How start-up collaborations can jump-start digital transformation in PE

Private equity firms can deploy new technology and create value through intentional collaboration with digital-first start-ups.

Private equity (PE) can develop and deploy digital capabilities in a portfolio company by building in-house capabilities, entering into collaborations, acquiring businesses with the necessary capabilities or outsourcing the need completely. Ambitious PE firms should consider the currently underexplored route of partnering with start-ups to stoke digital transformation.

Why work with start-ups?

Based on successful examples in industries and organizations outside of PE, there is good reason for General Partners (GPs) to consider an ambitious partnership strategy:

• Expertise: Start-ups tend to have specific expertise and the relevant talent in place – including highly specialized talent that would be costly or impractical for a PE firm or portfolio company to hire. Collaborations offer immediate access to this talent. Property and casualty insurer MS&AD partnered with start-up Tractable to use the latter’s AI talent in claims processing and realized efficiency gains of around 360,000 hours every year.

• Agility: Start-ups are inherently agile and can accelerate time-to-market for new products and services, allowing companies to react more quickly to changing market and consumer demands. JPMorgan recently partnered with FinTech start-up Marqeta to launch a digital-only credit card. Freed from the burden of having to develop capabilities in house, JPMorgan was able to deploy within a year of announcing the partnership – a journey that otherwise might have taken many years. For PE firms with tight exit timelines, speed is a critical success factor.

• Innovation: Start-ups tend to have bespoke technological capabilities designed to “solve big problems that people will pay for.” Coca-Cola partnered with Wonolo to build a platform that helped stock vending machines at retail outlets on-demand, a major challenge for the company and for the industry as a whole.

The start-up partnership model has delivered a range of successful outcomes and is seen as an increasingly attractive route to digital transformation. According to the EY Digital Investment Index, 64% of digital leaders have shifted focus from in-house development to M&A or collaborations to accelerate digital initiatives, and 45% of executives surveyed said collaborations as an investment vehicle for digital capabilities exceeded expectations, compared with 39% who said the same for homegrown capabilities. C-suite executives expect to increase investment in collaborations to accelerate digital initiatives over the next two years and to decrease in-house build investment.

PE firms and start-ups: integrating different cultures

While integrating different business cultures via collaborations can inspire innovation, the idea of potential disruption can deter executives who are wary of disrupting the status quo.

Start-ups tend to move quickly, embrace novel organizational structures and ways of working, and have different end goals compared with PE firms. They are often comfortable with a “fail-fast” approach to innovation, where speculative projects with a high chance of failure are pursued to test new ideas. This contrasts with PE firms that are less tolerant of risks that can potentially impact returns. Alignment and clear incentives are needed if collaborations are to work in a way that can deliver meaningful benefits to both partners.

Other challenges to navigate might include misalignment on the speed of decision-making and different communication styles. In a survey by Oxford Research, 58% of Nordic C-suite executives said that bureaucracy within their own corporations created an obstacle when they wanted to partner with start-ups. 

The right preparation can ensure a mutually beneficial and successful partnership. PE firms should consider establishing a small, specialized internal function to actively manage and facilitate the relationship between the two entities. Alternatively, they can employ an effective external mediator to do the same.

An effective intermediary can facilitate a start-up collaboration by sourcing and vetting potential partners and helping reconcile strategic goals and cultural differences. EY recently advised a PE firm on potential routes to digitizing a portfolio company in the health sector when the pandemic had closed their treatment centers. By identifying key areas of leakage, “burning platforms” and processes that would benefit from digitization, a suite of potential start-up partners capable of delivering the needed solutions was identified.

Scalable innovation at a speed that suits PE time frames

Despite potential challenges, the benefits of collaborations often outweigh the risks when it comes to the rapid delivery of scalable innovation capabilities. In order to use digital solutions as a value-creation lever at a pace conducive to exit time frames, PE firms must embrace new approaches and portfolio companies will need assistance. 

A well-managed start-up partnership model can be highly scalable when the PE firm itself is the partnering entity rather than a stand-alone portfolio company. With this engagement structure, the resulting digital solutions can be more easily rolled out to create value across the portfolio. There are significant economies of scale for a PE firm if they can embed themselves in the right start-up ecosystems and learn to identify opportunities in key areas that can be leveraged across the portfolio as opposed to assessing each company’s maturity level and appetite on an individual basis. 

As PE investors define value-creation opportunities at the onset of acquiring a company, they must think about digital from the start and what the right pathways and levers are to accelerate those capabilities within a two- or three-year time frame. In the article How private equity can define a business strategy for a digital world, author Richard Bulkley asserts: “Activating [digital] transformation — while already important before the pandemic — has now become a core component of the value creation agenda. The time has come for PE to embed a digital strategy throughout the deal cycle — from origination and due diligence, right through value creation and exit — as well as within the infrastructure of the firm itself.”

It is also important to note that, while the agile testing and iterating approaches that start-ups can bring to the table can be a great way to usher innovative techniques into an organization, engagement should not end there. In order to realize a path to scaling, companies will still have to take a close look at obstacles such as talent, operating model, governance and funding, and find approaches that make start-ups real partners in growth.

Whichever approach PE firms choose, it is a clear that in a world of increasing complexity with rapidly accelerating rates of digital transformation coupled with scarcity of talent, in-house development strategies are neither always the best nor the only potential solution. By engaging in start-up collaborations with the right approach and mindset – and an effective mediator – PE firms can realize rapid and effective digital transformation in their portfolio companies.