Investing excess corporate cash.

The investment of corporate cash doesn't always get the attention it deserves. Here are some basics on how to maximize return with little risk.

In the corporate treasury environment, treasury staff managers have responsibility for a number of activities, including, among other things, collections, disbursements, bank relationships, borrowing, and-of course-the investment of excess cash. With the pressure of all of the managers' other responsibilities, the investment of cash often falls to the bottom of the list of priorities, and managers come to rely on securities salespeople or on the investment departments of the banks with which their companies do business.

But, by abdicating responsibility for the investment of excess cash to others, and by not attempting to improve their own knowledge of the techniques and financial instruments that are best suited to such investments, they may expose their companies to loss and their superiors-and themselves-to embarrassment.

The cash cushion:

Excess cash typically refers to a surplus of cash resulting from company operations or the proceeds of the sale of a major asset-in other words, cash that is the product of normal business activity that is being held until it is used to pay down debt or reinvested in a long-term investment. In addition, there are circumstances in which companies find it advisable to maintain a certain amount of excess cash to meet unusual needs, even if they borrow funds regularly through lines of credit at banks or commercial paper or other forms of debt.

A cash cushion is often advisable because a company may not always have access to capital when it needs it. For example, if the company has an opportunity to purchase a large quantity of raw material, a capital asset, or other business opportunity with short notice, it may be difficult to arrange for the additional credit. There are also situations in which revenue falls suddenly as a result of a breakdown in the delivery of the company's product, for example, or problems with a billing system, or a labor dispute. And, if the company's earnings are down or its industry is in disfavor, the treasury manager may not be able to renew or expand credit lines or go into the commercial paper or corporate debt market. Finally, the company that has gone to the top of its borrowing lines or is negotiating to expand them will need a cushion of cash to meet liquidity requirements until the credit is secured.

So excess cash is, in effect, an insurance policy to cover the risk of a liquidity crisis. The cost of this insurance is the lower yield the company earns on the investment of its portfolio in reasonably secure, liquid investments.

Setting investment guidelines:

Each company needs to define the degree of risk it is willing to take in investing excess cash. Some companies invest with the objective of contributing to the company's bottom line, and they are willing to take a reasonable amount of risk to do so. If this is a company's objective, management needs to define exactly what percentage of its principal-5 percent, 10 percent, or more-it is willing to risk. It is often the case, however, that companies that say they want to maximize return are not willing to risk principal. Other companies want to take no risk whatsoever, and prefer to invest in U.S. Treasury securities. And others, which may not appreciate the fact that they can improve yield without sacrificing liquidity, simply leave their excess money in bank accounts.

A practical approach for investing company cash lies between these extremes. The appropriate objective in investing excess cash is to achieve a competitive rate of return with minimum risk and to have the money available when it is needed. The company should define its investment objectives, and the approach it will take to achieve them, in a written investment policy and set of guidelines.

The major concern in investing excess cash is the maturity of the investments. The maturity date of any investment should be determined by the date on which the cash will be needed. In deciding on the appropriate maturities, the investor must bear in mind that the longer the maturity, the greater the exposure to a loss of principal should the instrument have to be sold at a time interest rates are higher than they were when the instrument was purchased. obviously, the longer the maturity and the higher the move in interest rates, the greater the loss.

The company's need for liquidity determines the choice of both the maturity and the instrument; yield is a lesser concern. So the investor needs to know what instruments are available at what yield and with what liquidity.

Selecting investment maturities:

Depending upon the size of the company, the amount of excess cash it has, and the need it anticipates for the cash in the future, the manager will want to invest in instruments that mature at different times. The manager may choose to invest a small portion of the total investment pool in a short maturity to meet an immediate need for funds. The treasury department will need to determine the amount to be invested in short maturities. Some large investment portfolios have longer-term investments to achieve a higher rate of return, and maintain only a small portion of their total investments for immediate, unforeseen cash needs.

Once the treasury department has established the company's need for liquidity, the investor should begin with an analysis of the yield curves of the various instruments available (the yield curve is the rate of return for various maturities). Longer maturities should carry a higher rate of return because, as mentioned above, they will decline faster in price than those with shorter maturities if interest rates move higher. It is often difficult to separate analysis of yield curves from speculation on interest rates, but to the extent possible, the investor should avoid making investment decisions based on interest rate forecasts. The purpose of maintaining liquidity is to have funds readily available when they are needed, not to support speculation in interest rates. Having to liquidate a portfolio at a loss of capital is hard to defend.

