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Federated Investors, Inc. (NYSE:FII)

Q4 FY07 Earnings Call

January 25, 2008, 9:00 AM ET

Executives

Ray Hanley - IR

J. Christopher Donahue - President and CEO

Thomas R. Donahue - CFO, Treasurer and President, FII Holdings, Inc.

Deborah A. Cunningham - Sr. VP and Chief Investment Officer

Analysts

Ken Worthington - JP Morgan Chase

Marc Irizarry - Goldman Sachs

John Fox - Fenimore Asset Management, Inc.

Robert A. Lee - Keefe, Bruyette & Woods

Michael Hecht - Bank of America Securities LLC

Cynthia Mayer - Merrill Lynch

Prashant Bhatia - Salomon Smith Barney/Citigroup

Michael Carrier - UBS

William R. Katz - Buckingham Research Group

Operator

Greetings and welcome to the Federated Investors Q4 2007 Earnings Conference Call. At this time, all participants are in a listen-only mode. A brief 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, Mr. Ray Hanley, President of Federated Investors Management. Thank you, Mr. Hanley, you may begin.

Ray Hanley - Investor Relations

Good morning and welcome. Today we plan some brief remarks and then we'll open up for your questions. Leading today's call will be Chris Donahue, Federated's CEO; Tom Donahue, Chief Financial Officer and with us today is Dennis McCauley and Lori Hensler from the Corporate Finance Group and with us for the Q&A portion is Debbie Cunningham, Chief Investment Officer for Federated Money Market Fund.

Let me say that certain statements in our presentation including those related to money market assets, investment performance, sales and acquisitions, will constitute forward-looking statements that involve known and unknown risks and other factors that may cause actual results to be different from future results. For a discussion of the risk factors, see the risk factor and cautionary statement section in Federated's annual report on Form 10-K for year end 12-31-06 and other reports on file with the SEC. And as a result, no assurance can be given as to future results and neither Federated nor any other person assumes responsibility for the accuracy and completeness of such statements in the future.

And with that, I will turn it over to Chris.

J. Christopher Donahue - President and Chief Executive Officer

Thank you, Ray. Welcome and good morning. I will begin by reviewing Federated's recent business performance before turning the call over to Tom to discuss our financials.

Starting with the cash management business, money market assets grew by nearly $27 billion or 13% from the prior quarter and increased by $63 billion or 36% during the year 2007. This was by far the best year in Federated's history for asset growth overall and for money market assets in particular. These assets have continued to grow, adding another $7 billion so far here in January. With the outlook for additional Fed rate cuts and with our strong competitive position, we expect to see additional growth in money market assets.

We have experienced growth in all categories of money funds: govis, prime and muni, with the strongest growth coming in government products. The persistency of these assets is difficult to forecast. However, in past periods of accelerated money market growth, we have experienced higher highs and higher lows.

In addition to macroeconomic factors, our diverse client base considers the quality of our products and services and the strength of our credit worth is key point in determining the placement of assets that they control. These factors continue to work in our favor as our highly experienced team of portfolio managers, analysts and traders have worked hard and performed exceptionally well in the tough market conditions of the last several months.

Our prime money market funds continue to perform very well against the backdrop of very challenging markets. We continue to see the winding down of the SIV positions as those mature. We have received all payments when and as due and expect to continue to be paid on time and in full from these instruments.

On the Muni side, the down grades of Muni bond insurers have made the headlines. With approximately half of all municipal securities issued in the market insured, our funds, like others, hold these investments. However, we do not expect these issues to cause any credit or liquidity problems for our Muni funds. We are comfortable with the underlying credit of the issuers as well as by the liquidity support and short-term nature of nearly all of our holdings in Muni money market funds.

We remain comfortable with the credit quality of all of our money fund investments. We continue to have frequent contacts with our client. As the total asset indicates and the increases, our clients continue to have confidence in our money funds.

Now in terms of market share, we gained share during the fourth quarter and for the year 2007. As always, we think longer views of market share are more useful than the short-term figures, but still we expect to continue to grow our market share over time.

An update on functional equivalency efforts for money funds shows the CFTC and the OCC applications ended the year at over $2 billion combined. We continue to work through legislative efforts to enact changes we have been seeking with the SEC around the Rule 15c3-3 effort. This is broker cash.

Recently, the SEC determined that prime money market funds would not be included in the potential changes to the rule. We are proceeding with the effort to enable the use of government and agency money funds. We think that this change would be a partial victory for this application.

Turning to equity, assets decreased from the prior quarter due to market depreciation and net outflows. Net outflows from equity mutual funds decreased slightly from the prior quarter, and we saw improvement in flows during each month of the quarter. Returning to positive equity flows remains a top priority for 08. We believe that new products like the Federated InterContinental Fund and the Kaufmann Large Cap Fund combined with improvements in other funds will enable us to turn these flows positive during the year.

The new InterContinental fund was our top selling equity fund on a net basis in the fourth quarter. Launched in August following the acquisition from Rochdale, the fund has strengthened our international fund product line. Assets recently exceeded $600 million, up from $366 million at acquisition date.

The fourth quarter also saw the signing of new employment contracts with the principals of the Federated Kaufmann team. We are very excited about this development and the structures that it puts in place to enable us to continue to build upon the great success of the Federated and Kaufmann combination.

When we joined forces in April of 01, assets under management in the Kaufmann product were $3.2 billion. These assets stood at over $13 billion at the end of 07. The contract came to fruition along with plans for the launch of the new Federated Kaufmann Large Cap Fund, which we have just begun to sell. We agreed that a new long-term contract was useful to launching this product as it demonstrates the commitment of the team and the whole company to the success of this product and through all of our Federated Kaufmann products. We are confident that the Kaufmann team will continue to deliver strong investment performance to shareholders for many years to come.

