FORUM: Digital disruption in the private equity industry
September 2018 | SPECIAL REPORT: PRIVATE EQUITY
Financier Worldwide Magazine
September 2018 Issue
FW moderates a discussion on digital disruption in the private equity industry between Alasdair Redmond at Intuitus Limited, Jon Tanner at MitchelLake Group, and Kush Jhawar at Warburg Pincus.
FW: Could you provide an overview of how digital disruption is impacting the private equity (PE) industry?
Redmond: The pace and complexity of the change driven by digital continues to accelerate and this is a real challenge for both private equity (PE) and the management of portfolio companies to navigate. Digital disruption presents both threats and opportunities to exit value and its impact can be felt in both traditional businesses supported by technology, through to cutting-edge technology-led companies. Digital is mentioned in almost all discussions we have with PE and most are working to address this through good advisory support and the recruitment of in-house chief digital officers (CDOs). Where there is perhaps even greater risk is within portfolio companies, many of which lack the time or expertise to recognise and act on digital disruption.
Jhawar: The greatest impact to the industry is currently on the investment side. There is an enormous competitive advantage that comes from correctly predicting whether new investments will be advantaged or disadvantaged by digital disruption. This reinforces the importance of having investment professionals with the appropriate knowledge, experience and connections. Of course, PE, like most other industries, is adopting a range of new technologies, many of them with the potential to significantly improve operations. But at the moment, these do not appear to be technologies that will upend or compete with the PE business model.
Tanner: PE firms now need to contend with digital transformation as a ‘new dimension’ in terms of value creation, but also an imminent threat to legacy business models and industries. Perhaps we could describe this more recent dimension as driving the evolution of a ‘4D private equity’ model. Whether the investment outcome is focused on growth or efficiency, there is no doubt that data, customer engagement and process automation is likely to have an impact on short to mid-term success or even the viability of an organisation. Data and engagement are critical assets in B2C. I suspect the smartest PE firms are already ahead of the curve in this space, as it adds a new dimension to evaluation of investment opportunities, as well as their post-deal management treatment.
“Striking the right balance between aggressively leveraging the data exhaust, while maintaining an ethical business approach and reputation, may become difficult as competition for good assets increases.”
FW: In what ways should PE firms assess their existing portfolio companies from a digital disruption perspective? How might this influence value generation, exit routes and returns expectations, for example?
Jhawar: For new investments, opportunity for, or risk of, digital disruption is a part of technical due diligence, and potentially part of the core investment thesis. It is important for deal teams to consider and will be an important differentiator for teams or funds with expertise in this area. For existing portfolio companies, the same general approach will apply during ongoing monitoring and management. The key recommendation is to ensure that non-tech-focused deal teams are suitably augmented with appropriate technology resources to ensure they do not miss new opportunities and are not blindsided by disruptive competitors.
Tanner: PE firms should establish a clear view of their exposure to disruption from new and more agile entrants to the markets of their existing portfolio assets. All businesses should be focused on what data assets they have and whether or not they have a single view of a customer. If so, is this customer information current and how is data being enriched for future leverage of products and services? They should also establish how data is being leveraged to make informed decisions at executive and board level. They should be clear on what threats are being presented by new entrants and that new players may not be immediately obvious or from the incumbent industry, for example Google going into payments or Amazon moving into retail banking.
Redmond: Developing a clear understanding of a portfolio company’s digital maturity is an absolute priority. This should focus on identifying the primary digital threats and opportunities, as well as the ability of the company to lead and deliver digital transformation. In response to this challenge, technology due diligence firms can develop a digital maturity assessment to support PE firms with this process. This quickly gets to the impact on exit value and identifies the practical next steps to respond. This high-level triage of the portfolio is the best starting point, particularly if transformation represents a significant shift in the business model. For example, board buy-in is critical in developing a digital service that will transform a traditional business into a technology company at exit.
FW: What aspects of digital disruption should PE firms be particularly wary of? Are there any digital technologies that are likely to have a detrimental impact on returns across the current value chain, for example?
Redmond: There is a lot of buzz out there about different technologies and this creates a risk that organisations focus on the one thing they think will have an impact. For example, securing value from artificial intelligence (AI) is not trivial and starts with high quality, structured data and the skills to implement it. Digital extends beyond disruptive technology and there are many well-established technologies that can make a difference, such as implementing digital marketing in a B2C portfolio company. Firms need to start with the investment thesis and focus on the data and digital maturity of their portfolio companies, rather than start with a digital technology solution.
