A Sore Point in the Private Equity Business
What initially sounds like a dream target can quickly turn into a nightmare. "A few years ago, we analysed a company that passed all of our investment criteria (hypotheses). However, the software and code they were operating with were over 15 years old and would have had to be completely renewed in order to be offered as a SaaS solution," reports Stefan Sambol, partner and co-founder of the Munich-based digitalisation consultancy OMMAX.
These scenarios are not unique, and they reveal a sore point in the private equity business. The way some private equity investors currently approach the topic of digitalisation leaves a lot of money on the table and it is not uncommon for bad investments to be made.
What exactly does digital due diligence entail to enable such potential returns? And how does it protect against bad investments?
What Does Digital Due Diligence for Private Equity Investors Involve?
Digital due diligence determines the digital maturity level of a target and identifies potential investment opportunities through digitalisation. Depending on the complexity, the audit usually takes two to four weeks. The analysis starts relatively early. According to Sambol: "Many financial investors come to us with fundamental questions; first and foremost, as they want to better understand a target's business model." In addition, the buyers are often interested in competitive positioning from a digital perspective and the evaluation of digitalisation tools for the development of equity.
According to Sambol, there are often requests for key "digital" figures, such as key figures on digital brand awareness or the visibility of the company in digital customer channels. "Most private equity investors lack comparative figures to be able to assess what is good and what is bad". Without this information, however, it is difficult to evaluate the digital potential of a company.
At the client's request, OMMAX carries out a bottom-up analysis in addition to a top-down market analysis, using tools such as Semrush or Sistrix to examine the terms users search for on the internet. This can be a product category or the name of the company. "We then see the dynamics with which brand-related search terms have developed and can conclude how the company's relative market share has developed, and how the market will develop in the coming years," says Sambol. This makes the digitalisation potential of the potential target more tangible.
Another part of a digital due diligence process is examining topics such as cybersecurity and the handling of data. "Here we look at how secure and scalable the company's IT is, and whether other business models can be developed with the existing data," explains Sambol. This not only makes sense against the background of risk avoidance when, for instance, the private equity investor does not buy into a security problem, but additionally opens up new opportunities to expand the existing business model. Similar considerations regarding the use of data are currently being made by financial investors who are interested in SCHUFA, according to market reports.
The employees of the target company are also scrutinised during a digital due diligence. The predominant question here is: Does the team have the necessary skills to drive the digital transformation? According to Sambol, further areas of investigation in digital due diligence arise depending on the company and the business model. A plus point for digital due diligence is that private equity investors do not lose any time in the M&A process as the analysis can be started with publicly accessible data, even before the official start of the hot deal phase.
Quick Wins With Digitalisation
But how does digital due diligence ensure that financial investors can increase their returns? There are many "quick wins" in the area of digitalisation. "With a few simple steps, for example, Google rankings, reach on social networks and website metrics can be improved. This can have a direct impact on the perception of the company and subsequently generate more business," says Sambol.
The digital maturity of a company also impacts company valuations in two further ways. Firstly, digital due diligence can be used to identify investment opportunities in the area of digitalisation. "If the financial investor understands the business model and its opportunities of digitalisation in depth, he can be more aggressive with the valuation, and possibly even secure a higher purchase for the company," says Sambol. If a financial investor is also on the seller's side, he can achieve a higher purchase price with a digitally well-positioned company.
Multiple arbitrage is also possible with digitalisation projects. With a little skill, the multiple can be pushed down during the purchase price negotiations through reference to a digitalisation backlog that will only be tackled and financed after the takeover. However, financial investors should not be too aggressive, because entrepreneurs (still) have the upper hand in the transaction process.
Nevertheless, Sambol occasionally observes that financial investors engage in multiples arbitrage by buying interesting companies cheap(er) and later selling the digitised companies at a higher price. "For example, one digital due diligence we supervised showed that an investment of 5 million euros in the digitalisation of customer management would result in new orders with a volume of 60 million euros within the next three years".
Private Equity Fails to Recognise Wrong Digitalisation Initiatives
However, private equity investors should not blindly trust sellers. Companies and M&A advisors have now understood that a higher multiple can be demanded for the label of "digital business model". Sambol has found that a few black sheep do take advantage of this and artificially inflate their level of digitalisation. "For example, one company claimed to offer dynamic real-time pricing, but the reality of what we found was rather rudimentary"..From his point of view, however, the bigger problem is not embellished company presentations, but the fact that private equity investors often fall for them due to a lack of digital expertise."
Digital Due Diligence Reveals Unexpected M&A Opportunities
Due diligence also helps to find out where M&A opportunities are hidden. "Most private equity investors digitise the core business of their portfolio company, while strategists also like to invest in innovative digital business models that enable new revenue models," Sambol reports. He believes that such investment strategies are also attractive for private equity under two conditions: "the financial investor must have time and must dare to intervene in the organisational structures of the acquisition."
According to Sambol, it is precisely at the management level that many private equity investors encounter reluctance, or even resistance, when trying to launch digitalisation initiatives immediately. But "if you don't experience openness for new projects at the management level, you have to dare to integrate digitalisation experts into the management". Digital projects can only be implemented profitably if private equity investors and company leaders pull together.
This article was originally published in German by FINANCE.
About the Author
Olivia Harder is an editor at FINANCE and focuses on following current developments in the private equity and M&A business. She studied philosophy, political science, sociology and geography at the Justus Liebig University in Gießen, where she also held a teaching position. Before FINANCE, Olivia Harder worked in the editorial departments of several weekly and daily newspapers, including the Gießener Anzeiger.
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