The client situation
Cash investments are used by superannuation funds and fund managers to support portfolio liquidity and to reduce portfolio risk. In implementing cash investments, providers will often lend to related third parties who require cash for operations. This lending is often undertaken with the aim of securing competitive terms for the investment. While this practice can deliver efficiencies of scale, the inherent conflict between the investor and the debtor mean that lending of this nature can be perceived as being inappropriate if not managed correctly.
In this context and to ensure that the best interests of its investors were being upheld, the client engaged Rice Warner to provide an independent review of all cash investments held with related parties. This engagement aimed to assess whether the client’s related party cash investments were receiving an appropriate rate of return and whether the related nature of these investments gave rise to undue levels of counterparty risk.
To provide this independent assessment, we developed a quantitative framework to estimate the appropriate rate of return for at-call deposits using market-traded securities. In implementing this framework, we collected data from a range of sources to ensure that all relevant risks were captured in our calculation. The result of this calculation framework was a clear and objective reference point that could be used to determine whether the rate of return being received by investors was appropriate, at a given point in time, taking into account the level of risk being undertaken.
A critical component of our assessment was the extent to which counterparty and concentration risk in the selected deposit taking institution influenced the risk faced by cash investors. In making this assessment we undertook scenario analysis and stress testing to compare the risk posed by the related party to the risk posed by a series of alternative deposit taking institutions. This work was supported by analysis of share prices and other traded securities to assess the extent to which the risks faced by the related party were an isolated issue.
Following the analytical phase, the results of our analysis were collated into a report with extensive commentary on our calculations and actionable feedback on the implications of our work. We facilitated a meeting with key stakeholders to step through the results and the basis for our calculations. This ensured that the client had confidence that our findings were independent and supported by a robust model that was technically sound.
Outcome for the client
Our analysis enabled the client to determine whether the rate of return and risk applicable to its cash fund was appropriate. This was used by the client’s internal team to assess whether it was necessary to transition the existing cash investments to another deposit taking institution. In support of this decision, our reporting was used as substantiating evidence in trustee and regulator reporting.
Beyond the premise of our initial engagement, the client gained a greater understanding of the variables which influence the performance of cash investments. Through this work the client was able to leverage our framework to develop an ongoing review process to review the risk and return of cash investments and ensure that outcomes delivered to investors were appropriate, consistent with their best interests and competitive when considered in light of the risks being undertaken.