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'Takeover bait': Federated Investors bounces between private, public

| Sunday, June 25, 2006

Federated Investors Inc., the Pittsburgh mutual-fund firm, has weathered a tough three years.

It trading practices were investigated by securities regulators in 2003, culminating in $80 million in penalties and client refunds in 2005 -- the firm's 50th anniversary. Net profits have slid since peaking in 2002. And the stock of industry peers has increased sharply, while Federated's rose modestly and now is trading near 52-week lows.

So with its stock relatively cheap, industry watchers wonder if Federated could be headed for a management-led buyout or a takeover.

"They are very profitable and tend to trade at a discount to other investment managers," said stock analyst RachellBarnard of Morningstar, Chicago, which analyzes mutual funds. "And they have gone private before in their history."

Federated was among a half-dozen public companies mentioned in the Wall Street Journal's "Heard on the Street" column as management-led buyout candidates in early June because of its slow-growth prospects, under-valued stocks and stable cash flows. In a management-led buyout, insiders acquire the company's shares from the public, thus taking it private.

During the years, the firm has swung from private to public several times. Federated first went public in 1960, five years after it was founded. Its shares traded publicly for 22 years until 1982, when the firm was sold to Aetna Life & Casualty Co. Seven years later, the Donahue family and a group of senior executives bought control of the firm from Aetna.

Federated almost went public in late 1996 but instead paid $100 million to repurchase the remaining 27 percent of the stock that Aetna owned. Then in May 1998, the firm went public again, with a $375 million offering that netted $46 million.

"Federated is a stock that's significantly under-valued. We think it's worth about $46, and it's trading around $30," Barnard said. "They would be good takeover bait."

But only if that's the plan of the Donahue clan. The public owns 86 percent of Federated's class B stock, but it comes with no voting privileges. All of Federated's class A, voting shares are held by a three-member trust consisting of firm co-founder and chairman John "Jack" Donahue, his wife and son J. Christopher Donahue, Federated's chief executive.

CEO Donahue declined to be interviewed for this story and would not respond to e-mailed questions.

Federated manages 140 mutual funds consisting of stock and debt securities, plus manages some accounts separately. The total portfolio was worth about $217 billion at the end of March. Clients include corporations, banks, foundations, government entities and wealthy people.

The firm is the nation's third-largest manager of money-market funds, which invest in short-term commercial and government debt. It is the 13th-largest mutual-fund manager overall, measured by the value of managed investments, said a ranking by Lipper, a fund-tracking firm in Denver.

Federated was founded in 1955 by Richard Fisher, who remains vice chairman, and by Jack Donahue. They created stock mutual funds as a means of selling money-management services from its street-level office Downtown.

It developed fixed-income funds -- debt securities that pay out over several years -- for investors in the 1960s. In the early 1970s, Federated devised some of the nation's first money-market funds, bundling securities such as U.S. Treasury bills, certificates of deposit and short-term corporate debt.

The firm managed $300 million by the early 1970s, when CEO Donahue joined Federated as a law clerk . Today, Federated manages more than $200 billion.

But the value of other mutual-fund companies has left Federated far behind during the past three years. Its peer group's total returns (stock appreciation plus dividends) doubled from December 2002 to December 2005, while Federated's rose by one-third, said the firm's latest proxy statement.

Federated's stock has lagged its peers largely because of the type of mutual funds it manages, experts said. Namely, three-quarters of its $217 billion in managed funds are invested in short-term debt securities, not stocks.

"Stocks have been on a rocket since the bottom in 2002. And Federated's peers are mainly (stock)-focused, so their earnings have grown at a faster pace," said Rich Hummel, director of research for Kirr Marbach & Co.. The money manager based in Columbus, Ind., owns 300,000 shares of Federated.

"As (stock) markets rally, your managed assets go higher and your earnings go higher," Hummel said. "Federated hasn't seen that benefit and their earnings have been fairly flat."

A two-year scandal over the firm's mutual-fund trading practices didn't help. The Securities and Exchange Commission and New York's attorney general began probing Federated in fall 2003 and found some traders engaged in two illegal trading practices: market timing, or heavy trading mainly to reap extra transaction fees; and after-hours trading, or buying and selling securities after U.S. exchange floors close at 4 p.m. to benefit from late news.

Federated settled regulators' allegations in November by paying $80 million in penalties and client restitution. It also agreed to reduce fees by $20 million through 2010.

"We were very concerned with the trading practices. It was not a good way to treat investors," Barnard said. "And it's hurt them in terms of attracting new (investment) money."

For instance, clients pulled $405 million out of Federated stock funds in the first quarter, and $2.05 billion since fourth-quarter 2004.

"They don't have a terribly distinguished line of stock funds," said Reginald Laing, a mutual fund analyst for Morningstar. For instance, the Federated Capital Appreciation Fund, one of the firm's more prominent funds, had a 5.8 percent total return in the three years ended June 13. That was below 90 percent of the 679 similar funds tracked by Morningstar.

"For a long time, Federated has been known as the money-market place," said Jeff Tjornehoj, senior research analyst for Lipper. About 75 percent of Federated's $217 billion portfolio at March 31 was composed of money-market funds, while stocks accounted for 14 percent.

Federated has been trying to change that historical mix for about five years. It added $3.2 billion in stock funds when it acquired the well-known Kaufmann Fund in April 2001. Most recently, Federated last month agreed to buy MDT Advisors, which will add $7.1 billion in stock funds when the deal closes in July.

"Chris (Donahue) has said several times on analyst calls that they are willing to talk about anything that will maximize the value of the company," Barnard said. "But the current strategy seems to be to bulk up more on (stock) assets that are faster-growing, in order to augment the money-market side."

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