Legacy IT systems are a red flag for investors

25 Apr, 2023

For investors, outdated IT systems raise concerns. They signify that processes are inefficiently structured and decision-making is suboptimal. The fact that management has held onto outdated systems also reflects something about the professionalism of an organization. Consequently, there can be a significant disparity in valuation between companies operating on legacy systems and those with up-to-date IT infrastructure. The transition to state-of-the-art IT, therefore, represents a game-changing move.

There are substantial disparities among businesses in terms of IT investments. While some have proactively invested and are more future-proof, others are still running systems from the early 21st century or even older. From an investor's perspective, there is a significant divergence between these groups, as Thibault Thevissen, Associate Director at Carlyle Europe Technology Partners, a fund investing in small and medium-sized technology companies in Europe, part of the global investment firm Carlyle, explains.

The primary cause of this difference is that after acquisition, an investment overhaul will be necessary. "This incurs costs, as well as risks. It can be distracting, pulling people away from their daily tasks to focus on guiding internal IT projects."

Unlocking Cash

By addressing IT issues, many companies can make substantial efficiency gains, notes CFO Marius Haverkamp of HSO, a business transformation partner leveraging the full power of Microsoft technology and a portfolio company of Carlyle Europe Technology Partners. "We have clients still operating on legacy IT, which makes it difficult for them to assess their delivery needs accurately. To ensure they can always meet customer demands, they maintain excess inventory, tying up significant amounts of cash."

Haverkamp has witnessed clients reduce their inventories by as much as fifty percent after transitioning, thanks to the deployment of data intelligence, particularly at companies with multi-billion euro revenues. "This translates to a substantial increase in free cash flow, something that investors value."

Carve Out or Merger: the Opportunity to Transition to the Cloud

After a merger or acquisition, revamping IT systems is one of the initial major projects. Given the complexity and time constraints, many companies face considerable challenges here. Simultaneously, this represents an ideal opportunity to bid farewell to legacy systems and move towards cloud solutions.

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Enhancing Decision-Making Quality

Another critical factor for investors is the quality of decision-making, states Thevissen. A future-proof IT system can support this aspect. "It allows you to gauge whether you are doing things right or wrong much more effectively. Quantifying this is challenging, but in my view, it is the most crucial aspect of future-proofing IT." As an investor, he can already assess a company's position during due diligence. "We pose a question, and based on the time it takes to answer, we get a sense of the situation."

If no steps have been taken to future-proof IT, it also reflects on an organization's culture, he continues. "The first question is why it hasn't been done yet. What does it say about the leadership and process formalization? It has been a management team decision to delay, and that might necessitate personnel changes or expansion. In such cases, as an investor, you apply a discount."

Haverkamp agrees. "When a company thinks in terms of processes and knows that IT is necessary for growth, it instills more confidence than a company still relying on software from the mid-90s. It speaks to the mindset."

The Importance of Mindset

This mindset is always crucial when an organization considers transitioning to a new system, explains the CFO. "IT implementation isn't cheap; we're talking about several million euros. Therefore, we always start with the question 'why do you want this?' There must be a genuine driver, such as the company's desire for international expansion or readiness for the next step in a buy-and-build strategy. It's about identifying the necessary steps within internal processes and how IT can support them."

For private equity investors, growth potential and the ability to realize growth through acquisitions are vital factors. IT is a prerequisite to achieving this, as Thevissen points out, "You want to integrate an acquired entity onto your own systems as quickly as possible to gain control and steer decision-making. Systems need to be scalable and capable of international operation. Without that, part of the business operates on trust, making scaling difficult."

Need for Flexibility

Compared to ten or twenty years ago, companies now require more flexibility and the ability to adapt quickly, adds Haverkamp. "When companies want to do something today, it happens much faster than in the past. When they expand internationally or make acquisitions, they no longer let everything run on old systems for five years. Adjustments need to be made immediately."

Furthermore, businesses are increasingly combining various types of activities and services. "We have more and more clients who don't fit neatly into one category. Companies that produce also engage in some trading and undertake projects. They don't want to look for different IT solutions for each; they want a single provider with one platform that is easy to scale."

The transition to state-of-the-art IT is a multi-year journey that requires significant effort. However, if companies approach it with the right mindset, the effort is one hundred percent worthwhile, concludes Haverkamp. "Once you've replaced legacy IT with new systems and the management team and organization embrace innovation, you can handle growth. It can't be expressed in a percentage or a sum, but it's a tremendous game-changer."

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