The Fourth Industrial Revolution and Private Equity – How A Rapid Digitalisation Is Changing P.E.
Updated: Apr 2
By Elena Sergeeva, the Senior Research Analyst at KPEC
Every industry has been profoundly affected by the global digitization of goods, procedures, and services, as well as the conversion of analogue and manual processes to digital. Private equity firms are among the businesses that see digitalization as both an opportunity and a threat.
While some P.E. firms were already digitalizing prior to Covid-19, the black swan event, which served as a trigger in an already fast-changing environment, intensified the pressures toward digitalization. Consumer tastes are evolving, and technological innovation and adoption are speeding up, placing enormous pressure on businesses to keep up with the Fourth Industrial Revolution.
Why is digitalization important within the Private Equity Industry?
Traditionally, digital technologies have been adopted because there was an inherent desire to make lives easier and more efficient. Like any firm, the private equity industry strives towards efficiency and can benefit from integrating digital technologies into its operations.
In 2018, KPMG conducted a survey to identify the areas where private equity firms would benefit from digitalization. Unsurprisingly, all divisions of the P.E. companies will gain, with the back office reaping the most important benefits.
Firstly, technology can enable P.E. firms to manage and analyze data more effectively. In order to aid in investment decision-making, P.E. firms have to analyze huge amounts of data. Traditionally, this would include analyzing companies’ balance sheets and profit and loss statements, which could take longer periods of time, consequently making data irrelevant very rapidly. As stated by an industry specialist, the advantages of treating data faster are significant:
“I think it really comes down to having data available in a timely manner. Think about private equity in the past; investors would wait six months to get information. I think the reason technology is so important is because it improves efficiency, accuracy and dependability of data sharing.” - Jill Calton, Executive Director, Alternative Investments, UMB Fund Services.
Consequently, allowing more data to be accessed faster could revolutionizing deal assessment and sourcing. The use of deep learning, Artificial Intelligence, and algorithms can help general partners make informed decisions about the potential deals by sorting through unprecedented amounts of data within a matter of minutes. Each opportunity could be evaluated much more reliably by increasing the breadth of understanding of each potential deal and analyzing its strengths and weaknesses at the origination and due diligence, but also within the deal execution and valuation stages. In fact, combining this technology with already existing data can be vital in assessing the health, return and future expected returns of investments, which in turn would help general partners to model risk and the most effective strategies.
Actually, such technologies have already been adopted by many P.E. firms. The use of AI-based tools has already helped managers evaluate hundreds of potential funds and portfolios, facilitating the process because of the sheer amount of data involved. As such, 90% of P.E. firms expect Artificial Intelligence to have a fundamental impact on the industry, according to an Intertrust Survey. The usage of Data Analytics has also proved to be an advantageous tool when dealing with time-sensitive reporting information, building analytics platforms that aid investment decision-making, and fund structuring in terms of taxes, governance, and compliance.
Furthermore, in recent years, with increasing competition within the industry, margins have been steadily declining, putting more and more pressure on firms to lower fees while increasing transparency and operational efficiencies. Having technologies that can improve productivity by sorting through vast amounts of data can help firms achieve lower costs as less time is spent on data gathering and analysis, but it also increases transparency, as investors can be given better insights into the process. For example, the use of Blockchain technology can get rid of the manual, time-consuming task of record maintenance by enabling employees to collaborate on a “distributed ledger to maintain legal and contractual agreements and record transaction-related information”, decrease costs and increase transparency and security.
The relationship side of private equity is a key component of successful firms. Thus, through the use of data visualization tools and social platforms, P.E. firms can leverage technology to aid them in creating and maintaining relationships with investors. For example, interactive dashboards that compile data to be viewed in a singular panel can aid both buyers and sellers to review key metrics efficiently. Social platforms can help link investors and P.E. firms and thus enhance deal sourcing and decrease management fees.
A further opportunity that comes from digitalization is the opening of communication channels to investors. Sending customizable reports and providing models and analytics to investors gives them access to information they are seeking when investing in companies. Through the use of digital technologies, such communications can be standardized to increase transparency, credibility, and reach while lowering costs.
