10-Q 1 fii-2016930x10q.htm 10-Q Document

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 ____________________________________________________
FORM 10-Q
____________________________________________________
(Mark One)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2016
OR
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from              to             
Commission File Number 001-14818
___________________________________________________
Federated Investors, Inc.
(Exact name of registrant as specified in its charter)
____________________________________________________
Pennsylvania
 
25-1111467
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification No.)
Federated Investors Tower
Pittsburgh, Pennsylvania
 
15222-3779
(Address of principal executive offices)
 
(Zip Code)
(Registrant’s telephone number, including area code) 412-288-1900
 ___________________________________________________________________________
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  o.
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  o.
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer
 
x
  
Accelerated filer
 
o
 
 
 
 
Non-accelerated filer
 
o
  
Smaller reporting company
 
o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes  o    No  x.
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the last practicable date: As of October 24, 2016, the Registrant had outstanding 9,000 shares of Class A Common Stock and 102,212,183 shares of Class B Common Stock.

 

 
Table of Contents


Certain statements in this report on Form 10-Q constitute forward-looking statements, which involve known and unknown risks, uncertainties, and other factors that may cause the actual results, levels of activity, performance or achievements of Federated Investors, Inc. and its consolidated subsidiaries (Federated), or industry results, to be materially different from any future results, levels of activity, performance or achievements expressed or implied by such forward-looking statements. Forward-looking statements are typically identified by words or phrases such as "trend," "potential," "opportunity," "believe," "expect," "anticipate," "current," "intention," "estimate," "position," "projection," "assume," "continue," "remain," "maintain," "sustain," "seek," "achieve," and similar expressions, or future or conditional verbs such as "will," "would," "should," "could," "may" and similar expressions. Among other forward-looking statements, such statements include certain statements relating to: asset flows, levels and mix; business mix; sources and levels of revenues, expenses, gains, losses, income and earnings; obligations to make additional contingent or other payments pursuant to employment or incentive arrangements; business and market expansion opportunities; debt, future cash needs and cash flows; uses of treasury stock; legal proceedings; the timing and impact of increased laws, regulations and rules, including potential, proposed and final rules by U.S. and foreign regulators and other authorities; the components and level of, and prospect for distribution-related expenses; classification and consolidation of investments; the ability to raise additional capital; management's assessments, beliefs, expectations, assumptions, projections or estimates, including regarding fee rates, the level, degree, continuance, recovery and impact of fee waivers and reimbursements or assumptions of expenses (fee waivers), the effect, and degree of impact, of changes in customer relationships, the level, timing, degree and impact of changes in interest rates, yields or asset levels or mix, legal proceedings, the timing, impact, effects and other consequences of potential, proposed and final laws, regulations and other rules, borrowing, taxes, product and strategy demand, investor preferences, performance, product development and restructuring options and initiatives, including the plans for and timing of such options and initiatives, compliance, and related legal, compliance and other professional services expenses, interest payments or expenses, dedication of resources, indebtedness and certain investments, recovery of losses, and liquidity; future principal uses of cash; performance indicators; the adoption and impact of accounting policies, new accounting pronouncements and accounting treatment determinations; interest rate, concentration, market and other risks; guarantee and indemnification obligations; the impact of the special dividend on earnings per share and projected liquid assets; and various items set forth under Item 1A - Risk Factors included in Federated's Annual Report on Form 10-K for the year ended December 31, 2015 and the Quarterly Report of Form 10-Q for the quarter ended June 30, 2016. Among other risks and uncertainties, market conditions may change significantly resulting in changes to Federated's asset flows, asset levels, asset mix and business mix, which may cause a decline in revenues and net income, result in impairments and increase the amount of fee waivers incurred by Federated. The obligation to make contingent payments is based on net revenue levels and will be affected by the achievement of such levels, and the obligation to make additional payments pursuant to employment or incentive arrangements is based on satisfaction of certain conditions set forth in those arrangements. Future cash needs, cash flows and future uses of cash will be impacted by a variety of factors, including the number and size of any acquisitions, Federated's success in developing, structuring and distributing its products and strategies, potential changes in assets under management and/or changes in the terms of distribution and shareholder services contracts with intermediaries who offer Federated's products to customers, and potential increased legal, compliance and other professional services expenses stemming from additional regulation or the dedication of such resources to other initiatives. Federated's risks and uncertainties also include liquidity and credit risks in Federated's money market funds and revenue risk, which will be affected by yield levels in money market fund products, changes in fair values of assets under management, investor preferences and confidence, and the ability of Federated to collect fees in connection with the management of such products. Many of these factors may be more likely to occur as a result of the increased scrutiny of the mutual fund industry by domestic or foreign regulators, and any recent or ongoing disruption in global financial markets. As a result, no assurance can be given as to future results, levels of activity, performance or achievements, and neither Federated nor any other person assumes responsibility for the accuracy and completeness of such statements in the future. For more information on these items and additional risks that may impact the forward-looking statements, see Part II, Item 1A - Risk Factors included in this Form 10-Q for the quarter ended September 30, 2016 and Item 1A - Risk Factors included in Federated's Annual Report on Form 10-K for the year ended December 31, 2015.


Part I. Financial Information
Item 1. Financial Statements




Consolidated Balance Sheets
(dollars in thousands)
(unaudited)
 
 
September 30,
2016
 
December 31,
2015
ASSETS
 
 
 
 
Current Assets
 
 
 
 
Cash and cash equivalents
 
$
185,104

 
$
172,628

Investments—affiliates
 
129,208

 
141,748

Investments—consolidated investment companies
 
58,977

 
25,368

Investments—other
 
7,219

 
7,071

Receivables, net of reserve of $74 and $59, respectively
 
39,040

 
33,524

Prepaid expenses
 
9,718

 
10,722

Other current assets
 
3,225

 
4,767

Total current assets
 
432,491

 
395,828

Long-Term Assets
 
 
 
 
Goodwill
 
659,189

 
659,315

Renewable investment advisory contracts
 
70,378

 
70,582

Other intangible assets, net of accumulated amortization of $6,641 and $21,116, respectively
 
3,759

 
4,595

Property and equipment, net of accumulated depreciation of $61,944 and $56,034, respectively
 
39,738

 
35,743

Other long-term assets
 
24,962

 
21,140

Total long-term assets
 
798,026

 
791,375

Total assets
 
$
1,230,517

 
$
1,187,203

LIABILITIES
 
 
 
 
Current Liabilities
 
 
 
 
Short-term debt
 
$
25,500

 
$
25,500

Accounts payable and accrued expenses
 
54,430

 
43,551

Accrued compensation and benefits
 
61,781

 
75,691

Other current liabilities
 
10,623

 
14,466

Total current liabilities
 
152,334

 
159,208

Long-Term Liabilities
 
 
 
 
Long-term debt
 
172,125

 
191,250

Long-term deferred tax liability, net
 
172,853

 
158,895

Other long-term liabilities
 
22,367

 
20,144

Total long-term liabilities
 
367,345

 
370,289

Total liabilities
 
519,679

 
529,497

Commitments and contingencies (Note (12))
 

 

TEMPORARY EQUITY
 
 
 
 
Redeemable noncontrolling interest in subsidiaries
 
29,945

 
8,734

PERMANENT EQUITY
 
 
 
 
Federated Investors, Inc. shareholders’ equity
 
 
 
 
Common stock:
 
 
 
 
Class A, no par value, 20,000 shares authorized, 9,000 shares issued and outstanding
 
189

 
189

Class B, no par value, 900,000,000 shares authorized, 109,505,456 shares issued
 
315,562

 
298,390

Additional paid-in capital from treasury stock transactions
 
45

 
0

Retained earnings
 
607,161

 
545,785

Treasury stock, at cost, 7,223,273 and 5,411,429 shares Class B common stock, respectively
 
(242,703
)
 
(191,939
)
Accumulated other comprehensive loss, net of tax
 
(594
)
 
(4,609
)
Total Federated Investors, Inc. shareholders’ equity
 
679,660

 
647,816

Nonredeemable noncontrolling interest in subsidiary
 
1,233

 
1,156

Total permanent equity
 
680,893

 
648,972

Total liabilities, temporary equity and permanent equity
 
$
1,230,517

 
$
1,187,203


(The accompanying notes are an integral part of these Consolidated Financial Statements.)

3


 
 
 
 
 
 
 
 
 
 
Consolidated Statements of Income
(dollars in thousands, except per share data)
(unaudited)
 
 
Three Months Ended

Nine Months Ended
 
 
September 30,

September 30,
 
 
2016


2015


2016


2015

Revenue
 
 
 
 
 
 
 
 
Investment advisory fees, net—affiliates
 
$
169,327

 
$
133,569

 
$
490,059

 
$
385,067

Investment advisory fees, net—other
 
27,926

 
25,329

 
81,703

 
74,818

Administrative service fees, net—affiliates
 
53,577

 
53,275

 
160,181

 
157,897

Other service fees, net—affiliates
 
41,701

 
20,295

 
115,201

 
59,010

Other service fees, net—other
 
1,033

 
903

 
3,374

 
3,004

Other, net
 
1,056

 
950

 
2,949

 
3,174

Total revenue
 
294,620

 
234,321

 
853,467

 
682,970

Operating Expenses
 
 
 
 
 
 
 
 
Distribution
 
98,740

 
58,823

 
281,862

 
166,376

Compensation and related
 
75,731

 
70,624

 
227,726

 
218,062

Systems and communications
 
7,763

 
6,684

 
23,395

 
20,533

Office and occupancy
 
6,660

 
6,552

 
20,223

 
20,115

Professional service fees
 
7,360

 
7,823

 
19,886

 
22,990

Advertising and promotional
 
3,371

 
3,310

 
10,751

 
10,285

Travel and related
 
3,165


3,183

 
9,727

 
9,474

Other
 
3,194

 
3,078

 
9,036

 
12,574

Total operating expenses
 
205,984

 
160,077

 
602,606

 
480,409

Operating income
 
88,636

 
74,244

 
250,861

 
202,561

Nonoperating Income (Expenses)
 
 
 
 
 
 
 
 
Investment income, net
 
1,857

 
1,243

 
5,104

 
3,777

Gain (loss) on securities, net
 
2,032

 
(4,292
)
 
2,553

 
(5,526
)
Debt expense
 
(1,039
)
 
(979
)
 
(3,118
)
 
(3,325
)
Other, net
 
19

 
(8
)
 
13

 
(37
)
Total nonoperating income (expenses), net
 
2,869

 
(4,036
)
 
4,552

 
(5,111
)
Income before income taxes
 
91,505

 
70,208

 
255,413

 
197,450

Income tax provision
 
32,597

 
26,072

 
91,128

 
74,633

Net income including the noncontrolling interests in subsidiaries
 
58,908

 
44,136

 
164,285

 
122,817

Less: Net income attributable to the noncontrolling interests in subsidiaries
 
3,983

 
5

 
11,208

 
620

Net income
 
$
54,925

 
$
44,131

 
$
153,077

 
$
122,197

Amounts Attributable to Federated Investors, Inc.
 
 
 
 
 
 
 
Earnings per common share—Basic and Diluted
 
$
0.54

 
$
0.42

 
$
1.48

 
$
1.17

Cash dividends per share
 
$
0.25

 
$
0.25

 
$
0.75

 
$
0.75

(The accompanying notes are an integral part of these Consolidated Financial Statements.)


