Federated Hermes Inc (FHI) 2014 Q2 法說會逐字稿

Greetings, and welcome to the Federated Investors second-quarter 2014 analyst call and webcast. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation.

(Operator Instructions)

As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Ray Hanley, President of Federated Investors Management Company. Thank you. You may begin.

Good morning, and welcome. Thank you for joining us. Leading today's call will be Chris Donahue, Federated's CEO and President, and Tom Donahue, Chief Financial Officer. Joining us for the Q&A is Debbie Cunningham, our Chief Investment Officer for Money Markets.

During today's call, we make forward-looking statements, and we want to note that Federated's actual results may be materially different than the results implied by such statements. We invite you to review the risk disclosures in our SEC filings. No assurance can be given as to future results, and Federated assumes no duty to update any of these forward-looking statements. With that, I will turn it to Chris.

Thank you, Ray, and good morning. I will briefly review Federated's business performance, and then, Tom will comment on our financial results. Currently, money market funds are in the news with the SEC's recently release of the new regulations. I will, of course, have some comments on this development but choose to begin to review an outstanding quarter from the equity part of our business.

Q2 was another strong quarter for equity sales, flows, and performance. Equities comprised 44% of our second-quarter revenues, the highest percentage among the various asset classes. We also set another all-time high for equity assets reaching $50 billion in the second quarter. Equity funds gross sales grew by 12% from the prior quarter, and net sales more than doubled for the second straight quarter. Our equity business is very well-positioned with a strong combination of performance and products in the areas of investor interest.

Half of our equity strategy were in the top quartile for the trailing three years at quarter-end. While 80% were in the top half for the same period. In fact, eight of our strategies which is over 30%, are in the top decile on a trailing three-year basis at quarter end. Looking at the trailing one-year, 65% are in the top quartile, and 88% are above median.

On a trailing three-year basis, we have the number one rated fund out of over 1,000 funds in Morningstar large value category with our MDT stock trust. The MDT all cap and the clover value funds are also top decile in the same category. In addition, we have top-decile products in a range of other categories including conservative allocation, foreign large blend, and large growth.

Second-quarter net sales grew at a robust 15% annualized rate with growth coming from a range of strategies. We had 18 funds produce positive net sales in the second quarter. Standouts from multiple categories include: capital income fund over $450 million; strategic value dividend with over $325 million; and international pushing $100 million; International leaders over $250 million; MDT stock trust, just under $100 million; Muni stock advantage fund, again, pressing $100 million; and the Kaufmann large cap at about $70 million; and, the managed volatility fund had $44 million.

Equity separate account net sales also increased substantially from the prior quarter. Growth was led by strategic value dividends, domestic and international, clover all cap value. Our SMA business has grown dramatically with assets at nearly $15 billion at quarter-end, up 34% over the last year and up 17% year-to-date. We had our best quarters ever for both gross and net sales in the second quarter. And, we ranked in the top 10 of industry SMA managers as of Q1 of 2014, the most recent data point available. Early third-quarter equity fund net sales are over $250 million, led by the same products I've mentioned already.

Turning now to fixed income. Second-quarter net flows for both funds and separate accounts were negative. The majority of the fund outflows were from early-quarter redemptions which we previously covered. We had positive flows in our sterling cash plus, high yield, floating rate and ultrashort bond funds.

Within fixed income's separate accounts, we added a $68 million emerging market separate account, and we had a client internalize approximately $150 million as a result of an acquisition. We continue to see good levels of interest in our differentiated trade finance strategy and recently won two mandates for about $40 million. Fixed income flows are negative early in the third quarter, about $85 million at this point. At quarter-end, we had seven fixed income strategies in the top quartile three-year records including -- high yield, intermediate government, short intermediate, total return bond, ultrashort bond, and short intermediate duration muni.

Looking now at money markets. Period-end, an average money market fund assets decreased by about $15 billion from the prior quarter. We had one client redeem about $4 billion due to the persistent low yield environment. Our market share at quarter-end was approximately 8.3%, down about 1% from a year ago. We continued to see yield-based pressure from bank deposits and other cash vehicles and distribution pressure including certain competitors waiving additional fees in order to produce additional yield.

