Should Companies Retain "Strategic" Cash?

To enhance financial flexibility, companies have been retaining unprecedented amounts of cash on their balance sheets, calling it "strategic" cash to distinguish it from the "operating" cash that is needed to run the business.

Politicians have claimed that retaining cash balances is hurting the global economy—even characterizing the practice as unpatriotic—and many investors have argued that excess cash rightfully should be returned to shareholders through dividend payments or share repurchases.

This raises the question of whether retaining strategic cash makes economic sense and should be viewed as a legitimate corporate finance tool in today's environment.

Arguments for Strategic Cash

Often citing the maxim that "cash is king", CFOs know that strategic cash can enhance shareholder value in various ways. It can:

• Save Taxes. Much of the strategic cash is typically held outside the United States. As long as the CFO can stipulate that the company does not intend to repatriate the cash, it avoids the incremental tax that will be levied due to the territorial system of U.S. taxation. Barring a tax holiday, this cash is effectively "trapped" offshore.
• Facilitate Acquisitions. Strategic cash provides more flexibility concerning the timing and pricing of potential acquisitions; having cash on hand is the best insurance that CFOs will be able to respond with alacrity to opportunities and not be subject to the vagaries of the financial markets.
• Facilitate Investments. Strategic cash also can be used to finance long-term reinvestment programs in the business—which is especially valuable to companies in capital-intensive industries (e.g., energy or telecom) or research-intensive industries (e.g., high technology or pharmaceutical) that are investing in projects with uncertain long-range payoffs.
• Allow for Greater Responsiveness to Future Events. Strategic cash provides protection against downsides (such as disruptive technologies, economic recessions, and market turmoil) and also offers the opportunity to capture upsides. For example, a market downturn is a great time to repurchase stock or to introduce a new marketing campaign against weakened competitors.

Arguments Against Strategic Cash

Many shareholders, however, believe that excess cash should not be retained as a long-term corporate finance strategy, citing uncertainties about its eventual use and the relatively low returns on investment. They emphasize that it can:

• Lead to Undisciplined Spending. Unless a company has a strong track record as a superior acquirer or investor, shareholders may prefer the "bird in the hand" of a dividend or share repurchase and fear that any excess cash may result in unfocused strategies or uneconomic spending.
• Earn a Low Return on Investment. Strategic cash usually is invested in high quality short-term securities; this ensures safety and liquidity, but produces a meager return on investment—especially in a low interest rate environment—and does not achieve the company's cost of capital.

How Should You Approach Strategic Cash?

The arguments in favor of strategic cash are compelling—especially when economic conditions, market regulations, technology innovations, and tax policies are highly fluid and uncertain—but CFOs also should take steps to allay investor concerns. Specifically, firms should:

• Continuously Consider Alternative Uses. CFOs should always think about strategic cash within the context of a company's allocation priorities. They should continuously evaluate whether cash should be repatriated to the United States—even if it involves some tax costs—and provide reassurances to investors that any strategic cash will not be redeployed unless the investment will earn the company's cost of capital and compare favorably with dividend or share repurchase alternatives. They also should emphasize that the company will only pursue acquisitions that satisfy rigorous strategic, business, and financial criteria.
• Provide Additional Disclosure. CFOs also should provide additional disclosure concerning their cash balances. How much is needed to run the business? How much is restricted due to tax considerations? How and where is the strategic cash being invested? What are the factors that may cause the cash to be paid out as a dividend or share repurchase?
• Invest in Indexed Equities. Finally, companies should view their strategic cash as being invested in a fiduciary capacity on behalf of their shareholders. By investing the cash in equity index funds, CFOs could maintain safety and liquidity, while also giving investors a rate of return that would be roughly comparable, on average, with other investment alternatives available to their shareholders.

This strategy would create more volatility in the company's financial results, but investors could evaluate the earnings with and without this incremental component, in much the same way that they currently consider the effect on bank earnings due to debt valuation adjustments. This additional complexity would seem to be a reasonable tradeoff for the higher returns that could be realized.