Why Managing Liquidity Risk Proactively is Always a Good Idea

On this podcast we discuss the importance of proactive liquidity risk management planning for small- to medium-sized companies and dive into details including due diligence, stress testing and proper structuring of an associated policy framework. 

Transcript

Copy Transcript Copied

Steve Katz  0:10  
Hi, everybody, and thanks for taking time out of your busy schedule to listen in on our Hilco global smarter perspective podcasts. As return listeners know, I'm your host, Steve Katz. And if this is your first time joining us, welcome, we're glad you could tune in today. And today, we're going to be joined by Rob Wilson, who's Senior Director at Hilco performance solutions. And we're going to be talking about the gamble of sorts that small to medium sized companies take when they have no liquidity risk management plan in place, particularly during a time of economic uncertainty, like the one we're going through right now. So Rob, welcome to the podcast.

Rob Wilson  0:49  
Hey, thanks for having me, Steve. Looking forward to the conversation.

Steve Katz  0:52  
Yeah, as us as well. So, you know, universally speaking, Rob, having a plan in place is usually a good thing under any circumstances. But it seems to me that having a plan in place to manage liquidity risk is always a good thing for businesses, and particularly well advised now as we wrap up, what's been a really challenging year for many and enter the next year, which could it seems, bring a lot more of the same? So would you say that's a pretty accurate perspective on the way that businesses should be looking at their liquidity risk moving ahead?

Rob Wilson  1:29  
Yeah, no, that's, that's definitely accurate. You know, just just, if you think about the last 15 years alone, and kind of how many of the proverbial 100 year floods that we've seen, right, you know, we saw the great recession of, Oh, 809. And Brexit happened. And then obviously, the last few years have been COVID, the COVID pandemic, right. And so, you know, volatility is all around us. And I would say that the last year and two in particular, you've seen, like the supply chain disruptions, the record inflation, the Fed is hiking, at really a record pace, you know, it's, it's all types of issues going on around us, right. And so, all of this really impacts, you know, liquidity for a company, right, its ability to operate. And so, yes, it's very important to have a plan in place. And I think volatility is here to stay, it's not going anywhere, it's really about making sure you stay ahead of it. So I think, unfortunately, many companies, you know, don't really think about liquidity until they actually need it. And again, I'm hoping the last two years really have a wake up call for many companies. But, you know, many companies really focused on just running the business trying to grow, right, which is hard enough, let alone trying to think about liquidity risk, what can happen X years down the road, right. And so I think the companies that are really proactive, and think ahead and have a plan are the ones that really thrive in this environment, I think the ones that are really more reactive, are the ones that continue to struggle, or in some cases, unfortunately, could even go out of business, right. And so I kind of view it similar to you know, people's personal situations, right? If you think about, you know, you never know, when that car is gonna break down the basements gonna flood, you never know, when there's gonna be an unforeseen medical expense. Right. And so, having a plan for the unforeseen event is very important.

Steve Katz  3:18  
Yeah, you know, I think you hit on a good point there. I mean, this, the business of managing the business is a lot of work. And that's really where people's priorities need to be focused. But at the same time, you have to be able to safeguard against that type of risk. So what sorts of steps can companies take towards developing a liquidity risk strategy? Right now? And what's the best way to go about that?

Rob Wilson  3:44  
Yeah, no, I mean, I really think it just comes down at a high level, just just thinking about the drivers that impact your business. Right. And so, you know, for me, I come from the mortgage sector, right. And so interest rates are really one of those key components that we used to track a lot, right. And if you think about interest rates in the last year, in particular, how high that got and you know, it has a significant impact on future originations, profitability, etc. On the manufacturing side, and manufacturing companies, you know, they might care more about raw materials, right, or their access to certain raw materials to be able to produce their final goods. You know, for instance, if oil goes up by 40%, like how does that impact your business? Right? So really thinking about those critical drivers, and how they impact your business? And then I think from there, you think about Alright, well, how do I quantify that right? And so we kind of help out with thinking about stress scenarios, right? So if one of these events happens, how does it impact like my company's cash flow, profitability? You know, what can I do to mitigate that right? So what are some of the things I can do now to mitigate that outside of having a plan? Maybe there's you know, hedging, you could do in the case of like, you know, raw materials go up, you know, such as oil and chemicals, right. And so, or you might be able to diversify. If some of your products, right, so if you have highly concentrated products, maybe you can diversify to different products, different industries that are maybe not as correlated to the same risk, right. And so that's also something that you'll folks should be thinking about. And then I think one of the more important ones, too, is, is really developing, you know, KPIs and dashboards around these drivers. Right? And how do I, you know, think about reviewing them and communicating them across the company, right? I think that's, that's one of the most important things is like, you can have a lot of good information and data analysis. But if you don't communicate it, across the company, to the people that really matter. None of it really matters, right? In terms of like this. And so you got to make sure you have good communication, good reporting. And I think finally, just like making sure you have the appropriate systems and controls in place to really track these risks and impacts right across the enterprise. Right. So because, again, without proper framework, and proper reporting, and communication, none of the analysis really matters.

