Financial services industry outlook
Volume 7, Spring 2021
Technological changes, emerging investment trends and shifting consumer expectations continue to push financial services companies to take a proactive approach to innovation. Digital trends are reshaping the insurance sector, investments in minority stakes in asset management firms are on the rise, and banking and capital markets firms are seeing the growing opportunity that environmental, social and governance issues may have as a means to growth.
Looking to the rest of 2021, financial services providers should seek out opportunities to finance innovative projects, keep up with demand for multichannel approaches to products and services, and be diligent about possible forthcoming regulatory changes.
- Banking and capital markets firms have an immense opportunity to assist businesses affected by changing preferences as investors and consumers focus more on ESG.
- Millennials’ shifting preferences away from more traditional services will continue to be a driving force in the consumer lending market.
- Competition in the insurance space is poised to expand to include not just carriers but also companies in other industries that are starting to offer their own coverage, so it is critical for insurance businesses to evolve digitally.
- Following trading volatility early in the year, we expect regulators to increase their oversight of online activities and dramatic movements in stock prices, and more stringent restrictions on speculative trades.
- In recent years, new firms making general partner stakes investments have entered the market, closing deals on targets in the middle market and emerging manager categories, and this trend is set to continue.
As investor and consumer preferences shift to more acutely focus on environmental and social issues, businesses may need to realign their priorities in response. Banking and capital markets firms will have an immense opportunity to assist the businesses affected by these changing preferences.
While ESG issues are not new to banking and capital markets organizations, what may be less at the forefront of minds is how businesses can finance their efforts to deliver on their ESG strategies.
Social and sustainable financing
Social and sustainable financing instruments, including green bonds and loans, consist of a variety of fixed-income or loan instruments whereby the proceeds are used exclusively to finance projects with social and/or environmentally sustainable benefits. This in turn leads to more projects promoting a positive social impact or environmentally sustainable outcomes.
While the reasons for social and sustainable financings may vary, the end goal is often aligned between these interested parties:
- Issuer: Use of proceeds helps a business in delivering on a social or environmental strategy or promise
- Investor: An investment in such instrument aligns with personal beliefs that promote social or sustainable interests
- Originator: Supports issuers in delivering on corporate promises while providing investors an opportunity to support a business with mutually beneficial goals and interests while earning a return
In 2020, a record $757 billion in social and sustainability-linked instruments were issued around the world, representing a 33% increase over 2019 activity. While the U.S. share of total issuances made up less than 15%, or $112 billion, of the 2020 total, the activity in the United States is increasing. As of February 2021, the U.S. share of social or sustainable financing makes up over 18% of the total global financings in this category.
Opportunity to drive growth
As the markets continue to see consumer behaviors and preferences affect asset values (remember GameStop?), social and sustainable financing options offer banking and capital market participants a unique opportunity to help finance a more responsible future while driving growth.
As the markets continue to see consumer behaviors and preferences affect asset values, social and sustainable financing options offer banking and capital market participants a unique opportunity to help finance a more responsible future while driving growth.
In a report published by the Global Financial Markets Association, an estimated $100 trillion to $150 trillion of financing will be needed globally over the next three decades to reach compliance with the Paris Agreement. This equates to roughly $3 trillion to $5 trillion per year in financing needs. Contrast this potential need with the fact that as of Sept. 30, 2020, there were an estimated $119 trillion in fixed-income instruments outstanding in total, globally.
And while the report outlines the various types of financings needed under the Paris Agreement, those financings represent only the investments needed for sustainability. The report doesn’t make reference to the massive cultural shift that will drive socially responsible financing.
Meeting social and sustainable requirements
While the advent of social and sustainable financings is considered by some to still be in its infancy, voluntary guidance has been published—The Green Bond Principles and The Social Bond Principles, from the International Capital Market Association—to provide issuers and originators voluntary guidelines for instrument structuring features, disclosures and ongoing reporting. The principles are broken down between the following: green bonds, social bonds, sustainability bonds and sustainability-linked bonds.
