Annual industry outlook 2017

Transcription

1 Annual industry outlook 2017

2 Contents 03 Asset management 11 Banking 19 Exploration and production 27 Information technology 35 Life Sciences 43 Manufacturing 51 Real estate

3 Tightening pressure transforms the landscape The state of asset management

4 Tightening pressure transforms the landscape The state of asset management The entrepreneurial spirit of the industry will always encourage agile newcomers who are willing to rewrite the rules. Inflection points mean change, but they also create new opportunities for growth for a new breed of asset manager, one who is more diverse, transparent and savvy at finding ways to help investors manage their wealth and risk. Michael Patanella, Grant Thornton LLP s Asset Management national sector leader 4

5 Tightening pressure transforms the landscape The state of asset management After years of growth, the asset management industry faces new competitors, changing client needs and expectations, and additional regulatory requirements. With additional scrutiny on fees and more low-fee alternatives, asset managers are under heightened pressure to demonstrate value. Changing demographics and the newly wealthy in emerging markets are changing the profile of the investor: younger, more diverse, more frequently not from the U.S. Investors demand closer alignment to their expectations of transparency and insights related to managing their wealth. At its simplest level, that means having access to their asset manager 24/7. At a deeper level, these diverse investors are looking for asset managers who look and think more like them. Finally, a relentless regulatory burden is increasing at a time when there is pressure to restrict fees. Technology holds part of the promise to meet investor demands for more transparency, better risk management and new insights for finding alpha. But technology alone is not the answer. After years of robust growth, the industry is at an inflection point, and the landscape will transform. Consolidation will create larger asset management firms with the financial wherewithal to invest in needed technologies, build robust cyberdefense systems and increase their global footprint. 1 The entrepreneurial spirit of the industry will always encourage agile newcomers who are willing to rewrite the rules, explained Michael Patanella, Grant Thornton LLP s Asset Management national sector leader. Inflection points mean change, but they also create new opportunities for growth for a new breed of asset manager, one who is more diverse, transparent and savvy at finding ways to help investors manage their wealth and risk. Pressure on fees New competitors are developing creative alternatives to the traditional 2/20 fee model. The new hedge funds are slowly challenging industry norms, generally with incentives only if performance exceeds a certain market hurdle rate. Investors are dissatisfied with fees that do not adjust with substantial increases in assets under management (AUM) particularly when the investment strategy remains the same and overhead costs associated with the fund have not changed proportionally. New fund managers in need of investors are adding pressure by being more open to hurdle rates. For private equity (PE), scrutiny over the fees has increased. The SEC has been cracking down on PE firms regarding fee allocation (including transaction, monitoring and broken deal fees) and vague limited partnership agreements that include management fee offsets and ambiguous disclosure practices. For mutual funds, investors have sharply moved away from higher-fee actively managed funds to lower-cost passive index funds and exchange traded funds (ETFs). Index funds and ETFs now represent 30% of total mutual fund assets, double the ratio from 10 years ago. 2 ETFs built on algorithms that factor in strategies (e.g., value stocks outpace growth stocks) are beginning to gain a foothold with institutional investors. Technology-enabled robo-advisers are starting to pressure the lower end of the market. While dismissed by some in the industry, others compare the complacent attitude toward new competitors like Betterment LLC (with $5 billion AUM) to U.S. automakers reaction when low-cost Japanese cars first entered the American market in the 1960s. Roboadvisers like Betterment appeal to young investors, who are seeking low-cost advice in an era of low-return expectations (not unlike the first buyers of Japanese cars in the 1960s young baby boomers who became lifelong customers). 1 Grant Thornton LLP. Plan Now: Don t Let Your Books and Records Stall the Sale of Your RIA. 2 Thomas, Landon, Jr. At BlackRock, a Wall Street Rock Star s $5 Trillion Comeback, The New York Times, Sept. 15,

6 Tightening pressure transforms the landscape The state of asset management Grappling with a heavy regulatory burden At the same time asset managers are feeling pressures on fees, they see no relief from heavy, steadily increasing regulation. Asset managers looking for growth in emerging markets find themselves for the first time facing global anti-bribery and anti-corruption laws. Recently, a large publicly traded asset manager was charged with paying bribes to government officials in Africa to secure natural resource deals and other investments. As a result, the firm settled charges and agreed to pay penalties. In addition to the firm, a number of individuals from the asset manager were charged, including the CEO, who agreed to pay penalties to settle a record-keeping violation. But it is not just regulations from entering new markets that concern asset managers; the burden of existing regulations continues to grow as well. SEC regulations about Form ADV will require new levels of disclosure for asset managers. New SEC rules on liquidity risk management will affect open-end mutual funds. Regulators are renewing their focus on cybersecurity. Finally, taxing authorities are posing multiple new challenges on asset managers, not the least of which is the impact on carried interest. Form ADV revisions add to disclosure requirements On Aug. 25, 2016, the SEC released new amendments to Form ADV that add to disclosure requirements. The effective date is Oct. 1, 2017, for new advisers initiating their first form or amending an existing form, although most advisers won t be affected until the first quarter of 2018 as part of the annual 90-day Form ADV update. The new requirements focus on disclosures relating to separately managed accounts, many of which are modeled to create a Form PF type of transparency. Other new requirements include disclosing all of the adviser s websites and social media accounts, more information about other offices, and compensation paid for client referrals. In addition, advisers must maintain calculations for performance information communicated to any person. The SEC also updated Form ADV regarding umbrella registration for a group of advisers that operates as a single business, aiming to simplify the process. Asset managers looking for growth in emerging markets find themselves for the first time facing global anti-bribery and anti-corruption laws. 6

