i Deal activity
Despite the uncertainty in the European (and Italian, in particular) economic and political environment, private equity (PE) activity in the first half-year of 2018 (the most recent statistics available at the time of writing) has been positive, with the one of the strongest Q1s for Italian PE deal activity in terms of both deal numbers and value. Deal activity in 2018 has maintained the upward trend that started in 2016 and 2017.
According to the data made available in the AIFI and PwC report 'The Italian Private Equity and Venture Capital Market: 1 Semester 2018', in the first half of 2018, the value of investment amounts stood at €2,857 million (up 49 per cent compared to the first half-year of 2017) with 160 deals (up 15 per cent compared to the first half-year of 2017).
Investments in Italy have been characterised by a prevalence of investments in the industrial (30 per cent of deals), consumer (27 per cent) and financial (25 per cent) sectors. Investments in technology registered a decrease compared to 2016 and 2017. More specifically, the industrials and consumer goods sectors made up more than half of all deals, whereas in the past technology was the most dominant sector by some margin. The large deals in financial services can be explained by the crisis of certain Italian banks and the acquisition of non-performing loan portfolios by PE sponsors. PE investments are mainly concentrated in the north of Italy, and, in particular, in Lombardia (44.7 per cent), Veneto (10 per cent) and Emilia Romagna (8.7 per cent). Only a few investments have been made in the south of Italy (two deals in Puglia, one in Campania and one in Basilicata).
Some of the largest deals in 2018 indicate the level of interest in the traditional Italian strongholds. Peninsula and special purpose vehicle Space4 acquired Italian bottle-sealing manufacturer Guala Closures. Bain Capital acquired Ardian-owned Italmatch, a leading innovative chemical group for €700 million. Sun Hydraulics acquired Faster, a manufacturer of quick-release hydraulic couplings.
In terms of types of investments by PE sponsors, the interest in majority investments increased compared to the previous half-year (up from 67.66 per cent to 73.4 per cent). Investments providing for the acquisition of a minority interest registered a substantial decrease, namely down from 18.4 per cent in the second half-year of 2017 to 14.3 per cent in 2018.
In the first half-year of 2018, fundraising amounts totalled €1,852 million (as against €1,195 million in the same period in 2017), of which €1,289 million was raised by private independent entities (compared to €453 million raised by independent entities in 2017). More specifically, fundraising was largely the concern of individual investors and family offices (17.3 per cent), pensions funds (15.6 per cent), banks (14.4 per cent) and insurance companies (14.2 per cent).
As far as exit transactions are concerned, in the first half-year of 2018, the value of exit transactions decreased compared to the previous half-year, amounting to €1,109 million (down 10 per cent compared to the first half-year of 2017), with 59 deals (down 24 per cent compared to the first half-year of 2017).
ii Operation of the market
Management equity incentive arrangements
In 2018, management equity incentive plans for managers or key employees benefitted from the introduction of a relevant piece of legislation, namely Article 60 of Legislative Decree No. 50/2017.
This provision sets out a presumption of law by virtue of which the carried interest (namely the proceeds that key employees or directors receive from direct or indirect participation in companies) is subject to taxation as financial income (with a much lower rate, on average, than that applicable to employment income) if the underlying financial or participative instruments held in the company by the manager meet the following requisites:
- the total investment commitment of the relevant employees or directors triggers an actual disbursement of at least 1 per cent of the net assets of the company;
- the vesting of the instruments occurs only after the shareholders of the company hit a pre-determined hurdle rate (i.e., a minimum return rate) or, in the event of a change of control, on the condition that ordinary shareholders have realised a return at least equal to the invested capital plus the aforementioned hurdle rate; and
- the instruments are held by the managers concerned (or, in the event of death, by the heirs) for a period of no less than five years or, if prior to the five-year period, until the date on which a change of control takes place.
Standard sale process
Despite there being no mandatory process, competitive sales in Italy are usually structured in recurring phases.
