Earnings Call Transcript - FHN Q2 2022

Operator, Operator

Good day, ladies and gentlemen, and welcome to the Federated Hermes Q2 2022 Analyst Call and Webcast. It is now my pleasure to turn the floor over to your host, Ray Hanley, President of Federated Investors Management Company. Sir, the floor is yours.

Raymond Hanley, President

Good morning, and welcome. Leading today's call will be Chris Donahue, Federated Hermes CEO and President; and Tom Donahue, Chief Financial Officer. And joining us for the Q&A are Saker Nusseibeh who is the CEO of Federated Hermes Limited, our international business; and Debbie Cunningham, Chief Investment Officer for the 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 our 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?

John Donahue, CEO

Thank you, Ray. Good morning, all. I will review Federated Hermes business performance. Tom will comment on our financial results. Last week, we proudly announced the agreement to acquire C.W. Henderson and Associates, Inc., a Chicago-based registered investment adviser with more than three decades of experience specializing in the management of tax-exempt municipal securities in SMA products. C.W. Henderson manages approximately $3.6 billion in assets. The expected addition will enhance and complement our existing muni team and strategies where we manage about $13 billion at the end of the second quarter. It will also enhance our overall SMA business where we currently manage about $26.5 billion in 35 equity and fixed income strategies. The transaction is expected to close in the third quarter, and we welcome all of the employees of C.W. Henderson to Federated Hermes, and look forward to working together to develop growth opportunities and to continue to provide outstanding performance in customer service. Turning now to Q2. In the quarter that presented challenging markets across asset classes. Our business mix enabled Federated Hermes to end the quarter with an increase in both total assets and revenues as growth in money market assets offset decreases in long-term assets. Looking first at equities. More than 90% of the decrease in assets during Q2 was due to market losses and the impact of foreign exchange rates. Equity total net redemptions were $969 million. This included approximately $1.1 billion in institutional separate account redemptions by BTPS. Our equity mutual funds and SMAs produced combined net sales of just under $600 million. These net sales were driven by the strategic value dividend strategy. The domestic strategy had Q2 net sales of $1.9 billion, with both the fund at $1 billion and the SMA at $900 million producing solid net sales. The strategic value dividend fund was recently highlighted in our Wall Street Journal article as the top fund among the 32 out of 1,342 actively managed U.S. stock funds to finish the rolling 12-month period ending with Q2 in positive territory based on Morningstar data. The article further noted that the fund was the only one with double-digit positive returns for that period. We saw Q2 positive sales in 16 equity fund strategies including several international strategies such as International Strategic Value dividend, Asia ex-Japan, international equity and SDG engagement. Net redemptions were concentrated in growth strategies about $955 million, reflecting difficult market conditions for these strategies. We continue to emphasize asset classes and strategies that have responded well in past inflationary periods, including dividend income, international, emerging markets and value strategies. We are also expanding our equity product line, including the recent launch of a biodiversity equity fund in collaboration with London's Natural History Museum. The fund invests in companies that are helping to preserve and restore biodiversity. Our equity fund performance at the end of the second quarter compared to peers was solid. Using Morningstar data for the trailing three years at the end of Q2, 57% of our equity funds were beating peers and 29% were in the top quartile of their category. For the first three weeks of Q3, combined equity funds and SMAs had net redemptions of $50 million. We had 16 equity funds with positive net sales in the first three weeks of July, including strategic value dividend, Asia ex-Japan, MDT Small Cap Core and MDT Small Cap Growth and International Strategic Value dividend, among others. Turning now to fixed income. Q2 saw net redemptions of about $2 billion, down slightly from Q1. Fixed income separate account net sales of $1.8 billion were offset by $3.8 billion of fund net redemptions. Fixed income separate account net sales were driven by multi-sector strategies. Within fixed income funds, net redemptions of about $1.4 billion occurred in the three Ultrashort funds. In addition, high yield funds had about $900 million of redemptions. Most categories of bond funds had net redemptions, reflecting another quarter of difficult market conditions. Even so, we had 11 fixed income funds with positive net sales in the second quarter, including capital preservation, adjustable rate, conservative muni micro short, climate change high-yield credit, inflation-protected securities, among others. Regarding performance. At the end of the second quarter and using Morningstar data for the three trailing years, 66% of our fixed income funds were beating peers and 22% were in the top quartile of their category. For the first three weeks of the third quarter, fixed income funds and SMAs had net redemptions of about $524 billion. Again, mainly from the Ultrashort funds, $256 million and high yield of $172 million, each trending better. During the same period, however, we had 14 fixed income funds with positive net sales led by the municipal high-yield Advantage Fund, total return bond funds, and conservative municipal micro short. In the alternative private markets category, net sales of $25 million included positive sales in real estate, Prudent Bear, MDT Market Neutral and trade finance. These, however, were largely offset by net redemptions and in absolute return credit, infrastructure, private equity and unconstrained credit. We recently closed the second vintage of our European direct lending private market strategy with nearly $600 million of committed funding. Of the 19 investors who made these commitments, 13 were new investors. We expect these fundings to occur over the next 9 to 12 months. We launched our fifth vintage of PEC, our co-invest private equity structure in 2021. We were pleased to hold our first closing in the fourth quarter of '21 with $350 million. We held our second closing last month adding a significant Korean institution and bringing our total raise to $401 million. Due to demand, we will continue to market PEC 5 for the remainder of 2022. We recently launched our third vintage of the Horizon private equity fund with commitments so far of $1.05 billion, including $1 billion from BTPS as we announced this past May. We began Q3 with about $2.4 billion in net institutional mandates yet to fund, into both funds and separate accounts. About $1.9 billion of this total is expected to come into private market strategies, including direct lending, $900 million; private equity, $500 million and unconstrained credit $500 million. Now moving to money markets. Assets increased about $19 billion in the second quarter compared to the first quarter, with nearly all of the growth coming from money market funds. The funds benefited from higher yields from continued elevated liquidity levels in the financial system. Money funds also benefited from higher yields relative to deposit alternatives. Our money market mutual fund market share, which includes sub-advised funds, was about 7.3% at the end of the second quarter, up from 6.9% at the end of the first quarter. With the recent increases in short-term interest rates, money fund minimum yield-related waivers have nearly ceased. We continue to believe that the higher short-term rates will benefit money market funds over time, particularly as compared to deposit rates. Taking a look at recent total assets. Managed assets were approximately $631 billion, including $436 billion in money markets, $82.5 billion in equities, $88 billion in fixed income, $21.5 billion in alternative private markets and $3 billion in multi-asset. Money market mutual fund assets were at $296 billion. Tom?

