Federated Hermes, Inc. Q3 FY2025 Earnings Call

Greetings. Welcome to the Federated Hermes Q3 2025 Analyst Call and Webcast. Please note this conference is being recorded. I will now turn the conference over to your host, Ray Hanley, President of Federated Investors Management Company. You may begin.

Good morning, and welcome. Leading today's call will be Chris Donahue, CEO and President, Federated Hermes; and Tom Donahue, Chief Financial Officer; and participating in the Q&A are Saker Nusseibeh, the CEO of Federated Hermes Limited, and Debbie Cunningham, our Chief Investment Officer for Money Markets. During today's call, we may make forward-looking statements, and we want to note that Federated Hermes' actual results may be materially different than the results implied by such statements. Please review the risk disclosures in our SEC filings. No assurance can be given as to future results, and Federated Hermes assumes no duty to update any of these forward-looking statements. Chris?

Thank you, Ray. Good morning. I will review Federated Hermes business performance. Tom will comment on the financial results. We ended the third quarter with record assets under management of $871 billion, driven by gains from our money market and equity strategies. Equity assets rose by $5.7 billion or 6% from the previous quarter, primarily due to market gains. In Q3, equity net sales were slightly negative at $130 million, as strong net fund sales of $1.4 billion were counterbalanced by approximately $1.5 billion in separate account net redemptions from one client transitioning all their CIT strategies to passive ETFs. Another client's pension funds were merged, and the surviving plan opted for private strategies with passive approaches. Interestingly, we are also seeing other clients interested in switching from passive investments to our MDT strategies, as evidenced by several RFPs from investors considering this change. The MDT fundamental quant strategies delivered solid results again in the third quarter, with MDT equity strategies achieving Q3 net sales of $2 billion. As of September 30, 7 of the 8 MDT equity mutual fund strategies ranked in the top performance quartile of their Morningstar categories for the trailing one and three years, and all eight were in the top quartile for the trailing five and ten years. Four of these strategies placed in the top decile for the trailing three years. We experienced net sales in 20 equity fund strategies during the third quarter, including several MDT offerings, with the Asia ex-Japan fund leading the way. We are actively pursuing MDT distribution opportunities outside of the U.S. and are finding considerable interest from institutions, intermediaries, and others. For instance, the MDT U.S. equity UCITS fund, launched in June, is off to a strong start with $340 million in net sales since inception through last week. Regarding our equity fund performance as of the end of Q3, using Morningstar data for the trailing three years, 53% of our equity funds were outperforming their peers, with 33% in the top quartile of their category. For the fourth quarter through October 24, combined equity funds and SMAs reported net sales of $580 million. Now turning to fixed income, assets rose by $3.1 billion from the previous quarter, reaching a record high of $101.8 billion by the end of Q3. Fixed income total net sales improved by $4.1 billion, with $1.7 billion in net sales during the third quarter compared to net redemptions of $2.4 billion in the second quarter. Q3 net sales included about $1.4 billion from two large public entities with regular inflows and outflows. We had 24 fixed income funds with net sales in the third quarter, led by the three ultrashort funds with a combined $579 billion, along with a sustainable global investment-grade usage fund that garnered about $240 million. Regarding performance at the end of the third quarter, 44% of our fixed income funds outperformed their peers, with 15% in the top quartile of their category. In Q4, through October 24, combined fixed income funds and SMAs experienced net redemptions of about $250 million. This was influenced by positive results in ultrashorts and the Total Return Bond Fund, but these were offset by losses in high-yield bonds. In the alternative private markets segment, assets decreased by about $1.7 billion from the prior quarter, largely due to $1.1 billion in real estate fund transactions we previously discussed, including the restructuring of the U.K. Property Trust in the third quarter. This fund had been successfully managed by us for many years and was specifically designed for defined benefit clients, a dwindling group. The liquidity factor was significant, and the decision was made to transition it to one of the few remaining managers of this type of defined benefit fund, for which we received financial consideration that Tom will address. Real estate also saw net redemptions of $446 million from separate accounts in Q3, mainly due to property sales driven by a client’s change to their asset composition. The MDT market-neutral alternative strategy realized net sales of $173 million in Q3 and now has assets of approximately $1.7 billion. We are currently marketing European Direct Lending III, our third vintage of the European direct lending fund, and have secured about $680 million to date. For context, EDL raised $300 million, while EDL II raised about $640 million. We are also in the market with our global private equity co-investment fund, the sixth vintage of the PEC series, and have closed approximately $318 million so far, with PECs I through V each raising approximately $400 million to $600 million. Additionally, we are marketing a new European real estate debt fund, which is a pooled debt equity fund, with marketing set to continue into 2026. We’re actively pursuing Energy Solutions product development following our Q2 acquisition of a majority interest in Rivington. Last week, we announced our agreement to purchase a controlling interest in FCP, a U.S.-based real estate investment manager with $3.8 billion in assets under management as of June 30. This acquisition will allow Federated Hermes to enter the U.S. real estate market, particularly in the multifamily sector, which is experiencing strong fundamentals and significant growth opportunities. FCP is led by a seasoned management team that has steered the firm's growth over 25 years through various market conditions. FCP will complement our U.K.-based real estate business, where our team has over 40 years of experience, managing $5.5 billion as of Q3. We expect to close the purchase around the end of Q1 2026. Across our long-term investment platform, we entered Q4 with approximately $2.1 billion in net institutional mandates yet to fund, in both funds and separate accounts. Approximately $1.6 billion is anticipated in private market strategies, which include over $800 million in direct lending, just above $650 million in private equity, and $100 million in trade finance. Expected additions in equities are around $1.2 billion, with approximately $875 million into MDT and about $365 million into international and global equity strategies. Fixed income is expected to see net redemptions of around $650 million, with positive flows of about $380 million in high yield and short-duration funds offset by a single $1 billion high-yield redemption. Moving on to money markets, we reached another record high in total money market assets at the end of Q3, which rose by $18 billion to reach $653 billion. Money market fund assets increased by $24.7 billion or 5% in Q3, reaching a record high of $492.7 billion. Money market separate accounts fell by $6.3 billion in Q3, reflecting seasonal patterns. Market conditions remain favorable for cash as an asset class. The appeal of its relative safety during volatile periods, coupled with opportunities to earn attractive yields compared to alternatives such as bank deposits, direct investments in T-bills, and commercial paper, continues to benefit this category. We are also developing money market funds and share classes in tokenized form and collaborating on digital asset infrastructure. This includes a planned money market fund compliant with the GENIUS Act, designed to serve as collateral for stablecoins. Last week, we announced that two of our UCITS money market funds, our Sterling Prime and U.S. dollar Prime, are now available in tokenized form through Archax, a reputable digital assets operator in the U.K. This marks Federated Hermes' initial foray into non-U.S. digital asset initiatives. The Archax partnership complements our digital efforts, where we serve as the sub-adviser for the superstate short-duration U.S. government securities fund, a private tokenized fund currently holding about $735 million in assets. We will also be involved in a collaborative initiative between BNY and Goldman using blockchain technology to maintain a record of customers' ownership of select money market funds, a significant step in enhancing the utility and transferability of existing money market fund shares. We are exploring multiple other digital asset opportunities, as we remain committed to the digital space where we expect ongoing innovation and growth. Our estimate of money market mutual fund market share, including sub-advised funds, stayed at about 7.11% at the end of Q3. Recent asset totals as of a few days ago show managed assets of approximately $865 billion, which includes $645 billion in money markets, $96 billion in equities, $102 billion in fixed income, $19 billion in alternatives, and $3 billion in multi-asset.

