Digital Transformation in Mergers & Acquisitions and PE-Backed Companies

In our recent Transformation Ground Control podcast, we tackled a crucial topic that often doesn’t get enough attention in the world of digital transformations: mergers and acquisitions (M&A) in private equity-backed firms. While we frequently discuss digital transformations, ERP implementations, and best practices, this conversation delved into the unique challenges and nuances that M&A and private equity bring to the table.

Joining me in this episode was Deric Selchow , Managing Director at West Monroe Partners, who shared his valuable insights on this topic. I summarize our discussion below, but you can also watch the full podcast interview here:

Understanding the Current M&A Landscape

Deric began by highlighting some current trends in the M&A space, particularly within private equity (PE). The 2023 environment was unique due to higher interest rates, the pandemic's lingering effects, and various global events. Private equity activity cooled down slightly, pushing PE firms to focus on special cases such as distressed assets, underperforming businesses, and "tuck-ins" to existing portfolio companies to create something greater than the sum of their parts.

The M&A landscape in 2024 is witnessing an uptick in specific sectors like residential services, domestic manufacturing, and food and beverage. Interestingly, there’s also a surge in "carve-outs," where a part of a business is sold off, often involving untangling complex operations and technology landscapes.

Digital Transformations in M&A and Private Equity: What's Different?

When it comes to digital transformations in M&A environments, they are often guided by the investment thesis of the private equity firm. This thesis lays the groundwork for understanding the "why" behind pursuing a digital transformation. Unlike standard implementations, transformations in M&A situations are driven by a need to create value and enhance efficiency. Simply implementing new technology "because it's the right thing to do" isn't enough. It must align with the overarching strategy to maximize the acquired asset's potential.

Another key difference in PE-backed digital transformations is the emphasis on timelines. Derek stressed that time is of the essence in PE environments. There’s usually a set hold period, during which a private equity firm must implement significant changes and improvements to increase the company’s value. As a result, PE firms are less interested in "perpetual implementations" and instead focus on delivering a minimum viable product (MVP) and optimizing down the road.

How Digital Transformations Look in M&A Scenarios

In M&A scenarios, digital transformation strategies must address specific challenges. For example, in carve-out situations—where a company separates a business unit and sells it off—untangling complex systems like ERP can be a daunting task. The original parent company might have embedded the business unit's operations into a larger, interconnected system, such as SAP S/4HANA. Derek noted that determining how to "untangle" and "unwind" those systems while setting up the new standalone entity is often a significant challenge.

Another consideration is how transformations are affected by the intended exit strategy of the PE firm. For instance, if the goal is to sell the company to a strategic buyer who may use a different technology, the PE firm may hesitate to invest in a top-tier ERP system. Instead, they might opt for a more middle-of-the-road solution to avoid "gold-plating" their technology investments unnecessarily.

Private Equity Firms' Unique Approach to Digital Transformation

PE firms approach digital transformation with a different mindset compared to other companies. The key difference often lies in risk tolerance and strategic focus. PE-backed firms tend to shy away from moonshots and bleeding-edge technologies, opting for more established, reliable solutions. They want to leverage technology to create immediate value without becoming entangled in long-term, costly projects. This approach is driven by the firm’s need to sell or scale the company within a relatively short time frame, often three to five years.

Furthermore, private equity firms view digital transformation as an enabler for value creation. This emphasis on ROI and measurable benefits often drives the choice of technology, processes, and implementation strategies. In contrast, strategic buyers, which are established corporations, might already have a set of technologies and processes in place that they fold the acquired company into.

Assessing Digital Maturity in M&A Due Diligence

One of the critical aspects of digital transformation in the M&A space is the assessment of digital maturity and readiness during due diligence. According to Deric, his team looks at a range of factors, including CRM systems, ERP systems, operational technologies, and even the company’s cyber infrastructure.

