Can digital transformation have a significant impact on our portfolio companies' exit value? How can we identify the right opportunities in our portfolio? How can we best help our portfolio companies execute successful growth-oriented digital transformation programs? These are all critical questions most middle-market PE firms are currently trying to tackle. Here we share our expertise and ideas to help frame productive internal discussions.
A 2019 PwC report indicated that 75% of private equity firms surveyed planned to invest in portfolio companies' digitization over the next year to improve operational efficiency, accelerate revenue and earnings growth, and attain higher pricing multiples at the exit. Unfortunately, our analysis of the portfolio of about 30+ middle-market PE firms completed in Q4 2020 revealed that actual progress is often lagging.
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Digital transformation is a very hot topic nowadays, and often the term means different things to different people. For some, it merely means migrating IT applications and infrastructure to the cloud. For others, it means developing an e-commerce website and investing in digital advertising.
For Augeo Partners, digital transformation has a broader scope, and it encompasses the following three areas:
Driving "strategy & innovation" by:
At a portfolio company that presents both a market opportunity and a digital capability gap, implementing a pragmatic and fast-paced growth-oriented digital transformation program can drive an additional 10% to 25% increase in EBITDA and a multiple expansion of 5% to 15% over a 3 to 4 year period (relative to the management base case).
Typically, the key drivers of those results are:
Based on our work and analysis of 30+ portfolios of US-based middle-market PE firms, typically, 20% to 40% of portfolio companies present an opportunity for a growth-oriented digital transformation.
When a growth-oriented digital transformation is applicable, usually, 70% to 80% of the EBITDA increase will be driven by organic revenue growth. In other cases, companies will present only a more limited opportunity like, for example, accelerating new customer acquisition or migrating IT to the cloud.
The next questions are how to identify the right opportunities and how to best organize execution.
The portfolio companies suitable for a growth-oriented digital transformation are those that present both a market opportunity and a digital capability gap.
We engage with our clients only when together we can identify both a digital capability gap and a clear opportunity for value creation.
To be transparent, not all companies present a market opportunity that can be captured by enhancing their digital capabilities. Some companies, for example, operate in markets with only a few large potential customers where their manufacturing capabilities mostly drive organic growth (i.e., aerospace components manufacturing, specialty industrial chemicals, cosmetic products packaging, etc.). Others mainly depend on the development or acquisition of tangible assets (i.e., energy, infrastructure, and real estate) or need to improve their offering's competitiveness before focusing on accelerating organic growth.
Companies that present an upside market opportunity contingent on robust digital capabilities are, for example, those where a positive answer applies to two or more of the following questions:
Traditional market and competitive analysis are used to identify portfolio companies with a market opportunity to accelerate organic growth.
Portfolio companies that present a market opportunity contingent on robust digital capabilities have a competitive offering in at least some of the product or service categories in which they operate, face a fragmented market demand, or are dealing with an extensive product offering, or both.
Once a market opportunity is identified, the next phase regards assessing a portfolio company's digital capabilities with a two-steps process. The first step is to look at the technologies adopted by a portfolio company using one or more technology intelligence tools (i.e., Clearbit and BuiltWith). Companies that have not yet adopted certain technologies are typically lacking the corresponding capabilities and processes.
The second step is to follow up with a few management interviews to develop a granular understanding of existing digital capability gaps. In an appendix at the end of this article, we have included a sample list of detailed relevant questions organized in six key areas:
A negative answer to one or more of those questions reveals an opportunity to strengthen digital capabilities to improve business performance and create a competitive advantage.
Having identified a few portfolio companies that could accelerate organic growth and value creation by strengthening their digital capabilities, the final step is to decide how to best organize for execution.
In the remainder of this article, we are going to discuss the four approaches that we commonly see:
For many portfolio companies, the default approach to start the digital transformation journey is to initiate a search for a new executive with digital expertise (i.e., a VP of E-commerce and Digital Marketing).
Unfortunately, the market for senior executives with general management and digital expertise is very tight and competitive, and even Fortune 1000 companies are often unable to find a suitable candidate.
For middle-market companies at the beginning of their digital journey, this search is even more difficult. The dedicated team and budget for the position are still small, the definition of success fuzzy, and the level of uncertainty very high. In the best cases, these searches take a very long time, and the recruited candidate is a young professional with great potential but a level of expertise too narrow for the challenge ahead. In the worst cases, the position is never filled.
Another common approach, especially at larger PE firms, is to retain a major management or technology consulting firm. Nowadays, all major firms have a well developed digital transformation practice staffed with brilliant professionals. However, often, this approach is also not a good fit for middle-market companies.
Major management consulting firms are usually excellent at identifying the right portfolio opportunities and developing digital transformation strategies. Often, the only downside is the high level of their fees. In recent years, many have also started to build internal execution capabilities. To reconcile a business model designed to serve Global 2000 corporations with the economic reality of middle-market companies, however, the proposed execution projects end up being too short in duration to produce a lasting impact. After a few months, when the consultants are gone, internal processes quickly regress to the initial state, and performance improvement rapidly fades away.
Major technology consulting firms also have business models designed to serve Global 2000 corporations. They often are a viable solution to develop digital products and solve complex technology problems, but are not engineered to help middle-market companies drive an acceleration in organic growth.
A third approach is to engage with smaller specialized vendors directly. Nowadays, many excellent small specialized teams exist that can be a great partner for executives with digital expertise and know-how to orchestrate their work. However, most cover a very narrow specialty domain like digital paid advertising, search engine optimization, email marketing, B2B lead generation, CRM instrumentation, e-commerce development, data lake setup and maintenance, customer data platforms, BI and data analytics, and so on.
Many companies also specialize in specific technology tools: one firm might do email marketing using Pardot and another one using Marketo. One BI firm might specialize in Tableau implementations and another one in Power BI implementations. Before choosing a specialized consulting firm, therefore, a company needs to decide which technology tools to adopt. For a company lacking digital expertise this process can be overwhelming given the number of choices available in the market.
The chart below, for example, maps the landscape of marketing technology tools and lists 5,000 available products! (source: chiefmartec.com).
For the above reasons, this approach is also not recommended for middle-market companies without proper digital expertise.
Partnering with a fractional interim digital transformation officer is often the best choice for a middle-market portfolio company (Why every CEO needs a digital transformation officer). PE firms are also familiar with this engagement model and often refer to these executives as digital operating partners or advisors. Large PE firms might operate with affiliated executives, and smaller firms typically operate with independent executives.
To drive successful digital transformation programs at middle-market companies, these executives should share P&L and value creation responsibilities, be involved over a period of 18 to 36 months depending on the program scope, and have:
Augeo Partners is a group of senior leaders with a passion and a significant track record in driving organic growth and operational productivity through strategy, change management, and digital technologies, dedicated to partnering with middle-market PE firms and portfolio companies to accelerate organic growth and value creation. The time to start is now, and Augeo Partners can help.
Following is a sample list of detailed questions to help develop a granular understanding of existing digital capability gaps in six key areas. A negative answer to any question reveals an opportunity to improve business performance and create a competitive advantage.
For B2B companies:
For B2C companies: