Q&A: Digital opportunity and maturity in private equity portfolio companies
September 2021 | SPECIAL REPORT: PRIVATE EQUITY
Financier Worldwide Magazine
September 2021 Issue
FW discusses digital opportunity and maturity in private equity portfolio companies with Clément Mengue at PwC Germany.
FW: Could you provide an overview of the opportunities that digital transformation presents to the private equity (PE) industry? What key trends have you seen in recent years?
Mengue: Value creation has always been paramount to securing higher returns in private equity (PE). Historically, most PE firms created value in portfolio companies by focusing on predominantly two lever clusters: firstly, cost cutting and creating operational efficiencies, and secondly, revenue upliftment through sales and marketing optimisation, business and product innovation, and geographic and vertical expansion. Today, digital transformation is the latest value creation tool that enables a traditional business, typically a non-technology company, to transform into a data-driven one by leveraging de-risked technologies, such as data analytics, artificial intelligence (AI), and the internet of things (IoT), among others, to generate strong returns within the typical holding period of five to seven years. The PE industry has been very pragmatic about digital recently. PE firms are increasingly looking to validate the investment thesis through the digital lens. They are investing in digital earlier in the deal lifecycle through a series of digital initiatives, making available the same data-driven value-creation playbooks used by the world’s most valuable digital companies. As the holding period matures, even if a portfolio company is a ‘digital novice’, PE investors today still have the appetite to create a digital plan before exit, which the subsequent buyer can implement. To ensure the full digital potential of their portfolio companies is realised, innovative PE houses have been creating the role of digital operating partner. The digital operating partner identifies high impact digital initiatives, plans them with the investment team and portfolio company management, and then drives the execution by hiring the best technical service providers and subject matter experts from their industry or technology partner ecosystem.
FW: Based on your experience, how would you describe the digital maturity of PE portfolio companies in general? To what extent is there scope for greater innovation and value creation through digital solutions?
Mengue: The path to a traditional PE portfolio company becoming digital often begins with operational efficiency and product innovation and spans evolution to a platform business model. PE portfolio companies vary markedly in terms of their digital maturity and value-creation potential. Based on our regular assessments, we observe that the level of digital adoption is highly dependent on the industry, with knowledge-intensive sectors, such as technology, media and finance, having relatively high levels of adoption, but conversely, public sector, manufacturing, healthcare, hospitality, construction and agriculture are laggards. PE-backed innovators that are increasingly relying on software to enhance productivity and close digital capability gaps have not only invested in exponential technology, but have also digitised physical assets that are able to create greater value. IoT, digital twin and augmented reality, coupled with the power of data analytics and AI, improve innovation, making new insights available to increase efficiency, drive down costs and create revenue upside. Ultimately, the benefits of these technologies lead to higher earnings before interest, taxes, depreciation and amortisation (EBITDA), increased enterprise value and more attractive multiples. For example, we observe that innovative portfolio companies are collecting customer data with a smart product that gives access to a 24/7 window into the customer’s world and they can emulate what website companies do to optimise products. A PE-owned, US-based machinery provider, for example, is offering an open IoT platform to farmers for improving visibility of their assets, ultimately leading to better yields. Mid-maturity portfolio companies are making their first steps toward process automation in general, and administrative functions such as monthly closing and reporting, and onboarding of new employees, have adopted ecommerce and cloud platforms to increase their agility and scalability, or to implement integrated customer relationship management (CRM) and enterprise resource planning (ERP) systems. Low maturity companies typically lack these basic capabilities altogether.
FW: What digital transformation strategies are you seeing PE firms deploy to enhance the growth and performance of their portfolio companies?