They also evaluate the company’s human resources to identify potential gaps in staffing, areas of overstaffing, and the possibility of transitioning to managed services. This assessment provides a baseline that informs future strategies. For example, if the due diligence report reveals an outdated ERP system, that may become a priority for post-acquisition digital transformation.

Walking the management team through the due diligence report is another essential step. This practice helps build an understanding of where the company stands in terms of digital maturity and readiness for change, facilitating alignment on strategic objectives.

Strategies for a Successful Digital Transformation in PE-backed Firms

Digital transformation success in a PE-backed or M&A environment hinges on several factors. One of the most crucial is aligning with the investment thesis—the “why” behind the acquisition. When the transformation strategy is tied to the thesis, it ensures that every technological decision supports the end goal of value creation.

Here are a few key strategies that differentiate PE-backed transformations:

1. Strict Timeline Management

Time is a vital asset in the PE world. Most PE firms operate on a tight hold period during which they need to realize their value creation goals. As a result, they focus on projects that can be executed within a specific timeframe. This requires a disciplined project management approach to keep scope creep at bay. Often, the approach involves delivering an MVP and planning for further optimization phases later.

2. Leveraging the Investment Thesis

The investment thesis serves as the guiding star throughout the transformation process. Every decision, from the choice of technology to process redesign, should support this thesis. For example, if the thesis revolves around scaling the business, the technology chosen should facilitate this scaling without introducing unnecessary complexity or risk.

3. Focus on Post-Acquisition Value

Ensuring seamless digital transformation post-acquisition is all about unlocking value and driving growth. This is done by setting measurable KPIs to track progress. A vital part of this process involves aligning the company’s leadership and employees with the transformation’s objectives, ensuring they understand how these changes will create value.

4. Change Management

The human aspect of transformation can’t be overlooked. Whether it's a founder-led company resistant to change or a company undergoing its third private equity cycle, change management plays a critical role. Derek emphasized the importance of including employees, especially those with institutional knowledge, in the transformation process. This helps address concerns and provides them a sense of ownership in the project.

Technologies That Fit PE-backed Companies

When selecting technologies for PE-backed companies, firms typically avoid experimental or cutting-edge solutions. Instead, they look for tried-and-true technologies that can quickly provide value. The chosen technology should also be flexible enough to adapt to future changes, such as additional tuck-in acquisitions or further carve-outs.

An important trend in recent years has been the embrace of cloud computing. Initially, many companies resisted moving to the cloud due to concerns about data security. However, this mindset has shifted as businesses recognize the benefits of cloud infrastructure in terms of cost, flexibility, and maintenance.

Artificial Intelligence (AI) is another tool gaining traction, especially in uncovering insights in data that might not be immediately apparent to the human eye. However, companies remain cautious, viewing AI as an augmentation to human capabilities rather than a replacement.

First Steps for PE-backed Companies Embarking on Digital Transformation

For PE-backed companies starting their digital transformation journey, Deric advises revisiting the due diligence report to identify initial areas of focus. It’s essential to reconfirm the original assumptions that guided the acquisition and ensure that the management team is aligned with the strategic objectives.

Walking through the advisory report with the management team can be a valuable exercise. This not only helps identify risks and opportunities but also sets the stage for a collaborative approach to the transformation process.

Final Thoughts: A Playbook for All Companies

While this discussion has centered on PE-backed and M&A scenarios, many of the principles and strategies outlined here can apply to companies outside the private equity space. Approaching digital transformation with a focus on value creation, aligning with a strategic thesis, and adopting a disciplined approach to scope and timelines can benefit any organization.

Thinking like a private equity-backed firm forces companies to be efficient, measured, and strategic in their digital initiatives. It encourages organizations to avoid falling into the trap of implementing technology for its own sake and instead focus on how technology can enable business value, drive growth, and support long-term objectives.

For more on this topic, be sure to download our ERP Due Diligence Guide for Private Equity. This provides a detailed playbook for PE-backed firms and M&A integration teams to manage their digital transformation initiatives.