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Federated Investors, Inc. (NYSE:FII)

Q2 2014 Earnings Conference Call

July 25, 2014 9:00 AM ET

Executives

Ray Hanley - President, Federated Investors Management Company

Chris Donahue - CEO, President and Director

Tom Donahue - CFO, VP, Treasurer and President of FII Holdings

Debbie Cunningham - CIO of Federated Money Markets

Analysts

Ken Worthington - JPMorgan

Michael Kim - Sandler O’Neill

Robert Lee - Keefe, Bruyette & Woods

Bill Katz - Citigroup

Cynthia Mayer - Bank of America Merrill Lynch

Patrick Davitt - Autonomous Research

Marc Irrizary - Goldman Sachs

Greggory Warren - Morningstar

Ryan Sullivan - Credit Suisse

Tom Whitehead - Morgan Stanley

Operator

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.

Ray Hanley

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 and joining us for the Q&A is 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'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 of the future results and Federated assumes no duty to update any of these forward-looking statements.

And with that, I’ll turn it to Chris.

Chris Donahue

Thank you, Ray and good morning. I will briefly review Federated's business performance and then Tom will then comment on our financial results. Certainly money-market funds are in the news with the SEC’s recent release of the new regulations. And I will of course have some comments on this development but choose to begin by reviewing 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 fund 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 areas of investor interest. Half of our equity strategies 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 strategies, which is over 30%, are in the top decile on the trailing three year basis at quarter end. Looking at the trailing one year, 65% are in the top-quartile and 88% are above medium.

On the trailing three year basis, we have the number one rated fund out of over 1,000 funds in Morningstar’s 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 produced 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 and the Kaufmann Large Cap had about 70 million and the Managed Volatility Fund at 44 million. Equity separate account net sales also increased substantially from the prior quarter. Growth was led by strategic value dividend, domestic and international, Clover All Cap Value.

Our SMA business has grown dramatically with the assets at nearly 15 billion at quarter end, up 34% over the last year and up 17% year-to-date. We have our best quarters ever for both growth and net sales in the second quarter and we ranked in the top-10 of industry SMA managers as of Q1 of ’14, the most recent data point available. Early third quarter equity fund net sales are over 250 million, led by the same products I have 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 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 with 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 redeemed 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 continue 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 commissions 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 creates significant new operational burdens, for example, regarding the tax release 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 funds 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 cost and benefits of their proposal and related tax release 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 23rd 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 continue 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 sale capacity in our SMA business which I highlighted earlier of its 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 alternative 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 sales person 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 financing accounts. We have approximately 75 million in fixed income wins that are yet to fund. RFP activity remains high with interest in Kaufmann, 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 sales person and filled an internal sales position. We are beginning to see RFP activity from our sales efforts in Chile with a focus on U.S. 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 the U.S. dollars.

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 would turn it over to Tom, to discuss our financials.

Tom Donahue

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 Bill 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 fund 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 a 4.6 million decrease in distribution expense related to 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 in 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 effects 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 quarterly amortization will be 6.4 million for four years through 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.

Question-and-Answer Session

Operator

Thank you. Ladies and gentlemen, at this time we will be conducting the question-and-answer session. (Operator Instructions) Our first question is coming from the line of Ken Worthington with JPMorgan. Please proceed with your question.

Ken Worthington - JPMorgan

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, or rule changes in the reader screen that either flow through directly or indirectly that could have a meaningful impact on the money fund business here?

Chris Donahue

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

Ken Worthington - JPMorgan

But in your radar screen in terms of Repos or Basel or other things that you think could have a big impact on the business?

Chris Donahue

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 to review this perhaps been on the hook so the time has been improved on all the third party repos. And -- but there will 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 and 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.

Ken Worthington - JPMorgan

And then can you may be give us your expectations about the cost to implement the new money-market fund rules and would there be ongoing incremental costs to kind of comply with the rules going forward and if so like how big would those be are they small are they big, are they somewhere between?

Chris Donahue

Well, we’re not in a position to put any kind of a number on that yet. We’re 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. And when you have a lot of clients that are on omnibus accounts where you have both types of clients inside that omnibus it is very difficult for us to figure out what has to happen in the day and a half since the rates came out so I am 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 have got a lot of products to change around. And if you are 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.