The SEC released on Wednesday new rules for money market funds. Importantly, treasury, government, and retail funds as defined were exempted from the floating NAV requirements. However, Federated is disappointed that the SEC has voted to adopt a floating NAV for institutional prime and institutional muni money market funds.

Federated remains committed to providing a variety of liquidity management solutions to our clients including those that meet the needs of our institutional prime and institutional municipal fund shareholders. We offer a variety of cash management solutions and are developing new products for our customers. We intend to create privately-placed funds that will likely mirror existing Federated money market funds to serve the needs of groups of qualified investors as soon as reasonably practicable.

We will be reviewing the details contained in the Commission's 869-page rule-making as we consider next steps. The new rules will be subject to a lengthy implementation process including two years for the floating NAVs. We are communicating with our clients to work through the full breadth and scope of the final regulations.

The new rules also create significant new operational burdens. For example, regarding the tax relief announced yesterday, the SEC stated that the tax compliance burden has been lifted for investors in floating NAV money funds. We believe that money market fund sponsors and investors should have had an opportunity to review and comment on the proposed solution to the tax issues caused by floating the NAV in order to provide the SEC and the Treasury with a complete evaluation of the costs and benefits of their proposal and related tax relief prior to final adoption. In our view, such notice and opportunity to comment is essential if the ultimate goal is good public policy.

Now, taking a look at our most recent asset totals. As of July 23, managed assets were approximately $350 billion, including $244 billion in money markets, $50 billion in equities, $56 billion in fixed income including liquidation portfolios. Money market mutual fund assets stand at about $211 billion, and our July average money market assets are running at about $212 billion.

Taking a look at distribution, in the broker/dealer channel, we continued to make strides to increase our presence and leverage our strong investment product set. We are working on adding additional wholesalers and recently made some organizational changes to better align our resources with sales opportunities. Inside this, we are adding four field reps, and we recently added two internal reps so far this year.

We have also added sales capacity in our SMA business, which I highlighted earlier, towards growth in assets. We added a sales specialist to focus on new firms that have added Federated strategies to their platforms. We continue to expand distribution for SMAs as we had the international strategic value dividend strategy approved on three major platforms in the second quarter. We are working on some interesting new product opportunities in the alternatives space for SMAs. For example, a managed volatility product.

We are also continuing to invest in the institutional channel with the recent addition of a senior salesperson in the retirement area and the addition of another institutional position to focus on retirement key accounts and portfolio construction. We added the [EM] account mentioned earlier this -- earlier as well as several smaller accounts in the second quarter including a few trade finance accounts. We have approximately $75 million in fixed income wins that are yet to fund. RFP activity remains high with interest in cost Clover, MDT, Strategic Value, and international strategies for equities, short duration, core broad, muni, high yield, and trade finance for fixed income.

In terms of international channels, we are also adding sales resources to accelerate the growth we have seen in Canada for both retail and institutional markets. We recently hired an institutional salesperson and filled an internal sales position. We are beginning to see RFP activity from our sales efforts in Chile with a focus on US high-yield mandates.

In Asia PAC, we continue to look for an acquisition to move this effort forward. In London, we had a good quarter for flows in our Sterling cash, short duration bond fund, and basically those numbers were a little over $150 million translated into US dollars. If we -- and we are responding to increased interest in our trade finance strategy. We actively continue to seek alliances and acquisitions to advance our business in Asia, Europe, as well as in the United States. At this point, I'll turn it over to Tom to discuss our finances.

Thank you, Chris. Looking at money funds minimum yield waivers, the impact to pre-tax income in Q2 was $30 million. Based on current assets and assuming overnight repo rates for treasury and mortgage-backed securities run at roughly 5 to 7 basis points over the quarter and T-bills stay in the 2- to 5-basis-point range. The impact of these waivers to pre-tax income in Q3 would be about $31 million.

Looking forward and holding all other variables constant, we estimate that gaining 10 basis points in gross yields would likely reduce the impact of minimum yield waivers by about 45% and a 25-basis-point increase would reduce the impact by about 70%. Multiple factors impact waiver levels, and we expect these factors and their impact to vary. These factors include changes in funds assets, available yields for investments, actions by regulators, changes in the expense levels of the funds, changes in the mix of customer assets, changes in distribution fee arrangements with third parties, Federated's willingness to continue the fee waivers, and changes in the extent to which the impact of the waivers is shared by third parties.

