Managing Working Capital Risk and Return

Joseph G. Trainor
Senior Vice President for Finance University of the Sciences

Mark R. Wetzel
President Fiduciary Investment Advisors, LLC

Managing Working Capital Risk 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 Return

The TED Spread reached an all time high.

Source: JPMorgan Asset Management

Managing Working Capital Risk 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 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 Return

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 institutions risk tolerance and return goals

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

Managing Working Capital Risk and Return

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 investors 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

Lets look at two approaches

Managing Working Capital Risk and Return

Segmenting Cash by liquidity needs and profile
Risk Profile Strategic Cash Restricted Cash Reserve Cash Operating Cash Operating * Cash typically used for Reserve * Investment horizon of Total Balance Sheet Cash Restricted Strategic * Balances trapped in highly * No short-term forecasted regulated jurisdictions or use with tax issues * Cash on balance sheet * Cash collateral tied to that has not been historically credit used * Investment horizon of one year or longer

daily operating needs may be suject to unforeseen volitility * Requires preservation of capital * Late-day access * Same-day liquidity

6 - 9 months or longer
* Fairly Static, same-day

access not needed

For illustrative purposes. Source: JPMorgan Asset Management

Managing Working Capital Risk and Return

Tier 1 Operating Cash

Tier 2 Reserve Cash

Tier 3 Restricted and Strategic Cash

Source: PIMCO

Managing Working Capital Risk and Return

Tier 1 Operating Cash Purpose: Utilize for daily operating expenses Primary Objectives: Principal preservation, daily liquidity Typical Strategies: Money Market or STIF Typical Investment Discretion: Restrictive Tier 2 Reserve Cash Tier 3 Restricted and Strategic Cash

Source: PIMCO

Managing Working Capital Risk and Return

Tier 1 Operating Cash 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 portfolios impact on companys income statement

Tier 3 Restricted and Strategic Cash

Source: PIMCO

Managing Working Capital Risk and Return

Tier 1 Operating Cash Tier 2 Reserve Cash

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 Return

Tier 1 Operating Cash
Objective: preservation of principal and daily liquidity

Suitable strategies: money market funds STIF funds

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

Managing Working Capital Risk and Return

Tier 1 Historical Returns
1.80 1.60 1.40
Quarterly Returns

1.20
1.00 0.80 0.60 0.40 0.20 0.00

ML US Treasury Bills 0-3 Mon TR USD

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 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 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-forprofit, 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 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 Return

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 Capital Risk and Return

Tier 2 Historical Returns
4.00 3.00

2.00 Quarterly Returns

1.00

0.00

-1.00

-2.00 ML US Corp&Govt 1-3 Yr TR USD Data as of 3/31/10 Source: Morningstar Direct, ML US Corp/Govt 1-3 Year Index. Index returns shown for illustrative purposes only.

Managing Working Capital Risk and Return

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 Capital Risk 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 banks 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 Return

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 Capital Risk and Return

5.00

Tier 3 Historical Returns

4.00

3.00

Quarterly Returns

2.00

1.00

0.00

-1.00

-2.00

-3.00 BarCap US Agg Bond TR USD 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 Return

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 Capital Risk and Return

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 Capital Risk and Return

Due Diligence 101 Missteps
Dismiss 2008-2010 as an aberration Dont read the prospectus or financial reports Dont 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 Return

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 Capital Risk and Return

Summary
Risks are real and here to stay. Current yields on cash markets (i.e. Govt 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 Capital Risk and Return

Comments & Questions

Contacts and References

Contacts: Joseph G. Trainor, j.trainor@usp.edu or 215.596.8862 Mark Wetzel, mwetzel@fiallc.com 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 Moodys Investors Services: www.moodys.com Morningstar reviews: http://www.morningstar.com/