Operator

Thank you. The next question is coming from the line of Michael Kim with Sandler O’Neill. Please proceed with your question.

Michael Kim - Sandler O’Neill

So 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 overtime, just wondering how you 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?

Chris Donahue

Let’s divide this into two groups, first of all on the clients I will comment then I’ll have Debbie to comment. We had a, I call with six year has 700 clients yesterday the theme of what we presented was basically look, you have 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 kind of the main show. I have not had clients 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.

Debbie Cunningham

I will just reaffirm that we have had a tonne of clients contact over the course of this week both pre and post rule making and it has been very positive in nature, I already understand 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 fast time delineation between retail and institutional curve whatever this definition turns out to be and as far as kind of 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 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 expecting seeing -- to see new products and new ideas for transitions of current products. So, I’d say all-in-all, the reaction from clients has been, as we were hoping it would be which is the focus on the change but also the focus on the long timeframe from the implementation time period and no real need at this point to do anything different with what they are already doing with our cash.

Chris Donahue

And Mike with a follow-up on the second part of the question which is I am taking to mean the long-term viability to the cash management business, its earnings power and things like that make a couple of observation. 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 services and so the underlying customer demand is certainly there. We believe that our position both in terms of the leadership that we have taken and in terms of commenting on rules and getting 250 shout-outs and footnotes on the SEC rule and things like that, demonstrates our leadership position.

I think you are 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. And 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. There will be all the normal things, of competition, of pricing, packaging and all of that but this has only been so for four decades.

Michael Kim - Sandler O’Neill

Okay, that’s help and then may be one for Tom, any thoughts on the trajectory as the comp line in the back half of the year just given where you stand today?

Tom Donahue

Yes so if we have said what do we think comp would be for the third quarter, I think it will be about the same, so when sales increase and investment performance goes so well. Those numbers have possibilities of creeping up.

Operator

Thank you. The next question is coming from the line of Robert Lee with Keefe, Bruyette & Woods. Please proceed with your question.

Robert Lee - Keefe, Bruyette & Woods

And again I know it’s very early days and it is the 800 odd page document that they have put out. I am just kind of curious what any of the impact of reform could be on some of the state pools and kind of the separate account assets. I know they are in that 287 funds but I don’t know if there is any kind of impact that you think could be there as well?

Chris Donahue

We don’t expect there to be impact on the LGIP see, 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.

Robert Lee - Keefe, Bruyette & Woods

And then I guess, and I know this is probably hard to be precise on but there is always some number of clients I assume once the reform shapes out and you develop new products that just for a legal or PDUFA or whatever reason can’t have a floating rate product and I don’t know if you were to think of your kind of institutional clients is there any way of bucketing just what that client base would look like size wise if could just as we can have a footing with rate product?

Chris Donahue

Rob, we just don’t know that right now. I can give you some pointer fingers on the kind of a channel categories but once again it’s precisely because so many of them are on the books 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 and a little 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 personnel 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 quality and some will not and some of it as you know 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 looks like it will qualify as retail. On the broker-dealer side, we have got about 21 billion and on broker-dealer retail we think that the vast majority of that will qualify as retail.

And we have got 7 billion of non-U.S. international so that sits us on category that depending on where they are, and where they are invested, they may not be affected if they stay in international funds they come to U.S. 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 and that’s about just under, 4 billion. And then we have direct corporate and portal business of about 5.5 billion that looks like to us 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 handle the floating NAV product because of either their own indenture or state law.

Robert Lee - Keefe, Bruyette & Woods

And maybe a question on the equity business, so talk just to put some color around and I apologize if you mentioned it upfront but some color around some of the sources of the strong sales in the business do you seeing that kind of from the, is it across the board, is there any one or two channels that are driving kind of most of the flows or sales?

Chris Donahue

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

Robert Lee - Keefe, Bruyette & Woods

Great, that was all my questions, thanks.

Operator

Thank you. The next question is coming from the line of Bill Katz with Citi. Please proceed with your question.

Bill Katz - Citigroup

Okay, good morning, thank you very much for taking the questions. Just staying on the money-market reform for a moment, when you have talked to your clients I imagine that done so in anticipation of the rule working against you, and you have thought about other products, what’s the product efficacy and what I’m thinking about here is just the utility of separately managed accounts or private places as you mentioned. I mean how were the economic for those products compared to your regular money-market fund assuming we were in a more normal rate backdrop?