7 Tightening pressure transforms the landscape The state of asset management Liquidity risk management On Oct. 13, 2016, the SEC voted to adopt changes to modernize and enhance the reporting and disclosure of information provided by registered investment companies, as well as to improve the liquidity risk management by open-end funds, such as mutual funds and ETFs. The SEC believes that the former will improve the quality of information available to investors, and will allow the SEC to more closely and effectively monitor, collect and use data reported by the funds, explained John Stomper, Grant Thornton s Mutual Funds national sector leader. Improving the liquidity risk management by open-end funds will provide more transparent and relevant disclosures regarding fund liquidity and redemption practices, explained Jon Mayer, Mutual Funds national sector deputy. In addition, the new rules will permit mutual funds to use swing pricing, allowing funds to ensure that shareholders who remain invested in a fund do not shoulder the costs triggered by other investors who have redeemed out of the fund. More scrutiny on cybersecurity The SEC is issuing proposals on cybersecurity (including cybersecurity regarding third parties). Given their access to information about deals and investors, asset managers are already being targeted by cyberthreats. Breaches at the fund level can shake investor confidence and compromise the firm s ability to raise funds. Asset management firms are expected to incorporate cybersecurity into their business strategy and risk management policies, even weaving it into the diligence process. For PE, cybersecurity considerations extend from the fund to the portfolio companies. The complexity increases when third parties for both the fund and the portfolio companies are added to the mix. A common form of third-party cybersecurity risk review are Service Organization Controls (SOC 1, SOC 2 or SOC 3) Reports, which help vendors demonstrate the strength of their internal controls to current and prospective customers. Having access to a SOC report can be extremely helpful when evaluating potential vendors and monitoring third-party risk on an ongoing basis, explained Kristina Vieni, Grant Thornton Special Attestation Reporting leader for Metro New York and New England. However, the mere existence of a SOC report may not address all of the asset manager s specific concerns, and it is important to understand the scope of the SOC report. New tax rules and implications From a tax regulatory standpoint, the new rules dealing with partnerships, disguised sales, debt sharing and tax audits require rethinking traditional structures and positions. In addition, new rules dealing with tax reform (potentially affecting the taxation of carried interest) are expected, and will also call for rethinking traditional structures and positions. While it is possible to understand and plan within the new rules, the uncertainty regarding fallout from IRS audits of partnerships will remain unknown and complicate planning. For PE firms, tax complexity for their portfolio companies will increase as new IRS regulations (including Section 385 treatment of intercompany lending, and European Union base erosion and profit-shifting actions) gain traction. 7

8 Tightening pressure transforms the landscape The state of asset management Technology holds the promise, but not the single answer Today, asset managers tend to operate many different technology platforms that do not interact. Connecting disparate data systems, particularly across the finance, risk and treasury functions, could provide the intelligence and insights on the correlations between lagging and leading indicators of risk and performance. This would benefit investors, regulators and the asset managers themselves. Asset management firms are looking to artificial intelligence solutions to help respond to the need to perform a growing number of compliance tasks. In the financial services sectors, these solutions are often called regulatory technology or RegTech technologies designed to manage data and meet their particular regulatory challenges. A rush to embrace RegTech has been escalating since the financial crisis. SEC rules to amend Form ADV to modernize disclosure and reporting are a further impetus to make these critical technology investments. Regulations aren t going away, but asset management firms of all sizes have ample opportunity to comply with them more efficiently and effectively. Even more opportunity lies in changing the way asset managers think about the underlying data in their risk, treasury and finance functions, transforming what s usually viewed as an overhead function into a genuine competitive advantage. Asset managers know that connecting with the emotional needs of today s investor is as important as meeting traditional measures of success. Greater transparency is one factor in building trust. There are new technology platforms that are changing the rules in delivering accessible and transparent information and insight that today s investors demand consider the impact BlackRock Inc.'s Aladdin risk mitigation platform has had on the ETF market. Asset managers are considering how other asset classes could be integrated into new platforms to allow multistrategy platforms. A changing landscape Asset management is becoming essentially a zero-sum game certain sectors will benefit to the detriment of others. We ve seen passively managed index and ETFs grow at the expense of actively managed funds. PE has also managed to grow, as larger PE firms move downstream for deals and PE managers become more comfortable with add-on acquisition strategies. After decades of dramatic growth, hedge funds face the challenges of a persistent low interest rate environment and a bull market for equities that has raged since For the time being, it does not pay to be the contrarian. Consolidation is creating a bifurcated market. Large funds have the financial resources to invest in the technologies needed to address regulatory and risk concerns. Small funds can carve out a strategic niche to serve specific investor needs. This creates a squeeze on midsized funds, which are looking at their business models and assessing if they can make it on their own. Managers of the best-run firms will understand the changing landscape and strategically position their firms to deliver value based on their unique strengths. They will use this period of consolidation to create the transparency, insights and fee value that connect with global investors in innovative ways. They will understand all asset classes and demonstrate the agility to guide investors with effective technology platforms that cross multiple asset classes. In some cases, that will mean finding new efficiencies to profitably drive down costs and fees. In other cases, that will mean partnering with entrepreneurial competitors who have found niche investment strategies that can be integrated into their platforms. Most importantly, they will have the courage to follow through with promising innovations that will provide reliable results for clients and, perhaps, in the process, disrupt and redefine their industry. 8