Revenue was down from Q2 2013 mainly due to higher minimum yield waivers and lower money market assets partially offset by higher revenues from equity assets. Operating expenses were down from Q2 2013 due mainly to $4.6 million decrease in distribution expense related to the lower money market assets and higher minimum yield waivers. Non-operating income increased from Q2 2013 due to lower debt levels and increased from Q1 due to gains in investments including consolidated products.

Looking at our balance sheet, cash and investments totaled $264 million at quarter-end of which about $244 million is available to us. We amended and extended our credit facility in Q2. The structure has been reset to a new five-year term.

The changes affect the remaining $255 million balance of the previous term loan and the $200 million revolver that remains available. As a result, the total debt expense of the facility will decrease from about 4.5% in Q2 to about 3.5% in Q3. [The new quarterly amortization will be $6.4 million for] July 1, 2018 and then $36.7 million through the maturity in June, 2019.

We would now like to open the call up for questions.

(Operator Instructions)

Ken Worthington, JPMorgan.

Good morning. First, in terms of money market fund regulation, do you think the changes are substantially over when the SEC implements its rules, or are there other regulations and rule changes on the radar screen that either flow through directly or indirectly that could have a meaningful impact on the money fund business this year?

My estimation, though not being certain or have inside information on it, that the SEC has spent so much time, so much effort that they are delighted to have this, in their view, off of their agenda. Chair White has made it clear that she wanted this to be completed for the purpose of getting it off the agenda. So, right now, I would not expect them to be doing more.

I do note, however, that FSOC said that they saw the SEC moves as, quote, substantial regulations, but that they were going to be looking at what all of that meant. So, I would, for one, not expect, at this point, to see more money market fund regulations. They did put in that there is going to be a re-proposal on some things which are all part of this. I don't think that was really the spirit of your question.

Nothing in your radar screen in terms of repos or Basel or other things that you think could have a big impact on the business?

I think that there will be a continuing effort on the part of banking regulators to regulate the banks. I think there will be continuing efforts to tighten up the repo situation, although as has been mentioned at the SEC hearing that the repo activity has been very, very closely watched and improved in terms of cutting down the amount of time when some of the custodians were viewed as perhaps being on the hook. So, the time has been improved on all of the third-party repos, but there were probably still be improvements there.

The impact of Basel III and the liquidity coverage ratios, I think will be another thing that they'll be working on, and I think banks will also be working on to the extent to which they put out guarantees on securities. That's all part of the banking regulation, and I wasn't trying to comment on that, I was commenting on what the SEC would be doing.

Can you give us your expectations about the cost to implement the new money market fund rules? And, would there be ongoing incremental costs to comply with the rules going forward? And, if so, how big would those be? Are they small? Are they big? Are they somewhere in between?

Were not in a position to put any kind of a number on that yet. We are in the process of going through the kinds of products that we might want to come up with in order to respond to capture clients that don't fall into a group that would qualify for a private fund and a retail exemption. When you have a lot of clients that are on omnibus accounts where you have both types of clients inside that omnibus, it's very difficult for us to figure out what has to happen in the 1.5 days since the regs came out.

I'm not in a position to give you a number on our costs. I would say the costs will be substantial in terms of industry because you've got a lot of products to change around, and if you're going to maintain a floating net asset value product, you're going to have to go to four decimal places. And, we have commented extensively on those kinds of costs. Whether those products remain viable remains to be seen. So, it's pretty much up in the air right now as to what those costs will be.

Michael Kim, Sandler O'Neill.

First, Chris, like you said, it's only been a couple of days. But, any feedback from any of your institutional clients in terms of the transition to floating NAVs? And then, assuming you see a meaningful shift in the underlying mix of your money market business over time, just wondering how you would think about the longer-term implications on maybe the earnings power of the franchise once we work through all the fee waivers and upfront costs?

Let's divide this into two groups. First of all on the clients, I will comment, and then I will ask Debbie to comment. We had a call with 600 or 700 clients yesterday. The theme of what we presented was basically, look, you've got a two-year implementation. Nothing changes right now. Digest what is in the rule. Give us a shot at figuring out what kind of products can work and can come in here. Nobody wants to create any sudden consternation or any kind of difficulty so that's the main show. I have not had a client talking about shifting assets from this column to that column as of yet. And now, I will let Debbie talk about the call, and then, I will come back and talk about the business.