Chris Donahue

In terms of the privately placed money-market funds where you would have to have qualified investors, our suspensions are that it would be comparable at this point. In terms of separately managed accounts, traditionally they are lower in fees that if someone within a fund, how many of the clients would actually want a institutional separate account is something that remains to be seen and as much work as you might do with clients ahead of time Bill, clients really aren’t interested in determining whether they will 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 is another idea of floating around it doesn’t look all that viable now because of the rate environment which is the all 60 days and under prime fund may be you get a little spread on govies right now but certainly not what people would be used to but in a different rate environment that would work and its economics would be very comparable to the current fund. So those are three of the principle ideas, there are other ideas that are, that you could come up with for example a selective fund that would only be for retirement accounts, well, what’s that going to look like, well, we have our capital preservation fund as an example of that kind of a structure now 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.

Bill Katz - Citigroup

Okay. That’s very helpful perspective. Second question I have is, as you mentioned that, might be a bit more burden as you sort of go through some of the implementation particularly on the tax side, is that something that you can pass I guess assuming rates have been higher than they are today, is that something you might be able to pass along to a investor or is that something that you in response would have to absorb?

Chris Donahue

Well, it is something that would be a cost to the fund and to the investor and 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 “retail in it and institutional in it” then you has to more or less separate the fund. And 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. Now to the extent to which that impacts the indenture of the fund and/or state law remains to be seen, but all of those things are first and foremost fund and thereby shareholder expenses and as I say the marketplace through competition and otherwise will and in the end it’s not unrelated to what goes on with rates as well over the future period will determine how much of that is actually impacts the funds and the fund shareholders.

Operator

Thank you. We will move on to our next question which is coming from the line of Cynthia Mayer with Bank of America Merrill Lynch. Please proceed with your question.

Cynthia Mayer - Bank of America Merrill Lynch

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

Chris Donahue

Well, that’s what I tried hint before Cynthia that they -- what they really like is being a small part of a big money-market fund and as long as that existed that’s where they were going. In effect what a separate account in a money-market fund is, it is a giant redemption in kind odd initial at the beginning. And they would prefer to be a small part of the big machinery. However, you can get the $1 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, and they will be some who do it, willing to go into that kind of a structure. So it will just be the explanation of it and some of them will be willing to trade out the diversification and being in part of a larger pool in return for maintaining the $1 net asset value.

Cynthia Mayer - Bank of America Merrill Lynch

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 replacement or there are just some, bits here and there that would fall out not really have a product for them?

Chris Donahue

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 affect be retail as I discussed some of our actual trust business will be retail, but there are gaps in between where the client is not large enough to be qualified and not -- and doesn’t have a loud enough pulse to qualify for being a natural person. So there are again how much of our assets are in those gaps we do not know right now. And that’s where the answer to the question of is a variable net asset value product at all viable and that remains to be seen.

Cynthia Mayer - Bank of America Merrill Lynch

Okay. And then just a question on fee waivers and I am sorry, if I missed this but it sounded like they were going to get a little worst this quarter and in spite of the asset level going down, so I am 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?

Chris Donahue

Yes it is rates look we are not reacting to any other pressure or waiving more. It’s really where the rates are.

Tom Donahue

And 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.

Operator

Thank you. The next question is coming from the line of Patrick Davitt with Autonomous. Please proceed with your question.

Patrick Davitt - Autonomous Research

I just have one on the change in the non-conforming limit on 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 may be if you could give us some historical context for what percentage of your government funds overtime has been in non-conforming securities?

Chris Donahue

Debbie?

Debbie Cunningham

That is in fact if you look at the prospectuses of many of our products although the name would have allowed us to be 20% of the product in non-conforming, non-government product, we have never taken advantage of that nor have we, my perspective on taking any other funds ever been allowed to. If you look, sometimes they have been some reported misnomers, if you will, that in the day when various CDs where guaranteed from a government perspective. Government money funds that goes that is actually followed by the government security during that time period. There was also a student loan after that security program that was guaranteed from a government perspective that was held in a lot of government funds that was looked at it being non-government in nature but in fact it really was.

