CHAPTER FOUR

CHAPTER FOUR

It’s surprising that, in private equity, IT is almost synonymous with technology. Nothing could be further from the truth. There’s a lot more that PE can do with tech than implement back-office infrastructure.

Digital transformation is the transformation of a traditional company into a digital-traditional company by implementing a series of digital initiatives. Digital means technology, but in this context it’s important to distinguish the different types of technologies that companies can put to work and when these technologies have the most impact.

It’s surprising that, in private equity, IT is almost synonymous with technology. Nothing could be further from the truth. There’s a lot more that PE can do with tech than implement back-office infrastructure.

For our purposes, there are three levels of technology: low tech, mid tech and high tech (Figure 4.1). We will discuss what they are, how they create value and the best time to use them during the life cycle of the portfolio company. But mostly we will discuss the biggest moneymaker, digital transformation, and how the digital operating partner uses its high technologies to create value.

Figure 4.1 Tech Classified by Impact

We begin by defining the tech in each level.

LOW TECH

  • IT: Information technology is the plumbing (networking) that connects compute devices (computers, phones) to each other, storage (local, network, cloud) and business systems. In digital transformation the IT and OT (operating technology) networks connect the equipment that makes the smart product or is the network in the smart product.
  • Business systems: Each functional group has a business system to help with its operation. Examples include BI (business intelligence) for management, CRM for sales/marketing, PLM for manufacturing and ERP for operations. In digital transformation, business systems hold the data used and produced by smart products to create and improve data science models.

Low tech, as defined here, was considered high tech in the ’80s, but since then it has faded into the background and is now in use by all companies. Infrastructure tech like this enables value creation, but it has been commoditized to the point that it rarely produces competitive advantage. Low tech is low impact when it comes to value creation for the buyout firm.

MID TECH

  • Automation: Automation is used to replace repeatable human physical activities with mostly mechanical (e.g., robots, conveyers) and electronic (e.g., cameras) devices. These devices are controlled by simple software within a closed and proprietary network. In digital transformation the industrial internet of things or Industrie 4.0 is used to orchestrate these automated devices based on operating efficiency models and others.
  • Robotic process automation: RPA is used to replace repeatable human keyboard actions with software (called bots) that control one or more app interfaces. It is usually used to automate back-office tasks, such as inputting an invoice, that were previously done manually. A digital transformation initiative could have the smart product tell the RPA to submit a support ticket based on a smart product event.
  • Digital marketing: This is a process for automating repeatable demand generation tasks. It uses email, social, web, search, online advertising and other digital tools to fill and manage the sales and marketing funnel. An example is an automated email sequence designed to move the prospect down the funnel. A digital transformation initiative could gather customer data from the smart product to personalize marketing communications.
  • Ecommerce: Electronic commerce automates the buying and selling of products/services over the internet. An example is the storefront on a corporate website. A digital transformation initiative could have the smart product automatically order and bill a customer when a new consumable, part or product is needed or predicted to be needed.

For each stage in a company’s life cycle, there is a class of technology that delivers the greatest impact to value creation. From the perspective of the mature company, low tech has a low impact, mid tech has mid-level impact and high tech has a high impact.

The common theme for this 20–30-year-old class of technology is automation. Automating physical activity, automating keyboard activity, automating marketing and automating sales. Automation improves enterprise value by increasing EBITDA by reducing COGS and OPEX. It is a form of operating efficiency that improves output, capacity and performance, yielding expanded margins. This is good, but margin expansion doesn’t generally have the same impact on enterprise value as increasing sales or increasing the valuation model. Therefore, mid tech has a mid-level impact on value creation for the typical buyout firm.

HIGH TECH

  • IoT: The internet of things is an extension of the internet into physical devices. It consists of the software-defined product (application and data science model of how the smart product creates value), the hardware-defined product (compute, storage and communications), network fabric (IT and OT networks [fog] and cloud) and external systems (external data sources and other smart products). The purpose of IoT is to digitize the physical world for data science to produce digital twins of the product’s value creation mechanism. Digital transformation gathers and processes data from a smart product’s sensors and external data to create, improve and execute data science models.
  • Data science: Data science consists of two branches: analytics and AI, and is a superset of BI. Analytics is statistics, and AI today is machine learning, which is statistics wrapped in probabilistic learning algorithms. Both are wrapped in a software container to produce data science models. In digital transformation, data science ingests the data from IoT to create and improve models that can look into the past to make sense of what happened, understand what’s happening in the present and look into the future to make predictions of what may happen. In the context of cognitive automation, it can be used to replace repeatable human perception activities such as looking for signs of defects as discrete or process products come out of production/manufacturing.
  • Digital twin: A digital twin consists of a federation of data science models that together mathematically simulate a part, product or system. In digital transformation the digital twin describes how the product produces value. The digital twin’s value models simulate physical, biological or chemical processes. For example, in Chapter 2, how the road roller compresses asphalt was simulated with a usability model. This model is part of the road roller’s digital twin.

