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Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Good day, ladies and gentlemen, and welcome to the Federated Hermes Q1 2022 Analyst Call and Webcast. At this time, all participants have been placed on a listen-only mode, and the floor will be opened for questions and comments after the presentation. It is now my pleasure to turn the floor over to your host, Ray Hanley, President of Federated Management Company. Sir, the floor is yours.
Good morning, and welcome. Thank you for joining us today. 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, 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 than the results implied by such statements. Please review the risk disclosures in our SEC filings. No assurance can be given as to future results, and Federated Hermes assumes no duty to update any of these forward-looking statements. Chris?
Thank you, Ray, 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, impact opportunities.
Back on the domestic side, the MDT small cap core fund also produced $127 million in that sale. Not surprisingly, net redemptions were concentrated in growth strategies, reflecting difficult market conditions for these activities. With inflation concerns prevalent, the area of focus of our equity business include asset classes and strategies that have responded well in the 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 three years at the end of Q1, 61% of our equity funds were beating peers, and 39% were in the top quartile of their category. Now, for the first three 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 three 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 multi-sector strategies. Within fixed income funds, the three short - the three ultra-short 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 debt 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 micro-short. Regarding performance, at the end of the first quarter, and again, using Morningstar data for the trailing three years, 61% of our fixed income funds were beating peers, and 19% were in the top quartile of their category. For the first three weeks of Q2, fixed income funds and SMAs 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, Prudent Bear, about the same number, trade finance, $30 million. And 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 UN 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. Now, 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. Tom will update us on our yield waiver outlook. Market expectations are that the Fed will increase the pace of interest rate hikes. While we welcome higher money market yields, we believe that measured 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, and we've 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 a 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 two 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’s proposed requirement that stable NAV money market funds convert to a floating NAV of future market conditions, resulted in negative money market fund yields, would lead to material outflows from US government money funds to bank deposits, or again, other non-regulated 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. Tom?
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 expense increased 3% in Q1 compared to Q4. Looking at compensation and related expense, about $7.7 million of the $9.9 million increase from the prior quarter, was from 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 expense decreased due mainly to the timing of our ad campaigns. With short-term rates higher in Q1, the negative impact on operating income for 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. Non-operating results after subtracting the impact attributed to the non-controlling 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.
Paul, that completes our prepared remarks. We're happy to take questions now.
[Operator Instructions] And the first question is coming from Patrick Davitt from Autonomous Research. Patrick, your line is live.
Hey, good morning, everyone. 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 of 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.
Certainly, Patrick. And I think what Schwab was talking about there, not putting words into 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. So, I think both of those pose to be problematic for those that are offering deposit-type products.
On the other hand, when we look at what the yield curve is providing us with right now, what it may provide us with as investment opportunities next week after the Fed meets, we think that those are pretty substantial at this point, especially since the Fed is expected, and we would expect them to increase rates at a minimum of 50 basis points next week, and then following suit with another 50 basis points more, more or less likely in either June or July, you're going to see the return on money market funds following that Fed increase, quite quickly. Generally speaking, as the yield curve anticipates prime muni funds that have a little bit more of a laddered approach, or they have longer securities generally in a more barbell fashion out the curve, those catch up more quickly before the movement actually occurs, whereas government funds, which have more on an overnight basis in the repo market, generally speaking catch up much more quickly as soon as the Fed increases. So, it comes at different points throughout the cycle of sort of the Fed meeting cycle. But generally speaking, in a rising rate, as long as it's fairly well telegraphed, fairly well anticipated, and certainly what we have at this point is a Fed that's trying to do that, and communication is key, you end up with money market funds following quite quickly in the path of rising rates and reflecting those higher returns back to customers
Okay, helpful. Thanks. And just a follow-up on the flow guidance you gave. I just want to confirm, is that through April 22nd? You said the first three weeks. And could you also give us the multi-asset and alts flow through that period?
The answer to the first question is yes, April 22nd. The answer to the second question is about to arrive
Yes. The multi-asset would be about negative 15. And the alts is positive, about five.
Thank you.
Thank you. And the next question is coming from Bill Katz from Citigroup. Bill, your line is live.