These technologies have already been the focus of many companies in 2016. A survey by PwC shows that increasingly more P.E. firms have been paying attention to them as they can be seen as tools for value creation and growth.
As outlined in the report “Digitalization - The revolution transforming Private Equity” by PwC:
"P.E. houses have to embrace (digitalization) and the sooner they do, the quicker they will reduce holding periods and increase returns, while also reducing risks. On the contrary, if they don’t, they risk losing to the competition.”
How is technological adoption within the Private Equity Industry?
Private equity has always been and remains unfalteringly conservative and relationship-ship driven industry. As stated by Ernst & Young Global Private Equity Leader Andres Saenz, "The informal conversations are irreplaceable. (…) You have to schedule the informal to sustain relationships." There is resistance to change within the industry, not from a technological standpoint but from a cultural or mentality standpoint. As a result, the rapid speed of technological innovation has caught many private equity firms off guard. Consequently, the pandemic had the greatest effect on companies that were not digitizing.
Many PE firms have arguably been prioritizing digitalization for some time, but the pandemic has made it a vital component of the industry. Surveys conducted by price. Waterhouse Coopers showed that in 2016, 30% of U.K. firms have already assessed digitally transforming their organization or the portfolio of companies they were holding and a further 45% were in the process of doing so.
However, a survey conducted two years later by KPMG showed that although most firms were in the awareness-raising phase in their digital innovation journey, a meagre 17% were in the implementation phase. In addition, the lowest implementations were in the most significant parts, such as Blockchain, Robo-advisors, and cognitive computer and machine learning.
The covid-19 pandemic has undeniably hastened the transition to a more digitalized private equity sector. The shift to video conferences when communicating with investors and the remote working environment has pressured companies to make digital a top priority. Many private equity firms have been seen implementing new strategies by appointing dedicated leaders whose only focus is digital innovation.
Nevertheless, staying relationship-driven industry consistently, there is still much more to do with respect to digitalization and perhaps with new leadership; as more millennials reach senior-level management positions, technological integration is likely to intensify.
What are the risks that come from the increased digitization?
With every opportunity comes a threat - digitalization does not come without its own set of drawbacks, challenges and uncertainties. Cybersecurity has been a primary concern for many industries, but private equity firms that deal with large amounts of capital and are often involved with third parties have a much more prominent exposure to such attacks.
To begin, historically, private equity firms did not hold cybersecurity as a major concern. Previously, when deals were being made, the main focus was on deal performance and reputational risks, while the risk of cyber-attacks was effectively judged to be very low. Nonetheless, this has changed with the introduction of the E.U. General Data Protection Regulation (GDPR) and the California Consumer Privacy Act (CCPA), as a response to the potential scale of the impacts of a data breach within large organizations.
Secondly, the nature of the industry is such that P.E. firms are increasingly becoming targets of sophisticated cyberattacks. Large volumes of capital as well, as the frequency and volume of transactions, exposes these firms to attackers in such a way that might go overlooked or undetected for significant periods of time. In fact, when P.E. firms do acknowledge such risks, they often prioritize strengthening protection in their portfolio companies rather than their own.
Finally, the pandemic’s pressure on digitalization and the shift to working remotely have both increased firms’ exposure to risk. As more people work from home, protecting sensitive information and securing system access to employees becomes crucial. Moreover, with the growing use of devices outside offices, confidential information, intellectual property, or other sensitive information handling becomes significantly riskier. Internet security may be less stringent at home or while using the public internet; devices are easily lost or stolen, which may result in a breach of sensitive information such as intellectual property, trade secrets, or private data.
Like any industry in the 21st century, digitalization plays a crucial role in the private equity industry and brings about many opportunities and challenges. Accelerated by the pandemic, new technology adoption has been a priority for many P.E. firms in the last five years. Unfortunately, many have failed to respond as quickly as they should have and are now forced to adjust to a rapidly changing environment that is becoming the new normal.
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