Earnings Call Transcript - FHN Q1 2022

Operator, Operator

Good day, everyone, and welcome to the Federated Hermes Q1 2022 Analyst Call and Webcast. It is now my pleasure to hand it over to your host, Ray Hanley, President of Federated Management Company. Ray, 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. Joining us for the Q&A are Saker Nusseibeh, the CEO of the international business of Federated Hermes, 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 from 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?

John Donahue, CEO

Thank you, Ray, and good morning. I will review Federated Hermes' business performance over the quarter, and Tom will comment on our financial results. Looking first at equities for Q1, total net redemptions were $78 million, down from the prior quarter's $2.7 billion. Equity separate account net sales were a positive $80 million, while equity funds had net redemptions of about $158 million, each showing improvement from the prior quarter. Notably, the domestic Strategic Value Dividend Strategy had Q1 net sales of about $933 million, with both the fund at $442 million and the SMA at $490 million, producing solid net sales. We saw positive net sales in 18 equity fund strategies including several international equity strategies, such as Asia ex-Japan, SDG Engagement, International Equity, International Strategic Value Dividend, Global Equity ESG, and Impact Opportunities. Back on the domestic side, the MDT Small Cap Core Fund also produced $127 million in net sales. Not surprisingly, net redemptions were concentrated in growth strategies, reflecting difficult market conditions for these activities. With inflation concerns prevalent, the areas of focus of our equity business include asset classes and strategies that have responded well in past inflationary periods. These include dividend income, international, emerging markets, and value strategies. The Q1 sales improvements were concentrated in these categories. Our equity performance at the end of the first quarter compared to peers was solid. Using Morningstar data for the trailing 3 years at the end of Q1, 61% of our equity funds were beating peers, and 39% were in the top quartile of their category. In the first 3 weeks of Q2, combined equity funds and SMAs had net redemptions of $109 million. We had 21 equity funds with positive net sales in the first 3 weeks of April, including the Strategic Value Dividend, the International Strategic Value Dividend Fund, Global Equity ESG, Impact Opportunities, and International Equity. Now turning to fixed income, Q1 net redemptions were about $2 billion. Net sales of just under $1 billion in fixed income separate accounts were offset by $3 billion in fixed income fund net redemptions. Our fixed income separate account net sales of just under $1 billion were driven by multisector strategies. Within fixed income funds, the 3 Ultrashort funds had net redemptions of about $1.4 billion. The institutional high-yield bond fund had about $750 million of net redemptions. All categories of bond funds had net redemptions, reflecting market conditions. However, we had 17 fixed income funds with positive net sales in the first quarter: our Floating Rate Strategic Income Fund, the SDG Engagement High Yield Credit, Climate Change High Yield Credit, Strategic Income, Inflation Protected Securities, Short-Term Government, Total Return Bond Fund, and Conservative Municipal Microshort. Regarding performance, at the end of the first quarter and again, using Morningstar data for the trailing 3 years, 61% of our fixed income funds were beating peers, and 19% were in the top quartile of their category. For the first 3 weeks of Q2, fixed income funds and SMA had net redemptions of about $1.1 billion. In the alternative private market category, net sales of $139 million included real estate of $215 million, direct lending of about $57 million; Pru Bear, about the same number; and trade finance, $30 million. These were partially offset by net redemptions in private equity and in infrastructure. So we begin Q2 with about $1.1 billion in net institutional mandates yet to fund into both funds and separate accounts. Additions are expected to occur in alternatives private markets, including private equity, unconstrained credit, and direct lending. Fixed income wins include core, flexible credit, and government debt strategies. Moving to money markets, assets declined about $27 billion in Q1 compared to UM totals as money market fund assets decreased by $33 billion and our separate account money market assets increased by about $6 billion. Our total money market assets at the end of Q1 were just above the total that we had at the end of the first quarter of '21. Seasonal trends impacted both money market funds and separate accounts. Rising interest rates and competitive pressure also impacted money market fund asset levels. Our money market fund market share, including sub-advised funds, was about 6.9% at the end of Q1, down from about 7.4% at the end of 2021. With the first Fed hike last month and a series of additional increases expected, money market fund minimum yield-related fee waivers decreased in Q1. Market expectations are that the Fed will increase the pace of interest rate hikes. While we welcome higher money market yields, we believe that major increases would be better for money market funds compared to direct investments. However, though more rapid rate increases may initially favor direct investments, we believe that higher short-term rates will benefit money market funds over time, particularly compared to deposit rates. We noted this in history. We said during the last quarter that during the last Fed increase cycle that began in Q4 of '16 through the last rate hike in Q4 of '18, after an initial decline, our money market fund managed assets increased by 15%. The industry followed a similar pattern with an initial decline followed by growth of 11% over that same timeframe. The higher rates helped us continue to grow these assets by an additional 22% through the third quarter of '19 when the Fed began to ease. Industry money market fund assets also grew in this period, showing a 14% increase. Now on the regulatory front, we recently filed 2 comment letters with the SEC on their proposed money market fund rule changes, including a primary comment letter of 115 pages and a separate 45-page letter on the deviance of swing pricing. Our comments and those from others note that swing pricing is not a workable alternative for institutional prime and muni money market funds. We believe that most institutions would not use these products if swing pricing were to be imposed. In addition to uncertainty around redemption proceeds from a client's point of view, large-scale systems changes would be required by money fund managers, intermediaries, and investors to even enable swing pricing to function. In our view, few, if any, will undertake these efforts. As a result, we expect that most of the assets currently in institutional prime and municipal money market funds would shift to government money funds as many did with the last round of changes in 2016 or move to products like our private prime liquidity fund that are not subject to money market mutual fund regulation under 2a-7. We have approximately $8 billion in client assets in this category of institutional prime and municipal funds that we believe would be impacted if swing pricing were to be imposed as the SEC is proposing. We also commented that the SEC-proposed requirement that stable NAV money market funds convert to a floating NAV under future market conditions would result in negative money market fund yields, leading to material outflows from U.S. government money funds to bank deposits or other nonregulated investment products. Now taking a look at recent asset totals, managed assets were approximately $617 billion, including $413 billion in money markets, $87 billion in equities, $91 billion in fixed income, $22 billion in alternative private markets, and $4 billion in multi-asset. Money market mutual fund assets were $269 billion.

