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 am the Senior Equity Analyst covering the U.S. Asset Management Sector. And welcome to our fireside chat with Federated Hermes. I am very pleased to have with us Chris Donahue, Chairman, CEO and President; as well as Ray Hanley, President, Federated Investors, responsible for the Investor Relations. Mr. Donahue has served as President and CEO of the company since 1998. As a reminder, Federated Hermes is an asset manager, with roughly $669 billion of assets under management 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.

Thank you for having us Ken.

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.

With that, let's start off with a few questions. Let's start off with money market funds. Negative impact from minimum yield fee waivers are expected to decline rapidly over the next few quarters given the potential increases in short-term rates. And you've given some guidance around potentially impacting it in the first quarter. What gives you confidence in your guidance, assuming rates rise as the markets expect? And what would you highlight as factors that could impact the guidance, either to the upside or to the downside?

Okay. Let's just review from the earnings call what we said about these the negative impact on operating income from minimum yield waivers. In the fourth quarter, it was about $38 million, we expected Q1 to improve about to $22 million. Then if you have the 25 basis point rate increase here next week, then we would expect Q2 to go down about 90% or improved by 90% of the $22 million, basically almost wiping it out. And of course, these expectations are based on 100 things we're going to yield to asset levels, warranties, asset mix and every other factor now in demand. Okay. But when Paul says last week, he wants 25, which our CIO has been saying 25 for a long time. That's -- it's about the bets are about 92% now. So we're thinking they're going to do 25, and the other rates have moved up in anticipation of that. So if you look at the 3 months T-bills, that averaged about 5 in the fourth quarter, now they're in the mid-30s. If you look at the 6-month bills, they averaged 6, now they are up to around 70, and that repo rate won't move until the Fed moves and that's what goes on. So then as to the future, what we like, we like that old term measured. So we like the 25, and you can see why. The first 25 basically wipes out the majority of those waivers, but it also enables a money market fund to catch up to the spot rate faster than 50 or even higher increases. And we believe that they are going to be on track to do the 25. How many they'll do, that's 4 to 6. It all depends on who you're talking to. So that -- changing that would change some of where the interest rates go. But once we get the first increase, we're good to go in terms of the operating income.

Great. That's helpful. And then somewhat relatedly, I wonder if you could just talk about your outlook for money market fund AUM growth this year. And perhaps could you give us a sense of what will be the key factors that could determine money market fund asset growth this year, especially considering what could happen in a backdrop with rising rates?

Well, it is rising rates will drive the truck, but there are other factors, too, for example, a total risk-off scenario in the marketplace due to exogenous black swan events, such as going on over in Ukraine, could cause people to want to get back into money funds. But I think they have this discussion, we've got to look at the money markets overall, the way we look at it as our liquidity business, which includes both funds and separate accounts. And they were about $435 billion recently compared to $448 billion at the start of the year. Okay, that's down $13 billion. What happened? The LGIPs were up 20 and the -- I mean -- yes, we're down -- the money market funds were down about 20 and the separate accounts increased about 8, that's what gives us the 13. And so you can see that, that's being led down by the money funds. However, that basically just recaptured some seasonality and some activities on the money funds that occurred at the end of the year anyway. But what we think this really does is set the stage for increasing assets in up environments. After some little bit of time frame, our history is that when there's rising rates, we do better on the AUM side. And it's in large part because it's a cash management service, it's paying the investor more, but it is also which we could get into because the banks are managing their rate, we're paying a market rate and they tend to manage those deposit betas so they have profitability. And we have no choice but to pay the market rate, the way it works. One other thing that I'd like to mention is that the overall liquidity levels in the whole system have been enhanced, both by the Fed in terms of QE, in terms of printing in the money supply, in terms of COVID response, all that jazz increases the amount of liquidity in the system. And the money market fund is just a percentage of the total liquidity in the system. And this has given us a new opportunity in terms of talking to clients and coming up with solutions. We do a lot of portfolio construction work on the long side. But we found that there's a great interest among clients and solutions on the short side when people are really concerned about how short they're going to go over a 1- or 2-year period. And how do they manage that? What's their portfolio construction look like on the short side. So we obviously have the money funds, the Microshort, the Ultrashort, the Short-Intermediate and all our low-duration products, and we've been pretty good at coming up with answers, solutions and higher quality-type discussions with clients on these matters. So basically, if you talk to the salespeople or guys like me, we think assets will be up by year-end.

Got you. That's super helpful. And I think you touched upon this briefly. I wonder if you could just perhaps maybe elaborate a little bit further within the context of a rising rate environment, can you just talk about how you expect the competitive dynamics to unfold between money market funds and competing bank deposits?