I will just reaffirm that we have had a ton of client contact over the course of this week, both pre-and post-rule-making, and it has all been very positive in nature. Everybody understands the two-year implementation time period. Everybody understands that there will be a shifting of products from a mix perspective. Making sure that there is a [five] time delineation between retail and institutional per whatever this definition turns out to be. And, as far as shifting in assets, now nobody seems to be at all concerned or worried about that.

Our call yesterday with our underlying clients where we summarized the rules and gave some insight into the process that we will be undertaking to come up with new products for them went very, very well. A lot of Q&A. We probably had an hour's worth of Q&A in that call. But, all very positive. From a timing perspective, just trying to get a better handle on when to start seeing new products and new ideas for transitions of current products. I'd say, all in all, the reaction from clients has been, as we were hoping it would be, which is to focus on the change. But, also the focus on the long time frame from an implementation time period, and no real need at this point to do anything different with what they're already doing with their cash.

And, Mike, to follow up on the second part of the question which is -- I'm taking to mean the long-term viability to the cash management business, its earnings power, and things like that. Make a couple of observations. Observation number one is that with $2.6 trillion or $2.7 trillion in these money funds with very, very low yields for a very, very, very extended period, it tells you that there is a certain love for a cash management product as a cash management service. And so, the underlying customer demand is certainly there.

We believe that our position, both in terms of the leadership that we've taken and in terms of commenting on the rules and getting 250 shout-outs and footnotes on the SEC rule and things like that, demonstrates our leadership position. I think you're going to see a little more consolidation in the business as others take a look at this and throw in the towel. And, I think that the focus of this firm, as one of our key businesses, will enable us to be very, very competitive with the kinds of new products or new structures that might be available. So, there will be some balls up in the air, and we think that will be helpful to us.

So, long-term, the cash management business is very, very viable, and we think that our earnings power will be excellent here. It will be all of the normal things of competition, of pricing, packaging, and all of that. But, this has only been so for four decades

Okay. That's helpful. And then, maybe one for Tom. Any thoughts on the trajectory of the comp line in the back half of the year? Just given where you stand today? If we've said what do we think comp would be for the third quarter, I would say it would be about the same. So, when sales increase and investment performance goes so well, those numbers have possibilities of creeping up.

Thanks for taking my questions.

Robert Lee, Keefe, Bruyette & Woods.

I know it's very early days, and it's an 800-odd-page document that they put out, but I'm just curious what any of the impact to performance could be on some of the state pools and the separate account assets? I know they opted to not create seven funds, but I don't know if there's any kind of impact that you think could be there as well?

We don't expect there to be impact on the LGIPs, the state pools at this point. I think that they will be subject to the reporting that is called for by non-40 Act companies that are in the rule, but that has to be specifically delineated and looked at. But, my suspicion is that they intended to capture them. But, that's a reporting requirement.

Okay. That's helpful. And then, I know this is probably hard to be precise on, but there's always some number of clients I assume once the reform shakes out and you develop new products that, just for a legal or fiduciary or whatever reason, can't have a floating rate product. I don't know if you were to think of your institutional clients, is there any way of bucketing just what that client base would look like, size-wise of who just can't absolutely have a floating rate product?

Rob, we just don't know that right now. I can give you some pointer fingers on the channel categories. But once again, it's precisely because so many of them are omnibus and then they have a mixed group of clients in there that have never been segmented by -- oh, are you retail natural person? Are you one step removed from natural person? Are you two steps removed from natural person? And, what qualifies?

So, for example, we have $80 billion of prime money market fund assets. Right around $42 billion is in what we call wealth management and trust. Now, a good substantial portion of that is going to be what might be called actual trust or what you would think of as a personal trust-type business where you would quickly find a natural person. Other of it is going to be corporate trust. And, what's going to be in that bag? Well, some of it will qualify, and some will not. And, some of it, as you note, is required only to go to a stable NAV product. But, we have not yet determined how much of that, other than for me to be able to say that a substantial portion of that $42 billion looks like it will qualify as retail.

On the broker/dealer side, we've got about $21 billion. On broker/dealer retail, we think that the vast majority of that will qualify as retail. We've got $7 billion of non-US international, so that's its own category, that, depending on where they are, where they're invested, they may not be affected if they stay in international funds. They come to the US funds then they get subject to the natural person rule.

