Digital transformation is rapidly changing all three levels of private equity value creation. Many PE firms are already betting on what I call the digital value creation trifecta. Here’s how.
First, let’s take a step back. For those new to private equity, there are basically 3 ways PE firms generate outsize returns, which is called value creation. In an overly simplified way, these are:
- Multiple expansion – getting a higher valuation multiple when selling a business than the multiple paid when you purchased it. More on this shortly
- Operational Improvements – Growing Revenues – Reducing costs
- Paying down debt
So back to multiple expansion. There are many reasons a business may be worth a higher multiple at exit than when you bought it.
Normally private markets value companies less than public markets on a metric called EBITDA multiple. Let’s say the same business that sells for 10 times EBITDA in a private market may sell for 13 times EBITDA if it is public. There are many reasons for this, but public companies are considered more transparent and less risky than private ones. Also bigger companies sometimes sell for higher multiples than smaller ones. Also, often public companies are considered better run and that can fetch higher multiples.
The impact of digital technology on multiple expansion may not be obvious. Many investors realized though that a business with digital commerce, a more responsive supply chain, and more efficient operation and supply chain will get higher valuation multiples in public markets. Some believe digital transformation may add 20-30% to the realized EBITDA multiples on exit. Recently private valuation multiples became as high as public ones. The traditional arbitrage of buying lower private multiples and selling high public multiples has been shrinking. If that trend continues digital multiple expansion may become a key lever in multiple expansion.
The connection between operational improvements and digital technology seems more obvious. In recent years and especially in the current crisis, companies that completed digital transformation were better at driving revenues, reducing costs, and generating cash. For many PE investors digital became a key driver of operational value creation.
Digital enabled automation and more efficient operations, reducing overhead costs. Analytics, machine learning, and IoT also improved manufacturing and supply chain efficiency reducing operational costs. Better sales and marketing automation expanded growth and reduced customer churn resulting in higher revenues. Overall digital technologies had a major role in margin expansion as part of operational value creation.
What about the 3rd lever, debt repayment? Well, all those efficiencies will result in higher cash flow that allows for faster debt repayment and increasing the equity of the business. Completing the digital trifecta.
I spoke with at least 3 investment managers that believe digital transformation will become a key driver in all three levels of PE value creation. They are betting on these digital levers. Will the digital value creation trifecta create outsize returns through this crisis? I think so
During the disruption digital transformation is accelerating for many companies. Tactical projects are sidelined and companies that are watching the digital transformation from the sidelines are increasingly left behind.
My discussions on digital transformation in private equity circles shifted significantly. For many PE firms, digital transformation became a lot more pressing and short term.For the first time that I recall, digital transformation became part of many business continuity plans as some companies are frantically responding to the disruption by reinventing their business models. Businesses see traditional barriers to digital adoption by employees and customers go away in the crisis. This allows for a much better adoption of digital business models post-crisis.
This time around, no one has patience for 2-3 year transformation programs. Investors and boards of directors want to see both short term digital fixes and also a digital plan to emerge from the crisis as a much more resilient business.
Even companies that had digital in one side of their operation like e-commerce struggled with fulfillment issues for lack of flexible sourcing systems on their backend. Many realized digital transformation has to be end to end not just in certain functions. I heard from several PE investors that they are shutting down long term IT projects and anything that has no clear, bankable value.
Digital projects get prioritized especially if they help solve sales issues, customer service, and supply chain problems. Many firms believe that rapid digital transformation in e-commerce, data science, and automation can be a matter of significant market share and sometimes survival.
So what does that all mean?
Digital projects with high value that can solve urgent problems will get priority. Science projects, pilots will likely be put on hold.
Many firms believe that rapid digital transformation in e-commerce, data science and automation can be a matter of significant market share and sometimes survival.
In the last few weeks, I noticed that the private equity digital playbook is changing, What initiatives are given priority in a crisis?
