Private Equity and IIoT: Finding the Best Fit

The Industrial Internet of Things (IIoT) is attracting strong attention from large corporations and venture capital firms. To date, however, many industrial-focused private equity firms have treaded carefully in the IIoT space, due to intimidating valuations, uncertain returns, technical complexity, and participation by large strategic acquirers.

Yet, according to Harris Williams Industrials Group Managing Director John Arendale, Director Eric Logue, and Vice President Jenson Dunn, there are a wealth of compelling opportunities to be found. In this report, they share their thoughts on how private equity groups with expertise in industrial markets can tap into the meteoric growth prospects of IIoT and the digital transformation occurring within Industry 4.0.

Key Takeaways

  • IIoT has captured the attention of private equity investors but can be a challenging space in which to invest.
  • Harris Williams has identified five segments that provide a good fit for the private equity model.
  • Three principles can help investors make the most of opportunities within these segments.

Seeing Past the Hype

When originally coined by the Industrial Internet Consortium, the phrase “Industrial Internet of Things” drew a distinction between consumer and mobile applications and those relevant to industrial businesses. These included technologies that addressed challenges in industrial end markets such as manufacturing, oil and gas, energy, mining, and others.

Jargon aside, IIoT is fundamentally industrial equipment connected to a myriad of sensors and to the internet to facilitate data collection, monitoring, and predictive analytics, with the goal of optimizing operational efficiencies.

Logue cuts through the terminology clutter: “IIoT just means connecting machines used in manufacturing and engineering to the internet. You connect something and you gain access to vital information related to it. Therefore, you can manage it better. The visibility provides insight to be more efficient, faster, and/or safer. And that creates an economic opportunity—connected devices are providing value to asset owners.”  

Indeed, many IIoT solutions offer tangible, realizable cost benefits by helping to wring out inefficiency. Despite early challenges in compatibility, interoperability, integration, and lack of clarity around standards, successful implementations now typically drive measurable results in the form of increased machine uptime, greater yield, and increased inventory turns, boosting ROI while reducing risk.

That potential is drawing significant interest among investors seeking growth: Global funding to IIoT companies grew from $208 million in 2011 to nearly $1.2 billion in 2015.1

Five Promising IIoT Segments

Private equity investors are actively seeking ways to participate more aggressively in this growth. But where are the best opportunities? Based on its analysis and recent deal activity, Harris Williams believes there are five industrial segments ripe for IIoT-related investment by private equity firms: Extraction & Heavy Industry, Transportation & Fleet, Manufacturing & Supply Chain, Sensors & Infrastructure, and Utilities & Smart Grid.

Why? For one thing, these segments tend to be a better fit for the industrial private equity business model than other IIoT-related areas with a higher prevalence of potentially risky start-ups.

As Dunn attests, “There are some private equity groups that are comfortable investing in unprofitable businesses and will buy on multiples of revenue, but they are typically software-focused, where scalability and operational leverage justify valuations. It is otherwise rare, particularly in traditional industrial products businesses.”

Another reason the segments highlighted above provide solid opportunities for industrial investors: recent trading multiples in attractive ranges. In comparison, the high multiples other IIoT-linked segments are attracting can be a private equity deterrent.

Dunn believes that, “The last four or five years, because of the run-up in the public markets, valuations are high and typically beyond what the private equity model is capable of paying. It has to be a special situation, where a private equity firm not only has relevant experience with the market, but also a unique angle to add value to the business.” Arendale believes there is tremendous upside to many of the opportunities in these five sectors. “IIoT is an almost tidal wave trend in the industry,” he says. “Some of these platforms are primed to grow many times larger. If you make the right investment and do the right things with the company, you could create substantial value.”

He warns, however, that “private equity groups are going to need to adjust their approach. You can hit home runs here, but you have to know what to look for.”

Spotlight on Manufacturing

Andy Leed, a vice president in the Harris Williams’ Technology, Media & Telecom (TMT) Group, sees substantial opportunity for IIoT-related software in the manufacturing space: “There’s a major push underway to connect machines and capture data from them in real time.” The ultimate goal? Optimizing shop floors, improving quality, and streamlining supply chains through real-time data and actionable insights.

According to industry research, the convergence of the digital and physical worlds is ushering in a new era of smart manufacturing that is expected to drive $900 billion in global investment annually through 2020.1

Manufacturers are increasingly digitizing their production operations to capture valuable data and insights that allow more proactive decision-making. In particular, as more connected machines come online in factories, demand will continue to accelerate for interoperable next-generation Manufacturing Execution Systems (MES), Product Lifecycle Management (PLM), Enterprise Asset Management (EAM), and Supply Chain Management (SCM) applications, among others. “Heightened interest in manufacturing software is drawing the attention of both industrial and technology-minded private equity firms, which are making big bets on assets in the broader sector, often prevailing against legacy industrial incumbents,” says Leed.