Thomas Donahue, CFO

Thank you, Chris. Total revenue for the quarter increased $41 million or 13% from the prior quarter due mainly to lower money market fund minimum yield-related waivers of $66.3 million, an additional day in the quarter and higher carried interest and performance fees, partially offset by lower average long-term assets, which reduced revenue by $22.6 million and lower average money market assets which reduced revenue by $9 million. Q2 carried interest and performance fees were $2.5 million compared to about $100,000 in Q1. Operating expenses increased $33 million or 14% in Q2 compared to Q1, driven by $48.5 million of higher distribution expense from lower money market fund minimum yield-related waivers. The decrease in compensation and related expenses from the prior quarter reflects Q1 higher expenses for severance, seasonally higher stock compensation and payroll taxes and lower Q2 FX rates per pound sterling-based compensation. Higher advertising, promotional and travel expenses were due mainly to seasonally lower Q1 expense and rebounding travel opportunities in Q2 as we move from the low travel volume during the pandemic. The short-term rates higher in Q2, the negative impact on operating income from money market fund minimum yield-related waivers decreased to about $500,000 compared to $18 million in Q1. These waivers are now de minimis. Nonoperating results after subtracting the impact attributed to the noncontrolling interest reduced earnings per share for the quarter by about $0.10 due to the negative market impact on our investments. At the end of Q2, cash and investments were $430 million, of which about $379 million was available to us. Debt at the end of Q2 was $397 million, mostly from the $350 million of long-term debt added in Q1. During Q2, we repurchased 2.9 million shares of our stock for approximately $90 million. Chris mentioned in his comments, a large U.K. client that completed their planned multi-year drawdown in the public equity strategies. And we continue to have a great relationship with this large client since we purchased Hermes from them and completed that purchase last year. BTPS continues to be a great client and we have a great relationship in private markets in real estate, infrastructure and looking forward to growth further in private lending also. Chris also mentioned that we recently announced the definitive agreement to acquire substantially all the assets of C.W. Henderson and Associates, Inc., subject to customary closing conditions. The initial purchase price for the transaction is expected to be $30 million based on current asset levels and assuming a certain level of consent to assignment of C.W. Henderson Investment Advisory contracts are obtained. The transaction also involves the opportunity for C.W. Henderson to earn a series of contingent purchase price payments totaling as much as $20 million, which can become payable annually for the next five years based on certain levels of net revenue growth being obtained. We expect the transaction to be accretive by about $0.005 in the first year, excluding the upfront transaction costs. Holly, that completes our prepared remarks, and we'd like to open up the call for questions now.

