Top Risks Facing Financial Sponsors

The uncertainty and volatility hitting the world’s economies and financial markets is directly affecting the financial sponsors industry. 

The top five risks to the sector in our recent Global Risk Management Survey — cash flow or liquidity risk, capital availability, interest rate fluctuation, asset price volatility and business interruption — are interconnected and amplify the threat that each represents. 

According to our survey, respondents from the financial sponsors industry indicated the second-highest level of assessed risk at 40 percent, trailing financial institutions by just a single percentage point. Financial sponsors also have the highest reported quantified risk at 31 percent, eight percentage points more than insurance, the next-highest industry. On the other hand, financial sponsors take the lead in risk management, with 39 percent of respondents confirming they have risk management plans in place. 

These risk management measures have paid off: Respondents reported losses from these risks at 17 percent, the lowest among all 16 industries surveyed. Further, reported losses dropped 25 percent compared with 2021, the biggest decrease of any industry. This positive sign highlights the importance of preparedness and mitigation practices in staying ahead of risk-related losses. 

Current Risks

The biggest risks reported by financial sponsors reflect the industry’s concerns surrounding inflation, high interest rates and global economic uncertainty. A challenging global economic environment has led to contracted deal pipelines in many sectors. Soaring inflation and rising interest rates are squeezing the liquidity of funds at both ends, through both higher borrowing costs and valuation mismatches between buyers and sellers. However, abundant dry-powder reserves point to a slow but steady recovery for dealmakers that can navigate current economic challenges.

Top 10 Current Risks

1. Cash Flow or Liquidity Risk
2. Capital Availability
3. Interest Rate Fluctuation
4. Asset Price Volatility
5. Business Interruption
6. Vendor Management or Third-Party Risk
7. Cyber Attack or Data Breach
8. Economic Slowdown or Slow Recovery
9. Failure to Attract or Retain Top Talent
10. Regulatory or Legislative Changes

Fears surrounding these economic challenges are illustrated by the state of equity deals. A rapid decline in dealmaking in 2022 led to the lowest total value raised from equity deals since 2006. Additionally, while global deal volume remains higher than in 2020, current economic conditions are restricting access to capital and resulting in more regulation, creating value discrepancies and dampening the appetite for risk. In Aon’s 2022 M&A Risk in Review survey, 68 percent of dealmakers anticipated global mergers and acquisitions (M&A) deals would increase in the following 12 months. In Aon’s 2023 M&A Risk in Review survey, this figure dropped to 46 percent, reflecting increased caution and uncertainty.

The top three risks — cash flow or liquidity risk, capital availability and interest rate fluctuation — reflect the challenges financial sponsors are contending with because of tightened debt markets, high interest rates, longer hold periods on portfolio assets and more selective fundraising capital commitments from limited partners. 

The buoyant debt markets and abundant liquidity that fueled a frenzy of dealmaking in 2021 have been replaced by high inflation and interest rates, significantly affecting financial sponsors’ ability to close deals and finance acquisitions. As a result, many have had to adjust expectations and strategies to adapt to these new economic conditions, devoting more time and resources to post-closing value creation and risk mitigation measures for assets already in their portfolios.

Further, the reduced availability of credit has contributed to heightened concern over cash flow or liquidity risk and capital availability. As lenders tighten credit standards in response to higher interest rates, financial sponsors may find it difficult to secure debt financing, limiting the availability of funds for leveraged deals. The increased cost of borrowing elevates this issue and helps explain why interest rate fluctuation ranks third among the top current risks. Greater costs associated with higher interest rates are making debt financing avenues less attractive compared with other funding sources, such as cash and equity financing.

The number four risk, asset price volatility, highlights the impact of higher valuations and the current gap between seller and buyer expectations. Higher interest rates can lead to increased discount rates used in valuation models, creating potential discord between buyers looking for good value and sellers unwilling to accept lower offers. In addition, a higher debt service burden also contributes to concerns surrounding capital availability and business interruption (number five). Achieving growth and meeting financial obligations become increasingly challenging for financial sponsors when interest rates rise, potentially leading to higher default rates and lower overall returns.

