How Digital Transformation Creates New Investment Opportunities for Private Equity

Digital transformation isn’t just changing how large enterprises do business, it’s also bringing disruption to the middle market.

Fueled by market forces, changing consumer behavior and a pandemic that has shifted buying patterns, more companies are going online. In 2016, fewer than 50% of private companies had a website, but today more than 75% do, according to data from Top Design Firms. There’s now over $200 billion in market cap dedicated to helping businesses go online, with companies like Shopify, Squarespace, GoDaddy and Wix serving as key enablers of digital transformation.

This trend will only continue and potentially drive more visibility into the middle market, greater economic growth in this market segment, and more investment opportunities for private equity firms looking for the best deals.

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Digital Trends in the Middle Market

Middle-market companies are embracing digital innovation in many aspects of their operations.

A recent Capital One and Morning Consult study found that middle-market companies are prioritizing investments in areas such as data analytics (28% of companies), e-commerce (26%), artificial intelligence (AI), cloud migration and customer experience (24%). Thirty percent of middle-market companies are also focused on delivering a better employee experience, which signals more businesses are likely to invest in tools that drive backend and workforce automation to support emerging needs for greater agility and meet employee demands for remote and hybrid work.

These figures also suggest middle-market companies are more aware that to drive growth, they must build their digital capabilities. Investing in digital is one way to accomplish this. Digital investments can encompass initiatives such as developing a mobile app, launching a new website or upgrading an existing one, adding digital wallets, and using third-party payment solutions like Venmo. Social media integrations can also accelerate the customer path to product purchasing via features like “Shop Now” buttons, one-click ordering or shareable product pages.

Investing in technologies like AI, the cloud and data analytics can optimize sales and marketing channels, drive customer personalization and more relevant messaging, and support strategic approaches like account-based marketing that aim to attract high-value customers and increase market penetration for businesses.

And these potential benefits aren’t just based on theory. Research from the National Center for the Middle Market indicates that companies with a clear and comprehensive digital vision grow 75% faster than their peers. The center’s research also found middle-market companies that were more advanced or strategic in their approach to digital innovation experienced an average of just under 10% revenue growth over a 12-month period, compared with 6.5% revenue growth over the same period for companies that hadn’t yet made digital a core part of their business.

It’s clear that midsize businesses that want to build or maintain their competitive advantage and transform into high-growth companies need to become more digitally enabled. In the process, they might also make themselves more attractive acquisition targets in the future.

The Market Opportunity for Private Equity

The increased focus on digital transformation (DX) initiatives within the middle market isn’t just good for these businesses; it is also expanding the investable universe for PE firms.

Greater investment in automation, marketing tools, customer-facing technologies and communications are making this historically untapped market segment less opaque. Currently, it isn’t easy for dealmakers to gather accurate information about middle-market companies as they try to decide whether these businesses fit their investment criteria or have high enough growth potential to deliver at least a 4x return. DX investments increase the visibility of these companies, so potential investors can effectively search for them and better assess whether they are actually investable.  

DX investments will make certain mid-market companies more valuable, especially if these investments lead to improvements that reduce operational and financial risks, drive greater market share or help companies build a nearly impenetrable moat around their business—whether from a brand, price or customer experience perspective. In recent years, digitally enabled companies have sold at higher multiples, giving PE firms a way to get higher multiples that may rival those of software companies.  

While some PE firms’ bread and butter is bringing operational expertise to their portfolio companies, a middle-market company that already has advanced digital capabilities may also have more mature operations that accelerate its path to an IPO or acquisition. It just may need additional capital to get there—making the lift less heavy for a potential investor.

Middle-market companies have so much value just waiting to be unlocked, but private equity firms traditionally have had limited visibility into this market. However, rapid digital transformation in the middle market could change this. With more digital capabilities, companies in this sector can boost customer engagement, deliver a better customer experience, and optimize their operations to grow their margins and build a durable competitive advantage. All of which will make them prime targets for innovative dealmakers who want to help them realize their full potential.