The initial effort is generally made by the management of a target company or its shareholders with the help of a financial adviser. They put together a 'teaser' and, for those who show interest and sign a non-disclosure agreement, an information memorandum. Typically, management presentations follow and the potential purchasers are asked to submit non-binding offers. Due diligence checks usually take place before binding offers are submitted (sometimes, also second-round binding offers are provided) and are often preceded by vendor due diligence reports. Transaction documents (which are usually based on formats put together by the sellers) are often attached to the offers made by the potential acquirers.
The duration of a sale process may depend on a number of different factors, including the level of competition, necessity of authorisations for execution of the transactions (clearance from antitrust authorities, bank waivers, etc.) and the regulatory background to the sale.
The duration of competitive processes for mid-size acquisitions (whose closing occurs after signing) may range from two to six months depending on regulatory approvals.
II LEGAL FRAMEWORK
i Acquisition of control and minority interests
Acquisitions of control and minority interests are usually made by PE sponsors through special purpose companies. In Italy, the two most common types of companies are the joint-stock company (SpA)2 and the limited liability company (Srl).3
Generally, special purpose vehicles are SpAs since this type of company enjoys characteristics that are generally more appealing to investors, such as the option to issue bonds or to have different classes of shares with different rights. However, Srls have lower minimum capital requirements and are generally more flexible than SpAs.
Another main difference between SpAs and Srls concerns corporate capital. The SpA's corporate capital is divided into shares and represented by financial instruments that can be listed and negotiated in regulated markets, whereas the Srl's corporate capital is represented by a quota with no unitary value.
In this context, however, note that in 2017 the Italian legislature significantly amended this structure, introducing certain rules for Srls that were traditionally applicable only to SpAs. In detail, Law Decree No. 50 of 24 April 2017 and Legislative Decree No. 129 of 3 August 2017 established that small and medium-sized enterprises (SMEs) organised as Srls may derogate from the traditional corporate model for all Srls provided for in the Italian Civil Code. These companies (SMEs or SME Srls) are medium-sized and small Srls within the meaning of the Commission Recommendation of 6 May 2003, namely enterprises that employ fewer than 250 persons and that have an annual turnover not exceeding €50 million, or an annual balance sheet total not exceeding €43 million.
Different classes of quotas
According to the new rules, the by-laws of the SMEs may provide for 'classes' of quotas with different rights and, within the limits imposed by law, may freely determine the content of the various classes of quotas, in derogation of the provisions of Article 2468, Paragraphs 2 and 3, of the Italian Civil Code.
For example, it is now possible to have classes of quota holders without the right to vote at the general meetings or whose voting right is limited by specific conditions or on certain matters. Also, the by-laws may provide for classes of quota holders with voting rights not proportional to the percentage of corporate capital owned.
Public offering of quotas of SME Srls
The quotas of SME Srls can be the object of a public offering of financial products, including through crowdfunding portals. This option was already available to innovative small and medium-sized companies under the previous legislative framework; however, the 2017 reform extended this option to include SME Srls.
The SME Srls whose quotas are the object of a public offering can opt to dematerialise their quotas, thus derogating from the traditional system of quota transfers.
Operations on quotas
According to Article 2474 of the Italian Civil Code, traditional Srls may not grant loans or give guarantees for the purchase or subscription of their own quotas.
As an exception, SME Srls – in the context of the implementation of incentive plans that provide for the assignment of interests to employees, collaborators or members of the administrative body or service providers – are now entitled to grant loans or give guarantees for the purchase or subscription of their own quotas.
ii Shareholders' agreements
Usually PE funds effect the corporate governance of the target companies in which they invest through shareholders' agreements.
The duration of the agreement is a key provision in such agreements, as it represents the reconciliation between different demands of corporate law: on one hand, stabilising the ownership of a company and, on the other hand, preserving the freedom of economic initiative of the shareholders, who may terminate the agreement.
Article 2341 bis of the Italian Civil Code provides that shareholders' agreements (specifically those agreements that, to stabilise the company's ownership structure or governance, (1) have as their object the exercise of the right of to vote, (2) set limits on the transfer of related shares, or (3) have as their object or effect the joint exercise of a dominant influence on a certain company) may not provide for a duration exceeding five years, although shareholders' agreements may be voluntarily renewed by the parties upon expiration. If the shareholders' agreement does not provide for a term, each party may withdraw at any time following 180 days' notice.
