Greetings. Welcome to the Federated Hermes Q1 2023 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.

Thank you, Holly. Good morning, and welcome. Leading today's call are Chris Donahue, CEO and President of Federated Hermes; and Tom Donahue, Chief Financial Officer. Joining for the Q&A are Saker Nusseibeh, CEO of Federated Hermes Limited, our international business; and Debbie Cunningham, the Chief Investment Officer for the money markets. During today's call, we may make forward-looking statements. 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 these forward-looking statements. Chris?

Thank you, and good morning. I will review Federated Hermes' business performance. Tom will comment on our financial results. In a quarter that saw considerable market fluctuations and uncertainty, Federated Hermes ended the first quarter with record total assets under management of $701 billion, driven by Q1 growth of $29 billion in money market assets to a record-high of $506 billion. Turning to equities, assets increased by about $2.1 billion to $83.6 billion, which includes market gains of $1 billion and net positive sales of $900 million. The Strategic Value Dividend Strategy continued to produce solid net sales with $678 million in the first quarter. The U.S. Strategic Value Dividend ETF, which was launched in mid-November, now has $51 million in assets. We saw Q1 positive net sales in 25 equity strategies, including Global Emerging Markets, International Leaders, Asia ex-Japan, MDT Large Cap, MDT Mid Cap, and MDT All Cap Core. Our equity performance compared to peers remains solid. Using Morningstar data for the trailing 3 years at the end of the first quarter, 57% of our equity funds were beating peers and 34% were in the top quartile of their category. For the first 3 weeks of Q2, combined equity funds and SMAs had net redemptions of $246 million. Turning now to fixed income, assets increased by about $700 million in Q1 to $87.5 billion as higher market values were partially offset by net redemptions. Within funds, our flagship Core Plus strategy, Total Return Bond Fund, had first quarter net sales of about $1.1 billion, up from $650 million in the prior quarter. High-yield category net sales were positive at $231 million compared to net redemptions of $470 million in the prior quarter. Core Plus and other fixed income SMA strategies added $170 million of Q1 net sales, including about $43 million in our C.W. Henderson strategies. Within fixed income funds, first quarter net redemptions of about $1.2 billion occurred in the 3 offshore funds. That $1.2 billion redemption is down from $1.8 billion in the prior quarter. We had 16 fixed income funds with positive net sales in the first quarter, including obviously the Total Return Bond Fund, the SDG Engagement High Yield, and Sustainable Investment Grade Credit Funds. Regarding performance, at the end of the first quarter, again using Morningstar data for the trailing 3 years, 57% of our fixed income funds were beating peers and 24% were in the top quartile for their category. For the first 3 weeks of Q2, fixed income funds and SMAs had net redemptions of $69 million. In the alternative/private markets category, assets increased by approximately $400 million in the first quarter compared to the prior quarter, reaching $21.2 billion. This increase was due to net sales and positive FX impact, partially offset by market losses. Net sales were led by Absolute Return Credit, Direct Lending, Market Neutral, and Real Estate. We continue marketing PEC V, the fifth vintage of our Private Equity Co-Invest Fund, and Horizon III, the third vintage of our Horizon series of private equity funds. We have also begun marketing the Hermes Innovation Fund II, the second vintage of our Private Equity Innovation Fund, the first vintage of our Real Estate Debt Fund, and the first vintage of our Nature-based Solutions Fund. We began Q2 with about $3.8 billion in net institutional mandates yet to fund in both funds and separate accounts. Pay attention to the diversity of the types of mandates we're winning. About $1.9 billion of this net total is expected to come in equity strategies, which includes Asia ex-Japan, Global Emerging Markets, Biodiversity, and Global Equity. Approximately $1.3 billion of the net total wins is expected to come in these private market strategies: Private Equity, Direct Lending, and Unconstrained Credit. Fixed income is expected to have about $640 million, which includes wins in Investment Grade Credit, High Yield, and Core Plus. Moving to money markets, we reached record asset highs for money market funds, $357 billion; money market separate accounts; and total money markets, which I've already mentioned. The first quarter increase reflected movement into money market strategies from bank deposits in March as investors became increasingly concerned following the failure of certain banks. Money market strategies also continued to benefit from favorable market conditions for cash as an asset class, higher yields, elevated liquidity levels in the financial system, and favorable yields compared to bank deposits. As short-term interest rates peak, we expect market conditions for money market strategies will remain favorable compared to both direct markets and bank deposit rates. Our estimate of money market mutual fund market share, including sub-advised funds, was about 7.4% at the end of the first quarter, down from 7.7% at the end of 2022. Looking now at recent asset totals as of a few days ago, managed assets were approximately $707 billion, including $511 billion in money markets; $83 billion in equities; $89 billion in fixed income; $21 billion in alternative/private; and $3 billion in multi-asset. Money market mutual fund assets were $362 billion.

