Firms must actively manage their excess cash if they want to prevent unnecessary expense and reduce risk, say Rob Boyd and Ash Belur of ABN AMRO’s Financial Markets Advisory.

Having cash is a good thing, as long as there isn’t too much. This might seem counter-intuitive, but, as the economy emerges from recession and business optimism improves, many companies are realising that the hoarding of cash which seemed prudent during the lean years is now making their cash balances look bloated.

Furthermore, holding excessive levels of cash is costly. In response to the growing importance of liquidity management as a key financial issue facing corporations today, ABN AMRO has developed an analytical approach and a suite of product building blocks to help create tailored solutions to this dilemma for our clients.

The cost of liquidity

Cash held by a company is a funded asset. If it isn’t absolutely required for risk mitigation or operational purposes, then it should be viewed as unutilised capital which is being funded by the firm’s debt and equity. With most investment-grade corporates facing a weighted average cost of capital (WACC) in the 7%-10% range and money market returns in the eurozone at about 2%, this means that companies are paying in the order of 5%-8% for the privilege of holding cash on their balance sheet.

Given the level of cash balances with many firms today, this quickly adds up to a significant cost every year with a real EPS impact. And, as cash levels gradually rise over time, a real burden is placed on the company’s operations to work harder to subsidise this burgeoning cost of liquidity just to maintain the previous period’s profitability.

Of course, there are valid reasons for holding cash balances, sometimes even large cash balances. However, by recognising the real cost of liquidity we can see the importance of ensuring that the level held is appropriate for the company given its operational, competitive and risk environment. Furthermore, understanding this cost can incentivise us to actively explore ways to reduce this cost of liquidity for the cash that a firm is required to maintain.

When liquidity is crucial

Core liquidity is required by a company to be able to sustain itself during difficult business circumstances. During these times a firm’s access to external financing (bank debt, and debt and equity capital markets) may be limited or curtailed. Therefore, it is important that this core liquidity is of a magnitude to allow the company to meet its obligations during the period of difficulty. This would include meeting all its operational expenses as well as continuing to service its debt (both interest and principal payments).

Consideration should also be given to the fact that, during this period, put options linked to debt issues may be exercised and banks may choose to withdraw short-term facilities. Furthermore, a certain amount of flexibility will be required to manage certain discrete needs such as unanticipated mandatory capex, R&D requirements (very important for knowledge-based companies), adverse legal judgments or regulatory/fiscal changes. The core liquidity available to cover these needs will include cash, but also short-term cashflow (if positive) and committed, undrawn financing.

Calculating core liquidity

While many of the these core liquidity needs can be readily determined or estimated, the more difficult aspect to calculate is how much is required to cover operational expenses. However, by studying the key drivers of a firm’s cashflow and using statistical methods one can calculate the probability distribution of expected cashflow outcomes over the next relevant period (ie, 12 months). With this, one can estimate, with a degree of certainty, the liquidity required to cover the worst-case cashflow scenario (see chart 1).

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All of this results in an estimation of the core liquidity required for a firm based on its own performance and short-term commitments. However, to finalise this calculation one has to cross-reference the result with the firm’s own experience, as well as the expectations of relevant third parties such as suppliers, customers and investors.

Peer analysis should give some insight into these third party expectations. And, as rating agencies are increasingly opining on a firm’s liquidity, their view should also be considered. Once all of this has been reviewed, a company should have a good foundation upon which to base its determination of its core liquidity needs. Anything above this level should be considered “excess liquidity” (see chart 2).

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Maximising return on core liquidity

Having determined the level of liquidity required by the company, it is not a foregone conclusion that the full 5%-8% cost of liquidity is a necessary evil. There are ways to minimise this cost. An obvious solution is to make use of revolving credit facilities as much as possible such that the full cost of liquidity is only borne on the drawings (and only the much smaller commitment fee is paid for the undrawn amounts). Alternatively, by using some of the best-practice techniques of top portfolio managers, a company can increase the return they receive on their cash balances without taking inappropriate risk or giving up the liquid characteristic of their cash.

By investing in longer-dated instruments, a company can achieve returns superior to money market rates. Of course this strategy usually means that the investor will run the risk of capital losses or lack of liquidity (access to the funds on short notice). However, with some portfolio structuring, these concerns can be amply addressed:

Risk of capital loss: This risk can be mitigated by investing in products with principal protection at maturity. As long as the investment is held to maturity, the issuer guarantees that the investor will at least receive the original investment back. A further mitigant to this concern is to build a portfolio of instruments with different expected yield characteristics and sufficient diversity such that any underperformance in one asset or asset class should be compensated by the performance of another asset or asset class. Portfolio optimising models can be very effective in assisting with this portfolio creation, as well as dynamic re-balancing over the life of the investments.

Optimising programmes can help create portfolios with the desired risk and return characteristics. They can also be used to model and measure the impact of future investment, funding and hedging alternatives on a group’s expected net interest expense.

Risk of liquidity: There are several liquidity features which, when coupled with investments, can ensure that a corporate investor will have access to cash on short notice. These include:

  • investing in products with active market making;
  • stapling a stand-by credit facility to the investment (where the investment is used for collateral and often there is no charge for undrawn amounts); and
  • combining the investment with a committed repo agreement.

