In recent years private equity and venture capital have increasingly strengthened their importance to the Italian economy.
The Italian venture capital and private equity industry has grown rapidly over the last few years. This growth is reflected in an increase both in the number and in the amounts of investments made in Italy during the first half of 2005 compared to the same period of the preceding year.
From a legal and fiscal perspective, the sector is reaping the benefits of the recent reforms of both corporate and tax regulations in Italy. These reforms have encouraged a wide range of organizations to invest in this market. At present, the Italian private equity market mainly consists of Italian and international banks and their subsidiaries, investment companies, domestic funds of funds, closed-end funds, advisers to private equity funds and public or private players with regional focus.
In this article we will provide a brief overview of the main data relating to the Italian market of private equity and venture capital over the first half of 2005 and will hint at some of the legal and tax provisions which may be of particular relevance from a private equity perspective.
1. The Italian Market Of Private Equity And Venture Capital
1.1 Investment Activity
Although this analysis is limited to the first half of 2005, it appears that, compared to the same period of preceding years, 2005 may be considered as an exceptional year.
In particular, in the period comprised between 2000 and the first half of 2005, an average of approximately Euro 2,455 million (USD 2,975) has been invested in private equity and venture capital transactions in Italy. As regards the first half of 2005, Euro 1,205 million (approximately USD 1,460) was invested in 120 enterprises, representing a growth, compared to the same period of 2004, of 146 percent in terms of amount invested and the second highest result since 2000. The total number of investments amounted to 140, with an increase of 22 percent over the first half of 2004.
Analyzing the distribution of investments by stage, in the first half of 2005 the larger part of investments flew into buy-out deals, which proved to be the most important category in terms of amount invested (82 percent), followed by expansion (14 percent), replacement (3 percent) and early stage (1 percent). On the contrary, in terms of number of deals, it is worth pointing out the predominance, as in the previous years, of expansion investments with 71 deals representing 51 percent of the total number of deals which occurred over the period considered.
A more detailed analysis and comparison between venture capital and buy-out activity outlines some significant differences in trends. In particular, as far as early stage investments are concerned, during the first half of 2005 the average invested amount was Euro 0.4 million compared to Euro 0.5 million in the same period of 2004, whereas with respect to buy-out investments, the average invested amount in the first half of 2005 increased by Euro 1 million compared to the first semester of 2004 (from Euro 26.3 million to Euro 27.3 million). The average amount invested in the expansion stage remained substantially unchanged, at Euro 2.3 million.
In terms of sector distribution of target companies, enterprises operating in the retail sector were the largest category based on amount invested, attracting investments of approximately Euro 261 million (corresponding to 22 percent of the whole amount), followed by enterprises operating in the telecommunication and media sector with Euro 195 million and enterprises operating in the food and beverage sector with Euro 189 million.
The majority of the investments, in terms of number, went into small and middle sized companies, with a number of employees below 100 units, representing 67 percent of the overall activity and improving, in percentage, the 2004 results. Furthermore, it is worth noting that, as to investments in companies with more than 1,000 employees, the number of deals during the considered period almost doubled the results of the whole 2004, accounting for 9 percent of the entire number of deals made in the first half of 2005 (compared to 5 percent in 2004).
The preponderance of small and middle sized companies as favorite targets for the investment activity is confirmed by turnover figures, with 87 percent of the total companies that received capital from investors having a turnover below Euro 250 million. Nevertheless, investments in companies having a turnover in excess of Euro 250 million exceeded by 2 percent the 2004 results.
1.2 The Divestment Activity
Looking at the divestment activity, in the period between 2000 and the first semester of 2005, the Italian market has been characterized by an average divested amount equal to approximately Euro 530 million and an average number of 166 divestments each year.
Compared to the divestment activity over the first halves of previous years, starting from 2000, the first half of 2005 reported an increase of 23 percent in terms of amount, calculated at cost without considering capital gains, while the number of divestments was substantially in line with the average of the period.
In terms of divestment channels, it is worth pointing out that, compared to the entire 2004, the results of the first semester of 2005 show a substantial reduction of write-offs (which accounted for 5 percent of the total number of divestments compared to 23 percent of the preceding year) while trade sales, secondary buy-outs and IPOs reported a significant increase.
In particular, the use of the Stock Exchange as a way out accounted for 15 percent of the entire number constituting the divestment activity, registering the highest percentage since 2000.
1.3 Fund Raising Activity
With regard to fund-raising activity, in the first half of 2005 the total volume of capital raised reached Euro 526 million.
More in detail, 69 percent of such capital has been raised on the market from independent funds focused on Italy, 23 percent came from parent organizations of captive players and 8 percent was represented by capital gains available for reinvestment.
