More scrutiny required of digital services deal opportunities, says Zinnov

In this tough market, PE investors will need to dig deeper to identify truly digital services companies in order to extract real value from deals, say Zinnov’s CEO, Pari Natarajan, and managing partner Sidhant Rastogi.

This article is sponsored by Zinnov

How would you describe the state of the digital services market for PE today, and how is it developing?

Sidhant Rastogi

Sidhant Rastogi: We have been tracking the digital services space for more than 15 years, and 2021 was one of the most active periods we have ever seen, with some of the highest valuations. Going into 2022, the macro environment has been very different with investor sentiment becoming very cautious. Still, we think a significant number of digital services deals will take place, as it remains one of the most active verticals for private equity investments.

Last year, almost every digital services business grew significantly, and that brought comfort to investors. Given that some softness has set in, the scrutiny will have to be higher. PE firms will need to closely evaluate whether prior growth rates are going to be sustainable, while also focusing on the quality of work and the strength of customer relationships. They will also need to deep dive into margins and business engagement models, given that a significant amount of enterprise digital work will be done at or close to customer location.

However, with talent shortages continuing and the market softening, we expect companies to move to traditional offshore models, which might impact revenue.

Pari Natarajan

Pari Natarajan: The key reason that digital services grew so rapidly over the past two years was that covid accelerated technology adoption and companies that were not able to hire fast enough turned to third-party providers to drive digital transformation. Now, as we are in a slowdown, the way companies grow will be defined based on industry verticals, offshore delivery capabilities, business model flexibility, relationships and their ability to sell.

What are the key parameters that PE firms should use to evaluate the true digital potential of a tech services asset?

SR: While there are multiple things to assess, first, one needs to evaluate the investment made in the sales process and the ability of the team to get in front of customers. Last year, companies were able to show more than 40 per cent growth with a lean sales team, because it was all being done via MS Teams/virtually. Going forward, the classic sales channels with people on the ground meeting customers will once again become more valuable, and a steady sales engine will be key.

Second is the need to evaluate the type of delivery model that companies are enabling for customers. We have seen three models: predominantly delivering from Latin America and Eastern Europe; a mix of delivery from the US and Europe with the remainder in offshore locations; or purely in the US and Europe, close to customers. During covid, being close to customers worked and came at a premium; but we expect that to change. How the delivery model is aligned to customer needs is something that investors should be closely appraised with.

Third is the type of customer. We have seen a lot of work coming to digital services firms from well-funded fast-growing tech companies, particularly in fintech or retail tech. Since those companies are now coming under stress, that is a cause for concern.

Another thing to look at is margins. Most companies last year were in a good position. However, even the top digital service providers have seen margins drop 10 per cent, necessitating a close evaluation of the assets’ ability to sustain or even expand margins.

Which technology segments are most likely to drive growth and returns for investors?

PN: Because we are going into a recessionary scenario, only technology that is going to bring down prices will have a high level of adoption, whether improving productivity or de-risking businesses from labor supply cost increases. It is the more discretionary, nice-to-have technologies that are focused on improving the customer experience where we expect to see a bit of a pullback.

SR: There are two technologies on the intelligence side that we expect to grow. First is intelligent automation, which allows companies to improve their cost of service or cost of product. There are a handful of digital services firms that are bellwethers of implementing automation within companies, and while they weren’t the coolest technologies last year, they will be going forward.

The second is intelligent infrastructure, which includes tech on the manufacturing side playing into the reimagination of supply chains. Any new greenfield manufacturing site is now natively digital, and companies building those digital factories will see an increase in demand.

Intelligent infrastructure also plays into verticals like healthcare and life sciences, where we are seeing significant transformation through the use of data and analytics.

How are talent shortages having an impact?

SR: Seemingly, all digital services firms have open positions. But that is not something we expect to last through the year. We have already seen the largest tech firms freeze hiring or have strategies in place to stop people from leaving; so we expect talent shortages to normalize over the next two quarters.

PN: One of the biggest challenges for digital services firms versus traditional IT businesses is the need for full-stack engineers who can develop solutions holistically. Currently, there is a shortage for this skill, and services firms are hiring junior talent and rapidly upskilling them or breaking down the technology solution so that more junior talent can contribute more effectively. Doing this well is helping services firms to address the labor shortage and helping them unlock higher margins, as they are not reliant on senior engineers.

What impact are current market conditions and macroeconomic disruptions having on the tech services industry?

SR: Zinnov recently analyzed the macro factors that will most impact enterprises across different industry verticals. Interestingly, the analysis revealed that on the market side, any company that is working on significantly new technologies or not yet proven technologies is going to be under stress. But some of the verticals thatb we believe will continue to be resilient and continue to grow include defense, and energy and utilities.

Among the verticals that we believe will continue to be resilient and face a moderate impact are aerospace, automotive, healthcare and semiconductors, with the industrial sector set to accelerate its digital transformation agenda despite supply-chain constraints.
When we look at the most negatively impacted verticals, we think consumer software and retail end-customers will be most under pressure. We believe that private equity investors in digital services firms will need to look closely through to the profile of the end-customer to gauge the impact on a firm.

What is the outlook for the market and what themes should investors be prioritizing across the deal lifecycle?

SR: It becomes really important to look at services companies that are truly digital. We will continue to see companies entering the market, as they have had some of the best growth in the last two years and are looking to monetize the same. At the same time, the market is also willing to transact. Firstly, PE firms are not short of cash – in fact, they are inundated with record levels of dry powder across funds. Secondly, other services companies/strategics are actively looking at inorganic growth to compensate for the expected drag in revenue due to the impending slowdown.

Looking at the digital quotient of a business becomes important, and we use six dimensions to map that, namely verticals coverage mapped to macro trends; the current delivery footprint; strength of the sales process; talent strategy; M&A strategy and pipeline; and how well invested the business is in its own technology.

PN: We are seeing a lot of PE firms that have not historically invested in digital services firms now moving in. Valuations have been high for some time, forcing investors to stay on the sidelines, but now, given the normalization, there has been a renewal of interest.

This is also a good time for PE investors to create a platform of assets, capitalizing on the slower and more cautious investor cycle, easily buying two or three assets and creating a fairly large organization. To get to scale in digital services, consolidation is key, especially in tough times. However, it has become more important than ever to evaluate synergies of the assets, to extract real value and growth.