Southern belles

When it comes to private equity deals in Southern Europe it is the region’s two biggest economies, Italy and Spain, which account for the lion’s share of activity. But even though the Italian economy significantly outweighs that of Spain, private equity activity is less. For example last year, according to the Italian private equity association AIFI, some €3.1bn was invested in Italian deals compared to €4bn in Spain.

AIFI president Giampi Bracchi stresses that, by Italian standards, 2005 was a pretty good year in terms of financial volumes but less so when it came to the number of investments, which totalled around 280. “In spite of the huge number of small and medium companies in Italy we had fewer numbers of private equity transactions than other markets,” says Bracchi.

Another concern is that the vast majority, around 80% of deals, are concentrated in the north of the country and particularly the Lombardy region in and around Milan. While this is an illustration of the imbalances in the Italian economy it also offers opportunities. “It shows how much potential there could be in Italy, if we can extend private equity to the south,” says Bracchi.

Despite this, the Italian market continues to provide deals and exits for international funds. In January, for example, 3i sold its stake in AC Hoteles to a Spanish hotel group, while ABN AMRO Capital sold its minority interest in private hospital business Humanitas to existing shareholders. In the three-and-a-half years ABN AMRO Capital was invested in the company it grew revenues by an annual rate of 14%.

These deals show there are good business opportunities for private equity houses in Italy, both international and domestic. In fact, one of the most important trends in Italy in recent times has been the arrival of new players, particularly many of the larger pan-European funds. “We’ve seen a lot of the big international houses either open up offices in Italy or target the country for deals, but I think many of them are going to be disappointed because they tend to focus on the large deals and there aren’t that many of them,” says Giuseppe Campanella, managing director of Italy’s first fund-of-funds Fondamenta, which is part of State Street Global Investments.

Andrea Accornero, a partner at law firm Lovells in Milan, agrees: “When a sizable deal emerges there’s a lot of competition from the big funds, so I don’t think all the players that have set up shop in Italy will survive. There are some big international houses that have had offices here for a couple of years and still not done a single deal.”

Campanella believes frustration at the lack of big-ticket deals will lead to these international firms finding it hard to retain their staff and there will be executives leaving to set up their own funds, perhaps targeting mid-market investments. This is already happening to a certain degree, he says, with a former Carlyle executive setting up a fund with people from other international houses. One possible way out for the big international houses, he says, is doing the “unthinkable” and forming syndicates to try and take over some of Italy’s blue chips such as FIAT or Telecom Italia. The share structure of some of these companies means it would not be as hard as it might first appear to gain control, he argues: “But the big issue would be that any group seeking such a takeover would need political support to be successful.”

When it comes to Italy’s mid-market and smaller companies, which most observers believe is where future growth is going to come from, there are positive signs but still obstacles holding back the market. Campanella points out that there are fewer than 2,000 companies with a turnover of €200m to €500m and fewer than 200 companies with a turnover of more than €1bn.

This lack of large companies or decent-sized mid-market businesses is, says Lovells’ Accornero, because the Italian economy has not been through the same changes as, say, the UK economy. “We still have an economy dominated by small, family-owned businesses, some of which we may call mid-market but which in the UK would be seen as small,” says Accornero. He adds: “In the UK there has been consolidation, in which smaller companies become part of bigger businesses but the Latin countries have not seen much of that.”

Campanella says: “The mid-market is where the activity is but for Italy mid-market means deal sizes of €30m to €300m, and more often than not much closer to the bottom end of that range, which is small in international terms.”

But there has been some development of the mid-market, says Mara Caverni, a partner at PricewaterhouseCoopers in Italy. “A few years ago it was either very large deals or pretty small ones in Italy, but now we have a more developed mid-market like other countries.”

Given the preponderance of small companies, Campanella believes one of the best bets for Italian private equity is in buy-and-build. One of Fondamenta’s best Italian investments, for example, has been in funds that combine a number of small companies to create a sizable business that is bigger than the sum of its parts. “There are some bright managers and entrepreneurs in Italy so if you can harness that skill by bringing together small acquisitions it can work well,” he says, noting Fondamenta is a co-investor in a Natexis fund that takes this buy-and-build approach. “They’ve brought together half a dozen healthcare companies with sales of €5m to €25m and created one, large company that they will float,” he says: “It’s hard work and there are sometimes problems in getting entrepreneurs to work as part of a team but it can be a good investment.”