Operator, Operator

Your first question for today is coming from Patrick Davitt.

M. Davitt, Analyst

First question is on the money fund flow dynamics. Obviously, you had a monster June took a lot of share in the second quarter. But now in July, you're back in outflows, but the industry is still in significant inflow. So what do you think is driving that sudden divergence? And how should we think about your ability to take your fair share of these deposit rotations through the balance of the year?

John Donahue, CEO

First point, and then I'll let Debbie comment is very, very, very difficult to make a long-term comment on a couple of weeks. And so we have big clients, I'm looking at the list and you've got $2 billion, $4 billion, $6 billion, $3 billion days, up and down so far here in July. And it's just tough to make a prognostication from that, for more, Debbie will have a comment.

Deborah Cunningham, CIO

Thanks Chris, and ultimately, I'm just going to say that on those very negative days, we had a preauthorized client departure from about a year ago that was set for this summer. So we had some flows in outflows in May. They started in May, June, July, they got larger. If you mix those out, that single one large client that has moved into another type of product with their underlying client flows we are above the industry flows with that sort of data. So basically, large clients, similar to what Chris was saying, in this case, preauthorized that we knew about and we're not surprised.

M. Davitt, Analyst

Okay. Great. That's very helpful. And then a quick follow-up on the call. I just want to make sure I heard correctly that you said that BTPS has kind of finished with the base of the planned drawdown from the merger.

John Donahue, CEO

Yes.

Operator, Operator

Your next question for today is coming from Dan Fannon.

Daniel Fannon, Analyst

Dan Fannon from Jefferies. Just wanted to follow up on the money market business and make sure we understand kind of the flow-through for the income statement. As we think about exiting 2Q, is the geography of the fee waivers and how we should think about the economics of those products flowing through now kind of normalized with both on the revenue side as well as thinking about the relationship with distribution expense.

Raymond Hanley, President

Dan, it's Ray. I think that's largely true. I mean the yield improvement happened even coming out of Q1 continued into Q2. And of course, some of that came late. But so the waiver recovery was nearly complete. You'll still see a little bit of normalization in Q3, but it's largely complete. And so yes, the geography is at this point, reflective of what it will look like based on the current assets, current channels, current funds and all of that, that can change around, obviously, but that would be based on client changes, not the yield waivers.

Thomas Donahue, CFO

Dan, regarding the distribution expense line item for the full quarter, we would expect that number to increase primarily due to the complete restoration of the waivers. As Ray mentioned, we’ll need to monitor what happens with the assets and the remainder of the distribution expense line item.

Daniel Fannon, Analyst

Understood. And I believe there is also within investment management fees or advisory fees as well as other service fees, that mix also? Is that similar? There should still be some recovery in that, again, assuming the full flow-through of the full quarter just like the distribution expense.

