The Federal Reserve’s unprecedented interest rate hikes intended to combat equally unprecedented inflation have had a real impact on many firms that rely on outside sources of capital to fund business operations and growth. In response to the rising cost of capital, firms are understandably looking to conserve cash and lower spending. While it may be tempting, one area that heavily regulated firms should think long and hard about before cutting is compliance.
Impacts of the Rising Cost of Capital
The Fed’s July rate hike was the latest—but maybe not the last—in a long series of hikes that began in early 2022. It pushed the target federal funds rate to a range between 5.25% to 5.50%, a 525-basis-point increase from March 2022. Inflation has come down from its peak of 9.1% in June of 2022, but it’s still above the Fed’s target of 2%. So, the rate increases may continue as early as this month.
For firms seeking capital, a rising interest rate environment makes it more costly to use debt financing. What’s more, higher rates result in less venture capital funding being available for firms who look to that source.
According to a report by KPMG, VC deal speed continued to slow in the second quarter of 2023. The combination of ongoing geopolitical challenges and concerns about inflation and interest rates has resulted in the VC spigot being turned down, despite the availability of cash. In fact, the total number of VC deals in the US have fallen to level not seen since 2015. Unless it’s an AI-focused deal riding the ChatGPT wave, most funding rounds at all deal stages are taking longer to complete, if they are completed at all.
With the “free money” well running dry for now, many companies are at a point where they are unable to raise any more money in the current environment. In our business, we are seeing fintech startups, broker-dealers and asset managers resigning themselves to the reality that another round of financing may not be coming any time soon. These firms have started strategizing about the best way to attack their fixed and variable costs to slow their cash burns.
With much of the economy still in a relatively strong position, firms are reluctant to cut revenue generating areas. That leaves the typical cost center departments on the chopping block. For companies in our target industries, compliance departments are often a large target to find savings. And while some trimming of headcount and discretionary spending may be appropriate, a wholesale gutting of a firm’s compliance program, without a back-up plan, can be a costly mistake.
Outsourcing Compliance Functions May Be the Answer
The regulatory environment around wealth management continues to gain in complexity. The cost of headcount for good chief compliance officers, as well as staff and increasingly important technology tools, keeps rising. When capital was flowing easy, this was less of an issue. But not today. With increased regulations coming from Washington and the states, this is not the time to let up on compliance.
Instead of the fixed cost of hiring in-house compliance staff and installing expensive systems, firms may want to look to an outsourced model to scale their compliance program appropriately, especially over the near-term. As we know, regulators don’t give a firm a pass just because they may be short on cash.
Compliance executives should consider outsourcing overflow support if they are forced to go to a skeleton crew in house. A high-quality, experienced and well-staffed external resource can be the answer to filling the gap and keeping the compliance lights on. By pivoting to an external provider, they can weather this liquidity storm for the next six- to 12-months, then reassess and determine if a more permanent outsourced solution makes sense over the longer term.
Maintaining a Strong Compliance Program Should Be a Priority
As someone who has been in this business for decades, I’ve lived through many credit cycles. Today’s high cost of capital is a real issue, and it will not resolve itself quickly. And if the economy does slip into recession next year, that will only exacerbate the problem for firms. However, this is not the time to drastically cut compliance budgets.
That is a short-sighted move.
In fact, I believe it’s time to make sure you have your compliance house in order, because when cash is flowing again, firms will want to be well positioned to take advantage of improving conditions. Maintaining a strong compliance program, even if it means reallocating dollars to an outsourced solution, can help avoid regulatory issues during this period and set the firm up for future growth. That needs to be a priority.
Mitch Avnet is Founder and Managing Partner of Compliance Risk Concepts, a business-focused team of financial services industry senior compliance professionals and executives.