Thank you, Chris. Total revenue for Q1 increased $8 million or 2% from the prior quarter due mainly to higher average money market assets increasing revenue by $12.6 million and higher average equity assets increasing revenue by $6.9 million, partially offset by 2 fewer days and lower performance fees and carried interest. Q1 performance fees and carried interest were $1.4 million. Q1 operating expenses decreased $13.1 million or 4% compared to Q4, which included a $31.5 million noncash intangible asset impairment charge. The $12.9 million increase in compensation and related expense from Q4 included $3.7 million of seasonally higher payroll tax and $3.5 million of higher restricted stock expense, of which about $2.7 million was due to seasonality. The compensation and related increase also included $5.9 million of higher incentive compensation expense as we reset our accruals for 2023. Office and occupancy increased in Q1 from the prior quarter, primarily due to the acceleration of $1.4 million in depreciation expense related to a lease termination as we consolidated space in London. The decrease in advertising and promotional from the prior quarter is mainly due to the timing of expected ad spend. The increase in the other operating expense line item from the prior quarter includes an increase of $3.4 million in FX impact from the currency forwards used to hedge certain pound exposures and also includes a nonrecurring retention expense of $2.5 million related to a claim. In nonoperating income, investment gains, after subtracting the impact attributable to the noncontrolling interest, added earnings per share for Q1 of about $0.03 due to the positive market impact on our investments. Q4's positive EPS impact was about $0.04. The effective tax rate was 22.7% for Q1. The Q1 rate reflects tax deductions for certain stock compensation as shares vested at a higher price compared to the original grant price and the impact of nontaxable noncontrolling interests. Assuming no impact from the noncontrolling interests, we expect our effective tax rate to be in the range of 24% to 26% for the full year 2023. At the end of Q1, cash and investments were $448 million, of which about $453 million was available to us. As noted in the press release, the Board declared a dividend of $0.28, an increase of about 4% from the previous dividend. During the quarter, our share repurchases totaled approximately 133,000 shares for about $4.7 million. And Chris?

I said that our $1.2 billion net redemptions were in offshore funds. And those were in Ultrashort Funds. I think most of you probably knew that. But nonetheless, we should correct the record. Thank you. And now we turn it over for your questions.

Your first question for today is coming from Ken Worthington at JPMorgan.

Maybe first, can you talk about the outlook for the state pool and SMA money fund businesses? So how do you think higher rates impact the growth of this business over time in terms of municipality participation? And then to what extent are the banks really the competitors to these products? And does the mid-cap banking crisis position these pools for better growth? And then lastly, you manage a couple of these pools already, like Texas and Florida. Are there other states that pool together the municipalities? And is there more winnable business here like, say, California, where the regional banks seem to be located, that have struggled so much lately?

Ken, this is Chris. There are many other opportunities on the state pool front. Let's divide that up in certain ways. In many of these states, even where we have the main pool, there are sub-pools in the state as well. Those pools are always viewed as a polite competition for the big state pool. The extent to which those pools don't buy the right securities or don't have the right yields or don't have sufficient size to make things happen tends to enable the big pool to get bigger, and therefore, our claim on assets to manage to grow. That's one part of it. Another part of it, I can't say what will happen in California to what they do in their state pool. I don't have information on that. We can get you that. But overall, it does not appear that the things happening to the regional banks are impacting the state pools. That business is done based on long-term contracts with long lead times, with bid processes, RFPs that are very complicated. It's really hard for those state pools to turn on a dime. Certainly, that's a tough thing for getting new business, but it's a pretty good thing for keeping old business. The next point I'd make is that we have a separate sales group that calls on those groups all the time so that whenever there's an opportunity on whatever state, we are working on a small handful of states that I’m not going to mention, where we think we can become the manager of the pool.

Thanks, Chris. Ken, Chris brought up the extended lead time for the pools themselves, including state and local government investment pools. However, participants in these pools do not have the same long lead times. They have options and are not required to remain in the state pools; for instance, they could choose to invest in a bank. Many participants are exploring money market funds as an alternative. We manage a significant amount of cash in our money market funds sourced from participants in state pools, some of which we oversee and some managed by others. There are competitors in this space. However, similar to our expectations for money market funds, we have a positive outlook for participant asset growth in the state pools going forward. Generally, in a rising interest rate environment, assets do not increase rapidly. It is when rates stabilize and begin to decline that funds typically flow into these types of products. As I mentioned earlier regarding our money market outlook, we anticipate a similar trend for our state pools. It is important to note that there are various cash flow peculiarities associated with the state pools. Typically, local municipalities and school districts receive cash at certain times. They experience periods where they are no longer receiving cash inflows or state disbursements and are instead utilizing their funds. There are clear annual cycles that we navigate in these pools as well.