9 Tightening pressure transforms the landscape The state of asset management The SEC believes that recent changes will improve the quality of information available to investors, and will allow the SEC to more closely and effectively monitor, collect and use data reported by the funds. John Stomper, Grant Thornton s Mutual Funds national sector leader 9

10 Tightening pressure transforms the landscape The state of asset management 10

11 Driving profitability in a low-rate world The state of the banking industry

12 Tightening pressure transforms the landscape The state of asset management In this environment, even the best-run banks are challenged to deliver a satisfactory return on equity. And a disturbing number of the largest banks are worth more on paper than their share values reflect a situation that s clearly unsustainable. Nigel Smith, Grant Thornton LLP s national Financial Services leader 12

13 Driving profitability in a low-rate world The state of the banking industry Powerful trends are converging on the banking industry with a combined force that is shaking the sector to its core. Compression of net interest margin is now a structural issue for the industry. While the U.S. Federal Reserve Board moved beyond its zero interest-rate policy in 2016, rate increases have been slow and, from the banks perspective, frustratingly small. Five major central banks in Europe and Asia are trying to move their economic needles with below-zero rates. The regulatory changes that followed the financial crisis materially increased the cost of compliance. However, in the long term, the impact of altered capital requirements on profitability and, hence, the business portfolio may prove more consequential. Additional disruptive forces include a changing competitive environment and new frontiers in technology. Half of the 10 largest U.S. banks have price-to-book ratios of less than In this environment, even the best-run banks are challenged to deliver a satisfactory return on equity, observed Nigel Smith, Grant Thornton LLP s national Financial Services leader. And a disturbing number of the largest banks are worth more on paper than their share values reflect a situation that s clearly unsustainable. Banks have already gone through multiple rounds of cost cutting, but they must also address the fundamental complexities in their business models to drive profitability in the current low-rate environment. This is a tough challenge. Since opportunities for top-line growth are scarce, the ability to invest in the required transformation is significantly reduced. How should banks respond to these challenges? As our banking clients plan for and enter 2017, we urge them to take the following actions. Drive simplification throughout the business model Most banks have very complex operating models, with multiple processes and highly customized IT systems. Many U.S. banks, in contrast to their European peers, organize around products, such as credit cards or mortgages. This creates duplication and lack of accountability for total aggregate costs. U.S. banks tend to operate in product and channel silos, duplicating processes and missing opportunities to integrate data. This may be at least in part a failure to fully integrate previous acquisitions. In other cases, it may be the result of allowing individual businesses too much autonomy in their operations and technology. In addition, there has been a steady increase in the number of channels, including digital and social media. These may have been bolted on to existing solutions rather than legacy solutions re-engineered or upgraded to address the new omnichannel reality. This often results in fragmented middle- and back-office operations, and lower productivity. Traditional cost-saving approaches often focused on tightening procurement and reducing headcount eventually hit diminishing returns when confronted with this complexity. Source: Financial Information Systems, June 2016 Price-to-book ratios for the 10 largest banks by asset under management 13

