This article is part of the Assessing Financial Vitality Toolkit, which includes a host of resources that enable board members to take action in ensuring institutional sustainability.
Managing liquidity—a college or university’s ability to access cash quickly or to easily convert assets to cash—is an increasingly crucial component of enterprise risk management. Liquidity risks lurk around nearly every corner—in the endowment portfolio, the debt portfolio, and in working-capital management. It also influences students’ abilities to pay tuition, the federal government’s ability to reimburse research and medical center costs in a timely manner, states’ abilities to support their universities, and donors’ abilities to live up to agreed-upon pledge schedules.
Given its importance to financial stability, managing liquidity is a topic deserving of increased and sustained attention from board members. In fact, within each institution, operating budgets, capital budgets, and balance sheets should be linked together through a singular focus on liquidity.
Such a focus on liquidity or cash flow has often been absent in the past. During a venture capital conference at the Massachusetts Institute of Technology before the dot-com bust, participants wore T-shirts saying, “Cash flow is for wimps.” We can all recall the many amazingly successful IPOs in the late ’90s of companies that had never produced positive cash flow from operations. We can also recall what happened to the NASDAQ when those companies collapsed! A similar mindset may have prevailed at that time at many college and universities, as well.
Today, however, the pendulum seems to be swinging back almost 180 degrees, as many institutions are seeking to reduce their risk and increase their liquidity positions, sometimes dramatically. For example, some boards have instructed their institutions’ treasurers to maintain high operating cash balances; others have called for investing working capital only in U.S. Treasury bills. However they approach it, boards must increasingly pay attention to how their institutions plan and predict cash flow.
Indeed, institutions and their boards should routinely ask: Do cash-flow/liquidity risks lurk in the balance sheet? And where might these risks come from? Does the endowment retain sufficient liquid assets to assure annual payout?
On the liability side, is the bond portfolio potentially subject to refinancing shocks? Do we have sufficient access to cash to meet payroll and pay all obligations in a timely manner at a reasonable cost? And, do we have enough “reserve liquidity” to do so in severely stressed operating environments?
Questions like these expand financial managers’ roles. For example, as budget directors estimate investment returns on current fund balances, they must consider the broader impacts of low cash balances, increasing levels of accounts receivable, potential short-term borrowing needs, and the appropriate sizes of bank letters-of-credit necessary to deal with cash crunches. And budget and finance officers who are aware of liquidity and cash flow must subject their operating estimates of cash-in-versus-cash-out to stress testing.
Liquidity as a Leading Indicator: Recent History
Adequately answering such questions is crucial because many of the recent major financial problems that colleges and universities, as well as the American and world economies, have confronted have originated in the balance-sheet. Indeed, financial writers are increasingly using the term “balance sheet recession” to describe what has more commonly been called the Great Recession.
Before the Great Recession acquired its name, the first inkling that something was awry in the college and university financial world came in 2007 when auction- rate debt markets failed. When that occurred, covenants in many institutions’ debt agreements led to instant and large increases in interest rates, to immediate needs to refinance, or to draws on liquidity facilities like standby letters of credit. Chaos in the auction-rate debt market prevailed for months.
Next came the withdrawal from direct student lending by nearly every commercial bank. This forced a change in working- capital management, as colleges and universities were, at a minimum, forced to carry larger student receivables for longer periods than before.
Blows to the liability side of balance sheets were shortly followed by a meltdown in asset values: Endowments thought to be hedged through diversification lost as much as 30 percent of their value. Colleges and universities had enjoyed the extra returns of an “illiquidity premium” accruing from investing in illiquid assets such as private equity and real estate. But now they faced a host of illiquidity penalties. Some could not sell enough assets to meet payout obligations to their operating budgets. Moreover, cash flows within endowments were also often negative: Cash calls for private-equity investments materially exceeded cash returns from distributions as the initial public offering (IPO) markets were closed.
The compounding effect of unanticipated liquidity problems on both sides of the balance sheet has its origins on many campuses in silo thinking: an endemic lack of attention to potential relationships between financial assets and liabilities—and their implications for annual operating budgets. Indeed, silo thinking is often reified in higher education governance structures where treasurers’ offices are separate from investment offices and board budget and finance committees are separate from investment committees, with audit/risk-management committees separate from them all. Planning assumptions and risk assessments may not pass readily through those silo walls. Contributing further to silo thinking is the common absence of a comprehensive financial-planning model linking the operating budget with balance-sheet planning and forecasting.
Indeed, organizational silos sometimes seemed designed to obfuscate rather than illuminate when, for example, the provost is responsible for the operating budget, the chief financial officer for the liability side of the balance sheet, and the chief investment officer for the asset side—and robust coordinating processes are not in place. Board committees often reflect this same organizational problem.
To optimize their fiduciary roles, boards need to work with their presidents and other senior administrators to break down such silos. They should demand structures and processes that connect the dots in ways that are vital to understanding financial risk.
What We Have Learned: Liquidity as a Focus
One of the more important lessons of the “economic crisis” years—and the precipitating factors are certainly still with us in varying guises—is that all liquidity risks must be managed together. We can no longer treat the different components—the liquidity in the endowment fund investment pool, or the debt portfolio, or the operating budget, for example—as separate and distinct. We can no longer manage the various risks in separate silos as if they are not interconnected.
