Federated Hermes Q3 Analyst Call & Webcast - FEDERATED HERMES INC

Explicit Guidance:

• Full-Year 2026 Effective Tax Rate: Estimated to be in the 25% to 28% range.
• FY2026 Revenue/Expense Outlook: Management expects compensation expenses to increase in Q4 2026 as the firm continues to grow; no specific quantitative guidance provided for full-year revenue or earnings, though margin guidance targets industry averages (currently >30%).
• Q4 2026 Net Flows:
  • Equity Strategies: Expected net sales of approximately $7 billion, primarily driven by MDT additions.
  • Private Markets: Expected net inflows of approximately $1.2 billion (including direct lending, private equity, and trade finance).
  • Fixed Income: Expected net redemptions of approximately $1.7 billion, including a specific redemption in the multi-sector fund.
  • Money Markets: Q3 assets decreased by 4% ($27 billion) due to Fed rate hikes and tax payments; Q4 outlook notes assets peaked in Q2/Q3 and typically decrease in Q2/Q3 following year-end tax collection peaks.
• Pipeline Funding: $6.5 billion in net institutional wins identified at the start of Q4, expected to fund over the next two quarters (late 2026/early 2027).

Business-Segment Outlook:

• Equity (MDT): Record gross sales of $6 billion and net sales of $3.2 billion in Q3 2026; 7 of 9 MDT strategies in top Morningstar quartile (3-year); strong institutional SMA pipeline expected to drive 2026 net inflows.
• Fixed Income: Total Return Bond Fund (highest gross seller in Q3) remains a core product; demand anticipated to focus on the short end of the curve (ultra-shorts, micro-shorts) given current rate environment.
• Money Markets: Revenue capture tied to asset levels; 26% market share (inferred) expected to remain stable as assets recover in October post-Fed rate move.
• Private Markets: Launching 6th vintage of PEC Series (Global Private Equity Co-Invest) and new European Real Estate Debt Fund (senior/whole loans); expected $1.2 billion net inflow in Q4 2026.
• Digital Assets: Continued focus on liquidity and infrastructure development for tokenized money market funds; no immediate acceleration of tokenization for non-money market funds expected.

Market and Competitive Outlook:

• Flow Dynamics: Q3 2026 outflows attributed to routine intermediate-term portfolio construction adjustments and fee competition rather than structural loss of competitiveness; Q4 2026 shows recovery with money market assets up $3.7 billion in October.
• Pricing & Fees: Institutional separate accounts and sub-advised mandates (lower fee rates) expected to dilute the blended fee rate as the $6.5 billion pipeline funds over the next two quarters; retail/intermediary channel retains higher fee potential.
• Tax-Aware Products: Growing market demand for tax-aware long-short products; company exploring new mandates and structures (e.g., advisor overlays) but emphasizing performance over tax optimization ("don't let taxes drive the truck").
• Distribution: MDT strategies continue to see net inflows despite equity market choppiness; success driven by long-term performance records and large distribution force rather than "magic bullet" tactics.

Macro / Industry Outlook:

• Interest Rates: Q3 2026 Fed rate increase in September impacted money market flows and asset levels; management notes lagging direct market yield but has since "caught up."
• Liquidity Preferences: Strategy maintains a bias to daily liquidity at par, refusing to extend maturities beyond a "comfort zone" to chase incremental yield, prioritizing liquidity over margin expansion in volatile cycles.
• Inflation/Tax Cycles: Money market separate account assets historically peak with year-end to April tax collections before declining in Q2/Q3; Q3 2026 saw reduction due to September corporate tax payments.
• Market Share: Money market mutual fund market share (including sub-advised) estimated at 6.6% at end of Q3 2026, down from 6.7% in Q2, though revenue share likely remains strong due to mix of lower-fee institutional and higher-fee retail products.

Strategic Initiatives:

• Digital Distribution Partnerships:
  • Prometheum Inc.: Expanded reach for tokenized securities via FINRA-registered broker-dealer platform (announced Q3, active now).
  • BNY/Goldman (Domestic Initiative): Participation in mirrored tokenization.
  • ARCEX: Offering tokenized access to USITS money fund in the UK.
  • Conduit Digital: Supporting launch of tokenized money market fund in APAC region.
• Product Launches: Launch of money market management digital treasury fund to support traditional and on-chain distribution; new European Real Estate Debt Fund in private markets.
• M&A/Intangibles: Intangible asset amortization from Hermes acquisition largely complete; FCP acquisition transaction costs ($11.2M) recognized in Q3 2026.

Risks and Headwinds to Outlook:

• Asset Volatility: Equity and fixed income AUM values remain sensitive to market valuations (e.g., $1.8B FIO decrease in Q3 offset by inflows).
• Redemption Concentration: Significant exposure to client-specific redemption risk, evidenced by $1.7B in redemptions from a single Total Return Bond strategy client.
• Fee Rate Dilution: Inflow of large institutional mandates and sub-advisory contracts expected to lower the blended fee rate compared to 40-Act mutual funds.
• Expense Volatility: "Other" expenses remain unpredictable (e.g., withholding tax expenses, contingent payment adjustments).
• Digital Adoption: Client demand for tokenized products is not yet at a "beating down the doors" stage; infrastructure development is a long-term play without near-term financial impact.

Management Tone on the Future:

• Confidence: High confidence in MDT equity performance (7/9 strategies in top quartile) and institutional pipeline ($6.5B).
• Caution on Fees: Acknowledgement that short-term competitive dynamics (fees/flows) are "routine" and that long-term industry margin alignment is a "longer process."
• Steady Progress: Dismissive of hype regarding digital asset acceleration; views tokenization as "steady as we go" infrastructure building for "tomorrow."
• Strategic Patience: Willingness to forgo short-term yield maximization (via maturity extension) to preserve daily liquidity.

Miscellaneous:

• Capital Position: Cash and investments at end of Q3 2026 totaled $580 million ($483 million excluding non-controlling interests).
• Q3 2026 Performance Fees: Carried interest and performance fees totaled $726,000 (down from $1.4M in Q2), with $428k offset by compensation.
• Operating Expenses: Q3 expenses decreased 4% ($15.9M) primarily due to lower FCP transaction costs, intangible amortization, and lower compensation/advertising, partially offset by tax adjustments.