Mengue: Recent studies published by the Harvard Business Review show that the majority of traditional companies that have successfully embarked on their digital transformation journey have a higher total shareholder return, which is defined by a combined view on revenue growth, margin expansion, the impact on valuation multiples, and dividends. In the PE context, successful digitalisation typically rests on the foundation of a digital strategy, which should be scalable across the portfolio company, and aligned with the investment team and portfolio management teams. Digitally enabled growth strategies to create new revenue streams are predicated on portfolio companies’ understanding that they are producers and sellers of proprietary data and insights that cannot be replicated by competitors, and which can enable potential growth due to digital products and services. For example, a PE-backed gear manufacturing business based in Germany provides differentiated predictive maintenance services that combine IoT and AI by embedding the latest generation sensors into all large industrial gearboxes and providing solutions to predict and alert on equipment failures and maintenance needs. On the back end of the revenue generation, there is a growing awareness that data analytics, AI and automation can provide visibility to the executive leadership team on business performance and help optimise operational efficiency throughout intelligent workflows. We see both business-to-business (B2B) and business-to-consumer (B2C) companies’ strategies capitalising on the opportunity to collect product and business data, and enable automated customer interactions to improve customer and lead generation, optimise pricing and personalise customer experience. For example, a PE-owned specialty chemicals business uses digital configure price quote (CPQ) software as the single source of pricing and product data, where customers can be well informed about the product characteristics before they make a purchase decision. This ultimately allows the portfolio company to focus on customers through individual interactions while providing value-added services that promote customer loyalty and stickiness.
“In the PE context, successful digitalisation typically rests on the foundation of a digital strategy, which should be scalable across the portfolio company, and aligned with the investment team and portfolio management teams.”
FW: What considerations do PE firms need to make when evaluating potential digital opportunities, so they make the right choice to suit individual portfolio companies?
Mengue: Conducting an evaluation of the potential digital opportunities should be predicated on validating the investment hypotheses through a digital lens. This requires a thorough understanding of the industry and technology trends, inorganic competitive dynamics and breakthroughs, and the impact on both the individual portfolio company and the core market or adjacent sectors as a whole. Furthermore, the digital opportunity evaluation or assessment should provide a view of the value pools of the portfolio company, its pain points and challenges. This is a key step toward identifying digital solutions to address the pain points observed while lowering the traditional immune system of the portfolio company. On top of this, companies should assess current portfolio companies’ digital readiness and identify the required capabilities needed by each portfolio company to digitally transform and stay competitive over the long term. Typically, this results in the identification, quantification and prioritisation of various strategic and operational digital levers that could increase the EBITDA impact of a portfolio company’s business in the short to medium term. Other, less quantifiable value levers, such as digital employee experience or right-skilling across the individual portfolio company value chain, are critical to support digital transformation. Digital talent and skills can also be a source of digital opportunities. A portfolio company with a large cohort of data scientists, cloud architects or full-stack developers may be best equipped to capitalise on digital opportunity.
FW: When rolling out digital solutions, what are some of the common challenges and obstacles that PE firms might expect to encounter? What steps can they take to overcome problems and manage risk?
Mengue: One of the biggest hurdles for rolling out digital solutions is ensuring there is a common understanding of what digital is. Education and a strong alignment between the investment team, portfolio management and portfolio company leadership is needed to create a clear vision and digital plan by understanding how digital solutions will support the overall equity story. A further major hurdle is managing stakeholder expectations around the value of the impact and the timeline. It is key to prioritise digital initiatives based on profit models and investment requirements. However, it is also important to focus on and have the discipline to innovate, test, measure, improve and start all over again. Portfolio companies and PE firms alike must set their expectations correctly and avoid becoming impatient. Furthermore, it is important to start digital initiatives early within the holding period – shortly after deal closing – so the PE investment team has enough time to see results in the exit multiple. To overcome obstacles, it is critical to align through regular dialogue on performance, and tracking this via strong governance, such as a well-formed executive steering committee where operational stakeholders can collaborate with the company leadership team to review impediments to progress, financial performance of the specific initiative and to collaborate on significant decisions. Similarly, it is important to have a steering committee to manage day to day execution of the digital transformation plan and associated initiatives.
FW: How can PE firms draw a link between digital maturity and tangible value creation which leads to higher returns on exit? In what way can this be measured and quantified?
