How COVID-19 is changing the use of Scenarios in Finance

For many executives in finance, scenario planning considers imaginary counterfactuals in the tail of their economic modelling.

For us, scenario thinking needs to be used to question assumptions that underpin the economic model.

The first author discovered this several years ago when, with colleague and co-author Angela Wilkinson, they met corporate treasurers to discuss scenario planning. A good example of using scenario thinking to question assumptions of the model is the now famous speech by the then incoming Chief Economist in BP, Spencer Dale, questioning the assumptions of how oil has been priced.

It appears from the experience of the second author, an alumnus of our scenarios programme and a corporate finance adviser on Wall Street, that COVID-19 has accelerated the second usage of scenarios in the financial services industry.

This is because economic models cover past ranges of the possible, whereas COVID-19 has forced finance professionals to expand the range of possibilities they use to advise their clients.

There is now overwhelming evidence that relying only on quantitative approaches to financial planning is inadequate in complex environments.

This posting invites finance professionals to deploy scenario planning, a proven method that presents fundamentally different plausible futures based not only on data, systemic evidence, domain knowledge, but also on critical thinking and intuition.

It not only helps to prepare for things getting worse and to mitigate risks; but also to capture opportunities, and fortify or renew a firm’s sustainable performance.

It does so by questioning the assumptions of the model and by proposing alternatives that are not in the model.

Many firms are hesitant to move from the likelihood of traditional forecasting to the plausibility of scenario planning. Or they are skeptical to consider futures that may start unfolding now but are seen from a perspective that is a decade away.

Yet, with COVID-19, finance directors are coping with a rapidly evolving landscape of turbulence, unpredictable uncertainty, novelty, and ambiguity, and must find both opportunities and viable courses of action quickly.

The second author has adapted the Oxford Scenario Planning Approach to help finance professionals and the managers they advise to seize opportunities in short time horizons.  

Four examples of how scenario planning has helped finance-oriented decision makers in the COVID-19 business world. 

Freitag Lab is a pioneering market leader in one-of-a-kind bags and accessories made from recycled truck tarp and compostable textiles.

The company has 26 stores, over 300 resellers, an online store, and a consolidated virtual community of engaged followers. Looking at the horizon, Monika Walser, the CEO, adopted scenario planning to shape the company’s US strategy, developing four scenarios over a five-year time horizon.  One considered a situation which was not in their financial model, where Freitag would need to cease their NYC flagship retail efforts and refocus on resellers in different US regions. So the company was well prepared, when COVID-19 unfolded, to cope with a future that a few years earlier would have been unthinkable without the lens provided by scenario planning. 

When it was first presented, the scenario which guided the US strategy was considered extremely unlikely and was resisted by many stakeholders.

Khajak Keledjian, founder of Intermix, used scenarios to shape the strategy and create financial projections and contingency plans for his venture, Inscape, the first American audio-guided meditation studio. In COVID 19, scenario planning helped with a specific scenario that suggested a counterintuitive future, materially departing from past performance, management’s prior experience, and the models it had used. As the economic impact of COVID-19 began to unfold, the organization quickly seized retail expansion opportunities that would have otherwise been ignored. 

Fundkite offers alternative funding, with its own proprietary technology, working with over seventy thousand merchants. CEO Alex Shvarts and his team successfully used scenario planning to include uncertainties into their financial planning which had not been modelled before.  In one scenario, regulatory events would prevent the company from operating, or funding new deals, up to five months. While the scenario did not consider COVID-19, the economic shock turned out to be substantially the same.

So in March 2020, when restrictive measures were imposed on non-essential businesses, Fundkite was both prepared to cope with the unprecedented decrease in deal flow and was well positioned to capture market opportunities. The firm onboarded substantial investment liquidity, fast-tracking a planned acquisition of a shareholder’s position.  

An agile adaptation of the Oxford Scenario Planning Approach was used by a group of investors who intended to purchase Barneys out of bankruptcy. The project advice team, led by the second author, developed four scenarios to question the modelled financial and non-financial data and to inform the concurrent drafting of legal paperwork.  A contingency that in one of the scenarios had been considered as “extremely unlikely” indeed materialized; leading investors had to exit the process the evening before the final court hearing. But thanks to considering the possibilities in the scenario set, management was prepared and the losses were minimized: The best deal, at times, is the one that does not go through.  

More often than appropriate, even in situations of change less radical than COVID-19, many organizations have relied too much on the models and not enough on broader possibilities offered by scenario planning.

Such models typically reflect past performance, and when projected forward to prepare decisions, the views offered by models are assessed as being somewhere between “conservative” to “aggressive”. We saw above that in uncertain business conditions, even the most “conservative” projection of a model can turn out to be too narrow.  As one of our Oxford colleagues put it, the answers that the modelling provides offer a sense of security, partly because these answers are numerical, but that sense of security may prove false.

So instead of providing what can turn out to be false security, good advisors also challenge the views derived from models, and scenario planning can help to unearth the assumptions of the model and to critically assess these. As mathematician and philosopher of science Jerry Ravetz put it, ‘the faith that mathematical science provides certainty is a natural product of a scientistic culture in which critical reason is systematically neglected and betrayed”.

While COVID-19 hopefully goes away, uncertain business contexts will remain. The lesson from the experiences of the second author for finance professionals is to bring in critical reason to question the model assumptions by broadening possibilities to consider “almost implausible” outcomes, and then model the financial implications and develop a ‘playbook’ for each, to be ready for eventualities and to be able to  seize opportunities early and fast.

Rafael Ramirez and Angela Wilkinson are the authors of Strategic Reframing.