Okay. Thank you so much. Just a question, stay on the money markets for a moment. Could 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 behavior of money markets in that prior cycle? Thank you.
Good morning, Bill. On the competitive thing, there have been several features. One is the normal amount of money that goes out for taxes. And I think we have more than the average bear. So, that was a factor. Another factor is, of course, the competitive landscape where others are waving more than us and our yields are where they are. And that's what we've talked about before in terms of competitive situation. But overall, as you know, we don't end up losing clients on that score. As to how we look at the bounce back, it has to do with what Debbie was just talking about and what I mentioned in my remarks, that what we've seen is that when the rates get big and real, and they get caught up, and as Debbie points out, the banks don't want the money and can't use the money and don't want to have it anyway, because they'd rather have a good deposit beta, you get a spring back on the money fund assets, right?
Bill, I don't have the ‘90s data, but back in ’04, which - mid ’04, the Fed raised by 25, and then a series of 50 basis point hikes through - for the next two years. Our assets initially decreased at that time. The fund assets went into that up-rate cycle at about $123 billion, went about 10, $10 plus billion. And then came out of that with the last Fed movement up 50 basis points in mid ’06, we were up pushing $150 billion. So, the cycle was about the same back in that timeframe.
And I'd warn against comparing to the ‘94 cycle, Bill, just simply because it was a very different Fed back in 1994, number one. But number two, there were a lot of other things going on in the market during that timeframe when there were unexpected 75 and 100 basis point increases in rates, and they were basically derivatives floating rate securities that were in the marketplace. Inverse floaters was what was happening then, 10-year CMT floaters, non-dollar-based LIBOR floaters. All of those things were causing angst in the money markets, and they've all been purged at this point. So, I think I would hesitate to compare to that time.
Okay. That's helpful perspective. Thank you. And just as a follow-up, just coming back to the loan side, loan-only side of the business, and I appreciate that you have good sort of Morningstar performance, at least on the top half, but maybe a two-part question. Why do you think you're getting better traction in the separate account, separate managed account side, versus the mutual funds? And then when you break down your Morningstar categorization, the first quartile for equity fixed income, is pretty thin. Does that have an impact on sort of go-forward sales? Thank you.
Bill, on the equity side, the uptake you see this quarter, of course, is driven by a strategic value dividend. And if you look on the funds side, we've always consistently said that the Morningstar category, i.e., large cap value, is not really a good fit. And so, the funds produce pretty solid net inflows as well in this cycle, with a rotation into more of an appreciation of a high and growing dividend income stream. So, we tend to think that the quartiles and the rankings are sort of the be-all and end-all, and they certainly are very important. But in this particular case, with a strategy that's been around now for decades and sold through intermediaries who understand what it is and how to use it and how - what its place is in the portfolio, it's a little bit different than some of the others.
And the other thing to talk about with the fund flows, why we go through them, there's a whole series of international equity products that are consistently over the last year or so, producing solid net inflows. And the diversification of our equity business, sometimes that doesn't come to the floor because we've been at a period where it's been challenging for the domestic growth side. But we have certain categories that are doing quite well, and that does not always line up to the Morningstar ranking.
And Bill, overall, as I mentioned, when you have 39% of the equity funds in the top quartile over a three-year period, that's pretty good. We always aspire to more than that, but that's a very good situation. Then if you look at the sales of the funds, which now we're not talking net, we're talking gross. During the quarter, we had just about $7 billion worth of sales, which is more than in December by a great amount, and a hair less than it was March a year ago. And so, when you look at that over time, if you were to annualize those numbers that we have, this is - this year would be one of our best years ever in sales of equity products. That's really hard to forecast all of that. But one way to look at gross sales is whether the marketplace is seeing you're alive. That's why we mentioned the fact that we have so many individual funds with positive net sales, namely 18, during the quarter.
Thank you very much.
Thank you. And the next question is coming from Robert Lee from KBW. Robert, your line is live.
Great. Thank you. Good morning, everyone. Thanks for taking my questions. Maybe the first one is, going back to the competitive environment and money funds, and maybe want to look at it from the angle of, the industry has certainly consolidated a bunch over the years, maybe some more even since the last cycle. So, in thinking about - I mean, how do you kind of view - there's a lot of - there's fewer but larger players. Do you think as rates go up and money starts to flow back to the industry, do you see more rational players in the sense that gee, there's going to - there's always competition on price, but do you feel better or worse about the competitive environment as money starts to flow back, that there'll be those out there who try to pick up more market share than they used to on price. I mean, how do you kind of think of that competitive dynamic?