Underrated Risks

Global net-zero emissions targets and the physical risks of climate change mean that today, climate change is everyone’s business. Environmental social governance (ESG) factors are therefore a top priority of company boards and investment professionals. In Aon’s 2022 Risk in Review survey, only 2 percent of dealmakers cited the risk of environmental litigation as a concern. In 2023, this figure jumped to 24 percent. A further 98 percent of dealmakers said they had turned down one or more deals due to ESG concerns in the past year. While climate concerns are driving dealmaking in areas that help companies fulfill their ESG ambitions, banks and investors are also navigating the effects of extreme weather and its impact on global infrastructure.

Even though financial sponsors may feel the effects of climate change primarily through business interruption, ranked fifth in the top 10 current risks, the survey results only partially reflected the reverberations that ESG and climate change issues have on the financial sponsors industry. These residual effects can be seen in the forms of vendor management or third-party risk and regulatory or legislative changes. Those risks ranked sixth and 10th, respectively, yet deserve careful attention due to how they may be influenced indirectly by climate change. 

On technology, the increasing complexity of cyber threats is altering how sponsors address risk from a fund, transactional and portfolio perspective. While cyber attack or data breach was ranked seventh in the survey, the threat that cyber risks pose to financial sponsors should not be ignored. In Aon’s 2023 Risk in Review survey, 54 percent of respondents said they were likely to walk away from a deal if a material cyber-security risk had been discovered at the target company, with 32 percent saying they were very likely. Adopting a proactive approach to cyber security during dealmaking is essential to protecting deal value and preventing an asset from becoming a liability. While digitalization elevates cyber risks, it also presents opportunities, and the digital and tech landscape continues to be an area of focused investment for sponsors and value creation within existing portfolios. Financial sponsors must confirm cyber risk resilience to capitalize on the opportunities in the tech space. 

Future Risks

The top five future risks for financial sponsors are largely consistent with the top five current risks, with the notable exception of major project failure taking the place of business interruption. Although business interruption is conspicuously absent from the top 10 future risks, other similar risks that can lead to disruptions, such as climate change (number seven) and geopolitical volatility (number nine), appear in the future top 10.

Top 10 Future Risks

1. Capital Availability
2. Asset Price Volatility
3. Cash Flow or Liquidity Risk
4. Interest Rate Fluctuation
5. Major Project Failure
6. Cyber Attack or Data Breach
7. Climate Change
8. Vendor Management or Third-Party Risk
9. Geopolitical Volatility
10. Environmental Social Governance (ESG) or Corporate Social Responsibility (CSR)

Financial sponsors have refined their approach to well-understood risks, such as capital availability and cash flow or liquidity risk, particularly when navigating economic challenges. However, dealmakers face a constantly shifting risk landscape today and must also sharpen strategies for future growth. The organizations currently integrating risk mitigation measures (particularly in cyber security and climate change) into their larger overall business strategies will be well positioned for future growth. 

The rapid evolution of pressures on portfolio businesses is demonstrated by the presence of cyber attack or data breach (number six), geopolitical volatility (number nine) and ESG or corporate social responsibility (number 10) in the future risks for the industry. Without proper management, these risks can threaten the resilience of operations and have a material impact on cash flow, profit and loss and balance sheets. To address these concerns, financial sponsors may have to break out of their old modes of operation and take a renewed, proactive approach to quantifying and mitigating risk exposures. 

Economic slowdown or slow recovery, failure to attract or retain top talent and regulatory or legislative changes are three risks that appear in the current top 10 risk rankings but not among the future risks. This suggests dealmakers expect near-term changes in the industry will lead to restructured priorities. However, there could be an upturn in economic conditions over the next three years, or organizations may learn how to navigate a long-term downturn. Though organizations appear to be focused on risks with pressing immediate impact — such as cyber attack or data breach, geopolitical volatility and ESG —those organizations that can reduce the threats posed by economic, talent and regulatory risks will be best equipped to navigate the oncoming uncertainties. 

