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Why Private Equity Is Ripe for Digital Transformation

Digitalization has entered all industries and all types of businesses. At the same time, the number of private equity firms increased over the past years, making their execution capabilities even more important than the amount of capital they are ready to deploy

Why Private Equity Is Ripe for Digital Transformation

It has become more apparent that private equity firms need to accommodate themselves with digitalization more and more. Digital is everywhere – from how operations run inside the companies to engaging with customers and linking partners and suppliers. Digital has become a core part of running businesses, therefore also becoming an essential way to generate value within the investment horizons for most private equity investors.

  • 80% of private equity leaders “view mature digital investments at a portfolio company as a value driver at exit”
  • 80% of organizations that have completed the digital transformation report increased profits
  • The traditional ranges of productivity improvement of 3 to 5% per year have been overwhelmed by digitalization, with demonstrated potential for cost improvements well above 25%
  • To successfully transform companies into more digital, you require stage-relevant people who have the right experience and execution framework
  • Suitable targets for digitization during the holding period include non-digital, non-tech companies that are most likely to be traditional, mature companies operating in markets that haven’t been digitally disrupted yet

Signs and data are there

Many studies have proven that digitally transforming companies can increase their value and that private equity leaders are aware of it, with digital transformation strategies on top of their agenda.

A report released by West Monroe in 2019, where 100 executives of U.S.-based private equity firms that invest in middle-market organizations across a range of industries have been surveyed, found that 80% of private equity respondents “view mature digital investments at a portfolio company as a value driver at exit.”1 Digital transformation is on the radar of most firms; however, a lot less have caught up to what it actually means and how to execute it correctly. Only 42% of private equity firms have reported that they have a standard definition of digital that guides strategic decisions and aligns all parties.

A Digital Transformation Executive Study conducted by SAP2 has shown that digital transformation improves efficiency and profits. The findings include the following insights:

  • 80% of organizations that have completed the digital transformation report increased profits.
  • 85% say they have increased their market share.
  • On average, leaders expect 23% higher revenue growth than competitors.

It is evident that digital transformation is a hot topic for a reason. Another study has also compared the effects of digitalization to traditional productivity improvements, with the results again proving the point:

  • The traditional ranges of productivity improvement of 3 to 5% per year have been overwhelmed by digitalization, with demonstrated potential for cost improvements well above 25%, incorporating approaches to remote monitoring and robotization, and through process optimization placing the improvements in labor costs in percentages above 60%.3 It can be seen that digital transformation of companies leads to an increase in Alpha. A study by the Middle Market Center has shown that in the middle market specifically, companies achieve an average 27.5% ROI on their digital projects, and that percentage rises to 39% for those that spend at least 10% of their revenue on digital.4

Another study by McKinsey shows that, by digitizing information-intensive processes, companies can decrease costs by up to 90% and improve turnaround times by several orders of magnitude.5 Examples can be seen across a range of different industries:

  • One bank digitized its mortgage-application and decision processes, cutting the cost per new mortgage by 70 percent and slashing time to preliminary approval from several days to just one minute.
  • A telecommunications company created a self-serve, prepaid service where customers could order and activate phones without back-office involvement.
  • A shoe retailer built a system to manage its in-store inventory to immediately know whether a shoe and size were in stock – saving time for customers and sales staff.
  • An insurance company built a digital process to adjudicate a large share of its simple claims automatically.

Digital maturity leads to financial performance

A study by Deloitte that took place in 20206 has directly tested the relationship between digital maturity and financial performance. The results show that many benefits of digitalization, such as improved product quality and customer satisfaction, contribute to the increased financial performance of the company.

It was found that the companies with higher digital maturity were about three times more likely than lower-maturity companies to report annual net revenue growth and net profit margins significantly above their industry average. This pattern has held across all industries.

One of the points of interest was finding out how different digital implementations affected business outcomes and discovering the digital pivots that had the most significant impact. Data mastery and intelligent workflows were found to have the most substantial measurable effect on business performance. However, it’s important to note that companies should not only pursue these two areas for improvement while ignoring the other ones, as organizations that implement more digital pivots across a broader range of company’s departments achieve a higher level of overall digital maturity – with greater associated benefits.

The last finding that is interesting to outline is that most companies in the study are using digital technologies to address environmental sustainability. ESG is another hot topic across all industries, and this finding can be especially interesting for private equity firms that have been implementing ESG standards across their portfolio companies.