Boards may, in fact, want to consider one of several models that break down the silos and foster interconnectedness. For example, a number of institutions now manage their treasury operations as a consolidated service provider or “internal bank.” The bank integrates cash-flow management, transactions management, debt-portfolio management, operating-asset management, and risk management into a single cohesive framework. That approach promotes a careful analysis of all the sources and uses of available financial capital, especially their costs (including opportunity costs). An internal bank is also a useful tool for managing liquidity as it brings together cash management, liability management, and non-endowment asset management into a strategic and efficient whole.
Maximizing resources in that way leads to a stronger balance sheet, and a stronger balance sheet improves the institution’s access to the capital markets and can protect prudent levels of liquidity. This approach also demonstrates good stewardship and often results in a lower cost of funds. The internal bank can have an “internal board” that includes at minimum the treasurer, chief investment officer, CFO and budget director to ensure that multiple perspectives are presented and that investment and borrowing choices are mutually understood. The internal bank can invest some portion of the institution’s current fund balances in the endowment as may be warranted through the kinds of liquidity trade-off analyses presented in the box above.
Another strategy is a comprehensive financial-planning model that integrates operating-budget projections with balance-sheet projections. This model exists at only a handful of universities—indeed far too few. Here, along with the usual parameters estimated for operations, one has to focus as well on investment returns, gifts to endowments, capital projects (not just for operations), debt and debt-service requirements for cash flows and project financings, the impacts of receivables, and so on through the balance sheet. Different assumptions based on a comprehensive set of variables can be stress tested, and scenarios, including a doomsday version in which “all correlations turn to one,” can be portrayed, with contingency plans developed accordingly.
Our point is simply this: The development and use of such models forces integrated thinking among virtually all relevant parts of a university. Such models also help board members and other institutional leaders to understand the effects of volatility—apparently here to stay—and potential correlations between input variables. Thus risks can be quantified and assessed, and risk strategies developed.
Still another way to break down the silos within university administration is to create a budget and finance steering committee, which the provost and CFO could co-chair, that brings together all the relevant players—the provost, CFO, CIO, budget director, auditor/risk manager, chief development officer, and others—to jointly develop the operating and capital budgets and oversee development and assessment of financial statements. At the board level, one could establish formally a joint session of key committees—such as budget, finance, investment, and audit—to meet once a year to review and challenge key financial assumptions, the variability around them, and the logic and risk attending the balance being sought among them. The CFO, if his or her role is designed expansively, can provide the necessary linkages among those board committees. Already, in response to the recession, some institutions have established special or ad hoc board committees to develop “liquidity policies” that cut across finance, investment, budget, university relations/development, and even campus planning. From our perspective, if such committees are useful in a crisis, they will be more valuable as a way of life.
Fresh Thinking Required
At one time or another, all of us, including boards, have been captured, perhaps unwittingly, in group-think, in the ways “things have always been done.” Some out-of-thebox thinking and speculative questions can enhance choices and help make sense out of disparate planning inputs.
Some simple guides to fresh thinking:
- Think contingencies, both financial reserves and potential actions. For example, how would you react if historically uncorrelated revenue streams suddenly moved in the same direction?
- Imagine extreme volatility among key variables, and how you might respond.
- Demand comprehensive financial planning models that enable correlation assessments and stress testing of assumptions.
- Engage different minds, change conceptual lenses. For example, ask economists to assess the return and volatility assumptions coming from the finance area. Ask outrageous questions.
- And as investment managers are quantifying the illiquidity premium attaching to certain assets, ask for a calculation of the illiquidity penalty for the portfolio, as well.
While a focus on liquidity is crucial, it’s also important to note that one must not lose sight of strategic objectives. Cash hoarding or focusing singularly on minimizing risks incurs opportunity costs. It can lead to a critical kind of “shortfall” risk: the failure to meet institutional goals.
Thus, while there are costs attending too little liquidity, there are also costs attending too much liquidity. A key role of boards is working explicitly with administrators to find the right balance.
Is Your Institution Aware of Liquidity Risks?
Liquidity risks are often interconnected. For example, issuing variable-rate debt and establishing a commercial paper program can reduce an institution’s weighted average cost of capital. However, this reduction in capital costs is not “free,” as these borrowing structures require that the institution hedge liquidity risk and incur attendant costs in several ways:
- backstop lines of credit (with an explicit cost),
- other liquidity facilities, sometimes from the endowment with potentially high opportunity costs, and
- low-earning reserve cash balances.
One should ask the CFO: Is the reduction in capital costs over the variable-rate borrowing period greater or less than the forgone earnings that could have been achieved if we’d invested the same amount in illiquid assets? Or, put another way, if I am “budgeting” my liquidity risk, where is the better return for taking that risk—in the endowment, in the form of higher expected returns, or in the debt portfolio, in the form of a lower weighted average cost of capital?
This kind of question begins what should be a routine risk/return tradeoff analysis. If it is to be addressed properly, it also requires the chief investment officer to understand and estimate the returns to riskier investments, the treasurer to understand the net returns from a lower cost of capital, the budget director to assess the increases or decreases to cash as a function of annual operations, and senior leadership and the board to make an overall judgment of the university’s overall risk tolerance.
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