Podcast transcript: Why PE must embed geostrategy to win in the market

25 min approx | 2 September 2020

Winna Brown 

Hello, and welcome to EY’s NextWave Private Equity podcast. In our series we explore the impact that private equity can have on the economy and society, capturing insights from industry thought leaders and private equity practitioners from across the globe. I’m Winna Brown from EY and I’m your host.

Today we will be exploring how the shifting geopolitical landscape is affecting private equity. I am delighted to be joined by my colleague John Shame. John is a Senior Partner at EY. And in his 35 years at EY he’s worked with private equity firms for over a decade and also leads our geostrategic business group. This group helps companies understand the impact of geopolitics on their business and how to navigate the volatile global landscape and translate geopolitics into a business strategy. John, welcome to the podcast.

John Shames

Thank you, Winna.

Brown 

Excellent. John, many people in our audience are probably going to be surprised to hear that EY has a geostrategic business group. Are you able to explain a little bit more about what this group does and importantly why EY feels it’s a critical part of our business?

Shames

Yeah, absolutely. We started this group 3½ years ago and it really was in response to all the different geopolitical events that were taking place around the world. If you think about it, 3½ years ago in particular, this was the beginning of the rise of nationalism and populism. It was a start of much bigger focus around bilateralism, and we really felt that our clients were really challenged by that environment and really needed help, and we felt that EY with its 300,000 people around the world in almost every country, in almost every city, was really uniquely able to help our clients deal with these issues on a global basis as well as on a local basis. So we started this group. And we really have been focused on making sure that we provide insights around this topic. But it’s really around business. The intersection between strategy and geopolitics. And we call that geostrategy. And so we really feel that is a needed area where EY can really be helpful to its clients.

Brown 

That makes a lot of sense, and before we dive into the impact on the private equity sector specifically, perhaps you can explain a little bit about how EY sees the geopolitical landscape evolving and what you are actually sharing with our clients on the underlying trends. I imagine the geopolitical landscape over the last couple of years has certainly given you a lot to talk about.

Shames

Absolutely. And of course with the advent of the pandemic of COVID-19 at the beginning of this year that really has been a major change that we had not predicted in any way. So we look at this using the four and NextWave primary forces of disruption that EY has identified. And those are globalization, technology, demographics and the environment. But just to talk about those, obviously from a globalization perspective this world has been integrally linked over the last 20–30 years — especially the last five years because of technology in particular — than it ever has been before.

But what has happened recently, again, since the beginning of the rise in nationalism and populism has been really the fact that companies can no longer assume that globalization will continue, and in fact under COVID-19 we are really seeing a rise in regionalism. We are seeing the rise of three major economic political blocs with the US being one, China being the second and the EU with Europe being the third. And we think this trend is going to continue. We think that we are going to see more and more regionalism. If you look at where the trade agreements are going, they are no longer multilateral trade agreements. They are generally bilateral trade agreements. The US MCA with China and the US and Mexico is a little bit of an anomaly but most of them have been country to country. You know EU to the UK; EU to the US; UK to the US. So we think globalization is a major trend.

Secondly, we have technology. And you can’t avoid all the different discussions in the press right now around the issues around the US and China and Huawei and 5G and this battle that is going to take place now and in the future. And it’s having implications around public health. It’s having implications around privacy. There are cyber attack issues. The technology is much more at the forefront than it ever has been before. And again, the globalization of technology is now being changed into the regionalization of technology and we might be seeing three different blocs again around this topic.

The third area we are following is demographics. And what is happening here is that older regions could potentially lose economic steam while younger regions like those in Africa might really be countries that will have economic advantages over time. Now this is leading to a lot of different things, especially under COVID-19 around the issues around aging. Around the issues around political and social unrest. The implications of COVID-19 on the elderly populations. Will there be differences in terms of mortality rates? We are following all of those things but demographics is definitely a big topic.

And then finally, fourth is environment. and while under COVID-19 climate change in particular has taken a back seat, we think this is going to rear itself more and more over time and that, while the world is struggling to deal with a collaborative policy that is global in nature, we do think that over time there is going to have to be more and more focus in this area and more and more changing. So those are the four megatrends we are focusing on. We are also focusing on different themes and those themes are pretty obvious, but US-China relations is number one. Trade and the impact of trade on all these areas is number 2, and then finally with the beginnings of COVID-19 in 2020 that is also a major implication.

Brown 

Well there is certainly no part of our society that geopolitical forces are not currently influencing. If we turn to look at this though in terms of private equity, can you share some insights into how geopolitics is creating challenges and/or perhaps opportunity for value creation at funds?

Shames

This is an area that we have been spending a lot of time on, and let me take a step back by saying that we recently partnered with the Wharton Political Risk Lab to focus around the topic of risk and geopolitical risk around the world and as part of that we did a survey in 2019 at the end of 2019 for the first time and interviewed over 1,000 executives around the topic of where they see the world today as well as what they are doing internally within their organizations. As part of that, we did also do a number of these qualitative interviews and we focused specifically in one of the areas around private equity. And we’ve taken a look at private equity in terms of how these organizations, especially the largest ones, are organized to deal with geopolitical issues.

And then we spent some time interviewing three of them that we felt were best practices. And so from that we learned a couple of things. I think No. 1, we are definitely seeing that there is a shift from just worrying about emerging markets. So in the past I would say when you talked about geopolitics you really talked about emerging market risk. And what we are seeing now is that risk and those implications have really moved into developed markets and in fact when we ask executives and participants what the greatest sources of political risk are it’s no longer something to do with a third-world country. It really is about the US. It’s about China in particular. And even something like the advent of Brexit has resulted in a lot of different risks.

Secondly, I think that the major PE funds have moved from focusing on the basic risks around say, SCPA and those types of topics, into a lot of other areas like reputational risk, regulatory risk, legal risk, and of course a lot of this is encompassed around the focus around ESG. And so we really feel like that is a big area of change and in particular it’s focused again not just on the emerging markets but basically all the companies out there that are doing business, that have trade networks and so on. The third thing that we saw, especially around those funds that we think are at the forefront of best practices is that they are using what is happening in the world around geopolitics and moving away from just worrying about risks and focusing on opportunities. And so they really feel this is a differentiator in the competitive deal environment. For them to understand what it is like to do business in a particular country or region or around a specific topic, they really feel that they will be able to identify new opportunities. So to me this is the advent of what I would call a macro perspective. You know I think in the past there was much more focus around the micro perspective. How is a company going to be profitable? How is it going to grow? How is it going to help IRR? And now they are focusing on the macro opportunities out there and thinking about how interconnected the world is and then being able to figure out how they can identify companies, regions, geographies, sectors that are going to benefit from all this change taking place now and in the future.

Brown 

Given these macro opportunities and challenges that you’ve outlined, I’m wondering what firms can actually do to address these challenges. Specifically, how are you advising private equity executives to embed the consideration of geopolitical shifts into their everyday decision-making?

Shames

The first thing to mention is that each one of these PE funds is different and unique. There is no standard way of going about doing investing and focusing and running a fund. Some of them are very centralized. Some of them are very decentralized. Some of them are very collaborative. Some of them are not. So as a result there isn’t one answer for this but what we do believe is that you need to have a geo strategy and this is the intersection between having a strategy and focus on geopolitics. We think this has to be a proactive strategy. And really goes around what we will call the scan, focus and act framework, which is that they really need to understand what is happening from a macro perspective and then focus on a particular industry or investing area to really understand the key performance indicators, the political environment and understanding how companies are affected by that and then ultimately acting by developing the robust portfolio of companies that fit that criteria.

I think specific to PE firms it is really around setting the philosophy around how they want to deal with this. What kind of culture do they want around geopolitical issues? Do they want to have a centralized focus? Do they want it to be local? I think in the past, most funds when they needed some expertise around a local issue, say they wanted to invest in a country in Asia, they went out and hired someone. They probably didn’t have that person on staff. Well that is changing now. Now teams have a macro group. They have a geopolitical group. They have people who are specifically responsible for those things. And so I think that is the second thing is having a team, whether it is 1 person or 5 people or 10 people who are focused on the specific topic. And then finally, I think equally that they need a process again, around the philosophy, but what is their process? How is this embedded into the investment committee discussions? What requirements to they need to go through before they can go to the investment committee in terms of understanding geopolitics? We think that’s a really important part of this. and that is what we are advising our clients is to think about it along those lines.

Brown 

Do you think that a PE complex that actually embeds a geopolitical strategy within their framework has advantages over one that doesn’t?

