As the stock market continues its volatile trend and media highlight stories of institutional investors and banks taking heavy losses from subprime fallout, the venture debt market has, thus far, weathered the storm and remains largely unaffected. This healthy market in fact, is enjoying positive growth as companies continue to leverage their expensive equity funding with less dilutive debt financing. The current abundance of liquidity in VC (venture capital) funds, a resilient IPO market, and strong Merger and Acquisition (M&A) activity (which is at its highest level since the dot-com era), has enabled greater availability of venture debt.
The recent success of IPOs and M&As has increased liquidity in the capital markets, thus creating a robust venture debt market that enables VC-backed companies to increase their leverage and extend their cash runways. M&A activity has raised $28.4 billion year-to-date and $10.5 billion in the last quarter alone, marking a 31% increase from the same quarter last year1. VC financing continues to increase as firms invest and support companies in areas such as life sciences, technology and energy. With close to $23 billion invested through Q3 2007, compared to $20 billion through this time last year, VC funding is on pace to be at the highest level in the past six years2. In fact, VC funding reached over $8 billion in the last quarter, which marks the highest level of funding since the first quarter of 2001.
VC backed companies are also enjoying an abundance of liquidity due to the growing IPO market that has raised $4.7 billion already this year. The IPO market raised $2.7 billion in the second quarter of 2007 alone compared to $1.3 billion in Q2 2006, representing a 107% increase in just one year3. A director of global research at DowJones VentureOne referred to the amount raised by the M&A and IPO as, “[virtually guaranteeing] that 2007 will be the largest year for venture-backed liquidity – both in terms of IPOs and M&As – in the U.S. since the dot-com boom4.” The venture debt market benefits from this increase in liquidity because more VC money translates to more financing options for these firms in the debt markets.
VC funding continues to increase per round as investors exhibit increased confidence in their portfolio companies. The median deal size of money invested per round reached $8 million by the end of Q2 2007, the highest level in over three years, which shows the willingness of investors to infuse more funds into the market5. An Ernst and Young director reports, “The overall level of investment and larger deal sizes are suggestive of a continued bullish view of these companies’ prospects and liquidity options6.” With the median deal size for each round increasing, companies are leveraging their cash positions with debt financing in order to reach important milestones and inflection points. The current market conditions make it an opportune time for VC-backed firms to layer debt into their capital structures and strengthen their cash position to enhance growth strategies. With larger average equity deal sizes, companies are obtaining more funds in the venture debt market and growing their business more cost effectively than by utilizing the more expensive alternative: additional equity. With the availability of debt, companies that need to raise funds are looking for an optimum combination of venture debt and equity. Supplementing an equity round with venture debt can help to preserve ownership, as the equity kickers used in debt financing are far less dilutive than in equity raises.
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Liquidity
Reflecting On the 2007 Money Fund Debacle
Executive Summary
The concurrent use of commingled and separate accounts may help in
optimizing corporate cash management.
In corporate cash management, separate account management has a
limited following – about 20% vs. 76% in money funds and 22% in
other funds.
Six Advantages of Separately Managed Accounts:
- Tailored Risk Management
- Transparency
- Higher Return Potential
- Free from “Hot Money”
- Income and Capital Gains Management
- Versatile Reporting
Investments in time and research in a separate account relationship may bring just rewards in times of uncertainty.
Introduction
One of the lessons gleaned from the 2007 subprime credit crunch by corporate treasurers may be that money market funds, despite their appearance of safety and liquidity, are not completely without credit risk. In addition to disclosure of exotic commercial paper investments in several large money fundsi, supposedly conservative “yield-plus” and “ultra-short” funds suffered reported losses of as much as 37%. This evoked more uneasiness among treasury professionals who routinely use such commingled investment vehicles as mainstay cash management toolsii.
Whether to use a commingled asset pool like a mutual fund or an investment manager in a separate account format is an age-old debate among investors in different disciplines. Few would dispute the benefits of a constant $1 share price and the daily liquidity offered by an SEC-regulated money market fund today; however, an investor in a separate account with specific investment guidelines might have avoided the recent collateral damage from some of the poorly conceived investment strategies in commingled vehicles. Frustration from the inability to assess and remedy undesirable credit exposures in a fund by the individual investor was perhaps more agonizing than the severity of actual credit risks.
The recent growth of web-based portals took the popularity of fund investing to a new level. The events of the past summer, however, brought the argument for separate account management back to the front-burner for many corporate investors. In this paper, we point to a number of advantages of a separately managed account (SMA) relationship to further this discussion. We believe that the right answer is not an “either-or” decision, but rather the simultaneous use of both strategies in optimizing cash management solutions for the corporate investor.
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Liquidity Management Top Ten: Fine Tuning Cash Portfolios
Executive Summary
Few financial executives have a firm grasp of what liquidity means in a portfolio of individual cash assets.
The two main criteria in measuring liquidity are: 1. how long it takes to convert an asset to cash, and 2. how much of a price “haircut” must be taken on the sale.
The Top 10 Liquidity Factors may provide useful tools during the security selection process.
Additionaly, investors may benefit from the Six Steps to Better Liquidity in portfolio construction decisions.
While no one can pinpoint when the next market liquidity event may occur, portfolio liquidity management in times of smooth sailing is certainly within the control of the cash investor.