When I started with private equity value creation it was 2009, the height of the last recession. This was the time when private equity firms got more hands-on with their portfolio companies to help them through disruption. For most firms, this was the first time they formed an operating team focusing on cross-portfolio initiatives and hired their first IT operating partners. In my experience, PE firms always had an effective playbook for managing through business disruption and in 2009 they added some digital strategies to the mix. In those days it was spent analytics and e-sourcing to help companies reduce cost and maverick spending. It was also the time firms started using sales analytics and e-commerce as core elements of a crisis management playbook. A good example was how APAX turned a publisher called Auto Trader after the last crisis into a completely digital company. There were many examples like that. Fast forward to today and we’re going through another disruption and most PE investors have a well-tested digital playbook. Many have portfolio CTOs, CIOs or Chief Digital Officers. As business continuity plans are put in place at their companies, they now have digital strategies added to those plans. Many firms realized that companies with digital experience would come out of this crisis stronger. There is also an opportunity to accelerate the digital laggards to lead in the next economic expansion. Currently, I see 3 big digital value creation plays emerging:
- There is a wave of renewed E-commerce automation among PE portcos. Whether it is luxury apparel or eyecare, the biggest lesson of this crisis is that companies with limited e-commerce capability and inflexible distribution channels saw their revenues evaporate. Safe to say, there won’t be a successful company left without the ability to completely shift online as needed and have the proper distribution to back that up. With social distancing, automated e-commerce clearly outperforms other channels.
- The other major change is automating contact centers. As workers worked remote, contact centers had major issues with remote access and expanding call volumes. Those that had automated chatbots for example fared better as phone lines were jammed and emails went unanswered. This was worse in industries like healthcare clearly and also in financial services because of increased refinancing and business loans. There is a new automation wave in call centers with bots augmenting agents, handling non-critical inquiries and even automating remote access. There are also machine learning tools deployed to help triage customer calls and handle email inquiries.
- The third area of digital expansion is due to the disruptions of supply chain. Machine learning and analytical tools are being used to assess supply chain disruption and shifting customer demand. Bots are being used to reroute purchase orders, start renegotiating supplier contracts and step up customer retention efforts.
This crisis is changing the digital playbook again and it is being formulated as new digital winners are emerging from the chaos. In the end we will all learn from their stories.
For a digital project to make an impact, it has to move the needle. But do you know how your business keeps score?
Traditionally, success is measured through revenue, profitability, return on equity or EBITDA– but these are lagging indicators and not directly controllable. Many boards and CEOs use specific KPIs that more closely measure the impact of individual strategic initiatives. Ultimately, these impact the big metrics as well but provide more visibility into what areas of the business are producing the changes– to allow for more informed decision making.
Depending on your industry, different metrics will be most relevant to your business– for retail: these could be sales per square foot, for oil and gas: exploration success rates, for software: lead conversion rates, for banking: customer retention rates, or for healthcare: % claims rejected due to coding errors.
- Identify the leading indicators that determine success in your industry.
- Know where your company stands on these metrics in relation to your industry’s leaders. ? and THAT is the performance gap your digital project should help fill.
- Always start with the performance gap, not with the technology.
Unfortunately, many digital teams resort only to efficiency metrics like hours saved or reduced staffing needs to justify projects. It is shortsighted. Especially if the board does not really focus on those metrics.
I recall trying to convince a pharmaceutical company early in my career to reducing finance and procurement costs and all the board and C-suite cared about was ways to increase R&D pipeline. Similarly, in a high growth technology business, one project targeting customer renewals got priority over another aimed at reducing operating costs — even though the estimated impact on profitability was the same.
Any technology project should focus on impacting the top 3-4 KPIs that are the priorities for the board. Otherwise, the project will become a distraction and lack executive support. We need not only to move the needle but to move the right needles for the business– the ones that align with the board’s strategy.
So here are my 5 steps for moving the needle
- Identify 1-2 strategic KPIs where the digital project will make the most impact
- Take a baseline measurement of those KPIs to understand the current state.
- Determine how big the performance gap is between you and best in class in the industry.