Shames

Obviously, we think they do. We think that by doing it this way, again, I mentioned before about the issue of risk vs. opportunity. Geopolitics shouldn’t just be about risk. It shouldn’t just be about worrying about the downside. It should really be about driving this from an opportunistic perspective, from a proactive perspective and being able to find opportunities out there that maybe would have only come about because someone is thinking about it from a geopolitical perspective. So for example, it could be that they are focusing on a particular country that they really believe is going to be the beneficiary of say a US-China technology war. And as a result they are going to be much more focused and willing to make more investments and maybe even pay more multiples around a particular company that is in a sector that is really going to be beneficiary in a particular country. So, we really do believe that there is an opportunity here to really set yourself aside from other firms by having this very strategic, very geopolitical thought process going on at all times.

Brown

That’s really interesting if you think about the geopolitical environment and its impact on investment decisions. Can we maybe explore this a bit more? I mean you mentioned cross-border deals involving US and China. Are there other scenarios that have come up in your experience? And how have we worked with PE executives around navigating these situations?

Shames

The classic case is you want to make an investment in a particular country and you are worried about, again, third-world risk of areas like corruption. And so there is a particular process that you go through in terms of reviewing documents, hiring consultants, hiring lawyers, having some local people get involved. Reviewing media reports about that company and public records and that still happens. But I think that many of these situations are much more complicated. So you take a company that is doing business with US and China. Whether it is a Chinese company or US company or elsewhere. They have trade flows with those countries. They have trade flows with other countries. And so in that case, there is a lot more complexity out there, and I think that a fund that really understands these issues — that has a philosophy around dealing with them, has people centrally thinking about these topics and then really getting involved locally — I think they have an opportunity to win in the marketplace to invest in the company as well as succeed better in that company and understand it better. And so areas like scenario planning, a lot of this is qualitative, but there is some quantitative analysis that can be done. Enlisting external perspectives from a geopolitical perspective, not just from, say, an economic side. That is another area to think about. And then there is just all the legal and regulatory issues that come about as a result of these.

So I think there are a lot of things that companies could be doing differently. And I know that in our conversations with clients, this isn’t just about, a deal is going to get done and you are just going to make sure that you understand it better. This is really about making sure that the deal makes sense. And I know that in some cases we’ve seen that funds have not done deals and they’ve avoided investment because they determined that the risks out there and the opportunities that might present themselves were just not in balance. And so we do see many examples like that and I think you are seeing much more complicated areas than just kind of the standard, historical. We need to make sure there are no risks. You really need to make sure there is much more opportunity out there in today’s world.

Brown

So thinking about that then, do you think that the deal teams and investment committees of today are equipped to take on this challenge of geopolitical change? What kind of decisions around talent need to be made to make sure that the right people are in place to help navigate through the geopolitical landscape that we are in right now?

Shames

So I guess I would answer it by saying it depends. We have seen some funds that are very sophisticated, that have a centralized focus on geopolitics and well beyond that. And then we have other funds that really do this on an ad hoc basis. So I do think that some are better prepared than others. I do believe that in many cases there is opportunities for improvement. But I do see that there is an evolution taking place. And so if we had this conversation, if you go back 10 years, none of these funds had anyone in this world whatsoever. And so today, a lot of the major funds have some element of this and maybe just using their government relations team who are much more sophisticated about these topics than they were say 10 years ago. Or maybe that they have actually specific individuals who were hired, who have a global expertise and a global network to be able to dive deeper on these. So to me there is no one answer here. It really does depend, but I see funds moving closer to being where they need to be. I think there is still a lot more room to go.

Brown

John, we’ve had a lot of conversations with our clients and we’ve certainly seen a growing trend how companies are more purpose-led and purpose-led transformation is a growing trend. Are we seeing that having a geostrategy ultimately helps private equity firms to find their purpose? And is it changing how they are working in society and how they are evolving?

Shames

In a lot of ways the focus around geopolitics and geostrategies is part of a broader focus around ESG and so I do think that PE funds are in particular very sensitive to this topic and are doing more and more. We are seeing that there is much more due diligence being done on the front end around these topics than there ever has been before. For obvious reasons and for some not so obvious reasons. And we see this not only on the deal side and the origination side, but we see it in the portfolio in particular, and I think that companies need to make sure that the investments they make are aligned with their purpose and with their intentions and how they want to be seen by the public and by others. And so that means that it’s not just when they make the investment but it is around how the portfolio company responds and deals with issues over time, and we’ve clearly seen a big increase in reputational issues and clearly PE has not been immune to that. They have been, especially in the US, have been criticized quite a bit for investments they have made and they need to be careful going forward about how you deal with these things from a reputational perspective. So I do think that it is a topic on the mind of all PE funds. I don’t know if geopolitics is always aligned with that ESG focus but clearly it is an important part in making good investments that will return the proper amount of investment.

