Leveraged buyouts typically carry some financial credit risk along with unavoidable management and execution risks. But unlike venture capital, private equity has historically carried minimal risks related to already-proven products and established markets for the target asset categories they focus on.
Fast-moving technology creates additional net new risks for private equity models when working with traditional and established targets. The increased legacy software in those groups in the wake of a faster speed of technology poses both product and market risks.
By the same token, technology also provides an opportunity for smaller assets that have historically not been in the field of vision for private equity, but the playing field is not level. The shift requires some adaptations from private equity.
Let’s explore in depth those newly-imposed risks, the opportunities created by the speed of technology and industry examples of the strategies used.
Traditional asset categories for private equity
From private equity’s roots reaching back to the JP Morgan Carnegie Steel deal in 1901 and the booming 1980s with KKR, Bain, Blackstone and Carlyle, to the industry maturing in the 2000s, there were no profoundly significant changes.
Looking back at the past 20 years though, the biggest shift has been how quickly technology has become the “primary driver,” replacing traditional business structures and disrupting businesses at a much faster pace.
For more established companies, the speed of technology has incrementally placed both the product and market risks on the table front and center. Larger businesses, especially those less adaptive, grow more fragile and face an increased risk of disruption. By definition, established targets take years to reach a mature state, but often they lack a modern technology base and end up with legacy software and an inadequate IT infrastructure. Without deliberate investments, their technology can become legacy faster and they risk their business models becoming obsolete.
In addition, there is an added risk to the EBIDTA and management overhead due to the increased spending on risky transformations. The growth and expansion glass ceiling may at times be dwarfed by the amount of risk mitigation needed through transformations.
New asset category opportunity for private equity
Ironically, due to the technology speed, earlier-stage companies have also benefited from an overall smaller risk profile. Technology did that by providing better deployment platforms, a massive ecosystem of standard tools, faster speeds and broader global expansion possibilities in a shorter time than ever before. That can be visibly observed with VCs’ returns outperforming most other asset classes within shorter hold periods (PitchBook 2020).
The change has already been observed in the past two to three years, with private equity investing more in earlier-stage companies. In 2020, it was estimated by PitchBook that those investments accounted for 18 percent compared to an average of 9.5 percent for the past two decades. The distinctions between investor classes are beginning to blur and overlap more. This trend is set to accelerate after the covid-19 pandemic.
Seven strategies employed by investors and acquiring firms
Several changes are needed to help private equity manage those shifts. The traditional management approach that worked for the larger assets is not the same for small ones.
The seven strategies below are some observations in practice by executive teams acquiring assets in the age of technology, which can help adapt and reach a competitive advantage in a world run by technology.
Don’t skip the technical due diligence: Technology due diligence should be used as an essential tool with a strategic front-seat role. The focus should be on assessing the suitability of the technology and its ability to evolve against the investment thesis.
Deliberate early value creation planning: Leverage the technical due diligence “data” to drive the roadmap, get the necessary inputs for value creation and plan exit options from the start due to shorter hold times. Set the KPIs and leverage the data to measure value creation progress against the initial diligence baseline, and benchmark against similar assets and across the portfolio.
Explore the full value-add spectrum: The ability to extend to new markets and grow market share is often the primary focus. However, several other complementary strategies can help move the needle during the value creation phase. These include efficiency optimizations to improve time-to-revenue and optimize costs.
Invest to reduce the security gap: Often neglected until it’s too late. Actively investing to reduce the compliance and security gaps avoids unnecessary risks and impact on valuation. PE firms typically drive cross-portfolio initiatives and provide resources to ensure a healthy compliance and security state.
Consider exit multiples early on: A deeper dive during value creation should include mitigations and improvements at the technology level. These can include product quality improvements, reducing technical debt, adding technology flexibility to enable pivoting, improving customer support excellence and facilitating the ability to attract and retain talent.
Realize better exit multiples with early exit readiness: With shrinking hold periods (averages went from five to seven years to 4.3 in 2019 versus six in 2014, according to Bain), exit planning is also explored earlier. Some PE firms not only consider the exit plan from the start but use the exit strategy to drive the value creation direction. Exit readiness and sell-side preparation are key to higher exit valuations and faster liquidity. Allow the portfolio company to practice, prepare and address any shortcomings at least 12-18 months before a potential buy-side diligence.
Upgrade the technology know-how: Investors have also had to adapt and acquire a deeper understanding of technology and the IT landscape to help them make sound investments. This is accomplished by hiring multidisciplinary staff, or housing dedicated technology experts. Most are forging “deeper” partnerships with third-party providers to stay strategically aligned on investment goals.
Regardless of whether a fund focuses exclusively on software technology or tech-enabled targets, modern technology is driving practically every company. The strategies discussed are needed to minimize future risks, optimize and increase the focus on where to add value.
These strategies will help mitigate the growing product and market risks as well as level the playing field with smaller assets. They will also make the difference between the 2x and the 4x exit multiples spread with faster exits.
For some, technology may become a threat if they cannot adapt fast enough, while for others, it will provide a competitive edge.
Hazem Abolrous is a managing partner at RingStone