The final point I'd mention is we are at an all-time high of $148 billion in state pools.

Yes, great. And then Chris, you've been doing this for a long time. You've built a really big business. At some point, you'll retire. What does succession planning look like for Federated? And do you think that leadership stays in the family? Or are you thinking about an outsider as we think longer-term about leadership?

No human is indispensable. I appreciate your comment about my long tenure. However, my focus is on how our Board views my participation, health, enthusiasm, and contribution to the organization. As long as those remain positive, you will continue to hear from me. Regarding succession, according to New York Stock Exchange rules, we are required to review the succession plan with the Board annually. This doesn't mean we have specific candidates identified at all times; rather, we have a pool of candidates or a process to determine them. This is what we have discussed with the Board. Our Executive Committee has many strong candidates ready to take over if necessary. The enterprise would continue to thrive. Keep in mind that with the A/B stock structure, the family does control the voting, as we demonstrated yesterday. Our voting will aim to serve the best interests of the entire organization, and that will guide our decisions. While we can't predict the future with certainty, you can see the structure, pattern, and process that we will follow.

Your next question is coming from Patrick Davitt at Autonomous Research.

Before this quarter, you've been guiding to the big uptake in deposits and money fund rotation really starting once the Fed pauses. But the SVB situation has obviously driven a big spike, and it looks to be continuing in April, better than we would normally see in April. So do you think that the start has been pulled forward? Or do you think we'll see a lull now until we get more of an all-clear from the Fed?

I think taxes come due in April. It's generally sort of a beginning of a new quarter, where first quarter has outflows. That obviously didn't come to fruition. There were inflows this year. I expect that we'll continue to see upticks in rates, the comparison versus deposit products, especially with what happened to some of the regional banks in March of this year has kickstarted that process to some degree and will continue to impact in a positive way the flows into money funds even before the Fed approaches and reaches that terminal rate in the next several months or so.

And Patrick, it might be helpful on that point to take a look at the difference between institutional and retail, even though nobody has accurate numbers on what's institutional and what's retail. On the retail, we basically figured we've been gaining market share. These kinds of assets tend to be more sticky because they are related to the rates. The biggest risk for retail is going back into the market, which would be all good because we have buckets for that, too. In terms of the institutional, if you talk to some of our salespeople, they will tell you that the institutional trade, if you will, started a little early, like you were hinting. It was probably accelerated by a lot of those bank moves. How much of it is already in the pipeline is really hard to say.

Helpful. And then on expenses, you mentioned a lot of kind of little seasonal and one-time-type items. It wasn't entirely clear to me which those you consider one-time or what part is kind of a run rate step-up. Could you maybe frame how much of all those items in Q1 you expect to roll off in Q2, not repeat? And then more broadly, how should we expect the cadence of operating expenses to track this year, including what I imagine will be a continued step-up in distribution with a much higher money market fund asset.

Okay. So the London office, saving some space, it was $1.4 million. We don't expect that to reoccur. But we're going to get some savings from not having the space into the future. That's a $1.4 million number. The insurance claim I mentioned, that's a nonrecurring thing. So those two things add up to about $0.03 in terms of nonrecurring. For the future, the comments on comp, which I mentioned the seasonality on the payroll tax and on our incentive stock compensation, those numbers will be down by $3 million. But of course, you have all the other things that can change in comp. So that's just a change, not commenting on what else is going to happen in Q2 for comp. On distribution, we expect the distribution line item to go up. Obviously, we see the assets are up and still growing. Systems and communications and professional service fees are both getting the opportunity to spend more money with technology. So tech spending in both those line items, I would expect to go up.

Your next question for today is coming from Daniel Fannon at Jefferies.

The $3.8 billion of institutional backlog, you highlighted the diversity of it. Can you talk about the fee rates across that book of business that's coming in and how that compares to the overall kind of long-term fee rate that you have today?

Ray?

