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PE 4.0 – How can Financial Sponsors shape tomorrow’s Value Creation?A perspective on current potential and challenges in the context of digitalization and Industry 4.0

2 | PE 4.0 – How can Financial Sponsors shape tomorrow’s Value Creation?

Contents

3 Introduction

5 Highlights

6 2017 – Where do we stand?

15 What challenges lie ahead?

23 How can digital value creation be put into action?

24 1. Value Chain Optimization

25 2. Product/Service Enhancement

26 3. Business Model Transformation

27 a. Stand-alone

27 b. Buy-and-build

27 c. Restructuring

31 Contacts

3PE 4.0 – How can Financial Sponsors shape tomorrow’s Value Creation? |

Dr. Dierk BussPartner

Global PE fundraising has grown over the past years to reach pre-financial crisis level. Rising acquisition multiples reflect the increasing competition for targets and sellers’ price expectations. Focusing on new value creation levers is therefore key to achieving profitability targets, but traditional value creation levers such as financial engineering, cost optimization, and revenue growth may have reached a ceiling and may prove to be insufficient.

Today’s day and age marks the dawn of the “4th industrial revolution”, which denotes the capability of digital and networked technologies to increase efficiency throughout the entire value chain, to enhance products and services and to develop new business models that fundamentally disrupt industries. We expect the strides that have been made in the B2C segment to now begin affecting B2B as pertains to industrial production and engineering and all other related industries.

Digitalization offers an upside to value creation. This is particularly relevant for the majority of German medium-sized companies (Mittelstand) and hidden champions, which together form the backbone of the German economy and can use this to their advantage to transform their business models, meet the demands of the new digital age and derive new value. However, digitalization also presents a challenge to companies that fail to identify new value creation opportunities. These companies could be outperformed or commoditized by new entrants or successful adopters.

To understand the challenges of digitalization and Industry 4.0 in the PE world, we analyzed transaction data in the relevant domains and interviewed executives from PE firms, banks and associations with the aim of learning more about their views on the matter. Our findings point out the benefits of pursuing an approach targeting digital value creation in PE.

We believe that digitalization constitutes a significant value creation lever for financial sponsors, drives cost competitiveness and improves revenue by way of new products and services. But it requires strategic direction, boldness and a touch of creativity to reap these rewards. Like the affected companies and industries, PE firms will be called on to develop their own digital expertise in order to remain at the cutting edge of the game. The development of digital value creation strategies and the presentation of the first compelling cases will be required in the next step moving forward.

Introduction

Michael Kunz Partner

Christian BurmeisterSenior Manager



Highlights

►The M&A market has grown significantly in recent years, which can be seen in the rising deal count, volumes and multiples. Traditional value creation levers such as financial engineering, cost optimization and revenue growth may reach a ceiling and prove to be insufficient. Focusing on new value creation and digital transformation will therefore be key to deriving new value and achieving profitability targets.

►Digitalization is disrupting industries and serves as a key lever for supporting PE business cases. Digital technologies offer optimization potential along the entire value chain, for product/service enhancements and for new business models.

►Comparing Industry 4.0 domains, German and European M&A activity has a relatively strong foothold in traditional industries (engineering/machine building and production), while American and Chinese investors are driving new technology domains such as IT and high-tech. Moreover, a comparison of inbound/outbound balances of deal counts in the German market exemplifies the attractiveness of German targets for foreign investors and reveals a trend toward giving up key technology and profit pools too soon.

►Financial sponsors face five key challenges related to investing in digitalization and Industry 4.0:

• Digitalization is an entirely new value lever and still requires further development.• The full potential of digital value levers cannot always be quantified yet.• The rapid development of the digital ecosystem could put investments at risk.• PE are refinancing their investments – Digital investments are less bankable thus far.• Digital transformation needs to be synchronized with the investment horizon.

►Digital value creation levers follow different logic and require new approaches to accommodate the PE framework conditions such as risk acceptance and time horizons. Stand alone investments, buy-and-build and restructuring are key digital investment strategies that offer potential along the entire Industry 4.0 technology stack.

