To attract new capital, private equity professionals often emphasise their firm’s operational excellence, focusing on operations-related improvement initiatives, their portfolio companies’ corporate governance mechanisms, culture, organisation, and long-term objectives. However, with the increased competition of more than 8,000 private equity firms worldwide, does this continue to provide a competitive advantage in the marketplace?
According to Preqin – the leading provider of financial data and information on the alternative assets market – private equity buyouts reached an all-time peak of 5,106 deals globally, with an aggregate value of US$456 billion in 2018. With this record buyout activity at historically high valuations, it is obvious that private equity managers face significant pressure to identify new opportunities and operational angles to continue to deliver good risk-adjusted returns.
In response, many private equity firms have set up dedicated in-house operational value-creation teams. Yet, they are struggling to articulate exactly how these teams can add value to portfolio companies, and what differentiates them from their competitors. A small set of private equity fund managers have found an answer: they have decided to place digital transformation at the core of their operational toolkit.
Digital transformation involves using a combination of new technologies and methodologies, including big data analytics, high-performance computing, artificial intelligence (AI), machine learning, the internet of things, blockchain, cloud solutions, internet connectivity, mobility or robust cybersecurity. These innovations are a huge leap forward compared to the Excel spreadsheets that most private equity firms use.
Digital transformation leverages the large amounts of data generated by portfolio companies and private equity firms. It could be one of the greatest untapped sources of additional profit. Most importantly, it holds the promise of more objective decision-making, a critical advantage when markets are volatile.
Private equity firms should start thinking about digitalisation at the investment due diligence stage where they can ask critical questions. As recently highlighted in a report by PwC, using the target company’s business model, private equity firms can investigate if it:
Co-creation leads to faster product development and more innovation, as the company is more responsive to customers’ demands. On the production side, private equity firms can investigate whether tenders and supplier evaluations are automated and constantly evaluated. They can also see whether production processes are integrated to provide real-time visibility of ongoing production, and whether it is digitalised to identify bottlenecks and optimise workflows. On the logistics side, private equity firms can investigate if companies trace supplies electronically to lower inventory levels and optimise working capital needs.
Digitalisation provides even greater benefits for interactions with customers. Digitalisation can support and track customer satisfaction or facilitate omnichannel sales and personalised marketing. Due diligence can also assess whether the company’s accounting department can provide tailored and fast financial reporting. The rapid, automated analysis of financial data can allow private equity fund managers to judge the feasibility and likely profitability of new products and business models that the target company aims to promote.
"Private equity firms should start thinking about digitalisation at the investment due diligence stage where they can ask critical questions."
A well-managed digital transformation can turn a company into a technological leader with a first-mover advantage in its industry. Nevertheless, private equity firms need to assess whether these companies can make the cultural shift and commit to the information management, advanced analytics skills and technology investments that come with a successful digital transformation.
Digitalisation involves setting up systems that merge the best of the digital and physical worlds. These systems must facilitate big data analytics, which involves the rapid extraction, transformation, search, analysis, and sharing of massive datasets. Data processing could yield descriptive analytics (basic reporting and business intelligence), prescriptive analytics (suggestions for actions) and predictive analytics (insights into future developments).
For example, private equity firms could significantly transform and refine their portfolio companies’ sales processes using a system that tracks each step in the customer experience chain to personalise marketing campaigns. This would provide better product customisation, or help customers discover and purchase new products. A deep data analysis of customers that facilitates fine segmentation and a better understanding of demographics could improve targeted sales.
In a logistics business, the private equity firm could advise on the installation of sensors in various assets to better understand their use and efficiency and generate predictive analytics. Similarly, in a manufacturing business, data analytics could manage the flow of ingredients on the assembly line to minimise waste and aid automation processes that can predict when a piece of production equipment is likely to need maintenance.
By digitalising areas of operations such as manufacturing, supplier management, procurement, delivery, marketing or customer service, private equity firms can identify the areas where they can enhance efficiency and business decisions.
On the surface, the data generated by these transformations is useful; however, it might not provide immediate advantages. Often this data is only beneficial if it is acquired, organised, shared and analysed in real time. That can be very challenging, and investments that facilitate such data gathering and analysis could be very expensive and time-consuming.