MDT mutual funds contributed positively to equity fund flow. Assets in Federated MDT equity mutual funds increased 25% in the quarter to just over $1 billion, due mainly to a fund merger and modestly from positive net flows.

We've also had some recent platform wins and better sales results for the Capital Appreciation Fund which has had a strongly positive change in performance over the last two years. Overall, net outflows in our equity funds are running lower for the first three weeks of January than compared to the fourth quarter.

Turning to equity separate accounts, we won another new MDT institutional account in the fourth quarter for $20 million and we continue to see a lot of interest from consultants and institutional investors in the MDT strategies. MDT's SMA strategy, however, had net outflows in the fourth quarter as we continue to work to increase sales from the 07 reopening in the major broker platforms. MDT total managed assets closed the quarter at $8.9 billion, up $2.2 billion from the acquisition in mid 06. We continue to have success in expanding distribution for our Strategic Value SMA product as the strategy was added to the platform of another top wirehouse broker effective late in the fourth quarter.

We expect this win and the other major wirehouse win we talked about last quarter, which has not yet become operational, to helps flows in this area. SMA flows were negative in the fourth quarter, reflecting market conditions in 07 for portfolios like Strategic Value that emphasize dividend paying stock. Federated's SMA assets were $10.5 billion at year end, up about 10% for the year.

On the fixed income side, Federated continued to navigate difficult credit market conditions very successfully. Our total return bond strategy continues to rank in the top 4% of its Lipper category for three years ended 12-31-07 and is in the top 11% or better for the quarter 1, 3, 5 and 10-year periods at year end. Our overall fixed income performance is strong and our fund flows, though, still negative, improved significantly during the fourth quarter. Within, however, the fixed income separate accounts, we did have a $250 million redemption which was related to the client's exit from bankruptcy.

As of January 23rd, our managed accounts were approximately $308 billion. This includes $247 billion in money market assets, of which $222 billion were money market mutual funds. Also, $38 billion in equities and $23 billion in fixed income.

Looking at investment performance and using the year end Lipper rankings for Federated's equity funds, 70% of rated assets are in the first or second quartile over the last year; 79% three years; 72% five years and 54% ten years. For bond fund assets, the comparable first and second quartile percentages are 69% one year; 81% three years; 87% five years and 77% for ten years.

Let's address distribution. In the wealth management and trust market, money market assets grew by over $16 billion, driven by gains from institutional clients in bank trust and capital market channels. In the broker dealer channel, money market assets continued to grow, gaining about $7 billion in the quarter, and this includes additional growth from our assets within the Edward Jones system.

In the global institutional channel, we continue to have elevated activity for RFPs and finals presentations, reflecting strong investment performance in a number of areas. We are also seeing increased interest from state government pools and other institutional cash accounts attracted by our cash management capability as demonstrated during the tough market of the last several months.

Our strong investment performance on the cash side and in other areas may also help on the acquisition front and we continue to evaluate candidates for both consolidation or roll ups and center of excellence deals.

At this point, I will turn it over to Tom to discuss our financials.

Thomas R. Donahue - Chief Financial Officer, Treasurer and President, FII Holdings, Inc.

Thank you, Chris. For Q4, revenues increased 16% compared to Q4 06 and 5% from the prior quarter. The increases were due mainly to higher money market assets and to a lesser extent higher equity assets.

On the expense side, Q4 results were impacted by $15 million or $0.09 net per share from the new employment contracts with the principals of the Federated Kaufmann team. Going forward, these contracts will have $1.7 million of new bonus compensation expense each quarter for four years. Overall, incentive-related compensation increased, reflecting growth in assets and earnings as well as improved equity investment performance. Marketing and distribution expense increased from the prior quarter and from Q4 06, largely due to money market fund growth.

In the non-operating area, Federated recognized a non-cash impairment charge of $1.2 million in its equity investment and its CDO product launched in 2006 due to the impact of downgrades expected in securities held by the product. Despite its strong relative performance, i.e., none of the debt issued by this CDO has been downgraded and it continues to make payments to equity holders. We expect the equity returns to be much lower than expected at inception. The remaining book value of this investment is now approximately 200,000 and we continue to earn management fees from the product.

On the balance sheet, our cash and short-term investments were $146 million at the end of 2007. Our share repurchases were down in Q4. As we've discussed previously, there are a variety of factors that influence our activity level in any given quarter including overall market conditions, our market outlook, share price, as well as acquisition possibilities and other potential uses of cash and/or debt. We encourage investors to focus on our long-term record on share repurchases, dividends and acquisitions and we expect to continue to be active in all these areas going forward.

Anthony, we are ready to open up the conference call to questions now.

Question And Answer

Operator

Thank you. Ladies and gentlemen, we will now conduct a question and answer session. [Operator Instructions]. Our first question comes from the line of Ken Worthington with JP Morgan. Please proceed with your question.

Ken Worthington - JP Morgan Chase

Hi, good morning.

J. Christopher Donahue - President and Chief Executive Officer

Good morning Ken.

Ken Worthington - JP Morgan Chase

You've been typically a buyer of assets in the past. In this period of money market fund disruptions, are you seeing any increase in number of opportunities to either buy or partner with other companies in the money market fund area? Like, in other words, because there is so much disruption, are you seeing more opportunities than you have in the past?

J. Christopher Donahue - President and Chief Executive Officer

There is a constant pattern of deals available and discussions. We knock on as many doors as possible and we, like you, expect that there will be more opportunities occasioned by these disruptions. But it is very hard to go moment to moment and say there is a lot more deals available at any one given time. So we are working on some, as I mentioned, in my remarks, but it's very, very difficult to say, well, there has been a spike in offerings all of a sudden.