►Some PE firms have started to focus on digital value creation, introduce appropriate fund structures and build value creation teams. Others are expected to follow suit and establish a dominant focus in this field.

►We suggest the following three-step plan of action as a method of approaching digital value creation in PE:

• Build digital expertise and define a focused digital value creation strategy.• Drive value chain optimization projects based on clear business case logic.• Prepare ground for transformations by introducing new methods and experienced value creation teams.


2017 – Where do we stand?

The PE market has grown significantly in recent years

…in light of the volume of capital (Figure 1) and dry powder (Figure 2) on the market, the expectations for returns from alternative investments as well as the increasing competition among the funds for appropriate targets. This is also reflected by strong deal activity and rising acquisition multiples (Figure 3). Over the same period, Weighted Average Exit Multiples (Figure 4) and IRRs (Figure 5) have tapered off and remained constant at levels far below the pre-financial crisis levels. While fear of potential overheating and a downturn, compounded by early signs of a possible change in interest policies, have begun to spread, aggressive bidders are currently still driving transactions.

PE firms will need to utilize value creation levers to a greater extent than before in order to deliver value and achieve profitability targets.

Figure 1 – Global PE fundraising activity (in $bn)

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Figure 2 – PE buyout funds - Dry powder by region ($bn)

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Figure 3 – Global average acquisition multiples EV/EBITDA

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Figure 4 – Global Weighted Average Exit Multiples (WAEM) by exit year, all PE exists

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Source: EY Exit StudyTotal exits in year Exits excluding creditor exits

Figure 5 – Pooled global IRR by exit year, all PE exits

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016e 2017e

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Source: EY Exit Study


Digitalization is transforming industries and constitutes a key value lever to support business cases

Over the past decade, several industries have experienced the impact of digitalization (Figure 6), which targeted and reduced inefficiencies in industry value chains and produced new offers and business models. What started in the B2C domains (“platformization,” channel digitalization, etc.) is now coming to B2B, where connecting intelligent machines and products to an “Internet of Things” is expected to result in a disruptive industry shift.

Improved access to information gives rise to better transparency and manageability of value chains. Connectivity reduces system breaks and transaction costs. Digital structures allow for scalability and the establishment of network effects.

Figure 6 – Digital industry maturity


Early stage Next-in-line In process Digital pioneers

• Chemicals and pharmaceuticals

• Basic goods• Healthcare• Construction

• Public sector

• Automotive• Manufacturing and

engineering• Financial services• Wholesale• Utilities• Agriculture

• Information and communication technology

• Media• Hospitality• Retail

Digital maturity

Typical industry developments

• Integrated ERP systems• Separate systems with

many interfaces• Customer and agent

portals• Paperless processing• Traditional business

models

• Advanced ERP and MES systems

• Emerging digital platforms• IoT, big data analyses and

predictive analytics• Mobile apps and digital

channels• Many start-ups and

corporate initiatives

• End-to-end digitalization and automation

• Digital platforms settled• Advanced technologies

(e.g., Blockchain, artificial intelligence and machine learning, etc.)

• New business models established on the market

Source: EY


It predominantly means that intelligence will shift up the technology stack (Figure 7) from the hardware to the software level and the generation of profits will ensue. Software applications are increasingly serving as the interface to the customer and are also bridging intermediate value chain positions (B2B2C). Having this under control is key. Owners of hardware or process knowledge may use this to scale their capabilities through digital structures, but will face a new type of competition and commoditization risk in the opposite direction from software and service developers and particularly platform business models. Thus, digitalization offers significant potential for value-add but also a significant risk of value erosion.

Figure 7 – Targets and potential along the Industry 4.0 technology stack


In order to grow these enabling technologies and/or to add them as strategic capabilities, we would expect to see M&A activity in the IT (software, services) and high-tech (hardware and components) sectors. Engineering, machine building and production companies offer value potential by way of digitalization and could therefore serve as attractive targets for financial investors as well.

Industry 4.0 technology stack

Services

Potential targets RiskValue

potential

• Software designers/programmers• Data analysts• Consultants

Applications • Software houses (e.g., MES, data analytics, CAD, CAM, etc.)

