Digital Disruption and Private Equity: Understanding Effects and Opportunities

Disruption is an age-old force of change that both drives and destroys. Forces such as globalization and the increasing pace of innovation diffusion are accelerating the frequency of disruption and the impact it can have on industry. With the rise of digital technologies, the pace of disruption and the speed of its diffusion has increased dramatically. As a result, value can be both created and destroyed seemingly overnight.

By their nature, private equity (PE) firms have always had to be quick to respond to disruptive trends. If PE firms are to survive and thrive in this new era, they must consider the effect of digital disruption on their portfolios as well as their internal operations. They must also continuously adjust their strategy and decision-making framework, with consideration to how disruption affects industries, portfolios, and internal firm operations.

How does disruption alter industries?

1.Businesses

With new disruptive innovations come new markets and value networks. These innovations can fuel new business models (e.g. ride-sharing applications helping to launch the sharing economy) and can disrupt existing markets and networks (e.g. how ride-sharing changed the taxi industry).

Furthermore, the very nature of what a business is changing. The power of “open innovation” means that the advantages of the classical firm as the most efficient means of creating value are giving way to ecosystems that have a much larger and more efficient means of assembling and reconfiguring resources in the pursuit of value creation.

2. Customers

Digital disruption has irrevocably changed the customer journey. Customers of the “digital native” generation now expect information about a product to be accessible from the palms of their hands. They expect to be able to compare prices, see demonstrations, and receive feedback and recommendations from their social networks about products. Companies that can meet these new digital expectations can reap the value, while those that do not will rapidly succumb to irrelevance and insolvency.

3. Products

As pressure mounts to meet increasingly demanding customer expectations of “the newest thing,” product lifespans get shorter. Long established products can quickly become obsolete. The advent of the smartphone leading to the decrease in relevance of Nokia, Blackberry and Motorola is a clear example. The fate of Kodak, once one of the most powerful brands in the world, serves as a stark reminder of what can happen when digital disruption is ignored. This example is especially poignant as it was Kodak itself that invented the digital camera and the digital SLR camera. In Kodak’s case, the curse of a powerful product-linked brand, an aversion to self-disruption, and the inability to recognize customers’ latent desire to share photos with friends and family in real time, led Kodak to fall from the Fortune 500 to bankruptcy in less than 15 years.

How does disruption create new value opportunities for PE?

As industries are disrupted, PE firms must themselves ask the following:

1. Is a portfolio or target company at risk for becoming devalued by new technology?
2. Is a target company appropriately prepared to embrace new technology?
3. Is there an opportunity to capitalize on value emerging elsewhere as a result of disruption?

The ability to recognize the potential value of digital technologies in yet-unconsidered applications can add limitless value to a PE portfolio. Consider, for example, the emergence of bitcoin as a disruptive new asset class in the financial industry. It turns out that bitcoin’s underlying technology, blockchain, will be far more disruptive than bitcoin and will fundamentally impact countless industries. The ability to recognize the potential value of digital technologies in yet-unconsidered applications can add significant value to a PE portfolio.

Another source of value generated by digital disruption and efficient diffusion is accelerated innovation. Rather than focusing on developing a new product that may soon be outdated, accelerated innovation focuses on using new technologies to re-engineer research and development processes. Approaches include reducing lead times by engineering product elements simultaneously, reducing the learning curve by quickly incorporating user feedback, and increasing problem-solving efficiency by restructuring the organization. Despite the associated risk of failure, the ability of accelerated innovation to cut costs and reduce production times has proved highly valuable to customers, and worth considering not only as a framework to evaluate assets in a PE portfolio but as a means of improving the efficiency and effectiveness of the PE firm itself.  

How can PE firms realize new value opportunities?

In the age of digital disruption, it is no longer sufficient for PE firms to evaluate a target company using traditional value indicators (e.g. cash flow, capital expenditures, and historical performance). Historically valued companies may still be vulnerable to the newest wave of digital disruption. Others that appear to be digital laggards may actually have the potential for huge value generation given the right injection of capital, technology, and coaching.

