Christopher Donahue, president and CEO of Federated Investors Inc., is a member of an exclusive fraternity: money management executives who can look back fondly on 2008. Pittsburgh-based Federated, best known for its money market funds, had been as chic as a steel mill when hedge funds and private equity strategies were grabbing accolades. But last year, with leverage suddenly a dirty word, the firm co-founded by Mr. Donahue's father, John F. Donahue, proved especially well hedged. Investors seeking a safe haven buoyed Federated's money market assets at a time when most competitors were suffering breathtaking declines. Mr. Donahue wasn't spared entirely from the storm — with the government forced to backstop the money market sector in September after a run on funds offered by a major competitor briefly caused liquidity to dry up. Still, while executives at other big money management firms were culling staff and slashing expenses, Mr. Donahue was able to move ahead in December with two acquisitions Federated had announced earlier in the year, buying value equity shop Clover Capital Management Inc. and the Prudent Bear funds.
How was the past year for Federated? Obviously, very challenging with all of the turmoil in the marketplace, but the year for Federated was quite outstanding. We crossed $400 billion for the first time, added over $100 billion of money market assets. We watched a decrease in our equity assets, (but) our sales of equity and fixed-income products strengthened — over $1 billion a month throughout '08, whereas in '07 and '06, that number was about $850 million a month.
So over $1 billion a month on a gross basis? Correct. This is the way we look at it, and say, “Are we alive in the marketplace?” The pundits and article writers only talk about net flows, but if you have 185 salespeople and you don't have gross sales, there's not much you can do.
Money market flows were fantastic, but analysts noted that low market rates left Federated waiving some fees to ensure positive returns. In the fourth quarter, we had to waive about $1.5 million of operating income because of lower rates on some of the Treasury funds. We told (analysts) that that would increase, (but) as long as gross yields on those funds are in the 20- to 25-basis-point range, you're in pretty good shape.
Some analysts have predicted your fee waivers could exceed $100 million this year. On the last call I was on, I pointed out the $1.5 million for the fourth quarter and that it was about $560,000 through Jan. 21. It was increasing, but not at some alarming rate.
Does building Federated's equity business remain a focus of your growth plans? Absolutely. That's why we completed two deals in December — Prudent Bear and Clover value equity. The whole idea there is to get the equity franchise, which is under $25 billion, up to $50 billion in about five years. Our money market fund component supplied about 69% of our revenues for the fourth quarter. For the fourth quarter of '04, it was 39%. That's the strength of a diversified model that has a large component of money funds — able to grow when the stock market is in decline.
A well-hedged portfolio? Correct! That's what owner-operators like.
The downside is that those money fund inflows could gush out again when equity markets recover. Over time, we've discovered that we end up with higher highs and higher lows. Some of (last year's inflows) will go back into the market, but we send “thank you” notes for having had the pleasure of managing that money during the interim. The lion's share continues to stay. Since we've gone public, we've gone from something less than 5% to over 8.5% of money fund assets.
You garnered roughly $10 billion last quarter when Putnam Investments transferred what it called its subscale institutional money market business to you. Will consolidation continue? We expect this business to continue to consolidate. Unless you really have a lot of money, and a lot of different funds, and a lot of different features to the funds, it's very difficult to compete for the big assets. People are beginning to figure out that it isn't just close your eyes and ask the broker what to buy. You have to do real credit work.
In five years, what kind of scale will be needed? I've seen numbers at $100 billion, but it depends more on the mixture of that, where people are comfortable — accurately comfortable — with their credit quality. Another component people don't focus on is who are your customers. If you have a broad array, diversified customers, who are interested in cash management service, not simply who has the highest yield, then you have a very good franchise.
Your industry working group recently announced steps to strengthen the industry — reportedly eager to head off potentially more aggressive actions by regulators. This is correct, and notice why it's true. If you look at the responses our government made in money market funds — the Treasury with the insurance, the Federal Reserve with the corporate paper facility and the SEC with their understanding of the Putnam transaction — you have a trifecta that hit. And the reason it hit was because there were no fundamental problems in money funds. Look at all the work that's been done on all the other (financial) institutions. Can you say that they're fixed, and they work, and they have more assets in them than before? I don't think so.
The G30 suggested some more far-reaching possibilities. The G30 report had a couple of suggestions which we would totally oppose, for example, regulating money funds like banks. Why would you want to regulate money funds like banks, when you have 17 banks failed already this year? It just doesn't make sense.
What parts of the business is Federated investing in now? The Clover and Prudent Bear (acquisitions in December) more or less completed our areas-of-excellence shopping list. This is not to say we wouldn't look at other equity opportunities, but we have the teams in place we think are important for our future. We bought a quant manager (MDT Advisors in 2006) and early on we bought the Kaufman Group. So what we've created, by adding bull and bear, is a real serious expertise on the short side, you know, the Prudent Bear side, in combination with our Market Opportunity fund. We're very happy with Clover, which was the value equity franchise.
Any thoughts of a stronger push into alternatives? We've looked at this numerous times over the last decade. We could never get our mind right to the pricing, how we would sell it through our distribution. And we were never quite comfortable with the liquidity aspects of the business.
Are you keeping an eye on the sector? We do keep an eye on it. But think about what Prudent Bear is and what our Market Opportunity fund is. The Market Opportunity fund is basically an absolute-return fund and the Prudent Bear is basically a short fund. And the advantage of these two ways of doing alternatives is you get a mutual fund structure, which means you have a real custodian bank, you have the SEC, you have a prospectus, you have an accounting company, you have internal controls. You don't just have five guys named Moe buying things and then telling you what the result is. We've become more enamored of this “cumbersome” structure, namely the investment company, because of the fundamental protections that are involved.
