GenAI Disruption Risk for PE Investments: Lessons learned from previous waves of disruption

GenAI Disruption Risk for PE Investments: Lessons learned from previous waves of disruption
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Recently we have performed several AI risk assessments on prospective targets of our Private Equity partners, with the underlying question being: “Is this company at risk of being disrupted?” A question that has of course always been explicitly or implicitly part of a Due Diligence process for any PE transaction. But also a question that we last heard that often in the 2010s related to the mobile & eCommerce wave.

Technological change itself is not new. Over the centuries it has hit in waves — repeatedly remodeling society, triggering large-scale economic shifts, and creating new business giants. The difference with digital & AI however is that the key underlying technology — computer processing — roughly doubles in power every two years. This means the technological possibilities it opens up become exponentially more sophisticated, thus setting off successive waves of change, each bigger than the last.

<div class="insights_cta-component">“Disruption in the short-term is often exaggerated but the risk in the mid- to long-term is often underestimated.”</div>

The rapid progress in Generative AI and Large Language Models over the past 2.5 years has ushered in a new wave of technological advancements. As a result, Data & AI are showing signs of shifting towards digitized decision-making. Think of automated content creation, AI sifting through lengthy legal documents, personalized customer experiences, or enhanced code development & testing. The emerging applications of Generative AI transcend all departments of a typical company, but also the services of a typical marketing agency, development agency, legal advisory firm, or accounting business.

What does that mean for PEs? Whereas in the 2010s channels became digitized, with the main impact being on how customers are served across for example travel, retail, and CPG, we see that a new wave of disruption is emerging on how customers are served in and around professional and business services and software solutions. A popular investment theme for PEs over the last years. While we do believe in the value of the expertise of a “human-in-the-loop”, we want to share the example of how disruption played out for retailers & manufacturers over the last decade.

Figure 1: Stages of disruption in the mobile & eCommerce wave

How could disruption play out, especially for business services, where decision making is slowly becoming digitized, this time? Due to the rapid technological progress, nobody knows for sure, but it is certain that there will be new disruptors, focusing on serving customers faster, better, and cheaper leveraging the current technological progress with similar stages. While a target may claim in the IM that there are insurmountable walls for disruptors (e.g., people need to try things on before they buy clothes), disruptors innovate and remove them (e.g., free 60-day returns). Barriers are different for different industries, as well as at different times (e.g., trust in online payments was once a barrier), and in different markets. Think about barriers in your target’s industry (e.g., Legal: I need a perfect, error-free draft of this legal document) and how they may be removed (e.g., if I get an answer in a few seconds, maybe 95% is good enough).

Therefore, before investing into a business, PEs should start to ask new questions related to (Generative) AI and categorize the potential impact. For example,

Figure 2: Disruption Risk Assessment Questions

If the result of answering the questions above is direct, a service or business model risks obsolescence. The preferred strategic option for a PE here is to refrain from investing, even at an attractive price, or to pivot its business model as fast as possible if it is a current holding company. A transformative impact indicates a need to change the current proposition and take an active role in empowering management to reinvent the organization to stay relevant over time. This can be an attractive investment with strong growth potential but requires the right investment thesis and a tech enabled strategy from the beginning of the investment. Lastly, incremental impact allows for an optimization in the cost to serve, managing the transaction & ownership process as normal, adopting tools & best practices as they emerge.

Based on our experience of several AI risk assessments together with PEs, judging which category a potential target a company falls into can be difficult. Especially transformative disruption may not be apparent at first but will be during a typical holding period of 5-7 years. To assess the AI risks associated with M&A acquisitions for both traditional and AI-enabled companies, we have developed a comprehensive framework. Find out more here.

Figure 3: Different Approaches for assessing (Gen)AI risk at companies

Feel free to reach out if you want to discuss a potential investment and its AI disruption risk with us and how to incorporate the above questions in your DD process and investment thesis.

Stay tuned. We will share more content on the topic soon.

Vincent Vollebregt
Partner | Sector Lead Private Equity & M&A

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