14 Driving profitability in a low-rate world The state of the banking industry These conditions contribute to customer frustration and real competitive risk. New market entrants can design a simpler, more intuitive customer experience from scratch, leveraging digital channels from the outset with a once-and-done approach to capturing data. Banks need to radically simplify their operating models, starting with the markets and customer segments they serve. Eliminating unnecessary products and features can in itself be a major driver of increased efficiency. Product rationalization creates a multiplier effect through reduction in the associated costs of marketing, training, reporting and other administration. Moving to a rationalized set of operations and IT platforms is a tougher proposition, but is critical to drive out complexity and increase productivity. Given the spider web of existing architectures and interfaces, some banks may need to consider ring-fencing existing platforms while building new foundations. In fact, some banks used a variant of this good bank, bad bank approach for asset restructuring. There will be additional benefits arising from that simplification as time to market can be reduced and total cost of ownership falls. None of the previously mentioned ideas are straightforward, but each is critical to achieving sustainable long-term profitability. Invest in compliance optimization The challenges of keeping up with the Dodd-Frank Wall Street Reform and Consumer Protection Act (including the Volcker Rule), mandates from the Consumer Financial Protection Bureau, stress tests, capital requirements, and so on dominate boardroom conversations at leading banks, often at the expense of product and service innovation. The aggregate cost of compliance across all three lines of defense (business operations, risk management and compliance, and internal audit) now represents a material and often growing share of noninterest expense. So while banks are focusing on risk and regulatory compliance, new and unconventional competitors are bringing to market similar products and services to meet customers needs, usually without the same regulatory burden. Regulations aren t going away, but banks of all sizes have ample opportunity to comply with them more efficiently and effectively. According to Jose Molina, a principal in Grant Thornton s Financial Services Advisory practice, the opportunity for banks lies in reducing costs for activities that don t add value and refocusing their compliance teams to provide a competitive advantage. Banks need to radically simplify their operating models, starting with the markets and customer segments they serve. 14

15 Driving profitability in a low-rate world The state of the banking industry Many regulatory and associated reporting solutions were implemented in a hurry, to meet mandatory deadlines, and would certainly benefit from end-to-end process re-engineering, reducing duplication and driving productivity, Molina commented. At the same time, increased use of risk-based approaches, coupled with machine learning and analytics, can be leveraged to automate repetitive tasks and leverage human intervention where it will most reduce risk. A recent Grant Thornton survey of corporate governance, risk and compliance (GRC) functions including nearly 100 banks of all sizes bears out Molina s perspective: Nearly two-thirds of banking respondents are enhancing GRC activities by focusing more on risk management, and roughly half mentioned refining/improving existing enterprise risk management. More than 40% are implementing data analytics and risk modeling. More than two-thirds indicated that without existing constraints, their internal audit functions could add value to identifying improvement opportunities. More than a third are integrating GRC into their operations and business strategy. Others are pushing the envelope further, leveraging cross-bank utilities to drive economies of scale at an industry level (see Explore industry utilities ). Explore industry utilities On the innovation front, a number of leading banks are reaching outside their institutions, establishing cross-industry utilities to address core functions that are not a source of competitive advantage. Banks are looking at all their nonstrategic processes as the industry aims to operate in a fundamentally simpler way. Initial utility forays in banking include vital yet time-consuming administrative functions, such as client screening and third-party risk assessment and monitoring. The benefits are undeniable. For banks, the high volumes and innovative systems of these independent utilities lower costs, increase efficiency and improve performance. In some cases, the ability to look at risk and potential fraud across the industry may also enhance the collective ability to respond to threats. Benefits accrue to third parties as well. For example, industry suppliers need to respond to just one monitoring organization for most (if not all) of their banking clients. The burden of multiple responses and different reporting criteria is reduced, allowing suppliers to work more efficiently and pass savings to their banking customers. The banking sector has been exploring the benefits of collaborative utilities for many years now," explained Dennis Frio, managing director in Grant Thornton s Financial Services Advisory practice. "We see the model already extending to relieve the regulatory burden in areas such as Know Your Customer and Know Your Third Party consortiums." 15

16 Driving profitability in a low-rate world The state of the banking industry Identify value-added services In addition to simplifying products and services, banks need to identify where they can truly deliver value-added services that will command a market premium. By taking a customer segment approach, as opposed to a product approach, banks can identify and understand individual segments, life stages, specific life events and needs that drive opportunities to provide a richer array of value-added services. Those services should lend themselves to additional fees, as well as opportunities for bundling products and services that truly meet customer needs (as opposed to the banks cross-selling services that potentially don't). Consider, for example, the opportunity to bring retail customers a suite of home buying services rather than just a mortgage. What other products and services would be relevant to those customers, such as insurance or home improvement loans? How could the bank position those services in a way that would make them timely and relevant? How could they leverage third-party services in that process? Similarly, consider the needs of mass-affluent customers with respect to retirement planning. What service model would be appropriate for those customers? How might technology be used to provide those services at an appropriate price point for example, leveraging videoconferencing for customer interviews potentially a better customer experience and more efficient for the bank? Moving forward Having survived the challenges of recent years, banks can return to profitability if they can now effectively leverage the breadth and depth of their customer relationships in a manner that drives true economies of scale. That will require finally tackling underlying complexity to offer a better customer experience while driving a simplified operating model. During recent years, shareholders have had to absorb the significant costs associated with new regulations, restructuring, asset disposals, litigation and fines. Today, there is an understandable desire to see greater short-term returns. Further investment will be required to enable the banks to move to a structurally lower-cost base with increased productivity, which will enable sustainable long-term profitability. That may be a bitter pill for investors to swallow, but a necessary one. Which banks will be brave enough to come forward with those plans, accepting that there is only so far that traditional cost cutting can take them? Simply waiting for interest rates to rise is not a strategy. Generating acceptable returns on equity and reversing the disturbing imbalance between book value and share price demands focused and decisive action, and the sooner the better. What are the equivalent scenarios for small business and corporate clients? How can those solutions improve the bank s share of wallet with those customers? Growth in fee income and the overall contribution of fee income compared to net interest margin will be an important determinant of future profitability. Banks need to be laser-focused on that goal, while also simplifying their commodity offerings. 16