Despite the growth of private equity in Italy in recent years, domestic institutional investment still lags. Italian banks have been actively involved in the market, with most owning their own private equity arms, but many of these funds are pretty small with initial investment as low as €50m to €70m, says Campanella. “It seems that Italian banks have not followed the trend in other markets of banks spinning off their private equity funds because of the conflict of interest in lending to and investing in the same businesses,” he says. The small size of many banks’ funds means they are likely to find it hard to do deals and therefore hold onto their staff, he believes.

Apart from the banks, Italian institutions such as insurance companies and the under-developed pension fund industry, do not generally regard private equity as an attractive asset class because they still see it as risky and illiquid. That probably helps explain why only €1.4bn was raised in Italy last year for private equity, compared with €3.5bn in Spain.

Some observers point to legal restrictions on some institutions as accounting for part of the reluctance to invest. Alberto Barucci, director responsible for private equity at insurance company Rasfin, says: “One of the problems is that insurance companies are not allowed to invest policyholders’ money in private equity but can only invest their own capital.”

AIFI’s Giampio Bracchi comments that the private pension fund industry has been small in Italy historically because pensions were generally the preserve of the state, but now there are more private funds emerging and this could be a significant source of capital for private equity in the future.

Generally the legal framework is conducive to private equity. The consequences of a major corporate reform at the beginning of 2004 has only begun to filter through in the past year or so, says Francesco Portolano of law firm Portolano, Colella, Cavallo. He believes the reform will help in the setting up of funds and the establishment of private equity-related structures and contracts. “It was a major overhaul of corporate law and has meant that while it is more complex to set up corporate structures, once you do it you have a more solid foundation than before,” he says.

One concern he does have is a law restricting shareholders agreements to five years. “Some lawyers are still using the traditional shareholders agreement structures, on the basis that private equity investment is usually less than five years but then you run into problems if the investment period goes beyond five years. “In my opinion there are instruments in the new corporate law that enable us to get round this five-year restriction and lawyers should all be using those.”

For Giuseppe Campanella of fund-of-funds Fondamenta the medium-term future for Italian private equity is likely to be not so much in traditional buyouts but more in specialist areas such as buy-and-build or selling the assets of bankrupt companies. “We’ve just launched a fund to invest in the assets of bankrupt companies and if you have the right mix of skills you can make good returns by buying up the land, equipment and other assets of these businesses and finding the right buyer.”

It seems that it could be a while, therefore, before Italy starts to rival the dynamism of Spain’s private equity market, which has been booming in the last couple of years thanks largely to a steady supply of very large deals, such as the €4.3bn purchase of travel reservations firm Amadeus by BC Partners, the sale of clothing company Cortefiel for €1.4bn and Apax’s acquisition last August of bakery business Panrico for €900m.

So far this year activity has continued to be strong, with reports that Telefonica Espana is looking to sell its directories company TPI for up to €2bn and tourism group Iberostar is seeking to sell its travel services division comprising travel agency chains, a tour operator and chartered airline, for €1bn.

On TPI it is reported there are three main contenders: a consortium led by KKR-Carlyle, one led by Apax-Cinven, and interest from UK directories company Yell.

Kevin Woods, a partner at advisory firm GBS Finanzas in Madrid, says: “Almost anything that moves is being targeted by private equity, as there’s so much money around looking for investments.”

Part of the reason for the activity in Spain is that, unlike the sluggish Italian economy, Spain has been outpacing the eurozone average. Another key element, says Woods, is that until a couple of years ago Spain was not really on the radar of most international private equity investors. He says: “A couple of years ago not much was happening, whether you wanted to buy or sell, and now today companies that people wouldn’t have even considered as private equity targets, such as TPI, are in the frame to be acquired.”

As in Italy, in the past couple of years a lot of the international houses have opened offices in Spain. This influx has led to increased competition and pushed up prices. Javier Morera, a partner at law firm SJ Berwin in Madrid, says: “There are concerns in some sectors about high prices and high levels of debt but there’s been a lot of fund raising in the last year or so and people need to invest, so there’s more competition especially at the upper quartile.”

Prudencio Pedrosa, a partner at mid-market advisers Closa M&A, highlights the trend towards larger deals in Spain, such as the Panrico acquisition by Apax. Closa works in the €300m and below market, where Pedrosa says there has been significant activity. “We expect that activity level to continue, as the economy is doing well and there are generational issues emerging at many family-owned businesses, as well as larger companies continuing to divest.”

