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Political risk is creating challenges and opportunities for global organizations, including private equity (PE) firms and investors who are increasingly exploring cross-border deals as valuations soar across the US and Europe.
On a previous episode, we talked about why PE must embed a geostrategy so they are able to recognize unique opportunities and use that strategy to inform their investment decisions. Today, we dive into three specific areas of geopolitical risk that are especially impactful for and relevant to private equity funds right now.
Covid-19 pandemic: increased tension and competition between big regional powers will lead to an environment in which PE must carefully consider and anticipate the implications for cross-border deals.
Tech sector: governments and regulators will have a massive influence on the tech sector in the coming years and it will create both political risks and opportunities for investors.
Climate change: increasingly active governments and regulators will create a patchwork of environmental legislation which will make it much more difficult to operate across markets.
For your convenience, full text transcript of this podcast is also available.
Winna Brown
We’re currently living in an era of heightened geopolitical tension. To help us better understand the impact this is having on the investor community, and private equity specifically, I’m delighted to welcome to the podcast Famke Krumbmüller. Famke is a leader in our global geopolitical business group and is based in Europe. Famke, thank you for joining me today.
Famke Krumbmüller
Thank you Winna for having me.
Brown
The pandemic has certainly put a spotlight on global government relations as we’re seeing government’s increasingly focused on protecting their own people and their own economies. Famke, what is it that the EY geostrategic business group does?
Krumbmüller
Sure. We are a team that is very focused on helping clients understand the political environment in which they’re operating. And so this is about understanding the political risks that they are exposed to how does it impact their business; but then also, how can they act to manage these risks, but also understand the opportunities that come from the politics to which they are exposed.
Brown
Famke, can you help us understand to what degree geopolitical tension has either increased or decreased since the pandemic?
Krumbmüller
Yes, for sure. So, I think what has happened with the pandemic is that it has accelerated trends that already existed prior to the pandemic. And I think most importantly, probably the trend of regionalization of the world economy. So, we are in a broader context, already for some time of increasing great power competition let’s say certainly between the US and China, of course, but also within the EU, trying to find its place in the middle here. And this is something that has been greatly accelerated because of the pandemic. Because it has simply highlighted the fact that these global dependencies don’t only just bring benefit but also can create competition. It can create shortages, for example, as you are dependent on, for example, masks being delivered to you from China, etc. And I think what has happened is that, the fact that the pandemic has highlighted these dependencies has made some of them politically unacceptable and thus, this is where we are now. I mean, I can cite a couple of examples, but the fact that we saw these supply chain disruptions happening, that’s something where tensions but also, as a result, competition has just really been accelerated and highlighted through that.
Brown
Could you share a couple of those examples? That would be fabulous.
Krumbmüller
Yeah. Sure. So I mean, I think the most anecdotal example is the one that I just shared around masks and all of these very important and practical things that we needed access to in the very beginning of the crisis and that weren’t produced locally anymore and had to come from China, for example, and weren’t able to be delivered. I think on a much more strategic level and something that is playing out right now, and that’s relevant to industry across the board is, for example, the semiconductor shortages that we’re currently experiencing. So, these are produced in Asia and are a very, very technically difficult to produce. A lot of industries are very dependent on them, not only the IT industry, but also everything around carmakers, etc. And so, I think semiconductors is a good example of what’s happening here. They are crucial to countries’ strategic independence to a certain extent, because right, we’re all living online and we’re all using our cars, etc. And so countries are just much more aware of the fact that these components, for example, come from other parts of the world and that if they don’t have access to them anymore, they’re not able to produce things that are relevant or even strategic to them. And so, what will happen now, and this is what I mentioned before when I talked about these dependencies and about competition actually here, is that government will step in and has already stepped in, and this has happened across the board already to incentivize local production, for example. And why this is interesting is because to a certain extent, you know, businesses for many, many years have been kind of living in a world where we’re moving towards more globalization and more liberalization and more common standards, etc., and that was taken for granted to a certain extent, and I think, already before the pandemic, but again, certainly accelerated through the pandemic, this trend was at the very least decelerated, if not stopped, and so we’re moving towards more regionalization and more local production, etc., etc.
Brown
So really what we were saying is that we might start to see the beginning of a trend where cross-border investments and big global deals might be on the decline; however, local investment and propping up of sectors and specifically tech sectors or semiconductors or high-tech may be on the rise as each government effectively wants to look after its own and the investors see this and want to invest in that sector locally. Is that what you’re seeing as trend?