The drivers are simple, adds Leed: “End customers want faster, more responsive manufacturing. They also demand quality, which is facilitated by the data transparency these IIoT-enabled systems can provide. And the manufacturers themselves are under constant pressure to comply with an increasingly complex regulatory environment.”

Spotlight on Transportation

Connected equipment is nothing new in fleet management says Joe Conner, a managing director in the Harris Williams’ Transportation & Logistics (T&L) Group: “Especially in over-the-road transportation, companies have been tracking vehicle location, speed, and other variables for some time now.”

The next step, says Conner, could change how the world’s cities are run. A recent Harris Williams client, Safe Fleet, specializes in safety systems and devices for niche fleet vehicles, including municipal fleets. Categories include connected video monitoring systems that can livestream footage back to a central command post. The potential applications include real-time situation management, as well as ongoing security and surveillance.

“Imagine a major fire in a large city involving several crews of firefighters,” says Conner. “This technology has the potential to stream a view of the situation back to a centralized location, where commanders can make decisions outside of the heat of the moment.”

Such decisions could save lives by rapidly freeing up personnel and redeploying them to more pressing incidents, or by proactively escalating response to worsening situations. Conner also notes potential applications in missing-persons or fugitive scenarios. “City buses can use technology like this to record who gets on and who gets off,” he says. “Eventually this could come together into systems that use facial recognition to create a rolling mobile surveillance net.”

That net could help catch the good and the bad, says Conner: “School bus fleets could use it to know when a child doesn’t get on where they’re supposed to, and quickly notify parents and authorities.”

No matter the application, smart, connected cities are coming, and fleet vehicles will play a role: “They’re already out there, moving through the community, making them a perfect platform for gathering data.”

Three Principles for Identifying IIoT Opportunities

To be sure, in the highly competitive IIoT space finding the golden nuggets can be challenging, especially when they don’t necessarily conform to the typical private equity firm’s investment profile. Through experience, Harris Williams has identified three principles that will help guide firms wanting to make the most of IIoT opportunities.  

1. Look for mature companies with “real estate” in the early stages of connectivity.

Ironically, one of the best ways to gain access to the IIoT opportunity may be by investing in traditional industrial companies that have yet to undergo substantial digitization. Such companies can provide affordable “real estate” that provides an entry to IIoT through the addition of sensors, software, and connectivity.

In particular, opportunities exist among industrial companies active in large markets with distributed assets or infrastructure. That is especially true within industries characterized by specialization, a high cost of failure, rugged operating environments, and a focus on safety, uptime, and/or regulatory compliance. In these instances, there is substantial value to be gained by collecting and analyzing data on equipment performance and using it to make better decisions.

Many such markets have not advanced their monitoring or maintenance capabilities beyond traditional methods such as ad hoc monitoring, creating potential demand for IIoT solutions that can quickly detect issues and improve performance. Indeed, evolving technology and declining costs related to sensors, connectivity, data analysis, and computing make it relatively easy and cost-effective for these previously untapped markets to connect to the IIoT.

This trend has, in fact, played out in varying degrees across industries. Adoption of IIoT technologies is quite advanced in fleet management, for example, but much less pronounced in areas such as agriculture, lone/remote worker or location management, lower-value industrial equipment, tanks/containers, cold chain, waste management, and middle market factories, cities, and buildings, says Logue.

“We worked with a company with decades of experience in a relatively unsophisticated market, but one where yield is critical,” he says. “With increased capability in terms of data collection and analysis, they have been able to decrease energy costs and improve yield.”

The shifting economics of IIoT technology is also creating opportunities where none existed before, Logue explains. “Something like a multimillion-dollar centrifuge comes IIoT-ready, but it used to be that it didn’t make financial sense to apply those technologies to lower-value assets. As the cost of sensors and connectivity has decreased, some of these assets can begin to move from the technician/service model to an IIoT solution.”

2. Recognize there is a continuum of choices and consider looking smaller.

Optimized companies in the IIoT space sell at a premium, and private equity firms that want to enter the market in this way should be prepared to pay. There are also not as many midsize firms to choose from as in other sectors.

According to Logue, companies in the IIoT space tend not to go through the common maturity cycle.  “Typically you have a young company that becomes profitable. You might get some investors coming in, maybe private equity, to grow it to a certain scale. Then a strategic buyer will come in and acquire it after it has proven itself out. It's different in industrial technology, particularly IIoT. Companies go from founder or venture capital funding to being acquired or they scale so aggressively they quickly outgrow middle-market investors.”   

