As data has become ubiquitous, asset managers and hedge funds deepen their search data that will enable them to gain an advantage. At the same time, the digitization of our lives, enhanced by complex analytics and AI, has created the opportunity to use new data to supplement existing decision-making information and to uniquely identify predictive signals.
Quant trading firms—and many fundamental shops—have embraced this alternative data as a key input to their models. Private equity firms however, have been slower to embrace alternative data.Barely one in four PE firms use alternative data in their analysis and valuations, according to a recent study by AlternativeData.org (Exhibit 1).
Private equity’s focus on non-public entities and their stingier data budgets, together with the vendors’ lack of PE-targeted data products, are three of the reasons behind their lagging use of non-traditional data. But the growing acceptance of alternative data is driving increased consideration of its use by PE, as 25% of surveyed firms expect to use it in the near future. This is the move that will provide those adopters with an advantage to make better decisions.
The biggest PE managers are investing in alternative data to spotlight opportunities in promising industry segments, to presage reasons to exit a portfolio investment and to improve the precision of their pricing models. Indeed, Exhibit 2 notes that the effective integration of alternative data in private equity is valuable for idea generation (29% use it for entry into, and exit from, investments), valuing and pricing investments, and fundamental portfolio construction (38%).
Why Hasn’t Alternative Data Penetrated More PE firms?
With so many new types of data and creative applications emerging daily, it may be surprising to find PE usage at less than 50%. But a limited number of sources of non-traditional data are presently available for private companies and fewer still have enough depth, breadth and historical experience of private company data to prove meaningful correlation to performance. This results in the misalignment of the alternative data product to the client need. Simply put, most of the data from social media sentiment, credit card receipts and satellite parking lot surveys follow well-known public companies because that’s the easiest application of the data, provides the clearest test results and caters to the broadest investor market. But it hasn’t been enough to adequately service that industry segment.
Current applications of alt data do improve upon early-stage social media sentiment and GPS satellite tracking data, adding insight related to private companies’ payment behaviors, credit risk and cybersecurity factors. However, until the providers apply this data to private companies and broaden it to include these newer data sets, they will not maximize the value to private equity.
Next, the revenue models of most alt data products are misaligned with the PE model. PE’s areas of investment emphasis tend to be clearly defined and relatively narrow, with plainly stated commitment to specific industry segments, company sizes and growth stages (e.g., “US fintech businesses with greater than $50MM in revenue that show an operating profit, EBIDTA of 10.5X and growth > 20%”). With their budgets often tight, the PE’s data needs will follow suit. PEs don’t want to pay for alt data on thousands and thousands of private companies. Instead they benefit most from data only on the specific company or sector that aligns with their investment charter. This differs from the manner in which many alt data providers offer their products, which are more typically sold in a broader method, discouraging use by PE firms.
How the Uniqueness of PE Investing Aligns Best with Alt Data
So how does this data offer value PE firms? Simply put, private equity investments stand to benefit from alternative data as much, if not more than, do investments in public securities for three reasons,
- The time horizon for PE investments is typically longer than those for public companies (likely years, rather than months), lessening the importance of the short-term market fluctuations that arise from factors out of the company’s control and raising the value of the less quantitative data that is often the foundation of alternative data
- PE’s role within the investment company is meaningful. PEs are one of very few investors in any specific private business, rather than one of thousands or even millions of public company investors. Hence, their large, often majority stake in a company gives them an influential seat on its board and a practical level of control over the management of the company for the length of their ownership, and
- PEs have fewer investments than do asset managers and hedge funds, so the performance of each company has greater relative impact on the overall returns of the PE fund. As a result, the PE firm will allot a substantial amount of time to any single investment to ensure maximum value, placing increased value on the non-quantitative and often nuanced alternative data.
For these reasons, the more nuanced microenvironment factors that can be spotlighted by alt data make a real difference in tilting the PE’s investment decision and subsequent post-investment management of the private company. This highlights the value of alternative data, which may not be as deep or as robust as fundamental data but can wield influence sufficient to tip the scales of an investment decision and help guide the PE firm in its management of its investment.
Overcoming the Obstacles
If private equity recognizes greater value for alt data at the same time that more alt data on private companies is available, what is the key to overcoming the obstacles and increasing adoption? First, acknowledgment of the growing importance of private company data has led alt data providers to collect and offer more information on the private sector. Dozens of other providers are offering new data from private companies, as the expected demand grows, but most have not yet penetrated this sector to become prominent suppliers. For the PEs that use alt data in their analysis and valuation, 90% receive it from traditional data providers (Bloomberg, Thomson Reuters, IHS Markit, etc.…) and just 32% come from non-traditional alt data providers, most of which have been in the business for less than ten years (Exhibit 3).
Nasdaq’s recent acquisition of Quandl marks an important event for the mainstreaming of alternative data, further validating its importance. This extends beyond the expected actions of traditional data providers curating private company data in that Nasdaq is not only a primary original source of public company data to the industry, but now, via Quandl, will be acquiring and curating 3rd party data and selling it to the industry as well. I anticipate we will see more such acquisitions and partnerships of large established businesses with niche alt data providers in the coming year. Clearly, as alternative data for public companies has gone mainstream, the providers continue to expand their product set of private company data to service this underserved segment.
Conclusion: How PE Firms Can Best Use Alt Data
Whereas professional investors in public equities (hedge funds, asset managers) are heavily reliant on quantitative analysis and the precise correlations of data to market returns to identify buy/sell signals, investors in private companies (i.e., PE) retain greater value for the qualitative element. Fittingly, PE investing can more readily incorporate alternative data that may have a shorter historical association with returns (i.e., fewer years of back testing) or have correlation that is more directional in its nature than it is exact. Private equity firms will reap rewards from the alt data to sway decisions slightly in either direction, shift a bid price a tick up or down or help advise of a strategic approach for the business once the deal is closed.
The success of PE investment in smaller private companies is just as much a function of its micro-environment (e.g., company’s culture, capabilities of its executives, loyalty of its best clients) than of macroeconomics and quantitative analysis. This is what will lead PE to increase its use of non-traditional data by 25% in the next 24 months (Exhibit 3). With non-traditional data for public companies becoming so widely accepted, expect more providers (https://alternativedata.org/data-providers/) to make similar data available for private companies to fuel this growth.
The level of depth and detail undertaken by private equity firms in their due diligence leaves no stone unturned and contributes positively to their ultimate decisions. Their practice of hiring subject matter experts and other specialists on a project by project basis to uncover the “inside baseball”, including the microeconomic financial projections, market views of the business, and opinions of executive management confirms their interest in incorporating information that goes beyond the quantitative to enrich their decision-making. The incorporation of alt data in their process will support the hard facts as well as offer a more nuanced and qualitative understanding of their target investments, proving its value to the valuation equation.
In sum, adoption by PE is inevitable. Simply put, firms that don’t update their investment processes to incorporate alternative data face the risk of being outmaneuvered by competitors that can most effectively incorporate alt data into their valuation equations and trading models. Alt data vendors will align their products to serve the nascent market, while PE firms will join the party and benefit from the unique value that non-traditional data brings to their investment process.
Robert Iati is the Founder and Managing Principal of Fox Chase Advisors, a strategic partner for businesses in the capital markets. See more commentaries at www.foxchaseadvisors.com.