Steve Katz  6:05  
And it's interesting, because I think a lot of businesses either don't have that level of discipline, or we're just historically haven't been great communicators, or been great keepers of, of their own policy guidelines. So that's, I think that's a really good insight. Thanks for sharing those. Yeah, the other. The other thing is, I'm sure there's, I'm sure there's much more to what you're talking about. So so we're from that point, once you start looking at things that way, and you begin to structure and organize your thinking, where, where should companies go from there?

Rob Wilson  6:47  
Yeah, so they've got to just maybe just talk about some of the things that we do we let our clients you know, here at Hilco performance solutions, you know, so we work with our clients, we really think about some of the blind spots and drivers of risk in organizations, right. And so it's not only identifying them, but also thinking about the likelihood of that event and also the severity of the event. Right, those are also very important in terms of thinking about a risk framework. And then I think what we really do is to start out, we look at a company's, you know, funding plan, to really get a better idea of, you know, factors such as how much committed capacity a company has, we look at the strength and diversity of the bank relationships, you know, maturity profile, how much debt is going to be due this year versus not next, and one of the bigger ones is financial covenants, right. And I think that's one that's very important to highlight. So I mean, for those of you don't really don't know what financial covenants, it's really a lenders way of putting guardrails on the loan that they they gave you in to protect their downside risk, right. And these are things such as, you know, leverage, so like debt to equity debt to EBIT, da, minimum liquidity, minimum capital type standard, right. And so, just making sure that you've negotiated the proper levels of financial covenants with your lenders is something that we would work with our clients on, it's super important, because again, if one of those stress elements happens, or oil goes up, 40%, if you don't have enough cushion within your business model, to be able to hear those financial covenants, you could be in a situation where one of these stress events put you over the top, and you violate the financial covenants. And why that's important is because in some cases, if you violate the financial covenants, the lender will end up pulling their lending to you, right. And so that's obviously not a good situation, in many cases leads to some type of restructuring or bankruptcy type activity, which is always a bad thing. So I think also, you know, you'd be surprised how many companies out there, especially the small and mid sized ones that we typically work with, don't truly know how much cash they need to run their business, right? So they may have rule of thumbs and might say, hey, the last five years, we've always used $10 million as our minimum cash balance. But, you know, we really work with the company to understand what is the quantitative approach to that number, right. And so based upon quantitative drivers, not just rules of thumb, we also make sure that those are updated on a frequent basis, not something that sits static for years, right, and obviously will adjust those numbers based upon the business in the market as well. And so I think that's super important. And then within that, you know, how much cash do I need, versus contingent liquidity when I see why contingent liquidity, this is stuff like credit facilities, revolvers, maybe even having access to some of the capital markets and stuff of that nature. You'll holding too much cash actually can be a bad thing, right? And so I think getting the right level of cash is very important. Too much cash, you're in situations where maybe you're taking away from the growth of the business or you're not returning capital back to investors. And so coming up with the right level of cash is something that we help our clients with as well. Really also understanding you know, the difference capital markets to have access to whether it's the bond markets, the securitization markets, you know, commercial paper type markets and really understanding those and thinking about, you know, that market had the spreads widen, you know, in the secured market have delinquencies increase, or the bit more charge offs. And so it's really understanding not only your hard liquidity in terms of the cash, credit facilities, etc, but also you have access to some of those capital markets, solutions that you might need, during a stress type of events. I think that's very important as well. And then finally, one of the things we work with our clients on too, is thinking about counterparty risk, right. And so, you know, thinking about the financial strength of their key suppliers, customers, their lenders, you know, you never want to be in a situation where, when your key suppliers all sudden, is unable to ship critical raw materials or resources, which you've already seen a lot of in the last year or two, or a situation where maybe a lender decides to pull away from that sector for for various reasons, right. And so you're coming up with a way to provide surveillance on the financial health, and reputational health, each of these companies is very important. So you're tracking things such as like credit ratings, you know, CDS spreads, which is kind of a good real time indicator of the health of the company stock price. And also to stay in tune in terms of reputational concerns going out with the with your key Counterparty. So, so see if those are these are some of the things again, there's a whole there's a whole bunch of others, but these are some of the core things that we work your clients on, we start thinking about liquidity risk framework.