The latter two features can also be structured so as to avoid a deemed sale for accounting purposes and thereby avoid any gain or loss on sale of the investment prior to maturity.

Negative pledge and accounting treatment of investments

In order to make use of stapled stand-by facilities and committed repo agreements, an investor will have to make certain that these will not fall foul of existing negative pledge clauses in loan or bond documentation. This will have to be examined on a case-by-case basis; however, depending on how strict the wording is, exceptions of a certain magnitude or for certain assets may be permitted. Some structuring may also be able to avoid any conflict.

Corporate investors will also have to be aware of the full accounting impact of potential investments and bundled liquidity features. ABN AMRO believes that most investments of this nature (used for liquidity purposes) would best be classified as “Available for Sale” under International Accounting Standard 39 (IAS 39) accounting requirements. Under this classification, it is possible for the investor to record mark-to-market changes in value of the investment in either their profit and loss (P&L) or their balance sheet equity accounts.

It should be noted that there may be other ways to treat certain investments which are more suitable for certain companies and the treatment of embedded derivatives will need to be handled in a particular way (which will involve mark-to-market changes going to the P&L).

Liability management

Having identified the core liquidity need and developed a strategy for minimising its cost, the remaining issue in a firm’s liquidity management is what to do with the excess liquidity. Conventional wisdom would be to use the funds to buyback shares or pay a special dividend. While this may make sense in many cases, there is also the alternative of using the funds to buyback or retire existing debt.

As the euro was introduced five years ago, many European corporates now have bond issues that mature between 2005 and 2010. Many issuers are now studying these outstanding debt instruments as potential targets of liability management transactions.

Specific sectors have seen or will likely see more activity in liability management. The telecommunications sector is now generating cash but is still under ratings pressure, while oil, commodity and mining companies are generating significant cash balances.

The telecommunications industry saw large run-ups in its equity market capitalisation from 1999-2001 and increased gross debt outstanding over the same period. As equity market capitalisations collapsed, telco companies’ debt remained outstanding while their projected earnings fell – consequently, their credit ratios worsened. These factors have placed many companies under significant ratings pressure. Since January 2003, Alcatel, AT&T, British Telecom, Ericcson, Orange plc and Royal KPN have executed liability management transactions in Europe.

What is liability management?

Liability management is a set of execution strategies and tools that allow treasurers to better manage their capital structure. The tools enable issuers to execute strategies that effect debt retirement, debt modification, and debt exchange (see chart 3, attached below).

The basic tools of the liability management trade include public tender offers, public exchange offers, consent solicitations/covenant amendment, and discrete open market repurchase.

There are a number of key factors that drive issuers to execute liability management transactions and, typically, issuers are driven to act by a number of key reasons, including: effectively utilising excess cash; addressing ratings concerns (particularly in industries where ratings agencies are not viewing issuers on a net debt basis); reducing refinancing risk; and pre-funding. Finally, there is often a strong economic rationale.

Liability management transactions can offer interesting and effective solutions to particular issuer circumstances. For example, a telco issuer may be currently generating strong free cash flow, but facing significant debt maturities between 2005 and 2008. If this issuer is under ratings pressure, primarily due to shrinking margins and lower projected earnings, it may consider a public tender offer for some of its near-term maturities. This will result in the following important and positive consequences:

  • The ratings agencies will have the confidence that the issuer has proactively devoted some of its excess cash to debt retirement as opposed to potential acquisitions.
  • The issuer has significantly reduced near-term maturities to create significant flexibility in renegotiation of any one-to-three-year bank facility.
  • The issuer has also reduced the ‘negative carry’ of holding excess cash balances invested at LIBOR-flat that can now be invested in its own higher-yielding debt.

An alternate example is of an issuer that has been downgraded from investment grade to below investment grade and is concerned about a maturity spike represented by a security due in 2007. The issuer has reasonably strong cashflows, but is concerned about the potential for a double-dip recession or a potential drop in demand between now and 2007. The issuer can offer to exchange a portion of this note for a new 2014 note that is partially callable.

  • The issuer will have reduced its refinancing risk and exposure to poor economic conditions in 2007.
  • The pre-funding into a callable 10-year note allows the issuer to keep the option to refinance the 10-year earlier in the event that economic conditions improve significantly.
  • The issuer may, however, have to include some high yield covenants in the new issue created from the exchange offer.

Economics

There are a number of ways that issuers can create positive economics through executing a tender offer or exchange offer.

The execution of a tender offer for a high coupon security will create an upfront tax benefit that is higher than the present value of future tax benefits.

The execution of an exchange offer allows the issuer to pre-fund near-term maturities with a medium to longer-term funding and lock in today’s low rates and current attractive spreads. In essence it reduces the issuer’s exposure to near-term volatile rates and credit spreads and reduces refinancing risk.

Liability management strategies are an important tool for treasurers to effectively utilise excess cash balances, improve credit ratios, reduce refinancing risk, and/or extend the average maturity of its debt capital structure.

Rob Boyd is head of European corporate consulting, Financial Markets Advisory at ABN AMRO. Ash Belur is head of liability management, Financial Markets Advisory at ABN AMRO.

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