Ken Worthington - JP Morgan Chase

But is that what you would expect that you would expect there would be more opportunities because of this disruptions or --?

J. Christopher Donahue - President and Chief Executive Officer

Yes.

Ken Worthington - JP Morgan Chase

Okay. Perfect. Thanks. And then secondly, maybe you can talk about the impact of the kind of the surprise 75 basis point cut. Is the potential positive impact... I think you mentioned that there is... money funds are up $7 billion in January already, but does the magnitude of the ease play into the sales you get in the money fund area? Like would it have been any different if the Fed only eased 50 or 25?

J. Christopher Donahue - President and Chief Executive Officer

Well, the larger the ease, the more the disparity that erupts between the yield on a money fund and say the repo rate or other direct instruments. And so there is more incentive for more money to come into money funds on the larger amount, and it also happens quickly and that influences it as well. And I am going to let Debbie address her views on this as to how this has played out historically.

Deborah A. Cunningham - Senior Vice President and Chief Investment Officer

Hi Ken. This is Debbie Cunningham. And the 75 basis point rate cut, the magnitude of the cut, as Chris mentioned, definitely should have... historically, has had an impact on the flows that we've received, i.e., the larger the cut, the larger the volume on a percentage basis of increased flows. Having said that, I think to some degree we've already seen a substantial amount of flows and so expectations would be that the continuation of those based simply on the 75 basis point cut is likely. It's questionable whether the volume actually increases based on that. I think the 75 basis point cut was based on at this point concern in the market from a global perspective about an economic slowdown. What we saw based on the earlier rate cuts that took place in 2006, in our estimation, was due to some of the market disruptions, particularly the liquidity problems that had occurred in the money fund. The fact that this 75 point basis point cut, however, in our estimation, is more due to an economic slow down, may actually in fact have a larger impact on what we see from a flow perspective going forward.

Ken Worthington - JP Morgan Chase

Okay. And then lastly, Debbie, just your... I know there were comments in the prepared remarks, but just in your opinion, an update on the SIV issues and the financial guarantors?

Deborah A. Cunningham - Senior Vice President and Chief Investment Officer

From an SIV perspective, our core issuers are still the same ones that we continue to own within the various prime portfolios. As was mentioned, they continue to mature. We continue to work with each of those issuers to make sure that they are... continue to be high credit quality issuers within our portfolio and to continue to attempt to get additional liquidity into those structures in the forms that would acceptable for us to start to repurchase in some way. But again, that's a process that continues and we are very comfortable from a credit process, and our comfortability has been borne out in the context of those securities maturing and paying as they come due.

Our outlook is for continuation of the same, continue to work with those issuers and their supporters, their providers as we go forward over the next several months and into the summer of 2008. From a Muni bond insurer perspective, our monoline bond insurer perspective, as was also noted, a good portion of the municipal market is in fact guaranteed by variants of the monoline insurers. We do not except to have any kind of credit problems associated with downgrades of those monolines.

They have already been a few noted downgrades within marketplace from one or more of the NRSROs that rate those entities. In fact, though, this has not been thought of internally as a AAA rated market for some time now. So, if you will, the rating agencies are, in our estimation, catching up with the process at this point by affecting some of those downgrades. Again, the liquidity features that are available on those structures when we feel, they have been downgraded to a level that no longer meets our requirement or internally, we downgrade them to a level based on their own credit analysis process. The liquidity features back to the banks and broker dealers in those structures will then be affected and we would expect that the full payment and the liquidity that's provided in those transactions will be returned to the funds at that point in time. But again, we don't expect it to have any kind of credit or liquidity issues in those products.

Ken Worthington - JP Morgan Chase

Okay, great. Thank you very much.

Operator

Thank you. Our next question comes from the line of Marc Irizarry with Goldman Sachs. Please proceed with your question.

Marc Irizarry - Goldman Sachs

Great, thanks. A question, I guess, for you Chris. If you can just put some historical perspective on your business during recessionary periods in terms of what you see in the money fund business. Thanks.

J. Christopher Donahue - President and Chief Executive Officer

What has happened historically has been driven in large part by what's going on with rate. And if you recall Chris's charts, the charts in the 01,'02, 03 timeframe had high hats on them because of the flows occasioned by an easing cycle of the Fed. And as I mentioned in the remarks when I said that we have higher highs and higher lows, sometimes that money rolls off as the Fed changes in some later sequence. But we end up with more and more and more business as you go over time. So if you look at this business from the perspective of starting it in the mid 70s till today, once you are dedicated with your products and your approach to the long term and not the short term, that's why you can continually grow CV cycles, accept the money and have clients for the long haul, and that's what we are trying to do. So we try to build the products and the business so that it matters not what the Fed is doing at any one time in any one cycle. But our designs have last through all of these cycles and flourish and do what they are supposed to do, which is give customers daily liquidity, a part of [ph] the money market fund.

Marc Irizarry - Goldman Sachs

And this may be a little bit harder to assess... I don't know if you have any metrics internally to measure it, but obviously, some of your competitors have probably been more exposed to investment. Just sense for example that maybe aren't performing as well as the investments that you have in your money market funds. Are you seeing any evidence of market share gains on that front? Thanks.

J. Christopher Donahue - President and Chief Executive Officer

Well we have seen some monies coming from some states that have problems where money has moved around and then found its way into Federated funds. It is very difficult, though, for us to exactly say we got this money out of a competitors' money fund, because we have a lot of the clients already and they may be reallocating to us and we don't see it exactly that way. So, overall, we can detect that we have increases in market share any way we look at it, and so we are heartened by that. And in talking to the clients, we know that they have a great deal of confidence in keeping and building their cash positions with us and we tend not to try to focus on what the other players are doing.

