Digital transformation

Companies such as Netflix, Uber, Deliveroo, Amazon, Slack, Zoom, AirBnB, Lyft and Wish have changed the way people live by redeveloping the customer experience. Their business is in providing flexibility via new technologies and information. They incorporate access to technologies and solutions such as mobile payments, social media, content everywhere, smart infrastructure and predictive analytics.

Optimisation of resources and supply chain, automation of internal and external procedures, primary data collection coupled with advanced analytics of users' behaviour and needs and the ability to execute on the above are a domain of information-driven companies. Access to data and transformative technology is critical, however this requires cultural adoption and frequent behavioural change. From a technology stack point of view, it is easier to build a digital company from scratch than go through the pain of transformation. At the same time, building new business and growing it while managing a well-known portfolio allows capitalisation on existing assets.

The four pillars of digital transformation:

• operation and management
• customer acquisition and marketing
• R&D and innovation efforts
• products and services

IHS Markit asked 200 decision makers which of these four was their key transformation project in 2019 and which is going to be their next priority. As of 2019, 65% declared that operation and management is the most critical, followed by products and services, customer acquisition and marketing, risk management and R&D. Operation and management will remain a key priority for almost one third of companies through 2021, while for over one fourth, customer acquisition and marketing is next on the agenda. Activities falling under operation and management are key priorities for digitisation as they aim to reduce the cost of current operations, increase flexibility and ease adoption. If properly deployed, operation and management supports marketing, understanding clients' needs and preparing solutions that correspond with these by segmenting opportunities and providing targeted messages.

In the digital age, innovation is critical to capitalizing on new opportunities. Various start-ups offer solutions that established corporations would have until recently considered to be not feasible or simply not worth spending money on. Today, these corporates need to adjust and often reform their business models and go-to-market strategies to catch up. Newcomers usually have no burden of owning a technology stack, have no physical presence and operate in the virtual world. That world enables access to millions of customers, their habits and preferences, which are defined as the biggest asset in an information-driven reality.

Today's challenge is not just in analysing data, but more urgently in protecting it from various types of attacks and scams. Two examples are the security of sensitive customer data and protection against piracy of digital content. Hackers do not discriminate against attacking small and large companies, governmental institutions, individuals and corporates. The personal data of customers and employees at Yahoo, Marriot, eBay and Sony's PlayStation Network, amongst many others, have been hacked, proving that successful cyber fraud, malware and ransomware attacks happen every minute. Stealing content, and often sharing without permission, is less harmful from an individual's point of view, but directly impacts the authors, sponsors and those who paid for it. Illegal sharing is not just about P2P services with links to new movies or TV shows but also streaming of services (often Sports content) via paid websites. Both types of attacks not only damage citizens but also the global economy.

Cloud based services are considered to be an enabler for many other transformative technologies. Our respondents agreed that beyond storage and simple computing, modern business requires that companies have access to value-added tools built as easy to plug in APIs. Almost 40% of the 200 companies that took part in our research named cloud as the number one priority in their technology transformation. A high percentage of these companies are using a hybrid of public and private cloud today and are considering further migration. Amongst businesses built completely in the cloud or the ones that moved all operations to it, advanced analytics, big video and blockchain and ledger were named as future priority projects.

Advanced analytics is defined here as the ability to collect, process, analyse and act upon the data available. It includes all processes from smart manufacturing all the way to voice, face and object recognition, subject to the industry the company operates in. Similarly, looking at the functional area of a company, it may be used for instance in the product planning stage, but likewise in communication with customers and the ecosystem. The outcomes of processes built under advanced analytics initiatives should be aligned with companies' goals and support its agile decision making.

Video is omnipresent. On average, people spend over 280 minutes in front of various screens per day, amplified by their time with social media, screens in taxis, trains, buses or at work exchanging via collaboration platforms. Long-form content, short form content, advertisements, webinars, events and educational schedules are types of content that are easily available. People must decide what to absorb, when and for how long. The ratio of availability versus time constrain forces creators including businesses to prepare more targeted messaging. Companies implementing big video should be utilizing the benefits of advanced analytics to learn about the preferences of their target groups. Almost 20% of respondents named big video as the area they will concentrate on.

Over 14% of respondents are considering blockchain and/or ledger technology adoption or have existing projects related to it. Most of these companies would use this technology to reduce supply chain costs, improve the accuracy of data and other various processes. Although blockchain/ledger can be used in any industry, companies dealing with financial transactions, direct payments and with a wide number of internationally spread suppliers tend to favour it.