Platforms and databases• IoT platforms• Mass data bases• Cybersecurity

Networks • Network hardware • Network operators

Sensors & controllers• Component and sensor manufacturers• Controllers and interfaces• System providers

Machines/production systems • Machine manufacturers• Automators

Products • Producers of goods

Dat

a flo

w

Con

trol

Val

ue-a

dd

MES = Manufacturing execution system, CAD/M = Computer-aided design/manufacturing


We analyzed historical M&A transaction data in the relevant Industry 4.0 domains, i.e., IT (software and services), high-tech (hardware and components), engineering/machine building (incl. automation) and industrial production. We then aggregated the deal counts over the past three years (H2/2014 H1/2017) by the announced date and clustered the deals by the acquirers’ countries.

The data reveal different regional patterns of M&A activity (Figure 8). First, strategic investors appear to be driving M&A in Industry 4.0 domains, thereby securing new technologies and joining digital capabilities. Second, while German and European investors show the highest activity in traditional sectors (engineering/machine building and production), the US and China show the highest activity in IT and substantially higher deal counts in high-tech, which is an indication of their leading role in these domains (see also Figure 9). This becomes even more evident when solely looking at PE.

German and European M&A activity is largely centered around traditional sectors

Figure 8 – 3yrs (H2/2014-H1/2017) aggregated deal count by acquiring country – Corporate and PE


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Note: Shifts between regions may occur due to the location of the acquiring fund or holding

Deal count (#)



The strong American and Chinese involvement in new technology domains is undoubtedly related to spillovers from higher venture capital investing and risk acceptance. It further solidifies their experience and leadership positions in these domains. However, European and German activity also shows a steady increase in deals here in recent years.

Figure 9 – Development of relative shares of deal counts in I4.0 domains by acquiring region

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IT High-tech Engineering/machine building Production Source: EY analysis of mergermarket data

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A comparison of inbound/outbound deal flows (Figure 10) reveals a significant overbalance of inbound deals to Germany in all Industry 4.0 domains from almost all countries. The US and American PE funds in particular are investing in IT but also in German engineering and production targets, which reflects the attractiveness and value creation potential in German targets. Foreign strategic investors are longing to complement their know-how and reshape domestic industrial structures. Chinese buyers, for instance, target companies to support industrial automation and renewal. In the fast-moving IT and high-tech domains, M&A could serve as a more powerful strategy to keep pace with developments for the buyers. For the targets, this could also be an upside for the companies as they can use the capital and expertise to enter new markets and transform their businesses. However, this development also reflects a trend of selling key technology and profit pools to foreign acquirers where domestic capital could also be invested to drive value creation in digital and traditional businesses.

Figure 10 – Inbound/outbound deal count balance to/from Germany by acquiring/target country (sum of last three years H2/2014-H1/2017)

Outbound investments from

Germany to X

Inbound investments from

X to Germany

Despite extensive experience in new technologies in the US, lower price sensitivity on the Chinese side, and different economic structures in Germany with many family-owned SMEs and a tradition of organic growth, the data indicates that German investors are more hesitant to invest in new technology targets.

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To understand PEs’ challenges in investing in digitalization and Industry 4.0, we held discussions with 20 Germany-based executives from small to large cap PE firms, leveraged finance specialists from banks and experts from industry associations. Five key challenges were identified.


What challenges lie ahead?

Knowledge mainly resides in traditional value creation levers. Involving different domains such as engineering and IT, digitalization combines different levers and previously independent capabilities, which gives rise to the addition of significant complexity. Most interviewees indicate that more specialized and more technical experience is required to understand the interplay of analogue and digital worlds and their rapidly developing ecosystems.

Digital technologies offer new potential along the value chain and through new business models but also require investments to integrate them in existing infrastructure.

Digitalization is a new value lever and still needs to be fully developed

Interesting cost savings potential is available along the value chain and can be achieved especially by applying big data analysis of machine data, digital simulations and automation. In addition, new targets and new business models will arise along the technology stack to provide these technologies and offer new services.

