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Winna Brown

You're listening to the EY Next Wave Private Equity Podcast. I'm Winna Brown and I'm your host. As a result of the war in the Ukraine, three major power blocs are emerging. Developed markets are leading one block with the E.U. and U.S. having reached new levels of cooperation. Relatedly, the North Atlantic Treaty Organization, or NATO, has been reinvigorated. Russia is leading a small bloc of countries, including several autocracies, and a significant number of emerging markets, including China and India, are not aligning with either of these blocs, preferring to pursue a more neutral or transactional stance.

In this emerging multipolar world. It has become more critical than ever for companies to regularly assess and understand the geopolitical power dynamics of the markets in which they are invested. Today, I'm delighted to be joined by Famke Krumbmuller, EMEIA's leader for the EY Global Geostrategic Business Group. And we are going to discuss how these shifts in geopolitical power will affect growth and investment opportunities. I hope you enjoy our conversation.

So, Famke, the EY Geostrategy Team has described the outcomes of recent shifts in geopolitical power as multipolar, almost having three emerging blocs. Are you able to describe for us the economic power differentials between these blocs, and maybe their potential impact on trade and cross-border investment?

Famke Krumbmuller

Sure, yes. So, I mean, it's a concept that we have actually been talking about for some time. It's not entirely new to say that globalization has not necessarily ended but is definitely moving in a different direction — people call it deglobalization. I really like the word more regionalization, and that is really a tendency that has been greatly accelerated, first by the pandemic and now, even more so by the war in Ukraine.

The way that this looks like is that essentially three big power blocs emerge — the US, the EU and China. The global economy, let's say, will be increasingly structured around these blocs that kind of lead the regional blocs, if we might call them like that. The other thing that we're seeing is that, as a result of the war currently happening in Ukraine, there are some other types of alliances that are emerging.

So, we've got on the one hand, let's say the western allies, which is actually a much broader group than just western countries, that have responded to Russia's invasion of Ukraine in a relatively coherent way, sanctioning what is happening, etc., so, these are mostly developed markets as one leading bloc. Then we have Russia, which is leading a relatively small bloc of countries.

On the other hand, not if you look at the UN vote at the time condemning Russia's invasion of Ukraine, not many countries are actively supportive of Russia's action. And then you have a third bloc, which is quite a significant amount of emerging markets, so they're trying to not align so and trying to not pick any sides in this conflict between, essentially, the developed western allies. And then, on the other hand, Russia, because these markets, these emerging nonaligned markets — you could also call them swing states — have interests on both sides. They benefit on both sides and are really trying to not pick a side as a result of that. In terms of the economic power differentials between these blocs, it's quite interesting. When we look at the share of global GDP going back to the US, China, and the EU, I think the most interesting development is that China's share of global GDP has over the past decade, since 2010, has almost doubled. So, it shows you what the tendency is in terms of where the economic power is moving towards to.

Brown

Okay. So then as we think about this shift in geopolitical power and alliances and we think about rising economy or economic power, how is this impacting specific sectors? Are there some sectors that are feeling that pressure more pointedly?

Krumbmuller

Definitely, I think actually one of the most important concepts when we speak about this emerging multipolar world and the fact that, as a consequence, global business models will be impacted by that is the notion of strategic sectors, because strategic sectors are the sectors that are most concerned by this emerging idea of geostrategic competition between these great powers. And what strategic sector is a concept that that's actually a little bit fluid and has been influenced by what has happened over the past couple of years. So now, as an example, farmer and medical equipment has become part of the strategic sectors as a result of the pandemic, highlighting that these global dependencies are maybe not a great thing for that sector.

Another more recently qualified strategic sector is the agricultural and food commodities sector, as a result of the war in Ukraine, of course. Other more obvious strategic sectors are anything around technology that is associated with the energy transition, semiconductors, and digital technologies, and then anything around critical infrastructure. These are really the sectors that, because they're deemed to be strategic to national security, to economic growth, to independence from parts of the world that are maybe not your best friends, these are the ones, where states are increasingly intervening into the economy, investing into these sectors. So, creating opportunities on that front, but also, for example, scrutinizing cross-border movements much, much more.

Brown

So, how is this impacting M&A activity? I think about investors, such as private equity, who invest globally and may even currently hold global investments in these sectors or are looking at assets that are globally positioned. How should they be rethinking about these investments?

