Federated Hermes, Inc. (NYSE:FHI) Q2 2023 Earnings Call Transcript

Federated Hermes, Inc. (NYSE:FHI) Q2 2023 Earnings Call Transcript July 28, 2023

Operator: Good morning, everybody, and welcome to Federated Hermes, Inc. Q2 2023 Analyst Call and Webcast. [Operator Instructions] Please note, this conference is being recorded. I will now turn the conference over to your host, Raymond Hanley, President of Federated Investors Management Company. Raymond, over to you.

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

Chris Donahue: Thank you, Ray, and good morning all. I will review Federated Hermes business performance, and Tom will comment on our financial results. Looking first at equities. Assets were down $637 million to $83 billion due largely to net redemptions of $828 million, partially offset by market gains of about $115 million. Even so, we saw Q2 positive net sales in 15 equity strategies, including Asia ex-Japan, MDT’s large-cap growth, MDT Mid-Cap Growth and international leaders. Now the strategic value dividend domestic strategy had Q2 net redemptions of $700 million compared to net sales of $727 million in the first quarter. As we have talked about before, this strategy is outcome-driven and is benchmark-agnostic. It seeks a high and rising stream of dividend income from high-quality companies.

Over the last 10 years ended June 30, it has returned on average 7.4%. To make the point, the strategy returned 8.5% in 2022 compared to a loss of over 18% from the S&P 500 and thereby ranked in the top 1% of its Morningstar assigned category of large cap value for this 2022 performance. Year-to-date, however, through June of ’23, it has a negative return of 5.3% compared to the S&P 16.9% gain, and that ranked it in the 99th percentile of its assigned category. This year, the market, as you know, has been led by a small group of technology companies that are largely outside of this strategy’s objectives, as they either pay no dividends or have a low dividend yield. The top yielding quintile of stocks in the S&P 500 are underperforming the bottom yielding quintile by nearly 40% to-date.

Now this strategy would benefit and investors rotate back into cheaper high-yielding defensive stocks. Looking at our equity performance overall compared to peers and using Morningstar data for the trailing three years. At the end of the second quarter, 50% 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 $310 million. Now turning to fixed income. Assets decreased slightly in the second quarter to $87.4 billion. Fixed income funds and SMAs had Q2 net sales of $454 million, while fixed income institutional separate account net redemptions of $526 million were driven by regular cash flows from a large public entity.

Within funds, our flagship Core Plus strategy, Total Return Bond Fund had Q2 net sales of about $1 billion. Core Plus and other fixed income SMA strategies added $207 million of Q2 net sales while net redemptions of about $354 million occurred in the three Ultrashort funds. The Ultrashort net redemptions were down from $1.2 billion in the prior quarter. Just as a note, total AUM and Ultrashort are about $5.4 billion here at mid-July. We had 15 fixed income funds with positive net sales in the second quarter including, of course, total return bond fund and SDG Engagement High Yield Fund. Regarding performance. At the end of the second quarter and using Morningstar data for trailing three years, 49% of our fixed income funds were beating peers and 16% were in the top quartile of their category.

For the first three weeks of Q3, fixed income funds and SMAs had net positive sales of $20 million. In the alternative private markets category, assets increased by $428 million in Q2 compared to the prior quarter, reaching $21.6 billion. The increase was due to FX impact, partially offset by net redemptions and distributions. We had the final close of PEC 5, the fifth vintage of our private equity co-invest fund in June, reaching $486 million in commitments, which exceeded our $400 million target. Commitments came from existing PEC Series investors as well as new investors from Europe and South Korea. Federated Hermes GPE has a 22-year track record of making co-investments having committed $4.5 billion across 278 global co-investments as of March of ’23.

We continue to market Horizon 3, the third vintage of our Horizon series of private equity funds. Horizon 3 has commitments of a little over $1 billion through the second quarter. We are also in the market with the Hermes Innovation Fund, which is 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. Now we began the third quarter with about $5 billion in net institutional mandates yet to fund, both in the funds and separate accounts. These wins are diversified across fixed income, equity and private markets. Fixed income expected net additions totaled $2.5 billion. This includes wins in active cash, short credit, corporates, high yield and core plus.

Approximately $1.3 billion of total net wins is expected to come into private market strategies. This includes private equity, direct lending and absolute return credit. About $1.2 billion of total net wins is expected to come into equity strategies, including biodiversity, global emerging markets, MDT Mid-Cap Growth and Global Equity. Moving to Money Markets. We reached record highs for money market fund assets of $364 billion and total money market assets of $509 billion. The second quarter presented a challenging environment for managing money market strategies as the debt ceiling prices significantly impacted short-term debt markets. Despite this challenge, money market strategies continue 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 be favorable compared to both direct markets and bank deposit rates. Looking at flows in money funds in the second quarter, we saw good activity from products geared to the retail customers of financial intermediaries. Institutional product flows were challenged by the aforementioned debt crisis direct security yields and the regular June corporate tax period. Now the SEC, as you know, recently adopted new rules for money market funds. We continue to study these rules to assess their impact. We were pleased to see that swing pricing was not included and that the ability to use a reverse distribution mechanism was included as an option and a remote possibility that negative yields were to occur.

We were also pleased that the SEC agreed with our recommendation to remove temporary redemption gates and the link between weekly liquidity asset thresholds and liquidity fees, which we believe created an incentive for investors to redeem sooner in periods of market stress and prevented the manager from using as much liquidity as was available. The inclusion of mandatory redemption fees subject to certain conditions in institutional prime and muni funds presents a challenge for fund advisers and investors. We have approximately $11 billion in third-party institutional assets in institutional prime and muni funds that we believe could shift to alternative products that we offer, including our private prime fund and government money market funds.