Thomas Donahue, CFO

Thanks, Chris. Total revenue for the quarter increased 1% from the prior quarter due mainly to lower money market fund minimum yield-related waivers, an increase of $34.3 million and $2 million from higher average money market assets, offset by lower average equity assets reducing revenue by $17.4 million; fewer days in the quarter reducing revenue by $9.3 million; lower carried interest and performance fees of $3.6 million; and lower average fixed income assets reducing revenue by $2.4 million. Q1 carried interest and performance fees were $100,000 compared to $3.7 million in Q4. Operating expenses increased 3% in Q1 compared to Q4. Looking at compensation and related expenses, about $7.7 million of the $9.9 million increase from the prior quarter was due to severance, seasonally higher stock compensation and payroll taxes. Other factors included incentive compensation and base salary increases. Higher distribution expense resulted mainly from lower money market fund minimum yield waivers. Advertising and promotional expenses decreased due mainly to the timing of our ad campaigns. With short-term rates higher in Q1, the negative impact on operating income from minimum yield waivers on money market funds decreased to about $18 million compared to $38 million in Q4. We expect the Q2 negative impact to decrease to about $1 million. Nonoperating results after subtracting the impact attributed to the noncontrolling interest reduced earnings per share by about $0.07 due to the negative market impact on investments. At the end of Q1, cash and investments were $457 million, of which about $418 million was available to us. Debt at the end of Q1 was $397 million, including the $350 million of long-term debt added during Q1. Net cash and investments were $20 million at the end of the quarter. During Q1, we purchased over 3 million shares of our stock for approximately $102.5 million. All that completes our prepared remarks. We're happy to take questions now.

Operator, Operator

And the first question is from Patrick Davitt from Autonomous Research.

M. Davitt, Analyst

My first question is on the comments around the flow from deposits to money funds. Schwab recently called out this cash sorting as being an issue for their deposit accounts. So could you kind of square that through the lens of what you just said? And maybe, Debbie, give us an update on your thoughts on when you could actually see a more aggressive rotation from those deposits to your money funds if we do get a more aggressive Fed, as it looks like we will?