Then, we have the money that we invest from our funds into the funds, and the odds are high that a mutual fund would not qualify as a natural person. That's about just under $4 billion. And then, we have direct corporate and portal business of about $5.5 billion that looks less that it's unlikely to qualify as retail. So, that adds up to about $80 billion, but the numbers are not precise, Rob, in order to determine exactly how many of those clients can't handle the floating NAV product because of either their own indenture or state law.

That's helpful. Thank you. And, maybe a question on the equity business. Is it possible just to put some color around, and I apologize if you mentioned upfront. But, some color around some of the sources of the strong sales on the net business. Have you seen that from -- is it across the board? Is there any one or two channels that are driving most of the flows or sales?

It is definitely across-the-board. The leader in the pack is the broker/dealer.

That was all of my questions. Thanks.

Bill Katz, Citigroup.

Just staying on the money market reform for a moment. When you've talked to your clients, I imagine you had done some anticipation of the rule working against you, and you've thought about other products. What is the product efficacy? And, what I'm thinking about here is the utility of separately managed accounts or private placements, as you mentioned. How would the economics of those products compare to your regular money market funds, assuming we were in a more normal rate backdrop?

In terms of the privately-placed money market funds where you'd have to have qualified investors, our suspicions are that it would be comparable at this point. In terms of separately managed accounts, traditionally, they are lower in fees than if someone was in a fund. How many of the clients would actually want an institutional separate account is something that remains to be seen. As much work as you might do with clients ahead of time, Bill, clients really aren't interested in determining whether they'll go for an institutional separate account as long as they see the money market fund right in front of them which they like and enjoy because of the diversification. So, that would be the situation there, and there's another idea floating around. It doesn't look all that viable now because of the rate environment, which is the all 60-day and under prime fund. Maybe you get a little spread on govis right now, but certainly not what people would be used to. But, in a different rate environment, that would work. Its economics would be very comparable to the current fund.

So, those are three of the principal ideas. There are other ideas that you could come up with. For example, a collective fund that would only be for retirement accounts. Well, what is that going to look like? Well, we have our capital preservation fund, as an example of that kind of a structure. Can we make it look like that? Well, I don't know. That' s part of the work that we're doing as we look ahead.

That's helpful perspective. The second question I have is that you mentioned that there might be a bit more burden as you go through some of implementation, particularly on the tax side. Is that something that you can pass -- assuming rates are going to be higher than they are today. Is that something you might be able to pass along to your investor? Or, is that something that you as a sponsor would have to absorb?

Well, it is something that would be a cost to the fund and to the investor. The marketplace will let us know whether we can pass that on or not. Some of the things that are behind the curtain there, Bill, are that when you have a fund that has, quote, retail in it and institutional in it, then you have to more or less separate the fund. Part of the 869 pages is a section where the SEC has said that they are going to be very open to issuing whatever kinds of exemptions are necessary in order to accomplish altering the structure of some of the funds in order to accomplish getting the right shareholders in the right kinds of funds so far as the SEC is concerned.

The extent to which that impacts the indenture of the funds and/or state law remains to be seen. But, all those things are first and foremost fund and thereby shareholder expenses. As I say, the marketplace through competition and otherwise will -- and it is not unrelated to what goes on with rates as well over the future periods -- will determine how much of that is actually impacts the fund and the fund shareholders.

Cynthia Mayer, Bank of America Merrill Lynch.

Just a follow-up question on the potential substitute products. It seems like you have offered separate accounts for a while at lower fees. A lot of the institutional clients in money market could have migrated over and paid a lower fee if they wanted to. What is it about separate accounts that they haven't wanted, and what can you do to change that?

That's what I tried to hit before, Cynthia, what they really like is being a small part of a big money market fund. As long as that existed, that's where they were going. In effect, what a separate account in a money market fund is, it's a giant redemption in kind ab initio -- at the beginning. They would prefer to be a small part of a big machinery.

However, you can get the $1 dollar net asset value experience to them in the separate account. So, it's just going to be deciding what is the minimum amount that a client has to have in order to make that efficacious, and then are they -- are some of those clients -- there will be some who do it, willing to go into that kind of a structure. It will just be the explanation of it, and some of them will be willing to trade out the diversification as being a part of a larger pool in return for maintaining the $1 net asset value.