Krumbmüller
Yes, to certain extent for sure. Whether it means less cross-border deals, I’m not sure. I would say different cross-border deals maybe, operating in a very different environment. So operating in an environment where, which certainly creates new opportunities, so this is not just about risks, but also about the fact that as you just said certain regions, certainly the US and Europe are investing into industries that they now consider to be strategic, be important to them. I cited semiconductors; we can also think about, for example, electric vehicle batteries. All of these things that are crucial technologies, for example, for the future, countries are investing in them and are making efforts to make sure that they can be locally produced and this, of course, creates opportunities, but then at the same time, what happens at the same time is that, we see a new level of nationalism or protectionism even, because it also comes at the same time with more investment screening, and more measures to verify who is actually active in these industries, are we dependent on actors that we do not want to be dependent on for different reasons? And so, I think investors need to be aware of the fact that there is just much more scrutiny, certainly in certain sectors, around these issues and around these dependencies. And if you want to link back to the pandemic, it has legitimized that type of government action. Not only the fact that the government intervenes, but also, I think that level of protectionism has actually become much more politically acceptable than it might have been before because people lived through the pandemic and really felt themselves what it meant to be dependent on something that could simply not be supplied, or is supplied with a huge delay.
Brown
So do you think this will translate into like, this increased regulatory scrutiny, result in investors being handcuffed a little bit in terms of who they can do business with, the deals that they strike, because they’ll have to be a lot more in line with this new nationalism and protectionism that you described.
Krumbmüller
I’m not sure whether I would go as far as to say they will be handcuffed, but I think they will be obliged to really follow what’s happening in terms of regulation and that’s already kind of the second stage because the first stage is really understand what the political environment and the, even political vibe I would say, is in a certain region or in a certain country. What does the population feel and so what do their leaders do? What do they defend, as I meant, what will be politically acceptable or expected because that informs what we then see coming out in terms of regulation, which then obviously shapes the business environments in which investors operate and with which they need to deal when they do their deals.
Brown
So you’re also describing a world where investors need to be increasingly sophisticated in the way they approach their investments and increasingly aware of not only what’s happening around them in their own country but globally, because their investment decision will be either successful or less successful as a result of factors that they potentially never had to consider before.
Krumbmüller
I think that’s exactly right and on several levels. So, it’s not only considered the global level, what we just talked about, these great power politics, which also, even sometimes just seem very high level, but they have a concrete impact, right? Because the fact that there are tensions between the US and China means that we get sanctions, that we get certain protective regulations coming out of the US, etc. So not only consider that global environment, but the fact that we’re moving towards a regionalization obviously means they’re more constituencies that you need to follow and that where you need to be able to understand the politics and what’s happening locally and that just makes it much more complicated, of course.
Brown
Definitely. Okay. So, switching gears slightly. I mean, you can’t open a newspaper these days without seeing the weather events, the natural disasters, there was a recent report that came out from the UN; clearly climate change is high on just about every government’s agenda. To what extent do you think that this accelerated focus on climate risk and the increased regulatory scrutiny, certainly out of the EU, what do you think that’s going to do to impact the attractiveness of key markets, such as, you know, the EU, the US, China?
Krumbmüller
I think that’s definitely true. Of course, next to technology is sustainability is on everybody’s agenda and it’s definitely also the area in which, you know, we’ll see governments being the most active over the next months and years, certainly driven by also these events and the reports that you all just mentioned. I think maybe the key challenge that I see here, both for managing the climate transition effectively, but also for business and investors is the fact that there is no global governance around this. So that means the result of this will be and has already been a patchwork of environmental legislation, which will just make it so much more difficult to operate across markets because the different regulatory environments and they will also be rapidly changing as this becomes a priority in different markets. I think in terms of the attractiveness of these markets, I would argue that there probably just needs to be a generalized understanding that we’re moving towards more and faster decarbonization across the world. And so, companies need to act on this now because sooner or later they will face that tougher regulation, right? Countries that are, or regions that are maybe not acting yet will soon start acting. And the other thing is that this is not coming just from government, but it’s also of course coming from stakeholders. And so, of course, it’s increasing costs and it’s complicated, but the tendency is just extremely clear. So, if I was an investor, I would probably worry more about a company that does nothing or not enough in this space rather than the opposite. And so, sure. I mean some markets will require this tougher regulation now, but the others will follow suit.
Brown
Yeah, that’s what I was going to say. So, I mean clearly some markets are well down this path in terms of regulatory scrutiny and some are further behind. Do you think eventually everyone will catch up to each other and there is, perhaps a sign that at the end of the road, they’ll be some consistency around sustainability globally?