Well, what is said is that the banks don't want the deposits. However, we have a lot of evidence that they actually turn the deposits away. So what's going on. They're pricing them for profitability. And so therefore, even though the bank deposits tend to go up at various times, we tend to have a great rate advantage over them, especially as rates increase. And if you look at the last cycles, including '16 and the 1 before that, it's been pretty dramatic, which lights up the beauty of the cash management service, and I call it the money market fund. And another thing that goes on is that the extent to which the banks say they don't and really don't want the deposits because of the capital issues and other things, they will use the money fund a lot like squishing a balloon. So they'll squish money and allow it to go into the money fund. And then if they want it back on the balance sheet, back it goes. And this has been going on since I was selling mutual money market funds, the bank trust departments in the '70s, which is the stone age, but it's the same act all over again.

Got you. Very helpful there. And then perhaps let's switch over to some of the other asset categories. Fixed income net flows have been pretty strong for Federated the last few years. We did, however, see a modest slowdown in net inflows in the fourth quarter. Could you talk a little bit more about some of the trends you saw in that quarter? And then perhaps looking forward, how would you expect rising rates to have an impact on Federated's fixed income franchise?

So rising rates are not the best thing in the world for raising assets in fixed income. However, we've done a lot of work starting all the way back in mid last year of which products tend to do better, you might say, less worse as against a CPI increase. And so when you put this methodology and thought process into the sales force, you can have better solutions-oriented discussions with FAs and customers who are concerned about inflation. So now let's talk about the numbers. In the fourth quarter, overall fixed income net sales were positive by about $500 million. Okay. That's good. The mutual fund net sales of '40 Act were negative by about $330 million. And this was due to redemptions and primarily the short-term credit aspects, like Ultrashort Bond Fund. So that's the fourth quarter. Now here in '22, and we're looking quarter-to-date, so you can make your own judgments about how many -- how much weight you want to place on this. But when you combine the mutual funds, in the SMAs, fixed income had net redemptions of a hair over $2 billion. At the same time, the equities had positive net sales of just under $100 million. Now how did that happen? Well, the Ultrashort Bond Funds continued that trend. Now they're over $1 billion of negative flows. High-yield continued, added $500 million of negative flows, and yet strategic value dividend was up almost $400 billion year-to-date. So you're seeing that kind of a switch where when you get the big reversal from growth to value and people are looking for dividend income, the strategic value franchise functions as the way we thought it would inside a franchise for all seasons. So a lot of this trend may continue, it's hard to say, but that's where we are right now, Ken.

Got you. That's very helpful. That's very helpful. And then, Chris, in the past, you talked about potentially generating more institutional mandates down the line with Hermes products and you've been adding to your institutional sales force as well. Could you give us any update around this progress so far?

So in terms of cross-selling, I -- U.S. selling London product, London selling U.S. product, all 1 company, we raised $430 million in institutional mandates in specific answer to that question. And we're going to a lot of these opportunities here in '22. We've got about $1 billion of RFPs. RFPs does not count as pipeline. In fact, I'm usually not even allowed to say RFPs and what's in those because you can't really project it well. But nonetheless, you asked the question if that's what comes up. And these were in a variety of mandates like unconstrained credit and trade finance. Now this is just a part of the overall effort in institutional sales, where last year, we had over $3 billion of new wins. That's not net. That's gross, okay. But it was 21 new wins in all sorts of categories. The insurers led the pack with over $1 billion, government entities of about $900 million, health care enterprises was $600 million, corporations $300 million. And of course, you have to have other. And there were a wide variety of mandates to include global equity even a Kaufmann Small Cap, Global Small Cap and on a whole array of fixed income to include Ultrashort and other low-duration type products. So I give you this answer because the $3 billion includes the cross-selling, but the cross-selling is a part of this larger what we think is very successful ever.

Got you. That's very helpful there. And then within the alternatives and private markets categories, you mentioned recently some launches or initial fundings for some new strategies, including European direct lending fund as well as a private equity fund. Could you talk more about Federated's growth opportunities around alternatives in private markets? And perhaps as a percentage of overall assets under management, how large could the alternatives in private markets category eventually become for Federated?