Okay. And, if you look at your current AUM affected by the floating NAVs, what proportion is held by qualified investors? Would everybody be eligible for a separate account or private placement? Or, are there are just some bits and pieces here and there that would fall out and not really have a product for them.

There are definite gaps. In other words, there are some that would qualify as qualified. But, that's a pretty big number. There are some who would not be affected because they will, in effect, be retail. As I discussed, some of our actual trust business will be retail. There are gaps in between where the client is not large enough to be qualified and doesn't have a loud enough pulse to qualify for being a natural person. So, there are gaps. How much of our assets are in those gaps, we do not know right now. That's where the answer to the question of, is a variable of that asset value product at all viable? That remains to be seen.

Okay. And then, just a question on fee waivers. Sorry if I missed this, but it sounded like they were going to get a little worse this quarter in spite of the asset level going down. So, I'm wondering is that a function of the environment somehow? Or, are you reacting to the competitive pressure and waiving a little more? I couldn't tell what the driver was for that?

It's rates. We're not reacting to any other pressure or waiving more. It's really where the rates are.

Specifically, Cynthia, it would be the bill rates came in lower in Q2, the short bills, and we see them staying at those lower levels at least in the very near term.

Okay. Great. Thank s a lot.

Patrick Davitt, Autonomous.

I just have one on the change in the nonconforming limits on govi -- government funds to 0.5% from 20%. Curious if you think that will materially impact the ability of those funds -- not just for you, for anyone to generate a competitive yield. And maybe, if you could give us some historical context for what percentage of your government funds over time has been in nonconforming securities?

Debbie?

Yes. That is -- I think, Pat, if you look at the prospectuses of many of our products, although the name rule would have allowed us to be 20% of the product in nonconforming, non-government product, we have never taken advantage of that nor have we by prospective limitation [have] many of the funds ever been allowed to. If you look, sometimes there have been some reported misnomers, if you will, back in the day when various CDs were guaranteed from a government perspective -- they were government money funds that owned those. Those actually qualified as government securities during that time period.

There was also a student loan asset-backed securities program that was guaranteed from a government perspective that was held in a lot of government funds that was looked at as being non-government in nature, but it in fact really was. [Very worried in the end that it was] often times that are backed by the federal loan bank are looked at as being nonconforming when in fact, they are guaranteed. So what has been reported in many instances for our own funds as well as for others in the industry as being nonconforming or non-government has actually been incorrect. We tried to point that out in the context of our response back to a [Vadera] request on this particular subject so that's really the 99.5 versus the 80 on a current product basis, it's something that is no change in how we operate on a day-to-day basis.

Great. That's perfect. Thanks.

Marc Irizarry, Goldman Sachs.

I think if we look at just how much the assets in prime come down -- already I think you're at $110 billion down to $80 billion. I know there's a lot of different dynamics, but can you give a sense of the prime money market funds and your clients' willingness to shift just into governments? Any sort of updates there? And then, I just have a follow-up. Thanks.

Well, in terms of the shift, obviously these clients have had the ability to shift at any day, at any time, for any reason, or for no reason and have not done so. And therefore, they are looking for not only the daily liquidity of par but also the spread between the government funds and the prime funds. So, they are not really wanting to shift. And now, they have to make a tough decision. Go for some other product, ultrashort, something like that which violates the $1 net asset value or go for the lower yield. This is, as I said before, our client base has not really wanted to face that in terms of making a choice that they didn't currently have to make. And, one that they don't have to make right now anyway. Obviously, they have to make it soon.

So, we are, shall we say, evolving the decisions as clients look and decant the rule and figure out where they want to come out on the answer to that question. And once again, it's very difficult for us to peel back those clients and figure out how many or to what extent they will move into govis or into one of our private funds or into a separate account or into a collective fund or to a bank instrument. It just remains to be seen.

And then, just -- .

Just to comment, Marc, on the prime. What you've seen -- certainly in the industry you saw as what the ICI categorizes as institutional ramped up by over $60 billion over the second half of 2013. Now, that has essentially reversed over the first half of 2014. And retail, the retail category under ICI has had accelerated outflows from prime as well. You've got the usual suspects there. The low rate environment, uses of cash for taxes and other things. It has certainly been an industry phenomenon.

