This article is sponsored by SAP.
What kinds of digital innovation bets are private equity firms making across their portfolios right now?
Georgette Kiser: Digital transformation is extremely important to us at Carlyle. Around two years ago, we brought in Boston Consulting Group (BCG) to help us determine how to employ technology to drive value across our portfolio companies. What we found was that transformation starts with cultural change – getting people to understand what digital really means and what it can do for you. As our deal teams have become more educated on digital innovation, they are increasingly working with portfolio company CIOs to think strategically about their user experiences and how to leverage technology to make those experiences better.
A great example of this was with MacDonald’s in China. We implemented a digital strategy to transform how kiosks are used to place orders, which transformed and improved its food delivery models and added real value to the company. Another interesting example was with market research company Claritas, which we acquired in 2017. The strategy there was to help the firm move from using out-dated marketing techniques to digital marketing, which we achieved through acquisitions. Claritas acquired three companies in a three-year period to meet those objectives, which showed that digital transformation does not always have to happen organically. And as a result of those acquisitions, the Claritas $1 billion market research addressable market has transitioned to a $25 billion digital marketing addressable market.
Sean Epstein: There are a couple of areas of late where we are seeing PE firms placing cross-portfolio bets on digital technologies. One is cross-portfolio company spend management and supplier data analytics. We have worked with a few dozen firms in the last 12 months to help them to take all their portfolio companies’ data to create a spend cube and then leverage advanced analytics to compare unit costs, evaluate payment terms, and review supplier effectiveness in aggregate. Firms have been able to leverage the economies of scale across their network to get better terms, more competitive rates and to allow portfolio companies to better select preferred suppliers.
The other area where we are seeing a lot of funds get more active is around experience management technologies. Firms are using a very data science-driven approach to evaluating companies during due diligence to assess customer, brand, product and employee sentiment. In fact, many of the large strategic consulting firms have also embedded this capability into their due diligence services. They are then also comparing sentiments between portfolio companies to look for best practices and identify leading indicators of areas for improvement through that data.
Is that level of tech deployment only really an option for mega buyout houses?
SE: No, many strategies don’t cost a lot and don’t take long to execute on. From a supplier management perspective, for example, even if you are a mid-market private equity firm, this is still extremely relevant. There isn’t a private equity executive out there that wouldn’t want to strip 10 percent of indirect spend out of portfolio companies in a non-emotional way. This isn’t about laying people off. It’s not shutting down a business unit. It is just smarter procurement given the overall spend across a firm’s portfolio. On the experience management side there are some very simple ways to get started and approaches to comparing information across the portfolio and at all stages of the investment lifecycle that can immediately produce benefits and reduce risk cross-portfolio.
How do private equity firms prioritise their digital strategies?
SE: Everything starts with the investment thesis, rather than with digital transformation as a standalone strategy. The nature of the digital transformation will vary significantly, depending on what that thesis is. For example, if you are buying a business as an acquisition platform with the objective of acquiring a dozen other businesses across Europe, then your digital priorities will stem from that. The focus will be on putting in the digital infrastructure necessary to deal with cross-border supply chains, for example, as well as multi-language and multi-currency capabilities.
GK: You start with the investment thesis and from that develop a business strategy. Within the business strategy, there might be different ways in which you can leverage digital technology or theories on how to drive the business differently.
I tend to think that there are four ways, fundamentally, in which to address digital change. First, there are cultural, organisational changes that must be implemented. Second, there are operational changes, which often represent low-hanging fruit. Third, are business model changes. Fourth, the big one, is what I refer to as domain changes. Just think of Amazon, for example, which began as a retail company and then went into the cloud space. Amazon Web Services now represents over 50 percent of the company’s profits. Whichever way you address those four areas, it all starts with the investment thesis and business strategy.
To what extent are firms exploiting digital potential to the max with these full domain changes?
SE: I think about this in terms of digital transformation light versus digital transformation heavy. Digital transformation light will take place in just about every investment. It is the ‘keeping the lights on’ layer of digital – it is housekeeping. But then you see a private equity-backed company we have worked with that was recently purchased with the intent to fundamentally turn its business model upside down. The company leased heavy assets, air compressors. As the industry was evolving, the firm decided that they could significantly improve the value of this business if they began leasing the air instead of the compressors. I call that digital transformation heavy. Georgette may call it domain change. The strategy required that in addition to deploying advanced analytics and intelligent machines, they also had to redesign and re-evaluate almost every part of their business processes – how they sell, who they hire, what services they provide, how they go to market, how they price their products and services, etc.