Steve Katz  11:38  
Yeah. So, you know, as you're talking about that, I was thinking to myself, well, some companies might say to themselves, hey, you know, I wish I had that problem with too much cash. But yeah, and you know, and you have to think about, you have to think about things from a holistic perspective. And obviously, that can create problems in and of itself. So this, you know, the way you're explaining it, it's, it's clear that this is a very thorough and systematic process that needs to be undertaken. And obviously, that's, would you and the team at cocoa performance solutions specialize in once the policy framework that you talked about, as outlined, what's the next step that usually undertake with companies?

Rob Wilson  12:26  
Yeah, it's really putting it to use, right. And I think that will, that will vary from company to company to sector to sector, but you're running the stress scenarios, on a frequent basis, many, many times, it's quarterly, developing reporting rights to alert your key stakeholders of any early warning signs of risk. You know, for example, if you're coming close to violating financial covenant, which we talked about whether earlier, or if you have any concerns, you are the key counterparties. Right. And so really, you know, developing that reporting cadence, you know, when are you reviewing the reporting, and the stress scenarios with your senior leadership is also super critical. I see a lot of companies that might go through this exercise, and they just put it on the shelf, and they might not update it frequently. Or if they do update it, they're not getting it to the critical people. So coming up with the infrastructure of the review cadence, who is it going to, you know, how often is it going to be reviewed type of thing is super important. You know, a lot of the companies that I've worked with in the past, you typically would develop some type of monthly or quarterly liquidity risk review deck, with your key executives, like the CFO, treasurer, controller types, and even bringing in some of the key leaders across the business units as well, right to make sure that there's awareness there. And so, again, it's really all about that awareness and communication, making sure that all parts of the company really know what's going on. Here as an example, my prior company I worked at, during the early part of COVID, we actually were meeting daily to discuss liquidity. And again, it's the at the very highest levels all the way up to CEO, right. And so it's really, when I say putting this framework into use, it's going to it's going to vary based upon the company, but also the market in general, right, really part of COVID, obviously, a lot of uncertainty. So you have very frequent meetings, a lot of awareness spread throughout the organization. If it's more normal course, maybe it's more of a monthly or quarterly review that you have with your key senior leadership. But the point is that you have that in place you're reviewing and you're communicating. And finally, you're also updating that policy, right. So as you learn more about the risk of the company, and how you can address it, making sure that you do update your liquidity risk policy, at least on an annual basis. And then finally, I want to underscore really the importance of having a granular cash forecast, right, I think this is really foundational for really any good liquidity risk plan, right? And so, you know, we're not talking about you Seeing a simple percentage of sales or run rates, it's really getting very granular and understanding, you know what those true true true drivers are of cash and making sure that you have the most accurate cash forecast? You can because we because guess what, if you don't have a really good base cash forecasts, how well do you think your stress scenarios and your sensitivity analysis are going to be right? And so having a very good foundational cash forecast is super important as you develop a really good liquidity risk framework.

Steve Katz  15:30  
And the forecasting piece of it makes me think about the lenders, because I think we can all agree lenders don't like surprises, right? So what thoughts do you have on work, you know, these companies, and how they can best work with their lenders and things that lenders should be thinking about when working with these companies? And looking at these liquidity risks?

