Spain: hidden treasure

Spain is flourishing; the economy has enjoyed several years of high economic growth, a decrease in unemployment rates, controlled inflation, low interest rates and small public budget deficits. So far in 2003 Spain has outperformed most of its European peers, posting a 2.7% GDP growth in the third quarter and it is heading toward achieving a balanced budget by year-end. Even stock market performance has improved during 2003 recovering from the five-year low reached in October 2002. So for private equity firms the time is now to promote their industry, but how sustainable is the asset class for Spanish institutions given the legal and regulatory hurdles they face? Angela Sormani reports.

Attracting investors

“Institutional investors in the region is an interesting, if depressing subject,” says Mark Heappey of 3i. “There is very little investment by Spanish institutions in private equity funds. There are also no funds-of-funds in the region, which is probably due to the lack of appetite of Spanish institutions. This will probably change but not in the near future,” he says. This lack of activity results from the conservative nature of Spanish institutions and the lack of large independent pension funds. Telefónica is the largest pension fund in Spain with around €5bn in assets. This is a mere drop in the ocean compared to some of the larger pension funds in Europe, which have around ten times that amount under management.

“The pattern of money allocated to private equity in Spain is a little different to the rest of Europe,” says Mark Zuend of Lombard Odier Darier Hentsch Private Equity, which manages two fund-of-funds and has been investing in the Spanish market for several years. There are three categories of funds: local/regional funds such as Talde and Catalana d’Iniciatives mostly backed by local government and/or local banks; family-run funds such as Suala or 21 Invest; and the independent players raising money from international investors such as Corpfin, Excel, Mercapital and Nmás1 Electra Capital Privado.

Up to now, there has been little money from Spanish institutional investors flowing into the asset class. “However, there is latent interest for private equity investments and institutional investors have been bringing themselves up to speed. This, combined with further developments on the regulatory, tax and legal front, may open the opportunity for increased domestic involvement in private equity,” says Zuend.

But for foreign investors, the Spanish market is not as transparent as some of its European neighbours. “The minute you leave those independent funds that are well-known, the market becomes less transparent. Putting our ear to the ground, however, we see quite a movement among the local/regional funds as well as from the funds in a family sphere looking to attract funding from international investors. But for many, the generalist and often very opportunistic investment strategy of the past is a stumbling block,” says Zuend.

Guillermo Massó, partner in PricewaterhouseCoopers’ Spanish corporate finance practice, admits a major issue in the market is the size of transactions. “There are now funds having difficulty investing because of a lack of sizeable opportunities and this, accumulated with the difficult environment for exits, may in turn have an effect on the fund raising environment if players cannot show a proven track record from their first fund.”

According to Sebastien Chartier of Capital Corporate, the usual investors in private equity in Spain are traditional companies, most of them quoted on the Spanish Stock Exchange, such as Telefónica, Repsol, Agrolimen, Corporación Empresarial Once, Corté Inglés, Planeta, Indra, Amper and Gas Natuaral. Other active investors include the Spanish government, the FEI (Fondo Europeo de Inversiones) and high net worth individuals.

There are also the financial entities such as the savings banks and insurance companies (Sabadell, Pastor, BBVA, BSCH, Caja Madrid, Caixa Catalunya, Caixanova,

Bancaja, Agrupación Mutua, Caja Navarra, Caja Burgos, Unicaja, Caja de Ahorros del Mediterráneo, Caja Duero, Axa Seguros, Caja Avila and Caixa Galicia), which participate in various independent funds or have created their own private equity funds.

One such example is Caixa Galicia, a Spanish savings bank with €654m under management. In 2000 the bank launched its private equity division Gescaixa Galicia, run

by Javier Carral, a former HSBC executive. Gescaixa Galicia runs two funds investing in the Galician region; Fondo Invercaixa Galicia, a €30m generalist fund, and Fondo

Social Caixa Galicia, an €18m fund focusing on the social and cultural sector in the region. To date, Gescaixa manages investments of €27m from these funds. These include EUXA Servicios Sociosanitarios, Zeltinova (biotechnology), Grupo Continental Producciones (audiovisual), Seglan (IT), Resgal (care for the elderly) and Grupo Plásticos Ferro (pipes.) Corporación Caixa Galicia also invests in independent Spanish funds on a national level including Diana Capital and Ahorro Corporación Desarrollo, and at a regional level in vehicles such as Unirisco and Vigo Activo. The bank will typically allocate up to €15m in each fund. Carral says: “We decided to invest in independent national Spanish funds in order to gain a diversified exposure and access to new projects on a national level.”