Thanks, Chris. For Q3 compared to the prior quarter, total revenue increased by $44.6 million or 10%. Revenue from higher money market assets provided $17.6 million of this increase, while higher equity assets added $14.8 million. An extra day in the quarter added $4.9 million, higher performance fees added $2.4 million, and the Rivington acquisition added $1.2 million. Q3 revenue also included a termination fee of $4.6 million from the restructure of the U.K. property trust, and this is about one year's revenue from that mandate. Total Q3 carried interest and performance fees were $3.6 million compared to $1.4 million last quarter, approximately $733,000 of the Q3 fees were offset by nearly the same amount of compensation expense. Q3 operating expenses increased by $32.2 million or 10% from the prior quarter due mainly to higher distribution expense from higher fund assets of $14.2 million. We had about $2 million in transaction costs from the FCP acquisition in Q3 in the professional service fees line. In other expense line items, FX and related expense increased by $9.4 million in Q3 compared to the prior quarter. These expenses were $3.7 million in Q3 compared to a credit of $5.7 million for Q2 as the pound weakened against the dollar in Q3. The other expense line item for Q3 also included $2.8 million related to a U.S. withholding tax matter on certain non-U.S. funds. The effective tax rate was 24.4%. The tax rate was impacted by $1.6 million related to R&D tax credits. At the end of Q3, cash and investments were $647 million. Cash investments excluding the portion attributable to noncontrolling interests were $610 million. We expect to use about $216 million in cash and about $23 million in FHI Class B stock for the upfront purchase price of the FCP controlling interest acquisition. During Q3, the company paused its open market share repurchase as we entered exclusive negotiations with FCP. We expect to be active again in Q4 and repurchase shares in the open market.

