Managing Corporate Cash Reserves During Turbulent Times

The economic and market turbulence of 2007 illustrates how a slowdown in profit growth can radically change the level of liquidity and capital preservation corporations require from their cash reserves. Treasurers who experience this situation are often required to adjust their asset mix promptly and liquidate the riskier part of their reserves. This article focuses on non-financial corporations that tend to have more flexibility than banks and insurers in terms of assets permissible in their reserves.

Non-financial corporations accumulated substantial cash reserves between 2003 and mid-2007, as they re-invested only a fraction of the solid profits they generated over that period. Goldman Sachs estimate that, in 2007, the corporate cash reserves held in the US and in Europe reached US$9.4 trillion and US$9.2 trillion, respectively.¹ As cash reserves grew and asset volatility remained low, many treasurers aimed to enhance their returns with some riskier instruments than their core short-duration fixed income allocation. Corporations that included small allocations to below investment grade fixed income, some structured products and some public equities enjoyed very comfortable returns during this period.

However, in the second half of 2007 many corporations started to anticipate that their profit may no longer be sufficient to cover their spending and that they may have to become more dependent on their cash reserves. This prompted many treasurers to require more liquidity and capital preservation from their corporation’s reserves. The challenge that treasurers face is that slowing growth is not only associated with higher risks of running lower cash reserves, it often coincides with a series of other factors that tend to exacerbate corporations’ risk tolerance and need for liquidity. Figure 1 presents these factors that tend to be inter-related and have some implications for reserve management.

Figure 1: Slowing Growth Often Coincides With Many Other Challenges

As profit growth started to lose momentum from the summer of 2007, we believe that the following two factors may have contributed to a higher demand for liquid reserves.

Weaker profit outlook

Corporations that operate in cyclical sectors, such as manufacturing industries and retail, may not be able to rely solely on their profits to finance their capital expenditure and their cash re-distribution to shareholders. Figure 2 shows the non-financial corporate aggregate ratio of cash reserves to total assets that we derive from company data and the Goldman Sachs sell-side research analysts’ forecasts. While the ratio came down slightly in 2007, both in Europe and the US, analysts’ forecasts suggest that it could fall much further as profit growth slows. Therefore we would expect an increasing number of corporations to require high levels of liquidity from their reserves.

Figure 2: Corporate Cash Reserves Could be Significantly Lower in 2008

Source: Compustat, Goldman Sachs sell-side research analysts’ estimates, GSAM calculations

Higher costs of borrowing

We expect corporations to limit their reliance on costly external debt and favour the use of their reserves as a source of financing. We believe that the two factors that we have identified in relation to corporations’ need for liquidity are likely to act simultaneously. As happened during the second half of 2007, credit spreads (or rising borrowing costs) tend to coincide with periods of falling profit growth.

Another challenge that treasurers often face during periods of slowing growth is rising asset volatility. Combined with the demand for more liquid reserves, we believe that some corporations may become more averse to downside risk and may decide to liquidate the more volatile assets in their reserves.

Asset volatility has, since the summer of 2007, significantly risen across the majority of instruments that treasurers generally include in their cash reserves. The sharp rise in volatility during the sub-prime crisis was not confined to mortgage-related securities; it also spread to money markets and currencies.

Chasing the Profit Cycle Appears to Have Some Limitations

During previous downturns, treasurers often held most of the reserves in bank deposits and government bonds. However, we believe there are two reasons why this strategy is no longer appropriate in today’s economic environment:

1. Corporations with large allocations in bank deposits are exposed to significant counterparty risk. Following some recent defaults in the UK and the US,² the market has significantly re-priced the risk of default from financial institutions. Although a survey published in 2006³ showed that European non-financial corporations held on average 60% of their reserves in bank deposits, we believe that the recent market events will prompt many corporations to limit their allocation towards bank deposits. We would also expect treasurers to spread their bank deposits across a larger number of counterparties or diversify across other low risk asset classes, such as short-dated government bonds.
2. We believe that actively adjusting the asset mix of reserves along the profit cycle can introduce up to 20% more risk than running a portfolio with a stable allocation over time. While some treasurers adjust their asset mix over the profit cycle to target higher returns, we believe that they should not underestimate the level of risk associated with this style of reserve management.

We have run Monte Carlo simulations to estimate the level of risk that two illustrative cash reserves would be exposed to. Although both reserves are composed of the same asset classes and have the same allocation to risky assets over the long term, one runs a stable asset mix and the other an adjustable mix.

Our hypothetical cash reserves are composed of two asset classes: cash that is modeled as the effective overnight index average (EONIA⁴) and a risky asset that is represented by public equities (MSCI World Euro hedged). We have defined a rebalancing rule between cash and equities to illustrate the way in which a corporation could decide to adjust its cash reserves over the profit cycle.

Figure 3 shows that reserves managed with adjustable asset mixes tend to run 20% more risk than the portfolios that have stable allocations over the profit cycle. For example, our illustrative reserves that are managed with an adjustable asset mix show a realised volatility of 83bps, gross of tax. This is 20% higher than the realised volatility for the reserves that are run with a stable asset mix. The simulations that we run net of corporate tax⁵ show similar difference in risk between the two styles of reserve management.

Figure 3: Our Variable Asset Mix is 20% More Volatile Than Our Fixed Mix

Source: GSAM

Reserves’ Partitioning May Offer More Stable Allocations

Although one can assume that running cash reserves with a stable asset mix often implies that only low risk and return assets can be regarded as permissible investments, we believe that a portfolio construction framework can help treasurers to find the optimal balance between return, risk and liquidity. This construction framework is based on the partitioning of a corporation’s reserves into portfolios of distinct functions, time horizons, risk and return targets. We envisage four key steps to define the optimal allocation for a corporation’s cash reserves:

Step 1

Partition the reserves into three portfolios (primary, secondary & tertiary liquidity) based on distinct investment objectives, as shown in Figure 4.

Figure 4: Reserves Partitioned into Three Portfolios

Source: GSAM illustration

Step 2

Develop a strategic asset allocation for each portfolio. Once each portfolio’s target tracking error and the universe of permissible assets have been decided upon, an optimiser can be used to find the weights for various asset classes that target the highest level of return for a given level of risk. This exercise would require long-term risk, return and correlation assumptions on each of the portfolio’s asset classes.

Step 3

Stress test portfolios to validate optimal allocations. The recent market turbulence has revived the need to check that optimal portfolios would not deviate too far from their risk target during periods of market turbulence. One possible way of stress testing a portfolio is to simulate its performance over a certain history. The simulated performance is usually derived from historical market values of indices and maintaining the portfolio’s optimal weight constant.

Step 4

Implement each portfolio. The final step consists of identifying investment vehicles to implement the asset allocations that have been defined for each portfolio. The key questions that we believe treasurers typically need to address include:

• Are bank deposits spread across a sufficient number of counterparties?
• How much of the reserves can be managed internally?
• Can the corporation’s treasury department handle the trading of large volumes of short-dated bonds? Could money market funds ease the volume of bonds that are traded internally?
• Should some asset classes be outsourced to a specialist manager?

Conclusion

Many treasurers have in the past few quarters radically changed their reserves’ asset mix as their corporations required more liquidity and capital preservation. We expect the reserves of many corporations today to be solely allocated to short-dated government bonds, bank deposits and some high-quality corporate bonds. Before considering the introduction of riskier assets when market conditions improve, we recommend treasurers to first partition their reserves into portfolios of distinct functions and investment objectives. We believe that this process can help treasurers to better control risk and leave their reserves less exposed to abrupt changes.

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