LBOs (Leveraged Buy-Outs) 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 asset categories they focus on. This is changing due to increasing legacy software in established products and the wake of faster speed of technology development.
From the private equity 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 have been no profound, 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. According to Hg Research, Siblis Research, and S&P, IT went from the smallest component to the largest component in the S&P 500 in 25 years.
The speed of technology has incrementally placed both product and market risks on the table front and center for private equity in the past few years. 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 IT infrastructure. There are exceptions, of course. This not only leads to an increased risk of disruption but also increases spending on risky transformations, impacting EBITDA.
The speed of technology today is enabling new business models, creating new markets, and disrupting established products faster. This will result in several changes in the private equity approach and the supporting provider’s ecosystem.
The typical average hold time (5-7 years) is also likely to shrink (e.g., 4.3 years in 2019 vs 6 in 2014, according to Bain). Larger businesses, especially those less adaptable, will grow more fragile and face an increased risk of disruption. Without deliberate investments, companies’ technologies are becoming legacy faster, and the risk of their business models becoming obsolete is growing. The growth and expansion glass ceiling may at times be dwarfed by the amount of risk mitigation needed for transformations.
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 diligence providers to stay strategically aligned on investment goals and portfolio management.
Another significant change will be the pronounced use of data on multiple fronts. The first is the KPIs used in private equity today to measure success and value add. As target profiles and hold times change, so will the KPIs. The second is the growing need for baseline data obtained during diligences, creating dashboards, and using those throughout the value creation cycle to optimize and make data-driven decisions quicker. The data will be used not only for targets in a silo but also across the portfolio.
Diligence in a fragmented industry, once oriented towards making deals happen, surfacing static risks, or conducting a simple checkbox exercise, must also adapt. This is especially true for commercial and technology due diligence.
In particular, technology due diligence (Tech Due Diligence 2.0) will take a more strategic front-seat role. A focus on assessing the technology's suitability and ability to evolve will be more important to accommodate the fast-changing technology ecosystem and quickly evolving business strategies. In addition to assessing past and present risks, a future risk mindset will be more critical to provide the necessary inputs to the value creation and exit options.
Regardless of whether a fund focuses exclusively on technology or tech-enabled targets, modern technology diligence (i.e., Technology Due Diligence 2.0) is more suited as the crystal ball used to minimize future risks, optimize and increase the focus on where to add value.
All these changes will help mitigate the growing product and market risks. 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.
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About the Author
Hazem has been in the software and M&A industry for over 26 years. As a managing partner at RingStone, he works with private equity firms globally in an advisory capacity. Before RingStone, Hazem built and managed a global consultancy, coached high-profile executives, and conducted technical due diligence in hundreds of deals and transformation strategies. He spent 18 years at Microsoft in software development, incubations, M&A, and cross-company transformation initiatives. Before Microsoft, Hazem built several businesses with successful exits, namely in e-commerce, software, hospitality, and manufacturing. A multidisciplinary background in computer engineering, biological sciences, and business with a career spanning a global stage in the US, UK, and broadly across Europe, Russia, and Africa. He is a sought-after public speaker and mentor in software, M&A, innovation, and transformations. Contact Hazem at hazem@ringstonetech.com.