17 Tightening pressure transforms the landscape The state of asset management Many regulatory and associated reporting solutions were implemented in a hurry, to meet mandatory deadlines, and would certainly benefit from end-to-end process re-engineering, reducing duplication and driving productivity. Jose Molina, a principal in Grant Thornton s Financial Services Advisory practice 17

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19 Positioning for recovery The state of the exploration and production industry

20 Tightening pressure transforms the landscape The state of asset management I don t think we re coming back to $100 oil anytime soon. Companies have to produce oil and gas for less. Kevin Schroeder, leader of Grant Thornton LLP s national Energy practice 20

21 Positioning for recovery The state of the exploration and production industry At the end of 2016, the exploration and production (E&P) industry is showing signs of recovery after a prolonged period of pressure and uncertainty. Although a number of E&P companies are highly leveraged, and Chapter 11 filings are still a concern, history shows that energy prices can recover as quickly as they fall. West Texas Intermediate crude hovered at around $50 a barrel in late October nearly double February s lows. OPEC and other countries are starting to commit to production cuts that would further bolster prices. Still, Kevin Schroeder, leader of Grant Thornton LLP s national Energy practice, cautioned: I don t think we re coming back to $100 oil anytime soon. Companies have to produce oil and gas for less. US: Oil price (West Texas Intermediate) Source: West Texas Intermediate prices, U.S. Energy Information Administration, Department of Energy. Daily price in dollars per barrel. Producers have to learn to operate in the new normal, and be ready to move quickly as the market recovers. This may be a new way of thinking for companies that have been primarily focused on surviving through the downturn. In the 2016 Grant Thornton/Hart Energy survey, only 17% of respondents said they were ready to move quickly when the market recovers. Some 52% indicated that their current cash position allows them to maintain only current activity. Just 15% would add new rigs, and only 1% would add drilled but uncompleted wells. What can producers do now to adapt to the new normal? In the words of Winston Churchill, Never let a good crisis go to waste. The survey findings show that all producers need to secure talent they may have lost during the downturn, invest in creating more-efficient operations based on better data and analytics, and shore up their balance sheets. Many are going back to basics, using new technologies on welldeveloped fields with critical infrastructure already in place. Our survey findings also describe an industry that is wiser, more cautious and more willing to see the potential in areas where mutual collaboration and cooperation would benefit all parties. Securing talent The industry sharply cut staff in the wake of collapsing prices, but that trend is subsiding, and some producers are beginning to hire. About 45% of survey respondents indicated that they plan to keep current staffing levels; 31% have either begun hiring or plan to start hiring in 2017; and only 14% plan further cuts. But the industry faces constraints as it seeks to add staff. Demographics are unfavorable as the baby boomers, representing a high percentage of industry workers, prepare for retirement. The deep cuts have left laid-off workers wary of recommitting to such a volatile business. While the first round of hiring may still be easy to recover, the second will be harder. As one respondent commented, We need to expand staff, but finding qualified geoscientists and combating industry malaise remain a problem. 21

22 Positioning for recovery The state of the exploration and production industry Where will producers find the next generation of talent when prices recover? One solution will be to review processes and outsource or offshore routine functions. John LaBorde, Grant Thornton s Energy Tax leader, commented: We re seeing that happening in the tax area. For example, some of the large integrated energy companies have offshored portions of their tax compliance function. Reducing infrastructure for routine functions makes it easier for companies to ramp up in recovery and keep the best talent focused on the highest value-add activities. Investing in technology While producers were trying to survive the downturn, rapid advances in technology were taking place. Producers are realizing that their technologies and systems both in-house and in the field are outdated and negatively affecting operational efficiency. Additionally, they realize they may be missing out on the benefits of data analytics, cloud computing and improved communications. Out-of-date technology is particularly problematic for companies preparing for M&A. Real-time data and analytics, and cloud computing offer great advantages, but new technologies also create new concerns regarding data privacy and security, as well as the risk of cyberattacks if controls are not in place. In the survey, 25% of respondents indicated that access to relevant data for decision-making is their biggest technology infrastructure challenge. The survey also asked respondents what information they were having trouble getting that would help them run their business. At 33%, their No. 1 answer was play/basin analytics. Schroeder commented, There is a benefit to improved real-time information for decision-makers. Well performance is an example. Better use of analytics could optimize decisions around water content. Better data could improve controls on expenditures and essentially provide realtime information on each well to better handle the next cycle. Real-time data and analytics, and cloud computing offer great advantages, but new technologies also create new concerns regarding data privacy and security, as well as the risk of cyberattacks if controls are not in place. 22