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  • Sensor fusion: One or more physical- or biological- or chemical-based sensors are chosen based on the data requirements of the digital twin. Sensors are placed near, on or in the smart product. In digital transformation they output product data into IoT’s network fabric, which then transports it to computation that can live locally, in the fog (local network) or in the cloud.
  • Additive manufacturing: AM, or 3D printing, is a new form of discrete manufacturing that physically reproduces 3D geometry models by depositing material in 2D layers. Advancements revolve around materials science. AM can reproduce most CAD models or can be driven by AI to reproduce unimaginable designs. A digital transformation initiative could be to use additive manufacturing as part of a mass customization solution.
  • Augmented reality: AR visually combines the physical world with the digital world to provide insights not visible independently. This is not to be confused with VR (virtual reality), which only displays digital worlds. A digital transformation initiative can be to visually superimpose product data over the physical product when looking at it. This is useful for many operating tasks such as service for example, where a technician can overlay diagnostic or other information directly on the product being repaired.
  • Blockchain: Blockchain is a decentralized immutable list of activities locked to an asset. The subtech of interest for digital transformation is the distributed ledger technology (DLT) that, for example, is used publicly in bitcoin. A digital transformation initiative can use blockchain to validate the history of all the actions involving a supply chain or ingredients or parts. This securely disintermediates the middleman to improve efficiency and reduce costs.

For each stage in a company’s life cycle, there is a class of technology that delivers the greatest impact to value creation. From the perspective of the mature company, low tech has a low impact, mid tech has mid-level impact and high tech has a high impact.

IoT, data science, the digital twin—these are today’s highest technology and the fundamental tech used in today’s digital transformations. This is the technology the digital operating partner uses to create the most alpha and the biggest increase in enterprise value.

When put together, high technology is used to make portfolio companies data driven—or to be more precise, customer data driven. By using the internet of things to transform traditional products into data-emitting products, and then data science to produce analytical and machine learning models from the data gathered, traditional companies can better understand their customers: how the customers use their products, what the customers use their products for and how the customers make money from using their products. This information is used to innovate existing products and to invent new ones, leading to higher sales and EBITDA by increasing market share and market size. But being customer driven also empowers traditional companies to innovate their business models and invent new ones, following the playbooks of the most successful tech companies. A “digital rerate” justifies a higher valuation multiple, one that’s closer to those of tech companies than traditional companies. Of all the technologies available to LBO firms today, high tech has the highest impact on value creation.

WHICH TECH WHEN?

IoT, data science, the digital twin—these are today’s highest technology and the fundamental tech used in today’s digital transformations. This is the technology the digital operating partner uses to create the most alpha and the biggest increase in enterprise value.

When put together, high technology is used to make portfolio companies data driven—or to be more precise, customer data driven. By using the internet of things to transform traditional products into data-emitting products, and then data science to produce analytical and machine learning models from the data gathered, traditional companies can better understand their customers: how the customers use their products, what the customers use their products for and how the customers make money from using their products. This information is used to innovate existing products and to invent new ones, leading to higher sales and EBITDA by increasing market share and market size. But being customer driven also empowers traditional companies to innovate their business models and invent new ones, following the playbooks of the most successful tech companies. A “digital rerate” justifies a higher valuation multiple, one that’s closer to those of tech companies than traditional companies. Of all the technologies available to LBO firms today, high tech has the highest impact on value creation.

Figure 4.2 Tech Classified by Timing

Early-stage companies, because they have likely incorporated high tech from the start, are not candidates for digital transformation, but if they are still doing accounting using QuickBooks, then low tech, in the form of business systems, is valuable. Therefore, low tech has the most impact on early-stage (venture-backed) companies.

Conversely, mid-stage companies, in all likelihood, already have enterprise-level IT and business systems in place, so for them, low tech provides little incremental enterprise value. But mid tech, with its ability to automate repetitive human activities, is valuable. It’s rational to implement mid tech to gather the lowest-hanging fruit value before moving to the more specialized high technology. Implementing mid tech (and low tech) does not require unique talent. Mid technology is established enough to almost be plug and play, and there are plenty of resources, both internal and external, that have the needed implementation skills. Therefore, mid tech has the most impact on mid-stage companies, those older than early-stage companies and younger than mature companies. Mid-stage companies are most likely later-stage venture or growth capital companies.

Mature companies, specifically mature, nontech companies, have the most to gain from high technology. They are of a vintage before today’s high tech was invented. They already have low tech in place and most likely mid tech too. Of course, there are exceptions to when low or mid tech will provide value to mature companies. For example, integrating the business systems of an add-on and replicating a business system (lift and shift) in a carveout can both be important to mature portfolio companies. However, overall, low tech and mid tech are not as valuable as high technology to the mature LBO portfolio company. Though high tech is second nature to younger companies, the strategic use of high technology is still relatively rare for mature companies, so this presents a big opportunity to their owners.

From another perspective, each technology class builds upon the previous generation of tech. The low tech, or what can be considered the operational layer, is the foundation upon which all other techs sit. Atop the operational layer is the mid tech, or automation layer, that creates independent value and improves the operational layer with efficiency. And currently sitting on top of the mid tech is today’s high tech, or smart layer, that creates its own independent value and improves the automation layer with data-driven cognition. Each technology class builds upon the previous generation’s technology to create the full digital stack (Figure 4.3).

Figure 4.3 Full Digital Stack

LIFE CYCLE IMPACT

For each stage in a company’s life cycle, there is a class of technology that delivers the greatest impact to value creation. From the perspective of the mature company, low tech has a low impact, mid tech has mid-level impact and high tech has a high impact.

Digital transformation and its high technologies hold the most value for traditional, mature companies, like the ones found in many LBOs’ portfolios today. When done properly, digital transformation widens margins, but more importantly, it also grows sales and grows the valuation multiple by borrowing from the digital innovation playbooks used by today’s most valuable tech companies.

Because it’s new and a good fit, digital transformation as an operational value creation tool presents an untapped opportunity for most buyout firms to further increase the worth of their portfolio companies.

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