Thomas Donahue, CFO

Yes. I mean we were talking about it in both combined.

Raymond Hanley, President

But it's true of the line items as well, yes.

Daniel Fannon, Analyst

Got it. Looking at expenses for the latter half of the year, travel is increasing along with some discretionary spending. Are there areas where you're either spending less or more compared to the first half? Any insights on expectations for the second half of the year would be appreciated.

Thomas Donahue, CFO

I expect that incentive compensation will increase, although I've stopped making specific predictions. We have onboarded over 170 people this year, which impacts our run rate. Most of these hires were replacements, so the overall number was low. There are also factors like stock-based compensation and severance that balance each other out. Overall, I anticipate an increase in incentives. We also discussed distribution, so I won't go into that again. For advertising, including conferences, I expect a similar run rate to our systems in communications. We are continuing to invest while managing inflation in market data costs, professional fees, and travel expenses. I anticipate these factors will remain significant.

Operator, Operator

Your next question is coming from Kenneth Lee.

Kenneth Lee, Analyst

You mentioned in the prepared remarks ongoing fundraising for the PE funds, the direct lending fund as well. Just wondering how would you characterize the current fundraising environment? What are you seeing in terms of institutional investor demand for these products in the current environment?

John Donahue, CEO

Saker, I'm going to let you take this swing it that way.

Saker Nusseibeh, CEO, Federated Hermes Limited

Thank you very much, indeed. So if we look at the general demand for most of our private assets business, I say the demand is very strong. And this is evident by the fact that we closed our direct lending higher than we expected. We also have these three investments in our private equity fund, which was very encouraging. And remember, in that case, this is a commitment for several years. We've seen commitment to infrastructure as well. And we also announced one joint venture in our property fund. So it appears as if in this time of uncertainty, what we are seeing, I can't speak for the whole market, but what we are seeing is that there's demand for our private assets.

Kenneth Lee, Analyst

Great. That's very helpful. And just one follow-up, if I may, just in terms of the money market fund side. On the regulatory side, any updated thoughts or any updates around that area?

John Donahue, CEO

There aren't any real updates, Ken. We continue to repeat the sounding joy of the beauty of money market funds. We continue our efforts to talk with all of the commissioners to talk to the staff and even to talk to treasury when we can about the importance of these money funds in the market. The only update that I would have to be timing the rumors are notice rumors that perhaps in October, they might finalize the rule. What will be in it? I don't know. As you know, our comments have been that swing pricing is a plug on money funds, and it's a novel plague and that it's never been tried before. And we have also commented that all you have to do is detach the fees and gates from the liquidity requirements, and you're all set to go and let the Boards decide how to run these funds and use all the tools they have in order to do the best fiduciary response for the customers. So that's a little summary just fix what was broken, declare victory and move on has been our message.

Operator, Operator

Your next question for today is coming from Ken Worthington.

Kenneth Worthington, Analyst

Ken Worthington from JPMorgan. So first on SMAs, I believe strategic value is a big part of SMAs. Strategic value appears to be like just crushing it at the moment, but SMAs have are in reasonable redemptions. So I'm trying to sort of figure that out. How should we expect fund sales here to rebound in the SMA version of strategic value as we look forward. I'm a bit surprised that maybe things don't look better in SMAs given how well strategic values are doing. But anyway, help me reconcile the strength of strategic value and the weakness of SMA sales?

Raymond Hanley, President

Ken, it's Ray. For the quarter, the total net inflows for SMAs were just under $1 billion. While most of that came from strategic value, our fixed income SMAs also experienced net inflows, as did some other equity strategies, although strategic value made up the majority. SMAs fall under the category of separately managed account assets. When you see the negative figures, they reflect the $1.1 billion we mentioned regarding BTPS completing their drawdown, along with other client inflows and outflows. However, the SMA business on its own had a very strong quarter.

