Private Equity Funds as Drivers of Digitalization in Medium-sized Enterprises in Europe

Covid-19 has clarified one thing: the use of digital technologies is no longer only an option for companies – digital tools and business models have become key elements in the viability and sustainability of firms in the future. Business models and shopping patterns of customers are changing fast, and companies frequently are unable to keep pace with this change and to initiate the correct digital change processes for their long-term survival.

Experience with Covid-19 has turned a stronger technological orientation and digital normality into “a new reality”, leading world-wide to a kind of “forced digitalization” across industries and markets. This trend is not new. It was merely intensified by the global pandemic. There has been a drastic change in consumption and shopping habits: According to a study by Facebook, eighty percent of customers now prefer online-shopping with shipping to the home and consider this option a faster, cheaper, and more comfortable alternative to “traditional shopping”. Forty percent of customers are ready to change to new brands if their “old favorites” are not available online. Fifty percent of customers (and this aplies to B2B as well as B2C customers) are planning to retain their changed habits vis-à-vis digital business models and to accept them as integral part of the “new reality”.

This development is of great importance to business, as it points to sustained “tectonic shifts”. It underlines the importance of the course of the digital transformation and the redesign of business models towards “digital first”, also – and maybe especially – for traditional family firms.

It would be grossly negligent to ignore an increasing digital adaption and the use of information technology and data-based strategies. According to a recent analysis of the Swiss bank UBS, one-digit medium-term growth is expected for production and process automation. In contrast, the UBS forecast is for twelve percent annual growth for the field of robotics, seven percent for industrial software and even two-digit growth for the “new markets”. According to the same study, internet penetration will reach about 85 percent of the world population by 2030, consumers will spend 70 percent of their media time digitally, e-commerce will grow by 15 percent annually over the coming ten years, Fintech will show an annual growth rate of 10.5 percent between 2018 and 2030 and the volume of data in the “digital universe” will increase tenfold by 2030.

This “new reality” is arriving at a time, in which a second, publicly less visible “tectonic shift” is taking place: the global, inter-generational succession of owners of family businesses. According to Forbes, during the coming twenty years the glob- al economy will experience the largest transfer of wealth and property that has ever occurred. Coping with the “new reality”, while at the same time managing the generational succession at ownership and board levels, will become a decisive challenge for the long-term survival and success of family-controlled firms. If managed well, the generational change will offer immense opportunities. If missed, it will be at an enormous risk – probably the greatest single external risk facing family firms and their operational assets today. Family-owned firms, which are well prepared for succession and digitalization at the management and board levels, will wisely use the inflow of stimulus capital and allocate it to promising digital initiatives. In contrast, those who lack digital competency, will make poor investments, and misallocate family capital and miss out on the opportunities offered by the “new reality” and will become victims of it.

Digital competence of the stewardship will make all the difference

In view of these tectonic shifts, modern and digitally competent stewardship will make the difference. It is typically the board that represents the long-term ownership perspective. To safeguard the survival of the firm, the digital transformation process must be started today, and its consistent implementation must be ensured. For the digital transformation to be successful in the long run, owners, managers and boards, above all, must function as pioneers and must be – or become – true digital experts. In most cases, supervisory boards of family firms lack expertise in this area.

This is confirmed by recent analyses:

?“Only 16 percent of all board members of the 150 biggest family firms have proven digital expertise.”

?84 percent of all board members of the 150 biggest family firms in Germany have no digital expertise at all. For this finding, 975 curricula vitae of board members were analyzed (2021) according to three criteria:

?■?????????Management or board experience in the digital transformation of a comparable company (hypothesis: The person who codesigns the digital transformation of a comparable company has a profound understanding for the required change processes).

■?????????Entrepreneurship (hypothesis: the person also has practical experience as an entrepreneur and brings to bear the entrepreneurial spirit).

■?????????Digital experience and data-based customer orientation (hypothesis: The person has a basic technical understanding as well as profound expertise in the use of information and communication technologies. In addition, knowledge concerning digital trends, change in customer shopping patterns and its effect on value chains).

This leads to the central question: Who is to initiate and control the necessary transformation of the business model?

