CHAPTER FIVE

CHAPTER FIVE

Digital transformation is the operational transformation of a traditional company into a digital-traditional company. The digital operating partner uses high technology such as the internet of things and data science (analytics, AI/ML) to deliver digital initiatives designed to increase enterprise value.

Successful digital transformation is more about effective leadership than effective management.

Digital transformation is hard, but it’s for reasons that may seem counterintuitive. Tech such as IoT and data science is on the cutting edge, so of course it’s a challenge, but tech is a manageable challenge with the right experience and development partners. So it’s not really the hardware or the software that presents the biggest undertaking; it’s the wetware. As in any operational transformation, it’s the human element that presents the biggest risk. However, experience has shown that when employees are in the right environment, this risk can be mitigated.

And that is the purpose of this chapter: to compare how the working environments imposed by different company ownership structures contribute to digital transformation success and to recognize the resulting behaviors to be managed during the transformation.

Assuming similar capital, people and physical resources, we will examine the effect that company ownership structure and the actions they promote have on digital transformation success. To do this we will compare the environments of public and private companies, then private strategics and sponsor-owned companies and finally VC-owned and buyout-owned portfolio companies, to identify the best ownership structure and behaviors for digital transformation to succeed.

PUBLIC VERSUS PRIVATE

First let’s compare public company environments with private company environments as they pertain to supporting a successful digital transformation.

The most obvious place to start is governance. Having a multitude of public shareholders to answer to generally results in a more bureaucratic and hierarchical management structure than found in private companies. This structure is great for balancing many stakeholders’ demands but less great for changing priorities and making timely decisions. Public boards are also more defensive in nature, more concerned with risk and not losing, rather than playing offensively to win. Successful digital transformation is more about effective leadership than effective management. Leadership that can make big decisions and then rally the troops to make them happen. The concentrated ownership of private companies ensures more effective decision making and the prioritization of strategies deemed to have the greatest value. With fewer institutional loyalties and distractions, the private company is better able to make dispassionate decisions and then have them carried out.

One of a public company’s biggest distractions is quarterly reporting. The “end-of-the-quarter drill” can derail all business as usual, including, for example, diverting the digital team to help sales close those last few accounts before quarter end. Experience has shown it’s best to establish a digital team, almost like a startup, that’s insulated from public company gyrations so the team members can concentrate all their energy on implementing their digital mandate. This tends to be easier to do in private companies that can afford to have longer time horizons for their investments to pay off.

Defining a digital transformation strategy and creating an internal digital team to execute it implies top-down decisions. But in most public companies just the opposite occurs. Ideas for digital projects mostly come from engineering. Sometimes this can be great, but more often than not, engineering-driven digital initiatives are about the tech—the shiniest bells and the clearest whistles that are supercool technology but not so cool from an investment impact perspective. Experience has shown time and time again that without the right leadership and culture, digital initiatives will pop up in labs without business plans, consuming precious opportunity cost, only to be stillborn because the projects weren’t valuable enough to raise the internal funds necessary to go commercial.

Although most discourse on digital transformation centers on public companies, it is the privately owned enterprises that have a better chance of digital transformation success (Figure 5.1).

PRIVATE > PUBLIC
A private company has a
better ownership structure
for digital transformation
than a public company.

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CORPORATE VERSUS PORTFOLIO

Because private companies are better suited than public companies to digitally transform, let’s break them down into non–sponsor-owned companies (corporates) and sponsor-owned portfolio companies.

Digital transformation, as the name implies, requires a transformational change in business operations. Portfolio companies have a built-in platform for change—change is the reason private equity made the investment in the first place. Without change there is no new alpha, and new alpha is the difference between a good exit and a top-quartile exit. Suffice it to say, private portfolio companies are meant to change, and if digital transformation is part of the investment thesis, then the impetus for digital change will come from the top down, through ownership, board and then management.

Experience has shown that without CEO and C-suite support, digital transformation will never see the light of commercialization. Private corporates with long-term CEOs and boards tend to have a lower sense of urgency and a “current-state” bias, preferring to stay the course and make incremental changes rather than transformational ones, even if those hard decisions are what’s right for the company. If digital transformation is part of the investment thesis, private equity investors will ensure the current management team is ready and capable of making changes quickly, or adjustments will be made. Once the right team is in place, the compensation models will be structured to be tightly aligned with the value creation plans of ownership.