4


 
 
 
 
 
 
 
 
 
 
Consolidated Statements of Comprehensive Income
(dollars in thousands)
(unaudited)
 
 
Three Months Ended
 
Nine Months Ended
 
 
September 30,
 
September 30,
 
 
2016

 
2015

 
2016

 
2015

Net income including the noncontrolling interests in subsidiaries
 
$
58,908

 
$
44,136

 
$
164,285

 
$
122,817

 
 
 
 
 
 
 
 
 
Other comprehensive income (loss), net of tax
 
 
 
 
 
 
 
 
Permanent equity
 
 
 
 
 
 
 
 
Unrealized gain on interest rate swap
 
0

 
0

 
0

 
42

  Reclassification adjustment related to interest rate swap
 
0

 
0

 
0

 
227

Unrealized gain (loss) on securities available for sale
 
1,688

 
(2,999
)
 
2,673

 
(2,611
)
  Reclassification adjustment related to securities available for sale
 
(178
)
 
847

 
1,666

 
847

Foreign currency items
 
(47
)
 
(210
)
 
(324
)
 
(388
)
Temporary equity
 
 
 
 
 
 
 
 
Foreign currency translation loss
 
(16
)
 
0

 
(13
)
 
0

Other comprehensive income (loss)
 
1,447

 
(2,362
)
 
4,002

 
(1,883
)
Comprehensive income including the noncontrolling interests in subsidiaries
 
60,355

 
41,774

 
168,287

 
120,934

Less: Comprehensive income (loss) attributable to redeemable noncontrolling interest in subsidiaries
 
1,349

 
(905
)
 
3,242

 
(1,288
)
Less: Comprehensive income attributable to nonredeemable noncontrolling interest in subsidiary
 
2,618

 
910

 
7,953

 
1,908

Comprehensive income attributable to Federated Investors, Inc.
 
$
56,388

 
$
41,769

 
$
157,092

 
$
120,314

(The accompanying notes are an integral part of these Consolidated Financial Statements.)



5


 
 
 
 
 
 
 
 
 
 
Consolidated Statements of Changes in Equity
(dollars in thousands)
(unaudited)
 
 
Federated Investors, Inc. Shareholders' Equity
 
 
 
 
 
 
 
 
Common
Stock
 
Additional
Paid-in
Capital from
Treasury
Stock
Transactions
 
Retained
Earnings
 
Treasury
Stock
 
Accumulated
Other
Comprehensive
Loss, Net of
Tax
 
Total
Shareholders’
Equity
 
Nonredeemable
Noncontrolling
Interest in
Subsidiary
 
Total
Permanent
Equity
 
Redeemable
Noncontrolling
Interest in
Subsidiaries/
Temporary
Equity
Balance at December 31, 2014
 
$
271,020

 
$
0

 
$
505,394

 
$
(165,258
)
 
$
(1,662
)
 
$
609,494

 
$
158

 
$
609,652

 
$
3,697

Net income (loss)
 
0

 
0

 
122,197

 
0

 
0

 
122,197

 
1,908

 
124,105

 
(1,288
)
Other comprehensive loss, net of tax
 
0

 
0

 
0

 
0

 
(1,883
)
 
(1,883
)
 
0

 
(1,883
)
 
0

Subscriptions—redeemable noncontrolling interest holders
 
0

 
0

 
0

 
0

 
0

 
0

 
0

 
0

 
16,209

Consolidation/(deconsolidation)
 
0

 
0

 
0

 
0

 
0

 
0

 
0

 
0

 
(7,105
)
Stock award activity
 
21,137

 
5

 
(12,396
)
 
12,490

 
0

 
21,236

 
0

 
21,236

 
0

Dividends declared
 
0

 
0

 
(78,588
)
 
0

 
0

 
(78,588
)
 
0

 
(78,588
)
 
0

Distributions to noncontrolling interest in subsidiaries
 
0

 
0

 
0

 
0

 
0

 
0

 
(133
)
 
(133
)
 
(2,902
)
Purchase of treasury stock
 
0

 
0

 
0

 
(36,845
)
 
0

 
(36,845
)
 
0

 
(36,845
)
 
0

Balance at September 30, 2015
 
$
292,157

 
$
5

 
$
536,607

 
$
(189,613
)
 
$
(3,545
)
 
$
635,611

 
$
1,933

 
$
637,544

 
$
8,611

Balance at December 31, 2015

$
298,579


$
0


$
545,785


$
(191,939
)

$
(4,609
)

$
647,816


$
1,156


$
648,972


$
8,734

Adoption of new accounting pronouncements

123


0


(911
)

0


831


43


0


43


14,850

Net income

0


0


153,077


0


0


153,077


7,953


161,030


3,255

Other comprehensive income, net of tax
 
0

 
0

 
0

 
0

 
3,184

 
3,184

 
0

 
3,184

 
(13
)
Subscriptions—redeemable noncontrolling interest holders
 
0

 
0

 
0

 
0

 
0

 
0

 
0

 
0

 
14,040

Consolidation/(deconsolidation)
 
0

 
0

 
0

 
0

 
0

 
0

 
0

 
0

 
(4,579
)
Stock award activity
 
17,049

 
45

 
(13,160
)
 
13,337

 
0

 
17,271

 
0

 
17,271

 
0

Dividends declared
 
0

 
0

 
(77,630
)
 
0

 
0

 
(77,630
)
 
0

 
(77,630
)
 
0

Distributions to noncontrolling interest in subsidiaries
 
0

 
0

 
0

 
0

 
0

 
0

 
(7,876
)
 
(7,876
)
 
(6,342
)
Purchase of treasury stock
 
0

 
0

 
0

 
(64,101
)
 
0

 
(64,101
)
 
0

 
(64,101
)
 
0

Balance at September 30, 2016
 
$
315,751

 
$
45

 
$
607,161

 
$
(242,703
)
 
$
(594
)
 
$
679,660

 
$
1,233

 
$
680,893

 
$
29,945

(The accompanying notes are an integral part of these Consolidated Financial Statements.)




6


 
 
 
 
 
 
 
 
 
 
Consolidated Statements of Cash Flows
(dollars in thousands)
(unaudited)
 
 
Nine Months Ended
 
 
September 30,
 
 
2016

 
2015

Operating Activities
 
 
 
 
Net income including the noncontrolling interests in subsidiaries
 
$
164,285

 
$
122,817

Adjustments to Reconcile Net Income to Net Cash Provided by Operating Activities
 
 
 
 
Amortization of deferred sales commissions
 
8,979

 
11,774

Depreciation and other amortization
 
7,098

 
7,184

Share-based compensation expense
 
17,212

 
17,355

Loss on disposal of assets
 
1,417

 
2,196

Provision for deferred income taxes
 
13,686

 
13,035

Fair-value adjustments for contingent liabilities
 
0

 
377

Impairment of assets
 
1,637

 
1,342

Consolidation/deconsolidation of investment companies
 
(176
)
 
(227
)
Adoption of new accounting pronouncement
 
(2,653
)
 
0

Net purchases of trading securities
 
(8,753
)
 
(11,547
)
Deferred sales commissions paid
 
(10,137
)
 
(11,091
)
Contingent deferred sales charges received
 
1,636

 
1,826

Other changes in assets and liabilities:
 
 
 
 
Increase in receivables, net
 
(5,356
)
 
(764
)
(Increase) decrease in prepaid expenses and other assets
 
(4,776
)
 
6,120

Decrease in accounts payable and accrued expenses
 
(5,794
)
 
(13,354
)
(Decrease) increase in other liabilities
 
(2,787
)
 
5,180

Net cash provided by operating activities
 
175,518

 
152,223

Investing Activities
 
 
 
 
Purchases of securities available for sale
 
(2,273
)
 
(2,692
)
Proceeds from redemptions of securities available for sale
 
7,980

 
1

Cash paid for property and equipment
 
(10,391
)
 
(4,618
)
Net cash used by investing activities
 
(4,684
)
 
(7,309
)
Financing Activities
 
 
 
 
Dividends paid
 
(77,767
)
 
(78,607
)
Purchases of treasury stock
 
(61,440
)
 
(37,106
)
Distributions to noncontrolling interest in subsidiaries
 
(14,218
)
 
(3,035
)
Contributions from noncontrolling interest in subsidiaries
 
14,040

 
16,209

Proceeds from shareholders for share-based compensation
 
222

 
99

Excess tax benefits from share-based compensation
 
0

 
2,541

Cash paid for business acquisitions
 
(70
)
 
0

Payments on debt
 
(19,125
)
 
(19,125
)
Net cash used by financing activities
 
(158,358
)
 
(119,024
)
Net increase in cash and cash equivalents
 
12,476

 
25,890

Cash and cash equivalents, beginning of period
 
172,628

 
115,267

Cash and cash equivalents, end of period
 
$
185,104

 
$
141,157

(The accompanying notes are an integral part of these Consolidated Financial Statements.)

7

 
Notes to the Consolidated Financial Statements
(unaudited)



(1) Basis of Presentation

The interim Consolidated Financial Statements of Federated Investors, Inc. and its consolidated subsidiaries (collectively, Federated) included herein have been prepared in accordance with U.S. generally accepted accounting principles (GAAP). In the opinion of management, the financial statements reflect all adjustments that are of a normal recurring nature and necessary for a fair presentation of the results for the interim periods presented.

In preparing the financial statements, management is required to make estimates and assumptions that affect the amounts reported in the Consolidated Financial Statements and accompanying notes. Actual results may differ from those estimates, and such differences may be material to the Consolidated Financial Statements.

These financial statements should be read in conjunction with Federated's Annual Report on Form 10-K for the year ended December 31, 2015. Certain items previously reported have been reclassified to conform with the current period's presentation.

(2) Recent Accounting Pronouncements

(a) Recently Adopted Accounting Guidance
Consolidation
On February 18, 2015, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2015-02, Consolidation (Topic 810): Amendments to the Consolidation Analysis, which affects reporting organizations' evaluation of whether they should consolidate certain legal entities. This includes a scope exception for reporting entities with an interest in legal entities that are required to comply with or operate in accordance with the requirements similar to those in Rule 2a-7 of the Investment Company Act of 1940 for registered money market funds.

Effective January 1, 2016, Federated adopted ASU 2015-02 using the modified retrospective transition method, which did not require the restatement of prior years. In connection with the adoption of ASU 2015-02, Federated reevaluated all of its sponsored investment companies and other funds (Federated Funds). As a result, certain Federated Funds previously accounted for as variable interest entities (VIEs) now meet the characteristics of voting rights entities (VREs).

The adoption of ASU 2015-02 resulted in the consolidation of one Federated Fund that was not previously consolidated. Upon adoption, this entity was deemed to be a VIE and Federated was deemed to be the primary beneficiary. As a result of this consolidation, Federated recorded $29.4 million in assets, of which $11.5 million was included in Investments—affiliates at December 31, 2015, $0.2 million in liabilities and $17.7 million in Redeemable noncontrolling interest in subsidiaries. Federated also reclassified $0.8 million of unrealized losses from Accumulated other comprehensive loss, net of tax to Retained earnings. The adoption of ASU 2015-02 also resulted in the deconsolidation of one Federated Fund that was previously consolidated. Upon adoption, Federated was no longer deemed to be the primary beneficiary of this VIE. As a result, Federated deconsolidated $5.5 million in assets, $2.7 million in liabilities and $2.8 million in Redeemable noncontrolling interest in subsidiaries. There was no impact to the Consolidated Statements of Income upon adoption of ASU 2015-02. See Note (3) for the updated Principles of Consolidation accounting policy.