(Dropped audio) as the idea, as opposed to what we would think would be a more rational way to run the business. And we like to look at it in terms of market share of revenues as another feature, not just market share of the assets, although market share of the assets is important. And so, when you talk about consolidation, my suspicion is, you'll have more of it, whether - especially when you have the higher rates. People traditionally look at these things so long, and then they throw in the towel at some point. And as I've said here a lot of times, we're a warm and loving home for anyone who wants to get out of the money market fund business. And I think we are well appreciated in the marketplace for that when people think it's time to throw in the towel on that.
Rob, one additional kind of positive aspect, what Chris was mentioning initially in the regulatory response to the proposed rule 2a-7 changes for the two most problematic proposals, those being swing pricing for institutional prime and muni, and FNAB for all products, including government and retail, the industry was pretty much adjoined in a voice saying, both of those things are not workable. I mean, there were a few outliers, but very few. And I think that's a positive in that we attempt to work together for things that are really product and market-changing.
Great. And maybe as a follow-up on a capital usage, capital management, so, I mean, if I think back historically, generally you haven't taken down debt. I mean, you don't have in a - too often, except for maybe a transaction or so, yet obviously you’ve put some more debt on the balance sheet, share repurchases the last two quarters have picked up. How do we think about capital usage going forward? Is there greater appetite for - looks - seems like there's a greater - even greater appetite for repurchases than there used to be. And then maybe second part of that, on capital usage, a lot of your peers have felt the need to ramp up and scale up in the alternative business. There’s obviously been a bunch of acquisitions of different sizes. Could you maybe bear us on your thoughts? Do you feel that to be a competitive need, or not something you need to go out and spend a bunch of money on?
I'll do the alts part, and I'll let Tom do the capital part. So, the second question first, on alternatives, when we did the Hermes acquisition, there were some beautiful things inside that acquisition that weren't then currently discussed and broadcast. And that was the alternative business of real estate, private equity, infrastructure, and private lending. And so, what we're doing this year is building up the platform for those activities to present to the marketplace. And the reason we're doing that is because in the old days, under old Hermes, they had one or two clients, big pension plans. And so, the customer service angle was pretty simple. If somebody called you, you got the information and you passed it on, but it didn't create a platform that you could therefore broadcast to the world. And so, that's what we're doing right now as a way to build up the alternatives. If you look at the performance of the equity, of the private equity and the real estate that's been put together, it's been outstanding. And I would like Saker Nusseibeh to comment on these, and his views on how these alternatives and how the platform is going. And then we'll have Tom come back and talk about capital.
Thank you. So, if you look at the alternatives businesses we've got, and you look at something like real estate or private equity, we have a long provenance with very strong performance and very strong relationship with several very large pension schemes. But as Chris said, it was in fact limited to a smaller number of very large investors. The second point is, we ran them in the old Hermes before we became Federated Hermes Inc. We ran them effectively as separate units. And what we're doing is, we brought together all of our private market assets, as Chris has mentioned, that includes direct lending, that includes also infrastructure, in one platform so that there's - because we think in the alternative space, there is place for clients wanting to allocate to several such resources. We're building our platform. We're increasing our sales exposure in that, and we think we have a very strong proposition to bring to the market. And in fact, our clients that we do have, continue to support, and by that, I mean reinvest in our alternatives as we go through. So, it is very much an area where we have - where we're growing and where we think we're going to see further growth in the future.
Rob, this is Tom. On the debt and shares, so basically looking at the interest rates, and our teams here correctly expected rates to go up, so we determined to lock in the 350 on a fixed basis. We historically have not wanted to borrow money just to have it. And so, it came as a confluence because we have been very bullish on our value, and the marketplace, we don't believe, has reflected that, vis-à-vis lower stock price than we think is appropriate. And we run our free cash flow growth rate models, and the stock looks like we should buy it pretty actively, which we have done. And we actually, in terms of - we closed on that 350 in March, but we bought the shares back when - in December - in Q4 and in Q1, as you saw. So, we're 7 million shares purchased. We still think the price does not reflect our value, and we think it's a compelling purchase. So, we are going to continue to be active buyers of the stock.
