CHAPTER SIX

CHAPTER SIX

The most competitive companies of our age are digital companies. And the biggest of these digital/tech companies are being investigated for antitrust because they’re regarded as being so competitive that they’re repressing all their competition. Intrinsically related to this narrative is data. Facebook, Amazon and Google are said to know too much about us, their customers. This isn’t by chance. There is a causal relationship between customer data and competitiveness: the more the company knows about its customers, the more competitive it is. Privacy issues aside, this is what we want for our portfolio companies. Not the antitrust thing—well, maybe the antitrust thing—but what we want more is for our companies to be so competitive that they dominate their markets.

Identifying portfolio companies that are best suited for digital transformation is always the first phase of digital diligence. Ideal candidates are nondigital, nontech companies that are most likely to be traditional, mature companies operating in markets that haven’t been digitally disrupted yet.

Being data driven is the hallmark of all the most valuable and innovative companies today, and in history. Being data driven comes naturally to tech companies that sell digital products that are used online, create value online and predominantly operate online. Why? Because with software, customer data is easily accessible. This has put traditional competitors at a disadvantage. Amazon, Uber and Tesla have inherent competitive advantages over traditional bookstores, taxicab companies and traditional automotive manufacturers, but this hasn’t been lost on these traditional competitors. To various levels of success, they are all transforming themselves into digital-traditional companies so they too can reap the rewards of using customer data as a competitive weapon. This is and will be the same story for all industries.

Digital transformation is the process of transforming a traditional company into a digital-traditional company. The digital operating partner uses high technology to transform traditional companies into companies that use data to drive initiatives that increase competitiveness. This increased competitiveness helps traditional companies increase sales, expand margins and, in many cases, ratchet up their valuation multiple by taking advantage of the structural changes resulting from the transformation. Put another way, data-driven companies are more valuable companies.

Here we look at the traits that best identify portfolio companies that have the highest potential from being digitally transformed and becoming data driven.

THE COMPETITIVE ADVANTAGES OF BEING DIGITAL

The competitive advantages of being digital, or of being data driven, enable digital-traditional companies to outperform their traditional competitors and, in some cases, to be so competitive that they disrupt their industries. Digital-traditional companies have a comparative advantage over their traditional rivals from using tech and data to increase operating efficiency, which improves their margins. Perhaps more important though, digital-traditional companies can use the customer data they collect to increase their differential advantage over their competitors.

The differential advantage of being data driven results in smart products that are unique and of higher quality than the products of their traditional competitors. Think Amazon versus traditional bookstores, Uber versus traditional cab companies, Tesla versus traditional automotive manufacturers and you get the picture. When done properly, smart products are better products as measured by usability, functionality and performance, and by almost every other metric, because they know what their customers need. Data-driven companies have a full-time window into their customers’ worlds, and if the companies look, they can see how their customers use their products and what the customers use their products for. This leads to more innovative products that increase sales by earning more market share, and it leads to new products that increase sales by expanding market share (Figure 6.1).

Figure 6.1 Data-Driven Competitive Advantages

Knowing how your customers make money, and how much money they make from using your product, leads to more rational pricing and to inventing new business models. New business models can lead to the hypercompetitiveness that dominates and even disrupts industries. Of course this is not guaranteed, but interfacing your business model to your customer’s reduces monetization friction and in the process can have wide-ranging effects such as disintermediating the vulnerable, shifting the boundaries of competitiveness and subsuming conventional product categories, along with other novel and potentially disruptive strategies.

Because of the unique skills and company conditions necessary to create smart products, there is a high barrier to entry. And even if the digital functionality is duplicated, competitors can’t duplicate the amount of data that was captured in the meantime. It is important to be first. Where a traditional product’s value is in its physicality, the value of a smart product is derived not only from its physical characteristics but even more so from its software and data characteristics.

