Private equity in the age of digitalisation

Kenny Wastell: To what extent are the majority of investment opportunities today underpinned by technology-driven strategies?

Irina Hemmers: Not every company Inflexion invests in is a tech company, but of the 35-plus companies in the portfolio, there is not one that is not touched by technology and does not need to be digitally aware. That applies across the value chain from customer insights all the way to supply chain monitoring and management optimisation. There needs to be a real digital awareness across the portfolio, no matter which sector or business model you are looking at. Every generalist or specialist investor needs that.

Robert Fenner: There is barely a business today that is not a tech-driven business at a certain level – even traditional businesses have had to turn to technology. You also see a desire by some businesses to actively categorise themselves as specific subsets in technology. Currently, there are businesses claiming to be artificial intelligence (AI) businesses, as these are perceived to attract higher valuations than traditional software companies. There are many opportunities in the technology environment now, and it is growing.

David Coster: We are seeing a number of organisations that, as they step into new private equity ownership, are required to look at re-engineering into a more digital or AI focus, with exit value being the primary driver. Even the most traditional types of business could not survive for more than a day if their IT systems were turned off and so tech is a key part of the supply chain, the value chain and the whole organisation.

Philip Shapiro: The business models of huge traditional sectors are being challenged. In business services, for example, you need to understand what is going on in technology to invest in the space because a lot of what they do can be replicated by algorithms and robotic process automation (RPA). At Synova, we cover a variety of business types, all of which need digital transformation. They need a software platform that is best in class to give them an edge in the marketplace. While they may not fundamentally be challenged by technology, they have to embrace it to succeed.

KW: In which industries is the rate of digitalisation and disruption presenting the greatest opportunities for value creation?

PS: Fintech and the financial services arena are an area that is primed for disruption. There are different rates of adoption of technology by capital market participants. Banks are facing competition from upstart challengers and are having to radically change their business model; their profits are under pressure and their IT architecture is creaking. So companies providing agile cloud-hosted software to enable them to offer better services to their customers – with more seamless processing of settlements, transactions and regulatory tax reporting – are hugely attractive. Adjacent to that is payments, which is also going through transformational change and there are some fascinating businesses in that space.

DC: Interestingly, the players that have been disruptors historically are now being disrupted themselves, as the next generation comes through. The ability to scale fast, and service clients, is essential, because many good disruptive plays have built-in obsolescence early in the life cycle of their businesses. Many have not been built to grow over the long term and so leave themselves open to be disrupted.

RF: We are seeing a lot of investment from different parts of the world in fintech. Quite a number of challenger banks are making changes to the way people bank and, as a result, a number of the big incumbents are beginning to respond to those new methods. The automotive space is another huge area for change. Automated and electric cars are going to lead to a societal change. The energy market is also related to that. The Elon Musk approach of putting solar panels into roofing tiles on buildings and finding new ways of storing energy is going to be a big change.

IH: You could plot the rate of disruption - and subsequent adoption - on a curve, and I would put communications, entertainment and capital markets ahead of the curve, with automotive, transport, healthcare and education in the middle, and then areas such as the public sector. As private equity investors, we try to avoid the cutting edge, which is unproven and volatile. You want some visibility of track record and there are hopefully indications of where the related technology is going. We look for spaces that have either been disrupted, where we know the effect on incumbent business models, or where you have enough time for the disruptive wave to arrive and to prepare yourself.

KW: Could you share any insights about transactions you have been involved in that have stood out in terms of capturing this continuing shift towards a digital economy?

DC: I was involved in a transaction involving a very traditional outsourcing business with a huge footprint in India. Five years later, automation and digitalisation meant the headcount in India was significantly less than it had been and there were huge changes on the front end. Products went from expensive on-premises solutions to agile cloud-based services, which are quicker and cheaper to adopt. They really changed the market opportunity and also put pressure on groups such as national patent offices to build digital gateways, to enable digital renewals and even shaped policy in some of the more progressive countries.

IH: Prior to joining Inflexion, a lot of my investing experience was in online marketplaces. Auto Trader, for example, had been a collection of 30 regional magazines that were primarily sold on the news stand. That model was completely turned upside down and to huge benefit. It could have gone wrong had it been disrupted by a new player, but it was an incumbent that managed a transformation very well. There is also British Engineering Services, an Inflexion business, which is a testing and inspection company with engineers on the road. We have seen huge benefits in optimising their workload and efficiency by introducing scheduling software and tech enablement to optimise routes and the way they service clients.

RF: Private equity has gone into what was regarded as the more traditional side of technology investing – specifically enterprise software – with great success. I worked on the Access deal this year, where TA Associates sold an interest to Hg. Looking at the reported valuations at entry and exit, the increase in value over just a few years is very significant. We are not talking about creating a new and entirely disruptive proposition. This is an investment in a stable existing business that has grown partly organically and partly through acquisition, and created great returns.