Brown

You touched on portfolio companies. Can we maybe focus a little bit on that? How much have you’ve seen PE funds help or perhaps guide their investees with their own geostrategies?

Shames

I would again say it’s mixed. I think that some funds are very focused on this area. They have operating teams. Some of them don’t have as big operating teams. I think as a general trend you are seeing most funds with operating teams or at least operating executives or advisors in some way. But I would say that some funds are much more proactive around this than others. I think all of them, when they do have a geopolitical focus, they have their experts available to the portfolio companies. We do think that this can be more proactive and be offered up in a different way. I think also they have a big opportunity to structure the board in a very politically sensitive way and put people on the board who are experts in areas that are important to that company. And so if that company is doing business in Asia a lot, do they have someone who is an ASEAN expert? I think that, one thing to mention here is that, I mentioned the survey that we did at the end of 2019. Again, this was to 1,000-plus CXOs around the world. For example, we had 140 respondents from China. And what we saw was that clearly this is a topic of concern to business executives and companies. And I think that they rank geopolitical risks as one of the top risks. And they clearly are sensitive to this topic. They are doing more in this area. But there is probably a lot more to be done. and when you look at within companies, who owns the geopolitical space, there really isn’t an answer right now. Every company does it differently, just like the PE funds do, and we do believe there will be some more consistency over time. But I think that a PE fund can help a company think through those issues. It can help a company make sure that it has the right tools to succeed in this area. It can help a company think about how to do scenario planning and dealing with political risk because of its sophistication at the fund level, which probably doesn’t exist in most companies at least when they make the investment. And so I think this topic of being proactive vs. reactive is the big changer. I do believe that PE funds should be thinking about their portfolio clearly from a geopolitical perspective, not just at the deal stage, but all throughout the life cycle including the exit.

Brown

John, you’ve clearly painted the picture as to why the consideration of geopolitical risk is a critical business driver for private equity. And specifically how firms should be including this focus into their investment strategy and into their ongoing portfolio life cycle and growth focus. Are you maybe able to summarize what are your top three or four key leading practices that private equity firms should aspire to adopt as they think about addressing geopolitical risks?

Shames

I think No. 1 is they have to recognize that political risk, geopolitical risk, whatever you want to call it, is here to stay. It’s more complex than it ever was before. It’s not going to be less complex. And firms really need a more refined model both from a philosophical perspective as well as from an organizational perspective to deal with this. I think PE funds in particular need to think about this from origination all the way to exit. And each of those areas are important.

No. 2 — while not every fund is going to have a centralized team or function that can deal with this, it’s something for them to consider and to move beyond risk identification to opportunity assessment. What we saw is that those that we considered to be best practices really used that team who helped them in deal origination, who helped them think about topics that were global in nature and really home in on opportunities that maybe they would not have considered in the past. There definitely needs to be a local focus here, but I think a centralized focus could be helpful.

Thirdly, this is more than just check the box exercise and something they should be doing from a compliance perspective. This should be part of an investment decision process and it should be integral and incorporated into ESG and other types of considerations. It should be early. It should be comprehensive. It should be something that is culturally part of the organization. I think that this is a subtle topic. This group, whoever you have doing this, needs to bring value. They need to have support from the top of the firm and there needs to be a culture where this information is desired and that the deal teams and others in the organization are educated around this and that they understand the importance of making sure that they think about these interrelated geopolitical issues as part of the investment process as well as part of the portfolio growth process. So I think those would be the takeaways that I would tell you I think are the most important and we’ve heard from other PE firms that we talked to.

Brown

John, that’s brilliant. Thank you so much for being on the podcast today and for sharing your insights into how politics is shaping all facets of our world including how we conduct business and specifically how it is influencing the entire private equity life cycle from investment decisions through to value creation all the way to exit. There are certainly some very interesting times ahead for this sector and indeed for all global business. Thank you again.

Shames

Thank you — appreciate the time.

Brown

I hope you enjoyed this episode of the NextWave Private Equity podcast. Please subscribe, review and of course share it with your colleagues and your friends. To find out more about the topics we discussed, check out ey.com/private equity. I’ll see you on the next episode and in the meantime, please stay safe and healthy.