Deborah Cunningham, CIO of Money Markets

Certainly, Patrick. I think what Schwab was talking about there—not putting words in their mouth—is that deposit products, number one, don't follow interest rates in an upward fashion on a one-on-one basis. The deposit beta for the last time interest rates rose was about 20%, meaning that for every 1% the Fed raises rates, deposits went up 20 basis points. The other side of that equation, I think, that exacerbates things along the lines in this particular environment is that banks have more cash than they actually need at this point or want, and the demand for that cash is not high. So they have no real incentive to attract cash by increasing their rates more quickly than they otherwise would. I think both of those pose problematic for those offering deposit-type products. On the other hand, when we look at what the yield curve is providing us with right now, we think that those are pretty substantial at this point, especially since the Fed is expected to increase rates by a minimum of 50 basis points next week and then following suit with another 50 basis points, likely in either June or July. You'll see the return on money market funds following that Fed increase quite quickly. Generally speaking, as the yield curve anticipates, prime and muni funds that have a little bit more of a laddered approach or longer securities generally catch up more quickly before the movement actually occurs. Whereas government funds, which have more on an overnight basis in the repo market, catch up much more quickly as soon as the Fed increases. So it comes at different points throughout the cycle of the Fed meeting cycle. But generally speaking, in a rising rate environment—as long as it's well telegraphed and anticipated—you end up with money market funds following quickly in the path of rising rates and reflecting those higher returns back to customers.

M. Davitt, Analyst

Okay. Helpful. And just a follow-up on the flow guidance you gave. I just want to confirm, is that through April 22? You said the first 3 weeks. Could you also give us the multi-asset and alts flow through that period?

John Donahue, CEO

The answer to the first question is yes, April 22. The answer to the second question is about to arrive.

Thomas Donahue, CFO

Yes. The multi-asset would be about negative 15. And the alts is positive, about 5.

Operator, Operator

And the next question is coming from Bill Katz from Citigroup.

William Katz, Analyst

Okay. Just a question on the money markets for a moment. Can you unpack a little bit why your market share went down as much as it did quarter-on-quarter, maybe even year-on-year? And then as you sort of think about this rate cycle, is the more recent rate cycle the better cycle? Or should we go back to 1994? And if you have that kind of perspective, I was wondering how was the behavior of money markets in that prior cycle?

John Donahue, CEO

Bill, on the competitive landscape, a few factors contributed. One is the normal amount of money that goes out for taxes, which I think we saw more than the average. Another factor is the competitive landscape, where others are waiving more than we are, and our yields are where they are. Overall, as you know, we don't lose clients on that front. As for the rebound, it relates to what Debbie just discussed. When the rates increase significantly and get caught up, as Debbie pointed out, banks don't want the money and can't use it. They prefer a good deposit beta, which leads to a recovery in money fund assets.

Raymond Hanley, President

Bill, I don't have the '90s data. But back in '04, mid-'04, the Fed raised by 25, followed by a series of 50 basis point hikes for the next 2 years. Our assets initially decreased and then increased as the final Fed movement raised by 50 basis points in mid-'06. We were pushing $150 billion. So it’s a similar cycle.

Deborah Cunningham, CIO of Money Markets

I would warn against comparing this to the '94 cycle, Bill, as it was a different Fed back then. Moreover, other market dynamics were at play, with unexpected rate increases and various financial products causing disruptions in the money markets. Most of those instruments have since been purged.

William Katz, Analyst

Okay. That's helpful perspective. As a follow-up, coming back to the long side of the business. I appreciate your good Morningstar performance, at least in the top half, but I have a two-part question. Why do you think you're getting better traction in separate accounts versus the mutual funds? When you break down your Morningstar categorization, the first quartile for equity and fixed income is quite thin. Does that impact your future sales?

Raymond Hanley, President

Bill, the uptick you see this quarter is driven by Strategic Value Dividend. The Morningstar category, specifically large-cap value, isn't a good fit. The funds produced solid net inflows in this cycle because of a rotation toward appreciating high and growing dividend income streams. Although quartiles and rankings are important, with a strategy that has existed for decades, intermediaries understand its place in portfolios. Furthermore, despite challenges in domestic growth, several international equity products are consistently producing solid net inflows. This growth might not align with Morningstar rankings, but we have certain categories that perform well.

