Establishing Proper Due Diligence for Liquidity Investment
by Kathleen Hughes, Head of Global Liquidity EMEA, J.P. Morgan Asset Management
All funds are not the same
Over the past decade, money market funds have gained significant ground across Europe as a flexible, secure and rewarding alternative to bank deposits. Over the last five years alone, annual net inflows have averaged EUR52bn a year, with uptake dominated by financial institutions, corporates, sovereign wealth funds and pensions (source: iMoneyNet, 30 April 2009).
During this period of growth, money market funds have – like deposits themselves – largely been treated as a commodity. Yield has often been viewed as the key differentiator, followed by a fund’s credit rating. Beyond this, little attention has been generally paid to the internal mechanics of funds or the institutions that manage them.
But as recent events in credit markets have shown, all liquidity funds - even AAA-rated ones - are not built the same. Factors such as what a fund invests in, how it is constructed and who it is managed by, have been shown to have a real and significant impact on the performance, liquidity and security of investor capital.
Credit rating agency Moody’s reports that, in the US, 36 money market funds registered under SEC Rule 2a-7 had to be supported by their sponsors in 2007/08 to avoid their net asset value (NAV) falling below USD 1/share as the value of certain underlying investments were wiped out.
Whatever the size of an organisation, every company needs an up-to-date investment policy governing its cash investments.
Such interventions are extreme and rare, but they have been sufficient for many corporations to reassess how and where their cash is invested and the processes and policies they have in place to govern these investments.
In this article we are going to outline the practical steps that organisations can take to help ensure that clear and fully-understood parameters are in place to safeguard the security of cash investments – particularly those held in third-party money market funds – while still enabling the benefits of active cash management to be fully realised.
Creating a cash governance framework
On reviewing their cash investments, some companies are discovering two things: first, there is no consistent and documented policy across the firm as to how it should be investing its cash. Second, the process for policing cash investments may be found to be inadequate.
For organisations that find themselves in this position, there are two key actions that need to be implemented as swiftly as possible:
First, an investment policy needs to be developed that clearly and fully documents the acceptable parameters of all cash investments – both direct investment in individual securities and indirect investment via pooled money market funds.
Second, a rigorous and systematic due diligence process needs to be enforced to identify money market funds that comply with the investment policy and are able to deliver the levels of security and liquidity expected by the firm.
We will outline what these two elements should each entail, and while these activities are likely to be led by a company’s treasury function (and investment committee, if it has one), it is strongly recommended that the chief finance officer and other board members take a high-profile and active involvement to help ensure a firm-wide commitment to the principles and steps agreed. [[[PAGE]]]
Establishing an investment policy
Whatever the size of an organisation, every company needs an up-to-date investment policy governing its cash investments for the following reasons:
Ensures consistent approach
- Corporate cash objectives can quickly change. A well-stated investment policy provides essential guidance regardless of market conditions.
Provides internal clarity
- A documented investment policy allows everyone from the treasury analyst to the board of directors to share a common and clear understanding of the organisation’s objectives and permissible investments.
Imposes transparency over liabilities
- An investment policy also provides firms with the increasingly necessary financial transparency regarding corporate liabilities and serves as a mechanism for internal control.
Research in the US suggests that eight out of 10 companies already have an investment policy relating to liquidity investment (source: Treasury Strategies: 2006 Corporate Liquidity Study). But language within these documents has often been found to be vague or even contradictory and doesn’t adequately address relevant market risks – thereby leaving a company vulnerable to unknown and unwanted investment exposures.
Components of the investment policy
Within the Global Liquidity Team at J.P. Morgan Asset Management, we are encouraging our clients to ensure that they have a robust investment policy for their cash investments and that they conduct due diligence on their investment managers.
As mentioned above, an investment policy should be used to lay down parameters for all cash investments whether direct securities or managed liquidity funds. We do not have the space to go into depth into every component that an investment policy should comprise.
However, following are some of the key areas that should be considered for inclusion:
- Policy scope
First and foremost, the policy needs to stipulate who and what within the company structure will be covered by the policy. This will provide a robust and scalable policy that will continue to provide the appropriate coverage, even as a company expands and develops new entities.
- Roles and responsibilities
To ensure that an investment policy is properly enforced, it is vital to identify each position involved in the investment process and the responsibilities that role entails.
- Objectives
This section should clearly state the company’s objectives when investing its cash, e.g. necessary level of liquidity, required safety/preservation of capital and the desired investment return objectives - and how the company intends to meet each of these objectives.
- Benchmarks
An appropriate benchmark is essential to enable all parties involved in the investment process to maintain sight of the company’s investment goals and to assess the success of the chosen investment strategy in meeting those goals.
- Permissible investments
This section needs to define each type of security that will be permitted in the portfolio. It is important to incorporate a high level of specificity into the policy to safeguard against unwanted exposures, particularly where third-party managed funds are being used. The policy should also address minimum credit ratings and maximum maturity of investments. [[[PAGE]]]
Other areas to address might include acceptable levels of realised gains and losses in the portfolio; the level of liquidity that needs to be maintained day-to-day for the business; plus processes for reporting and custody, and evaluation of and compliance with the policy.
The managers who have come through recent events most successfully tend to be those who have invested heavily in thier own porprietary credit analysis.