Some interesting examples include:

  • Tesco is using AI analytics to measure its environmental impact and meet aggressive carbon emissions reduction targets.
  • In the construction industry, drones are helping to reduce material waste at construction sites, which makes up 25 to 40 percent of the solid waste generated in the United States.
  • In agriculture, robotic herbicide sprayers can cut farmers’ herbicide usage by a factor of 20 over traditional methods of dousing entire fields.

Is digitalization already playing an important role in the investment decisions of private equity firms?

Research done by PricewaterhouseCoopers in 20167, where 100 European mid- to large-cap private equity houses were surveyed, has shown that private equity houses are already assessing the level of digitalization of their targets.

  • 88% of the respondents said that they consider the level of digitization already in the due diligence phase when considering new investments, and 70% said that the level of digitization plays either an important or a very important role in their investment decision.
  • 76% said it had changed the way they look at new investments, and digitization is incorporated into their equity story already at the start.

At the same time, even in 2016, private equity houses already started to or were planning to start digitizing their portfolio companies, with the bets on digitalization being high as well:

  • 59% of the respondents believed it would speed up the realization of the equity story and decrease holding periods. 26% believed it would to a great extent.

A France-based PE partner of a fund with €1+ billion AUM has stated that: “We digitize all the companies that we invest in as we feel it is crucial in the development of companies. We have a strong operations team that assesses the companies under us and accordingly helps in carrying out our digital strategies.” Therefore, already in 2016, private equity houses were establishing special teams responsible for digitally transforming portfolio companies.

Barriers for PE firms to implement digital transformation strategies & countering digitization risks

There are two possible reasons why some private equity funds have not gone all-in on digitalization yet.

The first one is that digital transformation might not produce immediate results or immediate advantages, therefore increasing the holding period of the companies. However, based on the PwC report, 59% of the private equity houses believe that digitalization will speed up the realization of the equity story and decrease holding periods8. Even if it would increase the holding period, there is a high probability that the exit value generated from digital transformations will more than compensate for it. The reason is that strategic acquirers are more likely to pay higher multiples for successfully digitized companies, as it is faster and easier to analyze and integrate these9.

The second reason is that successfully transforming companies into more digital private equity firms requires people with the right experience and execution framework. The stage-relevant teams and the technology needed for digitally transforming companies are expensive and hard to find. Partnering with a digital innovation firm that already has the needed experience and expertise in-house can easily solve this problem.

Target companies for digital transformation during the holding period

Previous findings have shown that a company’s digitization state is an important factor during the due diligence phase. However, companies that have already digitized would be valued higher by the market, therefore representing smaller potential returns for the private equity houses. An exciting opportunity would be to target non-digitized firms that tick the boxes for being digitally transformed during the holding period, as these opportunities represent high returns during the investment period. The question is: which companies should the private equity firm target that are prime targets for digital transformation during the holding?

Choosing the potential disruptors typically begins with the asset-heavy portfolio companies that sell traditional products or services used offline. Bruce Sinclair, the author of “The Private Equity Digital Operating Partner”, says that “Choosing the wrong portfolio company is the first mistake that must be avoided. Private equity firms should choose a traditional portfolio company that has done business the same way for decades in an industry that has done business the same way for decades.10

He adds that “This usually means the best portfolio companies for private equity to transform are non-tech, traditional, mature companies in traditional markets that haven’t been digitally disrupted yet.

Positive externalities arising from focusing on digitally transforming portfolio companies

When asked, “What does innovation look like in private equity?” Adam Blumenthal, Founder and Managing Partner of the PE firm Blue Wolf, said that “the innovation in the industry, oddly, is getting away from the financial aspects and closer to the industrial roots.”11 Several reasons are driving that change. One of them is that with the increase of the number of PE funds and the amount of available capital, the amount of money offered to the founders or the management team of the target company is oftentimes not the deciding factor. Often, it’s about what else the PE fund can bring in terms of value to the target companies that can be the deciding factor for them to agree to the M&A transaction. Positioning digital transformation of the target company as part of the PE fund’s expertise can increase the chances of success.

At the same time, digital transformation is a way to increase a company’s efficiency and revenue in a more positive way for the founders or the management board of the target company. Due to the fact that private equity firms emphasize short-term financial results, founders or the management board sometimes do not agree with their decisions, which can produce a slightly negative view of the PE firms in the media. Digitally transforming the companies while the founders are still there after the M&A transaction, with them being able to witness their company flourishing, can also produce positive externalities in the media and improve the public image of the PE funds, therefore also increasing the number of transactions in the future. Private equity will start to be seen as more “human” by implementing digital transformation strategies in their portfolio companies, as they yield many positive long-term changes and results.

How U+ can help you to digitise your portfolio companies

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