Marc Irizarry - Goldman Sachs

Okay, great. And then as we just look out at the quarterly progression of earnings, it looks like the first quarter you're seeing a little bit of a spike up historically. Can you just talk about maybe the operating leverage and maybe some of the expenses as we head into the first quarter?

Thomas R. Donahue - Chief Financial Officer, Treasurer and President, FII Holdings, Inc.

Yes, well, spike up. Remember, there is usually less days in the first quarter, although this year is leap year, right. In terms of expenses, we usually recalibrate the incentive programs in terms of what we think is going to happen. So that's where we usually see a spike up in expenses. Other than that, the technology program and our other capital expenditures I think are going through normal process. In terms of the revenue side, of course, you are going to get a reflection of the kind of quick money fund increases. And you didn't ask this question, but what will I do on the margin basis? And it always seems that our distribution is in demand for more sharing from us and that just continues to be part of life. So I don't say that we have... expect any big increases in margins.

Marc Irizarry - Goldman Sachs

And how about on the comp side of equation in terms of the impact from Kaufmann going forward from the other [ph] contracts?

Thomas R. Donahue - Chief Financial Officer, Treasurer and President, FII Holdings, Inc.

Yes, well, we have $1.7 million a quarter in increased expenses for the next four years. And that's just going to be built in and then there are other incentive things in there that could happen if things work out well in terms of assets and performance. So it could be higher than that, but that's kind of a locked in number.

Unidentified Company Representative

And those things relate... the new things relate to the new funds. So, Marc, it will obviously take some time for that fund to get a footing in assets and revenue.

Marc Irizarry - Goldman Sachs

Okay, great. Thank you.

Operator

Our next question comes from the line of John Fox with Fenimore Asset Management. Please proceed with your question.

John Fox - Fenimore Asset Management, Inc.

Hey, thank you. Good morning everyone.

J. Christopher Donahue - President and Chief Executive Officer

Hi John.

John Fox - Fenimore Asset Management, Inc.

What is the... I know there is a lot of favorable things going on with the money funds. Could you just discuss what's the normal seasonal pattern between fourth quarter and first quarter? In terms of inflows, is there a seasonal pattern you've seen in the past?

J. Christopher Donahue - President and Chief Executive Officer

I'll let Debbie give you that answer.

John Fox - Fenimore Asset Management, Inc.

Okay, great.

Deborah A. Cunningham - Senior Vice President and Chief Investment Officer

I would say, John, that there is not a normal pattern, if you will, from fourth quarter to first quarter in that there is an increase or a decrease. What does happen, though, is a shifting around of assets. During the fourth quarter for window dressing purposes from many of our clients, there is a shift into government money market funds and out of prime and tax-free or municipal money market funds. Now, generally, those products on the govi side increase in the fourth quarter and the other two prime and Muni generally decreased. That reverses itself almost immediately at the beginning of the first quarter each year. Having said that, there is not really generally trend between fourth quarter and first quarter; it's just more of a trend amongst the three groupings.

J. Christopher Donahue - President and Chief Executive Officer

John, if you look at some of the different channels, you don't see much difference in the brokerage channel in terms of whether it was year end or January in terms of flows. It's more controlled by what's going on in the marketplace, rates and things like that. By the same token, in some of our large accounts like TexPool, it has its regular increases as we get into the first quarter, and then those things start to decrease as we get into October and then it's just a complete cycle. And if you plot the TexPool, you can get a pretty good flowchart, and those flows have been pretty much similar over the timeframe. And then you have clients who are just doing things differently at different times all the time. And that is a general rule that just doesn't change, and we have so many of these clients moving so much money, whether it's in and out of bankruptcy or for cash needs that you are just a general part of the economic system.

John Fox - Fenimore Asset Management, Inc.

Okay, great. And could you go over what your SIV maturity schedule is at this point?

Deborah A. Cunningham - Senior Vice President and Chief Investment Officer

With our four issuers in aggregate across our prime money market funds, we have maturities that flow fairly evenly on a per month basis with a little lumpiness in a couple of months out through the mid part of the summer of 2008.

John Fox - Fenimore Asset Management, Inc.

Okay. Thank you.

Operator

Our next question comes from the line of Robert Lee with KBW. Please proceed with your question.

Robert A. Lee - Keefe, Bruyette & Woods

Thanks, good morning.

J. Christopher Donahue - President and Chief Executive Officer

Hi Rob.

Robert A. Lee - Keefe, Bruyette & Woods

Not to harp on this issue, but at last call you gave some general guidance about in terms of sizing it. I think it was a couple of percent of money fund assets. And given the continued growth and assuming pay down of what you have owned, I mean how should we think about sort of trying to size just the general exposure now? Is it down to 1%, or I mean how should we think of that?

Deborah A. Cunningham - Senior Vice President and Chief Investment Officer

It's still in that 2... it's 2.4% of assets at this point, of money fund assets at this point. Spread out evenly in our prime funds, they range in exposure from a low of 0 to a high of about 10% in our offshore product. But across the board, if you look at it as a percent of our total assets, it's 2.4%.

Robert A. Lee - Keefe, Bruyette & Woods

Okay. And Chris, I guess this is a question is for you. If I look at your fixed income business, obviously, your performance has been pretty strong there. And withstanding the headwinds, and obviously you've had some improvement in flows, why do you think that maybe that business hasn't got the traction, maybe at least until very recently that it should have considering the track record of those products?