Connectivity is often neglected, and a high number of businesses do not consider it to be worthy of investment. Nonetheless, for over 5% of companies, investment in connectivity means access to new clients, new technology such as drones used for delivery or generally lower latency services. In other words, it can bring a competitive advantage.

IHS Markit has extended knowledge in providing information to companies interested in learning more about best practices and main misconceptions of digital transformation.

There are material valuation risks surrounding early stage companies that aim to disrupt consumer relationships via digital transformation and/or offer improvements to the infrastructure of industries via technology. Investors and valuation appraisers face the challenge of envisioning new technologies and business models before knowing whether early stage companies can execute their business plan.

When valuing an early stage innovative company, a number of factors should be considered, including:

1. The change in market and sector pricing conditions
2. The complexity of the company's capital structure
3. The specificity of the industry/segment targeted by the company
4. The recent developments in the underlying technology and the innovation of the business and the industry
5. The funding risk of the company
6. The timeline and exit plan for the investor

Due to the difficulty of gauging the probability and financial impact of the success or failure of development activities of early stage companies, one should consider that the traditional valuation techniques (such as discounted cashflows and multiple based approaches) cannot be used in all cases.

In their latest valuation guidelines, the IPEV (2018) and the AICPA (2019) both recognise the specificity of early stage companies and recommend the use of more complex valuation methodologies, when necessary. The treatment of liquidation preferences was also a key consideration for valuation appraisers. These complex valuation techniques may include:

1. Scenario-Based Model (or PWERM)
2. Option Pricing Model
3. Milestone-Based Model (or adjusted price or recent investment)

For more detail on the IPEV guidelines please see Appendix 1.

It's important to note that the key difference in dealing with early-stage unlisted equity assets is the heavily analyst-driven approach to valuation. Valuation appraisers analysing such investments must have the aptitude to review and understand the legal documentation of the deal, corporate finance theory, financial analysis and relevance of milestones and disclosures, as well as the modelling skills required to ensure that these are appropriately captured at inception and throughout the life of the deal. Rarely is there one unanimous view between the management of the company, the investment manager and the valuation appraiser; this is acceptable given the nature of the investment. However, the appraiser needs to understand the appropriate methodologies and concepts for challenging the investment firm's view and considering portfolio companies' forecasts with a healthy scepticism.

Applying calibration to arm's length transactions systematically (as opposed to alternating between the transaction date and the latest measurement date) whilst calibrating to a second or third tranche of the same share class should be reviewed for appropriateness each time (e.g. C2 shares issued at same price 12 months after C1 shares). The timeframe from moving from the transaction price to a calibrated value could be explored early in the life of the investment as well as the incorporation of an evidence-based analysis regarding the assumptions used in the calibrated valuation (for e.g. when calibrating to a DCF model, the assumptions include assumed exit multiples; growth, profitability and WC/capex). This process helps all parties in their review of the reasonableness of the assumptions used in the valuation. They may be appropriate transactions and fair values, as well as outcomes derived such from CSE valuation, (assuming full conversion to common equity) and OPM (applying the liquidation preferences) methodologies for example.

Summary

Information-driven companies have a competitive advantage over comparable businesses that do not use data in their day-to-day operations. The trend stands correct in almost every industry and geographical region. Transformation is not always easy due to legacy processes and equipment as well as the requirement for cultural change and acceptance. It has been proven that information can reduce cost, increase sales, create stronger customer traction and increase the value for investors and society.

IHS Markit primary research confirmed that there is a wide understanding between leaders about how transformative technology is critical to necessary process improvements. As with any major change there will be obstacles and debates; not all projects will finalize as planned but it is imperative to discuss pros and cons and decide on a company level what brings the best benefit and when is the right time to implement while assessing the TCO.

When evaluating such innovative businesses or projects, investment managers, valuation appraisers and end investors need to be acutely aware of the risks which are pertinent and the most appropriate techniques and methodologies to capture the materiality of those risks in light of accounting standards and industry guidelines such as IPEV and the investment managers valuation and risk policies.

Posted 27 February 2020 by Przemek Bozek, Private Equity, Technology Specialist, IHS Markit

and

Leon Sinclair, Global Head, Private Equity Services, IHS Markit

S&P Global provides industry-leading data, software and technology platforms and managed services to tackle some of the most difficult challenges in financial markets. We help our customers better understand complicated markets, reduce risk, operate more efficiently and comply with financial regulation.

This article was published by S&P Global Market Intelligence and not by S&P Global Ratings, which is a separately managed division of S&P Global.