Let's try the last question first. We got a couple of hundred billion of assets, fixed income and equity. And over time, I think this alternative business could easily become that big. Okay. Now I'm going to put a date on it. So therefore, you can't say all the growth rate is going to be less and so. But that's what's there. There's another point that when we bought Hermes, these were hidden jewels from the marketplace. We knew they were there on private equity, real estate, infrastructure, direct lending, but we didn't control the enterprise, we didn't control exactly how the private markets business work, and we are in the process of solidifying the rest of that control right now. So what that means is that we're in the process of investing in a platform that was originally designed to respond to BTPS, the pension scheme, who created this enterprise. Well, you can't go to third parties, the way we would go to 1 client deal wherever they call out, you put the papers together and send them on the way, you've got to have a system. So we're investing in the platform. And let's talk about how that platform is doing, which gets to the specifics of the first part of your question. At the end of '21, we had $23 billion in private markets and alternative strategies, which is about $9 billion in real estate, $5 billion in infrastructure, $4 billion in private equity and $5 billion in direct lending and some other things. On the last call, what we said in the fourth quarter was that we had a new vintage of what we call PEC 5, which is the private equity, which is basically booked in for $342 million. Then on the direct lending we had $272 million coming into European direct lending number 2. And we continue to market these efforts and get more in. Some of the real fun is in the real estate where because of MEPC, well-known regeneration developer that has its own staff and its own heritage, basically has its theme, we don't just build buildings, we create communities. And if you've ever been over there in North London and seen King's Cross, you'll see 67 acres with about 40% of it is public space. You'll see 8 million square feet, you see 50 building some rehabs, some new, you see colleges, you see everything, residential and a really complete development. You also see this going on smaller in Birmingham, in Leeds, Milton. So there's a bunch of this going on. And they have had extremely good performance records. And so this sets the stage for long-term sustainable type development. Just a word on the private equity. As much as we'd like to expand it, it has been a very successful effort with very good performance and basically beating the Morningstar ratings that it has, et cetera, it's a co-invest thematic type operation. And so we think we can set the stage for bringing that to the U.S. We have U.S. investment people there, and we're going to build out the distribution as well. So we think there's really good things can happen here, and this is one of the things that we built for once we did the Hermes acquisition at the beginning.

Got you. That's very helpful there. And then let's talk about for our next topic, M&A opportunities. And certainly, we've seen elevated M&A activity in the sector. And in the past, you stated that acquisitions were the highest and best use of excess capital. Wondering if you could just talk a little bit more about your current views? And if so, what could be potential opportunities in terms of M&A?

Yes, I still have the same view of the best, but best does not mean exclusive. And if you notice our heritage, we love paying the dividend and we love buying share back. And you heard me say 100 times, so we like to score on all 3 streams. What drives us to say that the acquisitions are the best is that when you look at the price of the marketplace, however you want to look at it, if we can do acquisitions at better than that price, we have got to do it forever. And that's how we look at. And that gets us into a little bit of share buybacks as well because it's the same type of analysis as against the share price of FHI. And so we've remained active here in the first part of the year on share buybacks as well. And so we are always looking at to our view of what is the best use of the capital right now. It's always [indiscernible] of what's happening now with a look towards sustainability into the future. So when we look at bolt-ons, we say, okay, we know how to value those. We don't bring on the people. We merge the funds. We know how the money got in. We know what the redemption risks are, and we think we're pretty good at doing that. Then there are areas of excellence. For [ PNC ], we buy the Cleveland group of international managers with 5-star funds. The whole Hermes things was an area of excellence acquisition. But those are built for long-term organic growth, consistent with who we are, which is high active share alpha-seeking, tire-kicking managers.

Got you. And then I think more recently, you mentioned possibly exploring debt financing arrangements for various purposes. Wondering if you could just talk a little bit further about some of the opportunities that you see here.

Well, what we mentioned was that we were looking at a $300 million piece of paper and borrowing $300 billion from a consortium. And at this point, I'm allowed to say that we are making substantial progress towards that goal.

Got you. Got you. And then...

I was talking [indiscernible].

Let's talk about expenses. At a high level, how do you think about operating expenses this year? And more specifically, which items could see a little bit more impact from ongoing inflation?

