Data, technology become new prized possessions

Private equity firms are writing a new chapter in their playbook to favor business models incorporating data utilization and technology.

The pandemic and COVID-19-induced recession have accelerated trends already in motion. In the new normal, every company — no matter the sector — will collect and use data to its advantage. All companies will replace existing business models with technology-enabled models that own few assets, making these companies higher priced and more nimble, industry executives said.

The digital transformation is a huge benefit in the COVID-19 world in which private equity and venture capital firms are trying to sell or take public as many portfolio companies as possible before the potential double whammy of a second wave of the virus and increased market volatility around the U.S. presidential election.

"There will not be a reversion to a pre-pandemic economy," said Jason Thomas, Washington-based managing director and head of global research at The Carlyle Group LP.

As the pace of digitization accelerates, investors should think more in terms of business model variations than differences between industries, Mr. Thomas said.

In a few years, technology may not be viewed as its own sector but instead as a differentiator between businesses that thrive or falter in a post-pandemic reality, irrespective of the industry, he said.

Companies able to shift to a technology-enabled model with fewer assets will be in better financial condition than comparable companies at the start of the pandemic that didn't make that shift, Mr. Thomas said.

Right now, the main focus is on sectors, he said. Companies not making big changes toward digitized, technology-enabled business models are losing market share, and their private equity owners will have tough exits in their futures, Mr. Thomas said.

Asset-light companies such as manufacturers that own neither their plants nor the trucks that take goods to market started after the Great Recession, he said.

"In the global financial crisis, the businesses with the biggest financing needs were the ones that needed to finance their physical assets and inventory," Mr. Thomas said. "Whereas, their biggest assets were their brand, people and data. So, they started to sell off their physical assets."

Advances in technology are making it easier for companies to shed their assets, making them more resilient, he said. Carlyle had $84 billion in private equity and $221 billion in total assets as of June 30.

And these aren't the only changes companies are making.

"Businesses have revised down their expectations for revenue and staffing needs relative to pre-pandemic levels," he said. "This is not just because of increased conservatism but because they're taking a closer look at what their business does and how they do it."

Even so, companies are in very early innings on figuring out how to use technology to increase companies' growth, said John Park, Menlo Park, Calif.-based partner and head of Americas technology private equity at KKR & Co. LP.

"Not every company that sits at the crossroads of lots of data is necessarily worth more. Companies that sit on a preponderance of rich data should have the ability to create products around that data. They should be able to leverage that data to grow faster," said Mr. Park, who leads the technology industry team within KKR's Americas private equity business.

"The issue today is that companies are very nascent in terms of understanding how to use the data at their fingertips and creating ways to monetize it," he said.

However, KKR evaluates most investment opportunities these days through a tech lens. For every deal now, KKR executives look at the market, the company, the product set and the strategy from a technology viewpoint, Mr. Park said.

"In the next decade, we will see real advancements around the use of data," he said. "As investors you have to get ahead of the curve and what we are doing is trying to figure out how to use it as a tool that's both offensive and defensive in allowing us to help price risk."

While he does not think the industry is yet at a place where it can value a company based only on its use of data, data usage is a factor KKR executives consider to value and evaluate a business, Mr. Park said. KKR managed $79 billion in private equity out of firmwide $222 billion as of June 30.

One example Mr. Park gave of a technology theme driving KKR's investment thesis is an investment in Calabrio, a company that assists customer service call centers. The company uses tools like speech-to-text analytics and data maps to give companies insights into support interaction and an agent's performance on calls. This technology gives Calabrio's customers a view into why their own customers are unhappy or issues with products. KKR invested in the company as a disruptive force in the call center sector that was slow to adapt to the cloud and understand the data behind customer service calls. Calabrio's business has tripled in four years.

David Lewin, Montreal-based senior partner at private equity firm Novacap, said COVID-19 has accelerated the trend toward investing in meaningful technology and a pivot from "what was historically more of a legacy business model to a more tech-enabled one."

But that trend is being sped up in industries that were already migrating to digital alternatives and solutions, he said in an email.

Data collection is not only increasingly important to portfolio companies but data also impacts how Novacap executives analyze investments, Mr. Lewin said.

"We have portfolio companies where data collection is core to the business model and where we believe that improving software algorithms/machine learning capabilities will result in significant value-added services and solutions," he said.

At the same time, access to structured and relevant data "definitely provides more pertinent information/insights about certain risks and opportunities associated with a given investment opportunity," Mr. Lewin said.

Executives at private debt firm Monroe Capital LLC are seeing more companies present themselves as technology companies, said Zia Uddin, Chicago-based managing director and portfolio manger of private credit.

Some private credit managers and other lenders are accepting the substitute, giving these companies higher valuations, and some lenders will push the leverage up on companies with "reoccurring" revenue, Mr. Uddin said.

"The market is pretty efficient. People are trying to dress up companies to be like tech companies," he said. "Some lenders are probably in a dangerous position."

Most companies want to have a technology aspect to them as technology has become "more and more of everybody's world," Mr. Uddin said.

The pandemic appears to be bolstering that trend.

It's very early on but in the past six to nine months, Monroe executives have seen companies with a "COVID premium," Mr. Uddin said. "Some companies have done better than expected in COVID. A lot of those companies tend to be on the tech side," he said.

Loans to software companies in Monroe's portfolio have held up "very, very nicely," Mr. Uddin said, as these companies have proven more resilient.

"It's no surprise that everyone is trying to go to the subscription model" because they have higher valuations, he said.

Companies with subscription models have recurring revenues with value based on multiples of that revenue. Those valuations are higher than businesses without recurring revenues, which are valued based on multiples of earnings before interest, taxes, depreciation and amortization.

To capture these higher valuations, some companies with "reoccurring" revenues are being presented as "just as good as" business with recurring revenues, Mr. Uddin said.

There is a big difference between recurring and reoccurring revenues, he said. A recurring revenue model is one in which the company has a contract with customers tying them to regular payments for a specific time period. Businesses with reoccurring revenues have customers that have a regular payment schedule but are not bound by contract, Mr. Uddin explained.

"A reoccurring bill is something like your cable bill. You pay it every month but you don't have a contract," he said. If times get tough, customers could discontinue the service at will.

Even before COVID-19, companies were trying to put a tech twist on what they were doing because typically it would lead to higher valuations, said Scott Hendon, Dallas-based global and national leader of private equity at BDO USA LLP, an assurance, tax and financial advisory firm.

However, since the pandemic, modeling future cash flow and revenue stream of a business is an uncertain process, Mr. Hendon said.

Some 77.5% of private equity and venture capital respondents to a BDO survey released in October said assets will be sold or taken public at prices 10% to 20% lower than they would have pre-COVID-19.

But the impact on price depends on the company. And technology companies and health-care private equity and venture capital-backed companies have had higher valuations, Mr. Hendon said.

Initial public offerings of technology and health-care companies have been "pretty frothy as well," he said.

Right now, private equity and venture capital firms are trying to sell companies or take them public before a potential second wave of COVID-19 and amid worries the presidential election in the U.S. might result in an economic downturn, Mr. Hendon said.