The Cash Investment Policy Statement (IPS)

by Britta Hion, Director, Head of International Corporate Cash Sales, BlackRock

The management and control of surplus cash is a critical treasury department function. The Cash Investment Policy Statement (IPS) allows a company’s board of directors to understand and define how surplus cash is managed, and delegate written authority allowing a treasury department to invest a company’s cash on a daily basis. For corporate treasurers who have yet to establish or have not recently evaluated their existing cash investment policies, now is the time.

What is an IPS?

An IPS is a document designed to identify the goals and objectives for a company’s investment portfolio(s), as well as allowable parameters for achieving those goals. Having a documented policy for the administration of the company’s cash is among the most effective means of risk management, serving as a clear and constant reminder of the firm’s goals and ability to tolerate risk. We believe the IPS should be part of every firm’s risk management protocol, incorporated into an annual board review process (typically by the audit committee) and updated on a regular basis.

In short, an effective IPS provides a means for communicating the objectives for and permitted level of risk in a company’s cash portfolio. The IPS should provide guidelines for those responsible for management of the company’s cash, whether that is an internal or external manager.

Getting started

Before developing an IPS, it is important to conduct a thorough evaluation of the company’s cash needs and to pinpoint its risk profile. Effective forecasting of liquidity needs and assessment of risk tolerance allows for the best opportunity to achieve excess returns within a cash portfolio.

It is important to assess company priorities. To that end, ask the questions: what is the general course of the company and where is cash likely to be deployed (e.g., toward acquisitions, to fund operations or more likely toward capital expenditures)? Of equal importance is obtaining a good understanding of the company’s outlook, taking into account the organisation’s view of the economy and the industry in which it functions. When constructing a cash portfolio, it is important to understand how and when the company may potentially need cash. Forward knowledge of a cash need—be it months, weeks or just days ahead—can have a beneficial impact on expected returns.

From there, treasury and finance staff are better equipped to judge the overall makeup of the company’s cash, a central concept that every corporate treasurer needs to understand when developing an IPS. In fairly simplistic terms, a company’s cash can fall into three distinct categories:

• Operating cash, working capital required to meet daily needs of the business.
• Core cash, which is generally earmarked for unknown future needs of the company.
• Strategic cash, the stable balance sheet assets not intended for specific expenditures. While still conservative by nature, strategic cash—which typically has a longer time horizon than operating cash or core cash—might have more of a total return objective.

Important considerations

Each company’s cash investment policy will be as unique as the company itself and a firm’s specific situation will dictate the policy constraints and benchmark for the cash portfolio.

While a company’s investment policy ultimately will be customised, there are several important factors that all corporations should take into account when developing a policy.

Risk tolerance

Risk tolerance is arguably the most important criterion upon which to begin building a cash investment policy. As a first step, company management must determine if the key priority is preservation of capital or maximisation of returns. As a next step, consider whether, within each category above, there is an ability to weather any deterioration in liquidity.

Risk can come in many forms—for example, short-term volatility, technical pressures (supply/demand) or headline risk, to name a few. The impact on the company’s cash portfolio can differ based on the ability to navigate these variables.[[[PAGE]]]

Portfolio objective

Based on the company’s risk tolerance, market views and liquidity needs, corporate treasurers are faced with the task of establishing objectives for their companies’ cash portfolios. A portfolio objective can be quantitative (e.g., seek returns that exceed a defined market hurdle) or qualitative (e.g., focus on safety and liquidity).

This is not to say that a corporation must establish a single objective for the management of its cash. In fact, as stated earlier, multiple objectives are often warranted. Ultimately, these objectives will guide portfolio construction and help the company to appropriately divide its cash assets into operating, core and strategic buckets. Following are some common examples of cash portfolio objectives:

• Preserve principal
• Meet forecasted cash flow needs
• Provide income/yield
• Provide tax-advantaged returns
• Deliver prudent, risk-managed total return
• Seek above-benchmark returns

Ideally, the portfolio objective(s) also should address the question of duration, specifically indicating whether duration should be actively adjusted to remain within a stated range or whether a buy-and-hold strategy is preferred. Typically, targeting a specific duration is better suited to a total return objective, while buy and hold is more often associated with capital preservation.

Of final note, when establishing an objective for cash accounts, consider the accounting associated with capital gains and losses and the tax implications when gains are realised.

Benchmark

A benchmark offers a means for comparing and measuring portfolio performance and risk. Importantly, a performance target is not a benchmark. While a cash portfolio may seek to match the return of a specific industry or peer group average, such as those for money market mutual funds, that alone does not constitute a benchmark. Generally speaking, every benchmark should be transparent and measurable, meaning it should be comprised of well-defined securities with readily available prices quoted on a daily basis. By definition, a benchmark must exhibit a certain level of comparability with the portfolio’s makeup (in terms of type of securities held, asset allocation and duration) in order to effectively convey risk.

Considering the impact of your liquidity and risk objectives relative to the benchmark is an essential part of evaluating performance. In most cases, a blended benchmark containing elements that closely resemble the cash portfolio’s expected allocation may be beneficial. This allows you to better match those portions of the portfolio that are intended to be more liquid.

Investment manager

When it comes to choosing an investment manager for a company’s cash accounts, there are generally two broad models—manage the assets internally with the firm’s own staff or hire an external investment advisor. The level of service provided under each arrangement can be quite different, as can the costs.

An external management model generally involves engaging with a professional investment management firm which has the authority to participate in the creation, execution and maintenance of the company’s cash investment policy. By definition, investment managers serve as fiduciaries for their corporate cash clients.[[[PAGE]]]

The question of duration

Every IPS should factor in the desired duration strategy for the company’s cash portfolio. Most often, this will be a choice between targeting a specific duration or a buy-and-hold approach:

• Target duration. For a longer-dated portfolio, a total return strategy measured against an appropriate benchmark is the best tool for measuring the effectiveness of the investment strategy, serving to accurately evaluate both the principal value and income portions of performance.
• Buy and hold. A buy-and-hold strategy is usually more appropriate for a capital preservation or short-dated portfolio, or one that is subject to liquidity requirements. Buy-and-hold strategies traditionally are yield-focused and do not have the gain/loss considerations of an actively managed portfolio.

Investment management: making the right choice for your company

Corporate treasurers might consider the following points to assist in making a well-informed decision regarding the most appropriate type of management for their company’s cash accounts:

• Goals. Is the company ready to move beyond money market mutual funds? The ability to move beyond money funds offers the potential for excess returns for those institutions that are willing and able to take that next step.
• Personnel considerations. Take stock of in-house expertise for cash management, including whether employees have experience managing cash assets, time to do so and what the opportunity costs might be.
• Trading partnerships. Consider whether the company itself or an outside cash investment manager has trading relationships that will allow for diversified opportunities, and more bargaining power, in the cash space.
• Support services. Managing cash is a multifaceted, complex activity that requires proper technology and support services (compliance, trading, valuation models, market data, accounting and reconciliation) to achieve optimal results. Ensure that the company or the external cash manager has access to these capabilities.

Conclusion

The importance of a well-documented and up-to-date cash investment policy cannot be overstated. The IPS serves as a critical roadmap for companies and the investment managers charged with navigating today’s increasingly complex cash and fixed income markets. By ensuring that all parties understand and observe the same objectives and guidelines, the IPS paves the way for successful administration of the company’s cash. For assistance with your company’s cash IPS or to learn more, contact your BlackRock® representative.