Articles

2023 Financial Services Outlook: 4 tips when seeking higher profits in the new year

Shared by FEAT Member Jack Clements and The Clements Group/Hub International 

Long-term management of portfolio companies with greater professionalism and best-in-class management is the name of the game in 2023. With challenging credit markets and heightened competition, private equity firms should focus on their existing businesses and the people who run them.

By Jack Clements and Jim White

The economy will have an impact on Arizona’s private equity market and their holdings in 2023, but the question remains, how much of an impact will it have?

PE firms and their holdings will contend with rising costs of raw materials, insurance premiums, and staffing costs. Rising interest rates will hamper PE firms’ ability to purchase companies on the front end and pressure existing prices on the back end. In April, the Phoenix metropolitan area reported the highest inflation rate increase in the nation, up 11% from the year prior. Interest rates overall are anticipated to rise 4% in the state by March 2023.

Even with the threat of a national recession causing higher unemployment and reduced job growth across the nation, Arizona — and Phoenix economies in particular — should be less impacted compared to other states in the nation due to some strong industries doing business in the state.

In the year ahead, firms should focus on improving their portfolio companies’ management to generate superior returns and keep their funding pipelines open. The following is some guidance on how to do just that.

1. Use non-traditional strategies for long-term rewards.

For PE firms that intend to hold portfolio companies for longer periods than they are accustomed, they should implement best-in-class management practices to build value.

To generate top-quartile profitability to raise sufficient capital in the future, PE executives should strive to improve management, closely examine everything from accounting to technology operations, and focus on securing top talent for long-term retention.

For many firms, this will represent a return to basics. PE firms traditionally have focused on short-term results to make portfolio companies attractive to sell. To play the long game, firms should play a greater role in managing their assets. Firms that professionalize operations will be rewarded with higher margins.

To counter the increased rates and threats to long-term viability, private equity managers are embracing risk management strategies that can ease the insurance burden at their portfolio companies. They’re examining all opportunities to maximize returns, and part of that will entail a management emphasis on taking a far more sophisticated approach to insurance.

For instance, we’ve seen forward-looking financial services firms find creative ways to manage product liability exposure and cut costs. Others have explored benefits captives to maximize cost savings and improve benefits overall.

What can you do?

With multiple businesses to manage, you’ll have multiple risk issues. Let your broker know what changes you’ve made so there are no surprises at renewal. Review exposures and insurance needs at least 90 days prior to policy renewal, so your broker can identify the best options.

2. Obtain more R&W coverage to stay viable.

The cost and availability of representations and warranties (R&W) insurance remains a major hurdle in keeping financial services firms viable.

Insurable events, such as catastrophes, have become more frequent and damaging. Global losses from catastrophes totaled $105 billion in 2021, with estimated insured losses reaching $35 billion in the first half of 2022. That doesn’t include losses from hurricane season, including Hurricane Ian, which alone could total $65 billion in damages.

Cyber insurance has been particularly fraught, with premiums expected to increase as much as 40% in 2023, following similar hikes the last two years. Carriers will expect portfolio companies to conduct security audits, have two-factor verification, endpoint detection and response, and continuing cybersecurity training before being considered for cyber coverage.

Forward-thinking managers will leverage advanced data analytics to improve their risk management, ascertain acquisition viability, and decide the correct amount of insurance coverages for portfolio companies.

What can you do?

As interest rates climb and deal volume falls, private equity firms need to be more mindful of their bottom line. Taking a higher deductible on any number of coverages can reduce premiums and improve your experience rating. Consult with your broker about captive solutions, self-insurance and risk retention groups.


3. Create a benefits strategy to retain employees.

In 2023, executives will examine an area they’ve haven’t emphasized in the past: benefits strategies at their portfolio companies. To meet growth targets, executives need to invest in HR systems, processes and technology at the companies they acquire.

For private equity firms and their portfolio companies that are experiencing worker shortages, professionalizing HR operations and rethinking benefits can increase profits and help companies stay fully staffed.

The biggest challenge for PE portfolios is the variety of industries, each with different benefits needs. Offering childcare and eldercare benefits are highly desired in healthcare and hospitality, but less so in construction and transportation.

What can you do?

A personalized benefits strategy can address this dilemma. By using data analytics and on-the-ground HR expertise at individual operations, companies can tailor benefits to meet individual employee needs without increasing their benefits spend. Personalized benefits result in positive employee experiences, which engenders loyalty and increases engagement.

4. Focus more on your portfolio companies’ bottom lines.

With credit tight, primary market deals may decline in 2023. However, the secondary market grew exponentially in recent years. Assets under management quadrupled over the past decade and the compound annual growth rate has risen 20.2% since 2000, far surpassing that of the overall private equity market (12.9%) during the same period.

Because higher interest rates could hamper deal-making, PE firms will generate more profit from their portfolio companies by managing costs and maximizing efficiencies. Investments in people and processes will pay off in the long run through improved valuations and attractiveness to prospective buyers when it’s time to sell.

PE firms will need to pay more attention to insurance costs, risk exposures and coverage. Insurance rates rose across the board in 2022 and are expected to rise in 2023, especially for certain lines, including catastrophe, general liability, umbrella, and property.

What can you do?

Boost margins through leveraged insurance purchasing programs among portfolio companies, which not only can cut costs but can reduce losses and claims.

Speak with your carrier about the root causes of large losses and how you plan on preventing future losses. Then work with them to determine the best time and frequency to review alternative markets.

About the authors

Jack Clements, CPA, CIC, is based in Tucson and is the President of Arizona Operations for global insurance brokerage Hub International. 

Jim White is Hub’s North American Financial Institutions Practice Leader.