Private Equity Funds as drivers of digitalization in German medium-sized enterprises (Mittelstand)

Based on the experience of more than 700 realized digital projects of financial investors in the past ten years, the OMMAX team learned in numerous cases that digitalization is one of the core value drivers for the equity story of companies. Private Equity Funds realized this need early on, and meanwhile there are highly specialized funds in Europe that focus on the digitalization, i.e., on the digital value enhancement of companies. For the in the past five years, we found strong optimism in corresponding investors, which is reflected in higher business valuations in acquisitions, as well as in an active participation in further developing the business model during the holding period.

PE funds are meanwhile also asking for a digital due diligence within the regular due diligence, to evaluate the related value-added potential at the start of the investment cycle.

?Based on their cross-industry experience, Private Equity Funds have recognized faster than other businesses the value-added potential of digitalization and the risks of not investing consistently and quickly in digital value-added programs. We at OMMAX always present the digital aspect very clearly in our M&A transactions, and it is a core component of the commercial due diligence. Some Private Equity Funds set up their own digital teams to implement the value-added programs in the portfolio with us. In this dynamic environment the investors digitalize their dedicated DNA and pass this on to their portfolio companies. In this way, investors are becoming pioneers who can impart a decisive impetus to the tradition based Mittelstand.

Investors are showing a high inclination to invest in digitalization – limiting factors are not money, but the speed and development of digital talent in the organization.

?How to approach digital processes in businesses?

?Whenever we are not active within an M&A transaction, we start with a digital maturity analysis, focused on the company, the market, and the competitors. On this basis we develop a digital value-added program including business case and milestones and start immediate implementation. Digital competition does not permit losing time.

The implementation focuses on the various areas of the company and is based on proven digitalization concepts (like digitalization of value added, products, distribution channels, data use and analysis, processes, as well as the development of a digital organization). Based on our self-developed database with more than 100 million data points from transactions and implementation advice, we can take data-based decisions and determine exactly the maturity and development potential of a business. In this our thinking is not short-term, but in investment cycles and holding periods.

Since we do not advise our clients only in strategic terms, but also support the implementation of the programs “from a single source” together with our internal expert teams, we can quickly react to new trends and adapt the strategies. Our approach: Not building castles in the air, but developing reliable, sustainable, and implementable solutions that can show initial success within three to six months. Meanwhile we are supporting some clients in the third ownership generation, with all OMMAX teams impacting significantly in the success stories, whether in the areas of transaction advisory, digital strategy, or digital execution.

A to-do list for the digitalization process

The OMMAX framework provides executives, who manage such complex transformation projects, with re-platforming a complex solution landscape of competing priorities and pressures, a way to assess approaches to growth and identify the capabilities needed to follow through.

As companies consider driving their growth strategies efficiently, they need to be clear about building the capabilities (experienced internal and external teams) and practices that will help them move with greater speed and precision.

?We have developed a 3-step framework which can help:

1. Planning: Define where the value of the business lies and design the digital roadmap for the next three years.
2. Developing: Conceptualize pilot projects and create MVPs.
3. Implementing: Transforming and capturing the potential digital value.

Summary

Private Equity Funds are driving digitalization – especially in the Mittelstand. In this endeavor their financial input is important; more important, however, is an intrinsically motivated digital DNA at the corresponding PE. Digitalization, accelerated by Covid-19, and the tectonic shifts within family-owned firms by global, inter-generational succession plans, sets the priority of safeguarding over time the competitiveness of companies by way of digital transformation processes.

The ever faster turning digital wheel makes two aspects indispensable: Speed, as digital competition does not permit any hesitation, and sustained commitment. Progressing digitalization is not a short-lived trend but will have to be on the agenda of every company in various manifestations and variations in the long-term. Neglecting today to digitalize the company’s DNA and either ignoring the digital transformation or failing to understand it as an intrinsic structural question, will mean not having any prospects in the future.

Many Private Equity Funds have realized this and have digital valuations ever more frequently included as an important factor in due diligence reports. The questions raised are mostly about the data infrastructure, technical scaling potentials, digital lead and customer acquisition with attractive CACs and ROI as well as digital organization. If they recognize gaps and still decide to invest, they usually push a digital roadmap after acquisition. Due to their often digitally characterized mindset, cross-industry experience and expertise, willingness to invest in digital infrastructure, they have become important drivers of digitalization.

The full article will be available at the Financial Year Book 2022 under the link www.fyb.de.

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