23 Positioning for recovery The state of the exploration and production industry Shoring up balance sheets The oil and gas business is very capital intensive. Producers raise billions of dollars each year through various forms of financing, but they still need to spend more than they raise to cover infrastructure and drilling expenses. Maybe they re raising $2 billion, but they are also spending about $2.3 billion each year, Schroeder said. The combination of falling profits and tightening credit markets has led to an unprecedented industry-wide focus on balance sheets. Any rise in investment activity puts severe working capital demands on already constrained balance sheets. For example, pressure-pumping rigs for fracking have faced years of extreme wear and tear with reduced upkeep and little or no reinvestment. But better news is on the horizon: Although about 40% of respondents in the 2016 survey think obtaining capital is slightly or much more difficult this year than last year, that s down from 54% in the 2015 survey. These results indicate that constraints to acquiring capital may be easing, if only moderately. Bryan Benoit, Grant Thornton s Energy Advisory leader, stated: E&P companies are looking to restructure before debt obligations become difficult, if not impossible, to refinance. Private equity firms appear increasingly interested in stepping up to the plate for needed capital. There is roughly $200 billion in dry powder in private equity funds. 1 Is this the time for private equity to activate that dry powder on the exploration and production industry? A return to basics Shoring up the balance sheets allows survivors to cherry-pick the best assets from struggling competitors, and many strong producers are using this opportunity to come home and concentrate holdings in the fields they know best. Indeed, some industry leaders have returned from the Bakken to the Permian, which was first drilled around 90 years ago. The Permian Basin has the critical infrastructure missing from the newer fields. Combined with new technologies for long, horizontal drilling, the deep reservoirs in the Permian are proving to be profitable plays for producers. An emphasis on solid, long-standing plays is reflected in our survey results. Asked which strategy fits your company within the next three years, respondents indicated they were pulling back to a few core areas and sharpening focus on them. Only 22% indicated a strategy to diversify the asset portfolio across multiple plays/basins. In a related trend, service companies are abandoning less active basins. In lightly drilled areas, producers are likely to experience higher costs and fewer choices. Politics and policy As players in a highly regulated industry, producers face fines and costs, as well as reputational risk, for noncompliance with myriad regulations. In 2016, the industry is anticipating new final rules from the U.S. Environmental Protection Agency (EPA) on emissions. The SEC approved a rule that required oil, gas and mining companies to disclose payments made to foreign governments; that rule was mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act, but had stalled in the courts until this year. 1 Butt, Rachel. A handful of investors are hoarding $200 billion, and Wall Street wants to know when they are going to spend it, Business Insider, May 3,

24 Positioning for recovery The state of the exploration and production industry In the survey, more than one-half of respondents indicated that regulatory hurdles and delays were a top business risk for their companies. Producers have long dealt with EPA and Bureau of Land Management regulations. A new wrinkle is that states are increasingly taking action, particularly on fracking. A charged political environment in state courthouses means that rules vary across state lines. Roughly 60% of respondents indicated that the following regulatory issues were either significant or very significant to their business decision-making: EPA regulations on emissions Water disposal issues State and federal regulations on fracking A willingness to collaborate There are indications that producers are working together more to meet their challenges. When asked where they saw the best potential for achieving operational efficiencies, the top response (25%) was consolidating field services such as water handling, recycling and disposal. Queried on which big data and data analytics were most relevant, the top responses indicated a desire for more open and transparent data across the industry on items like drilling permits, rig counts and reservoir data. Schroeder commented, Producers tend to cooperate in the downturn. You ll see transactions where there are acreage exchanges to support where individual producers have particular strengths. But there tends to be less cooperation in an upturn, and this is where a coordinated, smart national energy policy makes sense. Although there seems to be little cooperation between the opposite ends of the political spectrum these days, there are areas of common ground. A coordinated energy policy could address legitimate environmental concerns with ground water disposal in fracking that would simplify today s piecemeal policies that vary across state or even county lines. There are also legitimate business concerns where a fresh view on energy policy could challenge regulatory restraints that no longer make sense, such as the ban on exporting crude. Transparency in critical data could help all producers better manage their business and control risks, and anticipate and prepare for cycles. Optimism for the future Overall, the survey points to an industry cautiously optimistic about growth and the future. Asked about their companies plans for capital spending for U.S. expenditures in 2017 versus 2016, 45% of respondents indicated an increase, and less than 10% a decrease. Last year, only 36% said an increase, and 32% a decrease. In other results, 48% of respondents this year plan to increase acquisition and divestiture activity and just 2% plan to make cuts. On a question asking how their spending would be prioritized going forward, the top response was actively looking for strategic deals (31%), and only 7% said right-sizing their company. The overwhelming factor in the energy business will continue to be commodity prices. That s something individual producers can do little about. What they can do is find top people, make smart investments in technology and burnish their balance sheets. Producers can also look for ways to collaborate on smart policy that helps them manage their business and helps the country manage its energy needs into the future. Entering 2017, the best companies will position themselves to meet those challenges. 24

25 Tightening pressure transforms the landscape The state of asset management We re seeing that happening in the tax area. For example, some of the large integrated energy companies have offshored portions of their tax compliance function. Reducing infrastructure for routine functions makes it easier for companies to ramp up in recovery and keep the best talent focused on the highest value-add activities. John LaBorde, Grant Thornton s Energy Tax leader 25

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27 Disrupting the disruptors The state of the information technology industry

28 Tightening pressure transforms the landscape The state of asset management Reaching new markets has never been so straightforward or as lowcost. Information technology companies are aggressively blurring traditional industry boundaries. But there are challenges. Steve Perkins, technology leader at Grant Thornton LLP 28

29 Disrupting the disruptors The state of the information technology industry Renowned as the disruptors of other industries, information technology (IT) companies are now subject to a dizzying pace of change, driven by the global pervasiveness of their own technologies. We ve known for a while that the on-premise model has largely been supplanted by the cloud, making all technologies available as a service or everything-as-a-service, said Steve Perkins, technology leader at Grant Thornton LLP. Reaching new markets has never been so straightforward or as low-cost. Information technology companies are aggressively blurring traditional industry boundaries. But there are challenges. While quickly maturing, the global everything-as-a-service (XaaS) market is still forecast to grow at a compound annual growth rate (CAGR) of 38.2% from 2016 to 2020, according to research firm Technavio. 1 Storage-as-a-service will be the fastest-growing service segment in the XaaS market, delivering CAGR of more than 40% by U.S. companies will invest more than $232 billion in internet of things (IoT) hardware, software services, and connectivity in 2016, and IoT revenue is expected to skyrocket by 16.1% to $357 billion by 2019, according to research by International Data Corporation (IDC). 2 Shifts of this magnitude significantly disrupt all segments of the industry s value chain. Cloud computing, for example, changes the way software applications and infrastructure are consumed and acquired. There is more elasticity and volatility in demand. IT companies must be able to scale up seamlessly in response to rapidly rising demand. They also need to be able to anticipate when a product or service is reaching maturity and scale down in response by driving efficiency and reducing costs. Disruptive technologies like these inevitably rewrite the rules of how IT companies grow and compete. New competitors and threats are emerging. Established leaders are seeing revenues from traditional products stagnate and must pivot to new revenue sources, driving new M&A cycles. Regulatory oversight and scrutiny are growing both domestically and internationally at the same time as IT companies are moving into nontraditional industries. International expansion tests tax and privacy policies here and abroad. As technology becomes ever more ubiquitous and essential in our daily personal and business lives, increased scrutiny is inevitable. Winning companies must redefine their business models, building platform businesses underpinned by strong operational discipline. Today, several trends are shaping the state of play in the U.S. IT sector: hypercompetition, geopolitical volatility, regulatory and tax scrutiny, and the rise of the platform business. 1 Technavio. Global Anything as a Service Market , May 17, Shirer, Michael and Torchia, Marcus. IDC Spending Guide Finds U.S. Organizations Accelerating Their Investment in the Internet of Things as Meaningful Use Cases Find Their Way to Fruition, IDC, June 22,

30 Disrupting the disruptors The state of the information technology industry Hypercompetition exposes new risks The U.S. IT industry is not for the faint-hearted competitive intensity is part of its DNA. Increasingly, IT companies are crossing traditional industry boundaries to take on established companies on their home turf, as they have so successfully done in media and retail. But these moves expose IT companies to new risks. As they invest in moving into new sectors such as automotive, hospitality and transportation, they face entrenched competitors with finely honed capabilities. Suddenly, their core technical prowess isn t enough to succeed. There is a real danger they will stretch their business model and distract leadership, placing capital investments at increased risk. In some cases, they will also step into heavily regulated markets, such as health care or financial services. This exposes them to significant risk unless they have the capabilities and experience needed to meet the compliance requirements of the sector s policymakers. Established companies in these industry sectors have powerful support bases and won t cede market share quietly. In addition to battling on new fronts, IT companies need to protect their own borders as established firms in other industries begin to encroach on their territory. A notable example is General Electric s shift to a digital and industrial company. Today, it is a $4 billion software business that is actively working to build and deploy a dominant industrial IoT. According to the Financial Times, this 123-year-old group is investing $1 billion a year to boost its digital capabilities, hiring 1,000 software engineers and data scientists, and setting up a new data analytics center in San Ramon, Calif. 3 To prepare for the risks of expanding into new sectors, IT companies need to map and understand the current regulatory environment and potential future regulatory risks. They also need to carefully evaluate their partnership and acquisition strategy for moving into new sectors. Google, for example, managed the risk of moving into a new sector by buying the mobile wallet technologies and patents from Softcard as part of the technology giant s strategy for the booming mobile payments segment. 4 IT companies are crossing traditional industry boundaries to take on established companies on their home turf, as they have so successfully done in media and retail. 3 Crooks, Ed. General Electric: Post-industrial revolution, Financial Times, Jan. 12, Mishkin, Sarah. Google in deal to boost mobile payments; Search group buys technology from Softcard as it takes on Apple Pay, Financial Times, Feb. 23,