Kenneth Worthington, Analyst

Okay, great. I may have messed that up. Regarding the client redemption in money market funds that you announced and has occurred over the last couple of months, how much is still left with that client? Have they mostly completed the redemption, or is there still a significant amount remaining as part of that planned redemption?

John Donahue, CEO

Debbie?

Deborah Cunningham, CIO

Yes. The vast majority of that is out. There's still some tails to clean up, but the majority of it is gone.

Operator, Operator

Your next question is coming from Michael Brown.

Michael Brown, Analyst

Mike Brown from KBW. I wanted to take a moment to hear your thoughts on the outlook for the money fund business. We've seen a swift pace of rate increases from the Fed and markets are expecting a cut next year. I know you can't predict changes in the forward curve, but based on industry research or your historical experience, how should we view the performance of money fund flows over the next 12 to 18 months? We understand it's quite fluid, but we would appreciate your insights.

John Donahue, CEO

From a longer-term perspective, Mike, we put a chart in our booklet that shows you the increase in the money supply going up, on average, 7% over some long, long, long period. And the money funds going up both in industry and in Federated, of course, federated going higher than industry, but going up slightly higher. And what that tells you is that as the money stock goes up, people need to put it somewhere. And the money market funds as a group are a very, very valuable and efficacious place for short-term cash whether or not people are worried about inflation or rate hikes or down rates or whatever. So these things have proven for half a century of being very resilient securities and places for short-term cash, we would expect that to continue. And I would certainly expect, especially given what the Fed has done to see increased flows. All of that is subject to whatever the SEC comes up with, which probably doesn't get put into effect until sometime in '23, but you cannot let this question go by without hearing Debbie's view on it.

Deborah Cunningham, CIO

Thank you, Chris. At this moment, I would say we are quite optimistic, Michael. We are still observing the Fed raising rates, which is necessary in light of their ongoing fight against inflation, their top priority to regain control over it. The PCE report released this morning showed an annual increase of 4.8% and a monthly increase of 0.6%, both surpassing expectations. Therefore, it's hard to believe they feel confident that their goals are being met yet. However, looking back at when the rate hikes began, starting with just 25 basis points in March, we are still less than six months into this process. Typically, it takes about six months for these rate increases to affect the various aspects of the market. We believe they are starting to gain control, but we are not there yet. We anticipate further significant increases initially, with another 75 basis points likely in September, followed by a tapering off in the fourth quarter and into the first half of 2023. If we consider a terminal rate around 3.5% to 4%, we expect that to hold for about six months, depending on ongoing developments. The Fed has emphasized their data-dependent approach more than ever, indicating they will respond quickly to new information as it arises. We are actively listening to the Fed's communications and monitoring incoming data, adjusting our strategies based on their guidance with the hope that their actions begin to take effect. In line with what Chris mentioned, there is an influx of money, the money supply has grown, and we are no longer at zero interest rates. This creates a favorable environment for individuals to seek stability, for new cash to be invested, and for people to earn positive returns compared to other asset classes at this time.

Michael Brown, Analyst

Great. Debbie and Chris, I really appreciate that. And then if I just change gears to capital allocation. So you had $90 million of share repurchases in the quarter, you announced the acquisition of C.W. Henderson, which seems like a nice fit here. Can you just share an update on how you think about capital allocation going forward? And then just touch on if you're seeing any other attractive acquisition opportunities at this time?

Thomas Donahue, CFO

We borrowed $350 million at 3.29% over 10 years, and with that funding, we began purchasing shares, aiming for between 8 million to 10 million shares. We anticipated that interest rates would rise and believed our stock was undervalued. Over the past three quarters, we managed to buy about 10 million shares, and we also have the funds for the C.W. Henderson acquisition. I would say we will likely reduce the pace of buybacks given our recent activity. Historically, we've completed about 15 buyback programs since going public, resulting in a 33% reduction in our share count. Currently, we have a 5 million share buyback program approved and available for use, and we plan to remain active in this area. Regarding mergers and acquisitions, we just announced a deal and are already being asked about the next one. We need to close this deal before shifting our focus onto further growth opportunities, but our team is actively exploring possibilities in both M&A and alternative investments, although I don't have any specific details to share at this moment.