- Set that as the art of the possible for digital and set a realistic short term goal.
- Then focus on moving that one needle.
I had the opportunity to observe dozens of PE operators guide projects in their portfolio. I believe there are lessons from the relentless value focus of private equity that can make our digital projects better. So here is what I learned from PE about running more impactful transformations
#1 MAKE IT REAL
We need to bring our digital vision down to earth. Nobody really understands what Digital Means to them. We need to let the executive team experience what will be different. It could be by visiting a digital native disruptor in the industry, demoing actual capabilities, showing competitive benchmarks, and so on. We also need to have personalized outcomes for each key executive area – showing how the digital is driving measurable change in Customer Satisfaction, Revenue Conversion, Cash, Cost, Speed, Talent Development
It is also critical to define the art of the possible in financial terms not just in passionate technology vision. That should include the definition of what is the maximum value potential achievable. The best digital initiatives make it real by focusing on both revenue growth and cost-efficiency.
#2 DO FEW PROJECTS WELL
PE investors taught me to take only a few big bets and do them well. Often companies take endless small bets that don’t actually move the needle. I think that is why we have so many proofs of concepts and pilots in digital. The focus should be on tangible financial results, not technology aspirations Digital programs should have a short term focus to generate value – max 2 years. Project progress needs to be highly visible and measurable, preferably at the board level. And we need to make it personal: SLT members need to own each initiative or they should not be done.
#3 HAVE BIAS FOR ACTION
Time truly is money. We need to have a sense of urgency or create it. It is Finance 101 that the value our project can deliver now is worth much more than the same benefits 3 years from now. And because of that, there needs to be a strong bias for action not for analysis or planning. As a technology investor once told me, there should be 10% thinking and 90% doing. The best programs make decisions quickly – one and done the same day, preferably. Again time is money, have a bias for action. Overthinking is the enemy.
#4 MAKE CASH MATTER
I often heard PE colleagues say, make sure the juice is worth the squeeze. It is a reminder that the cost and distraction of your project should provide outsize benefits. The reality is that our project is either creating value or destroying it. Therefore everything can and should be broken down to cash flow impact. In fact, we all start with what PE firms call the J-curve. We have the project cost but no benefits to start with, so we are in the negative, of course. Successful projects have quickly delivered outsize benefits in months and not years. And we need to make sure all long term project deliver short term value too. For example, AI and data science programs can be self-funded by a series of automation projects that generate cash on a quarterly basis, while the program may take years to benefit the business
#5 REWARD TOP PERFORMERS
The biggest lesson from private equity is that management and investors should always be aligned on financial outcomes. Digital transformation will deliver major business value. The executives and project team delivering those results should be rewarded. Consider equity, bonuses for delivering on key initiatives
SO WHAT DOES THIS MEAN FOR YOU AND ME?
I think bringing short term value and bias for action can help more digital projects succeed by delivering benefits early and often; and once we have that digital value creation formula, PE would tell us to rinse and repeat.
We are planning a survey to share best practices among practitioners soon.
This has been the year where many private equity firms started adopting robotic process automation at scale in their investment theses. After the first six months of the year, there are a couple of best practices emerging from our engagements in private equity:
#1 Start with finance to gain experience and bankable value
The finance function is typically the most structured. It also tends to have a lot of manual processes and repetitive tasks that are ripe for automation. It is easy to drive significant cost savings in A/R, A/P and general accounting in weeks and not years.
For most PE investment theses optimizing back-office functions is secondary to driving revenue growth and streamlining the supply chain. Therefore software robots can deliver tangible short term savings while significant transformation initiatives are underway.
#2 Align with investment thesis for highest potential
In a 3-5 year holding period, there is little time for IT experiments and proofs of concepts. Robotic value creation should focus on driving EBITDA growth quickly and support the key pillars of the investment thesis.