31 Disrupting the disruptors The state of the information technology industry Geopolitical volatility and regulatory and tax scrutiny increase In the past, U.S. tech companies powered ahead in an environment that could be described as regulatory lite. They didn t face the same regulatory burden as their peers in other industries, such as utilities or financial services. But this is changing and fast as companies grow and expand internationally. A strong signal of this geopolitical volatility was the announcement by the EU s antitrust regulator that Ireland should recoup about $14.5 billion of unpaid taxes accumulated by Apple over a decade. 5 On the one hand, reaching international markets has never been so straightforward or as low-cost. Because of new technology platforms, ondemand services, global supply chains and increasing data speed, earlystage IT companies can operate globally from day one. Expansion is also growing more complex. To succeed with their international ambitions, IT businesses must overcome increasingly complex and diverse legal and regulatory obstacles that differ regionally. Their cloud offerings, for example, rely on the free flow of data across international and other jurisdictional borders. But governments around the world are impeding the free flow of data in the name of protecting privacy. A notable example was the decision of the European Court of Justice to strike out the safe harbor framework in October 2015, which had allowed the likes of Facebook and Google to move data from the EU to the U.S. As more IT companies become global enterprises, taxation authorities are taking an increasingly critical view of their tax strategies. Where an IT company physically supports, sells and innovates its products often has very little connection with where the products are consumed. IT companies are increasingly at odds with taxing authorities about this fundamental aspect of their business. The Organisation for Economic Co-operation and Development s base erosion and profit shifting initiative, aimed at closing international tax loopholes and establishing where taxes should be paid, is adding complexity. Within U.S. borders, the Supreme Court s reversal of Quill v. North Dakota has increased complexity as local state taxing authorities lay jurisdictional claims to out-of-state transactions. IT companies need to understand how these regulatory and tax risks affect how they structure their global operations, define their product and service offerings, and manage value chains that span borders. These risks affect multiple aspects of the business from the partnerships they forge, to how they manage risk, to their brand reputation. Joel Waterfield, Grant Thornton s national managing director for Technology, said, Information technology companies need to build a detailed view of the tax landscape in all their target markets understanding where the inconsistencies are, where changes are pending, and what the implications are for compliance and tax reporting. 5 Drozdiak, Natalia and Schechner, Sam. Apple Ordered by EU to Repay $14.5 Billion in Irish Tax Breaks, The Wall Street Journal, Aug. 30,

32 Disrupting the disruptors The state of the information technology industry The rise of the platform business redefines value creation Fortune favors the brave in the IT industry. In many cases, the winning tech companies are those that can develop the platforms that redefine an existing industry rather than seek incremental improvements. The network effects of aggregator platforms like ebay or social platforms like Facebook have delivered significant value to their creators. Tomorrow s IT winners will build and orchestrate pervasive and compelling platforms that connect producers and consumers. IT companies that own successful platform communities will be able to tap into and monetize user-generated content, creativity and data the currency of the future for tech companies. Success based on clear purpose U.S. IT companies are justifiably seen as world leaders. However, IT is also an unforgiving segment, where the leaderboard is constantly changing. It s difficult to predict which companies will provide the winning services and products in a cloud-based, open-source era. What is clear, though, is that success will entail a significant transition into how companies manage competitive risk, growing regulatory and tax scrutiny, and engagement with communities of consumers. By building executive understanding and alignment behind the key strategic themes facing the industry, U.S. IT companies can gain the clarity of purpose required to succeed. Creating long-term sustainable value requires strong operational discipline and constant vigilance to defend the platform from competitors. It can be easy for a platform business to be commoditized or imitated in different geographic markets. Orchestrators have to have the structures and processes in place to offer a compelling end-to-end customer experience. Given that platform operators learn and evolve based on data, they also need robust approaches to data governance. IT companies also need to re-evaluate their acquisition strategy in light of their platform ambitions. Perkins said, Constant prioritization of investments must be made to favor those features most apt to build and sustain customer participation in the platform. Should usability be enhanced? Should throughput be accelerated? Should an end-toend process be optimized? Should they go deep into a subindustry or functional specialization? IT must address all these questions, with constant customer feedback, an agile approach to development and an obsession with client service. 32