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 the U.S. asset management sector, and welcome to our fireside chat with Federated Hermes. I'm pleased to have with us, all the way to my left, Chris Donahue, Chairman, CEO and President; as well as Ray Hanley, Investor Relations. Mr. Donahue has served as President and CEO of the company since 1998. And as many of you probably know, Federated Hermes is an asset manager, with roughly $669 billion of assets under management and is one of the top players in the money market fund industry. Federated Hermes also manages a spectrum of assets across equity, fixed income, alternatives and multi-asset categories. Mr. Donahue, and Mr. Hanley, welcome.

Thank you, Ken. Thanks for having us.

Always great to have you guys with us here at this conference. We're going to keep this relatively interactive. So I'll start off with a few questions. And then every now and then, we'll open up to the floor if there's any questions from the audience. But let's start off with money market funds. Now you've recently mentioned some expectation around money market fund asset growth to be a lot more meaningful when rates reach a plateau. Could you talk about how quickly money market fund asset growth could pick up once rates plateau? In the meantime, what do you think could be some of the key factors at play for money market fund asset growth this year?

Well, let's talk about the key factors first, then we can back into the numbers. The key factors are that rates are continuing to go up. And you can listen to the Fed chair in his testimony longer for it's going to be longer and higher. Okay, that's fine. Once you put a fore handle on money market fund assets, the way I'd like to phrase it is there's now no penalty for pause mode. A lot of our clients, FAs, look at the world and say, "Well, I'm not risk on, I'm not risk off," and a fore-handle money market fund is a beautiful thing in weighting. At 0 interest or low handle rate, that was a big difference. Now in terms of the actual flows, if you look at our money market fund assets right now, they are at $338 billion, which is up a couple of billion from year-end. And if you look at the total liquidity assets, we're at $488 billion, which is up from $476 billion at year-end. So we've seen some decent flows there. The story I like to tell is the one related to the last time we had a Fed tightening, which was basically Q4 of '16 to Q4 of '18. And during that time frame, our assets went up 15%. Industry was up 11%. So everybody was up. It wasn't anything special. Of course, we beat them, the industry. That meant $30 billion for the home team. Then as we continue with the rest of the story in Q4 '18 to third quarter of '19, we were up another 22%, which was another $50 billion. So the round trip was $80 billion, coming off of about a $209 billion, $210 billion number, up to about $290 billion. And so the way I would look at that is that's a good base on which you could build the case that this is a pretty good time for money funds. Then you add the factor, the fore handle, you add the fact of the large spread between money fund returns and deposit returns of any kind, and you're seeing banks starting to react to this. And some of them now call it, cash sorting, which is a euphemism to make it look like the individual investor has some control over what's happening. But all cash sorting is, is deposit beta with a mask on. And it's basically a question of are you getting the market rate or are you getting a fully contrived rate or designated rate by the bank? The other thing I would note is that on the money fund side, we tend to not ever lose clients. So then they may go into hibernation for a while. But then when they close a bond deal, we get the money, and you see those flows operate like that. So just on the flows one second, if you look at December and January, they got to look -- you've got to look at them as flip sides of the same coin because you've got a lot of money rolling in for dressing and things like that, that it rolls out. Nine out of 11 times come April 15, we lose money net overall because people pay taxes. The offset to that is we have a lot of money from state pools, and they're gaining the money for the taxes up through that time frame. That gives you a little picture of how we see the dynamic. But a long time ago, we said there was going to be a $5 trillion industry. It's at $4.7 trillion. We don't see any reason to come back from that. And if you -- if I had a bet, I'd sure bet over it.

Okay. And let's stay on the topic of money market funds, but let's talk about more on the regulatory side. Wondering if you could just share with us any updated thoughts around the SEC's proposed amendments around swing pricing, which as many of you know, apply mainly to institutional prime tax money market.

So I'm coached to say that swing pricing on money funds is unworkable, but it's also brain dead because it really doesn't work and messes things up, and they know this. And originally, they say, "Well, they're doing it in Europe." No, they're not doing it on money funds in Europe. They're doing it on other funds in Europe. And it just adds an unnecessary level of confusion. There's no data to support it, and no way they could do a cost-benefit analysis that makes any sense. So what's the effect on us? The effect on us is we have $10 billion in institutional product. Before, when we gave these on maybe those 2 meetings ago or 3 quarters ago, it was about $8 billion. Now we're up to $10 billion. Well, what will happen to that money if they put swing pricing? I believe those customers will not go through all of the shenanigans you have to go through, will not take the concern about not getting their dollar back and will go into the government funds just like they did the last time when they put in those other rules. And the fees are basically roughly comparable. In terms of the timing, the SEC calendar has said it was going to be April. They had a calendar that said it was going to be surely during the fourth quarter of last year, and it hasn't happened. There's been a tremendous pushback from the industry on this because it doesn't make any sense. Will they do it? I just don't know. One of the things that's influenced the entire industry to be a lot more vocal on this is the fact that the SEC came up with the idea of doing swing pricing for fixed income and equity funds as well. And so they were just going to use the money funds as a stepping stone or as an experiment. That was the monkey they had in the cage, so they wanted to do it to go swing pricing. So we told them this was coming. I think that's been accepted now by the industry, and swing pricing on a voluntary basis is fine. It's requiring it is what makes no sense.

