27 Jan CHAPTER SEVEN
eet the digital operating partner, the newest member of the private equity operating team. The digital operating partner is a senior business executive with an interdisciplinary background in business strategy, in science and technology and in hands-on operations. Like that of other operating partners, the role of digital operating partner is to increase the enterprise value of the PE firm’s portfolio companies. But digital operating partners do it in a very different way. The tools of their trade are high technology, and their job is to use IoT and AI to transform select traditional companies in the portfolio, piece by piece, into digital-traditional companies. The newly data-driven companies will then use technology to further innovate and invent their products, their operations and their business models.
Meet the digital operating partner, the newest member of the private equity operating team. The digital operating partner is a senior business executive with an interdisciplinary background in business strategy, in science and technology and in hands-on operations.
This operational transformation is called digital transformation, and it represents a new angle for private equity at a time when fund managers are facing their highest competition. It’s a powerful angle that is new and produces a distinct source of alpha in an environment characterized by shorter financial levers, and less luck in arbitrage and discovering market inefficiencies.
The enterprise value created by the digital operating partner hits the financials in three places. First, sales alpha is increased by using high tech to improve products, increasing market share, and to invent new products, increasing market size. Second, margin alpha is produced by using technical efficiencies to lower COGS and, to a lesser extent, OPEX, by improving asset utilization (people and equipment), production yield, capacity and performance. Together they raise EBITDA, which is always a good thing. And third, technology, when used in the way the most valuable tech companies use technology, can also increase the valuation multiple through the deployment of better products and new business models and other novel and disruptive strategies (Figure 7.1).
The digital operating partner is a specialist who can use digital transformation in any sector where traditional, nontechnical companies are found. Although most in private equity think IT when they hear the word technology, it couldn’t be further from the truth, and for this reason it’s useful to differentiate between technologies. Low tech, which includes IT and business systems, is somewhat commoditized and therefore not in the realm of the digital operating partner because the opportunity costs are simply too high. Same thing for mid tech, which includes automation, RPA, digital marketing and ecommerce. A good rule of thumb is if you can find a local provider to implement the tech, then it is undifferentiated, is available to any competitor and yields commensurate returns. The digital operating partner’s domain is high technology, which includes the internet of things, data science (analytics and AI/ML), the digital twin, sensor fusion, additive manufacturing, AR and blockchain—tech that is highly specialized, exclusive and highly valuable.
Digital operating partners spend most of their time working outside of the buyout firm, and work in partnership with three very different groups of professionals: those responsible for investment, for management and for technology.
The digital operating partner works with the deal team throughout the life cycle of the investment. Together they work in diligence, and when an all-round strong asset is identified, they will develop the company’s digital investment thesis. They continue to work together during the hold period to smooth out any bumps in the plan. And at exit, they write the language communicating the remaining digital growth opportunities.
The digital operating partner is, then, part investor, part strategist and part geek.
Next the digital operating partner spends a lot of time on-site strategizing with select members of the portfolio company’s management team and engineering/production. Management, and whatever internal digital team there is at kickoff, is heavily involved in shaping the digital transformation plan.
And the last group of professionals the digital operating partner works with are the techies. They are selected from the digital operating partner’s proprietary partner ecosystem based on the specialized needs required to execute the bespoke digital transformation plan.
The digital operating partner is, then, part investor, part strategist and part geek. Let’s look at the responsibilities that make up the job (Figure 7.2).
The digital operating partner is responsible for delivering the digital investment thesis. This investment thesis identifies the main digital themes and strategies to be deployed over the lifetime of the investment. This is the hard part and the most consequential part of the job. It can be started during sourcing, is developed during diligence, is finalized postclosing and is revived during exit planning as part of the future growth narrative. Although each company is a snowflake, the digital operating partner applies their frameworks and detailed playbook to ensure nothing is missed and the longest digital value levers are prioritized. These value levers are stand-alone or play a supportive role to advance other themes in the investment thesis. The digital investment thesis is part of the overall investment thesis, and as such, it’s incorporated into the underwriting of the transaction by the deal team. Once the transaction has closed, it provides the starting point and directional vector for the digital transformation plan.
Next in the investment sequence for the digital operating partner is developing and delivering the digital transformation plan. This can be thought of as part business plan and part requirements document. Business planning for digital includes support for the investment thesis strategies and possibly product planning, competitive analysis, resource planning and operating programs to support and package the new digital value created and the transformation process itself.
The second part of the digital transformation plan details the technical requirements for the transformation. Transformation sounds broad and expensive, but it doesn’t need to be. A digital transformation simply consists of one or more digital projects to be executed. Whether this is a long list or a short list, the requirements document outlines what needs to be done.
The digital transformation plan is developed in conjunction with the portfolio company whose initial participation level is dependent on the internal digital resources available. A truncated version of the digital transformation plan is incorporated as a separate track in the 100-day plan. Besides ensuring management alignment and accountability, it includes quick wins and longer-term investments, and is used as a tool to report progress and challenges to the deal team. Its other main purpose, mostly the purpose of the requirements section, is as the input to the digital execution plan.
The unique job of the digital operating partner is to lead the portfolio company through its digital transformation by guiding it through the three main steps of identifying the value, planning the value and then executing the value.
The next phase, which is the longest phase of the digital transformation, is getting it done: delivering the digital initiatives that when pieced together assemble into a smart feature or smart product or smart system or smart way of operating the business.
The “getting it done” part is encapsulated in the digital execution plan, and it is the responsibility of the digital operating partner to deliver a sound plan with a sound budget. Since this is a development document, the heavy lifting of producing it comes from the developers—both in-house developers, if there are any, and external developers. As a development document, it outlines in high detail the human resources, milestones, interdependencies and budget. It holds the developers, internal or external, accountable to deliver the digital transformation on spec, on time and on budget.
This highlights the importance of the digital operating partner’s network. A digital transformation’s probability of success is directly proportional to the talent of its developers. Talent that not only is aligned with the tasks at hand but is the best available to deliver the tasks. For this, a deep bench of third-party resources is needed. The easy way out is to throw the requirements over the fence to a known consulting firm, but that is a mistake on many levels—starting with talent and ending with budget. It’s better to have an ecosystem in place consisting of a wide variety of technical service providers, vendors and subject-matter experts, who can be drawn upon differently for each digital transformation project. Each digital transformation is customized to the portfolio company’s value creation needs and strategy, and as such, the external team chosen must also be customized.
But over the long term, a great external team isn’t the goal. As part of the transformation, the digital operating partner also directs the buildup of an internal digital team within the portfolio company. A team to absorb the externally developed intellectual property and to carry on its development during the hold period and after the asset is sold to its next owner.
NEW AND UNIQUE
The new operating role of the digital operating partner is to create enterprise value by improving the portfolio company’s EBITDA and valuation multiple, and the alpha they create is unique and invisible to the other value creation methods used today. The unique job of the digital operating partner is to lead the portfolio company through its digital transformation by guiding it through the three main steps of identifying the value, planning the value and then executing the value (Figure 7.3).
Whether the digital operating partner will be represented as an internal digital operating partner or an external fractional digital operating partner or an external digital team will depend on the PE firm, but independent of who the digital operating partner is, the digital operating partner will slot into the operations team and improve the competitiveness of both the PE firm and the firm’s portfolio companies.