When private equity (PE) firms buy a company, they typically follow a standard playbook to create value—streamlining operations, restructuring debt, changing management, and cutting costs. However, as digital technologies and artificial intelligence allow companies to drive productivity and innovation, PE firms are discovering new sources of value creation, new research shows. Moreover, the PE industry itself has become more competitive as the number of PE firms grows, prompting firms to explore a new way of boosting the success of portfolio companies by investing in digital technologies.
“There are many more private equity firms than in the past, so it’s becoming difficult for them to generate returns and add value,” says Brian Baik, an assistant professor in the Accounting and Management Unit at Harvard Business School. “Investing in cutting-edge technologies could make their [portfolio] firms more efficient.”
“The growing success of digital transformation over the past decade has allowed PE firms to develop newer approaches to value creation. Digital technologies allow PE portfolio companies to gain both from top-line growth as well as improved efficiency and productivity,” added Suraj Srinivasan, the Philip J. Stomberg Professor of Business Administration at Harvard Business School.
“Pursuing a digital strategy is an especially valuable source of differentiated value creation by PE funds.”
Yet digital investments can be costly, which can be a tough sell for PE firms intent on trimming expenses. So is the investment worth it? Baik and Srinivasan explore this tension in their working paper, “Private Equity and Digital Transformation,” cowritten with Wilbur Chen of the Hong Kong University of Science and Technology. The researchers are affiliated with the Digital Value Lab at the Digital Data and Design Institute at Harvard.
The researchers found that PE investors often turn to digital transformation strategies and technology to help revamp portfolio firms, and this investment often accelerates their assets’ growth. “Pursuing a digital strategy is an especially valuable source of differentiated value creation by PE funds,” says Srinivasan. “Smaller and mid-sized businesses have limited expertise to pursue a digital transformation strategy. On the other hand, their size and sophistication give PE funds the ability to support a digital transformation strategy. PE funds can offer digital strategies, investment, and talent to their portfolio companies that the individual companies cannot access by themselves.”
Why invest in digital technology?
The researchers set out to discover whether PE firms are indeed investing in digital transformation to create value—and more importantly, whether such investments have paid off.
Digital investments can be as simple as moving manual processes online. “You might move to cloud storage instead of having data in a very large file cabinet,” Baik says.
More advanced techniques include incorporating artificial intelligence (AI) and data analytics into an organization’s day-to-day operations to streamline workflows and gain data-driven insights to improve the business.
“At this time, PE firms are finding that there’s a lot of low-hanging fruit in terms of digital value creation, especially in smaller and mid-sized companies.”
“Investing in those technologies would make portfolio companies better able to utilize the data they collect from customers and stakeholders, so they could make better business decisions.”
In all of these cases, such technology upgrades could lead to efficiencies that ultimately lift profits, Baik says. At the same time, they often require substantial investments in software, training, and perhaps subscriptions to digital platforms. “Some firms may choose not to invest in these technologies because it’s just too costly, even if it may bring some additional benefits down the road,” he says.
“At this time, PE firms are finding that there’s a lot of low-hanging fruit in terms of digital value creation, especially in smaller and mid-sized companies. PE firms bring in digitally savvy operating partners who can help their portfolio companies adopt digital technologies more efficiently,” says Srinivasan. “The challenge, however, is in implementing newer technologies in organizations with legacy systems.”
More PE firms see the value in digital technologies
To explore whether firms were turning to technology, the researchers studied some 35,000 PE transactions between 2010 and 2021 that were compiled by Capital IQ. The research team matched those transactions to financial data supplied by Dun & Bradstreet, as well as information on IT spending provided by Aberdeen Strategy & Research. Finally, they matched firms with data on job postings for AI-related positions listed by a labor research organization, Burning Glass Technologies.
“These findings collectively indicate that there is an association between increased digital investments after private equity investment.”
Crunching the numbers from these sources confirmed the researchers’ suspicions that PE firms are indeed investing in digital transformation. In fact, portfolio companies receiving PE investment saw an average 14 percent increase in their IT budgets, along with a nearly 4 percent increase in the number of AI-related job postings.
“These findings collectively indicate that there is an association between increased digital investments after private equity investment,” Baik says.
Reaping the rewards of technology
PE firms were more likely to invest in a portfolio company’s technology if:
- The portfolio company had previously limited its digital investment, since these companies would likely see the biggest benefit.
- Investors planned to grow the firm, rather than sell it quickly. Investors may be more willing to wait the time it takes for digital transformation to bear fruit.
- The PE firm already owned technology companies or had leaders who served on the boards of information technology companies. This was especially true for non-technology holdings.
“Investors who have more exposure in IT-related technology are more likely to be the ones driving the business results we are finding,” Baik concludes.
The value of digital investments
Do such investments actually add value? To answer that question, the researchers compared the performance of companies that had undergone some level of digital transformation with those that didn’t. They found that:
- Expanding IT budgets increased hiring by 11 percent and sales by 9 percent.
- Adding AI jobs increased hiring by nearly 8 percent and sales by 7 percent.
Moreover, the team found that improving digital technology increased innovation; companies that received more technology investment held more new patents afterward.
“If there are firms that haven’t been interested in this route in the past, maybe it’s time for them to take a look and see if there are opportunities for these investments,” Baik says.
Summarizing the takeaways from the study, Srinivasan says, “The top-line revenue growth finding is very interesting in that it shows the mechanism for value creation. I was surprised to find the growth in patenting activity, since traditionally PE investing has not been associated with greater innovation. Taken as a whole, the findings show that PE firms can use digital transformation as a viable means of increasing the value of their portfolio companies.”
Owners of target companies should consider asking PE investors about their interest in digital opportunities as they weigh whether to sell. As generative AI and other new technologies emerge, that question may become increasingly relevant to success, the researchers say.
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Image: Illustration created using image generated by Midjourney, an artificial intelligence tool
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