Operator, Operator

Your next question for today is coming from John Dunn.

John Dunn, Analyst

John Dunn, Evercore ISI. Could you maybe touch on where the sales discussions and kind of underlying gross decay picture is for the Kaufmann Small Cap Fund?

John Donahue, CEO

I missed some of your words there, John. Please repeat.

John Dunn, Analyst

Okay. Yes, sure. Okay. Sorry about that. Maybe could you just touch on where the sales discussions and maybe the underlying gross decay picture is for Kaufmann Small Cap?

John Donahue, CEO

In general, we closed that fund, which had been closed for over a year. The asset figures were at $10 billion and are now in the $6 billion range. We reopened it because some clients indicated this would be a good time to average in or invest in small cap growth. At this point, I'll let Ray explain some of the dynamics.

Raymond Hanley, President

Sure, John. If you look at the redemption trend in that fund in Q1, it was about $638 million. That dropped to $365 million for Q2 and through the early part here three weeks of Q3, it's running at more like 58%. So it continues to trend downward. Those are the numbers. Anecdotally, our sales force, our regional consultants are having, there's a lot of conversation about when is the right time to get back into this strategy and the growth, but into this strategy, in particular, given its long-term history and the record and strength of that team. So what we've seen so far is the diminution in redemptions, and we're anticipating ongoing improvement as there is considerable interest in that strategy.

John Dunn, Analyst

Great. And then maybe just one other on another recent drag on flows. You talked about better trends in Ultrashort and high-yield funds. Do you think that could continue to trend closer to, if not to neutral, less of a drag?

John Donahue, CEO

Well, the original wording I had was they're less worse, which was changed to say they were better. That still holds true. The only positive aspect of those redemptions, like with any, is that once they're gone, they're gone. That's the situation we're facing. Those products are still viable, and we even had one of our high-yield offerings experience positive flows. Ray will provide more details on that, but we don't expect them to stop anytime soon.

Raymond Hanley, President

Yes, same kind of picture. I mean, if you look at high yield collectively where we had about $860 million of redemptions in Q2, that's now more like about $170 million. Again, there's been challenge with that asset class with credit, but our clients certainly know our long-term record and the strength of the team we have. And so as conditions improve and as people become more confident in things like high-yield exposure. We would fully expect that, that would continue to improve and eventually get back to inflows. On the Ultrashort side, it's all part of the spectrum of what's happening with liquidity options. So Chris mentioned Microshorts having some inflows. Obviously, cash has had inflows. When you get the kind of rate movement that Debbie has talked about, and you had clients who moved out to Ultrashort when money market yields were down close to 0, and you could get 1% or plus or minus at an Ultrashort, there's less reason to do that now. And so we certainly, I'm sure, has some of that money that's left Ultrashort's wash up into the money market part of the complex. But the pace of the net redemptions looks to be decreasing. It went down slightly in Q2 compared to Q1, and it's trending to be down more again, through the very early part of Q3.

Operator, Operator

We do have a follow-up question coming from Patrick Davitt. Patrick.

M. Davitt, Analyst

Real quick one on the big money fund client loss that you were talking about this summer. I assume given what's clearly a pretty big chunk of money that the fee rate on that was quite small. Is that a fair assumption?

Raymond Hanley, President

It's difficult for us to discuss any specific client, although we haven't identified them. The best approach would be to consider the overall blended fee rate. Since it is an intermediary, there are both revenue and related distribution expenses, but there isn't a specific reason to treat this situation differently from others.

Operator, Operator

There are no further questions in queue. I would like to turn the floor back over to Ray for any closing remarks.

Raymond Hanley, President

Well, thank you very much, Holly, and that concludes our call, and we thank you for joining us today.

Operator, Operator

Thank you, ladies and gentlemen. This does conclude today's conference call. You may disconnect your phone lines at this time, and have a wonderful day. Thank you for your participation.