How Can Financial Sponsors Mitigate These Risks Effectively?

Insurance can play a critical role in facilitating transactions, helping financial sponsors to mitigate a risk, protect against an unknown risk or move a risk off the balance sheet. As businesses hunt for growth in an environment in which optimizing liquidity is a key priority, capitalizing on solutions in the credit and surety markets can support corporate strategy by introducing flexibility and efficiency, both in structuring the M&A deal and in the post-acquisition operational phase. Transactional insurances, such as representation and warranties insurance, as well as contingent risk and litigation and tax insurance, can lower risk in acquisitions and offer the seller an attractive exit package. Outside the context of a transaction, tax and litigation insurance can also provide more economic certainty around the outcome of tax and litigation risks, removing them from the balance sheet and freeing up otherwise constrained capital at the portfolio company level.

Heightened scrutiny and evolving regulatory requirements for climate-related disclosures demand a more diligent approach to ESG. Today, financial sponsors must integrate ESG risks with business strategy to minimize their exposure to climate-related risks and optimize investment performance. Extreme weather and natural disasters also pose threats to businesses in the industry. With the potential for natural catastrophes to grow in frequency and severity, companies should assess the increased exposure that portfolio companies and their supply chains face from chronic and acute physical risks, such as rising sea levels and hurricanes. 

Attaining a clear sense of where the risk exposures are is the first step in addressing them. In addition to quantifying exposures and assessing risk expenses, leaders can take several actions specific to the financial sponsors industry:

• Understand how the transition to net zero will affect portfolio companies, from the pressure of asset owners to consider climate risk in the investment life cycle to meeting regulatory and industry disclosure requirements for fund and portfolio companies.
• Assess and mitigate the litigation and reputational climate-related risks related to carbon emissions or the failure to meet climate targets.
• Develop credible decarbonization strategies, including climate data and risk information systems, that demonstrate meaningful progress in the journey toward climate resilience.
• Consider offtake, technology and supply chain risks when exploring investment opportunities in emerging climate technologies. Embrace intellectual property and counterparty risk solutions to help accelerate and unlock investment in green technologies.
• Build an engaging story and reporting tools to communicate proactively with stakeholders.

Done together, these practices create a comprehensive, multidimensional approach to addressing risk that can help position organizations for future success.

Another important factor in risk mitigation for financial sponsors is human capital. Recognizing that people are an organization’s biggest asset can help drive value within and across the talent profile of a fund and its portfolio. Thoroughly assessing a target’s talent, benefit and rewards programs and HR operations at the due diligence stage are important steps for quantifying liabilities and risks and can help with negotiating more competitive pricing. Identifying synergies early in integration planning can help leaders to optimize the approach to their human capital integration strategy. Financial sponsors can also rationalize and forecast HR spending by using data to create personalized and customizable employee value propositions and conducting detailed organizational planning to drive both immediate and long-term results.

Last, to address concerns over cyber attack or data breach (the number one global risk in our survey according to all respondents), financial sponsors should develop a proactive approach to reviewing and assessing the cyber posture of the general partner, along with portfolio-wide assessments. M&A cyber due diligence assessments will also help to protect future investments and can be beneficial in procuring cyber insurance for assets. Taking steps to understand financial exposures and assess cyber-security controls and capabilities throughout the organization, regularly updating cyber-risk resilience measures and having robust incident response plans in place can help organizations reduce the chance of damaging cyber attacks and data breaches.

General Disclaimer
This document is not intended to address any specific situation or to provide legal, regulatory, financial, or other advice. While care has been taken in the production of this document, Aon does not warrant, represent, or guarantee the accuracy, adequacy, completeness or fitness for any purpose of the document or any part of it and can accept no liability for any loss caused by reliance on it. Any recipient shall be responsible for the use to which it puts this document. This document has been compiled using information available to us up to its date of publication and is subject to any qualifications made in the document.