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Digital Transformation Opportunity Still Not That Well Understood By Private Equity

Migrating legacy technology applications to a cloud-based environment is hardly a new concept; proponents of doing so say that benefits include easier data backup and recovery, better security and flexibility with regards to a business increasing or decreasing its use of cloud-based services.

This most basic example of ‘Digital Transformation’ has been discussed in private equity circles for a few years now, but according to Thomas Ballard, Founder of London-based tech value creation consulting firm Market Hill, the industry at large has been slow on the uptake, still focusing heavily on a traditional private equity source of efficiencies when interacting with portfolio company technology executives.

“When I speak with buyout firms, I’d say that only 20% of the time are they engaging with the tech leaders of the companies they are looking to buy. And that conversation still mostly revolves around cost reduction,” he said.

Part of the reason for the lack of adoption of digital transformation strategies could be because it means different things to different people. For some, they hear the phrase ‘digital transformation’ and think that it simply means migrating technology applications to the cloud. For Bruce Sinclair, Founder and Principal Consultant at San Francisco-based Digital Operating Partner, there’s a bigger picture.

“True digital transformation – where you do something really additive to enterprise value - is transforming a non-digital company into a digital one,” he said. “It’s employing data science and machine learning to use your customer data to build new products and improve your existing processes.”

For those buyout firms who don’t know where to begin, Ballard says that there are quick wins to be had. That said, efforts to take advantage of low-hanging fruit should be approached with a longer-term strategy in mind – with a large dollop of patience on the side.

“You need the foundations sorted to make digital transformation effective – that includes simple things like making sure you understand all of your software licenses and their expiry dates so you can plan for points of failure. That’s a six-month job on its own and is more of a defensive approach. At the same time, you’re planning your offensive approach, which is where the real value gets added,” he said.

The time it takes to implement an effective digital transformation strategy is critical in terms of achieving results. Ballard adds that buyout shops who are serious about digital transformation need to brace themselves for a multi-year endeavour – for each portfolio company.

“I worked on a program once where the client came to me and said that they wanted to move all of their software to the cloud, and they wanted to do it in 6 months. I said that it can’t be done. And it completely crashed and burned, and everyone got fired. If you have a really good plan you can do one of the more basic digital transformations in 2 years. But for most, it’s 3-4 years. Controlled urgency is the key to a successful digital transformation effort,” he said.

So, for those private equity executives willing to be patient and put in a little elbow grease, what kind of impact can digital transformation have? Quite a significant one, according to Ballard.

“Let’s be clear – if you can’t put a dollar value on it then there’s no point doing it. You really should be looking at a 10x multiple here. If you can take $10mn Opex out of a portfolio company, that goes straight to EBITDA. That can have a 10x multiplier on the eventual sale price of the investment.”

The private equity firms best placed to benefit from implementing a digital transformation initiative are those which own portfolio companies that, perhaps unsurprisingly, are lower-tech. Sinclair says that tech-savvy portfolio companies can always improve, but the real opportunity lies in industries where technology investment has lagged.

“You can beat digital with better digital, but companies in an industry where the processes have largely been the same for ten or twenty years are the ones where there’s a real opportunity,” said Sinclair. “Take industrials, for example. These companies have a lot of field personnel. Taking advantage of the data that they can collect in the field and having technology that can make sense of that data can help these companies to truly change how they work to better serve their clients, save money, build new products and ultimately make more money.”

In addition, Sinclair believes that private equity firms are better placed than their competitors to undertake a digital transformation initiative with their portfolio companies than public companies or non-private equity owned private companies.

“Public companies have to deal with many shareholders; frankly, they’re more focused on doing what’s not wrong, than doing what’s right. It’s harder for them to make big changes in strategy. For other private companies, they probably aren’t as tech-savvy as private equity owned companies. They certainly don’t have access to the same expertise and resources as private equity-owned companies do. And buyout firms have the motivation to change because if they’re not making changes, they’re not increasing the value of their asset. But most importantly, they can align everyone’s incentives to be aligned with the change. That’s the big one,” he said.

A 2018 report by Everest Group says that 73% of enterprises failed to realise sustained returns on their digital investments and 87% failed to implement their change management plan for digital transformation. Ballard acknowledges the challenges but emphasises that the key to success is planning.

“The failure rate is significant. And for many that don’t fail, they overrun. Digital transformation is hard, and buyout firms need to think about it and plan it properly. The failure rate is not because the idea wasn’t the right one. It’s because the implementation was rushed or that it wasn’t spec-ed out properly.”

Sinclair adds another perspective.

“Digital transformation projects also fail because they don't create enough value and therefore don't get the funding to be developed past a proof of concept or trial. Spec-ing it out properly is very important but coming up with what you're going to spec out is even more important,” he said. “The implementation part is relatively simple if you have the right experience and development partners but you’re not going to do meaningful digital transformation in under 6 months. 6 months is probably the minimum, but it can be a multi-year endeavour. Also, digital transformation is never finished so the timeline will increase based on the magnitude of the investment made. Because of this, digital transformation provides a strong future growth narrative at exit for a buyout firm. For strategics, it gives them a great launching pad and for a sponsor sale in the secondary buyout market, digital transformation can continue to be a source of value creation for the next buyer. And over time, there isn’t going to be a ‘technology sector’ because any sector and company can be a digital one. Therein lies the opportunity for private equity.”

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