Accounting for Fees Paid in a Cloud Computing Arrangement
On January 1, 2016, Federated adopted ASU 2015-05, Intangibles - Goodwill and Other - Internal-Use Software (Subtopic 350-40): Customer's Accounting for Fees Paid in a Cloud Computing Arrangement. This update provides guidance about whether a cloud computing arrangement includes a software license. Management elected the prospective transition method and the adoption did not have a material impact on Federated's Consolidated Financial Statements.

Disclosure of Investments in Certain Entities that Calculate Net Asset Value per Share
On January 1, 2016, Federated adopted ASU 2015-07, Fair Value Measurement (Topic 820): Disclosures for Investments in Certain Entities That Calculate Net Asset Value (NAV) per Share (or Its Equivalent). This update modifies certain disclosure requirements and requires that all investments for which fair value is measured using the NAV practical expedient be excluded from the fair value hierarchy. The ASU required the retrospective adoption approach, which required the restatement of the prior period fair value hierarchy table. As a result, $31.8 million of investments were recategorized into the NAV practical expedient column and are no longer included in Level 2 as of December 31, 2015 (see Note (7)). The adoption did not have a material impact on Federated's Consolidated Financial Statements.

8

 
Notes to the Consolidated Financial Statements (continued)
(unaudited)
 
 

Share-Based Compensation
During the second quarter 2016, Federated adopted ASU 2016-09, Compensation - Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting, effective January 1, 2016. The areas for simplification in this update involve several aspects of the accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows.

The adoption of ASU 2016-09 requires that all excess tax benefits and deficiencies (including tax benefits from dividends paid on unvested restricted stock awards) now be recognized in the Income tax provision in the Consolidated Statements of Income. Accordingly, upon adoption, Federated reduced its income tax provision by $0.2 million and $0.4 million for the three and six months ended June 30, 2016, respectively. The ASU also requires excess tax benefits to be classified as operating activities along with other income tax cash flows within the Consolidated Statements of Cash Flows. These amendments were adopted on a prospective basis, which did not require the restatement of prior years.

ASU 2016-09 also allows entities to make an accounting policy election to either estimate the number of forfeitures expected to occur (as was previously required) or to account for actual forfeitures as they occur. Federated has elected to account for forfeitures as they occur. The ASU required the modified retrospective transition method through a cumulative-effect adjustment to retained earnings. Effective January 1, 2016, Federated recorded an adjustment of $0.1 million as a decrease to Retained earnings and an increase to Common stock to reflect this change in accounting policy.

(b) Recently Issued Accounting Guidance Not Yet Adopted

Revenue Recognition
On May 28, 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers (Topic 606), which supersedes virtually all existing revenue recognition guidance under GAAP. The update's core principle is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. On July 9, 2015, the FASB approved a one-year deferral of the effective date of the update, and issued ASU 2015-14, Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date, on August 12, 2015. As a result of the deferral, the update is effective for Federated on January 1, 2018, with early adoption permitted on January 1, 2017. During 2016, the FASB issued ASU 2016-08, which clarifies principal versus agent considerations, ASU 2016-10, which clarifies identifying performance obligations and the licensing implementation guidance and ASU 2016-12, which addresses implementation issues and provides additional practical expedients. ASU 2014-09 allows for the use of either the retrospective or modified retrospective adoption method. Management is currently evaluating the available transition methods and the potential impact of adoption on Federated's Consolidated Financial Statements.

Deferred Taxes
On November 20, 2015, the FASB issued ASU 2015-17, Income Taxes (Topic 740): Balance Sheet Classification of Deferred Taxes. The amendments in this update require that deferred tax liabilities and assets be classified as noncurrent on the balance sheet. The update is effective for Federated on January 1, 2017, with early adoption permitted. The update allows for the use of either a prospective or retrospective adoption approach. Management has elected the prospective transition method and does not expect this update to have a material impact on Federated's Consolidated Financial Statements.

Financial Instruments
On January 5, 2016, the FASB issued ASU 2016-01, Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities. The ASU significantly revises an entity's accounting related to (1) the classification and measurement of investments in equity securities and (2) the presentation of certain fair value changes for financial liabilities measured at fair value. The ASU also amends certain disclosure requirements associated with the fair value of financial instruments. The update is effective for Federated on January 1, 2018, and, except for certain provisions, does not permit early adoption. An entity should apply the amendments, with certain exceptions, by means of a cumulative-effect adjustment to the balance sheet as of the beginning of the fiscal year of adoption. Management is currently evaluating the potential impact of adoption on Federated's Consolidated Financial Statements.

Leases
On February 25, 2016, the FASB issued ASU 2016-02, Leases (Topic 842). The core principle of Topic 842 is that a lessee should recognize the assets and liabilities that arise from leases on the balance sheet, but retains a distinction between finance and operating leases. The update is effective for Federated on January 1, 2019, with early adoption permitted. The update

9

 
Notes to the Consolidated Financial Statements (continued)
(unaudited)
 
 

requires the modified retrospective adoption approach. Management is currently evaluating the potential impact of adoption on Federated's Consolidated Financial Statements.

(3) Significant Accounting Policies

As a result of the adoption of ASU 2015-02, the following Principles of Consolidation accounting policy has been updated to reflect the new guidance. For a complete listing of Federated’s significant accounting policies, please refer to Federated’s Annual Report on Form 10-K for the year ended December 31, 2015.

Principles of Consolidation
Federated performs an analysis for each Federated Fund or other entity in which Federated holds a financial interest to determine if it is a VIE or VRE. Factors considered in this analysis include, but are not limited to, whether (1) it is a legal entity, (2) a scope exception applies, (3) a variable interest exists and (4) shareholders have the power to direct the activities that most significantly impact the economic performance, as well as the equity ownership, and any related party or de facto agent implications of Federated's involvement with the entity. Entities that are determined to be VIEs are consolidated if Federated is deemed to be the primary beneficiary. Entities that are determined to be VREs are generally consolidated if Federated holds the majority voting interest. Federated's conclusion to consolidate a Federated Fund may vary from period to period, most commonly as a result of changes in its percentage interest in the entity.

To the extent Federated's interest in a consolidated entity represents less than 100% of the entity's equity, Federated recognizes noncontrolling interests in subsidiaries. In the case of consolidated Federated Funds, the noncontrolling interests represent equity which is redeemable or convertible for cash at the option of the equity holder. As such, these noncontrolling interests are deemed to represent temporary equity and are classified as Redeemable noncontrolling interest in subsidiaries in the mezzanine section of the Consolidated Balance Sheets. All other noncontrolling interests in subsidiaries are classified as permanent equity in the Consolidated Balance Sheets. All intercompany accounts and transactions have been eliminated.
Consolidation of Variable Interest Entities
Prior to the adoption of ASU 2015-02, Federated considered either a qualitative or quantitative model for identifying whether its interest in a VIE was a controlling financial interest. Considerations of the qualitative model included whether Federated had (1) the ability to direct significant activities of the VIE and (2) the obligation to absorb losses or the right to receive benefits from the VIE that could potentially be significant to the VIE. For the quantitative model, Federated evaluated the extent of its participation in the economic risks and rewards of the entity. In cases where the results indicated that Federated's interest in such an entity absorbed the majority of the variability in the entity's net assets, Federated was deemed to be the primary beneficiary and thus consolidated the entity.

Following the adoption of ASU 2015-02, Federated has a controlling financial interest in a VIE and is, therefore, deemed to be the primary beneficiary of a VIE if it has (1) the power to direct the activities of a VIE that most significantly impact the VIE's economic performance and (2) the obligation to absorb losses or the right to receive benefits from the VIE that could potentially be significant to the VIE.
Consolidation of Voting Rights Entities
Federated has a controlling financial interest in a VRE if it can exert control over the financial and operating policies of the VRE, which generally occurs when Federated holds the majority voting interest (i.e. greater than 50% of the voting equity interest).


10

 
Notes to the Consolidated Financial Statements (continued)
(unaudited)
 
 

(4) Concentration Risk

(a) Revenue Concentration by Asset Class

The following table summarizes the percentage of total revenue earned from Federated's asset classes for the periods presented:
 
 
Nine Months Ended
 
 
September 30,
 
 
2016

 
2015

Money market assets
 
46
%
 
32
%
Equity assets
 
38
%
 
47
%
Fixed-income assets
 
16
%
 
21
%

The change in the relative proportion of Federated's revenue attributable to money market assets for the first nine months of 2016 as compared to the same period in 2015 was primarily the result of the decrease in voluntary waivers (either through fee waivers or reimbursements or assumptions of expenses) in order for certain money market funds to maintain positive or zero net yields (Voluntary Yield-related Fee Waivers).

Current Regulatory Environment
Federated and its investment management business are subject to extensive regulation in the United States (U.S.) and abroad. Federated and its products, such as the Federated Funds, and strategies are subject to federal securities laws, principally the Securities Act of 1933 (1933 Act), the Securities Exchange Act of 1934 (1934 Act), the Investment Company Act of 1940 (1940 Act), the Investment Advisers Act of 1940 (Advisers Act), state laws regarding securities fraud, and regulations or other rules, promulgated by various regulatory authorities, self-regulatory organizations or exchanges, as well as foreign laws, regulations or other rules promulgated by foreign regulatory or other authorities. In 2014, among other developments, the Securities and Exchange Commission (SEC) promulgated new money market reform rules (2014 Money Fund Rules), which had a final compliance date of October 14, 2016. In 2015, among other developments, the SEC staff published the 2014 Money Market Fund Reform Frequently Asked Questions and Valuation Guidance Frequently Asked Questions (the Money Fund Rules Guidance). On December 11, 2015, the SEC proposed new rules that, if adopted as proposed, would enhance the regulation of the use of derivatives by investment companies. On April 6, 2016, the Department of Labor (DOL) released its final rule regarding the definition of "fiduciary" and conflicts of interest in connection with retirement investment advice (Final Fiduciary Rule). On June 28, 2016, the SEC also proposed a rule that would require registered investment advisers to adopt and implement written business continuity and transition plans. On October 13, 2016, the SEC adopted new rules relating to the modernization of investment company reporting and disclosure, the enhancement of liquidity risk management by open-end investment companies and the permitted use of "swing pricing" by open-end investment companies. Federated is analyzing the potential impact of these new rules. Federated will also continue to monitor developments and evaluate the impact of the 2014 Money Fund Rules and Money Fund Rules Guidance, the Final Fiduciary Rule and other regulatory initiatives on its products and strategies, product structuring and development initiatives and business. Internationally, among other developments, European money market fund reforms, similar in some respects to the U.S. reforms, continue to be considered but have not yet been finalized. Federated continues to dedicate internal and external resources to analyzing regulatory initiatives and planning and implementing product development and restructuring initiatives in response to various regulatory initiatives. See Management's Discussion and Analysis for additional information.