One challenge is that you need to integrate capabilities in existing machinery and IT systems. To do so, you need to elevate many targets to Industry 3.0 standards first and then join capabilities in engineering and IT domains to go further.

This is an indication that existing OT (operational technology) and IT systems as well as the organization need to be thoroughly analyzed in order to determine the baseline and investment needs to achieve the potential offered by Industry 4.0. As the topic is still evolving, we are just starting to develop a track record of proven benchmarks and business cases for digital applications.

Right now we are looking at straightforward digital initiatives such as channel digitalization and warehouse automation but not specifically at end-to-end transformations that would support enhanced business models.

We are very experienced in our business and target industries and have established routines in place on how to approach investment cases. Digital levers, however, combine several areas of knowledge and add new facets which need to be understood well first especially when making the investment decision.

(PE executive, small cap)


(PE executive, mid cap)




As of now, investment cases are mainly based on traditional value levers. Better visibility over financial benefits would be required to properly incorporate digital potential.

Even though most PE firms have started to look at digital value levers, they are often regarded as having high level upside potential but are not always factored in as hard figures that drive investment cases.

The full potential of digital value levers cannot always be quantified yet

We check digital potential and substitution risks during due diligence reviews. However, it is extremely difficult to factor them in as specific potential in our investment cases, as the measures remain abstract and complex.

Wherever possible, we try to factor digitalization measures into the equation, but digital value levers work differently than traditional ones. Experience and KPIs in this area, especially from example cases, are still scarce.

The aforementioned lack of a track record of many digital applications in the industry seems to be the main reason why potential is still treated with caution. The views offered by experts from associations are more critical in this respect:

Digital technologies offer many more value levers than are currently addressed. PE firms should be more creative to win against corporate investors (with their large transformation programs) and startups (with new business model ideas).

Even though digitalization has begun to transform industries and is having a severe impact on established companies, large parts of the German economy have still been performing extremely well in recent years and do not see the need for investing heavily in future technologies.

It’s a bit like a frog sitting comfortably in a cooker that is slowly heating up. Once the frog realizes what’s going on, it will be too late. This describes the German industry as well as our situation at private equity firms.

(PE executive, large cap)


(expert from M&A association)




Digital technologies are on the rise and first Industry 4.0 pilot cases have been presented but the ecosystem is (still) developing rapidly.

The rapid development of the digital ecosystem could put investments at risk

Digital technologies and products or services are evolving quickly and have shorter lifecycles than in traditional industries. It is difficult to keep track of technologies and players in the market.

Start-ups and corporates that develop new technologies and new business models are a major threat. We check for these risks in due diligence reviews but markets change quickly.

As ecosystems and digital technologies develop, companies may increase digital capabilities or accumulate an investment backlog that can pose a significant risk to acquirers.

Technology changes required us to invest an additional €20m to renew a legacy system that did not allow for the addition of important new capabilities.

A key challenge now will be to combine insights from commercial, operational and IT due diligence reviews to identify upsides but also risks related to the installed base and digital capabilities.

Thus, digitalization offers not only upside potential but also significant downsides stemming from external market and technology dynamics, which are increasing in speed and intensity, as well as targets’ digital readiness and investment backlogs. Target companies have therefore begun outlining digital strategies but this has not always been at a satisfactory level.

It is certainly improving but about half of the targets we look at, usually the smaller ones, have not fully analyzed threats in their environment and do not have a solid digital strategy. The majority of them remain at a high level with many buzzwords and are not executable.

Some digital cases build on technology that is unfinished or new markets which are difficult to grasp. We do invest in new business models but even the slightest venture risk is a showstopper.

(PE executive, small-mid cap)



(expert from M&A association)




Even though many PE firms are still hesitant to proactively drive digital value creation, especially when targets’ strategies and business cases are not clear, there are some market players that have dared to take this step.


Some funds, on the other hand, attempt to mitigate these shortcomings with targeted approaches.

It is our responsibility to bring the knowledge to the targets. We have a digital value creation team in place and complement it with specialized external consultants to outline strategies and drive forward these projects. If a company’s management has only limited digital expertise, we are happy to provide the best available expert for support.