Your first question for today is from Ken Worthington with JPMorgan.

This is Michael Cho, on for Ken. So my first question, I just wanted to touch on the MDT franchise. I mean there’s clearly some growing momentum there. You called out some new RFPs, a pretty sizable pipeline as well as some initiatives to expand distribution more notably outside the U.S. I mean, how do we think we should frame the potential sizing and maybe the pace of AUM or flows growth of the overall MDT franchise as you continue to scale and as the non-U.S. distribution starts to grow? I'm just trying to get a sense of how we should frame that opportunity set.

I think you should frame it with enthusiasm and optimism. If you look at the sales to date through this time frame, they're still running net sales of about $660 million up through October 24 so the pipeline continues. But for us, the exciting thing is the fact that we were able to sell these mandates across the globe. And if you look at where they're coming from, they're coming from different countries, in different ways, and in different mandates exactly on MDT. I can't get into exactly who the clients are, but in those pipeline numbers is a great variety of client types and geographies.

Understood. And then if I could just ask a quick follow-up on expenses. Just broader over the year ahead. You have a number of initiatives. You called out a bunch today. Clearly, alternatives and the FCP acquisition is ahead, but you also have a number of things happening within money market and blockchain, digital assets, and clearly, kind of extension of some of your key franchises. So I just think about the expense base and over the next 12 months or so, how should we kind of think about the trajectory there as you can continue to invest organically and inorganically across the business?

Okay, Mike. We finalized the FCP acquisition towards the end of the first quarter, and those expenses will begin to appear. We've already considered that in our recent discussions, and we believe it will be beneficial, especially in 2017, based on our projections. Therefore, we anticipate revenue will increase alongside expenses. Regarding your points about various initiatives, including digital ventures and money market expansions, I don’t foresee any significant unexpected expenses. If they occur, we expect them to be accompanied by revenue soon after. Looking ahead to the next quarter, I anticipate an increase in compensation and related costs due to rising sales and higher incentives resulting from investment management performance. We are also raising incentives on the corporate side, which reflects a positive outcome. For the distribution line item, we expect growth as average assets increase. Concerning professional service fees, we previously indicated that we expect additional FCP closing costs in Q4, with a potential increase of about $3 million. Additionally, the other line includes effects from the tax payment we discussed, and we'll need to monitor foreign exchange developments. However, these comments pertain to a quarterly perspective, not an annual one.

Your next question for today is from Bill Katz with TD Cowen.

This is Robin Holby on for Bill Katz. Heading into 2026, what are you hearing from your institutional investors on allocations? Where are you seeing opportunities? And how are you thinking about the pace of deployment for the institutional pipeline?

The institutional pipeline is very strong, with over $2 billion in it. This pipeline showcases performance across different countries. Previously, I provided a more general overview, but now I can specify that we've secured a Belgium All Cap Core mandate, a significant mandate in Canada, a global equity mandate in the U.K., a blended MDT in South Korea, and another All Cap Core mandate in the U.K. Additionally, we have an MDT win in the Middle East. Overall, this reflects a range of performance-oriented activity. If you examine the style box security of our various MDT offerings, it's evident that investors are considering them as viable options. There are some clients reflecting on their holdings in passive or indexed scenarios and contemplating MDT mandates as alternatives, though this is not a widespread trend.

Regarding the pace of funding for the pipeline, we anticipate funding about two-thirds of it in the fourth quarter with equity and fixed income equity inflows, alongside fixed income outflows taking place this quarter. Additionally, we expect roughly half of the alternative funding to occur this quarter. Since alternatives typically have a longer timeline, they will continue to receive funding through the first half of next year, with a fairly even distribution in the first and second quarters.

Okay. Holly, we must go to the next question.

We have reached the end of the question-and-answer session. And I will now turn the call over to Ray for closing remarks.

Okay. Well, thank you for joining us. That concludes our call.

Thank you. This concludes today's conference, and you may disconnect your lines at this time. Thank you for your participation.