By Shanu SHERWANI, Private Equity Analyst, published AGEFI Luxembourg, Novembre 2021, p36.
As I have previously stated in my articles, the private equity game has become more complex and competitive. Increased capital has flooded the market, driving up prices for fewer transactions. Global assets under management (AUM) are currently just shy of $5 trillion, and companies are acquiring more than they are selling.
This competition, fuelled by an abundance of available dry powder, is expected to reach an all-time high of over two trillion USD by December 2021. And the landscape for private equity is only going to get more complicated.
A growing number of private equity firms are looking to digital transformation to help them make portfolio acquisition decisions, drive revenue growth, and streamline and improve internal operations, record keeping, and regulatory reporting. In this increasingly competitive environment, the speed and accuracy of digital transformation can provide a firm with a competitive advantage.
Digitalisation is widely regarded as the most influential trend affecting new investments. According to a recent Preqin survey of 300 private equity fund managers, approximately 70% of respondents acknowledge that the degree of digitalisation could influence their investment decision.
However, let us be honest. Private equity firms have generally been late to the party regarding automation and innovative technology, with the majority still unfamiliar with digital innovation. On the other hand, many private equity firms rely on traditional manual processes for deal analysis and back-office operations. However, a few larger private equity firms have already implemented or are in the process of implementing digital tools to gain an advantage in this competitive private equity market segment. PE houses must embrace digitalisation as soon as possible to reduce holding periods and increase returns while minimising risk. On the contrary, if they do not, they risk losing to the competition.
PE firms must analyse massive amounts of data to help make investment decisions, which entails analysing companies’ balance sheets and profit and loss statements, which took time and made data obsolete. In my opinion, it all boils down to timely data. Technology is vital because it improves data sharing efficiency, accuracy, and reliability.
Going digital does not imply that you can or should abandon traditional criteria for locating, evaluating, and pricing potential portfolio acquisitions. You still make decisions based on market position, past performance, industry trends, cash flows, and capital expenditures. After acquiring a portfolio company, having digital capabilities such as D&A (Digital & Analytics) allows you to mine more considerable amounts of data to make it more productive and efficient.
As a result, allowing faster access to more data could revolutionise deal evaluation and sourcing. Deep learning, AI, and algorithms can help general partners make informed decisions about potential deals by sorting through massive amounts of data in seconds. It could evaluate each transaction more consistently by analysing its strengths and weaknesses during the origination, due diligence, deal execution and valuation stages. Combining this technology with existing data can be critical in assessing investment health, return, and future expected returns, allowing general partners to model risk and the most effective strategies.
Some PE firms have already adopted such technologies. As a result, according to an Intertrust Survey, 90 per cent of PE firms believe AI will significantly impact the industry.
Not surprisingly, some firms began to rethink their approach to new investments. For example, Blackstone established a Data Initiative focused on data science, big data, and advanced analytics. The team collaborates with the investment professionals at the firms to enhance the investment process, make new investments, and optimise the operations of existing portfolio companies.
At EQT, one of Europe’s leading private equity firms, the digital transformation of private equity is well underway and even pioneering. The company moved to cloud-based working and developed an advanced system called Motherbrain that sifts through large datasets in search of potential investment opportunities. The firm assembled a solid team to assist portfolio companies with digital transformation, assist with due diligence, and train firm personnel to understand digital market signals. The firm has established an open environment where information about emerging digital technologies can be shared freely between its venture capital fund team and the numerous personnel responsible for managing buyout and credit funds.
Furthermore, investing in digital capabilities is an effective and increasingly necessary strategy for private equity firms looking to streamline and improve the efficiency of their compliance and regulatory reporting processes and procedures and their stakeholder communications efforts. For example, PE funds are required to consider laws and regulatory requirements from various jurisdictions, such as the Alternative Investment Fund Managers Directive (AIFMD), before filing reports and forms, paying taxes, and sending communications to limited partners and other investors as K1s. To this regard, recently Fund administrator and wider financial services provider Apex Group forged a five-year digitalisation partnership with Luxembourg based Governance.com, which provides a low-code process managed platform for regulated entities,
Private equity firms’ digital transformation will also influence the investment process and fund administration and reporting, which continue to rely heavily on manual processes. One example is distributed ledger technology (or blockchain technology), which enables private equity funds and their investors to securely integrate capital calls, fee settlements, and reporting updates.
The result will increase transaction efficiency, fewer reconciliations, shorter settlement cycles, and simplified liquidity management. Additionally, it can help fund managers reduce their total expense ratios and increase investors’ net returns. A recent Preqin survey discovered that only 6% of global private capital managers consider blockchain for fund administration, and nearly 40% are unaware of its benefits.
Moreover, digitalisation can assist in supporting the investor relations department’s activities, which face increased demand for investor reporting, internal and external communications, marketing, and other corporate initiatives. Storing and processing fund and portfolio company data in the cloud enables fund managers, investors, and service providers to gain real-time insights and benchmarking. Thus, PE firms can use data visualisation tools and social platforms to assist them in developing and maintaining relationships with investors. For example, interactive dashboards that compile data into a single panel can help buyers and sellers review key metrics more efficiently. Social platforms can help connect investors and private equity firms, increasing deal sourcing and lowering management fees.
Furthermore, as competition in the business has expanded, margins have been progressively dropping in recent years, placing pressure on firms to reduce costs while enhancing transparency and operational efficiencies. Having technologies that increase productivity through data sorting enables businesses to save money by investing less time in data collecting and analysis.
As a result of digital transformation, private equity firms that own or manage portfolio companies in the same or similar fields have an unprecedented opportunity to improve efficiency and profitability. You may be able to connect all the portfolio companies’ systems and have them feed into your own, depending on their level of digital maturity and monitor them in real-time. The traditional approach would be to obtain monthly management reports from the various portfolio companies and then figure out who is or isn’t performing well and how performance can be improved.
Private equity has always been and will always be a conservative, relationshipdriven industry. There is resistance to change within the industry, not from a technological standpoint but a cultural or mentality standpoint. As a result, the rapid pace of technological innovation has caught many private equity firms off guard. Consequently, businesses that had not yet begun to digitise bore the brunt of the pandemic’s impact.
Even though many private equity firms have prioritised digitalisation, the pandemic has made it an essential industry component. The covid-19 pandemic has undeniably accelerated the transition to a more digitalised private equity sector. Companies are under pressure to prioritise digital as a top priority due to the shift to video conferences for investor communication and the remote working environment.
Every opportunity has its advantages, disadvantages, challenges, and uncertainties, and digitalisation is no exception. Many industries are concerned about cybersecurity, but private equity firms, which deal with large sums of money and are frequently involved with third parties, are especially vulnerable.
Finally, the impact of the pandemic on digitalisation and the shift to remote work has increased the risk for businesses. Working from home entails safeguarding sensitive data and limiting employee access to systems. Using devices outside of offices raises the possibility of handling confidential, intellectual property, or other sensitive information. Devices are easily misplaced or stolen, exposing sensitive information such as intellectual property, trade secrets, or private data.
Digitalisation plays a critical role in the private equity industry, as it does in any other industry in the twenty-first century, and it presents many opportunities and challenges. Adopting new technologies has been a focus for many private equity firms over the last five years, a trend hastened by the pandemic. Unfortunately, many organisations have been slow to respond and are now obliged to adapt to a rapidly changing environment that has become the new normal.