What are the biggest challenges that firms face when executing digital transformation?
GK: The biggest challenge definitely involves people. Change starts at the top. The CEO and CFO need to buy into the transformation which can involve a significant investment upfront, but the value add at the end can be huge. Once you have executive management on board, the other big issue is talent. You need to have people with the knowhow to leverage these new technologies. If not, you face a big problem.
SE: I agree. No digital transformation happens without getting the people piece right. Going back to this mega firm that had such great success with the spend cube, that firm had to find innovative CFOs that didn’t see this process of aggregating all their indirect spend as being big brotherly, but rather as a tool for improving their business.
So, they found these trailblazing CFOs and piloted the project with around 10 percent of their portfolio companies. They then shared the results at their next CFO conference and, unsurprisingly, there was not a CFO in the room that did not raise their hand to get on board in year two. Instead of forcing change down their throats, they found a way to demonstrate success. Now 85 percent of their portfolio companies are inputting information into that spend cube and the firm runs a shared service company to help all their investee businesses with procurement.
This idea of leveraging the network seems to have advanced significantly in recent years. Has this happened in parallel with the growing prominence of the operating partner function?
SE: A decade ago, only around a dozen private equity firms had strong operational teams. Those teams would complain about not having a seat at the table. They have that seat now. I was speaking to a firm recently where the operating team has two votes on the investment committee. That simply did not happen 10 years ago.
GK: The other big change is definitely the shared service layer that has been put in place. There will be a digital expert, an IT leader, an HR person, all with teams below them that we, as operating executives, can work with. All the major private equity players have a shared layer now, which is really important for leveraging the portfolio network.
What about the risks associated with technology? How do you identify and mitigate those?
GK: I love technology and I think what is happening in the digital world is exciting, but there are a lot of risks to consider, particularly around human capital. As we are transforming the way businesses operate and make everything more efficient, we need to think about how we ensure people who have jobs today, have jobs tomorrow. How they continue to have the skills they need for a changing technology environment.
Data privacy is another concern. As we collect more and more data, and increasingly use artificial intelligence and machine learning to manage that data, we need to think about data privacy and intellectual property risk. As the world changes, these ethical concerns will arise, and we need to be ready to deal with them.
What will the next wave of digital transformation look like?
GK: Obviously we have 5G on the way and all of the implications for the Internet of Things (IoT). That connectivity, when it does occur, is going to be incredible for enabling digital strategies going forward. If you consider 5G in conjunction with Wi-Fi 6, the speed at which we will be able to process data will be transformational.
As understanding of these existing technologies grows, we will be able to do more and more with them. With machine learning, we will be able to process larger data sets and drive change from that information. Blockchain is also becoming more ‘real’ with use cases in food safety, for example, and asset management. Is there new technology on the way? Undoubtedly. Can I predict what it will be right now? No. But I do know that all these existing technologies will mature and will increasingly prove enablers for value creation.
These days, every company is potentially a technology company. But are some industries more ripe for digital transformation than others?
GK: Information technology companies are ripe. Finance companies are ripe. Professional services companies are ripe. Then you have other industries such as manufacturing and distribution, healthcare and construction, which are really catching up. In those industries, technology can be more about physical robots streamlining processes than software.
SE: I would add that there is still huge room for improvement in the retail space. The more that the experience economy grows and the more that people feel entitled to disparage a business with a Tweet, YouTube video or Instagram post, the more important it becomes to engage. It happened here recently in Washington, D.C. A family-run restaurant went out of business a couple months after an angry customer shared a video of a dirty plate on various social media platforms. When I was growing up if I had a bad meal we would tell our closest friends, now you can go viral and a business can be ruined in an instant.
There is real potential, therefore, to embed technology in order to do a better job from an experience perspective – not just providing a better experience but listening and learning from your employees and customers. People are willing to tell you anything about your business, products, prices or brands if you make it simple enough. In retail clearly, but beyond, we are particularly excited about this whole category of experience management and what it affords companies from a value creation perspective.