March 31, 2008

Turbulent Credit Markets Require Carefully Crafted Cash Management Policies

The well-publicized volatility in the U.S. credit markets has caused many companies (as well as the investors in those companies) to turn their attention to the preparation and adoption of their cash management and investment policies. Although on occasion relegated to an afterthought by busy chief financial officers and boards of directors, the advisability of prudent investment policies has become increasingly clear in recent months.

Today, the creditworthiness of even the largest financial institutions has come into question as a result of their investments in sub-prime mortgages, leveraged loans and various derivatives. Likewise, many cash management investments offering enhanced yield have been exposed as illiquid and risky investments. For example, investments in illiquid auction-rate securities have in recent months made it harder for many companies to access their cash for short-term needs without suffering substantial losses.

These issues are of particular concern to start-up and development-stage companies, which typically need to raise and maintain significant pools of capital in order to fund current expenditures, usually in anticipation of commercial operations. Of course, the issue is just as relevant to the venture capital, private equity and other institutions that invest in these companies. These institutions understandably will demand that their growth capital is appropriately preserved and invested.

With these issues in mind, the time is now to reconsider best practices with regard to the establishment and maintenance of cash management and investment policies.

First, make sure you have an investment policy, and periodically review the policy for discussion with and approval by the board of directors.

Companies that have not yet adopted a formal investment policy should do so immediately. Companies that have previously adopted an investment policy should carefully review it, ideally in consultation with the company’s outside financial advisors, to ensure that it appropriately addresses the current financial objectives of the company. In particular, investment policies should be carefully tailored to appropriately balance the trade-off between the preservation of capital and return, and this trade-off will likely be informed by the financial health of the company and its business as well as the relative volatility of the credit markets; in fact for most emerging companies safety of principal and liquidity (i.e., the ability to turn short-term investments into cash) will trump yield as paramount factors. Investment policies should be periodically reviewed by management, then discussed with and approved by the board of directors, or a committee thereof. In addition, financial officers should be mindful of the parameters of the investment policy, and ensure that any modifications to the policy are appropriately communicated and approved by the board prior to implementation. The investment policy should also be communicated with the company’s outside financial advisors, to better ensure that investment decisions are made in accordance with the policy.

In addition, it should be noted that careful consideration and adoption of an investment policy can be an important factor in avoiding inadvertently falling within the definition of an “investment company” and thereby becoming subject to the regulatory regime of the Investment Company Act of 1940 (the “1940 Act”). This issue is of particular concern to many development-stage technology and life science companies for which a significant portion of their tangible assets are comprised of cash and cash equivalents. Companies for which research and development expense constitutes a substantial percentage of their total expenses are expressly exempt under current 1940 Act rules, provided that the board of directors has adopted a written investment policy with respect to capital preservation investments, among other requirements.

The adoption of an investment policy is also of particular concern to venture capital and private equity investors in the context of a financing transaction. These transactions typically result in a substantial cash infusion to relatively nascent organizations, often pre-revenue and thinly staffed, and thus prudent preservation of capital is of paramount importance. Investors should consider including in their standard financing documents a closing condition requiring that the portfolio company adopt an approved form of investment policy in connection with the financing, rather than waiting for the matter to be discussed at a future board meeting (if at all), as well as a covenant that the proceeds be invested in accordance with the policy. In addition, increased volatility and uncertainty in the credit markets might encourage venture capital and private equity investors to consider making more tranched (that is, time- or milestone-based) investments, as a way to mitigate against the loss of capital.

Remember that no cash investment is 100% risk-free, and the promise of increased returns will inevitably require the assumption of additional risk.

It goes without saying that no cash investment is 100% risk free, and investment decisions are inevitably made in accordance with the risk/reward objectives of the particular investor. For venture-backed start-ups, capital presentation and liquidity should be the paramount objectives. In this regard, not all money market funds are created equal, and confusion in this area is common. The practice point here is to make sure you fully understand the nature of the investment decisions you make.

