Managing Working Capital Liquidity July 29, :00 3:15 PM

Transcription

1 Managing Working Capital Liquidity July 29, :00 3:15 PM Paul L. Robertson III Managing Director Edge Capital Partners, LLC

2 Working Capital Management Process Introduction Importance of Working Capital Institution s solvency Financial strength Working Capital Definition Unrestricted operating funds Other non-endowment unrestricted funds Unrestricted Board Designated Endowment (Net Assets) as presented in the annual audit for private colleges according to UPMIFA definition. 2

3 Outline for Today s Discussion Framework View working capital in the context of the entire institution Investment Strategy Identify key investment risks impacting working capital Conduct scenario analysis to narrow risk tolerances Assess markets and potential impact on investment strategy Governance Develop a detailed and comprehensive investment policy statement Monitor portfolio and risk profile Reporting historical trends, current status & forecast 3

4 Framework 4

5 WORKING CAPITAL MANAGEMENT GOALS AND OBJECTIVES PROTECT PRINCIPAL to what extent PROVIDE LIQUIDITY when and how much OPTIMIZE RETURNS risk/reward tradeoff 5

6 WORKING CAPITAL MANAGEMENT FRAMEWORK Your Working Capital Management Framework should be adapted to your unique situation thereby creating the ability to provide customized investment management solutions to increase the probability of achieving your goals. DEVELOPING Understand your mission, goals, and objectives Investment policy statement > Determine portfolio investments > Define roles and responsibilities > Set expectations IMPLEMENTING Execute portfolio management process > Maturity/duration and yield curve allocation > Sector allocation and security selection > Risk Management, Trading & Compliance MONITORING Communication and reporting Relationship protocol Access and control Investment performance Portfolio characteristics and holdings Transactions Forecasting & Budgeting 6

7 WORKING CAPITAL MANAGEMENT FRAMEWORK Because working capital does not stand alone, your portfolio needs to be managed within the broader context of your organization, incorporating known variables as well as nonrecurring issues and potential risks impacting your working capital assets. Coordination and Collaboration Operating Tactical Strategic Applications Yield Tuition & fees Financial aid Net tuition Gifts & grants Endowment rev Operating expenses Competitive positioning Fund raising pipeline Debt structure and terms Compensation & benefits Reserves Renewals & replacement Strategic plan Diversification of business lines Endowment / Foundation assets Capital spending Government appropriations Economic environment Days cash on hand Expendable financial resources Liquidity to demand debt 7

8 Balances DEVELOPING YOUR INVESTMENT FRAMEWORK The sources, uses and timing of cash flows varies at each institution. Stratifying cash balances based on time horizon and risk tolerance will improve your ability to optimize investment strategy and returns. Coordination and Collaboration Operating Cash < 1 Year Tactical Cash 1-3 Years Strategic Cash 3+ Years Fiscal Time Period 8

9 Risk Management 9

10 Investment Process Risk Assessment DEVELOPING YOUR INVESTMENT FRAMEWORK Risk can be defined in many ways: Market Risks (systematic) include: interest rate, inflation, liquidity, sociopolitical, etc. Specific Risks (nonsystematic) include: corporate leadership, credit/default, product structure, etc. Goal Risks include: failure to meet obligations, reputational, and operational Data Discussion Decisions Market Risks Specific Risks Goal Risks Asset Allocation Risk Management Portfolio Construction 10

11 KEY INVESTMENT RISKS TO WORKING CAPITAL Have you considered Negative Yields Reinvestment Risk Spread Risk Interest Rate Risk Counterparty Risk Commingled Risk Liquidity Risk 11

12 REINVESTMENT RISK - NEGATIVE YEILDS Are you willing to pay a government for the privilege of holding your cash? Three European countries now have negative yields on their two year bonds. 12

13 SPREAD & INTEREST RATE RISK Short-term fixed income funds with relatively similar durations can have different returns based on their makeup and credit exposure. Source: Bloomberg, 5/31/11 As interest rates go lower, U.S. Treasury securities offer less protection against rising interest rates. 13

