How private equity firms are creating value through digital transformation

How to focus on digital

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.

What are the drawbacks?

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.

Why private equity firms don’t digitalise

Lack of scale

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.

Technology is expensive

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.

It requires collaboration and liaison

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.

Digital transformation in action

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.

Four steps to digitally driven value creation

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:

1. Hire professionals with technology backgrounds. These key employees should be able to advise the management team on the purchase or internal development of new hardware and software, and on hiring data scientists with the necessary skills.
2. Build data management capabilities internally. The process of collecting, aggregating, structuring, conditioning, safeguarding and using large amounts of data is complex. Portfolio companies need to be advised how to acquire data management skills or access them through third-party technology providers.
3. Be pragmatic. Private equity firms should start small and avoid solving everything at once. Trying to implement too many technological changes too soon in a portfolio company can end up in failure and a significant loss of capital. Target a significant technology shortcoming that could represent a major source of value creation.
4. Be transparent. Communicate progress on digitalisation efforts internally and publicly in annual reports, investor conferences, and other avenues.

Source: London Business School