J. Christopher Donahue - President and Chief Executive Officer

Well, I think we reoriented ourselves back on to fixed income last year. So that's part of it. I think another part of it was that you had to have a long-term top decile record in order to get into the club. That top quartile was not enough to generate positive flow. It was certainly enough to do a good job for the client, but not enough to generate the positive flows. So there has been a lot of work being down on the distribution side, a lot of work being done on the investment side to increase that [ph] along with risk controls in order to try and improve the overall performance to get it into the top decile.

Now that we are there, we are seeing the flows start to even out on a net basis. We even had one month late last year that crossed over and was positive. So we are pretty optimistic about where those flows can be right now, and we would expect them to turn positive here barring some other craziness that could occur in the marketplace.

Robert A. Lee - Keefe, Bruyette & Woods

Okay. And I apologize if you mentioned this in your prepared remarks. Could you give some color in terms of what fixed income flows will look like early in the quarter?

Thomas R. Donahue - Chief Financial Officer, Treasurer and President, FII Holdings, Inc.

I don't think we mentioned that Rob, but they are running about the same as in the fourth quarter. As Chris said that, they've flirted with positive, slightly positive at times, slightly negative at times.

J. Christopher Donahue - President and Chief Executive Officer

So they are slightly negative now, but man, it is slightly. I am talking about January till today.

Robert A. Lee - Keefe, Bruyette & Woods

Right. Okay, thanks guys.

Operator

Our next question comes from the line of Michael Hecht with Bank of America Securities. Please proceed with your question.

Michael Hecht - Bank of America Securities LLC

Hi guys, good morning. How are you doing?

J. Christopher Donahue - President and Chief Executive Officer

Hey.

Michael Hecht - Bank of America Securities LLC

I just wanted to follow up on the cycle a little bit. In the past, Chris, you've... out of your kind of standard slide deck, you guys have talked about and shown amongst the mix of just money fund assets if you look that kind of corporate other slice, which is may be last time I saw it was maybe $15 billionish or so or less than 10% of your total assets. If I remember, that tends to be the slice that's kind of most sensitive to these rate moves. I mean how big is that today and may be remind us how big that got in past cycles.

J. Christopher Donahue - President and Chief Executive Officer

Well it does include others, and in past cycles that has gotten into the $22 billion, $23 billion size. So that at year end that number was about $18 billion and it's increased now... I don't know what... I don't have the figure exactly as to what is the for the breakdown for January so far.

Michael Hecht - Bank of America Securities LLC

Got you, and that would be... okay, got it. Okay. Talk a little bit about the non-U.S. kind of money fund business. I mean how large your business is there and maybe a little color on kind of how large that market is and any expectations for growth the next few years. I think you've got a couple of strategic alliances there.

J. Christopher Donahue - President and Chief Executive Officer

Well we have some pretty good ideas for what we can do internationally. The offshore funds are about $10 billion, and the lion's share of that of course is in money market funds. And we have there our alliance with Paribas and Henderson, and we expect to get some big clients from that as we move forward. That hasn't moved as big and as fast as we thought, but there is a lot of good opportunities there, and we are discussing things with some big clients as we speak. So we would look forward to some meaningful assets on the international side as well at this point.

Michael Hecht - Bank of America Securities LLC

Okay. Maybe shifting back to MDT and the flows you are seeing there, which, especially on the separate account side, seemed a little bit softer than I would have expected. I mean just come back to, I mean is it... any sense that it's performance related or just kind of quan [ph] products falling out of favor? And you mentioned... you seem like you are having some success, and maybe interest rather in terms of conversations with consultants. I mean what's the kind of sticking point there that's... just it's not a product they are that familiar with or, and what do you think it's going to take to get some traction there?

Ray Hanley - Investor Relations

Mike, it's Ray. I will just make a couple of comments on that. The performance at MDT at this point is outstanding in all of the strategies which was pretty significant outperformance, especially over the last year. 2006 was a bit of a soft patch on performance, and of course that was when we acquired the business and in addition, MDT had been on the path of closing down the strategy following very rapid growth in the major wirehouse platforms. And there was a focus on trying to diversify the asset base and we're continuing to do that with growth on the mutual fund and on the institutional account side. But I would not look at it as through the lens of whether quant is up or down. It is very much a fundamental approach with a quant overlay. And if you think to look at their numbers, especially in '07, it gives us a lot of confidence on both the SMA side and on the institutional side that... and on the mutual fund side that the flows are going to improve. Another event on the flow side will be the bulk of their mutual fund product line does not have a three-year record, but we'll get that in the third quarter, I believe, of 2008 and we expect that to be very positive as well.

Michael Hecht - Bank of America Securities LLC

Okay, that's fair enough. And then on Kaufmann, and congrats by the way on reupping their employment agreements, I mean how should we think about the capacity in the existing products? And then how long you expect to take the kind of ramp growth in the new Large Cap product? I mean does it go on the shelf immediately wherever the over the Mid Cap product is offered and how long... how does the roll off of distributors work there in terms of timelines?

J. Christopher Donahue - President and Chief Executive Officer

Okay. In terms of the big fund, we do not see or foresee at this point any limit on that fund or any capacity issue in the big standard Federated Kaufmann Fund. On the Small Cap fund, we have talked about looking at it again it gets to $2.5 billion and then it may can... be able to contain somewhere between $2.7 billion and $3 billion. And these numbers are the results of discussions with the Kaufmann team. And that is the key to the capacity issue because it's how their act plays the way they want to manage the money. So there would be some capacity constraints there. On the Large Cap Kaufmann Fund, even though you didn't ask about capacity, Large Cap is obviously an unlimited amount of capacity there. Now what we did in terms of the distribution, we started marketing that fund immediately at the beginning of this year. So we are rolling it out as we speak. The marketing programs are in place, the training, the materials, and we look forward to having some good results with that fund as well.