Portfolio companies are motivated, supported and incented to be bold and make big moves, giving them a better chance of digital transformation success than corporates (Figure 5.1).

PORTFOLIO > CORPORATE
A portfolio company has a
better ownership structure
for digital transformation
than a corporate company.

VENTURE VERSUS BUYOUT

Because private equity–owned portfolio companies are better suited than corporate private companies for digital transformation, let’s zoom in to compare venture capital portfolio companies with LBO portfolio companies.

When comparing the two, it comes down to fit. Again, digital transformation is the operational transformation of a traditional company into a digital-traditional company. The best companies to transform are traditional, aka nontechnical companies. Furthermore, these companies are typically mature, because if they weren’t, they would have started out digital in the first place. Older nontech companies don’t fit the profile of a venture-backed company, but would be right at home in an LBO’s fund.

Having a platform for change, plus effective decision making, less distractions, plus a fit with the owner’s operating model adds up to LBO portfolio companies having the best ownership structure for digital transformation.

Moving to digital is also a better fit for the operating model of the buyout firm—one that uses active ownership and an internal team of operating partners or external service providers to actively improve the operations of its companies. In this case active ownership means the digital team identifies the digital initiatives, plans them with the deal team and portfolio company’s management and then implements them by hiring the right service providers, vendors and subject-matter experts from the digital operating partner’s ecosystem.

The percentage of company ownership also plays a role. Unlike the buyout firm that has majority ownership, the venture firm doesn’t generally own enough of the portfolio company to singlehandedly align management to a new digital strategy.

Portfolio composition and operating model make digital transformation a better fit for the buyout firm than the venture capital firm (Figure 5.1).

BUYOUT > VENTURE
A buyout portfolio company has a
better ownership structure for
digital transformation than a
venture capital portfolio company.
Figure 5.1 Ownership Structure Faceoff

OWNERSHIP STRUCTURE AS A COMPETITIVE ADVANTAGE

The buyout portfolio company has the environment most conducive to digital transformation success—better than venture portfolio companies and strategics, private or public. This is a big deal. One that represents a significant competitive advantage for the company and its owners.

The natural evolution of all products is to go digital and become smart. Some industries will transform into digital industries before others. But make no mistake about it—all industries and the companies within them are becoming digital; it’s just a matter of time.

If done properly, the first company to go digital will become or stay the dominant player in its industry. Therefore, the increased probability for digital transformation success represents a significant competitive advantage for the LBO portfolio company. It’s an advantage that can be parlayed into industry dominance or even industry disruption.

Tech such as IoT and data science is on the cutting edge, so of course it’s a challenge, but tech is a manageable challenge with the right experience and development partners. So it’s not really the hardware or the software that presents the biggest undertaking; it’s the wetware.

The LBO firm with the appetite and ability to apply digital transformation within its portfolio companies also has a competitive advantage over other LBO firms. It is the inevitability of digital within all sectors that makes digitally transformed companies so attractive to strategics. Because of this, LBO firms with digital chops will, on the whole, have more attractive assets, which ultimately leads to better-performing funds. On the buy side, more targets are attractive because digital transformation is well suited to be applied to assets in the secondary buyout market. No matter how well run the company, further value can be created with digital transformation, assuming the right company attributes.

A PLATFORM FOR CHANGE

Digitally transforming a traditional company into a digital-traditional company produces a data-driven company. Once the physical has been digitized, portfolio companies can take advantage of the same value creation strategies used by the most valuable tech companies. Data-driven companies build models such as usability models, utility models, prediction models, monetizability models and optimization models that in turn galvanize product innovation, product invention, business model innovation/invention and operating efficiency.

Digital transformation and its associated high technologies have been derisked so they can now deliver an important source of alpha additive to the other operational improvements typically applied by private equity operation teams. As a value generator, not only does digital improve margins, but it enables a variety of ways to increase the top line and valuation multiple, making digital one of the most powerful operational value creation tools available to GPs today.

Figure 5.2 Digital Transformation Success Factors

It’s simple arithmetic. Having a platform for change, plus effective decision making, less distractions, plus a fit with the owner’s operating model adds up to LBO portfolio companies having the best ownership structure for digital transformation.

Digital transformation is teed up to be private equity’s next dominant enterprise value creation tool, one that will result in better returns and higher competitiveness for both the PE’s portfolio companies and its fund. To do so the natural advantages afforded to the LBO company must be actively managed to maximize success.

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