Thinktiv on digital diligence for tech investors

Software and tech-enabled companies offer real rewards, provided GPs adequately vet both the technology and its market during due diligence, says A.J. Watson of Thinktiv

This article was sponsored by Thinktiv. It appeared in the Fund Services Special Report alongside the November 18 issue of Buyouts magazine.


Private equity is bullish on the tech sector and has been for quite some time. One year ago, tech-focused funds were close to raising $72.8 billion for that year, according to PEI data, up from the $60.2 billion raised the year before, and the trend hardly seems to be waning. But can all that capital be wisely committed?

Rob Kotecki spoke with A.J. Watson, chief growth officer of Thinktiv, a consulting firm that specializes in helping private equity firms navigate the complexity of software and technology enabled investments. They discussed best practices for software and tech-enabled investors to use during due diligence to help protect capital.

What makes due diligence into a software company more difficult for GPs than say for a manufacturer or a distribution business?

A.J. Watson

In many ways, software, and other tech-enabled businesses, are like any other product or service that GPs are acquiring, but there are unique complexities. GPs often bring in third-party experts to look at IT infrastructure, back-office security, or opensource compliance. But they sometimes overlook the connection between how the software gets designed, built, and brought to market.

There are three views that need to be integrated here.

First, understanding what problem the solution solves. Then there’s the product’s design, technical architecture and its limitations. Finally, there’s how this product is explained and sold to customers.

GPs might conduct this type of diligence in silos, but the threads have to be brought together because they all impact one another. Unfortunately, this unified perspective is easy to miss, which can create a hole right in the middle of the due diligence process. We sometimes see this because one group may be neck deep in sales diligence, while another team will be testing the technology without ever investigating the relationship between the two.

Returns potential can only be discerned if the firm understands where the product sits relative to its competitors, and if the product’s technical architecture can handle that growth. GPs have to understand the relationship between the technology and its market.

That best-practice approach asks if the technology is built for a purpose that customers want, if that value proposition can be sold, and if that technology can support further value creation. Otherwise tech may end up being a drag on the business.

The digital diligence we provide marries customer-centric inputs with product strategy and technical considerations to get to the heart of value for the investment. Traditional IT diligence just can’t answer these questions.

How well do private equity firms understand this?

Most do. Most know they don’t have that deep technology experience and will tap outside consultants. But they really need to understand exactly what those experts are bringing to the table because this unified perspective is hard to come by. You can’t get a value-focused perspective from advisory partners who are just career auditors or consultants. That’s why a partner like Thinktiv is so important. After bringing hundreds of products to market, we know what matters when the rubber hits the road. We bring decades of real-world experience to our private equity clients to help them during pre-transaction diligence.

How should GPs vet their outside consultants when looking for help in the due diligence process?

There aren’t a lot of providers that specialize in this type of diligence, but I think what’s important is that whoever is conducting the diligence has a clear perspective on the product and technology, in the specific terms of its market. Otherwise, digital diligence can end up missing major problems by simply looking at the technology out of context. This is critical because sometimes seemingly insignificant details become major issues. For example, in a situation where an IP address is part of the transaction, how are the addresses being managed? Are they coming along in the sale or not? Is this a critical deal point? Or does it even matter?

Frankly, for most software businesses, that detail is innocuous, unless they’re a marketing or a customer experience platform where the deliverability of email is directly tied to an IP address where they were sent from. In these instances, knowing if the IP addresses are healthy and coming over with the asset is critical. That’s not a technical question, that’s a value creation question, but it has massive implications for technology. More importantly, it has massive implications for the long-term viability of the business.

How else can digital due diligence help?

In another situation, diligence might ask if the architecture is performing and the company will say, “We have 100 percent up-time, but with a 15-second delay for a page load.” This seems like a clearly bad outcome in many situations, but it gets more nuanced depending on the nature of what that business is looking to offer. Vetting technology in these situations isn’t just about whether a software performs, it’s whether it performs in a way that creates value. For example, what customer outcome is more critical in this example, quality of answer, timeliness, or availability?

How does this approach differ from other vetting procedures?

To be clear, there’s a lot of great back-office IT due diligence teams in the space, but they’re looking at ERP systems, CRM systems, accounting systems, even the kind of software and systems that support the operational functions of the business. IT diligence has begun to superficially extend into the product itself; like server infrastructure or other operational elements, but it ends there. It provides very limited perspective on the importance or risk from the maturity of the product itself.

Back office IT doesn’t consider why a product is fundamentally valuable. Instead, it may prioritize the language the product is written in or focus solely on the structure of the tech. But it will miss how the technology interacts with other services being provided and how that amplifies or inhibits growth. IT diligence typically does not inquire about how software design and development lifecycles are correlated to customer behavior or the ability of the platform to scale. That’s problematic. Firms open themselves up to significant transaction risks when the digital diligence gets divorced from what actually drives value in the investment.

We believe that GPs need to know if technical decisions are working toward value creation or against it, and that’s hard to do. It requires knowing what experience the customer values and is willing to pay for, while stepping back and understanding how the engineers, designers, and marketers who are creating that product experience are aligned to that value.

Integrating these perspectives creates a more accurate picture of the potential of a given business. When we do this for clients, we also look at the value creation that’s likely to take place in that GP’s holding period, so they can optimize it. GPs don’t want to see a tech business plod along during their ownership, only to sell it for a modest return to a strategic buyer that ends up unlocking a fortune from the business.

Don’t PE firms tap ex-CEOs from the sector to deliver this as an in-house operating partner?

We work with operating partners all the time, and they’re a great asset, bringing a vertical experience that’s incredibly helpful. They’ve got a huge role to play when it pertains to market trends and operating the company post-close. But the pace with which technology is moving makes it difficult for any one operating partner to remain up to speed with the best practices in product development, product line and delivery.

And product or technical diligence is a skill in itself: knowing what questions to ask; when to dig deeper; that sense of when something doesn’t feel quite right. Great operating partners know that identifying all possible risks by themselves is impossible, so they rely on our maturity model that involves more than 25 modules that have been hardened and refined over 50 transactions supporting almost $8 billion in Enterprise Value over the last 24 months. We do this every day, and that experience makes our process both efficient and very rigorous, with concise reports to maximize the investment in that diligence. Ultimately, tech investments can be high-growth engines, but the only way to determine their potential is to understand not just if the technology works, but also if it works in a way customers are willing to pay a premium for.