Low Short-Term Interest Rates
In December 2015, the Federal Open Market Committee of the Federal Reserve Board (FOMC) increased the federal funds target rate range by 25 basis points to 0.25%-0.50%, slightly raising short-term interest rates late in 2015 and into 2016. At each of its 2016 meetings to date, the FOMC has deferred making additional increases in this target rate. The federal funds target rate, which drives short-term interest rates, had been close to zero for nearly seven years. As a result of the long-term near-zero interest-rate environment, the gross yield earned by certain money market funds is not sufficient to cover all of the fund's operating expenses. Since the fourth quarter of 2008, Federated has experienced Voluntary Yield-related Fee Waivers. These fee waivers have been partially offset by related reductions in distribution expense and net income attributable to noncontrolling interests as a result of Federated's mutual understanding and agreement with third-party intermediaries to share the impact of the Voluntary Yield-related Fee Waivers.


11

 
Notes to the Consolidated Financial Statements (continued)
(unaudited)
 
 

These Voluntary Yield-related Fee Waivers are calculated as a percentage of assets under management (AUM or managed assets) in certain money market funds and thus will vary depending upon the asset levels in such funds. In addition, the level of waivers are dependent on several other factors including, but not limited to, yields on instruments available for purchase by the money market funds, changes in expenses of the money market funds and changes in the mix of money market assets. In any given period, a combination of these factors impacts the amount of Voluntary Yield-related Fee Waivers. As an isolated variable, an increase in yields on instruments held by the money market funds will cause the pre-tax impact of fee waivers to decrease. Conversely, as an isolated variable, an increase in expenses of the money market funds would cause the pre-tax impact of fee waivers to increase.

With regard to asset mix, changes in the relative amount of money market fund assets in prime and government money market funds (or between such funds and other money market funds or other products) as well as the mix among certain share classes that vary in pricing structure will impact the level of fee waivers. Generally, prime money market funds waive less than government money market funds as a result of higher gross yields on the underlying investments. As such, as an isolated variable, an increase in the relative proportion of average managed assets invested in prime money market funds as compared to total average money market fund assets should typically result in lower Voluntary Yield-related Fee Waivers. The opposite would also be true.

The impact of Voluntary Yield-related Fee Waivers on various components of Federated's Consolidated Statements of Income was as follows for the periods presented:
 
 
Three Months Ended
 
Nine Months Ended
 
 
September 30,
 
September 30,
(in millions)
 
2016

 
2015

 
2016

 
2015

Revenue
 
$
(18.0
)
 
$
(83.3
)
 
$
(76.8
)
 
$
(261.6
)
Less: Reduction in Distribution expense
 
13.8

 
61.3

 
58.2

 
186.1

Operating income
 
(4.2
)
 
(22.0
)
 
(18.6
)
 
(75.5
)
Less: Reduction in Noncontrolling interests
 
0.0

 
1.7

 
0.0

 
6.0

Pre-tax impact
 
$
(4.2
)
 
$
(20.3
)
 
$
(18.6
)
 
$
(69.5
)

The negative pre-tax impact of Voluntary Yield-related Fee Waivers decreased for the nine-month period ended September 30, 2016 as compared to the same period in 2015 due primarily to higher yields on instruments held by the money market funds.

Although the FOMC implied in its economic projections from its December 2015 meeting that it would continue to raise the federal funds target rate in a measured and gradual way, the FOMC has continued to defer making additional increases at each of the 2016 meetings. Federated is unable to predict when, or to what extent, the FOMC will further increase its target for the federal funds rate. As such, Voluntary Yield-related Fee Waivers and the related reduction in distribution expense and net income attributable to noncontrolling interests could continue for the foreseeable future. See Management's Discussion and Analysis under the caption Business Developments - Low Short-Term Interest Rates for additional information on management's expectations regarding fee waivers.

(b) Revenue Concentration by Customer

Approximately 15% of Federated's total revenue for both the three- and nine-month periods ended September 30, 2016 was derived from services provided to one intermediary customer, the Bank of New York Mellon Corporation, including its Pershing subsidiary. Significant changes in Federated's relationship with this customer could have a material adverse effect on Federated's future revenues and, to a lesser extent, net income due to related material distribution expenses associated with this intermediary.

(c) Revenue Concentration by Investment Fund

Approximately 11% and 9% of Federated's total revenue for the three- and nine-month periods ended September 30, 2016, respectively, was derived from services provided to one Federated Fund, the Federated Strategic Value Dividend Fund. A significant and prolonged decline in the AUM in this fund could have a material adverse effect on Federated's future revenues and to a lesser extent, net income due to a related reduction to distribution expenses associated with this fund.


12

 
Notes to the Consolidated Financial Statements (continued)
(unaudited)
 
 

A listing of Federated’s risk factors is included in Federated’s Annual Report on Form 10-K for the year ended December 31, 2015 under Item 1A - Risk Factors.

(5) Consolidation

The Consolidated Financial Statements include the accounts of Federated, Federated Funds and other entities in which Federated holds a controlling financial interest. Federated is involved with various entities in the normal course of business that may be deemed to be VREs or VIEs. From time to time, Federated invests in Federated Funds for general corporate investment purposes or, in the case of newly launched products, in order to provide investable cash to establish a performance history. Federated's investment in these Federated Funds represents its maximum exposure to loss. The assets of the consolidated Federated Funds are restricted for use by the respective Federated Fund. Generally, neither creditors of, nor equity investors in, the Federated Funds have any recourse to Federated’s general credit. Given that the entities follow investment company accounting, which prescribes fair-value accounting, a deconsolidation generally does not result in gains or losses for Federated. Receivables from all Federated Funds for advisory and other services totaled $22.7 million and $16.9 million at September 30, 2016 and December 31, 2015, respectively.

In the ordinary course of business, Federated may choose to waive certain fees or assume operating expenses of various Federated Funds for competitive, regulatory or contractual reasons. For the three and nine months ended September 30, 2016, Federated waived fees, including Voluntary Yield-related Fee Waivers, totaling $101.2 million and $322.0 million, respectively, of which $75.4 million and $240.3 million, respectively, related to waivers for money market funds which meet the scope exception of ASU 2015-02. Like other sponsors of investment companies, Federated in the ordinary course of business may make capital contributions to certain Federated money market funds in connection with the reorganization of such funds into certain affiliated Federated money market funds or in connection with the liquidation of a fund. In these instances, such capital contributions typically are intended to either cover realized losses or other permanent impairments to a fund's NAV or increase the market-based NAV per share of the investment company's portfolio that is being reorganized to equal the market-based NAV per share of the acquiring fund. There were no contributions for the three months ended September 30, 2016 and no material contributions for the nine months ended September 30, 2016. Under new money fund regulations, and SEC staff guidance issued in 2015, Federated is now required to report these types of capital contributions to the SEC as financial support to the investment company that is being reorganized or liquidated.

In accordance with Federated’s consolidation accounting policy, Federated first determines whether the entity being evaluated is a VRE or a VIE. Once this determination is made, Federated proceeds with its evaluation of whether to consolidate the entity. The disclosures below represent the results of such evaluations pertaining to September 30, 2016 and December 31, 2015.

(a) Consolidated Voting Rights Entities

Effective January 1, 2016, most of the Federated Funds now meet the definition of a VRE. Federated consolidates certain VREs when it is deemed to have control. As of September 30, 2016, consolidated VREs included on Federated's Consolidated Balance Sheets included $14.2 million in Investments—consolidated investment companies and $2.5 million in Redeemable noncontrolling interest in subsidiaries.

(b) Consolidated Variable Interest Entities

As of September 30, 2016 and December 31, 2015, Federated was deemed to be the primary beneficiary of, and therefore consolidated, several Federated Funds as a result of its controlling financial interest. Certain of the VIEs consolidated as of December 31, 2015 were deemed to be VREs upon adoption of ASU 2015-02 and have been excluded from the September 30, 2016 balances in the table below. See the Consolidated Voting Rights Entities section above for information on consolidated VREs as of September 30, 2016.


13

 
Notes to the Consolidated Financial Statements (continued)
(unaudited)
 
 

The following table presents the balances related to the consolidated Federated Fund VIEs that were included on the Consolidated Balance Sheets as well as Federated's net interest in the consolidated Federated Fund VIEs for each period presented:
(in millions)
 
September 30, 2016
 
December 31, 2015
Cash and cash equivalents
 
$
0.0

 
$
3.1

Investments—consolidated investment companies
 
44.8

 
25.4

Receivables
 
0.8

 
0.2

Less: Liabilities
 
1.2

 
3.0

Less: Redeemable noncontrolling interest in subsidiaries
 
27.4

 
8.7

Federated's net interest in the consolidated Federated Fund VIEs
 
$
17.0

 
$
17.0


Federated's net interest in the consolidated Federated Fund VIEs of $17.0 million at both September 30, 2016 and December 31, 2015, represents the value of Federated's economic ownership interest in these Federated Funds. The liabilities of the consolidated Federated Fund VIEs primarily represent investments sold short and operating liabilities of the entities. The liabilities as of September 30, 2016 and December 31, 2015 are primarily classified as Other current liabilities and Accounts payable and accrued expenses, respectively, on Federated’s Consolidated Balance Sheets.

In addition to the table above, Federated has a majority interest (50.5%) and acts as the general partner in Passport Research Ltd. (Passport), a limited partnership. Edward D. Jones & Co., L.P. is the limited partner with a 49.5% interest. The partnership is an investment adviser to one sponsored fund as of September 30, 2016 and was deemed to be a VIE upon adoption of ASU 2015-02. Assets totaling $6.9 million primarily representing Cash and cash equivalents, liabilities totaling $4.4 million primarily representing operating liabilities and $1.2 million included in Nonredeemable noncontrolling interest in subsidiary are included on the Consolidated Balance Sheets as of September 30, 2016. There was no change to the Consolidated Financial Statements as a result of the adoption of ASU 2015-02 as Passport had been consolidated as a VRE under the previous guidance. See Part II, Item 5 of Federated's Quarterly Report on Form 10-Q for the quarter ended March 31, 2016 for additional information related to this partnership.

Other than those consolidated or deconsolidated upon the adoption of ASU 2015-02 (see Note (2)), Federated did not newly consolidate any VIEs or deconsolidate any material VIEs during the nine months ended September 30, 2016.

(c) Non-Consolidated Variable Interest Entities

Federated's involvement with certain Federated Funds that are deemed to be VIEs includes serving as the investment manager, or at times, holding a minority interest or both. Federated’s variable interest is not deemed to absorb losses or receive benefits that could potentially be significant to the VIE. Therefore, Federated is not the primary beneficiary of these VIEs and has not consolidated these entities.

At September 30, 2016, Federated’s investment and maximum risk of loss related to non-consolidated VIEs was entirely related to two Federated Funds and totaled $1.5 million, which was recorded in Investments—affiliates on the Consolidated Balance Sheets. AUM for these non-consolidated Federated Funds totaled $22.6 million at September 30, 2016.

At December 31, 2015, Federated’s investment and maximum risk of loss related to non-consolidated VIEs were entirely related to Federated Funds and totaled $301.5 million. Of this amount, $159.7 million represented investments in money market funds included in Cash and cash equivalents. The remaining $141.8 million is primarily recorded in Investments—affiliates on the Consolidated Balance Sheets as of December 31, 2015. AUM for these non-consolidated Federated Funds totaled $268.0 billion at December 31, 2015.

Upon adoption of ASU 2015-02 effective January 1, 2016, certain of the non-consolidated VIEs included in the balances as of December 31, 2015 were deemed to be VREs or are money market funds which meet the scope exception and have been excluded from the September 30, 2016 balances above. See the Consolidated Voting Rights Entities section above for information on consolidated VREs as of September 30, 2016.