Sure, Dan. Regarding the private market aspect, we mentioned that the current book is around 40 basis points. A significant portion of that funding originated from Hermes' relationship with BTPS as the owner. As we broaden our investor base, we aim to secure new mandates and additional capital that will come in at more favorable fee rates. This is developing in the marketplace and won't significantly impact the numbers in the next quarter or two. Regarding equity, which is the largest segment, the fee rates are usually negotiated on a case-by-case basis for separate accounts. When aggregated, they are approximately half of the fund advisory rates. You can expect figures in the low to mid-30s, with considerable variation depending on specific strategies and clients, unlike the funds. For fixed income, we see a similar situation, but our blended fee rate is around 10 basis points for fixed income separate accounts. This also varies by client and mandate, so there will be a range around that figure, but that's the current state of the fee rates, providing a solid foundation for the pipeline figures.

To provide more insight into the fee rates, I would like Saker to discuss some of those businesses.

Thank you very much. Ray sort of covered them. We’ve had a very good inflow into, for example, our GEM funds and our institutional fee rates are advertised. It's a negotiation based on the size of the institutional mandate and also the relationships we have with the same institution. The rule of thumb, if you win a huge mandate, the customer rightly expects you to give back some of that. In private markets, if you look at some of the wins we've had in our Direct Lending, a lot of that, although it's sold institutionally, is actually sold in the format of a fund. So there might be some discounts as is the practice in Europe. We're getting quite close to what we’d answer. A general point of view is as we move away from old mandates that we had with our client, BTPS, we are increasing our fee rates. This can be seen in our Direct Lending Fund and new clients that have come into the Nature Fund, which we believe we are innovators in, and I believe the first people to launch a fund in Europe in conjunction with the government in the U.K. The potential is huge if I listen to clients, but it's going to be a slow build because we've got to think about how we can innovate the actual investment process. Overall, there is a lot of opportunity.

No, that's very helpful. One follow-up on the balance sheet, cash balances continue to grow. Buybacks have been pretty quiet. Maybe talk about the M&A environment, your appetite for that versus buybacks. Where should we think about cash building as you go as the year progresses?

Yes, Dan, we're active. We don't have anything to talk about. We're still working on growing our C.W. Henderson business, which is going nicely there. We continue to buy modestly shares. When you analyze that, you notice we did also a modest increase in the dividend. All things continue to be on the table. I mentioned last quarter that our seed usage may increase as we develop new products around the globe. That's another use of the cash. We invest our money in a money market fund managed by a highly competent team, and we're getting some pretty nice yields on that now.

Just on the alternative side, you mentioned a couple of funds starting to be marketed like the Nature-based Solutions. How should we think about the potential contribution to AUM over time from some of these funds that you're starting to market?

I will give you a broad answer. The whole private markets effort, over time, could be as big as the rest of the entire enterprise. There are a lot of good things going on in private market, real estate, direct lending, unconstrained credit, and some work on infrastructure as well. That's a broad answer. Now you talk about individual funds there, I will let Saker fill in the current situation.

Broadly in line with what Chris says, the private market takes a long time because some of the products and some of our funds are long-term negotiations. For example, a big real estate project takes several years to negotiate. But generally, that pays back over 10 years, and we're talking about very large sums of assets under management. On the other hand, something like our Direct Lending, that is a business that's rapidly growing above the $1 billion we were at last year. We see that as continuing to grow because we have a differentiated product. The Nature Fund is launched but requires thought in the investment process. We have unique relations with the scientist community, and that supports fund growth. Overall, we believe the potential is significant, but it takes time.

Got you. Very, very helpful there. One follow-up if I may, just back on the money market fund side. I wonder if you could just share your thoughts about any potential impact from the ongoing debate around the U.S. government debt ceiling and money market funds.

I'm going to call it a Groundhog Day. We've been here before, keep waking up, and it's not resolved yet. Certainly, Treasury Secretary Yellen would like to continue to apply pressure to have it resolved sooner rather than later. Our expectations really at this point are she'll continue to use extraordinary measures until they're almost exhausted, and then there will be some resolution. Our expectation is, similar to past experiences, is that it will be passed. It will get resolved, maybe in some instances, temporary suspensions for a few months. There are disagreements from a congressional perspective. We are not expecting any type of even a technical default from a U.S. Treasury perspective.

Maybe you could level set for us higher rates and the impact on the shift in demand for your fixed income menu. And are you seeing institutions derisk into fixed income now that fixed income actually has income?

First of all, looking at the trends on the retail side, average mutual fund and SMA gross sales have averaged about $1.5 billion. In the first quarter, we were $1.434 billion. This tells you that there is excellent demand for these products. When I mentioned that we have 16 fixed income funds here with positive flows in the quarter, it's because people enjoy getting yield. The biggest one is the Total Return Bond Fund. However, there is always a component of fixed income in the portfolio, even if the stock market takes off. Last year, you had some of the biggest players have performance glitches, which helped us significantly in demonstrating the steady returns of our management in the core space.