In order to ensure issuances that are intended to support social or sustainable initiatives find the optimal demand and acceptance in the markets, banking and capital markets organizations need to familiarize themselves with these guidelines.
With consumers’ behaviors and sentiments shifting and the increasing likelihood that leaders in Washington, D.C., may push for more focus by businesses and corporations on social responsibility and environmental sustainability, banking and capital markets organizations should begin looking at their operations and resources to better understand if an opportunity to capitalize on this increasingly popular form of financing may provide an avenue for long-term growth.
Consumer lenders have managed to avoid significant bad debts so far during the pandemic, but new loan originations have been slower. Delinquency and charge-off rates on consumer debt have also remained very low over the past year, and government stimulus programs targeted to consumers have largely given Americans the cash needed to remain current on their debt obligations.
Altogether, this makes for a landscape in which lenders will need to explore strategies and approaches to regain volume and drive loan origination growth. In doing so, they should evaluate and strategize around the influence of the millennial generation.
In the current landscape, consumer lenders will need to explore strategies and approaches to regain volume and drive loan origination growth. In doing so, they should evaluate and strategize around the influence of the millennial generation.
This generation, defined as individuals born between 1981 and 1996, holds significantly more consumer debt as a share of net worth than any other generation as shown in the chart below. Millennials also interact very differently with their financial service providers and have preferences that differ from preceding generations. As a result, consumer lenders may need to alter the way in which they operate to maximize the potential for new growth from this important segment of the population.
This will be especially important given current figures on delinquencies and outstanding consumer credit. Quarterly delinquency rates on all consumer loans held by banks as reported by the Federal Reserve have been just under 2% for each quarter reported on since the first quarter of 2020. Prior to the second quarter of 2020, the last quarter where this measure was less than 2% was the first quarter of 2016.
For the year 2020, outstanding consumer credit decreased at a seasonally adjusted annual rate of 0.1%. Conversely, for the three prior years, consumer credit increased at an average seasonally adjusted annual rate of 4.9%, according to the Federal Reserve.
Here are two key millennial spending and borrowing traits that consumer lenders should be prepared to cater to as the anticipated economic recovery begins:
- Experiences over possessions: A study by Expedia and The Center for Generational Kinetics found that 74% of Americans prioritize experiences over products, and that the millennial generation more so than any previous generation values experiences over tangible items. There have been some signs of this trend manifesting among traditional financial institutions. Millennials are more likely than earlier generations to save for or seek financing to fund travel, social events, or other experiences shared with friends and family. Consumer financial services providers should evaluate the experience customers have when interacting with them, whether through physical locations or digital channels. Companies should also be thoughtful about how financial services products are designed and marketed to consumers. Products and services that allow consumers to create new experiences will have greater resonance with millennials than the products and services that are focused on helping to acquire a possession.
- Flexible, multichannel delivery: Consumers continue to place higher value on financial service providers that have multiple, on-demand access points to products and services. Millennials comprise the vast majority of users of web- and mobile-based personal finance apps, which are growing in popularity overall. Companies that continue honing a multichannel approach for their products and services—especially an approach that offers real-time, on-demand features—will have a better shot at drawing members of this key demographic.
Tying it all together
Millennials are a dominant group in the overall user base of consumer financial services, as demonstrated by the ratio of consumer debt to wealth by generation. As such, millennials’ shifting preferences away from more traditional services will continue to be a driving force in the market. For companies to remain competitive, they need to understand the way these consumers want to interact with financial services providers. This is especially important for consumer lenders who are seeking to grow their business and portfolio post-pandemic.
As the economy fell off a cliff and millions of people started working from home in 2020, shifts in the insurance industry underscored the importance of digital adoption in a sector that has historically lagged in that area.
Now, looking to a future in which competition in the insurance space will expand to include not just carriers but also companies in other industries that are starting to offer their own coverage, it is critical for insurance businesses to evolve digitally. Below, we look at some of the biggest trends reshaping the insurance industry today, and the importance of digital innovation across all of them.