It has been debated among practitioners whether an automatic renewal provision in the shareholders' agreement (which would therefore entail the renewal of the agreement for a term in excess of five years in the event that no party notifies the other of its intention not to renew the agreement) triggers a violation of Article 2341 bis or not. However, case law had not taken any specific position on this until, in a recent case law decision,4 the Court of Appeal of Brescia opted for the voidance of the clause of a shareholders' agreement that provided for tacit and automatic renewal of the fixed-term shareholders' agreement in the event that the relevant shareholder failed to communicate the termination of the agreement with one year's advance notice. According to the Court, this provision circumvented the mandatory five-year duration limit set out by Article 2341 bis of the Italian Civil Code. It seems, however, that the Court might have opted for the voidance of the provision not because of the existence of a tacit renewal clause in itself, but rather because of the burden imposed by the circumstance of having to notify the intention to terminate the agreement well in advance (one year) of the expiration of the shareholders' agreement. This may lead some to think that such tacit renewal clauses may still be considered valid if they provide for the possibility of the shareholder communicating its intention not to renew the agreement until the point of expiration of the agreement, thus preserving the freedom of economic initiative of the shareholders.
iii Fiduciary duties and liabilities
Management and coordination of SGRs
The Italian Civil Code regulates 'management and coordination' activity. This concept, which lacks precise legal definition, relates to the activity or direction exercised by a 'directing' company over another company, which is subject to this direction because of specific factors. In fact, according to Article 2497 sexies of the Italian Civil Code, it is presumed, unless otherwise proven, that the management and coordination of a (subsidiary) company is exercised by the (parent) companies or entities required to consolidate their financial statements or in any case that control them pursuant to Article 2359 of the Italian Civil Code, which, in turn, identifies cases in which control exists. In addition, case law and scholars have identified certain additional characteristics (such as the identity of board members) that help concretise the notion of management and coordination.
The Italian Civil Code provides for the fulfilment of specific requirements for both the directing company and the directed company in a management and coordination situation. In particular, the company subject to management and coordination has to indicate its subjection to the management and coordination activity in its records and correspondence. Both the directing company and the directed company must register themselves with specific registers kept by the Italian Business Register. Pursuant to Article 2497 ter of the Italian Civil Code, the decisions of the company subject to management and coordination, when influenced by the directing company, must be analytically motivated and must contain precise indications of the reasons and interests whose evaluation had an impact on the decisions.
Liability of the directing company may arise only in cases of prejudice to the remunerability and value of the shareholding or to the integrity of the company's assets. Article 2497 of the Italian Civil Code provides for the direct liability of the directing company towards the other shareholders, or the creditors, if the directing company acts in its own interest or in the interest of a third party in violation of the principles of correct corporate and business management.
Traditionally, questions of management and coordination were not considered in relation to asset management companies (SGR), as these manage only funds, which, in turn, hold interest in portfolio companies.
However, in a recent case law decision concerning the management and coordination of an SGR,5 the Court of Milan held that there was liability towards the other shareholders of the companies owned by the fund managed by the same SGR pursuant to Article 2497. According to the Court, as the SGR has the legal form of a company, it may well exercise management and coordination activity in relation to another company. Therefore, it is irrelevant that the ownership of the controlling interests held by an asset management company is owned by investment funds it manages, since the asset management company has the power to legally act in the name, and on the behalf, of those funds.
As a consequence of this case law, the Italian Private Equity Venture Capital and Private Debt Association (AIFI) issued guidelines to help PE operators to avoid situations where one can see the effective exercise of management and coordination activity for asset management companies. In particular, according to AIFI:
- it is advisable that the boards of directors of the portfolio companies are composed of members different from those sitting on the board of directors of the SGR;
- the SGR and the portfolio companies should adopt management protocols aimed at guaranteeing the autonomy of the target companies;
- the SGR shall ensure that decisions of the portfolio companies are always taken by the competent bodies of those companies (for example, it is advisable that the decisions of the portfolio companies shall be taken before the decision of the SGR on the same item);
- portfolio companies, in their records and documents, including the resolutions of the board of directors, should highlight not the SGR's decisions on the same topics but (1) the autonomy of the company in taking decisions on those matters; and (2) the interest of the portfolio company in taking those decisions;
- the board of directors of the portfolio companies shall resolve upon, with adequate reasoning, the exclusion of the management and coordination of the SGR; and
- the by-laws of the SGR can provide for the exclusion of management and coordination activity in relation to the portfolio companies.