Tanner: There is no doubt that automation and machine learning (ML) will have an impact on anything rules-based and process-driven. Anything that does not require a significant level of human intervention, service or curation will at some point, probably soon, rapidly diminish in value. Smart organisations are already applying these technologies to create greater back office and service efficiency. If they get this right then there may be an opportunity to increase margins as the gross value of a legacy product or service market deteriorates. This is really just an extension of the concept ‘disrupt your business before someone else does’.
Jhawar: There is potential for digital strategies or developments at portfolio companies, such as data breaches, unethical use of data and so on, to create reputational risk for the PE owner. Striking the right balance between aggressively leveraging the data exhaust, while maintaining an ethical business approach and reputation, may become difficult as competition for good assets increases. One other area of potential disruption is the growth of social networks and other services that improve users’ ability to evaluate and connect with other business resources.
“Our view is that no industries will be immune to the impact of digitisation, connectivity and globalisation over time.”
FW: How important is it for PE firms to have a sound understanding of the impact of digital disruption when sourcing targets, evaluating purchase prices and deploying capital?
Tanner: This is probably more dependent on what category the firm is investing in and how long their exit cycle is likely to be. No one knows the timing of anything with absolute certainty. Some categories of industry and business will be slower to change and there may be natural and enforced constraints that form a barrier to disruptive new entrants. That said, our view is that no industries will be immune to the impact of digitisation, connectivity and globalisation over time. Retail followed publishing, which followed music, as banking will eventually follow telco.
Jhawar: It is very important to consider digital disruption, but not overemphasise the potential upside. It provides another lens through which to view and evaluate industries, targets and value-creation strategies.
Redmond: It is crucial for firms to have a sound understanding of the impact of digital disruption. The risks and opportunities that go with this should be key considerations for the investment committee. We believe PE recognises this, as over the last 18 months we have seen an increase in the number of PE firms asking for advice, either on specific disruptors or more holistically. We saw a striking example earlier in the year, where issues identified in a digital assessment of a technology-led company revealed that it was overvalued. Ultimately this changed the deal dynamics and the transaction did not proceed.
FW: Are you seeing any tangible effects of digital disruption from an operational viewpoint, at PE fund level?
Jhawar: We are seeing tangible effects in a few areas. There have been basic efficiency improvements in labour-intensive areas, such as investor servicing. True disruption is not yet happening, but may occur if certain new technologies enable smaller firms and family offices to scale up significantly, allowing them to compete in a way they were not able to before. We are also seeing an impact in terms of business intelligence (BI) and analytics for fund performance. Continued improvement in BI tools and adoption will give limited partners (LPs) a greater insight into actual fund performance, but will also allow fund managers to better manage risk, exposure and entry/exit internal rate of return (IRR) planning.
Redmond: PE firms are not complex organisations, so we are not seeing the same impact of digital disruption as in, for example, B2C businesses. The biggest trend we are seeing is the addition of digital experts to sit alongside the investment management team within the PE firms to lead them through the digital conversation and build their strategy for portfolio companies. I think it could be interesting, though, to look at how the PE firms source the data for reporting on portfolio companies. There is potential for a digital solution to improve data management.
Tanner: Certainly there seems to be an acceptance that a level of expertise in digital transformation at a portfolio level is useful. My suspicion is that these are currently speculative hires. It is hard to know what level of investment in capability and experience is required or leveragable at this stage, but no doubt it follows the ‘entrepreneur in residence’ and more hands-on portfolio services models seen over the last decade. Given the relative maturity of PE investments to tech venture capital in this context, there is less of a focus on tactical ‘operational services’, but there is certainly broader potential for strategic services and symbiotic leverage than a token CDO.
“PE firms need to demonstrate their digital capability to target firms, to show that they have the expertise to support business growth.”
FW: Do you expect digital disruption to affect competitive dynamics between PE fund managers?
Tanner: Ultimately, getting an approach to investing and managing execution of digital transformation right will be the difference between success and annihilation in most industries. PE is no different. It will be interesting to see how aggressive funds become in terms of seeking out competitive advantage in technology, people and services.
Redmond: We are seeing a couple of trends in the market with regard to competition. First, there is a clear shift to buying technology-led companies – companies that are differentiated by their technology platform or products and services. These are providing opportunities for higher exit value. We are also seeing firms try to shortcut the buy process with early bids because competition is so high. This shortens the time available for due diligence, which means firms are not easily able to fully explore the impact of digital disruption on the way in.