On the other hand there are the independents such as Corpfin, Excel Partners and Mercapital all of which have an established track record and are onto their third and fourth generation of independent funds. These players are attracting a larger pool of capital and consequently target international investors, rather than the smaller domestic players.

Hamish Muir of international asset manager Martin Currie, an investor in Nmás1, Spain’s largest fund raising this year, says: “The pool of domestic capital focusing on private equity [in Spain] is quite limited so most of the larger funds have raised their money outside Spain. But there is nothing too unusual in this as even the more mature UK market has raised over half of its capital outside the UK.”

Nmás1 was raised relatively quickly, says Muir, and the main attraction for Martin Currie was that it was not over-ambitious with its target and also had a good track record of realisations with its listed vehicle Dinamia.

David Currie of Standard Life, which invests in several Spanish funds, says: “One of the issues for some international investors is that local funds and managers are relatively small so many of the large US institutions wouldn’t be able to put as much money to work in one fund as they would like to. But this is one of the issues that goes with the stage of development in the market.”

Javier Loizaga of Mercapital agrees: “For any institutional investor putting money to work in private equity in Spain, it is not harder than in any other main European market. But there are fewer bigger domestic funds and thus putting large amounts to work in individual managers maybe harder and evaluating smaller players may need

more work.”

Another well established player Corpfin Capital has a good mix of US and European investors in its funds and a well-established network of contacts overseas. It does

not have many Spanish investors in its fund due to their limited knowledge of the asset class, according to Felipe Oriol, CEO of Corpfin and also chairman of ASCRI. He explains: “Our priority was to raise the fund and we wanted investors who were convinced about the market and didn’t have time to explain what private equity is

to a market that was unfamiliar with the asset class.”

Corpfin will be back in the market at the beginning of next year with a third fund. Its last fund closed at €135m in 2001. Charles Cecil of Helix Associates, which acted as placement agent for the fund, has noted a raised profile of the Spanish market over the years. “A number of non-Spanish institutional investors have taken a pro-active approach to investing in Spain and there have been a number of trips by investors to Spain. I think the market has become better known to these investors.”

Kathleen Bacon of HarbourVest points out the biggest obstacle in Spain for a foreign investor; the lack of a well developed buyout market. There are also cultural issues.

Both Spain’s institutional investors and entrepreneurs remain unfamiliar with the asset class. Bacon says: “The biggest impediment is not necessarily getting the horse to the water, it’s getting the horse to drink, convincing the entrepreneur/owner to take your money.”

She adds that Spanish institutional investors are low profile people. “HarbourVest goes to Spain quite regularly to talk to institutional investors and there are slim pickings compared to other markets.” Javier Morera of SJ Berwin agrees: “It’s true, institutional investors are reluctant to talk in Spain. It’s a question of culture. Many are not familiar with private equity and are not as confident talking about their investments. Some others are familiar, but prefer privacy.”

But a strong base of domestic investors is crucial for any market. “If you don’t have it you’re reliant on outside investors and if they don’t see the domestic market supporting domestic funds, they are less likely to commit. It can be a vicious circle,” says Bacon.

Size matters

“The biggest reason for the small amount of domestic institutional capital investing in private equity in Spain is the small size of the pensions industry. The total pension assets managed in Spain are around €40bn to €50bn and the biggest managers do not exceed 10% of that figure,” says Javier Loizaga of Mercapital.

ASCRI, the Spanish venture capital association, has had the pension fund issue high on its agenda for some time. Felipe Oriol, chairman of the association, says: “The Spanish pension funds’ attitude towards private equity should change. It is subject to those institutions’ own policy and our own ability, as private equity firms, to persuade them that this is an attractive alternative asset for their portfolios.”

Javier Amantegui of Clifford Chance agrees: “Pension funds and insurance companies have certain limits in respect of the type of assets they can invest in and at the moment private equity is not expressly listed among the assets in which pension funds can invest or insurance companies may use to cover their technical reserves. A bit more flexibility

in this respect from the Spanish regulatory authority would be very beneficial for the private equity sector.”