14 COMMINGLED RISK In 2010, the Securities and Exchange Commission issued new rules governing money market funds. While these rules were intended to mitigate the risks of money market funds, they can still have very different profiles and compositions. It is important to know how the assets in a money market fund are deployed. 14

15 Tier 1 Capital Ratio COUNTERPARTY RISK EXPOSURE Evaluating counterparty exposure (size of the bubble) 14 coupled with an 13 indication of a counter-party s risk 12 profile (Tier 1 Capital Ratio X 11 Nonperforming Assets/Total Non Performing Assets/ Total Assets Assets) can be used to help manage risk at the Bank A Bank C Bank D Bank E Bank F Bank G Bank B institutional level. Company Tier 1 Capital Ratio Non Performing Assets/ Total Assets S&P Rating Texas Ratio Bank A A Bank B BBB Bank C A 6.41 Bank D A 7.45 Bank E A Bank F AA Bank G A

16 EARLY WARNING INDICATORS Early warning indicators that point to event risk or changes in an issuer s credit profile can be a valuable tool in risk management. Data source: Bloomberg 16

17 MITIGATING INVESTMENT RISKS TO WORKING CAPITAL Common sense should prevail throughout your risk management process. Risk Current Environment Mitigation Commingled Risk Money market fund boards have the authority to freeze redemptions Hedge funds have a wide array of redemption restrictions and potential gates Interest Rate Risk Interest rates are at historic lows a quick or large increase in interest rates will erode principal values Spread Risk Spreads across most fixed income sectors are well below 2008 levels and at or below historical averages - spreads could widen out if market conditions deteriorate Counterparty Risk Bank failures in the U.S. have increased Unlimited FDIC insurance reverts back to $250,000 limit January 1, Market Risk Volatility in the equity markets is increasing again Separately managed accounts Diversify among sponsors Shorten duration Utilize floating rate securities Hold to maturity through separate accounts Diversify portfolio Diversify counterparties Monitor financial strength Reduce exposure Geopolitical Risk Contagion Risk The financial crisis in Europe is escalating Reduce exposure Diversify 17

18 MANAGING RISK MANAGEMENT FRAMEWORK Common sense should prevail throughout your risk management process. Data Don t rely on stale or incomplete data Transparency is important Stress test all options Discussion Accept no unnecessary risk Anticipate and manage risk by planning Make decisions at the right level with appropriate input Decisions Distinguish between policy decisions (IPS) and operational or tactical decisions (execution) Document decisions and incorporate into reporting 18

19 Investment Strategy 19

20 INVESTMENT ENVIRONMENT Deleveraging is the name of the game. It is uncertain whether it will be a pretty or ugly process. What matters today Government Policy Fat Tail Probability/Magnitude Volatility Heartburn Interconnection/Correlation Potential Inflation Current Inflation Economic Growth INTERACTION Financial Market Repercussion Relevance of Fundamentals Valuations Fixed Income Yields (higher quality issuers) 20

21 INVESTMENT ENVIRONMENT Low duration fixed income has provided meaningful incremental returns above T-bills over long periods of time with a modest degree of volatility. Data source: Bloomberg 21

22 INVESTMENT ENVIRONMENT While interest rates have trended downward, there have been periods of rising rates. This has created volatility and impact on short-term returns. Government Intervention Data source: Bloomberg 22

23 INVESTMENT ENVIRONMENT A clearer characterization of return and volatility can be meaningful Data source: Bloomberg 23

24 INVESTMENT ENVIRONMENT While understanding and quantifying certain risks can help set expectations... Data source: Bloomberg 24

25 FLOATING RATE BONDS Floating rate bonds typically benefit from yield spread improvement as the bond approaches one year remaining to maturity and protects against rising rate environments. Gen Elec Cap Corp due 4/10/12 Long-Term Ratings: A1, AA+, N/A Short-Term Ratings: P-1, A-1, N/A Yield Differential versus USD LIBOR Yield Spread days: +46bp Yield Spread days: -3bp Change: -49bp 25

26 DEVELOPING YOUR INVESTMENT FRAMEWORK ILLUSTRATIVE STRUCTURE Analysis is comparison of annualized total return versus standard deviation of monthly returns and covers time period from December, 1999 to March, Data source: Bloomberg 26