Very void demand that often times that are banks like the Federal loan bank are looked at as being non-conforming but in fact they are guaranteed, so what has been reported in many instances for our funds as well as for others in the industry as being non-conforming or a non-government has actually been incorrect. We tried to point that out in the context of our response back to, get request on this particular subject and so that’s really, the 99.5% on a current product basis, it’s something that is no change in how we operate on a day-to-day basis.

Operator

Thank you. Our next question is coming from the line of Marc Irrizary with Goldman Sachs. Please proceed with your question.

Marc Irrizary - Goldman Sachs

I think if we look at just, how much the assets in prime come down, already I think you are at 110 million down to 80 million and I know there’s lot of different dynamics but can you give a sense of the prime money-market funds and your clients’ willingness to shift just into government, any sort of update there? And then it’s a follow-up thanks.

Chris Donahue

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 in-part 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 ultra-short something like that which violets the $1 net asset value or go for the lower yield. And this as I said before our client base is not really wanted to face that in terms of making a choice that they didn’t currently have to make and one they are going to have to make right now, anyway obviously they have to make it soon.

So, we are, shall we say, evolving the decisions as their 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 govies or into one of our private funds or into a separate account or into a collective fund or into a bank instrument, it’s just remains to be seen.

Marc Irrizary - Goldman Sachs

Okay and then just I guess in…

Tom Donahue

Just to comment Marc on the prime, I mean what you have seen certainly in the industry you saw what the ICI categorizes as institutional, ramped up by over 60 billion over the second half of ’13 and now that has essentially reversed over the first half of ’14 and retail, the retail category under ICI has had accelerated outflows from prime as well. And you have got usual suspects there the low rate environment, uses of cash for taxes and other things it’s certainly been an industry phenomenon.

Marc Irrizary - Goldman Sachs

Okay, and then just in terms of some of the solutions that in 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 sort of invested in the ideas and sort of all the now that the reform is in place I would presume that mostly ideas that could capture some of those assets are coming out of prime are sort of in place already? Thanks.

Chris Donahue

Well a lot of the people of product development who have been working earnestly on commentary and improvements to the proposals at the SEC has made, have been thinking about and initializing work on various new products that now have been released to go whole hog on the new products. So we are 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 a internal review of the entire money-market fund line up 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 client so that we do the best we can to leave no client behind.

Marc Irrizary - Goldman Sachs

Okay, and then just one more on a different topic, your equity business now 50 billion, can you just remind us where does sort what is growing that business inorganically sort of fit into the equation how are you thinking about acquisitions to grow even further here from the 50 billion and maybe an update on your capital priorities?

Chris Donahue

Well, I will talk about the intent here is overwhelmingly to grow organically and that’s why I spend 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, this is what we called maybe seven or eight years ago the power of income and these were funds like capital income equity income and strategic value dividend. And so now those products are all maturing and we talk about and in terms of being on their road to $5 billion funds. So, that has worked out well so then you say what’s heading into the future well if you look at the strategic value dividend fund as a outcomes based product i.e. a 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 have 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 so that’s where we are looking for another thing 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?

Tom Donahue

Right and to finish up on the M&A side and to the portfolios is roll ups and we have a team that is out there trying to add to our existing funds and we have 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 support the growth of the company is another one and dividends and share buybacks are the other two, we have always said our first choice given our disciplines and returns that we have seen in our M&A is to spend as much money as we can there but the following our disciplines has allowed us to spend all the money there. Dividends have been a 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 buyback it’s been, you know the amount that we have done for a number of years. So, we will really at that every quarter and models and at where we think the company is going to grow and is noteworthy to buy shares as dividends make acquisitions.

Marc Irrizary - Goldman Sachs

Great, thanks.

Operator

Thank you. Our next question is coming from the line of Greggory Warren with Morningstar. Please proceed with your questions.

Greggory Warren - Morningstar

Yes, thanks for taking my question guys. When we think about what’s going to happen with the prime funds as we move forward here, and I mean I appreciate the effort to try and find alternative products for clients, try developing that can basically replace what they have now. But let’s assume that it’s hard to do that and investors have to ship in the government, sort of, products would that not have a detrimental impact on -- the fee waivers, because my understanding is that most of the fee waivers that you guys are issuing are on government agency treasury funds. So if we have a mix shift in that direction wouldn’t that be a negative in sort of this with our low interest rate environment?

