Managing working capital risk and return
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Managing Working Capital Risk and Return. Mark R. Wetzel President Fiduciary Investment Advisors, LLC. Joseph G. Trainor Senior Vice President for Finance University of the Sciences. Managing Working Capital Risk and Return. Period of Global Turmoil 2008 - 2010.

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Managing working capital risk and return

Managing Working CapitalRisk and Return

Mark R. Wetzel

President

Fiduciary Investment Advisors, LLC

Joseph G. Trainor

Senior Vice President for Finance

University of the Sciences


Managing working capital risk and return1

Managing Working CapitalRisk and Return

Period of Global Turmoil 2008 - 2010

  • What happened during this period of turmoil?

  • Auction Rate Preferred securities failed at auction

  • The Reserve Primary Money Market fund broke the buck

  • Yields on 3-month treasuries went negative for the first time ever

  • Sovereign debt crisis impacts Club-Med & Euro


Managing working capital risk and return2

Managing Working CapitalRisk and Return

The “TED Spread” reached an all time high.

Source: JPMorgan Asset Management


Managing working capital risk and return3

Managing Working CapitalRisk and Return

  • How did Higher Education misread the markets?

    • Concentrated our liquid funds

    • Did not fully understand tail risks

    • Assumed prior results were an indicator of future performance risks

    • Increased leveraging, especially with low variable rate debt

    • Expanded operating budgets based upon continued strong endowment performance

    • Assumed market would always provide liquidity

    • Assumed alternative funds distribution would offset any capital calls


Managing working capital risk and return4

Managing Working CapitalRisk and Return

Those who cannot remember the past are condemned to repeat it. George Santayana

  • Impact upon Higher Education:

    • Liquidity

      • All money market-like funds were not liquid

      • Marketable securities were not as marketable as expected

      • Some investments liquidate at a deeply discounted price

      • Investment managers imposed new liquidity gates

      • Collateral postings were required

      • Alternative funds distributions did not offset capital calls

    • Debt

      • Failed remarketing of demand debt

      • Rising variable rate interest expense and letter of credit fees

      • Collateral posting and liquidation penalties for swaps

    • Operating budgets were cut due to weak investment performance


Managing working capital risk and return5

What is a VP of Finance to do?

Understand the relationship between risk and return

Understand and document the different types of risks involved

Re-evaluate the institution’s risk tolerance and return goals

What is the cost of liquidity? And what risks are being taken in search of return?

Managing Working CapitalRisk and Return


Managing working capital risk and return6

How can we balance risk and reward?

Solution: A tiered approach to working capital management

Allows for a custom cash investment strategy to fit the investor’s risk tolerance, liquidity requirements and preservation of capital needs

Ability to combine liquidity with the opportunity for yield enhancement by moving away from money market strategies to other short term strategies

Let’s look at two approaches…

Managing Working CapitalRisk and Return


Managing working capital risk and return7

Managing Working CapitalRisk and Return

Segmenting Cash by liquidity needs and profile


Managing working capital risk and return8

Managing Working CapitalRisk and Return

HIGHER RISK LOWER

Tier 1

LOWER LIQUIDITY HIGHER

  • Operating Cash

Tier 2

  • Reserve Cash

Tier 3

  • Restricted and Strategic Cash

Source: PIMCO


Managing working capital risk and return9

Managing Working CapitalRisk and Return

Tier 1 Operating Cash

HIGHER RISK LOWER

  • Purpose: Utilize for daily operating expenses

  • Primary Objectives: Principal preservation, daily liquidity

  • Typical Strategies: Money Market or STIF

  • Typical Investment Discretion: Restrictive

LOWER LIQUIDITY HIGHER

LOWERLIQUIDITY HIGHER

Tier 2 Reserve Cash

Tier 3 Restricted and Strategic Cash

Source: PIMCO


Managing working capital risk and return10

Managing Working CapitalRisk and Return

Tier 1 Operating Cash

HIGHER RISK LOWER

LOWER LIQUIDITY HIGHER

Tier 2 Reserve Cash

  • Purpose: Semi-permanent allocation to cash utilized for acquisitions, capital expenditures, R&D, dividends, stock repurchases (for-profit)