To realize a valuable investment, PE firms must conduct due digital diligence on potential investments, asking the following:

1. What is the target company’s level of digital maturity? I.e. have multiple aspects of the company–talent acquisition, marketing, sales, and customer relations, etc.—been digitized?
2. What is the target company’s strategy for managing digital disruption?
3. Does the target company have a method for measuring the financial impact of digital disruption and a formal discipline of data-driven decision making?
4. Are the target company’s operations being reshaped by any industry trends?
5. What technology has the potential to destroy profit across the current value chain?
6. Which companies might emerge as unexpected competitors?
7. Does the company’s senior leadership team support a culture of innovation and risk-taking?

Digital disruption can increase the potential revenue of a business that is culturally prepared embrace disruption. As a result, it can generate new business growth in new and adjacent markets. To capitalize on this potential value, PE firms must calculate risks and opportunities by conducting conduct rigorous digital due diligence on potential investments.  They should also consider what value they can contribute to prospective and existing investments to help those companies survive and prosper in an age of accelerating innovation.

How can disruption impact PE firms internally?

The primary focus of most PE firms is on the operations and business prospects of their portfolio companies. The internal operations of the firm itself are often of secondary importance. But digital disruption is as much of a risk, and a potential opportunity, for firms. Disruption can impact investors and partners alike, altering expectations of business conduct and introducing new security threats.

PE firms should address their own place in their digital ecosystems by asking:

1. How will new and growing threats to privacy and cybersecurity be addressed?
2. Should the firm buy an existing system to enhance its digital capabilities, or build its own?
3. Which disruptive technologies can be utilized to improve and enhance firm operations?

How can PE firms use disruptive technology to optimize internal operations?

Despite sophisticated financial tools, transactions currently rely on manual processes that are legally and paperwork-intensive. As a result, PE firms are an ideal environment for leveraging many disruptive technologies. The following technologies can all be implemented to optimize PE internal operations:

• Robotic process automation (RPA): Improves productivity through automation. Processes that can be improved using RPA include investor reporting, waterfall calculations, capital call and distribution notices, performance calculations, tax compliance, management reporting, and regulatory reporting.
• Advanced cybersecurity: Enables proactive protection and improves risk mitigation. Can be used to secure internal PE firm operations, including the exchange of money and sensitive information during deals and the management of the portfolio company post-deal. Cybersecurity ensures the safety of finances, intellectual property, and customer data.
• Cloud: Improves the operational speed and ease of deployment, resource utilization, the agility of adjustments, security of materials, and containment of costs.
• Advanced analytics: Drives decision making and insight with deep pattern recognition and outcome prediction. Use of analytics can also improve and accelerate the due diligence process. Advanced analytics also can rationalize unstructured and complex data sets already available.
• Blockchain: Improves workflow efficiency, fraud reduction, and onboarding and identity management. Blockchain can also be used to secure deal execution.
• Artificial Intelligence: Improves insight and exception handling. AI can be applied to valuations, using qualitative and quantitative variables to estimate the odds of achieving higher risk-adjusted returns. Natural language processing can improve sentiment analyses, identify trends, and automate call centres. A noteworthy example, Deep Knowledge Ventures uses an AI system, called VITAL, with its investment committees. This system makes decisions by scanning prospective companies’ intellectual property, clinical trials, financing, and previous funding rounds to determine the attractiveness of an investment and assess related risk. 

The final word on disruptive technology in PE

To develop the operational framework necessary to manage internal and external disruption, organizations require a well-designed strategy led by an aligned and engaged management team. By combining a robust operating framework with a formalized approach to strategic innovation, organizations can foster a culture of continuous improvement and adjustment. This includes looking outside of the organization to forecast possible scenarios, new domains, and potential offerings. Internally, this includes the reallocation and definition of roles and responsibilities with leadership capabilities. With these strategies in place, the focus can shift to the creation of an innovative culture that seeks new value in both internal operations and external performance.