PS: We typically look at where software can be introduced to present significant opportunities to scale. We invested in MinTec Global last year, which has 25 years of farming data related to 11,000 commodities. It delivered that via archaic software, but it is mission-critical for supermarkets and food manufactures when negotiating pricing with underlying suppliers. Harnessing that valuable data is where we saw the value. We adapted it into a proper software-as-a-service platform and identified other great uses of this data to really increase the ROI. Applying much more up-to-date technology and leveraging large pools of computer power enabled us to introduce forward forecast pricing based on factors such as weather patterns, labour rates and various other factors.

KW: What expectations are there from LPs for GPs to dedicate increasing levels of their funds towards tech companies or companies with tech-focused growth strategies?

PS: There is a strong desire from our LPs to see us adding value in our portfolio companies. Simply buying and holding in the current market does not deliver the returns they are looking for. Often that value-add is around digital transformation and they expect us to focus a lot on that. But I do not get LPs saying: ‘We want you to just do technology investing.’ While they see it as an important sector, LPs are sensitive to concentration risk and there is also the factor of valuations. If they want that very high technology exposure, they typically look to venture capital firms or the US technology-orientated growth equity firms.

KW: To what extent does the rate of digitalisation and the adoption of tech-enabled business models lead to increased due diligence requirements?

RF: Whenever an investor is investing in a tech-enabled business, due diligence needs to be carried out around the ownership of IP in software, which means investigating how it was developed, any terms under which it is licensed and whether it incorporates any open-source software. GDPR compliance is also a very active area. Many businesses are not as compliant as they should be because it is a difficult piece of legislation to comply with and compliance can be costly. Those are the sorts of areas we come across often that can lead to indemnity or retention arrangements in transactions.

DC: There are a couple of key requests I see increasingly from private equity firms. One is around understanding what tech businesses are doing with R&D spend. For every £1 of R&D, how much revenue is that going to generate? There are also a number of key hygiene elements people want to see around cybersecurity and GDPR, but there is a need to move quickly to get deals done. So you have to work out whether that risk is going to be material to a transaction or whether it is something you have to factor in as a cost afterwards, based on experience and risk appetite, rather than detailed diligence. Having said that, there are businesses where cyber-diligence is absolutely mandatory.

PS: Companies that have a B2C offering often face significant risk of new players emerging due to large addressable markets. With B2B you are less worried about something coming across the horizon overnight and causing you real difficulty. Instead, you have to think about how scalable the business is. Many businesses that are 10-15 years old have created bespoke products for multiple customers in a way that makes them vulnerable to businesses coming along with more scalable business models. At [portfolio company] Meritsoft, we have won a lot of business off more established fintech providers that have built big enterprise software architecture for banks. But every time the banks want to change something they just cannot handle that because they have too much legacy technology debt.

IH: We have talked about the challenges of enhanced due diligence for tech investing, but there is a huge advantage as well, in that you get a lot of data that was not there to the same extent 10 or 15 years ago. I agree with the points around scalability, not just from a technology angle, but also from a talent point of view. Digital talent is scarce and there is not an established career track, so selecting the best people and securing them early enough as you scale up is a challenge. We are constantly thinking about how we can grow talent within the portfolio to be able to scale up rapidly.

KW: While tech presents exciting opportunities to add alpha, that also means an increasing number of tech businesses have grown rapidly into conglomerates. What challenges does this present in terms of competition for assets and pricing?

RF: There is significant competition for good-quality tech assets from both private equity and trade buyers. Management teams are often drawn to private equity, because they see the possibility of sweet equity incentives and benefiting from that in the medium to long term. Trade buyers can bring different advantages, in terms of access to their larger customer base. On the subject of who pays more for a deal, it depends on who the trade buyer is. Some trade buyers might pay more because they are able to get more out of a business due to their position in the marketplace. But you need a very particular trade buyer for that. Private equity is very competitive for mature cash-generative tech businesses.

IH: Current valuations are probably at an all-time high. However, the strength of the more B2B-focused end of technology is that businesses are very entrenched with their customers, they have very good visibility on revenues and are very cash generative. So, you need to change your valuation metric somewhat. People are also increasingly thinking longer term about these investments because growth compounds. So it is competitive and valuations are high, but the fundamentals are still very strong and backable. And on the management team front, they are probably less willing to educate generic investors than they previously were. As an investor, having credibility, expertise, a sustained track record and ultimately eye-to-eye conversations with management teams is increasingly important.

PS: It is not just about valuations. We typically see bootstrapped businesses that have not taken on venture capital and have progressed based on endeavour, typically of the CEO and maybe one or two founding partners. Rather than crystallise value today, which is what happens in a trade sale, they are looking to bring on board a partner with the skills, expertise and track record to help scale the business. Quite often that means minority investments where they can take a little money off the table and obtain some fresh capital and fresh ideas. The plan is to drive a much bigger exit in a few years’ time and typically they do help around structuring their sales force, product roadmap development, internal financial reporting and strategic planning.

DC: There’s much more competition from private equity firms particularly having to step outside of standard deal processes. Private equity houses, particularly the larger-cap players, are looking for proprietary deals and are going to huge lengths to win them. We have seen private equity houses, for example, pitch to take first-generation businesses into private equity ownership and commission targeted marketing material to prove: ‘We get you. We are not going to ruin your brand, or your family heritage.’ You see a lot more innovative plays to get the quality assets, because there’s so much competition for every asset.

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