Let's pivot over to some of the other asset categories that you manage. Like many other asset managers, fixed income net flows reflected particularly a challenged rate backdrop last year. Could you talk about any patterns or trends you've been seeing more recently? And maybe perhaps give us some thoughts on the potential for seeing an inflection in fixed income net flows and in particular, just given how high yields have risen across the products? And then perhaps more broadly across the firm, maybe you could just give a little color around what you're seeing year-to-date in terms of fixed income net flows.

Okay. Let's do the last one first. Year-to-date, on the fixed income side, our net positive flows were $307 billion. And that's after taking out a little over $700 million. $700 million, I said billion. It's $307 million. And then taking out $700 million of Ultrashort negative flows, which means by the subtraction method, if you take out Ultrashorts, we have over $1 billion of long-term fixed income flows. Where are they coming from? And what's the story? Total Return Bond Fund is a core fund. It's been exceptional fund, priced in a beautiful way. And it has $900 million of positive flows. Next in order, believe it or not, is high yield. And this is where people are saying, "Well, I'm not totally risk on, but I'm willing to do this." And so you see over $300 million coming in there. Our corporate bond fund has done great, has a great record, over $100 million coming in there. And on the SMA side, even the recently purchased Henderson acquisitions, they have $40 million of positive flows, putting the SMA flows up to about $140 billion (sic) [ $140 million ], $40 million on top of $100 million that's coming in. So those are 4 stories about what's going on and the higher rates, the lack of conviction by FAs across the board on whether to go risk on or risk off has made this a very positive thing. And the total return bond funds' record longer term has been quite good. And this is -- this has been noticed in the industry.

Okay. And then over on the, I guess, the equity side, over the last few quarters, we've seen real momentum in terms of net flows within your strategic value dividend fund. Could you talk a little bit more about what you're seeing in terms of what's driving demand and whether it's related to the current rate backdrop? And then stepping up more broadly, what are you seeing in terms of equity net fund flows year-to-date?

Well, once again, let's talk the numbers first. On equity land, we are $760 billion positive net flows year-to-date, okay? So what's the story behind that? The answer is that the strategic value mandate, which is both in an SMA format and in a fund format is about $675 million to the good net flows. But you also have a big component of international/global funds, and I'll give you the names of them, but that's over $300 million as a gain, and that includes our global emerging markets, Asia ex Japan, our international leaders and even the international strategic value, which we put into the international side of it. And so what you're seeing is an across-the-board situation. I mean, we have 22 equity funds that have positive flows year-to-date. And that means there's a lot of the franchise for all seasons like we call it at work. It isn't just a one-trick pony. And so what we're seeing with the strategic value dividend tells a big story. That fund is in a goofy Morningstar category. So over its whole life, it has either been in the top decile, the bottom decile of that category that tells you it doesn't make any sense. Right now, of course, it's in the top. So I had to give you a sales lecture on how beautiful that fund performs. But it does what it does. Dividend paying, dividend growth, and this is what we do. And Dan Peris and his squad do this and keep doing it no matter what's going on in the marketplace. And that tells you a couple of stories. That's what people are looking for, that's what they do, and they do it come what may and don't deviate from that. And we love to see a lot of those global stories going well, especially on things like Asia ex Japan and the GEMs product, global emerging markets, which was closed because it got too big now and now it's open because it got -- lost some assets and there's more room in it.

And then within the alternatives and private markets side, you're out marketing PEC, the co-investment private equity fund. I believe you're also out marketing with the Horizon private equity fund as well. And I believe you recently mentioned that a meaningful amount of the institutional pipeline is composed of private market strategies. I wonder if you can just talk about potential contribution that you could see from net flows this year from private market strategies. And then perhaps longer term, how do you think about potential in new products or strategies that you can introduce over time?

Okay. So the private markets were hidden behind the curtain when we bought the Hermes enterprise in 2018. And I say behind the curtain because we bought that on the base they had $43 billion, mostly equity, good sales, good footprint, good management, good people. And then there was this private market side, which was basically Hermes doing services for BT, the British Telecom pension plan. So it was 1 customer. So if you had a problem, you called them. So what have we done? Last year, we spent GBP 5 million building up the platform, so you're going to answer a lot of questions, have a data room, have people with people to talk to if you had other clients. And what are the private markets enterprises there? Well, there is private equity. And as you mentioned, we announced it at year-end for the year-end call, I mean, that we had $4.8 billion in pipeline coming due. $3 billion of that is in these private markets. $1 billion of that is in the private equity, and that's committed but not yet in. And that gets into the AUM at the time when it comes in and then that's when the fee happens. And we expect that to come in all in this year. Then you have a direct lending, which is primarily a European direct lending enterprise where we only have $100 million in it right now, but we got $1 billion worth of commitments, and they're real. And so Patrick Marshall does a great job there, and that stuff is going to come in. We also have unconstrained credit, $200 million or $300 million lined up for that to come in. And then real estate gets a little more complicated. It isn't part of those numbers. But in real estate, the essence of the business is regeneration of old-line city environments. And so what MEPC did, which is the Hermes -- now Federated Hermes subsidiary, redo Kings Cross. They get a big effort, take tons of acres, build schools, Google's a customer in there on rents, retail, residential, et cetera. They've done this in Birmingham. They've done it in Leeds. They've done it in Oxford. We just put in some more money to do another one. And that doesn't work out in the flows or in the pipeline numbers. These are just projects. And one of the things we'd like to do is have this done in the U.S. of A at some point. And then you asked the question, "Well, how does it fold into our earnings and our AUM?" Well, we have about a little over $20 billion in these private markets. And because we're primarily a customer of BTPS and some of their cohorts, that averages about 40 basis points. So if you look at that pipeline, you can start to begin with that kind of a number. And these are not things that we usually have done. We are learning how to talk like this, like the alternative groups do as we go through it because that's kind of how what they do and we'll get better at it and be more articulate on it, but that's a way to kind of size it up. And if you do that, we're confident that you'll be on the low side of how that works. And that doesn't count whether you get performance fees or whether you get carry, which, of course, comes in down the road.

Okay. And then just staying on the topic of Hermes, in the past, Chris, you talked about potentially doing more institutional mandates with some of these Hermes products. Wondering if you could just give us an update on the progress on that asset over there.

Well, a lot of that $4.8 billion are institutional Hermes projects. One is a huge one in GEMs. Another one we recently just got up in Canada, which is $400 million that's not yet in the pipeline numbers. Maybe it's not even allowed to be in the pipeline numbers yet, but it's a committed deal. And so across the board, we're seeing more and more interest in a lot of the Hermes offerings, especially things like the SDG high yield, which is a different way of looking at high yield at what we do in Pittsburgh. And in fact, we've morphed one of our funds domestically into that. But they have a pretty good institutional setup doing that. And now we're getting more coordinated between Pittsburgh and London on sharing those resources to make that happen. So we're seeing a lot of very good institutional work going on, and that's -- it's especially nice when you get one in North America that's being managed in London by salespeople that work for old Pittsburgh Federated.

Okay. Let's take a moment here to pause and see if there's any questions from the audience here before I proceed. Okay. Let's just go on then. Well, let's move on to the topic of M&A. Always a hot topic in the sector. In the past, you've mentioned that acquisitions remains the highest and best use of excess capital. Do you still hold that view? And if so, what could be some potential opportunity out there?

So that's still a good quote, and I think that is the highest and best use. It's not the only use. Talking about capital last year, during the first part of the year, we bought back 10% of the company. In the fourth quarter, we were active. I would call it polite. We remain active. You can call it polite right now. So that's share buybacks. We do like that. You know our dividend history. Now on the M&A, which is specifically what you were getting at. We did the Henderson deal, and I've mentioned their flows. PS, we called on Henderson, the first time to try and deal with them 10 years ago. PS, it took us 6 years to finally do the Hermes deal. So we have kind of a long tail that we're willing to be patient on some of these things. In terms of what we would be interested in, we have a handful of good ETFs, but they're fledgling and in a big deal and then move the dial. So that would be one we would consider. We have a lot of collective funds and that's another bucket where you have our investment management so we'd be kind of looking at that. I did mention already the real estate. I'll tell you a story, we were in with one of our state clients right after we did the Hermes deal in the first quarter of '19, and we give the money market fund pitch on how we're doing, and all of a sudden, the state treasurer, says to me, "Hey, we want some of that Kings Cross stuff in our state." So we weren't even talking about regeneration projects, and that's what they want. So we'd love to get it in the U.S. Coming back to your question, that will probably require an acquisition because the U.K. act of working with the government with those people is really hard to bring over unless you've got people that can really do it. And their concept is we don't just build buildings, we create communities. And if we could get an acquisition that worked on that, that would be very good. And when you raise the issue of M&A, you're raising the issue of capital and what do you do? So we have $140 million on our balance sheet that we have invested in the funds and various things. We would expect that to go up as we increase offerings in the private markets area, but that would be by 5s and 10s, not gargantuan. We have $150 million of commitments. Don't write that down as a yearly number in technology that will come out over a number of years that will go on, okay? And when you're looking at a year like right now where the money market funds are positive, where the equities are positive, where the fixed income are positive and you've got a good story on the private markets. The total AUM is now $684 billion, up over the $669 million you mentioned, so we hit another all-time high-type deal. Believe it or not, there will be salespeople, investment people and operations people who will be entitled to more bonus money and we love to pay it.

Got you. Got you. Let me just pause here for a moment and see if there's a -- poll the audience to see if there's any questions out there before I go on. Well, let's stay on the topic of operating expenses. I think you mentioned a couple of items. And you've also recently mentioned that you spent -- expect several operating expense items to potentially increase this year. Wonder if you could just frame out any of these expense items in terms of the increase and what's driving some of the potential increases that...

Your turn, Ray.

Well, Chris mentioned compensation expense, of course, that and our third-party distribution expense are the 2 largest line items for us. We have not given explicit guidance on those things and in large part, the comp does depend on things like growth in gross sales, investment performance. Those are the things -- and of course, corporate earnings and performance. Those are the things that are going to drive the incentive comp. And we did give some guidance for Q1 to talk about a $13 million increase sequential quarters in comp with about $9 million of that really coming out of seasonal factors, which means that $4 million is really kind of more baseline things, merit increases. We, like other employers, of course, have had higher costs to attract and retain employees over the last year. Maybe there's some good leading indicators on that front. But there's also sort of a run rate that wasn't fully reflected in last year that we'll -- that you'll see in 2023. So there's upward pressure on comp. We've had the margin added some employees. We talked about building out the private market platform. We're looking to add some additional distribution capacity there. Not big numbers, but not insignificant on an individual employee basis. So there's some upward pressure on comp. I mentioned the distribution expenses. That's really tied to the level of fund assets on average, money market assets in particular. There's favorable outlook for that. That's another one like the incentive comp that we would have described as a success item that, that will go up as average asset levels go up. So we would fully expect -- we're looking for that to increase during the year. Beyond that, it's really inflation in which we deal with like everybody else. We've seen the travel expenses build back now post pandemic. Our salespeople have more receptivity with clients. They're back out being more fully engaged in person. So -- and technology, as Chris mentioned, there are a lot of projects there. So without putting a specific number on it, there's really some upward pressure in all of the line items.

Very helpful there. Well, we just have time for one more question here. Let's talk about ESG. Federated Hermes has an extensive lineup of offerings including the EOS business as well as several ESG-focused funds. I wonder if you can just talk a little bit more about what you're seeing in terms of demand from clients over the last couple of quarters. Have you seen any change there? Just talk a little bit more about those...

Our surveys show despite all the political mumbo jumbo that's going on, on the subject that the underlying customer is still interested in these factors being used to evaluate outcomes. Now that doesn't mean that the FAs in large parts of the country are promoting ESG-only funds. One of the ways I like to put it is that we have about $140 billion of state money. And if you look at the top 10 states in that group, 5 are red and 5 are blue. And therefore, you have to be able to be quite conversant about what you're doing with ESG. And the way we describe it is when you're doing risk-reward analysis with ESG factors, you are right on the line of a fiduciary attempting to get alpha and improve performance. When you go to accomplishing other things, you want to improve the climate, you want to reduce carbon, you want to do other things, you are now on an impact fund if you've done that in excess to what you're doing on the fiduciary side. So with these 2 types of funds, you can then answer the European demand with the impact funds, and you can answer the certain demands inside the U.S. with the risk reward funds. And all the noise, I think, is coming back to this point that using ESG factors is a good and it can be done. If you get rid of the political, the moral and all this other stuff, that we are investment managers managing to improve in performance over the long haul.

Well, we are all out of time here. Once again, thanks, again, Mr. Donahue and Mr. Hanley for joining us. Why don't we give them a round of applause?

Thank you. Thanks, Ken.

Thanks, Ken.

Thank you.