Jose Maria Balana, a partner at law firm Lovells in Spain, says in general there is an eagerness to do bigger deals and financial investors are increasingly keen to take majority stakes in companies. “There also a growing trend of targeting public companies, such as Amadeus and Cortefiel last year,” says Balana.

While public-to-privates are common in the UK there have only been a handful in Spain so far, says Balana, partly because of the lack of a specific regime governing PTPs and the lack of squeeze-out rights. However, there is a takeover directive that Spain is supposed to be implementing by May this year, which could include provisions that make PTPs more straightforward.

SJ Berwin’s Javier Morera agrees the Spanish market is becoming more sophisticated: “We’re starting to see fund-of-funds, a secondary market, PTPs and investment from private banking clients. We’re also seeing more complex funds set up, such as infrastructure funds.” Some of these developments have been facilitated by a legal reform at the end of 2005. The new regulation makes it much easier to set up and run private equity entities, known as entidades de capital riesgo (ECRs). It will be quicker to get authorisation for these entities and there is also a simplified vehicle for funds that are mainly aimed at institutional investors.

Before this legal change it was easier for Spanish organisations setting up funds to follow the Anglo-Saxon limited partnership approach, but the ECR route will make much more sense from a tax point of view, says Balana. ECRs preserve the 99% exemption from capital gains tax, which makes them an attractive vehicle for Spanish and international investors. For Spanish institutional investors ECRs will carry no tax on investment returns.

“Most Spanish investors pay 35% tax on profits from an overseas LP fund, but 0% on an ECR, which means we’re likely to see significant growth in ECRs among organisations seeking funds from Spanish investors,” says Balana. He says he is already working on establishing three or four ECRs: “In the future we could see international houses that are fund raising setting up ECRs to get the Spanish institutional money.”

As for the appetite of Spanish institutions towards private equity, Jose Maria Balana of Lovells says, historically institutional investors have not been that interested in private equity. This has been partly because of legal issues and partly because private equity was seen as risky and illiquid. This attitude is changing, however, helped by legal reforms such as the one establishing ECRs.

However, when it comes to the large Spanish banks, such as Santander and BBVA, it is more a case of getting out of rather than entering the private equity market. Traditionally these banks have had their own portfolios of stakes in industrial companies, but they are now selling off these stakes. Santander, for example, was one of the main shareholders in telecom company Auna, which was sold to private equity investors last year. Santander is taking the strategy, says Kevin Woods of GBS Finanzas, because it wants to acquire overseas banks.

The smaller savings banks in Spain are a different matter. “The savings banks aren’t big enough to invest in the big-ticket deals but are active at building stakes in medium-sized companies through direct investments,” says Woods. As in Italy, private pension funds are an under-developed market in Spain, but could be a source of funds in the longer term, says SJ Berwin’s Morera.

Although last year was a record-breaking one in terms of deal volumes, some argue the Spanish success story is not quite as solid as it may appear. “The figures are distorted because of a few large deals of over €500m, which a couple of years ago did not really exist in Spain,” says Mark Heappey, head of the 3i office in Spain. In 2005 there were four such deals, he says, which pushed total private equity invested up from around €2bn to €4bn. “Last year Spain happened to have four big deals, which for a relatively small market can have a dramatic effect on the overall financial volumes,” he says. He adds that even though the media focus has been on these big deals, it has led to greater awareness of private equity generally, which has also benefited the mid-market.

For a mid-market house like 3i, Spain is a good location, he says, as some of the house’s competitors have moved up leaving more space in the mid-market. “Last year was very good for us because there was a lot of liquidity in the market, which benefits houses like us with a large portfolio,” says Heappey: “We invested around €210m and divested €220m from our portfolio, some with quite high profits.”

Overall, competition has increased, especially for the big deals. “The difference with Spain isn’t that it is more competitive than other markets but that competition has grown dramatically over a pretty short period,” says Heappey. The question is, whether the growing competition will push prices up further and therefore affect returns, or whether equilibrium will be found.

Kevin Woods of GBS Finanzas is cautiously optimistic: “This time last year I’d have said I was bullish on 2006, but at the moment I’m less sure on 2007 because I don’t know if the levels of growth we’ve seen can be maintained. But I do expect the rest of this year to be pretty active.”