From a legal and fiscal point of view, the Italian private equity market is going through a phase of reorganisation following significant regulatory innovations introduced over the years. The most significant concerning LBOs will come into force in January. Italy’s Parliament has approved a bill of law under which the government has been given authority to issue a new set of rules on corporations, including LBO legislation. Will the new law boost Italy’s fledgling LBO market?
Finally, the ongoing legal issue that many say has hindered the development of the Italian LBO market looks set to be resolved. The approval of Article 7 (d) of the Delegation Law of October 3, 2001 has put an end to the uncertainty that surrounded leveraged buyout transactions in the Italian market. Prior to the introduction of the law there was some uncertainty surrounding the contradictory judgements on what constitutes financial assistance. Section 2358 of the Italian Civil Code prohibited some forms of LBO. It literally prohibited a company from giving financing or guarantees for the purchase of its own shares.
The new legislative decree requires the Italian government to provide that the merger between companies, one of which has borrowed funds to purchase the control of the other, shall not constitute the violation of the prohibition to grant loans or guarantees and securities for the acquisition or subscription of its own shares, as provided in article 2358 of the civil code. This means the financial assistance provision included in article 2358 will be overruled in an LBO situation and it will be accepted that the target company’s assets can be used as general security on any loans provided as part of the LBO transaction following a post completion merger of the two entities.
“The new legislative decree is being examined by the Camera dei Deputati and as far as has been made known to the public, the plan is still to make it come into force by January, although corporations will have some time to modify their by-laws to make them compliant with the new law. The provisions on Merger LBOs, however, should be effective immediately,” says Francesco Portolano of law firm Studio Prosperetti in Rome.
He adds that although Section 2358 on financial assistance remains unchanged (preventing a company from giving loans or guarantees for the purchase or subscription of its own shares), the new Section 2501-bis on Merger LBOs clarifies that merger LBOs are not illegal (provided that the target has not provided guarantees or loans). “In addition, and much more importantly, the new Section 2501-bis provides some guidelines as to how to structure Merger LBOs in that it requires the Merger Plan to indicate (in addition to the information required in “ordinary” mergers) the reasons for the merger, as well as the financial plan and an indication of the objectives of the merger,” says Portolano.
Many believed the old system, introduced by a European directive 25 years ago has dampened the enthusiasm for buyouts in the Italian market. The changes will make the traditional leveraged buyout lawful and there will be a considerable tax benefit, says Massimiliano Talli of law firm Monaco e Associati. “It will make good buyouts cheaper, easier and safer.”
In the past the structures of some financially troubled buyouts, which were not carried out by private equity players and lacked transparency have been found to violate principles of financial assistance. This generated uncertainties regarding the preferred legal structure of buyouts in Italy, but it hasn’t really prevented the development of the market, says Portolano.
Pierluigi De Biasi of law firm De Biasi & Rapini also sees a lot of uncertainty surrounding the issue, which will not be clarified until some complex transactions have been completed: “Frankly speaking, I don’t think that the reduced number of LBOs in the last year has anything to do with the law it is more to do with the lack of valuable opportunities in the market. The new law requires that you give information to shareholders and the market it is a case of transparency and corporate governance, which can only be beneficial to the market.” He adds that some players will be skeptical: “I don’t expect many players to rely on the new law for the time being it is still unclear what a reasonable interpretation of the law is and players who tend to be risk averse will be reluctant to be the first to try it out.”
But in the grand scheme of things Italian players believe the new law can only help to boost activity. The Italian market has already witnessed growth in 2002 with the first half recording 40 deals compared to 20 in the same period the previous year. Anna Gervasoni, general manager of the Italian venture capital association AIFI, said: “We are very happy because this law solves a big problem for Italian LBO players. Last year it was very difficult to organise LBOs in Italy with cash merger techniques. There were some very difficult positions now there is a clear law to facilitate the process.”
The environment for LBO transactions in Italy is becoming more favourable for two reasons she says firstly, the introduction of this new law and secondly due to the fiscal law reform on the taxation of closed-end funds, which will be advantageous for investors in private equity. A draft law is to be passed in January.