Michael Hecht - Bank of America Securities LLC

Okay, great. And just last question on capital management in terms of appetite and capacity for additional share repurchase. And you ended the year with like $146 million in cash. I think that was up a fair amount from last quarter I think. Just walk through any near-term uses of cash that you have and how should we think about that?

Thomas R. Donahue - Chief Financial Officer, Treasurer and President, FII Holdings, Inc.

Mike, we have to look at contingent payments that we have on a number of deals out there, MDT and looking at different acquisitions. And that's nice to look at the $146 million as up because we looked at it as down when it was below that previously. In terms of buying shares back, and just a little bit of work here. Since 2000, we averaged about 3.5 million shares and in '07, we were 3.3 million. So we kind of are going to look at all the different uses just like we always do.

Michael Hecht - Bank of America Securities LLC

Okay, great. Thanks guys.

Operator

Our next question comes from the line of Cynthia Mayer with Merrill Lynch. Please proceed with your question.

Cynthia Mayer - Merrill Lynch

Hi, good morning. Just I had a question on the $4 million increase in incentive comp in the quarter. It seemed like more than usual, and I guess in some fourth quarters in the past you've actually trued up and comp has gone down. So can you give us just a little more color on what products that relates to and is that 4Q only or does that roll forward in comp too?

Ray Hanley - Investor Relations

Yes, we are kind to happy to have it go up because, as I mentioned in my little comment, the performance is uptick. So we've had to uptick of the incentive, and then the other break down.

Unidentified Company Representative

In terms of the other $2 million.

Ray Hanley - Investor Relations

Well, it's a variety of things, but it clearly was weighted toward the incentive pay. And in terms of a run rate, Cynthia, we'd tell you to really look at the whole year. The number does bounce around. It bounced around a bit more this quarter than it has in other quarters. But that reflects what Tom's comments covered in terms of pretty good ramp up in performance-based pay... investment performance-based pay.

Thomas R. Donahue - Chief Financial Officer, Treasurer and President, FII Holdings, Inc.

Cynthia, we try to look at that as one of the oldest success items that I talked about a few years ago. We are paying more on incentive pay to investment management. That means the performance is better and that should lead to better things.

Cynthia Mayer - Merrill Lynch

How much of geared to performance versus assets? So for instance, if the equity market went down a lot, would that decrease the equity portion of that?

Thomas R. Donahue - Chief Financial Officer, Treasurer and President, FII Holdings, Inc.

Most of that is tied to performance and not assets.

Cynthia Mayer - Merrill Lynch

Okay. And I guess just coming back to the use of cash, it seems like you bought fewer shares in the quarter, and I am just wondering if that's a function of share price.

J. Christopher Donahue - President and Chief Executive Officer

It's more a function of our standard opportunistic view of share buyback. Tom gave you the figures on a year-to-year basis. And sometimes during some quarters, cash is a nice thing to have.

Cynthia Mayer - Merrill Lynch

Okay, thanks a lot.

Operator

Our next question comes from the line of Prashant Bhatia with Citigroup. Please proceed with your question.

Prashant Bhatia - Salomon Smith Barney/Citigroup

Hi. Just, again, going back to the sales more from a structural point, can you compare the sales structure in the money funds versus the tender option bond structure, the Muni fund? And does one give you more or less flexibility I guess?

Deborah A. Cunningham - Senior Vice President and Chief Investment Officer

They are really... there was an article out on this maybe a month or so ago, and there is really not a comparable comparison between the two structures, between the TOB structure and the SIV. The issue with the SIVs in the current market is one of lack of liquidity. The structures were initially brought to the market with somewhere in the neighborhood of external liquidity around the 10% to 20% range. And most of them are up to 40% to 50% at this point in time just given the demand in the marketplace for that additional liquidity.

The additional liquidity in those structures came from their ability to sell the public highly rated high quality assets that they held within their portfolios and that was the reason why more rating agency perspective and from a due diligence perspective, liquidity was not required to be 100% as it is in most of their transactions that are used or most of the security types that are used within money market funds. So when that market liquidity went away in the second half of 2007, its one additional external liquidity forms were needed to come in for those SIVs in order to allow issuers to continue to be comfortable holding them or, at some point, to potentially buy them going forward.

On the TOB side of the equation, those securities have 100% liquidity. They have a put feature on absolutely 100% of them that goes back to a bank or a broker dealer, very liquid issuers in the marketplace, and those are exercisable on either a daily or a 7 day demand feature. There are some that are a little bit longer than that. For the most part, 90% of the market is single day or 7-day demand feature exercising within those TOB structures. So the liquidity issue is what had caused the constraints in the SIV market on the taxable side of the equation. Those don't exist at all on the Muni side. It's entirely... the liquidity side of the equation is entirely covered by the put feature associated with those TOBs.

Prashant Bhatia - Salomon Smith Barney/Citigroup

Okay. And that tends to be about 100% of the external liquidity capacity?

Deborah A. Cunningham - Senior Vice President and Chief Investment Officer

Yes.

Prashant Bhatia - Salomon Smith Barney/Citigroup

Okay, great, that's very helpful. And then just on the money funds in terms of the competitive environment. I know it bounces around. Is there in this for the past quarter or so, are you seeing anyone being more or less aggressive in terms of pricing on the money fund side?

J. Christopher Donahue - President and Chief Executive Officer

We haven't noticed any difference on pricing at this point in the ballgame. There has been more attention to managing the money market fund for its standard old requirements of daily liquidity at par. So I don't see... we haven't seen that yet.

Prashant Bhatia - Salomon Smith Barney/Citigroup

Okay. And then just on the distribution platforms for the equity and fixed income product, could you just comment a little bit about the flows with Jones and may be the trend there and then the flows outside of Jones and the trends there as well?