There are two restrictions relating to pension funds, says Alejandro Hurtado of international law firm SJ Berwin. A Spanish pension fund cannot invest over 10% of its total portfolio in one asset, which amounts to a small commitment bearing in mind the small size of Spanish pension funds. Also, a pension fund’s investment in one entity cannot exceed 5% of the aggregate nominal value of the titles issued or guaranteed by the same entity.

So, for example, it may not be worth the time and effort for Telefónica, Spain’s largest pension fund that manages €5bn in assets, to invest just €5m in a €100m private equity fund. This type of pension fund would be looking to make larger investments for its exposure to private equity to be worthwhile and for this reason looks to invest in private equity funds outside Spain, where the funds are typically larger.

Approval is expected on an amended draft of the Pensions Funds and Schemes Regulation at the beginning of 2004. The draft increases the limit which pension

funds are allowed to invest in non-listed companies from the current 10% to 25%. At the moment funds have to invest 90% of their assets in financial securities dealt on the regulated markets, bank deposits, mortgages and real estate assets.


Currently there isn’t a single local private equity fund-of-funds player in Spain. “There may be appetite in the market for such a product but the critical mass necessary for the economics of a fund-of-funds to work is such that the focus is more on global managers

or consultants to sell their products in Spain, on their own or through local asset managers,” says Javier Loizaga of Mercapital.

Most Spanish institutional investors either set up their own captive funds and then start investing in local Spanish funds or they may invest in these local funds first and if they are happy with the results, then set up their own fund. Spanish bank Caixa Catalunya,

for example, had a type of fund-of-funds model investing in three or four private equity funds to ease itself into the market before setting up a vehicle of its own.

The international market is the next step for these participants. “It is a pity that private equity fund-of-funds are not yet developed in Spain, since they are the most typical instrument for a new private equity investor to take its first steps in the market through a reasonable spread of the investments, thus limiting the risks assumed,” says Javier Morera of SJ Berwin.

Jordy Jofrè of Fibanc, the Spanish arm of the Mediolanum banking group, agrees: “A fund-of-funds would be a good idea for first time Spanish investors; it is less risky than

a single investment in a Spanish private equity fund. The establishment of a Spanish fund-of-funds might encourage more investment into the sector.”

Jofrè says Fibanc intends to raise a fund-of-funds similar to the model of Mediolanum State Street’s Fondamenta, Italy’s first fund-of-funds model. But work will need to be done on a legal structure for such a fund because there is no formal legal structure for a Spanish fund-of-funds.

This is something that may change following the reform of the Spanish Venture Capital Act in 2002. Spanish venture capital entities must primarily invest in non-financial entities and prior to this reform, the act did not give a clear definition of the term non-financial entity. The reform provides that entities that simultaneously meet the following two requirements can be classified as non-financial entities:

(i) the main activity consists of holding shares/participations

and (ii) the relevant target companies (in which such holding companies invest) do not belong to the financial sector.

This amendment should improve the legal framework for fund-of-funds structures. But a more detailed regulation of these structures would be desirable, for example regulating whether the existing rules on investment restrictions are applicable at the level of the private equity funds in which the fund-of-funds would invest or at the level of the target companies in which the private equity funds invest.

Hurtado says: “While the Spanish Venture Capital Act has played an important role in the development of private equity in Spain, it still needs to be reviewed in a number of areas so as to render the underlying regulatory framework more flexible. In particular, these areas include the current authorisation regime for setting up the venture capital entity and for amending its by-laws/management regulations as well as the applicable rules on investment restrictions for funds-of-funds structures and public-to-private transactions.”

Fund structures

Funds in Spain can be structured in two different ways. The first is a traditional limited partnership structure domiciled either in the UK, Jersey or Guernsey, for example. Some

of the major domestic players in the Spanish market such as Corpfin and Mercapital have raised funds using this structure. But the use of this structure in Spain is reliant on a good base of international investors.