Acceleration of digital transformation
Well before 2020, many insurance companies had already shifted from using traditional models to offering coverage online in order to serve changing consumer preferences, but the pandemic has elevated the importance of that shift. Companies need to invest in digital technologies that streamline the entire customer journey, from binding a policy to paying a claim and everything between.
The extent to which the use of antiquated processes can hamper growth has only become more apparent over the last year, and companies that haven’t embraced digitization will struggle moving forward. Take, for instance, the life and health insurance segment, which continues to lag property and casualty (P&C) insurance in terms of digital adoption and which now faces suppressed growth in the near term. Carriers of all types will need to prioritize product innovation that supports customer demands if they want to continue to grow profitably.
Intelligent automation and the data revolution
The velocity and veracity of data available to and collected by insurance companies is rapidly increasing thanks to the rise of telematics, usage-based insurance and Internet of Things devices. Modern enterprise analytics platforms and advances in machine learning and artificial intelligence are fueling strong investment in R&D in these areas, and many operational processes are ripe for automation, including underwriting, pricing, claims and more.
Insurance companies that tap into this potential can set themselves up for future success. Personal lines P&C insurance, for instance, experienced growth tail winds over the last year as policyholders reassessed their insurance needs in the context of the pandemic. As more people worked from home, they started to seek out different types of coverage. Claims activity dropped, particularly for auto insurance claims, and more consumers shifted to using digital platforms.
But digital adoption doesn’t just mean more people buying their insurance online—mobile app adoption is up as well, creating new potential touchpoints and cross-sell opportunities between the carriers and their customers. One example that’s taking off in personal P&C is usage-based insurance, where customers don’t pay an annual auto insurance premium but instead pay by the mile.
Embedded insurance and alternative distribution models
More and more insurance carriers have invested in direct-to-consumer distribution models in recent years to deepen the connection with the customer and keep up with evolving consumer expectations. But that shift is now evolving to the next level; carriers are looking to partner with other consumer products companies to sell to the customer at the point of purchase of other goods.
These strategic partnerships create alternative distribution channels, in which the insurance itself is bundled with other goods and services. But carriers also need to be aware of the possibility that some consumer products companies could take this a step further and sell their own insurance, like when Tesla started selling auto insurance in 2019. If an auto manufacturer can use data from its connected vehicles to develop a better insurance cost model, that could lead to more cars sold.
While this trend is happening more in auto insurance than other parts of the market, the growing use of IoT devices in homes and elsewhere could unlock the potential for seismic shifts in the way insurance is sold in the future.
The GameStop trading volatility we observed beginning in late January has prompted questions from regulators around market manipulation, the functioning of capital markets, and the possible negative impacts these events have on investors and market confidence.
Core to all investing is the idea of driving organizational impact, and, in turn, increasing earnings and consequently investor wealth. For asset managers this has long been the case, but meme trading—which is defined as increased trading volume after going viral on social media or another online forum—largely focuses on just one of the two: investor wealth. As more security around trading arises, asset managers will need to be aware of coming regulations.
Following the GameStop trading frenzy, the ensuing meme trading craze—when small-time risk-takers banded together to drive up dozens of obscure stocks by hundreds or even thousands of percent—highlighted the significance of market pricing issues, given the popularity among casual investors. For example, despite GameStop’s declining business, its stock price surged from below $4 per share in early January to over $370 per share in late January. And other stocks like Blackberry, AMC and Nokia saw similar volatility.
The Securities and Exchange Commission has taken notice of these recent concerns. Legislators such as Sen. Elizabeth Warren are pressing the agency to respond with new regulations. In a Feb. 25 letter, the SEC’s Office of the Chair detailed its awareness of these issues and its plans for remediation, which, among other things, includes plans to safeguard a “fair, orderly and efficient” market function.
It remains to be seen exactly what that may look like. Insider trader hitches of the past revolved around a group of individuals acting on information that was not publicly available, but at the present time, there’s no court precedent for whether or not a concerted online effort qualifies as market manipulation, as meme traders seemingly act on publicly available information.