14

 
Notes to the Consolidated Financial Statements (continued)
(unaudited)
 
 

(6) Investments

Investments on the Consolidated Balance Sheets as of September 30, 2016 and December 31, 2015 included available-for-sale and trading securities. At September 30, 2016 and December 31, 2015, Federated held investments totaling $129.2 million and $141.7 million, respectively, in fluctuating-value Federated Funds that were classified as available-for-sale securities and were included in Investments—affiliates on the Consolidated Balance Sheets. The decrease in Investments—affiliates primarily related to a newly consolidated VIE as a result of the adoption of ASU 2015-02 and is now recorded in Investments—consolidated investment companies. See Note (2) for additional information.

Available-for-sale securities were as follows:
 
 
September 30, 2016
 
December 31, 2015
 
 
 
 
Gross Unrealized
 
Estimated
Fair
 
 
 
Gross Unrealized
 
Estimated
Fair
(in thousands)
 
Cost
 
Gains
 
(Losses)
 
Value
 
Cost
 
Gains
 
(Losses)
 
Value
Equity funds
 
$
23,649

 
$
1,623

 
$
(58
)
 
$
25,214

 
$
32,357

 
$
342

 
$
(2,416
)
 
$
30,283

Fixed-income funds
 
104,747

 
156

 
(909
)
 
103,994

 
115,396

 
109

 
(4,040
)
 
111,465

Total fluctuating-value funds
 
$
128,396

 
$
1,779

 
$
(967
)
 
$
129,208

 
$
147,753

 
$
451

 
$
(6,456
)
 
$
141,748


Federated’s trading securities totaled $66.2 million and $32.4 million at September 30, 2016 and December 31, 2015, respectively. The increase in trading securities primarily related to the aforementioned newly consolidated VIE which was previously recorded in Investments—affiliates on the Consolidated Balance Sheets. See Note (2) for additional information. Federated consolidates certain Federated Funds into its Consolidated Financial Statements as a result of Federated’s controlling financial interest in the Federated Fund (see Note (5)). All investments held by these Federated Funds were included in Investments—consolidated investment companies on Federated’s Consolidated Balance Sheets. Investments—other on the Consolidated Balance Sheets represented other trading investments held in Separate Accounts.

Federated’s trading securities as of September 30, 2016 and December 31, 2015, were primarily invested in domestic debt securities ($47.1 million and $9.0 million, respectively), investments in Federated Funds and other funds ($9.0 million and $11.0 million, respectively) and stocks of large U.S. and international companies ($6.2 million and $10.5 million, respectively).


15

 
Notes to the Consolidated Financial Statements (continued)
(unaudited)
 
 

The following table presents gains and losses recognized in Gain (loss) on securities, net on the Consolidated Statements of Income in connection with Federated's investments as well as economic derivatives held by certain consolidated Federated Funds:
 
 
Three Months Ended
 
Nine Months Ended
 
 
September 30,
 
September 30,
(in thousands)
 
2016

 
2015

 
2016

 
2015

Unrealized gain (loss)
 
 
 
 
 
 
 
 
Trading securities
 
$
1,684

 
$
(903
)
 
$
5,410

 
$
(1,485
)
Derivatives1
 
315

 
148

 
11

 
122

Realized gains2
 
 
 
 
 
 
 
 
Available-for-sale securities3
 
266

 
0

 
291

 
0

Trading securities
 
472

 
224

 
1,058

 
739

Derivatives1
 
28

 
17

 
583

 
313

Realized losses2
 
 
 
 
 
 
 
 
Available-for-sale securities3
 
0

 
(1,342
)
 
(1,645
)
 
(1,342
)
Trading securities
 
(273
)
 
(1,547
)
 
(2,048
)
 
(2,371
)
Derivatives1
 
(460
)
 
(889
)
 
(1,107
)
 
(1,502
)
Gain (loss) on securities, net4
 
$
2,032

 
$
(4,292
)
 
$
2,553

 
$
(5,526
)
Amounts related to the settlement of economic derivatives held by certain consolidated Federated Funds.
Realized gains and losses are computed on a specific-identification basis.
3
Proceeds from redemptions of available-for-sale securities were $7.8 million and $8.0 million for the three and nine months ended September 30, 2016.
4
Amounts related to consolidated entities, primarily Federated Funds, totaled $1.6 million and $3.5 million for the three and nine months ended September 30, 2016, respectively, and $(2.6) million and $(3.7) million for the three and nine months ended September 30, 2015, respectively.

(7) Fair Value Measurements

Fair value is the price that would be received to sell an asset or the price paid to transfer a liability as of the measurement date. A fair-value reporting hierarchy exists for disclosure of fair value measurements based on the observability of the inputs to the valuation of financial assets and liabilities. The levels are:
 
Level 1 – Quoted prices for identical instruments in active markets. Level 1 assets may include equity and debt securities that are traded in an active exchange market, including shares of mutual funds.
 
Level 2 – Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations in which all significant inputs and significant value drivers are observable in active markets. Level 2 assets and liabilities may include debt and equity securities, purchased loans and over-the-counter derivative contracts whose fair value is determined using a pricing model without significant unobservable market data inputs.
 
Level 3 – Valuations derived from valuation techniques in which one or more significant inputs or significant value drivers are unobservable in active markets.
 
NAV practical expedient – Investments that calculate NAV per share (or its equivalent) as a practical expedient. These investments have been excluded from the fair value hierarchy.


16

 
Notes to the Consolidated Financial Statements (continued)
(unaudited)
 
 

(a) Fair Value Measurements on a Recurring Basis

The following table presents fair value measurements for classes of Federated’s financial assets and liabilities measured at fair value on a recurring basis:
(in thousands)
 
Level 1
 
Level 2
 
Level 3
 
NAV Practical Expedient3
 
Total
September 30, 2016
 
 
 
 
 
 
 
 
 
 
Financial Assets
 
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
 
$
125,093

 
$
0

 
$
0

 
$
60,011

 
$
185,104

Available-for-sale equity securities
 
102,964

 
0

 
0

 
26,244

 
129,208

Trading securities—equity
 
13,490

 
0

 
0

 
5,643

 
19,133

Trading securities—debt
 
0

 
47,063

 
0

 
0

 
47,063

Other1
 
0

 
33

 
910

 
0

 
943

Total financial assets
 
$
241,547

 
$
47,096

 
$
910

 
$
91,898

 
$
381,451

 
 
 
 
 
 
 
 
 
 
 
Total financial liabilities2
 
$
30

 
$
0

 
$
2,229

 
$
0

 
$
2,259

 
 
 
 
 
 
 
 
 
 
 
December 31, 20153
 
 
 
 
 
 
 
 
 
 
Financial Assets
 
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
 
$
172,628

 
$
0

 
$
0

 
$
0

 
$
172,628

Available-for-sale equity securities
 
117,422

 
0

 
0

 
24,326

 
141,748

Trading securities—equity
 
15,900

 
65

 
0

 
7,433

 
23,398

Trading securities—debt
 
0

 
9,041

 
0

 
0

 
9,041

Other1
 
4

 
17

 
910

 
0

 
931

Total financial assets
 
$
305,954

 
$
9,123

 
$
910

 
$
31,759

 
$
347,746

 
 
 
 
 
 
 
 
 
 
 
Total financial liabilities2
 
$
2,681

 
$
59

 
$
2,630

 
$
0

 
$
5,370

1
Amounts include structured trade finance loans held by Federated as well as futures contracts and/or foreign currency forward contracts held within certain consolidated Federated Funds.
2
Amounts include acquisition-related future consideration liabilities and may include investments sold short, foreign currency forward contracts and/or futures contracts held within certain consolidated Federated Funds, as well as certain liabilities attributable to structured trade finance loans held by Federated.
3
Investments that calculate NAV as a practical expedient were recategorized and are no longer included within Level 2 of the valuation hierarchy as of December 31, 2015 (see Note (2) for additional information).

The following is a description of the valuation methodologies used for financial assets and liabilities measured at fair value on a recurring basis. Federated did not hold any nonfinancial assets or liabilities measured at fair value on a recurring basis at September 30, 2016 or December 31, 2015.

Cash and cash equivalents
Cash and cash equivalents include investments in money market funds and deposits with banks. Investments in Federated money market funds totaled $178.1 million and $162.2 million at September 30, 2016 and December 31, 2015, respectively. Cash investments in publicly available money market funds are valued under the market approach through the use of quoted market prices in an active market, which is the NAV of the funds, and are classified within Level 1 of the valuation hierarchy. For an investment in a money market fund that is not publicly available but for which the NAV is calculated daily and for which there are no redemption restrictions, the security is valued using NAV as a practical expedient and is excluded from the fair value hierarchy. This investment is included in the NAV practical expedient column in the table above.

Available-for-sale equity securities
Available-for-sale equity securities include investments in fluctuating-value Federated Funds and are included in Investments—affiliates on the Consolidated Balance Sheets. For investments in Federated Funds that are publicly available, the securities are valued under the market approach through the use of quoted market prices available in an active market, which is the NAV of the funds, and are classified within Level 1 of the valuation hierarchy. For certain investments in Federated Funds that are not

17

 
Notes to the Consolidated Financial Statements (continued)
(unaudited)
 
 

publicly available but for which the NAV is calculated daily and for which there are no redemption restrictions, the securities are valued using NAV as a practical expedient and are excluded from the fair value hierarchy. These investments are included in the NAV practical expedient column in the table above.
Trading securities—equity
Trading securities - equity primarily represent the equity securities held by consolidated Federated Funds (included in Investments—consolidated investment companies on the Consolidated Balance Sheets) as well as certain equity investments held in Separate Accounts (included in Investments—other on the Consolidated Balance Sheets). For publicly traded equity securities available in an active market, the fair value of these securities is classified as Level 1 when the fair value is based on unadjusted quoted market prices. The fair value of certain equity securities traded principally in foreign markets and held by consolidated Federated Funds are determined by a third party pricing service (Level 2). For certain investments in Federated Funds that are not publicly available but for which the NAV is calculated daily and for which there are no redemption restrictions, the investments are valued using NAV as a practical expedient and are excluded from the fair value hierarchy. These investments are included in the NAV practical expedient column in the table above.

Trading securities—debt
Trading securities - debt primarily represent domestic bonds held by consolidated Federated Funds. The fair value of these securities may include observable market data such as valuations provided by independent pricing services after considering factors such as the yields or prices of investments of comparable quality, coupon, maturity, call rights and other potential prepayments, terms and type, reported transactions, indications as to values from dealers and general market conditions (Level 2).

(b) Fair Value Measurements on a Nonrecurring Basis

Federated did not hold any assets or liabilities measured at fair value on a nonrecurring basis at September 30, 2016.

(c) Fair Value Measurements of Other Financial Instruments

The fair value of Federated’s debt is estimated by management based upon expected future cash flows utilizing a discounted cash flow methodology under the income approach. The fair value of the liability is estimated using observable market data (Level 2) in estimating inputs including the discount rate. Based on this fair value estimate, the carrying value of debt appearing on the Consolidated Balance Sheets approximates fair value.