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CANDIDATE COMPANY TRAITS

At a high level, one of the main components of digital transformation is the digitization of the value a company creates. The collected data is then transformed into useful information that is used to increase enterprise value. All this is independent of geography, the size of the company and, for the most part, the industry sector. With the exception of sectors like software, telecommunications or any other tech-heavy sector, digital transformation is broadly applicable to pretty much all other sectors, including aerospace, biotech/life sciences, consumer, energy, healthcare, industrials, infrastructure, manufacturing, natural resources, retail and transportation.

Although geography, company size and, for the most part, industry sectors are not significant, there are other traits that are and should be used to help identify the best candidate companies in a GP’s portfolio to digitally transform. The sweet spot comprises companies that are traditional, more mature and not already in a market that has been digitally disrupted. It is these companies that have the most potential for an enterprise value uplift from digital transformation.

Being data driven comes naturally to tech companies that sell digital products that are used online, create value online and predominantly operate online. Why? Because with software, customer data is easily accessible.

A TRADITIONAL COMPANY

The first trait to look for in potential digital transformation candidates is digitalization level. This translates into whether the company is considered traditional. Traditional companies sell nondigital products that are used offline in the physical world. Traditional companies create value offline, and although they may use digital products, they predominantly operate offline too. Traditional products are manufactured in atoms and are not connected to the traditional company’s business (systems) after being sold.

Until recently tech companies were the only data-driven companies, but now high technology makes it practical to digitize the offline products of traditional companies to make them data driven too. Traditional companies are candidates for digital transformation because, by definition, they are not already digital, and so they have the most to gain.

A MATURE COMPANY

The second company trait to look for in your fund is maturity. Not maturity as measured in elapsed time, although there’s a correlation, but technical maturity as measured in the technology that has so far been deployed within the enterprise.

From a value perspective there are three classes of technology. Low tech, which includes IT and business systems; mid tech, which includes automation, RPA, digital marketing and ecommerce; and high tech, which includes the internet of things, data science (analytics, AI/ML), the digital twin, additive manufacturing, AR and blockchain. It is high technology that digital transformation is made from.

There’s a natural progression to deploying technology in traditional companies. In the early stages the company will deploy its tech infrastructure—its low tech. Later on, it will deploy mid tech/automation to improve operational efficiency. Today’s mature company may have a high-tech initiative or two started (usually for the wrong reasons), but on the whole these companies generally don’t have the DNA to deploy high technology in a meaningful way. Even though high tech is second nature to younger companies, the fundamental use of high technology is still relatively rare for mature/legacy companies because of their vintage, so this presents a new opportunity to their owners.

Time has proved that digital companies become the most valuable companies in their market. There are those that are born digital (tech companies), and now there are those that have been transformed into digital.

COMPANIES IN NONDISRUPTED MARKETS

One way to look at a market within a sector is whether or not it has been digitally disrupted yet, or less dramatically, whether or not there already exists a dominant digital competitor. Although fighting digital with better digital is certainly a rational strategy, it’s an even better strategy to digitally transform a company in a market that doesn’t yet have a real digital player.

As discussed, companies in most sectors can be improved by digital, but digital transformation is most valuable and most disruptive in markets where the competitive space still uses traditional products in the physical world. Another important trait to look for in portfolio companies relates to the markets in which they operate. Are companies operating in a market that hasn’t changed much in years or even decades? Legacy markets that are less innovative are brimming with companies that are prime candidates for digital transformation.

THE IDEAL ASSET

Time has proved that digital companies become the most valuable companies in their market. There are those that are born digital (tech companies), and now there are those that have been transformed into digital. Both of these types of data-driven companies are the most competitive, capable of disrupting their markets and inventing new ones—and in the process, these companies become the most valuable in their market.

Identifying portfolio companies that are best suited for digital transformation is always the first phase of digital diligence (Figure 6.2). Ideal candidates are nondigital, nontech companies that are most likely to be traditional, mature companies operating in markets that haven’t been digitally disrupted yet.

Figure 6.2 First Phase of Digital Diligence

Private equity has a new value lever in digital transformation that once pulled will lift these companies up to the next valuation level.

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