The new route to value in Private Equity portfolio companies? Digital transformation

A pragmatic approach to digital

My role involves daily interactions with Private Equity investors. And recently, I’ve seen them taking a more pragmatic approach to digital than they have in the past.

What does this approach involve? It has two main aspects. First, PE firms are increasingly looking to validate the investment thesis through a digital lens. Second, they’re investing in digital earlier in the deal lifecycle through a series of initiatives, drawing on the same data-driven value creation playbooks used by the world’s most valuable digital companies.

As proof of digital execution becomes key to buying decisions

What does this rising focus on digital signify? In my view, we’re rapidly moving towards a world where PE buyers demand proof of digital execution – together with a clear data-driven roadmap showing how digitalisation will fuel ongoing value creation post-deal. That’s why PE firms are investing in digital initiatives earlier in the investment lifecycle, meaning they can reap the rewards of a productive digital flywheel by the time the holding period matures.

This same motivation applies even when a portfolio company is a ‘digital novice’. As the exit approaches, PE owners will often create a robust digital plan that any subsequent buyer can then implement. And to help realise the full digital potential of their portfolio companies, the more innovative PE houses have created the role of a digital operating partner, charged with identifying, planning, and driving the execution of high-impact digital initiatives alongside the investment team and portfolio company management.

Scoping out the opportunity

It isn’t hard to see why PE investors are zeroing in on digital. Recent studies show that the majority of traditional companies that have successfully embarked on their digital transformation journey have a higher total shareholder return. Similarly, a data-driven PE portfolio company enterprise can command a premium multiple through an increased revenue and value generation upside, thanks to its higher ability to monetise data, develop data-driven products and services, improve operational efficiency and asset utilisation, and integrate digital add-ons and platforms.

There are many real-world examples of these advantages in action. Take the PE-backed gear manufacturing business based in Germany that’s now providing predictive maintenance services by combining IoT and AI with the latest-generation sensors embedded into industrial gearboxes. Or the PE-owned speciality chemicals business that’s using digital configure-price-quote (CPQ) software as the single source of pricing and product data, boosting customers’ loyalty and stickiness by ensuring they’re well informed on a product’s characteristics before buying it.

And overcoming the challenges

However, as with any transformation strategy, successful digitalisation of portfolio companies involves overcoming some significant challenges. An initial hurdle is ensuring a common understanding of what digital actually is: there’s a need for education and a strong alignment between the investment team, portfolio management, and portfolio company leadership to create a clear vision for how digital solutions will support the overall equity story.

A further major challenge is managing stakeholder expectations around the value of the impact and the timeline for the transformation.

In parallel, throughout the deal lifecycle, a series of important questions need to be addressed. Such as:

• How can we validate the investment thesis through a digital lens?
• How can our portfolio company achieve the next level of maturity?
• Which digital add-ons and platform investments should we target?
• Can we generate a premium exit multiple through full or partial digital transformation?

A call to action

Time to connect with tech innovation

As technology continues to advance and the importance of digital transformation to value creation keeps rising, what lies ahead for PE firms? In my view, the key to success going forward will be to constantly connect with innovation and understand what early-stage technologies and businesses are disrupting the market.

With this in mind, I believe we’ll see PE investors take steps to boost their digital potential by entering partnerships or venture client relationships with tech companies, building digital ecosystems of suitable partners and suppliers, and co-executing digital initiatives such as process automation. These partnerships can play a vital role by enabling PE firms to share technologies broadly across their increasingly connected portfolios.

Boost product development, skills – and valuations

Beyond ecosystem building, I expect to see PE strategies increasingly using digital company add-ons to further strengthen the skills base available to their portfolio companies and accelerate their product innovation. Digitally mature portfolio companies are also better placed to acquire digital assets as the basis for deploying disruptive capabilities and platforms, further increasing their premium valuations.