With 40-60% typical savings in back-office and 20-30% in the front office, RPA has become a great value driver for PE firms. In fact, firms with very different investment styles have integrated RPA value creation into their overall theses:
- Turnaround firms managed to reduce repetitive back-office processes
- Carveout firms that wanted to keep the spinoff entity costs contained adopted a bot first strategy in building up the workforce
- In growth equity, we’ve seen bots used to contain back-office headcount growth in check as the revenue line expanded
- In rollups, the overlapping functions can be standardized and optimized with functional bots like digital finance clerks and data entry specialist
#3 Speed over perfection
Management teams often want to finish perfecting business processes. Often those projects started years ago with ERP and are still unfinished. Robotic value creation should be all about speed, not perfection
It is easy to change the bots as processes evolve or change compared to the herculean effort of enterprise system changes. Consequently, many firms now look at RPA to help avoid the cost and disruption of major ERP upgrades or IT transformation.
While many IT projects fail to deliver measurable value, most PE firms find RPA a clear example of short term, tangible IT value creation.
#4 Use consulting partners in doing not thinking
PE firms want consultants to focus on getting the results vs thinking about them. Digital transformation consulting projects are plagued with endless proofs of concepts or process evaluations that add little tangible value.
Leading PE firms and portfolio companies focus on delivering several smaller pilots with measurable EBITDA gains. For the price of a process design workshop, dozens of bots can be up and running
#5 Maximize value in holding period
In the 4-5 year holding period robotic value creation projects can be a major value contributor especially in SG&A and contact centers. Automation projects should be rinse and repeat with EBITDA gains delivered quarter after quarter.
The best practice calls for a small core team who knows how to drive value over and over again. PE firms tell me that it is critical not to leave too much money on the table for the next buyer.
Robotic process automation (RPA) also called Digital Workforce (DWF) software takes the mundane repetitive tasks and automates them to free up human workforce for more fulfilling jobs. Increasingly the types of tasks move beyond data entry and reconciliation to more cognitive tasks like process analysis, reporting, and even basic decision making that fit predefine tolerance levels. In the process, some companies reassign part of their human workers and establish a digital workforce. Imagine telling your digital assistant, “Alexa, please close the books, analyze overdue customers and initiate collections, prepare the report package for the board of directors, we’re at capacity so decide which customer order to delay”.
The most advanced automation happens in industries with experience in shared services, outsourcing and offshoring as that required them to displace and replace workforces and document processes well. The digital workforce leaders are in healthcare, telcos, financials and professional services and even manufacturing and the traditionally IT-savvy tech industry is a laggard in comparison.
Many private equity firms have focused on digital initiatives for a while with bankable results in areas like omnichannel commerce, online auctions, predictive analytics in sales and operations. Some of those digital initiatives took years to mature and often the ultimate gains in enterprise value ended up benefiting the next owners. Broad digital transformation is better suited in certain investment styles (growth equity) and does not have the short term benefits needed for others (turnaround, carveouts) or later in the investment cycle.
What is attractive about digital workforce or software based automation, is that projects are done in 3-4 months and EBITDA gains accrue in 9-12 months. This allows more flexibility in various investment styles and theses to incorporate automation as part of the main thesis elements or a side-car to the thesis (more on this below).
Working with firms with various approaches we have seen the following best practices:
- Establish digital workforce targets in due diligence then roll those targets to specific automation projects in the 100-day plan
- Use RPA as value accelerator for broader process optimization projects. While streamlining revenue lifecycle management in a healthcare portfolio company which will take years, you can partially fund the project with RPA-based savings by automating manual processes like claims entry, insurance coding, collections, etc. Some firms call it a side-car to an operating improvement element in the core thesis.
- Use RPA to generate PE-holding specific reporting requirements in the portfolio company like 13-week cash flow or debt reporting. There can be a digital worker (RPA bot) deployed to every new acquisition and start preparing board packages and reports. There is no need to change their ERP system or create massive manual processes in Excel
- Use bots to gather operational data not provided in underlying systems. This is especially true for a portfolio transitioning to Lean/Six Sigma. The cost of upgrading underlying ERP and MES systems could be cost-prohibitive. The bots can do data collection and analytics work.