Krumbmuller

That is a great question and I think a very relevant one to ask because it does have an impact on cross-border investments, because it influences cross-border business models. As I said, there is much more foreign direct investment (FDI) scrutiny in these types of sectors. When we look at the numbers, they confirm this. For example, China, outbound M&A has been halted into many countries, certainly in the tech and infrastructure sectors specifically. And overall, cross-border M&A is more tilted towards, what we would say, intra-area deals, so more within than the Asia-Pacific or more within the EU, for example. And then if you look at the evolution, we also see that, for example, cross-border deals make up a smaller share of global M&A in 2022, compared to just a couple of years ago — it was 24% in 2022 and still 36% in 2016 — so quite a significant drop there. The last number that I have is that also a more significant share of cross-border goes into nearby countries now versus in 2016 — 53% now go into your more local area, as opposed to 33% only in 2016. So, this is why I like the word regionalization because this is really what it shows. It's still happening, of course, but it stays more regional.

Brown

That's actually really interesting. So, long-term investment strategies are really going to be shifting more pointedly to a more local or regional or countries that are beside you focus, rather than big, sweeping global growth plans, just because of the changing nature of the geopolitical environment. I'm curious as I think about that next step, I think about, so we have this geopolitical shift, we have the pandemic that's impacted everything. And clearly, the war in Ukraine has impacted supply, agriculture, and sentiments. I'm wondering about supply chain. We've been talking about supply chain a lot. So, you may have a more localized or regionalized investment strategy, many of these sectors that we're talking about depend on supply coming from other countries. Are we seeing a shift in that? Governments and industry are focusing on building new types of industries to be able to be self-sufficient, and not get supply and have these issues that we had so pointedly during the pandemic.

Krumbmuller

Yes, definitely, and you're right. It's all about the supply chain these days for many different reasons. So definitely one thing that we can see is more investment, as I mentioned before, into these strategic sectors, as governments are trying to secure national, if not friendly, access to products or services that come out of these very strategic supply chains. So that creates investment opportunities locally. But then at the same time, what we can see with regards to supply chain these days is a trilemma as we see in other sectors as well around how do we balance the costs side of things — the increased costs of materials, of labor, of transport — then at the same time the resilience of supply chains. So how do we manage the disruption coming from geopolitics, from trade, from logistics, from labor, etc.? And then the third component, which is of course sustainability. So, both the regulatory but also the consumer demand for more sustainability in supply chains and these three — costs, sustainability, and resilience — they are almost opposing forces. The challenge these days for businesses is to really try and square that circle and manage these almost antagonistic forces in their supply chains. It will depend on where do you sit? What are your priorities? And how does the geopolitics play into this? What will you be able to do? And what will you be forced to do, depending on what sector and geography you are in?

Brown

A very different world than we imagined just a decade ago. Clearly, there's going to be an opportunity for investment and growth and new sectors — new industries will come up. But to your point, sounds like things are going to be a lot more expensive as well. And I'm curious as well as to how quickly countries will potentially advance certain technologies or certain sectors and who's going to be left behind, depending on where they sit in the geopolitical landscape? So that could be a really interesting accelerator for some countries that perhaps are developing, who can accelerate their development and maybe some of the western world maybe a bit more stagnant in terms of growth, just because of their positioning. It's going to be interesting to see how that unfolds.

Krumbmuller

Definitely, let's say those that will be successful, whether it is on the government’s side or on the business model side, are the ones that are able to find the right balance between these three opposing forces at any given time. And I think you mentioned we're in a very different world to the world ten years ago. I think that's right. I think the key difference maybe to understand if there's one main takeaway is that decades ago, we were still going towards more integration, more globalization, more of the same rules, it was less of a critical importance to your business model to really understand what are the different geopolitical and political dynamics in the markets that you're in. Whereas now, it is critical to understand who are the allies of the markets that you're in, who are not the allies, to put it the other way round, and so will it maybe create future challenges for you to be in different markets that might end up being in different blocs? It brings back a very old bloc type of thinking to a certain extent.

Brown

Yeah, exactly. And then just kind of taking what we're just talking about the next level and homing in on a topic that's top of mind for many ESG. Everyone's talking about ESG, everyone's talking about energy, and the current energy crisis with rising costs and countries access to energy. What do you think is going to be the short-, medium- and maybe long-term implications of the current energy crisis that we're in, and how that might impact the evolution and adoption of sustainability and sustainability measures? I mean, are we still going to forge down that path or are we going to give up on some of those principles because we're looking inwards if you will?

