Digital Transformation – in the area of private equity (part 1)

In two of my previous blog posts, I talked a little bit about digital transformation. I have been working in the private equity sector for almost a year now. For me – coming from industries with a strong focus on IT – a new area. During this year, I was able to make many new contacts – and through an intensive exchange of ideas, I also gained an overview of digital transformation within the private equity sector. It is a fascinating field, on which I would like to share my thoughts here.

The private equity industry is the catalyst for the growth of startups and private companies. It is – in my opinion – a silent sector for the vernacular. If you don’t have a direct line of contact, you don’t get much out of it. Yet private equity has been a flourishing industry for years. The goal is to find a target company with high and stable cash flow to choose a favorable risk/return ratio. Besides, the business segment in which the investment is to be made should have market entry barriers for potential competitors, and the target company should offer the potential for scaling.

In 2018, the total capital volume was approximately 5.8 trillion dollars, an increase of 12 percent compared to 2017, with 2019 being an even more golden year. In essence, an all-time high of 250 billion dollars was reached in the USA. In Europe, at 112 billion euros, a peak is approaching.
However, this increasing amount of cash in private markets also creates challenges. As the money supply in the markets continues to grow, so do the prices for target companies. This situation makes it increasingly difficult to achieve an appropriate increase in value until the exit. At the same time, the potential to be successful with conventional optimization is diminishing.

If conventional optimization promises only marginal growth and scaling is necessary to achieve value enhancement of the target company, there is only one way to go: The business model must be transformed into a sustainable, digital business model. This approach does not mean that all areas of the value chain on which the business model is based must be “digitized”. But the potentially most promising elements of a company’s value chain should be considered step by step (more on this in the next post).

In principle, digitization has the most significant leverage to achieve impact. It is not – as many always assume – about the application and implementation of technology. Rather, it is about gaining knowledge and efficiency – through meaningful digital concepts along the value chain (see Post “Corona crisis and digitalization – the Damocles Sword hovering overall” and “The Digital Transformation – from the data-driven viewpoint“), which entities experience throughout their life cycle.

Well, if the hypothesis is that digitization is the requisite way to master the current challenges and be more successful, the question arises what this means for the private equity sector.

In the upper section, we have outlined the challenges of a PE house. The argumentation was concentrated on “target companies” – exciting opportunities that a PE house might acquire. The acquired companies (portfolio companies) should grow over a period they are held. To enable this growth, the digitalization of the business model of the portfolio company may be the right step.

However, this is only one aspect of “digital thinking” within the private equity sector – which also has a strong, external point of view: namely the digital transformation of the portfolio company.

If one takes a step back and tries to sketch a holistic view for a digital transformation in context PE, it might look like Figure 1.

Figure 1 visualizes the different subject areas within a PE house. Like every company, a PE house has internal processes. These form the first pillar. The second pillar covers the area of hypothesis generation – i.e., what market trends are to be expected in the PE verticals. The last pillar – portfolio – stands for the key phases of the property life cycle: origination, transaction, governance, and exit.
Digital transformation means not just considering one of these three areas, but taking a holistic approach and “thinking digitally” in all three pillars (which is why Figure 1 is also visualized as a circle since the individual workstreams of the areas have intersections and interlock). After all, the essence of digital transformation is not the introduction and use of technology but the gain of knowledge through previous decisions and the standardization of the process model (e.g., through the support of digital assistants). Both elements, across all three pillars, bring cost savings, scaling, and efficiency. Let take a closer look at the three pillars in the following part.

The first part, the internal processes, is a “typical” digitization process. The aim is to store data objects in a meaningful way – according to their corresponding entity – and to map processes digitally to achieve a high degree of automation. The two blog posts (Corona crisis and digitalization – the Damocles Sword hovering overall” and The Digital Transformation – from the data-driven viewpoint) describe considering aspects.

The second area, hypothesis generation, reflects the field of market & trend analysis to discover potentially exciting industries. And to gain insights into the individual segments. This information flows into the last area, the portfolio. In a later post, I will explain which technical methods from AI, Information Retrieval, and Big Data can be used for hypothesis generation. The use of appropriate methods and technologies in these areas is a huge leap forward compared to today’s processes in PE houses, which are mostly Excel spreadsheets based.

The last area, the portfolio, encompasses the key phases of the property life cycle. It is all about increasing the value of the property. This value growth can be achieved, as described above, through the digital transformation of the portfolio company (i.e., with a holistic approach across the value chain of the company – how this can be reached is part of the second part of the blog post).

It should be noted that such a digital transformation -to achieve the described parts- means restructuring and requires rethinking. It will not be completed quickly and is expensive. However, it helps, in the long run, to remain competitive.

In the upper part, we have dealt with the structure of a PE house and have highlighted the three different subject areas to be digitized. What does this mean in concrete terms? Digital thinking in the private equity sector means making use of the large amounts of data generated internally and by the portfolio companies. In this way, decisions made and their effects become comprehensible. The resulting knowledge can be used for future decisions and helps to make objective and data-driven decisions. Evaluations and models can be generated, analyzed, and made available more quickly. “Digital thinking” focuses on the utilization of the untapped data sources of a PE house. Through such deep data integration, the competitive advantage can be expanded.

How can this holistic approach be achieved? By building up internal know-how and entering into cooperation with experts from data science, agile coaches, programming, and technicians. The typical conventional PE resources – top professionals from consulting, investment banking, and accounting firms – often do not have the necessary technical understanding. The “digital experts” – who know the disruptive nature of digital transformation and can put it in a holistic context – within the PE houses must be the bridge between the two worlds.

It means that the conventional structure in PE houses will change. This part will conclude with an illustration (the future PE organization to establish “digital thinking”, see Figure 2) and quote by Sinan Krückberger.

This blog post is about the potential of digital transformation in the field of private equity. “Digital Transformation” does not only mean to take a closer look at the portfolio companies but also to “digitalize” the own internal PE processes and structures – to make the untapped data treasure usable.
For this purpose, internal know-how must be built up, and cooperation must be entered. The competences of “digital thinking” thus gained will go into the playbooks of the PE houses and help to digitalize the portfolio companies.
In conclusion, for a successful, digitally controlled value chain, the following points should be considered:

1. Building up internal know-how carriers in the field of “digitization and technology” across all hierarchical levels This area introduces digital transformation and the associated digital thinking in lighthouse projects.
2. Entering into alliances with IT companies & research institutions to obtain any necessary expertise and skills at short notice.
3. Setting up an internal information architecture based on 1 and 2 (internal digital processes and digital hypothesis generation). It is a very complex process because the collection, aggregation, structuring, and utilization of data – based on the PE processes and their entities – is not an easy, short-term task.
4. Proceed step by step and in a structured way. Take everyone with you, and don’t overcharge. Because digitization is change management – i.e., if necessary, changing workflows, changing culture, and using new work tools (such as collaboration tools and databases).
5. Publish the procedure (in reports, studies, or papers) to become continuously better through an exchange.
6. Transfer the knowledge gained through internal digitization to the portfolio companies. Use of the growth lever of digitization to have an excellent digital equity story when exiting.

• Moonfare
• London Business School- How private equity firms are creating value through digital transformation
• Bain- Private Equity Report 2020
• Bain- Private Equity Report 2019
• Bain- Private Equity Report 2018
• Bain- The Impact of COVID-19 on Private Equity
• Sinan Krückeberg- Why true alpha is now digital activity
• PWC- Private Equity and Digitization