It’s worth noting that institutional prime and muni funds already have fluctuating net asset values and that there is an exception or a carve-out for so-called de minimis impact based on the hypothetical selling of a strip of securities that may occur on the rare days when we have a 5% redemption trigger. We will be talking with our institutional clients over the coming months on this topic. We believe that these investors will continue to use the institutional prime and muni funds, at least into late next year, when the new rules take effect. Our estimate of money market mutual fund market share, including sub-advised funds, was 7.2% at the end of the second quarter down from 7.4% at the end of the first quarter. Now looking at recent asset totals as of a few days ago, managed assets were approximately $707 billion, including $510 billion in money markets, $84 billion in equities, $89 billion in fixed income, $22 billion in alternative private markets and $3 billion in multi-asset.

Money market mutual fund assets were $365 billion. Thank you, on financials.

Tom Donahue: Thank you, Chris. As described in the press release, Q2 results included two transactions that impacted results for a combined loss net of tax of $800,000. The transactions include a sale by a shareholder in one of our private equity funds of a portion of their investment to a third party and a restructuring of one of our infrastructure funds. We continue to manage both funds. Total revenue for Q2 increased $51 million from the prior quarter due mainly to an increase of $38 million in carried interest and performance fees, of which $25.9 million is from carried interest revenue from consolidated carried interest vehicles that was offset mainly by compensation expense. Retained carried interest and performance fees increased by $12.1 million from the prior quarter.

Total Q2 performance fees and carried interest were $39.4 million. All other revenue increased by $13.1 million or 3% due mainly to higher average money market assets, bringing in $11.6 million of revenue and an additional day in the quarter, bringing in $4.6 million of revenue partially offset by lower average equity assets, reducing revenue by $2.5 million. Q2 operating expenses increased $37.8 million from the prior quarter due mainly to $25.7 million of compensation expense from the consolidated carried interest vehicles and from $9.8 million due to the restructuring of the infrastructure fund recorded in other expense. All other expenses increased by $2 million or 1%. The $23 million increase in compensation and related expense from Q1 included the $25.7 million in consolidated carry interest vehicle compensation and $1.4 million in severance partially offset by $4.1 million of lower incentive compensation expense.

The increase in professional service fees from Q1 was due mainly to higher legal and consulting fees. The increase in advertising and promotional from the prior quarter is mainly due to the timing of certain conference and advertising spending. The effective tax rate was 27.4% for the quarter. The Q2 rate was impacted by the restructuring of the infrastructure fund, which included the purchase rights to receive future carried interest, this purchase and related expenses were not deductible for tax purposes. As a result, our effective tax rate was higher this quarter compared to our expected rate of 24% to 26% for 2023. At the end of Q2, cash and investments were $521 million, of which about $459 million was available to us. Jenny, we would like to now open up the call for questions, please?

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Q&A Session

Operator: [Operator Instructions] Thank you. Your first question is coming from Daniel Fannon of Jefferies. Daniel, your line is live.

Daniel Fannon: Thanks. Good morning. So I wanted to start with just money market flows and understand your comments that as rates stabilize or peak, you expect to see those flows pick up. But also just want to contrast that to what we’re hearing just broadly about fixed income flows also picking up when that occurs. So how do you think investors and the balance between what bond funds and money market funds are going to look like as we – our allocations are going to trend as we get towards more of that peak rate or lower rates potentially dynamic.

Chris Donahue: Daniel, I’ll comment on the bond fund portion, and I’ll let Debbie add on the money market portion. So our franchise, the Core Plus franchise, total return bond has over $18 billion in it, and it is a great bucket to have a very good story over the long term. And so as we’re looking at the fixed income market, that is a big allocation, almost no matter what is going on in the marketplace. And therefore, we are winning mandates where that is a core position and how people are feeling is a little different than a core allocation. And so we’re winning in that space. If you talk to the FA, they are somewhat reticent to go into the market full bore, even though you’ve seen some changes along those lines with market performance. And so they are quite sanguine about a core position in the Core Plus fund that has this kind of record. And I’ll let Debbie comment on the money market portion, and then I’ll draw them back together after her comments.

Debbie Cunningham: Thanks, Chris. So from the money market side of the equation, much of the growth that we have seen so far has come from the retail side of the market. And that’s simply because compared to bank deposit rates where they were for a lot of the zero rate environment, money market funds are now paying much more attractive market rate of return. For institutional buyers, however, they have the ability generally to be able to be in direct markets specifically, so buying direct commercial paper, buying direct CDs. And as the market has increased, they have been purchasing direct market securities such as those in order to pick up the yield, the higher yield more quickly. Money market funds operate with a lag, maybe 25 to 30 days depending upon what our weighted average maturities are.

Once markets peak or plateau in this case. And even then, even more so when they start to go down the other side, the opposite occurs for the institutional investor where they come into those funds that actually lag the market and therefore, stay at that higher rate for a longer period of time. So generally, that’s when we would see institutional markets and the institutional flows pick up while retail will be maintained at that point. So it comes from two different sources. The retail side, as money is coming off as zero, and very attractive versus bank deposits. And then once rates plateau and start to go down even marginally, it comes from the institutional side. So that’s – and these are generally cash managers cash management flows. It doesn’t include what Chris was talking about, those flows that ultimately may make their way back to the longer side of the fixed income markets or even the equity markets for that matter.

Chris, back to you.