What Is Scenario Analysis? (And Why Is It So Hard to Do?)

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What will 2021 bring to the global economy and how will it impact your portfolio? It’s a perfectly reasonable question to be asking after the year we just lived through. Unfortunately, we don’t have an answer for you. But we do have a way to help you plan for the unexpected.

Scenario analysis: It’s not easy to do and there’s no magic wand to wave to make it doable. But with a process and a tool, it is possible to see how your portfolio will perform given certain sensitivities in the future.

Planning for the unknown has never been more important, and not just for asset managers. In a recent survey of CFOs, McKinsey found that 90 percent said they are now using at least three scenarios to support their company’s planning. “In pre-crisis times, scenario planning was often perceived as a stimulating, intellectual, and thought-provoking exercise—describing alternative future states and defining the best strategy for each one—but not one with a clear business impact,” McKinsey partners wrote in a recent report. “That notion has changed with the arrival of COVID-19.”

 

A dashboard on the Mercatus platform helps visualize scenario results in real-time.

 

In the private markets, where many asset managers are still relying on analysts and Excel to manage their investment data, few have a process to help them determine how a macroeconomic change might impact their portfolio or funds. But increasingly their investors are asking for these “what if” scenarios. What if interest rates rise and oil prices fall? What if commercial real estate has a dramatic downturn? What if the dollar plummets? Investors who cannot perform scenario analysis can’t see how certain trends present buying moments. They miss out on opportunities to divest certain assets before they crash.

Here we’ll explain how scenario analysis currently can be done across a portfolio with a very manual approach and how it can be improved with a system in place.

 

How It Works Without a Process and a Tool

Let’s use this fund manager as an example. ABC Fund Manager is a global fund with 50 assets, each with its own financial model. It has a large LP asking what will happen to the portfolio if interest rates change or power pricing decreases in a given region?

If ABC Infrastructure even agrees to deliver the analysis, this is how it happens:

  • Requestor sends a list of desired macro pricing updates and sensitivities to the people who manage the individual asset models (eg, power prices up 5% in one region, wind production down 5% globally).
  • Individuals first update each model with actual financial and operating data to have an effective forecast. Then they run the sensitivity analysis one by one, collect the outcomes and send them back to the requestor.
  • Requestor aggregates all the data into a single spreadsheet. Requestor is unsure if the data is accurate, but has little choice but to assume it is.

Resources needed for this exercise? Roughly 10 people and three weeks time. If the requestor wants to tweak the scenario to see a smaller 3% rise in power prices, they must start all over.

 

How It Works With a Process and a Tool

Now let’s assume ABC Infrastructure has a data management platform to manage its underlying investment data and create ad-hoc reports based on bespoke models housed in Excel. First it created a process, then it was able to deliver analysis for any number of sensitivities across its portfolio.

  • ABC Infrastructure implemented a centralized platform that connects to its Excel models at scale. During this implementation, it created a systematic process for onboarding individual assets to ensure that sensitivity analysis can be run on each model.
  • Once it defines a desired macro assumption, it chooses the asset models to include. These Excel models have been connected to the data platform, allowing a simple Bulk Calculate function to run the sensitivity.
  • A dashboard on the platform helps the team visualize portfolio valuation updates and scenario results in real-time.

Resources needed: Once the technology has been implemented and the process created, macro pricing updates for a global portfolio can be run by one person in 1-2 hours using the power of each asset’s bespoke valuation model.

Scenario analysis is a powerful feature that is increasingly becoming imperative for fund managers in the private markets, especially those with large institutional clients.

 

See it in action below:

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