Inflation, volatility & unpredictability

What LPs & GPs need to know about risk management in uncertain times

Dr. Gabriella Kindert, an independent director, shares her insights on the emerging risks and opportunities LPs & GPs should be aware of.

“I did not see this coming.”

This was one of the most common statements I heard during my recent trips to various European cities. For many of us, the world feels like a very different place today. In the current context of a brutal war, refugee crisis, nuclear threats, supply chain disruption, sanctions, energy crisis, and high inflation levels, COVID could start to seem like one of the smaller problems.

Though it is hard to predict when black swan events appear simultaneously, there seem to be certain trends, risk, and opportunities emerging. We experience major repricing of risks. Our resources are being priced differently. Our values are being challenged.

Borders and counterparty risks have new dimensions

Next to European Union, EURO area, we are looking at NATO membership more carefully to assess risks. The execution and enforceability of sanctions differ. Many organizations are lost regarding the inventorization and implementation of sanctions and assessing counterparty risks in the new order. Consequently, operational risks and understanding counterparties’ value chain and risks seem to gain new importance.

Repricing of raw materials

The supply chain has already been disrupted for 2 years because of COVID and many companies faced delays breaking down the proven concept of JIT inventory management. The current war and sanction will not make things easier. The commodity market is disrupted with high level of price volatility and margin calls already appearing. As a side effect, we are likely to experience lack of certain products, delayed productions, longer wait times, and inflation at a scale not seen before. How will companies manage product pricing, currency risks, hedging policies, and still maintain operating margin stability in this environment? Will they pass on increasing raw material prices? Which companies can manage rising rates? The answers to these questions are on uncharted territories to some extent.

New risks emerging and increasing default risks

The inflation and rising interest rate will impact purchasing power, per region, per customer, in currencies differently. In these situations, one needs to attach more value to financial flexibility and adaptation level, especially for highly levered companies. Management teams need different skills to deal with the crisis and deeper scenario-planning skills. Often, there are new or more profound risks we need to be mindful about, such as:

exposure to sanctions and ability to manage regulations related to sanctions (sometimes, companies are operating in conflicting legislations)
companies’ ability to manage volatile raw material prices and commodities
companies’ ability to pass on price increase, currency exchange rate volatility, hedging strategies (both in terms of raw material prices and interest rate)
impact regarding to changes of consumer demand as disposable income and/or willingness to spend is reduced
risks of repatriation of profit
operational disruption and reliance on outsourcing parties, understanding “connected risks; ability to manage penalties because of delays
interest rate exposure. (Some instruments in Private Debt are fixed rate; others, floating. Long-duration fixed-rated instruments will be reprised.
ESG risks at new dimensions (immediate replacement of resources might not be in line with ESG requirements)
cyber security related risks

Even in these uncertain times, private credit managers and investors have also many opportunities; to mention a few:

Supporting liquidity needs and distressed companies.
In case of higher volatility, companies need more buffer and liquidity. Distressed, dislocated companies will need to be supported. Experience shows that banks are less flexible and can be paralysed in these situations. Private credit managers can make a difference with a more flexible and agile attitude.

Portfolio repositioning.
Picking up under-priced assets based on relative value; do portfolio repositioning based on new principles and risks emerging. There are more uncertainties, which might lead people to gravitate to safer choices and focusing on the more liquid part of the market until the dust settles.

New dimension of ESG challenges; energy transition will be speeded up.
Europe has been slow regarding energy and becoming less dependent on Russian gas. We became vulnerable to environmental challenges. There is an expected massive inflow to support this transition.

Supporting asset purchases of our portfolio companies.
Picking up assets (companies and resources) at a discount will become a theme.

Social impact investments.
Supporting the humanitarian crisis by addressing the needs of refugees (new housing, consumer loans) and those in need as a result of food and other raw material prices increases.

One aspect about risk remains true: our ability to predict the future is limited. In January 2020, the World Economic Forum Risk Report, written by the most eminent risk leaders, failed to mention “global pandemic” in the top 10 risks. In 2022, “war” was not mentioned as a top 10 risk either. In both cases, one can argue that the elephant was already in the room.

In these circumstances, humility is a must. Further, our humble yet agile approach to financial flexibility, diversification, open-mindedness will make a difference! While dealing with the challenges, we need to find a balance between addressing risks and seeing business opportunities. The crisis is also creating new chances for those with an agile and flexible mindset.

With thanks to Dr. Gabriella Kindert for contributing this article. Dr. Kindert is a senior banking and investment professional specialized on Alternative Credit, Private markets and the digital transformation in the financial sector. She is currently a Supervisory Board member of Mizuho Europe and independent advisor to various entities, a.o. the EU on Fintech projects.