The objective of active portfolio management is to obtain the best relative value. Let us say, for example, the investor has invested in certificates of deposit, which yielded a higher return at the time they were purchased than did commercial paper. But if commercial paper has since become "cheap," and has begun to produce a higher yield than the CDs, the investor will sell the CDs and buy commercial paper. By so doing, the investor uses yield spreads to enhance yield without increasing risk.

The investor can also move on the yield curve to look for higher yielding maturities. Let's say you have an investment with a 90-day maturity, but the yield curve has changed so that yields have become sharply higher at six months than was the case when you bought the investment. You can sell your 90-day maturity and buy the six-month maturity in what is called an extension swap-extending the maturity-and pick up an additional margin of yield. Of course, when you extend maturities you should bear in mind when the funds will be needed.

Interest-bearing securities are the mainstay of the corporate excess cash portfolio. The prices of equities in general are too volatile to be reliable investments for short-term cash needs. The one exception is preferred stocks, which generally pay high dividends. Because dividends are entitled to a substantial exclusion from federal income taxes, these investments have a relatively high net after-tax return to the corporate investor. Further, variations in certain types of preferred stocks provide some immunity to fluctuations in market price and therefore put them in the category of interest-bearing securities, even though they do not have a specific maturity.

Money market mutual funds may be attractive to the investor who has a small pool of invested funds. These funds typically are invested in short maturities-less than 60 days-so their asset values remain constant and their yields are acceptable. But because management charges for money market funds range up to 0.7 percent, they are likely to be too expensive for the large investor. Companies with portfolios of $15 million or more may find it more efficient to manage their investments internally or to hire a money manager, from whom they will get personalized service, tailored reports, and a specific investment approach.

In assessing the different instruments, the investor must be well aware of the risk of default for each obligation. The most common way to protect against default or credit risk is to retain the services of credit review organizations that, for a fee, will provide you with credit ratings on the organizations that issue debt instruments to help you assess the default risk on the instruments you purchase.

Buying investment expertise:

Several options are available to the company that wants to improve its investment expertise. The least expensive option, of course, is to encourage those responsible for investing in corporate cash to enroll in one of the many educational programs provided by a number of different organizations. Although this option is inexpensive, sending the investment staff to such courses is time-consuming, and the company may not get the results it wants. Management may choose instead to bring in a consultant to train the staff, establish investment guidelines, tell them what credit services to use, what software, and so on.

Finally, the company may decide to hire a full-time investment manager, who would take responsibility for investing excess cash in coordination with the company's needs and guidelines. The investment management firm should give management periodic reports that provide a complete description of the instruments purchased, credit ratings, yield calculations, and perhaps accounting information, such as interest accruals, amortization, and accretion.

Outside money managers can be expensive. They typically charge from 0. 15 percent to 0.40 percent of the dollars managed, depending on the amount of money involved and the type of portfolio. But credit review services, analytical databases, reporting software, training, and other necessary investment services are not inexpensive, and management should be certain to include the costs of these services in deciding how to improve investment capabilities.

Investment services:

A number of excellent investment services are available. But because these services can be costly-and because they require considerable skill to be used effectively-they typically are appropriate only for the larger portfolios-those with $50 million or more.

Subscription financial data services give the corporate investor access to market prices and other data essential to the analysis of the relative values of the different instruments and yield curves. These services may cost between $600 and $1,500 a month. But with such a service, an experienced investor can fine-tune an investment decision and get a very competitive execution price.

Experienced corporate investors also need systems that give them the capability to compute yields quickly and accurately and to put into a single yield formula a number of different instruments-treasuries, government agencies, corporates, bank obligations, taxable equivalent yields for tax-exempt securities-in such a way that they are truly comparable.

Other data bases and software packages are also available that give the corporate investor the capability of doing "what-if" calculations: "What will happen to the portfolio if I buy such-and-such an instrument and interest rates go up-or down-by certain amounts?" Because systems are available to meet the needs of investors with varying skills, the system selected should match the level of sophistication of those who will use it.

Nothing is easy:

As is the case in any program, time and effort must be spent in finding the approach that best meets your company's needs and objectives. But in a time of increasing complexity of financial instruments and deteriorating profit margins, companies cannot afford to overlook opportunities for enhancing investment yield and minimizing risk of loss through well-informed, effective investment of excess cash.

Alan G. Seidner, who beads his own investment management and consulting firm in Pasadena, California, is a well-published author and lecturer on investing and related financial subjects. His article is based on an interview conducted by Financial Management Network.