  • Primary Objective: Enhance returns to cash

  • Typical Strategies: Short-Term (max. 1 yr duration) or Low Duration (1-3 yr duration)

  • Typical Investment Discretion: Depends on portfolio’s impact on company’s income statement

Tier 3 Restricted and Strategic Cash

Source: PIMCO


Managing working capital risk and return11

Managing Working CapitalRisk and Return

Tier 1 Operating Cash

HIGHER RISK LOWER

Tier 2 Reserve Cash

LOWERLIQUIDITY HIGHER

Tier 3 Restricted and Strategic Cash

  • Purpose: Used if institution has large cash balance and long-term spending needs

  • Primary Objective: Grow cash balance over long term

  • Typical Strategies: Moderate Duration, Total Return, High Yield, Emerging Markets, etc.

  • Typical Investment Discretion: Broad due to longer-term investment horizon

Source: PIMCO


Managing working capital risk and return12

Tier 1 – Operating Cash

Objective:

preservation of principal and daily liquidity

Suitable strategies:

money market funds

STIF funds

Managing Working CapitalRisk and Return

Data as of 3/31/10 Source: Morningstar Direct


Managing working capital risk and return13

Managing Working CapitalRisk and Return

Data as of 3/31/10 Source: Morningstar Direct, Barclays Capital 1-3 month US T Bill. Index returns shown for illustrative purposes only.


Managing working capital risk and return14

Managing Working CapitalRisk and Return

  • Tier 1 – Operating Cash

  • Implementation & Operational Considerations:

    • Develop a working capital investment policy

    • Develop a 12 month rolling cash flow forecast

      • Ask your bankers to prepare 1 – 3 year cash analysis with monthly cash flows, balances, returns and fees

    • Prepare weekly cash flash reports to monitor cycles, spikes, opportunities and risks

      • Anticipate major scheduled receipts (Direct and Alternative Loans)

    • Ask your banker for suggestions and/or perform RFP


Managing working capital risk and return15

Managing Working CapitalRisk and Return

  • Tier 1 – Operating Cash

  • Implementation & Operational Considerations:

    • Research and understand the factors affecting risks and returns for demand w/ & w/o compensating balances, money market, NOW, not-for-profit, repos and sweep accounts

    • Evaluate the tradeoffs between administration, internal control, net yield, liquidity, debt covenants, risk tolerance, collateral and safety

    • Integrate working capital solutions to be consistent with your institutional needs

    • Do not assume anything


Managing working capital risk and return16

Managing Working CapitalRisk and Return

  • Do you know the Money Market Fund Regulations?

    • Investment Company Act of 1940 - Rule 2a-7 & as amended in 2010 requires:

      • majority of funds being in the highest rated debt

      • separate rules & limits for illiquid or second tier assets

      • daily & weekly liquidity test

      • high quality securities to mature within 397 days & second tier within 45 days

      • Weighted Average Maturity (WAM) of 60 days or less

      • Weighted Average Life (WAL) of 120 days or less

      • ceiling in one issuer, except for govt. securities and repos at 5%

      • funds to report their portfolio holdings monthly to the Commission and post them on their Web sites

      • stress testing fund portfolios periodically to determine if they can withstand market turbulence


Managing working capital risk and return17

Tier 2 – Reserve Cash

Objective:

Enhanced return on cash not needed for daily use (6 – 9 month investment horizon)

Suitable strategies:

short term funds

low duration funds

laddered CDs

Managing Working CapitalRisk and Return


Managing working capital risk and return18

Managing Working CapitalRisk and Return

Data as of 3/31/10 Source: Morningstar Direct, ML US Corp/Gov’t 1-3 Year Index. Index returns shown for illustrative purposes only.