In December 2001, the Italian Government announced a draft legislation to completely reform the system of corporate income tax. This is being implemented by a series of legislative decrees, which the Government will adopt within two years. This reform provides for the gradual elimination of IRAP and Dual Income Tax System, introducing an ordinary corporate income tax (IRPEG) at a 33 per cent rate.
Closed-end funds are currently subject to a substitute tax rate of 12.5 per cent on the performance of the fund including realised and unrealised investments. Losses due to negative performance of the fund can be carried forward in subsequent years. Individual resident investors are fully exempt from taxation on the proceeds received from a fund. Corporate entities resident in Italy are fully taxable on net proceeds received from a fund, but a 15 per cent tax credit is granted.
All non-resident investors are fully exempt from Italian taxation and in order to recover the substitute tax paid by the fund they are entitled to receive from the state a 15 per cent reimbursement in cash, which is calculated on net proceeds received from the fund. Funds subscribed to by foreign investors are totally exempt from ordinary income tax and from the substitute tax. “It is not sure what the future will hold for Italian subscribers as yet, although the tax situation will definitely be more favourable,” says Gervasoni.
Fund raising in Italy should benefit from these changes, attracting a broader base of international institutional investors to the region. Luca Zerbini of Bain & Company says: “On a broad level, the new article of the Civil Code 2501-bis is going to send a strong message to international investors that Italy is following the right path of deregulation and clarification of the rule of law regarding LBOs. It will also require additional transparency on transactions and force management and PE funds to formally outline their strategy and auditors to certify it.” He says the more established funds in the Italian market may have no need for this, but for the less-experienced funds the improvement will be welcomed.
“On an operational level, the reform will make processes and approvals faster, accelerating LBOs processes and cutting by half the estimated time dependent on authorities approvals. Moreover, it reduces uncertainty on the risk of being accused by authorities for an alleged breach of article 2358,” says Zerbini. Clearly deregulation, decrease of legal risks and decrease of process costs are important steps to favour deal flow in Italy, says Zerbini.
However, economic conditions (sellers’ expectations slowing adapting to buyers’ ones), the cultural environment (an absence of an LBO and entrepreneurial education), industry structure (a dominance of small-medium businesses), and a general need for a greater professionalism are additional limiting factors, which strongly affect the Italian PE market, stresses Zerbini.
A veteran of the Italian buyout market, Fabio Sattin of Private Equity Partners is confident the new reform will at least boost the profile of private equity in Italy. “This is very positive for us. In Italy, LBO transactions have always been a grey area. The uncertainty in the law was affecting the possibility of carrying out LBO transactions. As the law was on the leveraged side it caused problems and very complicated structures in order to avoid potential risks.”
He adds that there were few companies that got into problems due to the leveraged structure of the deal, but it will certainly remove one of the issues that has hindered the Italian private equity market over the last few years. If it does not increase the number of transactions, it will nevertheless create a more favourable environment for buyouts in Italy also in attracting new funding. “Buyouts have always been able to be done in Italy, but it is always good to have clarifications of this structure. There was an area of uncertainty that needed to be clarified.”
Sattin is optimistic about the future, having closed the firm’s third fund four months ago. “There is a lot of movement. I think the next couple of years will be good years for investing in Italy. Deal flow is stable it is the right moment to buy. If you are in a liquid position, 2002 is a good vintage year to start a fund.”
Francesco Portolano concludes: “These new principles on Merger LBOs are certainly a significant step towards the creation of a pro-merger LBO culture in Italy and in fact they incorporate the opinions of lawyers and venture capitalists, who always advocated that the possibility of carrying out genuine mergers should not in any way have been impaired by the provisions on financial assistance.” As usual, he says much will depend on how these provisions are applied by the courts and there is no doubt that an increase in private equity and venture capital activity in Italy will bring about a better comprehension of merger LBOs and a better understanding of their potential benefits.
One thing is certain: when the new principles do come into force, it will be easier to assess, structure and carry out merger LBOs in Italy as venture capitalists and lawyers will be operating in a clearer and more favorable environment.