(8) Debt

Debt consisted of the following:
 
 
Interest Rates
 
 
 
 
 
 
September 30,
 
December 31,
 
 
 
 
(dollars in thousands)
 
2016
 
2015
 
September 30, 2016

 
December 31, 2015

Term Loan
 
1.655%
 
1.555%
 
$
197,625

 
$
216,750

Less: Short-term debt
 
 
 
 
 
25,500

 
25,500

Long-term debt
 
 
 
 
 
$
172,125

 
$
191,250


On June 24, 2014, Federated entered into an unsecured Second Amended and Restated Credit Agreement by and among Federated, certain of its subsidiaries as guarantors party thereto, a syndicate of 13 banks as Lenders party thereto led by PNC Bank, National Association as administrative agent, PNC Capital Markets LLC as sole bookrunner and joint lead arranger, Citigroup Global Markets, Inc. as joint lead arranger, Citibank, N.A. as syndication agent, and TD Bank, N.A. as documentation agent (Credit Agreement). The Credit Agreement amended and restated Federated's prior unsecured Amended and Restated Credit Agreement, which was dated June 10, 2011 and scheduled to mature on June 10, 2016 (Prior Credit Agreement). The borrowings under the Credit Agreement's term loan facility of $255 million (Term Loan) equaled the remaining principal balance from the Prior Credit Agreement's term loan facility. The Term Loan facility bears interest based on the London Interbank Offering Rate (LIBOR) plus a spread, currently 112.5 basis points. The Credit Agreement qualified for modification accounting treatment.


18

 
Notes to the Consolidated Financial Statements (continued)
(unaudited)
 
 

The Credit Agreement also refinanced the $200 million revolving credit facility under the Prior Credit Agreement. Federated had no borrowings outstanding on the previous revolving credit facility at the time of refinancing. As of September 30, 2016, the entire $200 million revolving credit facility was available for borrowings. Similar to the Prior Credit Agreement, certain subsidiaries entered into an Amended and Restated Continuing Agreement of Guaranty and Suretyship whereby these subsidiaries guarantee payment of all obligations incurred through the Credit Agreement. Federated pays an annual facility fee, currently 12.5 basis points. Borrowings under the Credit Agreement's revolving credit facility bear interest at LIBOR plus a spread, currently 100 basis points.

The Credit Agreement matures on June 24, 2019 and, with respect to the Term Loan, requires quarterly principal payments totaling $25.5 million in each of the years 2016 and 2017, $55.8 million in 2018 and $110.0 million in 2019. During the nine months ended September 30, 2016, Federated repaid $19.1 million of its borrowings on the Term Loan.

The Credit Agreement includes representations and warranties, affirmative and negative financial covenants, including an interest coverage ratio covenant and a leverage ratio covenant, reporting requirements and other non-financial covenants. Federated was in compliance with all covenants at and during the nine months ended September 30, 2016 (see the Liquidity and Capital Resources section of Management's Discussion and Analysis for additional information). The Credit Agreement also has certain stated events of default and cross default provisions which would permit the lenders/counterparties to accelerate the repayment of the debt if not cured within the applicable grace periods. The events of default generally include breaches of contract, failure to make required loan payments, insolvency, cessation of business, deterioration in credit rating to below investment grade, notice of lien or assessment, and other proceedings, whether voluntary or involuntary, that would require the repayment of amounts borrowed.

(9) Share-Based Compensation Plans

(a) Restricted Stock

During the first nine months of 2016, Federated awarded 529,660 shares of restricted Federated Class B common stock, nearly all of which was granted in connection with a bonus program in which certain key employees received a portion of their bonus in the form of restricted stock under Federated’s Stock Incentive Plan. This restricted stock, which was granted on the bonus payment date and issued out of treasury, will generally vest over a three-year period.

Federated awarded 863,137 shares of restricted Federated Class B common stock under its Stock Incentive Plan during 2015. Of this amount, 373,137 shares were awarded in connection with the aforementioned bonus program in 2015. The remaining shares were awarded to certain key employees and generally vest over a ten-year period.

(b) Stock Options

During the nine months ended September 30, 2016, there were no stock options exercised or granted. During the year ended December 31, 2015, there were 3,000 stock options exercised and no stock options granted.

(c) Non-Management Director Stock Award

Federated awarded 5,700 shares of Federated Class B common stock to non-management directors during each of the second quarters of 2016 and 2015. There were no additional awards to non-management directors in 2016 or 2015.

(10) Equity

In February 2015, the board of directors authorized a share repurchase program that allows Federated to buy back up to 4 million shares of Federated Class B common stock with no stated expiration date. No other programs existed as of September 30, 2016. This program authorizes executive management to determine the timing and the amount of shares for each purchase. The repurchased stock is to be held in treasury for employee share-based compensation plans, potential acquisitions and other corporate activities, unless Federated's board of directors subsequently determines to retire the repurchased stock and restore the shares to authorized but unissued status (rather than holding the shares in treasury). During the first nine months of 2016, Federated repurchased 2.3 million shares of Class B common stock for $64.1 million, 2.2 million of which were repurchased in the open market. The remaining repurchased shares represent restricted stock forfeited by employees and are not

19

 
Notes to the Consolidated Financial Statements (continued)
(unaudited)
 
 

counted against the board-approved share repurchase program. At September 30, 2016, 0.6 million shares remained available to be purchased under Federated's buyback program. See Note (14) for information regarding a new share repurchase program approved on October 27, 2016.

(11) Earnings Per Share Attributable to Federated Investors, Inc. Shareholders

The following table sets forth the computation of basic and diluted earnings per share using the two-class method for amounts attributable to Federated:
 
 
Three Months Ended
 
Nine Months Ended
 
 
September 30,
 
September 30,
(in thousands, except per share data)
 
2016

 
2015

 
2016

 
2015

Numerator – Basic and Diluted
 
 
 
 
 
 
 
 
Net income attributable to Federated Investors, Inc.
 
$
54,925

 
$
44,131

 
$
153,077

 
$
122,197

Less: Total income available to participating unvested restricted shareholders1
 
(2,035
)
 
(1,691
)
 
(5,987
)
 
(4,837
)
Total net income attributable to Federated Common Stock2
 
$
52,890

 
$
42,440

 
$
147,090

 
$
117,360

Denominator
 
 
 
 
 
 
 
 
Basic weighted-average common shares outstanding
 
98,805

 
100,449

 
99,397

 
100,606

Dilutive potential shares from stock options
 
1

 
2

 
1

 
1

Diluted weighted-average common shares outstanding
 
98,806

 
100,451

 
99,398

 
100,607

Earnings per share
 
 
 
 
 
 
 
 
Net income attributable to Federated Common Stock – Basic and Diluted2
 
$
0.54

 
$
0.42

 
$
1.48

 
$
1.17

1
Income available to participating unvested restricted shareholders includes dividends paid on unvested restricted shares and their proportionate share of undistributed earnings.
2
Federated Common Stock excludes unvested restricted shares which are deemed participating securities in accordance with the two-class method of computing earnings per share.

(12) Commitments and Contingencies

(a) Contractual

During the third quarter 2016, Federated amended its operating lease for its corporate headquarters building in Pittsburgh, Pennsylvania. The amendment extended the lease through 2030 and contained options to renew for additional periods through 2040. The amendment also included provisions for leasehold improvement incentives, rent escalation and early termination. As of September 30, 2016, payments due for the remainder of 2016 approximate $2 million. Payments approximate $6 million for each of the years 2017 through 2020 and a total of $75 million for 2021 through the current 2030 termination date.
Federated may be required to make certain compensation-related payments through 2019 in connection with various significant employment and incentive arrangements. Based on asset levels as of September 30, 2016 and performance goals, payments could total up to approximately $30 million over the remaining terms of these arrangements.

(b) Guarantees and Indemnifications
On an intercompany basis, various wholly owned subsidiaries of Federated guarantee certain financial obligations of Federated Investors, Inc., and Federated Investors, Inc. guarantees certain financial and performance-related obligations of various wholly owned subsidiaries. In addition, in the normal course of business, Federated has entered into contracts that provide a variety of indemnifications. Typically, obligations to indemnify third parties arise in the context of contracts entered into by Federated, under which Federated agrees to hold the other party harmless against losses arising out of the contract, provided the other party's actions are not deemed to have breached an agreed upon standard of care. In each of these circumstances, payment by Federated is contingent on the other party making a claim for indemnity, subject to Federated's right to challenge the other party's claim. Further, Federated's obligations under these agreements may be limited in terms of time and/or amount. It is not possible to predict the maximum potential amount of future payments under these or similar agreements due to the conditional

20

 
Notes to the Consolidated Financial Statements (continued)
(unaudited)
 
 

nature of Federated's obligations and the unique facts and circumstances involved in each particular agreement. As of September 30, 2016, management does not believe that a material loss related to any of these matters is reasonably possible.

(c) Legal Proceedings
CCM Rochester, Inc. (CCM). In December 2008, Federated completed the acquisition of certain assets of CCM (f/k/a Clover Capital Management, Inc.), an investment manager that specialized in value investing. The purchase was consummated in the midst of the U.S. financial markets crisis. The payment terms under the Asset Purchase Agreement, dated September 12, 2008 (APA), included an upfront payment of $30 million paid by Federated Investors, Inc. at closing and the opportunity for contingent payments over a five year earn-out period following the acquisition date based on the growth in revenue associated with the acquired assets. Under the APA, in order to reach the maximum contingent payments totaling approximately $55 million, the revenue associated with the acquired assets would have had to have grown at a 30% compound annual growth rate. Under the APA, Federated Investors, Inc. paid CCM an additional $18 million, in the aggregate, in contingent payments for the last three years of the earn-out period.
On May 20, 2014, shortly after the final contingent payment was paid to CCM, Federated Investors, Inc. was named as the defendant in a case filed by CCM in the U.S. District Court for the Southern District of New York (CCM Rochester, Inc., f/k/a Clover Capital Management, Inc. v. Federated Investors, Inc., Case No. 14-cv-3600 (S.D.N.Y.)). In this lawsuit, CCM asserted claims against Federated Investors, Inc. for fraudulent inducement, breach of contract (including CCM’s allegations relating to implied duties of best efforts and good faith and fair dealing) and indemnification based on Federated’s alleged failure to effectively market and distribute the investment products associated with the acquired assets and to pay CCM the maximum contingent payments. CCM seeks approximately $37 million in alleged damages plus attorneys’ fees from Federated Investors, Inc.
Federated filed a Motion to Dismiss the lawsuit on the basis that, among other reasons, CCM's claims are implausible, have no factual support, and are contrary to the express terms of the APA and to settled law. On November 25, 2014, the Court issued an order granting Federated's Motion to Dismiss in part and denying Federated's Motion to Dismiss in part. The Court dismissed CCM's claim for breach of contract and for breach of an implied obligation to use best efforts. Under the strict standards applicable to Motions to Dismiss that require the Court to accept the allegations of the Complaint as true and draw all inferences in CCM's favor, the Court concluded that CCM's "claim of fraud is at the edge of plausibility" but specifically noted that "[w]hether CCM can successfully prove facts necessary to support that artfully-pled theory remains to be seen."
Federated continues to believe that CCM's claims are meritless and without factual support and intends to continue to vigorously defend this lawsuit. Fact discovery and expert discovery have concluded. On June 9, 2016, following oral argument, the Court granted Federated's evidentiary motion seeking to exclude CCM's expert testimony, ruling CCM's expert reports and testimony inadmissible. Briefing is now concluded on Federated's motion for summary judgment, which was filed on July 15, 2016, seeking to have the Court rule in Federated’s favor as a matter of law. Federated continues to believe that at all times it acted in good faith and complied with its contractual obligations contained in the APA.
As of September 30, 2016, Federated believes a material loss related to this lawsuit is remote, and as such, does not believe this pending lawsuit is material to Federated or its Consolidated Financial Statements. Based on this assessment of the status and nature of CCM's claims, and the current stage of the lawsuit, no loss is estimable.
Other Litigation. Federated also has claims asserted and threatened against it in the ordinary course of business. As of September 30, 2016, Federated does not believe that a material loss related to these claims is reasonably possible.
See Item 1A - Risk Factors included in Federated's Annual Report on Form 10-K for the year ended December 31, 2015 for additional information regarding risks related to claims asserted or threatened against Federated.


