Barry Duncan

The Growing Importance of IT Due Diligence – The Empirical Strikes Back!

“Every company is a technology company”

Its oft been said and was first professed by Peter Sondergaard, Senior Vice President of Research at Gartner during the firm’s Symposium keynote address in 2013. We completely agree with that perception and, with few exceptions, those companies that don’t recognise that shift are missing opportunities to take advantage of the growing wealth of technology for them to be efficient, faster growing, risk protected and commercially profitable.

When we first wrote on the subject of private equity investors’ growing appetite for technology-first companies in How Technology Saw UK Private Equity Through The Worst Of Covid in the third quarter of 2021, we estimated that over a quarter of UK buyouts in 2020, had successfully classified themselves as technology businesses. That made perfect sense for both investors and for portfolio companies during a year severely impacted by the latest pandemic. More than a year on, global management consultancy, Bain & Co reported that over 1,300 global investments into technology classified companies accounted for 31% of all private equity buyout activity in the extraordinary growth story that was 2021. Just to put that into perspective, Bain estimates that over $840 billion was invested into the technology-first sector in 2021. That was up from just £260 billion in 2011, a 27% annual growth rate and 3.3 times the value invested five years before.

Hence the “empirical” movie reference. Private equity investment activity has moderated to more normal levels in the first quarter of 2022 but, like it or not, all the evidence points to the attractive qualities of technology-first companies and the rationale for all other companies to describe themselves as a “technology company”. At the very least, it can mean a higher valuation for those businesses that manage to successfully persuade investors of their technological infrastructure and competency. At best, a technology first approach, whether a true technology company or not, makes for a better performing and better risk-protected business model.

As we stated in 2021, for private equity investors “Comprehensive IT due diligence work does not just help mitigate risk and address inevitable gaps in value perception between buyers and sellers. It also affords opportunity for private equity investors to identify additional levers to help drive new portfolio company growth beyond 100-day value enhancement plans. That early insight can also provide an edge during due diligence, negotiation and manoeuvring with competitor investors. If your IT due diligence provides better insight into the potential for the application of technology to further improve the performance of any prospect, that can allow for a deal-winning value assessment.”

Bain’s Global Private Equity Report 2022 also reports the unprecedented growth in the asset classes’ uninvested capital, or “dry powder”. In 2021, this stood at an astonishing $3.4 trillion, of which the firm estimates $1 trillion is allocated to buyout investing. In May, Private equity information provider Pitchbook neatly reported how just eight global buyout houses added $120 billion to that total in 2021 and that, in all likelihood, Carlyle and KKR will add at least another $45 billion this year upon fund closings. Levels of dry powder of this magnitude are often portrayed as a concern for judicious private equity investing but, in fact, the industry is remarkably consistent and creative in how it sources investment opportunities and puts such volumes of limited partners’ capital commitments to work. That capital will mostly be invested, but that’s not to say the arena is an open and even playing field. The number of private equity firms continues to grow and the investment arena is consequently more competitive.

Whether this year or over the following three to four years, the inevitable increase in deal activity will mean greater competition between private equity houses for the most attractive investments, as they battle to put that mountain of dry powder to work. That will mean more due diligence, both for those transaction opportunities that fall away, as well as those deals getting across the finishing line to completion.

In our last article we wrote that for some private equity firms there remained a reluctance to go to the trouble of IT due diligence, or at least it could almost be an afterthought. That’s somewhat surprising given that as far back as 2011 research carried out by McKinsey & Co estimated  that more than half the synergies to be gained from completed M&A transactions was dependent upon successful integration of IT services.

As Financier Worldwide wrote earlier this year, “IT due diligence should examine the foundations of value in a target company to provide a better view of the prospects in a potential deal, as well as possible risks that could undermine it.” At Panamoure, we have been fortunate enough to observe a gradual increase in recognition of the value of IT due diligence from our private equity clients. But what a difference a year makes. Our own, admittedly anecdotal evidence, tells us that relative ambivalence with respect to IT due diligence has changed somewhat. Panamoure’s IT due diligence work with private equity clients increased more than 150% over the course of 2021. This year we’re pleased to see more clients recognising the importance and advantages of rapid IT due diligence and increasingly recognising the advantages of a consistent and repeatable arrangement, where each and every investment opportunity receives at least an initial IT “health check”. That is often followed by either a more comprehensive due diligence or sometimes a more comprehensive, complimentary digital transformation. That process enables investments to achieve their full growth potential and full value creation to the benefit of private equity investors, their limited partners and portfolio company management.

If you are one of those private equity investors that have been more reluctant to employ IT due diligence or are one of those looking for a more regular and predictable IT due diligence process, we’d encourage you to get in touch. We’d welcome the opportunity to share some of our client stories and to expand on the advantages we have observed in the course of our work with other private equity clients.

Similarly, if you are a private business considering a change of ownership with a private equity growth partner, or simply looking to become operationally efficient, then likewise please get in touch. The UK market is fast becoming more competitive and unforgiving of companies with only limited digital capabilities.

With so much capital to invest, many in the private equity investment community are viewing the UK as a rich seam of potential investment opportunity and particularly as a source of struggling companies at reduced valuations. Without the efficiency imparted by a fit-for-purpose digital business model, your company will not attain the best possible valuation during any ownership change transaction. A City AM article , citing audit and tax firm Mazars, estimated that £1.8 billion was invested into distressed UK assets in 2021. That was over 2.5 times the amount invested in 2020 and they confidently predicted this would increase given prospect of an increasingly hostile market environment that seems entirely likely for many companies to operate within. We would rather not see you sell at a lower-than-necessary valuation, nor become a distressed target, of which we are sure there are going to be a growing number into the second half of 2022 and beyond.

In this report, you can expect to find how our standard IT due diligence process, and more progressive version, can help private equity investors and their potential portfolio companies weather through what looks like another extended period of economic headwinds.

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We are pleased to announce the launch of a ninth pillar in our IT Due Diligence process, which identifies and generates value creation opportunities for private equity (PE) investors. This new pillar is designed to uncover additional levers for growth and drive both immediate 100-day plans and long-term digital value creation initiatives.  

The private equity (PE) landscape has seen better days. M&A activity is down, and exits have plummeted to their lowest point in over a decade, dropping 66% from their peak in 2021. High interest rates have made refinancing debt structures from as far back as 2019 increasingly expensive. As a result, exits are becoming more protracted, and many buyout funds are struggling to offload portfolio companies amid an uncertain environment that negatively impacts valuations. Now more than ever, there is a pressing need to maximise the value of existing portfolios.