I'll add one thing, too. Our expectation, even when the Fed reaches a terminal rate, is not for rates to go back to zero. This is not normal. When you get rates that are 3%, 4%, or 5%, you see flows into products like the Ultrashort Funds, the Microshort Funds, because they maintain higher rates for a longer period due to the Fed's position.

Got it. And then maybe just any comments on how the deposit slide is impacting roll-ups of money market funds? Do you think it makes it more or less likely that you could get more done?

It is inevitable. Over the years, there used to be over 200 people presenting money market funds to the money market world. Now it's 50. The bottom 25 are small and don't really compete for real money. Each of those eventually conclude that it costs too much to manage if they don't have enough size. There's risk here. Our sales force of M&A specialists calls on every one of these people. We are known as the go-to player if you were going to sell some money funds. I always say we are a warm home for all money market fund assets. Does this particular thing accelerate it? I can't give a good speech on why that will be a catalytic event, but it does add to the mixture.

The only thing I'd add to that is, generally, ETFs are settling on a T+2 basis, which is not what's expected for the liquidity world for money market funds. They expect T+0 settlement for cash.

Okay, great. I just wanted to ask a little bit of a nuance question about the money fund inflows in the quarter. Given that they came in later in the quarter post the bank stress, how did that impact the revenue contribution? I'm guessing, clearly it's not a very big piece of the revenues this quarter. But how did that also play out for the distribution expense in the quarter? Is there any nuance on the timing difference between how the revenues come through and how the expenses come through?

The engine of earnings at FHI are average daily assets. When it comes in later for the quarter, it has the obvious effect. In terms of how that impacts distribution, it's a pro-rata deal. I'll let Tom or Ray comment further on that.

There's not much more comment. It comes right in at the exact same time as we get revenue, our distribution payments go up, and we're happy. In the old days, I used to call that an expense success item because we got the revenue that came with the additional assets.

Remember that a lot of that, of course, are 12b-1 distribution fees built into the fund that, as Tom said, we collect and pass through in many instances.

Okay, great. Regarding the money market business, I see it primarily as a cash management tool. It is certainly an appealing investment option, and the current attractive yields reinforce that perspective. This situation differs from previous high-rate environments due to the abundance of ETFs. Is that a potential risk, or given how institutional municipalities manage their cash, is it more like comparing apples to oranges? Additionally, you mentioned that the competitive landscape has significantly narrowed over time.

Let's answer the last one first. Recently, we haven't noticed any new competitive pressures on pricing. The players haven't been doing any more than the normal amount that we've been dealing with for decades. One of the other things to remember about this, even though the biggest players want to keep money and get more, is that the customer has the ability to move even in an LGIP world. They like diversification. You may see more of that coming, given what happened in the banking world. The observation that we offer a cash management service gives it resiliency in the marketplace. When you mention other short-term investments like ETFs or Ultrashort Funds, they have variable net asset values. It’s a bit of a misalignment as the ETF isn’t really going to be competitive with the money market fund.

That’s a big negative from a comparative perspective to the ETF sector.

Great. Another one on money funds, a two-part question. Number one, are you able to guess what the outflow impact in the month of April was from tax payments? We saw a few days with elevated outflows that would otherwise imply much better than $4 billion of inflows in April. And then secondly, the cash sorting dynamic. Can you give some perspective on what inning you think we are on the retail bank side?

On cash sorting, what a lovely expression. We are very much in favor of the expression you're using. It describes it as if the customer is in charge of it. There’s been a shift in how people are looking at cash. As for where we are in the cycle, that's hard to say. The banks have not historically increased rates enough or quickly enough to keep customers. We don’t see those metrics in real time.

From the deposit beta side, if you look at deposits in the marketplace, total deposits are down several trillion. It started back in March of 2022 when the Fed began raising rates. There’s still a lot to go in this ballgame. We are still in the first half.

We got up to around $511 billion. A few days before the tax, money deposited. Then, money went back out following tax season. We ended up at around $511 billion.

Special dividends have always been a part of your toolkit. Since it sounds like you're not planning big repurchases, could you remind us how you think about that part of the capital return equation and how often you evaluate that?

We paid a number of special dividends in the past. We were highly disappointed with the number of them where the stock price was. It made sense to pay special dividends in those cases. The stock price has been up. We haven't bought as many shares. Our yield is higher than it used to be, so it's definitely in the mix as it has always been for us.

Thank you, Holly. That concludes our call, and we thank you for joining us today.

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