The Digital Challenge through a Private Equity Lens

This article originally appeared on Forbes.com.

For private equity investors (any investors, really), the digital revolution presents a bewildering mix of risks and opportunities. At a time when technology is disrupting markets and transforming businesses with alarming speed, the risk of getting blindsided is an ever-present concern. Yet it cuts both ways. The explosion of data, analytics and connectivity has dramatically enhanced PE funds’ ability to assess companies in due diligence and to improve their performance during the holding period. As markets rapidly transform, funds can find as many opportunities as risks if they have developed the ability to handicap change better than the competition.

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INDUSTRY EXPERTISE

Private Equity

HOW WE CAN HELP

Digital

The PE investment lens—“How can I increase cash flow over the next three to five years, and how can I boost the company’s franchise value at exit?”—remains the best one for assessing a company’s potential. The challenge has become learning how to blend investment savvy and analytics into a methodical, fact-based approach that sheds light on how digital innovation is reapportioning profits in a specific industry, and how ready a target company is for the change. This demands a fresh set of questions when evaluating assets: Is digital expanding or reducing the profit pool for a target company’s industry? How does the impact vary by industry segment? Is the target in fast- or slow-moving water? What is it doing, or what could it do, to seize the opportunities and mitigate the risks? What is the net effect on deal return?

Today forward, future back


As discussed in Bain & Company’s recently released Global Private Equity Report 2018, we find the most practical approach to sorting through the risks and opportunities is to look at each target company’s unique set of circumstances from two perspectives: today forward and future back.

  • Today forward assesses how digital is already affecting the profit pool of that company’s particular subsector and what the company needs to do to respond. That involves diagnosing the company’s strengths or weaknesses and then isolating a potent set of initiatives to produce a step change in performance over the next three to five years.
  • Future back comes from the opposite direction. It entails envisioning how technology will transform the profit pool over the longer term and then extrapolating backward to prioritize the steps a company can take now to best position itself for that future. When it comes time to exit, in other words, will this company have a longer-term story to tell about how it will thrive as the industry evolves?

Because PE investors are generally focused on creating value over the next three to five years, their primary emphasis during both due diligence and ownership is today forward—that is, what can they do now to generate earnings before interest, taxes, depreciation and amortization (EBITDA) and improve top-line growth? The combination of a short time horizon and high levels of leverage means the approach has to be grounded in what’s possible during ownership. While there might be a plausible “march through the valley of death” to transform a company for the future, a PE fund typically isn’t in a position to take that on.

That said, investors can profit from the future-back perspective for two very practical reasons. First, a thorough, fact-based analysis of what’s knowable about the future is the best defense against getting blindsided later. Considering the extraordinary pace of change in many industries, investors need assurance that an asset is secure for at least the next two PE cycles. Second, a firm grasp of what’s coming provides the foundation for the most effective value-creation plan. It gives direction to the short-term initiatives and helps the fund build the most compelling exit story.

The most effective value-creation plans marry today-forward and future-back thinking. They identify a clear point on the horizon and aim the company in that direction by laying out a set of practical initiatives (usually digitally enabled) that can create meaningful progress in the short term. These are stepping-stones—concrete measures that generate EBITDA now while bringing the company closer to its objective over the next couple of years.

In 2010, when CVC Capital Partners bought a majority stake in Swiss telecom carrier Sunrise Communications, it knew it had to improve the Sunrise customer experience in a hotly competitive market. But since the specific tactics weren’t clear, a key stepping-stone became setting up a “customer experience factory” to speed up decision making. The inputs at one end of this metaphorical factory were broken customer experiences. The factory floor was where cross-functional teams used agile development techniques to immerse themselves in fixing the worst customer pain points. Adopting a sprint style, they created prototypes of improved solutions and put them through an iterative process of test, learn and adapt. The outputs were new sets of processes and solutions designed to transform how customers view the company.

A good example is how Sunrise completely transformed its approach to handling delinquent bills. The company’s original dunning process made everybody miserable. Delinquent customers, no matter how loyal over time, would be cut off unceremoniously after receiving a short text message. This made for angry people flooding the customer service lines and resulted in high levels of lost revenue. It was the kind of customer experience that gives telephone companies a bad name.

But after putting the broken process through the customer experience factory, the company developed an entirely new, digitally enabled solution. By tapping a deep well of customer data, Sunrise could see which customers were most likely to overspend and send them an advance warning—a friendly nudge via text message detailing the amount due and notifying them that they were at risk of a service blockage. The company then developed a way for customers to unblock service automatically through a variety of payment options. By addressing specific pain points with well-tested solutions, the company changed the economics of dunning. It improved the customer experience and reduced the number of blocked customers by 35%, while cutting bad debt by half.

Amid all the hype around digital transformation, it’s important to remember that the PE value proposition is already well suited to finding value amid turbulence. To achieve top performance in the future, PE firms will need to effectively measure digital’s impact on industries and companies by evolving the same methodical, fact-based approach they bring to all investments. Understanding how digital is transforming markets is increasingly a critical capability. But success in the digital age will still rely on using the tools at hand—digital or otherwise—to execute a plan to create new and lasting value.

Elizabeth Spaulding is a Bain & Company partner based in San Francisco and a coleader of the firm’s Global Digital practice. Read Simmons and Nikki Ruklic are partners in Bain’s Private Equity practice and are based in New York and London, respectively.