Boosting Technology Due Diligence Effectiveness for Private Equity Investments

2021 was a record year for Private Equity (PE) with deal volume surpassing trillion dollar for the first time. This is almost double the amount from year before. Technology company or a non-technology company supported by a tech enabled business model remains the top sector of choice among majority of PE firms.?

Value creation has always been foremost in securing higher returns in every private equity investment. For technology or tech enabled companies, the value creation approach extends beyond EBITDA improvement through cost cutting measures. During every such investment, the PE firm examines the potential of value creation in terms of a revenue growth supported by a scalable digital strategy; data-driven growth capabilities supported by advanced analytics; cost transformation driven by reduction of technical complexity/debt; and operational efficiencies through better IT sourcing arrangements. The ability to accelerate these value creation goals in the immediate period post close will be crucial for unlocking value from the investments.

For technology companies or companies whose business model is supported by tech, PE firms should be armed with an innovative due diligence process that validates the investment thesis through digital lens. Typical commercial and financial due diligence might not be adequate to make informed investment and risk decisions. To find the true value, PE firms needs to generate deeper technical insights about the potential investment. Along with commercial and financial due diligence, a perspective on technology is required in the diligence phase. The output of technology diligence should be tied to the commercial and financial diligences to provide a meaningful analysis of the target company.

Revamping technology due diligence to maximize pre-deal insights and identify post-deal value creation opportunities

The traditional approach of tick the box to ensure that no massive technology red flag exists is no longer sufficient to support the deal thesis. Such tick the box approach provides a limited vision to PE firms towards deal analysis and post-deal value creation. Technology due diligence should help validate how technology is aligned to support the delivery of core business operations, as well as how it will help drive the future growth in terms of both top-line revenue expansion and bottom-line cost savings opportunities. Along with identifying technology red flags which will help in pre-deal decisions/valuation adjustments, it should also identify immediate and long-term improvement opportunities of the target company towards value creation.

The tech due diligence needs to provide the following outputs in alignment with financial and commercial diligence to evaluate the risk profile and value proposition of the target:

1.??????Technology red flags

2.??????Technology levers towards enabling revenue growth

3.??????Technology levers towards operational efficiencies

1.??????Technology red flags: Conduct a full technology stack assessment to highlight red flags by focusing mostly on historic factors such as IT architecture complexity, security, code quality, IT team expertise and IT cost.

?2.??????Technology levers towards enabling revenue growth: Focus on doing an assessment of the target digital capabilities to support revenue upliftment through sales and marketing optimization such as:

2a.??????Revenue growth supported by a scalable digital strategy - The existence of a digital strategy to maintain a competitive edge among peers that should be scalable and aligned with the overall business strategy of the target company.

2b.?????Data-driven growth capabilities supported by advanced analytics – The presence of analytics capabilities towards leveraging data for better decision making and providing insights to the management in areas such as sales, pricing, and manufacturing effectiveness.

?3.??????Technology levers towards operational efficiencies: IT operational efficiencies is not always associated with cost cutting measures. It generally equates to identify opportunities towards long term cost efficiencies such as:

3a.??????Reduction of technical complexity/debt – To remove technical challenges and fasten future value realization, the focus should be on technology standardization and platformization opportunities through implementing open architecture supported by a standardized set of technology capabilities.

3b.?????Operational efficiencies through better IT sourcing arrangements - Reduction of IT supplier cost through optimized sourcing arrangements among portfolio companies.

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Case Study

Technology Due Diligence on a fintech insurance provider (Target) to assess the investment rationale

1.??????Scenario: The PE firm wanted to validate the deal thesis by assessing the effectiveness of the current technology landscape to support future growth and profitability as projected by the Target.

2.??????Impact:

2a.??????Developed future IT cost projections to support the growth in gross written premium (GWP). The derived IT cost as percentage of GWP was higher than Target’s internal projection. The PE firm adjusted the pre-deal valuation of the target to accommodate for the higher future IT cost as percentage of GWP. ?

2b.??????Suggested replacement of the current on-premise Policy Admin System (PAS) with an Software-as-a-Service (SaaS) solution to meet the scalability needs of supporting 5X growth projections to support the deal thesis.

2c.??????Identified IT cost optimization levers in terms in terms of replacing the current data warehouse system and datacenters with cloud-based solutions towards post-deal value creation opportunities to support better exit valuation.

Conclusion

Technology due diligence for PE should evolve from traditional risk assessment exercise to an innovative approach of identifying value creation levers during the due diligence phase itself. Along with providing a perspective on the risks and challenges of the target company, it should also focus on validating how technology can support the deal rationale. The output of technology diligence should support the overall commercial and financial diligence in identifying valuation adjustment during the pre-deal phase and potential value creation opportunities to improve the post deal exit valuation.

Please note these are my own personal views and not necessarily those of my employer