As far as the geographical origin of the fund-raising activity is concerned, the domestic market increased by more than 10 percent compared to the entirety of 2004: other European countries accounted for 37 percent (up from 33 percent in 2004); while the U.S. weighed in at 10 percent, down from 19 percent for 2004.
The bulk of the funds, as in the preceding years, was obtained from banks, which made up 40 percent of the total funds raised, followed by international and domestic funds of funds, which contributed 20 percent of the total funds. Although the first half of 2005 may be considered a positive half for fund-raising and investment activity, it should be nevertheless pointed out that in this period fund-raising activity of pension funds collapsed down to 0.1 percent from 21 percent in 2004.
2. Legal And Fiscal Environment
2.1 Legal Aspects Relevant To Investment Activity
Following the reforms enacted by the Italian government in 2004, there have been no significant changes in the corporate and fiscal framework. Nevertheless, the growth of the private equity and venture capital market over the first half of 2005 has also been fostered by the novelties introduced by these reforms.
From a corporate prospective, the highlights are:
(i) the introduction of a specific regulation on leveraged buyouts that cast away doubts on whether merger leveraged buyouts are legal in Italy and brought a new, positive approach toward this type of transaction. The new rules provide that a merger between a leveraged vehicle and the acquired target, where the target acts as a general guarantee for, or source of reimbursement of, the debt incurred by the vehicle, will not, per se, breach the general prohibition of financial assistance structures, to the extent certain requirements are met. Those requirements include a description of the financial resources that are expected to be used by the merged company to fulfill its obligations, the indication of the reasons justifying the merger and the objectives that the merger is expected to accomplish;
(ii) the provision allowing companies (those incorporated in the form of an S.p.A.) to "pick and choose" from among a broad range of possible types of financial instruments, enabling them to tailor their equity, stock and financial structure to best suit their actual needs or the different roles played by different categories of their shareholders. Pursuant to the new rules, companies may choose to issue shares with different voting and/or dividend rights, shares with veto powers, no-par stock, redeemable shares, tracking stock, non-share instruments. Furthermore, the corporate reform also reduced, to a certain extent, the restrictions on the amount of bonds that a company can issue. The flexibility of the financial structure of the companies opens different opportunities, allowing private equity and venture capital funds to better tailor their risk profile depending on the type of target and investment they are prepared to make and to better deal with minorities;
(iii) the broadening of the available instruments to incentivize management. As the financial structure of the equity may vary, the possibility to issue new financial instruments offers an interesting alternative to structures that contemplate granting stock options or minority interests to incentivize the management to stay with the company. Now analogous management-retention goals may be achieved through financial instruments different from shares;
(iv) the introduction of three new alternative governance models providing for a clear separation of the ownership, management, audit and accounting control functions. These new governance models will give private equity and venture capital players a chance to structure the governance of the target in the most efficient manner, addressing their need to be continuously kept abreast of the development of the business without, however, being necessarily involved in the day-to-day management of the target.
2.2 Main Provisions Of Tax Law
The reform of the Italian tax system, which was enacted in 2004, has significantly changed corporate income taxation, introducing several options aimed at rendering Italy much more attractive for investment.
In particular, among the key changes which were introduced by the tax reform which are of interest when considering making an investment in an Italian target, it is worth mentioning the following:
(i) participation exemption. Upon recurrence of certain conditions, dividends received by either Italian resident companies or certain foreign companies would benefit from a 95 percent exemption. A 100 percent exemption, based on the same conditions, will apply to capital gains realized on the sale of shares held in resident as well as non- resident entities;
(ii) thin capitalization rules. The new rule amended the old rule governing interest deduction, introducing two sets of limitations on the deductibility of interest expense arising out of both debt made available or guaranteed by related parties and debt incurred to fund the acquisition of shares qualifying for the participation exemption. The rationale of this rule is the need to limit excessive undercapitalization of Italian companies forcing their shareholders to refrain from too heavily relying on debt to finance their companies rather than to contribute sufficient equity into them;
(iii) tax consolidation. Under certain conditions, companies belonging to the same group, including, to some extent, foreign companies, may elect for the application of group taxation. Such election will allow the group to consolidate profits and losses determining, for tax purposes, a single aggregate income which consists of the sum of the full amount of each company's taxable income, regardless of the percentage of the shareholding owned in each of them by the parent company;
(iv) consortium relief. This measure allows shareholders of companies, whether Italian or foreign (provided that in this latter case the foreign companies are eligible for the withholding tax exemption on dividends paid out of Italy), to elect to be treated on the basis of the transparent (i.e., look-through) tax regime usually granted to Italian partnerships.
Stefano Crosio is the Partner in charge of the New York office of Gianni Origoni Grippo & Partners. Gherardo Cadore is an Associate in the New York office. They can be reached at (212) 957-9600.