Investors and buyers may also encounter privately owned companies started by engineers with deep technical focus, but limited time or attention for the commercial side of the business. Such businesses can provide significant opportunities for acquirers able to see and develop the full potential of vertical IIoT solutions not yet adapted to broader markets, says Logue.

“I’ve seen examples where private equity groups have successfully combined small businesses with a common thread, adding a holding company/chairman structure,” he says. “You just have to be comfortable starting small.”

These companies may not look like acquisition platforms, but could still fit within a private equity firm’s larger portfolio. As Dunn notes, “There are gems to be found if evaluated through the right lens—spots where a focused private equity firm can add significant value.”

3. Develop themes, have angles, and enlist experts.

Most private equity firms would agree that they only have the capacity to be good at a few things.  Particularly when investing in an emerging opportunity like IIoT, they need to be clear on their expertise and investment strategy, which allows them to be aggressive with opportunities. 

As Logue explains, “There are certainly a number of experienced investors in the space, spanning strategic players and private equity. Generalist industrial investors should cultivate themes and be prepared to be aggressive when the right situation arises. This isn’t a market where many opportunities arise without significant competition.”

Arendale agrees: “Know where you're comfortable from a knowledge standpoint, that's what gives you angles. If you're brand new to a space and don't have a thesis or full understanding of an industry, it's going to be tough for you to compete. Having that background helps you, as a private equity group, find ways to bring value beyond capital.”  

Along the same lines, it is essential for investors looking to participate in IIoT to seek out the guidance of established experts.

“We've seen a number of private equity groups put together an advisory board on a particular theme,” says Logue. “They are trying to build a knowledge base of experts that have been in the field, have been operators, or are senior executives that have seen transformations in businesses and know what pitfalls to look out for and how to evaluate growth opportunities.” 

These experts can be invaluable when the PE firm needs to act quickly and aggressively on a new opportunity. In particular, they can help investors focus and streamline due diligence efforts, quantify the investments required to unlock a company’s latent IIoT potential, build rapport with management teams, and arrive at a value that will deliver satisfactory returns while giving the firm confidence it can prevail.

IIoT Investment Principles in Action: Potter Electric Signal Company

These principles are illustrated by the recent acquisition of Potter Electric Signal Company. Founded in 1898, Potter is a global leader in sprinkler monitoring devices that passively monitor the internal condition of a sprinkler system to ensure that it is capable of applying suitable suppression at the exact location of the hazard.

In recent years, Potter has entered the fire systems market with an integrated product that includes a networked fire panel and the associated peripherals that automatically detect heat and smoke, activate fire suppression and alarms, and provide emergency responders with the emergency location and type.

Potter also recently launched a market-leading intelligent nitrogen system that mitigates the risk of corrosion-related system failures. With the deployment of its overall facility management software, Potter’s new products play a critical role in ensuring safety while collecting a wealth of data on building status and condition.

The core architecture of Potter’s product lines—an IP-enabled, wireless sensor network that is monitored and controlled by a central management software—positions Potter to move beyond sprinkler and fire systems and potentially into overall building facility management. The industry has designated this market application as “smart building solutions,” an IIoT-enabled segment in which data from a broader sensor network is used to optimize building control and operations, including life safety systems (i.e., HVAC, security, access control, etc.).      

This IIoT potential factored into the investment thesis of several private equity investors who valued Potter’s growth trajectory beyond its core markets. As described in the principles above, the groups that progressed to the final stages possessed significant institutional knowledge of the industry, its relevant regulations, and customer segments. They also brought in thought partners with industry experience that held executive roles within larger industry players to help assess Potter and its growth potential.

Investors valued the resiliency of its core business, but also saw the potential to expand into a much broader smart building product offering. Additionally, with the launch of its intelligent nitrogen system and the data it was collecting on the health and status of a sprinkler system, investors understood the exciting opportunity to monetize the data feed into a potential recurring revenue source.

“Potter is a solid company with a long growth runway and potential to develop further into IIoT, smart buildings, and data analytics,” says Arendale. “It had a great revenue profile with downside protection in its stable sprinkler monitoring base business, plus several growth levers in attractive and potentially transformative adjacent opportunities.”

Conclusion

IIoT is an exciting space, but to date it has been a challenging application for the private equity investment model. There are, however, segments that fit that model, and offer private equity firms a way to be more active in this fast-growing market. By considering the right opportunities and bringing the right expertise, investors can tap into the surging growth potential created by this fast-moving trend.

1. “Funding to IoT Startups Rallies in Q1 ’16 to Second-Highest Quarter Yet,” CBInsights Research Briefs, April 2016, https://www.cbinsights.com/research/iot-funding-startups-q1-2016/

2. Source: IDC; McKinsey Research; PwC; Data, Strategy, Technology.