DIGITIZATION: A PATH TO CREATING VALUE
October 29, 2019
Have you ever walked into the office and pulled out your phone to check your schedule for the day— only to see a notification that it’s your mother’s birthday? And you forgot to get her a gift. Luckily, you recently sent her flowers for Mother’s Day through the local florist’s new website. The payment information and her address are stored in the florist’s database, and after one click, the birthday flowers are out for same day delivery. Thanks to the florist’s digitization efforts, you can be sure your name is not mud.
Digitization has far-reaching implications beyond just saving the forgetful child with last minute gifts. In particular, private equity (PE) firms invest in industries and companies facing the challenges of digital transformation. But what exactly is digitization, what benefits does it offer, and how do companies “digitize?”
Broadly, digitization is the improvement of a company’s business models, procedures, and operations through the adoption of digital technologies. These improvements allow companies to exploit increasing returns to scale and grow more sustainably and more quickly than traditional companies.[1] Harvard Business School’s Karim Lakhani and his colleagues at Keystone Strategy constructed the chart below that illustrates this relationship.
Because technological change happens fast, business leaders will undoubtedly face hurdles when implementing their digitization efforts. Enacting the organizational change needed to digitize is a costly process, and it takes time to observe the tangible benefits that this change can bring. More importantly, leaders need to understand technology’s impact on the human elements of the business. It is difficult to convince the data entry employees that the new data systems will not spell the end of their job. Companies can mitigate these concerns by implementing training programs to position the current employees so they benefit from the technology, and are not replaced by it.
While digitization efforts sound daunting, research has found they are worthwhile. In the 2014 book Leading Digital: Turning Technology into Business Transformation, Westerman et al. categorized 400 public companies as Digital Beginners, Conservatives, Fashionistas, or Masters. They found that Masters (i.e. those that had most successfully digitized their business) were 26% more profitable compared to the least digitized Beginners. The Masters also generated 9% more revenue from their physical assets.[2]
These results were later corroborated by Bock et al. in the 2017 study, “What the Companies on the Right Side of the Digital Business Divide Have in Common.”[3] The authors created a “digitization index” that separated businesses into quartiles based on how well they had digitized: Digital Leaders represent the companies in the top quartile and Laggards represent the companies in the bottom quartile. Digital Leaders outperform Digital Laggards across three important measures: gross margin, operating margin, and profit margin.
As the PE market matures and becomes more competitive, firms must find new ways to create value in their portfolio companies and to increase their own efficiency internally. Digitization is one way to do so. An important step in creating portfolio company value is investing in the companies’ information technologies (IT) and data infrastructures to capture, store, and share data more efficiently. To take advantage of the acquired data, companies also must develop the capabilities to analyze this material. Building networks to share the data and analysis between the firm and portfolio companies then allows for quicker and more accurate decision-making. These advantages are necessary for a company to grow sustainably and create value. As Blackstone’s CEO Stephen Schwarzman said, “You don’t create value by just buying the S&P 500 on leverage. You actually have to transform the company.”[4]
When working to digitize a portfolio company, the PE firm needs to analyze the situation from two perspectives.[5] First, PE firms should understand what is happening now by identifying how digital transformation is currently shaping the company’s industry and what steps are needed to adjust to this change. Second, PE firms must anticipate the long-term implications of digitization for the industry and develop a plan to address them. These two perspectives should be combined to form a holistic digital initiative for the portfolio company.
PE firms must also consider how to digitize their own operations. Firms can invest in data infrastructures, data analytics like machine learning and AI, and automation capabilities to improve their internal operations and investment processes. Investing in internal big data and advanced analytic capabilities can improve due diligence and narrow the deal pipeline more quickly to a smaller set of more desirable deals. Firms can also automate labor intensive tasks like data entry and report filing to free up human capital to focus on more value-added functions. Lastly, data analytics can better estimate the value of portfolio companies, which helps firms more accurately price exits when opportunities to monetize a position arise. Finally, by reviewing data trends, a firm can identify patterns of portfolio company growth over time, optimizing the timing around its exit decisions. Implementing these digital capabilities help the firm develop and maintain a competitive advantage. But how well are firms adjusting to a more digital age?
A 2019 PwC survey of 250 PE executives showed that the industry is paying attention to digitization.[6] Almost 80% of the respondents believe that digitization will be important for exiting current portfolio companies and that it will impact returns. Nearly all (97%) participants indicated they had invested in digitally transforming their firms or portfolio companies over the past year, and 75% said they would invest over the coming year. Of those planning to invest through 2019, almost all of them (93%) indicated that they would be targeting data analytics. The survey also showed that identification of potential investment targets, company valuation, due diligence, and predicting future portfolio company performance were the main areas where the firms planned to apply the increased data analytics capabilities.
Digitization is important, it is hard, and it happens fast. If a firm chooses the wrong digital plan to follow, or is slow to implement the plan, it could easily find itself perpetually trailing behind the competition. Investing in and developing the proper data infrastructure, data analytics capabilities, and digital platforms are ways for PE firms to gain a competitive advantage in an increasingly competitive environment.
[1] Robert Bock, Marco Iansiti, and Karim Lakhani; “What the Companies on the Right Side of the Digital Business Divide Have in Common”, Harvard Business Review, January 31, 2017: https://hbr.org/2017/01/what-the-companies-on-the-right-side-of-the-digital-business-divide-have-in-common.
[2] George Westerman, Didier Bonnet, Andrew McAfee; Leading Digital: Turning Technology into Business Transformation; Boston, MA: Harvard Business Review Press, 2014.
[3] Robert Bock, Marco Iansiti, and Karim Lakhani; “What the Companies on the Right Side of the Digital Business Divide Have in Common”, Harvard Business Review, January 31, 2017: https://hbr.org/2017/01/what-the-companies-on-the-right-side-of-the-digital-business-divide-have-in-common.
[4] William Stoffel and Herb Engbert, “How Can Private Equity Transform into Positive Equity”, EY Research, 2017: https://www.ey.com/Publication/vwLUAssets/ey-how-can-private-equity-transform-into-positive-equity/$File/ey-how-can-private-equity-transform-into-positive-equity.pdf.
[5] Elizabeth Spaulding, Read Simmons and Nikki Ruklic, “The Digital Challenge through a Private Equity Lens,” Bain, April 11, 2018: https://www.bain.com/insights/the-digital-challenge-through-a-private-equity-lens-forbes/.
[6] Steve Roberts and Elena Naydenova, “Private Equity Trend Report 2019: Powering through uncertainty”, PWC, February 2019: https://www.pwc.de/de/finanzinvestoren/pwc-private-equity-trend-report-2019.pdf.