Dealing in a digital world

One of the most significant challenges for business today is how and where to allocate capital to meet their digital ambitions. Companies are faced with a number of questions, the most pressing of which is whether to buy or build or seek another path – technological and behavioural change has changed the deal space too, including an increasing interest from private equity.

Our recent survey of 600 company executives shows that M&A remains the most popular route for companies, but that has its own challenges. History is littered with examples of a failed scatter gun approach and it’s clear that companies need to take a holistic view to deals. A smart digital future requires smart capital allocation.

The competitive digital life

Not so long ago, ‘digital strategy’ was mainly used to refer to customer facing elements such as a web site and ecommerce platform. Today, the digital world is all encompassing, covering just about all areas of corporate life from business operations and process to customer relationships and relationships with vendors and suppliers.

What’s clear from EY’s recent ‘Dealing in a digital world‘ survey is that this is adding to companies’ competitive pressures. Of the 600 executives we questioned, 90% said that their companies faced increasing competition from companies that had embraced digital. Moreover, these pressures are coming from many quarters – from longstanding competitors and new ones.

New start-ups are often asset light and technology enables them to build businesses with lightning speed compared with just a few years ago. This is adding to price and margin pressures as we’ve seen recently in UK profit warnings. It’s also notable that 76% of companies said they saw increasing industry convergence, the burring of the lines between sectors that creates new competitive pressures.

Automotive is a prime example of what used to be a pretty static sector with clearly defined boundaries that’s now developed into an industry where the lines have been blurred by technology. Consumers still need a car to take them from A to B, but they also want it perform as a seamless part of their digital lives. This has made the automotive industry a huge ecosystem that no company could possibly hope to cover. It’s clear that companies need new approaches.

New approaches

The most fundamental question for companies is whether they should buy or build. Most companies in our survey said that they planned to buy. The pace of change is such that it’s hard to develop quickly enough in house, so this shift is understandable – but it’s not an easy option. 

There is significant competition for assets and valuations are high for proven concepts. This means we’re seeing companies moving earlier, taking more of a risk on earlier stage companies. But, buying at this point is an unfamiliar process for many companies and it requires a different approach across the board – from wooing the target to due diligence and the expectations set down for the new acquisition. As we’ve discussed previously here, we’re seeing more companies taking the corporate venture fund route to ensure that they provide the right structures and entrepreneurial environment for these companies.

What we’re also seeing is companies looking at other ways to access what they need.  As sectors evolve, it may be that buying assets becomes less important than gaining access to platforms and intellectual property. Companies are increasingly looking at alliances – 55% of respondents – as well as using partnerships and joint-ventures to build their businesses.  M&A will still be important, but as technologies and behaviour evolve we can expect the deal space to change too.

 A holistic strategy

The scale of transformation – and the constant need to adapt – requires companies to develop a long term strategy. Companies can’t expect to meet their long-term needs with one acquisition, not when all companies face continual existential threats to their business models.  This requires companies to take a holistic view and integrate their digital strategy into their capital agenda. Companies need to make digital a key component of capital allocation to support the business – and this is where many companies can fall down. 

Our survey shows that 85% of companies have an established digital transformation function and 87% are considering digital transformation needs in their capital allocation planning for the next 2-3 years – but only 55% have a sophisticated quantification of those needs. If companies find that they cannot allocate necessary capital – or misallocate their capital – then they won’t be able to compete. For many companies, M&A and alliances will be the only way they can keep up – building capability in house will take too long.  We are seeing companies starting to rebalance their portfolios – 41% are considering divestments – but it seems that some companies will be left behind.

PE getting in on the action

Earlier this summer, The Wall Street reported figures from Dealogic that showed technology companies accountedfor 46% of all U.S. buyouts, the highest figure they’d recorded in over 20 years of tracking this data.

The technology sector is of course very active across the M&A board. Our figures show that July saw the highest monthly disclosed value for global technology M&A since October 2015 — and the second-highest in the 16 years since the dotcom boom.  But –as the WSJ points out – the focus on technology is a departure for private equity. Technology deals accounted for just 11% of buyouts in 2012 and PE has traditionally been wary of high valuations and the risks involved. 

So what’s changed? As technology companies have matured, they’ve begun to offer stable cash flows and the potential for improving management and efficiencies – especially in software – which is bound to attract PE interest. PE also has expertise in bringing together groups of companies to make them greater than the sum of their parts. Perhaps most pertinently, digital transformation is not a trend that PE can ignore given its growing role in corporate life. With houses sitting on so much dry power, this then adds to the increasingly competitive nature of the deal environment.