The list above may seem like a great many areas to address, but in fact an effective investment policy will be highly concise and specific.
The services of your asset manager or investment adviser with specific liquidity expertise may be of value when drafting the policy. They can also provide a useful external angle on what your company’s investment objectives should entail and how they can be achieved.
An investment policy is primarily an internal document, but it should be an integral part of any discussions with investment consultants and fund managers on investment strategy – which brings us to the second plank in the cash governance framework.
Due diligence for money market funds
Wherever third-party investment management is being used, it is essential to ensure it aligns completely with your own organisation’s investment parameters and risk tolerances (as stated in the investment policy).
But due diligence for money market funds is about more than simply assessing that a fund matches your specified limits on credit ratings, duration, security type and so on. Funds and their managers also need to be assessed closely to ensure as far as possible that the expertise and mechanics are in place to ensure that capital preservation and liquidity is maintained, whatever the external pressures on the fund.
As with “risk assets” such as pension equity funds, the due diligence process for money market funds should ideally involve a formal Request for Proposal (RFP), inviting managers to detail the mechanics of their process and their own capabilities and resources as a cash manager.
Areas to address include:
1. The strength, commitment and record of the fund sponsor
Where money market funds are looking to maintain stable net asset value, it is essential that they are backed by an organisation with the strength, stability and commitment to assure this. Perhaps more than any other asset class, money market funds demand detailed scrutiny of the sponsor’s current and historic financial position. It is also important to ascertain how long a firm has been involved in the money market fund sector and what proportion of their overall business and assets it represents.
2. The strength and track record of the credit analysis/investment process
The managers who have come through recent events most successfully tend to be those who have invested heavily in their own proprietary credit analysis. Extensive questions should be asked about the structure, experience and resources of the credit team. The last two years will, in fact, have served as a stern test of the robustness of a firm’s credit analysis capabilities and any RFP should request details of any security downgrades or security buy-outs that have taken place.
3. Levels of liquidity, investor concentration and access
A striking feature of events in money market funds in late 2008 was the speed at which certain funds in the US (and some in Europe) lost liquidity as credit spreads deteriorated and outflows accelerated. A fund can only assure daily liquidity if it has the scale of assets and level of investor diversification to honour redemptions of any size at any time. It is therefore essential to assess: the size of the specific fund in which assets are to be held (don’t just obtain a figure for a firm’s total money market assets); the level of client diversification within the fund; and the fund’s internal policy on shareholder concentration limits. Questions should also be asked about how much of the fund is invested in overnight securities and whether the manager has ever restricted withdrawals from the fund or been required to inject liquidity.
These are only a few areas that should be addressed as part of the due diligence process. Prospective investors will also want to assess a fund’s risk monitoring and security selection process, its policy on repo investment, its administration processes and its yield.
This depth of questioning is something quite new for the money market fund sector, but your asset manager should be rising to the challenge and taking steps to provide investors with transparent and comprehensive information about their funds, processes and resources.
Indeed, an asset manager’s ability to provide this depth and granularity of information swiftly and willingly can, in itself, be a fair indicator of their commitment to the money market fund sector and their investors. [[[PAGE]]]
IMMFA – a gold standard for Europe
European investors also have another valuable safeguard in the form of IMMFA-standard funds. Formed in 2000, the Institutional Money Market Funds Association (IMMFA) aims to enforce the highest standards of quality, security and service provision for investors.
In 2002, IMMFA introduced a code of practice to establish - for the first time - a European-wide standard of best practice comparable to the SEC Rule 2a-7 used to regulate money market funds in the US.
To be recognised as an IMMFA-standard fund, a money market fund must be AAA-rated by the major credit-rating agencies. In addition, the fund and its manager must adhere to a comprehensive Code of Practice with stipulations including:
- A weighted average maturity of no more than 60 days
- Same-day liquidity with no redemption penalties
- A legal entity separate from the asset manager to hold the funds
- Weekly monitoring of deviations between amortised and market value of underlying assets
As of early 2009, more than 30 asset managers across Europe are IMMFA members. Moreover, the IMMFA standard has swiftly gained currency among European investors: inflows into IMMFA-standard funds rose 29% between 31 August 2007 and 31 December 2008, compared to just 4% among non-IMMFA money market funds.
Conclusion
Even in the wake of the extraordinary events in credit markets in the second half of 2008, it is clear that demand for money market funds has not abated. Indeed as investors have become more risk-averse and interest rates have fallen, fund inflows have increased.
Research also suggests there has been a significant flight to quality among cash investors. In the J.P. Morgan Global Cash Management Survey, for example, the proportion of liquidity clients requiring a triple-A rating for pooled funds rose from 35% in 2007 to 50% in 2008.
We believe this marks a fundamental shift among cash investors, with the investment focus moving from yield to quality. By establishing a clear and relevant investment policy, investing in a robust due diligence process and subscribing to rigorous industry standards, such as those set by IMMFA, corporate treasurers and other investors are well placed to achieve and maintain the security, liquidity and risk-adjusted performance they require from their cash investments.
But due diligence should not be a one-off response to extraordinary market events. Even when market conditions normalise, it must be an ongoing process where the parameters for investment are regularly reviewed and updated to keep pace with the evolving needs and objectives of the organisation.