Chris Donahue

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

Debbie Cunningham

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 powers are to put some of their assets back out into the system which as to some degree on a repo basis that this qualifier government asset, it’s helpful along those lines that is also so the shift into government money funds has been to some degree what we were saying before contribute towards, which is a decline in fee rates when you got the similar to supply more demand obviously you’ve got yields going down. So it would not be an easy shift.

Greggory Warren - Morningstar

Okay. That’s helpful. And the just kind of follow-up on the same issue, if we think about flows as we move forward, my sense is that, you can talk with your client it doesn’t seem like as it’s going to be rush to the exists for this particular type of funds, I mean the two year implementation, helps with that, the, how effective are they been to, you’re finding alternative products for them. And is there reluctant on this part to take with this money in the bank deposits?

Chris Donahue

Well, they would much prefer where they are and therefore we will get first swing at the pitch in my opinion that the consensus I get out of, listening to that conference call yesterday and the power plus of questions that Debbie refer to is that they are most enthusiastic to hear what kinds of thing 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 it affect $1 net asset value and pay a given yield will be attractive to some of their clients. But overwhelmingly the first sense you said is true that we don’t see any evidence of anything like a rush to exist or anything like that.

Operator

Thank you. The next question is coming from the line of Craig Siegenthaler with Credit Suisse. Please proceed with your question.

Ryan Sullivan - Credit Suisse

This is Ryan Sullivan coming 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 if there possibility that they could ask for more economics in the relationship. Thank you.

Chris Donahue

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

Tom Donahue

Well, more specific is, yes, we have a whole process 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 waivers recovery types of things, that comes back but if we have arrangements with customers that change the distribution, then we pay them and it’s not in the waiver just a different type of payment that’s why we list through when I say one of the factors with and basis points going up and that’s getting back 45% we list in there, all the providers and one of this changes in distribution fee arrangement with third party and it is forever part of our life. I don’t know if Ray, do you want to add anything?

Ray Hanley

No I would, it has been a long-term trend and we should expect it to continue.

Ryan Sullivan - Credit Suisse

And just a quick follow-up so just from a, more the longer term perspective here, can you give the perspective on how you see operating margins currently in the future versus the current levels?

Chris Donahue

Yes. So operating margin has been depressed and they were particularly more depressed when the waiver situation for the lower basis point because we end up sharing more and more and if rates go up so 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 it actually is a pretty commendable around here in terms of all the people at the company, participating and realizing what’s going on and controlling expenses.

Ryan Sullivan - Credit Suisse

Great, thank you very much guys, I appreciate it.

Operator

Thank you. Our final question is comes from the line of Tom Whitehead with Morgan Stanley. Please proceed with your question.

Tom Whitehead - Morgan Stanley

Hey, guys good morning, thanks for taking question. Just in your comment you mentioned a number of strong performing funds both on the equity and fixed income side. Can you talk to sort of the fee rates in the margins in that new business you are winning, I know that the fee rate went up slightly quarter-on-quarter so just curious as to what the main drivers are going to be going forward and I want to make sure not anything more than just a mix shift towards the equity? Thanks.

Ray Hanley

Tom it’s Ray the fee rates would obviously adding our equity business would enhance a fee rate and you point out within a bid in that, the product that we mentioned would tend to have kind of average fee levels if you are looking at kind of industry mutual fund averages for equity funds. The separately managed accounts have lower fees and we have had substantial growth there so they are not as added to the fee rate but on an always basis the equity certainly controlling equity assets it is helpful to the overall blended fee rates.

Tom Whitehead - Morgan Stanley

Great, yes thank you. And then secondarily so, if we look at the overall level of growth fixed income sales it’s close to little bit in 2Q redemptions were country level so anything I mean you guys have some strong points product there is other could you maybe highlight for us any product that you think has been performing very well and you are little bit surprised that the demand for just hasn’t been there anything in particularly you can color out there? Thanks.

Chris Donahue

The one that comes to mind there would be high yield where we have very-very strong products than we have had multiple quarters of robust sales and net sales, we had very solid sales and high yield in the second quarter and solidly positive flows but both would have been lower than the several couple of quarters before that and that continue to into Q4. Still very attractive but and I think you can see that the industry numbers as well that has core up a little.

Tom Whitehead - Morgan Stanley

Alright, great thank you.

Operator

Thank you, 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.

Chris Donahue

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

Operator

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.

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