Alternative data as a competitive advantage in Private Equity

“The growing acceptance of alternative data is driving increased consideration of its use by Private Equity, as  [27% of surveyed firms currently use it, and a further] 25% expect to use it in the near future. This is the move that will provide those adopters with an advantage to make better decisions.”

– Robert Iati, Private Equity’s Increasing Value for Alternative Data

Alternative data: why is this an untapped advantage for Private Equity?

There is a great deal of analysis and content written about quant asset managers, hedge funds, public securities traders and more concerning how they’re looking to use alternative data. This data can also prove incredibly valuable in the Private Equity space, but today it’s not being used to its full potential.

According to Robert Iati, PE firms should be looking at alternative data for the following reasons:

• Alternative data provides an element of nuance that can be valuable to PE investors because PE trades slow. They buy and hold and take an active role in the management of a company over a number of years. They’re not trading in the short term, so the models they’re building are different than those of public traders
• PE still works on somewhat of a more subjective angle. But they can use this data to inform decisions
• Unlike public market traders who have an abundance of access to public company information, PE firms are looking for information about private companies, which can be much harder to come by. That makes the coverage alternative data providers can provide about private companies valuable

For PE investors, if the correlations they find help to inform them, they don’t need to be as precise. If this information helps them understand what’s happening at a particular company over time and helps them actively manage a portfolio, alter the price a tick or two in their bid, or better understand the inside workings of the business, that’s valuable.

What sort of alternative data is valuable to Private Equity traders?

Things like credit card receipts, how a company pays their bills, foot traffic data – also information about people in a company – are all interesting. While this data does not have the rigorous testing history that enables identification of correlations as clearly as with traditional data, it can help PE investors understand where things are going in a particular market.

According to Iati, in his experience at leading research firms, PE investors would look to such firms to help them understand more qualitative information about the industries they’re looking at. They use the information provided in their models to complement more hard core analytical data.

For instance, PE company X is always looking for leads and information on the next hot area or company to evaluate. They’re constantly looking for new opportunities, managing their existing portfolio and looking out at what’s happening in the industry. So they’ll engage a number of sources of information, including people they know in the industry.

They might ask, “Please help me understand how the following sectors in capital markets are going: capital market risk systems, core technology (i.e. cloud services) and capital markets regulatory systems.” Questions might include things like:

• • Are banks investing more or less in this sector?
  • Is there new technology coming up that will boost this sector?
  • Where is the money going – are you bullish or bearish?
  • Who are the top 10 private companies in this sector and why? Who are the newcomers and disruptors?

If that company had alternative data to complement this information, however, they can go deeper. They’d take that list of the top 10 players and see what they can find out about them. Who are their clients? How are the customers paying? Where are they hiring people?

Iati offered an example in which a PE firm once asked, “Can you tell me if private companies in a certain sector are opening or closing offices, paying rent on a new building, or purchasing real estate, based on some of their receipts?”

This data may not fit into a quant model that a public investment company would use, but it does offer valuable information. If they can put this together with the growth they’re seeing, and with research reports, they can make an assumption that the company they’re looking at is adding staff, for instance, and that might help them make a decision. While they can’t trade millions of shares on that information, it’s more knowledge.

They would then take this data, quantify it, and score it internally to understand what it’s worth to them. While P&L data weighs more heavily, this alternative data might tilt a decision one way or another. They can ask the team about it during due diligence, for instance. Then they’d filter this into their platform to build their own models and bring this information to their investment committee.

How can Private Equity investors begin to incorporate alternative data into their decision-making processes?

PE investors already consume much of the same data other investors do. But they need to become more aware of sources of alternative data – particularly the subset of alternative data firms that have information on private companies.

PE firms use data in two ways. The first is to inform about an opportunity for investment. For example, is spending on business in this particular sector growing or shrinking? How can I get into or out of a market or a company before the competition? The second is management of a particular asset or portfolio while they have it. All of this activity would benefit from alternative data.

Step by step:

1. Filter through the somewhat crowded alternative data space to identify sources of private company information
2. Filter that data in a way that fits your unique investment style. PE investors likely have a very narrow scope. They should look to understand who will cater specifically to them. Who has data for the industry you’re looking at?
3. Understand how to take this information in and how it can interface with the tools you already use. How can it fit into your existing workflow?
4. Work it into your model – incorporate it with all the other data you have to inform your decision-making overall

What’s next for the future of alternative data in Private Equity?

We’re in an age where we’re flooded with information. However, none of it replaces anything else – it all augments and supplements what we have. In this space, information is all additive – it’s not a zero sum game. Alternative data will not replace traditional data sources or make final decisions; rather, it needs to be applied to the mix and assigned a relative value that is likely more tilting, informing and improving the decision than it is making the decision.

Today, according to AlternativeData.org, 27% of PE investors currently use alternative data. Of those that don’t, 25% expect to in the near future. They use it to find new investment opportunities – a name or sector they wouldn’t necessarily find. One in three use it as part of a fundamental approach. 29% use it to find new opportunities. That shows that their eyes are open, but it’s a market that is still untapped.

According to Iati, 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.

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