It is highly likely that the exit value generated from digital transformations will more than compensate for the longer holding period due to the implementation of digitalisations in portfolio companies. Strategic acquirers are more likely to pay higher multiples for successfully digitalised companies, given that they are easier and faster to analyse and integrate.
While many private equity firms understand the benefits of digitalisation for their portfolio companies, the ironic reality is that, despite the availability of the new technologies, many private equity firms are still in the early stages of their own take-up of digital technologies. One factor that potentially slows down adoption is that private equity investing is a low-velocity business: most private equity teams only execute a couple of deals per year.
This lack of scale may not justify investment in developing digital capabilities. However, firms without robust digital solutions risk losing their competitive edge in the long term: they spend more time and energy generating analyses, and may fall behind their investors’ expectations. They might also struggle with an old mindset and culture.
It is important to note that digital transformation is very expensive as technological systems and digital skills come at high prices. Not all private equity firms will have the resources to invest in new digital technology.
Not all firms will be successful in collaborating with teams from diverse backgrounds on operational processes and private equity investing, as well as liaising with data scientists, programmers and engineers, often with PhD-level education.
Digitalisation is seen as the most important trend influencing new investments. In a 2018 Preqin survey of 300 private capital fund managers, about 70% of respondents acknowledge that the level of digitalisation could play an important role in their investment decision. The research yielded some interesting insights into how these firms use technological solutions. It also examines the factors that are blocking firms from adopting more efficient technologies.
Not surprisingly, some firms started to change the way they look at new investments. For instance, Two Six Capital, which has participated in more than US$32 billion of private equity transactions that have closed, is among the first to pioneer the use of data science in private equity investing. The firm became adept at using large-scale, cloud-based engineering to handle large data sets over a short timeframe. This capability brings insights into what is happening in a portfolio company on a day-to-day basis. Data-processing capabilities also give the firm a significant advantage over the competition in the commercial diligence phase where professionals have a very limited time for investment decisions.
Another example is Blackstone which created a Data Initiative team focused on data science, big data and advanced analytics. The team partners with the firms’ investment professionals to improve the investment process, make new investments and optimise existing portfolio company operations.
At EQT, one of Europe’s leading private equity firms, the digital transformation of private equity is now well underway with the transition to cloud-based working and the creation of an advanced system, called Motherbrain, that sifts through large datasets to find possible investment opportunities. The firm put together a strong team to support the digitalisation of portfolio companies, to help with due diligence, and train the firm’s staff to understand digital signals in the market. The firm has created an open environment where information about emerging digital technologies transfers between its venture capital fund team and the multiple personnel that manage buyout and credit funds.
Digitalisation of private equity firms can impact on the investment process and also on the fund administration and reporting, which still involve many manual processes. One example is distributed ledger technology (or blockchain) technology which can integrate directly and securely capital calls, fee settlements and reporting updates between the private equity funds and their investors.
This can lead to improved transactional efficiency, reduced reconciliations, shortened settlement cycles and easier management of liquidity requirements. It can also lower the funds’ total expense ratios and improve the net returns that investors achieve. The Preqin 2018 survey also found that only 6% of global private capital managers are currently considering using blockchain for fund administration, and close to 40% are unaware of its benefits.
Digitalisation can also help support the activities of the investor relations department that faces an increased demand for reporting to investors, internal and external communications, marketing and other corporate initiatives. Storing and processing fund and portfolio company data in the cloud can bring real-time insights and benchmarking to fund managers, fund investors and their service providers.
It is clear that private equity firms face increasing pressure from investors who demand good returns, more information, greater transparency, and improved data granularity. Digitalisation can alleviate this pressure. And it is just a matter of time until a critical mass of fund investors will start judging private equity professionals by their savviness about digital technologies and ability to implement them. To successfully implement a digitally driven value creation strategy, private equity firms should:
Florin Vasvari is Professor of Accounting at London Business School (LBS) and the Academic Director of LBS’s Masterclass in Private Equity – delivered in Hong Kong.
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