There are also questions around the role retail investors play in speculative trading, which includes investments that have substantial risk of losing value, but also carry the hopes of significant gains. Speculative trading requires a certain discipline and degree of financial stability that many Main Street investors don’t have and long-term investing doesn’t carry the same lure as short-term speculative trading. Hence the sudden interest in meme trading especially among younger, nonaccredited investors.
We don’t expect most asset managers to suffer losses like we observed with Melvin Capital, the hedge fund at the center of the GameStop trading frenzy. That fund lost 49% of its investments during the first three months of 2021 after its short selling backfired, according to Reuters.
But asset managers will be affected indirectly with added scrutiny by regulators and investors around its risk management practices. We expect added disclosures to be made, better monitoring and oversight of online activities and dramatic movements in stock prices, and more stringent trading restrictions on speculative trades.
Some asset management firms have undergone reviews of loss-limit systems to ensure those systems act as circuit breakers if trades suffer quick losses. Others are performing widespread reviews over compliance manuals to ensure surveillance over trading is appropriate. And regulators will play a major role in ensuring that they aggressively address fraud, manipulation and disclosure misrepresentation.
MIDDLE MARKET INSIGHT
Investments in minority stakes in asset management firms (also called general partner or GP stakes) have continued to accelerate over the last decade as GP stakes investors are focusing more on middle market and emerging asset managers.
Financial benefits include additional capital that can be used to scale up by allowing the manager to fund the GP’s commitments to larger funds in the future or to seed new investment strategies. The capital infusion from selling a stake may also be used to invest in new strategic hires or the infrastructure and technology needed to remain ahead of the competition. Selling a stake may also be one way to monetize the ownership interests in the investment firm which would allow retiring or exiting partners to cash out or younger partners to buy in down the line.
The strategic benefits of partnering with buyers of GP stakes include help with fundraising, either directly through allocations from the GP stakes investor as a limited partner in existing or future fund launches or opening access to their network and other distribution channels. They may also offer advice on business development and marketing strategy. For managers looking to launch new product offerings, GP stakes investors may offer market insights and feedback on the investment manager’s plans.
Investments in this space over the past decade have been dominated by a few large players making deals in established investment firms. But in recent years, new firms making GP stakes investments have entered the market, closing deals on targets in the middle market and emerging manager categories. This is set to continue and managers in the lower segments who have not explored this option may soon be getting a knock on the door from potential suitors. Investments have increasingly been targeted toward GPs of closed-end funds, as shown below.
GP stakes investors have ventured beyond the top-tier firms and toward the middle market as the number of top firms yet to sell a stake diminishes with each completed GP stakes transaction. Additionally, given the lower probability of failure with the top-tier firms, GP stakes investors focused on this upper segment take on less risk and therefore can expect a lower rate of return.
MIDDLE MARKET INSIGHT
Investors have increasingly assumed more risk by backing middle market and emerging market managers who present a higher risk profile but offer the possibility of greater outsized returns if all goes according to plan.
Middle market managers that make suitable targets for GP stakes transactions are those managers that have a good track record and have demonstrated some success in growing their assets through a step-up in fund size in their most recent fund launch. Emerging managers that offer high growth potential can also be good candidates. These can be managers developing an impressive track record or expanding on one developed from previous mandates, with differentiated or niche strategies that offer unique diversification benefits, or with talented investment teams that can benefit from greater scale and support to develop into a more institutionalized shop.
For managers seeking additional capital and strategic partnerships to grow their business, selling a minority stake to a GP stakes investors may be the answer. With capital dedicated to this investment approach growing and competition among the players in this space rising, the balance may be shifting in favor of investment firms that make for suitable candidates. For such firms, multiple bidders may soon be reaching out, if they have not begun doing so already. Proactively deciding how the parameters of such a transaction may be structured given the investment manager’s motivation for pursuing a deal and their investment firm’s unique circumstances may put the investment manager a step ahead in deciding the best partnership and getting the most out of the transaction.
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