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Old Dogs, Not-so-new Tricks: A Catch-22 for Private Equity Portfolio Companies

The conversation started pleasantly enough with discussion about stable, risk-managed growth, careful operational controls, market analysis, future targets, engaging customers, and so on. And then things got ugly. (Not really, but they may as well have.)

The discussion shifted to “operationalizing” these predictable ideas when the assembled executives began describing investments in personnel, infrastructure systems, process improvements, and some product-market fit and marketing ideas. I must’ve been failing at my poker face when one of the executives asked me, “what do you think?”

Realizing my facial expression was contorted, I relaxed. In reality I was thinking: None of this will work. They’re not making any changes to how they operate. It’s all old-school — very old school — and worse, it’s nothing better than more of the ‘more of the same’ that worked to get them this far, but wouldn’t get them any further. They need to join the rest of us in the 21st century. Their world is about to get rocked by some upstart that simply does better with digital technology than they do, and by the time they realize what’s happening it’ll be way.too.late.

Despite being paid to bring up ideas they might not think of themselves, I knew better than to blurt that out. Nonetheless, what I said instead was the first shovelful of dirt out of the ditch I was digging myself into, “I was just putting some thought into what the enterprise architecture would need to be to make all these great ideas happen.”

Exec: “What do you mean?”
Me: (to myself) Oh sh!t!

The problem wasn’t that I didn’t have an answer, the problem was that things were worse than I thought. They didn’t know what I meant by “enterprise architecture.” Which — not coincidentally — also meant they didn’t know they were about to be blindsided by a completely different way of looking at the world now, in the year 20-bzillion — in digital years. These people were still thinking in the same terms they learned in b-school and experience in the digital stone age of 1987 or something.

“Well,” I started, rapidly assembling words to make them look as good as possible, “I assumed that you would be carrying out these strategies digitally. That the changes and investments you’re discussing would all be focused on creating and operating from a digital platform that integrates the customer-facing sides of the company with the inwardly facing parts of the company. You know, to improve efficiencies, customer experience, and reach more people.”

Apparently, that was not what they were thinking.
Nor was I surprised. At this point I had been expecting this “confrontation” of sorts.

The fact is, companies in this scenario are far from alone. These sorts of revelations are happening in boardrooms all over the world. They’re especially prevalent in industries and businesses that can be characterized as “safe” or “mature.” Exactly the attributes of traditional private equity (PE) portfolio companies.

To stay competitive, PE portfolio companies are finding that even stable, mature businesses — despite their relative size or youth — are not immune from having to look at a complete revamp of everything that got them to where they are. But the PE parent firms are hardly in a position to guide their portfolio companies along a digital transformation if they are also stuck in their own digital stone age.

Why? Because solutions follow capabilities. Companies that don’t have capabilities can’t create solutions using them. Traditional remedies for value creation are no longer sufficient. What’s worked thus far will abruptly will stop working (if it hasn’t already). The digital competition is often too small to register on market radars until it’s too late and the upstarts blow a hole in the side of a PE firm’s mature hull.

Exponential technology applications are disrupting mature industries attractive to PE in the past. It’s not just AI and automation. The fundamentals of these industries are changing. Technologies are enabling capital-efficient “digitally native” business models that decouple assets and people from the transactions that leverage them. The very nature of modern firms is changing; rapidly building a global businesses with a handful of people. Instagram was acquired for $1B with just 13 employees.

From a strictly market vs. operations perspective, companies experiencing margin erosion (or growth impediments) are not keeping up with some change in the market. A nerdier way of saying it is that they’ve optimized their business for something the market no longer values or responds to (except to punish the company with higher costs or lower sales).

Companies in the crosshairs of the conundrum are in the PE sweet spot. Interestingly, Ernst & Young’s 2018 Global Private Equity Survey found that “19% of [private equity] CFOs said their firms have neutralized margin erosion by strategically cutting expenses and growing topline revenue.” And the digital investments they’re making are heavily in management reporting/portfolio analysis, and valuation technology.

Despite this, PE firms themselves “find implementing technology very difficult…” and “[t]he most challenging systems…include…fund accounting [and] …management reporting.” Their own core competencies.

When I read this, I see PE firms using old-school methods to improve performance, rather than truly becoming more digital. Sounds familiar. We also see that they’re looking at speeding up and optimizing their own financial operations and it’s not really working. Investing in systems that have little or nothing to do with customer engagement, adding market share, or product-market fit — which are often their portfolio companies’ usual challenges.

Put bluntly, PE portfolio companies are in a Catch-22. They are PE portfolio companies precisely because they’re “old dogs.” But not only are the “new tricks” already “old tricks” for competitors, the PE firms guiding them are playing catch-up on the same issues. With the current growth boom in PE firms, as reported in the Wall Street Journal, this was going to become an even bigger problem — faster.

In reality, no markets are safe. Digital age companies have already disrupted previously believed “safe” industries such as lodging, work space, and transportation leaving legacy companies scrambling to identify new value streams.

My experience in the boardroom that day was captured perfectly in the opening to the 2017 e-book by the Post Lean Institute, Post-Lean Thinking: A New Vision for Corporate Innovation, in which they wrote, “The technology disruption we see everywhere today is remaking our world … at a faster pace than today’s organizations are equipped to deal with. Humanity is transitioning to a post-industrial civilization, but our management thinking is still shaped by assumptions that go all the way back to the Bronze Age.”

Hope is far from lost. “Safe” firms have a depth of assets their more digital competitors would kill to have. Mature companies can leverage the fruits of their stability and maturity: data and existing customers. This is how the digital upstarts are succeeding against established firms. And, it’s how PE firms (and portfolio) can fortify their positions and beat these upstarts at their own game.

There’s no technological reason by PE firms and their portfolios can’t leverage data, connect with customers, and decouple capital from operations. The decoupling part may not be an immediate option, but data science and customer relationships have enabled significant leaps in business models and competitive advantages that PE firms and their portfolio companies are in excellent positions to embrace.

PE firms can help their portfolio companies dive into the wealth of data about themselves and their customers to analyse, learn, and take action. This takes a digital platform and an integrated enterprise architecture. Once in place, this data becomes a seemingly endless pot of gold.

PE firms and the companies in their portfolios are well-positioned to make transformative investments in their digital ecosystem to leverage their existing data and access to customers to become digital platforms from which to operate. Failing to make these transformations keeps many doors wide open for highly nimble, more digitally immersed competitors to pad over and eat from their bowl.