Directors' duty of care and the business judgement rule
As a direct effect of their appointment, directors of Italian companies are entrusted with the general and exclusive duty to 'manage the company with care' and to act in the best interest of the company and in compliance with the obligations set out by the Italian Civil Code and any other applicable laws and the company's by-laws.
The Italian Civil Code does not specify what degree of care is to be exercised by directors of Srls, whereas, by contrast, this duty is explicitly set out for directors of SpAs. In fact, pursuant to Article 2392 of the Italian Civil Code, directors of a SpA have the general duty to carry out the duties imposed by applicable laws or the company's by-laws with the care that is required in relation to the nature of their office and their specific responsibilities. According to the majority of Italian commentators, however, the standard of care required of directors of Srls should not diverge substantially from the standard of care required of directors of SpAs.
In particular, this standard of care should be the standard typical of professionals. To assess the degree of care that may be expected from each director in the performance of his or her management activity, the actual duties that the director performs within the company have to be taken into account.
Directors may not be considered liable for any damage suffered by the company as a result of erroneous or inappropriate business choices made during the course of their management, provided that (1) those choices could be considered potentially appropriate, or certainly not damaging for the company, by a person having the standard of care and knowledge expected from the director of a company dealing with the relevant business sector, and (2) the director followed all the procedural steps requested by the applicable laws before taking the decision (the business judgement rule). In particular, should directors act in such a manner that all the above-mentioned duties have been fulfilled, and also in relation to the decision-making process (collecting information, checking information, applying specific know-how and expertise, etc.) and the transparency of the activities, the judge cannot deem them liable for their managing activity, even if the activity has led to decisions that turned out to be inappropriate or inconvenient for the company.
III YEAR IN REVIEW
i Recent deal activity
Although there is no aggregate data available for 2018 yet, it seems that the year that just ended was characterised by a trend for the consolidation of PE activity in Italy, and this despite the general elections of March 2018, which left the country with basically no government for three months, and the gross domestic product (GDP) data of the final two quarters (GDP fell 0.2 per cent between October and December 2018, following a 0.1 per cent decline in the third quarter, throwing the country into recession).
In the first half-year of 2018, the total deal value had already surpassed the halfway mark of total deal value in 2017, and matched a third of the total volume for 2017.
The Italian market is still characterised by a large number of small- and medium-cap enterprises, mainly family-owned; according to the Italian Association of Family Businesses, there are an estimated 784,000 family-owned firms, which is almost 85 per cent of the firms in the country. The question of succession within such family-owned firms has been among the main drivers for PE deal flows, since PE ownership may circumvent the tensions that can arise from succession issues.
Moreover, Italian SMEs represent a key success factor, by producing high-quality products, mainly in the industrial and consumer goods sectors. More specifically, 'made in Italy' companies have earned a well-deserved reputation mainly in fashion, engineering and food. In 2018, there were 123 deals on SMEs registered (the strongest figures recorded since the financial crisis in 2008). According to a survey conducted by Deloitte,6 almost three-fifths of PE sponsors hold a portfolio of SMEs with an average turnover of €50 million.
In the first half-year of 2018, Italian investments utilised an average percentage of equity of between 41 per cent7 and 60 per cent, and transactions in which the equity component of the investment was between 61 per cent and 100 per cent increased by 8.2 per cent compared to the results registered in the previous half-year.
Deals were executed with a financial leverage of between two and four times the earnings before interest, tax, depreciation and amortisation (EBITDA). Average spreads ranged between 200 and 300 basis points. More specifically, 58.3 per cent of the transactions were financed with a leverage of between two and four times the EBITDA (down 17.4 points compared to the previous half-year), and transactions financed with a leverage of four to six times the EBITDA grew by 8.3 points compared to the previous half-year.