- In a carveout or rollup, the new entity has to consolidate data from endless systems. Bots can accelerate data migration, data consolidation and even move data between systems. This can delay the need for a major IT consolidation project especially in later years of the holding period. The payback on IT consolidation tends to point outside the holding period.
- Containing SG&A growth in both growth equity and carveout is also an issue. Inefficient processes force back-office cost growth in line or above the top-line growth of the business eroding EBITDA gains. Deploying bots for new backoffice (finance, admin, HR, procurement) jobs can curtail the cost growth.
- Job requisitions – go digital first. Another lean digital workforce practice is to go digital workforce first for new job requirements. Do you need an analyst? It can be a bot. Do you need an accountant? Can probably be a bot. Research shows 40-60% job tasks can be automated. It is a lot easier to automate jobs that have not been filled yet, than to reassign existing staff.
Automation is a rapidly evolving field with PE portfolios demonstrating major impact on EBITDA gains and enterprise value. As the industry matures, benchmarking will evolve to set realistic targets and comparables to better inform PE teams and their investment theses.
Planning is a risk reduction tool, not a value creation one. To create value, you have to have real commercial interactions in the market. Market feedback better informs strategy than brainstorming sessions ever will, yet companies may pay millions for strategy consultants but not the same amount for limited product experiments.
A friend of mine has been a technology investor all his life. He has a particular passion seeing startups take ideas, turn them into minimum viable products (MVP), test them in real markets and pivot as needed for the next iteration of products and services. Getting ideas out of the back-office and into the market quickly, as he would put it. He has guided such agile startups in industries ranging from software through fintech to telco equipment in both the US and China.
Whenever his companies “disrupt” incumbent competitors he admits to always being amazed that bigger rivals with better access to capital, talent, and channels are often incapable of mounting timely defenses in the market.
His observation is that there is a fundamental difference in how startups vs big companies perceive market strategy and more importantly how they spend their time when innovating. Big companies spend 80% of their time planning and strategizing and 20% actually trying products in markets. Startups are the opposite, most of the effort is releases and pivots with real customers and products.
For example, Tencent in China is famous for such iterative approach by funding and incubating mobile startups, encouraging them to launch products early and often and keep pivoting the product, pricing, promotions until the adoption reaches a certain threshold, say 5 or 10 million active users. If it does not, the product is shelved after a certain number of pivots. Early customers are actually funding later experiments and become customers for the future launches of similar products. It becomes a virtuous cycle. He believes this mindset is followed in many larger Chinese companies which is the reason they are moving so much faster in AI, blockchain, automation, fintech and other areas than their European or US counterparts.
No such iterative value creation happens in planning, proofs of concepts, strategy retreats and similar endeavors devoid of real, commercial market feedback. Planning is useful to avoid risk and traps but should be limited to a small portion of innovation time and resources.
Build, ship, get feedback and adjust the approach until the customer’s need is met. That’s value creation and it has always been. There is no ROI on planning alone.
At least that’s what my friend convinced me of.
I had an interesting and unexpected debate on the sidelines of a private equity conference last week in London. It was fascinating because the topic was automation and the protagonist, a hedge fund manager.
For years there have been arguments in various corners of digital advocacy about the future of digital enterprises comprised of mostly automated (doing the work of humans) and even autonomous (working completely without humans) businesses. We have seen this in the blockchain world with decentralized autonomous organizations (DAOs) based on smart contracts but nothing yet mainstream. The DAOs referred to humans as “oracles”, necessary to perform specific tasks in the physical world, like load a pallet, underwrite an insurance policy or raise investment funds. Although some argue, those functions can be eventually automated too.
My friend argued that the core business of hedge funds (trading) is already 80% automated, and the rest can be completely automatic. What’s left for humans is the “strategy bit,” like the investment thesis. On the other hand, traditional businesses, like manufacturing, services, and even technology, are laggards with less than 30-40% of their core business automated.