J. Christopher Donahue - President and Chief Executive Officer

When you say the flows outside Jones, are you talking about in the broker dealer area?

Prashant Bhatia - Salomon Smith Barney/Citigroup

Exactly.

J. Christopher Donahue - President and Chief Executive Officer

Okay. The trends in Jones are related to their goals of getting from around 1100 financial advisors to something... I mean 11,000 to 17,000. And as they grow, then they put new people out in the field with their one person offices and then they collect up clients, and that occasions more clients going into the money funds. And so you have two features at work. You have new offices being opened and therefore more assets and then you have in effect same-store sales also going there. And so that's what's happening with Jones. In other broker dealers, as you get defensive nature of some of the people in the marketplace, you will get some people going more for money funds. And I am going to let Ray review with you some incidents to give you some further color on that.

Ray Hanley - Investor Relations

Just generally on the broker dealer side for Q4, the sales were up actually quite a bit and the net sales improved. They are still negative, but they were improved quite a bit from the prior quarter. And the InterContinental Fund has gotten traction there pretty quickly and we have also had some success, we mentioned in the remarks, in some of the programs within the platform, annuity rep programs and other things where we are able to slot product. In fact, capital appreciation has had... the Capital Appreciation Fund has had some success there, which is pretty good evidence of the dramatic turnaround in performance. So the trends within broker dealer are positive, moving in the right direction.

Prashant Bhatia - Salomon Smith Barney/Citigroup

Okay, great. Thank you.

Operator

Our next question comes from the line Mike Carrier of UBS. Please proceed with your question.

Michael Carrier - UBS

Thanks guys. One question on the follow up on the munis. Thanks for the color. I think we agree like the underlying credit hasn't changed given what has happened with the insurers. And a lot of the munis that are insured are trading roughly in line with munis that don't have the insurance. But just in terms of looking like the money market rolls, like when you do have these downgrades like what can you own and can't you own? And then just on the liquidity support, like can you just kind of give us some color on that like what that provides you as order?

Deborah A. Cunningham - Senior Vice President and Chief Investment Officer

Certainly. From a Rule 2a-7 perspective, if the guarantor of an issuer, i.e., in this case the monoline, is downgraded below AA, the put feature has to be exercised because it is no longer an eligible security per the Rule 2a-7 amendments that went through back in the 1996 time period. So the long-term ratings are of an importance, and some of the downgrades that have most recently occurred... Ambac was downgraded by Fitch to AA back in the, I think was two Fridays ago. Just yesterday XLCA was downgraded by Fitch from AAA down to A. The other two rating agencies in each of those cases of Ambac and XLCA still rate those insurers AAA, AAA. So effectively, you need more then one of them to downgrade below the AA level in order for the security in its form to no longer be eligible with regard to Rule 2a-7 and as such, the put being required to be exercised at that point.

Once you exercise the put and going on to the liquidity side of the structure, the put is generally as I said... 90% of them are either single day or 7-day. Effectively what happens if we put it today on a daily... for the daily where we pay tomorrow by the put provider. On a 7-day, we'll repay 7 days from now by the put provider. So those securities are then taken out of the portfolios. The put provision does not go away at all on a conditionality basis unless the guarantors are downgraded below investment grade. So below BBB minus. So there is no concern in the structure about the put provider not being available even if an issuer goes from a AAA to a A. It's only if an issuer went down below... only if a guarantor went below BBB minus or into the non-investment grade territory would the put feature no longer be valid in the sector.

Michael Carrier - UBS

Okay, thanks. And then one other question on the distribution side. And you guys have talked in the past just the differences or the nuances between the different channels and the costs related to it. I think in the past typically been the broker dealer channel that in most areas of fund distribution have the higher distribution expense. And then on the institutional side, you'd expect that to be incrementally lower. So if you do get those flows from the Fed cuts on the institutional side, like is there a chance that the expenses, at least on the distribution side, would grow less and you get a little bit more operating leverage if those flows start to pick up?

J. Christopher Donahue - President and Chief Executive Officer

Well sometimes it doesn't work out exactly as you've tried to indicate because sometimes, depending on the institutional client who is coming in on a money fund, they may come into a money market fund that has a lower total expense. And then there might be various payments back to that institution so that you may be in a situation where sometimes on the retail side, even tough the payments are higher in basis points, the receipts by our company may be higher than on an institutional account. So it all depends on which fund they are in and what the arrangements are with that client. So that is not an autopilot type thing where you can characterize the brokers one way and the institution another and then make that comparison. And we don't even do those numbers internally to try and figure that out.

Michael Carrier - UBS

Okay. But just I mean just conceptually, there is scale in the business, meaning the more you have, there should be incremental operating leverage if the money market flows continue and --?

J. Christopher Donahue - President and Chief Executive Officer

Theoretically, that might be true, but I go through this with our independent directors. Tom has approached this in terms of his comments on the margin. But what tends to happen... yes, that can happen and has happened, but there is also other portions of the marketplace where our intermediaries are begging to share in those potential economies or scale, and that's what happens. We would, if we could, increase earnings as much as possible. But the marketplace constrains us in terms of the payments and other players in the marketplace who will offer those types of things. So we've got to stay in the marketplace, and that's what tends to... that is the principal ingredient for eating at a scale benefit.

Michael Carrier - UBS

Yes, I got that. Everyone has their hands out. That makes sense. Thanks a lot.

J. Christopher Donahue - President and Chief Executive Officer

Thank you.

Operator

Our next question comes from the line of William Katz with Buckingham Research. Please proceed with your question.

William R. Katz - Buckingham Research Group

Okay. Thank you, good morning.