Krumbmüller
That’s a great question. I mean, part of me wants to hope that because obviously, that’s where we should be moving. I think it will take some time until we see that. There’s such huge differences still right now between let’s say the EU, which is clearly the most ambitious area on this front, and then developing markets, who simply don’t have even the financial capacity to go for these types of changes right now. So I think we now tend to have goals, even China announced goals, the US announced a goal, etc., but pathways are extremely unclear and extremely divergent, and they will probably stay like that for some time I would presume. If I had to point into one direction, I would say look at what the EU is doing because they are the ones as I mentioned who were the most advanced on this. They do have the capacity, and this has happened in other areas as well. Just think about data protection for example, to set global standards. I can give a very concrete example of this, which is around what the Europeans called the carbon border adjustment mechanism. So it’s this proposal to introduce some type of a levee or a tax at the European borders on any imports that come into the EU from countries in which companies face less tough regulation than EU companies with regards to sustainability to make sure that there is a level playing field. But so, what does this do it? Obviously, incentivizes other countries to implement the same type of regulation so that their companies aren’t faced with that carbon border adjustment mechanism in the EU. So just to give a very concrete example of how the EU with what it’s doing in terms of environmental legislation can set global standards so, that’s a place to look for what’s happening if I had to point into one direction, I guess.
Brown
Yeah, and that makes me think of a couple of interesting points. If I’m an investor and I’m thinking about investing globally. I mean, the highest bar if you will, is the EU. So, you know, you can set the standard across the entire company, assuming you’ve got cross-border presence, you can set it to that highest standard, which obviously increases across the board; but to the extent that you are not dealing with the EU, or you have a market that is concentrated in countries which are perhaps less developed, there is potentially a short-term play where you can continue to not adhere to the highest standards and continue to hold those margins, which is kind of interesting I suppose if you’re making a short-term investment. If you’re making a long-term investment, that’s potentially going to backfire on you in the long run. But it would be interesting to see how this dynamic plays out as investors make those calculations.
Krumbmüller
Yes. I mean in the long term there is no doubt as you said, that’s clear. Even for the short to medium term, I would then cite what I said before about the fact that you’ve got stakeholder expectations as well.
Brown
Yes.
Krumbmüller
And that’s something that you have across the board and that will, same as regulation, it will just accelerate and become more prominent.
Brown
Yeah, and I would also argue, and I don’t know what your view is on this, but there’s the regulatory expectation, but there’s also the expectations from within companies themselves. I think we’re seeing more and more that the employees of companies want change, and they’re advocating for, you know, adherence to a higher level of sustainability and focus. And so, the change, if you will, is being driven, not only from external factors, but from internal factors and brand recognition. Companies want the market to know that they are leading. So it’s interesting. I think all these factors are coming together and shaping and being thankfully, you know, being supported by the government focus that we’re seeing globally.
Krumbmüller
For sure. I mean, there are a couple things here. First of all, stakeholders definitely in the wide sense of the term, including internal stakeholders and I think these consumer preferences and, you mentioned brand recognition, they are evolving quite rapidly. And, you know, we discussed the events over, over the summer, over these past couple of months and people become increasingly aware of the fact that climate change is real and realize that certain things maybe become less acceptable to them, etc. And obviously, if we want to link it back to government and regulators’ actions, these are people that are democratically elected most of the time, and therefore represent popular preferences, and this is what I mean when I say, investors really need to understand the local environment in which they are, and need to understand hence what governments stand for and what they will defend, because they will often, of course, defend what the majority of the population, things are what their preferences are.
Brown
Yeah, definitely. Okay, and so, sometimes you sit back and you look at what’s happening globally and the tensions, the changes, the regulatory environment rapidly moving; what do you think are going to be the biggest trends that are shaping the global economies and shaping the decisions that investors are going to be making? And what should they watch out for?
Krumbmüller
I think we discussed probably the two most important ones, which is geopolitical tech competition and everything that will come with it, and the move towards more sustainability. I think these are the two most important trends that we can see, and that we see across the board, right? When I even think about, for example, the European Recovery Fund, where does it invest? It invests into digital and into sustainability. These are just the priorities everywhere, and they bring so much implications both in terms of geopolitical and political interests and competition around it, and then, at the same time, what does it mean for business and how does it shape the business environment and will be with us, I’m sure, for the next years and even decades, if you want to think longer term.
Brown
Yes, I think there’s going to be a lot to watch out for over the years to come. Famke, thank you so much. Really appreciate you joining us today and providing these fantastic insights. I know our listeners will be extremely appreciative of the value-add that you’ve provided.
