Federated feels weight of rates, potential regs

Federated Investors, the money market giant that sailed through the global financial crisis on a wave of safe-haven inflows, is facing choppier waters this year because of rock-bottom interest rates and potential changes to regulations governing money funds.

The U.S. Federal Reserve Board's Aug. 9 vote to keep short-term rates between zero and 0.25% through mid-2013 was the latest rain on Federated's parade. Extremely low interest rates have left Federated waiving millions of dollars of fees on its money market funds — which accounted for 76% of the firm's assets under management as of June 30 and almost half of its revenue — to ensure a positive return for investors.

In a recent interview, Christopher Donahue, president and CEO of Pittsburgh-based Federated, conceded the Federal Reserve's recent pledge to keep rates low for another few years was “not exactly a positive.” But he said the tough environment will pressure a growing number of smaller money market competitors to “throw in the towel,” opening up continued “roll-up and acquisition opportunities” for Federated.

On the question of potential changes in money fund oversight, Mr. Donahue described the ongoing post-crisis review in Washington as part of a decades-long wrestling match with regulators who have never been entirely comfortable with money market funds.

While insisting he isn't losing sleep over that process, Mr. Donahue said the ideas being discussed in the latest round of deliberations - including introducing variable net asset values and capital requirements - would be “stepping stones” to eliminating money market funds entirely. Federated's leadership is “working very hard to try to have sanity rule,” he added.

The critical mass of economic and regulatory uncertainties haunting Federated now has left a number of investment banks — including Credit Suisse Group AG, J.P. Morgan Chase & Co. and Sandler O'Neill & Partners — maintaining “underweight” recommendations for the company's stock, even after a more than 37% drop since early 2011.

A day after the Federal Reserve's Aug. 9 vote to keep the federal funds rate between zero and 0.25% through mid-2013, William Katz, who covers publicly listed money managers for Citi Investment Research & Analysis, changed his Federated rating to “sell” from “hold,” and cut his 12-month price target for the company's stock to $16 from $21.

In his Aug. 10 report, Mr. Katz said his downgrade was prompted by the prospect that Federated will now have to continue its earnings-depressing fee waivers “well into 2012,” even as it faces the “tail risk” of material regulatory change.

For the quarter ended June 30, Federated reported fee waivers of $79.4 million, up $16 million from the prior quarter, which left revenue sagging 5.5% to $226 million — the company's lowest top-line result since the second quarter of 2005.

The prospect of those fee waivers dropping off sharply when interest rates eventually rebound was one factor cited by Bank of America Merrill Lynch analyst Cynthia Mayer for maintaining a “buy” recommendation, with a $28 price target, for Federated's stock in an Aug. 1 report — shortly after Federated reported its second-quarter results. Ms. Mayer couldn't be reached for comment on whether the Fed's Aug. 9 pledge to maintain rock-bottom interest rates through mid-2013 had appreciably affected her estimates for the company.

Mr. Donahue said even with the fee waivers cutting into management fees, the core expenses of Federated's money management business are still covered by the company's administrative fees, which are broken out separately. As long as the business produces close to 10 basis points in gross yields, “we can play this game indefinitely without subsidizing the funds,” he said.

In an interview, Craig Siegenthaler, a New York-based analyst with Credit Suisse, cited regulatory uncertainty as the biggest roadblock to being able to reach more positive conclusions about Federated's business prospects.

With regulators apparently considering things such as requiring capital reserves for money market funds or introducing a floating net asset value for those funds, the potential risks to a business that accounts for almost half of Federated's revenue remain considerable, Mr. Siegenthaler said.

“Until we get some clarity ... as to what the SEC ultimately opts to do,” the money market fund industry will bear watching, agreed Michael S. Kim, a New York-based managing director of equity research with Sandler O'Neill.

Mr. Kim said his recommendation for Federated's stock is “still a sell,” with the interest rate outlook having grown “incrementally worse” and the recent fall in equity markets a minus for Federated's $31 billion equity business as well.

Analysts who believe Washington is poised to impose additional regulations on the money market industry are more likely to recommend a “sell” or “underweight” than those who think managers may dodge that bullet.

Robert Lee, an analyst with Keefe Bruyette & Woods, and Jason Weyeneth, an analyst with Sterne, Agee & Leach Inc., both of New York, have neutral “hold” ratings for Federated. In separate interviews, both noted that a first round of regulatory reforms at the start of 2010 have already left money market funds much more liquid and therefore better placed to prove resilient should they face a spate of withdrawals.

With industry players making the case that specific regulatory changes being considered could make money market funds less attractive to investors, it's not entirely clear that anything dramatic — such as capital requirements — will be forthcoming from these ongoing deliberations, said Mr. Lee.

Likewise, both Mr. Lee and Mr. Weyeneth noted that market volatility over the past few months has reversed the flow out of money market funds into riskier assets seen for much of the period after equity markets began to rebound from the depths of the financial crisis starting in March, 2009.

In his interview with Pensions & Investments on Aug. 29, Mr. Donahue noted that Federated has seen more than $7 billion in money market inflows in July and August. The company had reported net outflows of more than $5 billion for the quarter ended June 30.

Other analysts see room for more regulation. Kenneth B. Worthington, an analyst with J.P. Morgan, said, “We view some sort of additional regulation as likely.” He pointed to recent hefty withdrawals from money market funds by institutional investors concerned about Europe's debt woes as a sign that the “smart money” doesn't feel entirely secure yet about money funds.

Mr. Donahue said Federated continues to buy its own stock, noting that he sees it as “a very good buying opportunity.” While he said he never questions the market's judgment, it is clearly valuing the stock now on the basis of the company's $80 billion in equity and fixed-income assets, while deeming its $270 billion money market business as “not worthy of a meaningful P/E, much to my dismay.”

He said the company continues to look — especially overseas — for acquisitions to further build up its equity and fixed-income operations. He would not identify any potential targets.