The most exciting segment of automation is about augmenting human performance. An oil & gas investor at the same event told me that they wanted their high priced engineers freed up from filing documents. A hospital chain wants its physicians ultimately augmented with robots that can take care of patient reports, insurance coding, and even preliminary diagnosis. A strategy firm wants its consultants to be 100% customer facing and file engagement status updates and expense reports with bots.
The brave new world is imminent, and as some of the early adopters of augmented robots have seen, augmented businesses will always outperform traditional ones both in EBITDA and in customer and employee engagement.
In recent years many PE operating groups noticed that acquired companies already had better processes and leaner operations than a decade earlier, especially in larger enterprises. While sourcing programs and improved sales effectiveness still provide benefits, many targets already have good procurement disciplines and most run a form of CRM or various e-commerce tools. More importantly it was getting harder to get step-change improvements with gains beyond 10-20% in most operational areas.
It became clear that the next frontier of operational value creation lied in digital, but consultants and technology vendors rarely addressed the rigorous value creation needs of PE firms. The order of magnitude improvements in effectiveness and efficiency were often anecdotal and some bordered on hyperbole. Yet the results for many are real and bankable with short term dramatic increase in EV.
So where to look for the biggest opportunities for short term, mature, digital value creation technologies?
Efficiency Based Digital Value Creation:
- Robotic Process Automation – HIGH value, LOW disruption, 3-9 months
- I believe robotic process automation and related cognitive AI may become the biggest value creator for PE firms in the next 10 years until labor efficiency gains taper off. The technology can be easily aligned with the investment thesis to focus on one part of the operation or scale across the business. While the focus is on labor efficiencies, RPA reduces errors and compliance risk and can increase customer service. The biggest challenge is the plethora of vendors and as a result some technologies becoming obsolete
- Predictive Analytics for Operations, Predictive Maintenance – MODERATE value, LOW disruption, 6-9 months
- Anyone with manufacturing and complex supply chain will get a boost from such tools. Many operational decisions like monitoring and anomaly detection, root cause analysis can be automated to prevent stoppage and waste. Predictive customer analytics especially consumer focused businesses provide better management of churn, attrition, analysis of customer choices but also related credit risk or anticipated reverse logistics costs. In all these areas value creation is easy to measure and with many vendors can be built in the tools themselves.
- Cloud migration – MODERATE value, HIGH disruption, 12-18 months
- Just get it over with it if you can do it early in the holding period. Cloud technologies are over a decade old, well established and mature. There is absolutely no reason for anyone to hug their own servers. If cloud vendors are secure enough for governments they should work for portfolio companies. There are endless migration and integration tools and providers. Of all digital transformations, this is the most painful to complete and therefore most companies will procrastinate.
Growth and Risk Avoidance Based Digital Value Creation:
- Digital Commerce – MODERATE growth value but sales/marketing is plagued with growth attribution problem
- Growth is clearly a major driver in investment theses and commerce tools absolutely have tangible benefits. They SHOULD be considered for any value creation plan. Many times however they end up falling short due to the business model change required to maximize the value ranging from customer segmentation, through channel conflicts to new compensation plans. Many projects end up with a commerce channel to existing sales and marketing functions and rarely create the multichannel digital interaction this innovation inspires to be and the related value it could create.
- IoT – MODERATE Efficiency value, Risk Avoidance value HIGH at full manufacturing capacity
- While the eventual value of IoT may match the hype, the complexity of broad IoT initiatives are hampered with system interoperability issues and complex projects. There are great use cases in manufacturing in environments running at full capacity like semiconductors or other flow manufacturing. Some portfolio companies also get quick IoT wins in predictive maintenance described above but broader supply chain to manufacturing transformation typically point outside the investment horizon or risk tolerance of PE boards
- Blockchain – Risk Avoidance and Efficiency Results Hard to Measure
- Most firms struggle with enterprise blockchains due to the nature of having to form or join consortia to maximize value. I see few blockchain projects initiated in PE portfolios. I explore blockchain value strategies in my other blog, Blockchain Farm.