27 DEVELOPING YOUR INVESTMENT FRAMEWORK OPERATING CASH (100% CASH EQUIVALENTS) Scenario testing can set expectations for your relative yield and total return given estimated sector allocations. Back testing hypothetical portfolios provides a realistic view of how they react in different economic environments. Understanding the best and worst monthly, quarterly and annual returns of a hypothetical portfolio enables you to refine the risk parameters for the portfolio. 27

28 DEVELOPING YOUR INVESTMENT FRAMEWORK TACTICAL Scenario testing can set expectations for your relative yield and total return given estimated sector allocations. Back testing hypothetical portfolios provides a realistic view of how they react in different economic environments. Understanding the best and worst monthly, quarterly and annual returns of a hypothetical portfolio enables you to refine the risk parameters for the portfolio. 28

29 DEVELOPING YOUR INVESTMENT FRAMEWORK STRATEGIC Scenario testing can set expectations for your relative yield and total return given estimated sector allocations. Back testing hypothetical portfolios provides a realistic view of how they react in different economic environments. Understanding the best and worst monthly, quarterly and annual returns of a hypothetical portfolio enables you to refine the risk parameters for the portfolio. 29

30 IMPLEMENTING YOUR PORTFOLIO Determining the appropriate investments for each segment of your working capital is critical. Time horizon, risk tolerance, sources, uses and timing of flows all factor into the decision making process. Risk Reward Spectrum Preserve Principal Operating Tactical Blended Target Strategic Provide Liquidity Optimize Returns 30

31 Governance 31

32 DEVELOPING YOUR INVESTMENT FRAMEWORK Your framework should be a comprehensive and dynamic University Mission Working Capital Investment Policy Statement Governance People Process Risk Management Strategy Compliance Data 3 rd Parties Portfolio Management 32

33 GOVERNANCE AT A GLANCE Existing working capital management frameworks are under attack by what is happening in the capital markets, the regulatory environment and the political sphere. Data Define the important information Consistently collect the data Discussion Involve stakeholders Review in a timely manner Look forward Decisions Adapt and change Develop contingencies 33

34 DEVELOPING YOUR INVESTMENT FRAMEWORK: INVESTMENT POLICY STATEMENT Sample Guideline Restrictions For Operating Funds Portfolio Allowable/Prohibited Investments Minimum Credit Quality Average Credit Quality % Liquid (Daily, Weekly, Monthly) Maximum Maturity Maximum Weighted Average Maturity Maximum Weighted Average Life Maximum Exposure Issuer Sector Security Type Trading Restrictions Approval List of Counterparties 34

35 CROSS REFERENCE ANALYSIS Analyzing your portfolio provides valuable insight into the risk profile of a portfolio. This detailed portfolio analysis views risk exposures by sectors, security types, credit ratings, and yield curve/duration buckets. 35

36 SAMPLE DASHBOARD REPORT A dashboard report can be an effective tool in managing and monitoring working capital The most valuable dashboard reports incorporate both historical results and forecasts for future activity and balances. Source: Composite Financial Index (CFI) framework - Strategic Financial Analysis for Higher Education (6 th ed.). Washington, DC. Salluzzo, Ronald and Fredrick Prager; Bearing Point, Prager, Sealy and KPMG. (2005) 36

37 SAMPLE DASHBOARD REPORT Sample Dashboard Report for Operating Funds Cash Flow Projections Managing your operating balances and investment portfolios to achieve their goals in a manner consistent with your investment policy and risk tolerances is a continuous process. Actual Monthly Cash Flow and Portfolio Totals This report is for illustration purposes only. The actual portfolio and cash flows should incorporate your risk tolerances and return objectives. 37

38 Take Away 38

39 WHY ALL THIS REALLY MATTERS Working Capital is essential - it requires meaningful attention. Are there opportunities to: Mitigate risk Add incremental return Increase the probably of obtaining your goals by: Gathering pertinent Data Conducting focused Discussions Making appropriate Decisions Leveraging internal & external resources Incorporating best practices 39

40 THANK YOU QUESTIONS? 40