Even though the war in Ukraine has entered its second month, private equity firms and investors are still dealing with both the humanitarian crisis and the uncertainty surrounding the future of the country’s business environment. Although most GPs do not have any direct exposure to Ukraine, most private equity funds expect the current crisis to have potential second-order effects (e.g. energy prices, input materials), which are hard to gauge.

Russia, Belarus and Ukraine are not major global end markets. A gross domestic product of $1.8trn places Russia at roughly a tenth of China’s economy in terms of gross domestic product. According to the World Bank, Ukraine and Belarus are even smaller economies, with GDPs of $0.2trn and $0.1trn, respectively.

On the other hand, these countries are important sources of supply for a wide range of global commodities. Russia is the world’s largest exporter of natural gas, accounting for 25% of global exports. Continental Europe is reliant on this supply for its food needs. Russia is also a significant supplier of metals such as nickel and palladium, and fertilisers such as ammonium nitrate and potassium nitrate. The Ukrainian agricultural industry is a major global supplier of agricultural commodities such as sunflower oil, wheat, and grains such as corn and barley. As a result of the invasion, prices for these commodities have skyrocketed, and there is growing concern about how long stockpiles will last as new supply becomes scarce. There is a significant probability of a downward correction in the valuation levels, which may impact most private equity funds’ unrealised portfolios and create attractive opportunities for new investments over time.

Sanctions

It is difficult to predict the mid-and long-term impact of the more than 5,000 sanctions currently in place against Russia and its key companies, financial institutions and key individuals, and the repercussions of these sanctions on non-Russian economies and companies. The invasion of Ukraine and the threat of sanctions and counter-sanctions immediately resulted in enormous price increases for commodities. Together, Russia and Ukraine provide a substantial portion of the world’s energy, agricultural and mineral raw materials. The Ukraine crisis and Russia’s sanctions have exacerbated tensions, and shortages in various marketplaces, albeit the consequences have varied by area. Depending on the outcome of the conflict, supply and price pressures could persist for an extended period of time.

Energy shock

Europe is heavily reliant on Russian natural gas and will be unable to find alternative sources of supply if pipelines are disrupted quickly. The EU relies on gas for a quarter of its primary energy consumption and imports about 40% of its gas from Russia. While it is almost impossible to replace Russian gas deliveries to Europe in the short term, the World Bank stated that there would be alternate gas sources in the long term.

Commodity prices

The more immediate concern is that the price of oil, gas and other commodities is rising, increasing inflation and putting pressure on consumers. Russia and Ukraine account for one-quarter of global grain exports and supply approximately 46% of the world’s palladium, which is used in catalytic converters for automobiles and electronic devices.

This significant supply-side shock affecting a number of commodities will contribute to the existing rising pressure on input costs in the coming months, worsening shortages and supply chain bottlenecks in several industries. It may also exacerbate socio-political concerns in emerging nations that rely on Russian-Ukrainian agricultural exports.

Inflation and interest rates

The conflict in Ukraine is unlikely to derail the Federal Reserve’s plan to raise interest rates, albeit at a slower pace. During the first quarter of 2022, the US Core PCE index (the Federal Reserve’s preferred inflation gauge) increased by 5.2% annually, the fastest annual increase since 1983 (once volatile items such as food and energy are factored in, the PCE index increased by 6.1 per cent). Inflation in Europe is currently at 5.8% and rising.

Despite the recent turmoil, the Federal Reserve raised interest rates by a quarter percentage point, or 25 basis points, last month, after keeping its benchmark rate near zero since the covid pandemic. The rate will now be in the range of 0.25% to 0.5% as a result of this. The Fed’s median federal funds rate projection was raised to 1.9% for 2022, which means the central bank can hike rates by 25 basis points in each of its remaining six meetings this year.

Stagflation is a real threat (characterised by high inflation and slow growth). Central banks will have to balance the risk of cutting interest rates too soon or too quickly to reduce inflation with the risk of having an excessively negative impact on growth. The invasion certainly adds to the difficulty of the situation. However, most analysts believe that stagflation (zero or negative growth) is improbable in Europe. For one thing, since the beginning of the pandemic, European households have amassed about €900bn in greater savings, which could mitigate the commodity price shock. Another factor is that company balance sheets on the continent are generally healthy, with manageable levels of debt. Finally, the removal of health constraints should increase household consumption.

Real rates are currently in deep negative territory, and it is expected that they will remain negative or very low in the foreseeable future.

Private equity sector

It is important to note that the private equity industry has also been thriving in economic downturns and times of high volatility during the last 20 years due to its specific ability to generate alpha. Private equity usually has little exposure to cyclical sectors. Though it is difficult to assess any long-term impact, I want to emphasise that public equity markets react more vigorously. In contrast, private equity has historically demonstrated comparably lower volatility during crises. I am confident that 2022 will be another busy and exciting year for the private equity industry. However, given the high prices paid for acquisitions, deal sponsors will inevitably face increased pressure to deliver results this year. It is critical for dealmakers to fully understand the sector’s microeconomics, the value creation levers available to them, and their risks.

On the other hand, analysts advise dealmakers to keep a close eye on the consequences of the Ukraine crisis. The Ukraine conflict adds several dimensions to the global macro picture. The Ukraine conflict will have far-reaching consequences. As a result, private equity investors and their portfolio companies will need to plan for a broader range of scenarios and keep a close eye on events as they unfold.

 is a private equity analyst. He advises several top quartile private equity and real estate funds in Luxembourg.