Friday, 4 March 2016

Liquidity in context III

Yesterday I talked about bottom up asset liquidity.  Today I shall continue reviewing the various forms of words which appear in discussions of liquidity.

Liquidity mismatch.
Think of a firm's need for cash as a demand curve.  And its ability to get its hands on cash as a supply curve.  A liquidity mismatch occurs when this set of curves are out of sync.

I shall give two made up examples - an industrial goods manufacturer and a multi-strategy hedge fund.  First the industrial goods company.

The company already has a number of loans, bonds, convertibles outstanding with a number of market participants.  It also has operating cash and holds a number of near-cash securities.  On top of all of this, it has a set of assets and new projects and ongoing projects.  These ongoing projects deliver cash flows into the organisation.  The expected magnitude and timing of these cash-flows is an ongoing estimation problem for the CFO.  It is also a function of the economy generally, of sales, of a broad range of conditions, in other words.

Meanwhile its financial liabilities (those loans and bonds) have a mostly very clear timeline of coupon payments and repayment dates.  It is, of course, part of the CFO's job to manage all of this, but they are operating in an uncertain world.  Projects may bleed, they may fail catastrophically.  Macro-economic disaster might befall the economy.  What resources does the firm have to draw on to meet those more-or-less well known short term cash demands?

Side note.  The need for cash doesn't in general need to be short term, but that is clearly the most pressing end of the timeline.  The immediate future is the period which most rapidly becomes 'now' and 'now' is when a creditor may declare its dissatisfaction with the borrowing firm.

The firm has cash and cash equivalents.  Some of this is considered operating cash - money in the till, to use a shop-keeping analogy.  This cash in a sense needs to be there for the smooth operation of the day to day business of the firm.  But in an emergency this might be considered a pot to be raided.  If the company is prudent, it will also have cash and near cash reserves (certificates of deposit, short term sovereign securities).  A very conservative company might chose to have enough cash in these reserves to pay the next n months, but of course, the n months will pass, and that pot needs to be replenished.  The pot itself is depleted only in exceptional circumstances.  The downside of having too big a pot of cash and cash equivalents is that it is capital sitting earning not much more than a risk free return.  And firms have as a goal the desire to produce a return on equity in excess of the risk free rate.  Otherwise why would an investor invest in a firm in the first place?

So, assuming a new demand for cash materialised, where else might the firm look?  Perhaps new loans or new bonds.  Perhaps a rights issue (a request from current and potential equity investors to give the company cash in return for ultimate fractional ownership in the company).  Perhaps cost savings.  Perhaps the shuttering of certain projects, with concomitant staff reductions.  Perhaps the sale of certain assets in the market - plant, financial securities.  Perhaps the monetisation of some fraction of its asset base.  But as you can imagine, all these options take time, and perhaps some mark down on sale prices - after all, the market might perceive the firm as executing a fire sale, so might be tempted to offer fire-sale prices.

This misalignment of (potentially immediate, potentially short term) demands for cash with (somewhat longer term) supply is what is known as a liquidity mismatch.  

If you think about it, to say that a firm is experiencing a liquidity problem in the first place is to identify a more or less dramatic liquidity mismatch.  So in a sense most liquidity problems are liquidity mismatch problems, and the word liquidity can often be considered as a synonym for a liquidity mismatch problem.

In case 2, the multi-strategy hedge fund, there is a little stub of a management company managing a potentially much larger pool of investments on behalf of investors.  The management firm itself, often a partnership, received equity investment by founding partners, who are said to have committed their cash for the long(-ish)term.  It will have well understood staffing costs and fixed costs.  In some ways, the investment management firm is a bit like 'head office' for a large goods manufacturer, but without the regional factories, offices, large staff, input supply chains, etc.  So the cash flows of the management firm are somewhat clearer.  Also those management firms might have loans but they won't typically be as well developed as with non-financial firms.  For multi-strategy hedge funds, the 'work' happens in the collection of financial assets and liabilities within its fund(s).  These investors in the fund can be flighty, and prime brokers can also adjust the generosity of their leverage terms.  Both of these create the possibility of a liquidity demand.  The fund manager only has the set of assets and liabilities in the fund to supply this needed cash.  So for them asset liquidity modelling and funding liquidity are important, as are a full incorporation of the set of firm constraints on liquidity scenarios.  And where it is unrealistic to fully model the constraints, to approximate them very conservatively.

Despite the seeming differences, both firms managing the possibility of liquidity mismatch are doing the same thing, namely being continually responsive to the balance between demands for cash with sources of cash.

In the next posting I look at the variance (and vol. of vol.) on the demand side of the 'liquidity mismatch' risk which firms of all kinds face.