We have launched a specialized venture fund to complement traditional investment vehicles (and bear these risks). The initial projects have been carried out very successfully.

PE investors usually invest in businesses with positive cash flows. These cash flows should be used in some cases, especially in extremely good economic conditions as we have today, to develop the businesses further and to invest in new technologies. This also allows ecosystems to be shaped actively to one’s advantage and attacking is the best strategy for defense.

While some PE firms have developed fund structures and teams to actively engage in digital projects, not all PE firms have thus far managed to define specific digital value creation strategies. In most cases, potential is identified in an opportunistic manner.

We invest very opportunistically. If we recognize any potential for value creation, whether it is traditional or digital, we will certainly look into it. But we do not have a concrete focus.

We focus on potential along the value chain, capitalize on it whenever possible and add complementary assets. But this is more on a case-by-case approach than pursuing a concrete strategy.

At this time, we do not yet have a concrete digital strategy in place. We find that realizing digital potential requires considerably more insight and urges us to define a solid strategy including setting up a team that is experienced in digital topics.



(expert from industry association)






PE investments require solid business cases to fulfill requirements set by fund structures and debt providers. However, certain headroom exists for focused and well-prepared digital initiatives.

PE investors usually refinance their investments and need to safeguard against covenant breaches as well as fulfill their LPs’ expectations. Digital strategies are seen as risky since the benefits still cannot be fully quantified and transformations can be costly and time consuming. Fund mandates sometimes do not allow for significant risk increase and investments in digital areas.

PE firms are refinancing their investments – Digital investments are less bankable thus far

Our LPs would not tolerate long dips in their returns. We have some headroom in our debt case but it does not allow for major transformations.

Our fund mandate is rather restrictive and does not allow us to take major risks. The value levers would need to be clear in advance.

Even though we have a very broad mandate, we need to assure that value levers can be realized and cannot stem extensive transformation risks if the plan is not 100% clear.

Banks are usually looking for downside protection but their restrictions are potentially not as strong as perceived:

We would actually be excited to see more digital cases and would also be happy to fund them if the strategy was solid and the levers along the value chain were strong. The more expertise that is involved, the better it becomes. Entire transformations are more difficult to finance due to the complexity and risk. But debt cases allow more headroom than is currently exploited by the funds.

Of course, we are rather conservative and first of all look at the current business model together with the current management. However, we are well aware that new technologies offer new possibilities. Digital process optimizations would be the first step. If the PE firm can prove it understands the market well and has a strong concept in place, it would be possible to approach transformations, ideally in small steps.




(leveraged finance specialist from a European bank)

(leveraged finance specialist from a European bank)



Overall, digital value creation comes with some inevitable peculiarities that affect all PE firms and can pose a challenge to the ways they currently approach value creation. Some companies have already introduced new methods to drive digital initiatives.

Digital value creation initiatives follow different logic than traditional operational optimization measures. Apart from the quantification of the benefits, challenges are mainly about implementation risks as well as the potentially long-time horizon of digital optimization and transformation.

Digital transformation needs to be synchronized with the investment horizon

Digital strategies are not sufficiently clear yet. Some value chain potential may be planned in advance but business model enhancements or transformations are not at all foreseeable.

We plan for three to five years and need to be finished by then. We are setting a clearly defined value creation agenda. There is little time for experimentation on large digital projects. Business model transformations cannot be completed in that amount of time.

Some funds, however, have developed ways to work around the timeframe and mitigate risks:

Digital potential can often be realized relatively quickly compared to changes of physical assets. Even if we cannot fully complete a transformation upon exit, the asset is fit and healthy by then.

We experiment with some business model innovations and then start the implementation for success cases. Even though the transitions are usually far from finished, we manage to present clear upside potential, which supports our equity story. It is a bit like a startup/venture approach but works out very well.

To powerfully drive digital initiatives and especially transformations, you need an experienced team or partner with very good consultants who take the lead.







How can digital value creation be put into action?

Digital value creation can be divided into three distinct value levers

… namely 1. value chain optimization, 2. product or service enhancement, and 3. business model transformation. Each of these is associated with different foci, risks, and benefits. These levers are backed by three private equity investment strategies, a) stand-alone investments, b) buy & build, and c) restructuring.