Just in terms of some of the solutions and new products and alternatives that are available or will be potentially available. How much -- I don't know if you want to call it product development, R&D spending, or just P&L has been invested in the ideas and are all the -- now that the reform is in place, I would presume that most of the ideas that could capture some of those assets coming out of prime are in place already? Thanks.

A lot of the people in product development who have been working earnestly on commentary and improvements to the proposals that the SEC has made have been thinking about and initializing work on various new products and now can be released to go whole hog on the new products. So, we're not looking to add new people or new resources to that but to shift from one effort to another. So, once again, it's hard for me to internally characterize how much the cost of the new product arrangements will be.

I will say this, that we were already underway with an internal review of the entire money market fund lineup just to take a look at it and see what should be done and what should be changed in any event. So, right now, that just more or less accelerates it and also focuses it on taking care of the clients so that we do the best we can to leave no client behind.

And then, just one more on a different topic. Your equity business, now $50 billion. Can you just remind us, where does growing that business inorganically fit into the equation? How are you thinking about acquisitions to grow even further here from the $50 billion? And then, maybe an update on your capital priorities?

Well, I will talk about -- the intent here is overwhelmingly to grow organically. That's why I spent all the time talking about the performance and the products, the names of the products, and things like that. And, if you look at what has matured, it is what we called maybe seven or eight years ago the power of income. These were funds like Capital Income, Equity Income, and Strategic Value Dividend. Now, those products are all maturing. We talk about them in terms of being on their road to $5 billion funds. So, that has worked out well.

Then you say, what is heading into the future? Well, if you look at the Strategic Value Dividend fund as an outcomes-based product, i.e., 5% in terms of a dividend and then an increase of 5% in the rate of dividends of the holdings, that's an outcome. Well, the alternatives section that we've put together here led currently by the Managed Volatility fund, which I mentioned, is one of the things we think is next on the agenda because it analyzes the risk for various activities and obviously getting these products into liquid form strengthens them. That's where we're looking for another big organic growth out into the future.

But, we would always be available to add, by acquisition, to various of our already successful portfolios. On the capital side, Tom?

To finish off on the M&A side, add to the portfolios is rollups, and we have a team that is out there trying to add to our existing funds and bids out there and letters out there and we will get some success there. The three choices that we -- four choices that we have -- what are we going to do with our capital? M&A is one. Of course, internally supports the growth of the Company is another one. And, dividends and share buybacks are the other two.

We've always said our first choice, given our disciplines and the returns that we've seen in our M&A, is to spend as much money as we can there. But, following our disciplines hasn't allowed us to spend all the money there. Dividends have been an excellent return to our shareholders, and we look at that on a total return basis. And so, we continue and expect to continue to reward our shareholders or share the earnings of the Company, which they deserve, with the shareholders.

Share buybacks, it has been -- you know the amount that we've done for number of years so we re-look at that every quarter and models and where we think the Company is going to grow. And, is it worth -- more worthy to buy the shares, pay the dividends, make acquisitions.

Great, thanks.

Greggory Warren, Morningstar.

When we think about what is going to happen with the prime funds as we move forward here -- I appreciate the effort to try and find alternative products for clients, try to develop things that can basically replace what they have now. But, let's assume that it's hard to do that and investors have to shift into government products. Would that not have a detrimental impact on the fee waivers? Because my understanding is that most of the waivers you are issuing are on government agency and treasury funds. So, if we have a mix shift in that direction, wouldn't that be a net negative in this low interest rate environment?

Greggory, it really in large part would depend on the timing of that hypothetical shift. With a two-year phase-in period, you really would have to ask the question of what the rates would be in two years, and by most forecasts, we would begin to see some recovery in the rates and you would not have the situation that you have today. It would -- Debbie could comment on the effect of a large portion of prime asset shifting into the government market, but it would not be good in today's environment.

In today's environment, there is certainly not enough from a product perspective to accommodate everything in a government [sense]. Having said that, the ability for the Federal Reserve to put some of their assets back out into the system would, to some degree on a repo basis at least, qualify as government assets -- it's how far along those lines. That's also though -- the shift into government money funds has been to some degree what Ray was saying before, contributory to the decline in T-bill rates. When you have got the same amount of supply and more demand, obviously you have got yields going down. It would not be an easy shift.