Great. I appreciate the answers. Thanks so much.
Thank you. And the next question is coming from Ken Worthington from JPMorgan. Ken, your line is live.
Hi. Good morning. Thanks for taking the question here. What I really wanted to do is dig a bit more into the Kaufmann franchise. And what I'm really trying to get after is sort of how I should think about the margins for that business. Now, I recall Kaufmann runs pretty lean. I think Larry retired a number of years ago, but I think Hans is still active. I guess, maybe first, is that true? If you can give me a sense of how many investment professionals work there, that would be great. And then lastly, I think you walled off the direct distribution years and years and years ago, and thus distribution for Kaufmann is all sort of centralized at that point. I just wanted to confirm that that was the case as well.
Let's go in reverse on those. The distribution is right through the normal regular distribution at FHI. And as you dutifully note, this was part of the standard pattern that we followed when we acquired areas of excellence to allow the investment manager to do their thing, and then we take over the distribution and other aspects of it, much like what we did with the PNC deal or MDT or any of those. As for Hans, he is still very active, and you can't make him non-active. He's one of these great analysts, portfolio managers who just has to have it. And as you know, since we've been discussing this forever, there have been a lot of discuss around succession, and we have very good plans in place. And Mr. Ettinger has taken on various leadership roles in that, along with Hans. And so, we have a very good setup over there.
In terms of what's happened with the performance, naturally, it's not like we would like, but as you can imagine, when they're heavy in biotech and not big on the energy side, you get the kind of results you have right now. They've had those kinds of results before, and they continue to buy companies which they believe are good growth companies for the long-term. We recently opened up the small cap Kaufmann fund. And this week, we had a couple of $10 million trades in it, as people wanted to get back in because of the buying opportunity that people who long-term see that franchise and that approach as a worthy part of their portfolio. Now, that isn't going to turn the tide on redemptions in that fund, but it certainly is a positive indication to how some clients look at that. As to the - what was the other question, Ray?
Size of the investment team.
Yes, size of the investment team.
It's - what's interesting is how much continuity there's been really over the 20 plus years now that we've been together and expanded the product line. The size is around a dozen investment portfolio managers and very senior analysts, and that number hasn't changed in the last several years.
And as to the margins, we don't do individual margin analys8s of segments of the business, whether it's Kaufmann or MDT or equity or fixed in equity. We just don't do the numbers that way. And so, it's - I just don't have a comment on the margin.
Yep. Nope. That was it. I'll try to figure it out myself. Thank you so much. It was an amazing deal. So, just wanted to dig in, given all that's going on in growth these days. So, thank you very much.
Thank you. And we did have a follow-up come from Patrick Davitt from Autonomous Research. Patrick, your line is live.
Hey, guys. Thanks for the follow-up. On strategic value dividend, in the past, when it's put up performance numbers like this, it took in a ton of net new flows. It seems like we could be in the beginning stages of that, given the 1Q experience. So, through that lens, is there kind of a building pipeline of SMA mandates, a shadow pipeline building there? And could you maybe frame that versus how it looked a quarter or two ago?
There is great interest in this particular mandate, and I don't have an eye on what is in the pipeline down the road for SMA growth there. As we pointed out in the comments, each of the funds and the SMAs were in the 400, 440 to 490 range SMA is a little bit ahead. But I don't think I can give you an accurate thing about where that would go. I think history shows that when the worm turns on this, it does quite well. And it's simply because the portfolio manager and the team, simply do the same thing they've been doing throughout. Don't forget, that franchise was over $30 billion and dropped down to $25 billion, and the $25 billion stayed. Why? Because they were consistently paying dividends and buying companies that they felt had growth of dividend potential. And guess what they're going to be doing today, tomorrow, and the next day. Exactly the same thing. And so, it is very much a portfolio management activity of repeating the sounding joy, repeating the sounding joy.
Thanks.
Thank you. 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.
Well, thank you for joining us today. This concludes our call and we appreciate your interest.
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.