Krumbmuller

Yes, as you say, definitely top of mind. And here comes my second trilemma and that's actually very similar to the supply chain trilemma. It's really that the challenge that the war in Ukraine highlighted is how do you balance and how do you prioritize among these three opposing forces in energy it’s around and security of supply. So, access to reliable energy, the ability to withstand system shocks, etc., as we have now really seen over the past couple of months what that can look like, versus the affordability of energy, so how do you get access to affordable sources of supply amid the rising costs and the increasing volatility in the energy markets for geopolitical reasons? And then the third is being the sustainability goals, the net-zero goals, how can we transition to a more carbon neutral economy, into more carbon neutral business models? And similar reasoning for the supply chains, the winners will be the ones that manage to find the right balance, which might be a shifting balance. To answer your question about short-, medium- and long-term, I would say definitely the war in Ukraine has led to the security of supply being the main priority in terms of energy. That prices have gone up, industry, as well as consumers and governments, need to deal with the consequences of that because for now, the main priority is to secure access. Of course, now a lot of the discussions are certainly at political levels, where these decisions get made, but also at a corporate level, where leaders decided to follow these new sustainability goals. There are now discussions of how can we then still in the medium- to long-term move towards net zero and make sure that at the same time we stay in a world where energy is affordable to a certain extent. Long story short, I would say that in the short term, I think the priority has shifted somewhat away from net zero because we're just struggling with the much more basic problem of immediate access to energy, but I would actually argue that in the medium to long-term, what has happened over the past couple of months probably accelerates to a certain extent the move towards alternative energy sources, as they are obviously also a way to become more independent from certain geographies. And that's the broader trend — the securing of more independence with regards to critical resources, commodities in strategic sectors, etc.

Brown

So, if I reflect on that, from a private equity perspective, they're certainly looking at ESG and sustainability, and thinking about what are the commitments they're going to make. I'm sure they're reflecting now in the current situation, as you say, the short term, but sounds like the smart money is in the medium and long-term, in that it does present opportunities for investment in new sectors. And those investors that take that plunge and think about not just the next two years, but think about where the economy is moving, where our needs are going, they're going to invest in those sectors that have the long-term potential and will be ahead of the curve in terms of reaping those rewards. So clearly an opportunity, not the time to stop thinking about investment in sustainable strategies and new emerging sectors.

Krumbmuller

Definitely, right. And to a certain extent, I would want to argue is as simple as following where the public money is going. When you look at the European corona recovery fund when you look at the money that is being spent on the economies, it's all going and it will still be going towards securing alternative sources of energy, and a majority of it, even though there's a short-term need for more fossil fuels, but in the medium to long-term, all of it is around more sustainable sources of energy. That's where the money is flowing to public money. Certainly, a lot of the private money, too.

Brown

Definitely. Okay. So, I'm going to ask you a really tough question. If you were to offer advice to corporations, to investors, to private equity, as they try to navigate this very different world, and, clearly, we've got the energy crisis, we've got war, we've got geopolitical shifts, what advice would you give them as they try to triangulate this, and really come up with a strategy around how to move forward and be successful?

Krumbmuller

Yes. I think one of the most important advice that I would have already highlighted a couple of times is to just look at the politics and the geopolitics. As these global events unfold, it becomes clearer and clearer that the impact on companies is very direct, and that there is this increasing need to understand them. So, it's just about regularly and proactively assessing current and future political risks. And I think the world in which you would update your strategy every five years, it just doesn't exist anymore. It doesn't work anymore. You need to update your strategy once a year and if something as disruptive as a war or a global pandemic happens probably even more often than that, and again, the emphasis is on regular and proactively here, this is really something that a lot of companies still don't do. The second piece of advice would be around really establishing some type of a geostrategic team. Maybe it's one person, maybe it's a couple of people that have an affinity for these types of developments, sit in the local markets, understand them — a lot of companies have them, but haven't created a forum where they can regularly get together and exchange what they're seeing on the ground, and actually make sure that this gets fed up into the strategic levels and the executive levels of the company, so that strategic decision makers are aware of what's happening and what the views are there. And then the final step would be to integrate these findings and these new geostrategic realities regularly into company strategy so that you don't get caught up in the new world that you could have seen coming, but you didn't adapt your own company strategy with regards to that.

Brown

Fantastic! What I'm hearing is to be nimble, don't have your head in the sand, be aware of the constantly evolving dynamics in the world around you, and build resiliency as well into your strategy, so that you can move because it feels like more so than ever. To your point, the world is shifting very quickly, and companies need to be able to react to that. Or they may find themselves in a difficult position as not only companies but investors in these companies. So interesting times, indeed.

Krumbmuller

Definitely.

VO

Thanks for tuning in to the EY NextWave Private Equity Podcast. For more thought-leading perspectives and to get in touch with Winna Brown, visit ey.com/privateequity. You can also follow us on Twitter @EYPrivateEquity. We'll see you on the next episode.

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