The economics of cloud computing in private equity

continuous learning with predictive models

July 7, 2020

Why private equity should consider cloud computing as a major value creation element in their portfolio company growth strategies

There is a significant upside opportunity for private equity leadership to look at cloud computing as a core element of their value creation strategy and planning within their portfolio. Taking a thoughtful approach to assessing the risks and impact to the business is essential in determining the real opportunity costs and value driving elements of implementing a cloud-first strategy.

There are reasons why private equity has not considered the business impact and related value creation opportunities of moving to the cloud. Private equity economics has historically favored capital expenditure (CAPEX) versus operational expense (OPEX) as the investment source for IT infrastructure across their portfolios. Firm leadership felt this allowed them to better manage a fund’s depreciation cycles and realize the associated benefits that came along with their enterprise value calculations.

The CAPEX spend associated with on-prem IT environments is time, resource and capital intensive. The upfront hardware and software costs associated to support these environments need to be very thoughtfully planned based on business growth projections. The challenge with this is predicting what the IT requirements will be based on complex external pressures like competition, market demand and economic climate. Compounding this challenge, the capital used for investments to support an on-prem IT environment cannot be redirected.

A cloud computing approach enables decision making that more accurately matches supply and demand, preventing over or under investing in IT. This ‘pay as you go’ structure provides greater budget flexibility to manage costs at a line of business or subsidiary level with more efficient resource utilization.

As the cloud computing market continues to mature and scale, the economics offers a compelling value proposition tied to a firm’s larger CAPEX investments in assets that are not central to their value creation strategy. Arguably, tying up capital in costly on-premises IT environments that can be resource intensive to maintain and inflexible to evolve with the business is doing very little to drive value.

IT environments impact on growth, value return and innovation

The rate of technology change continues to outpace most organizations ability to effectively maintain on-prem IT environments. Many companies have legacy applications that lack the flexibility to be modified or upgraded to take advantage of the latest innovations. This causes companies to get bogged down maintaining these costly, often functionally deficient environments, which in turn can hinder a company’s ability to grow. Cloud based environments provide the flexibility to take advantage of innovation advances by eliminating the sunk costs and inflexibility associated with the CAPEX heavy IT spend on legacy environments.

When to consider cloud migration as a value creation strategy within your portfolio

The answer lies in a firm’s growth and value creation thesis and how they view innovation through capital investment. If there are needs in a firm’s portfolio that require capital investment in core product or service offerings, cloud computing enables a firm to focus capital investments on these core value-creation activities. Concurrently, cloud-based platforms enable increased flexibility to make continuous enhancements as the business needs evolve, while eliminating the costly distractions that come along with managing an internal IT environment. For smaller portfolio companies, cloud-based environments provide a significantly lower cost-of-entry and total cost of ownership over time. It enables companies to take advantage of best of breed technology throughout the business life cycle on a cloud platform.

Cash flow is king

If there are capital constraints within the portfolio, cloud computing offers the flexibility to consume IT on an as-needed basis with monthly reoccurring expenses that align more closely with the portfolio revenue and investment cycles. This delivers much more predictability from a cash flow management perspective. Managing a business on a cloud platform also eliminates the periodic need for unexpected spikes in capital investments required for on-prem IT environments due to sudden changes in the business. From a cash management perspective, operating the business on a cloud-based platform enables increased efficiency of deployed capital by more effectively aligning IT expenses with the timing of revenue and receivables to keep cash flow strong.

Is information technology your core business?

Ask this question across the portfolio to understand whether IT is central to a portfolio company’s value proposition. A cloud-first strategy allows operating partners to focus on the elements of the business that are truly at the core of driving value, resulting in the multiples and related return a firm strives to achieve when exiting an investment.

At first glance, a cloud-first strategy might appear to create additional operating expenditures for a company. However, with careful consideration of all the opportunity costs of deployed capital, cloud-based economics will drive lower total cost of ownership and provide significantly more flexibility over a firm’s planned investment horizon.

In summary, while cloud environments deliver beneficial financial and operational advantages, there are important considerations that need to be factored into a cloud migration strategy and plan. PE firms and their investment companies need to carefully consider factors such as business impact (change and disruption) and plan for this accordingly. Done thoughtfully, with the right partners in the mix, the value of migrating to a cloud-first strategy can pay material dividends to both PE firms and the companies they invest in.

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