So the overall approach to expenses is the growth wins. Now I'm going to answer your question, but that's the overall approach to expenses is growth wins. So now the way we look at expenses, and you know this, is that -- we have growth investment expenses, which show up on the expense sheet as expenses, whether amortized or not. Then we have the good old friendly inflationary one. So on the growth side of investments, this is where we're building the platform in private markets, which I mentioned to you a couple of minutes ago. We're also enhancing the distribution capabilities on private markets to set the stage for what we think will be some strong growth. We've got new product launches that we just came out with the ETFs. We're planning to come up with another gang of them here later in the year. So we continue to make investments in new products. You can't talk about growth investments without talking about technology. I'm going to give you 1 example. Last year, we had a successful implementation of sales force in the U.S. distribution. The international London distribution already had it. Well, guess what shows up, Phase 2, which is interlocking the 2 in order to make it 1 company, and it's not a no-brainer. So there's more technology there. There's always technology on the investment management side to improve things, investment book of record, ESG integration and all of those things. So those are the package of high-level growth expenses. Then you have good old inflationary expenses. Yes, compensation that goes up on new hires, net new hires, not just musical chairs, wage increases, bonus changes, and we love bonus changes because that gets to the point where the expenses go up when everybody is cheering. I'd like to point out to the year -- years 2020 and 2021, when the travel budgets were basically almost eliminated and yet the sales bonuses were more than made up for those, and we were happy all the way to paying them. Another expense that shows up if we get what we think is going to happen in the money funds, then you get distribution expenses increasing because the money fund assets simply are cause for our partners to receive more distribution expenses. And then hopefully, as we discussed at the top of this program, the yield waivers [ behave ].

Got you. And that's a great overview there. And perhaps we could turn back to a longer-term topic, and this is around regulatory framework and more specifically, you recently mentioned that how the SEC posed amendments regarding swing pricing for institutional prime and tax-exempt money market funds could be not a workable solution. Wondering if you could just further elaborate upon that. And then as you see some of these institutional clients shifting assets towards government or private funds, what kind of impact could you expect for Federated?

Let's deal with the last one first again. The impact on Federated that relates to about $8 billion, which is what we said in the call, that's so much money. What happened in the last 9 months, the money basically moved over into the [ government ] funds. Because we have offshore and private funds, it could go there as well. So we don't tend to lose clients because they're looking at us for a cash management service. But I have to get on to some parts on swing pricing. To me, it's just a bunch of jungle bingo. They come up with this idea after doing the good thing of eliminating the linkage between 30-day average maturity and then having fees and gates, which is what caused the problem in the first place. Remember, the redemptions weren't hardly 30% of all the assets anywhere and we were never able to use that because it became a [indiscernible]. Okay, they recognize that. Everybody in the world recognizes it. So let's eliminate a mistake. And what do they tell us, oh, you have to do more. Why, leave no prices unutilized in order to beat up on the money funds. That's my view of it. So they come up with this swing pricing, which will cost a lot of money for a lot of people to go through and be able to do it. And what are you doing? When once a month, according to SEC stats, your redemptions are 4% or more, you have to then come up with a different NAV price through needing somebody at. So the treasurer is looking at it and thinking, once a month, I can get burdened with a crazy price. And the price wouldn't be the NAV and then you have to come up with it, and then you got to get checked on by the SEC, then you do it right. And frankly, it's going to be somewhat immaterial to anything except no one will do the computer operations to make it happen and the customers are not going to like. And so we think it's a bad idea and its time hasn't come. And so they ought to just declare victory by getting rid of the mistake and move on.

Got you. Got you. Well, we are running close to our allotted time. So I'll just finish off with 1 more question. And let's talk about ESG. It's an area we've seen gaining a lot more interest from clients, and Federated Hermes certainly has an extensive lineup of offerings, including the EOS business as well as several ESG-focused funds. Wondering if you could just talk a little bit more about what are you seeing in terms of demand from clients over the past year? And I know that Federated has been integrating ESG into its investment processes. I wonder if you could just talk a little bit more about some of the benefits that you've been seeing from these efforts.

So in '21, the U.K. London franchise sold about $4 billion worth of products with an ESG -- specific ESG nomenclature. In the U.S., not so much. But you have to consider the fact that this has been integrated into a lot of the investor management here. And therefore, it is a factor in consideration. And when you look at the uniqueness of the -- what we have in the offering with the EOS business, which now has $1.6 trillion, where we engage people, and the whole purpose of that is to engage with companies on where they're going and not to exclude them just because they're at a category. And this enables us to take a future look at the companies to improve investment performance. So we have integrated the ESG factors into almost all of the investment management in the United States, what I call a reverse transformational merger. We've taken our package of really in-depth integration tools to the SEC and told them we think this is very much a best practice and the way to do it to avoid the tag of greenwashing. And hopefully, as they go through their taxonomy and all of their analysis on what should be done, they will be cognizant of the reality of that kind of work. So to us, it was the beauty of the merger of Federated's fiduciary heritage and Hermes ESG-centric thinking that pay for a real strong operation.

Got you. Very helpful there. Well, our time is up now. So I would like to take this opportunity to thank Mr. Donahue and Mr. Hanley for joining us today. Thank you, everyone.

Thank you, Ken.