John Donahue, CEO

Overall, as I mentioned, having 39% of equity funds in the top quartile over 3 years is commendable. We always strive for more, but that's a strong position. Our sales of equity products this year would be among our best ever. Gross sales suggest the marketplace recognizes our presence, evidenced by the 18 individual funds with positive net sales during the quarter.

Operator, Operator

And the next question is coming from Robert Lee from KBW.

Robert Lee, Analyst

Great. Maybe the first one is going back to the competitive environment in money funds. Given the industry consolidation over the years, do you see more rational players as rates rise and money flows back to the industry? Do you feel better or worse about the competition as money returns? Is there a possibility that players may try to gain market share through price competition?

John Donahue, CEO

I suspect you'll see more consolidation, especially when rates rise. Traditional players tend to hold on for a while before eventually exiting the money market fund business. We welcome those looking to exit.

Deborah Cunningham, CIO of Money Markets

Rob, I’d add a positive note on the regulatory response to proposed Rule 2a-7 changes. The industry's collective response against swing pricing for institutional prime and muni funds, alongside the floating NAV for all products, signifies a unified stance that is encouraging.

Robert Lee, Analyst

Great. As a follow-up on capital management: I recall that historically you avoided taking on debt and doing so primarily for transactions. Notably, however, you've recently increased debt and share repurchases over the last two quarters. What can you tell us about your capital management strategy moving forward? Are you more inclined to repurchase shares than in the past? Additionally, could you provide your perspective on scaling up in the alternative business, which many peers have opted for through acquisitions?

John Donahue, CEO

Regarding alternatives, after our acquisition of Hermes, we found attractive elements in their alternative divisions—real estate, private equity, infrastructure, and private lending. We're currently building up our platform for these activities. Our past structure had limited clients, but now we're focused on expanding our outreach.

Thomas Donahue, CFO

Rob, concerning debt and shares, we anticipated rising interest rates, which led us to secure $350 million on a fixed basis. We've historically avoided borrowing just for the sake of it, but we're optimistic about our value in the market. Our strategy hinges on our free cash flow growth and taking advantage of stock repurchase opportunities when deemed appropriate—this is evident in our recent buybacks.

Kenneth Worthington, Analyst

What I want to dig into more is the Kaufmann franchise. How should I consider the margins for that business? And, is it true that Kaufmann runs lean? How many investment professionals are there?

John Donahue, CEO

The distribution for Kaufmann goes through the usual channels via FHI. Following the acquisition strategy, we let the investment manager operate independently while managing distribution. Regarding Hans, he’s been with the company for years and is still active. Succession plans are in place with Mr. Ettinger and Hans working together. Performance hasn’t met our expectations but is in line with our growth strategy in biotech. We've recently opened the Small Cap Kaufmann Fund, and there’s renewed interest evidenced by trades as clients take advantage of buying opportunities.

Raymond Hanley, President

The size of the investment team at Kaufmann is around a dozen portfolio managers and senior analysts, which has remained consistent over the years.

John Donahue, CEO

We don’t provide individual margin analysis per business segment. Unfortunately, I don't have any further comments on specific margins.

Kenneth Worthington, Analyst

No, that was it. I'll try to figure it out myself. It was an amazing deal, so just wanted to dig in, given all that's going on in growth these days.

Operator, Operator

And we did have a follow-up coming from Patrick Davitt from Autonomous Research.

M. Davitt, Analyst

On Strategic Value Dividend, in the past, when it put up strong performance figures, it attracted significant net new flows. It seems like we could be in the early stages of that given the Q1 figures. Is there a building pipeline of SMA mandates? Can you frame that versus how it looked a quarter or two ago?

John Donahue, CEO

There is great interest in this particular mandate. I can't specify what's in the pipeline for SMA growth, but historically, when performance improves, it tends to yield solid net flows. The portfolio manager and team will continue their consistent strategies. The franchise previously managed over $30 billion, and while it dropped to $25 billion, it remained steady due to consistent dividends. They will continue to manage the fund dynamically.

Operator, Operator

And there were no other questions in queue at this time. I would now like to hand the call back to Ray Hanley for any closing remarks.

Raymond Hanley, President

Well, thank you for joining us today. This concludes our call, and we appreciate your interest.

Operator, Operator

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