Figure 11 – Overview of digital value levers and investment strategies

Digital value levers

Value chain optimization

Product/service enhancement

Business model transformation

Dig

ital

inve

stm

ent

stra

tegi

es

• Optimizing value creating structures with a focus on all processes and their interfaces

• Rearranging, automating, integrating processes with the aid of digital technologies, e.g., I4.0 platforms, MES software, big data analyses, internet services, etc.

• Focus on clear business case logic

• Complementing products and services with digital technologies

• Adding network capabilities, interfaces, software, and services for enhanced use value and user experience

• Focus on value added for the client and differentiation advantage

• Changing business logic to better serve clients and enter or create new markets

• Change from product to service business, hardware-to-software, platform business models, etc.

• Focus on market growth/reach, more effective ways of value creation and capture

Potential

Risk

Stand-alone

Buy-and-build

Restructuring

Elevate single asset to digital leader

Build digital ecosystem, combine analogue and digital assets

Restructure analogue latecomers

a

b

c

1 2 3



1Value Chain Optimization

Digitalization measures and associated investments can largely be planned along the value chain and they offer benefits related to established KPIs such as material and labor cost (efficiency increase and input reduction), equipment efficiency (cycle time, downtime prevention and better utilization/alignment), batch size optimization, quality improvement and efficiency of support processes. New technologies like Industry 4.0 platforms (solving the biggest challenges of interfaces, mass data handling and secure data transfer), readiness kits (providing connectivity for older equipment as well) and production software are on the rise and already available. The first cases, mostly from corporate pioneers, indicate potential (Figure 12):

Figure 12 – Digital value chain optimization potential

Measures implemented in example cases

Cycle time –25–30%

+10–20%

–25–75%

+40–60%

1

–30–50%

–10–20%

–10–50%

–10–30%

–15%

–25–50%

OEE

Set-up time

On-time-delivery

Lot size

Labor cost

Material cost

Scrap rate

Quality cost

Energy cost

Parts design

KPI Benchmark potential1

• Integration/automation of production line ranging from CAM, ERP and MES systems

• Virtual production planning, simulation and testing with digital twins• Better process alignment through automated production planning (MES)• Implementation of predictive models and alignment of maintenance cycles

to prevent downtime• Online monitoring and control of production lines

• Automation through better sensors, smoother production processes through design• Replacement of human interfaces through networked production

• Identification of problem areas based on production data analysis• Automated material layout• Real-time detection of quality deviations and rework or early rejection

• Detection of leakages and demand planning through smart energy management• Alignment and automatic regulation of machines (automatic standby)

• Automation of labor-intense 3D design, 2D construction plans and NC programming• Introduction of co-creation through online interfaces and configurators

Sources: EY analysis of past project cases, Plattform Industry 4.0, IIC, several online case studies

Note 1: Depending on industry and initial situation

MES = Manufacturing execution system, CAD/M = Computer-aided design/manufacturing, ERP = Enterprise resource planning, NC = Numerical control



2Digitally enhanced products and services are a must in today’s business world and they help to create differentiation momentum by increasing use value and reducing associated costs for operation, integration, maintenance, etc. Moreover, they usually provide a direct interface to the customer and thus constitute an important sales instrument. Customers in the B2B space as well are increasingly expecting digital capabilities ranging from sensors, networking capabilities, state-of-the-art user interfaces to cloud enabled services with add-on options as are already available with any B2C product. While adding digital capabilities is just a first step, add-on services may complement the product and increase revenue as well as customer satisfaction.

Combining physical engineering with IT, however, requires capabilities that may not be readily available in every target company and which may be difficult or costly to create. Add-on acquisitions, partnering with specialized companies or opening up technologies for third party solutions may be a sensible way forward. KPIs in this category depend on the industry and target (What specific features will the client value? How much revenue increase or other benefit does this offer? What investments are needed to get there?). As this is an important value lever to create customer value, however, we recommend considering it as a definite upside and exploring this further following the acquisition.

