By Joseph Quinn, Director of Liquidity and Cash, Hazeltree
Shifts in economic realities over the last 12 to 18 months have pushed private fund managers to rethink their liquidity and cash management strategies. What may have once been an afterthought, cash management has now become a key competency for leadership teams entrusted with protecting the overall long-term health of their firms.
The convergence of two trends in particular is driving this change in mindset. The first is the rapidly rising interest rate environment. With the Federal Reserve’s latest rate hike in July 2023, the U.S. is facing its highest interest rates in more than two decades. Companies in all sectors are quickly becoming attuned to what they’re earning on their cash – and concerned about the cost of their floating rate debt.
The second is the continued fallout from the regional banking crisis, which put holistic treasury management planning, including the diversification of liquidity sources, at the top of the priority list for many fund sponsors seeking to reduce risk.
Current market conditions are pushing private fund managers to hone in on their cash management practices with many resorting to strategies more commonly used by their corporate counterparts. One approach being pursued by private fund firms is putting idle cash to work in money market funds, which has the dual benefit of earning a yield from cash holdings in addition to mitigating concentration risk.
Anecdotally, we’ve seen an increase in the number of our private fund clients that are re-evaluating their banking relationships and examining capabilities that can help them mitigate risk while putting excess liquidity to work.
MMFs are particularly attractive because they generate yield on idle cash and are highly liquid, suiting the needs of a private fund treasurer. They have an investment manager selecting the securities that are purchased by the MMF and assets are held in a custodial account for the benefit of the shareholders. MMFs charge a standard investment management fee and deduct other expenses from the overall pool of assets. These expenses generally range from 15 to 20 basis points per annum on the institutional class of shares.
In the elevated rate environment, yields on MMFs can represent a significant boost to balance sheets. As of August 8, 2023, the average yield on 100 of the largest money market funds tracked by Crane data was around 5.13%, the highest level since 2007.
New regulatory developments, such as the SEC reforms finalized in July 2023, should further serve to strengthen the MMF market. The reforms, finalized in July 2023, increased liquidity requirements for funds, making them better equipped to handle large redemptions. The new rules also removed the requirement for a fee or gate (i.e., a suspension of redemptions) that was linked to a fund’s liquidity levels. This will reduce the investors impetus to redeem when the liquidity levels of a fund dip.
In addition, a Reverse Distribution Mechanism (RDM) has been introduced, allowing for a share cancellation in the event there is a negative interest rate environment. This helps preserve the operational efficiency of funds by allowing the funds to continue to trade at a price of $1.00 while accounting for a negative rate by reducing shares.
Firms that are looking to expand their cash management practices to include strategies such as leveraging money market funds need to consider if their treasury operations systems are robust enough to keep up with the demands of running an efficient cash management program to maximize benefits.
A private fund CFO may already have to keep track of a complex web of banking relationships, counterparties, investor commitments, credit facilities, legal entities, and more. This has become even more difficult with additional diversification after the regional banking crisis which motivated CFOs and treasurers to be much more focused on mitigating counterparty risk while also having access to their liquidity. Coupled with a broader decline in exits and in fundraising across the private equity landscape, it’s easy to see how the path has been paved for cash management’s rise on the list of priorities.
Implementing a more robust cash management strategy as part of overall treasury management requires careful planning and the right tools. For example, the ideal platform can provide a fully automated sweep process that seamlessly connects bank, custodian and broker dealer accounts with yield-enhancing MMFs.
The benefits of such a platform are two-fold. The first is significant gains in efficiency. With holistic and technology-driven cash management practices in place, firms can automatically direct excess cash into the firm’s preferred MMFs or bank accounts and streamline cash withdrawals with the goals of mitigating risk and maximizing return and wallet share built in. The second is improved risk management. Outdated processes for keeping track of cash balances are ripe for counterparty and operational risk, underscoring the importance of technology as a risk mitigation tool.
In addition to the automation capabilities, having visibility across the treasury function is key for setting any new strategy in motion. However, the reality today is that many private market CFOs and treasurers are still navigating dozens of spreadsheets and banking portals to get a read on their cash balances, counterparty exposure, collateral requirements, and margin calls on a daily basis. Many lack an easy snapshot of their cash balances and requirements in a centralized, easy-to-navigate location. For example, having a view of the different money market funds your cash is invested in is useful for a CFO to easily gauge sources of liquidity and make better, more strategic decisions.
Perhaps no internal process is as fundamental to private funds operations as the cash lifecycle, which encompasses moving incoming investor cash contributions to outgoing cash for investments to investment realization and cash distributions back to investors. In between these steps, there are fund expenses and management fees, with cash flows following legal entity chains and complicated allocation matrices. And yet, this function was an afterthought for many firms for the past two decades when cash was cheap.
Today’s environment is pushing many firms to take a step back and evaluate their cash management programs as part of an overall strategy to profit from current market conditions. Adding tools to a treasury department’s arsenal, like the ability to easily and efficiently invest in MMFs, is more critical than ever.