FW: Are there any indications that digital disruption is coming into play during the fundraising process?
Redmond: PE continues to be a relationship-driven business and so there is a limit to how digital disruption will impact the fundraising process. However, there is a trend toward buying tech-led companies and therefore the LPs are aware and asking about the digital due diligence that is in place for these deals.
Jhawar: There will continue to be general improvement in tools used across the industry for contact and pipeline management, and in the quality of products provided to investors, who increasingly demand better service, access and data analysis. GPs who cannot respond to such requests may be at a disadvantage. The vast majority of PE capital – around 85 to 90 percent – comes from institutional investors, but in tandem with regulatory changes, new technologies, such as initial coin offerings for fundraising, or use of online distribution or pooled entities to bring in wealth management clients or high net-worth individuals, could significantly democratise PE, vastly increasing the pool of potential investors and potential assets under management (AUM).
FW: Going forward, how do you foresee the impact of digital disruption evolving across the PE industry? To what extent might such trends influence the way business is done?
Jhawar: It is possible that one or two successful deals that relied on some significant form of digital disruption will lead to subsequent inflated expectations and valuations. But more seasoned firms will remain measured in their expectations and balance digital against many other significant disrupting factors, such as regulation, the economy and others. That said, a confluence of improvements in deal team external communication tools, information sharing and reporting, and blockchain-based investment processes may radically speed up the pace of investments, for good and bad. Bid processes may accelerate, driving a need for faster, better analytics and risk assessment in some areas. The relationship-based approach to prospecting may give way to a more open, rapid, data-driven approach which will drive scale but also place an even greater premium on the right relationships.
Redmond: The impact of digital disruption will continue to be felt across the PE industry. If anything, the biggest change will be the speed the investment process moves at. I think we will see this increase even further. The firms which are actively using digital services to inform investment decisions will dominate the market. And PE firms need to demonstrate their digital capability to target firms, to show that they have the expertise to support business growth.
Tanner: PE and, more specifically, the top end of the mid-market, generally are among the best-placed players to take advantage of digital transformation opportunities and effectively navigate threats. The major inhibitors to any form of successful change are typically related to legacy stakeholders, organisational structures and scale itself. PE and sub-enterprise players are typically dealing with less inertia in terms of scale and complexity. They work to more direct outcomes in a more pointed and focused way. They are dealing with less technology debt and perceived risk to change. Hybrid models of corporate venture capital (CVC), joint venturing and co-funding are emerging. I expect CVC to evolve to reflect PE scale rather than early stage. Corporates are unlikely to get the depth and spread to ever make sense of early stage investment to their investors. They can, however, push much further up the value chain by making bigger bets at more mature levels of investment and partnership. This will provide either PE an opportunity for corporate collaboration and co-investment, or a new level of competition from F1000 companies as they become more aggressive in capital and M&A strategies.
Alasdair Redmond has more than 20 years experience in technology leadership and innovation. He has held C-level positions in a number of consultancies and systems integrators, including Convergys Corporation, a world-leading business process outsourcing (BPO) company before joining Intuitus in 2016. He was named to the UK CIO 100 in 2016 for his work leading digital transformation including research into the application of Internet of Things (IoT) and machine learning (ML) to enhance education. He can be contacted on +44 (0)13 1618 0510 or by email: alasdair.redmond@intuitusadvisory.com.
Jon Tanner co-founded the MitchelLake Group in 2001 and has been advising start-up, scale-up and enterprise clients on leadership, executive search and talent acquisition for digital ventures and initiatives for the best part of two decades. Based in Singapore, Mr Tanner works across the firm’s international hubs in Asia-Pacific (APAC), North America and Europe. He directly supports global clients, collaborating with the broader MitchelLake team and continuing to build an ecosystem of partner organisations. He can be contacted on +65 8111 7901 or by email: jon@mitchellake.com.
Kush Jhawar joined Warburg Pincus in 2018 and serves as the global chief information officer responsible for the firm’s internal technology. He brings over 20 years of global experience helping organisations shape and execute IT strategies to complement their business strategies, driving IT investment to business outcomes and building world-class IT organisations. Prior to joining the firm, Mr Jhawar held senior management positions at Accenture, most recently as the CIO for HR. Mr Jhawar holds a Bachelor’s degree in engineering from the University of Illinois at Urbana-Champaign. He can be contacted on +1 (212) 878 6346 or by email: kush.jhawar@warburgpincus.com.
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