  • Government Securities. Of course, investments made directly in securities issued or directly guaranteed as to principal and interest by the U.S. government are generally viewed as the safest investment from the standpoint of credit risk. Investments in securities issued or guaranteed by government-sponsored agencies are also generally regarded as safe investments, although the degree of safety depends on the agency and whether the agency or the government is guarantying principal, interest or neither. Agency securities are also sometimes less liquid than government securities. In light of the different safety and liquidity profile of agency securities, these sometimes trade at higher yields than treasury securities.
  • Money Market Deposit Accounts. Investments in interest-earning savings accounts or money market deposit accounts (MMDAs) issued by qualifying institutions are insured by the Federal Deposit Insurance Corporation (FDIC), but only up to $100,000 per institution.
  • Money Market Mutual Funds. Money market mutual funds (MMMFs) are not insured by the FDIC, however these are organized pursuant to Rule 2a-7 of the 1940 Act, which imposes conditions that govern the credit quality, diversification and maturity of the fund’s investments. MMMFs typically invest in government securities, certificates of deposits, commercial paper and other highly liquid and relatively low-risk securities, and are required by law to maintain at least 95% of the fund’s assets in “first tier” (the approximate equivalent of AA or AAA-rated) securities. Also, MMMFs attempt to keep their net asset value (NAV) at a constant $1.00 per share – only the yield goes up and down – and, although an MMMF reserves the right to “break a buck” and cause the per share NAV to fluctuate, this has occurred only rarely. MMMFs generally do not hold asset-backed securities like auction-rate securities (ARSs) in any significant amount.
  • “Money Market-Like” or “Enhanced” Funds. Not all money market funds are organized under Rule 2a-7 and these funds are not subject to the market-risk limitations described above. These funds, often referred to as “enhanced yield,” “money market-like,” or “money market plus” products, generally seek yields higher than those of MMMFs. The issuers of these funds seek to achieve those yields through investments in securities that are not only higher yield, but also likely to be higher risk than the securities that make up the majority of the portfolio of an MMMF.

In light of the above, consider whether a simple deposit account is adequate for your needs, particularly if cash is being used to fund current operations over the near term. For larger pools of capital, or for companies that generate sufficient cash to fund current operations, a diversified approach, including some or all of the options described above may be more appropriate. Financial officers should understand the risks and benefits of the securities or financial instruments in which their companies invest and not rely entirely on outside financial advisers.

Look carefully at the final maturity and marketability/liquidity profile of your investments.

In making investment decisions, close attention should be paid to the actual stated maturities of purchased securities, in order to match those maturities with your expected cash requirements. Relative marketability and liquidity of purchased securities are also important factors. Most investment policies cover both considerations.

For example, in recent months, illiquid debt instruments called auction-rate securities have gained notoriety by virtue of a near-complete collapse of the auctions for these securities. Auction rate securities are typically long-term corporate or municipal bonds for which the interest rate is periodically reset through a series of auctions managed by broker-dealers. With interest rates low, many companies invested in these securities in search of higher returns. Although in most cases the ultimate risk of default for these securities is low, failed auctions have resulted in significant concerns regarding short-term liquidity. Indeed, we are aware of some development-stage companies that have been forced to actually borrow against these securities as collateral, in some cases from the very institutions that recommended these investments in the first instance. It is important to keep in mind that generally securities with higher returns involve some degree of higher risk.

Remember that the financial institutions themselves also present risk.

As the recent downfall of financial institutions ranging from the high-flying online banking firm NetBank to blue-chip institutions like Bear Stearns & Co. makes clear, the long-term financial viability of the financial institution with which you place your money also presents risk. Accordingly, careful consideration should be given to which institution or institutions are engaged. Many investment policies include financial institution credit quality requirements, for example requiring that the subject financial institutions maintain minimum long-term unsecured debt and/or certificate of deposit credit ratings by corporate credit rating organizations such as Moody’s or Standard & Poors. In some cases, diversification among more than one financial institution may be advisable. It should be noted that some financial lenders, especially venture lenders, require that borrowers maintain an operating account with that institution, as a way of mitigating risk by facilitating their rights to set off. Such arrangements should be carefully considered in light of borrower’s investment policy.

Get good advice, and remember that broker-dealers generally work on commission.

Especially as investment decisions become more complex, consideration should be given to the quality of your financial advisors and the manner in which they are compensated. Investments made through registered broker-dealers may be subject to commission (or, in the case of fixed income securities, spreads), which has the potential to influence the advice given and/or the desirability of the trade. In some cases, particularly where large pools of capital are invested, it may be advisable to retain the services of a registered investment advisor or bank trust department. A registered investment advisor who manages $25 million or more in client assets generally must register with the Securities and Exchange Commission (SEC) and a bank trust department is subject to regulation and oversight by one of the banking agencies at a state or federal level. Investment advisors, whether registered or not, have an explicit fiduciary duty to their clients which brokers generally do not. The real advantages to establishing a fiduciary relationship with your financial advisor are transparency with respect to risk and accountability with respect to performance. Indeed, some investment policies require that investments be managed by qualified third-party advisors and that investment performance be measured against benchmarks, with regular reporting and commentary.

Finally, note that these issues arise in connection with exits as well.

It should be noted that prudent investment management is not only a concern for operating companies. Many private M&A exits require that a portion of the proceeds be escrowed for a year or more after closing. Too often, little if any attention is paid to the investment criteria for those proceeds or even the credit-worthiness of the escrow agent. For the reasons described above, these arrangements should be closely scrutinized. In addition, the sellers’ representative should have the ability to move the proceeds to another institution if credit concerns about the escrow agent arise after closing.