There are pros and cons with such a structure in Spain. “The plus side is that it is a well-known fund structure that prospective investors know and are familiar with. The negative side is that the limited partnerships are look-through entities and there is a risk that profits and capital gains made may be taxed and so for tax reasons it is sometimes necessary to complement the LP structure with other elements,” says Javier Amantegui of Clifford Chance.

The second route Spanish funds may take is registering as a Spanish venture capital entity (ECR), which is regulated by Spanish law and has a significant tax benefit for Spanish investors. But this is not so beneficial for foreign investors. Generally, if the majority of investors are Spanish, firms follow the Spanish structure.

At the beginning of this year a new law took effect which improves the Spanish tax treatment of foreign limited partnerships and other international private equity fund vehicles by confirming that all foreign entities whose legal nature is identical to the Spanish “look through” entities will be treated in the same tax way as the Spanish ones (i.e. as fully tax transparent).

This means that, from a tax point of view, the fund vehicle is ignored and the investment is treated as if it had been made directly by the investor. Greater legal certainty is achieved and, if certain conditions are met, the use of intermediate vehicles can be avoided. “These changes will in many cases eliminate the need for complex structuring, saving time and money for investing funds when they invest in Spain,” says Javier Morera.

In the past it had been suggested that foreign vehicles that were tax transparent in their own country should be taxed on a look-through basis in Spain. But nothing in Spanish law clearly stated that. The law only referred to Spanish entities.

Also, the tax regime in question has always been poorly defined and its application raised a number of concerns.

As a result, it was not advisable for a typically structured international private equity fund to invest directly in Spain and so most of these investments were channelled through an intermediate holding company (usually a Luxembourg-based vehicle, sometimes vehicles from other jurisdictions). For the same reasons, it was unusual for a Spanish-based investor in a foreign fund to hold its interest directly and so the use of an intermediate holding vehicle in this case was also the norm, which would give rise to additional structuring costs.

Some details of the new law have yet to be clarified. But the changes will represent a significant improvement in the Spanish regulatory environment for international venture and buyout investors. “This is good for promoting investments in Spanish companies and also good for fund raising and Spanish investors committing to an English LP and other similar vehicles,” says Morera.”Until now Spanish investors have been very reluctant to invest in LPs because the taxation of their investment was unclear. Now it is clear the Spanish authorities will follow a similar look-though principle as the one used by the UK authorities,” says Morera. “These rules will provide more clarity and enhance investment in the Spanish market as the Spanish authorities have in general terms accepted what the UK Inland Revenue has been practicing all these years and this is very important for fund raising in Spain.”

Smaller entities with only Spanish investors in their fund use local Spanish vehicles (ECRs), due to the favourable tax regime for Spanish investors and the fact that many Spanish investors are not yet sophisticated enough and still not used to investing in foreign partnerships. Spanish investors do not pay taxes on the profits obtained via ECRs, but if they were to invest in a limited partnership, they would have to pay Spanish taxes on the profits. The down side is that these entities are supervised by the Spanish Securities Market Commission (Comisión Nacional del Mercado de Valores), which imposes more constraints on a fund than a limited partnership might.

The Spanish regulatory structure for funds is a very inflexible environment, says Sebastian Waldburg of Spanish investment boutique Riva & Garcia, which closed its most recent fund Spinnaker at the end of June on €22m. The fund specialises in early stage VC investments and benefits from a Spanish structure. “For the smaller funds it can be tough. You have to be registered with the Securities & Exchange Commission. There is great fiscal benefit, but you have to comply with a very strict regime in terms of time frame for investments and you have to report back to the commission. But there are also many advantages; its regulated and transparent and Spanish investors like that.”

There have been some quite big regulatory issues that have prevented Spanish institutions committing to private equity, agrees Chris Davison of AltAssets. And he stresses the domestic support for the industry is essential as foreign investors do look closely at local investors.

“They would expect local institutions to support the industry and because there aren’t many investing in private equity it might work against those funds raising capital from investors outside Spain.”

Felipe Oriol is optimistic about the future: “We have a good legal and tax framework. Regarding foreign investors in Spanish vehicles there are a number of issues to be resolved from both a tax and legal perspective. But that’s not a main concern; you can invest in Spain through foreign vehicles. What restricts investment flow into Spain is a combination of reliable opportunities and a good track record of exits. This is something that is improving. We are seeing a much better flow of deals than in the past.”