PART 4 OF A SUSTAINING HIGHER ED BLOG SERIES
Sustaining Higher Ed is a monthly blog dedicated to helping college administrators and board trustees lead their organizations toward greater financial stability so they can stay on mission during challenging times.
Our prior posts in the Liquidity in Higher Education series provided key cash terminology, measures, and metrics for discussion with stakeholders along with advice for developing financial models to project cash. In this post, the last of our series, we address the question, “How much of my financial assets can be invested in securities that have a higher expected return than cash?”
The issue here, of course, is that as cash is invested, an institution incurs more risk that cash will not be available when it is needed; you can’t pay vendors, bondholders, and employees with certificates of deposit or stocks. Two types of risk are of primary concern for an institution that needs to convert an investment back into cash:
- Market value: the risk that a security will lose value
- Access: the risk that a security cannot be converted to cash when the cash is needed
We recommend the following steps to arrive at an investment structure that optimally balances these risks against the expectation of higher returns:
- Define expectations: Establish baseline financial and capital plan and assess financial health and debt capacity (as described in the second and third posts in this series).
- Assess risk position: Quantify your major risks and the steps available to mitigate them.
- Build an enterprise risk map to inventory and assess cash inflow and outflow risk. The map should include not only risk to planned or scheduled cash flows, but also risk to unplanned or contingent cash flows such as unionization or peer behavior.
- Derive unhedged or net risk map to identify dedicated offsets (e.g., LOC, insurance, swap collateral posting thresholds, asset/liability hedging structures) and management interventions (e.g., expense reductions, fund-balance utilization and gift-on-hand policies, transfer students, prospective asset sales).
- Quantify the net risk that requires a liquidity backstop along with the associated time horizon for the risks. We recommend at least two time horizons: short-term (less than 1 year) and intermediate-term (more than 1 year but less than 4 years). Institutions may elect to use more horizons or different durations for the horizons.
- Align net risk requirements with tiered investment portfolios: Establish investment portfolios that align the horizon (or “tier”) with underlying securities. For example, the short-term portfolio (Tier 1) should be invested in securities that can accommodate net-risk volatility identified within, say, one year. As a “hedge of last resort,” this portfolio should assume little market value risk and be comprised primarily of certificates of deposit or other fixed income securities with duration of less than one year. Investments in Tier I, which includes the operating account, should be structured so maturities align with anticipated troughs in the operating account. The intermediate-term portfolio (Tier 2) could, depending on institutional risk tolerance, accept more market value risk and potentially include an allocation to publicly traded securities such as common stock. We recommend that virtually no access risk should be tolerated for reserves devoted to net risk, whether short- or intermediate-term. The balance of available financial assets not required for the short- and intermediate-term portfolios can be invested in the institution’s long-term portfolio and thereby assume some access risk and more market-value risk.
The table below provides an example for an institution that has $340 million of available cash and investments (excluding the long-term portfolio). The institution estimates $185 million is required to manage the institution’s net risk, which leaves about $155 million that could be invested in the longer-term portfolio. If the size of the Tier 1 and 2 portfolios exceeded available cash and investments, the institution would need to reallocate some of its long-term investments (excluding true endowment) to the short- and intermediate-term portfolios.
It is critical that institutions think holistically about cash flow across investment, debt, operations, fundraising, capital expenditure, and other balance sheet assets/liabilities. Each has substantial cash flows and a distinct risk profile that can only be optimized if viewed in a single, integrated liquidity framework. In the end, vendors, employees, bond holders, and money managers don’t care where within the institution their dollar comes from so long as they receive their dollar when it is due. Likewise, effective assessment of risk and structuring of investment portfolios will require active collaboration between an institution’s Treasurer and Chief Investment Officer.
Finally, institutions should actively maintain their risk profile as plans advance and circumstances change. Benchmarking with other institutions has limited value here, since every institution’s risk profile is unique and will vary depending on things like portion of sponsored research that is federal, student demand, maturity of the investment portfolio, debt structure (demand debt, swaps, covenants), dependence on fundraising, internal bank depositor and designated fund balance policies, planned capital projects, and several other items.
Through an integrated and holistic approach to managing cash-flow risk, institutions can effectively hedge exposures with tiered investment portfolios. In many cases, institutions may discover they can augment resources by investing excess cash in longer-term securities.