The finance industry is not immune from the digital disruption we have witnessed over the past few years. As restaurants replace cashiers with kiosks, financial advisors face off against computer algorithms and even taxi drivers — already dealing with the ubiquity of Uber — now envisioning a future that promises self-driving cars, lenders are beginning to grapple with this brave new world.
Ten years ago, few of us in the lending business imagined we’d be competing against peer-to-peer platforms that could automate underwriting. For those intent on survival, the question will soon become how to pay for it all.
Eventually, the investment in digital technology will pay for itself through some combination of new customer growth, client retention or new efficiencies. However, these initiatives require considerable upfront investments that precede the ongoing recurring costs required to maintain and build upon digital strategies.
According to a recent Ernst & Young survey of more than 600 non-technology corporate executives, nearly 65% anticipate that as much as one-tenth of their total capital budget will be allocated to digital initiatives over the next three years. More than 33% projected it could even be higher.
In an effort to pursue digital transformation, many companies will likely turn to one of three possible solutions:
- Buy digital capabilities through acquisitions, usually requiring a series of deals that are part of a larger acquisition strategy.
- Build the capabilities themselves, organically.
- Sell the company or a stake of the business to a private equity firm that can fund and help orchestrate such a transformation.
Each option comes with its own considerations and challenges.
While acquiring a way toward digitalization goals seems to be the simplest alternative, these deals can differ dramatically from more traditional acquisition transactions.
For instance, just as due diligence tends to be more difficult for vertical transactions, acquisitions of digital assets can bring several new considerations. Scalability and customer-acquisition costs are perhaps most critical, but buyers will also want to understand the IP being acquired and the state of the code that supports the target.
As digital assets are typically more expensive than conventional acquisitions, how these transactions are financed can also make or break the deal. All-cash purchases, for instance, often leave buyers susceptible to overvalued goodwill. Beyond tapping into the debt markets, many buyers will also incorporate mechanisms such as earnouts into the transactions to de-risk the investment.
When luxury retailer Nordstrom acquired digital retailers Hautelook and Trunk Club, it negotiated sizeable deferred payments dependent upon reaching certain milestones. Given Nordstrom’s $197 million write down on Trunk Club earlier this year, these types of safeguards can look canny in hindsight.
Whenever a company reaches a certain scale, just about every initiative of significance hinges on the question: to buy or to build? In the middle market, particularly for founder-owned businesses, most executives will choose to build the necessary capabilities organically. Having funded several companies that have undergone digital transformations, I have several observations.
Business leaders who don’t have digital backgrounds will often underestimate the time required to put comprehensive, enterprise-wide digital initiatives in place. Many also overlook the potential ripple effects that can spread across the business during the rollout and after the initiative is complete.
Panera Bread, for instance, first began testing its kiosk and mobile-ordering platform in 2012, but it took another three to four years to roll these advances out completely. While some media billed the effort as replacing workers with machines, in reality Panera had to add back-of-house staff and re-engineer certain operations in order to keep up with digital order flow. Five years later, digital orders now account for more than a quarter of total sales.
The complexity of digital transformation demands domain expertise. As part of the underwriting process to capitalize these efforts, it’s also important to make sure that the company has the right team in place, or at least a plan to recruit the right team. A company can possess the best intellectual property or patent portfolios and still fail if it doesn’t have capable managers to set a vision and execute upon it.
Lenders will, of course, zero in on the ways a digital transformation will alter a company’s balance sheet and cash flow statements. The initial investment in technology often takes far longer than most executives anticipate and creates new recurring annual costs. The reason digital companies tend to fetch higher valuations is because they should be growing at a faster clip. But lenders are also very cognizant of what can happen with too much leverage. Top-line growth should be directed toward reinvesting in the platform to continually reinforce the technology backbone, not paying down excessive debt.
The decision to sell the company can be one of the harder choices for business owners. Given the alternative of obsolescence, however, more companies are teaming up with financial buyers that can bring both equity and strategic oversight to develop a digitalization plan. Beyond the capital infusion, private equity will also traditionally bring in advisors or consultant resources that can help executives create strategic roadmaps.
When Apollo Global Management acquired ADT, for instance, the company was already in the midst of an initiative to raise its profile in the connected, smart-home market. Consolidating ADT with Protection 1 and ASG Security — two of Apollo’s existing portfolio companies — allowed the combined business to leverage the initial digital investment better. Roughly a year after the $7 billion ADT deal, Apollo began prepping an IPO for the company that could be valued as high as $15 billion. Of course, not all deals are successful so quickly, but it reflects the role financial buyers can play.
Entrepreneurs don’t necessarily have to give up full control. A number of growth-oriented private equity firms have emerged in recent years that aren’t pursuing highly leveraged buyouts, per se, but seek to pair equity with smaller debt facilities to fund specific initiatives. This option allows companies to maintain flexibility in their capital structure, which can be critical during periods of transition.
Beyond activating digital initiatives, private equity is also keen to back the disrupters or companies that can help other legacy businesses facilitate the needed change. Ironically, these companies will become attractive acquisition targets for larger strategic buyers looking to build out their own digital capabilities.
AdTheorent, for example, is a digital advertising company that uses big data and machine learning to help advertisers identify the audiences most likely to engage with a given digital advertisement. The company also has an SaaS offering that helps brands understand their advertising ROI across all channels. H.I.G. Growth Partners recently invested in the company, a deal that included a senior credit facility and equity co-investment from Monroe Capital that will go toward ongoing investments in resources and technology. It’s the type of transaction in which management leverages both the resources and expertise of a financial sponsor.
Whether borrowers are funding acquisitions or looking to build out digital capabilities organically, the key is to create a capital structure that can account for the unknown unknowns. Every sector is effectively going digital. For those in transition, patient and flexible capital has more pronounced importance today than ever before to ensure management teams can see these efforts through, regardless of market conditions.