Product/Service Enhancement

Starting out as a sports apparel brand, their digital success story began in 2013 with the acquisition of several digital fitness companies such as MapMyFitness and EndoMondo and the launch of UA Record, a connected health and fitness network. Today they offer “smart gear” and approximately 200 million registered users worldwide produce data that is then analyzed by an analytics team and a total of 500 employees working in digital. By enhancing their products with digital capabilities and services, Under Armour managed to strengthen the customer relationships and establish new communication channels, resulting in personalized service offerings as well as innovations linked to actual usage.

Case: Under Armour



3Business Model Transformation

Digital technologies also offer the potential to change value creation and capture logic to better serve demand. Most prominent digital business models to date are platforms in the B2C space that connect industry participants as an intermediary between demand and supply. Frequently observed business model changes in B2B markets are from producers to service providers, e.g., offering software-as-a-service or air as-a-service in the case of Kaeser Kompressoren (see case below), moving from hardware production toward software and service design, or outsourcing key production processes to digitally well-integrated contract manufacturers, resulting in an asset light model.

Business model transformations are usually seen as complex and risky but sometimes necessary to keep pace with demand and safeguard against competitive moves. Indeed, they sometimes open access to entirely new markets and follow different value logics such as exponential network effects that are not easily predictable. Other than traditional businesses, digital structures are easily scalable with less capital employment but require fundamentally different approaches regarding operations, marketing and sales. Cases like Kaeser Kompressoren show that transitions can be smooth and easily manageable. Development risks can be mitigated using a “lean startup method” with an iterative process offering quick market feedback and targeted development. Transformation risk can be significantly reduced by initiating the process early on and allowing for a smooth transition involving organic changes as opposed to starting from a latecomer’s position lagging behind the competition.

Kaeser Kompressoren demonstrated one of the first IoT-based business model transformations, which had a significant positive impact on customer value and market positioning. The company, a German producer of air compressors established a service business model (air-as-a-service) over the past few years. Equipping their products with sensors and network modules enabled the company to monitor the assets and guarantee air availability to the customer. In combination with a global service model, they are able to forward integrate and realize additional margin pools for the company.

Case: Kaeser Kompressoren



Financial Sponsors can approach digital value creation with three suggested investment strategies

The Industry 4.0 technology stack ranges from analogue products at the bottom to digital services at the top and offers a range of investment opportunities with different value potential and risk profiles (Figure 7). As financial sponsors require bankable business cases, they may not target domains that are still developing with high market and technology uncertainty. Moreover, specialized IoT targets usually become expensive very quickly and thus require early entry. The combination of traditional and digital value levers may be particularly relevant for established analogue targets as pertains to digital optimization and transformation. Three major strategies are conceivable in this respect:

aThe most common PE investment strategy is likely one that involves value creation taking place within a single company. Typically, quick wins would first be realized in the operational area before various value chain optimization measures would be triggered. Soon after, it is recommended to assess potential for product/service enhancements and business model transformations. Even though transformations may not be completed within the usual three-to-five year holding period, the foundation is laid for growth and exit readiness.

Stand-alone

bDigital buy-and-build strategies could be aimed at combining analogue and digital assets in a portfolio as (stacked) solutions, scaling digital knowledge over several similar assets or combining specialized single companies to more versatile actors with joint capabilities. While significant synergies may exist between such assets, these strategies require business model adjustments.

Buy-and-build

cThe restructuring of latecomers may be an interesting strategy for turnaround investors. These companies suffer from disadvantages in competition either because their products lack digital capabilities, their value chain falls short of the industry standard or their business model was commoditized. Such targets already exist in industries that have experienced the digitalization wave – mainly in B2C domains – and will follow suit to an increasing extent in B2B. While technology and market risks have leveled off, digital incumbents’ unique scope and scale advantages may be irrecoverable.

