Private Equity Investments: The Impact of AI on Portfolio Strategies

AI as a value driver

AI technology offers unprecedented opportunities for innovation and efficiency across sectors, such as education, healthcare, finance, manufacturing, and e-commerce. Next to strategic buy-and-build portfolio considerations, following soft factors play a role when investing in a tech-focused business:

Market Growth

The AI-enabled products and services market is experiencing exponential growth, with bold estimates of its size reaching $1.43 trillion by 2029 with a CAGR of 37.44%, compared to the current market size of $292 billion. This growth trajectory presents a lucrative opportunity for funds looking to capitalize on a fast-expanding market.

Disruptive Potential

AI has the capacity to disrupt traditional business models by automating workflows, enhancing decision-making capabilities, and creating new revenue streams. Private equity firms recognize the value of investing in technology that can redefine industry standards. For instance, in a recent case study, we observed a 40% to 50% increase in efficiency after implementing an AI-driven digital marketing engine. Together with our client, we demonstrated the potential of AI in driving material business performance and operational excellence through process automation.

Data-Driven Insights

AI's ability to analyze vast amounts of data and generate actionable insights is valued across industries. Databricks, an AI-focused data analytics firm, is currently worth around $43 billion, highlighting the immense perceived value of a data-driven business backed by AI-enabled products. Data-driven organizations enhance the decision-making process, increasing market traction and competitiveness.

Scalability

In most cases, AI technologies underpin scalable digital products, allowing businesses to expand their operations without a proportional increase in costs. For example, AI-driven contact platforms can handle growing volumes of inquiries with minimal additional investment unlocking potential operational cost savings of up to 60%^. This scalability is particularly attractive, as it translates into higher potential returns on investments with controlled expenditure.

Competitive Advantage

Bold investments in tech-driven products and services provide companies with a competitive edge, allowing them to shape industry trends and outperform competitors. AI-driven solutions enable companies to streamline operations, reduce costs, and innovate faster than their peers. By fostering internal expertise in AI, companies can identify and implement cutting-edge technologies that drive business growth at higher rates than competitors.

Key considerations prior to investment

When evaluating in a potential transaction, private equity firms should consider several key elements to ensure successful investments:

Technology Assessment

Evaluating the technological capabilities and potential of the target company is crucial. This involves analyzing key areas such as:

1. AI Algorithms: Assess the robustness and accuracy of the company's AI algorithms. For example, determine if their machine learning models can consistently predict customer behavior or optimize complex supply chain operations.
2. Data Quality and Volume: Evaluate the quality and volume of data available. A company with extensive, clean data sets can leverage AI more effectively. For instance, a retail company with a detailed customer purchase history can create more accurate recommendation models.
3. Technological Infrastructure: Assess the technological infrastructure, such as cloud computing capabilities, data storage solutions, and cybersecurity measures. A fit-for-purpose infrastructure ensures that AI solutions can be scaled and maintained efficiently. Additionally, evaluate the target's access to specialized hardware, such as GPUs (Graphics Processing Units), which are essential for training and running complex AI models efficiently

These assessments help in understanding the company's readiness to implement and benefit from AI technologies, guiding better investment decisions.

Talent

The expertise and skillset of the target company's team are critical for AI development and deployment. Private equity firms must assess the talent pool to ensure the company has the necessary human resources to drive innovation. Additionally, firms must recognize that experienced AI professionals are in high demand. To attract top talent, firms should focus on competitive salaries, a strong company culture, and the opportunity to work with cutting-edge technologies.

Intellectual Property

Protecting intellectual property is vital in AI transactions. This involves evaluating the target company's patents, trademarks, and proprietary technologies to ensure they are secure and valuable. Effective IP protection safeguards competitive advantages and maximizes investment value.

Regulatory Compliance

AI technologies are subject to various regulatory frameworks depending on the industry and geographic location. Private equity firms must navigate these regulations, such as the General Data Protection Regulation (GDPR) in Europe, to avoid legal pitfalls and ensure compliance. Additionally, firms need to be aware of regulations concerning regulated materials and data. For instance, while automating content generation, it is often essential to include a human-in-the-loop to address concerns, such as those related to hallucination or plagiarism. Regulatory issues can directly limit the potential scalability of AI-driven solutions, highlighting the importance of understanding and adhering to relevant standards and guidelines.

Integration Potential

For buy-and-build strategies, the integration potential of the target company with existing portfolio companies is essential. This involves assessing cultural fit, technological compatibility, and strategic alignment. For example, ensuring the target company's AI-enabled products can integrate with existing data platforms is crucial for maximizing synergies and achieving common business goals.

The Buy-and-Build approach

The buy-and-build strategy involves acquiring multiple companies with AI-enabled products or services and integrating them to create a more diversified and competitive entity. This approach can enhance value creation and accelerate growth through synergies and scale. Here is how it works:

Acquisition Phase

The initial phase involves identifying and acquiring companies with complementary technologies, markets, or capabilities. For example, acquiring a company specializing in products utilizing proprietary natural language understanding techniques to complement an existing portfolio company focused on data products. These acquisitions are strategically selected to enhance the overall value proposition of the combined entity, such as entering new markets or acquiring new customer segments.

Integration Phase

Post-acquisition, the focus shifts to integrating the acquired companies. This involves aligning technological platforms, such as integrating AI software solutions into a unified platform, consolidating operations by streamlining overlapping functions like marketing and HR, and aligning corporate cultures to ensure a seamless transition. For instance, creating cross-functional teams to foster software development and innovation.

Growth Phase

With the integrated entity in place, the focus is on leveraging the combined strengths to drive growth. This includes expanding market reach by entering new geographic regions, enhancing product offerings through the development of new AI-driven features, and optimizing operational efficiencies by automating processes across the combined entity. For example, using AI to improve supply chain management and customer service.

Exit Phase

The final phase is realizing the value created through the buy-and-build strategy, typically through a sale to another private equity fund or a strategic buyer, or through issuing a public offering (IPO). The aim is to achieve a high ROI by creating value through product synergies. This can be realized by demonstrating an enhanced market position, increased revenue streams, and operational efficiencies achieved through the integration process.

Conclusion

The AI sector presents significant opportunities for private equity firms, with a buy-and-build strategy emerging as a powerful approach to value creation. As AI continues to disrupt businesses, investors are well-positioned to drive and benefit from this technological revolution. By strategically acquiring and integrating complementary AI capabilities, private equity firms can enhance their market position, drive innovation, and achieve substantial return on investment.

This article was written in collaboration with Dr. Andreas Vath from Luther Law, a leading German commercial law firm that offers comprehensive legal and tax services. In addition to employing more than 420 lawyers and tax advisors, Luther is represented at 10 German economic centers and 11 important investment locations and financial centers in Europe and Asia. Luther is a law firm with a business approach, whose innovation inspires them to provide their clients with customized legal advice that addresses individual needs and delivers the greatest possible economic benefit. Luther's lawyers and tax advisors have a solid understanding of interdisciplinary matters and a wealth of experience in collaborating on complex tasks.