In 2018, there was a slight increase in senior debt in relation to PE acquisitions; two-thirds of transactions were financed with an average Euribor rate of between 200 and 300 basis points and transactions financed with a Euribor rate of over 300 points grew by 5.6 per cent compared to the second half-year of 2017.
Senior debt is still the most popular financing option, confirming the trend observed in the past half-year. Shareholders' loan and mezzanine financing are the most popular alternative debt facilities. The percentage of PE sponsors relying on commercial banks for their financing needs is down compared to 2017 (down from 85.7 per cent to 73.5 per cent); syndication financing and other forms of financing are increasing, up by 8.8 per cent and 5.9 per cent respectively compared to the previous half-year, while use of investment banking is down by 5.5 percentage points.
In 2018, warranty and indemnity insurance (W&I) was still broadly used. The use of this insurance allows the parties in a transaction to find an easy and effective compromise with respect to the risk of breach of representations and warranties issued, in the context of a sale and purchase agreement, by the seller to the insurance company. As a matter of fact, on one hand, W&I is useful for sellers, who in this way can avoid direct liability in cases of breach of representations and warranties and, on the other hand, it is preferable for the purchaser, who can rely on the financial soundness of an insurance company.
IV REGULATORY DEVELOPMENTS
Law No. 124 of 4 August 2017 modified the thresholds for the notification of merger transactions to the Italian Competition Authority (AGCM).
The amended text of Article 16 of Law No. 287 of 10 October 1990 now provides that a concentration between companies must be notified in advance to the AGCM not only if the total turnover achieved at national level by all the companies concerned is more than €492 million (as provided in the previous version of Article 16), but also if the total turnover achieved individually at national level by at least two of the companies concerned is more than €30 million.
This amendment introduces into the national merger control system a second significant cumulative threshold, in addition to the existing national turnover limit. In line with the Recommended Practices of the International Competition Network, the rationale for this amendment is a response to the need to establish a significant link with the jurisdiction assigned to evaluate the transaction, with a specific focus on transactions that have a clear local element.
The new system of thresholds, applicable for transactions to be executed from 29 August 2017, brings the Italian merger control system in line with European legislation (EU Regulation No. 139/2004). Both the EU and the Italian legislation now require that at least two of the companies concerned each exceed a minimum 'domestic' turnover threshold, in addition to the additional requirement that all companies involved in the transaction exceed a certain turnover threshold aggregate.
By reducing the lower of the thresholds from €50 million to €30 million, and removing the reference to the company being acquired, this reform will increase the number of concentrations subject to prior notification in Italy and reduce the risk that certain problematic operations escape the control of the Italian Competition Authority. In any case, while the new set of thresholds might have a moderate impact on the notifications of acquisitions of a company by another single company, it could have a considerable effect in the case of 'joint ventures', in which at least two companies combine part of their activities or jointly acquire an existing company. Moreover, according to the new Article 16 of Law No. 287/1990, it is also mandatory to notify the transaction where only the turnover of the company resulting from the merger exceeds the turnover threshold. In this respect, it will be interesting to see how this criterion will actually be applied by the Italian Competition Authority to avoid transactions having to be notified when they have no effect on a national market or part of it.
It is difficult to predict how 2019 will turn out for PE sponsors and operators in general. As far as Italy is concerned, as discussed above, the latest GDP data is signalling that a recession has started and this might discourage investors or result in divestments by PE firms of their current participations in portfolio companies. The reforms introduced by the newly established government do not seem able to overturn the negative expectations regarding the macroeconomic framework in general. Nonetheless, the Italian market appears to be very competitive in terms of pricing, and this is because many potential target companies are still 'mom-and-pop stores', which have no real access to financing and face family governance issues, in turn representing ideal ground for a third-party investor to come in and create value. We would not be surprised, therefore, if 2019 ends up confirming the consolidating trend of 2018.
1 Ruggero Gambarota is a partner and Adele Zito is an associate at Lombardi Segni e Associati.
2 Società per azioni.
3 Società a responsabilità limitata.
4 Court of Appeal of Brescia, 8 October 2018, Decision No. 1568.
5 Court of Milan, 9 January 2018, Decision No. 90.
6 Deloitte, Italy Private Equity Confidence Survey: Outlook for the first semester 2018.