That's helpful. And then, just follow-up on the same issue. If we think about flows as we move forward, my sense is that in talking to your clients, it doesn't seem like there's going to be a rush to the exits for these particular kinds of funds. The two-year implementation helps with that. How receptive are they being to your finding alternative products for them? And then, is there reluctance on their part to say put this money into bank deposits?

Well, they would much prefer where they are. Therefore, we will get first swing at the pitch, in my opinion. The consensus I get out of listening to that conference call yesterday and the hour-plus of questions that Debbie referred to, is that they are most enthusiastic to hear what kinds of things we can structure in order to solve their cash management needs.

However, the extent to which banks may be willing to bid the money, and in effect, keep $1 net asset value and pay a given yield will be attractive to some of the clients. But, overwhelmingly, the first sentence you said is true, that we don't see any evidence of anything like a rush to exit or anything like that.

Good. Things for taking my questions.

Craig Siegenthaler, Credit Suisse.

This is Ryan Sullivan filling in for Craig Siegenthaler. Thanks for taking my question. With regards to the distribution line in a rising rate environment, how do you think your relationships with some of the larger distributors could be affected? And, is there a possibility that they could ask for more economics in the relationship?

Well, is it a possibility they could ask for more money? Yes. This has never not been the case. I will let Tom give you a more specific answer.

More specific is, we have a whole process where customers review their situations with us. And, in terms of affecting how we see the waivers, that usually ends up coming in other places. So, in terms of waiver recovery-type of things, that comes back. But, if we have arrangements with customers that change the distribution fees then we pay them and it's not in the waiver, it's just a different type of payment. That's why we list through, when I say what are the factors with the 10 basis points going up and us getting back 45%. We list in there all of the provisos, and one of them is changes in distribution fee arrangements with third parties and it is forever part of our life. I don't know, Ray, do you want to add anything?

No. It has been a long-term trend, and you should expect it to continue.

Great. Thanks very much. A quick follow-up. From more of a longer-term perspective here, can you just give some perspective on how you see operating margins currently -- in the future versus the current levels?

Operating margins have been depressed, and they were particularly more depressed when the waiver situation -- with the lower basis point because we end up sharing more and more. And, if rates go up, that depression won't be as bad. We have been managing the expenses. If you could look at the line items there, how many were down on the expense category and how many are up. And so, we are very attentive to that and doing a pretty good job. We actually had margin expansion in Q2 versus Q1, which actually is pretty commendable around here, in terms of all of the people at the Company participating and realizing what's going on and controlling expenses.

Thank you. Tom Whitehead, Morgan Stanley.

In your comments, you mentioned a number of strong performing funds, both on the equity and fixed income side. Can you talk to the fee rates and the margins of that new business you're winning? I noticed the fee rate went up slightly quarter-on-quarter so I'm just curious as to what the main drivers are going to be going forward? And, I want to make sure it's not anything more than just a mix shift towards equity? Thanks.

Tom, it's Ray. The fee rates would -- obviously adding equity business would enhance the fee rate, and as you point out, we've seen a bit of that. The products that we mentioned would tend to have average fee levels if you're looking at industry mutual funds averages for equity funds. The separately managed accounts have lower fees, and we've had substantial growth there. They're not as additive to the fee rate, but on an all-in basis, the equity -- certainly growing the equity assets is helpful to the overall blended fee rates.

Great. Thank you. And then, secondarily, so if we look at the overall level of gross fixed income sales, it slowed a little bit in 2Q. Redemptions were held pretty level. And again, you have had some strong performing product there. Could you maybe highlight for us any product that you think has been performing very well, and you're a little bit surprised as to the demand for it that just hasn't been there? Anything in particular you can call out there?

The one that comes to mind there would be high yield where we have very, very strong products, and we've had multiple quarters of robust sales and net sales. We had a very solid sales in high yield in the second quarter and solidly positive flows, but both would have been lower than the several couple quarters before that. And, that continues into Q4. So, still very attractive. But, I think you've seen that in the industry numbers as well, that that has cooled off a little.

We have reached the end of our question-and-answer session. I would now like to turn the floor back over to management for concluding comments.

That will conclude our call, and we thank you for joining us today.

Thank you, ladies and gentlemen,. This does conclude today's teleconference. We thank you for your participation, and you may disconnect your lines at this time.