Managing working capital risk and return19

Tier 2 – Reserve Cash

Implementation & Operational Considerations:

Build upon 12 month cash forecast

Leverage Fall & Spring cash receipts with funding needs for summer, capital and debt service

Options

Short and low duration funds

Positive

same to next day availability

can select fund to match institutional risk profile

limited market interest rate risks

Negative

interest rate risks

generally uninsured

credit risk tied to unknown underlying investments

Managing Working CapitalRisk and Return


Managing working capital risk and return20

Managing Working CapitalRisk and Return

Tier 2 – Reserve Cash

Implementation & Operational Considerations:

Options - continued

Laddered CDs (WAM < 1 year)

Considerations

purchase individually or through an intermediary or consortium

bank’s reserve capital ratio

FDIC registered number

Positive

FDIC insurance possible

minimal market volatility

match maturities to specific date fund needed

Negative

cumbersome if intermediary not used

broker and custodian risks

liquidity subject to CD terms or secondary market


Managing working capital risk and return21

Tier 3 – Strategic / Restricted Cash

Objective:

Grow cash balance earmarked for long term spending needs (investment horizon of 1 year or longer)

Suitable strategies:

moderate duration

high yield

total return

balanced funds

Managing Working CapitalRisk and Return


Managing working capital risk and return22

Managing Working CapitalRisk and Return

Data as of 3/31/10 Source: Morningstar Direct, Barclays Capital US Aggregate Bond Index. Index returns shown for illustrative purposes only.


Managing working capital risk and return23

Tier 3 – Strategic / Restricted Cash

Implementation & Operational Considerations:

What are the purposes for these funds?

Does investment timeline match utilization needs?

Is investment earnings budget too optimistic?

Should equities be part of investment strategy?

What happens if earnings are negative for fiscal year?

What if corpus is eroded or illiquid when project funding is needed?

Should corpus be transferred to quasi-endowment?

Managing Working CapitalRisk and Return


Managing working capital risk and return24

Tiers 1 - 3 Overall Considerations

Understand your cash cycles

Assess marketplace options

Develop working capital policy

Establish realistic guidelines and budgets

Address internal controls and due diligence

Evaluate concentration risks

Determine if equities should be part of working capital

Managing Working CapitalRisk and Return


Managing working capital risk and return25

Managing Working CapitalRisk and Return

Due Diligence 101 Missteps

  • Dismiss 2008-2010 as an aberration

  • Don’t read the prospectus or financial reports

  • Don’t evaluate inherent risks and long-term implications of strategies

  • Assume what others do has been tested & should be followed

  • Fail to recognize performance warning flags


Managing working capital risk and return26

Investment Policy Key Components

scope of policy

objectives in relation to investment strategy

roles and responsibilities

benchmarks

permissible investments

liquidity targets

reporting

custody

evaluation and compliance

Managing Working CapitalRisk and Return


Managing working capital risk and return27

Summary

Risks are real and here to stay.

Current yields on cash markets (i.e. Gov’t money market securities, T-bills, and Agency discount notes) are far from the investment targets set by most institutional investors.

The only constant is change.

At the end of the day, the optimal strategy is to manage your risks and maintain an ongoing evaluation of liquidity needs and return goals.

Managing Working CapitalRisk and Return


Managing working capital risk and return28

Comments & Questions

Managing Working CapitalRisk and Return


Contacts and references

Contacts and References

Contacts:

Joseph G. Trainor, [email protected] or 215.596.8862

Mark Wetzel, [email protected] or 860.697.7410

References:

FDIC locator and comparisons: http://www2.fdic.gov/idasp/main_bankfind.asp

FDIC failed banks: http://www.fdic.gov/bank/individual/failed/banklist.html

Moody’s Investors Services: www.moodys.com

Morningstar reviews: http://www.morningstar.com/


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