The Impact of Technology on Private Equity
By Greg Lindae
Posted: 10th April 2018 08:51“Software is eating the world” (M. Andreessen) and “AI is the new electricity” (A. Ng) are two phrases that indicate the seismic impact technology is having on traditional business models in general and on the Private Equity (PE) industry specifically. A PE investor’s return performance and risk exposure in a portfolio of investees is directly impacted by technology disruption. This phenomenon is occurring at an exponential rate on a global scale.
In general, larger and less nimble businesses are more fragile to this rapid change. The organisational momentum and legacy mindset of a large companies is the Achilles’ heel in their adaptive capabilities to weather rapid change and continue to thrive.
Private Equity often invests in larger companies driven by more traditional business models. Innovation in technology over the past 50 years has largely followed Moore’s Law in terms of rate of change, performance in relation to price (2x every 1.5 years over the past 60 years). The impact of this technology on business models has increased considerably in the past 10 years. For example, the birth of social media arrived on the back of digital connectivity and through social media, the dematerialised form of a multi-sided platform model, evolved into a hugely scalable sticky business strategy, (FB, LinkedIn, and many others).
The speed at which these innovative business models, (enabled by technology), are disrupting incumbents as well as creating entirely new markets is accelerating. Although the concept of disruption is not new, the rate of disruptive change from business models enabled by technology follows a similar power function to that of Moore’s Law. The landscape of disrupted incumbent businesses from digitised new entrants is littered with examples, from Blockbuster/Netflix in 2010 to the present with Walmart/Amazon or Waze/Navteq, (Iridium, Kodak, Polaroid, Philco, Nokia are other examples of obsolete models due to digitisation enabled competition). In 2011, Babson’s Olin School of Business predicted that in 10 years, 40% of existing Fortune 500 Companies would cease to exist. Richard Foster, Yale University, estimates that the average lifespan of SP 500 companies has decreased from 67 years in the 1920s to 15 years today. Private Equity investors typically hold investments from five to seven years, this is sufficient time for a company’s business model to become obsolete.
In order for Private Equity industry to adapt proactively to this backdrop of accelerating change without transforming into a venture capitalist, investors must be not only more tech savvy but perhaps more importantly understand and project with some accuracy the impact of technology on business models in different industries. Following the trend away from financial engineering in LBOs towards an emphasis on operating partners, PE firms need to take it a step further into coaching their investees on how to harness technology towards realising competitive strategies. PE firms are starting to focus more attention of Chief Information Officers than of Chief Operating Offices as companies become increasingly dematerialised and digitised. The use of data, not just its collection is key to putting in place proper feedback systems in dashboards and feeding algorithms that enable a business to respond quickly to change. Once an industry becomes information enabled and powered by information flows its financial performance has the potential to approximate a power law. An example is Tangerine (formerly ING Direct Canada) uses IT to create superior performance compared to its retail banking peer with seven-times more customers per employee and five-times more deposits per customer.
Private Equity investors need to focus on how IT enabled strategy can create greater and more scalable financial performance and shareholder value creation. This is increasingly the case in developed economies but is also starting to occur in emerging markets where business model copy-cat new entrants can be found, and a lack of legacy inertia allows for leap frog innovation on the back of technology infrastructure like 5G access’s impact of mobile computing. GSMA estimates that by 2025 China will represent 40% of global 5G connections.
This is not to say that traditional Mid-Market Growth Equity or Buyout/LBO investing in traditional businesses will not be a profitable strategy in the short to medium term but the opportunity set and threat landscape is shifting rapidly and PE investing needs to carefully consider the impact of technology and resulting new business models more than ever before. The difficulty with a power function is that in the beginning the curve is behind/below a linear function, when expectations are followed by disappointment, however, over time the power function curve overtakes the linear rate of change and far exceeds expectations, catching society, companies, and investors by surprise. AI is a perfect example of this singularity, as it has been around since the 1960s and basically failed to meet expectations for close to 50 years, but in the last five years it has become ubiquitous in many industries, first in advertising and retail and now it is found in many business intelligence applications where predictive analytics are required from Pharma to Logistics. It has permeated industries beyond what many expected and its impact on business models is dramatic. Many investors were frankly caught by surprise by its impact.
The competitive advantage from early adaptors was critical to companies like Netflix, and in many cases new business models – in particular platform models – are in a winner take all market, (LinkedIn), with accompanying economic profits. In the end PE investors need to assist their portfolio companies not in setting up defences against digitisation but to guide them forward in seeing digitisation as an opportunity, taking an offensive posture not a defensive posture. Technology is both a threat and an opportunity not just to industry but to PE professionals as well.
Investment industry expert Greg Lindae has more than 20 years in service. Over the course of his career, he has built an impressive CV and track record in venture capital and private equity markets, working with companies like BlackRock, Salomon Brothers, and FMO. He also launched investment companies Castlerock Capital Ventures, LLC and Sapient Asset Advisors, LLC, based in San Francisco, California. At present, he holds a senior management position focusing on Eastern Europe and Asia at The Dutch Entrepreneurial Development Bank.
Greg can be contacted on +31 70 314 9622 or by email at G.Lindae@fmo.nl