21

 
Notes to the Consolidated Financial Statements (continued)
(unaudited)
 
 

(13) Accumulated Other Comprehensive Loss Attributable to Federated Investors, Inc. Shareholders

The components of Accumulated other comprehensive loss, net of tax attributable to Federated shareholders are as follows: 
(in thousands)
Unrealized Loss
on Interest Rate Swap1

Unrealized
 (Loss)/Income on Securities
Available for
Sale2
 
 
Foreign Currency
Translation Loss

 
Total

Balance at December 31, 2014
$
(269
)
 
$
(1,126
)
 
$
(267
)
 
$
(1,662
)
Other comprehensive income (loss) before reclassifications and tax
67

 
(4,140
)
 
(597
)
 
(4,670
)
Tax impact
(25
)
 
1,529

 
209

 
1,713

Reclassification adjustments, before tax
358

 
1,342

 
0

 
1,700

Tax impact
(131
)
 
(495
)
 
0

 
(626
)
Net current-period other comprehensive income (loss)
269

 
(1,764
)
 
(388
)
 
(1,883
)
Balance at September 30, 2015
$
0

 
$
(2,890
)
 
$
(655
)
 
$
(3,545
)
 
 
 
 
 
 
 
 
Balance at December 31, 2015
$
0

 
$
(3,795
)
 
$
(814
)
 
$
(4,609
)
Other comprehensive income (loss) before reclassifications and tax
0

 
4,185

 
(497
)
 
3,688

Tax impact
0

 
(1,512
)
 
173

 
(1,339
)
Reclassification adjustments, before tax3
0

 
2,632

 
0

 
2,632

Tax impact3
0

 
(966
)
 
0

 
(966
)
Net current-period other comprehensive income (loss)
0

 
4,339

 
(324
)
 
4,015

Balance at September 30, 2016
$
0

 
$
544

 
$
(1,138
)
 
$
(594
)
 1
Federated entered into an interest rate swap in 2010 to hedge its interest-rate risk associated with its original term loan facility. The interest rate swap expired on April 1, 2015. Amounts reclassified from Accumulated other comprehensive loss, net of tax were recorded in Debt expense on the Consolidated Statements of Income.
 2
Other than as described in note 3 below, amounts reclassified from Accumulated other comprehensive loss, net of tax were recorded in Gain (loss) on securities, net on the Consolidated Statements of Income.
3
Amount includes reclassification of $0.8 million, net of tax from Accumulated other comprehensive loss, net of tax to Retained earnings on the Consolidated Balance Sheets as a result of the adoption of ASU 2015-02 (see Note (2) for additional information).

(14) Subsequent Events
 
On October 27, 2016, the board of directors declared a $1.25 per share dividend to shareholders of record as of November 8, 2016 to be paid on November 15, 2016. The dividend, which will be paid from Federated's existing cash balance, is considered to be an ordinary dividend for tax purposes and consists of a $0.25 quarterly dividend and a $1.00 special dividend. See Management's Discussion and Analysis under the caption Business Developments - Subsequent Event - Special Cash Dividend for more information on the estimated diluted earnings per share impact for the quarter ending December 31, 2016.

On October 27, 2016, the board of directors authorized another share repurchase program that allows Federated to buy back up to 4 million additional shares of Federated Class B common stock with no stated expiration date. This program authorizes executive management to determine the timing and the amount of shares for each purchase. The repurchased stock is to be held in treasury for employee share-based compensation plans, potential acquisitions and other corporate activities, unless Federated's board of directors subsequently determines to retire the repurchased stock and restore the shares to authorized but unissued status (rather than holding the shares in treasury). See Note (10) for additional information.

22


Part I, Item 2. Management’s Discussion and Analysis

 
of Financial Condition and Results of Operations (unaudited)
 

The discussion and analysis below should be read in conjunction with the consolidated financial statements appearing elsewhere in this report. Management has presumed that the readers of this interim financial information have read or have access to Management’s Discussion and Analysis of Financial Condition and Results of Operations appearing in Federated’s Annual Report on Form 10-K for the year ended December 31, 2015.

General

Federated is one of the largest investment managers in the U.S. with $364.3 billion in managed assets as of September 30, 2016. The majority of Federated’s revenue is derived from advising Federated Funds and Separate Accounts in both domestic and international markets. Federated also derives revenue from providing administrative and other fund-related services, including distribution and shareholder servicing.

Federated’s investment products and strategies are distributed in four markets. These markets and the relative percentage of managed assets at September 30, 2016 attributable to such markets are as follows: wealth management and trust (41%), broker/dealer (34%), institutional (21%) and international (4%).
Investment advisory fees, administrative service fees and certain fees for other services, such as distribution and shareholder service fees, are contract-based fees that are generally calculated as a percentage of the net assets of managed investment portfolios. Federated’s revenue is primarily dependent upon factors that affect the value of managed assets including market conditions and the ability to attract and retain assets. Nearly all managed assets in Federated’s investment products and strategies can be redeemed or withdrawn at any time with no advance notice requirement. Fee rates for Federated's services generally vary by asset and service type and may vary based on changes in asset levels. Generally, management-fee rates charged for advisory services provided to equity products and strategies are higher than management-fee rates charged on money market and fixed-income products and strategies. Likewise, funds typically have a higher management-fee rate than Separate Accounts. Accordingly, revenue is also dependent upon the relative composition of average AUM across both asset and product types. Federated may waive certain fees for competitive reasons such as to maintain certain fund expense ratios, to maintain positive or zero net yields on certain money market funds, to meet regulatory requirements or to meet contractual requirements. Since Federated’s products are largely distributed and serviced through financial intermediaries, Federated pays a portion of fees earned from sponsored products to the financial intermediaries that sell these products. These payments are generally calculated as a percentage of net assets attributable to the applicable financial intermediary and represent the vast majority of Distribution expense on the Consolidated Statements of Income. Certain components of Distribution expense can vary depending upon the asset type, distribution channel and/or the size of the customer relationship. Federated generally pays out a larger portion of revenue earned from managed assets in money market funds than revenue earned from managed assets in equity or fixed-income funds.
Federated’s most significant operating expenses are Distribution expense, as described above, and Compensation and related expense. Compensation and related expense includes base salary and wages, incentive compensation and other employee expenses including payroll taxes and benefits. Incentive compensation, which includes stock-based compensation, can vary depending on various factors including, but not limited to, the overall results of operations of Federated, investment management performance and sales performance.
The discussion and analysis of Federated’s financial condition and results of operations are based on Federated’s Consolidated Financial Statements. Federated operates in a single operating segment, the investment management business. Management evaluates Federated’s performance at the consolidated level. Management analyzes all expected revenue and expenses and considers market demands in determining an overall fee structure for services provided and in evaluating the addition of new business. Federated’s growth and profitability are dependent upon its ability to attract and retain AUM and upon the profitability of those assets, which is impacted, in part, by management’s decisions regarding Voluntary Yield-related Fee Waivers. Fees for mutual fund-related services are ultimately subject to the approval of the independent directors or trustees of the mutual funds. Management believes that meaningful indicators of Federated’s financial performance include AUM, gross and net product sales, total revenue and net income, both in total and per diluted share.

23


Management's Discussion and Analysis (continued)
of Financial Condition and Results of Operations (unaudited)
 

Business Developments

Money Market Fund Matters
For the nine-month periods ended September 30, 2016 and 2015, approximately 46% and 32%, respectively, of Federated’s total revenue was attributable to money market assets. A significant change in Federated’s investment management business (such as its money market business) or a significant reduction in AUM (such as money market assets) due to regulatory changes, changes in the financial markets, such as significant and rapid increases in interest rates over a short period of time causing certain investors to prefer direct investments in interest-bearing securities, the availability, supply and/or market interest in repurchase agreements and other investments, significant deterioration in investor confidence, further prolonged periods of low short-term interest rates or declines in short-term interest rates and resulting fee waivers, investor preferences for deposit products, other FDIC-insured products or passive investment products, changes in relationships with financial intermediaries, or other circumstances, could have a material adverse effect on Federated’s business, results of operations, financial condition and/or cash flows.

(a) Current Regulatory Environment
Domestic
Increased regulation and oversight of the investment management industry in the U.S. continues in 2016. This has required, and is expected to continue to require, additional internal and external resources to be devoted to technology, legal, compliance, operations and other efforts to address regulatory-related matters, and has caused, and may continue to cause, product structure, pricing, offering and development effort adjustments, as well as changes in asset flows and customer relationships. The current regulatory environment has affected, and is expected to continue to affect, to varying degrees, Federated's business, results of operations, financial condition and/or cash flows.
The implementation of changes in response to the amendments to Rule 2a-7 under the 1940 Act (Rule 2a-7), and certain other laws and regulations, adopted by the SEC as part of the 2014 Money Fund Rules, and the related Money Fund Rules Guidance, that was last revised by the SEC staff on May 23, 2016, was completed on or before October 14, 2016, the final compliance date for the 2014 Money Fund Rules. The 2014 Money Fund Rules built on initial money market fund reforms adopted by the SEC in 2010. Under the 2014 Money Fund Rules, compliance with certain current event and related website disclosure requirements was required on July 14, 2015. In addition to compliance with certain diversification, stress testing, and disclosure requirements, which was required by April 14, 2016, compliance with the 2014 Money Fund Rules was required by October 14, 2016 with respect to the floating NAV requirements for institutional prime and municipal (or tax-exempt) money market funds. These requirements required such funds to utilize market-based valuations to calculate a floating NAV rather than using the amortized cost method for valuing securities maturing in more than 60 days to seek to maintain a stable NAV. Government or retail money market funds are allowed to continue using the amortized cost method (and/or the penny rounding method of pricing) in calculating their NAVs. Compliance by October 14, 2016 also was required with respect to the provisions of the 2014 Money Fund Rules regarding the liquidity fees and redemption limits (gates) permitted, or in certain cases required, for money market funds (other than government money market funds), as well as related disclosure requirements.
On September 16, 2015, the SEC issued final rules, which became effective on October 26, 2015, that removed all references to credit ratings from Rule 2a-7 and created a uniform credit quality standard under Rule 2a-7 under which a money market fund may invest in a security only if the fund determines that the security presents minimal credit risk after analyzing certain prescribed factors. These amendments also require a money market fund to adopt certain procedures related to an ongoing review of the credit quality of each of the fund's portfolio securities, clarify stress testing requirements for an event indicating or evidencing a credit deterioration of a portfolio security, and subject certain additional securities to the issuer diversification requirements under Rule 2a-7.
On December 11, 2015, the SEC proposed new rules that, if adopted as proposed, would enhance the regulation of the use of derivatives by investment companies. Under these proposed rules, a fund would be required (among other requirements) to (1) comply with one of two alternative portfolio limitations designed to limit the amount of leverage the fund may obtain through derivatives and certain other transactions, (2) manage the risks associated with the fund's derivatives transactions by segregating certain assets in an amount designed to enable the fund to meet its obligations, including under stressed conditions, (3) establish a formalized derivatives risk management program if the fund engages in more than a limited amount of derivatives transactions or uses certain complex derivatives, and (4) segregate certain assets to cover the fund's obligations if a fund uses certain financial commitment transactions, such as reverse repurchase agreements and short sales. In a comment letter, dated March 23, 2016, Federated acknowledged certain constructive elements of the proposed rules, but opposed elements of the proposed rules in their current form, including, among other points, the adoption of a rules-based regime that