Restructuring

• Focus on relevant I4.0/digital domains depending on fund structure and investment strategy

• Identify potential and targets along the technology stack

• Increase market insight by building or acquiring market and technology knowledge

• Define value creation strategy

• Identify digital value levers and risks along the value chain

• Realize quick wins based on first data analyses and traditional value levers

• Implement digital technologies following business case logic

• Set development budget• Create ideas for product and business

model enhancements• Design, develop and test minimal

viable solutions in iterative processes• Build new capabilities or partner

relationships• Drive implementation and

transformation



We suggest a three-step plan of action to approaching digital value creation

With exit strategies in mind, digital value creation strategies require a focused approach with clear and executable actions to realize new value levers, reduce risk and drive increased returns in portfolios. To achieve this, we suggest the following three steps (Figure 13):

Figure 13 – Three steps for PE digital value creation

First, it is key to understand the potential but also the risks related to digital technologies and how they develop along the technology stack. Depending on the fund structure and investment strategy, it is recommended to focus relevant domains of interest and analyze potential using possible targets. In order to do so, PE firms may need to build or acquire additional market and technology knowledge. Due to the breadth and complexity of digital value creation, we expect PEs to increase their specialization to enhance the quality of their investment decisions and to offer even more compelling strategic and implementation competence to target companies.

Build digital expertise and define a digital value creation strategy 1

Build digital expertise and define digital value creation strategy

Drive value chain optimizationPrepare ground and drive transformations1 2 3

Basis for PE digital value creation Efficiency increase Revenue upside New market access

Protection against substitution and commoditization

Product/service enhancement

Business model transformation

Quick wins



2The implementation of a digital value creation strategy may start with the identification of compelling targets that offer potential for both traditional and digital value levers starting from safe grounds. At the same time, substitution and commoditization risks from start-ups and digital champions within the ecosystem (who do not need to be direct competitors) need to be analyzed thoroughly. Digital value chain optimization can be approached with clear business case logic along the processes. Implementation starts with quick wins, e.g., identification and mitigation of inefficiencies based on big data analyses. More complex projects such as networking of production and logistics systems and implementing Industry 4.0 platforms with centralized manufacturing execution systems can then be addressed. This way, quick results can be delivered and experience can be built up.

Drive value chain optimization projects

3Product/service enhancements and business model transformations are not as clear in advance and require creative development and market testing. Therefore, they may be seen as more risky and time consuming and thus require a slightly different approach. Using an iterative development process in which minimal viable solutions are created, tested and developed further toward a final product or new business model has several advantages. Small iterations deliver quick results, provide rapid feedback and do not bind excessive resources. Projects can easily be stopped if market fit or goals are not met without having generated substantial sunk costs. These projects can be financed from a set development budget that offers the option of diversifying risks internally. This makes it possible to develop bankable solutions within usual holding periods. They may not yet operate at full potential but they show clear growth paths sufficient for a compelling exit story.

Other than conventionally suggested, we do not recommend “outsourcing” such important changes to incubators or green-field start-ups straight away. In many cases it makes more sense to transform the existing business, thereby leveraging and developing its existing knowledge and resources further and hence preserving its value despite an increased transformation effort. Partnering or add-on acquisitions may be a way of closing capability gaps.

In summary, digitalization is a new value lever that offers value creation potential but comes with inherent challenges for financial sponsors. Some – usually larger – funds are already pursuing digital value creation actively and others are likely to increase their footprint. PE funds are an attractive partner especially for small and medium-sized companies and can complement them with strategic direction and operational expertise to drive digital value creation and transformation. We suggest PE firms to define targeted digital value creation strategies which entails the extension of capabilities and relationships with experts as well as the implementation of new value creation methods. Boldness and a touch of creativity will help to overcome the novelty behind the topic. Moving forward, as more pioneer case studies are presented by corporates and experience grows, we are expecting to see first cases from PE in the near future.

Prepare ground and drive transformations


Contacts

If you would like to discuss any of the topics covered in this publication, please contact your EY advisor or any of the contacts below:

Michael KunzPartner EY GSA Private Equity LeaderTransaction Tax

+49 160 939 [email protected]

Dr. Dierk BussPartner Head of Value Creation ServicesTransaction Advisory Services


Christian BurmeisterSenior Manager Digital Value Creation and Business Model InnovationTransaction Advisory Services


Author

Ernst & Young GmbHWirtschaftsprüfungsgesellschaft

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