Rob Wilson  15:54  
You know, it's a great question. And, you know, I've been fortunate to work with many great lenders, you know, all across the globe, and billions of dollars worth of liquidity and funding. And so I think the consistent theme is that, you know, lenders want to be kept informed, right? They want to know what's going on. And so, I think, you know, really making it a habit to give them frequent updates on your business. And not just when it's required on the annual due diligence basis is super important, right? And so, you know, if you anticipate a material impact on the business, let them know, you know, better yet, ask them if they can help out with providing additional liquidity or support expertise, many times they have good thought leadership in terms of how to solve certain problems. And then And then most importantly, you know, show them, what is your plan to kind of stabilize the business? How to get the business back on track? How are you going to shore up liquidity, right? I think all that super important. Sounds basic, but many companies don't do that. They typically, that I've seen in my experiences, they typically don't say anything until it's too late, or to tell the events actually occurred. I think by being proactive, and given the business updates, and kind of bring it under the tent, per se, I think it really helps to develop trust and rapport with your key partners. And this is something that, you know, just don't just don't call them when you need something, call them to kind of give updates about the business what's going on both good and bad. I think also, you know, really identifying a few core banking partners, is also super important, right? And if you can also do multiple pieces of business with them across the board, that's even better, right? So if you think about providing deposits, lending, corporate card lockbox services, you know, even like capital market transactions, right, so as many of these services that you can use, from your banking lending partners, it's going to lead to a more sticky relationship, right? So what happens is, you know, when there is a liquidity events and times are tough, you want to make it very, very difficult, very key lending partners to to pull away, right. And so I think having those multiple business lines within the deposits, a lending etc, will lead to a more solid and sticky type relationship with them. And in some cases, you know, can even buy you an extra few months and very severe stress scenarios, which, which can make all the difference. And then finally, you know, on the lending side, I would say, diversification is your friend, right? So if you think about the different lending partners, you know, banks in particular, there's large, there's regional, there's community, banks, making sure that you have good diversity throughout there in terms of the size of these partners. And also geographical dispersion, right, you know, US base versus Canada, Europe, Asia, based upon where your lenders that there can be different rules and different capital requirements, right. And so it's a good way to diversify. Some of that risk is by making sure that geographically your funding bases dispersed where it makes sense. And then finally, if you think about banks versus non banks, right, you know, in some markets such as, like mortgage, for example, non banks are actually the majority of the lenders, right? And so I think this really making sure you diversify in terms of banks versus non banks, as you guys know, your banks typically be are typically more regulated, have a different risk tolerance and capital requirements than non banks. And so just having really good diversity throughout that is super important as well.

Steve Katz  19:33  
Well, I'll tell you there, there certainly is quite a bit to digest from what you've covered today, Rob, and some of it, I have to say, seems relatively intuitive, but the majority is clearly nuanced. And given what's happening right now, with economic uncertainty and geopolitical upheaval, and overall market volatility. I think that it will be pretty tough to argue against taking steps to limit the potential for liquidity risk in the coming year from the perspective of any company so Well, thanks so much for joining us and sharing those insights. And if listeners want to get in touch with you with any questions they have about specific things that might be happening in their business right now, or lenders want to reach out what's the best way to get ahold of you? 

Rob Wilson  20:14  
Yeah, absolutely. Steve and thanks for having me on today. You know, we covered a lot of ground today. But I do think it's a very important topic, especially now more than ever, given all the volatility going on around us. And so yes, please reach out. If you have any questions you'd like to continue the conversation. I can be reached either by phone or email. So my email address is R Wilson, r w i l s o n, at Hilco global.com. and telephone numbers 847-849-2962. And see, thanks again for inviting me had a great time.

Steve Katz  20:53  
Yeah, absolutely great, great insights really, really well and concisely expressed, I appreciate it. And listeners. As always, we hope that this smarter perspective podcast provided you with at least one key takeaway that you can put to good use in your business or share with a colleague or client to help make them that much more successful moving forward. And one last thing, please remember that you can check out more great podcasts and articles featuring timely insights from Hilco experts like Rob at Hilco global.com forward slash smarter dash perspectives. Until next time for Hilco global. I'm Steve Katz.