Financial executives often consider liquidity as a major investment objective for their excess cash accounts. Few, however, have a firm grasp of what liquidity means beyond daily access to a money market fund. This is especially so in a portfolio of individual cash assets. As the Federal Reserve aggressively mops up excess liquidity from the financial system, now could be a good time to fine tune liquidity in your portfolio.
What is Liquidity and how to Measure Liquidity?
Liquidity can be different things in different situations. This article addresses a portfolio of supposedly liquid investments that a typical treasury account may keep for planned and unanticipated cash needs.
With marketable cash investments, liquidity generally means how easily and quickly one may exchange a security for cash with little price concession from its going rate. Using this definition, cash currency and demand deposits at financial institutions are certainly liquid. How, then, does one discern other types of cash assets?
The two main criteria in measuring liquidity are: 1). how long it takes to convert an asset to cash, and 2). how much of a price “haircut” must be taken on the sale. Sellers of Treasury bills and corporate commercial paper with Prime-1 credit ratings often can receive cash payments on the date of the transaction, and at a price very close to the dealer-quoted price. By contrast, a bank certificate of deposit usually does not qualify as a liquid asset. An investor either waits until the CD’s maturity date to withdraw funds, or pays a substantial penalty for early withdrawal. The liquidity of other cash instruments falls somewhere in between.
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Demystifying Asset-Backed Commercial Paper: Opportunities, Risks and Practical Considerations
Executive Summary
ABCP can be a good investment choice in large corporate treasury accounts due to the depth, liquidity, flexibility, and yield potential of the asset class.
ABCP gained popularity recently because increased event risk of corporate names resulted in concern about unsecured commercial paper.
A potential investor of ABCP should carefully review the strength of the sponsor bank, external support, program type, and asset collateral quality prior to investing.
The wide range of risks among different programs requires specialized credit knowledge and regular asset collateral monitoring to minimize risk.
Introduction
Created in the mid-1980s, asset-backed commercial paper (ABCP) trailed its term asset-backed securities (ABS) cousin in acceptance by fixed income investors, especially corporate cash managers. The stigma against ABCP started to change in the new millennium, when event risk of corporate names caused the unsecured commercial paper market to shrink dramatically.
Meanwhile, the increased demand by institutional investors for ABCP resulted in the proliferation of innovative ABCP structures that made it more difficult for buyers to discern the risks associated with newer programs. Many corporate cash investment policies still take a conservative stance on ABCP as eligible securities, even though well over half of the high-grade commercial paper market is ABCP.
Without delving too much into technical details, we will provide a brief introduction to ABCP, highlight some of the common advantages and risks of the traditional programs, and provide a practical guide for ABCP risk assessment. We believe ABCP are legitimate investment vehicles in large corporate treasury accounts due to the depth, liquidity, flexibility, and yield potential of the market. We also think that the wide range of risks among programs requires dedicated credit expertise and regular asset collateral monitoring when investing in ABCP.
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Treading Merck-y Waters: How to Cope with Event Risk?
On the day Merck announced the withdrawal of its arthritis drug Vioxx, its stock price closed down 27% from the previous day. By the time Moody’s downgraded Merck’s debt to Aa2 40 days later, the formerly AAA-rated company had lost 42%, or $58 billion of its equity value.
Is it time for investors of short-duration corporate securities to head for the exit on Merck? How does one prevent against Merck-like incidents in the future? These are but a few examples of the lingering questions from our corporate treasurer clients regarding their cash portfolios.
Merck’s fall from grace highlights the need to address event risk — a risk that inundates even the most experienced risk managers throughout credit cycles. Here, we offer some perspectives on dealing with this type of risk for corporate cash investors.
What is Event Risk?
Event risk refers to the risk of a severe and sudden loss in a security’s value due to an unexpected event. Such events may include corporate takeovers, operational errors and accounting fraud, stock market crashes, major regulatory changes, terrorism, and natural disasters.
Event risks can be either company-specific or industry-wide. Merck’s drug liability case represents a company-specific risk, while asbestos and tobacco litigations are industry-wide. Credit events can occur any where at any time. Fannie Mae, American International Group, and Shell Oil Company are some of the other AAA-rated companies that have subjected their investors to event risk in 2004.
Characteristics of Event Risk
It is important to be cognizant of the characteristics of event risk to appreciate its potential impact on a portfolio. It can be difficult to predict, frequently causes a liquidity crunch or even crisis, and often results in market contagion.
Difficult to predict: By definition, event risk refers to the occurrence of an adverse corporate or market event that catches the investor by surprise. Either by natural occurrence, such as a major hurricane, or by human design, such as the WorldCom fraud case, credit events often do not provide a clue ahead of their outbreak. When the market is focused on a certain type of event risk, it tends to correct itself until a different type of event risk shows up elsewhere.
Liquidity crunch: Liquidity problems from event risk are two-fold: inability to sell current holdings and reduced credit quality from the credit’s lack of funding. Unlike stocks, which are traded on exchanges, broker-dealers sell bonds “over-the-counter.” In volatile market conditions, liquidity often dries up, thanks to a lack the of interest by broker-dealers to “make a market.” In extreme cases, an investor may not be able to sell a security at all.
A credit event can also trigger a cash flow crisis that shut down an issuer’s funding channels, further reducing its credit quality. Finance companies are particularly vulnerable to liquidity crunches, as they finance major portions of their balance sheets with commercial paper and notes so as to support loan balances and to rollover old debt.
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