, those kinds of numbers. We think we can put some points on the Board with European direct lending, which comes out of the private market side. We think we could add assets in the private equity side by offer -- by another offering of our funds sometime this year. That's running back to the same clients. Overall, however, on the private market side, it's a longer-term thing before we move the dial by bringing that to the U.S. We have a New York office. We've hired a sales individual in the U.S. to tell the story, and we're doing that. On the real estate side, this is an outstanding opportunity. Chris Taylor over there was instrumental in that whole King's Cross development, which is a northern London development with 8 million square feet and 50 buildings, some rehabs, some new. And the proof of this is that it's been done in sustainable style while creating value. And there's a smaller one down in Birmingham that has the same kind of attributes. Bringing that over to the U.S. will take some work. And that's not a 21 deal where you'll see meaningful assets there. But the methodology and the results are certainly something we'd like to bring stateside. And I already mentioned about the private equity. The infrastructure will probably take a little longer. But overall, the private markets have a great long-term potential. And as I've said before, it's probably enough potential to make it as big as the whole operation is now. But as I mentioned, the 3 things I thought you'd get to near-term growth would be unconstrained credit, direct lending and some bucks in on the private equity side.

That's great. That's great. That's great color there. Now just switching topics. Let's talk about M&A. We've certainly seen a lot of discussion around potential for M&A activity in the sector. And in the past, you stated that acquisitions remains the highest and best use of excess capital. Just wondering, do you still hold that view. And what could be some potential opportunities that you see right now?

Yes, I do still hold that view. And as for current opportunities, it would be more roll up type situations. The deal we did with PNC a little over a year ago, has been outstanding. And the international growth of fund operation that came out of that is terrific. I mean they have a fun now that is we that is basically top decile, 1, 3 and 5 and among the top 1% or 2% going back almost a quarter of a century. So those kinds of things we're always looking for. Then you have certain bolt-ons that we've talked about before that we like maybe a muni SMA. But in terms of a lot of these big hairy deals that have been going through, they aren't so attractive to us because we'd rather spend time organizing organic growth than trying to do financial engineering and synergies, which are all good and set companies up for the long haul, and they're all fine and good. It's just that, that's how we approach it. So that's what we're looking at.

Got you. That's very helpful. That's very helpful. And then just to round out the discussion, so to speak, in terms of capital allocation, wonder if you can just share with us any updated thinking about share repurchases.

Well, we like the share repurchases. We continue to be active. And our rule of thumb is that we don't describe how many shares we bought until the end of the quarter. But we have always completed our programs, and we have every intention of completing the program we're on now, which has about 1.4 million shares left in it, something like that. So we continue to look to do that. The methodology used is to value the stock on a go-forward basis and make sure we're making a good investment with some money there. We tend to -- as you've noticed since we've been public to keep the shares as a total going down and to have bought enough shares to take care of the shares that we issue to people for compensation purposes.

That's great. And then just moving over to the topic of expenses. How do you think about operating expenses for this year? Do you envision expense levels recovering back to what you saw pre-COVID in terms of levels as the economy recovers?

Well, let's talk about travel. Travel expense is way the heck down last year. And is way the heck down in Q1, and it isn't going to come back in Q2. Q3, maybe it will start and maybe be back by Q4. Okay. In the meantime because we sold $60 billion worth of investment product last year as compared to $43 billion the year before, sales bonuses are all up way in excess of those travel savings. So that's one way of looking at the travel expenses. In terms of rent, we're not looking to save space at this point. We're not looking to add space, even though we're adding people. And we envision the return to work, including more space for the people that are here and therefore, keeping the same footprint. Now frankly, both here and in London, we're under long-term leases and yes, you can have food fights with landlords and stuff like that, but we're not interested in doing that. We'd rather reconfigure and get people back working on collaboration and culture to set the stage for the future. In terms of other expenses, what really drives the truck around here are expenses that are kind of self-correcting. Investment bonuses, sales bonuses, executive bonuses that are more related to how things go. And those are things that are self-correcting. The final comment I'd make on expenses is that we continue to invest for growth in the technology, in new products like some micro-short products, which are positioned in between money market funds and all for short funds, the ETF products that are going to come out midyear. These are active ETFs because we're kind of indifferent about what shell we're on. The 6 new products that are managed by our colleagues in London, and other things to help with the internals of the whole operation requires substantial technology investments. So all of that will continue a pace.

Got you. That's very helpful color there. Well, we just have time for one more question. So I'll ask this one about regulation. Since the publication of the report on potential reform options for the money market fund industry last December, there has been discussion on what could happen next. Could you just share with us your views on the likelihood of potential regulatory reform and perhaps maybe share with us as well, which options could be the most workable?

The most workable option, Ken, is to eliminate the marriage of the 30% weekly liquidity requirement with notice and an evaluation of whether to put fees and gates on money funds. Clients hate fees and gates. We told the regulators that this was unwise, and it would create unnatural trigger and that is exactly what happened. So eliminating that would be a very, very strong positive for resiliency. On the rest of it, where could it go and what is it well, the President's working group came up with a whole gang of things which we thought have been killed before. It's rather like the night of the living dead. And some of these zombies are back like a minimum balance at risk and swing pricing, capital buffers, liquidity exchange banks, all things which were found unworkable and basically kill the money fund. And the fact that these will get considered again, we have to deal with them, but I don't think they will work out. Remember, the money funds are a very, very, very successful $4 trillion player right at the spear point of offering market rates on short-term securities. So they buy securities from issuers and have investors invested in them. And it exactly at the time when the banks don't want the money. So all of these features, I think, and we will be working hard and happily to enhance the resiliency of money funds, but not do silly regulations, which cause them unnecessary problems.

Got it. Thanks again for your view there. That's very helpful. Well, our time is up now. So I'd like to take this opportunity to once again thank Chris and Ray for joining us today. Thank you, everyone.

Thank you, Ken.

Thanks, Ken.

Take care.