Mengue: To identify how digital payoff can influence higher returns on exit, it is important to understand current digital capabilities and maturity level, and determine what tangible technology-enabled initiatives can take the company to the next level of value creation. Generally, digital maturity increases enterprise value by improving EBITDA. Examples of this include driving revenue growth by increasing market share via data-centric and IoT-enabled products and services, driving down costs by improving operational efficiency, and asset utilisation and yield via low tech digital solutions such as ERP, CRM or mid tech solutions such as ecommerce, process automation or cloud infrastructure. We have observed that digitally transformed portfolio companies can command a premium on their valuation, with PE funds willing to pay a premium of more than 20 percent, compared to a financially identical, non-digitalised company. Integrating digital add-ons to the portfolio can increase digital maturity. As an anecdotal example on the back of a recent conversation with a Nordic mid-cap PE, roughly 20 percent of their add-on investments are small tech companies. These firms are either digitally native software companies or online marketplaces with existing digital capabilities. For the remainder of the portfolio, the portfolio management teams glean learnings from the tech companies and try to apply this same expertise within their company. In roughly 50 percent of these cases, digital has been a key return driver in manufacturing operations, workforce enablement and back-office automation. It must be noted, however, there is no universal set of digital key performance indicators (KPIs) for all companies and industries. Companies are too different and often digital transformation is used for different objectives. The right digital KPIs are those that work for the specific industry, specific business model or specific portfolio company. Portfolio companies must define their individual digital ambition and initiatives and map the relevant KPI to measure the return on exit. Clear business cases that fit within the PE owner’s exit horizon are paramount to overcome pushback and get stakeholders on board.
FW: What essential advice would you offer to PE firms on implementing and leveraging digital solutions to achieve digital maturity across their portfolios? How can they track the progress and ultimate success of the process?
Mengue: Often PE firms do not know where to start or how to write a digital plan before exiting an investment and leaving implementation to the next owner. PE firms must understand the key, applicable digital building blocks to achieve digital maturity across their portfolios. Based on our experience, full digital potential can be achieved by focusing on the following six building blocks. First, a digital strategy with a transformative agenda encompassing the first 100 days and a year one plan to identify initiatives spanning quick wins on disruptive opportunities. Second, seamless customer engagement that helps create a good customer experience. Third, smarter products and services that create new revenue streams. Fourth, efficient digital operations and automation that enable cost efficiency. Fifth, modern technology platforms and infrastructure. Finally, an agile workforce, digital partner ecosystems and add-ons that across the value chain are critical to digital transformation. Overall, it is important that PE firms have access to digital maturity playbooks and conduct regular digital maturity assessments, as well as portfolio review and rankings to identify capability gaps and share best practices across their portfolio for mutual benefit and growth. Digital maturity assessments conducted by the digital operating partner or external advisers should consider each portfolio company’s current initiatives and projects and recommend improvement of existing projects and identify more impactful ones.
FW: Looking ahead, do you expect to see more PE firms embrace digital? What predictions would you make for this space in the coming months and years?
Mengue: With the speed of technology innovation, it can be very challenging for PE investment and operating teams to stay relevant in terms of technology innovation and break out of the PE bubble. Key to overcoming this challenge is to constantly connect with innovation and understand what early-stage technologies and businesses are disrupting the market. I expect to see PE firms foster their digital potential plan by evaluating opportunities for partnerships or venture client relationships with tech companies, building digital ecosystems and assessing suitable partners and suppliers, and co-executing selected digital initiatives, such as process automation. Maintaining these partnerships and relationships that enable PE to serve their large portfolio of disconnected companies, so that technologies can be shared broadly across their portfolio, will become highly important. Beyond ecosystem building, incorporating digital add-ons can drive expansion of valuation multiples and enterprise value. I expect to see PE strategies increasingly using digital company add-ons to help strengthen a portfolio company’s digital skills and to accelerate technology enabled growth and product innovation. Portfolio companies that achieve digital maturity will be in a position to command a tech valuation multiple or at least a higher premium and deploy disruptive capabilities and platforms on the back of acquiring digital assets.
Dr Clément Mengue is a director in PwC Germany’s deals strategy practice. He leads commercial advisory and diligence services for private equity, venture capital and corporates around technology enabled growth, digital business opportunities and investment strategies leveraging on exponential technologies and digital ecosystems. Dr Mengue supports his clients in resetting their technology enabled growth strategy from linear to exponential. He can be contacted on +49 151 629 78769 or by email: clement.mengue@pwc.com.
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