J. Christopher Donahue - President and Chief Executive Officer

Good morning Bill.

William R. Katz - Buckingham Research Group

Hard to think there are more questions, but there are. I think number one, I am just trying to get a little bit deeper into this marginal profitability discussion. If I look sequentially, and maybe that's not the right way to be thinking about it, but if I look sequentially I'm calculating and giving back credit for the one-time payment to Kaufmann, it looks like the marginal profitability was about 24%. If I look year-on-year, it's closer to 40%. So I am trying to reconcile some of the rapid growth of the assets versus, Tom, your comments on margins. I do see... your overall margin did slip sequentially, again, ex the payment, one-time payment. So how much is it... can the volumes really dampen the margin compression or how should we be thinking about that?

Thomas R. Donahue - Chief Financial Officer, Treasurer and President, FII Holdings, Inc.

Bill, I didn't follow your numbers there, but in terms of where money comes in and which funds, as Chris said, it's a big driver. If you are trying to go through and go each quarter, I am not sure that we can do that right here with you.

William R. Katz - Buckingham Research Group

Well just conceptually, I mean how deep is incremental margin below your run rate margin based on your commentary early of saying that don't expect big margin lift?

Thomas R. Donahue - Chief Financial Officer, Treasurer and President, FII Holdings, Inc.

Yes, it's really hard for us to make an incremental margin comment. Bill, it does depend on where the money came from, and a lot of that's built into the product. And then the other thing to your sequential comment beyond Kaufmann, we had more of an increase in comp, and that gets smoothed out a bit whenever you go year-to-year. So there is more noise when you simply go quarter-to-quarter.

William R. Katz - Buckingham Research Group

Okay. Second question is just coming back to scale in the money market business for a second. Certainly, tremendous growth. That said, and I know it's a very scale business, is there any incremental investment spending needed now from a support perspective or a credit analysis perspective that could erode some of the incremental margin?

J. Christopher Donahue - President and Chief Executive Officer

Well, we don't see it... we don't tend to short sheet any of the expenses or resources devoted to doing the credit work and managing the money. So we are not looking forward to any kind of meaningful increase in hiring more new analysts or things like that. We think we have been covering the waterfront pretty well. Let's not just say that we wouldn't add people if Debbie and her people thought that was necessary. We certainly aren't looking at that right now.

If we win, there's enough for things out there that we are bidding on and we may have to address the people it probably would not really be big time in terms of direct money management in Debbie's area, but definitely would be new resources if we win a number of bids there going on?

William R. Katz - Buckingham Research Group

Okay and then took a transition maybe did, I appreciate your perspective on this. What gives... what external metrics or indicators should investors be looking at to sort of believe if you will and percent... David [ph] but that the residual of SIV exposure will sure benignly. Is it rates? Is it credit spreads? How should we get some comfortable [ph] on that?

J. Christopher Donahue - President and Chief Executive Officer

What the main thing is what is in this SIV? What is the underlying investment? What is it? What is its quality and how does it work? So that is the metric and that is an internal metric to the actual instrument that was purchased, and that is the main show. Now as for external metrics, I will let Debbie make a comment.

Deborah A. Cunningham - Senior Vice President and Chief Investment Officer

I mean externally as rates go down, obviously, use... the normal course of business is that bond values go up as long as those bonds are performing correctly. As Chris mentioned, these are very... the kind of analysis of each of the four issuers that we own is something that we pride ourselves on on an ongoing basis. The knowledge of what they own and how it's performing. Given the lower rate cuts... or the lower rates in the marketplace due to the Fed cut, the implications there are positive from a metrics perspective. As rates go down, prices on bonds usually go up. Doesn't always follow suit, but that's generally the case. And again, I think really emphasis is on the knowledge of the individual portfolio securities because we have seen in this industry of what was only 30 issuers, huge variances between the portfolios and sort of the quality and the performance of those.

Thomas R. Donahue - Chief Financial Officer, Treasurer and President, FII Holdings, Inc.

Also Bill, the funding, the SIVs are been funding themselves through... not just through asset sales; in fact, they have been able to do repo consistently with longer term and they continue to do that. So it's not purely a function of asset sales even though, as Debbie commented, with the decrease in rates, that would help the asset value.

William R. Katz - Buckingham Research Group

Okay, fine. And then just lastly, you seem to be bucking the trend in terms of the delta on equity flows into January versus the fourth quarter. Can you sort of give a little more detail of what is selling? Is it just the InterContinental Fund or is there any deeper breadth in that?

J. Christopher Donahue - President and Chief Executive Officer

Well the InterContinental Fund is leading the pack, and that's been a pretty good thing for us.

Thomas R. Donahue - Chief Financial Officer, Treasurer and President, FII Holdings, Inc.

It's also been cap app Bill.

J. Christopher Donahue - President and Chief Executive Officer

Yes, cap app when.... Capital Appreciation Fund went positive here in January, and that fund should have been positive for a long time, but it takes, as we've said here before and as you have questioned me before, it takes a long time to work through a negative situation in a fund. And that fund went positive in the first couple of weeks here.

Thomas R. Donahue - Chief Financial Officer, Treasurer and President, FII Holdings, Inc.

The other comment I would make on the January flows is that even though they are negative, the bulk of the outflows have been in index products. So the actively managed products have even actually fairly close to breakeven. Now we are talking about three weeks of data. So we want to be very cautious about that. But the outflows have been weighted to index product.

William R. Katz - Buckingham Research Group

Okay. Thank you very much.

Operator

There are no further questions at this time. I would like to turn the floor back over to management for closing comments.

J. Christopher Donahue - President and Chief Executive Officer

Well that concludes our call and we thank you all for joining us today.

Operator

This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.

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