24


Management's Discussion and Analysis (continued)
of Financial Condition and Results of Operations (unaudited)
 

employs fixed limits on notional exposure and disallows netting of most hedges, the proposed requirement that eligible coverage assets are limited to cash and cash equivalents, and the ability of advisers to adopt lesser standards for derivatives risk management programs where notional derivatives exposure is less than 50% of fund assets. Comments are available at http://www.sec.gov/comments/s7-24-15/s72415.shtml. It is unclear when the derivative rules will be finalized. Management does not expect these rules to be finalized before the second quarter of 2017 with an extended compliance period.
On June 28, 2016, the SEC proposed rules that would require registered investment advisers to adopt and implement written business continuity and transition plans. If enacted as proposed, the rules would require registered investment advisers to assess and inventory components of their businesses, including operational and other risks related to significant disruptions in operations, and to design, adopt and implement written business continuity and transition plans "reasonably designed to address operational and other risks related to a significant disruption in the investment adviser’s operations." Registered investment advisers also would be required to comply with certain additional recordkeeping and compliance requirements related to business continuity and transition plans. In a comment letter, dated September 2, 2016, Federated acknowledged the need for an updated framework to strengthen industry practices regarding business continuity, but respectfully asserted that the proposed rules: (i) set an unreasonable standard for advisers that is not justified by cost/benefit assessments; (ii) fail to acknowledge the obstacles advisers face due to the inability of critical service providers to provide adequate clarity regarding their business continuity programs because of the service providers' need for confidentiality (thus requiring greater redundancies by investment advisers); and (iii) fail to acknowledge and clarify the important role of disclosure in informing investors of the risks associated with business continuity events. Regarding transition plans, in Federated's comment letter, Federated respectfully asserted that the proposed rules: (i) are highly burdensome while having little practical value as they require meaningless speculation by the adviser regarding transactions it may undertake in hypothetical risk scenarios; (ii) are not cost/benefit justified based on the historical experience of advisers of registered vehicles that would be most affected by the proposed rules; and (iii) create a record to assist in regulatory oversight that could alternatively be achieved by far simpler and less costly means. Comments are available at https://www.sec.gov/comments/s7-13-16/s71316.htm.
On August 25, 2016, the SEC promulgated final rules (originally proposed on May 20, 2015) amending Form ADV (the registration form and disclosure brochure for investment advisers) to, in relevant part, require advisers to maintain additional performance records, and provide additional information regarding borrowing and the use of derivatives, relating to separately managed accounts. Compliance with these amendments is required with respect to any Form ADV, or amendment to Form ADV, filed on or after October 1, 2017.
On October 13, 2016, the SEC adopted new rules relating to the modernization of investment company reporting and disclosure, the enhancement of liquidity risk management by open-end investment companies and the permitted use of "swing pricing" by open-end investment companies. Among other requirements and changes, the new reporting modernization rules require registered investment companies (other than money market funds) to report monthly on Form N-PORT portfolio wide and position-level holding data, registered investment companies (other than face-amount certificate companies) to annually report on Form N-CEN certain census-type information, certain disclosures regarding securities lending activities, and use of a structured data format. The new rules also require standardized and enhanced disclosure regarding derivatives in fund financial statements. Reporting on Form N-PORT is required by June 1, 2018 for larger fund complexes (i.e., those with over $1.0 billion in aggregate assets under management). Reporting on Form N-CEN also is required by June 1, 2018. The compliance date for other disclosure requirements is August 1, 2017. The SEC did not adopt a proposed rule that would have permitted delivery of fund shareholder reports through website posting in lieu of mailing them to shareholders.
The new liquidity risk management rules require open-end investment companies (other than money market funds and certain exchange traded funds (ETFs)) to establish liquidity risk management programs that contain certain required elements, including (among others): (1) classification of the liquidity of fund portfolio investments into four "buckets" (i.e., highly liquid, moderately liquid, less liquid and illiquid); (2) assessment, management and periodic review of a fund's liquidity risk; (3) the establishment of a highly liquid investment minimum (i.e., a minimum percentage of cash and investments that can be liquidated in three business days without significantly changing the market value of the investment); (4) a limitation on illiquid investments (i.e., 15% of net assets) with board reporting of exceptions; and (5) fund board review and approval of the liquidity management program and the designation of a fund adviser or officer to administer the program. In addition to certain other policy and procedure, disclosure and recordkeeping requirements, the new rules require confidential reporting on Form N-LIQUID when a fund’s level of illiquid assets exceeds 15% of its net assets or when the fund’s highly liquid investments fall below its highly liquid investment minimum for more than a brief period of time. Larger fund complexes, such as Federated, are required to establish their liquidity risk management programs by December 1, 2018. Reporting on Form N-LIQUID also will be required by that date. Compliance with disclosure and certain other requirements is required by June 1, 2017.
The new swing pricing rule permits open-end investment companies (other than money market funds and ETFs) to use swing pricing to effectively pass on the costs stemming from shareholder purchase and redemption transactions to the shareholders

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Management's Discussion and Analysis (continued)
of Financial Condition and Results of Operations (unaudited)
 

transacting in the funds' shares. Specifically, swing pricing involves a fund determining its NAV (an "Unswung NAV") and adding to or subtracting from its Unswung NAV by a specified amount - a "swing factor" - to determine the price at which purchases and redemptions in fund shares would be transacted. The swing factor would be applied to a fund's Unswung NAV once the level of net purchases into or net redemptions from the fund has exceeded a specified percentage or percentages of the fund's Unswung NAV known as a "swing threshold." In addition to certain disclosure, reporting, recordkeeping and other requirements, for a fund that elects to adopt swing pricing, the new rule requires the fund’s board to adopt policies and procedures that specify the process for how the fund's swing factor and swing threshold would be determined (taking into account certain considerations) and establish and disclose an upper limit on the swing factor used, which may not exceed two percent of the fund’s NAV per share. The fund’s board also will be required to approve the fund’s swing factor upper limit, swing pricing threshold and any changes thereto, and to review a written report covering the adequacy of the fund’s swing pricing policies and procedures and the effectiveness of their implementation. The new swing pricing rule becomes effective two years after the date the new rule is published in the Federal Register.
The SEC staff has been engaging in a series of investigations, enforcement actions and/or examinations involving investment management industry participants, including certain sweep examinations of investment management companies involving various topics, such as fixed-income and high yield liquidity, liquidity controls, liquid alternatives, the impact of the United Kingdom's (UK) vote to exit the European Union (EU) (known as "Brexit"), cybersecurity, side-by-side management of private funds, private placements, separately managed or wrap-fee accounts, excessive trading, "distribution in guise," marketing support payments, and intermediary and other payments and related disclosures. The SEC staff also has continued to focus its attention on liquidity and redemption risks, leverage, information security, vendor risk management and other operational risks, and the failure/closing of investment industry participants. These investigations, actions and examinations have led, and may lead, to further regulation and scrutiny of the investment management industry. For example, on September 21, 2015, the SEC announced a settlement of an enforcement action brought against a third-party mutual fund investment adviser and distributor relating to alleged improper payments to intermediaries. In 2015, the SEC staff also issued guidance statements on (among other topics) cybersecurity and, in January 2016, issued a guidance statement on mutual fund distribution and sub-accounting fees, which provided guidance based, in part, on the SEC staff's "distribution in guise" sweep examination and outlined the SEC staff's views on issues that may arise when mutual funds make payments to financial intermediaries that provide shareholder and recordkeeping services to shareholders, particularly regarding whether a portion of those payments may be viewed as being used to finance distribution of fund shares. On March 2, 2016, the SEC staff issued a guidance statement on revising fund disclosure in light of changing market conditions. On June 28, 2016, the SEC staff also issued guidance addressing business continuity planning for registered investment companies, including the oversight of the operational capabilities of key fund service providers. Under this guidance, the SEC staff indicated that fund complexes should consider their compliance obligations when assessing their "ability to continue operations during a business continuity event" and suggests the development of plans related to potential breaches and disruptions at critical service providers and protocols for internal and external communications, including to investors, regulators and the press.
Regulation or potential regulation by other regulators, in addition to the SEC, also continues to affect investment management industry participants, including Federated. Among other regulatory changes, at the time the 2014 Money Fund Rules were adopted, the U.S. Treasury Department (Treasury Department) and Internal Revenue Service (IRS) issued certain rules, which were finalized on July 7, 2016, aimed at, among other things, addressing for investors in an institutional prime or municipal (or tax-exempt) money market fund with a fluctuating NAV the application of wash sale rules and relief from the administrative burdens of calculating small capital gains and losses for shareholders that frequently purchase or redeem shares (such as through a broker/dealer or bank "sweep arrangement"). On July 31, 2014, the Financial Stability Oversight Council (FSOC) indicated that it intended to monitor the effectiveness of the 2014 Money Fund Rules, which prompted concerns that the FSOC may recommend new or heightened regulation for "non-bank financial companies" under Section 120 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), which the Board of Governors of the Federal Reserve System (Governors) have indicated can include open-end investment companies, such as money market funds and other mutual funds. Management continues to respectfully disagree with this position and does not believe that asset managers and management products, such as money market funds, create systemic risk. The FSOC has since moved away from potential systemically important financial institution designations of asset managers or investment products, in favor of studying the financial stability implications of the asset management sector. At its September 2015 meeting, the FSOC indicated that it was engaged in an ongoing process of evaluating the asset management industry. On April 18, 2016, the FSOC released its Update on Review of Asset Management Products and Activities (Update), which discusses FSOC's views on potential risks to financial stability arising from certain asset management products and activities, including mutual funds, other pooled investment vehicles and separately managed accounts. In the Update, the FSOC focused on potential risks arising from liquidity/redemptions and leverage, as well as securities lending, operational risks of service provider concentrations and resolvability and transition planning. FSOC also indicated that, among other additional analysis, the FSOC would continue to review and monitor the SEC's proposed rules on modernization, liquidity management and derivatives and their implications for financial stability. At

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Management's Discussion and Analysis (continued)
of Financial Condition and Results of Operations (unaudited)
 

its July 18, 2016 meeting, the FSOC received an update on asset management products and activities, which included a discussion of SEC initiatives and data gaps. Certain proposed legislation currently pending in Congress also seeks to address, among other items relating to the FSOC's authority, the transparency of the FSOC's decision making process.
On April 6, 2016, the DOL's Final Fiduciary Rule was issued, which imposes a modified fiduciary standard for retirement plan advisers. The Final Fiduciary Rule modifies the definition of "fiduciary" under the Employee Retirement Income Security Act of 1974 and addresses conflicts of interest raised by the receipt of compensation (such as Rule 12b-1 fees) by retirement plan advisers by requiring such advisers to (among other requirements) put their clients' interests before their own profits, acknowledge their fiduciary status, enter into customer contracts addressing standards